DERIVATIVES 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. 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. ECONOMIC FUNCTION OF THE DERIVATIVE MARKET Inspite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

1. 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. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

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 other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By

using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator. LIMITATIONS OF FORWARD MARKETS Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence

avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

INTRODUCTION TO FUTURES Futures markets were designed to solve the problems that exist 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. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

FUTURES TERMINOLOGY Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-months 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 ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading. 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. Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. 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. 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. 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. 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. 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. OPTIONS Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment. OPTION TERMINOLOGY Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. 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. 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. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. 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.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow 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 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. 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-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if 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. Intrinsic value of an option: The option premium can be broken down into two 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 Max[0, (St K)] which means the intrinsic value of a call is the greater of 0 or (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. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option 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 an

option's time value, all else equal. At expiration, an option should have no time value. FUTURES AND OPTIONS An interesting question to ask at this stage is - when would one use options instead of futures? Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating "guaranteed return products". INDEX DERIVATIVES Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular. Institutional and large equity-holders need portfolio-hedging facility. Indexderivatives are more suited to them and more cost-effective than derivatives based

on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered.

What is meant by a Stock Exchange? The Securities Contract (Regulation) Act, 1956 [SCRA] defines Stock Exchange as any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. Stock exchange could be a regional stock exchange whose area of operation/jurisdiction is specified at the time of its recognition or national exchanges, which are permitted to have nationwide trading since inception. NSE was incorporated as a national stock exchange.

What is an Equity/Share? Total equity capital of a company is divided into equal units of small denominations, each called a share. For example, in a company the total equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is 12 said to have 20,00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights. What is a Debt Instrument? Debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender. In the Indian securities markets, the term bond is used for debt instruments issued by the Central and State governments and public sector organizations and the term debenture is used for instruments issued by private corporate sector. What is a Derivative? Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset. 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 twothirds of total transactions in derivative products.

What is a Mutual Fund? A Mutual Fund is a body corporate registered with SEBI (Securities Exchange Board of India) that pools money from individuals/corporate investors and invests the same in a variety of different financial instruments or securities such as equity shares, Government securities, Bonds, debentures etc. Mutual funds can thus be considered as financial intermediaries in the investment business that collect funds from the public and invest on behalf of the investors. Mutual funds issue units to the investors. The appreciation of the portfolio or securities in which the mutual fund has invested the money leads to an appreciation in the value of the units held by investors. The investment objectives outlined by a Mutual Fund in its prospectus are binding on the Mutual Fund scheme. The investment objectives specify the class of securities a Mutual Fund can invest in. Mutual Funds invest in 13 various asset classes like equity, bonds, debentures, commercial paper and government securities. The schemes offered by mutual funds vary from fund to fund. Some are pure equity schemes; others are a mix of equity and bonds. Investors are also given the option of getting dividends, which are declared periodically by the mutual fund, or to participate only in the capital appreciation of the scheme. What is an Index? An Index shows how a specified portfolio of share prices are moving in order to give an indication of market trends. It is a basket of securities and the average price movement of the basket of securities indicates the index movement, whether upwards or downwards. What is a Depository? A depository is like a bank wherein the deposits are securities (viz. shares,

debentures, bonds, government securities, units etc.) in electronic form. What is Dematerialization? Dematerialization is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited to the investors account with his Depository Participant (DP). 14 SECURITIES What is meant by Securities? The definition of Securities as per the Securities Contracts Regulation Act (SCRA), 1956, includes instruments such as shares, bonds, scrips, stocks or other marketable securities of similar nature in or of any incorporate company or body corporate, government securities, derivatives of securities, units of collective investment scheme, interest and rights in securities, security receipt or any other instruments so declared by the Central Government. What is the function of Securities Market? Securities Markets is a place where buyers and sellers of securities can enter into transactions to purchase and sell shares, bonds, debentures etc. Further, it performs an important role of enabling corporates, entrepreneurs to raise resources for their companies and business ventures through public issues. Transfer of resources from those having idle resources (investors) to others who have a need for them (corporates) is most efficiently achieved through the securities market. Stated formally, securities markets provide channels for reallocation of savings to investments and entrepreneurship. Savings are linked to investments by a variety of intermediaries, through a range of financial products, called Securities.

Which are the securities one can invest in? Shares Government Securities Derivative products Units of Mutual Funds etc., are some of the securities investors in the securities market can invest in. 15 2.1 Regulator Why does Securities Market need Regulators? The absence of conditions of perfect competition in the securities market makes the role of the Regulator extremely important. The regulator ensures that the market participants behave in a desired manner so that securities market continues to be a major source of finance for corporate and government and the interest of investors are protected. Who regulates the Securities Market? The responsibility for regulating the securities market is shared by Department of Economic Affairs (DEA), Department of Company Affairs (DCA), Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI). What is SEBI and what is its role? The Securities and Exchange Board of India (SEBI) is the regulatory authority in India established under Section 3 of SEBI Act, 1992. 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 corporates in the issuance of capital and transfer of securities, in addition to

all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for: Regulating the business in stock exchanges and any other securities markets Registering and regulating the working of stock brokers, subbrokers etc. Promoting and regulating self-regulatory organizations Prohibiting fraudulent and unfair trade practices Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, intermediaries, self regulatory organizations, mutual funds and other persons associated with the securities market. 16 2.2 Participants Who are the participants in the Securities Market? The securities market essentially has three categories of participants, namely, the issuers of securities, investors in securities and the intermediaries, such as merchant bankers, brokers etc. While the corporates and government raise resources from the securities market to meet their obligations, it is households that invest their savings in the securities market. Is it necessary to transact through an intermediary? It is advisable to conduct transactions through an intermediary. For example you need to transact through a trading member of a stock exchange if you intend to buy or sell any security on stock exchanges. You need to maintain an account with a depository if you intend to hold securities in demat form.

You need to deposit money with a banker to an issue if you are subscribing to public issues. You get guidance if you are transacting through an intermedia ry. Chose a SEBI registered intermediary, as he is accountable for its activities. The list of registered intermediaries is available with exchanges, industry associations etc. What are the segments of Securities Market? The securities market has two interdependent segments: the primary (new issues) market and the secondary market. The primary market provides the channel for sale of new securities while the secondary market deals in securities previously issued. 17 3. PRIMARY MARKET What is the role of the Primary Market? The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities; Government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. They may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt etc. They may issue the securities in domestic market and/or international market. What is meant by Face Value of a share/debenture? The nominal or stated amount (in Rs.) assigned to a security by the issuer. For shares, it is the original cost of the stock shown on the certificate; for bonds, it is the amount paid to the holder at maturity. Also known as par value or simply par. For an equity share, the face value is usually a very small amount (Rs. 5, Rs. 10) and does not have much bearing on the price of the share, which may quote higher in the market, at Rs. 100 or Rs. 1000

or any other price. For a debt security, face value is the amount repaid to the investor when the bond matures (usually, Government securities and corporate bonds have a face value of Rs. 100). The price at which the security trades depends on the fluctuations in the interest rates in the economy. What do you mean by the term Premium and Discount in a Security Market? Securities are generally issued in denominations of 5, 10 or 100. This is known as the Face Value or Par Value of the security as discussed earlier. When a security is sold above its face value, it is said to be issued at a Premium and if it is sold at less than its face value, then it is said to be issued at a Discount. 18 3.1 Issue of Shares Why do companies need to issue shares to the public? Most companies are usually started privately by their promoter(s). However, the promoters capital and the borrowings from banks and financial institutions may not be sufficient for setting up or running the business over a long term. So companies invite the public to contribute towards the equity and issue shares to individual investors. The way to invite share capital from the public is through a Public Issue. Simply stated, a public issue is an offer to the public to subscribe to the share capital of a company. Once this is done, the company allots shares to the applicants as per the prescribed rules and regulations laid down by SEBI. What are the different kinds of issues? Primarily, issues can be classified as a Public, Rights or Preferential issues (also known as private placements). While public and rights issues involve a

detailed procedure, private placements or preferential issues are relatively simpler. The classification of issues is illustrated below: Initial Public Offering (IPO) is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuers securities. A follow on public offering (Further Issue) is when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document. Rights Issue is when a listed company which proposes to issue fresh securities to its existing shareholders as on a record date. The rights are normally offered in a particular ratio to the number of securities held prior to the issue. This route is best suited for companies who would like to raise capital without diluting stake of its existing shareholders. A Preferential issue is an issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital. The issuer company has to comply with the Companies Act and the requirements contained in 19 the Chapter pertaining to preferential allotment in SEBI guidelines which inter-alia include pricing, disclosures in notice etc. What is meant by Issue price? The price at which a company's shares are offered initially in the primary market is called as the Issue price. When they begin to be traded, the market price may be above or below the issue price. What is meant by Market Capitalisation?

The market value of a quoted company, which is calculated by multiplying its current share price (market price) by the number of shares in issue is called as market capitalization. E.g. Company A has 120 million shares in issue. The current market price is Rs. 100. The market capitalisation of company A is Rs. 12000 million. Classification of Issues Issues Rights Preferential Initial Public Offering Public Further Public Offering Fresh Issue Offer for Sale Fresh Issue Offer for Sale 20 What is the difference between public issue and private placement? When an issue is not made to only a select set of people but is open to the general public and any other investor at large, it is a public issue. But if the issue is made to a select set of people, it is called private placement. As per Companies Act, 1956, an issue becomes public if it results in allotment to 50 persons or more. This means an issue can be privately placed where an allotment is made to less than 50 persons. What is an Initial Public Offer (IPO)? An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuers securities. The sale of securities can be either through book building or

through normal public issue. Who decides the price of an issue? Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have provided that the issuer in consultation with Merchant Banker shall decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role in price fixation. The company and merchant banker are however required to give full disclosures of the parameters which they had considered while deciding the issue price. There are two types of issues, one where company and Lead Merchant Banker fix a price (called fixed price) and other, where the company and the Lead Manager (LM) stipulate a floor price or a price band and leave it to market forces to determine the final price (price discovery through book building process). What does price discovery through Book Building Process mean? Book Building is basically a process used in IPOs for efficient price discovery. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. 21 What is the main difference between offer of shares through book building and offer of shares through normal public issue? Price at which securities will be allotted is not known in case of offer of shares through Book Building while in case of offer of shares through normal public issue, price is known in advance to investor. Under Book Building, investors bid for shares at the floor price or above and after the closure of the book building process the price is determined for allotment of shares.

In case of Book Building, the demand can be known everyday as the book is being built. But in case of the public issue the demand is known at the close of the issue. What is Cut-Off Price? In a Book building issue, the issuer is required to indicate either the price band or a floor price in the prospectus. The actual discovered issue price can be any price in the price band or any price above the floor price. This issue price is called Cut-Off Price. The issuer and lead manager decides this after considering the book and the investors appetite for the stock. What is the floor price in case of book building? Floor price is the minimum price at which bids can be made. What is a Price Band in a book built IPO? The prospectus may contain either the floor price for the securities or a price band within which the investors can bid. The spread between the floor and the cap of the price band shall not be more than 20%. In other words, it means that the cap should not be more than 120% of the floor price. The price band can have a revision and such a revision in the price band shall be widely disseminated by informing the stock exchanges, by issuing a press release and also indicating the change on the relevant website and the terminals of the trading members participating in the book building process. In case the price band is revised, the bidding period shall be extended for a further period of three days, subject to the total bidding period not exceeding ten days. 22 Who decides the Price Band? It may be understood that the regulatory mechanism does not play a role in setting the pric e for issues. It is up to the company to decide on the price or

the price band, in consultation with Merchant Bankers. What is minimum number of days for which a bid should remain open during book building? The Book should remain open for a minimum of 3 days. Can open outcry system be used for book building? No. As per SEBI, only electronically linked transparent facility is allowed to be used in case of book building. Can the individual investor use the book building facility to make an application? Yes. How does one know if shares are allotted in an IPO/offer for sale? What is the timeframe for getting refund if shares not allotted? As per SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 the Basis of Allotment should be completed with 8 days from the issue close date. As soon as the basis of allotment is completed, within 2 working days the details of credit to demat account / allotment advice and despatch of refund order needs to be completed. So an investor should know in about 11 days time from the closure of issue, whether shares are allotted to him or not. How long does it take to get the shares listed after issue? It takes 12 working days after the closure of the book built issue. 23 What is the role of a Registrar to an issue? The Registrar finalizes the list of eligible allottees after deleting the invalid applications and ensures that the corporate action for crediting of shares to the demat accounts of the applicants is done and the dispatch of refund

orders to those applicable are sent. The Lead Manager coordinates with the Registrar to ensure follow up so that that the flow of applications from collecting bank branches, processing of the applications and other matters till the basis of allotment is finalized, dispatch security certificates and refund orders completed and securities listed. Does NSE provide any facility for IPO? Yes. NSEs electronic trading network spans across the country providing access to investors in remote areas. NSE decided to offer this infrastructure for conducting online IPOs through the Book Building process. NSE operates a fully automated screen based bidding system called NEAT IPO that enables trading members to enter bids directly from their offices through a sophisticated telecommunication network. Book Building through the NSE system offers several advantages: The NSE system offers a nation wide bidding facility in securities It provide a fair, efficient & transparent method for collecting bids using the latest electronic trading systems Costs involved in the issue are far less than those in a normal IPO The system reduces the time taken for completion of the issue process The IPO market timings are from 10.00 a.m. to 5.00 p.m. What is a Prospectus? A large number of new companies float public issues. While a large number of these companies are genuine, quite a few may want to exploit the investors. Therefore, it is very important that an investor before applying for any issue identifies future potential of a company. A part of the guidelines issued by SEBI (Securities and Exchange Board of India) is the disclosure of information to the public. This disclosure includes information like the reason

for raising the money, the way money is proposed to be spent, the return 24 expected on the money etc. This information is in the form of Prospectus which also includes information regarding the size of the issue, the current status of the company, its equity capital, its current and past performance, the promoters, the project, cost of the project, means of financing, product and capacity etc. It also contains lot of mandatory information regarding underwriting and statutory compliances. This helps investors to evaluate short term and long term prospects of the company. What does Draft Offer document mean? Offer document means Prospectus in case of a public issue or offer for sale and Letter of Offer in case of a rights issue which is filed with the Registrar of Companies (ROC) and Stock Exchanges (SEs). An offer document covers all the relevant information to help an investor to make his/her investment decision. Draft Offer document means the offer document in draft stage. The draft offer documents are filed with SEBI, atleast 30 days prior to the registration of red herring prospectus or prospectus with ROC. SEBI may specify changes, if any, in the draft Offer Document and the issuer or the lead merchant banker shall carry out such changes in the draft offer document before filing the Offer Document with ROC. The Draft Offer Document is available on the SEBI website for public comments for a period of 21 days from the filing of the Draft Offer Document with SEBI. What is an Abridged Prospectus? Abridged Prospectus is a shorter version of the Prospectus and contains all the salient features of a Prospectus. It accompanies the application form of public issues.

Who prepares the Prospectus/Offer Documents? Generally, the public issues of companies are handled by Merchant Bankers who are responsible for getting the project appraised, finalizing the cost of the project, profitability estimates and for preparing of Prospectus. The Prospectus is submitted to SEBI for its approval. What does one mean by Lock-in? 25 Lock-in indicates a freeze on the sale of shares for a certain period of time. SEBI guidelines have stipulated lock-in requirements on shares of promoters mainly to ensure that the promoters or main persons, who are controlling the company, shall continue to hold some minimum percentage in the company after the public issue. What is meant by Listing of Securities? Listing means admission of securities of an issuer to trading privileges (dealings) on a stock exchange through a formal agreement. The prime objective of admission to dealings on the exchange is to provide liquidity and marketability to securities, as also to provide a mechanism for effective control and supervision of trading. What is a Listing Agreement? At the time of listing securities of a company on a stock exchange, the company is required to enter into a listing agreement with the exchange. The listing agreement specifies the terms and conditions of listing and the disclosures that shall be made by a company on a continuous basis to the exchange. What does Delisting of securities mean? The term Delisting of securities means permanent removal of securities of a listed company from a stock exchange. As a consequence of delisting, the

securities of that company would no longer be traded at that stock exchange. What is SEBIs Role in an Issue? Any company making a public issue or a listed company making a rights issue of value of more than Rs 50 lakh is required to file a draft offer document with SEBI for its observations. The company can proceed further on the issue only after getting observations from SEBI. The validity period of SEBIs observation letter is three months only i.e. the company has to open its issue within three months period. 26 Does it mean that SEBI recommends an issue? SEBI does not recommend any issue nor does take any responsibility either for the financial soundness of any scheme or the project for which the issue is proposed to be made or for the correctness of the statements made or opinions expressed in the offer document. SEBI mainly scrutinizes the issue for seeing that adequate disclosures are made by the issuing company in the prospectus or offer document. Does SEBI tag make ones money safe? The investors should make an informed decision purely by themselves based on the contents disclosed in the offer documents. SEBI does not associate itself with any issue/issuer and should in no way be construed as a guarantee for the funds that the investor proposes to invest through the issue. However, the investors are generally advised to study all the material facts pertaining to the issue including the risk factors before considering any investment. They are strongly warned against relying on any tips or news through unofficial means. 3.2 Foreign Capital Issuance

