deriv basics

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BASICS OFDERIVATIVES

BASICS OF DERIVATIVES

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CONTENTS

FOREWORD...................................................................................................................... 3

1.INTRODUCTION.......................................................................................................... 5

2. FUTURES .................................................................................................................... 11

3. OPTIONS.....................................................................................................................26

4. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 40

5. RISK MANAGEMENT IN DERIVATIVES............................................................ 50

6. SETTLEMENT OF DERIVATIVES........................................................................ 52

7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 57

8. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58

ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63

ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72

ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74

ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75


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Foreword

New ideas and innovations have always been the hallmark of progress made by

mankind. At every stage of development, there have been two core factors that

drives man to ideas and innovation. These are increasing returns and reducing

risk, in all facets of life.

The financial markets are no different. The endeavor has always been to

maximize returns and minimize risk. A lot of innovation goes into developing

financial products centered on these two factors. It has spawned a whole new

area called financial engineering.

Derivatives are among the forefront of the innovations in the financial markets

and aim to increase returns and reduce risk. They provide an outlet for investors

to protect themselves from the vagaries of the financial markets. These

instruments have been very popular with investors all over the world.

Indian financial markets have been on the ascension and catching up with global

standards in financial markets. The advent of screen based trading,

dematerialization, rolling settlement have put our markets on par with

international markets.


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As a logical step to the above progress, derivative trading was introduced in the

country in June 2000. Starting with index futures, we have made rapid strides

and have four types of derivative products- Index future, index option, stock

future and stock options. Today, there are 30 stocks on which one can have

futures and options, apart from the index futures and options.

This market presents a tremendous opportunity for individual investors .The

markets have performed smoothly over the last two years and has stabilized. The

time is ripe for investors to make full use of the advantage offered by this market.

We have tried to present in a lucid and simple manner, the derivatives market, so

that the individual investor is educated and equipped to become a dominant

player in the market.

Editorial Team

July 11, 2002


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1.Introduction

What are derivatives?

A derivative is a financial instrument that derives its value from an underlying

asset. This underlying asset can be stocks, bonds, currency, commodities,

metals and even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor,

collars etc. The most popular derivative instruments are futures and options.

There are newer derivatives that are becoming popular like weather derivatives

and natural calamity derivatives. These are used as a hedge against any

untoward happenings because of natural causes.

What exactly is meant by “ derives its value from an asset”?

What the phrase means is that the derivative on its own does not have any value.

It is considered important because of the importance of the underlying. When we

say an Infosys future or an Infosys option, these carry a value only because of

the value of Infosys.


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What are financial derivatives?

Financial derivatives are instruments that derive their value from financial assets.

These assets can be stocks, bonds, currency etc. These derivatives can be

forward rate agreements, futures, options swaps etc. As stated earlier, the most

traded instruments are futures and options.

What kind of people will use derivatives?

Derivatives will find use for the following set of people:

• Speculators: People who buy or sell in the market to make profits. For

example, if you will the stock price of Reliance is expected to go upto Rs.400

in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make

profits

• Hedgers: People who buy or sell to minimize their losses. For example, an

importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50

/$ from Rs 48/$, then the importer can minimize his losses by buying a

currency future at Rs 49/$

• Arbitrageurs: People who buy or sell to make money on price differentials in

different markets. For example, a futures price is simply the current price plus

the interest cost. If there is any change in the interest, it presents an arbitrage

opportunity. We will examine this in detail when we look at futures in a

separate chapter.


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Basically, every investor assumes one or more of the above roles and derivatives

are a very good option for him.

How has this market developed over time?

Derivatives have been a recent development in the Indian financial markets. But

there have been derivatives in the commodities market. There is Cotton and

Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,

Coffee futures in Bangalore etc. But the players in these markets are restricted to

big farmers and industries, who need these as an input to protect themselves

from the vagaries of agriculture sector.

Globally too, the first derivatives started with the commodities, way back in 1894.

Financial derivatives are a relatively late development, coming into existence

only in the 1970’s. The first exchange where derivatives were traded is the

Chicago Board of Trade (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE)

in June 2000. The first derivatives were index futures. The index used was Nifty.

Option trading was started in June 2001, for index as well as stocks. In

November 2001, futures on stocks were allowed. Currently, there are 30 stocks

on which derivative trading is allowed.


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The 30 stocks on which trading is allowed currently are:

Name of the Scrip Lot Size

ACC 1500

Bajaj Auto 800

BHEL 1200

BPCL 1100

BSES 1100

Cipla 200

Digital Global Soft 400

Dr Reddy Laboratories 400

Grasim 700

Gujarat Ambuja 1100

Hindalco 300

Hindustan Lever 1000

HPCL 1300

HDFC 300

Infosys 100

ITC 300

L&T 1000

MTNL 1600

M&M 2500


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Ranbaxy 500

Reliance Industries 600

Reliance Petroleum 4300

Satyam Computers 1200

SBI 1000

Sterlite Opticals 600

TELCO 3300

TISCO 1800

Tata Power 1600

Tata Tea 1100

VSNL 700

NIFTY 200

SENSEX 50

The trading is done on the exchange in the F&O (Futures and Option) segment.

Index F&O is also traded in the market. The indices traded are the Nifty and the

Sensex.

Since we have talked of hedging, can we compare derivatives to

insurance?

You buy a life insurance policy and pay a premium to the insurance agent for a

fixed term as agreed in the policy. In case you survive, you are happy and the


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insurance company is happy. In case you don’t survive, your relatives are happy

as the insurance company pays them the amount for which you are insured.

Insurance is nothing but transfer of risk. An insurance company sells you risk

cover and buys your risk and you sell your risk and buy a risk cover. The risk

involved in life insurance is the death of the policyholder. The insurance

companies bet on your surviving and hence agree to sell a risk cover for some

premium.

There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,

a derivative instrument can be compared to insurance, as there is a transfer of

risk at a financial cost.

Derivatives also work well on the concept of mutual insurance. In mutual

insurance, two people having opposite risks can enter into a contract and reduce

their risk. The most classic example is that of an importer and exporter. An

importer buys goods from country A and has to pay in dollars in 3 months. An

exporter sells goods to country A and has to receive payment in dollars in 3

months. In case of an importer, the risk is of exchange rate moving up. In case of

an exporter, the risk is of exchange rate moving down. They can cover each

others risk by entering into a forward rate after 3 months.


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2. Futures

Future, as the name indicates, is a trade whose settlement is going to take place

in the future. However, before we take a look at futures, it will be beneficial for us

to take a look at forward rate agreements

What is a forward rate agreement

A forward rate agreement is one in which a buyer and a seller enter into a

contract at a specified quantity of an asset at a specified price on a specified

date.

An example for this is the exporters getting into forward rate agreements on

currencies with banks.

But there is always a risk of one of the parties defaulting. The buyer may not pay

up or the seller may not be able to deliver. There may not be any redressal for

the aggrieved party as this is a negotiated contract between two parties.

What is a future?

A future is similar to a forward rate agreement, except that it is not a negotiated

contracted but a standard instrument.


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A future is a contract to buy or sell an asset at a specified future date at a

specified price. These contracts are traded on the stock exchanges and it can

change many hands before final settlement is made.

The advantage of a future is that it eliminates counterparty risk. Since there is an

exchange involved in between, and the exchange guarantees each trade, the

buyer or seller does not get affected with the opposite party defaulting.

Futures Forwards

Futures are traded on a stock

exchange

Forwards are non tradable, negotiated

instruments

Futures are contracts having standard

terms and conditions

Forwards are contracts customized by

the buyer and seller

No default risk as the exchange

provides a counter guarantee

High risk of default by either party

Exit route is provided because of high

liquidity on the stock exchange

No exit route for these contracts

Highly regulated with strong margining

and surveillance systems

No such systems are present in a

forward market.


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There are two kinds of futures traded in the market- index futures and stock

futures.

There are three types of futures, based on the tenure. They are 1, 2 or 3 month

future. They are also known as near and far futures depending on the tenure.

What are Index futures

Index futures are futures contract on the index itself. One can buy a 1, 2 or 3-

month index future. If someone wants to take a call on the index, then index

futures are the ideal instruments for him.

Let us try and understand what an index is. An index is a set of numbers that

represent a change over a period of time.

A stock index is similarly a number that gives a relative measure of the stocks

that constitute the index. Each stock will have a different weight in the index

The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.

For example, Nifty was formed in 1995 and given a base value of 1000. The

value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000


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was invested in the stocks that form in the index, in the same proportion in which

they are weighted in the index, then Rs 1000 would have become Rs 1172 today.

There are two popular methods of computing the index. They are price weighted

method like Dow Jones Industrial Average (DJIA) or the market capitalization

method like Nifty or Sensex.

What the terminologies used in a Futures contract?

The terminologies used in a futures contract are:

• Spot Price: The current market price of the scrip/index

• Future Price: The price at which the futures contract trades in the futures

market

• Tenure: The period for which the future is traded

• Expiry date: The date on which the futures contract will be settlec

• Basis : The difference between the spot price and the future price

Why are index futures more popular than stock futures?

Globally, it has been observed that index futures are more popular as compared

to stock futures. This is because the index future is a relatively low risk product

compared to a stock future. It is easier to manipulate prices for individual stocks

but very difficult to manipulate the whole index. Besides, the index is less volatile


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as compared to individual stocks and can be better predicted than individual

stock.

How is the future price arrived at?

Future price is nothing but the current market price plus the interest cost for the

tenure of the future.

This interest cost of the future is called as cost of carry.

If F is the future price, S is the spot price and C is the cost of carry or opportunity

cost, then

F=S+C

F = S + Interest cost, since cost of carry for a finance is the interest cost

Thus,

F=S (1+r)T

Where r is the rate of interest and T is the tenure of the futures contract.


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The rate of interest is usually the risk free market rate.

Example 2.1:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will

be the price of one-month future?

Solution

The price of a future is F= S (1+r)T

The one-month Reliance future would be the spot price plus the cost of carry.

Since the bank rate is 10 %, we can take that as the market rate. This rate is an

annualized rate and hence we recalculate it on a monthly basis.

F=300(1+0.10)(1/12)

F= Rs 302.39

Example 2.2:

The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys

is Rs 3100. The returns expected from the Gsec funds for the same period is 10

%. Is the future of Infosys overpriced or underpriced?


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Solution

The 1 month Future of Infosys will be

F= 3000(1+.0.10) (1/12)

F= Rs 3023.90

But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs

76.

What happens if dividend is going to be declared?

Dividend is an income to the seller of the future. It reduces his cost of carry to

that extent. If dividend is going to be declared, the same has to be deducted from

the cost of carry

Thus the price of the future in this case becomes,

F= S (1+r-d) T

Where d is the dividend.

Example 2.3:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will

be the price of one-month future? Reliance will be paying a dividend of 50 paise

per share

Solution:


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Since Reliance is paying 50 paise per share and the face value of reliance is Rs

10, the dividend rate is 5%.

So while calculating futures,

F=300(1+0.10-0.05) (1/12)

F= Rs. 301.22

What happens if dividend is declared after buying a future?

If the dividend is declared after buying a one month future, the cost of carry will

be reduced by a pro rata amount. For example, if there is a one month future

ending June 30th and dividend is declared on June 15th, then dividend benefit will

be reduced from the cost of carry for 15 days.

Since the seller is holding the shares and will transfer the shares to the buyer

only after a month, the dividend benefit goes to the seller. The seller will enjoy

the benefit to the extent of interest on dividend.

Thus net cost of carry = cost of carry – dividend benefits

Example 2.4:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance

declares a dividend of 5%. What will be the price of one-month future?

Solution:


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The benefit accrued due to the dividend will be reduced from the cost of the

future.

One month future will be priced at

F= 300(1+0.10) (1/12)

F = 302.39

Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39

The interest benefit of the dividend is available for 15 days, ie 0.5 months.

Dividend for 15 days = 300(1+0.05) (0.5/12)

Dividend Benefit = Rs300.61- Rs 300= Rs0.61

Therefore, net cost of the carry is,

Rs2.39-Rs0.61 = Rs 1.78

Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78

In practice, the market discounts the dividend and the prices are automatically

adjusted. The exchange steps into the picture if the dividend declared is more

than 10 % of the market price. In such cases, there is an official change in the

price. In other cases, the market does the adjustment on its own.

What happens in case a bonus/ stock split is declared on the stock in

which I have a futures position?

If a bonus is declared, the settlement price is adjusted to reflect the bonus. For

example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the


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position becomes 400 Reliance at Rs 150 so that the contract value is

unaffected.

But is the Future really traded in this way in the market?

What has been discussed above is the theoretical way of arriving at the future

price. This can be used as a base for calculation future price

But the actual market price that we see on the trading screen depends on

liquidity too. So the prices that we observe in real world are also a function of

demand-supply position in that stock.

How do future prices behave compared to spot prices?

Future prices lead the spot prices. The spot prices move towards the future

prices and the gap between the two is always closing with as the time to

Future vs Spot

0

10

20

30

1 2 3 4 5 6 7

Time

Pric

e Future Price

Spot Price


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settlement decreases. On the last day of the future settlement, the spot price

equals the future price.

Is the futures price always higher than the spot price?

The futures price can be lower than the spot price too. This depends on the

fundamentals of the stock. If the stock is not expected to perform well and the

market takes a bearish view on them, then the futures price can be lower than

the spot price.

Future prices can fall also due to declaration of dividend.

What happens in case of index futures?

In case of index futures, the treatment of the futures calculation is the same. The

future value is calculated as the spot index value plus the cost of carry.

What happens if I buy an index future and there is a dividend declared on a

stock that comprises the index?

Practically speaking, the index is corrected for these things in case there is a

dividend declared for such a stock.

Theoretically, dividend is adjusted in the following manner:


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1.The contribution of the stock to the index is calculated. The index, as discussed

earlier, is a market capitalization index.

2. Then the number of shares in the index is calculated. This is obtained by

dividing the contribution to the index by the market price.

3. The dividend on the index is the dividend on the number of shares of the stock

in the index.

4. The interest earned on the dividend is calculated and reduced from the cost of

carry to obtain the net cost of carry.

Example 2.5:

The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL

contributes to 15 % of the index. The market price of HLL is Rs 150. What will be

the cost of the 1 month future if the bank rate is 10%?

Solution :

The future will be priced at

F= 1000(1+0.10)(1/12)

F= 1008

The weight of HLL in the index is 15% ie 0.15*1000=150.

The market price of HLL is Rs 150

Therefore, the number of shares of HLL in the index=1

The dividend earned on this is Rs 5


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Dividend benefit on Rs 5 is 5(1+0.10) (1/12)

Dividend benefit = Rs 0.04

Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95

But in practice, the market discounts the dividends and price adjustment is made

accordingly.

All that is okay in theory, but what happens in the real world?

In the real world, derivatives are highly volatile instruments and there have been

lot of losses in the various financial markets. The classic examples have been

Long Term Capital Markets (LTCM) and Barings. We will examine what

happened exactly at various places later in the book.

