Abstract:

The past decade has witnessed

the multiple growths in the
volume of international trade
and
business due to the wave of
globalization and liberalization
all over the world. As a result,
the
demand for the international
money and financial
instruments increased
significantly at the
global level. In this respect,
change in exchange rates,

P a g e 1 | 51
interest rates and stock prices
of
different financial markets
have increased the financial
risk to the corporate world.
Adverse
changes in the macroeconomic
factors have even threatened
the very survival of business
world. It is therefore essential
to develop a set of new
financial instruments known as
derivatives in the Indian
financial markets, to manage
such risk. The basic purpose of
these
P a g e 2 | 51
instruments is to provide
commitments to prices for
future dates for giving
protection against
adverse movements in future
prices, in order to reduce the
extent of financial risks.
Today, the
financial derivatives have
become increasingly popular
and most commonly used in
the
world of finance. This has
grown with a phenomenal
speed all over the world that
now it is
P a g e 3 | 51
called as the derivatives
revolution. In India, the
emergence and growth of
derivatives market
is relatively a recent
phenomenon. Since its
inception in June 2000,
derivatives market has
exhibited exponential growth
both in terms of volume and
number of contract traded. The
market turnover has grown
from Rs.2365 Cr. in 2000-
2001 to Rs. 26444804.86 Cr.
in 2013-

P a g e 4 | 51
14. Within a short span of
twelve years, derivatives
trading in India has surpassed
cash
segment in terms of turnover
and number of traded
contracts. The passed study
encompasses
in its scope, history, concept,
definition, types, features,
regulation, market, trend,
growth,
Future prospects and
challenges of derivatives in
India and status of Indian
derivatives
P a g e 5 | 51
market vis-à-vis global
derivative marke
Abstract:
The past decade has witnessed
the multiple growths in the
volume of international trade
and
business due to the wave of
globalization and liberalization
all over the world. As a result,
the
demand for the international
money and financial
instruments increased
significantly at the

P a g e 6 | 51
global level. In this respect,
change in exchange rates,
interest rates and stock prices
of
different financial markets
have increased the financial
risk to the corporate world.
Adverse
changes in the macroeconomic
factors have even threatened
the very survival of business
world. It is therefore essential
to develop a set of new
financial instruments known as
derivatives in the Indian
financial markets, to manage
P a g e 7 | 51
such risk. The basic purpose of
these
instruments is to provide
commitments to prices for
future dates for giving
protection against
adverse movements in future
prices, in order to reduce the
extent of financial risks.
Today, the
financial derivatives have
become increasingly popular
and most commonly used in
the
world of finance. This has
grown with a phenomenal
P a g e 8 | 51
speed all over the world that
now it is
called as the derivatives
revolution. In India, the
emergence and growth of
derivatives market
is relatively a recent
phenomenon. Since its
inception in June 2000,
derivatives market has
exhibited exponential growth
both in terms of volume and
number of contract traded. The
market turnover has grown
from Rs.2365 Cr. in 2000-

P a g e 9 | 51
2001 to Rs. 26444804.86 Cr.
in 2013-
14. Within a short span of
twelve years, derivatives
trading in India has surpassed
cash
segment in terms of turnover
and number of traded
contracts. The passed study
encompasses
in its scope, history, concept,
definition, types, features,
regulation, market, trend,
growth,
Future prospects and
challenges of derivatives in
P a g e 10 | 51
India and status of Indian
derivatives
market vis-à-vis global
derivative marke
A
PROJECT REPORT
ON

STUDY OF DERIVATIVES IN THE STOCK MARKET AND THEIR

IMPORTANCE IN HEDGING.

SUBMITTED IN THE PARTIAL FULFILLMENT OF THIRD YEAR

BACHELOR OF BUSINESS ADMINISTRATION DEGREE OF
SAVITRIBAI PHULE PUNE UNIVERSITY SUBMITTED BY

MAST. ADITYA DILIP MAGAR

ROLL NO. 36

P a g e 11 | 51
 GUIDED BY
PROF. SHITAL INDANI
KARMAVEER KAKASAHEB WAGH ARTS, COMMERCE, SCIENCE
& COMPUTER SCIENCE COLLEGE, NASHIK 2022-2023

P a g e 12 | 51
 KARMVEER KAKASAHEB WAGH EDUCATION SOCIETY’S
K.K.WAGH ARTS, COMMERCE, SCIENCE & COMPUTER SCIENCE
COLLEGE, SARASWATI NAGAR, ADGAON ROAD, PANCHAVATI,
NASHIK-422403

CERTIFICATE

This is to certify that MAST. ADITYA DILIP MAGAR ROLL NO.36 has
satisfactorily completed the project report in the partial fulfilment of
University of Pune during the academic year
2022-2023.

-------------------- --------------------
Prof. Shital Indani Prof. Supriya Daware
(Guided by) (H.O.D)

--------------------- ---------------------
External Examiner Dr.A.D Nandurkar
(I/c Principal)

P a g e 13 | 51
 DECLARATION

I ADITYA DILIP MAGAR, the student of k. k. Wagh college, Nashik hereby

declare this project entitled “STUDY OF DERIVATIVES IN THE STOCK
MARKET AND THEIR IMPORTANCE IN HEDGING”. It was carried out by
me as the partial fulfilment of Bachelor of Business Administration Course
under University of Pune. This project can be undertaken as a part of academic
curriculum according to university rules & with no commercial interest &
motive.

