Akhil Derivatives

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A RESEARCH REPORT ONDERIVATIVES- AN INNOVATIVE TOOL FOR RISK

MINIMISATION

FOR THE FULFILLMENT OF THE REQUIREMENT FOR THE AWARD

OF THE DEGREE OF MASTERS OF BUSINESS ADMINISTRATION

U.P.TECHNICAL UNIVERSITY, LUCKNOW

Under the Guidance of Submitted by

MR. DURGESH AGARWAL AKHIL VARSHNEY

MBA-3rd SEM

Submitted to

MR. SAIF AZAM

ASSITANT PROFESSOR

(ABIMS)

AL-BARKAAT INSTITUTE OF MANAGEMENTSTUDIES, ALIGARH


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ACKNOWLEDGEMENT

I would like to take this opportunity to express my sincere gratitude to all the

people who have directly and indirectly aided my research and extended his

full support to my visit to his company.

I would also like to thank Mr. Durgesh Agarwal, for his support and help

anytime I approached him. His advice and support made all the difference to

my work and gave it the form it has.

AKHIL VARSHNEY

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Table of content

Chapters pageno.

1. Executive summery 52. Company profile 6-

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3. History of Religare 84. Introduction of derivatives 9-

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What are derivatives?

Features of derivatives

Kinds of derivative contracts Advantages and disadvantages of derivatives contracts

OTC v/s exchange derivative market

Application of derivatives derivative market in India

Factors driving the growth of derivatives

Pre-requisites for derivative

Global derivatives market

5. Review of literature36-47

The advent of derivatives

L.C Gupta committee report6. Present study

48-109

Derivatives instruments

Pay-off of futures and options

Options and future strategies for hedger

Options strategies

7. Methodology110-111

8. Results112-116

Current constraints Need for derivative

Market in India

Future prospects

Precautionary measures to be taken

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9. Discussion117-118

Are derivative a failure?

10. Recommendations119-123

11. Conclusions124

12. References125

13. Appendix126-133

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LIST OF TABLES

1. Forwards v/s futures2. Requirements for professional clearing membership3. Eligibility criteria for membership on the F&O segment

4. Option Strategies5. Option Strategies for a bullish and a bearish market6. Long call strategy7. Covered call strategy v/s Long stock strategy8. Long put strategy

9. Covered put strategy

LIST OF FIGURES

1. Types of derivative contracts2. Payoff for buyer of futures: long futures

3. Payoff for seller of futures: short futures4. Payoff of a long call5. Payoff of a short call6. Payoff of a long put7. Payoff of a short put8. Payoff of a strangle9. Up and in options10. Payoff for buyer of call options at various strikes11. Payoff for writer of put options at various strikes12. Payoff for seller of call options at various strikes13. Payoff for buyer of put options at various strikes14. Payoff of a bull spread15. Payoff of a bear spread16. Interest rate swap

LIST OF APPENDIX

1. Article- Fall of Barings Bank2. Article- Orange Club

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EXECUTIVE SUMMARY

Financial derivatives have crept into the nation's popular economic vocabulary on a

wave of recent publicity about serious financial losses suffered by municipal

governments,. Well -known corporations, banks and mutual funds that had invested

in these products. Government has held hearings on derivatives and financial

commentators have spoken at length on the topic.

In a way, derivatives are like electricity. Properly used, they can provide great

benefit. If they are mishandled or misunderstood, the results can be catastrophic.

Derivatives are not inherently "bad". When there is full understanding of these

instruments and responsible management of the risks, financial derivatives can be

useful tools in pursuing an investment strategy.

This is a modest attempt to provide an insight into the world of Derivatives,

covering the gamut of products, operators, institutional set up and regulatory

framework. A Derivatives is a contractual relationship established by two (or more)

parties where payment is based on (or derived from) some agreed upon benchmark.

Like any other financial instrument derivatives too require a conducive environment

for its success.

Although world derivative markets have existed in some form since at least 17 th

century, modern derivative markets developed in mid 19 th century with the opening

up of Chicago Board of trust Derivative trading. Since then derivatives have come a

long way. Derivative trading is now the worlds largest business with an estimated

daily turnover of USD 2.5 trillion and an annual growth rate of around 14%.

THIS PROJECT ATTEMPTS TO FAMILIARIZE THE READER WITHFINANCIAL DERIVATIVES, THEIR USE AND THE NEED TO

APPRECIATE AND MANAGE RISK. IT IS NOT A SUBSTITUTE;

HOWEVER, COMPETENT PROFESSIONAL ADVICE SHOULD BE

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SOUGHT BEFORE BECOMING INVOLVED IN A FINANCIAL

DERIVATIVE PRODUCT.

COMPANY PROFILE

Religare Enterprises Limited (REL) is a global financial services

group with a presence across Asia, Africa, Middle East, Europe and

the Americas. In India, RELs largest market, the group offers a

wide array of products and services ranging from insurance, asset

management, broking and lending solutions to investment banking

and wealth management. The group has also pioneered the

concept of investments in alternative asset classes such as arts

and films .With 10,000 plus employees across multiple

geographies, REL serves over a million clients, including corporate

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and institutions, high net worth families and individuals, and retail

investors

Religare is driven by ethical and dynamic process for wealth

creation. Based on

This, the company started its endeavor in the financial market.

Religare Enterprises Limited through Religare Securities Limited,

Religare

Finevest Limited, Religare Commodities Limited and Religare

Insurance

Advisory Services Limited provides integrated financial solutions to

its

corporate, retail and wealth management clients. Today, we

provide various financial services which include Investment

Banking, Corporate Finance, Portfolio Management Services, Equity

& Commodity Broking, Insurance and Mutual Funds. Plus, theres a

lot more to come your way.

Religare is proud of being a truly professional financial service

provider managed by a highly skilled team, who have proven track

record in their respective domains. Religare operations are

managed by more than 1500 highly skilled professionals who

subscribe to Religare philosophy and are spread across its country

wide branches.

Our business philosophy is to treat each client situation as unique,

requiring customized solutions. Our list of corporate clients reads

like a Whos Who of the Indian Industry and we have been

successful in providing them with practical customized solutions

for their requirements. We are propelled by our group vision and

desire to strive tirelessly and aim to be the best within this

category.

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The primary focus of RCL is to cater to services in Commodity

Market. The Company is a member of the Multi commodity

exchange (MCX) and National commodity derivative exchange

(NCDEX). The growing list of financial institutions with whom FCL is

empanelled, as approved Broker is a reflection of the high levels of

services maintained by the Company.

Religare has a very credible team in its Research & Analysis

division, which not only caters to the need of our Institutional

clientele but also gives their valuable input to Investment Dealers.

History of Religare Ltd.

Religare Securities Limited, a Ranbaxy Promoter Group Company,

was founded by late Dr. Parvinder Singh (CMD Ranbaxy

Laboratories Limited), with the vision of providing integrated

financial care driven by the relationship of trust & confidence. To

realize its vision the Religare group provides various financial

services which include broking (stocks & commodities), depository

participant services, portfolio management services, advisory on

mutual fund investments and many more. Working on the

philosophy of being Financial Care Partner, Religare unlike other

traditional broking firms not only executes the trades for the

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clients but also provides them critical and timely investment

advice. The growing list of financial institutions with which Religare

is empanelled as an approved broker is a reflection of the high

levels of service standard maintained by the company. Religare is

a truly professional financial service provider managed by a team

of highly skilled professionals who have proven track record in

their respective domains. Religare has the widest reach through its

Regional, Zonal and Branch Offices spread across the length &

breadth of the country.