As a result, the regulators have decided that a minimum of Rs 2 lacs should be

the contract size. This is done primarily to keep the small investors away from a

volatile market till enough experience and understanding of the markets is

acquired. So the initial players are institutions and high net worth individuals who

have a risk taking capacity in these markets.

Because of this minimum amount, lots are decided on the market price such that

the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in

case of Sensex, 50.


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Similarly minimum lots are decided for individual stocks too. Thus you will find

different stock futures having different market lots. The lots decided for each

stock was such that the contract value was Rs 2 lacs. This was at the point of

introduction of these instruments. However the lot size has remained the same

and has not been adjusted for the price changes. Hence the value of the contract

may be slightly lower in case of certain stocks.

Trading, i.e. Buying and Selling take place in the same manner as the stock

markets. There will be an F & O terminal with the broker and the dealer will enter

the orders for you.

Another fact of the real world is that, since the future is a standard instrument,

you can close out your position at any point of time and need not hold till

maturity.

How is the trading done on the exchange?

Buying of futures is margin based. You pay an up front margin and take a

position in the stock of your choice. Your daily losses/ gains relative to the future

price will be monitored and you will have to pay a mark to market margin. On the

final day settlement is made in cash and is the difference between the futures

price and the spot price prevailing at that time


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For example, if the future price is Rs 300 and the spot price is Rs 330, then you

will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a

cash loss of Rs 10. Thus futures market is a cash market.

In future, there is a possibility that the futures may result in delivery. In such a

scenario, the future market will be merged with the spot market on the expiration

day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

How does the mark to market mechanism work?

Mark to market is a mechanism devised by the stock exchange to minimize risk.

In case you start making losses in your position, exchange collects money to the

extent of the losses up front. For example, if you buy futures at Rs 300 and its

price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This

is over and above the margin money that you pay to take a position in the future.


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3. Options

What are options?

As seen earlier, futures are derivative instruments where one can take a position

for an asset to be delivered at a future date. But there is also an obligation as the

seller has to make delivery and buyer has to take delivery.

Options are one better than futures. In option, as the name indicates, gives one

party the option to take or make delivery. But this option is given to only one

party in the transaction while the other party has an obligation to take or make

delivery. The asset can be a stock, bond, index, currency or a commodity

But since the other party has an obligation and a risk associated with making

good the obligation, he receives a payment for that. This payment is called as

premium.


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The party that had the option or the right to buy/sell enjoys low risk. The cost of

this low risk is the premium amount that is paid to the other party.

Thus we have seen an option is a derivative that gives one party a right and the

other party an obligation to buy /sell at a specified price for a specified quantity.

The buyer of the right is called the option holder. The seller of the right (and

buyer of the obligation) is called the option writer. The cost of this transaction is

the premium.

For example, a railway ticket is an option in daily life. Using the ticket, a

passenger has an option to travel. In case he decides not to travel, he can cancel

the ticket and get a refund. But he has to pay a cancellation fee, which is

analogous to the premium paid in an option contract. The railways, on the other

hand, have an obligation to carry the passenger if he decides to travel and refund

his money if he decides not to travel. In case the passenger decides to travel, the

railways get the ticket fare. In case he does not, they get the cancellation fee.

The passenger on the other hand, by booking a ticket, has hedged his position in

case he has to travel as anticipated. In case the travel does not materialize, he


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can get out of the position by canceling the ticket at a cost, which is the

cancellation fee.

But I hear a lot of jargons about options? What are all these jargons?

There are some basic terminologies used in options. These are universal

terminologies and mean the same everywhere.

a. Option holder : The buyer of the option who gets the right

b. Option writer : The seller of the option who carries the obligation

c. Premium: The consideration paid by the buyer for the right

d. Exercise price: The price at which the option holder has the right to buy or

sell. It is also called as the strike price.

e. Call option: The option that gives the holder a right to buy

f. Put option : The option that gives the holder a right to sell

g. Tenure: The period for which the option is issued

h. Expiration date: The date on which the option is to be settled

i. American option: These are options that can be exercised at any point till the

expiration date

j. European option: These are options that can be exercised only on the

expiration date

k. Covered option: An option that an option writer sells when he has the

underlying shares with him.


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l. Naked option: An option that an option writer sells when he does not have the

underlying shares with him

m. In the money: An option is in the money if the option holder is making a profit

if the option was exercised immediately

n. Out of money: An option is in the money if the option holder is making a loss

if the option was exercised immediately

o. At the money: An option is in the money if the option holder evens out if the

option was exercised immediately

How is money made in an option?

The money made in an option is called as the option pay off. There can be two

pay off for options, for put and call option

Call option:

A call option gives the holder a right to buy shares. The option holder will make

money if the spot price is higher than the strike price. The pay off assumes that

the option holder will buy at the strike price and sell immediately at the spot price.

But if the spot price is lower than the strike, the option holder can simply ignore

the option. It will be cheaper to buy from the market. The option holder loss is to

the extent of premium he has paid.


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But if the spot price increases dramatically then he can make wind fall profits.

Thus the profits for an option holder in a call option is unlimited while losses are

capped to the extent of the premium.

Conversely, for the writer, the maximum profit he can make is the premium

amount. But the losses he can make are unlimited.

Put option

The put option gives the right to sell. The option holder will make money if the

spot price is lower than the strike price. The pay off assumes that the option

holder will buy at spot price and sell at the strike price

But if the spot price is higher than the strike, the option holder can simply ignore

the option. It will be beneficial to sell to the market. The option holder loss is to

the extent of premium he has paid.

But if the spot prices falls dramatically then he can make wind fall profits.

Thus the profits for an option holder in a put option is unlimited while losses are

capped to the extent of the premium. This is a theoretical fallacy as the maximum


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fall a stock can have is till zero, and hence the profit of a option holder in a put

option is capped.

Conversely, the maximum profit that an option writer can make in this case is the

premium amount.

But in the above pay off, we had ignored certain costs like premium and

brokerage. These are also important, especially the premium.

So, in a call option for the option holder to make money, the spot price has to be

more than the strike price plus the premium amount.

If the spot is more than the strike price but less than the sum of strike price and

premium, the option holder can minimize losses but cannot make profits by

exercising the option.

Similarly, for a put option, the option holder makes money if spot is less than the

strike price less the premium amount.

If the spot is less than the strike price but more than the strike price less

premium, the option holder can minimize losses but cannot make profits by

exercising the option.


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Example 3.1:

The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What

will be the profit for the option holder if the spot price touches a) Rs. 350 b)337

Solution

a. The option holder can buy Reliance at a price of Rs 330.

He has also paid a premium of Rs 10 for the same. So his cost of a share of

Reliance is Rs 340.

He can sell the same in the spot market for Rs 350.

He makes a profit of Rs 10

b. The option holder can buy Reliance at a price of Rs 330.

He has also paid a premium of Rs 10 for the same. So his cost of a share of

Reliance is Rs 340.

He can sell the same in the spot market for Rs 337

He makes a loss of Rs 3.

But he has reduced his losses by exercising the option. Had he not exercised the

option, he would have made a loss of Rs 10, which is the premium that he paid

for the option.


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But should one always buy an option? The buyer seems to enjoy all

advantages, then why should one write an option?

This is not always the case. The writer of the option too can make money.

Basically, the option writers and option holders are people who are taking a

divergent view on the market. So if the option writer feels the markets will be

bearish, he can write call options and pocket the premium. In case the market

falls, the option holder will not exercise the option and the entire premium amount

can be a profit

But if the option writer is bullish on the market, then he can write put options. In

case the market goes up, the option holder will not exercise the option and the

premium amount is a profit for the option writer.

The other area that an option writer makes money is the spot price lying in the

range between the strike price and the strike plus premium

For example, if you write a call option on Reliance for a strike price of Rs 300 at a

premium of Rs 30. If the spot price is Rs 320, then the option holder will exercise

the option to reduce losses and buy it at Rs 300. But you have already got the

premium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs

10 above the spot price! This profit increases even more if you calculate the

opportunity cost of Rs 30 as this amount is received up front.


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Let us look at a typical pay off table for a call option, for the buyer as well as

writer. Let us assume a call option with a strike price of Rs 200 and a premium of

Rs 10

Table 3.1: Pay off Table for buyer and writer of an option

Spot Price Whether

Exercised

Buyer’s

gain/loss

Writer

gain/loss

Net

180 No -10 +10 0

190 No -10 +10 0

195 No -10 +10 0

200(=Strike

Price)

Yes/No -10 +10 0

205 Yes -5 +5 0

210 Yes 0 0 0

220 Yes +10 -10 0

In the above pay off table, if we take 200 as the median value, we see that the

writer has made money 5 out of 7 occasions. He has made money even when

the option is exercised, as long as the spot price is below the strike price plus the

premium.

Thus writers also make money on options, as the buyer is not at an advantage all

the time.


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What are the options that are currently traded in the market?

The options that are currently traded in the market are index options and stock

options on the 30 stocks. The index options are European options. They are

settled on the last day. The stock options are American options.

There are 3 options-1, 2,3 month options. There can be a series of option within

the above time span at different strike prices.

Another lingo in option is Near and Far options. A near option means the option

is closer to expiration date. A Far option means the option is farther from

expiration date. A 1 month option is a near option while a 3 month option is a far

option.

In option trading, what gets quoted in the exchange is the premium and all that

people buy and sell is the premium.

We said we could have different option series at various strike prices. How

is this strike price arrived at?

The strike price bands are specified by the exchange. This band is dependent on

the market price.

Market Price Rs. Strike Price Intervals Rs.


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<50 2.5

50-150 5

150-250 10

250-500 20

500-1000 30

>1000 50

Thus if a stock is trading at Rs. 100 then there can be options with strike price of

Rs 105,110,115, 95, 90 etc.

How is the premium of an option calculated?

In practice, it is the market that decides the premium at which an option is traded.

There are mathematical models, which are used to calculate the premium of an

option.

The simplest tool is the expected value concept. For example, for a stock that is

quoting at Rs 95. There is a 20 % probability that it will become Rs 110. There is

a 30 % probability that it will become Rs 105. There is 30% probability that the

stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.


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If the strike price of a call option is to be Rs 100, then the option will have value

when the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs

90.

If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively.

The expected returns for the above distribution is

0.20*15+0.30*10=Rs 6.

Thus this the price that one can pay as a premium for a strike price of Rs 100 for

a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the

option holder this opportunity.

This is a very simple thumb calculation. Even then, one would require a lot of

background data like variances and expected price movements.

There are more advanced probabilistic models like the Black Scholes model and

the Binomial Pricing model that calculates the options. One need not go deep

into those and it would suffice to say that option calculators are readily available.

Please visit www.indiainfoline.com/stok/ to use an option calculator based on

Black Scholes Model. The Black Scholes Model is presented in greater detail in

Annexure-3.


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I keep reading about option Greeks? What are they? They actually sound

like Greek and Latin to me.

There are something called as option Greeks but they are nothing to be scared

of. The option Greeks help in tracking the volatility of option prices.

The option Greeks are

a. Delta: Delta measures the change in option price (the premium) to the change

in underlying. A delta of 0.5 means if the underlying changes by 100 % the

option price changes by 50 %.

b. Theta: It measures the change in option price to change in time

c. Rho: It is the change in option price to change in interest rate

d. Vega: It is the change in option price to change in variance of the underlying

stock

e. Gamma: It is the change in delta to the change in the underlying. It is a

double derivative (the mathematical one) of the option price with respect to

underlying. It gives the rate of change of delta.

These are just technical tools used by the market players to analyze options and

the movement of the option prices.


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We saw that the stock options are American options and hence can be

exercised any time. What happens when one decided to exercise the

option?

When the option holder decides to exercise the option, the option will be

assigned to the option writer on a random basis, as decided by the software of

the exchange.

The European options are also the similarly decided by the software of the

exchange. The index options are European options.

In future, there is a possibility that the options may result in delivery. In such a

scenario, the option market will be merged with the spot market on the expiration

day and it will follow the T+ 3 rolling settlement prevalent in the stock markets


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4. Trading Strategies using Futures and Options

So far, we have seen a lot of theoretical stuff on derivatives. But how is it

going to help me in practice?

There are a lot of practical uses of derivatives. As we have seen, derivatives can

be used for profits and hedging. We can use derivatives as a leverage tool too.

How do I use derivatives as a leverage?

You can use the derivatives market to raise funds using your stocks. Conversely,

you can also lend funds against stocks.

Does that mean derivatives are badla revisited?

The derivative product that comes closest to Badla is futures. Futures is not

badla, though a lot of people confuse it with badla. The fundamental difference is

badla consisted of contango and backwardation (undha badla and vyaj badla) in

the same market. Futures is a different market segment altogether. Hence

derivatives is not the same as badla, though it is similar.

How do I raise funds from the derivatives market?

This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You

have shares lying with you and are in urgent need of liquidity. Instead of pledging

your shares and borrowing from banks at a margin, you can sell the stock at Rs


41

3000. Suppose you need this liquidity only for a month and also do not want to

part with Infosys. You can buy a 1 month future at Rs 3050. After a month you

get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the

financing cost for the liquidity.

The other beauty about this is you have already locked in your purchase cost at

Rs 3050. This fixes your liquidity cost also and you are protected against further

price losses.

How do I lend into the market?

The lending into the market is exactly the reverse of borrowing. You have money

to lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000

and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs

3000 to the market for a month and earned Rs 100 on it.

Suppose I don’t want to lend/borrow money. I want to speculate and make

profits?

When you speculate, you normally take a view on the market, either bullish or

bearish. When you take a bullish view on the market, you can always sell futures

and buy in the spot market. If you take a bearish view on the market, you can buy

futures and sell in the spot market.


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Similarly, in the options market, if you are bullish, you should buy call options. If

you are bearish, you should buy put options

Conversely, if you are bullish, you should write put options. This is so because, in

a bull market, there are lower chances of the put option being exercised and you

can profit from the premium

If you are bearish, you should write call options. This is so because, in a bear

market, there are lower chances of the call option being exercised and you can

profit from the premium

How can I arbitrage and make money in derivatives?

Arbitrage is making money on price differentials in different markets. For

example, future is nothing but the future value of the spot price. This future value

is obtained by factoring the interest rate.

But if there are differences in the money market and the interest rates change

then the future price should correct itself to factor the change in interest. But if

there is no factoring of this change then it presents an opportunity to make

money- an arbitrage opportunity.


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Let us take an example.

Example 4.1:

A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005.

The risk free interest rate is 12%. What should be the trading strategy?

Solution:

The strategy for trading should be : Sell Spot and Buy Futures

Sell the stock for Rs 1000. Buy the future at Rs 1005.

Invest the Rs1000 at 12 %. The interest earned on this stock will be

1000(1+.012)(1/12)

=1009

So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4

Thus one can make a risk less profit of Rs 4 because of arbitrage

But an important point is that this opportunity was available due to mis-pricing

and the market not correcting itself. Normally, the time taken for the market to

adjust to corrections is very less. So the time available for arbitrage is also less.

