WHAT IS A DERIVATIVE? A derivative is a product/ contract, which does not have any value on its own i.e.

it, derives its value from some underlying. Derivatives or derivatives securities are contracts which are written between two parties (counter parties) and whose values is derived from underlying widely held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short term and long term financial instruments tangible things like commodities price index (inflation rate), equity price index or bond price index. The counter parties to such contract are those other than the original issuer (holder) of the underlying assets. The exchange-traded derivatives are quit liquid and have low transaction cost. It is possible to combine them to match specific requirements. The value of derivatives and those of their underlying assets are closely related. Usually in trading derivatives, the taking or making of delivery of underlying assets is not involved; the transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is therefore, no effective limit on the claims, which can be traded in respect of underlying assets. Derivatives are off balance instruments, a fact is said to be obscure the leverage and financial might give to the party. They are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the companies. Although the standardized, general exchange traded derivatives are being increasingly evolved, still there are many privately negotiated, customized, OTC- traded financial contracts which are in vogue and which expose the uses to operational risk. There is also and uncertainty about the regulatory status of such derivatives. Derivatives are used to facilitate hedging of price risk of inventory holding or a financial / commercial transaction over a certain period. In practice, every derivatives contract has a fixed expiration date , mostly in the range of 1 to 12 months from the date of commencement of the contract. (Presently 1,2,3, months contracts are available in India)

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CLASSIFICATION OF DERIVATIVES Derivatives markets can basically be classified into commodity and Financial Derivatives market. Commodity markets are further classified into tangible commodities & intangible commodities. Financial derivatives broadly has four branches viz. Real Estate, Forex, Equity derivatives and Debt Derivatives. Equity derivatives are further divided into index Products and derivatives on securities and Debt derivatives are further divided into Interest rate Products and GOI Securities , bonds, T-bills.

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HISTORY OF DERIVATIVES The first centralized commodities market in Britain was founded in the 1560s in the Royal Exchange (later to become the first home of the London International Financial Futures Exchange). Unfortunately the Great Fire of London destroyed the Royal Exchange in 1666, although trading continued in the various coffee houses that were springing up in the City of London at the time. Eventually each coffee house started to specialize in one particular product: the London Commodity Exchange in the Virginian and Baltic coffee house the London Metal Exchange in Jerusalem and the London Stock Exchange in Jonathans. At the same time there was an options market in Holland at the Amsterdam Trade Center based on tulips. Unfortunately the speculative use of these options brought about the collapse of the Dutch economy Organized futures markets, as we know them today really developed in the last century, primarily in the US, when the Chicago Board of Trade (CBOT) was established in 1848. At that time Chicago was not only at the center of the railroads; it was also an important port on the Great Lakes and close to the Midwest farmlands. With Chicago being such an important center for agricultural markets the CBOT was established to provide farmers with a central market place to guarantee the prices for their livestock and grain.

The need for a derivatives market The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk averse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk averse people in greater numbers 5. They increase savings and investment in the long run

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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, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

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TYPES OF DERIVATIVES o Forward contract o Future contract o Option contract o Swap contract

Forward Contract A forward contract is an agreement to buy or sell an asset on a specified date for a specified price agreed upon today . It is a deal for the purchase or sale of a commodity, security or other asset in the spot or forward market. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. Usually no party changes hands when forward contracts are entered. Although a forward contract is a good means of avoiding price risk but it entails an element of risk that the party to the contract may not honor its part of the obligation. Once a position of buyer or seller is taken an investor cannot retreat except through mutual consent or buy entering into an identical contract by reversing his position. With forward contracts entered into on a one to one basis and with no standardization the forward contracts have a very low degree of liquidity. Therefore, the problem associated with the forward contracts led to the emergence of future contracts.

Example Imagine you are a farmer. You grow 1,000 dozens of mangoes every year. You want to sell these mangoes to a merchant but are not sure what the price will be when the season comes. You therefore agree with a merchant to sell all your mangoes for a fixed price for Rs 2 lakhs. This is a forward contract wherein you are the seller of mangoes forward and the merchant is the buyer. The price is agreed today in advance and the delivery will take place sometime in the future.

