Derivatives

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Derivatives

  1. 1. DERIVATIVES {A TWO EDGED SWORD} with LUDHIANA STOCK EXCHANGE Ltd.TRAINING REPORT SUBMITTED IN THE PARTIAL FULFILMENT FOR THE“MASTERS OF BUSINESS ADMINISTRATION(2011-13)”Submitted to:Mrs. JIWAN JYOTI MAINI Submitted by:- VANDANA Roll no.-1174501 Malout institute of Management and Technology (Malout) {aff. PTU jalandhar} 1
  2. 2. Acknowledgement“You cannot discover new oceans unless you have the courage to lose sight of the share”The world of capital market was far from us,but we got an opportunity to emission the capitalmkt at Ludhiana stock exchange. We are indebted to our Teachers and Gurus who molded atthis junction of our career from where we can take off better in the competitive scenario oftoday‟s world.We would like to thanks Mrs. Pooja M Kohli Ludhiana stock exchange limited for givingme an opportunity to do our SUMMER TRAINING in this esteemed organization.It‟s my privilege to express the everlasting feeling of indebtness to Mr. Sadhram for theirvaluable suggestions constructive outcome and untiring help during the summer training.my heartiest thanks, deep sense of gratitude to all member who deliver lectures and sharetheir valueable experiences with us. 2
  3. 3. EXECUTIVE SUMMARYNew ideas and innovations have always been the hallmark of progress made by mankind. Atevery stage of development, there have been two core factors that drives man to ideas andinnovation. 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 returnsand minimize risk. A lot of innovation goes into developing financial products centred onthese 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 toincrease returns and reduce risk. They provide an outlet for investors to protect themselvesfrom the vagaries of the financial markets. These instruments have been very popular withinvestors all over the world.Indian financial markets have been on the ascension and catching up with global standards infinancial markets. The advent of screen based trading, dematerialization, rolling settlementhave put our markets on par with international markets.As a logical step to the above progress, derivative trading was introduced in the country inJune 2000. Starting with index futures, we have made rapid strides and have four types ofderivative products- Index future, index option, stock future and stock options. Today, thereare 30 stocks on which one can have futures and options, apart from the index futures andoptions. This market presents a tremendous opportunity for individual investors .The marketshave performed smoothly over the last two years and has stabilized. The time is ripe forinvestors 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 theindividual investor is educated and equipped to become a dominant player in the market 3
  4. 4. 1] INTRODUCTION TO STOCK EXCHANGEA stock exchange is an institution of capital mkt which generates capital and provides thesame to industrial houses. A stock exchange is nervous system of capital mkt. the changes inthe capital mkt are brought about by a complex set of factore, all operating on the mktsimultaneously.A stock exchange is the key institution facilitating the issues and sale of various types ofsecurities it is a pivot around which every activity of the capital mkt revolves. In the absenceof stock exchanges, the people with saving would hardly invest in cooperate securities forwhich there would no liquidity (buying and selling facility). Corperate investments from thegeneral public would have been thus lower.Stock exchanges thus represent the mkt place for buying and selling of securities andensuring liquidity to them in interest of the investors. The stock exchanges are virtually thenerve centre of the capital mkt and reflect the health of the country‟s economy as a whole.The stock exchange is a place or a mkt were securities, shares, debentures, bonds. Mutualfunds of join stock companies, central and state govt. organization, local bodies and foreigngovt. are brought and sold. A stock exchange is a plateform for the trade of already issuedsecurities through primary mkt. It is the essential pillar of the private sector and corporateeconomy. It is the open auction mkt were buyer and seller meet and evolve a competitiveprice for the security. It reflect hope aspiration and fears of people regarding the performanceof the economy.It is a mkt as well as the sources for the capital. Corporate and government raise sources fromthe mkt. The house hold invest there savings in the securities. 4
  5. 5. Stock exchangeA stock exchange is a form of exchange which provides services for stockbrokers and traders to trade stocks, bonds, and other securities. Stock exchanges also providefacilities for issue and redemption of securities and other financial instruments, and capitalevents including the payment of income and dividends. Securities traded on a stock exchangeinclude shares issued by companies, unit trusts,derivatives, pooled investment productsand bonds.To be able to trade a security on a certain stock exchange, it must be listed there. Usually,there is a central location at least for record keeping, but trade is increasingly less linked tosuch a physical place, as modern markets are electronic networks, which gives themadvantages of increased speed and reduced cost of transactions. Trade on an exchange is bymembers only.The initial offering of stocks and bonds to investors is by definition done in the primarymarket and subsequent trading is done in the secondary market. A stock exchange is often themost important component of a stock market. Supply and demand in stock markets are drivenby various factors that, as in all free markets, affect the price of stocks (see stock valuation).There is usually no compulsion to issue stock via the stock exchange itself, nor must stock besubsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that derivatives and bonds are traded. Increasingly, stockexchanges are part of a global market for securities.The supreme court of India has defined the role of stock exchanges in these words:“A stock exchange fulfills the vital function in the economic development of a nation. Itsmain function is to liquefy capital by enabling a person who has invested money in, say afactory or a railway to convert it in by disposing off his share in the enterprises to someoneelse.” 5
