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A Study on

Derivatives Market in India

A Project Submitted to
University of Mumbai for partial completion of the degree of
Master in Commerce (Banking & Finance)
Under the Faculty of Commerce

By
Harsh Paresh Upadhyay
Roll No 47

Under the Guidance of


Prof. Rishika Bhojwani

Shri Vile Parle Kelavani Mandal


Narsee Monjee College of Commerce and Economics
Juhu Scheme,
Ville Parle (West),
Mumbai

November 2017
Shri Vile Parle Kelavani Mandal
Narsee Monjee College of Commerce & Economics
Vile Parle (West), Mumbai

Certificate
This is to certify that Mr. Harsh Paresh Upadhyay has worked and duly completed
his Project Work for the degree of Master in Commerce under the Faculty of
Commerce in the subject of Banking & Finance and his project is entitled, “A Study
on Derivatives Market in India” under my supervision.
I further Certify that the entire work has been done by the learner under my guidance
and that no part of it has been submitted previously for any Degree or Diploma of
any University.
It is his own work and facts reported by his personal findings and investigations.

Name and Signature


of Guiding Teacher

COLLEGE SEAL

Date of Submission: ___/____/___


Declaration by Learner

I the undersigned Mr. Harsh Paresh Upadhyay here by, declare that the work
embodied in this project work titled “A Study on Derivatives Market in India”,
forms my own contribution to the research work carried out under the guidance of
Prof. Rishika Bhojwani is a result of research work and has not been previously
submitted to any other University for any other Degree/Diploma to this or any other
University.

Wherever reference has been made to previous work of others, it has been clearly
indicated as such and included in the bibliography.

I, here by further declare that all information of this document has been obtained and
presented in accordance with academic rules and ethical conduct.

Name and Signature of the learner

Certified by

Name & Signature of the Guiding Teacher.


Acknowledgment
To list who all helped me is difficult because they are so numerous and the depth is
so enormous.

I would like to acknowledge the following as being idealistic channels and fresh
dimensions in the completion of this project.

I take this opportunity to thank the University of Mumbai for giving me a chance to
do this project.

I would like to thank my Principal, Dr. Parag Ajgaonkar for providing the
necessary facilities required for completion of this project.

I take this opportunity to thank our Coordinator Prof. Dr. Anupama Chavan, for
her moral support and guidance.

I would like to express my sincere gratitude towards my project guide, Prof. Rishika
Bhojwani whose guidance and experience made the project successful.

I would like to thank my College Library, for having provided various reference
books and magazines related to my project.

Lastly, I would like to thank each and every person who directly or indirectly helped
me in the completion of the project especially my Parents and Peers who supported
me throughout my project.
INDEX
Particulars Page No.

1. Research Abstract 01-03

2. Introduction 04-39
2.1 Introduction 05
2.2 Growth of Derivative Market in India 08
2.3 What is a Derivative? 14
2.3.1 Types of Derivatives
2.3.2 Risk involved in Derivatives
2.4 Market Participants and Makers 33
2.4.1 Hedgers
2.4.2 Speculators
2.4.3 Arbitrageurs
2.5 Regulation and its structure 35
2.5.1 Reserve Bank of India
2.5.2 Securities and Exchange Board of India
2.5.3 Securities Contracts (Regulation) Act, 1956
2.5.4 Forwards Market Commission
2.6 Badla System in Indian Stock Market 36
2.6.1 The history of Badla
2.7 Risk Management Techniques in Derivatives Market 37

3. Review of Literature 40-45


3.1 Development of Financial Derivatives Market in India- A Case
Study. 42
By :- Ashutosh Vashishtha & Satish Kumar
3.2 Role and Growth of Financial Derivative in the Indian Capital Market. 42
By :- Dr. Himanshu Barot & Dr. Nilesh B. Gajjar
3.3 Derivative market in India: Prospects & Issues. 43
By :- Dr. Priyanka Saroha & Dr. S.K.S. Yadav
3.4 Development of Financial Derivatives Market in India and its
Position in Global Financial Crisis. 43
By :- Dr. Shree Bhagwat, Ritesh Omre & Deepak Chand

A
3.5 Trends of Capital Market in India. 44
By :- Jency S
3.6 Assessing the Expansion of Financial Derivatives in India. 45
By :- Pankaj Tiwari

4. Research Methodology 46-49


4.1 Purpose of Study 47
4.2 Objectives 47
4.3 Hypothesis of The Study 47
4.4 Methodology 48
4.5 Scope 48
4.6 Tools 48
4.6.1 Primary Data
4.6.2 Secondary Data
4.6.3 Design of Questionnaire
4.6.4 Limitation of the study
4.7 Collection of Primary Data 49
4.8 Collection of Secondary Data 49

5. Data Analysis, Interpretation and Presentation 50-68

5.1 Analyzing Growth of Derivative Market through Secondary Data. 51


5.2 Analyzing Investor’s views towards Derivatives Products through
Primary Data. 53
5.3 Hypothesis Testing 66
5.3.1 Comparing Income and Investment in Derivative market
5.3.2 Comparing Age and purpose of Investing in Derivative
market
5.3.3 Comparing Risk taking Strategy and Rate of Return

6. Findings & Recommendations 69-70

7. Annexure (Questioner) 71-74

8. Bibliography 75

B
A Study on Derivatives Market in India

CHAPTER 1

RESEARCH ABSTRACT

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1. Research Abstract
A derivative instrument broadly is a financial contract whose payoff structure is
determined by the value of underlying commodity, security, interest rate, share price
index, exchange rate, oil price, or the like. So a derivative is an instrument which
derives its values from some underlying variable /asset. A derivative instrument by
itself does not constitute ownership. It is, instead, a promise to convey ownership.

All derivatives are based on some cash products. The underlying asset of a derivative
instrument may be any product of the following types: -

1.Commodities (grain, coffee, beans, orange juice etc.)

2.Precious metals (Gold, Silver, Copper)


3.Foreign exchange rate
4. Bonds of different types including medium to long-term negotiation debt
securities.

5.Short term debt securities like T- bills


6.Over the Counter (OTC) money market products such as loans or deposits.
We have observed that derivative markets in commodities, equity, foreign exchange
etc are in existence in the world since a very long time. In India too we find that
derivative markets were in existence in commodities for a long time in an
unorganized format. Although derivative market have been formalized through an
exchange at later stage. The equity derivative market was introduced in the year 2000
as a step towards an efficient stock market after a series of financial mishaps in the
Indian stock market after the liberalization process in 1990‟s.

Academicians and experts over the years have studied and built theories and models
around the functioning of derivative markets.

Maximizing earnings with minimum efforts/ costs/ risks is the fundamental of


financial management. Abnormal sums of money in modern times could be made
through Stock Exchanges, Currency trading, Commodity Exchanges and the like. The
basic qualities on which these exchanges operate are high risk and high volatility
(which may / may not result in high returns). People get exposed to risky situations/
positions in order to earn profits derived out of the transactions entered into.

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The equity market in India has under gone a transformation after the liberalization
reforms in 1990s. The reforms included establishment of Securities and Exchange
Board of India (SEBI) in 1998 and granting it a statutory status on January 30, 1992.
The primary objectives for establishing SEBI was to protect the interest in securities
promote the development of securities markets and regulate them. Establishing
National Stock Exchange (NSE) was also a major initiative as a part of the reforms.
Introducing derivative trading and banning the badla system for a more transparent
trading of securities was also a major development.

Introducing derivatives by the still evolving SEBI to Indian stock markets was part of
the exercise. It was first introduced in the National Stock Exchange and is now in
existence in the Indian system since year 2000.

SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop


appropriate regulatory framework for the derivatives trading and to recommend
suggestive bye-laws for Regulation and Control of Trading and Settlement of
Derivatives Contracts. The Committee was to focus on the financial derivatives. The
Committee submitted its report in March 1998. LCGC believed that regulation should
be designed to achieve specific and well-defined goals. It was inclined towards
positive regulation designed to encourage healthy activity and behavior.

1. This study helps to know the important concepts of derivative, history &
development of derivative market in India & present regulatory structure.

2. Also a research is made on the conception of retail investors, aim of investors of


investors on Derivatives Market in India.

There is a vast scope for our markets to develop vis-a-vis the growth and development
around the world. Currently, Indian derivative market is passing through teething
problems and testing waters. Maturity in this segment would come over the years with
passage of time. Our regulators approach towards developing this segment seems to
be positive but conservative. This of course is to protect the investor‟s interest and
setbacks to our financial systems. There is a wide scope to study the functioning of
derivative markets and models in Indian conditions to determine the market‟s
functionality and effectiveness.

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CHAPTER 2.

INTRODUCTION

2.1 Introduction

2.2 Growth of Derivative Market in India

2.3 What is a Derivative?


2.3.1 Types of Derivatives

2.3.2 Risk involved in Derivatives

2.4 Market Participants and Makers


2.4.1 Hedgers

2.4.2 Speculators

2.4.3 Arbitrageurs

2.5 Regulation and its structure


2.5.1 Reserve Bank of India

2.5.2 Securities and Exchange Board of India

2.5.3 Securities Contracts (Regulation) Act, 1956

2.5.4 Forwards Market Commission

2.6 Badla System in Indian Stock Market


2.6.1 The history of Badla

2.7 Risk Management Techniques in Derivatives Market

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2.1 Introduction:

Maximizing earnings with minimum efforts/ costs/ risks is the fundamental of


financial management. Abnormal sums of money in modern times could be made
through Stock Exchanges, Currency trading, Commodity Exchanges and the like. The
basic qualities on which these exchanges operate are high risk and high volatility
(which may / may not result in high returns). People get exposed to risky situations/
positions in order to earn profits derived out of the transactions entered into.

„Need‟ as they say is the mother of all inventions. Derivatives are the modern man‟s
business invention, which help people to maximize returns on their investments by
taking minimum risk. It involves postponement of receipts of benefits till you have
reached an optimum/ satisfied level.

Majority of middle class Indians / Indian Markets were unexposed to the benefits of
investing their money in stock exchanges till early 90‟s. Till then they were quite
happy parking their money in Banks, Chit funds and other Government backed
instruments. They were happy too with the fixed returns, which these instruments
would offer to them. The definition of „earning money‟ changed in the 80‟s with Mr.
Dhirubhai Ambani ushering in the era of putting one‟s money in the stock exchanges
as an alternate investment option. In early 90‟s Mr. Harshad Mehta took the
momentum forward to dizzying heights and motivated many more in making equity
investment part of a person‟s financial portfolio. Dr. Manmohan Singh by bringing in
tax reforms also facilitated India‟s common middle class man access and opportunity
to invest and reap benefits from the country‟s most powerful and money spinning
institution.

The equity market in India has under gone a transformation after the liberalization
reforms in 1990s. The reforms included establishment of Securities and Exchange
Board of India (SEBI) in 1998 and granting it a statutory status on January 30, 1992.
The primary objectives for establishing SEBI was to protect the interest in securities,
promote the development of securities markets and regulate them. Establishing
National Stock Exchange (NSE) was also a major initiative as a part of the reforms.
Introducing derivative trading and banning the badla system for a more transparent
trading of securities was also a major development.

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The major reforms in Indian Equities Market could be listed as follows:


Table 1: Major Reforms in Indian Equities Market
Year Activity
A committee was appointed under the chairmanship of Shri.
M. Narasimham, to examine all aspects of the structures,
1991 organization, function and procedures of the financial
system.

Free pricing of issues, FDI & FII norms relaxed.


1992 Parliament passed SEBI Bill &accorded statutory status as
on autonomous body to SEBI.
1993 Private MFs allowed.
1994 Automated screen - based trading.
1998 Dematerialization.
Rolling settlement.
2000
Index derivatives.
2001 Stock Derivatives
2003 T+2 Settlements.
Corporatization and Demutualization of Exchanges.
Reforms in Corporate governance.
2005 Comprehensive Risk management framework.
IPO grading.
Gold exchange traded fund.
Initiatives to develop Corporate Bond market.
2007
Short selling and Stock lending and Borrowing.
Source: India’s Financial Sector- An Assessment- Volume V, Advisory Panel on Institutions
and Market Structure- Committee on Financial Sector Assessment March 2009, RBI,
Government of India.

