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INTRODUCTION:

The only stock exchange operating in the 19th century were those

of Bombay set up in 1875 and Ahmadabad set up in 1894. These were

organized as voluntary non-profit-making association of brokers to

regulate and protect their interests. Before the control on securities

trading became a central subject under the constitution in 1950, it was a

state subject and the Bombay securities contracts (control) Act of 1925

used to regulate trading in securities. Under this Act, The Bombay stock

exchange was recognized in 1927 and Ahmadabad in 1937.

During the war boom, a number of stock exchanges were

organized even in Bombay, Ahmadabad and other centers, but they were

not recognized. Soon after it became a central subject, central legislation

was proposed and a committee headed by A.D.Gorwala went into the

bill for securities regulation. On the basis of the committee's

recommendations and public discussion, the securities contracts

(regulation) Act became law in 1956.

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SEBI Advisory Committee Derivatives
Report on
Development and Regulation of
Derivative Markets in India

1 Background
The SEBI Board in its meeting on June 24, 2002 considered some
important issues
Relating to the derivative markets including:
· Physical settlement of stock options and stock futures contracts.
· Review of the eligibility criteria of stocks on which derivative products
arepermitted.
· Use of sub-brokers in the derivative markets.
· Norms for use of derivatives by mutual funds
The recommendations of the Advisory Committee on Derivatives on
some of these issues
were also placed before the SEBI Board. The Board desired that these
issues be reconsidered by the Advisory Committee on Derivatives
(ACD) and requested a detailed report on the aforesaid issues for the
consideration of the Board. n the meantime, several other important
issues like the issue of minimum contract size,
the segregation of the cash and derivative segments of the exchange and
the surveillance
issues in the derivatives market were also placed before the ACD for its
consideration.
The Advisory Committee therefore decided to take this opportunity to
present a comprehensive report on the development and regulation of
derivative markets including a review of the recommendations of the L.
C. Gupta Committee (LCGC). Four years have elapsed since the LCGC
Report of March 1998. During this period there
have been several significant changes in the structure of the Indian
Capital Markets which include, dematerialization of shares, rolling
settlement on a T+3 basis, client level and Value at Risk (VaR) based
margining in both the derivative and cash markets and Proposed
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demutualization of Exchanges. Equity derivative markets have now been
in Existence for two years and the markets have grown in size and
diversity of products.
This therefore appears to be an appropriate time for a comprehensive
review of the Development and regulation of derivative markets.

2 Regulatory Objectives

The LCGC outlined the goals of regulation admirably well in Paragraph


3.1 of its report. We endorse these regulatory principles completely and
base our recommendations also on these same principles. We therefore
reproduce this paragraph of the LCGC Report:.2 “The Committee
believes that regulation should be designed to achieve specific, well-
defined goals. It is inclined towards positive regulation designed to
encourage healthy activity and behaviour. It has been guided by the
following objectives:

(a) Investor Protection: Attention needs to be given to the following four


aspects:

(i) Fairness and Transparency:


(ii) Safeguard for clients’ moneys:
(iii) Competent and honest service:
(iv) Market integrity:

(b) Quality of markets: The concept of “Quality of Markets” goes well


beyond market integrity and aims at enhancing important market
qualities, such as cost-efficiency, price-continuity, and price-discovery.
This is a much broader objective than market integrity.

(c) Innovation: While curbing any undesirable tendencies, the regulatory


framework should not stifle innovation which is the source of all
economic progress, more so because financial derivatives represent a
new rapidly
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Developing area, aided by advancements in information technology.”.

3 Derivative Products

3.1 Interest and Currency Futures

3.2 Single Stock Derivatives


3.2.1 Introduction of single stock Derivativ
3.2.2 Position limits
3.2.3 Margins

3.3 Eligibility Required

3.4 Contracts on New Indices

3.5 Minimum Contract Size

3.6 Adjustment for Corporate Actions

4 Risk Containment

4.1 VaR Framework

4.2 Cross Margining: Basic Principles

4.3 Cross Margining between single stock derivative and the underlying

4.4 Cross margining between index futures and a basket of constituent


stocks
4.4.1 Eligibility Condition for Cross Margining with Basket

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4.4.2 Margin offset between index futures and replica
portfolio
4.4.3 Margin on total deviation portfolio
.
4.5 Cross margining between index options and options on constituent
stocks

4.6 Cross margining between two indices

4.7 Cross margining between two stocks

5 Market Structure and Governance

5.1 Separation of cash and derivatives markets

5.2 Sub brokers

5.3 Inspection

5.4 Surveillance
.
5.5 Physical Settlement
.

6 Use of Derivatives by Mutual Funds



“6.1 New Schemes: Utilising mainstream governance and disclosure
mechanisms
,
6.2 Existing Schemes: Rules governing hedging and portfolio
rebalancing.

6.3 Ongoing disclosure requirements

5
7 SEBI Related Issues

7.1 Derivatives Cell and Advisory Committee

7.2 SEBI and RBI

Appendix A: Methodology for Corporate Adjustments


Methodology laid down in SEBI Circular of June 2001

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OBJECTIVES OF STUDY:

1. To study various trends in derivative market.

2. Comparison of the profits/losses in cash market and derivative

market.

3. To find out profit/losses position of the option writer and option

holder.

4. To study in detail the role of the future and options.

5. To study the role of derivatives in Indian financial market.

6. To study various trends in derivative market.

7. Comparison of the profits/losses in cash market and derivative

market.

8. To find out profit/losses position of the option writer and option

holder.