  6. 6. 1.1) HISTORY OF STOCK EXCHANGE IN INDIAThe stock started in the pre independence era. It is discussed as below:-S.No YEAR Development of stock exchanges1. 18th century Trading of shares of east India company in kolkata and Mumbai was started.2. 1850 Joint stock companies came into existence3. 1860 Speculations in securities was done for first.4. 1875 Formation of stock exchange in Mumbai.5. 1894 Formation of Ahmadabad stock exchange.6. 1908 Formation of Calcutta stock exchange7. 1939 Formation of Lahore and madras stock exchange.8. 1940 Formation of U.P and Delhi stock exchange9. 1956 Securities contract(regulation)Act was enacted10. 1988 SEBI was setup.11. 1992 SEBI was given statutory powers under SEBI Act.12. 1993 NSE was formed for first.13. 2000 Depositories was introduced. 6
  7. 7. 14. 2002 Start of rolling settlement and banning of BADLA trading.15. 2003 Introduction of T+2 settelment. 1.2) LIST OF VARIOUS REGIONAL STOCK EXCHANGES:S.NO Name of Stock Exchange Year of Type of Organizations establishment1. Bombay stock exchange 1875 Voluntary non-profit organization2. Ahmadabad Stock exchange 1897 Voluntary non-profit organization3. Calcatta stock exchange 1908 Public limited company4. M.P stock exchange Indore 1930 Voluntary non-profit organization5. Madras stock exchange 1937 Co. limited by guarantee6. Delhi stock exchange 1940 Public limited company7. Hydrabad stock exchange 1943 Co. limited by guarantee8. Banglore stock exchange 1957 Pvt. Converted into public ltd. Company9. Cochin stock exchange 1978 Public limited company10. U.P stock exchange kanpur 1982 Public limited company11. Pune stock exchange 1982 Co. ltd. By guarantee12. Ludhiana stock exchange 1983 Public limited company13. Jaipur stock exchange 1983 Public limited company14. Gwahati stock exchange 1984 Public limited company15. Kanaar stock exchange 1985 Public limited company16. Magadh stock exchange 1986 Co. ltd. By guarantee17. Bhubaneshwar stock exchange 1989 Co. ltd. By guarantee18. Saurashtra stock exchange 1990 Co. ltd. By guarantee, unrecognised19. Vadodara stock exchange 1990 Private limited company. 7
  8. 8. 20. Meerut stock exchange 1991 Private limited company21. OTCEI stock exchange 1993 Pure demutulised22. National stock exchange 1995 Pure demutulised23. Coimbatore stock exchange 1997 Private limited company24. Sikkim stock exchange 1997 Private limited company25. Multi commodity 2008 Public limited company exchange(MCX)26. NCDEX 2009 Private limited organisationFrom above Saurashtra, Magadh, Hyderabad,and Mangalore are unrecognized and rest arerecognized. BSE is in worlds 5th position in transaction.MCX and NCDEX are the new exchanges which only deals in commodities. 8
  9. 9. 2]Ludhiana stock exchangeThe Ludhiana Stock Exchange Limited was established in 1981, by Sh. S.P. Oswal ofVardhman Group and Sh. B.M. Lal Munjal of Hero Group, leading industrial luminaries, tofulfill a vital need of having a Stock Exchange in the region of Punjab, Himachal Pradesh,Jammu & Kashmir and Union Territory of Chandigarh. Since its inception, the StockExchange has grown phenomenally. The Stock Exchange has played an important role inchannelizing savings into capital for the various industrial and commercial units of the Stateof Punjab and other parts of the country. The Exchange has facilitated the mobilization offunds by entrepreneurs from the public and thereby contributed in the overall, economic,industrial and social development of the States under its jurisdiction.Ludhiana Stock Exchange is one of the leading Regional Stock Exchange and has been in theforefront of other Stock Exchange in every spheres, whether it is formation of subsidiary forproviding the platform of trading to investors, for brokers etc. in the era of Screen basedtrading introduced by National Stock Exchange and Bombay Stock Exchange, entering intothe field of Commodities trading or imparting education to the Public at large by way ofstarting Certification Programmes in Capital Market.The vision and mission of Stock Exchange is:"Reaching small investors by providing services relating to Capital Market includingTrading, Depository Operations etc. and creating Mass Awareness by way of education andtraining in the field of Capital Market.To create educated investors and fulfilling the gap ofskilled work force in the domain in Capital Market."Further, the Exchange has 295 members out of which 162 are registered with National StockExchange as Sub-brokers and 121 with Bombay Stock Exchange as sub-brokers through oursubsidiary. 9
  10. 10. 2.2) DETAILS OF PRESIDENTS AND VICE PRESIDENTSLSE SALUTES ITS PRESIDENT/ CHAIRMEN VICE PRESIDENT/ VICE CHAIRMENPRESIDENTS/ CHAIRMENSr. No. Name of the person Tenure1 Sh. S.P. Oswal 16.08.1983 to 27.07.19862 Sh. B.M. Lal Munjal 28.07.1986 to 15.10.1989 16.10.1989 to 30.10.19923 Sh. V.N. Dhiri 30.09.1998 to 04.10.20004 Sh. G.S. Dhodi 31.10.1992 to 22.12.1993 23.12.1993 to 05.10.19955 Sh. Jaspal Singh 01.10.1996 to 29.09.1998 06.10.2001 to 01.07.20026 Sh. M.S. Gandhi 06.10.1995 to 30.09.19967 Sh. R.C. Singal 05.10.2000 to 05.10.20018 Dr. B. B. Tandon, Chairman 25.06.2007 to 10.12.20079 Sh. S.P. Sharma, Chairman 15.07.2007 to 23.09.200810 Sh. Jagmohan Krishan 23.09.2008 to 29.09.200911 Prof Padam Parkash Kansal 30.09.2009 to till dateVICE PRESIDENTS/ VICE CHAIRMENSr. No. Name of the person Tenure1 Sh. Rajinder Verma 14.07.1984 to 08.08.1987 09.08.1987 to 15.10.19892 Sh. B.K. Arora 31.10.1992 to 22.12.19933 Sh. G.S. Dhodi 28.10.1991 to 30.10.1992 16.10.1989 to 27.10.19914 Sh. B.S. Sidhu 23.12.1993 to 05.10.19955 Sh. D.P. Gandhi 06.10.1995 to 26.09.19976 Sh. M. S. Sarna 27.09.1997 to 29.09.19987 Sh. T.S. Thapar 30.09.1998 to 04.10.20008 Sh. Tarvinder Dhingra 05.10.2000 to 05.10.2001 10