Introducing derivatives by the still evolving SEBI to Indian stock markets was part of
the exercise. It was first introduced in the National Stock Exchange and is now in
existence in the Indian system since year 2000. Indian academia‟s research could
focus on the success stories of the growth and development of Derivative Markets in
India.

We can trace the introduction of Derivatives way back to 1700 BC {according to the
Bible (Genesis, Chapter 29)}. Around 580 B C Thales the Milesian purchased options
on olive presses and made a fortune off of a bumper crop in olives. So derivatives
could be traced back before the time of the Christ. The uses of which have been
passed through generations. We can trace derivatives existence in India way back in

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2000 BC. Forward trading in Japan could be traced back to the 17th century. The first
futures markets in the western hemisphere were developed in the United States, in
Chicago. It later transpired into a formal modern exchange called as The Chicago
Board of Trade (CBOT), which is in operation since 1848. Till today it‟s the largest
futures market in the world. The rules framed by CBOT in 1865 are followed and
have become pace setter for many other markets. The London Metal Exchange was
established in 1877 and is now a leading market in metal trading.

The point is Derivatives have a long history worldwide and have evolved in many
forms to take their present structure.

The Indian stock exchanges were dominated by the badla system of trading until
recently. The system had many loopholes, which lead to its abuse and later failure
resulting into major revamping in its structure. It compelled SEBI to look into
alternate methods of trading and to keep the stock markets active; it resulted into
introduction of derivatives trading.

SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop


appropriate regulatory framework for the derivatives trading and to recommend
suggestive bye-laws for Regulation and Control of Trading and Settlement of
Derivatives Contracts. The Committee was to focus on the financial derivatives. The
Committee submitted its report in March 1998.

The Board of SEBI in its meeting held on May 11, 1998 accepted the
recommendations and approved the introduction of derivatives trading in India
beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-
laws" recommended by the L C Gupta Committee for Regulation and Control of
Trading and Settlement of Derivatives Contracts.

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2.2 Growth of Derivative Market in India.

In India, derivatives markets have been functioning since the nineteenth century, with
organized trading in cotton through the establishment of the Cotton Trade Association
in 1875. Derivatives, as exchange traded financial instruments were introduced in
India in June 2000. The National Stock Exchange (NSE) and Bombay Stock
Exchange (BSE) are the largest exchanges in India in derivatives trading. The first
derivative contract in India was launched on NSE was the Nifty 50 index futures
contract. The equity derivatives segment in India is called the Futures & Options
Segment or F&O Segment. A series of reforms in the financial markets paved way for
the development of exchange-traded equity derivatives markets in India. L.C. Gupta
Committee, set up by the Securities and Exchange Board of India (SEBI),
recommended a phased introduction of derivatives instruments with self-regulation by
exchanges, with SEBI providing the overall regulatory and supervisory role. In 1999,
the Securities Contracts (Regulation) Act of 1956, or SC(R) A, was amended so that
derivatives could be declared as “securities”. This allowed the regulatory framework
for trading securities to be extended to derivatives. The Act considers derivatives on
equities to be legal and valid, but only if they are traded on exchanges. At present, the
equity derivatives market is the most active derivatives market in India. Trading
volumes in equity derivatives are, on an average more than three and a half times the
trading volumes in the cash equity markets.

Milestones in the Development of Indian Derivative Market


Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2000. SEBI permitted the derivative segments of two
stock exchanges, NSE and BSE, and their clearing house/corporation to commence
trading and settlement in approved derivative contracts. The trading in index options
commenced in June 2001 and those in options on individual securities commenced in
July 2001. Futures contracts on individual stock were launched in November 2001.
Table 2 shows the sequence of events in the development of derivative market in
India.

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Table 2: Milestones in the Development of Indian Derivative Market

Date Milestone Achieved

December,1995 NSE asked SEBI for permission to trade index futures


SEBI setup L.C.Gupta Committee to draft a policy
November,1996 framework for index futures.

May,1998 L. C. Gupta Committee submitted report.


RBI gave permission for OTC forward rate agreements
July,1999 (FRAs) and interest rate swaps
SIMEX chose Nifty for trading futures and options on an
May,2000 Indian index.
SEBI gave permission to NSE and BSE to do index futures
May,2000 trading.

June,2000 Trading of BSE Sensex futures commenced at BSE.

June,2000 Trading of Nifty futures commenced at NSE.


Trading of futures and options on Nifty to commence at
August,2000 SIMEX.

Trading of Equity Index Options at NSE


June,2001
Trading in BSE SENSEX options commenced

July,2001 Trading of Stock Options at NSE

November,2002 Trading of Single Stock futures at BSE

June,2003 Trading of Interest Rate Futures at NSE

September,2004 Weekly Options at BSE

January,2008 Trading of Mini Sensex at BSE

January,2008 Trading of Mini Index Futures & Options at NSE

August,2008 Trading of Currency Futures at NSE

October,2008 Trading of Currency Futures at BSE

August,2009 Interest rate derivatives trading commences on the NSE

February,2010 Launch of Currency Futures on additional currency pairs

October,2010 Introduction of European style Stock Options

October,2010 Introduction of Currency Options

Source: Compiled from the BSE and NSE Fact Book.

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The growth in the volume of trading in derivative products between years 2003-17 on
the National Stock Exchange (NSE) are indicated in the tables below:

Table 3: Daily Trends in FII Derivative Trades – November 03, 2017


Daily Trends in FPI Derivative Trades on 03-Nov-2017
Open Interest at the
Buy Sell
Derivative end of the date.
Products No. of Amount No. of Amount No. of Amount
Contracts in Crore Contracts in Crore Contracts in Crore
Index
14364 1251.54 24319 2011.26 305160 24498.8
Futures
Index
638226 60810.87 601619 57236.73 955732 76804.92
Options
Stock
93080 6652.17 98094 6984.8 947684 66736.69
Futures
Stock
84910 6266.82 84481 6203.75 91289 6483.38
Options
Interest
Rate 1955 38.84 9470 188 19830 395.04
Futures
The above report is compiled on the basis of reports submitted to depositories by NSE and
BSE on 03-Nov-2017 and constitutes FPIs/FIIs trading / position of the previous trading day.
Source: www.fpi.nsdl.co.in

Table 4: Daily Trends in FII Derivative Trades – November 03, 2003


Daily Trends in FPI Derivative Trades on 03-Nov-2003
Open Interest at the
Buy Sell
Derivative end of the date.
Products No. of Amount No. of Amount No. of Amount
Contracts in Crore Contracts in Crore Contracts in Crore
Index
620 19.23 0 0 15506 483.74
Futures
Index
0 0 0 0 0 0
Options
Stock
413 20.23 4440 141.81 64834 2452.49
Futures
Stock
0 0 0 0 0 0
Options
Interest
Rate 0 0 0 0 0 0
Futures
The above report is compiled on the basis of reports submitted to SEBI by NSE and BSE on
November 03, 2003 and constitutes FIIs trading / position of the previous trading day i.e.
October31 , 2003.
Source: http://www.sebi.gov.in/

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Figure 1: The growth in the derivative trading (Buy volume of number of


contracts) over the years from 2003-2017 has been shown in the following chart.

700000
600000
500000
400000
300000
200000
100000
0 2003
Index Futures Index Options Stock Futures Stock Options Interest Rate 2008
Futures
2017

Figure 2: The growth in the derivative trading (Sell volume of number of


contracts) over the years from 2003-2017 has been shown in the following chart.

700000
600000
500000
400000 2003
300000
200000 2008
100000
2017
0
Index Futures Index Options Stock Futures Stock Options Interest Rate
Futures

Figure 3: The growth in the derivative trading (Open Interest at the end of the
date of number of contracts) over the years from 2003-2017 has been shown in
the following chart.

1000000

800000

600000
2003
400000 2008

200000 2017

0
Index Futures Index Options Stock Futures Stock Options Interest Rate
Futures

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Figure 4: The growth in the derivative trading (Buy value in Rs. in crore’s) over
the years from 2003-2017 has been shown in the following chart.

70000
60000
50000
40000
30000
20000
10000
0
Index Futures Index Options Stock Futures Stock Options Interest Rate 2003
Futures 2008
2017

Figure 5: The growth in the derivative trading (Sell value in Rs. in crore’s) over
the years from 2003-2017 has been shown in the following chart.

60000
50000
40000
2003
30000
2008
20000
2017
10000
0
Index Futures Index Options Stock Futures Stock Options Interest Rate
Futures

Figure 6: The growth in the derivative trading (Open Interest at the end of the
date value in Rs. in crore’s) over the years from 2003-2017 has been shown in the
following chart.

80000
70000
60000
50000
2003
40000
30000 2008
20000 2017
10000
0
Index Futures Index Options Stock Futures Stock Options Interest Rate
Futures

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Figure 7: The growth in the Contracts Traded over the years in NSE & BSE
Exchange from 2000-2017 has been shown in the following chart. (2017-2018
figures are for month from April to October)(Data Source:- NSE & BSE Website)

2,500,000,000.00

2,000,000,000.00

1,500,000,000.00

1,000,000,000.00

500,000,000.00

0.00

The Figure7 shows the increasing trend in number of contracts traded in exchange. In
the years of global slow down the amount of contracts traded are decreased but again
there is increase in number of contracts traded.

Figure 8: The growth in the Total Turnover (cr.) over the years in NSE & BSE
Exchange from 2000-2017 has been shown in the following chart. (2017-2018
figures are for month from April to October) (Data Source:- NSE & BSE Website)
100,000,000
90,000,000
80,000,000
70,000,000
60,000,000
50,000,000
40,000,000
30,000,000
20,000,000
10,000,000
0

The Figure8 shows the increase in turnover from the year of inception to current year.
The line graph shows a continuous increasing trend in the turnover. There was a
decrease in single year of 2015-2016 but again the turnover rose.
The above charts shoes that there is a tremendous increase in the number of contracts
traded and also the rise in turnover over the period of time.

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2.3 What is a Derivative?

A derivative could be defined as a financial instrument whose value depends on the


values of an underlying asset. The variables underlying derivatives are the prices of
traded assets. For e.g. price of a stock (share), price of commodities like wheat, rice,
pulses, interest rates, currency prices etc.

A derivative is an instrument whose value is „derived‟ from another security or


economic variable. The dependence of the derivative‟s value on other prices or
variables makes it an excellent vehicle for transferring and managing risk.

John C. Hull, “A derivative can be defined as a financial instrument whose value


depends on (or derives from) the values of other, more basic underlying variables.”

Robert L. McDonald “A derivative is simply a financial instrument (or even more


simply an agreement between two people) which has a value determined by the price
of something else.”

According to the Securities Contract (Regulation) Act, 1956, derivatives include:

 A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.
 A contract, which derives its value from the prices of index or prices of
underlying securities.

Therefore, derivatives are specialized contracts to facilitate temporarily for hedging


which is protection against losses resulting from unforeseen price or volatility
changes. Thus, derivatives are a very important tool of risk management.

Derivatives perform a number of economic functions like price discovery, risk


transfer and market completion.

Prerequisites for Derivatives Market


There are five essential prerequisites for derivatives market to flourish in a country.
a) Large market capitalization
At a market capitalization of near $1.5 trillion, India is well ahead of many other
countries where derivatives markets have succeeded.

