Derivative Market Analysis-

7/30/2019 Derivative Market Analysis-

1/96

DERIVATIVE MARKET MARKET

ANALYSIS


2/96

ABSTRACT

Market deregulation, growth in global trade, and continuing technological developments have

revolutionized the financial marketplace during the past two decades. A by-product of this

revolution is increased market volatility, which has led to a corresponding increase in demand

for risk management products. This demand is reflected in the growth of financial derivatives

from the standardized futures and options products of the 1970s to the wide spectrum of over-

the-counter (OTC) products offered and sold in the 1990s.

Many products and instruments are often described as derivatives by the financial press and

market participants. In this guidance, financial derivatives are broadly defined as instruments

that primarily derive their value from the performance of underlying interest or foreign

exchange rates, equity, or commodity prices.

Financial derivatives come in many shapes and forms, including futures, forwards, swaps,

options, structured debt obligations and deposits, and various combinations thereof. Some are

traded on organized exchanges, whereas others are privately negotiated transactions. Derivatives

have become an integral part of the financial markets because they can serve several economic

functions. Derivatives can be used to reduce business risks, expand product offerings tocustomers, trade for profit, manage capital and funding costs, and alter the risk-reward profile of

a particular item or an entire balance sheet.

Although derivatives are legitimate and valuable tools for banks, like all financial instruments

they contain risks that must be managed. Managing these risks should not be considered unique

or singular. Rather, doing so should be integrated into the bank's overall risk management

structure. Risks associated with derivatives are not new or exotic. They are basically the same as

those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk). Fundamentally,

the risk of derivatives (as of all financial instruments) is a function of the timing and variability

of cash flows.

Risk is the potential that events, expected or unanticipated, may have an adverse impact

Accurate measurement of derivative-related risks is necessary for proper monitoring and control.


3/96

All significant risks should be measured and integrated As measurement and performance

systems have continued to develop, techniques to evaluate business risks and corresponding

earnings performance have evolved. The ability to measure and assess the risk-return

relationship of various businesses has resulted in further steps to measure the risk-adjusted return

on capital. This analysis allows senior management to judge whether the financial performance

of individual business units justifies the risks undertaken.Re-evaluate risk measurement models

helps in providing a reasonable estimate of risk. Management should ensure that the models are

used for their intended purpose and that material limitations of the models are well understood at

appropriate levels within the organization.

Although VAR is the most common method of measuring price risk, it is important that

management and the board understand the systems limitations. VAR is appealing to users

because it reduces multiple price risks into a single value-at-risk number or a small number of

key statistics. However, VAR results are highly dependent upon assumptions, algorithms, and

methods. VAR does not provide assurance that the potential loss will fall within a certain

confidence interval (e.g., 99 percent); rather, it estimates the potential loss based on a specific set

of assumptions.

Value-at-Risk Limits: These sensitivity limits are designed to restrict potential loss to an

amount equal to a board-approved percentage of projected earnings or capital. All dealers exceptTier II dealers with largely matched positions should use VAR limits VAR limits are useful for

controlling price risk. However, as discussed in Evaluating Price Risk Measurement, one

limitation of VAR is that the results produced are highly dependent upon the algorithms,

assumptions, and methodology used by the model. Changes in any of these elements can produce

widely different VAR results. In addition, VAR may be less useful for predicting the effect of

large market moves. To address these weaknesses, dealers should complement VAR limits with

other types of limits such as notional and loss control limits.


4/96

Table of contents

SLNO CONTENT PAGE NO

CHAPTER I INTRODUCTION

CHAPTER II LITERATURE REVIEW

CHAPTER III INDUSTRY PROFILE, COMPANY PROFILE

CHAPTER IV THEORETICAL FRAME WORK

CHAPTER V DATA ANALYSIS & INTERPRETATION

CHAPTER VI FINDINGS &SUGGESTIONS

CHAPTER VII SUMMARY & CONCLUSION

CHAPTER VIII BIBLOGRAPHY

APPENDICES


5/96

CHAPTER IINTRODUCTION

Need and significance for the study

Objectives of the study

Scope of the study

Research Methodology

Limitations of the study


6/96

NEED OF THE STUDY:

To have a general study on derivatives, an insight on risk return analysis and to identify and

reduce risk by using hedging strategies and speculation.

OBJECTIVES:

1. To identify and prioritize potential risk events

2. Help develop risk management strategies and risk management plans

3. Use established risk management methods, tools and techniques to assist in the

Analysis and reporting of identified risk events

4. Find ways to identify and evaluate risks

5. Develop strategies and plans for lasting risk management strategies

SCOPE OF THE STUDY:

Introduction of derivatives in the Indian capital market is the beginning of a new era, which is

truly exciting. Derivatives, worldwide are recognized risk management products. These products

have a long history in India, in the unorganized sector, especially in currency and commodity

markets. The availability of these products on organized exchanges has provided the market

participants with broad based risk management tools.

This study mainly covers the area of hedging and speculation. The

main aim of the study is to prove how risks in investing in equity shares can be reduced and how

to make maximum return to the other investment


7/96

LIMITATIONS OF THE STUDY:

1. While applying the strategies, transaction cost and impact cost are not taken into

Consider

ation. So, it will reflect in the profit calculation on each month of the study

2. Data were collected only on the basis of NSE trading

3. Hedging strategy is applied on historical data. So the direction of each trend in the stock

market is known before hand for the period selected. As a result, some bias could have been

done for the application of hedging strategy.

4.Data mining.

5. In India especially derivatives are became a tool for speculation rather than a

risk management tool.

RESEARCH METHODOLAGYThe research design specifies the methods and procedures for conducting a particular study. The

type of research design applied here are

TITLE OF STUDY

The topic, which is selected for the study, is DERIVATIVE MARKET in the firm so the

problem statement for this study will be FUTURES AND OPTIONS

Exploratory research

An exploratory research focuses on the discovery of ideas and is generally based on secondary

data.

DATA COLLECTION METHOD


8/96

The sources of data collection method which is being used for the studies:-

Primary source of data

On line trading from NSE

Secondary Source Of Data:

For having the detailed study about this topic, it is necessary to have some of the secondary

information, which is collected from the

Following:-

Books.

Magazines & Journals.

Websites

Newspapers, etc


9/96

CHAPTER IILITERATURE REVIEW


10/96

Financial derivatives are so effective in reducing risk because they enable financial Institutionsto hedge that is, engage in a financial transaction that reduces or eliminates risk. When a

financial institution has bought an asset, it is said to have taken a long position, and this exposes

the institution to risk if the returns on the asset are uncertain. Conversely, if it has sold an asset

that it has agreed to deliver to another party at a Future date, it is said to have taken a short

position, and this can also expose the Institution to risk. Financial derivatives can be used to

reduce risk by invoking the following basic principle of hedging: Hedging risk involves

engaging in a financial transaction that offsets a long position by taking an additional short

position, or offsets a short position by taking an additional long position. In other words, if a

financial institution has bought a security and has therefore taken a long position, it conducts a

hedge by contracting to sell that security (take a short position) at some future date.