Date: Sign:

Place: Nashik Name: ADITYA MAGAR

P a g e 14 | 51
 ACKNOWLEDGEMENT

Any accomplishment requires the effort of many people and this

work is not different. Regardless of the source, I wish to express my
gratitude to those who may have contributed to this work, even
though anonymously.
First I would like to express my deepest sense of gratitude to K.K.WAGH ARTS
COMMERCE SCIENCE AND COMPUTER COLLEGE for providing me with an
opportunity for training and encouragement in conducting the research work.
I would like to pay my sincere thanks to my project guide, Prof. Shital
Indani under whose guidance I was able to complete my project
successfully. I have been fortunate enough to get all the support,
encouragement and guidance from her needed to explore, think new
and initiate.
My final thank goes out to my parents, family members, teachers and friends
who encouraged me countless times to persevere through this entire process.

Date: ADITYA DILIP MAGAR

Place: Nashik (T.Y B.B.A)

P a g e 15 | 51
INTRODUCTION

P a g e 16 | 51
Abstract:
The past decade has witnessed the multiple growths in the volume of international
trade and business due to the wave of globalization and liberalization all over the
world. As a result, the demand for the international money and financial instruments
increased significantly at the global level. In this respect, change in exchange rates,
interest rates and stock prices of different financial markets have increased the
financial risk to the corporate world. Adverse changes in the macroeconomic factors
have even threatened the very survival of business world. It is therefore essential to
develop a set of new financial instruments known as derivatives in the Indian financial
markets, to manage such risk. The basic purpose of these instruments is to provide
commitments to prices for future dates for giving protection against adverse
movements in future prices, in order to reduce the extent of financial risks. Today, the
financial derivatives have become increasingly popular and most commonly used in
the world of finance. This has grown with a phenomenal speed all over the world that
now it is called as the derivatives revolution. In India, the emergence and growth of
derivatives market is relatively a recent phenomenon. Since its inception in June 2000,
derivatives market has exhibited exponential growth both in terms of volume and
number of contract traded. The market turnover has grown from Rs.2365 Cr. in 2000-
2001 to Rs. 26444804.86 Cr. in 2013-14. Within a short span of twelve years,
derivatives trading in India has surpassed cash segment in terms of turnover and
number of traded contracts. The passed study encompasses in its scope, history,
concept, definition, types, features, regulation, market, trend, growth, Future prospects
and challenges of derivatives in India and status of Indian derivatives market with
regard to global derivative market.

INTRODUCTION
P a g e 17 | 51
The securities markets in India
have perceived several policy
initiatives, leading to refined
market micro-structure,
modernized operations and
broadened investment choices
for the
investors. The securities
market has two interdependent
and inseparable segments, the
new
issues (primary market) and
the stock (secondary) market.
The primary market provides
the

P a g e 18 | 51
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 in domestic
market and/or international
market.
Secondary market refers to a
market where securities are
traded after being initially
offered to
P a g e 19 | 51
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 and provides liquidity
to the stocks. Majority of
trading takes place in India on
two
stock exchanges namely
National Stock Exchange
(NSE) and Bombay Stock
Exchange
P a g e 20 | 51
(BSE). BSE was founded in
1875 and is the oldest
exchange. It includes 30
companies while
NSE was founded in 1992 and
started trading in 1994. It
consists of 50 companies .Both
of
them operates on same rules
and mechanisms and consists
of most of the India‘s major
firms.
Their Indexes are popularly
known as SENSEX and the
S&P CNX NIFTY

P a g e 21 | 51
INTRODUCTION

The securities markets in India have perceived several policy initiatives, leading to refined
market micro-structure, modernized operations and broadened investment choices for the
investors.
The securities market has two interdependent and inseparable segments, the new issues
(primary market) and the stock (secondary) 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 in domestic market and/or international 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 and provides liquidity to the stocks.

Majority of trading takes place in India on two stock exchanges namely National Stock
Exchange (NSE) and Bombay Stock Exchange (BSE). BSE was founded in 1875 and is the
oldest exchange. It includes 30 companies while NSE was founded in 1992 and started
trading in 1994. It consists of 50 companies .Both of them operates on same rules and
mechanisms and consists of most of the India‘s major firms. Their Indexes are popularly
known as SENSEX and the S&P CNX NIFTY.

P a g e 22 | 51
Research Methodology

In order to conduct the research an appropriate methodology became necessary. In this

direction secondary data were attempted to be collected. The methodology for collecting data
with reference to the secondary data was taken from the different published articles, journals,
and the relevant websites. Methodology became a pre-planned strategy in collecting, editing,
tabulating and in interpreting the required information for the research. Thus, methodology
relied on secondary data with the help of case studies, questionnaires, discussions,
observations as well as published work and unpublished work.

Data Collection Method :

Secondary Data:
Secondary data is taken by the researcher from secondary sources, internal or external.
Therefore, secondary data is when the investigator does not collect data originally for the
research enquiry but uses data already collected and available in published or unpublished
from data.

