Research Supervisor:
Submitted by
Remarks of Evaluator
Approved/Disapproved (I Evaluation)
Session 2009-2011
DIRECTORATE OF DISTANCE EDUCATION GURU JAMBHESHWAR UNIVERSITY OF SC. & TECH. HISAR
RESUME OF SUPERVISOR/GUIDE 1. 2. 3. 4. 5. 6. NAME- Ajit Kumar DESIGNATION: - Assistant Professor QUALIFICATION: - M Phil (Management), MBA (Finance) AREA OF SPECIALIZATION: - Finance & Information Technology EXPERINECE: - 16+ yrs OFFICIAL ADDRESS: - NSB School of Business, MCIE Delhi- Mathura Road, Delhi- 110044 7. 8. 9. TELEPHONE No.:- 011- 41676794/95 MOBILE: - +91- 9999917651 E-MAIL:- Ajit.Kumar@nsb.in
I am willing to supervise Ms Neha Enrolment No.:- 09061148182 On the topic: - A PROJECT REPORT ONDERIVATIVES MARKET IN INDIA
CERTIFICATE
This is to certify that Mr. Piyush Enrolment No. 09061148227 has completed under my supervision his/her Research Project Report on Derivatives Market in India in the specialization area Finance. The work embodied in this report is original and is of the standard expected of an MBA student and has not been submitted in part or full to this or any other university for the award of any degree or diploma. He/she has completed all requirements of guidelines for the Research Project Report and the work is fit for evaluation.
DECLARATION
This is to certify that the project Report entitled on Derivatives Market in India is my original work and this has not been submitted in part or full to this or any other university/institution for the award of any degree or diploma.
Signature of candidate NAME: - Piyush ENROLMENT NO.:-09061148227 SPECILIZATION: - Finance SESSION: 2009-11
ACKNOWLEDGEMENT
The beatitude, bliss and euphoria that accompany the successful completion of any task would not be complete without the expression of appreciation of simple virtues to the people who made it possible. The final project report is submitted to Directorate of Distance Education Guru Jambheshwar University of Science & Technology Hisar (India) for partial fulfilment of Master of Business Administration This project is an attempt to study Derivatives Market in India. I express my thanks to all Finance Faculty and other Faculty under whose guidance and direction, I gave a good shape to my Report. Their constant review and excellent suggestions throughout the project are highly commendable. My heartfelt thanks go to the entire Faculty who helped me to gain knowledge about the Financial Market. I would also like to sincerely thank to my Project guide Mr. AJIT KUMAR whose guidance has helped me to Understand and complete my project in a timely and proper manner.
EXECUTIVE SUMMARY
New ideas and innovations have always been the hallmark of progress made by mankind. At every stage of development, there have been two core factors that drive man to ideas and innovation. These are increasing returns and reducing risk, in all facets of life. The financial markets are no different. The endeavour has always been to maximize returns and minimize risk. A lot of innovation goes into developing financial products centred on these two factors. It has spawned a whole new area called financial engineering. Derivatives are among the forefront of the innovations in the financial markets and aim to increase returns and reduce risk. They provide an outlet for investors to protect themselves from the vagaries of the financial markets. These instruments have been very popular with investors all over the world. Indian financial markets have been on the ascension and catching up with global standards in financial markets. The advents of screen based trading, dematerialization, rolling settlement have put our markets on par with international markets. As a logical step to the above progress, derivative trading was introduced in the country in June 2000. Starting with index futures, we have made rapid strides and have four types of derivative products- Index future, index option, stock future and stock options. Today, there are 30 stocks on which one can have futures and options, apart from the index futures and options. This market presents a tremendous opportunity for individual investors .The markets have performed smoothly over the last two years and has stabilized. The time is ripe for investors to make full use of the advantage offered by this market. We have tried to present in a lucid and simple manner, the derivatives market, so that the individual investor is educated and equipped to become a dominant player in the market
TABLE OF CONTENTS
Contents
INTRODUCTION INTRODUCTION TO DERIVATIVES
a) Derivative defined b) Types of market c) History of derivatives d) Indian derivative market e) Need for derivatives in India today f) Myths and realities about derivatives g) Comparison of new system with existing system h) Factor contributing to the growth of derivatives i) Benefits of derivatives
Page No
10 11
DEVELOPMENT OF DERIVATIVE MARKET IN INDIA NATIONAL EXCHANGES RESEARCH OBJECTIVE RESEARCH METHODOLOGY
46 50 53 53
56 68 70
Questionnaire Abbreviations
71 73
INTRODUCTION
A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-thecounter markets in other words, there is no single market place organized exchanges. Interpretation The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities, stocks, bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.
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 it was sown to the time it was ready for 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 contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or 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 into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence.
