S i P FinalRisk Report

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APROJECT REPORT

ON

Study Of Risk Management on Derivative Instruments in IndiaInfo line ltd

SubmittedIn partial fulfillment for the award of the degree

Of

MASTER OF BUSINESS ADMINISTRATION(ICFAI University, Thirupura)

SubmittedBy

SURESH.S(MO208085)

Under the guidance of: Company Guide Faculty GuideMr. BIJU JOY Prof. BRINDHAVEN

KATESHRelationship Manager Magnus School of Business

SubmittedOn

17 June 2009

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DECLARATION

I hereby declare that this project report, entitled A study of risk management onderivative instrument in Indiainfoline is a record of work carried out by me under the guidance of Prof. Brindhavenkatesh.

I also declare that this report has not been submitted for the award of any degree or diploma or associate ship or any other similar titles.

PLACE:DATE: SURESH.S(MO208085)

2nd

Semester, MBAMagnus School Of Business,

Bangalore

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CERTIFICATE

This is to certify that SURESH.S of 2nd semester M.B.A., student of Magnus School Of Business, Bangalore has successfully completed Summer Internship Project from 20thApril 2009 to 15st June 2009 titled A study of risk management on derivativeinstrument in Indiainfoline ltd.r

This report is submitted in partial fulfillment of the requirement for the degree of Master Of Business Administration and not submitted for any other degree or diploma for other similar title.

PLACE:

DATE:Prof.Brindha venkatesh

(Faculty guide)Magnus School Of Business,

Bangalore

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ACKNOWLEDGEMENT

I have done my project successfully on An evaluation of performance appraisal system inBig bazaar, Hebbal, Bangalore.

So first of all I would like to thank Allah without his mercy nothing is possible.I would like to take this opportunity to thankMr. Biju joy (Relationship Manager-

Indiainfoline ltd.) andMr.Nizamudin (Relationship Manager-Indiainfoline ltd.) and alsoMr. Riaz . (Sales Manager- Indiainfoline ltd.Bangalore) for given me the opportunity tothe project in his esteemed organization.

I am thankful to them for the constant support and Guidance during the project.

I would like to thank toProf.Brindha Venkatesh for having time to guide me during theproject.

Last but not the least, I thank to THEIR Big bazaar-family for the support and strength givento me during this project.

SURESH.S

(MO208085)2nd Semester, MBA

Magnus School Of Business,Bangalore

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ABSTRACT:-

This project is on studying of risk management on derivative instruments . Analyzing the

various types of risk associated with futures & options in india info line . The systemused by company to over come the problem in risk derivative instruments. Also thetrading process and investment process.

OBJECTIVES

To study the various types of risk associated with futures and options. To study the system used by company to overcome problem associated

with margin money problem. To study the Investment & Trading Process of the company

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INDUSTRY PROFILE

Stock Exchanges

Everyday, stocks are exchanged and traded in numerous stock markets around

the world. The liquidity they bring are a vital component of economic growth.

Stock exchanges are open markets that trade financial assets. Whether associated witha company or acting as an individual, a stock exchange is the place where stocks arebought and sold. There are a number of major stock exchanges around the world andeach of these plays a part in determining the overall financial and economic condition of any economy.

Stock exchanges deal with a number of financial instruments such as stocks, bonds andequities. Both corporate and government bonds are traded in stock exchanges. Equities

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With the help of stockbrokers, the buyers and sellers participating in a stock marketcarry out their transactions. The brokers representing selling parties take their orders tothe stock exchange floor and then find brokers representing parties willing to invest insimilar stocks. If both parties agree to trade at the fixed price, the transaction takesplace

.BSE STOCK EXCHANGE:

Bombay Stock Exchange is the oldest stock exchange in Asia with a rich heritage, nowspanning three centuries in its 133 years of existence. What is now popularly known asBSE was established as "The Native Share & Stock Brokers' Association" in 1875.

BSE is the first stock exchange in the country which obtained permanent recognition (in1956) from the Government of India under the Securities Contracts (Regulation) Act1956. BSE's pivotal and pre-eminent role in the development of the Indian capitalmarket is widely recognized. It migrated from the open outcry system to an onlinescreen-based order driven trading system in 1995. Earlier an Association Of Persons(AOP), BSE is now a corporatized and demutualised entity incorporated under theprovisions of the Companies Act, 1956, pursuant to the BSE (Corporatization andDemutualization) Scheme, 2005 notified by the Securities and Exchange Board of India(SEBI). With demutualization, BSE has two of world's best exchanges, Deutsche Borseand Singapore Exchange, as its strategic partners.

Over the past 133 years, BSE has facilitated the growth of the Indian corporate sector byproviding it with an efficient access to resources. There is perhaps no major corporate inIndia which has not sourced BSE's services in raising resources from the capital market.

Today, BSE is the world's number 1 exchange in terms of the number of listed companiesand the world's 5th in transaction numbers. The market capitalization as on December 31, 2007 stood at USD 1.79 trillion. An investor can choose from more than 4,700 listedcompanies, which for easy reference, are classified into A, B, S, T and Z groups.

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The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature,and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. TheSENSEX is constructed on a 'free-float' methodology, and is sensitive to marketsentiments and market realities. Apart from the SENSEX, BSE offers 21 indices,including 12 sect oral indices. BSE has entered into an index cooperation agreementwith Deutsche Brse. This agreement has made SENSEX and other BSE indicesavailable to investors in Europe and America. Moreover, Barclays Global Investors(BGI), the global leader in ETFs through its shares brand, has created the 'iSharesBSE SENSEX India Tracker' which tracks the SENSEX. The ETF enables investors inHong Kong to take an exposure to the Indian equity market.

The first Exchange Traded Fund (ETF) on SENSEX, called "SPICE" is listed on BSE. Itbrings to the investors a trading tool that can be easily used for the purposes of investment, trading, hedging and arbitrage. SPICE allows small investors to take a long-term view of the market.

BSE provides an efficient and transparent market for trading in equity, debt instruments andderivatives. It has a nation-wide reach with a presence in more than 359 cities andtowns of India. BSE has always been at par with the international standards. Thesystems and processes are designed to safeguard market integrity and enhancetransparency in operations. BSE is the first exchange in India and the second in theworld to obtain an ISO 9001:2000 certification. It is also the first exchange in the countryand second in the world to receive Information Security Management System StandardBS 7799-2-2002 certification for its BSE On-line Trading System (BOLT).

BSE continues to innovate. In recent times, it has become the first national level stock

exchange to launch its website in Gujarati and Hindi to reach out to a larger number of investors. It has successfully launched a reporting platform for corporate bonds in Indiachristened the ICDM or Indian Corporate Debt Market and a unique ticker-cum-screenaptly named 'BSE Broadcast' which enables information dissemination to the commonman on the street.

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In 2006, BSE launched the Directors Database and ICERS (Indian Corporate ElectronicReporting System) to facilitate information flow and increase transparency in the Indiancapital market. While the Directors Database provides a single-point access toinformation on the boards of directors of listed companies, the ICERS facilitates thecorporates in sharing with BSE their corporate announcements.

BSE also has a wide range of services to empower investors and facilitate smoothtransactions:

Investor Services: The Department of Investor Services redresses grievances of investors.

BSE was the first exchange in the country to provide an amount of Rs.1 million towardsthe investor protection fund; it is an amount higher than that of any exchange in thecountry. BSE launched a nationwide investor awareness programme- 'Safe Investing inthe Stock Market' under which 264 programmes were held in more than 200 cities.

The BSE On-line Trading (BOLT): BSE On-line Trading (BOLT) facilitates on-line screenbased trading in securities. BOLT is currently operating in 25,000 Trader Workstationslocated across over 359 cities in India.

BSEWEBX.com: In February 2001, BSE introduced the world's first centralized exchange-based Internet trading system, BSEWEBX.com. This initiative enables investorsanywhere in the world to trade on the BSE platform.

