Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
SUBMITTED TO:
DR. YP SINGH
(Faculty)
2
CONTENTS
1.1 Early toothpastes
1.2 Tooth powder
S.NO PARTICULARS PAGE
NO.
1 ACKNOWLEDGEMENT 5
2 NEED OF THE STUDY 6
3 OBJECTIVE 7
4 SCOPE 8
5 RESEARCH METHODOLOGY 9
6 LIMITATIONS OF THE STUDY 10
7 LITERATURE REVIEW 11
8 EXECUTIVE SUMMARY 13
9 INTRODUCTION-INDIAN INVESTMENT 22
INDUSTRY
10 OVERVIEW:INDIAN SECURITIES MARKET 26
11 INDIAN DERIVATIVE MARKET 35
12 DERIVATIVE MARKET AND ITS INSTRUMENTS 44
13 MARKET TRENDS IN FUTURE AND OPTION 56
14 COMPARISION OF NEW SYSTEM WITH THE 68
EXISTING ONE
15 DEVELOPMENT OF DERIVATIVE MARKET IN 77
INDIA
3
NO.
16 MAJOR APPLICATIONS OF FINANCIAL 85
DERIVATIVES
17 FINANCIAL DERIVATIVES-INSTRUMENTS 89
IN STRATEGIC RISK MANAGEMENT
18 HEDGING 96
19 SPECULATION 111
22 BIBLIOGRAPHY 116
ACKNOWLEDGEMENT
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I am extremely grateful to all those who have shared their views, opinions,
ideas and experiences which have significantly improved this Project Report.
I would like to express my sincere thanks to, Mr.YP SINGH International
Institute for Special Education, Lucknow for his guidance and sincere efforts
towards bringing in years of his vast industrial experience into this project. I
am very thankful to all the respondents and the employees for their
cooperation in the course of my study.
A special thanks to my friends and family for their encouragement and help
in the successful completion of the study.
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The study has been conducted to know about the derivative market of
India as well as the instruments used in strategic risk management. This
study also covers the recent developments in the derivative market taking
into account the trading in past years.
Through this study I came to know the trading done in derivatives and
their use in the stock markets as well as the recent trends in the field of
hedging and speculation.
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To understand the concept of the Derivatives and Derivative Trading.
To know different types of Financial Derivatives
To know the role of derivatives trading in India.
To analyse the performance of Derivatives Trading since 2001with
special reference to Futures & Options
To understand the concepts of hedging and speculation in Indian
derivative market
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The project covers the derivatives market and its instruments. For better
understanding various strategies with different situations and actions have
been given. It includes the data collected in the recent years and also the
market in the derivatives in the recent years. This study extends to the
trading of derivatives done in the National Stock Markets.
RESEARCH METHODOLOGY
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Method of data collection:-
Secondary sources:-
It is the data which has already been collected by some one or an
organization for some other purpose or research study .The data for study
has been collected from various sources:
Books
Journals
Magazines
Internet sources
Time:
2 months
Statistical Tools Used:
Simple tools like bar graphs, tabulation, line diagrams have been used.
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LIMITATIONS OF STUDY
1. VOLATALITY:
Share market is so much volatile and it is difficult to forecast any thing
about it whether you trade through online or offline
2. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a
wide topic had a limited time.
3. LIMITED RESOURCES:
Limited resources are available to collect the information about the
commodity trading.
4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.
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LITERATURE REVIEW
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Even small investors find these useful due to high correlation of the popular
indices with various portfolios and ease of use. The lower costs associated
with index derivatives vis-vis derivative products based on individual
securities is another reason for their growing use.
As in the present scenario, Derivative Trading is fast gaining
momentum, I have chosen this topic.
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EXECUTIVE SUMMARY
My project is all about THE INDIAN DERIVATIVE MARKET and its
instruments.a thorogh study has been conducted to know the recent trends
and factual aspects of Indian derivative market and its intruments
WEALTH CREATION
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our money. Inflation makes our money less powerful each day. This is the
reason why we need to fight inflation (to protect our money) by a great tool
called investment. India is growing and a person who is investing is actually
contributing to the growth of the nation; in return he/she will get the desired
returns. Important is to identify a suitable "asset class" for oneself and start
investing in it. Like retired people would like to invest in bonds, deposits;
middle aged men would like to invest in mutual funds, real estate but people
who are young and dynamic would like to invest in direct equity like stocks.
Why we have seen this transition and change of shift form savings to
investment? The answer clearly lies in the confidence of Indian Investors in
the future growth prospects of India. This confidence is fueled by a
consistent GDP growth of around 8%. Average performance of various asset
classes is as listed below:
Talking about short term investment horizon and GDP growth almost
assured at 7% to 8%, the focus on investors in Indian market shall be more
on selecting a suitable asset class for investment rather then debating of
growth and risks of investment. India will grow and top brains are convinced
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and assures average retail investors of this growth scene. People who are
already in the boat (investing) might have realized the power of investment
in Indian economy, but for people who have not started yet for them its not
late. In long run India is certain to make big money for its investors but
consistent GDP growth rate proves very encouraging even for short-term
investors.
But India is India and volatility is only the other name for this dynamic
country. Changes in political scenario, inflation, drought, flood, rise of
interest rates, market demands all in totality effect the performance of the
market. People should realize that India is a growing economy and such
volatility is expected. The price of stocks may fall and rise but investors
must not loose faith; it is important to keep the focus and attention of the
bigger picture of India's growth.
With over 25 million shareholders, India has the third largest investor base in
the world after USA and Japan. Over 7500 companies are listed on the
Indian stock exchanges (more than the number of companies listed in
developed markets of Japan, UK, Germany, France, Australia, Switzerland,
Canada and Hong Kong.). The Indian capital market is significant in terms
of the degree of development, volume of trading, transparency and its
tremendous growth potential.
India’s market capitalization was the highest among the emerging markets.
Total market capitalization of The Bombay Stock Exchange (BSE), which,
as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every
twelve months and was over US$ 834 billion as of January, 2007. Bombay
Stock Exchanges (BSE), one of the oldest in the world, accounts for the
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largest number of listed companies transacting their shares on a nationwide
online trading system. The two major exchanges namely the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5
in the world, calculated by the number of daily transactions done on the
exchanges.
The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in
2006 – An increase of 82% from US $ 1237 billion in 2004 in a short span of
2 years only. Turnover in the Spot and Derivatives segment both in NSE &
BSE was higher by 45% into 2006 as compared to 2005. With daily average
volume of US $ 9.4 billion, the Sensex has posted excellent returns in the
recent years. Currently the market cap of the Sensex as on July 4th, 2009
was Rs 48.4 Lakh Crore with a P/E of more than 20.
Derivatives are assets, which derive their values from an underlying asset.
These underlying assets are of various categories like
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• Commodities including grains, coffee beans, etc.
• Precious metals like gold and silver.
• Foreign exchange rate.
•Bonds of different types, including medium to long-term negotiable debt
securities issued by governments, companies, etc.
• Short-term debt securities such as T-bills.
• Over-The-Counter (OTC) money market products such as loans or
deposits.
• Equities
For example, a dollar forward is a derivative contract, which gives the buyer
a right & an obligation to buy dollars at some future date. The prices of the
derivatives are driven by the spot prices of these underlying assets.
However, the most important use of derivatives is in transferring market risk,
called Hedging, which is a protection against losses resulting from
unforeseen price or volatility changes. Thus, derivatives are a very important
tool of risk management.
Hedging risk has been an integral part of the financial markets for many
years. In the 1800s, commodity producers and merchants began using
forward contracts for protection against unfavorable price changes. This
system is still very active today.