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Today derivatives contracts exist on 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.
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 change in price 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. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security in the Securities Contracts (Regulation) Act, 1956 (SCRA), 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 SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of underlying securities
Index Future
Index option
Stock option
TYPES OF DERIVATIVES
Derivatives
Future
Option
Forward
Swaps
FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The 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. n o r m a l l y traded outside the exchanges. The forward contracts are
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 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 often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. size,
FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement
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price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.
The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate.
The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.
The last trading date. Other details such as the tick, the minimum permissible price fluctuation.
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2. Margin:
Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as
determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price
.
Mark to market Margin: Because a series of adverse price changes may exhaust the
initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid.
3. Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
Physical delivery - The amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the
buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).
Cash settlement - A cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market.
Expiry: - Is the time when the final prices of the future are determined. For many equity
index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract.
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows.
2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit.
investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.
Traded directly between two Traded on the exchanges. parties (not traded on the exchanges).
Exists.
Exists.
However,
assumed
by
the
clearing corp., which becomes the counter party to all the trades or unconditionally settlement. guarantees their
Liquidation Profile
Low, as contracts are tailor High, as contracts are standardized made contracts catering to exchange traded contracts. the needs of the needs of the parties.
Price discovery
Not efficient, as markets are Efficient, as markets are centralized and scattered. all buyers and sellers come to a common platform to discover the price.
Examples
OPTIONS
A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price. There are two types of options i.e., CALL OPTION AND PUT OPTION.
CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.
PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.
Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.
SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a SWAP. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.
FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.
The other kind of derivatives, which are not, much popular are as follows:
BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.
LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.
WARRANTS Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
SWAPTIONS Swap is options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swap is an option to pay fixed and receive floating.
HISTORY OF DERIVATIVES:
The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralised location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between
two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984. Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a
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number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.
1991 14 Dec 1995 18 Nov 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 25 Sep 2000 2 June 2001
Liberalisation process initiated NSE asked SEBI for permission to trade index futures. SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Nifty futures trading commenced at SGX. Individual Stock Options & Derivatives
remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets increasing market liquidity and efficiency and facilitating the flow of trade and finance.
Asia with a market capitalisation of more than Rs.765000 crores. High Liquidity in the underlying The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the countrys Market capitalisation gets traded. These are clear indicators of high liquidity in the Trade guarantee underlying. The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the A Strong Depository clearing. National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the A Good legal guardian security settlement in our country. In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
Derivatives will find use for the following set of people: Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$ Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will examine this in detail when we look at futures in a separate chapter. Basically, every investor assumes one or more of the above roles and derivatives are a very good option for him.
Speculators
Existing
SYSTEM
New
Approach
1) Deliver based Trading, margin trading& carry forward transactions. 2) Buy Index Futures hold till expiry.
Peril &Prize
1)Maximum loss possible to premium paid
Advantages
Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.
Arbitrageurs
Existing
SYSTEM
New
Approach
1) Buying Stocks in one and selling in another exchange. forward transactions. 2) If Future Contract more or less than Fair price
Peril &Prize
1) Risk free game.
Hedgers
Existing
SYSTEM
New
Approach
1) Difficult to offload holding during adverse market conditions as circuit filters limit to curtail losses.
Peril &Prize
1) No Leverage available risk on market prices
Approach
Peril &Prize
1) Additional cost is only premium.
1)Fix price today to buy latter by paying premium. Option. If market goes up, long position benefit else exercise the option.
3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie
Advantages
Availability of Leverage
Small Investors
Existing
SYSTEM
New
Approach
1) If Bullish buy stocks else sell it.
Peril &Prize
1) Downside protected & upside unlimited.
Advantages
Losses Protected.
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. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized 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, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change
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rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counterparty, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.
the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. These price volatility risks pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.
GLOBALISATION OF MARKETS
Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality
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goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.
TECHNOLOGICAL ADVANCES
A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.
BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
2.]
PRICE DISCOVERY
Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism.
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Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset.
3.]
OPERATIONAL ADVANTAGES
As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.
4.]
MARKET EFFICIENCY
The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.
5.]
EASE OF SPECULATION
Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.
The derivative market performs a number of economic functions. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
Market Structure
Indian securities market is fairly large as compared to several other emerging markets. There are 22 stock exchanges in the country, though the entire liquidity is shared between the countries two national level exchanges namely, the National Stock Exchange of India and the Bombay Stock Exchange Ltd. The number of brokers in various stock exchanges rose from 6,711 in 1994-95 to 9,335 in FY06. Sub-brokers are an important constituent of Indian stock markets. Sub-brokers work under brokers with specified limits for trading and risk management. Sub -brokers are term as useful part in the value chain since they provide active interface with a large number of investors across the country and also extend the reach and access of the services of the brokerage firms. With the rapid growth of securities trading and deepening of the stock markets, the number of sub-brokers nearly doubled in the last ten years from 9,957 in FY01 to 23,479 in FY06. In the national level stock exchanges, a large portion of the brokers are corporatised though enough incentive does not appear to exist for similar trends to appear in the regional stock exchanges.