Surveillance: BSE's On-Line Surveillance System (BOSS) monitors on a real-time basis theprice movements, volume positions and members' positions and real-time measurement

of default risk, market reconstruction and generation of cross market alerts.

BSE Training Institute: BTI imparts capital market training and certification, in collaborationwith reputed management institutes and universities. It offers over 40 courses on

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various aspects of the capital market and financial sector. More than 20,000 peoplehave attended the BTI programs.

COMPANY PROFILE

Company Vision and Corporate Philosophy

We are a one-stop financial services shop, most respected for quality of itsadvice, personalized service and cutting-edge technology

VISION

Our vision is to be The most respected company in the financial services space .

CORPORATE PHILOSOPHYPeople Organization:

It is rightly said about the service sector all our assets go down the elevator at the end of every day. We have to make sure that they come back next morning. Being in theservice industry, people are our biggest and most important assets. The entireorganizations philosophy is centered on how best to ensure our people get anenvironment conducive to perform and excel.

Owner Mindset :What distinguishes India Info Line from other organizations is the fact that Owner Mindset

drives all employees. This is a privilege as well as responsibility. The environmentprovides tremendous autonomy to operate, be creative and deliver results.

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Equal Opportunities Employer :India Info Line shall provide equal opportunity to all its employees and all qualified

applicants for employment without the regards to their race, caste, religion, color, maritalstatus, sex, age, nationality, and veteran status. Employee polices and practices shallbe administrated in a manner that will ensure that in all matters, equal opportunity isprovided to those are eligible and the decisions are merit based.

India Infoline Group

The India Infoline group, comprising the holding company, India Infoline Limitedand its wholly-owned subsidiaries, straddle the entire financial services space

with offerings ranging from Equity research, Equities and derivatives trading,Commodities trading, Portfolio Management Services, Mutual Funds, LifeInsurance, Fixed deposits, GoI bonds and other small savings instruments toloan products and Investment banking. India Infoline also owns and managesthe websites www.indiainfoline.comand www.5paisa.com

The company has a network of 758 business locations (branches and sub-brokers) spread across 346 cities and towns. It has more than 800,000

customers.

CORPORATE STRUCTURE

The India Infoline group, comprising the holding company, India Infoline Limitedand its wholly-owned subsidiaries, is in the business of advising and servicing entiregamut of financial services including Equity research, Equities and derivatives trading,Commodities trading, Portfolio Management Services, Mutual Funds, Life Insurance,

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Fixed deposits, GoI bonds and other small savings instruments to loan products andInvestment banking.

Equity Broking & Investment Banking NBFC Financing Commodities Broking New Company for international operations Equity Research, Portal & Online Media Insurance Distribution

INDIA INFOLINE LTD

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A SEBI authorized Portfolio Manager; it offers Portfolio Management Services to clients.These services are offered to clients as different schemes, which are based on differinginvestment strategies made to reflect the varied risk-return preferences of clients.

India Infoline Ltd

India Infoline Limited is listed on both the leading stock exchanges in India, viz.the Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE)and is also a member of both the exchanges. It is engaged in the businessesof Equities broking, Wealth Advisory Services and Portfolio ManagementServices. It offers broking services in the Cash and Derivatives segments of the NSE as well as the Cash segment of the BSE. It is registered with NSDL

as well as CDSL as a depository participant, providing a one-stop solution for clients trading in the equities market. It has recently launched its Investmentbanking and Institutional Broking business.

India Infoline Media and Research Services Limited.

The content services represent a strong support that drives the broking,

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dia InfolineInvestment

services ltdBFC FOR FINANCING)

India InfolineCommoditiesltd(COMMODITIESBROKING)

IIFL (Asia) Pte Ltd(NEW COMPANYFOR INTERNATIONALOPERATIONS)

India Infoline Media &Research Services Pvt Ltd

(EQUITY RESEARCH,PORTAL&ONLINE MEDIA)

India InfolinMarketing servic

ltd(INSURANC

DISTRIBUTION)

IIL H OUSINGFINANCE LTD

NEY LINE CREDITCARD

IIL D ISTRIBUTIONCO LTD

IIL INSURANCESERVICE LTD(CORPORATE

AGENCY)

IIL INSURANCEBROKERS LTD


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commodities, mutual fund and portfolio management services businesses.Revenue generation is through the sale of content to financial and mediahouses, Indian as well as global.

It undertakes equities research which is acknowledged by none other thanForbes as 'Best of the Web' and 'a must read for investors in Asia'. IndiaInfoline s research is available not just over the internet but also oninternational wire services like Bloomberg (Code: IILL), Thomson First Calland Internet Securities where India Infoline is amongst the most read Indianbrokers.

India Infoline Commodities Limited.

India Infoline Commodities Pvt Limited is engaged in the business of commodities broking. Our experience in securities broking empowered uswith the requisite skills and technologies to allow us offer commoditiesbroking as a contra-cyclical alternative to equities broking. We enjoymemberships with the MCX and NCDEX, two leading Indian commoditiesexchanges, and recently acquired membership of DGCX. We have a multi-channel delivery model, making it among the select few to offer online as wellas offline trading facilities.

India Infoline Marketing & Services

India Infoline Marketing and Services Limited is the holding company of India

Infoline Insurance Services Limited and India Infoline Insurance BrokersLimited.

(a) India Infoline Insurance Services Limited is a registered Corporate Agent withthe Insurance Regulatory and Development Authority (IRDA). It is the largestCorporate Agent for ICICI Prudential Life Insurance Co Limited, which is

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India's largest private Life Insurance Company. India Infoline was the firstcorporate agent to get licensed by IRDA in early 2001.

(b) India Infoline Insurance Brokers Limited India Infoline Insurance Brokers

Limited is a newly formed subsidiary which will carry out the business of Insurance broking. We have applied to IRDA for the insurance broking licenseand the clearance for the same is awaited. Post the grant of license, wepropose to also commence the general insurance distribution business.

India Infoline Investment Services Limited

Consolidated shareholdings of all the subsidiary companies engaged in loans

and financing activities under one subsidiary. Recently, Orient Global, aSingapore-based investment institution invested USD 76.7 million for a 22.5%stake in India Infoline Investment Services. This will help focused expansionand capital raising in the said subsidiaries for various lending businesses likeloans against securities, SME financing, distribution of retail loan products,consumer finance business and housing finance business. India InfolineInvestment Services Private Limited consists of the following step-downsubsidiaries.

(a) India Infoline Distribution Company Limited (distribution of retail loanproducts)

(b) Money line Credit Limited (consumer finance)

(c) India Infoline Housing Finance Limited (housing finance)

IIFL (Asia) Pte Limited

IIFL (Asia) Pte Limited is wholly owned subsidiary which has been incorporatedin Singapore to pursue financial sector activities in other Asian markets.

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Further to obtaining the necessary regulatory approvals, the company hasbeen initially capitalized at 1 million Singapore dollars.

Products and Services at India Info Line Pvt ltd

India Info line Pvt Ltd is a one-stop financial services shop, most respected for Quality of its advice, personalized service and cutting edge technology.

Equities

India info line provided the prospect of researched investing to its clients, whichwas hitherto restricted only to the institutions. Research for the retail investor did notexist prior to Indiainfoline. Indiainfoline leveraged technology to bring the convenience of trading to the investors location of preference (residence or office) through

computerized access. Indiainfoline made it possible for clients to view transaction costsand ledger updates in real time.

Portfolio Management Service

Our Portfolio Management Service is a product wherein an equity investmentportfolio is created to suit the investment objectives of a client. We at Indiainfoline investyour resources into stocks from different sectors, depending on your risk-return profile.This service is particularly advisable for investors who cannot afford to give time or don'thave that expertise for day-to-day management of their equity portfolio.

Research

IIL special research cell where some of India's finest financial analysts bring youintensive research reports on how the stock market is faring, when is the right time toinvest, when to execute your order and more. IIL make sure that investors are always prepared to make own investment decision

when the opportunity arises.IIL bring you intensive research reports - whether spectral or company-wise or more -that tell you exactly when and where to invest. So whenever there is an excitinginvestment opportunity, you are in the know and always ready to invest. Researchreports IIL will help you choose your investments wisely, without wasting time.