Alternatively, if it has taken a short position by selling a security that it needs to deliver at a

future date, then it conducts a hedge by contracting to buy that security (take a long position) at a

future date. We look at how this principle can be applied using forward and futures

PARTICIPANTS OF DERIVATIVE

There are three broad categories of participants hedgers, speculators and

arbitrageurs. Hedgers face risk associated with the price of an asset. They use futures or options

markets to reduce or eliminate this risk. Speculates wish to bet on future movement in the price

of an asset. Features and options contracts cangue them an extra leverage; they can increase both

the potential gains and losses in a speculative venture. Arbitrageurs are in business

To take advantage of a discrepancy between prices in two different markets. Derivative products

initially emerged, as hedging devices against fluctuation in Commodity prices and commodity-

linked derivatives remained the sole form of such products for almost three hundred years. In

recent years, the market for financial derivative has grown tremendously in terms of variety of

instruments available. The emergence of the market for derivative products, most notable

forwards, futures and options, can be traced back to the willingness of risk-averse economic


11/96

agents to guard themselves against uncertainties arising out of fluctuations in asset prices.

Though the use of derivative products, it is possible to partially or fully transfer price risks by

locking in asset prices. As instrument of risk management, these generally do not influence the

fluctuations in the underlying asset prices

DEFINITIONS

According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value

depends on (or derives from) the values of other, more basic underlying variables.

According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even

more simply an agreement between two people) which has a value determined by the price of

something else 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:-

Derivative includes: -

A. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk

Instrument or contract for differences or any other form of security;

B. contract which derives its value from the prices, or index of prices, of underlying Securities

Derivatives were developed primarily to manage, offset or hedge against risk but some were

developed primarily to provide the potential for high returns

.


12/96

CHAPTER III

INDUSTRY PROFILE

COMPANY PROFILE


13/96

INDUSTRY PROFILE

In general, the financial market divided into two parts, Money market and capital market.

Securities market is an important, organized capital market where transaction of capital is

facilitated by means of direct financing using securities as a commodity. Securities market can

be divided into a primary market and secondary market.

PRIMARY MARKET

The primary market is an intermittent and discrete market where the initially listed shares are

traded first time, changing hands from the listed company to the investors. It refers to the process

through which the companies, the issuers of stocks, acquire capital by offering their stocks to

investors who supply the capital. In other words primary market is that part of the capital

markets that deals with the issuance of new securities. Companies, governments or public sector

markets that deals with the issuance of new securities. Companies, governments or public sector

institutions can obtain funding through the sale of a new stock or bond issue. This is typically

done through a syndicate of securities dealers. The process of selling new issues to investors is

called underwriting. In the case of a new stock issue, this sale is called an initial public

offering(IPO). Dealers earn a commission that is built into the price of the security offering,

though it can be found in the prospectus.

SECONDARY MARKET

The secondary market is an on-going market, which is equipped and organized with a place,

facilities and other resources required for trading securities after their initial offering. It refers to

a specific place where securities transaction among many and unspecified persons is carried out

through intermediation of the securities firms, i.e., a licensed broker, and the exchanges, a


14/96

specialized trading organization, in accordance with the rules and regulations established by the

exchanges.

A bit about history of stock exchange they say it was under a tree that it all started

in1875.Bombay Stock Exchange (BSE) was the major exchange in India Till1994.National tock

Exchange (NSE) started operations in 1994.

NSE was floated by major banks and financial institutions. It came as a result of Harshad Mehta

scam of 1992. Contrary to popular belief the scam was more of a banking scam than a stock

market scam. The old methods of trading in BSE were people assembling on what as called a

ring in the BSE building. They had a unique sign language to communicate apart from all the

shouting. Investors weren't allowed access and the system was opaque and misused by brokers

The shares were in physical form and prone to duplication and fraud.

NSE was the first to introduce electronic screen based trading. BSE was forced to follow suit

The present day trading platform is transparent and gives investors prices on a real time basis.

With the introduction of depository and mandatory dematerialization of shares chances of fraud

reduced further. The trading screen gives you top 5 buy and sell quotes on every scrip.

A typical trading day starts at 10 ending at 3.30. Monday to Friday. BSE has 30 stocks which

make up the Sensex .NSE has 50 stocks in its index called Nifty. FII s Banks, financial

institutions mutual funds are biggest players in the market. Then there are the retail investors and

speculators. The last ones are the ones who follow the market morning to evening Market can be

very addictive like blogging though stakes are higher in the former.

ORIGIN OF INDIAN STOCK MARKET

The origin of the stock market in India goes back to the end of the eighteenth century when long

term negotiable securities were first issued. However, for all practical purposes, the real

beginning occurred in the middle of the nineteenth century after the enactment of the companies

Act in 1850, which introduced the features of limited liability and generated investor interest in

corporate securities.

An important early event in the development of the stock market in India was the formation of

the native share and stock brokers 'Association at Bombay in 1875, the precursor of the present


15/96

day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in

Ahmedabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of

ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during

depressing times subsequently.

Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life. Without a

stock exchange, the saving of the community- the sinews of economic progress and productive

efficiency- would remain underutilized. The task of mobilization and allocation of savings could

be attempted in the old days by a much less specialized institution than the stock exchanges. But

as business and industry expanded and the economy assumed more complex nature, the need for

permanent finance' arose. Entrepreneurs needed money for long term whereas investors

demanded liquidity the facility to convert their investment into cash at the stock exchange any

given time. The answer was a ready market for investments and this was how came into being.

Stock exchange means anybody of individuals, whether incorporated or not, constituted for the

purpose of regulating or controlling the business of buying, selling or dealing in securities. These

securities include:

(i) Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like nature in

or of any incorporated company or other body corporate;

(ii) Government securities; and

(iii) Rights or interest in securities.

The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are

the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges.

However, the BSE and NSE have established themselves as the two leading exchanges and

account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equal

in size in terms of daily traded volume. The average daily turnover at the exchanges has

increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further to Rs 2,273

crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a total market

capitalization of around Rs 9, 21,500 crore.

The BSE has over 6000 stocks listed and has a market capitalization of around Rs 9, 68,000

crore. Most key stocks are traded on both the exchanges and hence the investor could buy them


16/96

on either exchange. Both exchanges have a different settlement cycle, which allows investors to

shift their positions on the bourses. The primary index of BSE is BSE Sensex comprising 30

stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex

is the older and more widely followed index.

Both these indices are calculated on the basis of market capitalization and contain the heavily

traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the

exchanges have switched over from the open outcry trading system to a fully automated

computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT(National

Exchange Automated Trading) System.

It facilitates more efficient processing, automatic order matching, faster execution of trades and

transparency; the scrip's traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z'

groups. The 'A' group shares represent those, which are in the carry forward system (Badla). The

'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrip's are

the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' &'B2' groups

and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories,

Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and

primary market is the Securities and Exchange Board of India (SEBI) Ltd.