Religare Enterprises Limited (REL) is one of the leading integrated

financial services groups of India. Backed by a blue chip promoter

pedigree and a proven track record, RELs businesses are broadly

clubbed across three key verticals, the Retail, Institutional and

Wealth spectrums, catering to a diverse and wide base of clients.

REL offers a multitude of investment options and a diverse

bouquet of financial services and can boast of a reach that spreads

across the length and breadth of the country with its presence in

more than 1460 locations across more than 450 cities and towns.

CHAPTER 1

INTRODUCTION

The word Derivative has gained popularity by acting as an insulator to risk

management. Derivative products such as Options, Futures or Swaps have become a

standard risk management tool that involves risk sharing and thus facilitates the

efficient allocation of capital to productive investment opportunities. Derivativeshave enabled commercial corporations, governments, financial firms, and other

institutions worldwide to reduce their exposure to fluctuations in interest rates,

currency exchange rates, and the prices of equities and commodities. Derivatives

also have enabled users to reduce funding costs and speculate on changes in market

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rates and prices. A derivative is simply a new name for a tried and trusted set of

risk management instruments. It covers any transaction where there is no movement

of principle and where the price performance of derivatives is driven by an

underlying commodity. "Derivatives is cited as a simile to Aspirin, which when

taken as an antidote for headache, will make the pain go away. Paradoxically if the

whole bottle is consumed it might lead to disastrous consequences.

What are derivatives?

The primary objectives of any investor are to maximize returns and minimize risks.

Derivatives are contracts that originated from the need to minimize risk.

The word 'derivative' originates from mathematics and refers to a variable, which

has been derived from another variable. Derivatives are so called because they have

no value of their own. They derive their value from the value of some other asset,

which is known as the underlying.

Therefore, derivative is a product which derives its value from the value of one or

more basic variables, called bases (underlying asset, index or reference rate) in a

contractual manner. The underlying asset can be equity, forex, commodity or anyother asset. For example, a derivative of the shares of Infosys (underlying), will

derive its value from the share price (value) of Infosys. Similarly, a derivative

contract on soybean depends on the price of soybean.

With Securities Laws (Second Amendment) Act, 1999, Derivatives has been

included in the definition of Securities. The term Derivative has been defined in

Securities Contracts (Regulations) Act, as:-

A Derivative includes: -

1. a security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument or contract for differences or any other form of security;

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2. a contract which derives its value from the prices, or index of prices, of

underlying securities

Features of derivatives:

Derivatives are specialized contracts which signify an agreement or an

option to buy or sell the underlying asset of the derivate up to a certain time

in the future at a prearranged price, the exercise price.

The contract also has a fixed expiry period mostly in the range of 3 to 12

months from the date of commencement of the contract. The value of the

contract depends on the expiry period and also on the price of the underlying

asset. For example, a farmer fears that the price of soybean (underlying),

when his crop is ready for delivery will be lower than his cost of production.

Lets say the cost of production is Rs 8,000 per ton. In order to overcome

this uncertainty in the selling price of his crop, he enters into a contract

(derivative) with a merchant, who agrees to buy the crop at a certain price

(exercise price), when the crop is ready in three months time (expiry

period).In this case, say the merchant agrees to buy the crop at Rs 9,000 per

ton. Now, the value of this derivative contract will increase as the price of

soybean decreases and vice-a-versa. If the selling price of soybean goes

down to Rs 7,000 per ton, the derivative contract will be more valuable for

the farmer, and if the price of soybean goes down to Rs 6,000, the contract

becomes even more valuable. This is because the farmer can sell the soybean

he has produced at Rs .9000 per tonne even though the market price is much

less. Thus, the value of the derivative is dependent on the value of the

underlying.

If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton,

gold, silver, precious stone or for that matter even weather, then the derivative is

known as a commodity derivative.

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If the underlying is a financial asset like debt instruments, currency, share price

index, equity shares, etc, the derivative is known as a financial derivative.

Derivative contracts can be standardized and traded on the stock exchange.

Such derivatives are called exchange-traded derivatives. Or they can be

customized as per the needs of the user by negotiating with the other party

involved.

Such derivatives are called over-the-counter (OTC) derivatives. Continuing

with the example of the farmer above, if he thinks that the total production

from his land will be around 150 quintals, he can either go to a food

merchant and enter into a derivatives contract to sell 150 quintals of soybean

in three months time at Rs 9,000 per ton. Or the farmer can go to acommodities exchange, like the National Commodity and Derivatives

Exchange Limited, and buy a standard contract on soybean. The standard

contract on soybean has a size of 100 quintals. So the farmer will be left with

50 quintals of soybean uncovered for price fluctuations.

However, exchange traded derivatives have some advantages like low

transaction costs and no risk of default by the other party, which may exceed

the cost associated with leaving a part of the production uncovered.

TYPES OF DERIVATIVE CONTRACTS

FUTURES

LEAPS BASKETS

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DERIVATIVE

CONTRACTS


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FORWARDS OPTIONS

WARRANTS

SWAPOPTIONS

SWAPS

FORWARD CONTRACTS

A cash market transaction in which delivery of the commodity is deferred until after

the contract has been made. Although the delivery is made in the future, the price is

determined on the initial trade date. Most forward contracts don't have standards

and aren't traded on exchanges. A farmer would use a forward contract to "lock-in"

a price for his grain for the upcoming fall harvest.

FUTURES CONTRACT

Futures Contract means a legally binding agreement to buy or sell the underlying

security on a future date. Future contracts are the organized/standardized contracts

in terms of quantity, quality (in case of commodities), delivery time and place for

settlement on any date in future. The contract expires on a pre-specified date whichis called the expiry date of the contract. On expiry, futures can be settled by delivery

of the underlying asset or cash. Cash settlement enables the settlement of obligations

arising out of the future/option contract in cash.

FORWARDS FUTURES

OTC in nature Traded on an organized exchange

Customized contract terms Standardized contract terms

Less liquid More liquid

No margin payment Requires margin paymentSettlement happens at the end of the

period

Follows daily settlement

Counterparty risk No counterparty risk

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OPTIONS CONTRACT

Options Contract is a type of Derivatives Contract which gives the buyer/holder of

the contract the right (but not the obligation) to buy/sell the underlying asset at a

predetermined price within or at end of a specified period. The buyer / holder of the

option purchases the right from the seller/writer for a consideration which is called

the premium. The seller/writer of an option is obligated to settle the option as per the

terms of the contract when the buyer/holder exercises his right. The underlying asset

could include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act, 1956 options on securities has been

defined as "option in securities" means a contract for the purchase or sale of a right

to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a

mandi, a teji mandi, a galli, a put, a call or a put and call in securities;

An Option to buy is called Call option and option to sell is called Put option.

Further, if an option that is exercisable on or before the expiry date is called

American option and one that is exercisable only on expiry date, is called European

option. The price at which the option is to be exercised is called Strike price orExercise price.

Therefore, in the case of American options the buyer has the right to exercise the

option at anytime on or before the expiry date. This request for exercise is submitted

to the Exchange, which randomly assigns the exercise request to the sellers of the

options, who are obligated to settle the terms of the contract within a specified time

frame.

As in the case of futures contracts, option contracts can be also be settled by

delivery of the underlying asset or cash. However, unlike futures cash settlement in

option contract entails paying/receiving the difference between the strikes

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price/exercise price and the price of the underlying asset either at the time of expiry

of the contract or at the time of exercise / assignment of the option contract.

SWAPS

Traditionally, the exchange of one security for another to change the maturity

(bonds), quality of issues (stocks or bonds), or because investment objectives have

changed. Recently, swaps have grown to include currency swaps and interest rate

swaps.