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Presented in a lucid and easy-to-understand format; these reports help you makeinformed decisions.

Commodities

India Infolines extension into commodities trading reconciles its strategic intent toemerge as a one stop solutions financial intermediary. Its experience in securitiesbroking has empowered it with requisite skills and technologies. Increased offering: TheCompanys commodities business provides a contra-cyclical alternative to equitiesbroking. The Company was among the first to offer the facility of commodities trading inIndias young commodities market (the MCX commenced operations only in 2003).Average monthly turnover on the commodity exchanges increased from Rs 0.34 bn to

Rs 20.02 bn. The commodities market has several products with different and non-correlated cycles. On the whole, the business is fairly insulated against cyclicalgyrations in the business.

Mortgages

They say you mustn't trust a man till you know his house. Everyone likes hearing peoplesay Wow, what a beautiful house you have! From cave dwelling, we have evolved andnow a house provides far more than just shelter...it also becomes a source of pride. AHousing Loan is used as finance to help you buy or modify that perfect home.

The different Housing Loan products can be classified as:Home Loans & Home Extension LoansNRI LoansLand Loans

Home Equity Loans

Invest Online In Mutual Funds & IPOs

India Infoline has made investing in Mutual funds and primary market soeffortless. All you have to do is register with us and thats all. No paperwork noqueues and No registration charges.

If you are 5p customer use your existing login ID and Ledger (fund transfer) password.Indiainfoline offers you a host of mutual fund and IPO choices under one roof;backed by in-depth information and research to help you invest effortlessly.

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INVEST IN MUTAL FUNDS

Indiainfoline offers you a host of mutual fund choices under one roof, backed byin-depth research and advice from research house and tools configured as investor friendly. Investing in Mutual Funds has never been easier.

APPLY IN IPOs

Get in-depth analyses of new IPOs issues (Initial Public Offerings) which areabout to hit the market and analysis on these recent IPO listings, prospectus/offer documents, and IPO reports are few of the features, which help you, keep on top of theIPO markets.

STOCK MESSAGING SERVICEStay connected to the market. The trader of today, you are constantly on the

move. But how do you stay connected to the market while on the move? Simple,subscribe to India Info lines Stock Messaging Service and get Market on your Mobile!

There are four products under SMS Service:

Global Cues Market on the move. Best of the lot. VAS (Value Added Service)

Global Cues

Be amongst the first to know things as they happen.... Real-time!!!!Get throughout the day updates on Global & Asian Indices, Crude & Gold Prices & many mon your mobile (5-6 SMSs per day).

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American and European indices and news throughout the day.Crude prices (till 9 pm)Gold prices (till 9 pm)Asian indices


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Market on the move.

Get daily market updates and stock ideas on your mobile through SMS (5 messages per day).

Best of the lot.Do you get confused with too many stock ideas? Get the Best of the lot!

One intra-day tip.One BTST/Delivery idea.

VAS (Value Added Service)

We are the proud pioneers to launch VAS Service - One of its kind in the stock market industry.you are a 5paisa customer, we dont want you to make an effort to seek information about youstocks. Instead we aim to provide you with all the vital information over SMS. Real-time Npertaining only to your portfolio.

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Real Time Trading Tips (Inclusive Intra-day, Delivery, Futures and BTST TipLatest Company Results.Market Sensitive News.Investment Ideas.


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Insurance

An entry into this segment helped complete the clients product basket;concurrently, it graduated the Company into a one-stop retail financial solutionsprovider. To ensure maximum reach to customers across India, we have employed amulti pronged approach and reach out to customers via our Network, Direct and Affiliatechannels. Following the opening of the sector in 1999-2000, a number of private sector insurance service providers commenced operations aggressively and helped grow themarket.

The Companys entry into the insurance sector de-risked the Company from apredominant dependence on broking and equity-

Linked revenues. The annuity based income generated from insurance intermediationresult in solid core revenues across the tenure of the policy.

Wealth Management Service

Backed by a team of experts, IIL team will recommend an appropriate financial

strategy to meet your needs.The key to achieving success is having a carefully planned financial strategy based on

a thorough understanding of your needs and appetite for risk.Analysis of your needs to develop your customized investment and insurance

portfolio.

Our relationship manager will help you

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Real-time News pertaining only to your portfolio.Daily Equity and Bullion Market Updates.Net Position of your Top 5 stocks (Scrip, Qty,

and Closing Price).Updates on Ledger Balance on daily basis.Stock ideas based on strong research.Updates on your stock price during market

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analyze:

Newsletters

The Daily Market Strategy is your morning dose on the health of the markets. Fiveintra-day ideas, unless the markets are really choppy coupled with a brief on theglobal markets and any other cues, which could impact the market. Ocassionallyan investment idea from the research team and a crisp round up of the previousday's top stories. That's not all. As a subscriber to the Daily Market Strategy, youeven get research reports of India Infoline research team on a priority basis.

The India Infoline Weekly Newsletter is your flashback for the week gone by. Aweekly outlook coupled with the best of the web stories from India Infoline andlinks to important investment ideas, Leader Speak and features is delivered inyour inbox every Friday evening.

List of Newsletters we provide :

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Your cash-flowrequirements

Your risk appetiteDesired investment

horizonLong-term goals

Daily NewslettersWeekly NewslettersMonthly NewslettersYearly NewslettersCommodity

NewslettersMutual Fund

Newsletters


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INTRODUCTION

The word return is always used with an antinomy risk. All over the world many investmentactivities are taking place namely infrastructure level. Invest in shares and debenture,business, factory building, social activities etc, with an anticipated future return. Most of the investments are not taking place in under develop as economically weak countries

because of the risk of return attached with it.In any of the investment there is a risk of loss. The risk may include earth quake,cyclone, storm and or monsoon failure which are uncontrollable caused by nature. Butthese can insure. Risk such as default of debtor, interest rate, inflation , trend, demandand supply etc are the business risk; which one can manage to some extend but someunpredictable, which make a business to go to loss.

Business risk can be managed by proper planning, procedure, program andsystem. Through our study we have attempted to know the planning program, andsystem used by investor, broker and individuals to manage the risk associated withfuture and options.

i) DERIVATIVE

A derivative is an instrument (commonly shortened to Derivative) a security or contractdesigned in such a way that its value is derived from the price of an underlying assets,

which may be stock, stock indices, commodities, foreign exchange, bonds etc. Futuresand options are one of the derivative instruments.

The past decade has witnessed an explosive growth in the use of financialderivatives by a wide range of corporate and financial institutions. This growth has run-in parallel with the increasing direct reliance of companies on the capital markets as themajor source of long term funding. In this respect, derivatives have a vital role to play in

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enhancing shareholder value by ensuring access to the cheapest source of funds.Furthermore, active use of derivative instruments allows the overall business risk profileto be modified, thereby providing the potential to improve earnings quality by off setting-desired risks. The derivatives came into the spotlight along with the rise in uncertainty of post 1970, when US announced an end to the Breton Woods System of fixed exchangerates leading to introduction of currency derivatives followed by other innovationsincluding stock index futures. Since then, derivatives have quickly spread to anincreasing number of developed and developing countries. They are recognized as thebest and most cost-efficient way of meeting the felt need for risk hedging in certaintypes of commercial and financial operations. Countries not providing such globallyaccepted risk hedging facilities are disadvantaged in todays rapidly integrating global

economy. The liberalization and opening up of the Indian economy has precipitated theprocess of integration of Indias financial market with the international financial markets.

Evolution of Derivatives

In the 17th century, in Japan, the rice was been grown abundantly, later the trade in ricegrew and evolved to the stage where receipts for future delivery. Were traded with ahigh degree of standardization. This led to forward Trading. The trade known as "cho-ai-mai a kinai" (rice - trade - on - book), centered on Dojima, a district of Osaka. In 1730,the market received official recognition from the "Tokugawa Shogunate" (the ruling clanof shoguns or feudal lords). The Dojima rice market can thus be regarded as the firstfutures market in the sense of an organized exchange with standardized trading terms.