9. To study in detail the role of the future and options.

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10. To study the role of derivatives in Indian financial market.

NEED OF THE STUDY

• Different investment avenues are available investors. Stock

market also offers good investment opportunities to the investor

alike all investments, they also carry certain risks. The investor

should compare the risk and expected yields after adjustment off

tax on various instruments while talking investment decision the

investor may seek advice from exparty and consultancy include

stock brokers and analysts while making investment decisions.

The objective here is to make the investor aware of the

functioning of the derivatives.

• Derivatives act as a risk hedging tool for the investors. The

objective if to help the investor in selecting

the appropriate derivates instrument to the attain maximum risk

and to construct the portfolio in such a manner to meet the

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investor should decide how best to reach the goals from the

securities available.

• To identity investor objective constraints and performance,

which help formulate the investment policy?

• The develop and improvement strategies in the with investment

policy formulated. They will help the selection of asset classes

and securities in each class depending up on their risk return

attributes.

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SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to

futures and options in the Indian context; the study is not based on the

international perspective of derivative markets.

The study is limited to the analysis made for types of instruments

of derivates each strategy is analyzed according to its risk and return

characteristics and derivatives performance against the profit and

policies of the company.

The present study on futures and options is very much

appreciable on the grounds that it gives deep insights about the F&O

market. It would be essential for the perfect way of trading in F&O. An

investor can choose the fight underlying or portfolio for investment

3which is risk free. The study would explain the various ways to

minimize the losses and maximize the profits. The study would help the

investors how their profit/loss is reckoned. The study would assist in

understanding the F&O segments. The study assists in knowing the

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different factors that cause for the fluctuations in the F&O market. The

study provides information related to the byelaws of F&O trading. The

studies elucidate the role of F&O in India Financial Markets.

Derivative Markets today


• The prohibition on options in SCRA was removed in 1995.

Foreign currency options in currency pairs other than Rupee were

the first options permitted by RBI.

• The Reserve Bank of India has permitted options, interest rate

swaps, currency swaps and other risk reductions OTC derivative

products.

• Besides the Forward market in currencies has been a vibrant

market in India for several decades.

• In addition the Forward Markets Commission has allowed the

setting up of commodities futures exchanges. Today we have 18

commodities exchanges most of which trade futures.

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e.g. The Indian Pepper and Spice Traders Association (IPSTA) and

the Coffee Owners Futures Exchange of India (COFEI).

• In 2000 an amendment to the SCRA expanded the definition of

securities to included Derivatives thereby enabling stock

exchanges to trade derivative products.

• The year 2000 will herald the introduction of exchange traded

equity derivatives in India for the first time.

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METHODOLOGY

To achieve the object of studying the stock market data ha been


collected.

Research methodology carried for this study can be two types

 Primary

 Secondary

PRIMARY

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The data, which is being collected for the time and it is the
original data is this

project the primary data has been taken from IIFL staff and guide
of the project.

SECONDARY

The secondary information is mostly from websites, books,


journals, etc.

INDUSTRY PROFILE

STOCK MARKET :

Indian stock market has shown dramatic changes last 4 to 5

years. As of 2004 march-end, Indian stock exchanges had over 9400

companies listed. Of course, the number of companies whose shares are

actively traded is smaller, around 800 at the NSE and 2600 at the BSE.

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Each company may have multiple securities listed on an exchange.

Thus, BSE has over 7200 listed securities, of which over 2600 are

traded. The market capitalization of all listed stocks now exceeds Rs. 13

Lakh crore. Total turnover-or the value of all sales and purchases – on

the BSE and the NSE now exceeds Rs. 50 lakh crore.

As large number of indices are also available to fund

managers. The two leading market indices are NSE 50-shares (S&P

CNX Nifty) index and BSE 30-share (SENSEX) index. There are index

funds that invest in the securities that form part of one or the other index.

Besides, in the derivatives market, the fund managers can buy or sell

futures contracts or options contracts on these indices. Both BSE and

NSE also have other sect oral indices that track the stocks of companies

in specific industry groups-FMCG, IT, Finance, Petrochemical and

Pharmaceutical while the SENSEX and Nifty indices track large

capitalization stocks, BSE and NSE also have Mid cap indices tracking

mid-size company shares. The number of industries or sectors

represented in various indices or in the listed category exceeds50. BSE

has 140 scrips in its specified group A list, which are basically large-
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capitalization stocks. B 1 Group includes over 1100 stocks, many of

which are mid-cap companies. The rest of the B2 Group includes over

4500 shares, largely low-capitalization.

National Stock Exchange (NSE):

The NSE was incorporated in NOVEMBER 1994 with an


equity capital of Rs.25 Crores. The International Securities Consultancy
(ISC) of Hong Kong has helped in setting up NSE. The promotions for
NSE were financial institutions, insurance companies, banks and SEBI
capital market ltd,Infrastructure leasing and financial services ltd.,stock
holding corporation ltd.
NSE is a national market for shares, PSU bonds, debentures
and government securities since infrastructure and trading facilities are
provided. The genesis of the NSE lies in the recommendations of the
Pherwani Committee (1991).

NSE-Nifty:

The NSE on April22, 1996 launched a new equity index. The


NSE-50 the new index which replaces the existing NSE-100, is expected

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to serve as an appropriate index for the new segment of futures and
options.
“Nifty” means National Index for Fifty Stocks.
The NSE-50 comprises 50 companies that represent 20 broad
industry groups with an aggregate market capitalization of around Rs.
1,70,000 crores. All the companies included in the Index have a market
capitalization in excess of Rs. 500 crores. Each and should have traded
for 85% of trading days at an impact cost of less than 1.5%.