If firms in separate countries have comparative advantages on interest rates, then a

swap could benefit both firms. For example, one firm may have a lower fixed

interest rate, while another has access to a lower floating interest rate. These firms

could swap to take advantage of the lower rates.

WARRANTS

Options generally have lives upto one year, the majority of options traded on options

exchanges having a maximum maturity of nine months. Longer dated options are

called warrants and are generally traded over- the- counter.

LEAPS

The acronym LEAPS means Long Term Equity Anticipation Securities. These are

options having a maturity of upto three years.

BASKETS

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Basket options are options on portfolio of underlying assets. The underlying asset is

usually a moving average of a basket of assets. Equity index options are a form of

basket options.

SWAPTIONS

They are options to buy or sell a swap that will become operative at the expiry of the

options. Thus a swaption is an option on a forward swap. Rather than have calls and

puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

swaption is an option to receive fixed and pay floating. A payer swaption is an

option to pay fixed and receive floating.

ADVANTAGES OF DERIVATIVES

The advantages are:

1. A tool for hedging: Derivatives provides an excellent mechanism to hedge the

future price risk. Think of a farmer, who doesnt know what price he is going to get

for his crop at the time of harvest. He can sell his crop in the futures market & lock

in the price. If the future spot price is more than the futures price, he can take the off

setting position & can get out of the market (with a marginal loss). Otherwise he

will get the locked in price.

2. Risk management: Derivatives provide an excellent mechanism to Portfolio

Managers for managing the portfolio risk and to Treasury Managers for managing

interest rate risk. The importance of index futures & Forward Rate Agreement

(FRA) in this process cant be overstated.

3. Better avenues for raising money: With the introduction of currency & interest

rate swaps, Indian corporate will be able to raise finance from global markets at

better terms.

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4. Price discovery: These derivative instruments make the spot price discovery

more reliable using different models like Normal Backwardation hypothesis. These

instruments will cause any arbitrage opportunities to disappear & will lead to better

price discovery.

5. Increasing the depth of financial markets: When a financial market gets such

sort of risk-management tools, its depth increases since the Institutional Investors

get better ways of hedging their risks against unfavorable market movements.

6. Derivatives market on Indian underlying elsewhere: These days, with the

advent of technology, Indian prices are available globally on Reuters & Knight

rider. Nothing prevents any foreign market from launching derivatives on these

Indian underlying. This will put Indians in a disadvantageous position as they cant

take the advantages of derivatives of securities or commodities traded in India but

someone lese can take. So we will have to move fast in this direction.

Empirical evidence: There is strong empirical evidence from other countries that

after derivative markets have come about, the liquidity and market efficiency of the

underlying market has improved.

DISADVANTAGES OF DERIVATIVES

1. Speculation: Many people fear that these instruments will unnecessarily increase

the speculation in the financial markets, which can have far reaching consequences.

The recent Barrings Bank incident is the classic case in point.

2. Market efficiency: Many people fear that the Indian markets are not mature &

efficient enough to introduce these instruments. These instruments require a well

functioning & mature spot market. Like recently The Economic Times reported the

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strong correlation of Indian equity markets to the NASDAQ. Such type of market

imperfections makes the functioning of derivatives market all the more difficult.

3. Volatility: The increased speculation & inefficient market will make the spot

market more volatile with the introduction of derivatives.

4. Counter party risk: Most of the derivative instruments are not exchange traded.

So there is a counter party default risk in these instruments. Again the same Barrings

case, Barrings declared itself bankrupt when it faced huge losses in these

instruments.

5. Liquidity risk: Liquidity of a market means the ease with which one can enter or

get out of the market. There is a continued debate about the Indian markets

capability to provide enough liquidity to derivative trader.

Hence, the pros of derivatives outweigh the cons. And moreover, by imposing

margin requirements, by limiting the exposure one can take and other measures like

that, these vices of derivatives can be controlled. The importance of derivatives for

any financial market cant be overstated.

RISKS IN DERIVATIVES

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As derivatives are risk shifting devices, it is important to identify and fully

comprehend the risks being assumed, evaluate those risks and continuously

monitor and manage those risks. Each party to a derivative contract should

be able to identify all the risks that are being assumed (interest rate,

currency exchange, stock index etc) before entering into a derivative

contract.

Risk management is a logical development and execution of a plan to deal with

potential losses. The risk management process involves 3 basic steps:

Identification of risk

Measurement of risk

Monitoring and managing of risks

The fundamental risks involved in derivative business include:

Credit RiskThis is the risk of failure of a counter party to perform its obligation as

per the contract. Also known as default or counter party risk, it differs with different

instruments. Credit risk associated with OTC derivative contracts is generally lower

than the exchange-traded derivative instruments.

Liquidity Risk: There are two types of liquidity risk.

i) Market liquidity risk: Market liquidity risk is the risk that an institution

may not be able to, or cannot easily, liquidate or offset a particular position

at or near previous market price because of inadequate market depth or

disruption in the market place.

ii) Funding liquidity risk: Funding liquidity risk is the risk that an institution

will be unable to meet its payment obligation on settlement dates or in the

event of margin calls

Legal Risk: Derivatives cut across judicial boundaries; therefore the legal aspects

associated with the deal should be looked into carefully. Legal risk is the risk that

contracts are not legally enforceable or documented correctly. There should be

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guidelines and processes in place to ensure the enforceability of counter party

agreements.

Operational Risk: the risk of direct loss resulting from inadequate or failed

internal processes, people and systems or from external events. The Board ofdirectors and senior management should ensure proper dedication of resources

(financial and personnel) to support operations and systems development and

maintenance

Market Risk:Market risk is the risk to an institution's financial condition resulting

from adverse movement in the level or volatility of market prices of the underlying

asset/instrument.

OTC V/S EXCHANGE TRADED DERIVATIVES

The OTC derivative markets have witnessed rather sharp growth over the last few

years, which have accompanied the modernization of commercial and investment

banking and globalization 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 stated that the

highly leveraged institutions and their OTC derivative positions were the main cause

of turbulence in financial markets in 1998. These episodes of turbulence revealed

the risks posed to market stability originating in features of OTC derivative

instruments and markets.

The OTC derivatives market has the following features compared to exchange trade

derivatives:

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1. The management of counter-party (credit) risk is decentralized and located

within individual institutions.

2. There are no formal centralized limits on individual positions, leverage or

margining.

3. There are no formal rules for risk and burden sharing.

4. there are no formal rules or mechanisms for ensuring market stability and

integrity and for safeguarding the collective interests of market participants

and

5. The OTC contracts are generally not regulated by a regulatory authority and

the exchanges self regulatory organization although they are affected

indirectly by national legal systems, banking supervision and market

surveillance.

Some of the features of OTC derivatives markets embody risks to financial market

stability. The following features of OTC derivatives markets can give rise to

instability in institutions, markets, and the international financial system:

1. The dynamic nature of gross credit exposure

2. information asymmetries

3. the effects of OTC derivative activities on available aggregate credit

4. the high concentration of OTC derivative activities in major institutions

5. the central role of OTC derivative activities in the global financial system

Instability arises when shocks, such as counter-party credit events and sharp

movements in asset prices that underlie derivative contracts occur, which

significantly alter the perceptions of current and potential future credit exposures.

When asset prices change rapidly, the size and configuration of counter-party

exposures can become unsustainable large and provoke a rapid unwinding of

positions.

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There has been come progress in addressing these risks and perceptions. However,

the progress has been limited in implementing reforms in risk management;

including counterparty, liquidity and operational risks, and OTC derivatives market

continue to pose a threat to international financial stability. The problem is more

acute as heavy reliance on OTC derivatives creates the possibility of systematic

financial events, which fall outside the more formal clearing house structures.