The first futures markets in the Western hemisphere were developed in the United States inChicago. These markets (in grain) had started as spot markets and gradually evolvedinto futures trading. This evolution occurred in stages. The first stage was the starting of

agreements to buy grain in the future at 'e- determined price with the intension of actualdelivery. Gradually these, contracts became transferable and over a period of time,particularly delivery of "physical produce. Traders found that the agreementsthemselves, instead of taking delivery of the physical produce. Traders found that theagreements were easier to buy and sell if they were standardized in terms of quality of

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grain, market lot and place of delivery. This is how modern futures contracts first came,into being. The Chicago Board of Trade (CBOT), which opened in 1848, is, to this day,the largest futures market in the world.

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 beenderived 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 asthe underlying.

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 onthe price of soybean. Derivatives are specialized contracts which signify an agreementor an option to buy or sell the underlying asset of the derivate up to a certain time in thefuture at a prearranged price, the exercise price. The contract also has a fixed expiryperiod mostly in the range of 3 to 12 months from the date of commencement of thecontract. 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 readyfor delivery will be lower than his cost of production. Let's say the cost of production isRs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, heenters into a contract (derivative) with a merchant, who agrees to buy the crop at acertain price (exercise price), when the crop is ready in three months time (expiryperiod). 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, thederivative contract will be more valuable for the farmer, and if the price of soybean goesdown to Rs 6,000, the contract becomes even more valuable. This is because thefarmer can sell the soybean he has produced at Rs .9000 per ton even though the

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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 acommodity derivative .

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 fromhis land will be around 150 quintals, he can either go to a food merchant and enter intoa derivatives contract to sell 150 quintals of soybean in three months time at Rs 9,000per ton. Or the farmer can go to a commodities exchange, like the National Commodityand Derivatives Exchange Limited, and buy a standard contract on soybean. Thestandard contract on soybean has a size of 100 quintals. So the farmer will be left with50 quintals of soybean uncovered for price fluctuations. However, exchange tradedderivatives have some advantages like low transaction costs and no risk of default bythe other party, which may exceed the cost associated with leaving a part of theproduction uncovered.

Some of the most basic forms of Derivatives are Futures, Forwards and Options .Futures and Forwards:

As the name suggests, futures are derivative contracts that give the holder the opportunityto buy or sell the underlying at a pre-specified price some time in the future. They comein standardized form with fixed expiry time, contract size and price. Forwards are similar

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contracts but customizable in terms of contract size, expiry date and price, as per theneeds of the user.

Options:

Option contracts give the holder the option to buy or sell the underlying at a pre-specifiedprice some time in the future. An option to buy the underlying is known as a Call Option.On the other hand, an option to sell the underlying at a specified price in the future isknown as Put Option.

In the case of an option contract, the buyer of the contract is not obligated toexercise the option contract. Options can be traded on the stock exchange or on theOTC market.

History of derivatives

The history of derivatives is surprisingly longer than what most people think. Some textseven find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that dateback to the ages before Jesus Christ. However, the advent of modern day derivativecontracts is attributed to the need for farmers to protect themselves from any decline inthe price of their crops due to delayed monsoon, or overproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japanaround 1650. These were evidently standardized contracts, which made them much liketoday's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange inthe world, was established in 1848 where forward contracts on various commoditieswere standardized around 1865. From then on, futures contracts have remained moreor less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivative markethas been functioning in India since the nineteenth century with organized trading incotton through the establishment of Cotton Trade Association in 1875. Since thencontracts on various other commodities have been introduced as well. Exchange tradedfinancial derivatives were introduced in India in June 2000 at the two major stock

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exchanges, NSE and BSE. There are various contracts currently traded on theseexchanges.

National Commodity & Derivatives Exchange Limited (NCDEX) started itsoperations in December 2003, to provide a platform for commodities trading.

The derivatives market in India has grown exponentially, especially at NSE. Stock Futuresare the most highly traded contracts on NSE accounting for around 55% of the totalturnover of derivatives at NSE, as on April 13, 2005.

Development of derivatives market in India:

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition onOptions in securities. The market for derivatives, however, did not take off, as there wasno regulatory framework to govern trading of derivatives. SEBI set up a 24member Committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to developappropriate regulatory framework for derivatives trading in India. The committeesubmitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivativesshould be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for riskcontainment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charginginitial margins, broker net worth, deposit requirement and realtime monitoringrequirements. The Securities Contract Regulation Act (SCRA) was amended in

December 1999 to include derivatives within the ambit of securities and the regulatoryframework was developed for governing derivatives trading. The act also made it clear that derivative shall be legal and valid only if such contracts are traded on a recognizedstock exchange, thus precluding OTC derivatives. The government also rescinded in

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March 2000, the threedecade old notification, which prohibited forward trading insecurities. Derivatives trading commenced in India in June 2000 after SEBI granted

the final approval to this effect in May 2001. SEBI permitted the derivative segments of twostocks Exchanges, NSE and BSE, and their clearing house/corporation to commencetrading and Settlement in approved derivatives contracts. To begin with, SEBI approvedtrading in Index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index.This was followed by approval for trading in options based on these two indexes andoptions on individual securities. The trading in BSE Sensex options commenced onJune 4, 2001 and the trading in options on individual securities commenced in July2001. Futures contracts on individual stocks were launched in November 2001. The

derivatives trading on NSE 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 optionson individual securities commenced on July 2, 2001. Single stock futures were launchedon November 9, 2001. The index futures and options contract on NSE are based onS&P CNX trading and settlement in derivative contracts is done in accordance with therules, byelaws, and regulations of the respective exchanges and their clearinghouse/corporation duly approved by SEBI and notified in the official gazette. ForeignInstitutional Investors (FIIs) are permitted to trade in all Exchange traded derivativeproducts.

Some of the factors driving the growth of financial derivatives:

1. Increased volatility in asset prices in financial markets,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.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 astransactions costs as compared to individual financial assets.

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Two important derivatives are futures and options:

(i) Futures Contracts: A futures contract is an agreement for buying or selling acommodity for a predetermined delivery price at a specific future time. Futures arestandardized contracts that are traded on organized futures exchanges that ensureperformance of the contracts and thus remove the default risk. The commodity futureshave existed since the Chicago Board of Trade (CBOT, www.cbot.com) was establishedin 1848 to bring farmers and merchants together. The major function of futures marketsis to transfer price risk from hedgers to speculators. For example, suppose a farmer isexpecting his crop of wheat to be ready in two months time, but is worried that the priceof wheat may decline in this period. In order to minimize his risk, he can enter into afutures contract to sell his crop in two months time at a price determined now. This way

he is able to hedge his risk arising from a possible adverse change in the price of hiscommodity.

(ii)Options contracts : Like futures, options are also financial instruments usedfor hedging and speculation. The commodity option holder has the right, but not theobligation, to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date. Option contracts involve two parties the seller of the optionwrites the option in favor of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options: a call option givesthe holder a right to buy a commodity at an agreed price, while a put option gives theholder a right to sell a commodity at an agreed price on or before a specified date(called expiry date). The option holder will exercise the option only if it is beneficial tohim; otherwise he will let the option lapse. For example, suppose a farmer buys a putoption to sell 100 Quintals of wheat at a price of $25 per quintal and pays a premium of $0.5 per quintal (or a total of $50). If the price of wheat declines to say $20 before

expiry, the farmer will exercise his option and sell his wheat at the agreed price of $25per quintal. However, if the market price of wheat increases to say $30 per quintal, itwould be advantageous for the farmer to sell it

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Directly in the open market at the spot price, rather than exercise his option to sell at $25per quintal.