  11. 11. 9 Dr. Rajiv Kalra 06.10.2001 to 01.07.200210 Sh. D.K. Malhotra, Vice Chairman 025.06.2007 to 10.12.200711 Sh. Jagmohan Krishan, Vice Chairman 15.07.2007 to 23.09.200812 Sh. Ravinder Nath Sethi 23.09.2008 to 08.10.200813 Prof Padam Parkash Kansal 09.10.2008 to 29.09.200914 Sh. Joginder Kumar 30.09.2009 to till dateGovernance and management:LSE has a strong governance and administration, which encompasses a right balance ofIndustry Experts with highest level educational background, practicing professionals andindependent experts in various fields of Financial Sector. The administration is presentlyheaded by Sr. General Manager CUM Company Secretary and team of persons having in-depth knowledge of Secretarial, Legal and Education & Training.The Governing Board of our Exchange comprises of eleven members, out of which two arePublic Interest Directors, who are eminent persons in the fields of Finance and Accounts,Education, Law, Capital Markets and other related fields, Six are Shareholder Directors, andThree are Broker Member Director and the Exchange has four Statutory Committees namelyDisciplinary Committee, Arbitration Committee, Defaults Committee and Investor ServicesCommittee. In addition, it has advisory and standing committees to assist the administration.LSE has a Code of Conduct in place that governs the elected Board Members and the SeniorManagement Team. The same is monitored through periodic disclosure procedures. TheExchange has an Ethics Committee, which looks into any issue of conflict of interest and hasin place general code of conduct for the Senior Officials.The composition of the Governing Board is as under:- 11
  12. 12. Composition of the Governing BoardSr. No. Name of Director Category Chairman1 Prof. Padam Parkash Kansal (Shareholder Director) Vice Chairman2 Sh. Joginder Kumar (Shareholder Director)3 Sh. Rajinder Mohan Singla Shareholder Director4 Sh. Satish Nagpal Shareholder Director5 Sh. Vikas Batra Shareholder Director6 Sh. Ashok kumar Shareholder Director Registrar of Companies (Public Interest7 Dr. Raj Singh Director)8 Sh. Ashwani Kumar Public Interest Director9 Sh. V.P. Gaur Public Interest Director10 Sh. Jaspal Singh Trading member Director11 Sh. Sunil Gupta Trading Member Director12 Sh. Sanjay Anand Trading member Director 12
  13. 13. 2.3) Infrastructure and asset base at Ludhiana stock exchangeThe Exchange building is situated at Feroze Gandhi Market, Ferozepur Road, Ludhiana. It isa six storeyed building, which is centrally air-conditioned. The building has 262 rooms,which are located on various floors ranging from second to fifth. The first floor of thebuilding houses the administrative office and rooms from second to fifth floors have beenleased out to brokers. The first floor also has canteen and banking facilities. Investor ServiceCentre is also located at first floor which houses a well-equipped library and view-terminalsto provide “live” rates of NSE and BSE to investors. Investors are also provided with CableTV for the purpose of viewing the latest happenings in the Capital Market and around.Basement of the building has air-conditioning plant and Generators to provide air-conditioned environment and twenty-four hours power back up.The Exchange has also an additional plot of land measuring 2333 sq. yards in the primelocation of city, to enhance its infrastructure and source of income.The Company in its continuous endeavour to provide qualitative services to its valued clients,has started e-broking trading services for its clients, thereby increasing the geographicalreach of the company. 13
  14. 14. 2.4) ACHIEVEMENTS OF LSE First regional stock exchange to give proposal of making subsidiary as broker of NSE and BSE for survival of stock exchange and second to start operations like broker of NSE and BSE. First regional stock exchange to starttrading in commodities market by subsidiary. First regional stock exchange to start courses on capital market,only BSE is performing this sort of activities andNSE uis also performing courses on capitqal market only for members but LSE will star outsiders also. Derivative trading is done in LSE. Commodity trading is also done here. LSE also introduced a settlement guarantee fund (SGF). The SGF guarantees settlement of transactions and the carryforward facility provides liquidity to the market. LSE became the first in India to start LSE Securities Ltd., a 100% owned subsidiary of the exchange. The LSE Securities got the ticket as sub-broker of the NSE. In 1998, the exchange also got permission to start derivative trading. For the settlement of dematerialised securities, the Ludhiana Stock Exchange has also been linked up with National Securities Depository Ltd. (NSDL). Beside them some more achievements are:- 1. “LSE” brand is popular among masses. The brand image of LSE can be capitalized. 2.LSE have requisite infrastructure for the Capital Market activities which includes a multi-storeyed, centrally air conditioned building situated in the financial hub of the city i.e. Feroze Gandhi Market. 3. LSE have well experienced staff handling operations of Stock Exchange. 4. LSE have competent Board and professional management. 5. LSE have much needed networking of sub brokers in the entire region, who are having rich experience in Stock Market operations for the last 25 years. 6. LSE have more than 40,000 clients spread across Punjab, Himachal Pardesh, Jammu & Kashmir and adjoining areas of Haryana and Rajasthan. 7. The turnover of LSE subsidiary is the highest amongst all subsidiaries of Regional Stock Exchanges in India.14
  15. 15. 15
  16. 16. 3] DerivativesAccording to dictionary, derivative means „something which is derived from anothersource‟. Therefore, derivative is not primary, and hence not independent. In financial terms,derivative is a product whose value is derived from the value of one or more basic variables.These basic variable are called bases, which may be value of underlying asset, a referencerate etc. the underlying asset can be equity, foreign exchange, commodity or any asset.For example: - the value of any asset, say share of any company, at a future date dependsupon the share‟s current price. Here, the share is underlying asset, the current price of theshare is the bases and the future value of the share is the derivative. Similarly, the future rateof the foreign exchange depends upon its spot rate of exchange. In this case, the futureexchange rate is the derivative and the spot exchange rate is the baseDerivatives are contract for future delivery of assets at price agreed at the time of thecontract. The quantity and quality of the asset is specified in the contract. The buyer of theasset will make the cash payment at the time of delivery.Meaning:Derivatives are the financial contracts whose value/price is dependent on the behavior of theprice of one or more basic underlying assets (often simply known as the underlying). Thesecontracts are legally binding agreements, made on the trading screen of stock exchanges, tobuy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollarexchange rate, sugar, crude oil, soybean, cotton, coffee etc.In the Indian Context the Security Contracts (Regulation) Act, 1956 (SC(R) A) defines“derivative” to include –A security derived from a debt instrument, share, loan whether secured or unsecured, riskinstrument or contract for differences or other form of security.A contract, which derives itsvalue from the prices, or index of prices of underlying securities.While derivatives can beused to help manage risks involved in investments, they also have risks of their own.However, the risks involved in derivatives trading are neither new nor unique – they are thesame kind of risks associated with traditional bond or equity instruments. 16