Brief History of Stock Exchanges

Do you know that the world's foremost marketplace New York Stock Exchange(NYSE), started

its trading under a tree (now known as 68 Wall Street) over 200 years ago? Similarly, India's

premier stock exchange Bombay Stock Exchange (BSE) can also trace back its origin to as far as

125 years when it started as a voluntary non-profit making association.

News on the stock market appears in different media every day. You hear about it any time it

reaches a new high or a new low, and you also hear about it daily in statements like'The BSESensitive Index rose 5% today'. Obviously, stocks and stock markets are important. Stocks of

public limited companies are bought and sold at a stock exchange. But what really are stock

exchanges? Known also as the stock market or bourse, a stock exchange is an organized

marketplace for securities (like stocks, bonds, options) featured by the centralization of supply

and demand for the transaction of orders by member brokers, for institutional and individual


17/96

investors. The exchange makes buying and selling easy. For example, you don't have to actually

go to a stock exchange, say, BSE - you can contact a broker, who does business with the BSE,

and he or she will buy or sell your stock on your behalf.

Market Basics

Electronic trading

Electronic trading eliminates the need for physical trading floors. Brokers can trade from their

offices, using fully automated screen-based processes. Their workstations are connected to a

Stock Exchange's central computer via satellite using Very Small Aperture Terminus (VSATs).

The orders placed by brokers reach the Exchange's central computer and are matched

electronically.

Exchanges in India

The Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE) are the country's

two leading Exchanges. There are 20 other regional Exchanges, connected via the Inter-

Connected Stock Exchange (ICSE). The BSE and NSE allow nationwide trading via their VSAT

systems.

Index

An Index is a comprehensive measure of market trends, intended for investors who are

concerned with general stock market price movements. An Index comprises stocks that have

large liquidity and market capitalization. Each stock is given a weight age in the Index equivalent

to its market capitalization. At the NSE, the capitalization of NIFTY (fifty selected stocks) is

taken as a base capitalization, with the value set at 1000. Similarly, BSE Sensitive Index or

Sensex comprises 30 selected stocks. The Index value compares the day's market capitalization

vis--vis base capitalization and indicates how prices in general have moved over a period of

time.

Execute an order


18/96

Select a broker of your choice and enter into a broker-client agreement and fill in the client

registration form. Place your order with your broker preferably in writing. Get a trade

confirmation slip on the day the trade is executed and ask for the contract note at the end of the

trade date.

Need a broker

As per SEBI (Securities and Exchange Board of India.) regulations, only registered members can

operate in the stock market. One can trade by executing a deal only through a registered broker

of a recognized Stock Exchange or through a SEBI-registered sub-broker.

Contract note

A contract note describes the rate, date, time at which the trade was transacted and the brokerage

rate. A contract note issued in the prescribed format establishes a legally enforceable relationship

between the client and the member in respect of trades stated in the contract note. These are

made in duplicate and the member and the client both keep a copy each. A client should receive

the contract note within 24 hours of the executed trade. Corporate Benefits/Action.

Split

A Split is book entry wherein the face value of the share is altered to create a greater number of

shares outstanding without calling for fresh capital or altering the share capital account. For

example, if a company announces a two-way split, it means that a share of the face value of Rs

10 is split into two shares of face value of Rs 5 each and a person holding one share now holds

two shares.

Buy Back

As the name suggests, it is a process by which a company can buy back its shares from

shareholders. A company may buy back its shares in various ways from existing shareholders on

a proportionate basis; through a tender offer from open market; through a book-building process;

from the Stock Exchange; or from odd lot holders. A company cannot buy back through


19/96

negotiated deals on or off the Stock Exchange, through spot transactions or through any private

arrangement.

Settlement cycle

The accounting period for the securities traded on the Exchange. On the NSE, the cycle begins

on Wednesday and ends on the following Tuesday, and on the BSE the cycle commences on

Monday and ends on Friday. At the end of this period, the obligations of each broker are

calculated and the brokers settle their respective obligations as per the rules, bye-laws and

regulations of the Clearing Corporation. If a transaction is entered on the first day of the

settlement, the same will be settled on the eighth working day excluding the day of transaction.

However, if the same is done on the last day of the settlement, it will be settled on the fourth

working day excluding the day of transaction

Rolling settlement

The rolling settlement ensures that each day's trade is settled by keeping a fixed gap of a

specified number of working days between a trade and its settlement. At present, this gap is five

working days after the trading day. The waiting period is uniform for all trades. In a Rolling

Settlement, all trades outstanding at end of the day have to be settled, which means that the buyer

has to make payments for securities purchased and seller has to deliver the securities sold. In

India, we have adopted the T+5 settlement cycle, which means that a transaction entered into on

Day 1 has to be settled on the Day 1 + 5 working days, when funds pay in or securities pay out

takes place.

The Advantages of Rolling Settlements

As mentioned earlier, this is the system practiced in developed countries. Pay outs are quicker

than in weekly settlements, and investors will benefit from increased liquidity. The other benefit

of the modified system is that it keeps cash and forward markets separate. In the current system,

the trader has five days to square off his transaction which leads to a high level of speculation as

people even without funds tend to "play" the market. During volatile markets, especially in a

bearish market, this often leads to a payment problem which has dogged the Indian stock

exchanges for a long time. It provides for a higher degree of safety, and once mechanisms such


20/96

as futures and stock-lending become popular, it would result in quality speculation and genuine

investor interest.

When does one deliver the shares and pay the money to broker

As a seller, in order to ensure smooth settlement you should deliver the shares to your broker

immediately after getting the contract note for sale but in any case before the pay-in day.

Similarly, as a buyer, one should pay immediately on the receipt of the contract note for purchase

but in any case before the pay-in day.

Short selling

Short selling is a legitimate trading strategy. It is a sale of a security that the seller does not own,

or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers

take the risk that they will be able to buy the stock at a more favorable price than the price at

which they "sold short."

The selling of a security that the seller does not own, or any sale that is completed by the

delivery of a security borrowed by the seller, Short sellers assume that they will be able to buy

the stock at a lower amount than the price at which they sold short.

Auction

An auction is conducted for those securities that members fail to deliver/short deliver during pay

in. Three factors primarily give rise to an auction: short deliveries, un-rectified bad deliveries,

and un-rectified company objections

Separate market for auctions

The buy/sell auction for a capital market security is managed through the auction market. As

opposed to the normal market where trade matching is an on-going process, the trade matching

process for auction starts after the auction period is over.

If the shares are not bought in the auction

If the shares are not bought at the auction i.e. if the shares are not offered for sale, the Exchange

squares up the transaction as per SEBI guidelines. The transaction is squared up at the highest


21/96

price from the relevant trading period till the auction day or at 20 per cent above the last

available Closing price whichever is higher. The pay-in and pay-out of funds for auction square

up is held along with the pay-out for the relevant auction.