Moreover, those who provide OTC derivative products, hedge their risks associated

with OTC derivatives, and their dependence on exchange traded derivatives, Indian

law considers them illegal.

APPLICATIONS OF DERIVATIVES

Any organization which has to divert its time to foreign exchange problems needs

and seeks information.

Most often, it is confronted with some dilemmas depending on whether the concern

is mainly with imports or with exports, with overseas investments, or with the

purchase of raw materials or factory installations from abroad.

With this view in mind, this section highlights the typical choices and decisions

which confront Indian industry today.

The analysis is based on the views of a cross section of the industry. The sample

interviewed and questioned includes banks, FIs on the one hand and hand and

companies into software exports, production and training on the other.

The areas discussed below were found to be of the most relevance for the largest

number of managing or financial directors in industrial and commercial firms.

Spot or Forward?

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Should those who have entered into a firm commercial commitment to buy from

abroad and pay in foreign currency, cover the currency straight away on a forward

basis or should they wait until the time of payment or receipt and then cover it on

spot basis?

Normal prudence suggested that customer should cover forward all their

commitments as they provide a professional service to be used without the end-

beneficiary being involved in difficult considerations.

However, this view was not tenable to more sophisticated companies with frequent

and substantial involvement in international transactions. To such a company the

argument is like not interviewing a prospective secretary because one's business is

the manufacture of shoes and not the assessment of personnel.

The Siemens Case presented in the next section highlights the above corporate view.

Unfortunately, no two companies have the risks or the cost of cover the same in any

weeks of the year. Yet, some common relevant guiding questions emerged from the

study:

1. Is it likely that the currency to be bought will be up valued or will

float upwards before the time of payment (or that currency to be sold

will be devalued or will float downwards)?

2. Is the home currency likely to change its official parity or actual

exchange rate against some, many or all foreign currencies or to float

out side present limits?

3. Is the foreign currency or home currency likely to be involved in any

general realignment of rates during this period, such as occurs in the

European Monetary System (EMS) from time to time?

4. How might the foreign currency or home currency fare if there are

further changes in the international monetary system, such as the

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introduction of new intervention points or the extension of floating

rates or the re-fixing of now freely floating currencies?

5. What is the most that changes feared (whether likely or unlikely to

occur) will cost the organization (i) as a percentage, (ii) in actual

cash.

6. What is the actual cost of forward cover (the difference between spot

now and forward now) : (i) in as a percentage per annum and

adjusted for the period of concern, (ii) in actual cash?

7. What is (i) the likely and (ii) the possible improvement or worsening

in the spot rate between now and the end of the period?

8. Is the forward rate, as sometimes happens, actually more favorable

than the spot rate, so that the forward cover is desirable even though

risks (questions a g) are deemed insufficient to justify insurance?

Nobody denied the difficulty in answering the above questions.

The costs and losses consequent upon an exposed position are such as to merit the

most careful consideration in taking the appropriate decisions.

These decisions do not always remain valid for long periods and therefore need

frequent and careful review.

The Duty to Cover Forward

For a commercial transaction which relies heavily on overseas raw materials or

overseas sales the fluctuations in exchange rates due to their being floating, profits

can be wiped out or doubled.

Hence, banks apply the following advice:

1. If already bought in one currency and already sold in another currency, cover

forward.

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Deviate from above if there is a danger ahead or only the likelihood of a change in

favour and if the amount is small in relation to total trade. Deviate only if

knowledge is sufficient and advice good. This is rare and specific to situations.

2. If already bought in one currency and yet to sell in another, the decision is more

difficult as in both cases there is an unavoidable risk which contains a large

speculative element inevitable to business.

Time options or Swap?

When the exact data of need of foreign currency may not be known, organizations

tend to use time options but these are costly.

Thus, some have shown a definite inclination towards a fixed date forward contract

followed by an adjusting swap, which may give only partial protection but are

cheaper.

These are those with a fair volume of business, adequate foreign exchange staff andthe will to take small risks.

Invoicing in Foreign/Home Currency?

Conventionally, firms have been invoicing in their home currency.

The study shows that invoices in foreign currency for exports can increase

profitability.

Even imports transactions should be analyzed in real terms before taking the course

of convenience without thought.

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Do banks advise or merely serve?

There was considerable divergence of opinion among banks and their customers on

this issue.

However, it is true that professional service needs to be an integral part of a good

foreign exchange department while awareness among the customers also has to rise.

Currency options : an essential tool in certain situations

Useful to firms which have to tender for projects or some other transactions in a

foreign currency.

Costing calculations are impossible until it is established in which currency the

contract will materialize, but such calculations must be completed before

negotiations begin.

For most firms however, they are inappropriate where a firm commercial contract

already exists.

Very few professionals with suitable skills and experience have used them in India

as better alternative instruments.

The Siemens Case

Siemens, the $60 billion German industrial conglomerate, installed a financial risk

management system developed by Wall Street Systems to track all its worldwide

assets, liabilities, and risks. Not only does it coordinate the company's exposure to

foreign currencies in the more than 100 countries where Siemens operates, but it

also monitors interest rates on the company's sizable debt portfolio and produces

accounting entries for its treasury department. It gives management a better comfort

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level to know exactly where they stand and know exactly what their position in

derivatives and currencies is at any point in time.

The system allows Siemens to offset its positions in different parts of he world. A

few years ago, if an American subsidiary needed Deutschmarks, Siemens might

have hired a bank to match the subsidiary with another Siemens operation willing to

swap excess Deutschmarks. Instead of going out and paying a spread to a bank, all

financial engineering is done internally.

DERIVATIVES MARKET IN INDIA

Approval for derivatives trading

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern trading of

derivatives. SEBI set up a 24-member committee under the chairmanship of

Dr.L.C.Gupta on November 18, 1996 to develop appropriate framework for

derivatives trading in India. The committee submitted its report on March 17, 1998prescribing pre-conditions for introduction of derivatives trading in India. The

committee recommended that derivatives should be declared as securities so that

regulatory framework applicable to trading of securities could also govern trading

of derivatives. SEBI also set up a group in June 1998 under the chairmanship of Prof

.J.R.Varma, to recommend measures for risk containment in derivatives market in

India. The report, which was submitted in October 1998, worked out the operational

details of margining system, methodology for charging initial margins, broker net

worth, deposit requirement and real-time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit

of securities and the regulatory framework was developed for governing

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derivatives trading. The act also made it clear that derivatives shall be legal and

valid only if such contracts are traded on a recognized stock exchange, thus

precluding OTC derivatives. The government also rescinded in March 2000, the

three-decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this effect in may 2000. 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. To begin with, SEBI

approved trading in index futures contracts based on S&P CNX Nifty and BSE-30

(Sensex) index. This was followed by approval for trading in options based on these

two indexes and options on individual securities. The trading in index optionscommenced in June 2001, and the trading in options on individual securities

commenced in July 2001. Futures contracts on individual stocks were launched in

November 2001. Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws, and regulations of the respective exchanges and

their clearing house/ corporation duly approved by SEBI and notified in the official

gazette.

Derivatives market at NSE

The derivatives trading on the exchange commenced with S&P CNX Nifty Index

futures on June 12,2000. The trading in index options commenced on June 4, 2001

and trading in options on individual securities commenced on July, 2 2001. Single

stock futures were launched on November 9,2001. The index futures and options

contract on NSE are based on S&P CNX Nifty index. Currently, the futures

contracts have a maximum of 3-month expiration cycles. Three contracts are

available for trading with 1 month, 2 months and 3 months expiry. A new contract is

introduced on the next trading day following the expiry of the near month contract.