As everyone rushes to cash in on the arbitrage, the market corrects itself.


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How is a future useful for me to hedge my position?

One can hedge one’s position by taking an opposite position in the futures

market. For example, If you are buying in the spot price, the risk you carry is that

of prices falling in the future. You can lock this by selling in the futures price.

Even if the stock continues falling, your position is hedged as you have firmed

the price at which you are selling.

Similarly, you want to buy a stock at a later date but face the risk of prices rising.

You can hedge against this rise by buying futures.

You can use a combination of futures too to hedge yourself. There is always a

correlation between the index and individual stocks. This correlation may be

negative or positive, but there is a correlation. This is given by the beta of the

stock.

In simple terms, what β indicates is the change in the price of a stock to the

change in index. For example, if β of a stock is 0.8, it means that if the index

goes up by 10, the price of the stock goes up by 8. It will also fall by a similar

level when the index falls.


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A negative β means that the price of the stock falls when the index rises. So, if

you have a position in a stock, you can hedge the same by buying the index at β

times the value of the stock.

Example 4.2:

The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I

can hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.

Scenario 1

If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800

The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gain

of Rs 800.

Thus my net position is zero and I am perfectly hedged.

Scenario 2

If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800

But the value of the stock also falls by 8 %. The value of this stock becomes Rs

9200 a loss of Rs 800.

Thus my net position is zero and I am perfectly hedged.

But again, β is a predicted value based on regression models. Regression is

nothing but analysis of past data. So there is a chance that the above position

may not be fully hedged if the β does not behave as per the predicted value.


46

How do I use options in my trading strategy?

Options are a great tool to use for trading. If you feel the market will go up. You

should buy a call option at a level lower than what you expect the market to go

up.

If you think that the market will fall, you should buy a put option at a level higher

than the level to which you expect the market fall.

When we say market, we mean the index. The same strategy can be used for

individual stocks also.

A combination of futures and options can be used too, to make profits.

We have seen that the risk for an option holder is the premium amount. But

what should be the strategy for an option writer to cover himself?

An option writer can use a combination strategy of futures and options to protect

his position. The risk for an option writer arises only when the option is exercised.

This will be very clear with an example.

Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium

of Rs 20. The risk arises only when the option is exercised. The option will be


47

exercised when the price exceeds Rs 300. I start making a loss only after the

price exceeds Rs 320(Strike price plus premium).

More importantly, I have to deliver the stock to the opposite party. So to enable

me to deliver the stock to the other party and also make entire profit on premium,

I buy a future of Reliance at Rs 300.

This is just one leg of the risk. The earlier risk was of the call being exercised.

The risk now is that of the call not being exercised. In case the call is not

exercised, what do I do? I will have to take delivery as I have bought a future.

So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need to

pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully

covered and my net cash flow would be

Premium earned from selling call option : Rs 20

Premium paid to buy put option : (Rs 10)

Net cash flow : Rs 10

But the above pay off will be possible only when the premium I am paying for the

put option is lower than the premium that I get for writing the call.


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Similarly, we can arrive at a covered position for writing a put option too,

Another interesting observation is that the above strategy in itself presents an

opportunity to make money. This is so because of the premium differential in the

put and the call option. So if one tracks the derivative markets on a continuous

basis, one can chance upon almost risk less money making opportunities.

What are the other strategies using derivatives?

The other strategies are also various permutations of multiple puts, calls and

futures. They are also called by exotic names , but if one were to observe them

closely, they are relatively simple instruments.

Some of these instruments are:

• Butter fly spread: It is the strategy of simultaneous buying of put and call

• Calendar Spread - An option strategy in which a short-term option is sold and

a longer-term option is bought both having the same striking price. Either puts

or calls may be used.

• Double option – An option that gives the buyer the right to buy and/or sell a

futures contract, at a premium, at the strike price

• Straddle – The simultaneous purchase and sale of option of the same

specification to different periods.


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• Tandem Options – A sequence of options of the same type, with variable

strike price and period.

• Bermuda Option – Like the location of the Bermudas, this option is located

somewhere between a European style option which can be exercised only at

maturity and an American style option which can be exercised any time the

option holder chooses. This option can be exercisable only on predetermined

dates


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5. RISK MANAGEMENT IN DERIVATIVES

Derivatives are high-risk instruments and hence the exchanges have put up a lot

of measures to control this risk.

The most critical aspect of risk management is the daily monitoring of price and

position and the margining of those positions.

NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that

has origins at the Chicago Mercantile Exchange, one of the oldest derivative

exchanges in the world.

The objective of SPAN is to monitor the positions and determine the maximum

loss that a stock can incur in a single day. This loss is covered by the exchange

by imposing mark to market margins.

SPAN evaluates risk scenarios, which are nothing but market conditions.

The specific set of market conditions evaluated, are called the risk scenarios, and

these are defined in terms of:

(a) how much the price of the underlying instrument is expected to change over


51

one trading day, and

(b) how much the volatility of that underlying price is expected to change over

one trading day.

Based on the SPAN measurement, margins are imposed and risk covered. Apart

from this, the exchange will have a minimum base capital of Rs 50 lacs and

brokers need to pay additional base capital if they need margins above the

permissible limits.


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6. SETTLEMENT OF DERIVATIVES

How are futures settled on the stock exchange?

Mark to market settlement

There is a daily settlement for Mark to Market .The profits/ losses are computed

as the difference between the trade price or the previous day’s settlement price,

as the case may be, and the current day’s settlement price. The party who have

suffered a loss are required to pay the mark-to-market loss amount to exchange

which is in turn passed on to the party who has made a profit. This is known as

daily mark-to-market settlement.

Theoretical daily settlement price for unexpired futures contracts, which are not

traded during the last half an hour on a day, is currently the price computed as

per the formula detailed below:

F = S * e rt

where :

F = theoretical futures price

S = value of the underlying index/ stock

r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)

t = time to expiration


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Rate of interest may be the relevant MIBOR rate or such other rate as may be

specified.

After daily settlement, all the open positions are reset to the daily settlement

price.

The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =

Trade day). The mark to market losses or profits are directly debited or credited

to the broker account from where the broker passes to the client account

Final Settlement

On the expiry of the futures contracts, exchange marks all positions to the final

settlement price and the resulting profit / loss is settled in cash.

The final settlement of the futures contracts is similar to the daily settlement

process except for the method of computation of final settlement price. The final

settlement profit / loss is computed as the difference between trade price or the

previous day’s settlement price, as the case may be, and the final settlement

price of the relevant futures contract.

Final settlement loss/ profit amount is debited/ credited to the relevant broker’s


54

clearing bank account on T+1 day (T= expiry day). This is then passed on the

client from the broker. Open positions in futures contracts cease to exist after

their expiration day

How are options settled on the stock exchange?

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The

premium payable position and premium receivable positions are netted across all

option contracts for each broker at the client level to determine the net premium

payable or receivable amount, at the end of each day.

The brokers who have a premium payable position are required to pay the

premium amount to exchange which is in turn passed on to the members who

have a premium receivable position. This is known as daily premium settlement.

The brokers in turn would take this from their clients.

The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade

day). The premium payable amount and premium receivable amount are directly

debited or credited to the broker, from where it is passed on to the client.


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Interim Exercise Settlement for Options on Individual Securities

Interim exercise settlement for Option contracts on Individual Securities is

effected for valid exercised option positions at in-the-money strike prices, at the

close of the trading hours, on the day of exercise. Valid exercised option

contracts are assigned to short positions in option contracts with the same series,

on a random basis. The interim exercise settlement value is the difference

between the strike price and the settlement price of the relevant option contract.

Exercise settlement value is debited/ credited to the relevant broker account on

T+3 day (T= exercise date). From there it is passed on to the clients.

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike

prices existing at the close of trading hours, on the expiration day of an option

contract. Long positions at in-the money strike prices are automatically assigned

to short positions in option contracts with the same series, on a random basis.

For index options contracts, exercise style is European style, while for options

contracts on individual securities, exercise style is American style. Final Exercise

is Automatic on expiry of the option contracts.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts


56

of the relevant broker with the respective Clearing Bank, from where it is passed

to the client.

Final settlement loss/ profit amount for option contracts on Index is debited/

credited to the relevant broker clearing bank account on T+1 day (T = expiry

day), from where it is passed

Final settlement loss/ profit amount for option contracts on Individual Securities is

debited/ credited to the relevant broker clearing bank account on T+3 day (T =

expiry day), from where it is passed

Open positions, in option contracts, cease to exist after their expiration day.


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7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES

Since derivatives are a highly risky market, as experience world over has shown,

there are tight regulatory controls in this market.

The same is true of India. In India, a committee was set up under Dr L C Gupta

to study the introduction of the derivatives market in India. The report of the LC

Gupta Committee is attached as Annexure-4.

This committee formulated the guidelines and framework for the derivatives

market and paved the way for the derivatives market in India.

There other committee that has far reaching implications in the derivatives

market is the J R Verma Committee. This committee has recommended norms

for trading in the exchange. A lot of emphasis has been laid on margining and

surveillance so as to provide a strong backbone in systems and processes and

ensure stringent controls in a risky market.

As for the taxation aspect, the CBDT is treating gains from derivative

transactions as profit from speculation. Similarly losses in derivative transactions

can be treated as speculation losses for tax purpose.


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8. CASE STUDY- When things go wrong!

In the earlier part, we saw how useful derivatives are as hedging and risk

management tools. However, derivatives do not come without their share of

problems and dangers. Derivatives are highly sophisticated instruments and

users with inadequate information and understanding expose themselves to all

the risks inherent in using derivatives. Spectacular losses have been made and

some companies have even come to the point of collapse after using derivative

instruments. Some examples of the unfortunate use of derivatives are:

• In 1994, American consumer products giant Procter and Gamble (P&G), lost

an estimated US$ 200 million on a complex interest rate Swap. The Swap

was intended to lower funding costs for P&G if interest rates moved in a

certain manner. However, the Swap turned out to be a sophisticated bet on

future interest rate changes. It was the result of speculation and lax controls.

The company ought not to have betted on interest rate changes. This case

can be viewed as a classic case of how not to use derivatives.

• Sumitomo lost 1.17 billion pounds on copper and copper derivative

instruments from 1995- 1996.

• NatWest Markets, in 1997,announced it had lost 77m pounds as a result of

mispriced interest rate Options and Swaps.


59

• The German metals and services group, Metallgesellschaft, came to the

verge of destruction in 1994 after losses exceeding DM 2.3 billion on energy

derivatives.

• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei

Index contracts on the Singapore and Osaka Derivatives Exchanges,

ultimately leading to the bank’s near collapse in 1995. The main person

involved was Nick Leeson, the bank’s derivatives trader.

• In 1994, Orange County, USA’s richest local authority went bankrupt after

trading in high-risk derivatives. On the advice of Merrill Lynch, county

treasurer, Robert Citron invested the county’s assets in interest sensitive

derivatives. The market moved against him and the county faced losses of

around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange

County over US$ 400m rather than face trial, in a friendly agreement.

The above examples are enough to make any potential user of derivatives

apprehensive. However, the stories not told about derivatives represent the

majority of cases where derivatives effectively reduce risk. Today, almost all

large, non-financial organizations use financial derivatives and the number of

users is fast increasing. Derivatives are no different than the majority of modern

inventions: if used in a proper way they are powerful and, indeed valuable tools.


60

In wrong hands, they can cause tremendous destruction as the above examples

testify. The function of a corporate financial officer is to reduce risk by using

derivatives and not to speculate. Yet, in any derivative disaster, an element of

speculation seems to be present. Another cause of losses is decisions taken by

people with inadequate knowledge and who do not fully understand the complex

structure of derivatives. Derivatives are highly complex instruments and are often

research-derived and computer generated. The case of the Orange County

derivatives amply demonstrates this. It is clear that the derivative products used

by the county treasurer were not fully comprehended by him.

Barings—What went wrong?

A careful study of the Barings case brings to light several issues. Extensive data

obtained by Singapore inspectors show that Nick Leeson lost 4.8m pounds

sterling between July and October 1992. Leeson covered all the losses by July

’93. But it appeared that Leeson recovered his losses by selling options in a way

that stored up trouble. He used a strategy called “Straddling”. Simply put, Leeson

traded in a way that he was severely exposed to the market movement and a

slight movement against him would lead to huge losses. After the Kobe

earthquake, the volatility of the Nikkei increased sharply and Leeson and

Barings’ were left facing huge losses.


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Leeson did not take the relatively small losses he would have made had he sold

the contracts when the market started to go against him, but waited in the hope

that the situation would reverse and he would make good the losses. But this

was not to be, and the rest, they say, is history.

What Leeson did was to engage in highly speculative trading. He primarily used

derivatives, not as risk mitigating instruments, but as means of earning

speculative profits. The downside risk was huge and the risk of losses was great.

Derivatives—irreplaceable tools or weapons of destruction?

Derivatives have acquired a myth of danger and mystery. One reason is the

sensational media coverage of the derivatives disasters. However, what often

escapes notice is that these disastrous transactions involve speculation

(intentional risks to make profits) or poor oversight. Derivative instruments, per

se, rarely, if ever, cause disasters. It is to be noted that most companies use

derivatives for risk reduction and only very few businesses with poor

management hurt themselves.

As explained earlier, derivative contracts can be geared to many times their

value. In other words, contracts, which may be worth millions, if the market

moves in a certain way, cost only a fraction of that value.


62

Usually, the market will not move that much and the contract will be settled or

sold to somebody else for a small gain or loss. However, if it does shift

significantly, big losses can be incurred, which are magnified due to the gearing

effect.

Banks have complex computer programmes to tell them how much they could

lose if the market moves by a certain amount. Regulations require them to put

money aside to protect against possible losses.

On exchanges, traders have to pay any losses incurred on their position at the

end of each day. This "margin" payment is to prevent risks getting out of hand.


63

ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES

1. Arbitrage - The simultaneous purchase and sale of a commodity or financial

instrument in different markets to take advantage of a price or exchange rate

discrepancy.

2. Backwardation – The price differential between spot and back months when

the nearby dates are at a premium. It is the opposite of ‘contango.’

3. Butterfly spread – The placing of two inter-delivery spreads in opposite

directions with the centre delivery month common to both. The perfect

butterfly spread would require no net premium paid.

4. Calendar Spread - An option strategy in which a short-term option is sold and

a longer-term option is bought both having the same striking price. Either puts

or calls may be used.

5. Call option – An option that gives the buyer right to buy a futures contract at a

premium, at the strike price.

6. Contango – The price differential between spot and back months when the

marking dates are at a discount. It is the opposite of ‘backwardation.’


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7. Currency swap – A swap in which the counterparties’ exchange equal

amounts of two currencies at the sot exchange rate.

8. Derivative – A derivative is an instrument whose value is derived from the

value of one or more underlying assets, which can be commodities, precious

metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the

trading of rights or obligations based on the underlying product, but do not

directly transfer property.

9. Double option – An option that gives the buyer the right to buy and/or sell a

futures contract, at a premium, at the strike price.