  17. 17. Market RiskDerivatives exhibit price sensitivity to change in market condition, such as fluctuation ininterest rates or currency exchange rates. The market risk of leveraged derivatives may beconsiderable, depending on the degree of leverage and the nature of the security.Liquidity RiskMost derivatives are customized instrument and could exhibit substantial liquidity riskimplying they may not be sold at a reasonable price within a reasonable period. Liquiditymay decrease or evaporate entirely during unfavorable markets.Credit RiskDerivatives not traded on exchange are traded in the over-the-counter (OTC) market. OTCinstrument are subject to the risk of counter party defaults.Hedging RiskSeveral types of derivatives, including futures, options and forward are used as hedges toreduce specific risks. If the anticipated risks do not develop, the hedge may limit the fund‟stotal return. 17
  18. 18. 3..1)FUNCTION OF DERIVATIVES MARKET:-The derivative market performs a number of economic functions:-  Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivative converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future as well as current prices.  The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.  Derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of the derivatives, the underlying market witnesses higher trading volumes because of the participation by more players who would not otherwise participate for lack of arrangement to transfer risk.  Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivative market, speculators trade in the underlying cash market.  An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.  The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.  Derivatives markets help increase savings and investment in the end. Transfer of risk enables market participants to expand their volumes of activity 18
  19. 19. 3.2)PARTICIPANTS OF THE DERIVATIVE MARKET:- Market participants in the future and option markets are many and they performmultiple roles, depending upon their respective positions. A trader acts as a hedger when hetransacts in the market for price risk management. He is a speculator if he takes an openposition in the price futures market or if he sells naked option contracts. He acts as anarbitrageur when he enters in to simultaneous purchase and sale of a commodity, stock orother asset to take advantage of mispricing. He earns risk less profit in this activity. Suchopportunities do not exist for long in an efficient market. Brokers provide services to others,while market makers create liquidity in the market.HedgersHedgers are the traders who wish to eliminate the risk (of price change) to which they arealready exposed. They may take a long position on, or short sell, a commodity and would,therefore, stand to lose should the prices move in the adverse direction.they always try tominimize risk.SpeculatorsIf hedgers are the people who wish to avoid the price risk, speculators are those who arewilling to take such risk to maximize their profits. These people take position in the marketand assume risk to profit from fluctuations in prices. In fact, speculators consumeinformation, make forecasts about the prices and put their money in these forecasts. In thisprocess, they feed information into prices and thus contribute to market efficiency. Bytaking position, they are betting that a price would go up or they are betting that it would godown.The speculators in the derivative markets may be either day trader or position traders. Theday traders speculate on the price movements during one trading day,open and closeposition many times a day and do not carry any position at the end of the day.They monitor the prices continuously and generally attempt to make profit from just a fewticks per trade. On the other hand, the position traders also attempt to gain from pricefluctuations but they keep their positions for longer durations may is for a few days, weeksor even months. 19
  20. 20. ArbitrageursArbitrageurs thrive on market imperfections. An arbitrageur profits by trading a givencommodity, or other item, that sells for different prices in different markets. The Institute ofChartered Accountant of India, the word “ARBITRAGE” has been defines as follows:-“Simultaneous purchase of securities in one market where the price there of is low and salethereof in another market, where the price thereof is comparatively higher. These are donewhen the same securities are being quoted at different prices in the two markets, with a viewto make profit and carried on with conceived intention to derive advantage from differencein prices of securities prevailing in the two different markets”Thus, arbitrage involves making risk-less profits by simultaneously entering intotransactions in two or more markets. 20
  21. 21. 3.3] TYPES OF DERIVATIVEThere are four basic types of derivative products which are: Derivatives Future Forward Option SwapsFutures contract:A futures contract is an agreement between two parties to buy or sell an asset at a certaintime in the future at a certain price. Futures contracts are special types of forward contracts inthe sense that the former are standardized exchange-traded contracts.FUTURES PAYOFFSA payoff is the likely profit/loss that would accrue to a market participant with change in theprice of the underlying asset. This is generally depicted in the form of payoff diagrams whichshow the price of the underlying asset on the X-axis and the profits/losses on the Y-axis.Futures contracts have linear payoffs. In simple words, it means that the losses as well asprofits for the buyer and the seller of a futures contract are unlimited. Options do not havelinear payoffs. Their pay offs are non-linear. These linear payoffs are fascinating as they canbe combined with options and the underlying to generate various complex payoffs. 21