Books, Magazines, websites, already published reports, TV, Radio, Newspapers, Films,
Journals and publications, Research papers etc. The methods of collecting primary and
secondary data differ since primary data are to be originally collected, while in case of
secondary data the nature of data collection work is merely that of compilation.

P a g e 23 | 51
 Objectives of the study

1. To study and understand the derivative markets in India, what are the different types of
derivatives available in the Indian stock market and how can the investors make use of them.
2. To analyse the growth of equity derivative segment in NSE.
3. To evaluate the turnovers of stock futures, stock options, index futures, index options
effectively right from they were introduced to the Indian investors.
4. To compare the Indian equity market [ that is derivatives market] with respect to the
other global markets.
5. what role does derivates play in hedging and minimising the risk of loss of the investors.

P a g e 24 | 51
 HISTORICAL DEVELOPMENT OF DERIVATIVE MARKET IN INDIA

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. Derivative markets in India have been in existence in one
form or the other for a long time. In the area of commodities, the Bombay Cotton Trade
Association started future trading way back in 1875. This was the first organized futures
market. Then Bombay Cotton Exchange Ltd. in 1893, Gujarat Vyapari Mandall in 1900,
Calcutta Hesstan Exchange Ltd. in 1919 had started future market. After the country attained
independence, derivative market came through a full circle from prohibition of all sorts of
derivative trades to their recent reintroduction. In 1952, the government of India banned cash
settlement and options trading, derivatives trading shifted to informal forwards markets. In
recent years government policy has shifted in favour of an increased role at market based
pricing and less suspicious derivatives trading. The first step towards introduction of financial
derivatives trading in India was the promulgation at the securities laws (Amendment)
ordinance 1995. It provided for withdrawal at prohibition on options in securities. The last
decade, beginning the year 2000, saw lifting of ban of futures trading in many commodities.
Around the same period, national electronic commodity exchanges were also set up.

P a g e 25 | 51
Concept of Financial Derivatives:

Concept of Financial Derivatives: At present the Indian stock markets are not having any risk
hedged instruments that would allow the investors to manage and minimize the risk. In
industrialized countries apart from money market and capital market securities, a variety of
other securities known as „derivatives‟ have now become available for investment and
trading. The derivatives originate in mathematics and refer to a variable which has been
derived from another variable. A derivative is a financial product which has been derived
from another financial product or commodity. The derivatives do not have independent
existence without underlying product and market. Derivatives are contracts which are written
between two parties for easily marketable assets. Derivatives are also known as deferred
delivery or deferred payment instruments. Since financial derivatives can be created by
means of a mutual agreement, the types of derivative products are limited only by
imagination and so there is no definitive list of derivative products. A derivative is a financial
product which has been derived from another financial product or commodity. D.G. Gardener
defined the derivatives as “A derivative is a financial product which has been derived from
market for another product.” The securities contracts (Regulation) Act 1956 defines
“derivative” as under section 2 (ac). As per this “Derivative” includes
(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.”
(b) “a contract which derived its value from the price, or index of prices at underlying
securities.” The above definition conveys that the derivatives are financial products.
Derivative is derived from another financial instrument/ contract called the underlying. A
derivative derives its value from underlying assets. Accounting standard defines “a derivative
instrument is a financial derivative or other contract which will comprise of all three of the
following characteristics:
(i) It has one or more underlying asset, and one or more notional amount or payments
provisions or both. Those terms determine the amount of the settlement or settlements.
(ii) It requires no initial net investment or an initial net investment that is smaller than would
be required for other types of contract that would be expected to have a similar response to
changes in market factors.
(iii) Its terms require or permit net settlement. It can be readily settled net by a means outside
the contract or it provides for delivery of an asset that puts the recipients in a position not
substantially different from net settlement .From the aforementioned, derivatives refer to
securities or to contracts that derive from another whose value depends on another contract or
assets. As such the financial derivatives are financial instrument whose prices or values are
derived from the prices of other underlying financial instruments or financial assets.
The underlying instruments may be an equity share, stock, bond, debenture, Treasury bill,
foreign currency or even another derivative asset.

P a g e 26 | 51
Hence, financial derivatives are financial instruments whose prices are derived from the
prices of other financial instruments. As defined above, its value is entirely derived from the
value of the underlying asset. The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else. In other way the underlying asset may assume many
forms:
(i) Commodities including grain, coffee beans, orange juice;
(ii) Precious metals like gold & silver;
(iii) Foreign exchange rates or currencies;
(iv) Bonds of different types, including medium to long term negotiable debt, securities
issued by governments, companies etc;
(v) Shares and share warrants of companies traded on recognized stock exchanges and stock
index;
(vi) Short term securities such as T-bills;
(vii) Over the counter (OTC) money market products such as loans or deposits.