The term "hedge fund" dates back to only 1949. In 1949, almost all
investment strategies took only long positions. A reporter for Fortune
magazine, named Alfred Winslow Jones, published an article pointing out
that investors could achieve higher returns if hedging were implemented into
an investment strategy. This was the beginning of the Jones model of
investing.
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To prove his hypothesis, Jones launched an investment partnership
incorporating two investment tools into his strategy: short selling and
leverage. The purpose of these two strategies was to limit risk and enhance
returns simultaneously.
In addition, Jones established two important characteristics that are still part
of the industry today. He used an incentive fee of 20% of profits and he kept
most of his own personal money in the fund. This ensured that his personal
goals and the goals of his investors were in alignment.
Exceptional results were obtained through this hedged approach. During the
period from 1962 to 1966, Jones outperformed the top mutual fund by more
than 85%, net of fees. The success of Jones stimulated the interest of high
net worth individuals in hedge funds.
Not only did Jones attract the interest of high net worth individuals to hedge
funds, but also many top money managers were drawn to hedge fund
because of the unique fee structure. A 20% incentive fee made it possible
for managers to earn 10 to 20 times as much in compensation when
compared to long-only money management services.
Between 1966 and 1968, nearly 140 new hedge funds were launched as a
consequence of the new dynamics of investing and managing money. Many
of these funds, however, did not follow the Jones model of hedging risk.
Instead of hedging, only leverage was used to enhance returns, ignoring the
short-selling aspect that Jones employed. Using a leveraged, long-only
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strategy made these funds highly susceptible to the market downturn that
began in late 1968. Some hedge funds dropped in value by more than 70%
within two years.
Large hedge fund losses due to the 1973-1974 bear market caused many
investors to turn away from hedge funds. For the next ten years, few
managers could attract the necessary capital to launch new partnerships. By
1984, there were only 68 funds in existence.
In the late 1980s, a small group of extremely talented hedge fund managers,
including George Soros, Michael Steinhart, and Julian Robertson, gave
hedge funds a restored credibility. Despite difficult market conditions, these
managers produced annual returns of greater than 50%.
Many of the world¡s best money managers left the traditional institutional
and retail investment firms because of potentially higher fees and great
flexibility with managing hedge fund products. By 1990, there were over
500 hedge funds worldwide with assets of about $38 billion.
Hedge funds now represent one of the largest segments of the investment
management industry. Currently, it is estimated that there are over 6,000
hedge funds in existence with total money under management in excess of
$1 trillion.
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1. Forwards
2. Futures
3. Options
4. Swaps
“An Options contract confers the right but not the obligation to buy (call
option) or sell (put option) a specified underlying instrument or asset at a
specified price – the Strike or Exercised price up until or an specified future
date – the Expiry date. The Price is called Premium and is paid by buyer of
the option to the seller or writer of the option.”
A call option gives the holder the right to buy an underlying asset by a
certain date for a certain price. The seller is under an obligation to fulfill the
contract and is paid a price of this, which is called "the call option premium
or call option price".
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A put option, on the other hand gives the holder the right to sell an
underlying asset by a certain date for a certain price. The buyer is under an
obligation to fulfill the contract and is paid a price for this, which is called
"the put option premium or put option price".
“Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount”
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Investment is referred to as the concept of deferred consumption, which
might comprise of purchasing an asset, rendering a loan, keeping the saved
funds in a bank account such that it might generate lucrative returns in the
future. The options of investments are huge; all of them having different
risk-reward trade off. This concludes that the investment industry is really
broad and that is why understanding the core concepts of investments and
accordingly analyzing them is essential. After thorough understanding of the
investment industry, can an investor create and manage his own investment
portfolio such that the returns are maximized with the least risk exposure.
STOCKS: Investors can also buy stocks (equities) from the secondary
markets and be a part of any business corporates that are listed in the
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bourses. By this way, one can become the part of the profits that the
company generates. But one should remember that stocks are generally more
volatile and carries more risk than bonds.
MUTUAL FUNDS: They are usually a collection of stocks and bonds that a
fund manager selects for an investor such that the returns are maximum. The
investor does not have to track the investment, be it a bond, stock- or index-
based mutual funds.
COMMODITIES: The items that are traded on the commodities market are
agricultural and industrial commodities and they need to be standardized.
Commodities trading have always been giving high returns and thus they are
the riskiest of all investment options. One, who trades in commodities,
requires specialize knowledge and analytical abilities
REAL ESTATE: Investing in real estate has to be a long term affair. Funds
get hooked into the real estate sector for a considerable time period.
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India's equity market has doubled since March 2009, with ADRs like Dr.
Reddy's Laboratories and Tata Motors only getting doubled and tripled. So,
do we say that the Indian investment industry is overheated at the moment or
may we infer that the stocks are fairly valued?
Warren Buffett has always mentioned that investment in India should always
be a long-term story - as the industry has been growing from an emerging
market to a developed one. The next 10 years in India will surely give good
returns.
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major propelling force towards India's attainment of self-sustained growth by
way of rapid industrialization. The pioneers of the investment industry has
been Foreign Direct Investment (FDI) and Investments made by NRIs.
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Exchange in the country. At present 24 stock exchanges operate all over
India. These stock exchanges provide facilities for trading securities,
Securities markets provide a common platform for transfer of funds from the
person who has excess funds to those who need them. Securities market is
regulated by the Securities& Exchange Board of India (SEBI).
Units
3. Intermediaries-Brokers, Sub brokers, Custodians, Share transfer
agents,
4. Merchant Bankers
Financial
6. Institutions, Mutual funds, Banks
Institutions, Foreign
8. Institutional Investors
• Primary Market
• Secondary Market
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• Derivatives market
INTERMEDIARIES
Intermediaries provide various services to investors and issuers and have
grown to become among both powerful and knowledgeable due to due to
substantial growth of securities markets over the last century. A large variety
and number of intermediaries provide intermediation services in the Indian
securities market.
ISSUERS OF SECURITIES
Every organisation, whether if be a company, institution or a Government
body needs funds for various operations. Organisations issue securities in the
primary market depending on their needs. The Securities market in India is
an important source for corporate and government. The corporate sector does
depend significantly on equity and debt markets for meeting its funding
requirements though the share of equity markets has been decreasing over
the recent years in view of the rather dull primary market. During the year
2001-02 total funds raised through capital issues were Rs. 43,700 crores
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approx. The share of the Public Sector was Rs. 33,300 crores and Private
Sector Rs. 10,400 crores. Equity component of the Capital Issues was 5,400
crores and whereas Debt component was the major one at Rs 38,300 crores.
Investors are those who have excess funds with them and want to employ it
for returns. Indian securities market has more than 20 million investors,
comprising Individuals, Companies, Mutual funds,Financial Institutions,
Foreign Institutional Investors. A review of shareholding pattern of all BSE
Companies shows that, more than 50% of the shares are heldby the
promoters of companies, whereas 15% by Institutional Investors.
MARKET REGULATORS
Securities market is regulated by following governing bodies:
5. Stock exchanges
Significant among the legislations for the securities market are the following:
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1. The SEBI Act, 1992, which establishes SEBI to protect investors and
development and regulate securities market. All the powers under this act are
exercised by SEBI.
2. The Companies Act, 1956 which set out the code of conduct for the
corporate sector in relation to issue, allotment and transfer of securities,
disclosures to be made in public issues and nonpayment of dividend. Powers
under this Act are exercised by SEBI in case of listed public companies and
public companies proposing to get their securities listed.