NSE-Midcap Index:

The NSE midcap index or the Junior Nifty comprises 50 stocks


that represents 21 board Industry groups and will provide proper
representation of the midcap. All stocks in the index should have market
capitalization of greater than Rs.200 crores and should have traded 85%
of the trading days an impact cost of less 2.5%.
The base period for the index is Nov 4, 1996 which signifies
2 years for completion of operations of the capital market segment of the
operations. The base value of the index has been set at 1000. Average
daily turnover of the present scenario 258212(laces) and number of
average daily trades 2160(laces).

Bombay Stock Exchange (BSE):

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This stock exchange, Mumbai, popularly known as “BSE” was
established In 1875 as “The native share and stock brokers association”,
as a voluntary non-profit making association .It has evolved over the
years into its present status as the premier stock exchange in the country.
It may be noted that the stock exchange is the oldest one in Asia, even
older than the Tokyo Stock Exchange, this was founded in 1878.

The Bombay Stock Exchange Limited is the oldest stock


exchange in Asia and has the greatest number of listed companies in the
world, with 4700 listed as of August 2007.It is located at Dalal Street,
Mumbai, India. On 31 December 2007, the equity market capitalization
of the companies listed on the BSE was US$ 1.79 trillion, making it the
largest stock exchange in South Asia and the 12th largest in the world.

A governing board comprising of 9 elected directors, 2 SEBI


nominees, 7 public representatives and an executive director is the apex
body, which decides the policies and regulates the affairs of the
exchange.

BSE Indices:

In order to enable the market participants, analysts etc., to track


the various ups and downs in Indian stock market, the exchange had
introduced in 1986 an equity stock index called BSE-SENSEX that
subsequently became the barometer of the moments of the share prices
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in the Indian stock market. It is a “market capitalization –weighted”
index of 30 component stocks representing a sample of large, well
established and leading companies. The base year of sensex is 1978-79.
The Sensex is widely reported in both domestic and
international markets through print as well as electronic media. Sensex is
calculated using a market capitalization weighted method. As per this
methodology, the level of index reflects the total market value of all 30-
component stocks from different industries related to particular base
period. The total value of a company is determined by multiplying the
price of its stock by the number of shares outstanding.

Statisticians call an index of a set of combined variables (such


as price number of shares) Composite index. An Indexed number is used
to represent the results of this calculation in order to make the value
easier to work with and track over a time. IT is much easier to graph a
chart base on indexed values then one based on actual values world over
majority of the well known indices are constructed using “Market
capitalization weighted method”. The divisor is only link to original base
period value of the sensex.

New base year average = old base year average*(new market


value/old market value)

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OTC Equity Derivatives

• Traditionally equity derivatives have a long history in India in the


OTC market.
• Options of various kinds (called Teji and Mandi and Fatak) in un-
organized markets were traded as early as 1900 in Mumbai
• The SCRA however banned all kind of options in 1956.

BSE's and NSE’s plans


• Both the exchanges have set-up an in-house segment instead of
setting up a separate exchange for derivatives.
• BSE’s Derivatives Segment, will start with Sensex futures as it’s
first product.
• NSE’s Futures & Options Segment will be launched with Nifty
futures as the first product.

Product Specifications BSE-30 Sensex Futures


• Contract Size - Rs.50 times the Index
• Tick Size - 0.1 points or Rs.5
• Expiry day - last Thursday of the month
• Settlement basis - cash settled
• Contract cycle - 3 months
• Active contracts - 3 nearest months

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Product Specifications S&P CNX Nifty Futures
• Contract Size - Rs.200 times the Index
• Tick Size - 0.05 points or Rs.10
• Expiry day - last Thursday of the month
• Settlement basis - cash settled
• Contract cycle - 3 months
• Active contracts - 3 nearest months
Membership
• Membership for the new segment in both the exchanges is not
automatic and has to be separately applied for.
• Membership is currently open on both the exchanges.
• All members will also have to be separately registered with SEBI
before they can be accepted.
Membership Criteria
NSE
Clearing Member (CM)
• Networth - 300 lakh
• Interest-Free Security Deposits - Rs. 25 lakh
• Collateral Security Deposit - Rs. 25 lakh
In addition for every TM he wishes to clear for the CM has to deposit
Rs. 10 lakh.
Trading Member (TM)

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• Networth - Rs. 100 lakh
• Interest-Free Security Deposit - Rs. 8 lakh
• Annual Subscription Fees - Rs. 1 lakh
BSE
Clearing Member (CM)
• Networth - 300 lacs
• Interest-Free Security Deposits - Rs. 25 lakh
• Collateral Security Deposit - Rs. 25 lakh
• Non-refundable Deposit - Rs. 5 lakh
• Annual Subscription Fees - Rs. 50 thousand
In addition for every TM he wishes to clear for the CM has to deposit
Rs. 10 lakh with the following break-up.
• Cash - Rs. 2.5 lakh
• Cash Equivalents - Rs. 25 lakh
• Collateral Security Deposit - Rs. 5 lakh
Trading Member (TM)
• Networth - Rs. 50 lakh
• Non-refundable Deposit - Rs. 3 lakh
• Annual Subscription Fees - Rs. 25 thousand
The Non-refundable fees paid by the members is exclusive and will be a
total of Rs.8 lakhs if the member has both Clearing and Trading rights.
Trading Systems

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• NSE’s Trading system for it’s futures and options segment is
called NEAT F&O. It is based on the NEAT system for the cash
segment.
• BSE’s trading system for its derivatives segment is called DTSS. It
is built on a platform different from the BOLT system though most
of the features are common.
Certification Programmes
• The NSE certification programme is called NCFM (NSE’s
Certification in Financial Markets). NSE has outsourced training
for this to various institutes around the country.
• The BSE certification programme is called BCDE (BSE’s
Certification for the Derivatives Exchnage). BSE conducts it’s own
training run by it’s training institute.
• Both these programmes are approved by SEBI.
Rules and Laws
• Both the BSE and the NSE have been give in-principle approval on
their rule and laws by SEBI.
• According to the SEBI chairman, the Gazette notification of the
Bye-Laws after the final approval is expected to be completed by
May 2000.
• Trading is expected to start by mid-June 2000.