Bad Delivery

SEBI has formulated uniform guidelines for good and bad delivery of documents. Bad delivery

may pertain to a transfer deed being torn, mutilated, overwritten, defaced, or if there are spelling

mistakes in the name of the company or the transfer. Bad delivery exists only when shares are

transferred physically. In "Demat" bad delivery does not exist.

STOCK&EXCHANGE BOARD OF INDIA

REGULATION OF BUSINESS IN THE STOCK EXCHANGES

Under the SEBI Act, 1992, the SEBI has been empowered to conduct inspection of stock

exchanges. The SEBI has been inspecting the stock exchanges once every year since 1995-96.

During these inspections, a review of the market operations, organizational structure and

administrative control of the exchange is made to ascertain whether:

The exchange provides a fair, equitable and growing market to investors.

The exchange's organization, systems and practices are in accordance with the

Securities Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under.

The exchange has implemented the directions, guidelines and instructions issued by the

SEBI from time to time.

The exchange has complied with the conditions, if any, imposed on it at the time of renewal/

grant of its recognition under section 4 of the SC(R) Act, 1956.

During the year 1997-98, inspection of stock exchanges was carried out with a special focus

on the measures taken by the stock exchanges for investor's protection. Stock exchanges were,


22/96

through inspection reports, advised to effectively follow-up and redress the investors' complaints

against members/listed companies. The stock exchanges were also advised to expedite the

disposal of arbitration cases within four months from the date of filing.

During the earlier years' inspections, common deficiencies observed in the functioning of the

exchanges were delays in post trading settlement, frequent clubbing of settlements, delay in

conducting auctions, inadequate monitoring of payment of margins by brokers, non-adherence to

Capital Adequacy Norms etc. It was observed during the inspections conducted in 1997-98 that

there has been considerable improvement in most of the areas, especially in trading, settlement,

collection of margins etc.

Dematerialization

Dematerialization in short called as 'demat' is the process by which an investor can get physical

certificates converted into electronic form maintained in an account with the Depository

Participant. The investors can dematerialize only those share certificates that are already

registered in their name and belong to the list of securities admitted for dematerialization at the

depositories.

Depository: The organization responsible to maintain investor's securities in the electronic form

is called the depository. In other words, a depository can therefore be conceived of as a "Bank

for securities. In India there are two such organizations viz. NSDL and CDSL. The depository

concept is similar to the Banking system with the exception that banks handle funds whereas a

depository handles securities of the investors. An investor wishing to utilize the services offered

by a depository has to open an account with the depository through Depository Participant.

Depository Participant: The market intermediary through whom the depository services can be

availed by the investors is called a Depository Participant (DP). As per SEBI regulations, DP

could be organizations involved in the business of providing financial services like banks,

brokers, custodians and financial institutions. This system of using the existing distribution

channel (mainly constituting DPs) helps the depository to reach a wide cross section of investors

spread across a large geographical area at a minimum cost. The admission of the DPs involves a

detailed evaluation by the depository of their capability to meet with the strict service standards

and a further evaluation and approval from SEBI. Realizing the potential, all the custodians in


23/96

India and a number of banks, financial institutions and major brokers have already joined as DPs

to provide services in a number of cities.

Advantages of a depository services:

Trading in demat segment completely eliminates the risk of bad deliveries. In case of transfer of

electronic shares, you save 0.5% in stamp duty. Avoids the cost of courier/notarization/ the need

for further follow-up with your broker for shares returned for company objection No loss of

certificates in transit and saves substantial expenses involved in obtaining duplicate certificates,

when the original share certificates become mutilated or misplaced. Lower interest charges for

loans taken against demat shares as compared to the interest for loan against physical shares. RBI

has increased the limit of loans availed against dematerialized

Securities as collateral to Rs 20 lakh per borrower as against Rs 10 lakh per borrower in case of

Loans against physical securities. RBI has also reduced the minimum margin to 25% for loans

against dematerialized securities, as against 50% for loans against physical securities. Fill up the

account opening form, which is available with the DP. Sign the DP-client agreement, which

defines the rights and duties of the DP and the person wishing to open the account. Receive your

Client account number (client ID)

This client id along with your DP id gives you a unique identification in the depository system.

Fill up a dematerialization request form, which is available with your DP, Submit your share

certificates along with the form; write "surrendered for demat" on the face of the certificate

before submitting it for demat) Receive credit for the dematerialized shares into your account

Within 15 days

Derivatives

The term derivative instrument is generally accepted to mean a financial instrument with a

payoff structure determined by the value of an underlying security, commodity, interest rate, or

index. According to some notable surveys, over 80% of private sector corporations consider

derivatives to be important in implementing their financial policies. Derivatives have also gained

wide acceptance among national and local governments, government sponsored entities, such


24/96

as the Student Loan Marketing Association and the Federal Home Loan Mortgage Corporation,

and supranational, such as the World Bank.

Derivatives are used to lower funding costs by borrowers, to efficiently alter the

proportions of fixed to floating rate debt, to enhance the yield on assets, to quickly modify the

assets payoff structure to correspond to the firm's market view, to avoid taxes and skirt

regulations, and perhaps most importantly, to transfer market risk (hedge)- where the term

market risk is used to connote the possibility of losses sustained due to an unforeseen price or

volatility change. A firm may execute a derivative transaction to alter its market risk profile by

transferring to the trade's counter party a particular type of risk. The price that the firm must pay

for this risk transfer is the acceptance of another type of risk and/or a cash payment to the

counter party. The term "derivative" indicates that it has no independent value, i.e. its value is

entirely "derived" from the value of the cash asset. A derivative contract or product, or simply

derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset brought /

sold in the cash market on normal delivery terms. A general definition of "derivative" may be

suggested here as follows: "Derivative" means forward, future or option contract of

predetermined fixed duration, linked for the purpose of contract fulfillment to the value of

specified real or financial asset or to index of securities. Derivatives offer organizations the

opportunity to break financial risks into smaller components and then to buy and sell those

components to best meet specific risk management objectives.

As both forward contracts and futures contracts are used for hedging, it is important to

understand the distinction between the two and their relative merits. Forward contracts are

private bilateral contracts and have well established commercial usage. They are exposed to

default risk by counter-party. Each forward contract is unique in term of contract size, expiration

date and the asset type/ quality. The contract price is not transparent, as it is not publicly

disclosed. Since the forward contract is not typically tradable, it has to be settled by delivery of

the asset on the expiration date. In contrast, futures contracts are standardized tradable contracts.

They are standardized in terms of size, expiration date and all other features. They are traded on

specially designed exchanges in a highly sophisticated environment of stringent financial

safeguards. They are liquid and transparent. Their market prices and trading volumes are


25/96

regularly reported. The futures trading system has effective safeguards against defaults in the

form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark to

market) to the accounts of trading members based on daily price change. Futures are far more

cost-efficient than forward contracts for hedging.

EVOLUTION OF DERIVATIVE

FORWARD TRADING

It is not clearly established when and where the first forward market came into existence. There

are reports that forward trade exited in India as for back as 2000 BC and in Roman times

forward training is believed to have been existence in the 12 th century in Japan.