Can companies in India raise foreign currency resources? Yes. Indian companies are permitted to raise foreign currency resources through two main sources: a) issue of foreign currency convertible bonds more commonly known as Euro issues and b) issue of ordinary shares through depository receipts namely Global Depository Receipts (GDRs)/American Depository Receipts (ADRs) to foreign investors i.e. to the institutional investors or individual investors. What is an American Depository Receipt? An American Depositary Receipt ("ADR") is a physical certificate evidencing ownership of American Depositary Shares ("ADSs"). The term is often used to refer to the ADSs themselves. 27 What is an ADS? An American Depositary Share ("ADS") is a U.S. dollar denominated form of equity ownership in a non-U.S. company. It represents the foreign shares of the company held on deposit by a custodian bank in the company's home country and carries the corporate and economic rights of the foreign shares, subject to the terms specified on the ADR certificate. One or several ADSs can be represented by a physical ADR certificate. The terms ADR and ADS are often used interchangeably. ADSs provide U.S. investors with a convenient way to invest in overseas securities and to trade non-U.S. securities in the U.S. ADSs are issued by a depository bank, such as JPMorgan Chase Bank. They are traded in the same manner as shares in U.S. companies, on the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) or quoted on NASDAQ and the over-the-counter (OTC) market. Although ADSs are U.S. dollar denominated securities and pay dividends in

U.S. dollars, they do not eliminate the currency risk associated with an investment in a non-U.S. company. What is meant by Global Depository Receipts? Global Depository Receipts (GDRs) may be defined as a global finance vehicle that allows an issuer to raise capital simultaneously in two or markets through a global offering. GDRs may be used in public or private markets inside or outside US. GDR, a negotiable certificate usually represents companys traded equity/debt. The underlying shares correspond to the GDRs in a fixed ratio say 1 GDR=10 shares. 28 4. SECONDARY MARKET 4.1 Introduction What is meant by Secondary market? Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets. What is the role of the Secondary Market? For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduitby facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions. What is the difference between the Primary Market and the Secondary Market? In the primary market, securities are offered to public for subscription for

the purpose of raising capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued securities are traded among investors. Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market. 29 4.1.1Stock Exchange What is the role of a Stock Exchange in buying and selling shares? The stock exchanges in India, under the overall supervision of the regulatory authority, the Securities and Exchange Board of India (SEBI), provide a trading platform, where buyers and sellers can meet to transact in securities. The trading platform provided by NSE is an electronic one and there is no need for buyers and sellers to meet at a physical location to trade. They can trade through the computerized trading screens available with the NSE trading members or the internet based trading facility provided by the trading members of NSE. What is Demutualisation of stock exchanges? Demutualisation refers to the legal structure of an exchange whereby the ownership, the management and the trading rights at the exchange are segregated from one another. How is a demutualised exchange different from a mutual exchange? In a mutual exchange, the three functions of ownership, management and trading are concentrated into a single Group. Here, the broker members of the exchange are both the owners and the traders on the exchange and they further manage the exchange as well. This at times can lead to conflicts

of interest in decision making. A demutualised exchange, on the other hand, has all these three functions clearly segregated, i.e. the ownership, management and trading are in separate hands. 30 4.1.2 Stock Trading4.2 Products in the Secondary Markets What are the products dealt in the Secondary Markets? Following are the main financial products/instruments dealt in the Secondary market which may be divided broadly into Shares and Bonds: Shares: Equity Shares: An equity share, commonly referred to as ordinary share, represents the form of fractional ownership in a business venture. Rights Issue/ Rights Shares: The issue of new securities to existing shareholders at a ratio to those already held, at a price. For e.g. a 2:3 rights issue at Rs. 125, would entitle a shareholder to receive 2 shares for every 3 shares held at a price of Rs. 125 per share. Bonus Shares: Shares issued by the companies to their shareholders free of cost based on the number of shares the shareholder owns. 36 Preference shares: Owners of these kind of shares are entitled to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the companys creditors, bondholders/debenture holders. Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remained unpaid. All arrears of preference

dividend have to be paid out before paying dividend on equity shares. Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company. Bond: is a negotiable certificate evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. The various types of Bonds are as follows: Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond. Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price. Treasury Bills: Short-term (up to one year) bearer discount security issued by government as a means of financing their cash requirements. 37 4.2.1Equity Investment Why should one invest in equities in particular? When you buy a share of a company you become a shareholder in that

company. Shares are also known as Equities. Equities have the potential to increase in value over time. Research studies have proved that the equity returns have outperformed the returns of most other forms of investments in the long term. Investors buy equity shares or equity based mutual funds because : Equities are considered the most rewarding, when compared to other investment options if held over a long duration. Research studies have proved that investments in some shares with a longer tenure of investment have yielded far superior returns than any other investment. The average annual retrun of the stock market over the period of last fifteen years, if one takes the Nifty index as the benchmark to compute the returns, has been around 16%. However, this does not mean all equity investments would guarantee similar high returns. Equities are high risk investments. Though higher the risk, higher the potential returns, high risk also indicates that the investor stands to lose some or all his investment amout if prices move unfavourably. One needs to study equity markets and stocks in which investments are being made carefully, before investing. What has been the average return on Equities in India? If we take the Nifty index returns for the past fifteen years, Indian stock market has returned about 16% to investors on an average in terms of increase in share prices or capital appreciation annually. Besides that on average stocks have paid 1.5% dividend annually. Dividend is a percentage of the face value of a share that a company returns to its shareholders from its annual profits. Compared to most other forms of investments, investing in equity shares offers the highest rate of return, if invested over a longer duration.

Debt Investment What is a Debt Instrument? Debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender. In Indian securities markets, the term bond is used for debt instruments issued by the Central and State governments and public sector organizations and the term debenture is used for instruments issued by private corporate sector. What are the features of debt instruments? Each debt instrument has three features: Maturity, coupon and principal. Maturity: Maturity of a bond refers to the date, on which the bond matures, which is the date on which the borrower has agreed to repay the principal. Term-to-Maturity refers to the number of years remaining for the bond to mature. The Term-to-Maturity changes everyday, from date of issue of the bond until its maturity. The term to maturity of a bond can be calculated on any date, as the distance between such a date and the date of maturity. It is also called the term or the tenure of the bond. Coupon: Coupon refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond. Principal: Principal is the amount that has been borrowed, and is also called the par value or face value of the bond. The coupon is the product of the principal and the coupon rate.

The name of the bond itself conveys the key features of a bond. For example, a GS CG2008 11.40% bond refers to a Central Government bond maturing in the year 2008 and paying a coupon of 11.40%. Since Central Government bonds have a face value of Rs.100 and normally pay coupon semi-annually, this bond will pay Rs. 5.70 as six- monthly coupon, until maturity. 42 What is meant by Interest payable by a debenture or a bond? Interest is the amount paid by the borrower (the company) to the lender (the debenture-holder) for borrowing the amount for a specific period of time. The interest may be paid annual, semi-annually, quarterly or monthly and is paid usually on the face value (the value printed on the bond certificate) of the bond. What are the Segments in the Debt Market in India? There are three main segments in the debt markets in India, viz., (1) Government Securities, (2) Public Sector Units (PSU) bonds, and (3) Corporate securities. The market for Government Securities comprises the Centre, State and State-sponsored securities. In the recent past, local bodies such as municipalities have also begun to tap the debt markets for funds. Some of the PSU bonds are tax free, while most bonds including government securities are not tax-free. Corporate bond markets comprise of commercial paper and bonds. These bonds typically are structured to suit the requirements of investors and the issuing corporate, and include a variety of tailor- made features with respect to interest payments and redemption. Who are the Participants in the Debt Market? Given the large size of the trades, Debt market is predominantly a wholesale

market, with dominant institutional investor participation. The investors in the debt markets are mainly banks, financial institutions, mutual funds, provident funds, insurance companies and corporates. Are bonds rated for their credit quality? Most Bond/Debenture issues are rated by specialised credit rating agencies. Credit rating agencies in India are CRISIL, CARE, ICRA and Fitch. The yield on a bond varies inversely with its credit (safety) rating. The safer the instrument, the lower is the rate of interest offered. How can one acquire securities in the debt market? You may subscribe to issues made by the government/corporates in the primary market. Alternatively, you may purchase the same from the secondary market through the stock exchanges. 7. MUTUAL FUNDS What is the Regulatory Body for Mutual Funds? Securities Exchange Board of India (SEBI) is the regulatory body for all the mutual funds. All the mutual funds must get registered with SEBI. What are the benefits of investing in Mutual Funds? There are several benefits from investing in a Mutual Fund: Small investments: Mutual funds help you to reap the benefit of returns by a portfolio spread across a wide spectrum of companies with small investments. Professional Fund Management: Professionals having considerable expertise, experience and resources manage the pool of money collected by a mutual fund. They thoroughly analyse the markets and economy to pick good investment opportunities. Spreading Risk: An investor with limited funds might be able to invest in only one or two stocks/bonds, thus increasing his or her

risk. However, a mutual fund will spread its risk by investing a number of sound stocks or bonds. A fund normally invests in companies across a wide range of industries, so the risk is diversified. Transparency: Mutual Funds regularly provide investors with information on the value of their investments. Mutual Funds also provide complete portfolio disclosure of the investments made by various schemes and also the proportion invested in each asset type. Choice: The large amount of Mutual Funds offer the investor a wide variety to choose from. An investor can pick up a scheme depending upon his risk/ return profile. Regulations: All the mutual funds are registered with SEBI and they function within the provisions of strict regulation designed to protect the interests of the investor. 49 What is NAV? NAV or Net Asset Value of the fund is the cumulative market value of the assets of the fund net of its liabilities. NAV per unit is simply the net value of assets divided by the number of units outstanding. Buying and selling into funds is done on the basis of NAV-related prices. The NAV of a mutual fund are required to be published in newspapers. The NAV of an open end scheme should be disclosed on a daily basis and the NAV of a close end scheme should be disclosed at least on a weekly basis Are there any risks involved in investing in Mutual Funds? Mutual Funds do not provide assured returns. Their returns are linked to their performance. They invest in shares, debentures, bonds etc. All these investments involve an element of risk. The unit value may vary depending

upon the performance of the company and if a company defaults in payment of interest/principal on their debentures/bonds the performance of the fund may get affected. Besides incase there is a sudden downturn in an industry or the government comes up with new a re gulation which affects a particular industry or company the fund can again be adversely affected. All these factors influence the performance of Mutual Funds. Some of the Risk to which Mutual Funds are exposed to is given below: Market risk If the overall stock or bond markets fall on account of overall economic factors, the value of stock or bond holdings in the fund's portfolio can drop, thereby impacting the fund performance. Non-market risk Bad news about an individual company can pull down its stock price, which can negatively affect fund holdings. This risk can be reduced by having a diversified portfolio that consists of a wide variety of stocks drawn from different industries. Interest rate risk Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall and this decline in underlying securities affects the fund negatively. 50 Credit risk Bonds are debt obligations. So when the funds invest in corporate bonds, they run the risk of the corporate defaulting on their interest and principal payment obligations and when that risk crystallizes, it leads to a fall in the value of the bond causing the NAV of the fund to take a beating.

What are the different types of Mutual funds? Mutual funds are classified in the following manner: (a) On the basis of Objective Equity Funds/ Growth Funds Funds that invest in equity shares are called equity funds. They carry the principal objective of capital appreciation of the investment over the medium to long-term. They are best suited for investors who are seeking capital appreciation. There are different types of equity funds such as Diversified funds, Sector specific funds and Index based funds. Diversified funds These funds invest in companies spread across sectors. These funds are generally meant for risk-averse investors who want a diversified portfolio across sectors. Sector funds These funds invest primarily in equity shares of companies in a particular business sector or industry. These funds are targeted at investors who are bullish or fancy the prospects of a particular sector. Index funds These funds invest in the same pattern as popular market indices like S&P CNX Nifty or S&P CNX 500. The money collected from the investors is invested only in the stocks, which represent the index. For e.g. a Nifty index fund will invest only in the Nifty 50 stocks. The objective of such funds 51 is not to beat the market but to give a return equivalent to

the market returns. Tax Saving Funds These funds offer tax benefits to investors under the Income Tax Act. Opportunities provided under this scheme are in the form of tax rebates under the Income Tax act. Debt/Income Funds These funds invest predominantly in high-rated fixed-income-bearing instruments like bonds, debentures, government securities, commercial paper and other money market instruments. They are best suited for the medium to long-term investors who are averse to risk and seek capital preservation. They provide a regular income to the investor. Liquid Funds/Money Market Funds These funds invest in highly liquid money market instruments. The period of investment could be as short as a day. They provide easy liquidity. They have emerged as an alternative for savings and shortterm fixed deposit accounts with comparatively higher returns. These funds are ideal for corporates, institutional investors and business houses that invest their funds for very short periods. Gilt Funds These funds invest in Central and State Government securities. Since they are Government backed bonds they give a secured return and also ensure safety of the principal amount. They are best suited for the medium to long-term investors who are averse to risk. Balanced Funds These funds invest both in equity shares and fixed-income-bearing instruments (debt) in some proportion. They provide a steady return

and reduce the volatility of the fund while providing some upside for capital appreciation. They are ideal for medium to long-term investors who are willing to take moderate risks. b) On the basis of Flexibility Open-ended Funds 52 These funds do not have a fixed date of redemption. Generally they are open for subscription and redemption throughout the year. Their prices are linked to the daily net asset value (NAV). From the investors' perspective, they are much more liquid than closed-ended funds. Close-ended Funds These funds are open initially for entry during the Initial Public Offering (IPO) and thereafter closed for entry as well as exit. These funds have a fixed date of redemption. One of the characteristics of the close-ended schemes is that they are generally traded at a discount to NAV; but the discount narrows as maturity nears. These funds are open for subscription only once and can be redeemed only on the fixed date of redemption. The units of these funds are listed on stock exchanges (with certain exceptions), are tradable and the subscribers to the fund would be able to exit from the fund at any time through the secondary market. 53 What are the different investment plans that Mutual Funds offer? The term investment plans generally refers to the services that the funds provide to investors offering different ways to invest or reinvest. The

different investment plans are an important consideration in the investment decision, because they determine the flexibility available to the investor. Some of the investment plans offered by mutual funds in India are: Growth Plan and Dividend Plan A growth plan is a plan under a scheme wherein the returns from investments are reinvested and very few income distributions, if any, are made. The investor thus only realizes capital appreciation on the investment. Under the dividend plan, income is distributed from time to time. This plan is ideal to those investors requiring regular income. Dividend Reinvestment Plan Dividend plans of schemes carry an additional option for reinvestme nt of income distribution. This is referred to as the dividend reinvestment plan. Under this plan, dividends declared by a fund are reinvested in the scheme on behalf of the investor, thus increasing the number of units held by the investors. What are the rights that are available to a Mutual Fund holder in India? As per SEBI Regulations on Mutual Funds, an investor is entitled to: 1. Receive Unit certificates or statements of accounts confirming your title within 6 weeks from the date your request for a unit certificate is received by the Mutual Fund. 2. Receive information about the investment policies, investment objectives, financial position and general affairs of the scheme. 3. Receive dividend within 30 days of their declaration and receive the redemption or repurchase proceeds within 10 days from the date of redemption or repurchase. 4. The trustees shall be bound to make such disclosures to the unit

holders as are essential in order to keep them informed about any information, which may have an adverse bearing on their investments. 54 5. 75% of the unit holders with the prior approval of SEBI can terminate the AMC of the fund. 6. 75% of the unit holders can pass a resolution to wind-up the scheme. 7. An investor can send complaints to SEBI, who will take up the matter with the concerned Mutual Funds and follow up with them till they are resolved. What is a Fund Offer document? A Fund Offer document is a document that offers you all the information you could possibly need about a particular scheme and the fund launching that scheme. That way, before you put in your money, you're well aware of the risks etc involved. This has to be designed in accordance with the guidelines stipulated by SEBI and the prospectus must disclose details about: Investment objectives Risk factors and special considerations Summary of expenses Constitution of the fund Guidelines on how to invest Organization and capital structure Tax provisions related to transactions Financial information What is Active Fund Management? When investment decisions of the fund are at the discretion of a fund

manager(s) and he or she decides which company, instrument or class of assets the fund should invest in based on research, analysis, market news etc. such a fund is called as an actively managed fund. The fund buys and sells securities actively based on changed perceptions of investment from time to time. Based on the classifications of shares with different characteristics, active investment managers construct different portfolio. Two basic investment styles prevalent among the mutual funds are Growth Investing and Value Investing: 55 Growth Investing Style The primary objective of equity investment is to obtain capital appreciation. A growth manager looks for companies that are expected to give above average earnings growth, where the manager feels that the earning prospects and therefore the stock prices in future will be even higher. Identifying such growth sectors is the challenge before the growth investment manager. Value investment Style A Value Manager looks to buy companies that they believe are currently undervalued in the market, but whose worth they estimate will be recognized in the market valuations eventually. What is Passive Fund Management? When an investor invests in an actively managed mutual fund, he or she leaves the decision of investing to the fund manager. The fund manager is the decision- maker as to which company or instrument to invest in.