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Where are forwards used? Forwards have been used in the commodities market since centuries. Forwards are also widely used in the foreign exchange market.

Essential features of a forward contract Contract between two parties (without any exchange between them) Price decided today Quantity decided today (can be based on convenience of the parties) Quality decided today (can be based on convenience of the parties) Settlement will take place sometime in future (can be based on convenience of the parties) No margins are generally payable by any of the parties to the other

Limitations of forwards Forwards involve counter party risk. In the above example, if the merchant does not buy the mangoes for Rs 2 lakhs when the season comes, what can you do? You can only file a case in the court, but that is a difficult process. Further, the price of Rs 2 lakhs was negotiated between you and the merchant. If somebody else wants to buy these mangoes from you, there is no mechanism of knowing what the right price is.

Thus, the two major limitations of forwards are: Counter party risk Price not being transparent Counter party risk is also referred to as default risk or credit risk.

Future Contract Futures trading was started in the mid western part of USA during 1970s , but today it is traded through out the world. Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time 6 2010-2011

in the future at a certain price. Futures are similar to forwards but unlike forward contracts, the futures contracts are standardized and exchange traded. . Prices are available to all those who want to buy or sell because the trading takes place on a transparent computer system. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

Features of futures Contract between two parties through an exchange Exchange is the legal counter party to both parties Price decided today Quantity decided today (quantities have to be in standard denominations specified by the exchange) Quality decided today (quality should be as per the specifications decided by the exchange) Tick size (i.e. the minimum amount by which the price quoted can change) is decided by the exchange Delivery will take place sometime in future (expiry date is specified by the exchange) Margins are payable by both the parties to the exchange In some cases, the price limits (or circuit filters) can be decided by the exchange.

Limitation of future:

Futures suffer from lack of flexibility.

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Suppose you want to buy 103 shares of Satyam for a future delivery date of 14th February, you cannot. The exchange will have standardized specifications for each contract. Thus, you may find that you can buy Satyam futures in lots of 1,200 only. You may find that expiry date will be the last Thursday of every month. Thus, while forwards can be structured according to the convenience of the trading parties involved, futures specifications are standardized by the exchange.

Future terminology

Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-months expiry cycles, which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered under one contract. For in-stance, the contract size on NSEs futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin ac-count is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket. 8

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Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Maturity of futures contract :Index futures of different maturities trade simultaneously on the exchanges. For instance, BSE trades three contracts on BSE SENSEX with one, two and three months maturity. These contracts of different maturities are called near month (one month), middle month (two months) and far month (three months) contracts. At any point of time there will be three futures contracts available for trading.

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WHAT TYPE OF MARGINS ARE PAYABLE ON FUTURES?

Both buyers and sellers of Futures should pay an Initial Margin to the exchange at the point of entering into Futures contracts. This Initial Margin is retained by the exchange till these transactions are squared up. Further, Mark to Market Margins are payable based on closing prices at the end of each trading day. These Margins will be paid by the party who suffered losses and will be received by the party who made profits. The exchange thus collects these margins from the losers and pays them to the winners on a daily basis. MARK TO- MARKET

Every day all the open positions in Futures contracts are marked to the closing price and the variation, if any, is collected / paid to the members by debiting / crediting their settlement bank accounts with the respective clearing banks on T + 1 morning. Also, where the positions are closed, profit / loss on such positions is also credited / debited to the members bank accounts.

Methodology for calculating closing price for daily mark to market:

The daily closing price of the futures contract for calculating mark-to-market margin arrived at using following algorithm:-

is

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Weighted average price of all the trades in last half an hour of the continuous trading session. If there are no trades during last half an hour, then the theoretical price would be taken as the official closing price. The theoretical price is arrived at by using the following algorithm:-

Theoretical price = Closing value of underlying + (closing value of underlying * No. of days to expiry * risk free interest rate ( at present 7.5% ) / 365 ).