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b) Liquidity in the underlying


A few years ago, the total trading volume in India used to be around Rs-300crores a
day. Today, daily trading volume in India is around Rs-15000 crores a day. This
implies a degree of liquidity, which is around six times superior to the earlier
conditions. There is empirical evidence to suggest that there are many financial
instruments in the country today, which have adequate to support derivative market.

c) Clearing house that guarantees trades


Counter party risk is one of the major factors recognized as essential for starting a
strong and healthy derivatives market. Trade guarantee therefore becomes imperative
before a derivatives market could start. The first clearinghouse corporation guarantees
trades have become fully functional from July 1996 in the form of National Securities
Clearing Corporation (NSCC). NSCC is responsible for guaranteeing all open
positions on the National Stock Exchange (NSE) for which it does the clearing. Other
exchanges are also moving towards setting up separate and well-funded clearing
corporations for providing trade guarantees.

d) Physical infrastructure
India‟s equity markets are all moving towards satellite connectivity, which allows
investors and traders anywhere in the country to buy liquidity services from anywhere
else. This telecommunications infrastructure, India‟s capabilities in computer
hardware and software, will enable the establishment of computer system for creation
of derivatives markets. Setting up of automated trading system as an experience with
various prospective exchanges will also be beneficial while setting up the derivative
market.

e) Risk-taking capability and Analytical skills

India‟s investors are very strong in their risk-bearing capacity and can cope with the
risk that derivatives pose. Evidence of the volumes traded on the capital markets,
which are parallel to a futures market, is indicative of this capacity.
On the subject of analytical skills, derivatives require a high degree of analytical
capability for many subtle trading strategies to pricing. India has an enormous pool of
mathematically literate finance professionals, who would excel in this field. Lastly, an
obvious advantage for the Indian market is that we have enormous experience with

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futures markets through the settlement cycle oriented equity which is not truly a spot
market but a futures market (including concepts like market-to-market margin, low
delivery ratios, and last-day-of settlement abnormalities in prices). We also have
active futures markets on six commodities.

2.3.1 Types of Derivatives.

a) Classification of Derivatives

Derivatives

Commodity Financial

i. Commodity derivatives

Commodity derivatives are the financial instruments, the value of which is based on
the value of underlying commodities like rice, paddy, gold, silver, oil etc., Initially,
the idea behind commodity derivatives was to provide a means of risk protection for
farmers. They could promise to sell crops in the future for a pre-arranged price.

ii. Financial derivative

It is a financial instrument, the value of which is based on the value or values of one
or more underlying assets or indexes of assets. Derivatives can be based on equities
(stocks), debt (bonds, bills, and notes), currency (USD, JPY, GBP and EUR) and
indexes of these various things.

b) Types of Derivatives Products

Derivatives

Forwards Future Options Swap

i. Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The promised asset may be currency, commodity, instrument etc. The other

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party assumes a short position and agrees to sell the asset on the same date for the
same price. Other Contracts details like delivery date, price and quantity are
negotiated bilaterally by the parties to the contract. The forward are normally traded
outside the exchange.

Basic Features of Forward Contract


Highly customized - Counterparties can determine and define the terms and
features to fit their specific needs, including when delivery will take place and
the exact identity of the underlying asset.
All parties are exposed to counterparty default risk - This is the risk that the
other party may not make the required delivery or payment.
Transactions take place in large, private and largely unregulated markets
consisting of banks, investment banks, government and corporations.
Underlying assets can be stocks, bonds, foreign currencies, commodities or
some combination thereof. The underlying asset could even be interest rates.
They tend to be held to maturity and have little or no market liquidity.
Any commitment between two parties to trade an asset in the future is a
forward contract.
Physical Settlement
A forward contract can be settled by the physical delivery of the underlying asset by a
short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of
the agreed forward price by the buyer to the seller on the agreed settlement date.
Cash settlement
It does not involve actual delivery or receipt of the security. Each party either pays
(receives) cash equal to the net loss (profit) arising out of their respective position in
the contract.

ii. Future Contracts


Like a forward contract, a futures contract is an agreement between two parties in
which the buyer agrees to buy an underlying asset from the seller, at a future date at a
price that is agreed upon today. However, unlike a forward contract, a futures contract
is not a private transaction but gets traded on a recognized stock exchange. In
addition, a futures contract is standardized by the exchange. All the terms, other than
the price, are set by the stock exchange. Also, both buyer and seller of the futures

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contracts are protected against the counter party risk by an entity called the Clearing
Corporation. The Clearing Corporation provides this guarantee to ensure that the
buyer or the seller of a futures contract does not suffer as a result of the counter party
defaulting on its obligation. In case one of the parties defaults, the Clearing
Corporation steps in to fulfill the obligation of this party, so that the other party does
not suffer due to non-fulfillment of the contract. To be able to guarantee the
fulfillment of the obligations under the contract, the Clearing Corporation holds an
amount as a security from both the parties. This amount is called the Margin money
and can be in the form of cash or other financial assets.

Basic Features of Future Contracts


Organized Exchanges: Unlike forward contracts which are traded in an over-
the-counter market, futures are traded on organized exchanges with a
designated physical location where trading takes place. This provides a ready,
liquid market in which futures can be bought and sold at any time like in a
stock market.
Standardization: In the case of forward currency contracts, the amount of
commodity to be delivered and the maturity date are negotiated between the
buyer and seller and can be tailor-made to buyer‟s requirements. In a futures
contract, both these are standardized by the exchange on which the contract is
traded.
Clearing House: The exchange acts as a clearing house to all contracts traded
exchange. For instance, the exchange interposes itself in every contract and
deal, where it is a buyer to every seller and a seller to every buyer. The
advantage of this is that A and B do not have to undertake any exercise to
investigate each other‟s creditworthiness. It also guarantees the financial
integrity of the market.

Margins: Like all exchanges, only members are allowed to trade in futures
contracts on the exchange. Others can use the services of the members as
brokers to use this instrument. Thus, an exchange member can trade on his
own account as well as on behalf of a client. A subset of the members is the
“clearing members” or members of the clearing house and non- clearing
members must clear all their transactions through a clearing member. The

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amount of the margin is generally between 2.5% to 10% of the value of the
contract but can vary. A member acting on behalf of a client, in turn, requires
a margin from the client. The margin can be in the form of cash or securities
like treasury bills or bank letters of credit.

Marking to Market: The exchange uses a system called marking to market


where, at the end of each trading session, all outstanding contracts are reprised
at the settlement price of that trading session. This would mean that some
participants would make a loss while others would stand to gain. The
exchange adjusts this by debiting the margin accounts of those members who
made a loss and crediting the accounts of those members who have gained.

Actual Delivery is Rare: In most forward contracts, the commodity is


actually delivered by the seller and is accepted by the buyer. Forward
contracts are entered into for acquiring or disposing off a commodity in the
future for a gain at a price knowstoday. In contrast to this, in most futures
markets, actual delivery takes place in less than one per cent of the contracts
traded.

Flow of Transactions in a Futures Contract


The basic flow of a transaction between three parties, namely Buyer, Seller and
Clearing Corporation is depicted in the figure below

Source: NSE Workbook.

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Future’s Terminology
Contract Size
The value of the contract at a specific level of Index. It is Index level *
Multiplier.
Multiplier
It is a pre-determined value, used to arrive at the contract size. It is the price
per index point.
Tick Size
It is the minimum price difference between two quotes of similar nature.
Contract Month
The month in which the contract will expire.
Expiry Day
The last day on which the contract is available for trading and gets matured.
Open interest
Total outstanding long or short positions in the market at any specific point in
time. As total long positions for market would be equal to total short positions, for
calculation of open Interest, only one side of the contracts is counted.
Volume
No. Of contracts traded during a specific period of time. During a day, during
a week or during a month.
Long position
Outstanding/unsettled purchase position at any point of time.
Short position
Outstanding/ unsettled sales position at any point of time.
Open position
Outstanding/unsettled long or short position at any point of time.
Physical delivery
Open position at the expiry of the contract is settled through delivery of the
underlying. In futures market, delivery is low.
Cash settlement
Open position at the expiry of the contract is settled in cash. These contracts
alternative Delivery Procedure (ADP) - Open position at the expiry of the
contract is settled by two parties - one buyer and one seller, at the terms other

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than defined by the exchange. Worldwide a significant portion of the energy


and energy related contracts (crude oil, heating and gasoline oil) are settled
through Alternative Delivery Procedure.

Pay off for futures:


A Pay off is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. Futures contracts have linear payoffs. In
simple words, it means that the losses as well as profits, for the buyer and the seller of
futures contracts, are unlimited.

Pay off for Buyer of futures: (Long futures)


The pay offs for a person who buys a futures contract is similar to the pay off
for a person who holds an asset. He has potentially unlimited upside as well as
downside. Take the case of a speculator who buys a two-month Nifty index
futures contract when the Nifty stands at 1220. The underlying asset in this
case is the Nifty portfolio. When the index moves up, the long futures position
starts making profits and when the index moves down it starts making losses.

P
PROFIT

E2
F E1
LOSS

CASE 1:- The buyers bought the futures contract at (F); if the futures

Price Goes to E1 then the buyer gets the profit of (FP).

CASE 2:- The buyers gets loss when the futures price less then (F); if

The Futures price goes to E2 then the buyer the loss of (FL).

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Pay off for seller of futures: (short futures)


The pay offs for a person who sells a futures contract is similar to the pay off
for a person who shorts an asset. He has potentially unlimited upside as well
as downside. Take the case of a speculator who sells a two-month Nifty index
futures contract when the Nifty stands at 1220. The underlying asset in this
case is the Nifty portfolio. When the index moves down, the short futures
position starts making profits and when the index moves up it starts making
losses.

P
PROFIT

E2
E1 F

LOSS

CASE 1:- The seller sold the future contract at (F); if the future goes to E 1 Then the
seller gets the profit of (FP).

CASE 2:- The seller gets loss when the future price goes greater than (F) If the future
price goes to E2 then the seller get the loss of (FL).

iii. Options Contracts


An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying asset on or before a stated date/day, at a stated price, for a price. The party
taking a long position i.e. buying the option is called buyer/ holder of the option and
the party taking a short position i.e. selling the option is called the seller/ writer of the
option.
The option buyer has the right but no obligation with regards to buying or selling the
underlying asset, while the option writer has the obligation in the contract. Therefore,
option buyer/ holder will exercise his option only when the situation is favorable to

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him, but, when he decides to exercise, option writer would be legally bound to honor
the contract.

Categorization of Option Contracts:

Options Contacts

Call Options Contact Put Options Contact

i. Call Option Contracts


A contract that gives its owner the right but not the obligation to buy an underlying
asset (Stock, Bond, Currency & Commodity) at a specified price on or before a
specified date is known as a „Call option‟. The owner makes a profit provided he sells
at a higher current price and buys at a lower future price.
ii. Put Option Contracts
A contract that gives its owner the right but not the obligation to sell an underlying
asset (Stock, Bond, Currency & Commodity) at a specified price on or before a
specified date is known as a „Put option‟. The owner makes a profit provided he buys
at a lower current price and sells at a lower future price. No option will be exercised if
the future price does no increase.

Option’s Terminology
Index option: These options have index as the underlying asset. For example options
on Nifty, Sensex, etc.
Stock option: These options have individual stocks as the underlying asset. For
example, option on ONGC, NTPC etc.
Buyer of an option: The buyer of an option is one who has a right but not the
obligation in the contract. For owning this right, he pays a price to the seller of this
right called „option premium‟ to the option seller.
Writer of an option: The writer of an option is one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer of option exercises his right.
American option: The owner of such option can exercise his right at any time on or
before the expiry date/day of the contract.
European option: The owner of such option can exercise his right only on the expiry
date/day of the contract. In India, Index options are European.

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Option price/Premium: It is the price which the option buyer pays to the option
seller.
Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of
Nifty option contracts is 50.
Expiration Day: The day on which a derivative contract ceases to exist. It is the last
trading date/day of the contract. The expiration day of contracts is the last Thursday
of the month.
Spot price (S): It is the price at which the underlying asset trades in the spot market.
Strike price or Exercise price (X): Strike price is the price per share for which the
underlying security may be purchased or sold by the option holder.
In the money (ITM) option: This option would give holder a positive cash flow, if it
were exercised immediately. A call option is said to be ITM, when spot price is
higher than strike price. And, a put option is said to be ITM when spot price is lower
than strike price. In our examples, call option is in the money.
At the money (ATM) option: At the money option would lead to zero cash flow if it
were exercised immediately. Therefore, for both call and put ATM options, strike
price is equal to spot price.
Out of the money (OTM) option: Out of the money option is one with strike price
worse than the spot price for the holder of option. In other words, this option would
give the holder a negative cash flow if it were exercised immediately. A call option is
said to be OTM, when spot price is lower than strike price. And a put option is said to
be OTM when spot price is higher than strike price. In our examples, put option is out
of the money.
Intrinsic value: Option premium, defined above, consists of two components -
intrinsic value and time value.
For an option, intrinsic value refers to the amount by which option is in the money i.e.
the amount an option buyer will realize, before adjusting for premium paid, if he
exercises the option instantly. Therefore, only in-the-money options have intrinsic
value whereas at-the-money and out-of-the-money options have zero intrinsic value.
The intrinsic value of an option can never be negative.
Time value: It is the difference between premium and intrinsic value, if any, of an
option. ATM and OTM options will have only time value because the intrinsic value
of such options is zero.
Open Interest: As discussed in futures section, open interest is the total number of
option contracts outstanding for an underlying asset.