The first organized forward market came into existence in late 19th and early 20th century in

Kolkata (jute & jute goods)and in Mumbai (cotton)

FUTURES TRADING

The Dojima rice market can be consider as the first future market in the sense of an organized

exchange. The first futures in the western hemisphere were developed in United States in

Chicago. First they were started as spot markets and gradually evolved into futures trading.

First stage was starting of agreements to buy grain in future a

predetermined price with the intention of actual delivery. Gradually these contracts become

transferable and during. American civil war, it become commonplace to sell and resell

agreements instead of taking delivery of physical produce. Traders found that the agreements

were easier to but and sell. This is how modern futures contract came into being.

OPTION TRADING


26/96

Options trading are of more recent origin. It is estimated that they existing in Greece and Rome

as early as 400 BC. Option trading in agriculture products and shares came in us from the

1860s.chicago started the first option market board of trade (CBOT)in 1973.standard maturities ,

standard strike price, standard delivery arrangement were evolved. The risk of default laws

removed by introducing a clearing house and margin system. The introduction of trade option

opened the way for the evaluations of more complex derivative.

SWAP TRADING

The first swap transaction took place between World Bank and IBM (international business

machine) they were currency swaps. Interest rates swap also commenced 1981.


27/96

COMPANY PROFILE


28/96

Comoft securities company profile

Management Profile

Our Board includes a combination of members who not only bring us signification business and

industry experiences but also their expertise and acumen creates such "Think Tank" to focusand succeed ourselves. The Board comprises of a wide cross-section of industry veterans.

Their multi-faceted expertise is evident in the positive direction and productive functioning of the

Company.

Management Team comprise of Professional from different fields with financial expertise and

abundant experience. The management becomes further competent & strengthen with

incumbent of qualified key personnel with hands-on experience & designated departments

supported by competent team members.

Management Team:

Mr. Anil Agrawal, Chairman is a qualified chartered accountant and has equipped with more

than 20 years of experience in the field of finance, Capital markets and related activities and

besides this he has also promoted a listed company namely Comfort Intech Ltd. and he is the

man behind the success of the company. He leads our Companys overall planning & general

business, generating strategies, identifying opportunities and his high expertise in business

advisory and Investments-Capital Markets, Mutual Funds and taxation is precious for the

company in the long run.

Mr. Jugal Thacker, Director is a qualified chartered accountant and veteran of finance and

investment Field. He is President of the Merchant Banking Division of the company and he has

served to Merchant Banking Firms, Multi national consultancy firms. He has vast experience indebt syndication, Issue Managements, Buy-back, delisting, open offers and many more endless

activities.

Mrs. Annu Agrawal, Designated Director, is equipped with various courses and diplomas of

capital market and has 8 years experience in the stock market across research, dealing and

execution and besides this she has also operated as sub-broker and members of regional stock

exchanges and her experience is proven remarkable in acquiring the memberships of BSE,

NSE etc.

Mr Bharat Shiroya ,Directorthe young and energetic face of the Company, he is a graduate &

MBA . However, Shri Shiroya has more than 12 years of invaluable experience in Securities and

Financial Services. He is also qualified for Derivatives trading in stock exchange and possesses

a diploma in same. He is responsible for Company's dealings in shares and investment

portfolio. He will be actively looking into the Consumer Finance division.

Mr. Amit Khemka, Designated Director, a Young Graduate ,and active in day to day

operations of company. He also leads our Company's derivatives business, generating trading


29/96

strategies, arbitrage business. He also have strong qualities of managing good client

relationship and identifying market opportunities.

Mrs Chandrakala Purohit, DirectorMasters in Finance, she also holds an advance diploma in

finance from ICFAI. She has strong analytical proficiency in areas of Financial research,

Financial modeling and Trend forecasting. Earlier, She had experience in working in firms like

Walt Disney, Transparent value etc.

Mr Shiv Ratan Agarwal, DirectorMr Agrawal is a qualified chartered account by profession ,

he brings his vast experience of more than 24 years to the company in fields of accounting and

finance like auditing, taxation and capital markets .He is also advisor for various primary and

right issues of various companies.

Our Core Values

Integrity:

A company honoring commitment with highest ethical and business practices.

Excellence:

Constantly strive to achieve the highest possible standards in our work and in the quality of the

services, we provide.

Unity:

Work cohesively with our colleagues across the Group and with our customers and partnersaround the world, building strong relationships based on understanding and mutual cooperation.

Introduction of Comfort securities Pvt. Limited

The Comfort Group ventured in the financial services arena in 1994. It has grown deep and

wide during more than 14 years. It has made available all essential platforms in BSE, NSE,

MCX, Merchant Banking and Non Banking Finance Activities covering all primary market,

investment solution, debt services, capital markets, Equity derivatives and currency derivatives

segments to our client community.

At Comfort, what our clients find best and advantageous is our warehouse of knowledge,

personalized services, Cost Effectiveness and many more, which of course adds to their are our

in making a move towards us.


30/96

Comfort Securities Pvt. Ltd. was founded on 19th July 2002, by dynamic group of Professionals

namely Mr. Anil Agrawal and Mrs. Annu Agrawal. In the expansion era company achieves the

business development objectives by the channeling the resources of company. In the recent

past company has grown potentially and it has been able to usher an era of a modern regime of

capital market. Company has successfully acquired the membership of:

* Bombay Stock Exchange Ltd. [CM & Derivatives segments]

* National Stock Exchange of India Ltd.[CM & Derivativessegments]

* Depository Participant _ CDSL

* BSE, NSE & MCX-SX -Currency Derivatives segment

* Multicommodity Exchange of India Ltd.

* SEBI Authorized Category I Merchant Bankers

Products & Services

1. Capital Market Services

Our experienced trading consultants and advanced trading tools will provide the personalizedsupport to achieve your long-term goals via the stock markets. With our client centric approach,

state of art infrastructure we were able to add around 1000 clients in our basket in short span of

2 years of our registration. We serve multitude of our retail investing customers through our own

office at Mumbai with numerous & efficient dealers eager to respond on your wise call. We feel

proud with our rapidly increasing client base in a little time horizon, and we serve to our valuable

clients in the following segments.

Capital Market Segment

Future & Option Market Segment

Investment Advisory Services

2. Commodity Market Services

Futures Trading in Commodities has opened up spectacular growth opportunities and


31/96

advantages not only for large cross section of market participants like: producers, processors,

traders, corporate, trading centers, importers, exporters, co-operatives, industry associations

but for investors community too. It offers unparalleled efficiencies, unlimited growth and

infinite rewarding opportunities to all market participants and investors.

This market affords us a very dynamic field for diversified investment & trading opportunities in

addition to equity markets. The immense benefits of futures trading are opened, for all market

participants and investors alike, to be realized.

This Commodity segment has proved to be our one more pillar of strength of the COMFORT

GROUP, of course due to positive and enthusiastic response from our Business Associates and

our retail clientele spread over many trading centers in multi-states.