Sometimes such decisions may be right, rewarding the investor handsomely. However, chances are that the decisions might go wrong or may not be right all the time which can lead to substantial losses for the investor. There are mutual funds that offer Index funds whose objective is to equal the return given by a select market index. Such funds follow a passive investment style. They do not analyse companies, markets, economic factors and then narrow down on stocks to invest in. Instead they prefer to invest in a portfolio of stocks that reflect a market index, such as the Nifty index. The returns generated by the index are the returns given by the fund. No attempt is made to try and beat the index. Research has shown that most fund managers are unable to constantly beat the market index year after year. Also it is not possible to identify which fund will beat the market index. Therefore, there is an element of going wrong in selecting a fund to invest in. This has lead to a huge interest in passively managed funds such as Index Funds where the choice of investments is not left to the discretion of the fund manager. Index Funds hold a diversified basket of securities which represents the index while at the same time since there is not much active turnover of the portfolio the cost of managing the fund also remains low. This gives a dual advantage to the investor of having a diversified portfolio while at the same time having low expenses in fund. 56 What is an ETF? Think of an exchange-traded fund as a mutual fund that trades like a stock. Just like an index fund, an ETF represents a basket of stocks that reflect an index such as the Nifty. An ETF, however, isn't a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's

price changes throughout the day, fluctuating with supply and demand. It is important to remember that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. By owning an ETF, you get the diversification of an index fund plus the flexibility of a stock. Because, ETFs trade like stocks, you can short sell them, buy them on margin and purchase as little as one share. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. When buying and selling ETFs, you pay your broker the same commission that you'd pay on any regular trade. 57 8.2 Index What is the Nifty index? S&P CNX Nifty (Nifty), is a scientifically developed, 50 stock index, reflecting accurately the market movement of the Indian markets. It comprises of some of the largest and most liquid stocks traded on the NSE. It is maintained by India Index Services & Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. The index has been co-branded by Standard & Poors (S&P). Nifty is the barometer of the Indian markets. SECURITIES MARKET IN INDIAAN OVERVIEW 1.1 INTRODUCTION The securities markets in India have witnessed several policy initiatives, which has refined the market micro-structure, modernised operations and broadened investment choices for the investors. The irregularities in the securities transactions in the last quarter of 2000-01, hastened the introduction and implementation of several reforms. While a Joint Parliamentary

Committee was constituted to go into the irregularities and manipulations in all their ramifications in all transactions relating to securities, decisions were taken to complete the process of demutualisation and corporatisation of stock exchanges to separate ownership, management and trading rights on stock exchanges and to effect legislative changes for investor protection, and to enhance the effectiveness of SEBI as the capital market regulator. Rolling settlement on T+5 basis was introduced in respect of most active 251 securities from July 2, 2001 and in respect of balance securities from 31st December 2001. Rolling settlement on T+3 basis commenced for all listed securities from April 1, 2002 and subsequently on T+2 basis from April 1, 2003. The derivatives trading on the NSE commenced with the S&P CNX Nifty Index Futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. Due to rapid changes in volatility in the securities market from time to time, there was a need felt for a measure of market volatility in the form of an index that

would help the market participants. NSE launched the India VIX, a volatility index based on the S&P CNX Nifty Index Option prices. Volatility Index is a measure of markets expectation of volatility over the near term. The Indian stock market regulator, Securities & Exchange Board of India (SEBI) allowed the direct market access (DMA) facility to investors in India on April 3, 2008. To begin with, DMA was extended to the institutional investors. In addition to the DMA facility, SEBI also decided to permit all classes of investors to short sell and the facility for securities lending and borrowing scheme was operationalised on April 21, 2008. The Debt markets in India have also witnessed a series of reforms, beginning in the year 2001-02 which was quite eventful for debt markets in India, with implementation of several important decisions like setting up of a clearing corporation for government securities, a negotiated dealing system to facilitate transparent electronic bidding in auctions and secondary market transactions on a real time basis and dematerialisation of debt instruments. Further, there was adoption of modified Delivery-versus-Payment mode of settlement (DvP III in March

2004). The settlement system for transaction in government securities was standardized to 12 T+1 cycle on May 11, 2005. To provide banks and other institutions with a more advanced and more efficient trading platform, an anonymous order matching trading platform (NDSOM) was introduced in August 2005. Short sale was permitted in G-secs in 2006 to provide an opportunity to market participants to manage their interest rate risk more effectively and to improve liquidity in the market. When issued (WI) trading in Central Government Securities was introduced in 2006. As a result of the gradual reform process undertaken over the years, the Indian GSec market has become increasingly broad-based and characterized by an efficient auction process, an active secondary market, electronic trading and settlement technology that ensures safe settlement with Straight through Processing (STP). This chapter, however, takes a review of the stock market developments since 1990. These developments in the securities market, which support corporate initiatives, finance the exploitation of new ideas and facilitate management of financial risks, hold out necessary

impetus for growth, development and strength of the emerging market economy of India. 1.2 PRODUCTS, PARTICIPANTS AND FUNCTIONS Transfer of resources from those with idle resources to others who have a productive need for them is perhaps most efficiently achieved through the securities markets. Stated formally, securities markets provide channels for reallocation of savings to investments and entrepreneurship and thereby decouple these two activities. As a result, the savers and investors are not constrained by their individual abilities, but by the economys abilities to invest and save respectively, which inevitably enhances savings and investment in the economy. Savings are linked to investments by a variety of intermediaries through a range of complex financial products called securities which is defined in the Securities Contracts (Regulation) Act, 1956 to include: (1) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or body corporate; (a) derivatives; (b) units of any other instrument issued by any collective investment scheme to the investors in such schemes; (c) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act,

2002; (d) units or any other such instrument issued to the investors under any mutual fund scheme; (e) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortagage debt, assigned to such entity, and acknowledging 13 beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be; (2) government securities, (a) such other instruments as may be declared by the Central Government to be securities; and (3) rights or interest in securities. There are a set of economic units who demand securities in lieu of funds and others who supply securities for funds. These demand for and supply of securities and funds determine, under competitive market conditions in both goods and securities market, the prices of securities which reflect the present value of future prospects of the issuer, adjusted for risks and also prices of funds. It is not that the users and suppliers of funds meet each other and exchange funds for securities. It is difficult to accomplish such double coincidence of wants. The amount of funds supplied

by the supplier may not be the amount needed by the user. Similarly, the risk, liquidity and maturity characteristics of the securities issued by the issuer may not match preference of the supplier. In such cases, they incur substantial search costs to find each other. Search costs are minimised by the intermediaries who match and bring the suppliers and users of funds together. These intermediaries may act as agents to match the needs of users and suppliers of funds for a commission, help suppliers and users in creation and sale of securities for a fee or buy the securities issued by users and in turn, sell their own securities to suppliers to book profit. It is, thus, a misnomer that securities market disintermediates by establishing a direct relationship between the savers and the users of funds. The market does not work in a vacuum; it requires services of a large variety of intermediaries. The disintermediation in the securities market is in fact an intermediation with a difference; it is a risk-less intermediation, where the ultimate risks are borne by the savers and not the intermediaries. A large variety and number of intermediaries provide intermediation services in the Indian securities market 1.3 SECURITIES MARKET AND FINANCIAL SYSTEM

The securities market has two interdependent and inseparable segments, the new issues (primary market) and the stock (secondary) market. PRIMARY MARKET The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities; government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. They may issue the securities at face value, or at a discount/premium and these securities 15 may take a variety of forms such as equity, debt etc. They may issue the securities in domestic market and/or international market. The primary market issuance is done either through public issues or private placement. A public issue does not limit any entity in investing while in private placement, the issuance is done to select people. In terms of the Companies Act, 1956, an issue becomes public if it results in allotment to more than 50 persons. This means an issue resulting in allotment to less than 50 persons is private placement. There are two major types of issuers who issue securities. The corporate entities issue mainly debt and equity instruments (shares, debentures, etc.), while

the governments (central and state governments) issue debt securities (dated securities, treasury bills). The price signals, which subsume all information about the issuer and his business including associated risk, generated in the secondary market, help the primary market in allocation of funds. SECONDARY MARKET Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets. The secondary market enables participants who hold securities to adjust their holdings in response to changes in their assessment of risk and return. They also sell securities for cash to meet their liquidity needs. The secondary market has further two components, namely the over-the-counter (OTC) market and the exchange-traded market. OTC is different from the market place provided by the Over The Counter Exchange of India Limited. OTC markets are

essentially informal markets where trades are negotiated. Most of the trades in government securities are in the OTC market. All the spot trades where securities are traded for immediate delivery and payment take place in the OTC market. The exchanges do not provide facility for spot trades in a strict sense. Closest to spot market is the cash market where settlement takes place after some time. Trades taking place over a trading cycle, i.e. a day under rolling settlement, are settled together after a certain time (currently 2 working days). Trades executed on the National Stock Exchange of India Limited (NSE) are cleared and settled by a clearing corporation which provides novation and settlement guarantee. Nearly 100% of the trades settled by delivery are settled in demat form. NSE also provides a formal trading platform for trading of a wide range of debt securities including government securities. A variant of secondary market is the forward market, where securities are traded for future delivery and payment. Pure forward is out side the formal market. The versions of forward in formal market are futures and options. In futures market, standardised securities are traded

for future delivery and settlement. These futures can be on a basket of securities like an 16 index or an individual security. In case of options, securities are traded for conditional future delivery. There are two types of optionsa put option permits the owner to sell a security to the writer of options at a predetermined price while a call option permits the owner to purchase a security from the writer of the option at a predetermined price. These options can also be on individual stocks or basket of stocks like index. Two exchanges, namely NSE and the Bombay Stock Exchange, (BSE) provide trading of derivatives of securities. The past few years in many ways have been remarkable for securities market in India. It has grown exponentially as measured in terms of amount raised from the market, number of stock exchanges and other intermediaries, the number of listed stocks, market capitalisation, trading volumes and turnover on stock exchanges, and investor population. Along with this growth, the profiles of the investors, issuers and intermediaries have changed significantly. The market has witnessed fundamental institutional changes resulting in drastic reduction in

transaction costs and significant improvements in efficiency, transparency and safety. Reforms in the securities market, particularly the establishment and empowerment of SEBI, market determined allocation of resources, screen based nation-wide trading, dematerialisation and electronic transfer of securities, rolling settlement and ban on deferral products, sophisticated risk management and derivatives trading, have greatly improved the regulatory framework and efficiency of trading and settlement. Indian market is now comparable to many developed markets in terms of a number of qualitative parameters. Stock Market Indicators: The most commonly used indicator of stock market development is the size of the market measured by stock market capitalization (the value of listed shares on the countrys exchanges) to GDP ratio. This ratio has improved significantly in India in recent years. At the end of year 2001, the market capitalization ratio stood at 23.1 and this has significantly increased to 114.57 % at end of December 2010. Similarly, the liquidity of the market can be gauged by the turnover ratio which equals the total value of shares traded on a countrys stock exchange divided by stock market capitalization.

Turnover Ratio is a widely used measure of trading activity and measures trading relative to the size of the market. As per the Standard and Poors Global Stock Market Fact Book 2007, India ranked 11th in terms of Market Capitalisation and 11th in terms of total traded value in stock exchanges. 1.4 DERIVATIVES MARKET Trading in derivatives of securities commenced in June 2000 with the enactment of enabling legislation in early 2000. Derivatives are formally defined to include: (a) 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, and (b) a contract which derives its value from 17 the prices, or index of prices, or underlying securities. Derivatives trading in India are legal and valid only if such contracts are traded on a recognised stock exchange, thus precluding OTC derivatives. Derivatives trading commenced in India in June 2000 after SEBI granted the approval to this effect in May 2000. SEBI permitted the derivative segment of two stock exchanges, i.e.

NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivative contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty Index and BSE-30 (Sensex) Index. This was followed by approval for trading in options based on these two indices and options on individual securities. The derivatives trading on the NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in S&P CNX Nifty Index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. In June 2003, SEBI-RBI approved the trading on interest rate derivative instruments. The Mini derivative Futures & Options contract on S&P CNX Nifty was introduced for trading on January 1, 2008 while the long term option contracts on S&P CNX Nifty were introduced for trading on March 3, 2008. 1.5 REGULATORY FRAMEWORK The five main legislations governing the securities market are: (a) the SEBI Act, 1992 which established SEBI to protect investors and develop and regulate securities market; (b) the

Companies Act, 1956, which sets out the code of conduct for the corporate sector in relation to issue, allotment and transfer of securities, and disclosures to be made in public issues; (c) the Securities Contracts (Regulation) Act, 1956, which provides for regulation of transactions in securities through control over stock exchanges; (d) the Depositories Act, 1996 which provides for electronic maintenance and transfer of ownership of demat securities; and (e) the Prevention of Money Laundering Act, 2002 which prevents money laundering and provides for confiscation of property derived from or involved in money laundering. 1.5.1 Legislations Capital Issues (Control) Act, 1947: The Act had its origin during the war in 1943 when the objective was to channel resources to support the war effort. It was retained with some modifications as a means of controlling the raising of capital by companies and to ensure that national resources were channelled into proper lines, i.e. for desirable purposes to serve goals and priorities of the government, and to protect the interests of investors. Under the Act, any firm wishing to issue securities had to obtain approval from the Central Government, which

also determined the amount, type and price of the issue. As a part of the liberalisation process, the Act was repealed in 1992 paving way for market determined allocation of resources. 18 SEBI Act, 1992: The SEBI Act, 1992 was enacted to empower 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 corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. It can conduct enquiries, audits and inspection of all concerned and adjudicate offences under the Act. It has powers to register and regulate all market intermediaries and also to penalise them in case of violations of the provisions of the Act, Rules and Regulations made there under. SEBI has full autonomy and authority to regulate and develop an orderly securities market. Securities Contracts (Regulation) Act, 1956: It provides for direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges and aims to prevent

undesirable transactions in securities. It gives Central Government regulatory jurisdiction over (a) stock exchanges through a process of recognition and continued supervision, (b) contracts in securities, and (c) listing of securities on stock exchanges. As a condition of recognition, a stock exchange complies with conditions prescribed by Central Government. Organised trading activity in securities takes place on a specified recognised stock exchange. The stock exchanges determine their own listing regulations which have to conform to the minimum listing criteria set out in the Rules. Depositories Act, 1996: The Depositories Act, 1996 provides for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline the settlement process, the Act envisages transfer of ownership of securities electronically by book entry without making the securities move from person to person. The

Act has made the securities of all public limited companies freely transferable, restricting the companys right to use discretion in effecting the transfer of securities, and the transfer deed and other procedural requirements under the Companies Act have been dispensed with. Companies Act, 1956: It deals with issue, allotment and transfer of securities and various aspects relating to company management. It provides for standard of disclosure in public issues of capital, particularly in the fields of company management and projects, information about other listed companies under the same management, and management perception of risk factors. It also regulates underwriting, the use of premium and discounts on issues, rights and bonus issues, payment of interest and dividends, supply of annual report and other information. Prevention of Money Laundering Act, 2002: The primary objective of the Act is to prevent money-laundering and to provide for confiscation of property derived from or involved in money-laundering. The term money-laundering is defined as whoever acquires, owns, possess or transfers any proceeds of crime; or knowingly enters into any transaction which is related 19

to proceeds of crime either directly or indirectly or conceals or aids in the concealment of the proceeds or gains of crime within India or outside India commits the offence of moneylaundering. Besides providing punishment for the offence of money-laundering, the Act also provides other measures for prevention of Money Laundering. The Act also casts an obligation on the intermediaries, banking companies etc to furnish information, of such prescribed transactions to the Financial Intelligence Unit- India, to appoint a principal officer, to maintain certain records etc. 1.5.2 Rules Regulations and Regulators The Government has framed rules under the SCRA, SEBI Act and the Depositories Act. SEBI has framed regulations under the SEBI Act and the Depositories Act for registration and regulation of all market intermediaries, and for prevention of unfair trade practices, insider trading, etc. Under these Acts, Government and SEBI issue notifications, guidelines, and circulars which need to be complied with by market participants. The SROs like stock exchanges have also laid down their rules and regulations. The absence of conditions of perfect competition in the securities market makes the role of

regulator extremely important. The regulator ensures that the market participants behave in a desired manner so that securities market continues to be a major source of finance for corporate and government and the interest of investors are protected. The responsibility for regulating the securities market is shared by Department of Economic Affairs (DEA), Department of Company Affairs (DCA), Reserve Bank of India (RBI) and SEBI. The orders of SEBI under the securities laws are appellable before a Securities Appellate Tribunal (SAT)l. Most of the powers under the SCRA are exercisable by DEA while a few others by SEBI. The powers of the DEA under the SCRA are also con-currently exercised by SEBI. The powers in respect of the contracts for sale and purchase of securities, gold related securities, money market securities and securities derived from these securities and ready forward contracts in debt securities are exercised concurrently by RBI. The SEBI Act and the Depositories Act are mostly administered by SEBI. The rules under the securities laws are framed by government and regulations by SEBI. All these are administered by SEBI. The powers under

the Companies Act relating to issue and transfer of securities and non-payment of dividend are administered by SEBI in case of listed public companies and public companies proposing to get their securities listed. The SROs ensure compliance with their own rules as well as with the rules relevant for them under the securities laws. 1.5.3 Reforms Since 1990s Corporate Securities Market With the objectives of improving market efficiency, enhancing transparency, preventing unfair 20 trade practices and bringing the Indian market up to international standards, a package of reforms consisting of measures to liberalise, regulate and develop the securities market was introduced. The practice of allocation of resources among different competing entities as well as its terms by a central authority was discontinued. The issuers complying with the eligibility criteria were allowed freedom to issue the securities at market determined rates. The secondary market overcame the geographical barriers by moving to screen based trading. Trades enjoyed counter-party guarantee. The trading cycle shortened to a day and trades

are settled within 2 working days, while all deferral products were banned. Physical security certificates almost disappeared. A variety of derivative products were permitted. The following paragraphs discuss the principal reform measures undertaken since 1992. SEBI Act, 1992: It created a regulator (SEBI), empowered it adequately and assigned it with the responsibility 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 corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. All market intermediaries are registered and regulated by SEBI. They are also required to appoint a compliance officer who is responsible for monitoring compliance with securities laws and for redressal of investor grievances. The courts have upheld the powers of SEBI to impose monetary penalties and to levy fees from market intermediaries. Enactment of SEBI Act is the first attempt towards integrated regulation of the securities market. SEBI was given full authority and jurisdiction over the securities market under the