How are futures prices determined?

Prices are determined based on forces of demand and supply and are discovered during trading hours. Prices of Futures are derived from the price of the underlying. For example, prices of Reliance Futures will depend upon the price of Reliance Industries in the cash market. You can expect Futures prices to rise when Reliance Industries price rises and vice-versa.

How can I square up a futures contract?

If you have bought a Futures contract, you can sell it and thus square up. If you sold a Futures contract, you can buy it back and square up. If you do not square up till the day of expiry, it will be automatically squared up by the exchange.

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TRADERS/ PARTICIPANTS/ OPERATORS OF FUTURE MARKETS Hedger Speculator Arbitrageurs Spreaders

Future contracts are bought and sold buy large number of individuals, business organizations, governments and others for variety of purposes. The trader in the future market can be categorized on the basis of the purposes for which they deal in the market. Usually financial derivatives attract following types of traders as under: Hedger

A Hedging is a position taken in futures or other markets for the purpose of reducing exposure to one or more types of risk. A person who undertakes such position is called as Hedger. In other words, a hedger uses future markets to reduce risk caused by the movement in prices of securities, commodities, exchange rate, interest rate, indices, etc. as such, a hedger will take an opposite position to a perceived risk is called (hedging strategy in future markets. The essence of hedging strategy is the adoption of future position that, on average, generates profits when the market value of the commitment is higher than the expected value.

Speculator

A Speculator may be defined as investors who are willing to take a risk by taking future position with the expectation to earn profits. The speculators forecast the future economic condition and decide which position (long and short) to be taken that will yield a profit if the forecast is realized. In other words, Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity, etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand, supply, market positions, open interests, economic fundamentals and other data to take their positions. Arbitrageurs

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Arbitrageurs are another important group of participants in the future markets. An arbitrageur is a trader who attempts to make profits by locking in a risk less trading by simultaneously entering into two or mare markets. In other words arbitrageurs try to earn risk less profit from discrepancies between future and spot prices and among future prices. An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In Index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market). Take the case of the NSE Nifty. Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300. The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. If there is a difference then arbitrage opportunity exists.

Spreaders

Spreading is a specific activity trading activity in which offsetting futures position is involved by creating almost net position. So the spreads believes in lower expected return but at the less risk. A successful trading in spreading, the spreaders must forecast the relevant factors which affect the changes in the spreads. Interest rate behaviour is an important factor which causes changes in the spreads. In a profitable spread position, normally, there is a large gain on one side of the spread in comparison to the loss on the other side of the spread. In this way, a spread reduces the risks even if the forecast is incorrect. On the other hand, the pure speculators would make money by taking only the profitable side of the market but at very high risk.

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OPTIONS

Option is a security that represents the right, but not the obligation, to buy or sell a specified amount of an underlying security (stock, bond, futures contract, etc.) at a specified price within a specified time. Option Holder is the buyer of either a call or put option. Option Writer is the seller of either a call or put option. Options are different from futures in many ways. Not only both the instrument have separate payoff profiles but also Options have host of parameters that affect their pricing compared to just expectations and time in the case of Futures pricing. The risk return profile of options is different from futures.