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SEBI regulates the business in stock exchanges and any other securities
markets and the working of collective investment schemes, including mutual
funds, registered by it. SEBI promotes investor’s education and training of
intermediaries of securities market. It prohibits fraudulent and unfair trade
practices relating to securities markets, and insider trading in securities, with
the imposition of monetary penalties, on erring market intermediaries, It also
regulates substantial acquisition of shares and takeover of companies and can
call for information from, carry out inspection, conduct inquiries and audits
of the stock exchanges and intermediaries and self regulatory organizations
in the securities market.
PRIMARY MARKET
Fresh issues of shares and other securities are effected though the Primary
market. It provides issuers opportunity to issue securities, to raise resources
to meet their requirements of business. Equity issues can be effected at face
value or at discount/premium. Issues at discounts are rare and almost
unheard of. Issuers can issue the securities in domestic market and/or
international market through ADR/GDR/ECB route.
SECONDARY MARKET
Investors can buy and sell securities in secondary market from/to other
investors. The securities are traded, cleared and settled through
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intermediaries as per prescribed regulatory framework under the supervision
of the Exchanges and oversight of SEBI. The regulatory framework has
prohibited trading of securities outside the exchanges. There are 24
exchanges (The Capital Stock Exchanges, the latest in the list, is yet to
commence trading) today recognised over a period of time to enable
investors across the length and breadth of the country to access the market.
DERIVATIVES MARKET
Derivatives are contracts that are based on or derived from some underlying
asset, reference rate, or index. Most common financial derivatives are:
forwards, futures, options and swaps.
Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2000 for trading in index futures,
Currently, the Indian markets provide equity derivatives of the following
types:
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transfer those they do not want to other companies that are more willing to
accept them. From a market-oriented perspective, derivatives offer the free
trading of financial risks.
Financial derivatives have changed the face of finance by creating new ways
to understand, measure, and manage financial risks. Ultimately, 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. Moreover, under a market-oriented philosophy,
derivatives allow for the free trading of individual risk components, thereby
improving market efficiency. Using financial derivatives should be
considered a part of any business’s riskmanagement strategy to ensure that
value-enhancing investment opportunity can be pursued.
The derivatives markets are the financial markets for derivatives, financial
instruments like futures contracts or options, which are derived from other
forms of assets.
The market can be divided into two, that for exchange traded derivatives and
that for over-the-counter derivatives. The legal nature of these products is
very different as well as the way they are traded, though many market
participants are active in both
what are derivatives:-
In most cases derivatives are contracts to buy or sell the underlying asset at a
future time, with the price, quantity and other specifications defined today.
The contract may bind both parties, and just one party with the other party
reserving the option to exercise or not. The underlying asset either has to be
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traded or some kind of cash settlement has to transpire. Derivatives are
traded either in organized exchanges or over the counter. Examples of
derivatives include forwards, futures, options, caps, floors, swaps, collars,
and many others.
EQUITY MARKET
Publicly traded equities form a significant source of capital for firms, and
equity markets are a key part of the process of allocating capital among
competing uses in our economy, Through issuance of equities, companies
enable a broad set of investors to share in the risk and reward of economic
activities.
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MEANING – EQUITY MARKET
The market in which shares are issued and traded, either through exchanges
or over-thecounter markets. Also known as the stock market, it is one of the
most vital areas of a market economy because it gives companies access to
capital and investors a slice of ownership in a company with the potential to
realize gains based on its future performance.
The history of derivatives is quite colourful and surprisingly a lot longer than
most people think. Forward delivery contracts, stating what is to be delivered
for a fixed price at a specified place on a specified date, existed in ancient
Greece and Rome. Roman emperors entered forward contracts to provide the
masses with their supply of Egyptian grain. These contracts were also
undertaken between farmers and merchants to eliminate risk arising out of
uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into
existence in the early 1700’s in Japan. The first formal commodities
exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the
US to deal with the problem of ‘credit risk’ and to provide centralised
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location to negotiate forward contracts. From ‘forward’ trading in
commodities emerged the commodity ‘futures’. The first type of futures
contract was called ‘to arrive at’. Trading in futures began on the CBOT in
the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives
contract, known as the futures contracts. Futures trading grew out of the need
for hedging the price risk involved in many commercial operations. The
Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in
1919, though it did exist before in 1874 under the names of ‘Chicago
Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB).
The first financial futures to emerge were the currency in 1972 in the US.
The first foreign currency futures were traded on May 16, 1972, on
International Monetary Market (IMM), a division of CME. The currency
futures traded on the IMM are the British Pound, the Canadian Dollar, the
Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and
the Euro dollar. Currency futures were followed soon by interest rate futures.
Interest rate futures contracts were traded for the first time on the CBOT on
October 20, 1975. Stock index futures and options emerged in 1982. The
first stock index futures contracts were traded on Kansas City Board of
Trade on February 24, 1982.The first of the several networks, which offered
a trading link between two exchanges, was formed between the Singapore
International Monetary Exchange (SIMEX) and the CME on September 7,
1984.
Options are as old as futures. Their history also dates back to ancient Greece
and Rome. Options are very popular with speculators in the tulip craze of
seventeenth century Holland. Tulips, the brightly coloured flowers, were a
symbol of affluence; owing to a high demand, tulip bulb prices shot up.
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Dutch growers and dealers traded in tulip bulb options. There was so much
speculation that people even mortgaged their homes and businesses. These
speculators were wiped out when the tulip craze collapsed in 1637 as there
was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an
American financier, Russell Sage, in 1872. These options were traded over
the counter. Agricultural commodities options were traded in the nineteenth
century in England and the US. Options on shares were available in the US
on the over the counter (OTC) market only until 1973 without much
knowledge of valuation. A group of firms known as Put and Call brokers and
Dealer’s Association was set up in early 1900’s to provide a mechanism for
bringing buyers and sellers together.
On April 26, 1973, the Chicago Board options Exchange
(CBOE) was set up at CBOT for the purpose of trading stock options. It was
in 1973 again that black, Merton, and Scholes invented the famous Black-
Scholes Option Formula. This model helped in assessing the fair price of an
option which led to an increased interest in trading of options. With the
options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began
trading in options in 1975.
The market for futures and options grew at a rapid pace in the eighties and
nineties. The collapse of the Bretton Woods regime of fixed parties and the
introduction of floating rates for currencies in the international financial
markets paved the way for development of a number of financial derivatives
which served as effective risk management tools to cope with market
uncertainties.
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The CBOT and the CME are two largest financial exchanges in the world on
which futures contracts are traded. The CBOT now offers 48 futures and
option contracts (with the annual volume at more than 211 million in
2001).The CBOE is the largest exchange for trading stock options. The
CBOE trades options on the S&P 100 and the S&P 500 stock indices. The
Philadelphia Stock Exchange is the premier exchange for trading foreign
options.
The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and
the Nikkei 225 trade almost round the clock. The N225 is also traded on the
Chicago Mercantile Exchange.
Until the advent of NSE, the Indian capital market had no access to
the latest trading methods and was using traditional out-dated
methods of trading. There was a huge gap between the investors'
aspirations of the markets and the available means of trading. The
opening of Indian economy has precipitated the process of
integration of India's financial markets with the international
financial markets. Introduction of risk management instruments in
India has gained momentum in last few years thanks to Reserve
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Bank of India's efforts in allowing forward contracts, cross currency
options etc. which have developed into a very large market.
DERIVATIVES MARKET
38
National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange
CHRONOLOGY OF INSTRUMENTS
39
1995 futures.