The performance of the company in this segment has been very satisfying one due to whole-

hearted involvement and encouraging response from our Business Associates and retail

investor-clients spread over many trading centers in multi-states in the country.

The COMFORT GROUP is in the high gear still to cover many more cities & trading centers in

wider variety of commodities reaching out to more and more retail end-use investors to realize

the countrys dream of making our India an International Hub of Trading in many agricultural

commodities and precious metals.

3. Depository Services

Depository: A depository holds shares and securities in electronic form in your name, just as a

bank holds your deposits in your account. Besides holding securities, a depository also provides

services related to your transactions in securities.

Central Depository Services (India) Ltd., (CDSL) : It has received approval from SEBI in

February 1999. It is promoted by The Stock Exchange, Mumbai (BSE) jointly with leading banks

such as State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered

Bank, Union Bank of India and Centurion Bank. CDSL commenced its operations from July

1999. It has depository participants (like agents called branches) through out India.

We offer following services as D.P..

Opening of Demat account

Dematerialization

Rematerialization


32/96

Maintaining record of holdings in electronic form

Settlement of trades by delivering/ receiving underlying securities

Settlement of off-market trades

Providing electronic credit in respect of securities allotted under IPO

Receiving non-cash corporate benefits, such as, allotment of bonus and rights shares,

stock split, etc.

Pledging/Un-pledging of securities

Providing periodical statement of transactions

Registering nomination.

1. Merchant Banking Services

CSPL is a Category I Merchant Bankerregistered with Securities & Exchange Board of India.

We work with strong management teams, finical sponsors and corporate partners to help

companies to achieve financial & strategic goals. We work on client centric approach and

provide flexible solutions to fit the precise requirement of business.

At CSPL-Merchant Banking Division, we offer a wide range following of services:

o IPO / FPO / Rights Issueo Preferential Allotment

o ESOP / ESOS

o Takeovers and Acquisitions

o Mergers & Amalgamations

o Buyback of Shares

o Project Approval / Identification

o Preparing Feasibility Report

o Placement of Debt / Equity Instruments

o Devising Marketing Strategies

o Marketing support for New Issues


33/96

o Delisting

o Debt Syndication Services

o Project Financing Services

The comprehensive range of services from conception to completion provided under one roof

reinforces our commitment on quality assurances through total involvement. The spacious office

of the Company at Mumbai fully equipped with state of art facilities including in house Research

and computerized database information system has enabled us to broad base and enlarge our

area of operations

The scope of services outlined below emanates form a broad understanding of bunch of

Services offered by Merchant Banking Department of CSPL:-

preparation of offer documents / prospectus in compliance with the regulatory

requirements of SEBI, Stock Exchanges, Register of Companies (ROC) and authorities

under varying corporate laws and laws for issue of securities

Market various arrangements with Qualified Institutional Buyers (QIBs), High Net Worth

Individuals (HNIs), Corporate and Retail investors in Indian Markets and placement in

foreign markets

To act as the Book running Lead Manager / Lead Manager / Co-manager to the

proposed public issues by Corporates

To Act as manager to Buy back offer of Shares

To Act as manager to the take over offer and other miscellaneous compliances

Act as manager for delisting of securities from stock exchange (s) by Corporates

Assist Corporates in formulating ESOP/ESOS

Assist and advising corporates in compliances under the Listing Agreement

Assist in IPO Grading

Assist the Client in all post issue formalities including Listing of Securities with the

Exchanges.


34/96

Assists in co-ordination with the intermediates viz Registrars, Bankers, Brokers and

Advertisers etc

Assists in Finalization of Advertising Campaign in association with the media &

Advertising Agency

Advise on purchase and sale of business and industrial units in India or outside India.

Advise on strategic investors, financial investors or a combination of both including cross

borders M & A.

Assists in working out appropriate sale / buy strategies and negotiating with the other

party.

Assists in complying with business accounting and legal due diligences.

Conduct business research and analysis and advice on valuation of business sought

to be acquired, merged or sold.

Assists in arranging necessary acquisition finance either from banks, institutions and/or

otherlenders

Assists in Valuation of Business

Assists in completing the formalities from High Courts, R. D.; Takeover code regulation,RBI etc.

2. Currency Derivatives

Indian investor can now add one more 'investment option' in their portfolio current derivatives.

Regulatory approval from RBI and SEBI was recently made available (Aug 2008) and this

allows exchanges in India to launch currency derivatives for trading, similar to

equity/commodities derivatives trading.

With launch of currency derivatives in India through stock exchanges, there would be dynamic

shift in currency trading and hedging. Indian entity would be able to take positions on the

external value of the rupee without having an underlying foreign currency exposure. It would

enhance overall efficiency of the currency market via transparency in pricing, increase investor


35/96

based and categories, enhancing opportunities to invest and eliminate counter-party risk.

Currency Derivatives is a emerging segment in India & to tap this emerging segment we have

acquired the membership of Currency Derivatives under lucrative investment options.

We offer our broking services in Currency Derivatives segment which provides access to a new

asset class for trading to all Resident Indians

Currency derivatives is a product with benefits, such as:

Access to a new asset class for trading to all Resident Indians

Hedging current exposure:

A. Importers and exporters can hedge future payables and receivables

B. Borrowers can hedge Foreign Currency loans for interest or principal payments

C. Hedge for offshore investment for Resident Indians

Arbitrage opportunity for entities who can access onshore and non deliverable forward

markets

Volatility and multiplier make it a significant trading option for traders


36/96


37/96


38/96

CHAPTER IV

THEORETICAL FRAME WORK

Investment Basics

What is Investment?

The money you earn is partly spent and the rest saved for meeting future expenses. Instead of

keeping the savings idle you may like to use savings in order to get return on it in the future. This

is called Investment.

Why should one invest?

One needs to invest to:

1. earn return on your idle resources


39/96

2. generate a specified sum of money for a specific goal in life

3. make a provision for an uncertain future

One of the important reasons why one needs to invest wisely is to meet the cost of Inflation.

Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs

to buy the goods and services you need to live. Inflation causes money to lose value because it

will not buy the same amount of a good or a service in the future as it does now or did in the

past. For example, if there was a 6% inflation rate for the next 20 years, a Rs. 100 purchase today

would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a factor in any

long-term investment strategy. Remember to look at an investment's 'real' rate of return, which is

the return after inflation. The aim of investments should be to provide return above the inflation

rate to ensure that the investment does not decrease in value. For example, if the annual inflation

rate is 6%, then the investment will need to earn more than 6% to ensure it increases in value. If

the after-tax return on your investment is less than the inflation rate, then your assets have

actually decreased in value; that is, they won't buy as much today as they did last year.

When to start Investing?

The sooner one starts investing the better. By investing early you allow your investments more

time to grow, whereby the concept of compounding (as we shall see later) increases your

income, by accumulating the principal and7the interest or dividend earned on it, year after year.

The three golden rules for all investors are:

Invest early

Invest regularly

Invest for long term and not short term

What care should one take while investing?