Act, and was given concurrent/delegated powers for various provisions under the Companies Act and the SC(R)A. Many provisions in the Companies Act having a bearing on securities market are administered by SEBI. The Depositories Act, 1996 is also administered by SEBI. SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations 2009 The SEBI (Issue of Capital and Disclosure Requirements) Regulation, 2009. are applicable for public issue; rights issue, preferential issue; an issue of bonus shares by a listed issuer; qualified institutions placement by a listed issuer and issue of Indian Depository Receipts. The issuer should appoint one or more merchant bankers, at least one of whom should be a lead merchant banker. The issuer should also appoint other intermediaries, in consultation with the lead merchant banker, to carry out the obligations relating to the issue. The issuer should in consultation with the lead merchant banker, appoint only those intermediaries which are registered with SEBI. Where the issue is managed by more than one merchant banker, the rights, obligations and responsibilities, relating inter alia to disclosures, allotment, refund and underwriting obligations, if any, of each merchant banker should be predetermined and

disclosed in the offer document. The issuer determines the price of the equity shares and convertible securities in consultation with the lead merchant banker or through the book building process. In case of debt instruments, the issuer determines the coupon rate and 21 conversion price of the convertible debt instruments in consultation with the lead merchant banker or through the book building process. Screen Based Trading: The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. This imposed limits on trading volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced a nationwide on-line fully-automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. SBTS electronically matches orders on a strict price/time priority and hence cuts down on time,

cost and risk of error, as well as on fraud resulting in improved operational efficiency. It allows faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enables market participants to see the full market on real-time, making the market transparent. It allows a large number of participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market. It provides full anonymity by accepting orders, big or small, from members without revealing their identity, thus providing equal access to everybody. It also provides a perfect audit trail, which helps to resolve disputes by logging in the trade execution process in entirety. This diverted liquidity from other exchanges and in the very first year of its operation, NSE became the leading stock exchange in the country, impacting the fortunes of other exchanges and forcing them to adopt SBTS also. As a result, manual trading disappeared from India. Technology was used to carry the trading platform to the premises of brokers. NSE carried the trading platform further to the PCs in the residences of investors through

the Internet and to hand-held devices through WAP for convenience of mobile investors. This made a huge difference in terms of equal access to investors in a geographically vast country like India. Trading Cycle: The trades accumulated over a trading cycle and at the end of the cycle, these were clubbed together, and positions were netted out and payment of cash and delivery of securities settled the balance. This trading cycle varied from 14 days for specified securities to 30 days for others and settlement took another fortnight. Often this cycle was not adhered to. Many things could happen between entering into a trade and its performance providing incentives for either of the parties to go back on its promise. This had on several occasions led to defaults and risks in settlement. In order to reduce large open positions, the trading cycle was reduced over a period of time to a week. The exchanges, however, continued to have different weekly trading cycles, which enabled shifting of positions from one exchange to another. Rolling settlement on T+5 basis was introduced in respect of specified scrips reducing the trading cycle to one day. It was made mandatory for all exchanges to follow a uniform

weekly trading cycle in respect of scrips not under rolling settlement. All scrips moved to rolling settlement from December 2001. T+5 gave way to T+3 from April 2002 and T+2 since April 2003. The market also had a variety of deferral products like modified carry forward 22 system, which encouraged leveraged trading by enabling postponement of settlement. The deferral products have been banned. The market has moved close to spot/cash market. Derivatives Trading: To assist market participants to manage risks better through hedging, speculation and arbitrage, SC(R)A was amended in 1995 to lift the ban on options in securities. However, trading in derivatives did not take off, as there was no suitable legal and regulatory framework to govern these trades. Besides, it needed a lot of preparatory work- the underlying cash markets strengthened with the assistance of the automation of trading and of the settlement system; the exchanges developed adequate infrastructure and the information systems required to implement trading discipline in derivative instruments. The SC(R)A was amended further in December 1999 to expand the definition of securities

to include derivatives so that the whole regulatory framework governing trading of securities could apply to trading of derivatives also. A three-decade old ban on forward trading, which had lost its relevance and was hindering introduction of derivatives trading, was withdrawn and derivatives trading took off in June 2000. The Mini derivative Futures & Options contract was introduced for trading on S&P CNX Nifty on January 1, 2008 while the long term option contracts on S&P CNX Nifty were introduced for trading on March 3, 2008. Demutualisation: Historically, brokers owned, controlled and managed stock exchanges. In case of disputes, the self often got precedence over regulations leading inevitably to conflict of interest. The regulators, therefore, focused on reducing dominance of members in the management of stock exchanges and advised them to reconstitute their governing councils to provide for at least 50% non-broker representation. This did not materially alter the situation. In face of extreme volatility in the securities market, Government proposed in March 2001 to corporatise the stock exchanges by which ownership, management and trading membership would be segregated from one another. Government offered a variety of tax incentives to

facilitate corporatisation and demutualization of stock exchanges. NSE, however, adopted a pure demutualised governance structure where ownership, management and trading are with three different sets of people. This completely eliminated any conflict of interest and helped NSE to aggressively pursue policies and practices within a public interest (market efficiency and investor interest) framework. Currently, there are 19 demutualised stock exchanges. Depositories Act: The earlier settlement system on Indian stock exchanges gave rise to settlement risk due to the time that elapsed before trades are settled. Trades were settled by physical movement of paper. This had two aspects. First, the settlement of trade in stock exchanges by delivery of shares by the seller and payment by the purchaser. The stock exchange aggregated trades over a period of time to carry out net settlement through the physical delivery of securities. The process of physically moving the securities from the seller to the ultimate buyer through the sellers broker and buyers broker took time with the risk of delay somewhere along the chain. The second aspect related to transfer of shares in

favour of the purchaser by the company. The system of transfer of ownership was grossly 23 inefficient as every transfer involved physical movement of paper securities to the issuer for registration, with the change of ownership being evidenced by an endorsement on the security certificate. In many cases the process of transfer took much longer, and a significant proportion of transactions ended up as bad delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities were rampant, and in addition the issuer had the right to refuse the transfer of a security. All this added to costs, and delays in settlement, restricted liquidity and made investor grievance redressal time consuming and at times intractable. To obviate these problems, the Depositories Act, 1996 was passed to provide for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities

in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline both the stages of settlement process, the Act envisages transfer of ownership of securities electronically by book entry without making the securities move from person to person. In order to promote dematerialisation, the regulator mandated trading and settlement in demat form in an ever-increasing number of securities in a phased manner. The stamp duty on transfer of demat securities was waived. Two depositories, namely, NSDL and CDSL, came up to provide instantaneous electronic transfer of securities. All actively traded scrips are held, traded and settled in demat form. Demat settlement accounts for over 99% of turnover settled by delivery. This has almost eliminated the bad deliveries and associated problems. To prevent physical certificates from sneaking into circulation, it is mandatory for all IPOs to be compulsorily traded in dematerialised form. The admission to a depository for dematerialisation of securities has been made a prerequisite for making a public or rights issue or an offer for sale. It has also been made compulsory for public listed companies making IPO of any security

for Rs.10 crore or more to do the same only in dematerialised form. Risk Management: Market integrity is the essence of any financial market. To preempt market failures and protect investors, the regulator/exchanges have developed a comprehensive risk management system, which is constantly monitored and upgraded. It encompasses capital adequacy of members, adequate margin requirements, limits on exposure and turnover, indemnity insurance, on-line position monitoring and automatic disablement, etc. They also administer an efficient market surveillance system to curb excessive volatility, detect and prevent price manipulations. Exchanges have set up trade/settlement guarantee funds for meeting shortages arising out of non-fulfillment/partial fulfillment of funds obligations by the members in a settlement. As a part of the risk management system, the index based market wide circuit breakers have also been put in place. The anonymous electronic order book ushered in by the NSE did not permit members to assess credit risk of the counter-party necessitated some innovation in this area. To effectively address 24 this issue, NSE introduced the concept of a novation, and set up the first clearing corporation,

viz. National Securities Clearing Corporation Ltd. (NSCCL), which commenced operations in April 1996. The NSCCL assures the counterparty risk of each member and guarantees financial settlement. Counterparty risk is guaranteed through a fine tuned risk management system and an innovative method of on-line position monitoring and automatic disablement. NSCCL established a Settlement Guarantee Fund (SGF). The SGF provides a cushion for any residual risk and operates like a self-insurance mechanism wherein the members contribute to the fund. In the event of failure of a trading member to meet his obligations, the fund is utilized to the extent required for successful completion of the settlement. This has eliminated counterparty risk of trading on the Exchange. The market has now full confidence that settlements will take place in time and will be completed irrespective of default by isolated trading members. In fact such confidence is driving volumes on exchanges. Traditionally, brokerage firms in India have been proprietary or partnership concerns with unlimited liabilities. This restricted the amount of capital that such firms can raise. The growing volume of transactions made it imperative for such firms to be well capitalised and

professional. The necessary legal changes were effected to open up the membership of stock exchanges to corporates with limited liability, so that brokerage firms may be able to raise capital and retain earnings. In order to boost the process of corporatisation, capital gains tax payable on the difference between the cost of the individuals initial acquisition of membership and the market value of that membership on the date of transfer to the corporate entity was waived. In response, many brokerage firms reorganised themselves into corporate entities. Investor Protection: The SEBI Act established SEBI with the primary objective of protecting the interests of investors in securities and empowers it to achieve this objective. SEBI specifies the matters to be disclosed and the standards of disclosure required for the protection of investors in respect of issues and issues directions to all intermediaries and other persons associated with the securities market in the interest of investors or of orderly development of the securities market. The Central Government established a fund called Investor Education and Protection Fund (IEPF) in October 2001 for the promotion of awareness amongst investors

and protection of the interest of investors. The Government issued the following guidelines for the purpose of financial assistance from IEPF: (a) Any organisation/entity/person with a viable project proposal on investors education and protection would be eligible for assistance from the fund. (b) The entity should be registered under the Societies Registration Act or formed as Trusts or incorporated Companies; should be in existence for a minimum period of 2 years prior to its date of application for registration for assistance; should have a minimum of 20 members and a proven record of 2 years; and should have rules, regulations and or by-laws for its governance and management. (c) No profit making entity shall be eligible for financial assistance from the fund. 25 (d) Notwithstanding the above, the Committee on IEPF can give a project to any organisation. (e) While considering proposals, the IEPF Committee takes into account the audited accounts and the annual reports of the last three years of the entity seeking assistance from IEPF. (f) The limit for each entity for assistance would be subject to 5% of the budget of IEPF during that financial year and not exceeding 80%1 of the amount to be spent on the proposed programme/activity. DEA, DCA, SEBI and exchanges have set up investor grievance cells for redressal of investor

grievance. The exchanges maintain investor protection funds to take care of investor claims, which may arise out of non-settlement of obligations by a trading member for trades executed on the exchange. DCA has also set up an investor education and protection fund for the promotion of investors awareness and protection of interest of investors. All these agencies and investor associations are organising investor education and awareness programmes. Globalisation: Indian securities market is getting increasingly integrated with the rest of the world. Indian companies have been permitted to raise resources from abroad through issue of ADRs, GDRs, FCCBs and ECBs. ADRs/GDRs have two-way fungibility. Indian companies are permitted to list their securities on foreign stock exchanges by sponsoring ADR/GDR issues against block shareholding. NRIs and OCBS are allowed to invest in Indian companies. FIIs have been permitted to invest in all types of securities, including government securities. The investments by FIIs enjoy full capital account convertibility. They can invest in a company under portfolio investment route upto 24% of the paid up capital of the company. This can

be increased up to the sectoral cap/statutory ceiling, as applicable, provided this has the approval of the Indian companys board of directors and also its general body. Indian Stock Exchanges have been permitted to set up trading terminals abroad. The trading platform of Indian exchanges is now accessed through the Internet from anywhere in the world. Mutual Funds have been permitted to set up off-shore funds to invest in equities of other countries. They can also invest in ADRs/GDRs of Indian companies. Mini Nifty and long dated options: The year 2008 witnessed the launch of new products in the F&O Segment. The mini derivative (futures and options) contracts on S&P CNX Nifty were introduced for trading on January 1, 2008. The mini contracts are a fraction of normal derivative contracts and extend greater affordability to individual investors, helps the individual investor to hedge risks of a smaller portfolio, offers low levels of risk in terms of smaller level of possible downside compared to a big size contract and also increases overall market liquidity and participation. The Long Term Options Contracts on NSEs S&P CNX Nifty were launched on March 3, 2008. The long-term options are similar to short-term options, but the later expiration

dates offer the opportunity for long-term investors to take a view on prolonged price changes 1 Sourced from http://www.iepf.gov.in/Reg_Fin. 26 without needing to use a combination of shorter term option contracts. The premiums for long term options tend to be higher than that of short term option because the increased expiration period means increased possibility of larger movement in the price of the underlying. Short Selling: Pursuant to the recommendations of the Secondary Market Advisory Committee (SMAC) of SEBI and the decision of the SEBI Board, it was decided to permit all classes of investors to short sell. Short selling is defined as selling a stock which the seller does not own at the time of trade. It increases liquidity in the market, and makes price discovery more efficient. Besides, it curbs manipulation of stocks as informed investors are able to go short on stocks they feel are higher than fair value. This facility was available to non-institutional investors. Vide a circular in February 2008, SEBI permitted all classes of investors, viz., retail and institutional investors to short sell. It, however, does not permit naked short sales and accordingly,

requires participants to mandatorily honour their obligation of delivering the securities at the time of settlement. It does not permit institutional investor to do day trading i.e., square-off their transactions intra-day. In other words, all transactions are be grossed for institutional investors at the custodians level and the institutions are required to fulfill their obligations on a gross basis. The custodians, however, continue to settle their deliveries on a net basis with the stock exchanges. It has put in a scheme for Securities Lending and Borrowing to provide the necessary impetus to short sell. The facility of short sales is made available in respect of securities traded in derivatives segment of exchanges. Securities Lending and Borrowing: SEBI issued a SLB scheme on December 20, 2007. The salient features of the scheme are as under: All Clearing members of NSCCL including Banks and Custodians referred to as Participant are registered as Approved Intermediaries (AIs) under the SLS, 1997. The SLB would take place on an automated, screen based, order-matching platform which will be provided by the AIs. This platform would be independent of the other trading platforms. Currently, securities available for trading in F&O segment of National Stock Exchange

of India Ltd. (NSEIL) would be eligible for lending & borrowing under the scheme. Securities lending and borrowing is permitted in dematerialized form only All categories of investors including retail, institutional etc. will be permitted to borrow and lend securities. The borrowers and lenders would access the platform for lending/ borrowing set up by the AIs through the clearing members (CMs) who are authorized by the AIs in this regard. The tenure of lending/borrowing would be fixed as standardised contracts. Accordingly the return of securities by borrower is scheduled on the respective reverse leg settlement day. Each reverse leg settlement date is assigned a specific series number. The tenure of lending and borrowing ranges from 1 month up to a maximum period of 12 months. 27 The first leg of the transactions across all series including early recall/repayment transactions are settled on T+1 day on a gross basis.. The settlement of lending and borrowing transactions would be independent of normal market settlement. The settlement of the lending and borrowing transactions should be done on a gross basis at the level of the clients i.e. no netting of transactions at any level will be permitted.

NSCCL, as an Approved Intermediary (AI) launched the Securities Lending & Borrowing Scheme from April 21, 2008. Lending & Borrowing is carried on an automated screen based platform where the order matching is done on basis of price time priority. Direct Market Acess: During April 2008, Securities & Exchange Board of India (SEBI) allowed the direct market access (DMA) facility to the institutional investors. DMA allows brokers to offer clients direct access to the exchange trading system through the brokers infrastructure without manual intervention by the broker. DMA facility give clients direct control over orders, help in faster execution of orders, reduce the risk of errors from manual order entry and lend greater transparency and liquidity. DMA also leads to lower impact cost for large orders, better audit trails and better use of hedging and arbitrage opportunities through the use of decision support tools/algorithms for trading. Volatility Index: With rapid changes in volatility in securities market from time to time, a need was felt for an openly available and quoted measure of market volatility in the form of an index to help market participants. On January 15, 2008, Securities and Exchange Board

of India recommended Exchange to construct and disseminate the volatility index. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualised volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options. On April 08, 2008, NSE launched the Volatility Index, India VIX, based on the Nifty 50 Index Option prices. From the best bid-ask prices of Nifty 50 Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. The India VIX is a simple but useful tool in determining the overall volatility of the market Cross Margining: Many trading members undertake transactions on both the cash and derivative segments of an Exchange. They keep separate deposits with the exchange for taking positions in two different segments. In order to improve the efficiency of the use of the margin capital by market participants and as in initial step towards cross margining across cash and derivatives markets SEBI allowed Cross Margining benefit in May 2008. For Cross margining the stock positions of the institutions in capital market segment after

confirmation by the custodian on T+1 day shall be compared with the stock futures position of the same institution in derivative segment based on the CP code of the institution at the end of the day. The position shall be considered for cross margining only if the position in the capital market segment off set the position in the derivative segment. 28 SEBI has allowed the following to start with: a. Cross margin is available for institutional trades. b. Cross margin is available to positions in cash market having corresponding offsetting positions in the stock futures market. c. For positions in the cash market which have corresponding offsetting positions in the stock futures, VaR margin is not be levied on the cash market position to the extent of the off-setting stock futures market position. d. Extreme Loss margin and Market to Market margin shall continue to be levied on the entire cash market position. e. The near-month stock futures positions are not considered for crossmargin benefit three days prior to expiry (the last Thursday of every month) and there will be no change in the margins on the F & O positions. In December 2008, SEBI extended the cross margin facility across Cash and F&O segment

and to all the market participants. The salient features of the cross margining are as under : 1. Cross margin is available across Cash and F&O segment and to all categories of market participants. 2. The positions of clients in both the Cash and F&O segments to the extent they offset each other shall be considered for the purpose of cross margining as per the following priority. a. Index futures and constituent stock futures in F&O segment. b. Index futures and constituent stock positions in Cash segment. c. Stock futures in F&O segment and stock positions in Cash segment 3. In order to extend the cross margin benefit as per 2 (a) and (b) above, the basket of constituent stock futures/ stock positions shall be a complete replica of the index futures 4. The positions in F&O segment for stock futures and index futures shall be in the same expiry month to be eligible for cross margin benefit. 5. Positions in option contracts shall not be considered for cross margining benefit. 6. The Computation of cross margin shall be at client level on an on-line real time basis. 7. For institutional investors the positions in Cash segment shall be considered only after confirmation by the custodian on T+1 basis and on confirmation by the clearing member in F&O segment. 8. The positions in the Cash and F&O segment shall be considered for cross margining

only till time the margins are levied on such positions. 9. The positions which are eligible for offset, shall be subject to spread margins. The spread margins shall be 25% of the applicable upfront margins on the offsetting positions. 29 Government Securities Market The government securities market has witnessed significant transformation in the 1990s. With giving up of the responsibility of allocating resources from securities market, government stopped expropriating seigniorage and started borrowing at near-market rates. Government securities are now sold at market related coupon rates through a system of auctions instead of earlier practice of issue of securities at very low rates just to reduce the cost of borrowing of the government. Major reforms initiated in the primary market for government securities include auction system (uniform price and multiple price method) for primary issuance of Tbills and central government dated securities, a system of primary dealers and noncompetitive bids to widen investor base and promote retail participation, issuance of securities across maturities to develop a yield curve from short to long end and provide benchmarks for rest

of the debt market, innovative instruments like, zero coupon bonds, floating rate bonds, bonds with embedded derivatives, availability of full range ( 91-day, 182 day and 364-day) of T-bills, etc. The reforms in the secondary market include Delivery versus Payment system for settling scripless SGL transactions to reduce settlement risks, SGL Account II with RBI to enable financial intermediaries to open custody (Constituent SGL) accounts and facilitate retail transactions in scripless mode, enforcement of a trade-for-trade regime, settlement period of T+1 for all transactions undertaken directly between SGL participants and for transactions routed through NSE brokers, routing transactions through brokers of NSE, OTCEI and BSE, repos in all government securities with settlement through SGL, liquidity support to PDs to enable them to support primary market and undertake market making, special fund facility for security settlement, etc. Other measures include abolition of TDS on government securities and stamp duty on transfer of demat debt securities. Market Infrastructure: As part of the ongoing efforts to build debt market infrastructure, two new systems, the Negotiated Dealing System (NDS) and the Clearing Corporation of India