18 November SEBI setup L.C.Gupta Committee to draft a
1996 policy framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate
agreements (FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and
options on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do
index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at
BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September Nifty futures trading commenced at SGX.
2000
2 June 2001 Individual Stock Options & Derivatives
ABOUT DERIVATIVES
Derivatives are nothing but a kind of security whose price or value is
determined by the value of the underlying variables. It is more like a contract
of future date in which two or more parties are involved to alleviate future
risk. Usually, derivatives enjoy high leverage. Its value is affected by the
volatility in the rates of the underlying asset. Some of the widely known
underlying assets are:
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• Indexes (consumer price index (CPI), stock market index, weather
conditions or inflation)
• Bonds
• Currencies
• Interest rates
• Exchange rates
• Commodities
• Stocks (equities)
TYPES OF DERIVATIVES
The range of derivatives is really wide. But some of the most commonly known
derivatives are:
OPTIONS-It is of two different kinds such as calls and puts. Those who
take calls option, they are not obligated to purchase given quantity of the
underlying variable, at a mentioned price on or prior to a scheduled future
date. On the other hand, buyers in case of puts option may not necessarily
sell a mentioned quantity of the underlying variable at a mentioned price on
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or prior to a given date.
INTEREST RATE SWAPS-in this case, only interest related cash flows
can be exchanged between the entities in one currency.
IMPORTANCE OF DERIVATIVES
Financial transactions are fraught with several risk factors. Derivatives are
instrumental in alienating those risk factors from traditional instruments and
shifting risks to those entities that are ready to take them. Some of the basic
risk components in derivatives business are:
• CREDIT RISK: When one of the two parties fails to perform its
role as per the agreement, this is called the credit risk. It can also be
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referred to as default or counterparty risk. It varies with different
sources.
• MARKET RISK: This is a kind of financial loss that takes place
due to the adverse price movements of the underlying variable or
instrument.
• LIQUIDITY RISK: When a firm is unable to devise a transaction
at current market rates, it can be referred to as liquidity risk. There are
two kinds of liquidity risks involved in the scenario. First is concerned
with the liquidity of separate items and second is related to supporting
the activities of the organization with funds comprising derivatives.
• LEGAL RISK: Legal issues related with the agreement need to be
scrutinized well, as one can deal in derivatives across the different
judicial boundaries.
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of launching derivative markets in India got started. In the year 1999,
derivatives trading took place in India.
Indian derivatives markets can be divided into two types including 1) the
transaction which depends on the exchange, and 2) the transaction which
takes place 'over the counter' in one-to-one scenario. They can thus be
referred to as:
There are different kinds of traders in the derivatives market. These include:
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A forward contract is an agreement to buy or sell an asset on a specified
date for a specified price. One of the parties to the contract assumes a
long position and agrees to buy the underlying asset on a certain
specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date
for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are n o r m a l l y traded outside the exchanges.
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However futures are a significant improvement over the forward
contracts as they eliminate counterparty risk and offer more
liquidity.
FUTURE CONTRACT
A futures contract gives the holder the right and the obligation to buy or sell,
which differs from an options contract, which gives the buyer the right, but
not the obligation, and the option writer (seller) the obligation, but not the
right. To exit the commitment, the holder of a futures position has to sell his
long position or buy back his short position, effectively closing out the
futures position and its contract obligations. Futures contracts are exchange
traded derivatives. The exchange acts as counterparty on all contracts, sets
margin requirements, etc.
1. STANDARDIZATION:
Futures contracts ensure their liquidity by being highly standardized, usually
by specifying:
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• The underlying. This can be anything from a barrel of sweet crude oil
to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be
the notional amount of bonds, a fixed number of barrels of oil, units of
foreign currency, the notional amount of the deposit over which the
short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In case of bonds, this specifies which
bonds can be delivered. In case of physical commodities, this specifies
not only the quality of the underlying goods but also the manner and
location of delivery. The delivery month.
• The last trading date.
• Other details such as the tick, the minimum permissible price
fluctuation.
2. MARGIN:
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in
value, and creates a credit risk to the exchange, who always acts as
counterparty. To minimize this risk, the exchange demands that contract
owners post a form of collateral, commonly known as Margin requirements
are waived or reduced in some cases for hedgers who have physical
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ownership of the covered commodity or spread traders who have offsetting
contracts balancing the position.
• Initial Margin: is paid by both buyer and seller. It represents the loss
on that contract, as determined by historical price changes, which is
not likely to be exceeded on a usual day's trading. It may be 5% or
10% of total contract price.
3. SETTLEMENT
Settlement is the act of consummating the contract, and can be done in one
of two ways, as specified per type of futures contract:
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• Physical delivery - the amount specified of the underlying asset of the
contract is delivered by the seller of the contract to the exchange, and by
the exchange to the buyers of the contract. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale (covering
a short), or selling a contract to liquidate an earlier purchase (covering a
long).
• Cash settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such as Euribor, or
the closing value of a stock market index. A futures contract might also
opt to settle against an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For
many equity index and interest rate futures contracts, this happens on the
Last Thursday of certain trading month. On this day the t+2 futures contract
becomes the t forward contract.
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In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying
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DISTINCTION BETWEEN FUTURES AND
FORWARDS CONTRACTS
FEATURE FORWARD FUTURE CONTRACT
CONTRACT
Operational Traded directly between Traded on the exchanges.
Mechanism two parties (not traded on
the exchanges).
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OPTIONS -
A derivative transaction that gives the option holder the right but not the
obligation to buy or sell the underlying asset at a price, called the strike
price, during a period or on a specific date in exchange for payment of a
premium is known as ‘option’. Underlying asset refers to any asset that is
traded. The price at which the underlying is traded is called the ‘strike price’.
There are two types of options i.e., CALL OPTION & PUT OPTION.
CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an
underlying asset-stock or any financial asset, at a specified price on or before
a specified date is known as a ‘Call option’. The owner makes a profit
provided he sells at a higher current price and buys at a lower future price.
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PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an
underlying asset-stock or any financial asset, at a specified price on or before
a specified date is known as a ‘Put option’. The owner makes a profit
provided he buys at a lower current price and sells at a higher future price.
Hence, no option will be exercised if the future price does not increase.
Put and calls are almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.
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MARKET TRENDS IN FUTURES AND OPTIONS
Volatility in the markets has affected both structured derivatives along with
futures and options
Research from the consulting firm Greenwich Associates indicates that while
the use of over-the-counter, dealer traded, structured derivatives has seen a
marked decline in recent months, the use of exchange traded standard futures
and option contracts has seen the opposite, a rise in their use by institutional
investors for a variety of reasons. Perhaps some of the strategies employed
by these institutions can help the average retail investor.
Slightly less than two-thirds of institutions use futures and options to execute
their opinion on the general direction of the market, sector or individual
issues and just under half use exchange traded derivatives to establish more
complex strategies.
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PRODUCT SECTOR USAGE
Just over half of North American institutions use index futures with hedge
funds participating in this sector at just under half. The opposite is true in
usage of Exchange Traded Funds (ETF) with just over a half of institutions
using ETF’s and not quite two-thirds hedge funds.
To a lesser extent, institutions use futures and option contracts for index or
sector swaps and swaps on a particular portfolio or basket of stocks while
usage for access to the underlying sector or issue is a distant last.
POPULAR STRATEGIES
There are some slight differences between institutional investors overall and
hedge funds, but on balance the most popular strategy is single-stock listed
options with roughly three-quarters using them. The next most popular with
60% to 70% participation is listed index options and the third most popular
strategy with roughly half of institutions using them is options on sector
Exchange Traded Funds.