10. Futures contract – A legally binding agreement for the purchase and sale of a

commodity, index or financial instrument some time in the future.

11. Hedge fund – A large pool of private money and assets managed

aggressively and often riskily on any futures exchange, mostly for short-term

gain.


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12. In-the money option – An option with intrinsic value. A call option is in-the-

money if its strike price is below the current price of the underlying futures

contract and a put option is in-the-money if it is above the underlying.

13. Kerb trading - Trading by telephone or by other means that takes place after

the official market has closed. Originally it took place in the street on the kerb

outside the market.

14. Margin call – A demand from a clearing house to a clearing member or from a

broker to a customer to bring deposits up to a required minimum level to

guarantee performance at ruling prices.

15. Mark to market – A process of valuing an open position on a futures market

against the ruling price of the contract at that time, in order to determine the

size of the margin call.

16. Naked option – An option granted without any offsetting physical or cash

instrument for protection. Such activity can lead to unlimited losses.

17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock

at a set price on or before a given date. Investors who purchase call options

bet the stock will be worth more than the price set by the option (the strike


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price), plus the price they paid for the option itself. Buyers of put options bet

the stock's price will go down below the price set by the option.

18. Out-of-the money option – An option with no intrinsic value. A call option is

out-of-the money if its strike price is above the underlying and a put option is

so if its below the underlying.

19. Premium - The price of an option contract, determined on the exchange,

which the buyer of the option pays to the option writer for the rights to the

option contract.

20. Spread – The difference between the bid and asked prices in any market.

21. Stop-loss orders – An order placed in the market to buy or sell to close out an

open position in order to limit losses when the market moves the wrong way.

22. Straddle – The simultaneous purchase and sale of the same commodity to

different delivery months or different strategies.

23. Swap – An agreement to exchange one currency or index return for another,

the exchange of fixed interest payments for a floating rate payments or the


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exchange of an equity index return for a floating interest rate.

24. Underlying – The currency, commodity, security or any other instrument that

forms the basis of a futures or options contract.

25. Writer – The person who originates an option contract by promising to

perform a certain obligation in return for the price of the option. Also known as

Option Writer.

26. All-or nothing Option – An option with a fixed, predetermined payoff if the

underlying instrument is at or beyond the strike price at expiration.

27. Average Options - A path dependant option that calculates the average of the

path traversed by the asset, arithmetic or weighted. The payoff therefore is

the difference between the average price of the underlying asset, over the life

of the option, and the exercise price of the option.

28. Barrier Options - These are options that have an embedded price level,

(barrier), which if reached will either create a vanilla option or eliminate the

existence of a vanilla option. These are referred to as knock-ins/outs that are

further explained below. The existence of predetermined price barriers in an

option makes the probability of pay off all the more difficult. Thus the reason a


68

buyer purchases a barrier option is for the decreased cost and therefore

increased leverage.

29. Basket Option – A third party option or covered warrant on a basket of

underlying stocks, currencies or commodities.

30. Bermuda Option – Like the location of the Bermudas, this option is located

somewhere between a European style option which can be exercised only at

maturity and an American style option which can be exercised any time the

option holder chooses. This option can be exercisable only on predetermined

dates,

31. Compound Options - This is simply an option on an existing option such as a

call on a call, a put on a put etc, a call on a put etc.

32. Cross-Currency Option – An outperformance option struck at an exchange

rate between two currencies.

33. Digital Options - These are options that can be structured as a "one touch"

barrier, "double no touch" barrier and "all or nothing" call/puts. The "one

touch" digital provides an immediate payoff if the currency hits your selected

price barrier chosen at outset. The "double no touch" provides a payoff upon


69

expiration if the currency does not touch both the upper and lower price

barriers selected at the outset. The call/put "all or nothing" digital option

provides a payoff upon expiration if your option finishes in the money

34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii)

down and in. With knock-in options, the buyer starts out without a vanilla

option. If the buyer has selected an upper price barrier and the currency hits

that level, it creates a vanilla option with maturity date and strike price agreed

upon at the outset. This would be called an up and in. The down and in option

is the same as the up and in, except the currency has to reach a lower

barrier. Upon hitting the chosen lower price level, it creates a vanilla option.

35. Multi-Index Options – An outperformance option with a payoff determined by

the difference in performance of two or more indices.

36. Outperformance Option – An option with a payoff based on the amount by

which one of two underlying instruments or indices outperforms the other.

37. Rainbow Options - This type of option is a combination of two or more options

combined each with its own distinct strike, maturity, etc. In order to achieve a

payoff, all of the options entered into must be correct.


70

38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate

currency risk by effectively hedging it. It involves combining an equity option

and incorporating a predetermined fx rate. Example, if the holder has an in-

the-money Nikkei index call option upon expiration, the quanto option terms

would trigger by converting the yen proceeds into dollars which was specified

at the outset in the quanto option contract. The rate is agreed upon at the

beginning without the quantity of course, since this is an unknown at the time.

39. Secondary Currency Option – An option with a payoff in a different currency

than the underlying’s trading currency.

40. Swaption – An option to enter into a swap contract.

41. Tandem Options – A sequence of options of the same type, usually covering

non-overlapping time periods and often with variable strikes.

42. Up-and-Out Option – The call pays off early if an early exercise price trigger is

hit. The put expires worthless if the market price of the underlying risks is

above a pre-determined expiration price.


71

43. Zero Strike Price Option – An option with an exercise price of zero, or close to

zero, traded on exchanges where there is transfer tax, owner restriction or

other obstacle to the transfer of the underlying.


72

ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA

The derivatives market in India has rapidly grown and is fast becoming very

popular. It is offering an alternate source for people to deploy investible surplus

and make money out of it

The table below indicates the growth witnessed in the derivatives market.

Month/Year

Index Futures Stock Futures Index Options Stock Options

No. ofcontracts

Turnover(Rs. cr.)

No. ofcontracts

Turnover(Rs. cr.)

Call Put Call Put

No. ofcontracts

NotionalTurnover(Rs. cr.)

No. ofcontracts


No. ofcontracts


No. ofcontracts


Jun.00 1,191 35 - - - - - - - - - -

Jul.00 3,783 108 - - - - - - - - - -

Aug.00 3,301 90 - - - - - - - - - -

Sep.00. 4,376 119 - - - - - - - - - -

Oct.00 6,388 153 - - - - - - - - - -

Nov.00 9,892 247 - - - - - - - - - -

Dec.003 9,208 237 - - - - - - - - - -

Jan.01 17,860 471 - - - - - - - - - -

Feb.01 19,141 524 - - - - - - - - - -

Mar.01 15,440 381 - - - - - - - - - -

00-01 90,580 2,365 - - - - - - - - - -

Apr.01 13,274 292 - - - - - - - - - -

May.01 10,048 230 - - - - - - - - - -

Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -

Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106

Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263

Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690

Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801

Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638

Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674

Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253

Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864

Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,094

01-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383

Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170

May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643

Source: www.nseindia.com

Note: 1.Stock futures were started only in November 2001

2.Index options and stock options were started only in June and July 2001 respectively


73

Growth of Derivatives in India

0500

10001500200025003000

Jun.

00

Aug

.00

Oct

.00

Dec

.003

Feb

.01

Apr

.01

Jun.

01

Aug

.01

Oct

.01

Dec

.01

Feb

.02

Apr

.02

From June 2000 to May 2002

Val

ue R

s C

rore

s


74

ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA

The options price for a Call, computed as per the following Black Scholesformula:C = S * N (d1) - X * e- rt * N (d2)

and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)

where :d1� �>OQ��6��;��U��1

2�� W@��1� �VTUW�W�d2� �>OQ��6��;��U��1

2�� W@��1� �VTUW�W�= d1��1� �VTUW�W�

C = price of a call optionP = price of a put optionS = price of the underlying assetX = Strike price of the optionr = rate of interestt = time to expiration1� �YRODWLOLW\�RI�WKH�XQGHUO\LQJN represents a standard normal distribution with mean = 0 and standarddeviation = 1ln represents the natural logarithm of a number. Natural logarithms are based onthe constant e (2.718).


75

ANNEXURE 4- L C GUPTA COMMITTEE REPORT

EXECUTIVE SUMMARY

1. The Committee strongly favours the introduction of financial derivatives in order to

provide the facility for hedging in the most cost-efficient way against market risk. This is

an important economic purpose. At the same time, it recognises that in order to make

hedging possible, the market should also have speculators who are prepared to be

counter-parties to hedgers. A derivatives market wholly or mostly consisting of

speculators is unlikely to be a sound economic institution. A soundly based derivatives

market requires the presence of both hedgers and speculators.

2. The Committee is of the opinion that there is need for equity derivatives, interest rate

derivatives and currency derivatives. In the case of equity derivatives, while the

Committee believes that the type of derivatives contracts to be introduced will be

determined by market forces under the general oversight of SEBI and that both futures

and options will be needed, the Committee suggests that a beginning may be made with

stock index futures.

3. The Committee favours the introduction of equity derivatives in a phased manner so that

the complex types are introduced after the market participants have acquired some

degree of comfort and familiarity with the simpler types. This would be desirable from the

regulatory angle too.

4. The Committee's recommendations on regulatory framework for derivatives trading

envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main

emphasis is on exchange-level regulation by ensuring that the derivative exchanges

operate as effective self-regulatory organisations under the overall supervision of SEBI.

5. Since the Committee has placed considerable emphasis on the self-regulatory

competence of derivatives exchanges under the over-all supervision and guidance of


76

SEBI, it is necessary that SEBI should review the working of the governance system of

stock exchanges and strengthen it further. A much stricter governance system is needed

for the derivative exchanges in order to ensure that a derivative exchange will be a totally

disciplined market place.

6. The Committee is of the opinion that the entry requirements for brokers/dealers for

derivatives market have to be more stringent than for the cash market. These include not

only capital adequacy requirements but also knowledge requirements in the form of

mandatory passing of a certification program by the brokers/dealers and the sales

persons. An important regulatory aspect of derivatives trading is the strict regulation of

sales practices.

7. Many of the SEBI's important regulations relating to exchanges, brokers-dealers,

prevention of fraud, investor protection, etc., are of general and over-riding nature and

hence, these should be reviewed in detail in order to be applicable to derivatives

exchanges and their members.

8. The Committee has recommended that the regulatory prohibition on the use of

derivatives by mutual funds should go. At the same time, the Committee is of the opinion

that the use of derivatives by mutual funds should be only for hedging and portfolio

balancing and not for speculation. The responsibility for proper control in this regard

should be cast on the trustees of mutual funds. The Committee does not favour framing

of detailed SEBI regulations for this purpose in order to allow flexibility and development

of ideas.

9. SEBI, as the overseeing authority, will have to ensure that the new futures market

operates fairly, efficiently and on sound principles. The operation of the underlying cash

markets, on which the derivatives market is based, needs improvement in many respects.

The equity derivatives market and the equity cash market are parts of the equity market

mechanism as a whole.


77

10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic

Research Wing. It would need to develop a competence among its personnel in order to

be able to guide this new development along sound lines.

Chapter 1

THE EVOLUTION AND ECONOMIC PURPOSE

OF DERIVATIVES

Appointment of the Committee

1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by

a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory

framework for derivatives trading in India". List of the Committee members is shown in

the end

2. The Committee’s concern is with financial derivatives in general and equity derivatives in

particular.

The evolution of derivatives

3. The development of futures trading is an advancement over forward trading which has

existed for centuries and grew out of the need for hedging the price-risk involved in many

commercial operations. Futures trading represents a more efficient way of hedging risk.

Futures vs. Forward contracts

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

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

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

exposed to default risk by counterparty. Each forward contract is unique in terms of

contract size, expiration date and the asset type/quality. The contract price is not


78

transparent, as it is not publicly disclosed. Since the forward contract is not typically

tradable, it has to be settled by delivery of the asset on the expiration date.

5. In contrast, futures contracts are standardized tradable contracts. They are standardized

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

designed exchanges in a highly sophisticated environment of stringent financial

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

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

in the form of Clearing Corporation guarantees for trades and the daily cash adjustment

(mark-to-market) to the accounts of trading members based on daily price change.

Futures are far more cost-efficient than forward contracts for hedging.

6. Forward contracts are being used in India on a fairly large scale in the foreign exchange

market for covering currency risk but there are neither currency futures nor any other

financial futures in India at present. This report deals only with exchange-traded

derivatives. Over-the-Counter derivatives are not covered here.

A world-wide long-term process

7. The evolution of markets in commodities and financial assets may be viewed as a

worldwide long-term historical process. In this process, the emergence of futures has

been recognized in economic literature as a financial development of considerable

significance. A vast economic literature has been built around this subject. From

"forward" trading in commodities emerged the commodity "futures". The emergence of

financial futures is a more recent phenomenon and represents an extension of the idea of

organized futures markets.

8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A.,

followed soon by interest rate futures. Stock index futures and options first emerged in

1982 only. Since then, financial futures have quickly spread to an increasing number of

developed and developing countries. They are recognized as the best and most cost-

efficient way of meeting the felt need for risk-hedging in certain types of commercial and


79

financial operations. Countries not providing such globally accepted risk-hedging facilities

are disadvantaged in today’s rapidly integrating global economy.

9. The Committee noted that derivatives are not always clearly understood. A few well-

publicized debacles involving derivatives trading in other countries had created

widespread apprehensions in Indian public mind also. While the economic literature

recognizes the efficiency-enhancing effect of derivatives on the economy in general and

the financial markets in particular, the Committee feels that there is need for educating

the public opinion as also the need to ensure effective regulatory checks. Such regulation

should be aimed not only at ensuring the market’s integrity but also at enhancing the

market’s economic efficiency and protecting investors.

Derivatives concept

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

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

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

bought/sold in the cash market on normal delivery terms. A general definition of

"derivative" may be suggested here as follows: "Derivative" means forward, future or

option contract of pre-determined fixed duration, linked for the purpose of contract

fulfillment to the value of specified real or financial asset or to index of securities.

11. Derivatives are meant essentially to facilitate temporarily (usually for a few months)

hedging of price risk of inventory holding or a financial/commercial transaction over a

certain period. In practice, every derivative "contract" has a fixed expiration date, mostly

in the range of 3 to 12 months from the date of commencement of the contract. In the

market’s idiom, they are "risk management tools". The use of forward/futures contracts as

hedging techniques is a well-established practice in commercial and industrial operations.

Their application to financial transactions is relatively new, having emerged only about 25

years ago.


80

12. In order to illustrate the use of this risk hedging technique, we may take the familiar

example of a processor or manufacturer, for whom an important source of risk is the

fluctuation in the market price of his main raw material. For instance, a maker of gold

jewellery may have accepted an export order to be delivered over the next three months.

If, in the meanwhile, the cash price of gold (the raw material) rises, the jewellery maker’s

manufacturing and exporting activity can become economically unviable. The availability

of gold futures alleviates the manufacturer-exporter’s problem. He can buy gold futures.

