AN ASSIGNMENT On

Evolution of Derivative Trading in India

(International Financial Management)
(Given By:- Faculty of School of Management of Studies, Punjabi University, Patiala.) MASTERS OF BUSINESS ADMINISTRATION (Session : 2010-2012)

Submitted By:
Pankaj Kumar Goyal (5408) Sushil Goyal (5427) M.B.A.- II(A)

Submitted To:
Dr. Liaqat Ali Assistant Professor. (Faculty of SMS, PUP.)

SCHOOL OF MANAGEMENT STUDIES PUNJABI UNIVERSITY, PATIALA-147002

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TABLE OF CONTENT

TOPICS

Page No.

Introduction: Derivatives Definition and Evolution (Table) Types of Derivative Markets in India EXCHANGE-TRADED vs. OTC DERIVATIVES MARKETS Types of Contracts Forward/ Future Contracts Classification of Derivatives Contracts Participants and Application of derivative market Trading Mechanism and Regulatory Framework Bibliography

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Introduction Risk has the feature of all the markets whether it is capital market or commodity market. Over the period, Fluctuation in the prices of ferrous and non-ferrous goods occur as a result of interacting of demand and supply powers. The last two decades have seen a many-fold appreciation in the numbers of international trade and business due to the ever booming cycle of globalization and liberalization going across the world. Due to that, financial markets have gone through many fluctuations whether is commodity or interest rates, stock market prices thus exposing the corporate world to the booming economy era. Appreciated financial risk leads losses to an otherwise lucrative organization. This emphasized the role of risk management to save or to hedge against uncertain conditions. Derivatives provide a tool to the problem of risk caused by uncertain conditions and fluctuation in underlying commodities or value. Derivatives are risk management tools that help an organization to minimize risk. Derivatives are instruments which have no independent worth. Their worth bank on the underlying asset. The underlying asset may be financial or non-financial. . Derivatives The term derivatives, tells about the broad class of financial instruments which mainly involve options and futures. These instruments get their value from the price and other related variables of the underlying asset. They do not have value of their own and derive their value from the claim they give to their owners to own some other financial assets or security. A simple example of derivative is butter, which is derivative of metals. The price of butter depends upon price of metals, which in turn depends upon the demand and supply of metals. The general definition of derivatives means to derive something from something else. Some other meanings of word derivatives are: derived function: the result of mathematical differentiation; the instantaneous change of one quantity with respect to other; Derivative instrument: a financial instrument whose worth is based on another security, a word that is derived from another etymology; "`Gold' is a derivative of Non-ferrous metals. The asset underlying a derivative may be commodity, goods or a financial asset. Derivatives are those financial papers or say instruments that get their value from the other commodities. For
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example, the price of silver to be delivered after six months will depend on the present and expected price of this commodity and the other commodities on the respective assets. Definition of Financial Derivative Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: a) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instruments or contract for differences or any other form of security; b) a contract which derives its value from the prices, or index of prices, of underlying assets and securities. Derivative in Indian Market In India, all efforts are being emphasized to introduce derivatives in the capital market. The NSE has been planning to incept index-based futures options in the capital market. A criteria for the members are introduced who wishes to enroll themselves ranges 7 to 10 crore Rs. But, it has not get approval from the Security Exchange Board of India undertaking of Indian Government. In the foreign exchange market, there are brighter opportunities of incepting derivatives on a mammoth scale. In reality, the necessary homework for the start of derivatives in the foreign exchange market was suggested by a high-level expert committee appointed by the Reserve Bank of India. It was tabuled before Mr. O.P. Sodhani. Committees report was already presented to the Government of India in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements have started and provided on a lower scale. It is viable to incept derivative in the capital market because most of these products are OTC products and they are highly fluctuating. In which there is only one middle man and two parties involved in the business or the transactions take place. Evolution of Derivative Market Year Wise: Year 1972 1973 1974 1975 1977 1979 1980 Financial Instruments Foreign Currency Futures Equity futures; Futures on Mortgage Backed bonds Equity Future, Equity options T-bill futures on mortgage backed bonds T-bond Futures Over- the counter currency options Currency swaps