Limited (CCIL) commenced operations on February 15, 2002. NDS, interalia, facilitates screen based negotiated dealing for secondary market transactions in government securities and money market instruments, online reporting of transactions in the instruments available on the NDS and dissemination of trade information to the market. Government Securities (including T-bills), call money, notice/term money, repos in eligible securities, Commercial Papers and Certificate of Deposits are available for negotiated dealing through NDS among the members. The CCIL facilitates settlement of transactions in government securities (both outright and repo) on Delivery versus Payment (DVP-II) basis which provides for settlement of securities on gross basis and settlement of funds on net basis simultaneously. It acts as a central counterparty for clearing and settlement of government securities transactions done on NDS. Further, there was adoption of modified Delivery-versus-Payment mode of settlement (DvP III in March 2004). The settlement system for transaction in government securities was standardized to T+1 cycle on May 11, 2005. To provide banks and other institutions with a more advanced and more efficient trading platform, an anonymous order matching trading

platform (NDS-OM) was introduced in August 2005. Short sale was permitted in G-secs in 30 2006 to provide an opportunity to market participants to manage their interest rate risk more effectively and to improve liquidity in the market. When issued (WI) trading in Central Government Securities was introduced in 2006. As a result of the gradual reform process undertaken over the years, the Indian GSec market has become increasingly broad-based and characterized by an efficient auction process, an active secondary market, electronic trading and settlement technology that ensures safe settlement with Straight through Processing (STP). Research in Securities Market In order to deepen the understanding and knowledge about Indian capital market, and to assist in policy-making, SEBI has been promoting high quality research in capital market. It has set up an in-house research department, which brings out working papers on a regular basis. In collaboration with NCAER, SEBI brought out a Survey of Indian Investors, which estimates investor population in India and their investment preferences. SEBI has also tied

up with reputed national and international academic and research institutions for conducting research studies/projects on various issues related to the capital market. In order to improve market efficiency further and to set international benchmarks in the securities industry, NSE supports a scheme called the NSE Research Initiative with a view to develop an information base and a better insight into the working of securities market in India. The objective of this initiative is to foster research, which can support and facilitate (a) stock exchanges to better design market micro-structure, (b) participants to frame their strategies in the market place, (c) regulators to frame regulations, (d) policy makers to formulate policies, and (e) expand the horizon of knowledge. The Initiative has received tremendous response. Testing and Certification The intermediaries, of all shapes and sizes, who package and sell securities, compete with one another for the chance to handle investors/issuers money. The quality of their services determines the shape and health of the securities market. In developed markets and in some of the developing markets, this is ensured through a system of testing and certification of

persons joining market intermediaries in the securities market. This sort of arrangement ensures that a person dealing with financial products has a minimum standard of knowledge about them, market and regulations so as to assist the customers in their dealings. This allows market participants and intermediaries to build their own tailored staff development strategies and improves career prospectus of certified professionals, while maintaining and enhancing the confidence of the investors in the market. A testing and certification mechanism that has become extremely popular and is sought after by the candidates as well as employers is unique on-line testing and certification programme called National Stock Exchanges Certification in Financial Markets (NCFM). It is an on-line fully automated nation-wide testing and certification system where the entire process from generation of question paper, testing, assessing, scores reporting and certifying is fully automated - there is absolutely no scope for human intervention. It allows tremendous 31 flexibility in terms of testing centres, dates and timing and provides easy accessibility and

convenience to candidates as he can be tested at any time and from any location. It tests practical knowledge and skills, that are required to operate in financial markets, in a very secure and unbiased manner, and certifies personnel who have a proper understanding of the market and business and skills to service different constituents of the market. The above reforms have come in stages. As some deficiency is noted or some malpractice surfaces in the working of the market, the authorities initiate further reforms and corrective steps. As such, the process of reform in the securities market is far from complete. At the same time the reforms undertaken so far have aimed to improve operational and informational efficiency in the market by enabling the participants to carry out transactions in a cost effective manner and providing them with full, relevant and accurate information in time. A number of checks and balances have been built up to protect investors, enhance their confidence and avoid systemic failure of the market. Stability of the system as a whole has been protected by allowing for contestability of the market and imposing entry criteria for issuers and intermediaries. Financial integrity of the market is ensured by prudential controls

on intermediaries. 1.6 ROLE OF NSE IN INDIAN SECURITIES MARKET National Stock Exchange of India Limited (NSE) was given recognition as a stock exchange in April 1993. NSE was set up with the objectives of (a) establishing a nationwide trading facility for all types of securities, (b) ensuring equal access to all investors all over the country through an appropriate communication network, (c) providing a fair, efficient and transparent securities market using electronic trading system, (d) enabling shorter settlement cycles and book entry settlements, and (e) meeting the international benchmarks and standards. Within a short span of life, above objectives have been realized and the Exchange has played a leading role as a change agent in transforming the Indian Capital Markets to its present form. NSE has set up infrastructure that serves as a role model for the securities industry in terms of trading systems, clearing and settlement practices and procedures. The standards set by NSE in terms of market practices, products, technology and service standards have become industry benchmarks and are being replicated by other market participants. It provides screen-based

automated trading system with a high degree of transparency and equal access to investors irrespective of geographical location. The high level of information dissemination through online system has helped in integrating retail investors on a nation-wide basis. The Exchange currently operates three market segments, namely Capital Market Segment, Wholesale Debt Market Segment and Futures an Options segment. NSE has been playing the role of a catalytic agent in reforming the market in terms of microstructure and market practices. Right from its inception, the exchange has adopted the purest form of demutualised set up whereby the ownership, management and trading rights are in the hands of three different sets of people. This has completely eliminated any conflict of interest and helped NSE to aggressively pursue policies and practices within a public interest framework. It has helped in shifting the trading platform from the trading hall in the premises of the exchange to the computer terminals at the premises of the trading members located country-wide and subsequently to the personal 32 computers in the homes of investors and even to hand held portable devices for the mobile

investors. Settlement risks have been eliminated with NSEs innovative endeavors in the area of clearing and settlement viz., reduction of settlement cycle, professionalisation of the trading members, fine-tuned risk management system, dematerialisation and electronic transfer of securities and establishment of clearing corporation. As a consequence, the market today uses the state-of-art information technology to provide an efficient and transparent trading, clearing and settlement mechanism. NSE provides a trading platform for of all types of securities-equity and debt, corporate and government and derivatives. On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, it commenced operations in the Wholesale Debt Market (WDM) segment in June 1994, in the Capital Market (CM) segment in November 1994, and in Futures & Options (F&O) segment in June 2000. The Exchange started providing trading in retail debt of Government Securities in January 2003. The Wholesale Debt Market segment provides the trading platform for trading of a wide range of debt securities. Its product, which is now disseminated jointly with FIMMDA, the

FIMMDA NSE MIBID/MIBOR is used as a benchmark rate for majority of deals struck for Interest Rate Swaps, Forwards Rate Agreements, Floating Rate Debentures and Term Deposits in the country. Its Zero Coupon Yield Curve as well as NSE-VaR for Fixed Income Securities have also become very popular for valuation of sovereign securities across all maturities irrespective of its liquidity and facilitated the pricing of corporate papers and GOI Bond Index. NSEs Capital Market segment offers a fully automated screen based trading system, known as the National Exchange for Automated Trading (NEAT) system, which operates on a strict price/time priority. It enables members from across the country to trade simultaneously with enormous ease and efficiency. Its Futures & Options segment provides trading of a wide range of derivatives like Index Futures, Index Options, Stock Options and Stock Futures. NSEs Futures & Options segment provides trading of a wide range of derivatives like Index Futures, Index Options, Stock Options and Stock Futures. NSEs Currency Derivatives segment provides trading on currency futures contracts on the US $-INR which commenced on August 29, 2008. In February 2009, trading on additional pairs such as GBP-INR, EUR-INR and JPY-INR was allowed while trading in US $-INR currency

options were allowed for trading on October 29, 2010. The interest rate futures trade on the currency derivatives segment of NSE and they were allowed for trading segment on August 31, 2009 Technology and Application Systems in NSEIL NSE is the first exchange in the world to use satellite communication technology for trading. Its trading system, called National Exchange for Automated Trading (NEAT), is a state of-theart client server based application. At the server end all trading information is stored in an in-memory database to achieve minimum response time and maximum system availability for users. It has uptime record of 99.7%. The system also ensures data integrity with past record of a single error in 10 million bits. NSE has been continuously undertaking capacity 33 enhancement measures so as to effectively meet the requirements of increased users and associated trading loads. NSE has also put in place NIBIS (NSEs Internet Based Information System) for on-line real-time dissemination of trading information over the Internet. As part of its business continuity plan, NSE has established a disaster back-up site at Chennai

along with its entire infrastructure, including the satellite earth station and the highspeed optical fibre link with its main site at Mumbai. This site at Chennai is a replica of the production environment at Mumbai. The transaction data is backed up on near real time basis from the main site to the disaster back-up site through the high-speed optical fibre to keep both the sites all the time synchronised with each other. NSEIL is a technology driven exchange and since its inception it has been harnessing technology to provide the best possible and efficient service to all market participants and stake holders. The various application systems that it uses for trading as well clearing and settlement and other operations are the backbone of the Exchange. The application systems used for the day-to-day functioning of the Exchange can be divided into (a) Front end applications and (b) Back office applications. In the front end, there are 6 applications: (a) NEAT CM system takes care of trading of securities in the Capital Market segment that includes equities, debentures/notes as well as retail Gilts. The NEAT CM application has a split architecture wherein the split is on the securities and users. The application runs on three Stratus systems with Open Strata Link (OSL). This

application also provides data feed for processing to some other systems like Index, OPMS through TCP/IP. This is a direct interface with the Trading members of the CM segment of the Exchange for entering the orders into the main system. There is a two way communication between the NSE main system and the front end terminal of the Trading Member. (b) NEAT WDM system takes care of trading of securities in the Wholesale Debt Market (WDM) segment that includes Gilts, Corporate Bonds, CPs, T-Bills, etc. This is a direct interface with the Trading members of the WDM segment of the Exchange for entering the orders/trades into the main system. There is a two way communication between the NSE main system and the front end terminal of the Trading Member. (c) NEAT F&O system takes care of trading of securities in the Futures and Options (F&O) segment that includes Futures on Index as well as individual stock and Options on Index as well as individual stocks. This is a direct interface with the Trading members of the F&O segment of the Exchange for entering the orders into the main system. There is a two way communication between the NSE main system and the front end terminal of the Trading Member. (d) NEAT IPO system is an interface to help the initial public offering of companies

which are issuing the stocks to raise capital from the market. This is a direct interface with the Trading members of the CM segment who are registered for undertaking 34 order entry on behalf of their clients for IPOs. NSE uses the NEAT IPO system that allows bidding in several issues concurrently. There is a two way communication between the NSE main system and the front end terminal of the Trading Member. (e) NEAT MF system is an interface with the Trading members of the CM segment for order collection of designated Mutual Funds units. (f) NEAT- CD system is trading system for currency derivatives. Currently, currency futures are trading in the segment. (g) Surveillance system offers the users a facility to comprehensively monitor the trading activity and analyse the trade data online and offline. In the back office, the following important application systems are operative: (i) NCSS (Nationwide Clearing and Settlement System) is the clearing and settlement system of the NSCCL for the trades executed in the CM segment of the Exchange. The system has 3 important interfaces a) OLTL (Online Trade loading) that takes each and every trade executed on real time basis and allocates the same to the clearing members, b) Depository Interface that connects the depositories for settlement of securities and Clearing Bank Interface that connects the 13 clearing banks for settlement of funds. It also interfaces with the clearing members for all required reports. c) Through collateral management system it keeps an account of all available

collaterals on behalf of all trading/clearing members and integrates the same with the position monitoring of the trading/clearing members. The system also generates base capital adequacy reports. (ii) FOCASS is the clearing and settlement system of the NSCCL for the trades executed in the F&O segment of the Exchange. It interfaces with the clearing members for all required reports. Through collateral management system it keeps an account of all available collaterals on behalf of all trading/clearing members and integrates the same with the position monitoring of the trading/ clearing members. The system also generates base capital adequacy reports. (iii) OPMS the online position monitoring system that keeps track of all trades executed for a trading member vis-a-vis its capital adequacy. (iv) PRISM is the parallel risk management system for F&O trades using Standard Portfolio Analysis (SPAN). It is a system for comprehensive monitoring and load balancing of an array of parallel processors that provides complete fault tolerance. It provides real time information on initial margin value, mark to market profit or loss, collateral amounts, contract-wise latest prices, contract-wise open interest and limits. 35 (v) Data warehousing that is the central repository of all data in CM as well as F&O segment of the Exchange, (vi) Listing system that captures the data from the companies which are listed in the Exchange for corporate governance and integrates the same to the trading system for necessary broadcasts for data dissemination process and (vii) Membership system that keeps track of all required details of the Trading Members of the Exchange. ADRs/GDRs

Indian companies are permitted to raise foreign currency resources through two main sources:(a) issue of Foreign Currency Convertible Bonds (FCCBs) more commonly known as Euro Issues and (b) issue of ordinary equity shares through depository receipts, namely, Global Depository Receipts (GDRs)/American Depository Receipts (ADRs) to foreign investors i.e. institutional investors or individuals (including NRIs) residing abroad. A depository receipt (DR) is any negotiable instrument in the form of a certificate denominated in US dollars. The certificates are issued by an overseas depository bank against certain underlying stock/shares. The shares are deposited by the issuing company with the depository bank. The depository bank in turn tenders DRs to the investors. A DR represents a particular bunch of shares on which the receipt holder has the right to receive dividend, other payments and benefits which company announces from time to time for the share holders. However, it is nonvoting equity holding. DRs facilitate cross border trading and settlement, minimize transactions costs and broaden the potential base, especially among institutional investors. An American Depository Receipt (ADR) is a negotiable U.S. certificate representing ownership

of shares in a non-U.S. corporation. ADRs are quoted and traded in U.S. dollars in the U.S. securities market. Also, the dividends are paid to investor in U.S. dollars. ADRs were specifically designed to facilitate the purchase, holding and sale of non-U.S. securities by U.S. investor, and to provide a corporate finance vehicle for non-U.S. companies. Any non-U.S. company seeking to raise capital in the U.S. or increase their base of U.S. investor can issue ADRs. Advantages of ADRs are: ADRs allow you to diversify your portfolio with foreign securities easily. 47 ADRs trade, clear and settle in accordance with U.S. market regulations and permit prompt dividend payments and corporate action notification. If an ADR is exchange-listed, investor also benefits from readily available price and trading information. Global Depository Receipts (GDRs) may be defined as a global finance vehicle that allows an issuer to raise capital simultaneously in two or more markets through a global offering. GDRs may be used in either the public or private markets inside or outside the US. GDR, a negotiable certificate usually represents a companys publicly traded equity or debt.