Any loss caused by rise in the cash price of gold purchased for the export order will then

be offset by profit on the futures contract. Any extra profit due to fall in gold price will also

be offset as there will be loss on the futures contract. Thus, hedging is the equivalent of

insurance facility against risk from market price variation. A world without hedging facility

is like a world without insurance with respect to the particular kind of risk.

13. The manufacturer-exporter in the example given above could, of course, have bought all

the raw material requirement in advance but that would have entailed heavy interest,

insurance and storage costs. Thus, the facility of futures trading offers a cost-efficient and

convenient way for hedging against price risk.

14. Apart from the risk from variation of raw material price, the manufacturer-exporter, in the

above example, also faces another risk from variation of exchange rate. If the rupee

appreciates before he is able to bring the export proceeds into India, his rupee receipts

would be reduced. He may hedge against such currency risk too.

Both Futures and Options needed

15. Futures and options have many similarities and serve similar purposes but the risk profile

of an option contract is asymmetric and regulatory complexities are greater as compared

to futures contract. Options are contracts giving the holder the right (but not the

obligation) to buy (known as "call option") or sell (known as "put option") securities at a

pre-determined price (known as "strike price" or "exercise price"), within or at the end of a

specified period (known as "expiration period"). American options are exercisable at any


81

time prior to expiration date while European options can be exercised only at the

expiration date. For the call option holder, it is worthwhile to exercise the right only if the

price of the underlying securities rises above the exercise price. For the put option holder,

it is worthwhile to exercise the right only if the price falls below the exercise price. There

can be options on commodities, currencies, securities, stock index, individual stocks and

even on futures. Options strategies can be highly complicated.

16. In order to acquire the right of option, the option buyer pays to the option seller (known as

"option writer") an Option Premium, which is the price paid for the right. The buyer of an

option can lose no more than the option premium paid but his possible gain in

unbounded. On the other hand, the option writer’s possible loss is unbounded but his

maximum gain is limited to the "option premium" charged by him to the holder. The most

critical aspect of options contracts is the evaluation of the fairness of option premium, i.e.

option pricing.

17. The Committee feels that the availability of both financial futures and options would

provide to the users a wider choice of hedging instruments than any of them alone.

Hedgers vs. Speculators

18. Hedging is the key aspect of derivatives and also its basic economic purpose. In the U.S.,

the Commodity Futures Trading Commission (CFTC), the futures regulatory authority,

while considering proposals for approval of a new derivative product, particularly

examines the ability of the product to provide hedging. While the Committee has also

emphasized the hedging aspect of derivatives, it fully recognises that the derivatives

market’s capacity to absorb buying/selling by hedgers is directly dependent on the

availability of speculators to act as counter-parties to hedgers. Hedging will not be

possible if there are no speculators.

19. For the above reason, decisions about many aspects of derivatives trading, e.g., contract

size, design and duration, would have to strike a balance between the needs of the

hedgers and the necessity to attract an adequate number of well-capitalised speculators


82

who are prepared to take upon themselves the price risk which hedgers want to give up.

The fact is that a futures market, to be able to operate and be liquid, should have both

hedging participation and speculative appeal. Some studies of futures markets in the U.S.

have shown that hedging activity accounts for about 50-60 per cent of the market’s total

volume.

Remove prohibition on hedging by institutions

20. The Committee is of the opinion that a futures market based wholly or mostly on

speculation will not be a sound economic institution. There presently exist in India legal

restrictions on the use of derivatives by investment institutions even for purposes of

hedging. Such restrictions should be removed in the interest of the institutions

themselves.

21. In the case of a hedger, seeking to offset the price risk on his holding of inventory of

bonds, equities, foreign currency or commodities by selling futures in the same, his

position will as follows:

Regarding

Inventory

Regarding futures

transactions

Remarks

If price falls There will be loss

on inventory held

There will be profit

on futures Sold

Hedger wants to

insure against the

loss

If price rises There will be Profit

on inventory

There will be loss

on futures sold

The inventory profit

is Unanticipated

and is neutralised

by loss on futures.

In the case of a pure speculator, as distinguished from a hedger, futures trading is a

business by itself as he has no offsetting commercial position. He is not seeking to

reduce or transfer risk. On the contrary, he is accepting risk in the pursuit of profit. It


83

is a highly specialised business. His success depends on his forecasting skills in

regard to future prices of the particular commodity or financial asset traded in the

futures market.

The hedging test: practical importance

21. The test of whether a futures transaction is for hedging or for speculation hinges on

whether there already exists a related commercial position which is exposed to risk of

loss due to price movement. The distinction between hedging and speculation is of great

practical importance because some organisations, either by voluntary choice or by

regulatory restriction, are allowed to hedge but not to speculate in the forward or futures

markets.

Financial Derivative Types

18. The Committee’s main concern is with equity based derivatives but it has tried to

examine the need for financial derivatives in a broader perspective. Financial

transactions and asset-liability positions are exposed to three broad types of price risks,

viz:

a. equities "market risk", also called "systematic risk" (which cannot be

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

from time to time).

b. interest rate risk (as in the case of fixed-income securities, like treasury

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

and

c. exchange rate risk (where the position involves a foreign currency, as in

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

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

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

futures have been the last to emerge.


84

Need for coordinated development

23. The recent report of the RBI-appointed Committee on Capital Account Convertibility

(Tarapore Committee) has expressed the view that "time is ripe for introduction of futures

in currencies and interest rates to facilitate various users to have access to a wide

spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore

Committee has also opined that "a system of trading in futures ... is more transparent and

cost-efficient than the existing system (of forward contracts)".

24. There are inter-connections among the various kinds of financial futures, mentioned

above, because the various financial markets are closely inter-linked, as the recent

financial market turmoil in East and South-East Asian countries has shown. The basic

principles underlying the running of futures markets and their regulation are the same.

Having a common trading infrastructure will have important advantages. The Co1mmittee,

therefore, feels that the attempt should be to develop an integrated market structure.

SEBI-RBI coordination mechanism

25. As all the three types of financial derivatives are set to emerge in India in the near future,

it is desirable that such development be coordinated. The Committee recommends that a

formal mechanism be established for such coordination between SEBI and RBI in respect

of all financial derivatives markets. This will help to avoid the problem of overlapping

jurisdictions.

Chapter 2

USES OF EQUITY DERIVATIVES

Survey findings about potential for financial derivatives in India

1. The Committee made an assessment of the nature of felt-need and interest

in the various types of financial derivatives among potential market

participants through a Questionnaire-based survey. The survey covered all


85

types of potential players in the derivatives market, such as mutual funds,

other financial institutions, commercial banks, investment bankers and

stockbrokers. Out of about 300 Questionnaires sent out by the Committee in

May 1997, the number of replies received was 112, comprising 67 brokers

and 45 others.

In addition, the Committee held a full day session to interact with groups

representing each of the above categories of interests. A total of about 35

persons attended the group-wise discussions.

2. The survey clearly revealed that there was wide recognition of the need for

all the three major types of financial derivatives, viz., equity derivatives,

interest rate derivatives and currency derivatives. The results of the survey

are summarized in Table 2.1 given at the end of this chapter.

3. Interestingly, the survey findings showed that stock index futures ranked as

the most popular and preferred type of equity derivative, the second being

stock index options and the third being options on individual stocks.

Considerable interest exists in all the three types of equity derivatives

mentioned above. The fourth type, viz. individual stock futures, was favoured

much less. It is pertinent to note that the U.S.A. does not permit individual

stock futures. Only one or two countries in the world are known to have

futures on individual stocks. Stock Index Futures are internationally the most

popular forms of equity derivative.

4. The difference in relative preferences among the various financial derivative

types is shown more sharply when we look at answers to the question:

Which of the derivative products should be introduced first? The respondents

who placed stock index futures as first represented 65% of the sample,


86

compared to 39 per cent who placed stock index options as first (see Table

2.1).

5. The survey also showed that there exists widespread demand for hedging

facility, as indicated by the finding that nearly 70% of the respondents in our

sample indicated that they would like to use the various types of equity

derivatives for hedging purpose. On the other hand, about 39% of

respondents would like to participate in the derivatives market as

dealer/speculator, 64% as broker and only about 36% as option writer. Many

of the respondents would like to participate in more than one capacity.

6. In terms of contract duration of Stock Index futures and options, the 3 months

duration was the most favoured, as may be expected. As regards the choice

between the American and European types of options, the former was

favoured overwhelmingly.

7. As regards expectations of growth of stock index futures and options trading

in India, about 33% of respondents expected it to grow very fast, 41%

expected it to grow moderately and the remaining 16% expected slow growth

of trading. On the whole, the survey findings are very positive about the need

and prospects of equity derivatives trading in India.

Popularity of Stock Index Futures

There are many reasons for the wide international acceptance of stock index

futures and for the strong preference for this instrument in India too compared to

other forms of equity derivatives. This is because of the following advantages of

stock index futures :

1. Institutional and other large equityholders need portfolio hedging facility.

Hence, index-based derivatives are more suited to them and more cost-

effective than derivatives based on individual stocks. Even pension funds in

U.S.A. are known to use stock index futures for risk hedging purposes.


87

2. Stock index is difficult to be manipulated as compared to individual stock

prices, more so in India, and the possibility of cornering is reduced. This is

partly because an individual stock has a limited supply which can be

cornered. Of course, manipulation of stock index can be attempted by

influencing the cash prices of its component securities. While the possibility

of such manipulation is not ruled out, it is reduced by designing the index

appropriately. There is need for minimizing it further by undertaking cash

market reforms, as suggested by the Committee later in this chapter.

3. Stock index futures enjoy distinctly greater popularity, and are, therefore,

likely to be more liquid than all other types of equity derivatives, as shown

both by responses to the Committee’s questionnaire and by international

experience.

4. Stock index, being an average, is much less volatile than individual stock

prices. This implies much lower capital adequacy and margin requirements in

the case of index futures than in the case of derivatives on individual stocks.

The lower margins will induce more players to join the market.

5. In the case of individual stocks, the positions which remain outstanding on

the expiration date will have to be settled by physical delivery. This is an

accepted principle everywhere. The futures and the cash market prices have

to converge on the expiration date. Since Index futures do not represent a

physically deliverable asset, they are cash settled all over the world on the

premise that the index value is derived from the cash market. This, of course,

implies that the cash market is functioning in a reasonably sound manner

and the index values based on it can be safely accepted as the settlement

price.


88

6. Regulatory complexity is likely to be less in the case of stock index futures

than for other kinds of equity derivatives, such as stock index options, or

individual stock options.

Cash and futures market relationship

1. The objective of SEBI is to make both derivatives market and cash market

fair, efficient and transparent. Economically, it is important to realise that

equity cash market and equity derivatives market are of one piece. Their

sound development is inter-related closely. The Committee has kept this

objective in view and would like to ensure that the new derivatives market is

developed along sound lines. This objective can best be achieved by

separating cash market and futures market and thereby regulating them

effectively. At present, almost 90 per cent of the trading volume in the cash

market does not settle in deliveries of the stock. The great bulk (over 85 per

cent) of such trading is in 5 scrips only. The Committee noted that several

earlier committees on stock exchange reforms, including the G.S. Patel

Committee (1984-85), had expressed concern at the small percentage of

deliveries in Indian exchanges. They had also lamented the illiquidity of a

majority of listed shares and the practice of switching of positions from one

exchange to another due to different exchanges having different settlement

cycles.

2. The Committee hopes that some of the speculative transactions, which are

presently conducted in the cash market, would be attracted towards the

proposed derivatives market.

3. The Committee recognises that an efficient cash market is required for an

efficient futures market. The Committee also recognises the danger that if the

cash market behaviour is erratic or does not reflect fundamentals, a futures


89

market, based on such a cash market, will fail to give a correct indication of

future spot prices and its usefulness for price discovery will be reduced.

4. The Committee is of the opinion that the following revisions could lead to a

further strengthening of the underlying cash market:

a. uniform settlement cycle among all the stock exchanges moving towards

rolling settlement cycles to prevent the cash market from effectively being

used as an unregulated futures market;

b. strengthening of administrative machinery of the existing stock exchanges

wherever necessary to tighten the exchange’s regulatory oversight; such

tight supervision being essential for successful derivatives trading.

c. speeding up dematerialisation of securities without which options on

individual securities should not be allowed as non-dematerialised securities

involve settlement delays and problems; allowing options without

dematerialisation is likely to make the options market manipulable; and

d. taking steps to encourage more delivery based transactions in a greater

number of securities.

The Committee is of the view that arbitrage transactions between the index

futures market and the cash market for equities is likely to have a beneficial

effect on the functioning of the cash market in terms of price discovery,

broadening of liquidity and over-all efficiency.

Strengthening the influence of fundamental factors

1. The Committee thought of ways to ensure that fundamental factors

adequately enter into the price discovery process in the cash market and,

through it, in the futures market. In this connection, the Committee noted that

it was important in the case of futures markets, whether commodity futures or

other futures, to assist the price discovery process by promoting the

dissemination of all relevant market information about the "real" factors, such


90

as supplies, demand, prospects, etc. In regard to stock index futures, the

Committee feels that there are two important ways of promoting its linkage to

fundamental factors. First, there must be a requirement that average P/E

ratio of the index used for futures trading should be made available by the

exchange concerned on daily basis as essential market information. Second,

the arbitrage between the index futures market and the cash market for the

shares composing the index should be facilitated by requiring such shares to

be traded in the depository mode and also by making available the facility of

stock borrowing so that short-selling is rendered possible.

Strategic uses of stock index futures

2. It was represented to the Committee by mutual funds and other financial

institutions that they were handicapped in their investment strategy because

of the non-availability of portfolio hedging facility in India. They need

derivatives, not for generating speculative profits, but for strategic purposes

of controlling risk or restructuring portfolios. Given below are some practical

examples from a presentation made before the Committee by some

institutional representatives :

i. Reducing the equity exposure in a mutual fund scheme: Suppose that a

balanced mutual fund scheme decides to reduce its equity exposure from,

say, 40% to 30% of the corpus. Presently, this can be achieved only by

actual selling of equityholdings. Such selling entails three problems: first, it is

likely to depress equity prices to the disadvantage of the Scheme and the

whole market; second, it cannot be achieved speedily and may take some

months, and third, it is a costly procedure because of brokerage, etc. The

same objective can be achieved through index futures at once, at much less

cost and with much less impact on the cash market. The scheme may

immediately sell index futures. The actual sale of equityholdings may be


91

done gradually depending on market conditions in order to realise the best

possible prices. As unloading of holdings progresses, the index futures

transaction may be unwound by an opposite transaction to the same extent.

ii. Investing the funds raised by new schemes: When a new scheme is floated,

the money raised does not get fully invested for considerable time. Suitable

securities at reasonable prices may not be immediately available in sufficient

quantity. Rushing to invest the whole money is likely to drive up prices to the

disadvantage of the scheme. Timing is important in the case of equity

schemes. If the scheme is launched to take advantage of low equity prices,

such advantage may be lost due to delay in acquiring suitable securities as

the market situation may change. The availability of stock index futures can

take care of this entire problem.

iii. Partial liquidation of portfolio in case of open-ended fund: In the case of an

open-ended scheme, repurchases may sometimes necessitate liquidation of

a part of the portfolio but there are problems in executing such liquidation.