Before making any investment, one must ensure to:


40/96

1. Obtain written documents explaining the investment

2. Read and understand such documents

3. Verify the legitimacy of the investment

4. Find out the costs and benefits associated with the investment

5. Assess the risk-return profile of the investment

6. Know the liquidity and safety aspects of the investment

7. Ascertain if it is appropriate for your specific goals

8. Compare these details with other investment opportunities available

9. Examine if it fits in with other investments you are considering or you

Have already made

10. Deal only through an authorized intermediary

11. Seek all clarifications about the intermediary and the investment

12. Explore the options available to you if something were to go wrong,

And then, if satisfied, make the investment.

These are called the Twelve Important Steps to Investing.

INTRODUCTION TO DERIVATIVES

The emergence of the market for derivative products, most notably forwards, futures and options,

can be traced back to the willingness of risk-averse economic agents to guard themselves against

uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets

are marked by a very high degree of volatility. Through the use of derivative products, it is

possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk

management, these generally do not influence the fluctuations in the underlying asset prices.


41/96

However, by locking in asset prices, derivative products minimize the impact of fluctuations in

asset prices on the profitability and cash flow situation of risk-averse investors.

1.1 DERIVATIVES DEFINED

Derivative is a product whose value is derived 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 any other asset. For example, wheat farmers may wish

to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a

transaction is an example of a derivative. The price of this derivative is driven by the spot price

of wheat which is the "underlying".

In the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R) A) defines "derivative" to include-

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.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by

the regulatory framework under the SC(R) A.

1.2 FACTORS DRIVING THE GROWTH OF DERIVATIVES

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

variety of derivative contracts have been launched at exchanges across the world. Some of the

factors driving the growth of financial derivatives are:

1. Increased volatility in asset prices in financial markets,


42/96

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns over a

large number of financial assets leading to higher returns, reduced risk as well as transactions

costs as compared to individual financial assets.

1.3 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures,

options and swaps. We take a brief look at various derivatives contracts that have come to be

used.

Forwards: A forward contract is a customized contract between two entities, where settlement

takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts

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.

Warrants: Options generally have lives of 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.


43/96

Baskets: Basket options are options on portfolios 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.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future

according 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

Swaptions: Swaptions are options to buy or sell a swap that will become Operative at the expiry

of the options. Thus a Swaptions 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.

PARTICIPANTS IN THE DERIVATIVES MARKETS

The following three broad categories of participants - hedgers, speculators, and arbitrageurs trade

in the derivatives market. Hedgers face risk associated with the price of an asset. They use

futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future

movements in the price of an asset. Futures and options contracts can give them an extra

leverage; that is, they can increase both the potential gains and potential losses in a speculative

venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two

different markets. If, for example, they see the futures price of an asset getting out of line with

the cash price, they will take offsetting positions in the two markets to lock in a profit.yer

swaption is an option to pay fixed and receive floating.

1.5 ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Inspite of the fear and criticism with which the derivative markets are commonly looked at, these

markets perform a number of economic functions


44/96

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 markets. Margining,

monitoring and surveillance of the activities of various participants become extremely difficult in

these kinds of mixed markets.

1.7 NSE's DERIVATIVES MARKET

The derivatives trading on the NSE commenced with S&P CNX Nifty Index futures on June 12,

2000. The trading in index options commenced on June4, 2001 and trading in options on

individual securities commenced on July 2, 2001. Single stock futures were launched on

November 9, 2001. Today, both in terms of volume and turnover, NSE is the largest derivatives

exchange in India. Currently, the derivatives 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.

1.7.1 Participants and functions

NSE admits members on its derivatives 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


45/96

segment. Trading and clearing members are admitted separately. Essentially, a clearing member

(CM) does clearing for all his trading members (TMs), undertakes risk management and

performs actual settlement. There are three types of CMs:

Self Clearing Member: A SCM clears and settles trades executed by him only either on his

own account or on account of his clients.

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 client's trades as well as clear and settle for other TMs.

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.

1.7.2 Trading mechanism

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

fully automated screen-based trading for Index futures & options and Stock futures & options on

a nationwide basis and an online monitoring and surveillance mechanism. It supports an

anonymous order driven market which provides complete transparency of trading operations and

operates on strict price-time priority. It is similar to that of trading of equities in the Cash Market

(CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading

Members (TM) 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 on the system. Various conditions like Immediate or Cancel, Limit/Market price, Stop

loss, etc. can be built into an order. The Clearing. Members (CM) use the trader workstation for

they can the purpose of monitoring the trading member(s) for whom they clear the trades.

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

CLEARING AND SETTLEMENT

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement

of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal

counterparty to all trades on the F&O segment and guarantees their financial settlement.

6.1 CLEARING ENTITIES


46/96

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help

of the following entities:

6.1.1 Clearing members

In the F&O segment, some members, called self clearing members, clear and settle their trades

executed by them only either on their own account or on account of their clients. Some others,

called trading member-cum-clearing member, clear and settle their own trades as well as trades

of other trading members (TMs). Besides, there is a special category of members, called

professional clearing members (PCM) who clear and settle trades executed by TMs. The

members clearing their own trades and trades of others, and the PCMs are required to bring in

additional security deposits in respect of every TM whose trades they undertake to clear and

settle

.6.1.2 clearing banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearing

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

F&O segment. The Clearing and Settlement process comprises of the following three main

activities:

1) Clearing

2) Settlement

3) Risk Management

6.2 CLEARING MECHANISM

The clearing mechanism essentially involves working out open positions and obligations of

clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is

considered for exposure and daily margin purposes. The open positions of CMs are arrived at by

aggregating the open positions of all the TMs and all custodial participants clearing through him,

in contracts in which they have traded. A TM's open position is arrived at as the summation of


47/96

his proprietary open position and clients' open positions, in the contracts in which he has traded.

While entering orders on the trading system, TMs are required to identify the orders, whether

proprietary (if they are their own trades) or client (if entered on behalf of clients) through 'Pro/

Cli' indicator provided in the order entry screen. Proprietary positions are calculated on net basis

(buy - sell) for each contract. Clients' positions are arrived at by summing together net (buy -

sell) positions of each individual client. A TM's open position is the sum of proprietary open

position, client open long position and client open short position

6.3 SETTLEMENT MECHANISM

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, with respect

to their obligations on MTM, premium and exercise settlement.

6.3.1 Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which happens on a

continuous basis at the end of each day, and the final settlement which happens on the last

trading day of the futures contract.

MTM settlement:

All futures contracts for each member are marked-to-market (MTM) to the daily settlement price

of the relevant futures contract at the end of each day. The profits/losses are computed as the

difference between:

1. The trade price and the day's settlement price for contracts executed during the day but not

squared up.

2. The previous day's settlement price and the current day's settlement price for brought forward

contracts.