Much less popular were the more exotic type of uses such as futures and
options on volatility, dispersion and correlation type trades and variance
swaps on indexes and single stocks.
CONSIDERATIONS
There are a number of considerations any investor should make about their
broker. Being penny wise and pound foolish about commissions is a major
point. Institutional investors use a "high-touch" sales professional over half
the time for futures and three-quarters of he time for options. Electronic
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execution accounts for the reciprocal, whether to the broker’s desk or
directly to an exchange.
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SWAPS -
Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount. The two
commonly used swaps are:
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and
the interest on loan in one currency are swapped for the principle and the
interest payments on loan in another currency. The parties to the swap
contract of currency generally hail from two different countries. This
arrangement allows the counter parties to borrow easily and cheaply in their
home currencies. Under a currency swap, cash flows to be exchanged are
determined at the spot rate at a time when swap is done. Such cash flows are
supposed to remain unaffected by subsequent changes in the exchange rates.
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FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to
access one market and then exchange the liability for another type of
liability. It also allows the investors to exchange one type of asset for another
type of asset with a preferred income stream.
Illustrative Example
Shares of IBM trade on both the New York Stock Exchange and the Pacific
Stock Exchange. Suppose the shares of IBM trade for $65 on the New
York market and for $60 on the Pacific Exchange. A trader could make
the following two transactions simultaneously: Buy 1 share of IBM on
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the Pacific Exchange for $60Sell 1 share of IBM on the New York
Exchange for $65 The two transactions generate a riskless profit of $5.
Because both trades are assumed to occur simultaneously, there is no
investment.
The no-arbitrage principle states that any rational price for a financial
instrument must exclude arbitrage opportunities. This is one of the
minimal requirements for a feasible or rational price for any financial
instrument.
A good example of this kind is a future contract. Here the traders will
involve in an agreement that in a future date they both agree to exchange the
underlying asset. Derivatives usually have high leverage because even a
small change in the asset value can cause high difference in the derivative.
Derivatives are used by investors mainly for speculating and making profit
in the financial market. But, this will work only if the value of the asset
follows the trend in the financial market as expected. If the asset price moves
in a downward direction in the financial market then it could prove risky. In
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such cases where traders are uncertain of the assert price trend they can use
hedge or can enter into agreement for which the opposite derivative moves in
opposite direction.
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INDIAN DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments
in India gained momentum in the last few years due to liberalisation process
and Reserve Bank of India’s (RBI) efforts in creating currency forward
market. Derivatives are an integral part of liberalisation process to manage
risk. NSE gauging the market requirements initiated the process of setting up
derivative markets in India. In July 1999, derivatives trading commenced in
India.
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MYTHS AND REALITIES ABOUT DERIVATIVES
In less than three decades of their coming into vogue, derivatives markets
have become the most important markets in the world. Financial derivatives
came into the spotlight along with the rise in uncertainty of post-1970, when
US announced an end to the Bretton Woods System of fixed exchange rates
leading to introduction of currency derivatives followed by other innovations
including stock index futures. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major parts of the world.
While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the
realities that are different especially for Exchange traded derivatives, which
are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives?
• Derivatives increase speculation and do not serve any economic
purpose
• Indian Market is not ready for derivative trading
• Disasters prove that derivatives are very risky and highly leveraged
instruments.
• Derivatives are complex and exotic instruments that Indian investors
will find difficulty in understanding
• Is the existing capital market safer than Derivatives?
Derivatives increase speculation and do not serve any economicpurpose:
Numerous studies of derivatives activity have led to a broad consensus, both
in the private and public sectors that derivatives provide numerous and
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substantial benefits to the users. Derivatives are a low-cost, effective method
for users to hedge and manage their exposures to interest rates, commodity
prices or exchange rates. The need for derivatives as hedging tool was felt
first in the commodities market. Agricultural futures and options helped
farmers and processors hedge against commodity price risk. After the fallout
of Bretton wood agreement, the financial markets in the world started
undergoing radical changes. This period is marked by remarkable
innovations in the financial markets such as introduction of floating rates for
the currencies, increased trading in variety of derivatives instruments, on-
line trading in the capital markets, etc. As the complexity of instruments
increased many folds, the accompanying risk factors grew in gigantic
proportions. This situation led to development derivatives as effective risk
management tools for the market participants.
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By providing investors and issuers with a wider array of tools for
managing risks and raising capital, derivatives improve the allocation of
credit and the sharing of risk in the global economy, lowering the cost of
capital formation and stimulating economic growth. Now that world markets
for trade and finance have become more integrated, derivatives have
strengthened these important linkages between global markets, increasing
market liquidity and efficiency and facilitating the flow of trade and finance
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PRE-REQUISITES INDIAN SCENARIO
Large market India is one of the largest market-capitalised
Capitalisation countries in Asia with a market capitalisation of
more than Rs.765000 crores.
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COMPARISON OF NEW SYSTEM WITH EXISTING
SYSTEM
Many people and brokers in India think that the new system of Futures &
Options and banning of Badla is disadvantageous and introduced early, but I
feel that this new system is very useful especially to retail investors. It
increases the no of options investors for investment. In fact it should have
been introduced much before and NSE had approved it but was not active
because of politicization in SEBI.
Speculators
Advantages
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Arbitrageurs
Hedgers
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Advantages
• Availability of Leverage
Small Investors
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The OTC derivatives markets have the following features compared to
exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and
located within individual institutions,
2. There are no formal centralized limits on individual positions,
leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability
and integrity, and for safeguarding the collective interests of market
participants, and
5. The OTC contracts are generally not regulated by a regulatory
authority and the exchange’s self-regulatory organization, although
they are affected indirectly by national legal systems, banking
supervision and market surveillance.
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exposures. When asset prices change rapidly, the size and configuration of
counter-party exposures can become unsustainably large and provoke a rapid
unwinding of positions.
There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and
OTC derivatives markets continue to pose a threat to international financial
stability. The problem is more acute as heavy reliance on OTC derivatives
creates the possibility of systemic financial events, which fall outside the
more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives,
and their dependence on exchange traded derivatives, Indian law considers
them illegal.
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FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES:
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BRETTON WOODS agreement brought and end to the stabilising role of
fixed exchange rates and the gold convertibility of the dollars. The
globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets.
Nations that were poor suddenly became a major source of supply of goods.
The Mexican crisis in the south east-Asian currency crisis of 1990’s has also
brought the price volatility factor on the surface. The advent of
telecommunication and data processing bought information very quickly to
the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.
These price volatility risks pushed the use of derivatives like futures and
options increasingly as these instruments can be used as hedge to protect
against adverse price changes in commodity, foreign exchange, equity shares
and bonds.
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis-à-vis depreciated currencies. Export of
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certain goods from India declined because of this crisis. Steel industry in
1998 suffered its worst set back due to cheap import of steel from south East
Asian countries. Suddenly blue chip companies had turned in to red. The fear
of china devaluing its currency created instability in Indian exports. Thus, it
is evident that globalisation of industrial and financial activities necessitates
use of derivatives to guard against future losses. This factor alone has
contributed to the growth of derivatives to a significant extent.
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technological developments increase volatility, derivatives and risk
management products become that much more important.