  22. 22. Payoff for buyer of futures: Long futuresThe payoff for a person who buys a futures contract is similar to the payoff for a person whoholds an asset. He has a potentially unlimited upside as well as a potentially unlimiteddownside. Take the case of a speculator who buys a two-month currency futures contractwhen the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD.When the value of dollar moves up, i.e. when Rupee depreciates, the long futures positionstarts making profits, and when the dollar depreciates, i.e. when rupee appreciates, it startsmaking losses. Figure shows the payoff diagram for the buyer of a futures contract. P R O F 43.19 I 0 T USD D L O S S 22
  23. 23. Payoff for seller of futures:The payoff for a person who sells a futures contract is similar to the payoff for a person whoshorts an asset. He has a potentially unlimited upside as well as a potentially unlimiteddownside. Take the case of a speculator who sells a two month currency futures contractwhen the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD.When the value of dollar moves down, i.e. when rupee appreciates, the short futures positionstarts 25 making profits, and when the dollar appreciates, i.e. when rupee depreciates, it startsmaking losses. The Figure below shows the payoff diagram for the seller of a futurescontract. P R O F 43.19 I 0 T USD D L O S S 23
  24. 24. Forwards contract:A forward contract is a customized contract between two entities, where settlement takesplace on a specific date in the future at today‟s pre-agreed price.DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTSFEATURE FORWARD CONTRACT FUTURE CONTRACTOperational Traded directly between two Traded on the exchanges.Mechanism parties (not traded on the exchanges).Contract Differ from trade to trade. Contracts are standardized contracts.SpecificationsCounter-party Exists. Exists. However, assumed by the clearingrisk corp., which becomes the counter party to all the trades or unconditionally guarantees their settlement.Liquidaty Low, as contracts are tailor High, as contracts are standardized made contracts catering to the exchange traded contracts. 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.sattlement At the end of period Daily/as per contract 24
  25. 25. Options Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. OPTION CALL PUTRight to buy Obligation Right to sell Obligation to to sell buyNo obligation No obligation Buyer Seller Buyer Seller 25
  26. 26. Call Option :A contract that gives its owner the right but not the obligation to buy an underlying asset-stock 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 buysat a lower future price.Call Option (Buyer)Why call option ?If u think market will riseExample.Buy a call with a strike of Rs .2340(NIFTY) at a premium of Rs. 50Maximum Profit Potential : Unlimited.Maximum Risk Potential : Limited to Rs. 50Break Even : Rs.2390 Pay off call option (Buyer) 2340 0 50 indexloss 26
  27. 27. Call option (Seller)Why sell Option : If u think market will remain neutral or slightly bearish .ExampleSell a call with a strike price of Rs.2340(Nifty) at a premium of Rs.50Maximum Profit Potential : Rs.50Maximum Risk Potential : UnlimitedBreak Even : Rs. 2390Desired Movement :Market will not go down Seller call option 0 1250 index loss 27
  28. 28. Put OptionA contract that gives its owner the right but not the obligation to sell an underlying asset-stock 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 ata higher future price. Hence, no option will be exercised if the future price does not increase.Why Buy a Put Option (Buyer)If u think market will fallExampleBuy a Put with a strike of Rs.2360(Nifty) at a premium of Rs.25Maximum Profit Potential : SubstantialMaximum Risk Potential.Break Even : 2335Desired Movement : Bearish Put Option Buyer Profit 0 2360 index loss 28
  29. 29. Put Option sellerWhy Sell a Put OptionIf u think market will remain neutral or moderately bullishExampleSell a put with a strike of Rs.2360(Nifty) at a premium of Rs.50Maximum Profit Potential : Rs 50Maximum Risk Potential : SubstantialBreak Even : Rs. 2310Desired Movement : Market will not go down Pay off put option (seller) profit 0 2360 index loss 29
  30. 30. TABLE SHOWING THE DEALING OF CALL & PUT OPTIONCall Option Holder (Buyer) Call Option Writer (Seller) Pays Premium  Receives premium Right to exercise & buy the shares  Obligation to sell shares if Profit from rising prices exercised Limited losses, potentially  Profits from falling prices or unlimited gains remaining neutral  Potentially unlimited losses, limited gainsPut Option Holder (Buyer) Put Option Holder (Seller) Pays Premium  Receives premium Right to exercise & buy the shares  Obligation to buy shares if Profit from rising prices exercised Limited losses, potentially  Profits from rising prices or unlimited gains remaining neutral  Potentially limited losses, unlimited gains 30
  31. 31. OPTION TERMINOLOGY1. Buyer of an option : The buyer of an option is the one who by paying the option premium buys the right but not the obligation exercise his option on the seller/writer.2. Writer of an option : The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercise on him.3. Option price : Option price is the price, which the option buyer pays to the option seller. It is also referred as option premium.4. Expiration date : The date specified in the options contract is known as expiration date, the exercise date, the strike date or the maturity.5. Strike Price : The price specified in the options contract is known as strike price or the exercise price.6. American options : these are the options that can be exercised at any time upto the expiration date. Most exchange-traded options are Americans.7. European options: These are the options that can be exercised only on the expiration date itself. These are easier or analyze than American option, and properties of American options are frequently deducted from those of its European counterpart.8. In the money option : An in the money option is an option that would lead to a positive cash flow to the holder if it will exercise immediately. A call option in the index is set to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price>strike price). If the index is much higher than the strike price, the call is set to deep ITM. In the case of a put, the put is ITM if the index is below the strike price.9. At-money option : (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price.10. Out-of-the money option : (OTM) options is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is OTM when the31