Kinds of Financial Derivatives

1) Forwards2) Futures3) Options4) Swaps

1) Forwards

A forward contract refers to an agreement between two parties to exchange an agreed

quantity of an asset for cash at a certain date in future at a predetermined pricespecified in that agreement. The promised asset may be currency, commodity,instrument etc In a forward contract, a user (holder) who promises to buy the specifiedasset at an agreed price at a future date is said to be in the 'Long Position'. On the other hand, the user who promises to sell at an agreed price at a future date is said to be in'Short Position'.

2) Futures

A Futures contract represents a contractual agreement to purchase or sell a specified assetin the future for a specified price that is determined today. The underlying asset couldbe foreign currency, a stock index, a treasury bill or any commodity. The specified priceis known as the future price. Each contract also specifies the delivery month, which maybe nearby or more deferred in time.

The undertaker in a futures market can have two positions in the contract:"a) Long Position when the buyer of a futures contract agrees to purchase the underlying

asset.b) Short Position is when the seller agrees to sell the asset.

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Futures contract represents an institutionalized, standardized form of forwardcontracting. They are traded on an organized exchange, which is a physical place of trading floor where listed contract are traded face to face. The important point tounderstand futures is that when one has a futures contract, one does not own foreignexchange. A futures contract, in fact, represents a pure bet on the direction of price(exchange rate) movement of the underlying currency. A futures trade will result in afutures contract between 2 sides - someone going long at a negotiated price andsomeone going short at that same price. Thus, if there were no transaction costs,futures trading would represent a 'Zero Sum Game. What one side wins, which willexactly match what the other side loses.

Types of Futures Contractsa) Agricultural Futures Contracts:

These contracts are traded in grins, oil, meal, livestock, forest products, textiles and foodstuff. Several different contracts and months for delivery are available for differentgrades or types of commodities in question. The contract months depend on theseasonality and trading activity.

b) Metallurgical Futures Contract:

This category includes genuine metal and petroleum contracts. Among the metals,contracts are traded in gold, silver, platinum, and copper of the petroleum products onlyheating oil, crude oil and gasoline is traded.

c) Interest Rate futures Contract:

These contracts are traded on treasury bills, notes, bonds, and banks certification of deposit, euro-dollar, deposits and single-family mortgages.

d) Foreign Exchange Futures contract

These contracts are traded in the British pound, the Canadian dollar, the Japanese Yen,the Swiss Franc and the Deutsche Mark. Contracts are also listed on French

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Francs, Dutch Guilders and the Mexican Peso, but these have met with only limitedsuccess.

e) Stock Index Futures Contract: -

A stock index futures contract is a contract to buy or sell the face value of the underlyingstock index where the face value is defined as being the value of index multiplied by thespecified monetary amount.

3) Options

An Options Contract is a contract where it confers the buyer the right to either to buy or tosell of an underlying asset (Stock, Bond, Currency, commodity) etc. At a pre-determined price, on or before a specified date in the future. The price so pre-determined is called the 'Strike Price' or 'Exercise Price'. Depending on the contractterms, an option may be exercisable on any date during a specified period or it may beexercisable only on the fin~1 or expiration date of the period covered by the optioncontract.

Option Premium

In return for the guaranteeing the exercise of an option at its strike price, the option seller or writer charges a premium, which the buyer usually pays upfront. Under favorablecircumstances the buyer may choose to exercise it. Alternatively, the buyer may beallowed to sell it. If the option expires without being exercised, the buyer receives nocompensation for the premium paid. This option premium consists of two component,intrinsic value and time value.

a) Intrinsic value: The intrinsic value is equal to the amount by which it is inthe money. Therefore an option, which is out of the money or at themoney, has zero intrinsic value. Intrinsic value of any option can never benegative. A call will be in the money or will have intrinsic value only if its

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strike price is lower than the current price of the underlying asset. A putwill be in the money or will have intrinsic value only if its strike price isabove than the current price of the underlying asset.

b) Time value: time value of an option is also called as extrinsic value of option is the quantification of the probability of the change in theunderlying price that determines the value of option during the remainingtime until the expiration that is the chances of an out of money or at themoney option going the money or an in the money option going deeper inthe money during currency of the contract. This value depends on time toexpiration of option and the volatility of the underlying prices.Mathematically, time value is the difference between the option premium

and the intrinsic value. So in case of out of the money or at the money, theentire premium is the time value of options. Time value of the option isalso cannot be negative.

Option Pricing

Price of option depends on six factors. Namely, spot price, strike price, time of expiration,volatility, risk free rate of interest, dividend. Unlike futures which derives there pricesprimarily from prices of the undertaking. Option prices are far more complex.

Option Writer

In an option contract, the seller is usually referred to as "writer", since he is said to write towrite the contract.

If an option can be exercised on any date during its lifetime it is called anAmerican Option. However, if it can be exercised only on its expiration date, it is called a

European Option.

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Option Instruments

a) Call Option

A Call Option is one, which gives the option holder the right to "buy" an underlying asset ata pre - determined price.

b) Put Option

A Put Option is one, which gives the option holder the right to "sell" an underlying asset at apre - determined price on or before the specified date in the future.

c) Double Option

A Double Option is one, which gives the option holder both the right to "buy" or "sell"underlying asset at a pre - determined price on or before a specified date in the future.

Definitions used in options

1) Intrinsic Value of Option

It is the gain to the holder of the option on the immediate exercise. For a call option it isdefined as Max [(S-X), O], where US" is the current spot price and "X" is the strike price.If S> X then the call has a positive intrinsic value. Similarly, for a put option, intrinsicvalue Max [(X-S), O].

2) Time Value of the Option

The difference between the value of an option at any time and its intrinsic value at the time

is called the time value of the option.At the Money, In the money and Out of money optionsA call option is said to be at.a) At the money, if S=Xb) In the money, if S>X

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Interest Rate SWAPAn Interest Rate swap is an agreement between 2 parties to exchange interest obligations

or receipts in the same currency on an agreed amount of notional principal for anagreed period of time.

a) Currency SWAPA Currency SWAPS is an agreement between 2 parties to exchange to payments or

receipts in one currency for payment or receipts of another.

b) Commodity SWAP

A Commodity SWAP is an arrangement by which one party (a commodity user/buyer)agrees to pay a fixed price for a designated quantity of a commodity to the counter party(commodity producer/seller), who in turn pays the first party f the first party a pricebased on the prevailing market price (or an accepted index t~ thereof) for the samequantity,

c) Equity SWAPSAn Equity SWAP is an arrangement by which one party pays to the counter party an

amount based on the value of the shares of the company, and receives from thecompany party an amount of fixed or floating interest on an equivalent notional value.

Risks of Derivatives

Financial markets are, extremely volatile and hence the risk factor is an important concernfor financial agents. To reduce this risk, the concept of derivatives comes into the

picture. Derivatives are products whose values are derived from one or more basicvariables called bases. These bases can be underlying assets (for example forex,equity, etc), bases or reference rates. 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. The

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transaction in this case would be the derivative, while the spot price of wheat would bethe underlying asset.

The appreciation of these products' effective benefits would however be partial andincomplete with out an analysis of some of the risks inherently linked. The major preoccupation of regulatory bodies, banks and other market participants wouldessentially gravitate around the identification and qualitative appreciation of these risks.The kinds of risks associated with derivatives are no different from those associatedwith traditional financial instruments, although they can be far more complex i.e., credit,market, operational, and legal risk.

Background of the Study

Risk is a characteristic feature of all derivatives and capital markets. Prices of any underlying asset like shares or stocks and debentures or bonds and other securitiesare subject to continuous change. Similarly commodities like wheat, cotton rice, coffeeor tea or non-agricultural like silver, gold etc are also subject to fluctuation over time inkeeping with prevailing demand and supply conditions. Producers or processors of these commodities obviously cannot be sure of the prices

that their production or processors are not sure what they would have to pay for their buy.Those who are charged with the responsibility of managing money, their own or of others are therefore constantly exposed to the threat of risk.