Selling each holding in proportion to its weight in the portfolio is often

impracticable. Some of the holdings may be relatively illiquid. Rushing to the

cash market to liquidate would drive down prices. The price actually realised

may be different from the price used in NAV computation for repurchase. The

timing of liquidation may not be right because of market depression. Stock

Index Futures can help to overcome these problems to the advantage of

unitholders.

iv. Preserving the value of portfolio during times of market stress: There are

times when the main worry is the possibility that the value of the entire equity

portfolio may fall substantially if, say, event "X" occurs. Sale of Stock Index

Futures can be used to insure against the risk. Such insurance is specially

important if the accounts closing date is nearby because the yearly results


92

will get affected if the risk materialises. Stock index futures can neutralise

such risk.

v. International investors: The buying and selling operations of FIIs presently

cause disproportionate price-effect on the Indian equities market because all

transactions are through the cash market only. This is an important factor

making the Indian equities market highly volatile from day to day. The FIIs'

buying/selling is aimed at either increasing or reducing their exposure to the

Indian equities market. In other words, what the FIIs buy/sell is a "piece" of

the whole Indian equities market. If stock index futures are available, this can

be carried out with greater speed and less cost and without adding too much

to market volatility. The FII flows show sudden changes from time to time.

While trying to maximise the net inflow of FII portfolio investment, its

disturbing effects on the cash market for Indian equities can possibly be

minimised if the facility of stock index futures is available. The availability of

such a hedging device is likely to increase the international investors'

appetite for Indian equities.

Phasing needed

1. The Committee believes that the types of equity derivatives to be introduced

in India should ultimately be left to the market forces under over-all general

supervision of SEBI. It is likely to be an evolutionary process, as has been

the case in other countries. The experience in other countries also shows

that only a small proportion of new futures contracts prove to be successful

and survive for long. The market decides which ones will succeed.

2. The consensus in the Committee was that stock index futures would be the

best starting point for equity derivatives in India. The Committee has arrived

at this conclusion after careful examination of all aspects of the problem,

including the survey findings and regulatory preparedness. The Committee


93

would favour the introduction of other types of equity derivatives also, as the

derivatives market grows and the market players acquire familiarity with its

operations. Other equity derivatives include options on stock index or on

individual stocks. There may also be room for more than one stock index

futures. It is bound to be a gradual process, shaped by market forces under

the over-all supervision of SEBI. One member of the Committee, i.e. Mr. P.S.

Mistry, formally dissociated himself from the consensus mentioned above by

favouring the introduction of options contracts before the introduction of

futures.

The enabling legal changes

3. It is understood that the Central Government is already considering the legal

action required in order to enable the use of stock index derivatives by

expanding the definition of "securities" under Section 2(h)(iia) of the

Securities Contracts (Regulation) Act, 1956, by declaring derivatives

contracts based on index of prices of securities and other derivatives

contracts to be securities. The Committee recommends that this should be

done expeditiously. The Committee also recommends that the notification

issued by the Central Government in June 1969 under Section 16 of the

SC(R)A be amended so as to enable trading in futures and options contracts.

The prohibition of trading in options on securities has already been

withdrawn by the Securities Laws Amendment Act with effect from January

25, 1995.

Table 2.1

ANALYSIS OF REPLIES TO THE COMMITTEE’S QUESTIONNAIRE

ADDRESSED TO POTENTIAL PLAYERS IN THE FINANCIAL

DERIVATIVE MARKET IN INDIA


94

Q. No. Question Number and percentage of

affirmative replies

(Total respondents=112)

Number % to total

1a. Which risks are of most concern in your operations?

i. Systematic risk 96 85.71

Interest rate risk 35 32.25

Exchange rate risk 27 24.11

Default risk 71 63.39

Asset-liability mismatch 23 20.54

Any other 11 9.82

1c. Are you handicapped because index-based futures and

options are not available in India?

85 75.89

2a. Is there a need for having

i. Stock Index Futures 98 87.50

Stock Index Options 92 82.14

Futures on Individual Stocks 71 63.39

Options on Individual Stocks 90 80.36

Interest rate futures 68 60.71

Currency futures 67 59.82

2b. Which of the above do you favour most?





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3a. In which of the following would you like to participate?







3b. Which of the derivative products mentioned above

should be introduced first?







4a. In the case of the first four products mentioned in the

previous question will you like to participate as:

i. hedger 78 69.64

dealers/speculators 44 39.29

broker 72 64.29


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option writer 40 35.71

any other 6 5.36

4c. Which derivative product is likely to be the most

popular in India?







5a. Which derivative product are needed most in India for

improving stock market efficiency?







6a. Do you expect that the trading in Stock Index Futures

and Options in India will

i. Grow very fast 37 33.03

Grow moderately 46 41.07

Grow slowly 18 16.07

Not grow much 2 1.79


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Can’t say anything 2 1.79

11. What contract maturity period would interest you for

trading in:

i. Stock Index Futures and Options

3 months 93 83.04

6 months 70 62.50

9 months 37 33.04

12 months 35 31.25

(ii) Futures and Options on Individual Stocks

3 months 88 78.57

6 months 60 53.57

9 months 27 24.11

12 months 31 27.68

12. In case of Options do you favour:

i. American 79 70.54

European 30 26.79

Note: Questions 2b, 3b and 4c expected respondents to tick against one type only

but some respondents ticked more than one, resulting in double counting. Hence, the

percentages add to more than 100. This does not, however, vitiate the relative

comparison among the derivative types.

Chapter 3

REGULATORY FRAMEWORK FOR DERIVATIVES:

THE GUIDING PRINCIPLES

Regulatory objectives


98

1. The Committee believes that regulation should be designed to achieve

specific, well-defined goals. It is inclined towards positive regulation designed

to encourage healthy activity and behaviour. It has been guided by the

following objectives :

a. Investor Protection: Attention needs to be given to the following four aspects:

i. Fairness and Transparency: The trading rules should ensure that

trading is conducted in a fair and transparent manner. Experience in

other countries shows that in many cases, derivatives

brokers/dealers failed to disclose potential risk to the clients. In this

context, sales practices adopted by dealers for derivatives would

require specific regulation. In some of the most widely reported

mishaps in the derivatives market elsewhere, the underlying reason

was inadequate internal control system at the user-firm itself so that

overall exposure was not controlled and the use of derivatives was

for speculation rather than for risk hedging. These experiences

provide useful lessons for us for designing regulations.

ii. Safeguard for clients' moneys: Moneys and securities deposited by

clients with the trading members should not only be kept in a

separate clients' account but should also not be attachable for

meeting the broker's own debts. It should be ensured that trading by

dealers on own account is totally segregated from that for clients.

iii. Competent and honest service: The eligibility criteria for trading

members should be designed to encourage competent and qualified

personnel so that investors/clients are served well. This makes it

necessary to prescribe qualification for derivatives brokers/dealers

and the sales persons appointed by them in terms of a knowledge

base.


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iv. Market integrity: The trading system should ensure that the market's

integrity is safeguarded by minimising the possibility of defaults. This

requires framing appropriate rules about capital adequacy, margins,

clearing corporation, etc.

a. Quality of markets: The concept of "Quality of Markets" goes well beyond

market integrity and aims at enhancing important market qualities, such as

cost-efficiency, price-continuity, and price-discovery. This is a much broader

objective than market integrity.

b. Innovation: While curbing any undesirable tendencies, the regulatory

framework should not stifle innovation which is the source of all economic

progress, more so because financial derivatives represent a new rapidly

developing area, aided by advancements in information technology.

1. Of course, the ultimate objective of regulation of financial markets has to be

to promote more efficient functioning of markets on the "real" side of the

economy, i.e. economic efficiency.

2. Leaving aside those who use derivatives for hedging of risk to which they are

exposed, the other participants in derivatives trading are attracted by the

speculative opportunities which such trading offers due to inherently high

leverage. For this reason, the risk involved for derivative traders and

speculators is high. This is indicated by some of the widely publicised

mishaps in other countries. Hence, the regulatory frame for derivative

trading, in all its aspects, has to be much stricter than what exists for cash

trading. The scope of regulation should cover derivative exchanges,

derivative traders, brokers and sales-persons, derivative contracts or

products, derivative trading rules and derivative clearing mechanism.

3. In the Committee's view, the regulatory responsibility for derivatives trading

will have to be shared between the exchange conducting derivatives trading


100

on the one hand and SEBI on the other. The committee envisages that this

sharing of regulatory responsibility is so designed as to maximise regulatory

effectiveness and to minimise regulatory costs.

Major issues concerning regulatory framework

4. The Committee's attention had been drawn to several important issues in

connection with derivatives trading. The Committee has considered such

issues, some of which have a direct bearing on the design of the regulatory

framework. They are listed below :

a. Should a derivatives exchange be organised as independent and separate

from an existing stock exchange?

b. What exactly should be the division of regulatory responsibility, including

both framing and enforcing the regulations, between SEBI and the

derivatives exchange?

c. How should we ensure that the derivatives exchange will effectively fulfill its

regulatory responsibility.

d. What criteria should SEBI adopt for granting permission for derivatives

trading to an exchange?

e. What conditions should the clearing mechanism for derivatives trading satisfy

in view of high leverage involved?

f. What new regulations or changes in existing regulations will have to be

introduced by SEBI for derivatives trading?

Should derivatives trading be conducted in a separate exchange?

1. A major issue raised before the Committee for its decision was whether

regulations should mandate the creation of a separate exchange for

derivatives trading, or allow an existing stock exchange to conduct such

trading. The Committee has examined various aspects of the problem. It has

also reviewed the position prevailing in other countries. Exchange-traded


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financial derivatives originated in USA and were subsequently introduced in

many other countries. Organisational and regulatory arrangements are not

the same in all countries. Interestingly, in U.S.A., for reasons of history and

regulatory structure, futures trading in financial instruments, including

currency, bonds and equities, was started in early 1970s, under the auspices

of commodity futures markets rather than under securities exchanges where

the underlying bonds and equities were being traded. This may have

happened partly because currency futures, which had nothing to do with

securities markets, were the first to emerge among financial derivatives in

U.S.A. and partly because derivatives were not "securities" under U.S. laws.

Cash trading in securities and options on securities were under the Securities

and Exchange Commission (SEC) while futures trading was under the

Commodities Futures Trading Commission (CFTC). In other countries, the

arrangements have varied.

2. The Committee examined the relative merits of allowing derivatives trading to

be conducted by an existing stock exchange vis-a-vis a separate exchange

for derivatives. The arguments for each are summarised below.

Arguments for allowing existing stock exchanges to start futures trading:

a. The most weighty argument in this regard is the advantage of synergies

arising from the pooling of costs of expensive information technology

networks and the sharing of expertise required for running a modern

exchange. Setting-up a separate derivatives exchange will involve high costs

and require more time.

b. The recent trend in other countries seems to be towards bringing futures and

cash trading under coordinated supervision. The lack of coordination was

recognised as an important problem in U.S.A. in the aftermath of the October

1987 market crash. Exchange-level supervisory coordination between futures


102

and cash markets is greatly facilitated if both are parts of the same

exchange.

Arguments for setting-up separate futures exchange:

a. The trading rules and entry requirements for futures trading would have to be

different from those for cash trading.

b. The possibility of collusion among traders for market manipulation seems to

be greater if cash and futures trading are conducted in the same exchange.

c. A separate exchange will start with a clean slate and would not have to

restrict the entry to the existing members only but the entry will be thrown

open to all potential eligible players.

Recommendation

From the purely regulatory angle, a separate exchange for futures trading seems to

be a neater arrangement. However, considering the constraints in infrastructure

facilities, the existing stock exchanges having cash trading may also be permitted to

trade derivatives provided they meet the minimum eligibility conditions as indicated

below :

1. The trading should take place through an online screen-based trading system, which

also has a disaster recovery site. The per-half-hour capacity of the computers and

the network should be at least 4 to 5 times of the anticipated peak load in any half-

hour, or of the actual peak load seen in any half-hour during the preceding six

months. This shall be reviewed from time to time on the basis of experience.

2. The clearing of the derivatives market should be done by an independent clearing

corporation, which satisfies the conditions listed in a later chapter of this report.

3. The exchange must have an online surveillance capability which monitors positions,

prices and volumes in real-time so as to deter market manipulation. Price and

position limits should be used for improving market quality.


103

4. Information about trades, quantities, and quotes should be disseminated by the

exchange in real-time over at least two information vending networks which are

accessible to investors in the country.

5. The Exchange should have at least 50 members to start derivatives trading.

6. If derivatives trading is to take place at an existing cash market, it should be done in

a separate segment with a separate membership; i.e., all members of the existing

cash market would not automatically become members of the derivatives market.

7. The derivatives market should have a separate governing council which shall not

have representation of trading/clearing members of the derivatives Exchange beyond

whatever percentage SEBI may prescribe after reviewing the working of the present

governance system of exchanges.

8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be

a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he

shall not carry on any Broking or Dealing Business on any Exchange during his

tenure as Chairman.

9. The exchange should have arbitration and investor grievances redressal mechanism

operative from all the four areas/regions of the country.

10. The exchange should have an adequate inspection capability.

11. No trading/clearing member should be allowed simultaneously to be on the governing

council of both the derivatives market and the cash market.

12. If already existing, the Exchange should have a satisfactory record of monitoring its

members, handling investor complaints and preventing irregularities in trading.

3.9 The next chapter will elaborate how the regulatory responsibilities placed on the

derivative exchange and the SEBI are to be carried out in a dovetailed manner.

Chapter 4

DIVISION OF REGULATORY RESPONSIBILITY

Two levels of regulation


104

1. The task entrusted to the Committee is to develop the "regulatory framework

for derivatives trading". Such regulatory framework really comprises two

distinct levels, viz.(1) a derivatives exchange's own operational rules and

regulations and (2) SEBI rules and regulations with which the exchange and

its members must comply. The Committee feels that since the Securities

Contracts (Regulation) Act, 1956 and the Rules framed thereunder, SEBI Act

and various Rules and Regulations regarding stock exchanges and

brokers/dealers are of general and over-riding nature, they could be reviewed

and designed to be applicable equally to derivatives exchanges also.

Emphasis on exchange-level regulation

2. A crucial pre-condition for the success of derivatives trading is that the

derivatives exchange should be capable of acting as an effective self-

regulator on its own. In the Committee's opinion, the derivatives exchange,

being in day to day touch with the market, will be in a position to spot a

problem and take prompt corrective action. As a statutory body, SEBI will first

have to enquire, collect all the facts and go through a certain statutory

procedure before acting. In addition, the regulatory costs can also be

minimised by shifting the administrative and compliance costs as much as

possible to the exchanges which are the beneficiaries from the business

opportunity provided. These considerations have led the Committee to

emphasize that a derivatives exchange should be designed, right from the

start, as a competent and effective regulating organisation in every possible

way.