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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 on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The
committee submitted its report on March 17, 1998 prescribing necessary
pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‘securities’
so that regulatory framework applicable to trading of ‘securities’ could also
govern trading of securities. SEBI also set up a group in June 1998 under the
Chairmanship of Prof.J.R.Varma, to recommend measures for risk
containment in derivatives market in India. The report, which was submitted
in October 1998, worked out the operational details of margining system,
methodology for charging initial margins, broker net worth, deposit
requirement and real–time monitoring requirements. The Securities Contract
Regulation Act (SCRA) was amended in December 1999 to include
derivatives within the ambit of ‘securities’ and the regulatory framework
were developed for governing derivatives trading. The act also made it clear
that derivatives shall be legal and valid only if such contracts are traded on a
recognized stock exchange, thus precluding OTC derivatives. The
government also rescinded in March 2000, the three decade old notification,
which prohibited forward trading in securities. Derivatives trading
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commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2001. SEBI permitted the derivative segments of two
stock exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts. To
begin with, SEBI approved trading in index futures contracts based on S&P
CNX Nifty and BSE–30 (Sense) index. This was followed by approval for
trading in options based on these two indexes and options on individual
securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. 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 options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures
and options contract on NSE are based on S&P CNX Trading and settlement
in derivative contracts is done in accordance with the rules, byelaws, and
regulations of the respective exchanges and their clearing house/corporation
duly approved by SEBI and notified in the official gazette. Foreign
Institutional Investors (FIIs) are permitted to trade in all Exchange traded
derivative products.
The following are some observations based on the trading statistics provided
in the NSE report on the futures and options (F&O):
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• Single-stock futures continue to account for a sizable proportion of the
F&O segment. It constituted 70 per cent of the total turnover during June
2002. A primary reason attributed to this phenomenon is that traders are
comfortable with single-stock futures than equity options, as the former
closely resembles the erstwhile badla system.
• Put volumes in the index options and equity options segment have
increased since January 2002. The call-put volumes in index options have
decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put
volumes ratio suggests that the traders are increasingly becoming pessimistic
on the market.
• Farther month futures contracts are still not actively traded. Trading in
equity options on most stocks for even the next month was non-existent.
• Daily option price variations suggest that traders use the F&O segment
as a less risky alternative (read substitute) to generate profits from the stock
price movements. The fact that the option premiums tail intra-day stock
prices is evidence to this. If calls and puts are not looked as just substitutes
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for spot trading, the intra-day stock price variations should not have a one-
to-one impact on the option premiums.
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This period has also witnessed several relaxations in regulations relating
to forex markets and also greater liberalisation in capital account
regulations leading to greater integration with the global economy.
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BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
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As opposed to spot markets, derivatives markets involve lower transaction
costs. Secondly, they offer greater liquidity. Large spot transactions can
often lead to significant price changes. However, futures markets tend to be
more liquid than spot markets, because herein you can take large positions
by depositing relatively small margins. Consequently, a large position in
derivatives markets is relatively easier to take and has less of a price impact
as opposed to a transaction of the same magnitude in the spot market.
Finally, it is easier to take a short position in derivatives markets than it is to
sell short in spot markets.
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The derivative market performs a number of economic functions.
• The prices of derivatives converge with the prices of the underlying at
the expiration of derivative contract. Thus derivatives help in
discovery of future as well as current prices.
• An important incidental benefit that flows from derivatives trading is
that it acts as a catalyst for new entrepreneurial activity.
• Derivatives markets help increase savings and investment in the long
run. Transfer of risk enables market participants to expand their
volume of activity.
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better off the economic agents are in the economy. Financial derivatives
play a valuable role in financial markets because they help to move the
market closer to completeness.
If we consider two financial markets that are the same, except that one
includes financial derivatives, the market with financial derivatives will
allow traders to shape the risk and return characteristics of their
portfolios more exactly, thereby increasing the welfare of traders and
the economy in general.
MARKET COMPLETENESS
• A complete market is a market in which any and all identifiable payoffs can
be obtained by trading the securities available in the market.
SPECULATION
• For example traders can speculate on a rise or fall in interest rates, change
in currencies against each other or on a host of other specific
propositions.
RISK MANAGEMENT
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• Financial derivatives are a powerful tool for limiting risks.
• If interest rates rise before the bond is issued, the firm will have to pay
considerably more over the life of the bond.
• This firm can use interest rate futures to control its exposure to this risk.
TRADING EFFICIENCY
• For example an option position can mimic the profit or loss performance of
an underlying stock index.
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SUMMARY
1) A derivative instrument is one whose value depends on the value of
something else.
d) All futures contracts require that traders post margin in order to trade.
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4) A clearinghouse is a financial institution associated with the futures
exchange that guarantees the financial integrity of the market to all
traders.
6) Call option – The owner of a call has the right to purchase an underlying
good at a specific price, and this right lasts until a specific date
7) Put option – The owner of a put option has the right to sell the underlying
well at a specific price, and this right lasts until a specific date.
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FINANCIAL DERIVATIVES – INSTRUMENT
IN STRATEGIC RISK MANAGEMENT
The financial derivatives aren’t new at all; they have been there since years.
You will find a description of initial known options contract in the
Aristotle’s writings. The financial derivatives are vital instruments for
assisting the organizations to reach the risk management objectives.
Basically, it’s with all instruments that the user needs to understand the
function of the instrument and then the safety precautions should be taken to
make use of the instrument.
As the builder makes use of the power saw for constructing houses for
effectiveness as well as efficiency, the financial derivatives could be a useful
instrument for helping the corporations as well as banks to become more
effective and efficient in meeting the risk management goals. But, the power
saw can also get dangerous when used improperly or blindly.
Therefore, if the users of the power saws are not careful, it will cause serious
harm and ruin the entire project. Similarly, if the financial derivatives aren’t
used properly, they can cause serious damage leading to losses impelling the
organization in a wrong direction damaging the future.
Financial derivatives have to be used properly and will surely help the
organization to fulfill the risk management goals so that the funds are handy
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for making the best investments. Also, the company’s decision to utilize the
financial derivatives should have the risk management strategy based on
wider corporate targets.
The most basic form of questions regarding the strategies in the risk
management needs to be addressed. For example, which kind of risk needs to
be hedged and further which ones should remain unhedged ? Which type of
trading strategies and derivatives are the most appropriate? How is the
performance of these instruments going to be in case of decrease or increase
in the rate of interest? What will be the impact of these instruments if there
are terrific fluctuations in the exchange rates?
In short, the financial derivatives are just not a latest fad of the risk
management. The financial derivatives are going to stay. We are right on the
track to the true world financial market that will go on continuing with new
innovations for improving the risk management practices. They are surely
not a fad but are vital tools for helping the organizations for better
management of the risk exposures.
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In the end, the financial derivatives need to be considered as a part of any of
the company’s strategy of risk management for ensuring that the value
enhancing opportunities in investment are achieved.
RISK-
Risk is a characteristic feature of most commodity and capital markets.
Variations in the prices of agricultural and non-agricultural commodities are
induced, over time, by demand-supply dynamics. The last two decades have
witnessed many-fold increase in the volume of international trade and
business due to the wave of globalization and liberalization sweeping across
the world. This has led to rapid and unpredictable variations in financial
assets prices, interest rates and exchange rates, and subsequently, to
exposing the corporate world to an unwieldy financial risk. In the present
highly uncertain business scenario, the importance of risk management is
much greater than ever before. The emergence of derivatives market is an
ingenious feat of financial engineering that provides an effective and less
costly solution to the problem of risk that is embedded in the price
unpredictability of the underlying asset. In India, the emergence and growth
of derivatives market is relatively a recent phenomenon. Since its inception
in June 2000, derivatives market has exhibited exponential growth both in
terms of volume and number of traded contracts. The market turn-over has
grown from Rs.2365 crore in 2000-2001 to Rs. 11010482.20 crore in 2008-
2009. Within a short span of eight years, derivatives trading in India has
surpassed cash segment in terms of turnover and number of traded contracts.