Trading mechanism

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The futures and options trading system of NSE, called NEAT- F&O trading system,

provides a fully automated screen based trading for nifty futures & options and

stock futures and options on a nationwide basis and an online monitoring and

surveillance mechanism. It supports an anonymous order driven market which

provides complete transparency of trading operations and operated on strict price-

time priority. It is similar to that of trading of equities in the cash market segment.

The NEAT- F&O trading system is accessed by two types of users. The trading

members have access to functions such as order entry, order matching, and order

and trade management. It provides tremendous flexibility to users in terms of kinds

of orders that can be placed to the system. Various conditions like good-till-day,

good-till-canceled, good-till-date, immediate or cancel, limit/ market price, stop

loss, etc can be built into an order. The clearing members use the trader workstation

for the purpose of monitoring the trading members for whom they clear the trades.

Additionally, they can enter and set limits to positions, which a trading member can

take.

Membership criteria

NSE admits members on its derivative segment in accordance with the rules and

regulations of the exchange and the norms specified by SEBI. NSE follows 2- tier

membership structure stipulated by SEBI to enable wider participation. Those

interested in taking membership on F&O segment are required to take membership

of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing

members are admitted separately. Essentially, a clearing member does clearing for

all his trading members, undertakes risk management and performs actual

settlement. There are three types of CMS:

1. Self clearing member: a SCM clears and settles trades executed by him only

either on his own account or on account of his clients.

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2. Trading member clearing member: TM-CM is a CM who is also a TM. TM-

CM may clear and settle his own proprietary trades and clients trades as well

as clear and settle for other TMs.

3. Professional clearing member: PCM is a CM who is not a TM. Typically,

banks or custodians could become a PCM and clear and settle for TMs.

Requirements for professional clearing membership

Particulars (all

values in Rs. Lakh)

F&O segment CM & F&O segment

Eligibility Trading members of

NSE/SEBI registered

custodians/ recognized banks

Trading members of

NSE/SEBI registered

custodians/ recognized banks

Networth 300 300

Interest Free

Security Deposit

(IFSD)

25 34

Collateral security

deposit

25 50

Annual

subscription

nil 2.5

Note: the PCM is required to bring in IFSD of Rs. 2 lakh and CSD of Rs.8 Lakh per

trading member whose trades he undertakes to clear and settle in F&O segment.

Eligibility criteria for membership on F&O segment

Particulars (all values in

Rs Lakh)

CM and F&O segment CM,WDM and F&O

segment

Net worth(1) 100 200

Interest free security

deposit(IFSD)(2)

125 275

Collateral security deposit

(CSD)(3)

25 25

Annual subscription 1 2

1: No additional net worth is required for self clearing members. However, a net

worth of Rs. 300 lakhs is required for TM-CM and PCM.

2&3: Additional Rs. 25 lakh is required for clearing membership (SCM, TM-CM).

in addition, the claring member is required to bring in IFSD of Rs. 2 lakh and CSD

of Rs. 8 lakh per trading member he undertakes to clear and settle.

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The TM-CM and the PCM are required to bring in additional security deposit in

every TM whose trades they undertake to clear and settle. Besides this, trading

members are required to have qualified users and sales persons, who have passed a

certification programme approved by SEBI.

Turnover

The trading volumes on NSEs derivatives market have seen a steady increase since

the launch of the first derivatives contract, i.e. Index futures in June 2000. The

average daily turnover now exceeds a 1000 crore. A total of 41, 96,873 contracts

with a total turnover of Rs. 1, 01,926 crore was traded during 2001.02.

Clearing and settlement

NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O

segment. It acts as legal counterparty to all deals on the F&O segment and

guarantees settlement.

1. Clearing

The first step in clearing process is working out open positions or obligations ofmembers. A CMs open position is arrived at by aggregating the open position of all

the TMs and all custodial participants clearing through him, in the contracts in

which they have traded. A TMs open position is arrived at as the summation of his

proprietary open position and clients open positions, in the contracts in which they

have traded. While entering orders on the trading system, TMs are required to

identify the orders, whether proprietary ( if they are their own trades) or clients( if

entered on behalf of clients). Proprietary positions are calculated on net basis (buy-

sell) position of each individual client for each contract. A TMs open position is the

sum of proprietary open position, client open long position and client open short

position.

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2. Settlement

All futures and options contracts are cash settled .i.e. through exchange of cash. The

underlying for index futures/ options of the nifty index cannot be delivered. These

contracts, therefore, have to be settled in cash. Futures and options on individual

securities can be delivered as in the spot market. However, it has been currently

mandated that stock options and futures would also be cash settled. The settlement

amount for a CM is netted across all their TMs/ clients in respect of MTM,

premium and final exercise settlement. For the purpose of settlement, all CMs are

required to open a separate bank account with NSCCL designated clearing banks for

F&O segment.

Risk management system

The salient features of risk containment measures on the F&O segment are:

1. Anybody interested in taking membership of F&O segment is required to take

membership of CM and F&O or CM, WDM and F&O segment. An existing

member of CM segment can also take membership of F&O segment.

2. NSCCL charges an upfront margin for all the open positions of a CM upto client

level. It follows the VaR based margining system through SPAN system. NSCCL

computes the initial margin percentage for each nifty index futures contract on a

daily basis and informs the CMs. The CM in turn collects the initial margin from

the TMs and their respective clients.

3. NSCCLS on line position monitoring system monitors A CMs open positions on

a real time basis. Limits are set for each CM based on his base capital and

additional capital deposited with NSCCL. The on-line position monitoring system

generates alerts whenever a CM reaches a position limit set up NSCCL. NSCCL

monitors the CMs and TMs for mark to market value violation and for contract-

wise position limit violation.

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4. CMs are provided with a trading terminal for the purpose of monitoring the open

positions of all the TMs clearing and settling through them. A CM may set

exposure limits for a TM clearing and settling through him. NSCCL assists the

CM to monitor the intra-day exposure limits set up by a CM and whenever a TM

exceeds the limits, it withdraws the trading facility provided to such TM.

5. A separate settlement guarantee fund for this segment has been created out of the

capital deposited by the members with NSCCL.

Factors driving the growth of derivatives

Over the last three decades, the derivatives market has seen a phenomenal growth. A

large variety of derivatives contracts have been launched at exchanges across the

world. Some of the factors driving the growth of financial derivatives are:

a. increased volatility in asset prices in financial markets,

b. increased integration of national financial markets with the

international markets

c. marked improvement in communication facilities and sharp decline

in their costs,

d. development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and

e. innovations in the derivatives markets, which optimally combine the

risks, returns over a large number of financial assets leading to higher

returns, reduced risk as well as transaction costs as compared to

individual financial assets.

Economic function of the derivatives market

Inspite of the fear and criticism with which the derivative markets are commonly

looked at, these markets perform a number of economic functions.

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1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the

perceived future level. The prices of derivatives converge with the prices of

the underlying at the expiration of the derivative contract. Thus derivatives

help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but

may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash

markets. With the introduction of derivatives, the underlying market

witnesses higher trading volumes because of participation by more players

who would not otherwise participate for lack of an arrangement to transfer

risk.

4. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators trade

in the underlying cash market. Margining, monitoring and surveillance of the

activities of various participants become extremely difficult in these kinds of

mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity. The derivatives have a

history of attracting many bright, creative, well-educated people with an

entrepreneurial attitude. They often energise others to create new businesses,

new products and new employment opportunities, the benefit of which are

immense.