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Factors Determining Option Value:


Underlying Price: - The most influential factor on an option premium is the
current market price of the underlying asset. In general, as the price of the
underlying increases, call prices increase and put prices decrease. Conversely, as
the price of the underlying decreases, call prices decrease and put prices increase.
Strike price: - The strike price determines if the option has any intrinsic value.
Remember, intrinsic value is the difference between the strike price of the option
and the current price of the underlying. The premium typically increases as the
option becomes further in-the-money (where the strike price becomes more
favorable in relation to the current underlying price) & vice versa.
Time to expiration: -The longer an option has until expiration, the greater the
chance it will end up in-the-money, or profitable. As expiration approaches, the
option's time value decreases. The underling‟s volatility is a factor in time value:
If the underlying is highly volatile, you can reasonably expect a greater degree of
price movement before expiration. The opposite holds true where the underlying
exhibits low volatility:
Volatility: Volatility is the degree to which price moves, whether it goes up or
down. It is a measure of the speed and magnitude of the underlining‟s price
changes. Historical volatility refers to the actual price changes that have been
observed over a specified time period.
Risk free interest rate: -Interest rates and dividends have small, but measurable,
effects on option prices. In general, as interest rates rise, call premiums increase
and put premiums decrease. This is because of the costs associated with owning
the underlying: The purchase incurs either interest expense (if the money is
borrowed) or lost interest income (if existing funds are used to purchase the
shares). In either case, the buyer will have interest costs.
Dividend: - Dividends can affect option prices because the underlying stock's
price typically drops by the amount of any cash dividend on the ex-dividend date.
As a result, if the underlining‟s dividend increases, call prices will decrease and
put prices will increase. Conversely, if the underlining‟s dividend decreases, call
prices will increase and put prices will decrease.

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Pay off Charts for Options


Pay off for Buyer of Call Option: (Long Call)
The Pay-off of a buyer options depends on a spot price of an underlying
asset. The following graph shows the pay-off of buyers of a call option.

PROFIT
R

ITM

ATM E1

OTM

E2 LOSS P

S = Strike price ITM = In the Money


SP = Premium / loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E1
CASE 1: (Spot Price > Strike price)

As the Spot price (E1) of the underlying asset is more than strike price (S).

The buyer gets profit of (SR), if price increases more than E 1 then profit also increase
more than (SR)

CASE 2: (Spot Price < Strike Price)

As a spot price (E2) of the underlying asset is less than strike price (S)

The buyer gets loss of (SP); if price goes down less than E 2 then also his loss is
limited to his premium (SP)

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Pay off for Seller of Call Option: (Short Call)


The pay-off of seller of the call option depends on the spot price of the underlying
asset. The following graph shows the pay-off of seller of a call option:

PROFIT

PROFIT
P
ITM ATM
E2
E1
S
OTM

LOSS

S = Strike price ITM = In the Money


SP = Premium / loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E2

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying is less than strike price (S). The seller gets the
profit of (SP), if the price decreases less than E 1 then also profit of the seller does not
exceed (SP).

CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S) the Seller
gets loss of (SR), if price goes more than E 2 then the loss of the seller also increase
more than (SR).

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Pay off for Buyer of Put Option: (Long Put)


The Pay-off of the buyer of the option depends on the spot price of the underlying
asset. The following graph shows the pay-off of the buyer of a call option.

PROFIT
R

ITM
S
E2
E1 ATM
OTM

P LOSS

S = Strike price ITM = In the Money


SP = Premium / loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S). The buyer
gets the profit (SR), if price decreases less than E 1 then profit also increases more than
(SR).

CASE 2: (Spot price > Strike price)


As the spot price (E2) of the underlying asset is more than strike price (S),
The buyer gets loss of (SP), if price goes more than E 2 than the loss of the buyer is
limited to his premium (SP).

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Pay off for Seller of Put Option: (Short Put)


The pay-off of a seller of the option depends on the spot price of the underlying asset.
The following graph shows the pay-off of seller of a put option.

PROFIT
P
ITM

E1 ATM

E2
S
OTM

LOSS

S = Strike price ITM = In the Money


SP = Premium / loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E2

CASE 1: (Spot price < Strike price)


As the spot price (E1) of the underlying asset is less than strike price (S), the seller
gets the loss of (SR), if price decreases less than E 1 than the loss also increases more
than (SR).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price (S), the seller
gets profit of (SP), of price goes more than E 2 than the profit of seller is limited to his
premium (SP).

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Summary of options
Call option buyer Call option writer (seller)
Pays premium Receives premium
Obligation to sell shares if
Right to exercise and buy the share exercised
Profits from falling prices or
Profits from rising prices remaining neutral
Limited losses, potentially Potentially unlimited losses,
unlimited gain limited gain

Put option buyer Put option writer (seller)


Pays premium Receives premium
Obligation to buy shares if
Right to exercise and sell shares exercised
Profits from rising prices or
Profits from falling prices remaining neutral
Limited losses, potentially Potentially unlimited losses,
unlimited gain limited gain

iv. Swap Contracts


A swap is a derivative contract through which two parties exchange financial
instruments. These instruments can be almost anything, but most swaps involve cash
flows based on a notional principal amount that both parties agree to. Usually,
the principal does not change hands. Each cash flow comprises one leg of the swap.
One cash flow is generally fixed, while the other is variable that is, based on a
benchmark interest rate, floating currency exchange rate or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade
on exchanges, and retail investors do not generally engage in swaps. Rather, swaps
are over-the-counter contracts between businesses or financial institutions.

 Interest Rate Swap


An interest rate swap is a contractual agreement between two counterparties to
exchange cash flows on particular dates in the future. There are two types of legs (or
series of cash flows). A fixed rate payer makes a series of fixed payments and at the
outset of the swap, these cash flows are known. A floating rate payer makes a series
of payments that depend on the future level of interest rates (a quoted index like
LIBOR for example) and at the outset of the swap, most or all of these cash flows are

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not known. In general, a swap agreement stipulates all of the conditions and
definitions required to administer the swap including the notional principal amount,
fixed coupon, accrual methods, day count methods, effective date, terminating date,
cash flow frequency, compounding frequency, and basis for the floating index.
An interest rate swap can either be fixed for floating (the most common), or floating
for floating (often referred to as a basis swap). In brief, an interest rate swap is priced
by first present valuing each leg of the swap (using the appropriate interest rate curve)
and then aggregating the two results.

 Commodity Swap
A commodity swap is a swap in which one of the payment streams for a commodity is
fixed and the other is floating. Usually only the payment streams, not the principal,
are exchanged, although physical delivery is becoming increasingly common.
Commodity swaps have been in existence since the mid-1970's and enable producers
and consumers to hedge commodity prices. Usually, the consumer would be a fixed
payer to hedge against rising input prices. The producer in this case pays floating (i.e.,
receiving fixed for the product) thereby hedging against falls in the price of the
commodity. If the floating-rate price of the commodity is higher than the fixed price,
the difference is paid by the floating payer, and vice versa.

 Foreign-Exchange (FX) Swaps


An FX swap is where one leg's cash flows are paid in one currency, while the other
leg's cash flows are paid in another currency. An FX swap can be either fixed for
floating, floating for floating, or fixed for fixed. In order to price an FX swap, first
each leg is present valued in its currency (using the appropriate curve for the
currency).

 Total Return Swap


A total return swap (TRS) is a bilateral financial contract in that one counterparty
pays out the total return of a specified asset, including any interest payment and
capital appreciation or depreciation, in return receives a regular fixed or floating cash
flow. Typical reference assets of total return swaps are corporate bonds, loans and
equities. A total return swap can be settled at the terminating date only or periodically,
e.g., quarterly.

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Uses of Swap:
1. To create either synthetic fixed or floating rate liabilities or assets,
2. To hedge against adverse movements,
3. As an asset liability management tool,
4. To reduce the funding cost by exploiting the comparative advantage that each
counterparty has in the fixed/floating rate markets, and
5. For trading.

2.3.2 Risk involved in Derivatives


The primary risks associated with trading derivatives are market, counterparty,
liquidity and interconnection risks. Derivatives are investment instruments that consist
of a contract between parties whose value derive from and depend on the value of an
underlying financial asset. Among the most common derivatives traded are futures,
options, contracts for difference, or CFDs, and swaps.

 Market Risk
Market risk refers to the general risk in any investment. Investors make decisions and
take positions based on assumptions, technical analysis or other factors that lead them
to certain conclusions about how an investment is likely to perform. An important part
of investment analysis is determining the probability of an investment being profitable
and assessing the risk/reward ratio of potential losses against potential gains.

 Counterparty Risk
Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a
derivatives trade, such as the buyer, seller or dealer, defaults on the contract. This risk
is higher in over-the-counter, or OTC, markets, which are much less regulated than
ordinary trading exchanges.

 Liquidity Risk
Liquidity risk applies to investors who plan to close out a derivative trade prior to
maturity. Such investors need to consider if it is difficult to close out the trade or if
existing bid-ask spreads are so large as to represent a significant cost.

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2.4 Market Participants and Makers


There are broadly three types of participants in the derivatives market - hedgers,
traders (also called speculators) and arbitrageurs. An individual may play different
roles in different market circumstances. It can ve any of the following:
• Banks
• Producers/ Corporations/ Traders/ Farmers
• Financial Institutions like Insurance companies, Investment Banks,
Merchant Banks
• Exporters and Importers
• Individuals
• Governments: National, State, Local
2.4.1 Hedgers
They face risk associated with the prices of underlying assets and use derivatives to
reduce their risk. Corporations, investing institutions and banks all use derivative
products to hedge or reduce their exposures to market variables such as interest rates,
share values, bond prices, currency exchange rates and commodity prices.

For example farmer growing wheat is uncertain about the price he would get during
harvest season. Similarly a flour mill is unsure about the price at which it may have to
procure the wheat in future. Both the farmer and the flour meal would enter into a
forward contract where the farmer agrees to sell his wheat to the flour mill at a pre-
determined price. The farmer is expecting a price fall during harvest season and the
flour meal is expecting a price rise. Hence both the parties face price risk. The
forward contract in which they have entered into would eliminate the price risk for
both the parties. This is called as hedging and the participants are called as hedgers.
The hedgers would like to conclude the contract with the delivery of the underlined
asset. In the example mentioned the contract would be settled by the farmer delivering
the wheat to flour meal on the agreed date and the agreed price.

2.4.2 Speculators
They try to predict the future movements in prices of underlying assets and based on
the view, take positions in derivative contracts. Derivatives are preferred over
underlying asset for speculation purpose, as they offer leverage, are less expensive

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(cost of transaction is generally lower than that of the underlying) and are faster to
execute in size (high volumes market).

For example, the forward price in US dollars for a contract maturing in three months
is Rs. 48. If the speculator believes that three months later the price of US dollar
would be Rs. 50, he/she would buy forward today and sell later. On the contrary if he
believes that US dollar would depreciate to Rs. 46 in one month, he would sell now
and buy later. The intention is not to take delivery of underline but instead gain from
the differential in price. Speculators render liquidity to the market and make markets
competitive and expand the market size. They also helps hedgers find counter parties
conveniently.

2.4.3 Arbitrageurs
Arbitrage is a deal that produces profit by exploiting a price difference in a product in
two different markets. Arbitrage originates when a trader purchases an asset cheaply
in one location and simultaneously arranges to sell it at a higher price in another
location. Such opportunities are unlikely to persist for very long, since arbitrageurs
would rush in to these transactions, thus closing the price gap at different locations.