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REVIEW LITERATURE

A Derivative is a financial instrument that derives its value


from an underlying asset. Derivative is an financial contract whose
price/value is dependent upon price of one or more basic underlying
asset, these contracts are legally binding agreements made on trading
screens of stock exchanges to buy or sell an asset in the future. The most
commonly used derivatives contracts are forwards, futures and options,
which we shall discuss in detail later.

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The emergence of the market for derivative products, most
notably forwards, futures and options, can be traced back to the
willingness of risk-averse economic agents to guard themselves against
uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of
volatility. Through the use of derivative products, it is possible to
partially or fully transfer price risks by locking-in asset prices. As
instruments of risk management, these generally do not influence the
fluctuations in the underlying asset prices. However, by locking-in asset
prices, derivative products minimize the impact of fluctuations in asset
prices on the profitability and cash flow situation of risk-averse
investors.
Derivative products initially emerged, as hedging devices
against fluctuations in commodity prices and commodity-linked
derivatives remained the sole form of such products for almost three
hundred years. The financial derivatives came into spotlight in post-
1970 period due to growing instability in the financial markets.
However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total
transactions in derivative products. In recent years, the market for
financial derivatives has grown tremendously both in terms of variety of
instruments available, their complexity and also turnover. In the class of
equity derivatives, futures and options on stock indices have gained

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more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives. Even small
investors find these useful due to high correlation of the popular indices
with various portfolios and ease of use. The lower costs associated with
index derivatives vie derivative products based on individual securities
is another reason for their growing use.
The main objective of the study is to analyze the derivatives
market in India and to analyze the operations of futures and options.
Analysis is to evaluate the profit/loss position futures and options.
Derivates market is an innovation to cash market. Approximately its
daily turnover reaches to the equal stage of cash market

In cash market the profit/loss of the investor depend the market


price of the underlying asset. Derivatives are mostly used for hedging
purpose. In bullish market the call option writer incurs more losses so
the investor is suggested to go for a call option to hold, where as the put
option holder suffers in a bullish market, so he is suggested to write a
put option. In bearish market the call option holder will incur more
losses so the investor is suggested to go for a call option to write, where
as the put option writer will get more losses, so he is suggested to hold a
put option.
Initially derivatives was launched in America called Chicago.
Then in 1999, RBI introduced derivatives in the local currency Interest

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Rate markets, which have not really developed, but with the gradual
acceptance of the ALM guidelines by banks, there should be an
instrumental product in hedging their balance sheet liabilities.
The first product which was launched by BSE and NSE in the
derivatives market was index futures
The following factors have been driving the growth of financial
derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the
international markets,
3. Marked improvement in communication facilities and sharp
decline in their costs,
4. Development of more sophisticated risk management tools,
providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine
the risks and
returns over a large number of financial assets, leading to higher
returns, reduced
risk as well as trans-actions costs as compared to individual
financial assets.

Derivatives defined

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Derivative is a product whose value is derived from the value of
one or more basic variables, called bases (underlying asset, index, or
reference rate), in a contractual manner. The underlying asset can be
equity, forex, commodity or any other asset. For example, wheat farmers
may wish to sell their harvest at a future date to eliminate the risk of a
change in prices by that date. Such a transaction is an example of a
derivative.
The price of this derivative is driven by the spot price of wheat
which is the “underlying”.
In the Indian context the Securities Contracts (Regulation) Act, 1956
(SC(R) A) defines
“equity derivative” to include –
1. A security derived from a debt instrument, share, loan
whether secured or
unsecured, risk instrument or contract for differences or any other form
of security.
2. A contract, which derives its value from the prices, or index
of prices, of
underlying securities.

Derivatives is derived from the following products:


A. Shares
B. Debuntures

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C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.

DEFINATIONS
According to JOHN C. HUL “ A derivatives can be defined as a
financial instrument whose value depends on (or derives from) the
values of other, more basic underlying variables.”
According to 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.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by


the derivatives markets. They are:

 Prices in an organized derivatives market reflect the perception of


market participants about the future and lead the prices of underlying
to the perceived future level.

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 Derivatives market helps to transfer risks from those who have them
but may not like them to those who have an appetite for them.
 Derivative trading acts as a catalyst for new entrepreneurial activity.
 Derivatives markets help increase savings and investment in the long
run.

TYPES OF DERIVATIVES:

The most commonly used derivatives contracts are


forwards, futures and options which we shall discuss in detail later.
Here we take a brief look at various derivatives contracts that have
come to be used.