In a nut shell, derivatives markets help increase savings and investment in the long

run. Transfer of risk enables market participants to expand their volume and activity.

Pre-requisites for Derivatives

Strong and healthy cash market

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The first and the foremost requirement is the existence of a strong and healthy

cash market. An efficient, transparent and fair cash market with short settlement

cycles help in building an efficient derivatives market.

Empirical evidence from international markets suggests that the derivativesmarket and cash market are synergistic. A healthy cash market is a prerequisite

for developing a good derivatives market, while good derivative volumes make

the cash market even healthier. As the derivatives volume grow, it contributes

significantly to the cash market volumes resulting from growing opportunities

for arbitrage.

Clearing corporation and settlement guarantee

Existence of a common clearing corporation providing settlement guarantee as

well as cross margining is essential for speedy settlement as well as for risk

minimization. This is particularly important in case of derivatives where there

are often no securities to be delivered; the settlement is arranged in the form of

cash 'difference'.

Reliable wide area telecommunication network

Since derivatives trading must be introduced on nation wide basis so as to

providing equal opportunities for hedging to the investors population

throughout the country, existing of proven automated trading systems is

extremely important.

Risk containment mechanism

There should exist a strong and disciplined margining system in the form of

daily and mark-to-market margins, which provide a cover for exposure along

with price risk and notional loss in case of default in settling outstanding

positions; thereby minimizing market risk.

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The Indian Derivatives market continues to remain in the Stone Age. This is evident

from the fact that only fifteen to twenty corporate including the blue-chips and the

government owned companies have been able to make effective use of the limited

foreign exchange. While most of the smaller forex earners are undeterred by the

developments in the forex and derivatives market.

Hedging is an exercise, which involves using derivatives to manage risks. Risk

management involves both understanding risks and choosing appropriate techniques

to be protected against the risk. The forex market provides a forum in which the

operators can exchange risks. To hedge or not to hedge is the million dollar

question. Very few corporation have in use policies on the extent to which

speculation is permitted in terms of budgets associated and overnight open position

to be carried.

Examples

Essar Gujarat Ltd., one of the leading corporate players in the forex market, has a

well defined policy on hedging. Their policy includes a core cover to total exposure

ratio in keeping with the market condition which implies that the policy covers a

certain minimum proposition of every exposure.

Reliance Industries it is which figures among the bigger corporate dealers, has

raised funds through Euro in the past one year. The companies foreign exchange

exposures are reviewed daily on a market to market basis and the hedging sharing is

formulated accordingly Reliance also has an internal loss limits, depending on

market conditions.

GLOBAL DERIVATIVES MARKETS

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The significant growth of the formal, organized and officially recognized derivatives

market globally has taken place only during the past two decades. There are about

forty futures and options exchanges in Europe and Japan and about twelve in the

U.S. The U.S. alone accounted for 60 per cent of the total futures business in the

world in 1990. In the US, the financial futures market accounted for about 73

percent of the total future trading volume in 1990. Among interest rates futures,

treasury bonds futures dominate the market. The share of futures in equity indices,

foreign currencies, treasury bonds, and interest rates was 5 per cent, 10 per cent, 27

per cent and 45 per cent respectively in 1990 in America. At the global level, the

total value of derivatives trading has increased phenomenally from just $ 1,118

billion to $ 27,175 billion i.e. 2,331 percent or at the annual average rate of 259

percent during 1986 to 1995. As a part of this total, the share of OTC traded

derivatives has increased over the years. It was 66 percent in 1995, the rest being

accounted for by the exchange traded derivatives. Among the later, interest rates

futures and interest rates options accounted for 60 to 65 per cent and 24 to 30 per

cent respectively during 1986-95.

THE INTERNATIONAL DIMENSION

One of the more remarkable stories in the history of financial markets came about in

the aftermath of the worldwide stock market crash of October 1987. In Japan,

regulators asked themselves what needed to be done to prevent such occurrences in

future. Regulators and economists who worked with them pondered and came with a

completely incorrect diagnosis: they decided that "Programme trading" was to

blame. Programme trading enters the picture when the cash index and futures are out

of sync. When this happens, arbitrageurs use programme trading to rapidly buy (or

sell) all the index stocks using the computer. Japan's regulators made the arbitrage

very difficult by putting restrictions upon programme trading.

Today, the working of index futures markets is better understood - arbitrage is

essential to the functioning of any futures markets. Without the index arbitrage, the

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index futures market would be useless for hedgers since the price of futures would

often stray away form their fair values. But this was perhaps not clearly understood

at that time.

The sequence of events which followed the clamp down by Japan's regulators was

interesting. Thanks to the pervasive mispricing of the Japanese index futures without

index arbitrage, the Japanese futures market was unable to meet the needs of the

users.

Singapore saw a strong derivative exchange as an essential part of its desire to be

center for international finance. Simex was created in the early 80s as an example

of strategic policy making. It perceived the unmet demand among Japanese users of

index futures. A great deal of usage of the futures on the Nikkei 225 moved off to

Simex. This was bad for Japanese financial industry as it lost fees but it was good

for users who were not locked into using their inferior domestic market: they were

able to use the offshore market. The idea commonly recurs with foreign

competition: when foreign airlines start operating in India, 8000 workers of Indian

Airlines will be hurt and eight million users of air travel in India will benefit.

Japan's regulators since removed many restrictions but a very important Nikkei 225

future market remains in Singapore. This is because liquidity is hard to dislodge

once it comes about, also because of he elevated transaction and brokerage fees in

Japan's highly rigid financial industry. This story is one of the important battles in a

burgeoning industry of exchanges competing for order flow on an international

scale.

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CHAPTER 5

REVIEW OF LITERATURE

The introduction of derivatives trading will separate leveraged positions from the spot markets

and make it easier for exchanges to implement rolling settlement. This should reduce volatility

in the existing markets, and make risk containment and regulation easier by making markets

safer."

Ashish Kumar Chauhan, Vice-President, National Stock Exchange (NSE).

"It had to start at one point of time or the other. Just like a plant needs soil, water and

minerals to nurture well, for derivatives you need a healthy cash market in place."

- Alok Churiwala, Member of Bombay Stock Exchange (BSE).

INTRODUCTION

Derivatives may have become popular now but their origin can be traced back to

Aristotles writings. Aristotle tells the story of Thales; a poor philosopher who

developed a financial devise, which he said, could be universally applicable. Thales

had great skill in forecasting and predicting how good the harvest would be in the

autumn. Confident about his prediction, he made agreements with area olive press

owners to deposit what little money he had with them to guarantee him exclusive

use of their olive presses when the harvest was ready. Thale successfully negotiated

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low prices because the harvest was in future and one knew whether the harvest

would be plentiful or pathetic and because the olive press owners were willing to

hedge against the possibility of poor yield and these contracts were exercised

some 2500 years ago.

Derivatives have probably been around for as long as people have been trading with

one another. Forward contracting dates back at least to the 12th century, and may

well have been around before then. 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.

The concept of forward delivery, with contracts stating what is to be delivered for a

fixed price at a specified place at a specified date, existed in ancient Greece and

Rome. Perhaps the first organized commodity exchange on which forward contracts

existed in early 1700s in Japan. Futures and options trading in commodities appear

to have originated in the 17th century. The first formal commodity exchange in the

United States for spot and forward trading was formed in 1848: the Chicago Board

Of Trade (CBOT).

Options also have a long history. The concept of options existed in ancient Greece

and Rome. Options were used by speculators in the tulip craze of 17 th century

Holland. Unfortunately there was no mechanism to guarantee the performance of

options, terms, and when the tulip craze collapsed in 1636 many of the speculators

were wiped out. In particular the put writers refuse to take delivery of the tulip bulbs

and pay high prices they had originally agreed to pay.