ADRs and GDRs are identical from a legal, operational, technical and administrative standpoint. The word global denotes receipts issued are on a global basis that is to investors not restricted to US. The FCCBs/GDRs/ADRs issued by Indian companies to non-residents have free convertibility outside India. In India, GDRs/ADRs are reckoned as part of foreign direct investment and hence need to conform to the existing FDI policy. Resource mobilisation by Indian corporates through Euro issues by way of FCCBs, GDRs and ADRs has been significant in the 1990s. As per current guidelines, the proceeds of ADRs/GDRs/FCCBs cannot be used on investment in real estate and stock markets. This prohibition not only puts restriction on Indian bidders in the first stage offer to the Government, but also to fund second stage of mandatory public offer under SEBI Takeover Code. In order to promote the disinvestment programme, it has been decided that ADR/GDR/FCCB proceeds could be used in the first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public, in view of their strategic importance. It has been clarified by SEBI that the scheme of

two-way fungibility of ADR/GDR issues will be only operated for foreign investors other than OCBs. As regards transfer of shares (on conversion of GDRs/ADRs into shares) in favour of residents, the non-resident holder of GDRs/ADRs should approach the Overseas Depository bank with a request to the Domestic Custodian bank to get the corresponding underlying shares released in favour of the non-resident investor for being sold by the non-resident or for being transferred in the books of the issuing company in the name of the non-resident. In order to improve liquidity in ADR/GDR market and eliminate arbitrage, RBI issued guidelines in February 2002 to permit two-way fungibility for ADRs/GDRs which means that investors (foreign institutional or domestic) in any company that has issued ADRs/GDRs can freely convert the ADRs/GDRs into underlying domestic shares. They can also reconvert the domestic shares into ADRs/ GDRs, depending on the direction of price change in the stock. 3.2.1 Stock Exchanges The stock exchanges are the exclusive centres for trading of securities. Listing of companies on a Stock Exchange is mandatory to provide an opportunity to investors to invest in the securities

of local companies. The trading volumes on exchanges have been witnessing phenomenal growth for last few years. Since the advent of screen based trading system in 199495, it has been growing by leaps and bounds and reported a total turnover of Rs.51,30,816 crore during 2007-08. The growth of turnover has, however, not been uniform across exchanges as may be seen from Table 3.1. The increase in turnover took place mostly at big exchanges(NSE and BSE) and it was partly at the cost of small exchanges that failed to keep pace with the changes. The business moved away from small exchanges to big exchanges, which adopted technologically superior trading and settlement systems. The huge liquidity and order depth of big exchanges further diverted liquidity of other stock exchanges. The 19 small exchanges put together reported less than 0.02% of total turnover during 2007-08, while 2 big exchanges accounted for over 99.98 % of turnover. For most of the exchanges, the raison detre for their existence, i.e. turnover, has disappeared. NSE and BSE are the major exchanges having nationwide operations. NSE operated through 2,956 VSATs in 245 cities at the end of March 2008. .

(Table:3.1): Turnover on NSE vs. Turnover on other Exchanges (in Rs.crore) Exchange 2006-07 2007-08 2008-09 2009-10 NSE 19,45,287 35,51,038 27,52,023 4138023 BSE 9,56,185 15,78,857 11,00,074 1378809 Uttar Pradesh 799 475 89 25 Ahmedabad 0 0 0 0 Calcutta 694 446 393 0 50 (in Rs.crore) Exchange 2006-07 2007-08 2008-09 2009-10 Madras 1 0 0 0 OTCEI 0 0 0 0 Delhi 0 0 0 0 Hyderabad 92 0 0 0 Bangalore 0 0 0 0 ICSE 0 0 0 Magadh 0 0 0 0 Bhubaneshwar 1 0 0 0 Cochin 0 0 0 0 Coimbatore 0 0 0 0 Gauhati 0 0 0 0 Jaipur 0 0 0 0 Ludhiana 0 0 0 0 Madhya Pradesh 0 0 0 0 Mangalore 0 0 0 0 Pune 0 0 0 0

SKSE 0 0 0 0 Vadodara 0 0 0 0 Total 29,03,058 51,30,816 38,52,579 55,16,857 NSE+BSE 29,01,472 51,29,895 38,52,097 55,16,832 Total (Except NSE + BSE) 1,586 921 482 25 Corporatisation & Demutualisation of Stock Exchanges: Corporatisation means the succession of a recognized stock exchange, being a body of individuals or a society registered under the Societies Registration Act 1860 (21 of 1860) by another stock exchange, being a company incorporated for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities carried on by such individuals or society. Demutualisation means the segregation of ownership and management from the trading rights of the members of a recognized stock exchange in accordance with the scheme approved by the Securities and Exchange Board of India. Demutualization is the process through which a member-owned company becomes shareholderowned company. Worldwide, stock exchanges have offered striking example of the trend towards demutualization, as the London Stock Exchange (LSE), New York Stock Exchange (NYSE), Toronto Stock Exchange (TSE) and most other exchanges across the globe have

moved towards demutualization and India is no exception to it. In January 2002, SEBI directed all the recognised stock exchanges to suitably amend their Rules, Articles etc. within a period of two months from the date of the order to provide that 51 no broker member of the stock exchanges shall be an office bearer of an exchange, i.e. hold the position of President, Vice President, Treasurer etc. This was done to give effect to the decision taken by SEBI and the policy decision of Government in regard to demutualisation/ corporatisation of exchanges by which ownership, management and trading membership would be segregated from each other. Corporatisation and demutualisation of stock exchanges are complex subjects and involve a number of legal, accounting, Companies Act related and tax issues. Therefore, SEBI set up in March 2002 a Group on Corporatisation & Demutualisation of Stock Exchanges under the Chairmanship of Shri M. H. Kania, former Chief Justice of India. The Group submitted its report in August 2002 with the following recommendations: (a) A common model for corporatisation and demutualisation may be adopted for all stock

exchanges. Each stock exchange would be required to submit a scheme drawn on the lines of the recommendations of the Group to SEBI for approval. Any stock exchange failing to comply with the requirement of corporatisation and demutualisation by the appointed date may be derecognised. (b) The SCRA may be amended to provide that a stock exchange should be a company incorporated under the Companies Act. The stock exchanges set up as association of persons or as companies limited by guarantee may be converted into companies limited by shares. (c) The Income Tax Act may be amended to provide that the accumulated reserves of the stock exchange as on the day of corporatisation are not taxed. The reserves may be taxed in the hands of the shareholders when these are distributed to shareholders as dividend at the net applicable tax rate. All future profits of the stock exchange after it becomes a for-profit company may be taxed. Further, the issue of ownership rights (shares) and trading rights in lieu of the card should not be regarded as transfer and not attract capital gains tax. However, at the point of sale of any of these two rights, capital gains tax would be attracted. (d) The Indian Stamp Act and the Sales Tax laws may be amended to exempt from stamp duty and sales tax, the transfer of the assets from the mutual stock exchange and the

issuance of shares by the new demutualised for-profit company. (e) While the Group favours the deposit system for trading rights, it likes to leave the choice of adopting either the card or the deposit system to the exchanges. If the deposit system is accepted, the value of the card will be segregated into two independent rights namely the right to share in the net assets and goodwill of the stock exchange and the right to trade on the stock exchange. (f) The three stakeholders viz. shareholders, brokers and investing public through the regulatory body should be equally represented on the governing board of the demutualised exchange. The roles and hence the posts of the Chairman and Chief Executive should be segregated. The Chairman should be a person who has considerable knowledge and experience of the functioning of the stock exchanges 52 and the capital market. The Chairman of the Board should not be a practicing broker. The exchange must appoint a CEO who would be solely responsible for the day to day functioning of the exchange, including compliance with various regulations and risk management practices. The board should not constitute any committee which would dilute the independence of the CEO. (g) The demutualised stock exchanges should follow the relevant norms of corporate

governance applicable to listed companies in particular, the constitution of the audit committee, standards of financial disclosure and accounting standards, disclosures in the annual reports, disclosures to shareholders and management systems and procedures. It would be desirable for the demutualised exchanges to list its shares on itself or on any other exchange. However, this may not be made mandatory; in case the exchange is listed the monitoring of its listing conditions should be left to the Central Listing Authority or SEBI. (h) No specific form of dispersal need be prescribed but there should be a time limit prescribed, say three years which can be extended by a further maximum period of 2 years with the approval of SEBI, within which at least 51% of the shares would be held by non-trading members of the stock exchange. There should be a ceiling of 5% of the voting rights, which can be exercised by a single entity, or groups of related entities, irrespective of the size of ownership of the shares. Thereafter, various activities associated with the C&D were completed by the stock exchanges within time specified in the respective approved schemes. During the year 2007, SEBI approved and notified the corporatisation and Demutualisation Schemes of 19 stock exchanges, under Section 4B(8) of the Securities Contracts (Regulation) Act, 1956. Stock Exchanges Subsidiary

SEBI required with effect from February 28, 2003 that the small stock exchanges which are permitted to promote/float a subsidiary/company to carry out the following changes in management structure of their subsidiaries and to ensure the compliance: 1. The subsidiary company should appoint a CEO who should not hold any position concurrently in the stock exchange (parent exchange). The appointment, the terms and conditions of service, the renewal of appointment and the termination of service of CEO should be subject to prior approval of SEBI. 2. The governing board of the subsidiary company should have the following composition viz., (a) the CEO of the subsidiary company should be a director on the Board of subsidiary and the CEO should not be a sub-broker of the subsidiary company or a broker of the parent exchange (b) at least 50% of directors representing on the Governing Board of subsidiary company should not be sub-brokers of the subsidiary company or brokers of the promoter/holding exchange and these directors should be called the Public Representatives (c) the public representatives should be nominated by the parent exchange (subject to prior approval of SEBI) (d) public representatives 53 should hold office for a period of one year from the date of assumption of the office or

till the Annual General Meeting of subsidiary company whichever is earlier (e) there should be a gap of at least one year after a consecutive period of three years before re-nomination of any person for the post of non-member director (f) the parent exchange should appoint a maximum of two directors who are officers of the parent exchange. 3. The subsidiary company should have its own staff none of whom should be concurrently working for or holding any position of office in the parent exchange. 4. The parent exchange should be responsible for all risk management of the subsidiary company and shall set up appropriate mechanism for the supervision of the trading activity of subsidiary company. CHAPTER 1: Introduction To Derivatives The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time of sowing to the time of crop harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board of Trade (CBOT) was established to bring farmers and merchants together. A group of traders got together and created the `to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved

useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc. 1.1 Derivatives Defined A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that 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 this case. 7 The Forward Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in commodities all over India. As per this Act, the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. However, when derivatives

trading in securities was introduced in 2001, the term 'security' in the Securities Contracts (Regulation) Act, 1956 (SC(R)A), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. The Securities Contracts (Regulation) Act, 1956 defines '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. 1.2 Products, Participants And Functions Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories: hedgers, speculators, and arbitragers. 1. Hedgers: The farmer's example that we discussed about was a case of hedging.

Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk. 2. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses. 3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. Whether the underlying asset is a commodity or a financial asset, derivatives market performs a number of economic functions. 8 Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the

derivative contract. Thus, derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives the underlying market witnesses higher trading volumes, because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.

1.3 Derivatives Markets Derivatives markets can broadly be classified as commodity derivatives market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts are those for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade contracts have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as the underlying. The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. 9 Box 1.1 Emergence of financial derivative products 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. Financial derivatives came into the spotlight in the post-1970 period

due to growing instability in the financial markets. However, since their emergence, these products have become 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 in terms of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of indexlinked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis--vis derivative products based on individual securities is another reason for their growing use. 1.3.1 Spot versus Forward Transaction Every transaction has three components - trading, clearing and settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves finding out the net outstanding, that is exactly how much of goods and money the two should exchange.

For instance, A buys goods worth Rs.100 from B and sells goods worth Rs. 50 to B. On a net basis, A has to pay Rs. 50 to B. Settlement is the actual process of exchanging money and goods. Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. 'on the spot'. Consider this example. On 1st January 2010, Aditya wants to buy some gold. The goldsmith quotes Rs. 17,000 per 10 grams. They agree upon this price and Aditya buys 20 grams of gold. He pays Rs.34,000, takes the gold and leaves. This is a spot transaction. Now suppose, Aditya does not want to buy the gold on the 1st January, but wants to buy it a month later. The goldsmith quotes Rs. 17,100 per 10 grams. They agree upon the 'forward' price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith Rs. 34,200 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the

underlying goods only happens at the future date as specified in the contract. In a forward contract, the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period. 10 A forward contract is the most basic derivative contract. We call it a derivative because it derives value from the price of the asset underlying the contract, in this case- gold. If on the 1st of February, gold trades for Rs. 17,200 per 10 grams in the spot market, the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs.17,100 per 10 grams. If however, the price of gold drops down to Rs. 16,900 per 10 grams he is worse off because as per the terms of the contract, he is bound to pay Rs. 17,100 per 10 grams for the same gold. The contract has now lost value from Aditya's point of view. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya. 1.3.2 Exchange Traded Versus OTC Derivatives

Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century and may well have been around before then. These contracts were typically OTC kind of contracts. Over the counter (OTC) derivatives are privately negotiated contracts. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Box 1.2: History of Commodity Derivatives Markets Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However, 'credit risk' remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865,

the CBOT went one step further and listed the first 'exchange traded' derivatives contract in the US, these contracts were called 'futures contracts'. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and CME remain the two largest organized futures exchanges, indeed the two largest 'financial' exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently, the most popular stock index futures in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eightees, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in Europe, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. 11

Later many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange. The OTC derivatives markets have the following features compared to exchangetraded derivatives: 1. The management of counter-party (credit) risk is decentralised and located within individual institutions. 2. There are no formal centralised limits on individual positions, leverage, or margining. 3. There are no formal rules for risk and burden-sharing. 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants. 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance. The derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts

offer many benefits, the former have rigid structures compared to the latter. The largest OTC derivative market is the inter-bank foreign exchange market. Commodity derivatives, the world over are typically exchange-traded and not OTC in nature. 1.3.3 Some commonly used Derivatives Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage. Forwards: A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded. Options: There are two types of options - call and put. A Call option gives 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. A Put option gives 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 12

options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted 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: 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. 1.4 Difference Between Commodity And Financial Derivatives The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these

contracts are cash settled. Since financial assets are not bulky, they do not need special facility for storage even in case of physical settlement. On the other hand, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However, in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues. 1.4.1 Physical Settlement Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on

interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. 13 We take a general overview at the process flow of physical settlement of commodities. Later on in chapter 9, we will look into the details of physical settlement through the Exchange providing platform for commodity derivatives trading, National Commodity and Derivatives Exchange Limited (NCDEX). Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period'. Assignment Whenever delivery notices are given by the seller, the clearing house of the Exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. Delivery

The procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. The period available for the buyer to take physical delivery is stipulated by the Exchange. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. The clearing house decides on the delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. 1.4.2 Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the

contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close at Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly, the person who sold this futures contract at Rs.100 does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. It means that if the seller chooses to hand over the commodity instead of the difference in cash, 14 the buyer must take physical delivery of the underlying asset. This requires the Exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Such warehouses have to perform the following functions: Earmark separate storage areas as specified by the Exchange for storing commodities; Ensure proper grading of commodities before they are stored; Store commodities according to their grade specifications and validity period; and Ensure that necessary steps and precautions are taken to ensure that the quantity and

grade of commodity, as certified in the warehouse receipt, are maintained during the storage period. This receipt can also be used as collateral for financing. In India, NCDEX has accredited over 775 delivery centres which meet the requirements for the physical holding of goods that are to be delivered on the platform. As future trading is delivery based, it is necessary to create the logistics support for the same. 1.4.3 Quality of Underlying Assets A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the Exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Trading in commodity derivatives also requires quality assurance and certifications from specialized agencies. In India, for example, the Bureau of Indian Standards (BIS) under the

Department of Consumer Affairs specifies standards for processed agricultural commodities. AGMARK, another certifying body under the Department of Agriculture and Cooperation, specifies standards for basic agricultural commodities. Box. 1.3 Specifications of some commodities underlying derivatives contracts The Intercontinental Exchange (ICE) has specified for its orange juice futures contract "US Grade A with a Brix value of not less than 62.5 degrees". The Chicago Mercantile Exchange (CME) in its random length lumber futures contract has specified that "Each delivery unit shall consist of nominal 2x4's of random lengths from 8 feet to 20 feet. Each delivery unit shall consist of and be grade stamped #1 or #2 AND BETTER. Each delivery unit shall be manufactured in California, Idaho, Montana, Nevada, 15 Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from and grade stamped Hem Fir (except that Hem-Fir shall not be deliverable if it is manufactured in Canada; nor that portion of Washington including and to the west of Whatcom, Skagit, Snohomish, King, Pierce, Lewis and Skamania counties; nor that portion

of Oregon including and to the west of Multnomah, Clackamas, Marion, Linn, Lane, Douglas and Jackson counties; nor that portion of California west of Interstate Highway 5 nor south of US Highway 50), Englemann Spruce, Lodgepole Pine, Englemann Spruce/Lodgepole Pine and/or Spruce Pine Fir (except that Spruce-Pine-Fir shall not be deliverable if it is manufactured in those portions of Washington, Oregon and California that are noted above)". 16

CHAPTER 2: Commodity Derivatives Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodity futures market. It is only in the last decade that commodity futures exchanges have been actively encouraged. In the commodity

futures market, the quinquennium after the set up of national level exchanges witnessed exponential growth in trading with the turnover increasing from 5.71 lakh crores in 2004-05 to 52.48 lakh crores in 2008-09. However, the markets have not grown to significant levels as compared to developed countries. In this chapter, we take a brief look at the global commodity markets and the commodity markets that exist in India. 2.1 Evolution Of Commodity Exchanges Most of the commodity exchanges, which exist today, have their origin in the late 19th and earlier 20th century. The first central exchange was established in 1848 in Chicago under the name Chicago Board of Trade. The emergence of the derivatives markets as the effective risk management tools in 1970s and 1980s has resulted in the rapid creation of new commodity exchanges and expansion of the existing ones. At present, there are major commodity exchanges all over the world dealing in different types of commodities. 2.1.1 Commodity Exchange Commodity exchanges are defined as centers where futures trade is organized in a wider sense; it is taken to include any organized market place where trade is routed through one

mechanism, allowing effective competition among buyers and among sellers. This would include auction-type exchanges, but not wholesale markets, where trade is localized, but effectively takes place through many non-related individual transactions between different permutations of buyers and sellers. 2.1.2 Role of Commodity Exchanges Commodity exchanges provide platforms to suit the varied requirements of customers. Firstly, they help in price discovery as players get to set future prices which are also made available to all participants. Hence, a farmer in the southern part of India would be able to know the best price prevailing in the country which would enable him to take informed decisions. For this to happen, the concept of commodity exchanges must percolate down to the villages. Today the farmers base their choice for next year's crop on current year's price. Ideally this decision 17 ought to be based on next year's expected price. Futures prices on the platforms of commodity exchanges will hopefully move farmers of our country from the current 'cobweb' effect where additional acreage comes under cultivation in the year subsequent to one when a commodity

had good prices; consequently the next year the commodity price actually falls due to oversupply. Secondly, these exchanges enable actual users (farmers, agro processors, industry where the predominant cost is commodity input/output cost) to hedge their price risk given the uncertainty of the future - especially in agriculture where there is uncertainty regarding the monsoon and hence prices. This holds good also for non-agro products like metals or energy products as well where global forces could exert considerable influence. Purchasers are also assured of a fixed price which is determined in advance, thereby avoiding surprises to them. It must be borne in mind that commodity prices in India have always been woven firmly into the international fabric. Today, price fluctuations in all major commodities in the country mirror both national and international factors and not merely national factors. Thirdly, by involving the group of investors and speculators, commodity exchanges provide liquidity and buoyancy to the system. Lastly, the arbitrageurs play an important role in balancing the market as arbitrage conditions, where they exist, are ironed out as arbitrageurs trade with opposite positions on different

platforms and hence generate opposing demand and supply forces which ultimately narrows down the gaps in prices. It must be pointed out that while the monsoon conditions affect the prices of agrobased commodities, the phenomenon of globalization has made prices of other products such as metals, energy products, etc., vulnerable to changes in global politics, policies, growth paradigms, etc. This would be strengthened as the world moves closer to the resolution of the WTO impasse, which would become a reality shortly. Commodity exchanges would provide a valuable hedge through the price discovery process while catering to the different kind of players in the market. 2.1.3 Commodity Derivative Markets in India Commodity futures markets have a long history in India. Cotton was the first commodity to attract futures trading in the country leading to the setting up of the Bombay Cotton Trade Association Ltd in 1875. The Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over the functioning of Bombay Cotton Trade Association.