Forwards:
A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future
at today’s pre-agreed price

Futures:

A futures contract is an agreement between two parties to buy


or sell an asset at a certain time in the future at a certain price. Futures
contracts are special types of forward contracts in the sense that the
former are standardized exchange-traded contracts
Options:
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Options are of two types - calls and puts. Calls give the buyer
the right but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future date. Puts give the
buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
Warrants:
Options generally have lives of up to one year; the majority of
options traded on options exchanges having a maximum maturity of
nine months. Longer-dated options are called warrants and are
generally traded over-the-counter.

Leaps:
The acronym LEAPS means Long-Term Equity Anticipation
Securities. These are options having a maturity of up to three years.

Baskets:
Basket options are options on portfolios of underlying assets.
The underlying asset is usually a moving average of a basket of assets.
Equity index options are a form of basket options.
Swaps:
Swaps are private agreements between two parties to exchange
cash flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used
swaps are

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⇒ Interest rate swaps:
These entail swapping only the interest related cash flows
between the
Parties in the same currency.
⇒ Currency swaps:
These entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different
currency than those in the opposite Direction.
Swaptions:
Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a Swaptions is an option on a
forward swap.

PARTICIPANTS IN THE DERIVATIVES MARKET:


The following three broad categories of participants in the
derivatives market.

HEDGERS:
Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk.

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SPECULATORS:
Speculators wish to bet on future movements in the price of an
asset. Futures and options contracts can give them an extra leverage; that
is, they can increase both the potential gains and potential losses in a
speculative venture.

ARBITRAGEURS:
Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the
futures price of an asset getting out of line with the cash price, they will
take offsetting positions in the two markets to lock in a profit.

ANY EXCHANGE FULFILLING THE DERIVATIVE SEGMENT


AT NATIONAL STOCK EXCHANGE:

The derivatives segment on the exchange commenced with S&P


CNX Nifty Index futures on June 12, 2000. The F&O segment of NSE
provides trading facilities for the following derivative segment:
1. Index Based Futures
2. Index Based Options
3. Individual Stock Options
4. Individual Stock Futures

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REGULATORY FRAMEWORK:

The trading of derivatives is governed by the provisions


contained in the SC (R) A, the SEBI Act and the regulations framed
there under the rules and byelaws of stock exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of


Dr.L.C.Gupta develop the appropriate regulatory framework for
derivative trading in India. The committee submitted its report in March
1998. On May 11, 1998 SEBI accepted the recommendations of the
committee and approved the phased introduction of Derivatives trading
in India beginning with Stock Index Futures. SEBI also approved he
“Suggestive bye-laws” recommended by the committee for regulation
and control of trading and settlement of Derivatives contracts.

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The provisions in the SC (R) A govern the trading in the
securities. The amendment of the SC (R) A to include
“DERIVATIVES” within the ambit of ‘Securities’ in the SC (R ) A
made trading in Derivatives possible within the framework of the Act.

1. Eligibility criteria as prescribed in the L.C. Gupta committee report


may apply to SEBI for grant of recognition under Section 4 of the
SC ( R ) A, 1956 to start Derivatives Trading. The derivatives
exchange/segment should have a separate governing council and
representation of trading / clearing members shall be limited to
maximum of 40% of the total members of the governing council.
The exchange shall regulate the sales practices of its members and
will obtain approval of SEBI before start of Trading in any
derivative contract.

2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not


automatically become the members of the derivative segment. The
members of the derivative segment need to fulfill the eligibility
conditions as lay down by the L.C.Gupta Committee.
4. The clearing and settlement of derivates trades shall be through a
SEBI

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approved Clearing Corporation / Clearing house. Clearing
Corporation /
Clearing House complying with the eligibility conditions as lay
down
By the committee have to apply to SEBI for grant of approval.

5. Derivatives broker/dealers and Clearing members are required to


seek registration from SEBI.

6. The Minimum contract value shall not be less than Rs.2 Lakh.
Exchanges should also submit details of the futures contract they
purpose to introduce.

7. The trading members are required to have qualified approved user


and sales person who have passed a certification programmed
approved by SE

INTRODUCTION TO FUTURE MARKET:

Futures markets were designed to solve the problems that exit


in forward markets. A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in the future at a certain
price. There is a multilateral contract between the buyer and seller for a
36
underlying asset which may be financial instrument or physical
commodities. But unlike forward contracts the future contracts are
standardized and exchange traded.

PURPOSE:
The primary purpose of futures market is to provide an efficient
and effective mechanism for management of inherent risks, without
counter-party risk. The future contracts are affected mainly by the prices
of the underlying asset. As it is a future contract the buyer and seller has
to pay the margin to trade in the futures market.
It is essential that both the parties compulsorily discharge their
respective obligations on the settlement day only, even though the
payoffs are on a daily marking to market basis to avoid
default risk. Hence, the gains or losses are netted off on a daily basis and
each morning starts
with a fresh opening value. Here both the parties face an equal amount
of risk and are also
required to pay upfront margins to the exchange irrespective of whether
they are buyers or
sellers. Index based financial futures are settled in cash unlike futures on
individual stocks which
are very rare and yet to be launched even in the US. Most of the
financial futures worldwide are

37
index based and hence the buyer never comes to know who the seller is,
both due to the presence
of the clearing corporation of the stock exchange in between and also
due to secrecy reasons

EXAMPLE:

The current market price of INFOSYS COMPANY is


Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is
bullish and kishore is
bearish in the market. The initial margin is 10%. paid by the both
parties. Here the Hitesh has
purchased the one month contract of INFOSYS futures with the price of
Rs.1650.The lot size of
Infosys is 300 shares.

Suppose the stock rises to 2200.


Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)]
and notional profit for
the buyer is 500.
Unlimited loss for the buyer because the buyer is bearish in the market

38
Suppose the stock falls to Rs.1400
Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and
notional profit for the seller is
250.
Unlimited loss for the seller because the seller is bullish in the market.
Finally, Futures contracts try to "bet" what the value of an
index or commodity will be at some date in the future. Futures are often
used by mutual funds and large institutions to hedge their positions when
the markets are rocky. Also, Futures contracts offer a high degree of
leverage, or the ability to control a sizable amount of an asset for a cash
outlay, which is distantly small in proportion to the total value of
contract.

DEFINITION
A Futures contract is an agreement between two parties to buy or
sell an asset at a certain time in the future at a certain price. To facilitate
liquidity in the futures contract, the exchange specifies certain standard
features of the contract. The standardized items on a futures contract
are:
♦ Quantity of the underlying
♦ Quality of the underlying
♦ The date and the month of delivery

39
♦ The units of price quotations and minimum price change
♦ Locations of settlement

Types of futures:
On the basis of the underlying asset they derive, the futures are
divided into two types:

 Stock futures:
The stock futures are the futures that have the underlying asset as
the individual securities. The settlement of the stock futures is of cash
settlement and the settlement price of the future is the closing price of
the underlying security.

 Index futures:
Index futures are the futures, which have the underlying asset as an
Index. The Index futures are also cash settled. The settlement price of
the Index futures shall be the closing value of the underlying index on
the expiry date of the contract.

STOCK INDEX FUTURES


Stock Index futures are the most popular financial
futures, which have been used to hedge or manage the systematic risk by
the investors of Stock Market. They are called hedgers who own

40
portfolio of securities and are exposed to the systematic risk. Stock
Index is the apt hedging asset since the rise or fall due to systematic risk
is accurately shown in the Stock Index. Stock index futures contract is
an agreement to buy or sell a specified amount of an underlying stock
index traded on a regulated futures exchange for a specified price for
settlement at a specified time future.
Stock index futures will require lower capital adequacy
and margin requirements as compared to margins on carry forward of
individual scrips. The brokerage costs on index futures will be much
lower.
Savings in cost is possible through reduced bid-ask
spreads where stocks are traded in packaged forms. The impact cost will
be much lower in case of stock index futures as opposed to dealing in
individual scrips. The market is conditioned to think in terms of the
index and therefore would prefer to trade in stock index futures. Further,
the chances of manipulation are much lesser.
The Stock index futures are expected to be extremely
liquid given the speculative nature of our markets and the overwhelming
retail participation expected to be fairly high. In the near future, stock
index futures will definitely see incredible volumes in India. It will be a
blockbuster product and is pitched to become the most liquid contract in
the world in terms of number of contracts traded if not in terms of
notional value. The advantage to the equity or cash market is in the fact

41
that they would become less volatile as most of the speculative activity
would shift to stock index futures. The stock index futures market
should ideally have more depth, volumes and act as a stabilizing factor
for the cash market. However, it is too early to base any conclusions on
the volume or to form any firm trend.
The difference between stock index futures and most
other financial futures contracts is that settlement is made at the value of
the index at maturity of the contract.

Futures terminology :-

a) Spot price : The price at which an asset trades in the spot


market
b) Futures price : The price at which the futures contract trades
in the futures market.
c) Contract cycle : The period over which a contract trades.
The index futures contracts on the NSE have one-month,
two-month and three-months expiry cycles which expire on
the last Thursday of the month. Thus a January expiration
contract expires on the last Thursday of January and a
February expiration contract trading on the last Thursday of
February. On the Friday following the last Thursday, a new

42
contract having a three-month expiry is introduced for
trading.
d) Expiry date : It is the date specified in the futures contract.
This is the last day on which the contract will be traded, at
the end of which it will cease to exist.
e) Contract size : The amount of asset that has to be delivered
under one contract. For instance, the contract size on NSE’s
futures market is 200 Nifties.
f) Basis :In the context of financial futures, basis can be defined
as the futures price minus the spot price. There will be a
different basis for each delivery month for each contract. In a
normal market, basis will be positive. This reflects that
futures prices normally exceed spot prices.
g) Cost of carry : The relationship between futures prices and
spot prices can be summarized in terms of what is known as
the cost of carry. This measures the storage cost plus the
interest that is paid to finance the asset less the income
earned on the asset.
h) Margin: Margin is money deposited by the buyer and the
seller to ensure the integrity of the contract. Normally the
margin requirement has been designed on the concept of
VAR at 99% levels. Based on the value at risk of the

43
stock/index margins are calculated. In general margin ranges
between 10-50% of the contract value.
i) Initial margin : The amount that must be deposited in the
margin account at the time a futures contract is first entered
into is known as initial margin. Both buyer and seller are
required to make security deposits that are intended to
guarantee that they will infact be able to fulfill their
obligation. These deposits are Initial margins and they are
often referred as performance margins. The amount of
margin is roughly 5% to 15% of total purchase price of
futures contract
j) Marking-to-market : In the futures market, at the end of
each trading day, the margin account is adjusted to reflect the
investor’s gain or loss depending upon the futures closing
price. This is called marking-to-market.
k) Maintenance margin : This is somewhat lower than the
initial margin. This is set to ensure that the balance in the
margin account never becomes negative. If the balance in the
margin account falls below the maintenance margin, the
investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading
commences on the next day.

44
PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller.
The buyer of the futures contract is one who is LONG on the futures
contract and the seller of the futures contract is one who is SHORT on
the futures contract.