For example if the share price of Infosys is Rs. 1750/- in National Stock Exchange
and Rs. 1770/- in Bombay Stock Exchange the arbitrageurs will buy at NSE and sell
at BSE simultaneously and pocket the difference of Rs. 20/- per share. An arbitrageur
takes risk neutral position and makes profits in markets which are imperfect. He
cashes upon these short live opportunities as these imperfections are extremely short
live.

Fundamentally the speculators and arbitrageurs fall in the same category since they do
not own or disown the underlying asset by taking or giving physical delivery like
hedgers. Both render competitiveness to the market there by helping the price
discovery process. The difference between the two categories lies in the amount of
risk they assume. While speculators have their opinions about the future price of the
underlined asset the arbitrageurs concentrates on the price differential in different
markets by taking riskless position with no investment of their own.

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2.5 Regulation and its structure

2.5.1 Reserve Bank of India


Reserve Bank of India (RBI) was established in 1935 and is the Central / Federal bank
of India. RBI is the regulator for financial and banking system, formulates monetary
policy and prescribes foreign exchange control norms. The Reserve Bank of India
regulates a large segment of financial institutions in India which includes commercial
banks, cooperative banks, non-banking financial institutions and various financial
markets.

With a view to enable entities to manage volatility in the currency market, RBI on
April 20, 2007 issued comprehensive guidelines on the usage of foreign currency
forwards, swaps and options in the OTC market. At the same time, RBI also set up an
Internal Working Group to explore the advantages of introducing currency futures.
The Terms of Reference to the Committee were as under:
1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of
Currency and Interest Rate Futures on the Exchanges.
2. To suggest the eligibility norms for existing and new Exchanges for Currency
and Interest Rate Futures trading.
3. To suggest eligibility criteria for the members of such exchanges.
4. To review product design, margin requirements and other risk mitigation
measures on an ongoing basis
5. To suggest surveillance mechanism and dissemination of market information.
6. To consider microstructure issues, in the overall interest of financial stability.

2.5.2 Securities and Exchange Board of India


SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India
(SEBI) with statutory powers for (a) protecting the interests of investors in securities
(b) promoting the development of the securities market and (c) regulating the
securities market. Its regulatory jurisdiction extends over corporate in the issuance of
capital and transfer of securities, in addition to all intermediaries and persons
associated with securities market.

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2.6 Badla System in Indian Stock Market


The Badla system as prevailed in the Indian capital market, prior to ban by SEBI in
December 1993, was a unique system. The term „Badla‟ denotes the system whereby
the buyers or sellers of shares may be allowed to postpone the payment of money, or
delivery of the shares, as the case may be, in return for paying or receiving a certain
amount of money. It is also known as carry forward trading.
For example, on January 2, A buys the share of company X at a price of Rs. 100/- A is
required to pay Rs. 100 to take the delivery of share on the settlement day, i.e., 15th
January. On that day, the price of the share is still Rs. 100/-. Instead of paying Rs.
100, he informs his broker that he would like to carry forward the transaction to the
next settlement date ending on January 30. The broker locates a seller who is also
willing to carry forward the transaction, i.e., who does not want payment of the share
price on the 15th. In return for agreeing to postpone the receipt of money from
January 15th till 30th, the seller levies charges on the buyer. This charge is known as
a Badla. Essentially Badla is a form of interest on the postponed payment to be made
by A. Suppose; the prevailing Badla rate is 4 percent per month. A, therefore pays the
seller Rs. 2 per share being the Badla charge for half a month. In this example, it is
assumed that there is no change in the prices of shares on the settlement date. Under
the Badla system if the share has appreciated, the seller has to pay the buyer the
amount of appreciation. Of course he would separately receive from the buyer the
Badla charge.
2.6.1 The history of Badla
 The Joint Parliamentary Committee on Irregularities in Securities and Banking
Transactions, 1992 (JPC of 1992) discussed the irregularities of badla.
 SEBI issued a directive in December 1993 prohibiting the carry forward of
transactions.
 However it was recommended by the G.S PATEL COMMITTIE in the year
1995 and the carry forward transaction in the security market were permitted
 It was further modified by the J.R VARMA COMMITTIE in the year 1997
a daily margin of 10 % was to be paid 50 % of which was to be paid in
advance forward trading limit was fixed for 20 crores
 The NSE introduced futures contracts on the Nifty in the year 2000
 Finally badla was banned in the year 2000-01.

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2.7 Risk Management Techniques by using Derivatives Market

With proper planning and management, derivatives can be seen as a valuable tool for
hedging or reducing existing exposure, as financial risks like Currency, Interest Rate,
Default/Credit Risk can be minimized by the help of derivatives. For doing this, it is
essential to identify business risks accurately and to use the right control techniques,
because derivative products can be used as insurances policies by paying premium.
An Individual/Corporate may think that they can reduce their risk, but in case of event
specific risk and unsystematic risk it‟s not the same thing. Event specific risks can
only be managed by buying insurance & unsystematic risks can be managed by
diversification.
Major Financials Risks and Possible Way outs through Derivatives
Foreign Exchange/Currency Risk
Commodity Price Risk
Interest Rate Risk
Credit Risk/default Risk
Managing Foreign Exchange/Currency Risk
Foreign exchange is the market, where money in one currency is exchanged for
another currency. Companies dealing in other than domestic currencies face risks of
currency fluctuation, the risks of variation in the exchange rates can be managed by
instrument like forward, futures, option & swap. With the help of an example we will
see how companies can manage their Currency by taking position in derivates
instrument.
For example ABC Steel Ltd, a Kolkata based Aluminum Manufacture Company
imports 60% of its total steel from USA. During the year, ABC Steel Ltd. expecting to
Imports 10MTeach priced at 2000 USD. Here, our constant assumption is that ABC
Steel Ltd import 20000 USD worth of Aluminum on credit.
To minimize the effects of any USD/INR exchange rates, ABC Steel Ltd.can purchase
foreign exchange forward contracts, Future contracts, Option or can enter into swaps
against the USD/INR exchange rate. In the instant case the best option for ABC Steel
Ltd is to buy the call option, by doing this ABC Steel Ltd. can minimize the risk of
upwards movement of USD & the positive part of it is that if in near-term future rupee
will appreciate, then the decreased import prices will not offset by losses on the
derivatives contracts, because here the maximum loss will be the premium of the call.

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While buying the option, one thing which is most important is comparing the cost of
hedging against the future or forward contract, because buying option is always
costlier than future/forward contacts.
Yet another option with ABC Steels Ltd. could be to enter into a swap arrangement.
Managing Commodity Price Risk
By Commodity risk we understand the uncertainties of future market values, caused
by the fluctuation in the prices of commodities. Eg. For Airline companies-
fluctuation in the prices of fuel is major concern. This type of commodity risk can be
managed through various derivatives products.
If the Company is planning to hedge with the option then commodity buyer can buy
call option & to minimize the cost selling, put option will be good strategy .Apart
from it, Commodity seller can also follow the same by entering into the reverse
position e.g. by buying put & selling call.

Managing Interest Rate Risk


Volatility in the Interest Rate Risk always affects the cash flow & probability of the
Company. Interest fluctuation not only affects Corporate but also an Individual as
well. Hike in the interest rate directly affects the EMI.
Covering the risk of changing interest rates can be done through various products of
derivatives like Forward Rate Agreements (FRA) & Interest Rate
Future/Option/Swaps. Brief Introduction ofall the interest rate products are explained
below:
Forward Rate Agreements: -FRA is a contract to lend or borrow fund in future for a
specified maturity at interest rate fixed now. Buy entering into FRA borrower covers
risks of rising interest rate while the lenders cover him from the falling interest rates.
Interest Rate Future: - T-bills are the instrument which are used to hedge basically the
short term Interest rate risk& to cover the long term interest rates we use future on
treasury bonds, buying a T-bills/T-bonds is advisable if you are expecting the Interest rate
to fall & selling a Tbills/ bonds future is always beneficial if Interest rate is expected to
rise.
Interest Rate Option: - Interest Rate options are known as Caps, Floors & collars.
Interest Rate Cap: Put a cap on the maximum interest rate the floating rate
borrower will have to pay in the event of increase in interest rates, by buying the
Interest Rate Cap the borrowing company ensure himself from rising interest

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rate, because in caps the counter party (Normally bank/Finance Company)


compensate if the interest rate rise from the specific level.
Interest rate floor: Specifies the minimum interest rate the floating rate lender
will receive in the event of decrease in interest rates. Lender buys the floor to
ensure a minimum interest rate
Collar: It is a kind of derivatives product which is used for reducing the cost of
hedging, so it is nothing but the combination where one option is bought &
another sold, for e.g lender would always buy cap to ensure minimum return.
The use of products mentioned differs from company to company & Corporate to
individuals, because different products being appropriate for different scenarios amount
For e.g. for short term purpose T-bills are good options and for long term Interest rate
hedging FRA and interest rate option are always preferred.

Raising Fund @Low Cost


Interest Rate Swaps:
Interest rate swap is a contract to exchange cash flow streams that might be associated
with some fixed income obligations. The most popular interest rate swaps are fixed-to-
floating swaps, under which cash flows of a fixed rate loan are exchanged for those of a
floating rate loan. Again by taking the example of ABC Ltd. Example, will try to
understand the plain vanilla interest rate swap contract:
ABC Steel Ltd. with AAA+ rating has loan income at rate of LIBOR + 3% but gives
fixed rate of interest on its deposits @ 4%.ABC Steel Ltd is concerned that LIBOR may
fall owing to the prevailing market conditions and intends to hedge its risk. On the other
hand, LSW Steel Group Company of ABC Steel Ltd. with BBB- rating has fixed loan
income at a rate of 5% but gives floating rate of interest @ LIBOR + 2%. In such a case,
ABC Steel Ltd and LSW Steel Ltd may enter into swap arrangement and exchange their
respective interest obligations.

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CHAPTER 3.

REVIEW OF LITERATURE

3.1 Development of Financial Derivatives Market in India- A Case Study.


By :- Ashutosh Vashishtha & Satish Kumar

3.2 Role and Growth of Financial Derivative in the Indian Capital Market.
By :- Dr. Himanshu Barot & Dr. Nilesh B. Gajjar

3.3 Derivative market in India: Prospects & Issues.


By :- Dr. Priyanka Saroha & Dr. S.K.S. Yadav

3.4 Development of Financial Derivatives Market in India and its Position in


Global Financial Crisis.
By :- Dr. Shree Bhagwat, Ritesh Omre & Deepak Chand

3.5 Trends of Capital Market in India.


By :- Jency S

3.6 Assessing the Expansion of Financial Derivatives in India.


By :- Pankaj Tiwari

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Review of Literature

Ashutosh Vashishtha & Satish Kumar, examines that derivative turnover has grown
from 2365 crores in 2000-01 to Rs11010482 crores, within a short span of eight years
derivative trading in India has surpassedcash segment in terms of volume and
turnovers.

Dr. Himanshu Barot & Dr. Nilesh B. Gajjar, examines that derivative products serve
the extremely important economic functions of price discovery as well as risk
management. The analysis done in research paper, 25.58%, 9% and 33.35% of
compounding annual growth in terms of institutional investors, retail investors and
proprietary investors respectively, which indicates that proprietary investors are
participating more in equity derivatives market followed by institutional and retail
investors. However, in proprietary and institutional investors‟ percentage share in
total turnover increased whereas in retail investors it decreased.

Dr. Priyanka Saroha & Dr. S.K.S. Yadav, examines that derivatives help in efficient
capital allocation in the economy; at the same time their misuse also poses a threat to
the stability of the financial sector and the overall economy. Also this paper presents
accounts of the major developments in the Indian commodity, exchange rate and
financial derivatives markets, and outlines the regulatory provisions that have been
introduced to minimize misuse of derivatives.

Shree Bhagwat, Ritesh Omre & Deepak Chand, have presented that the Launch of
equity derivatives in Indian market has been extremely encouraging and successful. It
has surpassed the growth of its counterpart globally. Research sates that global
financial crisis has proved to be a structural break in the financial derivative segment
of NSE & BSE through turnover structure. Also shift in investor‟s obsession from
Single Stock Futures contracts to Index Option contracts

Jency S, has studied the rising trends in Indian financial market. Also states that
innovation and reforms have added value to technology, system & reduced cost of
capital. The change in operational and systematic risk management parameters,
settlement system, disclosures, accounting standards are studied along with their
parity with global standards.