Subsequently, many exchanges came up in different parts of the country for futures trading in various commodities. Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trade in groundnut, castor seed and cotton. 18 Before the Second World War broke out in 1939, several futures markets in oilseeds were functioning in Gujarat and Punjab. Futures trading in wheat existed at several places in Punjab and Uttar Pradesh, the most notable of which was the Chamber of Commerce at Hapur, which began futures trading in wheat in 1913 and served as the price setter in that commodity till the outbreak of the Second World War in 1939. Futures trading in bullion began in Mumbai in 1920 and subsequently markets came up in other centres like Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in raw jute and jute goods. But organized futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the

East India Jute & Hessian Ltd. to conduct organized trading in both raw jute and jute goods. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur (jaggery). After independence, with the subject of `Stock Exchanges and futures markets' being brought under the Union list, responsibility for regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A. D. Shroff and select committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted. The Act provided for 3-tier regulatory system: (a) An association recognized by the Government of India on the recommendation of Forward Markets Commission, (b) The Forward Markets Commission (it was set up in September 1953) and (c) The Central Government. Forward Contracts (Regulation) Rules were notified by the Central Government in July, 1954. According to FC(R) Act, commodities are divided into 3 categories with reference to extent of regulation, viz: Commodities in which futures trading can be organized under the auspices of recognized

association. Commodities in which futures trading is prohibited. Commodities which have neither been regulated nor prohibited for being traded under the recognized association are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission. 19 India was in an era of physical controls since independence and the pursuance of a mixed economy set up with socialist proclivities had ramifications on the operations of commodity markets and commodity exchanges. Government intervention was in the form of buffer stock operations, administered prices, regulation on trade and input prices, restrictions on movement of goods, etc. Agricultural commodities were associated with the poor and were governed by polices such as Minimum Price Support and Government Procurement. Further, as production levels were low and had not stabilized, there was the constant fear of misuse of these platforms which could be manipulated to fix prices by creating artificial scarcities. This was also a period which was associated with wars, natural calamites and disasters which invariably led to shortages

and price distortions. Hence, in an era of uncertainty with potential volatility, the government banned futures trading in commodities in the 1960s. The Khusro Committee which was constituted in June 1980 had recommended reintroduction of futures trading in most of the major commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. With the gradual trade and industry liberalization of the Indian economy pursuant to the adoption of the economic reform package in 1991, GOI constituted another committee on Forward Markets under the chairmanship of Prof. K.N. Kabra. The Committee which submitted its report in September 1994 recommended that futures trading be introduced in the following commodities: Basmati Rice Cotton, Kapas, Raw Jute and Jute Goods Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean and oils and oilcakes

 Rice bran oil Castor oil and its oilcake Linseed Silver Onions The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed, may be upgraded to the level of international futures markets. 20 UNCTAD and World Bank joint Mission Report "India: Managing Price Risk in India's Liberalized Agriculture: Can Futures Market Help? (1996)" highlighted the role of futures markets as market based instruments for managing risks and suggested the strengthening of institutional capacity of the Regulator and the exchanges for efficient performance of these markets. Another major policy statement, the National Agricultural Policy, 2000, also expressed support for commodity futures. The Expert Committee on Strengthening and Developing Agricultural Marketing (Guru Committee: 2001) emphasized the need for and role of futures trading in price risk management and in marketing of agricultural produce. This Committee's Group on

Forward and Futures Markets recommended that it should be left to interested exchanges to decide the appropriateness/usefulness of commencing futures trading in products (not necessarily of just commodities) based on concrete studies of feasibility on a caseto-case basis. It, however, noted that all the commodities are not suited for futures trading. For a commodity to be suitable for futures trading it must possess some specific characteristics. The liberalized policy being followed by the Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. The National Agriculture Policy announced in July 2000 and the announcements of Hon'ble Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to put in place a mechanism of futures trade/market. As a follow up, the Government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited.

The year 2003 is a landmark in the history of commodity futures market witnessing the establishment and recognition of three new national exchanges [National Commodity and Derivatives Exchange of India Ltd. (NCDEX), Multi Commodity Exchange of India Ltd (MCX) and National Multi Commodity Exchange of India Ltd. (NMCE)] with on-line trading and professional management. Not only was prohibition on forward trading completely withdrawn, the new exchanges brought capital, technology and innovation to the market. These markets depicted phenomenal growth in terms of number of products on offer, participants, spatial distribution and volume of trade. Majority of the trade volume is contributed by the national level exchanges whereas regional exchanges have a very less share. With developments on way, the commodity futures exchanges registered an impressive growth till it saw the first ban of two pulses (Tur and Urad) towards the end of January 2007. Subsequently the ban of two more commodities from cereals group i.e. Wheat and Rice in the next month. The commodity market regulator, Forward Markets Commission as a measure of abundant caution, suspended futures trading in Chana, Soya oil, Rubber and Potato w.e.f. May 21

7, 2008. However, with the easing of inflationary pressure, the suspension was allowed to lapse on November 30, 2008. Trading in these commodities resumed on December 4, 2008. Later on futures trading in wheat was re-introduced in May 2009. These bans affected participants' confidence adversely. In May 2009, futures trading in sugar was suspended. Due to mistaken apprehensions that futures trading contributes to inflation, futures trading in rice, urad, tur and sugar has been temporarily suspended. Box 2.4 : Futures Trading The Government of India had appointed a committee under the chairmanship of Prof. Abhijit Sen, Member, Planning Commission to study the impact of futures trading, if any, on agricultural commodity prices. The Committee was appointed on March 2, 2007 and submitted its report on April 29, 2008. The main findings and recommendations of the committee are: negative sentiments have been created by the decision to delist futures trades in some important agricultural commodities; the period during which futures trading has been in operation is too short to discriminate adequately between the effect of opening of futures markets, if any, and what might simply be the normal cyclical adjustments in prices; Indian data analyzed does not show any clear evidence of either reduced or increased volatility; the vibrant agriculture markets including derivatives markets are the frontline institutions to provide early signs of future prospects of the sector. The committee recommended for upgradation of regulation by passing of the proposed amendment

to FC(R) Act 1952 and removal of infirmities in the spot market (Economic Survey, 2009-10). The "Study on Impact of Futures Trading in Wheat, Sugar, Pulses and Guar Seeds on Farmers" was commissioned by the Forward Markets Commission and undertaken by the Indian Institute of Management, Bangalore. While the study was primarily intended to find out how futures trading is helping major stakeholders in the value chain of these commodities; it also dealt with the impact of futures trading on the prices of these commodities. The study did not find any visible link between futures trading and price movement and suggested that the main reason for price changes seemed to be changes in the fundamentals (mainly on the supply side) of these commodities, Price changes were also attributed to changes in government policies. 2.1.4 Indian Commodity Exchanges There are more than 20 recognised commodity futures exchanges in India under the purview of the Forward Markets Commission (FMC). The country's commodity futures exchanges are divided majorly into two categories: National exchanges Regional exchanges

22 The four exchanges operating at the national level (as on 1st January 2010) are: i) National Commodity and Derivatives Exchange of India Ltd. (NCDEX) ii) National Multi Commodity Exchange of India Ltd. (NMCE) iii) Multi Commodity Exchange of India Ltd. (MCX) iv) Indian Commodity Exchange Ltd. (ICEX) which started trading operations on November 27, 2009 The leading regional exchange is the National Board of Trade (NBOT) located at Indore. There are more than 15 regional commodity exchanges in India. Table 2.1: Commodity Futures Trade in India (Rs Crore) Category 2008-09 Total 52,48,956.18 Bullion 29,73,674.60 Agri 6,27,303.14 Others 16,47,978.45 Table 2.2: Trade Performance of leading Indian Commodity Exchanges for January 2010 Traded Value MCX NCDEX NMCE ICEX NBOT (Rs Crore) January 2010 5,62,703 87,824 16,990 32,901 4,245 Box 2.5 : Indian Commodity Exchanges. Some of the features of national and regional exchanges are listed below: 23 National Exchanges Compulsory online trading

 Transparent trading Exchanges to be de-mutualised Exchange recognised on permanent basis Multi commodity exchange Large expanding volumes Regional Exchanges Online trading not compulsory De-mutualisation not mandatory Recognition given for fixed period after which it could be given for re regulation Generally, these are single commodity exchanges. Exchanges have to apply for trading each commodity. Low volumes in niche markets Table 2.3: Commodity Exchanges in India No. Exchanges Main Commodities 1 Multi Commodity Gold, Silver, Copper, Crude Oil, Zinc, Lead, Nickel, Natural Exchange of India Ltd., gas, Aluminium, Mentha Oil, Crude_Palm_Oil, Refined Mumbai* Soya Oil, Cardamom, Guar Seeds, Kapas, Potato, Chana\Gram, Melted Menthol Flakes, Almond, Wheat, Barley, Long Steel, Maize, Soybean Seeds, Gasoline US, Tin, Kapaskhali, Platinum, Heating Oil 2 National Commodity & Guar Seed, Soy Bean, Soy Oil, Chana,RM Seed, Jeera, Derivatives Exchange Ltd, Turmeric, Guar Gum, Pepper, Cotton Cake, Long Steel, Mumbai* Gur, Kapas, Wheat, Red Chilli, Crude Oil, Maize, Gold, Copper, Castor Seeds, Potato, Barley, Kachhi Ghani Mustard Oil, Silver, Indian 28 Mm Cotton, Platinum

3 National Multi Commodity Rape/Mustard Seed, Guar Seeds, Nickel, Jute, Refined Exchange of India Soya Oil, Zinc, Rubber, Chana\Gram, Isabgul, Lead, Gold, Limited, Ahmedabad* Aluminium, Copper, Turmeric, Copra, Silver, Raw Jute, Guar Gum, Pepper, Coffee Robusta, Castor Seeds, Mentha oil 24 4 Indian Commodity Gold, Crude Oil, Copper, Silver Exchange Limited, Gurgaon * 5 National Board of Trade. Soy bean, Soy Oil Indore. 6 Chamber Of Commerce., Gur, Mustard seed Hapur 7 Ahmedabad Commodity Castorseed Exchange Ltd. 8 Rajkot Commodity Castorseed Exchange Ltd, Rajkot 9 Surendranagar Cotton & Kapas Oilseeds Association Ltd, S.nagar 10 The Rajdhani Oil and Gur, Mustard Seed Oilseeds Exchange Ltd., Delhi 11 Haryana Commodities Mustard seed, Cotton seed Oil Cake Ltd.,Sirsa 12 India Pepper & Spice Pepper Domestic-MG1,Pepper 550 G/L,

Trade Association. Kochi 13 Vijay Beopar Chamber Gur Ltd.,Muzaffarnagar 14 The Meerut Agro Gur Commodities Exchange Co. Ltd., Meerut 15 Bikaner Commodity Guarseed, Exchange Ltd.,Bikaner 16 First Commodity Exchange Coconut oil of India Ltd, Kochi 17 The Bombay Commodity Castor Seed Exchange Ltd. Mumbai 25 18 The Central India Mustard seed Commercial Exchange Ltd, Gwaliar 19 Bhatinda Om & Oil Gur Exchange Ltd., Batinda. 20 The Spices and Oilseeds Turmeric Exchange Ltd., Sangli 21 The East India Jute & Raw Jute Hessian Exchange Ltd, Kolkatta 22 The East India Cotton Cotton Association Mumbai. Main commodities for regional exchanges refer to the fortnight 16-31 Jan 2010.

*Note: Please visit the website of national exchanges for detailed list of all the products traded. The growth in commodity futures trade has led to an upsurge of interest in a number of associated fields, viz. research, education and training activities in commodity markets, commodity reporting for print and visual media, collateral management, commodity finance, ware-housing, assaying and certification, software development, electronic spot exchanges etc. Markets and fields almost non-existent some years ago now attract significant mind-share nationally and internationally. 2.2 Global Commodity Derivatives Exchanges Globally commodity derivatives exchanges have existed for a long time. The evolution of the exchanges was fuelled by the needs of businessmen and farmers. The need was to make the process of buying and selling commodities easier by bringing the buyers and sellers together. In the US, the development of modern futures trading began in the early 1800s. This development was tied closely to the development of commerce in Chicago, which started developing as a grain terminal. At that time, supply and demand imbalances were normal.

There was a glut of commodities at harvest time in some years and severe shortages during years of crop failure. Difficulties in transportation and lack of proper storage facilities aggravated the problem of demand and supply imbalances. The uncertain market conditions led farmers and merchants to contract for forward delivery. 26 Some of the first forward contracts were in corn. To reduce the price risk of storing corn in winter, these merchants went to Chicago in spring and entered into forward contracts with processors for the delivery of grain. The grain was received from farmers in late fall or early winter. The earliest recorded forward contract was on March 13, 1851. As the grain trade expanded, a group of 82 merchants gathered at a flour store in Chicago to form the Chicago Board of Trade (CBOT). CBOT started the "to arrive" forward contract, which permitted farmers to lock in the price and deliver the grain much later. The exchange's early years saw the dominance of forward contracts. However, certain drawbacks of forwards such as lack of standardization and non-fulfillment of commitments made CBOT take steps in 1865 to formalize grain trading.

By the mid 19th century, futures markets had developed into effective mechanisms for managing counterparty and price risks. The clearinghouse of the exchange guaranteed the performance of contracts and started collecting margins to ensure contract performance. Trading practices were further formalized as contracts started getting more refined and rules of conduct and procedures for clearing and settlement were established. New exchanges were formed in the late 19th and early 20th centuries as trading started in non-agricultural commodities such as precious metals and processed products, among others. Financial innovations in the post-Bretton Woods period led to trading in financial futures, the most successful contract in the futures industry. Financial derivatives became important due to the rising uncertainty in the post-1970s period, when the US announced the end of the Bretton Woods System of fixed exchange rates. This led to the introduction of currency derivatives followed by other innovations including stock index futures. Commodities' trading in some developing economies also has a long history. The Buenos Aires Grain Exchange in Argentina (founded in 1854) is one of the oldest in the world. Though

developing countries saw the early use of commodity risk-management instruments, increased government intervention and policies impeded the development of futures markets. Failure of government-led price-stabilisation schemes and the adoption of liberalisation and globalisation policies since the 1980s have contributed to the resurgence of commodity markets in these countries. 1.1.4 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: 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. INTEREST RATE AND CURRENCY SWAPS

In this chapter, we cover alternative strategies for hedging currency or interest rate risk, in addition to forward contracts, futures, and options (short-term), especially strategies for long-term risk.