The explosion of growth in the derivative markets coincided with the collapse of the

Bretton Woods fixed exchange rate regime and the suspension of the dollars

convertibility into gold. Trading in financial futures began in the early 1970s after

almost a decade of accelerating inflation, which exposed market participants to the

unprecedented levels of exchange and interest rates volatility. A means of managing

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risk was required. To mitigate this risk, foreign currency derivatives were

introduced on an Over the Counter (OTC). Growth in this area has come from the

two directions namely innovations in technology and financial economics.

This eventually resulted in the creation of the financial derivatives industry.(seetable 1 & 2 in the appendix)

The process of development in the derivatives market still continues. Over 50

exchanges throughout the world now trade in some form of derivatives or other.

Recent trends

The global market for derivatives has grown substantially in the recent past. The

Foreign Exchange and Derivatives Market Activity survey conducted by Bank for

International Settlements (BIS) points to this increased activity. The total estimated

notional amount of outstanding OTC contracts increasing to $111 trillion at end-

December 2001 from $94 trillion at end-June 2000. This growth in the derivatives

segment is even more substantial when viewed in the light of declining activity in

the spot foreign exchange markets. The turnover in traditional foreign exchange

markets declined substantially between 1998 and 2001. In April 2001, average daily

turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14%

decline when volumes are measured at constant exchange rates. Whereas the globaldaily turnover during the same period in foreign exchange and interest rate

derivative contracts, including what are considered to be "traditional" foreign

exchange derivative instruments, increased by an estimated 10% to US $1.4 trillion.

(see table 3 in the appendix)

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka,

Japan around 1650. These were evidently standardized contracts, which

made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the

world, was established in 1848 where forward contracts on various

commodities were standardized around 1865. From then on, futures

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contracts have remained more or less in the same form, as we know them

today.

Derivatives have had a long presence in India. The commodity derivative

market has been functioning in India since the nineteenth century with

organized trading in cotton through the establishment of Cotton Trade

Association in 1875. Since then contracts on various other commodities have

been introduced as well.

Exchange traded financial derivatives were introduced in India in June 2000

at the two major stock exchanges, NSE and BSE. There are various contracts

currently traded on these exchanges. On June 9, 2000, the Bombay Stock

Exchange (BSE) introduced India's first derivative instrument - the BSE-

30(Sensex) index futures. It was introduced with three month trading cycle -

the near month (one), the next month (two) and the far month (three). The

National Stock Exchange (NSE) followed a few days later, by launching the

S&P CNX Nifty index futures on June 12, 2000 .

National Commodity & Derivatives Exchange Limited (NCDEX) started its

operations in December 2003, to provide a platform for commodities trading.

The initial steps to launch derivatives were taken in 1995 with the introduction ofthe Securities Laws (Amendment) Ordinance, 1995 that withdrew the prohibition on

trading in options on securities in the Indian stock market. In November 1996, a 24-

member committee was set up by the Securities Exchange Board of India (SEBI)

under the chairmanship of LC Gupta to develop an appropriate regulatory

framework for derivatives trading. The committee recommended that the regulatory

framework applicable to the trading of securities would also govern the trading of

derivatives.

The L C Gupta Committee report

SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop

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appropriate regulatory framework for the derivatives trading and to recommend

suggestive bye-laws for Regulation and Control of Trading and Settlement of

Derivatives Contracts. The Committee was also to focus on the financial derivatives

and equity derivatives. The Committee submitted its report in March 1998.

The Board of SEBI in its meeting held on May 11, 1998 accepted the

recommendations and approved the introduction of derivatives trading in India

beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-

laws" recommended by the LC Gupta Committee for Regulation and Control of

Trading and Settlement of Derivatives Contracts. SEBI circulated the contents of the

Report in June 98.

The LC Gupta Committee had conducted a wide market survey with contact of

several entities relevant to derivatives trading like brokers, mutual funds, banks/FIs,

FIIs and merchant banks. The Committee observation was that there is a widespread

recognition of the need for derivatives products including Equity, Interest Rate and

Currency derivatives products. However Stock Index Futures is the most preferred

product followed by stock index options. Options on individual stocks are the third

in the order of preference. The participants took interviews, mostly stated that their

objective in derivative trading would be hedging. But there were also a few

interested in derivatives dealing for speculation or dealing.

Goals of Regulation - Regulatory Objectives

LCGC believes that regulation should be designed to achieve specific and well-

defined goals. It is inclined towards positive regulation designed to encourage

healthy activity and behavior. The Committee outlined the goals of regulation

admirably well in Paragraph 3.1 of its report.

The important recommendations of L.C.Gupta Committee are reproduced

hereunder.

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Need for coordinated development

To quote from the report of the Committee -"The Committee's main concern is with

equity based derivatives but it has tried to examine the need for financial derivatives

in a broader perspective. Financial transactions and asset-liability positions are

exposed to three broad types of price risks, viz:

"Equities "market risk", also called "systematic risk" (which cannot be

diversified away because the stock market as a whole may go up or down

from time to time).

"Interest rate risk (as in the case of fixed-income securities, like treasury

bond holdings, whose market price could fall heavily if interest rates shot

up), and

"Exchange rate risk (where the position involves a foreign currency, as in the

case of imports, exports, foreign loans or investments).

"The above classification of price risks explains the emergence of (a) equity futures,

(b) interest rate futures and (c) currency futures, respectively. Equity futures have

been the last to emerge.

"The recent report of the RBI-appointed Committee on Capital Account

Convertibility (Tara pore Committee) has expressed the view that "time is ripe for

introduction of futures in currencies and interest rates to facilitate various users to

have access to a wide spectrum of cost-efficient hedge mechanism" (p.24). In the

same context, the Tara pore Committee has also opined that "a system of trading in

futures ... is more transparent and cost-efficient than the existing system (of forward

contracts)". There are inter-connections among the various kinds of financial

futures, mentioned above, because the various financial markets are closely inter-

linked, as the recent financial market turmoil in East and South-East Asian countries

has shown. The basic principles underlying the running of futures markets and their

regulation are the same. Having a common trading infrastructure will have

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important advantages. The Committee, therefore, feels that the attempt should be to

develop an integrated market structure. SEBI-RBI coordination mechanism

"As all the three types of financial derivatives are set to emerge in India in the near

future, it is desirable that such development be coordinated. The Committee

recommends that a formal mechanism be established for such coordination between

SEBI and RBI in respect of all financial derivatives markets. This will help to avoid

the problem of overlapping jurisdictions."

Cash and Futures Market Relationship

The Committee felt that the operations of the cash market, on which the derivatives

market will be based, needed improvement in many respects. It therefore suggested

improvements to the Cash Market.

Derivatives Exchanges

The Committee strongly favoured the introduction of financial derivatives to

facilitate hedging in a most cost-efficient way against market risk. There is a need

for equity derivatives, interest rate derivatives and currency derivatives. There

should be phased introduction of derivatives produces. To start with, index futures

to be introduced, which should be followed by options on index and later options on

stocks. The derivative trading should take place on a separate segment of the

existing stock exchanges with an independent governing council where the number

of trading members should be limited to 40 percent of the total number. Common

Governing Council and Governing Board members not allowed. The Chairman of

the governing council should not be permitted to trade (broking/dealing business) on

any of the stock exchanges during his term. Trading to be based on On-line screen

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trading with disaster recovery site. Per half hour capacity should be 4-5 times the

anticipated peak load. Percentage of broker-members in the council to be prescribed

by SEBI. Other recommendations of the Committee about the structure of

Derivative Exchanges are as under:

The settlement of derivatives to be through an independent clearing

corporation/clearing house, which should become counter party for all trades or

alternatively guarantee the settlement of all trades. The clearing corporation to have

adequate risk containment measures and to collect margins through EFT. The

derivative exchange to have both on-line trading and surveillance systems. It should

disseminate trade and price information on real time basis through two information

vending net works. It should inspect 100 percent of members every year. The

segment can start with a minimum of 50 members. The Committee recommended

separate membership for derivatives segment. Members of equity segment cannot

automatically become members of derivative segment. Provision for arbitration and

investor grievances cells to be set up in four regions. Provision of adequate

inspection capability and all members to be inspected.