Pankaj Tiwari, attempts to deals with the concept, definition, appearance and types of
banking derivatives initially. After that he, have displayed heat of advancement of

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derivative market, adjustment & action development of market. At last he has


discusses cachet of all-around derivatives bazaar adverse Indian derivatives market.

3.1 Development of Financial Derivatives Market in India- A Case Study.


By: - Ashutosh Vashishtha & Satish Kumar

Innovation of derivatives have redefined and revolutionized the landscape of financial


industry across the world and derivatives have earned a well deserved and extremely
significant place among all the financial products. Derivatives are risk management
tool that help in effective management of risk by various stakeholders. Derivatives
provide an opportunity to transfer risk, from the one who wish to avoid it; to one, who
wish to accept it. India‟s experience with the launch of equity derivatives market has
been extremely encouraging and successful. The derivatives turnover on the NSE has
surpassed the equity market turnover. Significantly, its growth in the recent years has
surpassed the growth of its counterpart globally.

The turnover of derivatives on the NSE increased in 2007-08. India is one of the most
successful developing countries in terms of a vibrant market for exchange-traded
derivatives. This reiterates the strengths of the modern development of India‟s
securities markets, which are based on nationwide market access, anonymous safe and
secure electronic trading, and a predominantly retail market.

3.2 Role and Growth of Financial Derivative in the Indian Capital


Market.
By: - Dr. Himanshu Barot & Dr. Nilesh B. Gajjar

Derivatives products serve the extremely important economic functions of price


discovery as well as risk management. The transparency, which emerges from their
trading mechanism, ensures the price discovery in the underlying market. Further,
they serve as risk management tools by facilitating the trading of risks among the
market participants.

The analysis done in research paper, 25.58%, 9% and 33.35% of compounding annual
growth in terms of institutional investors, retail investors and proprietary investors
respectively, which indicates that proprietary investors are participating more in
equity derivatives market followed by institutional and retail investors. However, in

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proprietary and institutional investors‟ percentage share in total turnover increased


whereas in retail investors it decreased. But as a logical step to the derivatives
segment progress in the Indian capital market, this segment presents wide opportunity
to the investors to get better return with hedge the portfolio and equipped to become a
dominant player in the market.

3.3 Derivative market in India: Prospects & Issues.

By: - Dr. Priyanka Saroha & Dr. S.K.S. Yadav

Derivatives products provide certain important economic benefits such as risk


management or redistribution of risk away from risk-averse investors towards those
more willing and able to bear risk. Derivatives also help price discovery, i.e. the
process of determining the price level for any asset based on supply and demand.
These functions of derivatives help in efficient capital allocation in the economy.

This paper presents accounts of the major developments in the Indian commodity,
exchange rate and financial derivatives markets, and outlines the regulatory
provisions that have been introduced to minimize misuse of derivatives. In the mid-
1990s India started reviving the exchange traded commodity derivatives market and
introduced a variety of instruments in the foreign exchange derivatives market, while
exchange traded financial derivatives were introduced in 2001.

Overall it was found from the research paper that in the early years of the equity
derivatives market there was a degree of concentration in the market and consequent
lack of width and depth across segments.

3.4 Development of Financial Derivatives Market in India and its


Position in Global Financial Crisis.
By: - Dr. Shree Bhagwat, Ritesh Omre & Deepak Chand

Financial derivatives have earned a well deserved and extremely significant place
among all the financial instruments (products), due to innovation and revolutionized
the landscape. Derivatives are tool for managing risk. Derivatives provide an
opportunity to transfer risk from one to another. Launch of equity derivatives in

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Indian market has been extremely encouraging and successful. The growth of
derivatives in the recent years has surpassed the growth of its counterpart globally.
The equity derivatives market is playing a major role in shaping price discovery.
Volatility in financial asset price, integration of financial market internationally,
sophisticated risk management tools, innovations in financial engineering and choices
at risk management strategies have been driving the growth of financial derivatives
worldwide, also in India. From paper we can say there is big significance and
contribution of derivatives to financial system. The global financial crisis has proved
to be a structural break in the financial derivative segment of NSE & BSE. As has
been reflected by the analysis, the turnover structure of NSE & BSE of India, the
exchange with dominating position in India, has shown that the derivatives trading
has been a substantial & significant component of Indian stock market. Within this
segment, the investors have been spotted with their obsession with Single Stock
Futures contracts in the pre global financial crisis period. This obsession has now
been altered in the post-crisis period.
However, the obsession is now with the Index Option contracts. However, with such
preference for Index based derivative products, studies focusing on the interaction of
derivatives trading with spot market on aspects of lead-lag relationship, impact on
liquidity, transfer of trading, etc. can now be justified to come up with robust
conclusions. Such studies have been inconclusive so far in Indian contexts.
Nevertheless, such a skewed preference is not desirable situation for an emerging
economy like India. Reasonable mix of the derivative products should provide a better
alternative to the investors by supplementing the avenues for investment and risk
management with the growing maturity of India‟s derivatives market.

3.5 Trends of Capital Market in India.


By: - Jency S

India being an emerging economy needs innovations and reforms in the financial
market. Innovation and reforms not only add value in the existing technology and
system but also lead to decrease in the cost of capital and mitigate the risk exposure of
the capital market instruments. There has been a revolutionary change over a period
of time. In fact, on almost all the operational and systematic risk management
parameters, settlement system, disclosures, accounting standards, the Indian Capital

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Market is at par with the global standards. The goal of SEBI is to make market
competitive, transparent and efficient. A 96 perception is steadily growing about the
Indian Capital Market, as a dynamic market, among the International community.

3.6 Assessing the Expansion of Financial Derivatives in India.


By :- Pankaj Tiwari

Innovation of derivatives acquire redefined and revolutionized the mural of banking


industry beyond the apple and derivatives acquire becoming a able-bodied adapted
and acutely cogent abode a part of all the banking products. Derivatives are accident
administration apparatus that advice in able administration of accident by assorted
stakeholders. Derivatives accommodate an befalling to alteration risk, from the one
who ambition to abstain it; to one, who ambition to acquire it. India‟s acquaintance
with the barrage of disinterestedness derivatives bazaar has been acutely auspicious
and successful. The derivatives about-face on the NSE has surpassed the
disinterestedness bazaar turnover. Significantly, its advance in the contempt years has
surpassed the advance of its analogue globally.

India is one of the lots of acknowledged developing countries in agreement of a active


bazaar for exchange-traded derivatives. This reiterates the strengths of the avant-garde
development of India‟s balance markets, which are based on civic bazaar access,
bearding safe and defended cyber banking trading, and a predominantly retail market.
There is an accretion faculty that the disinterestedness derivatives bazaar is arena a
above role in abstraction amount discovery. Factors like added animation in banking
asset prices; growing affiliation of civic banking markets with all-embracing markets;
development of added adult accident administration tools; added choices of accident
administration strategies to bread-and-butter agents and innovations in banking
engineering, acquire been active the advance of banking derivatives common and
acquire as well fuelled the advance of derivatives here, in India. There is no bigger
way to highlight the acceptation and addition of derivatives but the comments of the
longest confined Governor of Federal Reserve, Alan Greenspan: “Although the
allowances and costs of derivatives abide the accountable of active debate, the
achievement of the abridgement and the banking arrangement in contempt years
suggests that those allowances acquire materially exceeded the costs."

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CHAPTER 4.

RESEARCH METHODOLOGY

4.1 Purpose of Study

4.2 Objectives

4.3 Hypothesis of The Study

4.3 Methodology

4.4 Scope

4.5 Tools
4.5.1 Primary Data

4.5.2 Secondary Data

4.5.3 Design of Questionnaire

4.5.4 Limitation of the study

4.6 Collection of Primary Data

4.7 Collection of Secondary Data

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4.1 Purpose of Study

Since a considerable time has passed (since year 2000) after the introduction of the
derivative instruments in Indian financial system, this study attempts to know the
different types of derivatives and also to know the derivative market in India. This
study also covers the recent developments in the derivative market taking into account
the trading in past years. Through this study I came to know the trading done in
derivatives and their use in the stock markets.

4.2 Objectives

To know different types of Derivatives instruments.


To analyse the performance of Derivatives Trading since 2001with special
reference to Futures & Options
(a) In terms of Turnover
(b) In terms of Traded Quantity
(c) In terms of No of Contracts Traded
To know the investors perception towards investment in Derivative Market.

4.3 Hypothesis of the Study

H0: Income and investment in derivative instruments are not related.


H1: Income and investment in derivative instruments are related.

H0: Age and purpose of Investing in Derivative market are not related.
H1: Age and purpose of Investing in Derivative market are related.

H0: Risk taking Strategy and Rate of Return are no related.


H1: Risk taking Strategy and Rate of Return are related.

4.4 Methodology

The primary sources of collection of the data would be from general investors
(students, individuals working in financial market, professionals, Business
Individual).
The research would include primarily the study of existing different type of
derivative product, history of derivatives in India & Development of
derivative market.

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Study the pace at which the trading in different contract‟s increased whit
statistical data present at NSE, BSE & SEBI website.
Studying the investor‟s perception towards derivatives trading & Derivative
market.
Descriptive and Exploratory research methods are used to gather and analyze
data. Exploratory research would rely on collection of data through secondary
research such as reviewing available literature and/or data, or qualitative
approaches such as informal discussions with respondents (here brokers,
investors & professionals) Internet research methods like posting of
questionnaire through Google support would be used to reach respondent. The
results of exploratory research would provide significant insight into a given
situation or concept.

4.5 Scope

The research would involve study of how derivatives market evolved and its
growth from inception.
The research would include study of Investor perception towards derivative
market and their thoughts.

4.6 Tools

The information for the research would be collected through following modes:

4.6.1 Primary Data

Primary data was collected through a structured questionnaire. The


Questionnaire was distributed through online tool using Google
Forms.

4.6.2 Secondary Data

Written Material on Derivatives available in Books, on Internet and


Research Papers.
Statistical Data of derivative trading available on NSE, BSE & SEBI
website.

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4.6.3 Design of Questionnaire

Questionnaires were designed to seek responses from the different investor/trader


in the derivative market. It is attached as annexure.

4.6.4 Limitation of the study

The time available to conduct the study was only 2 months. Being a wide topic
I had a limited time.
The primary data has been collected through a structured questionnaire to a
sample of ~100 investors, which may not reflect the opinion of the entire
population.

4.6.5 Measurement Techniques Used

CHI SQUARE test is used for testing the Hypothesis

4.7 Collection of Primary Data

Primary data was collected through a structured questionnaire. The questionnaire was
circulated to the Graduate and Post Graduation students, Market Players (trader‟s),
Investors, Businessman‟s, Professional. It includes combination of selective and
scaled questions. It also includes combination of open ended questions. Likret Scale
was used to collect responses from the respondents.

4.8 Collection of Secondary Data

Secondary data was collected through journals of NSE (Market Plus, Indian
Securities Market A Review).
Also book on topic for Derivative markets to understand different concept of
derivates.
Also statistical data was collected form NSE, BSE, SEBI, RBI & NSDL
website.
Modules provided by NSE are used in order to understand the derivatives
products in details along with back end process.

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CHAPTER 5.

DATA ANALYSIS, INTERPRETATION AND PRESENTATION

5.1 Analyzing Growth of Derivative Market through Secondary Data.

5.2 Analyzing Investor’s views towards Derivatives Products through Primary Data.

5.3 Hypothesis Testing

5.3.1 Comparing Income and Investment in Derivative market

5.3.2 Comparing Age and purpose of Investing in Derivative market

5.3.3 Comparing Risk taking Strategy and Rate of Return

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5.1 Analyzing Growth of Derivative Market through Secondary Data.

5.1.1 Chart showing comparison of Derivatives Contract Traded and Equity Traded
in BSE
25,000.00

20,000.00

15,000.00

10,000.00

5,000.00

0.00

Total Derivative Contracts Traded (in lakh) Equity Traded Qty.(Cr.)