Governance of derivative exchange

3. The Committee was informed about the regulatory concerns regarding the

working of governance system in many stock exchanges and took note of

reported problems in this area. The Committee regards this as important


105

matter in the context of introducing derivatives. The Committee recommends

that SEBI should review its own experience of the present stock exchange

governance system in terms of how far the system has been able to ensure

the functioning of stock exchanges as effective self-regulatory organisations

and what further improvements, if any, are needed. As most of the regulatory

responsibility in regard to derivatives trading has to be carried out by the

exchanges themselves and any slackness in this regard can be disastrous, it

is necessary to ensure that a proper governance structure is in place. If

necessary, SEBI may lay down a separate governance structure for

exchanges which are allowed to have derivatives trading.

4. Most of the new regulations required for derivatives trading are exchange-

level regulations. Such regulations have necessarily to be very detailed and

highly technical. It will require the formulation of detailed rules, regulations

and bye-laws and the creation of a really effective monitoring and

enforcement mechanism, covering all aspects of the exchange's operation.

The exchange-level regulations include entry requirements for derivatives

traders/members, design of derivatives contracts, broker-client relationship

including sales procedures and risk disclosure to clients, trading and

reporting procedures, internal risk control systems, margining, clearing,

settlement and dispute resolution. In the Committee's opinion, a derivatives

exchange must necessarily be consciously designed to play the role of

effective self-regulator. This is so important that if there is any doubt in the

exchange's ability in this regard, SEBI should not allow it to conduct

derivatives trading. The role of SEBI will be to provide over-all supervision

and guidance to the exchange and to act as the regulator of last resort.

5. The Committee is of the view that all the above regulations have to be much

stricter for derivatives trading than the existing regulations for cash trading.


106

Another demanding requirement is that derivatives trading, clearing,

settlement, margining, reporting and monitoring, all involve the application of

most modern on-line screen-based systems which should be designed to be

both fool-proof and fail-proof.

6. The Committee also feels that every derivative trader/member (not just 10

per cent of them) should be inspected by the derivative exchange annually,

both to provide guidance in the initial years and to check compliance. This is

particularly important at the initial stage of derivatives trading. The derivative

exchange should be required to have a strong inspection department. Its

staff should be given specialised training for the purpose.

SEBI's Regulatory Responsibility

7. SEBI should approve the rules, bye-laws and regulations of the derivative

exchange and should also approve the proposed derivative contracts before

commencement of trading. Any change in the rules, bye-laws and regulations

of the Derivative Exchange would need prior approval of SEBI.

8. The Committee feels that SEBI need not be involved in framing exchange-

level rules but it should evaluate them, identify deficiencies and suggest

improvements. Its regulatory staff should have a thorough understanding of

the theory and practice of financial derivatives so that it can provide guidance

and can evaluate various kinds of derivative products. SEBI's overseeing

function cannot be delegated. SEBI will have to acquire the necessary

expertise by training its own people and recruiting some specialized

personnel. SEBI will function as an overseeing authority. It would have to be

closely involved in guiding this new and complex development along right

lines. It would have to ensure a successful launch of futures trading in India

by providing appropriate guidance and over-all supervision of the process.

Such success will be beneficial for the country's economy and will bring


107

credit to SEBI. SEBI's obligation to oversee the functioning of derivatives

exchange is bound to be a demanding task in terms of new knowledge and

understanding required by its staff.

Regulatory review of Derivative Contract

9. In most countries regulatory approval is required for new derivatives

contracts to be traded. The regulatory authority has to determine whether

such trading would be in public interest. In U.S.A., the Commodities Trading

Futures Commission, before granting its approval to a new contract, has to

be satisfied that the contract would serve an economic purpose, such as

making fairer pricing possible or making hedging possible. Providing an

arena for speculation is not regarded as enough to show that a futures

contract would serve an economic function. According to the information

provided to the Committee by courtesy of Price Waterhouse LLP under

USAID's FIRE Project, more than 90 per cent of countries with established

derivatives markets use a contract review procedure as a threshold test to

permit a new derivatives contract to trade on an authorised derivative

exchange.

10. The Committee suggests that before starting trading in a new derivatives

product, the derivatives exchange should submit the proposal for SEBI's

approval, giving (a) full details of the proposed derivatives contract to be

traded (b) the economic purposes it is intended to serve (c) its likely

contribution to the market's development and (d) the safeguards incorporated

to ensure protection of investors/clients and fair trading. SEBI officers should

be in a position to provide effective supervision and constructive guidance in

this regard.

SEBI Derivative Cell, Advisory Council and Economic Research Wing


108

11. In view of what has been said above, the Committee recommends the

following steps to be taken by SEBI :

a. SEBI should immediately create a special Derivatives Cell because

derivatives demand special knowledge. It should encourage its staff

members to undergo training in derivatives and also recruit some specialised

personnel.

b. A Derivatives Advisory Council may also be created to tap the outside

expertise for independent advice on many problems which are bound to arise

from time to time in regard to derivatives.

c. SEBI should urgently consider the creation of an Economic Research Wing.

Complex economic questions arise about derivatives, e.g. their effect on

cash market volatility and price discovery. Many such questions have been

raised from time to time in other countries. Administrative persons are

unlikely to have the time to study and analyse data. They can be usefully

assisted by the Economic Research Wing. SEBI, as the country's capital

market authority, should be regularly conducting studies of critical problems

affecting the market and collecting data.

4.12 The division of regulatory responsibility at two levels as suggested above by the

Committee, is aimed at securing the triple advantages of (a) permitting desirable

flexibility, (b) maximising regulatory effectiveness and (c) minimising regulatory cost.

Chapter 5

SPECIAL ENTRY RULES FOR DERIVATIVES

BROKERS/DEALERS

No automatic entry for existing stock brokers

1. The Committee feels that the derivatives market will have to be subjected to

more stringent requirements than is the case with present cash markets. This

implies that when an existing exchange decides to start derivatives trading,


109

the members of the existing cash market will not automatically become

members of the derivatives market. Only those who satisfy the stricter

eligibility conditions of the derivatives market will be admitted to derivatives

trading.

Capital adequacy

2. The experience of Indian exchanges has been that the credibility of the

broker firm’s balance sheet figures of networth is questionable and that, in

any case, a broker’s or dealer’s stated networth is very often not available to

meet the claims payable to the exchange. Hence, for effectively ensuring

capital adequacy, principal reliance has to be placed on the capital and

margins actually deposited by the brokers/dealers with the exchange. Taking

note of the above, the views of the Committee regarding capital adequacy

requirements for derivatives brokers/dealers are presented below:

Guiding considerations

a. The absolute amount of minimum capital adequacy requirement for

derivative brokers/dealers has to be much higher than for cash market.

Further, if a broker/dealer is involved both in cash and futures segments, or

in several exchanges, the capital adequacy requirement should be satisfied

for each exchange/segment separately. A decision on minimum capital

adequacy requirement involves balancing the need for ensuring market’s

integrity against the need for having sufficient participation of brokers/dealers

and sufficient competition. Too high a requirement may keep most Indian

firms out of the derivatives market.

Clearing and Non-clearing members

b. In order to somewhat ease the constraint on participation in the derivatives

market due to high capital adequacy requirements, the Committee

recommends that consideration may be given to a two-level system of


110

members, viz., Clearing Members and Non-Clearing Members, as found in

several countries, an example being the Singapore International Monetary

Exchange. Under such a system, networth requirement for the Clearing

Members is higher than for the Non-Clearing members. The Non-Clearing

members have to depend on the Clearing Members for settlement of trades.

The Clearing Member has to take responsibility for the non-clearing

member’s position so far as the Clearing Corporation is concerned. The

Clearing Member thus becomes the guarantor for the Non-Clearing

members. In a sense, a Clearing Member has a number of satellite traders

for whom he takes financial responsibility towards the Clearing Corporation.

The advantage of the two-level system is that it can help to bring in more

traders into derivatives trading, thus enhancing the market’s liquidity.

Networth and initial margin

1. The Committee recommends that the Clearing Members of the derivatives

exchange should have a minimum net worth of Rs. 300 lakh as per SEBI’s

definition and shall make a deposit of Rs.50 lakh with the Exchange/Clearing

Corporation in the form of liquid assets, such as Cash, Fixed Deposits

pledged in the name of the Exchange, or other securities. Bank Guarantee in

lieu of such deposit may also be accepted. The Clearing Corporation can

permit clearing members to clear the trades of non-clearing trading

members. The regulations for the non-clearing trading members shall be

specified by the Derivatives Exchange/Division. The Committee further

recommends that the requirement of minimum networth and deposit in case

of Option writers will need to be still higher.

Certification Requirement


111

2. The broker-members, sales persons/dealers in the derivatives market must

have passed a certification programme which is considered adequate by

SEBI.

Registration with SEBI

3. Brokers/dealers of Derivatives Exchange/Division should be required to be

registered as such with SEBI. This would be in addition to their registration

as brokers/dealers of any stock exchange. SEBI may require registration of

sales persons working at Derivatives brokerage firms.

Chapter 6

CLEARING CORPORATION

Importance of separate Clearing Corporation

6.1In the Committee’s view, the clearing mechanism should be organised as

separate and independent entity, preferably in the form of a Clearing Corporation.

Clearing Corporation should become a legal counterparty to all trades and be

responsible for guaranteeing settlement for all open positions. Hence, if any Clearing

Member defaults, settlement for other Clearing Members would not be affected. This

would protect the reputation of the Exchange and would minimise the default risk of

trading/clearing members as the risks arising from insolvency of any individual

Clearing Member are shouldered effectively by the Clearing Corporation. The

credibility of the Clearing Corporation, therefore, will have to be assured.

6.2 The Clearing Corporation will collect initial (i.e. upfront) margin to which the

exposure limits of the broker/dealer would be linked, as explained later. The Clearing

Corporation will enforce the "mark-to-market margin" system. In case of failure of a

clearing/trading member, the Clearing Corporation should have recourse to disable

the Clearing/trading member from trading in order to stop further increase in his

exposure.


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6.3The requirements for capital adequacy and upfront margin should be set taking

into account the volatility of the underlying market. For this purpose, normally, daily

volatility (as measured by standard deviation of average return from one-day holding

periods) is taken into account. Such daily volatility in India for major stock indices is

around 1.3-1.4 per cent compared to just around 1 per cent for the S&P 500 Index in

U.S.A.. In addition, we have to take into account two more facts, viz., first, the

collection of daily mark-to-market margin may take more than one day because

electronic funds transfer facility is not yet universal in India; and second, the worst

scenario possibility, i.e. largest 1-day or 2-day fluctuation experienced over the last

few years.

6.4 Since market volatility changes over time, the Committee feels that the Clearing

Corporation should continuously analyse this problem and may modify the margin

requirements to safeguard the market. The dual objective has to be guaranteeing its

own solvency and avoiding unnecessary tying up of members’ capital.

6.5The Committee recommends that the Clearing Corporation should be an

independent corporation. Its Governing Board should be immune to any interference

or direct/indirect pressure by trading interests. For this reason, there is no need to

have the representation of trading interests on its Governing Board.

6.6The Committee feels that ideally an independent centralised Clearing Corporation

for the stock exchanges would be most effective arrangement. However, since this

may be difficult to achieve in the immediate future, it should remain as the ultimate

goal to be achieved. Efforts should continue to be made in this direction. Until such

an independent centralised entity is created, the Committee recognises that existing

Clearing Corporations/Houses may continue to be used by existing exchanges

provided the following conditions are satisfied:

1. the Clearing Corporation/House becomes counterparty to all trades or

provides unconditional guarantee for settlement of all trades; and


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2. the Exchange agrees to participate in the Central Clearing Corporation as

and when that entity comes up.

The Committee strongly urges SEBI to take the initiatives with potential promoters to

set up a national-level Clearing Corporation.

Maximum exposure limit

6.7 Apart from the minimum networth requirement, there should be a maximum

exposure limit computed on gross basis for each broker/dealer. Such exposure

limit should be linked to the amount of deposits/margins kept by a broker/dealer

as deposit with the Clearing House/Clearing Corporation in the prescribed liquid

assets. It was strongly represented to the Committee, as mentioned earlier, that,

in Indian context, the minimum networth requirement has not proved adequate.

Mark-to-market margins

6.8 The Committee feels that even the system of mark-to-market margins on

daily basis will not be adequate for safeguarding the market’s integrity unless the

margins are actually collected before the start of the next day’s trading. Even a

day’s delay in actual collection of mark-to-market margin can pose a serious

threat to the market’s integrity. The Committee noted that electronic funds

transfer (EFT) was not yet pervasive in India. If the mark-to-market margins

cannot be collected before the start of next day’s trading, the networth

requirement and initial deposit with the exchange would have to be higher. The

Committee recommends that the aim should be to collect mark-to-market

margins before the next day’s trading starts. For this purpose all derivatives

dealers/brokers should be required to be connected to Electronic Funds Transfer

Facility. The capital adequacy requirement for derivatives trading should be

finally decided after taking into account both the extent of volatility and the time

taken for funds transfer from dealers/members to the exchange.

Cross-margining


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6.9 At the initial stage of derivatives market in India, the Committee does not favour

cross-margining which takes into account a dealer’s combined position in the cash

and derivative segments and across all stock exchanges. The Committee recognises

that cross-margining is logical and would economise the use of a trading member’s

capital, but a conservative approach would be more advisable until the reliability of

systems has been fully established. The systems capability has to emerge before

adopting sophisticated systems.

Margin Collection from clients

6.10In the Committee’s view, collection of initial and mark-to-market margins by

brokers from their clients should be insisted upon in the case of derivatives trading. In

other words, margin collection from clients should not be left to the discretion of

brokers/dealers. SEBI should require derivatives exchanges to ensure, through

systems of inspection, reporting, etc., that margins are actually collected from all

clients without exception, including financial institutions. This is necessary because of

the high leverage and consequently higher risk involved in derivatives trading. Two

indirect methods of ensuring this should also be adopted, viz. (1) exposure limits for

dealers/traders in relation to upfront initial margin deposited with the exchange

should be fixed on gross basis and (2) brokers/dealers should be required to disclose

to the exchange the trading done on their own behalf separately from trading on

clients’ behalf at the time of order entry. The trading volume should also be divided

into sales and purchases.

Safeguarding client’s money

11. The Committee further recommends that the Clearing Corporation should

segregate the upfront/initial margins deposited by Clearing Members for

trades on their own account from the margins deposited with it on client

account. The Clearing Corporation shall not utilise the margins deposited

with it on client account for fulfilling the dues which a Clearing Member may


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owe to the Clearing Corporation in respect of trades on the member’s own

account. The principle which the Committee would like to advocate regarding

client moneys is that these should be regarded as held in trust for client

purpose only and should not be allowed to be diverted to any other purpose.

Such moneys are sacrosanct as they usually represent the client’s hard

earned savings.