P a g e 27 | 51
CONCEPT OF DERIVATIVES AND TYPES OF
DERIVATIVES

P a g e 28 | 51
TYPES AND CLASSIFICATION OF DERIVATIVES

There are many ways in which the derivatives can be categorized based on the markets where
they trade, based on the underlying asset and based on the product feature etc. some ways of
classification are following:

(1) On the basis of linear and non-linear: On the basis of this classification the financial
derivatives can be classified into two big class namely linear and non-linear derivatives:
(a) Linear derivatives: Those derivatives whose so over-the-counter (OTC) traded derivative:
These values depend linearly on the underlying’s value are called linear derivatives. They are
following:
(i) Forwards
(ii) Futures
(iii) Swaps
(b) Non-linear derivatives: Those derivatives whose value is a non-linear function of the
underlying are called non-linear derivatives. They are following:
(i) Options
(ii) Convertibles
(iii) Equity linked bonds
(iv) Reinsurance
(2) On the basis of financial and non-financial: On the basis of this classification the
derivatives can be classified into two category namely financial derivatives and non-financial
derivatives.
(a) Financial derivatives: Those derivatives which are of financial nature are called financial
derivatives. They are following:
(i) Forwards
(ii) Futures
(iii) Options
(iv) Swaps
The above financial derivatives may be credit derivatives, forex, currency fixed-income,
interest, insider trading and exchange traded.
(b) Non-financial derivatives: Those derivatives which are not of financial nature are called
non-financial derivatives. They are following:
(i) Commodities
(ii) Metals
P a g e 29 | 51
(iii) Weather
(iv) Others
(3) On the basis of market where they trade: On the basis of this classification, the derivatives
can be
classified into three categories namely; OTC traded derivatives, exchange-traded derivative
and common derivative. Derivative contracts are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. The OTC
derivative market is the largest market for derivatives and largely unregulated with respect to
disclosure of information between parties. They are following:
(i) Swaps
(ii) Forward rate agreements
(iii) Exotic options
(iv) Other exotic derivative
(b) Exchange traded derivative: Those derivative instruments that are traded via specialized
derivatives exchange of other exchange. A derivatives exchange is a market where individual
trade standardized contracts that have been defined by the exchange. Derivative exchange act
as an intermediary to all related transactions and takes initial margin from both sides of the
trade to act as a guarantee. They may be followings:
(i) Futures
(ii) Options
(iii) Interest rate
(iv) Index product
(v) Convertible
(vi) Warrants
(vii) Others
(c) Common derivative: These derivatives are common in nature/trading and classification.
They are following:
(i) Forwards
(ii) Futures
(iii) Options
(iv) Binary options
(v) Warrant
(vi) Swaps
P a g e 30 | 51
The various types of financial derivatives based on their different properties like, plain.
Simple or straight forward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged,
customized or OTC traded, standardized or organized exchange traded, regulated and
unregulated etc. are available in the market be classified into two big class namely linear and
non-linear derivatives.

Classification of derivatives contracts in India:

The Indian financial market woke up to the new generation of financial instrument and the
Indian derivatives markets‟ Odyssey in modern times commenced with FOREX derivatives
in 1997 has also seen the introduction of many derivatives on different underlying. Currently
the following contracts are allowed for trading in Indian markets:

P a g e 31 | 51
FORWARD CONTRACT:

A forward contract is a customized contract between the buyer and the seller where
settlement takes place on a specific date in future at a price agreed today. In case of a forward
contract the price which is paid/ received by the parties is decided at the time of entering into
contract. It is simplest form of derivative contract mostly entered by individual in day to day
life. The holder of a long (short) forward contract has an agreement to buy (sell) an asset at a
certain time in the future for a certain price, which is agreed upon today. The buyer (or seller)
in a forward contract:

 Acquires a legal obligation to buy (or sell) an asset (known as the underlying asset)

 At some specific future date (the expiration date)

 At a price (the forward price) which is fixed today.

The basic features of a contract are given in brief here as under:

1. Forward contracts are bilateral contracts, and hence, they are exposed to the counter party
risk. There is risk of non-performance of obligation either of the parties, so these are riskier
than to futures contracts.
2. Each contract is custom designed, and hence, is unique in terms of contract size, expiration
date, the asset type, quality etc.
3. In forward contract, one of the parties takes a long position by agreeing to buy the asset at
a certain specified future date. The other party assumes a short position by agreeing to sell the
same asset at the same date for the same specified price. A party with no obligation offsetting
the forward contract is said to have an open position. A party with a close position is,
sometimes, called a hedger.
4. The specified price in a forward contract is referred to as the delivery price. The forward
price for a particular forward contract at a particular time is the delivery price that would
apply if the contract were entered into at that time. It is important to differentiate between the
forward price and the delivery price. Both are equal at the time the contact is entered into.
However, as time passes, the forward price is likely to change whereas the delivery price
remains the same.
5. In the forward contract, derivative asset can often be contracted from the combination of
underlying assets; such assets are often known as synthetic assets in the forward market.
6. In the forward market, the contract has to be settled by delivery of the asset on expiration
date. In case the party wishes to reverse the contract, it has to compulsory go to the same
counter party, which may dominate and command the price it wants as being in a monopoly
situation.
7. In a forward contract, covered party or cost of carry relations are relation between the
prices of forward and underlying assets.
P a g e 32 | 51
8. Forward contract are very popular in foreign exchange market as well as interest rate
bearing instruments. Most of the large and international banks quote the forward rate through
their forward desk lying within their foreign exchange trading room. Forward foreign
exchange quotes by these banks are displayed with the spot rates.