Options unlike futures are also concerned with speed of the trend and not just the underlying trend. This makes them a little more complex than Futures, but then it's this inbuilt complexity in them that also makes them more versatile instruments. With Options traders can play non - directional strategies i.e. strategies which will make money for you no matter whether markets move up, down or remain sideways. Even Directional strategies can be implemented using Options. Just like Futures there can be an underlying view even in Options, a view to buy or a view to sell. But the buyer pays up an upfront premium to protect himself if his view is incorrect. The seller on the other hand though is playing on a view wants to be the one to book an upfront premium, as a trade off against a possible loss. The seller gets paid only because he is providing the hedge to the long positions at his own risk. Options can be categorized as call and put options. The option, which gives the buyer a right to buy the underlying asset, is called Call option and the option, which gives the buyer a right to sell the underlying asset, is called Put option. Options are instruments that give the buyer a right and the seller an obligation. However, a buyer can buy a right to buy or right to sell an underlying security. The writer on the other hand charges a premium to fulfil both these obligations. We will discuss this at length later. Long option (a call or a put) position has no downside risk as his loss is protected to the premium he pays whereas a seller (of a call or put) aka writer can suffer an unlimited loss if the market moves against him. There are four basic payoffs that an option has a long call, a short call, a long put and a short put. The four payoffs or as we call them strategies are discussed later. These are the basic four payoffs are at the heart of the Option theory. 14 2010-2011

HISTORY OF OPTIONS

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock indexes, foreign currencies and futures contracts. The first trading in options began in Europe and the US as early as the eighteenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. It was in 1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

OPTION TERMINOLOGY Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the

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obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price which the option buyer pays to the option seller. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be inthe-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price)._ Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of- the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call isNP which means the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the (St K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the strike price and St is the spot price.

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Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. A call that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is a calls time value, all else equal. At expiration, a call should have no time value. 1

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TYPES OF OPTIONS Call option Put option

Call Option Call Options give the buyer the right to buy a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Call Option gives the Buyer the right to buy Satyam at a price of Rs 60 per share on or before the last Thursday of February. The price of 260 in the above example is called the strike price or the exercise price. Call Options are also called teji in the Indian markets.

Put Option Put Options give the buyer the right to sell a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Put Option gives the Buyer the right to sell Satyam at a price of Rs 260 per share on or before the last Thursday of February. Put Options are also called mandi in the Indian markets.

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OPTIONS CLASSIFICATIONS

Options are often classified as: In the money - These result in a positive cash flow towards the investor At the money - These result in a zero-cash flow to the investor Out of money - These result in a negative cash flow for the investor

'IN THE MONEY','AT THE MONEY'& OUT OF THE MONEY' OPTIONS. OPTION: An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. CALL OPTION: A call option is said to be in the money when the strike price of the option is less than the underlying asset price. For example: A Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value. The call option holder has the right to buy a Sensex at 3900, no matter by what amount the spot price exceeded the strike price. With the spot price at 4100, selling Sensex at this higher price can make a profit.

On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700 and allow his option right to lapse. PUT OPTION : A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset.

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For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put option holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value and therefore in this scenario, the put option holder Will allow his option right to lapse.

CALL OPTION

PUT OPTION

In-the-money

Strike price < Spot price of underlying asset Strike price = Spot price of underlying asset Strike price > Spot price of underlying asset

Strike price > Spot price of underlying asset Strike price = Spot price Of underlying asset Strike price < Spot price Of underlying asset

At-the-money

Out-of-themoney

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WHAT ARE SWAPS? A contract between two parties, referred to as counterparties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counterparties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.

WHY DID SWAPS EMERGE? In the late 1970's, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-toback loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement lead to development of more sophisticated swap market of today.

TYPES OF SWAP 1) Currency swaps Currency swaps can be defined as a legal agreement between two or more parties to exchange interest obligation or interest receipts between two different currencies. It involves three steps: Initial exchange of principal between the counter parties at an agreed upon rate of exchange which is usually based on spot exchange rate. This exchange is optional and its sole objective is to establish the quantum of the respective principal amounts for the purpose for calculating the ongoing

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payments of interest and to establish the principal amount to be re-exchanged at the maturity of the swap. Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. Re-exchange of principal amount on maturity at the initial rate of exchange.

This straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency.

2) Interest Rate Swap

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap period-Cash payments based on fixed/floating and floating rates are made by the parties to one another. 3) Debt Equity Swap In Debt Equity Swap , a firm buy a counter debt on the secondary loan market at a discount & Swap it into local eqyuity . in other words , the debts are exchanged for equity by one firm with another.