Regulatory framework

Regulatory control should envisage modern systems for fool-proof and fail-proof

regulation. Regulatory framework for derivatives trading envisaged two-level

regulation i.e. exchange-level and SEBI-level, with considerable emphasis on self-

regulatory competence of derivative exchanges under the overall supervision and

guidance of SEBI. There will be complete segregation of client money at the level

of trading /clearing member and even at the level of clearing corporation. Other

recommendations are as under:

Regulatory Role of SEBI

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SEBI will approve rules, bye-laws and regulations. New derivative contracts to be

approved by SEBI. Derivative exchanges to provide full details of proposed

contract, like - economic purposes of the contract; likely contribution to the market's

development; safeguards incorporated for investor protection and fair trading.

Specifications Regarding Trading

Stock Exchanges to stipulate in advance trading days and hours. Each contract to

have pre-determined expiration date and time. Contract expiration period may not

exceed 12 months. The last trading day of the trading cycle to be stipulated in

advance.

Membership Eligibility Criteria

The trading and clearing member will have stringent eligibility conditions. The

Committee recommended for separate clearing and non-clearing members. There

should be separate registration with SEBI in addition to registration with the stock

exchange. At least two persons should have passed the certification program

approved by SEBI. A higher capital adequacy for Derivatives segment

recommended than prescribed for cash market. The clearing members should

deposit minimum Rs. 50 lakh with the clearing corporation and should have a net

worth of Rs. 3 crore. A higher deposit proposed for Option writers.

Clearing Corporation

The Clearing System to be totally restructured. There should be no trading interests

on board of the CC. The maximum exposure limit to be liked the deposit limit. To

make the clearing system effective the Committee stressed stipulation of Initial and

mark-to-market margins. Extent of Margin prescribed to co-relate to the level of

volatility of particular Scripps traded. The Committee therefore recommended

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margins based on value at risk - 99% confidence (The initial margins should be

large enough to cover the one day loss that can be encountered on the position on

99% of the days. The concept is identified as "Worst Scenario Loss"). It did not

favour the system of Cross-margining (This is a method of calculating margin after

taking into account combined positions in futures, options, cash market etc. Hence,

the total margin requirement reduces due to cross-hedges). Since margins to be

adjusted frequently based on market volatility margin payments to be remitted

through EFT (Electronic Funds Transfer). To prevent brokers who fail/default to

provide/restore adequate margin from trading further the stock exchange must have

the power/facility to disable the defaulting member from further trading.

Brokers/sub-brokers also to collect margin collection from clients. Exposure limits

to be on gross basis. Own/clients margin to be segregated. No set off permitted.

Trading to be clearly indicated as own/clients and opening/closing out. In case of

default, only own margin can be set off against members' dues and the CC should

promptly transfer client's margin in separate account. CC to close out all open

positions at its option. CC can also ask members to close out excess positions or it

may itself close out such positions. CC may however permit special margins on

members. It can withhold margin or demand additional margin. CC may prescribe

maximum long/short positions by members or exposure limit in quantity / value / %

of base capital.

Mark to Market and Settlement

There should the system of daily settlement of futures contracts. Similarly the

closing price of futures to be settled on daily basis. The final settlement price to be

as per the closing price of underlying security.

Sales Practices

Risk disclosure document with each client mandatory

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Sales personnel to pass certification exam

Specific authorization from client's board of directors/trustees

Trading Parameters

Each order - buy/sell and open/close

Unique order identification number

Regular market lot size, tick size

Gross exposure limits to be specified

Price bands for each derivative contract

Maximum permissible open position Off line order entry permitted

Brokerage

Prices on the system shall be exclusive of brokerage

Maximum brokerage rates shall be prescribed by the exchange

Brokerage to be separately indicated in the contract note

Margins from Clients

Margins to be collected from all clients/trading members

Daily margins to be further collected

Right of clearing member to close out positions of clients/TMs not paying

daily margins

Losses if any to be charged to clients/TMs and adjusted against margins

Other Recommendations

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Removal of the regulatory prohibition on the use of derivatives by mutual

funds while making the trustees responsible to restrict the use of derivatives

by mutual funds only to hedging and portfolio balancing and not for

speculation.

Creation of derivatives Cell, a derivative Advisory Committee, and

Economic Research Wing by SEBI.

Declaration of derivatives as securities under section 2(h)(iia) of the SCRA

and suitable amendment in the notification issued by the Central

Government in June 1969 under section 16 of the SCRA

Consequent to the committee's recommendations the following legal

amendments were carried out:

Legal Amendments

Securities Contract Regulation Act

Derivatives contract declared as a 'security' in Dec 1999 Notification in June

1969 under section 16 of SCRA banning forward trading revoked in March

2000.

In order to recommend a guideline for effective implementation of the

recommendations of LC Gupta Committee Report, SEBI entrusted the task

to another Committee, i.e. JR Verma Committee appointed by it.

The derivatives market in India has grown exponentially, especially at NSE. Stock

Futures are the most highly traded contracts on NSE accounting for around 55% of

the total turnover of derivatives at NSE, as on April 13, 2005.

The plan to introduce derivatives in India was initially mooted by the National Stock

Exchange (NSE) in 1995. The main purpose of this plan was to encourage greater

participation of foreign institutional investors (FIIs) in the Indian stock exchanges.

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Their involvement had been very low due to the absence of derivatives for hedging

risk. However, there was no consensus of opinion on the issue among industry

analysts and the media. The pros and cons of introducing derivatives trading were

debated intensely. The lack of transparency and inadequate infrastructure of the

Indian stock markets were cited as reasons to avoid derivatives trading. Derivatives

were also considered risky for retail investors because of their poor knowledge

about their operation. In spite of the opposition, the path for derivatives trading was

cleared with the introduction of Securities Laws (Amendment) Bill in Parliament in

1998.

The introduction of derivatives was delayed for some more time as the infrastructure

for it had to be set up. Derivatives trading required a computer-based trading

system, a depository and a clearing house facility. In addition, problems such as low

market capitalization of the Indian stock markets, the small number of institutional

players and the absence of a regulatory framework caused further delays.

Derivatives trading eventually started in June 2000.

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CHAPTER 6

PRESENT STUDY

Derivative instruments

FORWARDS

A cash market transaction in which delivery of the commodity is deferred until after

the contract has been made. Although the delivery is made in the future, the price is

determined on the initial trade date. Most forward contracts don't have standards

and aren't traded on exchanges. A farmer would use a forward contract to "lock-in"a price for his grain for the upcoming fall harvest.

FUTURES

Futures Contract means a legally binding agreement to buy or sell the underlying

security on a future date. Future contracts are the organized/standardized contracts

in terms of quantity, quality (in case of commodities), delivery time and place for

settlement on any date in future. The contract expires on a pre-specified date which

is called the expiry date of the contract. On expiry, futures can be settled by delivery

of the underlying asset or cash. Cash settlement enables the settlement of obligation

Akhil Derivatives

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