Futures Contracts
Futures contract is an agreement between two parties to buy or sell a specified quantity of an
asset at a specified price and at a specified time and place. Future contracts are normally
traded on an exchange which sets the certain standardized norms for trading in futures
contracts.
The features of a futures contract may be specified as follows:
1. Futures are traded only in organized exchanges.
2. Futures contract required to have standard contract terms.
3. Futures exchange has associated with clearing house.
4. Futures trading required margin payment and daily settlement.
5. Futures positions can be closed easily.
6. Futures markets are regulated by regulatory authorities like SEBI.
7. The futures contracts are executed on expiry date.
8. The futures prices are expressed in currency units, with a minimum price movement called
a tick size. The quality of positive economic theory explains about its ability with precision
clarity and simplicity.

The main characteristics of futures explained by a good economic theory are as follows:

1. There are a limited number of actively traded products with futures contracts.
2. The trading unit is large and indivisible.
3. It has no more than maturity of 3 months.
4. The success ratio of new contract is about 25% in the world financial markets.
5. Futures are seldom used by farmers.
6. There are both commercial and non-commercial users of futures contract in interest rates
and foreign exchange.

P a g e 33 | 51
7. The main use of the future by the commercial users is to hedge corresponding cash and
forward positions.
8. The positions of the non-commercial users take almost entirely speculative positions. In
foreign exchange futures, the positions of the commercials users are unbalanced.

There are different types of contracts in financial futures which are traded in the various
futures market of the world.
The followings are the important types of financial futures contract:
1. Stock future or equity futures
2. Stock index futures
3. Currency futures
4. Interest rate futures
FUTURES TERMINOLOGY
Contract Size
Contract size, or lot size, is the minimum tradable size of a contract. It is often one
unit of the defined contract.
Tick Size
It is the minimum price difference between two quotes of
similar nature.Tick Size is the minimum movement
allowed by the exchange in Price Quotation.
Contract Month
The month in which the contract will expire.
Expiry Day
The last day on which the contract is available for trading.
Open interest
Total outstanding long or short positions in the market at any specific point in
time.as total long positions for market would be equal to total short positions, for
calculation of open Interest, only one side of the contracts is counted.
Volume
No. Of contracts traded during a specific period of time. During a day, during

P a g e 34 | 51
a week or during a month.

Long position
Outstanding/unsettled purchase position at any point of time.
Short position
Outstanding/ unsettled sales position at any point of time.
Open position
Outstanding/unsettled long or short position at any point of time.
Physical delivery
Open position at the expiry of the contract is settled through delivery of the
underlying. In futures market, delivery is low.
Cash settlement
Open position at the expiry of the contract is settled in cash. These contracts
Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is
settled by two parties - one buyer and one seller, at the terms other than defined by the
exchange. World wide a significant portion of the energy and energy related contracts
(crude oil, heating and gasoline oil) are settled through Alternative Delivery
Procedure

P a g e 35 | 51
Options Contract
Options are derivative contract that give the right, but not the obligation to either buy or sell a
specific underlying security for a specified price on or before a specific date. In theory,
option can be written on almost any type of underlying security. Equity (stock) is the most
common, but there are also several types of nonequity options, based on securities such as
bonds, foreign currency, indices or commodities such as gold or oil. The person who buys an
option is normally called the buyer or holder. Conversely, the seller is known as the seller or
writer again we can say “An option is a particular type of a contract between two parties
where one person gives the other person the right to buy or sell a specific asset at a specified
price within a specified time period.” Today, options are traded on a variety of instruments
like commodities, financial assets as diverse as foreign exchange, bank times deposits,
treasury securities, stock, stock indexes, petroleum products, food grains, metals etc. The
main characteristics of options are following:
1. Options holders do not receive any dividend or interest.
2. Option yield only capital gains.
3. Options holder can enjoy a tax advantages.
4. Options are traded on OTC and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying assets.
6. Options create the possibility of gaining a windfall profit.
7. Options holder can enjoy a much wider risk- return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable with the investors to gain a better returns with a limited amount of
investment.
A call which is the right to buy shares under a negotiable contract and which do not carry any
obligation. The buyers have the right to receive the delivery of assets are known as call
option. In this option the owner has the right to sell the underlying asset under the negotiable
contract. Put option holder has the right to receive the payment by surrendering the asset. The
writer of an option is a stock broker, member or a security dealer. The buyer of an option
pays a price depending on the risk of underlying security and he as an investor or a dealer or
trader.

The basic features of options or followings:

1. The option is exercisable only by the owner namely the buyer of the option.

P a g e 36 | 51
2. The owner has limited liability.
3. Owners of options have no voting rights and dividend right.
4. Options have high degree of risk to the option writers.
5. Options involving buying counter positions by the option sellers.
6. Flexibility in investor’s needs.
7. No certificates are issued by the company.
8. Options are popular because they allow the buyer profits from favourable movement in
exchange rate.