3. The buy price and the sell price for contracts executed during the day and squared up.


48/96

Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures contracts on

such day. The closing price for a futures contract is currently calculated as the last half an hour

weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the

closing price of the relevant underlying index/security in the capital market segment of NSE, on

the last trading day of the contract. The closing price of the underlying Index/security is currently

its last half an hour weighted average value in the capital market segment of NSE.

6.3.2 Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise settlement,

interim exercise settlement in the case of option contracts on securities and final settlement.

Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him.

Similarly, the seller of an option is entitled to receive the premium for the option sold by him.

The premium payable amount and the premium receivable amount are netted to compute the net

premium payable or receivable amount for each client for each option contract.

Exercise settlement

Although most option buyers and sellers close out their options positions by an offsetting closing

transaction, an understanding of exercise can help an option buyer determine whether exercise

might be more advantageous than an offsetting sale of the option. There is always a possibility of

the option seller being assigned an exercise. Once an exercise of an option has been assigned to

an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash

settlement amount in the case of a cash-settled option) even though he may not yet have been

notified of the assignment.

Interim exercise settlement

Interim exercise settlement takes place only for option contracts on securities. An investor can

exercise his in-the-money options at any time during trading hours, through his trading member.

Interim exercise settlement is effected for such options at the close of the trading hours, on the


49/96

day of exercise. Valid exercised option contracts are assigned to short positions in the option

contract with the same series (i.e. having the same underlying, same expiry date and same strike

price), on a random basis, at the client level. The CM who has exercised the option receives the

exercise settlement value per unit of the option from the CM who has been assigned the option

contract.

Final exercise settlement

Final exercise settlement is effected for all open long in-the-money strike price options existing

at the close of trading hours, on the expiration day of an option contract. All such long positions

are exercised and automatically assigned to short positions in option contracts with the same

series, on a random basis. The investor who has long in-the-money options on the expiry date

will receive the exercise settlement value per unit of the option from the

Exercise process

The period during which an option is exercisable depends on the style of the option. On NSE,

index options are European style, i.e. options are only subject to automatic exercise on the

expiration day, if they are in-the-money. As compared to this, options on securities are American

style. In such cases, the exercise is automatic on the expiration day, and voluntary prior to the

expiration day of the option contract, provided they are in-the-money. Automatic exercise means

that all in-the-money options would be exercised by NSCCL on the expiration day of the

contract. The buyer of such options need not give an exercise notice in such cases. Voluntary

exercise means that the buyer of an in-the-money option can direct his TM/CM to give exercise

instructions to NSCCL. In order to ensure that an option is exercised on a particular day, the

buyer must direct his TM to exercise before the cut-off time for accepting exercise instructions

for that day. Usually, the exercise orders will be accepted by the system till the close of trading

hours. Different TMs may have different cut -off times for accepting exercise instructions from

customers, which may vary for different options. An option, which expires to exercise, or have

procedures for the exercise of every option, which is in the money at expiration. Once an

exercise instruction is given by a CM to NSCCL, it cannot ordinarily be revoked. Exercise

notices given by a buyer at anytime on a day are processed by NSCCL after the close of trading

hours on that day. All exercise notices received by NSCCL from the NEAT F&O system are


50/96

processed to determine their validity. Some basic validation checks are carried out to check the

open buy position of the exercising client/TM and if option contract is in-the-money. Once

exercised contracts are found valid, they are assigned.

Assignment process

The exercise notices are assigned in standardized market lots to short positions in the option

contract with the same series (i.e. same underlying, expiry date and strike price) at the client

level. Assignment to the short positions is done on a random basis. NSCCL determines short

positions, which are eligible to be assigned and then allocates the exercised positions to any day

on which exercise instruction is received by NSCCL and notified to the members on the same

day. It is possible that an option seller may not receive notification from its TM that an exercise

has been assigned to him until the notification from its TM that an exercise has been assigned to

him until the next day following the date of the assignment to the CM by NSCCL.

Exercise settlement computation

In case of index option contracts, all open long positions at in-the-money strike prices are

automatically exercised on the expiration day and assigned to short positions in option contracts

with the same series on a random basis. For options on securities, where exercise settlement may

be interim or final, interim exercise for an open long in-the-money option position can be

affected on any day till the expiry of the contract. Final exercise is automatically affected by

NSCCL for all open long in-the-money positions in the expiring month option contract, on the

expiry day of the option contract. The exercise settlement price is the closing price of the

underlying (index or security) on the exercise day (for interim exercise) or the expiry day of the

relevant option contract (final exercise). The exercise settlement value is the difference between

the strike price and the final settlement price of the relevant option contract. For call options, the

exercise settlement value receivable by a buyer is the difference between the final settlement

price and the strike price for each unit of the underlying conveyed by the option contract, while

for put options it is difference between the strike prices and the final settlement price for each

unit of the underlying conveyed by the option contract. Settlement of exercises of options on

securities is currently by payment in cash and not by delivery of securities. It takes place for in-


51/96

the-money option contracts. The exercise settlement value for each unit of the exercised contract

is computed as follows:

Call options = Closing price of the security on the day of exercise Strike price

Put options = Strike price Closing price of the security on the day of exercise

For final exercise the closing price of the underlying security is taken on the expiration day. The

exercise settlement value is debited / credited to the relevant CMs clearing bank account on T +

1 day (T = exercise date).

Special facility for settlement of institutional deals

NSCCL provides a special facility to Institutions/Foreign Institutional Investors(FIIs)/Mutual

Funds etc. to execute trades through any TM, which may be cleared and settled by their own

CM. Such entities are called custodial participants (CPs). To avail of this facility, a CP is

required to register with NSCCL through his CM. A unique CP code is allotted to the CP by

NSCCL. All trades executed by a CP through any TM are required to have the CP code in the

relevant field on the trading system at the time of order entry. Such trades executed on behalf of

a CP are confirmed by their own CM (and not the CM of the TM through whom the order is

entered), within the time specified by NSE on the trade day though the on-line confirmation

facility. Till such time the trade is confirmed by CM of concerned CP, the same is considered as

a trade of the TM and the responsibility of settlement of such trade vests with CM of the TM.

Once confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of

deals of such custodial clients. FIIs have been permitted to trade in all the exchange traded

derivative contracts subject to compliance of the position limits prescribed for them and their sub

accounts, and compliance with the prescribed procedure for settlement and reporting. A FII/a

sub-account of the FII, as the case may be, intending to trade in the F&O segment of the

exchange, is required to obtain a unique Custodial Participant (CP) code allotted from theNSCCL. FII/sub-accounts of FIIs which have been allotted a unique CP code by NSCCL are

only permitted to trade on the F&O segment. The FD/sub-account of FII ensures that all orders

placed by them on the Exchange carry the relevant CP code allotted by NSCCL.

6.5 RISK MANAGEMENT


52/96

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The

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

1. The financial soundness of the members is the key to risk management. Therefore, the

requirements for membership in terms of capital adequacy (net worth, security deposits) are quite

stringent.

2. NS

Derivative Market Analysis-

Documents

Transcript of Derivative Market Analysis-