1981

Equity Index Futures; Options ON T-bond futures; Bank CD Futures, Tnote futures; Euro-dollar futures; Interest rate swaps

1982 1983

Exchange listed currency options Interest rate caps and floor; options on T-note, Futures; Currency futures: Equity Index futures

1985 1987

Euro Dollar options; Swap options; Futures on US Dollar & Municipal Average options, commodity swaps, Bond futures, Compound options, OT compound options, OTC average options Three- month Euro DM futures Captions ECU; Interest-rate futures on Interest rate swaps

1989

1990 1991 1992 1993 1994 1995 1996-98 2003-04

Equity Index swaps Portfolio swaps Differential swaps Captions; Exchange listed FLEX options Credit Default Options Credit Derivatives Exotic Derivatives Energy Derivatives, Weather Derivatives

Derivatives Markets Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the those traded one to one or over the counter. They are hence known as

Exchange Traded Derivatives OTC Derivatives (Over The Counter)

Derivative Markets in India

5 Exchange Traded Derivatives

OTC Derivatives (Over with Derivatives have probably been around for as long as people have been tradingThe one another. Forward contracting dates back at least to the 12th century, and may Counter) been around well have before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts. EXCHANGE-TRADED vs. OTC DERIVATIVES MARKETS The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. 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. Types of Contracts The overall derivatives market has five major classes of underlying asset:

interest rate derivatives foreign exchange derivatives credit derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are the following: UNDERLYING Exchangetraded futures Equity One Stock Future CONTRACT TYPES Exchangetraded options OTC swap OTC forward OTC option

Option on Nifty S&P

Equity Swap Repurchase

Warrants

options

Index future Single-share option

(N/A in India) agreement

Interest rate

Eurocurrency future

Option on Euro Interest rate Currency swaps future Option on future Option on debenture or bond future

Forward rate Interest agreements rate floor and Cap swap option Credit default options and futures

Credit

Debenture future

Credit Default Repurchase Swap options agreement Or say back to back agreements

Foreign exchange

Euro currency Future

Option on Eurocurrency future or currency Environment Derivatives

Currency Swap

Currency Forward

Currency Option

Commodity

Copper Future

Commodities Swap

NonFerrous forward contract

Silver option

Forward/ Future Contracts

Classification of Derivatives Broadly derivatives can be classified in to two categories: Commodity derivatives and financial derivatives. In case of commodity derivatives, underlying asset can be commodities like wheat, gold, silver etc., whereas in case of financial derivatives underlying assets are stocks, currencies, bonds and other interest rates bearing securities etc. Since, the scope of this case study is limited to only financial derivatives so we will confine our discussion to financial derivatives only. Forward Contract A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future. 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 the simplest form of derivative contract mostly entered by individuals in day to days life. Futures Contract Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a specified price at a specified future date through a specified exchange. Futures contracts are traded on exchanges that work as a buyer or seller for the counterparty. Exchange sets the standardized terms in term of Quality, quantity, Price quotation, Date and Delivery place (in case of commodity).The features of a futures contract may be specified as follows:
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o These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT etc. o These involve standardized contract terms viz. the underlying asset, the time of maturity o and the manner of maturity etc. o These are associated with a clearing house to ensure smooth functioning of the market.

o There are margin requirements and daily settlement to act as further safeguard. o These provide for supervision and monitoring of contract by a regulatory authority. o Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset. Futures contracts being traded on organized exchanges impart liquidity to the transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honouring of the contract and ensuring very low level of default. Following are the important types of financial futures contract:i Stock Future or equity futures, ii Stock Index futures, iii Currency futures and iv Interest Rate Futures Options Contract In case of futures contact, both parties are under obligation to perform their respective obligations out of a contract. But an options contract, as the name suggests, is in some sense, an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A call option gives one the right to buy; a put option gives one the right to sell. Options are the standardized financial contract that allows the buyer (holder) of the option, i.e. the right at the cost of option premium, not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges. Options contracts are of two types: call options and put options. Apart from this, options can also be classified as OTC (Over the Counter) options and exchange traded options. In case of exchange traded options contract, contracts are standardized and traded on recognized exchanges, whereas OTC options are customized contracts traded privately between the parties. A call options gives the holder (buyer/one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Swaps Contract A swap can be defined as a barter or exchange. It is a contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts or we can say, a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties. The two commonly used swaps are: i) Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency, and ii) Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than the cash flows in the opposite direction.