Options can be classified into different categories like:

(i) Call options
(ii) Put options
(iii) Exchange traded options
(iv) OTC traded options
(v) American options
(vi) European options
(vii) Commodity options
(viii) Currency options
(ix) Stock options
(x) Stock Index options

OPTIONS TERMINOLOGY:
Call option: A call is an option contract giving the buyer the right to purchase the stock.
Put option: A put is an option contract giving the buyer the right to sell the stock.
Expiration date: It is the date on which the option contract expires.
Strike price: It is the price at which the buyer of a option contract can purchase or sell the
stock during the life of the option
Premium: Is the price the buyer pays the writer for an option contract.
Writer: The term writer is synonymous to the seller of the option contract.
Holder: The term holder is synonymous to the buyer of the option contract.

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Straddle: A straddle is combination of put and calls giving the buyer the right to either buy or
sell stock at the exercise price.
Strip: A strip is two puts and one call at the same period.
Strap: A strap is two calls and one put at the same strike price for the same period.
Spread: A spread consists of a put and a call option on the same security for the same time
period at different exercise prices. The option holder will exercise his option when doing so
provides him a benefit over buying or selling the underlying asset from the market at the
prevailing price. These are three possibilities.
1. In the money: An option is said to be in the money when it is advantageous to exercise it.
2. Out of the money: The option is out of money if it not advantageous to exercise it.
3. At the money: If the option holder does not lose or gain whether he exercises his option or
buys or sells the asset from the market, the option is said to be at the money.

The exchanges initially created three expiration cycles for all listed options and each issue
was assigned to one of these three cycles.
January, April, July, October.
February, March, August, November.
March, June, September, and December.
In India, all the F and O contracts whether on indices or individual stocks are available for one or
two- or three-months series and they expire on the Thursday of the concerned month

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Advantages of option trading:
Risk management: put option allow investors holding shares to hedge against a possible fall
in their value. This can be considered similar to taking out insurance against a fall in the share
price.
Time to decide: By taking a call option the purchase price for the shares is locked in. This
gives the call option holder until the Expiry Day to decide whether or exercised the option
and buys the shares. Likewise, the taker of a put option has time to decide whether or not to
sell the shares
Speculations: The ease of trading in and out of option position makes it possible to trade
options with no intention of ever exercising them. If investor expects the market to rise, they
may decide to buy call options. If expecting a fall, they may decide to buy put options. Either
way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading
options has a lower cost than shares, as there is no stamp duty payable unless and until
options are exercised.

Leverage: Leverage provides the potential to make a higher return from a smaller initial
outlay than investing directly however leverage usually involves more risks than a direct
investment in the underlying share. Trading in options can allow investors to benefit from a
change in the price of the share without having to pay of the share.

FACTORS DETERMINIG OPTION VALUE:

I. Stock price:
• The option premium keeps fluctuating with the price of the underlying stock
• The rate of change will be the highest for the strike price closer to the spot price.

II. Strike price:

• It is the price which a call owner may purchase stock, and the put owner may sell stock.
• In the case of a stock split there would be change in the strike price.

III. Time to expiration

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• The longer the time to expiration date, the more valuable the Call/Put options
• It is because there is greater the probability call/put option to turn from OTM to ITM

IV. Volatility
• Volatility is a measure of how rapidly and how widely a stock price swings up and down
• An option of a volatile stock is much more expensive than one of a less volatile stock.

V. Risk free interest rate

• When interest rates are on the rise, the value of call options rise and the value of puts will
fall.

VI. Dividend
• Stock dividends also have little effect on option prices
• Call prices fall and put prices rise with all other factors remaining same
• It is because the price of the stock is reduced by the amount of the dividend for the next
trading session.

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Swaps Contract
A swap is an agreement between two or more people or parties to exchange sets of cash flows
over a period in future. Swaps are agreements between two parties to exchange assets at
predetermined intervals. Swaps are generally customized transactions. The swaps are
innovative financing which reduces borrowing costs, and to increase

control over interest rate risk and FOREX exposure. The swap includes both spot and
forward transactions in a single agreement. Swaps are at the centre of the global financial
revolution. Swaps are useful in avoiding the problems of unfavourable fluctuation in FOREX
market. The parties that agree to the swap are known as counter parties. The two commonly
used swaps are interest rate swaps and currency swaps.
Interest rate swaps which entail swapping only the interest related cash flows between the
parties in the same currency. Currency swaps entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a different currency than the
cash flows in the opposite direction.

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DERIVATIVES MARKET IN INDIA

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DERIVATIVES MARKET IN INDIA
In India, there are two major markets namely National Stock Exchange (NSE) and Bombay
Stock Exchange (BSE) along with other Exchanges of India are the market for derivatives.
Here we may discuss the performance of derivatives products in Indian market.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and
Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges,
NSE and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivatives contracts. Initially, SEBI approved trading in index futures contracts
based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently,
index-based trading was permitted in options as well as individual securities.

DERIVATIVE PRODUCTS TRADED AT BSE

The BSE started derivatives trading on June 9, 2000 when it launched “Equity derivatives
(Index futures-SENSEX) first time. It was followed by launching various products. They are
index options, stock options, single stock futures, weekly options, stocks for: Satyam, SBI,
Reliance Industries, Tata Steel, Chhota (Mini) SENSEX, Currency futures, US dollar-rupee
future and BRICSMART indices derivatives.