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CURRENT TRENDS IN INDIAN SWAP MARKETS

The guidelines released by the Reserve Bank of India (RBI) for trading in interest rate swaps (IRS) and forward-rate agreements (FRAs) would deepen the market and pave the way for derivatives development.

Some of the players in the market feel that the most prudent rate seemed to be the National Stock Exchange Mibor*** (Mumbai inter-bank offer rate) as the Mibor is based on sophisticated statistical methods. Other rates proposed were the Treasury bill rates and an average of the daily Mumbai interbank bid (Mibor) and Mibor rates. The need to develop standard market conventions for various aspects while dealing in IRS and FRAs is felt.

Some foreign and private banks seem to be well equipped to face the challenges involved in conducting IRS and FRAs. However, the nationalized banks were doubtful about venturing into swap deals until the next year. This would slow down the market for IRS initially as large volumes are needed to allow this market to mature, which can only be provided by participation of financial institutions and nationalized banks.

Most of the important transactions today have been hedged with different counter parties overseas. These derivative transactions include FRAs, interest rate options, currency swaps, and interest rate swaps. HDFC Bank was the first bank to book a long dated dollar / rupee swap after the RBI permitted them freely some months back.

FOOTNOTES Mibor***: Mumbai Inter Bank Offer Rate.

Standard Chartered Bank has struck an IRS deal with GE Capital Services India for Rs.100 crores for a tenor of six months. 23

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GE Capital received a fixed rate and paid the bank a floating rate linked to the National Stock Exchange (NSE) Mibor

Stanchart swapped loans with Electrolux, ICICI and I-Sec. The tenors ranged from one month to six months. Electrolux had a fixed rate loan of about 13.75 per cent, which it swapped for a floating rate loan at Mibor plus a spread. The tenor of the swap is one month.

Stanchart concluded deals on the reverse way too from floating rate to fixed rate. In this case, a client is trying to hedge its risk by locking floating interest rate to a fixed rate. Total deals done on 8th July 1999 were worth over Rs.150 crore for Stanchart.

Future

Going by the first lot of swaps, where most corporates have switched from a fixed to a floating rate, there seems to be an overall expectation of lower interest rates. The development of the swap market also requires participants to have varying views in order to take opposite positions.

However, market participants also feel that rate swaps will take time to get off the ground until documentation, legal and tax issues are resolved.

What can one do with swaps? (From Indian perspective) If interest rates are expected to fall, swap ones fixed rate on loans for a floating rate.

If interest rates are expected to rise, swap ones floating rate on loans for a fixed rate.

If one has loans benchmarked to a floating rate, one can swap it with another floating rate. Example: Switch from floating rate tied to the 91-day T-bill rate to another tied to NSEs 3month Mibor.

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WHAT ARE THE RISK EXPOSURES?

1. Credit Risk This is the risk of failure of counterparty to perform its obligation as per the contract. Also known as default or counterparty risk, it differs with different instruments. 2. Market Risk Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument. 3. Liquidity Risk The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks Related to liquidity of separate products Related to the funding of activities of the firm including derivatives.

4. Legal Risk Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked into carefully.

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DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of 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 24member 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 mark et 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 realtime 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 was 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 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(Sensex) 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. 26 2010-2011

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.

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Questionnaire (for Broking Firms)

Name of the Broking firm : ______________________________________________ Name of the person : ______________________________________________ Branch : ______________________________________________

1. Do you deal in Derivative instruments? Yes No

2. Which of the following Derivative instruments do you deal in? Stock Futures Index Futures Stock Options Index Options

3. How much do Stock Futures contribute to your entire business? (Such that Q. 3,4,5 & 6 sum up to 100%) More then 75% 50% 75% 25 less than 50% 25%

4. How much do Index Futures contribute to your entire business? More then 75% 50% 75% 25 less than 50% 25%

5. How much do Stock Options contribute to your entire business? More then 75% 50% - 75% 25 less than 50% 25%

6. How much do Index Option contribute to your entire business? More then 75% 50% 75% 25 less than 50% 25%

7. Please rate the following factors on point scale of 1 to 5,with 5 being most dominant factor and 1 being least dominant factor, which have necessitated the use of stock Index futures? Hedging Arbitrage ( ( ) ) Speculation ( )

8. What is the Liquidity Perception regarding Index Futures? 28 2010-2011

 9.