Risk is an essential yet precarious element of investing, one should, regardless of what kind of investor you are; gain a fairly good awareness of how investors andcompanies work to protect themselves. Whether or not you decide to start practicingthese intricate uses of derivatives, learning about how hedging works will help advanceyour understanding the market, which will always help you be a better investor. In thesame way, the foreign exchange rates are also subject to continuous change. Thus animporter of a certain price of machinery is not sure of the amount he would have to payin rupee terms when the payment becomes due. While example where risk is seen toexist can be easily multiplied, it may be observed that parties involved in all such casesmay see the benefits of and are likely and to desire having some contractual from

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whereby forward prices may be fixed and the price risk facing them is eliminated.Determine came into being primarily for the reason of the need to eliminate price risk.

Risk Management:

The central objective of Risk Management System is to assess and managethe risk of the market in an expeditious manner to ensure smooth and timely pay-in/pay-out process of the Exchange. Some of the basic functions of Risk Management:

Clearing and Settlement:

The Clearing and Settlement System of the Exchange is system driven and rule based.The Exchange has its own in-house clearing house, which undertakes to clear each and

every trade and is counter-party for all trades; thus offering notation (zero counter-partyrisk) to each and every trade executed on the Exchange.

Clearing Bank Interface:

Exchange maintains electronic interface with its Clearing Banks. All members of theexchange have their Settlement and Client Accounts for exchange operations with theClearing Bank. All debits and credits are affected electronically through Settlementaccount only.

Delivery and Final Settlement:

All contracts on maturity are for delivery. MCX specifies tender and delivery periods. For example, such periods can be from the 8th working day till the 15th day of the month -

where 15th is the last trading day of the contract month - as tender and/ or deliveryperiod. A seller or a short open position holder in that contract may tender documents tothe exchange expressing his intention to deliver the underlying commodity. Theexchange would then select the buyer from the long open position holder for thetendered quantity. Once the buyer is identified, seller has to initiate the delivery process

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and the buyer has to take delivery according to the delivery schedule prescribed by theexchange.

Risk Management Tools:

Derivatives are powerful risk management tools. To illustrate, lets take the example of aninvestor who holds the stocks of Infosys, which are currently trading at Rs 2,096.Infosysoptions are traded on the National Stock Exchange of India, which gives the owner theright to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30thJan 2009. Now if the share price of Infosys remains less than or equal to Rs 2,200, thecontract would be worthless for the owner and he would lose the money he paid to buythe option, known as premium. However, the premium is the maximum amount that the

owner of the contract can lose. Hence he has limited his loss. On the other hand, if theshare price of Infosys goes above Rs 2,220, the owner of the call option can exercisethe contract, buy the share at Rs 2,220 and make profits by selling the share at themarket price of Infosys. The upward gain can be unlimited. Say the share price of Infosys zooms to Rs .3,000 by Jan 2009, the owner of the call option can buy the sharesat Rs 2,220, the exercise price of the option, and then sell it in the market for Rs 3,000.

Making a profit of Rs 780 less the premium that has been paid. If the premiumpaid to buy the call option is say Rs 10, the profit would be Rs 770.

Derivatives are an innovation that has redefined the financial services industry and it hasassumed a very significant place in the capital markets. However, trading in derivativesis complicated and risky. The derivatives have been blamed for the loss of fortunes atmany times in history.

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ii) To know the trading process

Online trading is the process of buying and selling financial securities, commodities andcurrencies through the Internet. In order to trade online, investors need to exercisepatience and use the right proprietary softwares provided by various brokers.

How to Trade Online

In online trading, orders are implemented with the help of online trading platforms offeredby various brokers. Investors place the orders directly on a brokers site. The broker executes the orders on the stock exchange and makes payments on behalf of hisclients. Brokers also provide their clients with market data, news and charts throughtheir online platforms. This is done to help them in taking informed decisions. They

charge software usage fees and trading commissions for their services. An investor cantrade in more than one product or market through the same account and software.

Benefits of Online Trading

Transparency: Online traders have complete information from the time of order placement till the final settlement. Every stage of online trading is

subject to scrutiny, as this provides transparency to the trading process.

Best prices: Investors can get the best quotes for securities due to hightransparency in the system.

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Added convenience and liquidity: Online trading can be carried out anytimeduring business hours. This provides liquidity to investors.

Low commissions: Investors can make transactions frequently, withoutworrying about the burden of commissions. This makes day trading and short-term trading more feasible.

Dangers of Online Trading

Technology problems: This includes delays in transactions due to Internetconnection outages or power failures.

A mentors absence: Lack of guidance from an experienced broker may leadto formulation of improper trading strategies, resulting in huge losses.

Overtrading: Online traders generally have a long term strategy beforeinvesting. However, the lure of capitalizing on short term movements makes

them buy and sell more frequently. The low level of commission in onlinetrading further lures the investors into day trading. This takes the traders awayfrom their well-researched long term trading strategy, causing losses in thelong run.

Tips for Online Trading

Set limit orders on the trading of stocks. Avoid overtrading. Do not trade a large number of stocks at once. Do not base decisions on daily ups and downs. Observe the long term trends.

Avoid trading based on rumors.

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Online trading is a good tool to earn a living as well as to supplement regular income.However, before venturing into online trading, an investor should carefully research onthe risks associated with it and prepare for them.

The normal course of online trading in the Indian market context is placed below:

Step 1 . Investor / trader decides to tradeStep 2. Places order with a broker to buy / sell the required quantity of respectivesecuritiesStep 3. Best priced order matches based on price-time priorityStep 4. Order execution is electronically communicated to the brokers terminalStep 5. Trade confirmation slip issued to the investor / trader by the broker

Step 6. Within 24 hours of trade execution, contract note is issued to the investor /trader by the broker Step 7 Pay-in of funds and securities before T+2 dayStep 8. Pay-out of funds and securities on T+2 day

In case of short or bad delivery of funds / securities, the exchange orders for an auction tosettle the delivery. If the shares could not be bought in the auction, the transaction isclosed out as per SEBI guidelines.

III) To know the investment process

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For investing in the stock market any investor should posses following proof and

details. Permanent Account Number (PAN), which has been made mandatory for allthe investors participating in the securities market.

Your name, date of birth, photograph, address, educational qualifications,occupation, residential status(Resident Indian/ NRI/others) Bank and depository account details If you are registered with any other broker, then the name of broker and concernedStock exchange and Client Code Number.

For proof of address (any one of the following):

Passport Voter ID Driving license Bank Passbook Rent Agreement Ration Card Flat Maintenance Bill Telephone Bill Electricity Bill Insurance Policy

Each client has to use one registration form. In case of joint names /family members, aseparate form has to be submitted for each person.

In case of Corporate Client, following information has to be provided: Name, address of the Company/Firm Date of incorporation and date of commencement of business. Registration number(with ROC, SEBI or any government authority) Details of PAN

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Details of Promoters/Partners/Key managerial Personnel of the Company/Firm inspecified format. Bank and Depository Account Details Copies of the balance sheet for the last 2 financial years (copies of annual balancesheet to be submitted every year) Copy of latest share holding pattern including list of all those holding more than 5%in the share capital of the company, duly certified by the Company Secretary / Wholetime Director/MD. (copy of updated shareholding pattern to be submitted every year) Copies of the Memorandum and Articles of Association in case of a company /body corporate, partnership deed in case of a partnership firm Copy of the Resolution of board of directors' approving participation in equity /

derivatives / debt trading and naming authorized persons for dealing in securities. Photographs of Partners/Whole time directors, individual promoters holding 5% or more, either directly or indirectly, in the shareholding of the company and of personsauthorized to deal in securities. If registered with any other broker, then the name of broker and concerned Stockexchange and Client Code Number.

Beneficial owner Account (B.O. account) / Demat Account: It is an account openedwith a depository participant in the name of client for the purpose of holding andtransferring securities.

Trading Account: An account which is opened by the broker in the name of therespective investor for the maintenance of transactions executed while buying andselling of securities.