The present study encompasses in its scope an analysis of historical roots of
derivative trading, types of derivative products, regulation and policy
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developments, trend and growth, future prospects and challenges of
derivative market in India. Some space is devoted also to a brief discussion
of the status of global derivatives markets vis-a–vis the Indian derivatives
market.
By the same token, the most successful companies in every sector and in
each generation – General Motors in the 1920s, IBM in the 1950s and
1960s, Microsoft and Intel in the1980s and 1990s and Google in this
decade- share a common characteristic. They achieved their success not by
avoiding risk but by seeking it out.There are some who would attribute the
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success of these companies and otherslike them to luck, but that can explain
businesses that are one-time wonders – a singlesuccessful product or service.
Successful companies are able to go back to the well againand again,
replicating their success on new products and in new markets. To do so,
theymust have a template for dealing with risk that gives them an
advantage over thecompetition. In this chapter, we consider how best to
organize the process of risk takingto maximize the odds of success. In the
process, we will have to weave through manydifferent functional areas of
business, from corporate strategy to finance to operationsmanagement, that
have traditionally not been on talking terms.
Financial transactions are fraught with several risk factors. Derivatives are
instrumental in alienating those risk factors from traditional instruments and
shifting risks to those entities that are ready to take them. Some of the basic
risk components in derivatives business are:
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• Credit Risk: When one of the two parties fails to perform its role
as per the agreement, this is called the credit risk. It can also be referred
to as default or counterparty risk. It varies with different sources.
• Market Risk: This is a kind of financial loss that takes place due to
the adverse price movements of the underlying variable or instrument.
• Liquidity Risk: When a firm is unable to devise a transaction at
current market rates, it can be referred to as liquidity risk. There are
two kinds of liquidity risks involved in the scenario. First is concerned
with the liquidity of separate items and second is related to supporting
the activities of the organization with funds comprising derivatives.
• Legal Risk: Legal issues related with the agreement need to be
scrutinized well, as one can deal in derivatives across the different
judicial boundaries.
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Share markets across the world are flooded with different types of financial
instruments. Instruments because they directly do not give us money, but
acts as a channel to gain money. Today let us discuss in detail about
financial derivatives.
In this, the stock holder enters into a deal with a person, who is ready to buy
the stock at a recognized price or at a different price in the near future.
However; amongst both the latter part is the most popular one.
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HEDGING INSTRUMENT IN DERIVATIVE
MARKET
It was while writing an article about current investment trends for Fortune in
1948 that Jones was inspired to try his hand at managing money. He raised
$100,000 (including $40,000 out of his own pocket) and set forth to try to
minimize the risk in holding long-term stock positions by short selling other
stocks. This investing innovation is now referred to as the classic long/short
equities model. Jones also employed leverage in an effort to enhance
returns.
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partnership with other investors and a compensation system based on
investment performance, Jones earned his place in investing history as the
father of the hedge fund.
The industry was relatively quiet for more than two decades, until a 1986
article inInstitutional Investor touted the double-digit performance of Julian
Robertson's Tiger Fund. With a high-flying hedge fund once again capturing
the public's attention with its stellar performance, investors flocked to an
industry that now offered thousands of funds and an ever-increasing array of
exotic strategies, including currency trading and derivatives such
as futures and options.
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managers. Unfortunately, history repeated itself in the late 1990s and into the
early 2000s as a number of high-profile hedge funds, including Robertson's,
failed in spectacular fashion.
Despite troubles in the last few years, the hedge fund industry continues to
thrive. The development of the "fund of funds", which is simplistically
defined as a mutual fund that invests in multiple hedge funds, provided
greater diversification for investors' portfolios and reduced the minimum
investment requirement to as low as $25,000. The introduction of the fund of
funds not only took some of the risk out of hedge fund investing, but also
made the product more accessible to the average investor.
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CONCLUSION
Hedge funds have evolved significantly since 1949. Modern hedge funds
offer a variety of strategies, including many that do not involve traditional
hedging techniques. The industry has also rapidly grown, with recent
estimations pegging its size at $1 trillion - quite the leap from the $100,000
used to start the first fund half a century ago.
With a fascinating past that has twice seen media-fostered publicity push the
industry to stratospheric highs and vilify it when it fell from grace, it seems
highly probable that the cycle will repeat itself at some point in the future.
While it is easy to get sucked in by the hype or repelled by the negative
press, it's always advisable to take a step back and conduct some due
diligence, just as you would prior to making any investment.
Before you put your hard-earned money at risk, you have to make sure you
are choosing the right investment for the right reason. Don't blindly chase
performance, and remember that past performance is not an indicator of
future performance.
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HEDGING:
This technique reduces the risk involved in financial market. In this method,
the risk involved in the derivative can be transferred from one trader to the
other. For example consider a derivative agreement between a wheat farmer
and a miller. They can sign for an agreement so that the wheat farmer can
hand over a certain amount of wheat to the miller and the miller in turn gives
a certain amount of cash..
So the thing that has cleared happened for both the parties is that risk has
been minimized. Derivatives play a pivotal role in hedging because they are
uncomplicated and don’t require any form of balance sheet calculations. The
products in derivatives can be put up, without regarding the fact that these
products actually cease to exist in reality.
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RISK HEDGING AND RISK MANAGEMENT
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Many a times when you think of derivatives, the first thing that strikes your
mind is the reduction of risk involvement, the simple ways of tracking it, the
volatility of the market affecting your financial instrument, the speculations
and the hedging involved in it. But a derivative market is much more than
that. If you have researched about it you will come to know about it.
We have all heard how derivatives have an impact on the economy, we will
today learn more about the derivatives which are very lucrative and
valuable in nature.
Let’s take couple of examples to understand what exactly derivatives
are.
Two farmers, one of them growing wheat and the other growing corn, come
together and decide to trade three sacks of wheat for three sack of corn. In
this way, they are just trying to steady the value of both the crop, regardless
of what may the actual cost in the market. It also does not consider the
supply and the demand of the products.
Let’s take an example of a nation producing oil and a firm into oil brokering,
here in this case – when they come to trade, they do not base it on exchange.
Here, the contract is just based on the trading of oil and no exchange of
anything else. However; one barrel of oil will be traded against dollar.
In this case, as the cost of oil kept increasing the brokering company would
have noticed the trend and must have fixed a value to buy oil. For example,
if they decided to pay $60 throughout the year, and the barrel prices increase
to $100 the oil brokering company would still pay $60 thereby gaining
profit, but it can also affect them badly if the prices turn towards a
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downward trend. This is what we call a forward contract in the financial
markets.
Another derivative type, which has caused a lot of issues in the current
economy, is the credit swap. Let’s take an example, everyone must have
heard of sub prime crisis. The credit started getting swapped from sub prime
loaners to investment brokers and eventually to different investment firms.
What happened because of this, the paper worth of the mortgaged houses
reduced and in the meanwhile, a lot of home buyers started defaulting on
their loans. This particular phenomenon grew out of proportion and
attributed to the fall of big and old financial institutions.
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HEDGING RISK
Hedging risk has been an integral part of the financial markets for many
years. In the 1800s, commodity producers and merchants began using
forward contracts for protection against unfavorable price changes. This
system is still very active today.
The term "hedge fund" dates back to only 1949. In 1949, almost all
investment strategies took only long positions. A reporter for Fortune
magazine, named Alfred Winslow Jones, published an article pointing out
that investors could achieve higher returns if hedging were implemented into
an investment strategy. This was the beginning of the Jones model of
investing.