Very High High Moderate

Low Very Low

What kind of investors usually approach you for trading in Stock Index Futures? Hedger Speculator Arbitrageur

10. What is the Perception about Risk reduction through Index Futures? Very High High Moderate Low Very Low

11. What is the awareness level about Stock & Index Futures? Very High High Moderate Low Very Low

13. How much Margin Money in Equity Derivative Market? A) On Cash Basis: 1 to 5 times 6 to 10 times B) On Delivery Basis: 1 to 5 times 6 to 10 times 11 to 15 times 16 to 20 times 11 to 15 times 16 to 20 times

14. What is the quantum of CASH & DELIVERY basis trading in your business? A) On Cash Basis: 10-20% 41-60% 21-40% 61-80% B) On Delivery Basis: 10-20% 41-60% 21-40% 61-80% 15. Impact of Recession fiasco on your Business Very High High Moderate Low Very Low

16. Which kind of Investors were active during the past 2 years Traders Investors 29 2010-2011

17.Would you like to give any suggestions regarding improvement of trading in Stock & Index Futures? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ _______________________________

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ANALYSIS On the Basis of Investment in Derivatives

7 6 5 4 3 2 1 0 Less than 25% 25-50% 50-75% More than 75 Stock Futures Index Futures Stock Options Index Options

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On the basis of Liquidity Perception

Liquidity Perception
Very Low low moderate high very high

13%

12% 12%

63%

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On the basis of Risk Perception

Risk Perception
high 22% Very Low 22%

moderate 45%

low 11%

Derivatives are considered as one of the most risk carrying instruments in India. The profit margins are also high compared to other instruments. After the developments of various systems and techniques to reduce the risk involved in the derivatives the perception of the broking firms has gradually changed over the time. Today derivatives are not seems as a instruments with high risk but is considered as instruments with moderate risk. After conducting the survey it was found that only 45% feel that derivatives carry moderate risk whereas 22% felt that they carry low risk and the same percentage feels that they carry high risk and as low as 11% feel they carry low risk. In the near future due to development and initiatives taken by the SEBI we can see there are more percentage of broking firms and investors views changing from high risk to moderate risk and from moderate risk to low risk.

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Impact of Recession Fiasco

Impact of Recession Fiasco

11% 44% 45%

Very Low low moderate high very high

The fear of recession had a very great impact on the stock markets and especially Derivative market. There were many stock broking firms who closed down their branches which were less profit making and due to fear among the investors they withdrew their investments from the market at a marginal loss which in turn affected the brokers and which worsened the market. Only 11% of the brokers feel the impact of the recession was low whereas 44% and 45% feel it was high and moderate respectively. It has been a year the market collapsed and the market is gaining gradually. There is more investment in the derivative market as the investor and traders are gaining confidence in the market and it is generating revenue for the brokers and investors are making profits because of the stable market.

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CONCLUSION

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BIBLIOGRAPHY

Primary Sources: Religare Securities Limited Mr. Ekant Desai Angel Broking Mr. Nikhil Gohil ANS Pvt. Ltd. Mr. Kandarp Domadia Arcardia Shares & Stock Brokers Pvt. Ltd. Mr. Shailesh Gohil Bonanza Mr.Harsh Garg Edelweiss Mr. Nitin Bihari GEPL Mr. Devang Agasiwala JM Financial Mr. Nitin Mehta Nirmal Bang Mr. Himanshu Shah & Mr. Jignesh Shah Proactive Universal Group Mr. Sanjay Wadhvana

Secondary Sources: www.moneycontrol.com www.investopedia.com www.money.rediff.com

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