  32. 32. current index stands at a level, which is less than the strike price (spot price<strike price). If the index is much lower than the strike price, the call is set to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. SwapsSwaps are private agreements between two parties to exchange cash flows in the futureaccording to a prearranged formula. They can be regarded as portfolios of forward contracts.The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 32
  33. 33. 3.4)Derivatives: two edged swordI view derivatives as time bombs, both for the parties that deal in them and the economicsystem. Basically these instruments call for money to change hands at some future date,with the amount to be determined by one or more reference items, such as interest rates,stock prices, or currency values. Forexample, if you are either long or short an S&P 500 futures contract, you are a party to avery simple derivatives transaction, with your gain or loss derived from movements in theindex. Derivatives contracts are of varying duration, running sometimes to 20 or moreyears, and their value is often tied to several variables.Unless derivatives contracts arecollateralized or guaranteed, their ultimate value also depends on the creditworthiness ofthe counter-parties to them. But before a contract is settled, the counter-parties recordprofits and losses – often huge in amount – in their current earnings statements without somuch as a penny changing hands. Reported earnings on derivatives are often wildlyoverstated. That‟s because today‟s earnings are in a significant way based on estimateswhose inaccuracy may not be exposed for many years.In 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-TermCapital Management, caused the Federal Reserve anxieties so severe that it hastilyorchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledgedthat, had they not intervened, theoutstanding trades of LTCM – a firm unknown to the general public and employing only afew hundred people – could well have posed a serious threat to the stability of Americanmarkets. In other words, the Fed acted because its leaders were fearful of what might havehappened to other financial institutions had the LTCM domino toppled. And this affair,though it paralyzed many parts of the fixed-income market for weeks, was far from aworst-case scenario. 33
  34. 34. Purposes of derivative investmentsthe main purposes of derivative investments and why it is necessary for all investors.1. Discovery of prices. The prices in the market depend on the climate conditions, thecurrent situation in politics, the supply and demand of basic commodities, among manyfactors. All these affect market prices and with derivative investment investors are able to seehow volatile their markets could be or how much losses or gains will they get.2. Risk management. This is often one of the most important benefits of derivativeinvestments. With a derivatives market, investors can easily identify the actual level of risk inthe market. This is usually associated with hedging and speculation, which are both usefultools for companies in managing their risks effectively.3. Reduce market transaction costs. Since derivatives investments are like forms ofinsurance, it is cost-efficient. With derivatives, investors may avoid involuntary risks; theycan also easily implement different marketing ideas on many markets at a low cost, avoidingclashes and compromises.4. Improve market efficiency. For instance, investors can invest in risk-free bonds. Doingso, investors can be neutral and have the freedom to choose whether to sell richer assets orbuy the cheaper ones until equilibrium in prices is reached.Benefits of derivatives  Derivatives help in transferring risks from risk-averse people to risk-oriented people.  Derivatives assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets and thereby, render both cash and derivatives markets more efficient.  Derivatives catalyze entrepreneurial activities.  By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of capital across the economy and, thus, increasing productivity in the economy.  Derivatives increase the volume traded in markets because of participation of risk- averse people in greater numbers.  Derivatives increase savings and investment in the long run. 34
  35. 35. Risks involved with derivates  Needs proper knowledge:-while investing in derivatives an investor must know everything deeply about derivative market .because with half or without investor can,t know about volatility of market and he/she can earn maximum loss.  Large investment:-in derivatives large investment is involved because of lot size trades. Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systemic problems Warren Buffett  Rapid growth:- Know days derivative market growing fastly which cause increse in prices fastly and make share too expensive. The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system.  Dependent:-derivative market is dependent on cash market or other factor.a small change in cash market cause a huge effect on derivative market. 35
  36. 36. 3.5)OPERATIONAL MECHANISM OF DERIVATIVES 1. Registration with broker : The first step towards trading in the derivatives market is selection of a proper broker with whom the investor would trade. Investors should complete all the registration formalities with the broker before commencement of trading in the derivatives market. The investors should also ensure to deal with a broker (member of the exchange) who is a SEBI registered broker and possesses a SEBI registration certificate. 2. Client Agreement : The investor should sign the Client Agreement with the broker before the broker can place any order on his behalf. The client agreement includes provisions specified by SEBI and the derivatives segment. 