12. The following process may be adopted by the Clearing Corporation for

segregating the margin money held against a broker’s own position from that

held against the client position. At the time of opening a position, the

dealer/broker should indicate whether the position is for the client or for the

broker himself. On all client positions, both buy or sell, margins should be

collected on gross basis (i.e. on buy and sell positions separately without

netting them). Similarly, when closing a position, the Clearing Corporation

would have to be informed by the Clearing Member whether it was a client

position or Member’s own position. In case of a Clearing Member default, the

margin paid by such Member on his own account only would be allowed to

be used by Clearing Corporation for realising its own dues from the Member.

There should be an independent Investor Protection Fund for the Derivative

Division/Exchange which should be available to compensate clients in case

of Member default.

SEBI approval for clearing corporation

6.13 The Committee feels that a clearing corporation must have SEBI approval

for functioning as such. To be eligible for such approval, it should satisfy the

following conditions :

1. The clearing corporation must perform full novation, i.e. the clearing

corporation should interpose itself between both legs of every trade,


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becoming the legal counterparty to both or alternatively should provide an

unconditional guarantee for settlement of all trades.

2. The clearing corporation should have the capacity to monitor the overall

position of members across both cash and derivatives markets for those

members who are participating in both.

3. The level of initial margin required on a position should be related to the risk

of loss on the position. The concept of "value at risk" should be used in

calculating required levels of initial margin. The initial margin should be large

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

99% of the days. These capital adequacy norms should apply intra-day, so

that there is no instant of time where the good funds deposited by the

member to the clearing corporation are smaller than the value at risk of the

position at that point in time. The clearing corporation should have intra-day

monitoring software to ensure that this condition is met at every single instant

within the day. "Good funds" here are defined as the initial margin and the

mark to market margin available with the clearing corporation.

4. In the event of unusual positions of a member, the clearing corporation

should charge special margin over and above the normal margins.

5. The clearing corporation must establish facilities for electronic funds transfer

(EFT) for swift movement of margin payments. In situations where EFT is

unavailable, the clearing corporation should collect correspondingly larger

initial margin to cover the potential for losses over the time elapsed in

collection of mark to market margin. For example, if two days elapse in

moving funds, then the value at risk should be calculated based on the

prospective two-day loss.

6. In the event of a member default in meeting its liabilities, the Clearing

Corporation/House should have processing capability to require either the


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prompt transfer of client positions and assets to another member or to close-

out all open positions.

6.14 The clearing mechanism is the centre-piece of a derivatives market, both for

implementing the margin system and for providing trade guarantee. Hence, the

arrangements must require SEBI approval. The policy should be to nudge the

system towards a single national clearing corporation for all stock exchanges.

Chapter 7

REGULATION OF SALES PRACTICES AND

DISCLOSURES FOR DERIVATIVES

Why derivatives sales practices need regulation

1. The Committee has identified broker-client relationship and sales practices

for derivatives as needing special regulatory focus. The potential risk

involved in speculating (as opposed to hedging) with derivatives is not

understood widely. In the case of pricing of complex derivatives contracts,

there is a real danger of unethical sales practices. Clients may be fooled or

induced to buy unsuitable derivatives contracts at unfair prices and without

properly understanding the risks involved. Many widely reported legal

disputes between broker-dealer and the client have arisen in U.S.A. on some

such ground. That is why it has become a standard practice in other

countries to require a "risk disclosure document" to be provided by

broker/dealer to every client in respect of the particular type of derivatives

contracts being sold.

2. Also, derivatives brokers/dealers are expected to know their clients and to

exercise care to ensure that the derivative product being sold by them to a

particular client is suitable to his understanding and financial capabilities.

Derivatives may tempt many people because of high leverage, which is a

double-edged instrument, having, at the same time, the potential of high


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profitability on the margin money invested and high risk. The concept of

"know-your-client" needs to be implemented and every broker/trader should

obtain a client identity form, as suggested in Model Rules for Derivatives

Exchanges, being formulated by the Committee separately.

Options and their complexity

3. The risk and complexity vary among derivative products. While some

derivatives are relatively simple, many others, specially options, could be

highly complex and would require additional safeguards from investors’

viewpoint. In due course, a derivatives exchange may decide to introduce

options on stock index or on individual stocks. Options are a more complex

derivative product than index futures because evaluating the fairness of

option premium is a complex matter, not being apparent. Regulations in the

U.S.A. clearly recognise the greater complexity of options by requiring stricter

supervision over sales of options contracts.

4. In order to give some idea in this regard, the Committee enquired into sales

practice regulations relating to derivatives in U.S. in order to learn from the

experiences of U.S. regulatory authorities. The U.S. authorities have

recognised that derivatives, based on options trading strategies, could be

highly complex. Hence, there is a special regulatory regime for options. This

is instructive for Indian authorities. In order to give a concrete idea about

what the regulation of sales practices, particularly for complex type of

derivatives, may involve, some special features found in the U.S. are

enumerated below:

a. The options trading rules of a derivative exchange require heightened

suitability standards. Such rules prohibit brokers-dealers from recommending

to any client any options transaction unless they have reasonable grounds to

believe that the entire recommended transaction is not unsuitable for the


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customer on the basis of information furnished after reasonable inquiry

concerning the customer’s investment objectives.

b. In addition, the rules prohibit brokers-dealers from recommending opening

options transaction unless they have a reasonable basis for believing that the

customer has such knowledge and financial experience that he or she can be

expected to be capable of evaluating, and financially able to bear, the risks of

the transaction.

c. The broker-dealer must seek to obtain and verify specific categories of

information about its customers including, but not limited to, their net worth,

annual income and investment experience and knowledge. A separate

approval also may be required for trading in particular types of options

strategies and types of options contracts, such as foreign currencies.

d. In addition, the approval of account opening must be in writing and can be

made only by a senior options supervisor who must ensure that investors are

offered an explanation of the special characteristics and risks applicable to

the trading of options.

e. The derivatives exchange also requires that all the supervisory and sales

personnel pass a general securities examination that includes options

materials. People selling or supervising the sale of options on debt securities

or foreign currency also must pass a separate interest rate options or foreign

currency examination.

f. The exchange also requires the brokers-dealers to keep a current customer

complaint log for all options-related complaints which include: (a) the name of

the complainant; (2) the date when the complaint was received; (3) the sales

person servicing the account; (4) a description of the complaint; and (5) a

record of the action taken.


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g. In addition, the broker-dealer firm is required to submit all sales literature and

educational material to the exchange for pre-use approval.

h. The disclosure document about options should contain information

describing the mechanics and risks of options trading, transaction costs,

margin requirements and tax consequences of margin trading. The broker-

dealer must provide a copy of this document at or prior to the time such

customer’s account is approved for standardized options trading.

i. There are also special trading rules applicable to the options markets. These

rules include separate surveillance procedures, front-running prohibitions and

position limits.

Exchange’s responsibility

1. The Committee recommends that attention be given to proper supervision of

sales practices for derivatives from the very beginning. It should be the

responsibility of the Derivatives Exchange, as a self-regulatory organisation,

to take the necessary steps in this regard under the general oversight of

SEBI. Risk Disclosure to the client is an important aspect of the regulation of

sales practices. In connection with entry requirements for derivative

brokers/dealer, the Committee has earlier recommended that, not only

derivatives brokers/dealers, but also sales persons working for derivatives

brokers should have passed a certification programme. If sufficient attention

is not paid to this initially, we may have a situation analogous to a large

number of ill-trained drivers whom it becomes difficult to control later.

2. Basically, the regulation of derivatives sales practices aims at enforcing

strictly the "know your customer" rule and requires that every client trading in

derivatives should be registered with the derivatives broker. Data base on

clients should be available with the broker. Customers should be given a risk

disclosure document prior to their registration by the derivatives broker.


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Sales to corporate clients

3. In the case of corporate clients, banks, financial institutions and mutual

funds, they should be allowed to trade derivatives only if and to the extent

authorised by their Board of Directors/Trustees. Such authorisation should

specify the scope of permissible derivative trading, i.e. the purposes or

objectives for which derivatives trading may be undertaken, (e.g. hedging

etc.), over-all limits for derivative exposure, the authority level for giving

approval in this regard, the type of derivatives contracts (e.g. futures,

forwards, options, swaps) and broad derivative category (e.g. derivatives on

interest rate, exchange rate, equities and commodities). Derivatives

broker/dealer may execute orders for such clients only if the orders are

supported by the necessary authorisation of the client’s Board of

Directors/Trustees.

Accounting and disclosure requirements

4. The accounting treatment and disclosure requirement about an

organisation’s involvement in derivatives trading is important so that

shareholders and investors can know how such involvement fits into the

organisation’s objectives and affects its revenues, financial position and risk

profile. The Committee was informed that a Study Group on Derivatives

constituted by the Institute of Chartered Accountants of India is examining

the accounting and disclosure norms for derivatives trading by corporate

bodies.

Mutual Funds as clients

5. The SEBI (Mutual Fund) Regulations presently prohibit the use of derivatives

by mutual funds. The Committee is of the opinion that mutual funds need

hedging facility. They will be among the most important users of equity

hedging through stock index derivatives. Hence, the regulatory prohibition


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should be removed. The soundness of the derivatives market depends on

the presence of both hedgers and speculators. A derivatives market

consisting wholly or mostly of speculators is unlikely to be a healthy market.

It is, therefore, all the more important that the regulatory prohibition on the

use of derivatives for hedging by mutual funds should be withdrawn

immediately.

6. Mutual funds should be allowed to use financial derivatives for hedging

purposes (including anticipated hedging) and portfolio re-balancing within a

policy framework and rules laid down by their Board of Trustees who should

specify what derivatives are allowed to be used, within what limits, for what

purposes, for which schemes, and also the authorisation procedure. The

responsibilities of the trustees of mutual funds as per SEBI regulations

should be re-defined to cover this aspect.

7. At this stage, the Committee does not consider it advisable to frame detailed

SEBI regulations about the use of derivatives by mutual funds as this would

stifle the development of ideas. The Committee prefers that the responsibility

for proper control in this regard should be placed on the trustees of mutual

funds. This would help evolution of practices on sound lines without creating

a strait jacket.

8. Further, what has been said earlier about internal control, accounting

treatment and disclosure of derivatives trading by corporate clients should

apply to mutual funds also. The offer documents of mutual fund schemes

should disclose whether the scheme permits the use of derivatives and the

details in this regard. Also the income and balance sheet of each mutual fund

scheme would have to disclose the impact of derivatives trading and of any

open position in this regard.

Concluding observations


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9. There is no doubt that equity derivatives and other financial derivatives have

some definite positive uses and serve an economic purpose, as clearly

recognised in economic literature. They represent a financial innovation of

considerable significance. They can be helpful in making financial markets

more efficient and enhancing economic efficiency in general.

10. At the same time, derivatives trading inherently involves high leverage. For

this reason, it can be a temptation to inadequately capitalised traders or

speculators. Also some users may not fully understand derivatives and use

them inappropriately. The regulatory system has to be designed to minimise

these possible dangers.

11. In drawing up a regulatory framework for derivatives, the Committee has kept

in view not only the need for allowing adequate flexibility in order to permit

the derivatives market to develop in India but also the need for strict watch so

that the development is along sound lines.

CONSTITUTION OF THE COMMITTEE ON DERIVATIVES

Chairman :

1. Dr. L.C. Gupta

Director

Society for Capital Market Research

and Development, 32 Raja Enclave

Pitampura, DELHI-110 034.

Member-Secretary :

2. Mr. O.P. Gahrotra

Sr. Executive Director

Securities & Exchange Board of India

Mittal Court, "B" Wing, Nariman Point,


124

MUMBAI-400 021.

Other Members :

3. Dr. Ajay Shah

Indira Gandhi Institute of Dev. Research

Gen. Vaidya Marg, Goregaon (East),

MUMBAI-400 065.

4. Mr. B.G. Daga

Chief General Manager, Unit Trust of India

New Marine Lines, MUMBAI-400 020.

5. Mr. Balaji Srinivasan,

Jardine Fleming, Amerchand Mansion

16, Madame Cama Road, MUMBAI-400 001.

6. Mr. D.C. Anjaria

Asian Capital Partners

38, Jolly Maker Chambers II

3rd Floor, Nariman Point

MUMBAI-400 021.

7. Ms. D.N. Raval

Executive Director (Legal)


Mittal Court, "B" Wing, Nariman Piont

MUMBAI-400 021.

8. Mr. Dennis Grubb

Price Waterhourse LLP

128 T.V. Industrial Estate

Worli, MUMBAI-400 025.

9. Mr. L.K. Singhvi, Sr. Executive Director


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Mittal Court, "B" Wing, Nariman Point

MUMBAI-400 021.

10. Mr. M.G. Damani, President

The Bombay Stock Exchange

Dalal Street, Fort, MUMBAI-400 001.

11 Mr. M.R. Mayya

1/19 Kadri Park, Irla, S.V. Road, Vile Parle

MUMBAI-400 056.

12. Mr. Marti Subrahmanyam

Professor New York University

NYU, Saloman Centre

N.Y., 10012-1118, U.S.A.

13. Prof. P.G. Apte

Indian Instt. of Management

Bannerghatta Road, BANGALORE-560076.

14. Mr. Percy Mistry

Oxford International

Oxford Centre, 10, Shroff Lane

Colaba Causeway, Colaba

MUMBAI-400 005.

15. Dr. Prasanna Chandra

Indian Institute of Management

Bannerghatta Road, BANGALORE-560 076.

16. Mr. Pratip Kar, Executive Director

Securities and Exchange Board of India

Mittal Court, "B" Wing, Nariman Point


126

MUMBAI-400 021.

17. Prof. R. Vaidyanathan

Indian Instt. of Management

Bannerghatta Road, BANGALORE-560076.

18. Mr. R. Ravi Mohan

Credit Rating Information Services of India

301 A, Neelam Centre

Worli, MUMBAI-400 025.

19. Dr. R.H. Patil, Managing Director

National Stock of India Ltd.

Mahindra Towers, "A" Wing, 1st Floor,

RBC, Worli, MUMBAI-400 018.

20. Mr. Ramachandra

Bangalore Stock Exchange Ltd.

No. 51, 1st Cross, J.C. Road

BANGALORE-560 027.

21. Mr. S.S. Sodhi

Delhi Stock Exchange Assn. Ltd.

Gate A, West Plaza,I.G. Stadium

Indraprastha Estate, NEW DELHI-110 002.

22. Mr. Uday Kotak

Kotak Mahindra Finance Ltd.

Bakhtawar, 2nd Fl., Nariman Point

MUMBAI-400 021.

23. Mr. V.K. Agarwal

Forward Market Commission

"Everest", 3rd Floor, 100 Marine Lines


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MUMBAI-400 002.

24. Mr. Vallabh Bhansali

Enam Financial Services Ltd.

Ambalal Doshi Marg

24 BD Rajabahadur Compound

MUMBAI-400 023.


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deriv basics

Documents

financial derivatives

settlement of derivatives

newer derivatives

growth of derivatives

financial assets

index futures

stock options

indian financial markets