Client Account / Bank Account: A bank account which is in the name of therespective client and is used for debiting or crediting money for trading in the securitiesmarket.If the investor appoints a broker for trading he should know some details about thebroker like

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Before choosing a broker/sub-broker the investor should be aware of the followingthings:- From where the broker/sub-broker has learnt the business? How long has he been serving the securities industry? Whether he has eligible qualifications as a broker? How many clients does he serve? What fees and expenses does he charge?The trading member can charge: 1. Brokerage charged by member broker.2. Penalties arising on specific default on behalf of client (investor)3. Service tax as stipulated.4. Securities Transaction Tax (STT) as applicable.

The brokerage, service tax and STT are indicated separately in the contract note.

The maximum brokerage that can be charged by a broker has been specified in the Stock

Exchange Regulations and hence, it may differ from across various exchanges. As per the BSE & NSE Bye Laws, a broker cannot charge more than 2.5% brokerage from hisclients.

RESEARCH DESIGN

Research design can be defined as a particular procedure or a set of procedures, theanalysis of principles of the enquiry in a particular field. It consists of blue print for thecollection, measurement and data analysis.

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STATEMENT OF THE PROBLEM

Stock broking firms will be under pressure many a time due to margin moneyproblems. The non payment of dues by clients on time and insufficient fund to have

particular future or options, long or short position always create lot of problem in thesebroking house. The study is conducted to understand the system followed by IndiaInfoline to handle these crucial situations and techniques used by customer to overcomeproblems also used at NSE.

SCOPE OF THE STUDY

The scope of the study is limited to the back office support system followed by

IndiaInfoline ltd. Primary data collected from the customers of IndiaInfoline to knowthere objective in investment as well as, how they are managing the risk pertaining tofutures and options. Other potential investors & existing investors opinion is beyond thescope of study. Study is descriptive type of research & findings are based on customers& expert officials opinion.

LIMITATIONS OF THE STUDY

The data collected are based on quota sampling and sample size is limited to100,which may lead to sampling error. As time is one of the constraints wecould not go beyond sample size 50to avoid sampling error.

The study cannot be generalized. Research is done by researcher with the help of interviewers and analysts, with

the assistance of internal and external guide & few others, I have attempted to do this

study. So this research is not an exhaustive one but gives insight of risk management infutures & options

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Risk Management

The first objective of the study was to know the various types of risk associated with futuresand options.

RISK is a concept that denotes a potential negative impact on an asset or somecharacteristic of value that may arise from a present process or future event.

In daily parlance, risk is often used synonymously with the probability of a known loss or injury.

Risk Management is the process of measuring or assessing risk and thendeveloping strategies to manage the same. It has to be enforced at every operationaland business process level. The risk involved in every process of business has to beidentified, quantified and limits assigned. The basic idea is to monitor and ensure that

risk levels do not exceed the limits set by the management in accordance with their guidelines. Ideally, under risk management, a prioritization process is followed wherebyrisks with the greatest loss and the greatest probability of occurrence are handled first,while risks with the lower probability of occurrence and lower loss are handled later.

The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that substitutes deliberate ignorance for thoughtfulplanning.

Risks can be of two types mainly,Systematic RiskUnsystematic Risk

Systematic Risk : The Systematic risk affects the entire market. The entire market ismoving in a particular direction either upward or downward is due to the economic

conditions, political situation and sociological changes that affect the securities market. Thesystematic risk is further sub-divided into :

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Market Risk: The tangible event like Pokaran blast and intangible event like investorspsychology affects the entire stock market, which are known as market risk.

Interest Rate Risk: It is the variation in return caused by the changes in the market interestrate. The rise and fall in the interest rate affects the cost of borrowing.

Purchasing Power Risk: Variation in the return is caused also by the loss of purchasingpower of currency. Inflation is the reason behind the loss of purchasing power. Inflationreduces the real rate of return earned from the securities.

Unsystematic Risk : Unsystematic risk is the unique type of risk associated to the

particular industry or company. Unsystematic risk stems from managerial inefficiency,technological change in the production process, availability of raw material, changes incustomer preference, and labor problems. Unsystematic risk can be classified into

1. Business Risk2. Financial Risk

Business Risk: the operating environment of the business causes Business risk. This maybe caused by internal factors like fluctuations in sales or personnel management or external factors like government policies, rules and regulations.

Financial Risk: Financial Risk emerges from the debt component of the capital structure. Itrefers to the variability of the income to the equity capital due to the debt capital.

Risk can also be classified as to that of risk related to the equity market can be summarized

under two broad categories:

1. Internal Risks2. External Risks

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Internal risks : Internal risks can be defined as occurrence of loss due to failure on the partof an organization to take protective measures.

Credit Risk: This is the risk of failure of counter party to perform its obligation as per thecontract. Also known as default or counter party risk, it different instruments.

Vault Risk: There is a risk involved when a client/ group of clients take an overexposure inone or two scrip in the market. The total consolidated number of shares in particular scrip of all such clients should not exceed a certain percentage

of total outstanding shares floating in the market nor should there be low volume scrips as itbecomes extremely difficult to sell such stocks in the market. This kind of risk is called

vault risk.

Legal And Compliance Risk: Legal and compliance risk is associated with lack of adherence to SEBIs rules and regulations, and applicable laws. It is also associatedwith know your client (KYC) norms, prevention of money laundering (PMLA), insider trading with price- sensitive information, circular trading and rules related to NRIinvestments.

System Risk: Most of the online products offered by India Info line ltd are highly dependenton the performance of systems/ technology. The failure/ malfunction of the system isregarded as system risk.

EXTERNAL RISKS : External risk can be defined as occurrence of loss due to factors beyond the control of the organization.

Market Risk: Market risk is a risk of financial loss as a result of adverse movement of prices of the underlying asset/ instrument.

Liquidity Risk: The inability of a firm to arrange a transaction at prevailing market prices istermed as liquidity risk.

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Global Market Risk: Global capital markets now play a major role in the Indian stockmarket. Any information about major global markets can affect the movement of stockprices in India.

Currency Risk: Currency appreciation or depreciation can change the pricemovement of a particular industry or sector, for example Technology, petroleum etc.,Hence, currency also influence stock price.

Margin Money

One of the objective of the study was to find out the system used by company to overcomeproblem associated with margin money problem.

A sound risk management system is integral to an efficient clearing and settlement system.NSE introduced for the first time in India, risk containment measures that were commoninternationally but were absent from the Indian securities markets.

NSCCL has put in place a comprehensive risk management system, which is

constantly upgraded to pre-empt market failures. The Clearing Corporation ensures thattrading member obligations are commensurate with their net worth. Risk containmentmeasures include capital adequacy requirements of members, monitoring of member performance and track record, stringent margin requirements, position limits based oncapital, online monitoring of member positions and automatic disablement from tradingwhen limits are breached, etc.

Just as we are faced with day-to-day uncertainties pertaining to weather, health,traffic etc and take steps to minimize the uncertainties, so also in the stock markets,there is uncertainty in the movement of share prices. This uncertainty leading to risk issought to be addressed by margining systems by stock markets. Suppose an investor,purchases 1000 shares of xyz company atRs.100/- on September 1, 2008. Investor has to give the purchase amount of Rs.1, 00,000/- (1000 x 100) to his broker on or before September 2, 2008. Broker, in turn, has to give this money to stock exchange on

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September 3; 2008.There is always a small chance that the investor may not be able tobring the required money by required date. As an advance for buying the shares,investor is required to pay a portion of the total amount of Rs.1, 00,000/- to the broker atthe time of placing the buy order. Stock exchange in turn collects similar amount fromthe broker upon execution of the order. This initial token payment is calledmargin.

For every buyer there is a seller and if the buyer does not bring the money, seller may not get his / her money. Margin is levied on the seller also to ensure that he / shegives the 100 shares sold to the broker who in turn gives it to the stock exchange.Margin payments ensure that each investor is serious about buying or selling shares.