DERIVATIVE PRODUCTS TRADED AT NSE

The NSE started derivatives trading on June 12, 2000 when it launched “Index Futures S & P CNX
Nifty” first time. It was followed by launching various derivative products. They are index options,
stock options, stock future, interest rate, future CNX IT future and options, Bank Nifty futures and
options, CNX Nifty Junior futures and options, CNX100 futures and options, Nifty Mid Cap-50 future
and options, Mini index futures and options, long term options. Currency futures on USD-rupee, defty
future and options, interest rate futures, SKP CNX Nifty futures on CME, European style stock
options, currency options on USD INR, 91 days GOI T.B. futures, and derivative global indices and
infrastructures indices.

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CONTRACT PERIODS:

At any point of time there will always be available near three months contract periods. For
e.g., in the month of June 2009 one can enter into either June Futures contract or July Futures
contract or August Futures Contract. The last Thursday of the month specified in the contract
shall be the final settlement date for that contract at both NSE as well BSE. Thus June 29,
July 27 and August 31 shall be the last trading day or the final settlement date for June
Futures contract, July Futures Contract and August Futures Contract respectively. When one
futures contract gets expired, a new futures contract will get introduced automatically. For
instance, on 30th June, June futures contract becomes invalidated and a September Futures
Contract gets activated.

SETTLEMENT:

Settlement of all Derivatives trades is in cash mode. There is Daily as well as Final
Settlement. Outstanding positions of a contract can remain open till the last Thursday of that
month. As long as the position is open, the same will be marked to Market at the Daily
Settlement Price, the difference will be credited or debited accordingly and the position shall
be brought forward to the next day at the daily settlement price. Any position which remains
open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the
Exchange at the Final Settlement Price which will be the closing spot value of the underlying
(Nifty or Sensex, or respective stocks as the case may be).

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Regulation for Derivatives Trading
SEBI set up a 24-member committee under Chairmanship of Dr.L.C. Gupta to develop the
appropriate regulatory framework for derivatives trading in India. The committee submitted
its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the
committee and approved the phased introduction of derivatives trading in India beginning
with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the
committee for regulation and control of trading and settlement of derivatives contracts. The
provisions in the SC(R) A and the regulatory framework developed there under govern
trading in securities. The amendment of the SC(R) A to include derivatives within the ambit
of „securities‟ in the SC(R) A made trading in derivatives possible within the framework of
the Act.
1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee
report may apply to SEBI for grant of recognition under Section 4 of the SC(R) a, 1956 to
start trading derivatives. The derivatives exchange/segment should have a separate governing
council and representation of trading / clearing members shall be limited to maximum of 40%
of the total members of the governing council. The exchange shall regulate the sales practices
of its members and will obtain approval of SEBI before start of trading in any derivative
contract
2. The exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not automatically become the
members of derivative segment. The members of the derivative segment need to fulfil the
eligibility conditions as laid down by the L C Gupta committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI approved
clearing corporation / house. Clearing corporation / houses complying with the eligibility
conditions as laid down by the committee have to apply to SEBI for grant of approval.
5. Derivative brokers/dealers and clearing members are required to seek registration from
SEBI.
6. The minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also
submit details of the futures contract they propose to introduce.
7. The trading members are required to have qualified approved user and sales person who
have passed a certification programme approved by SEBI.

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While from the purely regulatory angle, a separate exchange for trading would be a better
arrangement. Considering the constraints in infrastructure facilities, the existing stock (cash)
exchanges may also be permitted to trade derivatives subject to the following conditions.
I. Trading should take place through an on-line screen based trading system.
II. An independent clearing corporation should do the clearing of the derivative market.
III. The exchange must have an online surveillance capability, which monitors positions,
price and volumes in real time so as to deter market manipulation price and position limits
should be used for improving market quality.
IV. Information about trades quantities, and quotes should be disseminated by the exchange
in the real time over at least two information-vending networks, which are accessible to
investors in the country.
V. The exchange should have at least 50 members to start derivatives trading.
VI. The derivatives trading should be done in a separate segment with separate membership;
That is, all members of the cash market would not automatically become members of the
derivatives market.
VII. The derivatives market should have a separate governing council which should not have
representation of trading by clearing members beyond whatever percentage SEBI may
prescribe after reviewing the working of the present governance system of exchanges.
VIII. The chairman of the governing council of the derivative division / exchange should be a
member of the governing council. If the chairman is broker / dealer, then he should not carry
on any broking or dealing on any exchange during his tenure.
IX. No trading/clearing member should be allowed simultaneously to be on the governing
council both derivatives market and cash market.