The pay off for the buyer and the seller of the futures contract are as
follows.

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.

PAYOFF FOR A BUYER OF FUTURES:

45
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

E
2
F
LOSS E
1

CASE 1:
The buyer bought the future contract at (F); if the futures price
goes to E1 then the buyer gets the profit of (FP).
CASE 2:
The buyer gets loss when the future price goes less than (F), if the
futures price goes to E2 then the buyer gets the loss of (FL).
46
PAYOFF FOR A SELLER OF 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.

PROFIT

E
2

E F
1

LOSS

F – FUTURES PRICE
47
E1, E2 – SETTLEMENT PRICE.

CASE 1:
The Seller sold the future contract at (f); if the futures price goes to
E1 then the Seller gets the profit of (FP).

CASE 2:
The Seller gets loss when the future price goes greater than (F), if
the futures price goes to E2 then the Seller gets the loss of (FL).

Pricing the Futures:


The fair value of the futures contract is derived from a model
known as the Cost of Carry model. This model gives the fair value of
the futures contract.

Cost of Carry Model:


F=S (1+r-q) t
Where

F – Futures Price S – Spot price of the Underlying r – Cost of Financing q – Expected Dividend Yield T – Holding

Period.

48
INTRODUCTION TO OPTIONS:

It is a interesting tool for small retail investors. An option is a contract,


which gives the buyer (holder) the right, but not the obligation, to buy or
sell specified quantity of the underlying
assets, at a specific (strike) price on or before a specified time
(expiration date). The underlying
may be physical commodities like wheat/ rice/ cotton/ gold/ oil or
financial instruments like
equity stocks/ stock index/ bonds etc.

Option Terminology:-
a) Index options: These options have the index as the underlying.
Some options are
i. European while others are American. Like index futures
contracts, index options
ii. contracts are also cash settled.
b) Stock options: Stock options are options on individual stocks.
Options currently

49
i. trade on over 500 stocks in the United States. A
contract gives the holder the right
to to buy or sell shares at the specified
price.
c) Buyer of an option: The buyer of an option is the one who by
paying the option
i. premium buys the right but not the obligation to
exercise his option on the
ii. seller/writer.
d) Writer of an option: The writer of a call/put option is the one who
receives the
i. option premium and is thereby obliged to sell/buy the
asset if the buyer exercises on
ii. him. There are two basic types of options, call options
and put options.
e) Call option: A call option gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price.
f) Put option: A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.
g) Option price: Option price is the price which the option buyer
pays to the option
seller.

50
h) Expiration date: The date specified in the options contract is
known as the
expiration date, the exercise date, the strike date or the
maturity.
i) Strike price: The price specified in the options contract is known
as the strike price
or the exercise price.
j) American options: American options are options that can be
exercised at any time
Up to the expiration date. Most exchange-traded
options are American.
k) European options: European options are options that can be
exercised only on the
expiration date itself. European options are easier to
analyze than American options, and properties of an
American option are frequently deduced from those of
its European counterpart.
l) In-the-money option: An in-the-money (ITM) option is an
option that would lead to a positive cash flow to the holder if it
were exercised immediately. A call option on the index is said to be in-
the-money when the current index stands at a level higher than the strike
price (i.e. spot price > strike price). If the index is much higher than the

51
strike price, the call is said to be deep ITM. In the case of a put, the put
is ITM if the index is below the strike price.

m) At-the-money option: An at-the-money (ATM) option is an


option that would lead
to zero cashflow if it were exercised immediately. An option on the
index is at-themoney
when the current index equals the strike price (i.e. spot price = strike
price)._

n) Out-of-the-money option: An out-of-the-money (OTM)


option is an option that
would lead to a negative cash flow it were exercised immediately. A call
option on
the index is out-of- the-money when the current index stands at a level
which is less
than the strike price (i.e. spot price < strike price). If the index is much
lower than the
strike price, the call is said to be deep OTM. In the case of a put, the put
is OTM if
the index is above the strike price.
o) Intrinsic value of an option: The option premium can be
broken down into two

52
components - intrinsic value and time value. The intrinsic value of a call
is the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic
value is zero.
Putting it another way, the intrinsic value of a call is N.P which means
the intrinsic
value of a call is Max [0, (St – K)] which means the intrinsic value of a
call is the (St –
K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the
greater of 0 or
(K - St ). K is the strike price and St is the spot price.
p) Time value of an option: The time value of an option is
the difference between its premium and its intrinsic value. A call that is
OTM or ATM has only time value. Usually, the maximum time value
exists when the option is ATM. The longer the time to expiration, the
greater is a call’s time value, all else equal. At expiration, a call
should have no time value.

TYPES OF OPTION:

 CALL OPTION
A call option gives the holder (buyer/ one who is long call),
the right to buy specified quantity of the underlying asset at the strike

53
price on or before expiration date. The seller (one who is short call)
however, has the obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy. To acquire this right
the buyer pays a premium to the writer (seller) of the contract.

Illustration
Suppose in this option there are two parties one is Mahesh
(call buyer) who is bullish in the market and other is Rakesh (call seller)
who is bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600
and premium is Rs.25

1) Call buyer
Here the Mahesh has purchase the call option with a strike price
of Rs.600.The option will be excerised once the price went above 600.
The premium paid by the buyer is Rs.25.The buyer will earn profit once
the share price crossed to Rs.625(strike price + premium). Suppose the
stock has crossed Rs.660 the option will be exercised the buyer will
purchase the RELIANCE scrip from the seller at Rs.600 and sell in the
market at Rs.660.