5.1.2 Chart showing comparison of Derivatives Turnover and Equity Turnover in


BSE

2,000,000.00
1,500,000.00
1,000,000.00
500,000.00
0.00

Total Derivative Turnover in (Rs.Ten Thousand)


Total Equity Turnover in (Rs.Ten Thousand)

The above charts represent the Turnover & Contracts traded at BSE exchange. From
the chart we are able to see that there is high increase in the volume of the contract
traded in exchange from 1.43Lakh in 2003-04 to 4300.58 Lakh in 2017-18(till
November 23rd). Also there was a new high where 8,166.88 Lakh contracts were
traded in year 2014-15and saw an increase of 139%. The amount of turnover is also
increased by 13% averagely.

The above Chart represent that there is steady increase in Volume and contracts
traded at BSE exchange.

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5.1.3 Chart showing comparison of Derivatives Contract Traded and Equity Traded
in NSE

30,000.00
25,000.00
20,000.00
15,000.00
10,000.00
5,000.00
0.00

No. of Traded Quantity (00s) No. of Contracts Traded

5.1.2 Chart showing comparison of Derivatives Turnover and Equity Turnover in


NSE
1,200.00
1,000.00
800.00
600.00
400.00
200.00
0.00

DerivativeTurnover (Rs. Trillion.) EquityTurnover (Rs. Trillion.)

The above charts represent the Turnover & Contracts traded at NSE exchange. From
the chart we are able to see that there is high increase in the volume of the contract
traded in exchange from 90580 in 2000-01 to 163.39 crore in 2017-18(till November
23rd). Also there was a new high where 277.22 crore contracts were traded in year
2015-16 and saw an increase of 19.61%YoY. The amount of turnover is also
increased by 319% averagely, as there is a steep rise in turnover from year 2008-09.

The above Chart represent that there is steady increase in Volume and contracts
traded at NSE exchange with tremendous growth in trading.

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5.2 Analyzing Investor’s views towards Derivatives Products through Primary


Data.

This part includes the study of the responses received for the questioner circulated
among the respondent. It gives a view on the responses received from the
respondent‟s (sample of the population) about their perception on Derivative Market.

1. Gender Participation in Research Data Collection.

Gender Frequency Percent


Female 09 7.76%
Male 107 92.24%
Grand Total 116 100.00%

Female
8%

Male
92%

Interpretation: From the questionnaire it is observed that 92% of the respondents are
Male and 8% of them are Female.

2. Occupation of the respondents

Occupation Frequency Percent


Business 19 16.38%
Professional 17 14.66%
Salaried 69 59.48%
Student 11 9.48%
Grand Total 116 100.00%

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Student Business
9% 16%

Professional
15%

Salaried
60%

Interpretation: From the above chart it is clear that majority of the respondents are
Salaried employee with a weight age of 60% , Next are Businessman with a total of
16% and Professionals being 15% and Students 9%.

3. Annual Income of the respondents

Income Slab Frequency Percent


Upto Rs. 1 lac 15 12.93%
Rs. 1 lacs to Rs. 5 lacs 33 28.45%
Rs. 5 lacs to Rs. 10 lacs 30 25.86%
Rs. 10 lacs Rs. 15 lacs 13 11.21%
Rs. 15 lacs Rs. 25 lacs 13 11.21%
Above Rs. 25 lacs 12 10.34%
Grand Total 116 100.00%
Upto Rs. 1 lac

Rs. 1 lacs to Rs. 5


10% 13% lacs
11%
Rs. 5 lacs to Rs. 10
11% 29% lacs
Rs. 10 lacs Rs. 15
lacs
26% Rs. 15 lacs Rs. 25
lacs
Above Rs. 25 lacs

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Interpretation: 13% of the respondents have annual income of up to Rs.1 Lacs, were
as respondents having income above from l lacs to 5 lacs are 29%, between 5 lacs to
10 Lac are 26%, between 10 lacs to 15 Lac & between 15 lacs to 25 Lac are 11% each
& Above 25 Lacs are 10%.
It states that majority of respondent income is between Rs.1 lacs to Rs.10 lacs
accounting to 54% to total population.

4. Respondent’s Preferred period of investment

Term Frequency Percent


Long Term (More than 5 years) 48 41.38%
Medium Term ( 1-5 years) 52 44.83%
Short Term (Less than 1 year) 16 13.79%
Grand Total 116 100.00%
Long Term (More than 5 years) Medium Term ( 1-5 years)
Short Term (Less than 1 year)

14%
41%

45%

Interpretation: 45% of the respondents have Medium Term (1 year to 5 year)


preference of period of investment, where 41% of the respondents have Long Term
(More than 5 year) preference of period of investment & only 14% prefer Short term
that is less than 1 year.
This denotes that respondents prefer investing their money for more than 1 year.

5. Respondent of Total sample invest in Derivative Markets

Frequency Percent
Yes 43 37.07%
Do not invest due to lack of knowledge of derivatives 28 24.14%
Do not invest since I consider investing in derivatives is risky 45 38.79%
Grand Total 116 100.00%

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Yes
Do not invest due to lack of knowledge of derivatives
Do not invest since I consider investing in derivatives is risky

No
37% 63% 24%
39%

Interpretation: The above chart represents the total percentage of sample who invests
in derivative market. From the sample 37% respondent invest in derivative market,
Where 63% do not. From 63% of respondent 24% do not invest in derivatives because
of lack of knowledge & others 39% do not because they find derivative risky.

6. Age of the respondents Trading in Derivative Markets

Age Frequency Percent


18 - 25 Years 13 30.23%
26 - 35 Years 15 34.88%
36 - 45 Years 7 16.28%
45 - 60 Years 8 18.60%
Above 60 Years 0 0.0%
Grand Total 43 100.00%

45 - 60 Years Above 60 Years


19% 0%
18 - 25 Years
36 - 45 Years 30%
16%

26 - 35 Years
35%

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Interpretation: 30.23% of the respondents fall under the age category of 18–25 years,
34.88% of them fall under 26-35 years were as 16.28% of the respondents are
between the age category of 36-45 years and 18.60% of the respondents are Between
the age group of 45 – 60 years.

This shows that the participation of young people ageing between 18 to 35 years is
highest and makes up 65.12% of the total population investing in Derivatives.

7. Respondents preferred Risk Taking strategy in Derivative market

Pattern Frequency Percent


High Risk 5 11.63%
Low Risk 5 11.63%
Moderate Risk 33 76.74%
Grand Total 43 100.00%

High Risk
11%
Low Risk
12%

Moderate Risk
77%

Interpretation: 77% of the respondent who invest in derivative approach for Moderate
risk taking strategy. Whereas 11% & 12 % of respondent approach for High risk and
Low risk respectively.

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8. Risk which is of most concern in the equity derivative market to


respondents.

Risk Frequency Percent


Behavioral 1 2.33%
Legal Risk 1 2.33%
Liquidity Risk 2 4.65%
Market Risk/Price risk/Potential Loss Risk 31 72.09%
Settlement risk 1 2.33%
Systematic risk 7 16.28%
Grand Total 43 100.00%

3% 2% Behavioral

16% 5%
2% Legal Risk

Liquidity Risk

Market Risk/Price
72% risk/Potential Loss Risk
Settlement risk

Systematic risk

Interpretation: 72% of the respondents who invest in derivative find Market Risk as
concerning. 16% of the respondent who invest in derivative find Systematic Risk
concerning. Other risk account for 12 % which concern respondents who invest in
derivative market.

9. Participation in different type of Derivative instrument

Instrument Frequency Percent


Equity 42 98%
Currency 4 9%
Commodity 4 9%

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45 42
40

35

30
Equity
25
Currency
20
Commodity
15

10
4 4
5

Interpretation: 42 of the respondents invest in Equity Derivative instrument, 4


respondents in Currency Derivative instrument & Commodity Derivative instrument
each.

98% of total respondent who invest in derivative market invest in Equity Derivative
instrument. And 9% of total respondent who invest in derivative market invest in
Currency Derivative instrument & Commodity Derivative instrument each.

The numbers of investor are high in equity derivative as they are more famous and
less complex than currency and commodity.

10. Respondent preference to the type product in Equity Derivatives.

Product Frequency Percent


Currency forwards 1 2.33%
Index Futures 19 44.19%
Index Options 28 65.12%
Stock Futures 19 44.19%
Stock Options 22 51.16%

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22

19
Stock Options
Stock Futures
28
Index Options

19 Index Futures
Currency forwards
1

0 5 10 15 20 25 30

Interpretation: Among 43 respondents who invest in derivatives 1 respondent invest in


Currency Forwards Contracts, 22 respondents invest in Stock Option Contracts, 19
respondents invest in Stock Future Contracts, 28 respondents invest in Index Option
Contracts, 19 respondents invest in Index Future Contracts.

The most famous products where investors invest are Index Option Contracts, Stock
Option Contracts, Index Future Contracts & Stock Future Contracts.

11. What periodicity of contracts do respondent normally prefer to invest.

Contract Tenure Frequency Percent


Contracts expiring in 1 Month 36 83.72%
Contracts expiring in 2 & 3 Month 14 32.56%
Contracts expiring in 3 to 6 Month 4 9.30%
Contracts expiring in 6 to 12 Month 1 2.33%
Contracts expiring after 12 Month 0 0.00%

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Contracts expiring after 12


Month
1 Contracts expiring in 6 to 12
Month
4 Contracts expiring in 3 to 6
Month
14
Contracts expiring in 2 & 3
36 Month
Contracts expiring in 1 Month
0 10 20 30 40

Interpretation: The most famous contract among investors is that expiring in 1 month.
From the above chart its states that investor does not prefer investing in contracts
more than 6 moths.

12. Derivative Trading has resulted in exposure to high risk.

Frequency Percent
Agree 17 39.53%
Disagree 5 11.63%
Neutral 13 30.23%
Strongly agree 7 16.28%
Strongly disagree 1 2.33%

Strongly agree Agree Neutral Disagree Strongly disagree

7 17 13 5 1

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Interpretation: 24 respondents have agreed that Derivative Trading has resulted in


exposure to high risk, where 13 have neutral view about it, and 6 have disagreed to it.

So it can be understood that as per chart that Derivative Trading has resulted in
exposure to high risk.

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13. Characterizing respondent trading activity in the equity derivatives


segment.

Trading Activity Frequency Percent


Arbitrage 3 6.98%
Hedging 11 25.58%
Speculation 28 65.12%
Strategy Trading 1 2.33%

Arbitrage Hedging Speculation Strategy Trading


2%
7%
26%

65%

Interpretation: 65.00% (28 respondents) are using derivative for speculative purpose
where as 25.58% (11 respondents) are using it for hedging purpose.

This makes sure that the derivatives products are used for speculative or hedging
purpose, where arbitraging is done at relatively low level.

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14. Respondent views on factors which may lead to financial crisis

Factor Frequency Percent


Introduction of Exotic and complex derivatives products 9 21%
Lack of regulation in Derivative Markets. 12 28%
Lack of regulation in Cash Market 5 12%
Greed 14 33%
Improper use of derivative instruments 17 40%
Inadequate understanding on the Use of derivative
21 49%
instruments
Human Nature 13 30%
Lack of regulation in OTC derivatives market 12 28%
All of the above 2 5%

All of the above


2
Lack of regulation in OTC
12 derivatives market

Human Nature
13

21 Inadequate understanding on
the Use of derivative
instruments
17 Improper use of derivative
instruments
14 Greed

5
Lack of regulation in Cash
Market
12
Lack of regulation in
Derivative Markets.
9
Introduction of Exotic and
0 5 10 15 20 25 complex derivatives products

Interpretation: Inadequate understanding on the Use of derivative instruments is the


factor that investor think that can led to financial cries. Improper use of derivative
instruments & Greed are the other factors that investors think can led to financial
crises.

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15. Respondents view about the growth of the trading in Derivatives Segment
in India since its start in 2000.

View Frequency Percent


Grew at very fast pace 68 58.62%
Growth was moderate 39 33.62%
Growth was slow 7 6.03%
Did not grow much. 2 1.72%

Grew at very fast pace Growth was moderate Growth was slow Did not grow much.
2%
6%

34%
58%

Interpretation: The 68 respondents (58.62%) view is that the trading in derivative


segment has grown at vary fast pace. Where 39 respondents (33.62%) view is that the
trading in derivative segment has grown at moderate pace. Where 9 respondents states
that it have grown slow.