Market Capitalization
Market capitalization of stocks in India rose from Rs 67.50 bn in 1980 to Rs 705.21 bn in 1990 to Rs 11,926.30 bn in 2000. BSE market capitalization as of mid-2007 is about Rs 40,000 bn, which in the background of the appreciating rupee takes it to among the small group of exchanges with a trillion dollar market cap. Market capitalization as percent of gross domestic product which was about 25% in the early 2000s, now equals it. Several leading emerging economies have market capitalization as a multiple of GDP, and in the manner in which stock prices are appreciating in India, the prospects for Indian market capitalization rising further look good.
Trading Volumes
Secondary market operations gained greater momentum in the last decade. In the last ten years, the value of trading in both NSE and BSE rose six times making the Indian stock markets the leading market in the Asian region, and is also remarkable as compared to the growth in the world equity markets. Average number of transactions rose 5 times at the NSE and about 4 times at the BSE in the last ten years, thus indicating a strong surge in stock market operations as also predominance of retail investing. Exchanges with national presence and infrastructure are gaining from this development which is expected to continue further in the future. A major development in Indian equity markets is the dematerialization of shares which led to speedy securities settlement. Delays and bad deliveries also reduced after dematerialization. Progress made in Indian markets in dematerialization was noticed in the international markets as an important achievement and landmark. By FY06, more than 6,000 companies signed agreements for dematerialization with NSDL and 5,500 companies with CDSL.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with 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. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment.
It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continue to remain poor.
This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.
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Farther month futures contracts are still not actively traded. Trading in equity options
on most stocks for even the next month was non-existent. Daily option price variations suggest that traders use the F&O segment as a less risky
alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.
The spot foreign exchange market remains the most important segment but the derivative segment has also grown. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives in India followed by forwards and options. Significant milestones in the development of derivatives market have been (i) permission to banks to
undertake cross currency derivative transactions subject to certain conditions (1996) (ii) allowing corporate to undertake long term foreign currency swaps that contributed to the development of the term currency swap market (1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of currency futures (2008). I would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into rupees. However, since banks could not carry open positions the risk was allowed to be transferred to any other resident corporate. Normally such risks should be taken by corporate who have natural hedge or have potential foreign exchange earnings. But often corporate assume these risks due to interest rate differentials and views on currencies. This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy.
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Cash settled exchange traded currency futures have made foreign currency a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recognized stock exchanges with credit risks being assumed by the central counterparty
Since the commencement of trading of currency futures in all the three exchanges, the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same period. The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between 2 3 per cent.
Table 4.1ForexMarketActivity April05Total turnover (USD billion) Inter-bank to Merchant ratio Spot/Total Turnover (%) Forward/Total Turnover (%) Swap/Total Turnover (%) Source: RBI Mar06 4,404 2.6:1 50.5 19.0 30.5 April06Mar07 6,571 2.7:1 51.9 17.9 30.1 April07Mar08 12,304 2.37: 1 49.7 19.3 31.1 April08Mar09 9,621 2.66:1 54.9 21.5 32.7
National Exchanges
In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmadabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. National Status implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. commenced operations in October/ December 2003 respectively.
MCX
Ahmadabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai
MCX (Multi Commodity Exchange of India Ltd.) an independent and de-mutualised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank of Baroda, Cannara Bank, Corporation of India, Bank Bank
Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure.
MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading.
NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN). NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate
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process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.
NCDEX
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a worldclass commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.
Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow soyabean meal.
RESARCH METHODOLOGY
Method of data collection:Secondary sources:It is the data which has already been collected by someone or an organization for some other purpose or research study .The data for study has been collected from various sources: Books Journals Magazines Internet sources
RESEARCH DESIGN
Non probability
The non probability respondents have been researched by selecting the persons who do the trading in derivative market. Those persons who do not trade in derivative market have not been interviewed.
SAMPLING METHODOLOGY
Sampling Technique
Initially, a rough draft was prepared a pilot study was done to check the accuracy of the Questionnaire and certain changes were done to prepare the final questionnaire to make it more judgmental.
Sampling Unit
The respondents who were asked to fill out the questionnaire in the National Capital Region are the sampling units. These respondents comprise of the persons dealing in derivative market. The people have been interviewed in the open market, in front of the companies, telephonic interviews and through other sources also
Sample Size
The sample size was restricted to only 50 respondents.