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There are four main types of participants in any Derivatives Market. They are: 1. Dealers 2. Hedgers 3. Speculators and 4. Arbitrageurs Applications of Financial Derivatives Some of the applications of the financial derivatives that are given below: 1. Risk Management: This is the vital function of derivatives. Risk management is about sorting out of risk rather it is about the management of risk. Financial derivative is a powerful tool for minimizing risks that individuals and organizations face in the usual conduct of their businesses. It requires a thorough understanding of the basic principles that conduct the valuation of financial derivatives. Effective use of derivatives can save cost, and it can fulfill the need of wealth maximizations 2. Efficiency in trading: Financial derivative provides efficiency in the market by the main powers of the markets. In the derivative market, if a commodity or the stock is not performed well then it has to be underwent a loss in the long run. On the other hand if the commodity or the derivative security is doing well then it has to suffer according to his performance it is only happened because of powers of the markets and the investments made by the investors and their decisions that make the market efficient. 3. Speculation: Financial derivatives are considered to be risk averse people that is meant for profit in the uncertain. If it is not get benefitted properly then it would be a fatal decision. Albeit, these instruments plays a greater role for the risk averse that is known for exposing their investment in the perilous situation. 4. Price discovery: Another main function of derivatives is the price discovery which means exposing information about future prices through the future rate prevailing in the market. Derivatives markets provide a mechanism by which demand and supply of futures are interacted and price is discovered. In this way it plays an important role for price discovery. 5. Price stabilization function: Derivative market helps to stabilize the prices of the various securities through the interaction of the supply and demand function that is finally automatically adjusted according to the prices in this way stabilization is another main area of the derivative market. Trading mechanism The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an
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anonymous order driven market which provides complete transparency of trading operations and operates on strict price-time priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is 13 accessed by two types of users. The Trading Members (TM) have access to functions such as order entry, order matching, order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) use the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take. Regulatory Framework The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets including:

Physical settlement of stock options and stock futures contracts. Review of the eligibility criteria of stocks on which derivative products are permitted. Use of sub-brokers in the derivative markets. Norms for use of derivatives by mutual funds

The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed before the SEBI Board. The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board. In the meantime, several other important issues like the issue of minimum contract size, the segregation of the cash and derivative segments of the exchange and the surveillance issues in the derivatives market were also placed before the ACD for its consideration. The Advisory Committee therefore decided to take this opportunity to present a comprehensive report on the development and regulation of derivative markets including a review of the recommendations of the L. C. Gupta Committee. Four years have elapsed since the LCGC Report of March 1998. During this period therehave been several significant changes in the structure of the Indian Capital Markets which include, dematerialisation of shares, rolling settlement on a T+3 basis, client level and Value at Risk (VaR) based margining in both the derivative and cash markets and proposed demutualization of Exchanges. Equity derivative markets have now been in existence for two years and the markets have grown in size and diversity of products.This therefore appears to be an appropriate time for a comprehensive review of the development and regulation of derivative markets.

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BIBLIOGRAPHY Books: Derivative Module, National Stock Exchange of India, National Certification in Financial Markets. Derivatives and Risk Management, Author:- Sundaram Janakiramanan, Page No:- 18. Security Analysis & Portfolio Management, Author- Sudhindra Bhatt, Page 582.

Websites:-

www.derivativesindia.com/scripts/derixchg/index.asp www.financialexpress.com/news/otc-derivatives-market-in-india/618489/ www.iimcal.ac.in/community/finclub/dhan/dhan1/art16-idm.pdf http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf.

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