3. Unique Client Identification Number : After signing the client agreement, the investors gets a unique identification number (ID). The broker would key this identification number in the system at the time of placing the order on behalf of the investors. This ID is broker specific i.e. if the investors chooses to deal with different brokers, he needs to sign the client agreement with each one of them and resultantly, he would have different Ids. 4. Risk Disclosure Documents : As stipulated in the Bye-Laws provide his particulars to the investors. The particulars would include his SEBI registration number, the name of the employees who would be primarily responsible for the client‟s affairs, the precise nature of his liability towards the client in respect of the business done on behalf of the investor. The broker must also apprise the investor about the risk associated with the business in derivative trading and the extent of his liability. This information forms part of the Risk Disclosure document, which the broker issues to the client. The investor should carefully read the risk disclosure document and understand the risks involved in the derivatives trading before committing any position in the market. The risk disclosure document has to be sign3ed by the client and a copy of the same is retained by the broker for his records. 5. Free Copy of Relevant Regulations : The client is also entitled to a free copy of the extracts or relevant provisions governing the rights and obligations of clients, relevant manuals, notifications, circulars and any additions or amendments etc. of the 36
  37. 37. derivatives segment or of any regulatory authority to the extent it governs the relationship between the broker and the client.6. Placing order with the broker : The investor should place orders only after understanding the monetary implications in the event of execution of the trade. After the trade is executed, the investor can request for a copy of the trade confirmation slip generated on the systems on execution of the trade. The investor should also obtain from the broker, a contract note for the trade executed within 24 hours. The contract note should be time (order receipt and order execution) and price stamped. Execution prices, brokerage and other charges, if any, should be separately mentioned in the contract note. If desired, the investors may change an order anytime before the same is executed on the exchange.7. Margining System in Derivatives : The aim of margin money is to minimize the risk of default by either counter-party. The payment of margin ensures that the risk is limited to the previous day‟s price movement on each outstanding position. The different types of margins are: a) Initial Margin : The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposited before the opening of the position in the futures transaction. This margin is calculated by SPAN by considering the worst case scenarion. b) Mark to market margin : All daily losses must be met by depositing of further collateral-known as variation margin, which is required by the close of business, the following day. Any profits on the contract are credited to the client‟s variation margin account.8. Investors Protection Fund: The derivatives segment has established an “Investors Protection Fund” which is independent of the cash segment to protect the interest of the investors in the derivatives market.9. Arbitration : In case of any dispute between the members and the clients arising out of the trading or in relation to trading/settlement, the party thereto shall resolve such complaint, dispute by arbitrations procedure as defined in the rules and regulations and Bye-Laws of the respective exchanges.37
  38. 38. 3.6)REGULATORY FRAMEWORKThe trading of derivatives is governed by the provisions contained in the SC (R) A, the SEBIAct, the rules and regulations framed there under and the rules and bye-laws of stock-exchanges.Securities contracts (Regulation) Act, 1956SC(R) A aims at preventing undesiarable transactions in securities by regulating the businessof dealing therein and by providing for certain other matters connected therewith. This is theprincipal Act, which governs the trading of securities in India. The term “securities” has beendefined in the SC(R)A. As per Section 2(h), the „Securities‟ include: 1. Shares, scrips, stock, bonds, debentures, stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes. 4. Government securities. 5. Such other instruments as may be declared by the Central Government to be securities. 6. Rights or interests in securities “Derivative” is defined to includes: A 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 price, of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are:Traded on a recognized stock exchange.Settled on the clearing house of the recognized stock exchange, in accordance with the rulesand bye-laws of such stock exchanges. 38
  39. 39. 4] RESEARCH METHODOLOGYResearch is a procedure of logical and systematic application of the fundamentals of scienceto the general and overall questions of a study and scientific technique by which provideprecise tools, specific procedures and technical, rather than philosophical means for gettingand ordering the data prior to their logical analysis and manipulations.Different type of research design is available depending upon the nature of research project,availability of able manpower and circumstances.The study about DERIVATIVES A TWO EDGED SWORD” is exploratory as well asdescriptive in nature .Discussion with experts, internet surfing, and journals were studied toexplore more about the concerned objective and better understanding of the problem. Afterthat questionnaire was prepared to meet the desired objectiveSources of Data:The source of data includes primary and secondary data sources.Primary SourcesPrimary data is data collected for first time specially for the purpose for which study is beingconducted i.e. the problem under study..Secondary SourcesThe secondary data is data, which is collected and compiled for the different purpose, whichare used in research for this study. The secondary data include material collected from: - Newspaper - Magazine. - Internet. 39