Sampling Area The area of the research was National Capital Region (NCR).
Time:
2 months
ANALYSIS
Q. Education qualification of investors who investing in derivative market.
No. of result 6 10 23 11
No. of Result 1 9 14 26
Q. Normally what percentage of your monthly household income could be available for
investment
Investment
Between 5% to 10% Between 11% to 15% Between 16% to 20% Between 21% to 25% More than 25% No. of result 2 6 13 18 11
Q. What kind of risk do you perceive while investing in the stock market?
Risk in stock market Uncertainty of returns Slump in stock market Fear of windup of company Others
No.of result 19 22 6 3
Reasons Lack of knowledge & understanding Increase speculation Risky & highly leveraged Counter party risk
No.of result 27 2 17 4
Purpose of investment Hedge their fund Risk control More stable Direct investment without buying & holding assets
No. of Result 27 9 1 13
No. of Result 23 2 8 17
Q. From where you prefer to take advice before investing in derivative market?
Advice From Brokerage houses Research analyst Websites News Networks Others
No. of Result 15 7 2 23 3
Participate in Stock index futures Stock index Options Future on individual stock Currency futures Options on individual stock
No. of Result 19 13 6 9 3
Q. What contract maturity period would interest you for trading in?
Q. What is best describes the overall approach to invest as a mean of achieving investors goals.
OPTIONS Relative level of stability in overall investment portfolio increasing investment value while minimizing potential for loss of principal Investment growth with moderate high levels of risk Maximum long term returns with high risk
NO. of Result 17 19 4 10
INTERPRETATION
Most of the investors who invest in derivatives market are post graduate. Investors who invest in derivative market have a income of above 5,00,000 Investors generally perceive slump in stock market kind of risk while investing in derivative market. People are generally not investing in derivative market due to lack of knowledge and difficulty in understanding and it is very risky also. Most of investor purpose of investing in derivative market is to hedge their fund. People generally participate in derivative market as a investor or hedger. People generally prefer to take advice from news network before investing in derivative market. Most of investors participate in stock index futures. From this survey we come to know that most of investors make a contract of 3 month maturity period. Investors invest regularly in derivative market.
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A knowledge need to be spread concerning the risk and return of the derivative market. More variation in stock index future need to be made looking a demand side of investors. RBI should play a greater role in supporting derivatives There must be more derivative instruments aimed at individual investors. SEBI should conduct seminars regarding the use of derivatives to educate individual investors.
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LIMITAITONS OF STUDY
1. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a wide topic, had a limited time..
2. LIMITED RESOURCES:
Limited resources are available to collect the information about the commodity trading
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast anything about it whether you trade through online or offline
4. ASPECTS COVERAGE:
BIBLIOGRAPHY
Books:
Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah NSEs Certification in Financial Markets: - Derivatives Core module
Reports:
Report of the RBI-SEBI standard technical committee on exchange traded Currency Futures (Reserve Bank of India, 2008).
Regulatory Framework for Financial Derivatives in India by Dr. L.C.GUPTA. (Reserve Bank of India, April 2008) Websites visited:
www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.derivativesindia.com
ABBREVATIONS
A AMEX- America Stock Exchange B BSE- Bombay Stock Exchange BSI- British Standard Institute C CBOE - Chicago Board options Exchange CBOT - Chicago Board of Trade CEBB - Chicago Egg and Butter Board CME - Chicago Mercantile Exchange CNX- Crisil Nse 50 Index CPE - Chicago Produce Exchange CWC- Central Warehousing Corporation D DTSS- Derivative Trading Settlement System F FIIs- Foreign Institutional Investors F & O Future and Options FMC- Forward Markets Commission FRAs- Forward Rate Agreements
G
GAICL-Gujarat Agro Industries Corporation Limited GSAMB- Gujarat State Agricultural Marketing Board I IMM - International Monetary Market IPSTA- India Pepper & Spice Trade Association
M
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MCX Multi Commodity Exchange N NAFED-National Agricultural Co-Operative Marketing Federation Of India NCDEX National Commodities and Derivatives Exchange NIAM- National Institute Of Agricultural Marketing NMSE- National Multi Commodity Exchange NOL- Neptune Overseas Limited NSCCL- National Securities Clearing Corporation NSDL- National Securities Depositories Limited NSE - National Stock Exchange O OTC- Over The Counter P PHLX - Philadelphia Stock Exchange PNB- Punjab National Bank R RBI- Reserve Bank Of India S SC(R) A - Securities Contracts (Regulation) Act, 1956 SEBI- Securities Exchange Board Of India SGX- Singapore Stock Exchange SIMEX - Singapore International Monetary Exchange V VPN- Virtual Private Network