In the above example, assume that margin was 15%. That is investor has to giveRs.15,000/-(15% of Rs.1, 00,000/) to the broker before buying. Now suppose thatinvestor bought the shares at 11 am on September 1, 2008. Assume that by the end of the day price of the share falls by Rs.25/-. That is total value of the shares has comedown to Rs.75,000/-. That is buyer has suffered a notional loss of Rs.25, 000/-. In our example buyer has paid Rs.15, 000/- as margin but the notional loss, because of fall inprice, is Rs.25, 000/-. That is notional loss is more than the margin given. In such asituation, the buyer may not want to pay Rs.1, 00,000/ - for the shares whose value hascome down to Rs.75, 000/-. Similarly, if the price has gone up by Rs.25/-, the seller maynot want to give the shares at Rs.1, 00,000/-. To ensure that both buyers and sellersfulfill their obligations irrespective of prices movements, notional losses are also need tobe collected. Prices of shares may keep on moving every day. Margins ensure thatbuyers bring money and sellers bring shares to complete their obligations even thoughthe prices have moved down or up.

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However, historical volatility number would tell you that shares of W may move up or downby large percentage whereas shares of Z may see a small percentage variationcompared to close price on September 22, 2008. This is only an estimate based on pastprice movements. Since the uncertainty of price movements is very high for W itsshares would attract higher initial margin whereas shares of Z should attract lower initial margin since its volatility is low. Let us deal with this aspect in more detail whileexploring different types of margins.

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Date Closingprice of Sharesof W

Daily LNReturns

Closingprice of Sharesof X

Daily LNReturns

Closingprice of Sharesof Y

Daily LNReturns

Closingprice of Sharesof Z

Daily LNReturns

1-9-08 2800 2420 2825 2510

2-9-08 2850 1.77% 2480 2.45% 2758 -2.40% 2515 0.20%3-9-08 2700 -5.41% 2515 1.40% 2742 -0.58% 2520 0.20%4-9-08 2750 1.83% 2550 1.38% 2725 -0.62% 2512 -0.32%5-9-08 2900 5.31% 2565 0.59% 2708 -0.63% 2508 -0.16%6-9-08 2800 -3.51% 2592 1.05% 2686 -0.82% 2514 0.24%7-9-08 2650 -5.51% 2614 0.85% 2667 -0.71% 2523 0.36%8-9-08 2700 1.87% 2635 0.80% 2635 -1.21% 2510 -0.52%10-9-08 2750 1.83% 2667 1.21% 2614 -0.80% 2505 -0.20%11-9-08 2650 -3.70% 2686 0.71% 2592 -0.85% 2515 0.40%12-9-08 2640 -0.38% 2708 0.82% 2565 -1.05% 2502 -0.52%13-9-08 2520 -4.65% 2725 0.63% 2550 -0.59% 2510 0.32%17-9-08 2670 5.78% 2742 0.62% 2515 -1.38% 2515 0.20%21-9-08 2720 1.86% 2758 0.58% 2480 -1.40% 2511 -0.16%22-9-08 2790 2.54% 2825 2.40% 2420 -2.45% 2514 0.12%Volatality 3.85% 0.62% 0.62% 0.32%


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Categorisation of stocks for imposition of margins at NSCCL

The Stocks which have traded atleast 80% of the days for the previous six months shallconstitute the Group I and Group II.

Out of the scrips identified above, the scrips having mean impact cost of less thanor equal to 1% shall be categorized under Group I and the scrips where the impact costis more than 1, shall be categorized under Group II. The remaining stocks shall beclassified into Group III.

The impact cost shall be calculated on the 15th of each month on a rolling basisconsidering the order book snapshots of the previous six months. On the basis of the

impact cost so calculated, the scrips shall move from one group to another group fromthe 1st of the next month.

For securities that have been listed for less than six months, the trading frequencyand the impact cost shall be computed using the entire trading history of the security.

Categorisation of newly listed securities

For the first month and till the time of monthly review a newly listed securitywill be categorised in that Group where the market capitalization of the newly listedsecurity exceeds or equals the market capitalization of 80% of the securities in thatparticular group. Subsequently, after one month, whenever the next monthly review iscarried out, the actual trading frequency and impact cost of the security shall becomputed, to determine the liquidity categorization of the security.

In case any corporate action results in a change in ISIN, then the securities bearing thenew ISIN shall be treated as newly listed security for group categorization.

Daily margins payable by members consists of the following:

1. Value at Risk (VaR) marginVaR is a technique used to estimate the probability of loss of value of an asset or

group of assets (for example, share or a portfolio of a few shares), based on the

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statistical analysis of historical price trends and volatilities. A VaR statistic has threecomponents: a time period, a confidence level and a loss amount (or loss percentage).

2.Extreme loss marginThe extreme loss margin aims at covering the losses that could occur outside the coverage

of VaR margins. The Extreme loss margin for any stock is higher of 1.5 times thestandard deviation of daily LN returns of the stock price in the last six months or 5% of the value of the position. This margin rate is fixed at the beginning of every month, bytaking the price data on a rolling basis for the past six months.

3. Mark to market MarginMTM is calculated at the end of the day on all open positions by comparing transaction

price with the closing price of the share for the day.

Daily margin, comprises of the sum of VaR margin, Extreme Loss Margin and mark tomarket margin is payable.

Value at Risk Margin For the securities listed in Group I , scrip wise daily volatility calculated using theexponentially weighted moving average methodology shall be applied to daily returns inthe same manner as in the derivatives market. The scrip wise daily VaR would be 3.5times the volatility so calculated subject to a minimum of 7.5%.

For the securities listed in Group II , the VaR margin shall be higher of scrip VaR (3.5sigma) or three times the index VaR, and it shall be scaled up by root

For the securities listed in Group III , the VaR margin would be equal to five times theindex VaR and scaled up by root 3.

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VaR margin rate for a security constitutes the following:Value at Risk (VaR) based margin, which is arrived at, based on the methods stated above.

The index VaR, for the purpose, would be the higher of the daily Index VaR based onS&P CNX NIFTY or BSE SENSEX. The index VaR would be subject to a minimum of 5%.

The VaR margin rate computed as mentioned above will be charged on the net outstandingposition (buy value-sell value) of the respective clients on the respective securitiesacross all open settlements. There would be no netting off of positions across differentsettlements. The net position at a client level for a member are arrived at and thereafter,it is grossed across all the clients including proprietary position to arrive at the gross

open position.

For example, in case of a member, if client A has a buy position of 1000 in a security andclient B has a sell position of 1000 in the same security, the net position of the member in the security would be taken as 2000. The buy position of client A and sell position of client B in the same security would not be netted. It would be summed up to arrive at themembers open position for the purpose of margin calculation.

The VaR margin shall be collected on an upfront basis by adjusting against the totalliquid assets of the member at the time of trade. The VaR margin so collected shall bereleased on completion of pay-in of the settlement.

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Extreme Loss Margin

The Extreme Loss Margin for any security shall be higher of:5%, or 1.5 times the standard deviation of daily logarithmic returns of the security price in

the last six months. This computation shall be done at the end of each month by takingthe price data on a rolling basis for the past six months and the resulting value shall beapplicable for the next month.

The Extreme Loss Margin shall be collected/ adjusted against the total liquidassets of the member on a real time basis. It shall also be collected on the gross openposition of the member. The gross open position for this purpose would mean the grossof all net positions across all the clients of a member including its proprietary position.

There would be no netting off of positions across different settlements. TheExtreme Loss Margin collected shall be released on completion of pay-in of thesettlement.

Mark-to-Market Margin

Mark to market loss shall be calculated by marking each transaction in securityto the closing price of the security at the end of trading. In case the security has notbeen traded on a particular day, the latest available closing price at the NSE shall beconsidered as the closing price. In case the net outstanding position in any security isnil, the difference between the buy and sell values shall be considered as notional lossfor the purpose of calculating the mark to market margin payable.The mark to market margin (MTM) shall be collected from the member before the startof the trading of the next day. The MTM margin shall also be collected / adjustedfrom/against the cash/cash equivalent co

S i P FinalRisk Report

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