  40. 40. Data Collection InstrumentsThe various methods of data gathering involves the use of appropriate recording forms.These are called „tools‟ or „instruments of data collection. Data was collected throughstructured questionnaire administered by sitting with guide and discussing problemsSampling TechniqueThe small representative selected out of large population is selected at random is calledsample. Well-selected sample may reflect fairly, accurately the characteristic of population.The chief aim of sampling is to make an inference about unknown parameters from ameasurable sample statistics. Sampling technique used was Snowball sampling was used forthe purpose of data collection as reference was taken form sample to reach other sample.Sample Size : Sample size refers to the number of items to be selected from the universe toconstitute a sample. Due to constraints of cost and time, the sample size selected for theresearch is 50.Sampling Unit : The sampling unit was the person who had an account and was investingin stock market and broker who were trading in stock market . 40
  41. 41. 4.1) DATA ANALYSIS AND INTERPATION 1)Education qualification Qualification 20% 40% undergraduate graduate 30% post graduate professional 10%From the total respondents 40% are professionals,30% have done PG, 20% and 10% aregraduate and under graduate simultaneously. this shows all the respondents are wellqualified 41
  42. 42. 2)Participation in derivative market as role 20% 40% investor speculators 30% broker hedgers 10%40% of respondents are investors who invest their money where 30% are brokers 42
  43. 43. 3)Participation in derivative products Partication 10% 40% future option 50% swapHalf of the respondents i.e 50% participate in future and 40% are in option.so the majorproducts of intrest are future and option. 43
  44. 44. 4) Income used for investment income invested 20% 30% b/w 5-10% 15% b/w 11-15% b/w 16-20% more than 20% 35%From about analysis we get to know that b16-20% of household income is invested inderivative market by most of investors. 44
  45. 45. 5) Purpose of investment Purpose 15% 30% hedging 25% risk control stability direct investment 30%Most of people invest in derivatives to control their risk of cash market and to achievestability. 45
  46. 46. 6) why people not invest in derivative market Very risky and highly leveraged instrument Lack of knowledge and difficulty in understanding Increase speculation Counter party riskPeople rate riskiness of market as major decision for why people not invest in derivatives andits less knowledge as 2nd and so on. 46
  47. 47. 7) People invest for period of contract 20% 1 month 55% 25% 2 months 3 maonthsMost of the respondents invest in 1 month contract that is upto 55%. 47
  48. 48. 8) number of investment in derivative market per year no. of times 18% 20% 1-10 times 11-50 times 22% more than 50 40% regularFrom the total respondents 40% of respondents take part in derivative market more then 50times per year.meams all are the regular investors. 48
  49. 49. 9) Result of investment results 27% 48% great results acceptable disappointed 25%48% of total respondents get great results from investment they earn maximum profits.andthe other 25% says results are acceptable means they bear loss as well as they earn profits,butthe 27% people bear much loss because they invest without proper consideration/knowledge. 49
  50. 50. 10) Still doing investment 15% yes no 85%From the total respondents 85% means approx 42 respondents are still investing in marketsome of which are those who earn good profits in past and some are who bear loss i.e 10. 50
  51. 51. FINDINGS AND CONCLUSION1) From the study I get to know that the derivative market is fastest growing market. its highly volatile.2) Trading is done in lot size so it can‟t attract small investors3) Derivatives are the main instrument to control or minimize risk.4) Now days speculation became major aspect it also de motivate the investors5) Derivatives are the instruments which gives much as profits and also takes more and give loss.6) Proper knowledge is required to get success51
  52. 52. SUGGESTIONS1) LOT SIZE: Lot size should be reduced so that the major segment of an India society i.e. small saving class can come under F & O trading. There is strong need for revision of lot sizes as the lot sizes of some of the individual scrips that were worth of Rs. 200000 in starting, now same lot size amount to a much larger value.2) SCRIPS: More scrips of reputed companies etc. should be introduced in "F & O segment".3) TRAINING CLASSES OR SEMINARS: There should be proper classes on derivatives for investors, traders, brokers, students and employees of stock exchanges. Because lack of knowledge is the main reason of its less development. The first step towards it should be seminars provide to brokers & LSE employees and secondly seminar to students.4) Speculation : SEBI should take proper steps to control speculation52
  53. 53. LIMITATIONS OF THE STUDYNo study is complete in itself, however, good it may and every study has some limitations: Time is the main constraint of my study. Availability of information was not sufficient because of less awareness among investors / brokers. Sample size is not enough to have a clear opinion. 53
  54. 54. SURVEY QUESTIONNAIRE OF INVESTORSSir/Ma‟am,This questionnaire is meant for educational purposes only. The information provided by youwill be kept secure and confidential.NAME- __________________________________________________CONTACT- ______________________________________________GENDER-________________________________________________OCCUPATION-___________________________________________1. Educational Qualification  Undergraduate  Graduate  Post Graduate  Professional Degree Holder2. You participate in derivative market as:  Investor  Speculator  Broker/Dealer  Hedger3. In which of the following would you like to participate?  Future  Options  Swap 54
  55. 55. 4. Normally what percentage of your monthly household income could be available forinvestment?  Between 5% to 10%  Between 11% to 15%  Between 16% to 20%  More than 20%5. What is the purpose of investing in derivative market?  To hedge their fund  Risk control  More stable  Direct investment without buying and holding assets6. Why people do not invest in derivative market? (Rank your preference 1-4)  Lack of knowledge and difficulty in understanding  Increase speculation  Very risky and highly leveraged instrument  Counter party risk7. What contract maturity period would interest you for trading in?  1 month  2 month  3 month8. How often do you invest in derivative market per year?  1-10 times in a year  11-50 times  More than 50 times  Regularly 55
  56. 56. 9. What was the result of your investment?  Great results  Moderate but acceptable  Disappointed10.Are you investing in market?  Yes  No 56

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