16. Respondent’s views which factors will help to regulate the derivatives
market efficiently?

Factor Frequency Percent


High Margins 27 23.28%
Maintenance of High Net worth by brokers/ traders 7 6.03%
Periodic Audits and Reporting 31 26.72%
Adequate awareness generation of dynamics of derivative trading 39 33.62%
Monitoring of high volume/ value trades 29 25.00%
Monitoring Speculative tendencies 28 24.14%
Ensuring basic compliance for competent Market Participants 27 23.28%
Periodic Training to Market Participants 27 23.28%
All of the above 38 32.76%

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All of the above


38
Periodic Training to Market
27 Participants
Ensuring basic compliance for
27 competent Market Participants

28 Monitoring Speculative
tendencies
29 Monitoring of high volume/
value trades
39 Adequate awareness
generation of dynamics of
31 derivative trading
Periodic Audits and Reporting

7
Maintenance of High Net
worth by brokers/ traders
27
High Margins
0 10 20 30 40 50

Interpretation: The 38 respondents have selected all of the above option that means
investors above factor (given in chart) are needed to regulate the derivative market
efficiently. Adequate awareness generation of dynamics of derivative trading is the
other factor where the investing that this can help to minimize any regulatory breech.

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5.3 Hypothesis Testing

5.3.1 Comparing Income and Investment in Derivative market.

H0: Income and investment in derivative instruments are not related.


H1: Income and investment in derivative instruments are related.

Annual Income of Respondent * Type of product in Equity Derivatives


respondent invest.

Type of product in Equity Derivatives respondent invests.


COUNT
Currency Index Index Stock Stock
forwards Futures Options Futures Options Total

Upto
0 10 0 2 1 13
Rs. 1 lac
Rs. 1 lac
to Rs. 5 0 13 5 1 1 20
lacs
Rs. 5 lac
to Rs. 0 15 7 2 1 25
10 lacs
Annual
Income of Rs. 1 lac
to Rs. 1 0 4 2 0 7
Respondent
15 lacs
Rs. 15
lac to
0 15 0 1 1 17
Rs. 25
lacs
Above
Rs. 25 0 4 1 0 2 7
lacs

1 57 17 8 6 89
Total

Chi-square: 41.321

degrees of freedom: 20

p-value: 0.00338716

The value of chi-squared statistic is 41.321. The chi-squared statistic has 10 degree of
freedom. The p value (.003) is less than 0.05. Hence there is significant relationship
between income and investment in different type of derivative instruments.

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5.3.2 Comparing Age and purpose of Investing in Derivative market

H0: Age and purpose of Investing in Derivative market are not related.
H1: Age and purpose of Investing in Derivative market are related.

Age of Respondent * Purpose of Investing in Derivative market

Purpose of Investing in Derivative market


Count Grand
Arbitrage Hedging Speculation Strategy
Total
18 - 25
2 5 6 0 13
Years
26 - 35
0 2 13 0 15
Age of Years
Respondent 36 - 45
0 2 5 0 7
Years
45 - 60
1 2 4 1 8
Years
Grand Total 3 11 28 1 43

Chi-square: 11.436

degrees of freedom: 9

p-value: 0.247

The value of chi-squared statistic is 11.436. The chi-squared statistic has 9 degree of
freedom. The p value (.247) is more than 0.05. Hence there is not a significant
relationship between age and purpose of Investing in Derivative market.

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5.3.3 Comparing Risk taking Strategy and Rate of Return

H0: Risk taking Strategy and Rate of Return are no related.


H1: Risk taking Strategy and Rate of Return are related.

Risk taking Strategy * Rate of Returns

Respondents preferred Risk Taking strategy in


Derivative market
Count
High Low Grand
Moderate Risk
Risk Risk Total
Less than 12% 0 1 2 3
Rate of 12% - 24% 2 1 26 29
Return 24% - 36% 1 2 3 6
36% & above 2 1 2 5
Grand Total 5 5 33 43

Chi-square: 12.225

degrees of freedom: 6

p-value: 0.057

The value of chi-squared statistic is 12.225. The chi-squared statistic has 6 degree of
freedom. The p value (0.057) is more than 0.05. Hence there is marginal significant
relationship between Rate of Return and Preferred risk taking strategy in Derivative
market.

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CHAPTER 6.

FINDINGS & RECOMMENDATIONS

Finding for Growth of Derivative Market in India


There is substantial growth in the turnover and contract traded in NSE and
BSE, which represent the tremendous growth in Derivative trading in India.
Also the view of respondent is that the derivative market have grown at fast
pace from year 2003.
Finding for Investors Perception on Derivative Market in India
92.24% of the respondents are Male and 7.76% of them are Female.
54% of respondent fall under age group of 18-35.
37% respondent invests in derivative market, Where 63% do not. From 63%
of respondent 24% do not invest in derivatives because of lack of knowledge
& others 39% do not because they find derivative risky.
33% respondent investing in Derivative Market are from the age group of 26-
35 years & 31% from 18-25 years age group.
Investors prefer moderate risk taking strategy while investing in Derivatives.
Market Risk/Price risk/Potential Loss Risk concerns the investor most.
Investor prefers to invest in Equity & Index Contract, than commodity or
currency contracts.
Index Options are the preferred by investor in order to trade in Derivative
Markets following by Stocks Options.
Investors prefer contracts expiring in 1 month than going for far maturity date
contracts.
56% of respondents believe that Derivative Trading has resulted in exposure to
high risk.
Majority of Respondent‟s state‟s that they trade in derivatives for speculation
purpose.
Inadequate understanding on the Use of derivative instruments is the factor
that can lead to financial crises as per views of respondent.
Trading in Derivatives Segment in India since its start in 2000 has grown at
very fast pace as per 58% responses.

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Hypothesis test shown that there is relationship Income and Investment in


Derivative market, Risk taking Strategy and Rate of Return. Where as, there is
not a significant relationship between age and purpose of Investing in Derivative
market.
Recommendations
Knowledge needs to be spread concerning the risk and return of derivative
market.
Investors should have knowledge of technical analysis, especially 5 Day
moving averages as derivatives trading is for a short period of time Investors
should analysis their script with the help of 5 Day moving average before
making their trades.
Investors „portfolio should only consist of 15 – 20% Derivatives contracts or
scripts.
As derivatives trading is very risky investors should have only a small portion
of their portfolio consisting of derivatives.
SEBI should conduct seminars regarding the use of derivatives to educate
individual investors.
As FII play a prominent role in Derivatives trading, an individual investor
should keep himself updated with various economic trends, government
policies, company & industry announcements.

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CHAPTER 7.

ANNEXURE

Derivatives Market in India


Dear Respondent: I am Harsh Upadhyay perusing M.Com (Part II) at Narsee Monjee
College, under the guidance of Prof. Rishika Bhojwani, having title „Derivatives
market in India‟. I am conducting a survey to study viewpoint of respondent on
Derivatives market in India. Please help me by filling this questioner. This survey
includes some basic question about your investment perspective and investment
pattern in derivative market. This survey will not take more than 10 minutes of you
valuable time. Your responses will be kept confidential, & will be used only for an
academic research work purpose.

Regards,
Harsh Upadhyay
Email id:- Uharsh25@yahoo.com
* Required

Name of the Investor: ________________________

Gender *
Male
Female
Age *
18 - 25 Years
26 - 35 Years
36 - 45 Years
45 - 60 Years
Above 60 Years
Highest Education *
10th Std
12th std
Graduate
Post graduate
Doctorate
Other:
Please enter the Occupation details. *
Salaried
Professional
Business
Retired

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Other:
What is the Annual Income Range you will fall in. *
Upto Rs. 1 lac
Rs. 1,00,001 Rs. 5 lacs
Rs. 5,00,001 Rs. 10 lacs
Rs. 10,00,001 Rs. 15 lacs
Rs. 15,00,001 Rs. 25 lacs
Above Rs. 25 lacs
Preferred period of investment. *
Long Term (More than 5 years)
Medium Term ( 1-5 years)
Short Term (Less than 1 year)
Total Experience in Capital Market *
Less than 1 Year
More than 1 Year but less than 2 Years
More than 2 Years but less than 5 Years
More than 5 Years but less than 10 Years
More than 10 Years but less than 15 Years
More than 15 Years
Do you invest in Derivative Markets ? *
Yes
Do not invest since I consider investing in derivatives is risky
Do not invest due to lack of knowledge of derivatives
Indian Derivative Markets are efficiently regulated. *
Strongly disagree
Disagree
Neutral
Agree
Strongly agree
Your preferred Risk Taking strategy in Derivative market *
Low Risk
High Risk
Moderate Risk
Which risk is of most concern in the equity derivative market to you
today? *
Systematic risk
Market Risk/Price risk/Potential Loss Risk
Settlement risk
Credit Risk/Counterparty Default risk
Liquidity Risk
Operational Risk

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Legal Risk
Other:

State the expected rate of return (ROR) per annum. *


Less than 12%
12% - 24%
24% - 36%
36% & above
You invest in which Derivatives Markets *
Equity
Currency
Commodity
Other:
Please provide your preference to the type product in Equity Derivatives
*
Index Futures
Stock Futures
Index Options
Stock Options
Other:
What periodicity of contracts do you normally prefer to invest in? *
Contracts expiring in 1 Month
Contracts expiring in 2 & 3 Month
Contracts expiring in 3 to 6 Month
Contracts expiring in 6 to 12 Month
Contracts expiring after 12 Month
Derivative Trading has resulted in exposure to high risk. *
Strongly disagree
Disagree
Neutral
Agree
Strongly agree
Which of the following characterizes your trading activity in the equity
derivatives segment? *
Hedging
Speculation
Arbitrage
Other:
Derivative Instruments help in earning wealth. *
Strongly disagree
Disagree

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Neutral
Agree
Strongly agree
What could be the factors from the following which may lead to financial
crisis? *
Introduction of Exotic and complex derivatives products
Lack of regulation in Derivative Markets.
Lack of regulation in Cash Market
Greed
Improper use of derivative instruments
Inadequate understanding on the Use of derivative instruments
Human Nature
Lack of regulation in OTC derivatives market
All of the above
What do you think about the growth of the trading in Derivatives
Segment in India since its start in 2000 *
Grew at very fast pace
Growth was moderate
Growth was slow
Did not grow much.
Does derivatives’ trading throw up new threats to the financial system? *
Yes
No
Maybe
Which factors will help to regulate the derivatives market efficiently. *
High Margins
Maintenance of High Net worth by brokers/ traders
Periodic Audits and Reporting
Adequate awareness generation of dynamics of derivative trading
Monitoring of high volume/ value trades
Monitoring Speculative tendencies
Ensuring basic compliance for competent Market Participants
Periodic Training to Market Participants
All of the above
Other:

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CHAPTER 8.

BIBLIOGRAPHY

Websites
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.moneycontrol.com
www.rbi.org.in
Research Paper
Ashutosh Vashishtha and Satish Kumar “Development of Financial
Derivatives Market in India- A Case Study”
Dr. Himanshu Barot 'Role and Growth of Financial Derivative'
Dr. Priyanka Saroha 'Derivative market in India Prospects Issues'
Dr. Shree Bhagwat1, Ritesh Omre, Deepak Chand “Development-of-
Financial-Derivatives-Market-in-India-and-its-Position-in-Global-Financial-
Crisis”
Jency S 'Trends of Capital Market in India'
Pankaj Tiwari 'Assessing the Expansion of Financial'
Snehal Bandivadekar and Saurabh Ghosh “Derivatives and Volatility on
Indian Stock Markets”
Books & Reports
Market Plus (NSE monthly Report)
Indian Security Market A Review
Option Future and other Derivatives by John C Hull
Derivatives FAQ by Ajay Shah
NCFM Modules Currency Derivatives: A Beginner's Module.
NCFM Modules Equity Derivatives: A Beginner's Module.
Financial Markets & Services by Gordan & Natrajan.
“Investment Analysis and Portfolio Management”, Second Edition- Prasanna
Chandra
NSE Annual Report 2016.

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