INTEREST RATE SWAPS Somewhat complex, innovative financing arrangement for corporations that can reduce borrowing costs and increase control over interest rate risk and foreign exchange exposure. Relatively new market, due to financial deregulation, integration of world financial markets, and currency and interest rate volatility. Market has grown significantly, see Exhibit 14.1, p. 339. Total amount of outstanding interest rate swaps in 2004 was $128T, and $7T in currency swaps, fastest growth was for Interest Rate Swaps. 5 main currencies: $, , , BP and SF see Exhibit 14.2 on p. 340. Interest Rate Swap financing involves two parties (MNCs) who agree to exchange CFs, results in benefits for both parties. A single-currency interest rate swap is called an Interest Rate Swap, and a cross-currency interest rate swap is called a Currency Swap. Basic (plain vanilla) Interest Rate Swap involves exchanging (swapping) interest payments on Floating-rate debt for interest payments on Fixed-rate debt, with both payments in the same currency. Reason: One party actually wants fixed rate debt, but can get a better deal on floating rate; the other party wants floating rate debt, but can get a better deal on fixed rate. Both parties can gain by swapping loan

payments (CFs), usually through a bank as a financial intermediary (FI), which charges a fee to broker the transaction. Currency Swap - One party swaps the interest payments of debt (bonds) denominated in one currency (USD) for the interest payment of debt (bonds) denominated in another currency (SF or BP), usually on a "fixed-for-fixed rate" basis. Currency swap is used for cost savings on debt, or for hedging long term currency risk. SWAP BANK - Financial Institution (FI) in the swap business, either as dealer or broker, usually large commercial and investment banks. Broker bank: Arranges and brokers the deal, but does not assume any of the risk, just charges a commission/fee for structuring and servicing the swap. Dealer bank: Bank that is willing to take a position on one side of the swap or the other, and therefore assume some risk (interest rate or currency). Dealer would not only receive a commission for arranging and servicing the swap, but would take a position in the swap, at least until it sold its position later. Example: Banks trading currency forward contracts. If they always match shorts and longs, there is no risk, acting as brokers. For every party who want to buy BP forward from the bank, there is a party selling BP forward to the bank. If the bank has a client who wants to sell 10m forward (short position) in 6 months, and accepts the contract without a forward BP buyer (long), it is exposed to currency risk by taking the long position itself. As a trader-broker, the bank can do more business than just a broker, but involves assuming risk exposure. EXAMPLE 14.1, FIXED-FOR-FLOATING INTEREST RATE SWAP, pages 340-342.

Bank A is AAA-rated bank in U.K., and needs a $10m cash inflow to finance 5year, floating-rate (based on LIBOR), Eurodollar term loans to its commercial clients. To minimize (eliminate) interest rate risk, bank would prefer to match floating-rate debt (CDs or notes) with its expected floating-rate assets (Eurodollar loans). Bank has two sources of debt/deposits available: a) 5-YR FIXED-RATE BONDS @ 10% or b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR With floating rate loans and fixed rate debt, there is interest rate risk. Worried about? ___________ Therefore, bank prefers floating-rate debt, to match the floating rate loan (asset). For example, if the bank pays LIBOR for its deposits and charges LIBOR + 2% on its loans, it will always have a 2% spread (profit margin), whether LIBOR increases or decreases. Company B is a BBB rated MNC in U.S., and needs $10m debt for 5 years to finance a capital expenditure (new project, investment in property/plant, replace worn out equipment, etc.). MNC has two sources of debt available: a) 5-YR FIXED-RATE BONDS @ 11.25% (higher risk than AAA bank) b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR + .50% With FRNs there is interest rate risk for the MNC if interest rates _____. Therefore, MNC prefers fixed-rate debt to guarantee a fixed, stable interest expense.

Swap Bank can broker an interest rate swap deal (for a fee) with Bank A and Company B that will benefit both counterparties. When structured properly, all three parties will benefit (Bank A, Company B, and the swap bank). Similar to the gains from trade in Ch. 1. Here is how (Exhibit 14.3): "Risky" BBB Company B Premium for Co. B Fixed-Rate Fixed-rate Floating-Rate LIBOR +.5% Variable-rate) QSD 0.75% The key to an interest-rate swap is the QSD (Quality Spread Differential), the difference or spread between fixed interest rates (Risky - Safe), and variable interest rates (Risky - Safe). Co. B would have to pay 1.25% more than Bank A for fixed rate debt, but only .50% more for variable rate. The QSD is 0.75%, reflecting the difference, or additional default risk premium on fixed rate debt for MNC. The yield curve for fixed-rate risky debt is much steeper than for safe debt, since with fixed-rate debt lenders will: 1) Not have an opportunity to adjust (raise) the rate once fixed, and 2) Not have the opportunity to cancel the debt if the company gets in trouble, and 3) Not be able to change the terms of the loan. All of these would be possible under floating-rate agreements, and lenders therefore have to "lock-in" a high default risk premium for fixed-rate debt at the beginning of the loan. LIBOR (LIBOR + .5%) - LIBOR (.50% 11.25% 10% (11.25 - 10%) +1.25% "Safe" AAA Bank A Difference Risk

When a QSD exists, it represents the potential gains from trade if both parties get together, through the swap bank. Here is one example of how the 0.75% QSD can be split up: Bank A will save .375% per year in interest savings (or $37,500 per year for 5 years for $10m) and the MNC will save .25% in the form of interest rate savings (or $25,000 per year for 5 years), and the swap bank earns .125% per year profit on $10m to arrange the deal (or $12,500 per year for 5 years). Or there is $75,000 in annual savings ($10m x 0.75%) to split 3 ways: $37,500, $25,000 and $12,500 every year, or $375,000 in total savings over 5 years ($187,500, $125,000 and $62,500). Without the swap, Bank A will pay variable-rate @ LIBOR, and Co. B will pay fixed-rate @ 11.25%. With the swap, Bank A will pay all-in-cost (interest expense, transactions cost, service charges) interest expense of LIBOR - .375% (saving .375%) and Co. B will pay all-in-cost interest expense of 11% (saving . 25%). Here is how: Instead of actually issuing the type of debt they really want, each party issues the opposite of what they want, and then they swap CFs. Instead of variable debt at LIBOR, Bank A issues fixed-rate Eurodollar bonds at 10%. Instead of issuing fixed rate at 11.25%, Co. B issues variable-rate debt at LIBOR + .50%. The parties issue the debt that they don't want, and make interest payments directly to the bondholders for 5 years. The swap bank then arranges the following CF payments: 1. Co. B pays 10.50% fixed-rate interest (on $10m) to the Swap Bank, and the bank passes on 10.375% interest payment to Bank A in U.K. (Swap bank makes the difference = 10.50% - 10.375% = .125%).

2. Bank A pays LIBOR on $10m to the Swap Bank and they pass on LIBOR to Company B. As a result, here is the net position of each party: Bank A Pays -10% fixed-rate interest to bondholders Pays variable-rate -LIBOR interest to Swap Bank Receives +10.375% fixed interest rate from Swap Bank NET INTEREST = PAY LIBOR - .375% variable rate (w/swap), vs. LIBOR (w/o swap) Company B Pays variable-rate (LIBOR + .5%) to bondholders Pays -10.50% fixed-rate to Swap Bank Receives +(LIBOR) from Swap Bank NET INTEREST = PAY 11.00% Fixed Rate (w/swap), vs. 11.25% (w/o swap) Swap Bank Receives 10.50% fixed-rate from Co. B Pays 10.375% to Bank A (Net of +.125% on fixed-rate debt) Receives LIBOR from Bank A Pays LIBOR to Co. B NET INCOME = .125% Net result: Bank A borrows $10m at LIBOR - .375% instead of LIBOR, gets a variable-rate, and saves 0.375% per year interest rate, or $37,500 per year in interest expense ($187,500 over 5 years).

Co. B borrows $10m at 11% instead of 11.25%, gets a fixed rate, and saves .25% per year in interest rate, or $25,000 per year in interest expense ($125,000 over 5 years). Swap Bank makes .125% per year on $10m to arrange the deal, or $12,500 per year ($62,500) total. Outcome: Gains from trade (swap): WIN-WIN-WIN for all three parties. Note: All interest payments/CFs are in USD. Actually, only the net difference in dollar CFs actually needs to be exchanged, NOT the gross amount. Example: Suppose that when the first payment is due LIBOR = 8%. CFs for Bank A: Receive $1.0375m from Swap Bank (10.375% of $10m) Pay $800,000 to Swap Bank (LIBOR = 8% x $10m) Net RECEIPT from SWAP BANK = +$237,500 Pay ($1m) to bondholders ($10m x 10%) Total Interest Expense = $1m - $237,500 = $762,500 (7.625% of $10m, @LIBOR -.375%), vs. $800,000 @ LIBOR without Swap, or a savings of $37,500. CFs for Co. B: Pay $1.050m to Swap Bank (10.50% x $10m) Receive $800,000 from Swap Bank (LIBOR = 8% x $10m) Net PMT to SWAP BANK = ($250,000)

Pay ($850,000) to bondholders (LIBOR + .5% = 8.5%) x $10m. Total interest expense = $250k to swap bank + $850k to bondholders = $1.10m (or 11% of $10m), vs. $1.125m @ 11.25% without swap, or a savings of $25,000 per year for MNC. Swap Bank Receives $250,000 from Co. B, and pays $237,500 to Bank A, profit of $12,500/year. Regardless of what happens to LIBOR, the Swap Bank will always receive $12,500 profit/year. Problem Set question: Show the CFs above when LIBOR = 6% and verify that the bank will make $12,500. Repeat for LIBOR = 10%. Note: Like before in CH 1 Gains from Trade, the swap arrangement above is not unique, and is just one of many possible outcomes. The QSD of .75% tells us only that there is $75,000 per year and $375,000 over five years in gains from trade using an interest rate swap. Negotiations among the three parties will determine the exact outcome. In this case, Bank A got the greatest share of gains, and the swap bank got the least this is just one outcome, many others are possible. Also, this interest rate swap was used for long-term (5-year) interest rate risk. BASIC CURRENCY SWAP Currency Swap Example 14.3 on p. 343. U.S. MNC like GM has a subsidiary in Germany, and there is an investment opportunity for expansion in Germany that will require 40m and will have an economic life of 5 years. Current spot rate is $1.30/, so the firm could consider raising $52m in U.S. by issuing bonds at 8%

(payable in dollars), and converting $52m to 40m to finance the expenditure. Hopefully CFs (in Euros) would be generated from the project to make the interest payments in $. Problem: Transaction Exposure (potential change in the financial position of the project due to currency changes over 5 years), because German earnings are in Euros, interest payments due in U.S. are in USD. What is the MNC worried about??? Alternative Loan: Raise 40m in the Eurobond market by issuing 5-year Eurobonds, payable in Euros. Eurobond rate is 6% for a well-known German or European firm, but the U.S. subsidiary in Germany must pay 7% because it might be relatively unknown or new, so there is a +1% risk premium. Assume there is a German MNC with a mirror-image financing need. It has a U.S. subsidiary needing $52m for an expansion project in U.S. with a 5-year life. German MNC could borrow 40m in Germany at 6%, and convert to dollars, but there is also transaction exposure since dollar CFs would be generated in U.S. to make Euro interest payments in Germany. Worried about what over 5 years??? Company could issue Eurodollar bonds in U.S., but would face a 9% (normal rate is 8%) interest rate because the German subsidiary is not well-known in U.S., and would pay a +1% risk premium. Swap Bank could arrange a Currency Swap to: 1) Eliminate the long-term currency risk for both MNCs (transaction exposure), and 2) Reduce interest expense for both companies. Each company has a "comparative advantage" at raising money in its home country, so each MNC would issue debt domestically at a savings of 1% compared to the foreign MNC raising funds (U.S. company raises $52m in U.S. at 8%, vs. 9% for the German MNC; German company raises 40m in Germany at 6%, vs. 7% for the U.S. MNC).

IRP review question: Based on the difference in interest rates (8% in the U.S. and 6% in Germany), what is expected to happen to the Euro over the next 5 years? How much? The principal sums would be exchanged through a Swap Bank - U.S. company issues $52m debt in U.S. @8% and transfers $52m to the German subsidiary in U.S. and the German company issues 40m of debt Germany @ 6% and transfers 40m to the U.S. subsidiary in Germany. Every year the U.S. subsidiary in Germany would submit 2.4m (40m @ 6% instead of borrowing at 7%) to its parent company in U.S., which would transfer the money to the Swap Bank, which transfers funds to the German MNC to pay the Euro loan. The German subsidiary in U.S. would submit $4.16m ($52m @ 8% instead of 9% on its own) to the German MNC, which would transfer the money to the Swap Bank, and the bank would transfer funds to the U.S. MNC to pay for the dollar loan. At maturity, principal payments would take place the same way. Each company saves 1% per year on $52million (40m), or $520,000 annually (400,000), or $2.6m (2m) over 5 years! Currency swap not only saves interest expense, but locks in three ex-rates and eliminates ex-rate risk: 1. Principal sums are exchanged now at the current ex-rate, $52m/40m = $1.30/. 2. The contractual (implicit) exchange rate for the annual payments would be $1.733/, since the payments exchanged are: $4.16m / 2.40m = $1.7330/.

3. The implied exchange at maturity for the last interest payment and principal payment is $56.16m ($52m principal + $4.16m interest) / 42.40m (40m principal + 2.40m interest) = $1.3245 /. Therefore, the currency swap locks in a fixed exchange rate for YRS 1-4 and another ex-rate for YR 5, and there is no currency risk. See CF diagram on p. 346, Exhibit 14.6, and Line 3 Contractual FX rate. At first it might seem like the German company is not getting as good of a deal compared to the U.S. firm. The German MNC borrows Euros at 6% but pays 8% in U.S. dollars. However, IRP should hold, making the two interest rates equal after adjusting for the expected change in the value of the currencies. Since int. rates are higher (lower) in the U.S. (Germany), the dollar () is expected to depreciate (appreciate), by 2% per year. German MNC pays back the loan with a currency (USD) that is depreciating (USD is depreciating by 2% per year), Euro is appreciating by 2% per year. German MNC borrows s @ 6%, pays loan back in USDs at 8%, but since the dollar is depreciating by 2%/year, and the euro is appreciating by 2% per year, the effective borrowing cost in Euros is 6%. U.S. MNC borrows $s @ 8%, pays back Euros @ 6%, but since the USD is getting weaker and euro is getting stronger by 2% annually, the effective borrowing cost in $s is 8%. Point: In equilibrium (IRP), If the Euro is selling at a forward premium of +2%/year, the Borrowing Euros at 6% is exactly equivalent to borrowing dollars at 8%. See Exhibit 14.6 for Swap CFs.

What about the swap bank? In the example above and in Exhibit 14.5, there is no profit for the Swap Bank. See Example 14.6 on p. 346-347 for a more realistic example. The US MNC still borrows $52m in the US for 8%, and the German MNC still borrows 40m in Germany for 6%. But the swap bank makes a profit by charging the U.S. MNC a rate of 6.10% for its debt in Germany for its subsidiary, and the bank makes .10% each year on 40m, or 40,000 annually ($52,000 at the current ex-rate). The swap bank charges the German MNC a rate of 8.15% for its debt in the US for its subsidiary, and makes .15% of $52m, or $78,000 annually. Annual CFs for Swap Bank Receive Pay Profit Receive Pay Profit 2,440,000 from US MNC (40m @6.10%) 2,400,000 to German MNC (40m @6.00%) 40,000 $4,238,000 from German MNC ($52m @8.15%) $4,160,000 to US MNC ($52m @8.00%) $78,000

RISKS FOR THE SWAP BANK IN THE SWAP MARKET 1. Interest rate risk, from a change in interest rates before the bank finds an opposing counterparty for the other side of an interest rate swap. Swap banks that are traders stand ready to take just one side of the swap now, and then later find a client for the other side.

Example from beginning of chapter: Suppose swap bank makes deal with company B, where swap bank will receive 10.50% from Co. B. They hope to find a customer like Bank A, and make fixed rate pmts of 10.375%, and the swap bank makes 12.5 bp or .125%. If rates rise by only .50% before they finalize deal with Bank A, they would have to pay out 10.875% to Bank A (instead of 10.375%), and the swap bank would lose money. 2. Basis risk, when the floating rates are NOT pegged to the same index. Example: One counterparty's payments are pegged to LIBOR and the other to the U.S. T-Bill rate. When the two interest rate indexes do not move perfectly together, the swap could periodically be less profitable, or even unprofitable for the bank. 3. Ex-rate risk, like int. rate risk, from changes in ex-rates during the time it takes to offset the position with an opposing counterparty. 4. Mismatch risk, from a mismatch with respect to the size of the principal sums of the two counterparties, the maturity date, or the debt service dates. In Example 14.3, we assumed that both the German and U.S. MNCs wanted debt for the same maturity (5-year), we assumed that the debt was the same for both MNCs: $52m (40m), and we assumed the payments are made on the same date. 5. Political risk, from foreign exchange controls or taxes on capital flows, other political problems that affect the swap, resulting in loss of profits for the bank. To facilitate trading and make the swap market more efficient, there is an intl. swap organization, International Swaps and Derivatives Association (ISDA), which acts to coordinate swap activities, disseminate information, etc. The ISDA has developed two standard swap agreements/contracts, one for int. rate swaps and one for currency swaps, that outline the terms and conditions of a standard swap,

address issues like default, early termination, etc.

EFFICIENCY ISSUES OF SWAPS Issue: Does the existence of a market for swaps indicate market inefficiency? Does the QSD (quality spread differential) imply mispricing of default risk premiums on some debt? Does a QSD imply that there are arbitrage opportunities from exploiting interest rate discrepancies? If QSD did represent mispricing of debt, you would expect that the swap market would disappear over time due to arbitrage. Just the opposite has happened, the swap market has exploded. Explanation: The credit/currency/stock markets are efficient for securities that are traded, but there is a problem of Market Completeness - all types of debt are not always available for all types of borrowers. Swaps are an innovative, creative way to meet the demand for unique credit needs that are not met in standard, traditional credit markets. There are gains to trade (exchange) for both counterparties, and the swap banks create a market by acting as financial intermediaries, for a fee, to bring together the two counterparties.

FINAL ISSUES 1. Swaps are off-book transactions for both counterparties and the swap bank they do not appear as either assets or liabilities on the balance sheet, they are included in the footnotes of financial reports.

2. Swaps are important source of revenue for international banks, e.g. $128 trillion in Interest Rate Swaps (Exhibit 14.1) x .125% average swap bank fee = $16 billion in income. 3. Banks have to meet internationally standardized capital requirements/standards, on a risk-adjusted basis. Guidelines are now in place for how to treat swaps, since they are off-balance-sheet activities, but can increase risk for banks.