In addition, Jones established two important characteristics that are still part
of the industry today. He used an incentive fee of 20% of profits and he kept
most of his own personal money in the fund. This ensured that his personal
goals and the goals of his investors were in alignment.
Exceptional results were obtained through this hedged approach. During the
period from 1962 to 1966, Jones outperformed the top mutual fund by more
than 85%, net of fees. The success of Jones stimulated the interest of high
net worth individuals in hedge funds.
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Not only did Jones attract the interest of high net worth individuals to hedge
funds, but also many top money managers were drawn to hedge fund
because of the unique fee structure. A 20% incentive fee made it possible
for managers to earn 10 to 20 times as much in compensation when
compared to long-only money management services.
Between 1966 and 1968, nearly 140 new hedge funds were launched as a
consequence of the new dynamics of investing and managing money. Many
of these funds, however, did not follow the Jones model of hedging risk.
Instead of hedging, only leverage was used to enhance returns, ignoring the
short-selling aspect that Jones employed. Using a leveraged, long-only
strategy made these funds highly susceptible to the market downturn that
began in late 1968. Some hedge funds dropped in value by more than 70%
within two years.
Large hedge fund losses due to the 1973-1974 bear market caused many
investors to turn away from hedge funds. For the next ten years, few
managers could attract the necessary capital to launch new partnerships. By
1984, there were only 68 funds in existence.
In the late 1980s, a small group of extremely talented hedge fund managers,
including George Soros, Michael Steinhart, and Julian Robertson, gave
hedge funds a restored credibility. Despite difficult market conditions, these
managers produced annual returns of greater than 50%.
Many of the world¡s best money managers left the traditional institutional
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and retail investment firms because of potentially higher fees and great
flexibility with managing hedge fund products. By 1990, there were over
500 hedge funds worldwide with assets of about $38 billion.
Hedge funds now represent one of the largest segments of the investment
management industry. Currently, it is estimated that there are over 6,000
hedge funds in existence with total money under management in excess of
$1 trillion.
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THE LONG-TERM FUTURE FOR THE HEDGE FUND
During the recent economic downturn, the reputation of the hedge fund has
been exposed to a battering which many believe will leave a permanent
marker in the reputation of this business structure. The belief in rampant
capitalism is no longer taken to mean gospel truth. Rather people are
insisting that capitalism is always tempered by common sense approaches to
economic policy to ensure that there is no exploitation of weak economic
structures.
The people who used to own and run hedge funds still have that burning
desire to make profits and they will always look for ways to resurrect their
ambitions. This is in spite of the widespread condemnation that has been
leveled at the system.
As for the various economies, they have to get over the initial shock of the
economic downturn and think of new ways to improve the lives of their
people. Of course they will be far more cautious about the presence of hedge
funds but at some point they will have to invite them back to do business. In
fact some bold governments have already set up initiatives to ensure that
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they can attract the hedge fund once again before other rival governments get
in on the act.
LESSONS LEARNED
One would like to think that the hedge fund managers have learn a good
lesson and will not go back to the practices of making unmitigated risky
investments. That they will learn the value of building good community
relationships and ensuring that the people in the countries in which they
invest get a reasonable benefit from their presence. This is not to say that
they will all over sudden abandon their business instinct and start giving all
their profits to charity. It merely means that they will balance their ambitions
with recognition that they operate within a community and that they will feel
the obligation to give back to that community.
However experience tells me that none of this is going to happen. The hedge
fund will continue to be an instrumentof exploitation to the maximum. They
might make some half hearted attempts to appear to be socially responsible
especially given the new obsession with environmental matters. However
their core purpose can never move away from making maximum profits at
minimum profits. It would be unthinkable to believe that a successful hedge
fund will suddenly put the interests of the community above that of the
people who give them money.
As for the communities themselves, they will continue to question the fund
within their communities and will demand to understand why they are not
receiving the full benefit of such a lucrative business opportunities. The
excuses will probably run out and eventually the hedge find might acquire a
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socialist twist in as much as it might increase the access to ordinary people
who want to invest their savings.
Many people have been hearing the term derivatives over and over because
of their role in the 2008 financial crisis. Some have called derivatives the
'nuclear weapons' of the financial world. Indeed, derivatives are far more
complicated financial instruments than stocks or bonds, but the danger they
pose to the investor - or the greater economy - ultimately depends on
whether they are used to hedge or to bet.
Most people look to derivatives as hedging instruments - that is, they use
them to reduce the risk of doing business in a particular market. A farmer,
for example, may purchase a corn futures contract to make sure he can sell
his corn at a good price. A wholesaler of corn may purchase the other end of
the same futures contract to make sure he can buy corn at a good price.
Between the time the parties purchase the futures contract and the time the
contract settles, the price of corn may go up or down. If the price of corn is
higher at the time the contract settles, the farmer will have to sell his corn at
a lower price than he could get in the market at that time, but he still benefits
from the contract because he has avoided the risk of having to sell his corn at
a price that was lower than he had hoped.
On the other end of the contract, the wholesaler has benefited from buying
the futures contract because he can now purchase the corn below the current
market price. Even if the market had gone the other way and he had to pay
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more than the current market price, he would still benefit from having
reduced his exposure to price increases.
When parties use derivatives as a hedge, they usually have some business
risk or exposure to the value of the underlying asset of the derivative (in our
example, the corn). In a hedge, a derivative works like insurance and protects
the parties from losses.
SPECULATIONS:
In short, speculation is nothing but plain speculative trading, where in you
just speculates what could be the possible cost of share or an asset. There are
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many financial institutions who firmly believe that they can speculate the
trend of a particular stock or financial instruments. Directional playing is
how they understand this term as. Apart from this speculation can be done
based on the volatility of the security.
Many of the firms have been found making use of financial derivatives as a
source to reduce the risk involved. Because of the minimizing risk factor
derivatives are probably one of the most popular financial instruments
available in the financial market today. Apart from reducing the risk, some
firm also uses financial derivatives to reduce the tax liability of the firm. But
it has its own consequences, there are certain times it may do well for you,
but the other time it can fall flat on your face.
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1. Most people look to derivatives as hedging instruments - that is, they
use them to reduce the risk of doing business in a particular market. A
farmer, for example, may purchase a corn futures contract to make
sure he can sell his corn at a good price. A wholesaler of corn may
purchase the other end of the same futures contract to make sure he
can buy corn at a good price.
2. After analyzing data it is clear that the main factors that are driving the
growth of Derivative Market are Market improvement in
communication facilities as well as long term saving & investment is
also possible through entering into Derivative Contract. So these
factors encourage the Derivative Market in India.
take more risk & earn more return. So in this way it helps the Indian
Economy by developing entrepreneurship. Derivative Market is more
regulated & standardized so in this way it provides a more controlled
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environment. In nutshell, we can say that the rule of High risk & High
return apply in Derivatives. If we are able to take more risk then we
can earn more profit under Derivatives.
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Along with the above recommendations, following are some more
suggestions that could be implemented for better opportunities in derivative
market:-
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RBI should play a greater role in supporting derivatives.
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BIBLIOGRAPHY
BOOKS REFERRED:
NSE’s Certification in Financial Markets: - Derivatives Core module
REPORTS:
Report of the RBI-SEBI standard technical committee on exchange
traded Currency Futures
Regulatory Framework for Financial Derivatives in India by
Dr.L.C.GUPTA
WEBSITES VISITED:
www.derivativesindia.com
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.ncdex.com
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