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GROWTH OF INDIAN DERIVATIVES MARKET

The NSE and BSE are two major Indian markets have shown a remarkable growth both in
terms of volumes and numbers of traded contracts. Introduction of derivatives trading in
2000, in Indian markets was the starting of equity derivative market which has registered on
explosive growth and is expected to continue the same in the years to come. NSE alone
accounts 99% of the derivatives trading in Indian markets. Introduction of derivatives has
been well received by stock market players. Derivatives trading gained popularity after its
introduction in very short time. If we compare the business growth of NSE and BSE in terms
of number of contracts traded and volumes in all product categories with the help of table and
the last table which shows the NSE traded 636132957 total contracts whose total turnover is
Rs.16807782.22 cr in the year 2012-13 in futures and options segment while in currency
segment in 483212156 total contracts have traded whose total turnover is Rs.2655474.26 cr
in same year. In case of BSE the total numbers of contracts traded are 150068157 whose total
turnover is Rs.3884370.96 Cr in the year 2012-13 for all segments. In the above case we can
say that the performance of BSE is not encouraging both in terms of volumes and numbers of
contracts traded in all product categories. The tables specifies the updated figures since 2003-
04 to 2012-13 about number of contracts traded and total volumes in all segments.

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MAJOR PLAYERS IN THE FINANCIAL DERIVATIVES TRADING

There are three major players in the financial derivatives trading:

1. Hedgers: Hedgers are traders who use derivatives to reduce the risk that they face from
potential movements in a market variable and they want to avoid exposure to adverse
movements in the price of an asset. Majority of the participants in derivatives market belongs
to this category.
2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back
profitably at a later point in time. They want to assume risk. They use derivatives to bet on
the future direction of the price of an asset and take a position in order to make a quick profit.
They can increase both the potential gains and potential losses by usage of derivatives in a
speculative venture.
3. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same (or
different, but related) assets in an effort to profit from unrealistic price differentials. They
attempts to make profits by locking in a riskless trading by simultaneously entering into
transaction in two or more markets. They try to earn riskless profit from discrepancies
between futures and spot prices and among different futures prices.
4. Margin Traders: Margin traders are speculators who make use of the payment
mechanism, which is peculiar to the derivative markets. When you trade in derivative
products, you are not required to pay the total value of your position up front. You are only
required to deposit a fraction (called margin) of the value of your outstanding position

Hedging through derivatives: What is it and how is it done

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Hedging is a form of investment made to reduce the risk of unanticipated price changes of an
asset. Usually, a hedge entails taking a position opposite to the investment that is being
hedged. It is, at times, compared to an insurance policy. When someone buys a house, he
would want to protect it from unpredictable situations such as a fire. By taking fire insurance
for, which he would pay a premium he can mitigate the losses he would incur in the fire.
It is important to note that hedging, just as insurance, comes at a price. Investment in hedging
leaves proportionately less money to invest in the asset that is being hedged. But still,
investors tend to do it to minimise the risk.

One of the most common methods of hedging is via derivatives. The derivatives such as
options, swaps, futures and forward contracts, invariably move in the same direction as the
underlying asset. Interestingly, the availability of an array of derivative contracts enables
investors to hedge them against almost any kind of investment: stocks, commodities, indices,
currencies, bonds or interest rates. The derivatives are believed to be effective hedges against
their underlying assets.
Sometimes, investors use derivatives to make a trading strategy wherein loss in investment
can be recouped by a gain in a derivative contract. For instance, when Ms A buys 100 shares
of ABC at ₹10 per share, she would perhaps hedge her investment by buying a ‘put’ option
with a strike price of ₹7 expiring in six months. This will enable her to sell the shares at the
reduced rate of ₹7 anytime in the next six months. If she has to pay a premium of Re 1 per
share for the option, then ₹100 will be the cost of hedging.
If the share price rises in next six months, she will not exercise her option, but if it falls to ₹3
per share, then she will exercise her option and sell her shares for ₹7 per share, incurring a
loss of ₹300 on shares, plus ₹100 on premium, which makes a total of ₹400. But without
hedging, the loss would have been much higher at ₹1,000.
So, it is worth remembering that hedging is a strategy that comes at a price, and is meant to
prevent, or at least minimise, the losses. Also, hedging is imperfect and despite being based
on calculated risks, it might not work.

Summary and Conclusion

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 Financial derivatives have earned a extremely significant place among all the financial
instruments (products), due to innovation and revolutionized the landscape. Derivatives are
tool for managing risk. Derivatives provide an opportunity to transfer risk from one to
another. Launch of equity derivatives in Indian market has been extremely encouraging and
successful. The growth of derivatives in the recent years has surpassed the growth of its
counterpart globally. The Notional value of option on the NSE increased from 1195.691178
lakhs USD in 2003 to 354648.1941 lakhs USD in 2012 and notional value of NSE futures
increased from 14329.35627 lakhs USD in 2003 to 39228.38563 lakhs USD in 2012. India is
one of the most successful developing country in terms of a vibrate market for exchange-
traded derivatives. The equity derivatives market is playing a major role in shaping price
discovery. Volatility in financial asset price, integration of financial market internationally,
sophisticated risk management tools, innovations in financial engineering and choices at risk
management strategies have been driving the growth of financial derivatives worldwide, also
in India finally we can say there is big significance and contribution of derivatives to
financial system.

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 BIBLIOGRAPHY

https://www.5paisa.com/stock-market-guide/derivatives-trading/hedging-strategy
https://www.livemint.com/money/personal-finance/hedging-through-derivatives-what-is-it-
and-how-is-it-done-mintgenie-explains-11659150671788.html
Derivatives as hedging instrument - The Economic Times
https://economictimes.indiatimes.com › Magazines

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