54
Unlimited profit for the buyer = Rs.35{(spot price – strike price) –
premium}
Limited loss for the buyer up to the premium paid.

2) Call seller:
In another scenario, if at the tie of expiry stock price falls below
Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose
not to exercise the option.
Profit for the Seller limited to the premium received = Rs.25
Loss unlimited for the seller if price touches above 600 say 630
then the loss of Rs.30
Finally the stock price goes to Rs.610 the buyer will not exercise the
option because he has the
lost the premium of Rs.25.So he will buy the share from the seller at
Rs.610.

Thus from the above example it shows that option contracts are
formed so to avoid the unlimited losses and have limited losses to the
certain extent

Thus call option indicates two positions as follows:

 LONG POSITION

55
If the investor expects price to rise i.e. bullish in the market he
takes a long position by buying call option.

 SHORT POSITION
If the investor expects price to fall i.e. bearish in the market he
takes a short position by selling call option.

 PUT OPTION
A Put option gives the holder (buyer/ one who is long Put),
the right to sell specified quantity of the underlying asset at the strike
price on or before a expiry date. The seller of the put option (one who is
short Put) however, has the obligation to buy the underlying asset at the
strike price if the buyer decides to exercise his option to sell.

Illustration
Suppose in this option there are two parties one is Dinesh (put
buyer) who is bearish in the
market and other is Amit(put seller) who is bullish in the market.
The current market price of TISCO COMPANY is Rs.800 and premium
is Rs.2 0

1) Put buyer(dinesh)

56
Here the Dinesh has purchase the put option with a strike price
of Rs.800.The option will be excerised once the price went below 800.
The premium paid by the buyer is Rs.20.The buyer’s breakeven point is
Rs.780(Strike price – Premium paid). The buyer will earn profit once the
share price crossed below to Rs.780. Suppose the stock has crossed
Rs.700 the option will be
exercised the buyer will purchase the RELIANCE scrip from the market
at Rs.700and sell to the
seller at Rs.800
Unlimited profit for the buyer = Rs.80 {(Strike price – spot price)
– premium}
Loss limited for the buyer up to the premium paid = 20

2) put seller(Amit):
In another scenario, if at the time of expiry, market price of
TISCO is Rs. 900. the buyer of the Put option will choose not to exercise
his option to sell as he can sell in the market at a higher rate.
Unlimited loses for the seller if stock price below 780 say 750 then
unlimited losses for
the seller because the seller is bullish in the market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

57
 LONG POSITION
If the investor expects price to fall i.e. bearish in the market he
takes a long position by buying Put option.

 SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he
takes a short position by selling Put option

FACTORS AFFECTING OPTION PREMIUM:

 Price of the underlying asset: (s)


Changes in the underlying asset price can increase or decrease
the premium of an option. These price changes have opposite effects on
calls and puts. For instance, as the price of the underlying asset rises, the
premium of a call will increase and the premium of a put will decrease.
A decrease in the price of the underlying asset’s value will generally
have the opposite effect

 Strike price: (k)


The strike price determines whether or not an option has any
intrinsic value. An option’s premium generally increases as the option

58
gets further in the money, and decreases as the option becomes more
deeply out of the money.

 Time until expiration: (t)


An expiration approaches, the level of an option’s time value,
for puts and calls, decreases.

 Volatility:
Volatility is simply a measure of risk (uncertainty), or
variability of an option’s underlying. Higher volatility estimates reflect
greater expected fluctuations (in either direction) in underlying price
levels. This expectation generally results in higher option premiums for
puts and calls alike, and is most noticeable with at- the- money options.

 Interest rate: (R1)


This effect reflects the “COST OF CARRY” – the interest that
might be paid for margin, in case of an option seller or received from
alternative investments in the case of an option buyer for the premium
paid. Higher the interest rate, higher is the premium of the option as the
cost of carry increases.

59
FUTURES V/S OPTIONS:

Right or obligation :
Futures are agreements/contracts to buy or sell specified quantity of
the underlying assets at a
price agreed upon by the buyer & seller, on or before a specified time.
Both the buyer and seller
are obligated to buy/sell the underlying asset. In case of options the
buyer enjoys the right & not the obligation, to buy or sell the underlying
asset.

Risk:
Futures Contracts have symmetric risk profile for both the buyer as
well as the seller.
While options have asymmetric risk profile. In case of Options, for a
buyer (or holder of the

60
option), the downside is limited to the premium (option price) he has
paid while the profits may
be unlimited. For a seller or writer of an option, however, the downside
is unlimited while profits
are limited to the premium he has received from the buyer.

Prices:
The Futures contracts prices are affected mainly by the prices of the
underlying asset.
While the prices of options are however, affected by prices of the
underlying asset, time
remaining for expiry of the contract & volatility of the underlying asset.

Cost:
It costs nothing to enter into a futures contract whereas there is a
cost of entering into an options contract, termed as Premium.

Strike price:
In the Futures contract the strike price moves while in the option
contract the strike price
remains constant .

61
Liquidity:
As Futures contract are more popular as compared to options. Also
the premium charged is high in the options. So there is a limited
Liquidity in the options as compared to Futures. There is no dedicated
trading and investors in the options contract.

Price behavior:
The trading in future contract is one-dimensional as the price of
future depends upon the price of the underlying only. While trading in
option is two-dimensional as the price of the option
depends upon the price and volatility of the underlying.

62
BIBLIOGRAPHY

1. Economic Times

2. www.nseindia.com

1. www.google.com

1. www.bseindia.com

1. Business Standard

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