derivatives project (1)
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INTRODUCTION
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RESEARCH PROBLEM
The turnover of the stock exchange has been tremendously increasing from Last 10 years. The
number of trades and the number of investors, who are participating, have increased. Theinvestors are willing to reduce their risk, so they are seeking for the risk management tools.
There were no effective measures for the investors for hedging strategies in trading on
underlying assets.
Prior to this there were some manipulations for the traded derivative stocks which could not be
resolved easily by the authorities.
The evaluation and analysis of the incomes from the derivatives also became complex in the
bearish and bullish markets.
Hence, the analysis will be made on the above stated problem and measures are to be suggested
to overcome the above stated problem
OBJECTIVES OF THE STUDY
To analyze the derivatives market in India.
To analyze the operations of futures and options.
To find the profit/loss position of futures buyer and also
the option writer and option holder.
To study about risk management with the help of derivatives.
To study and analyze the purpose of hedging in futures and options in the
derivatives market.
To make suggestions to the authorities concerned regarding the effective
usage of the derivatives.
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SCOPE OF THE STUDY
The Study is limited to Derivatives with special reference to futures and Option in the
Indian context and the data had been taken through INDIAINFOLINE LIMITED as arepresentative sample for the study. Any alteration may arise to the actual situations. The
research study is only made as an attempt to evaluate derivatives market only in specified
Organization. The study is based only on the Indian perspective of derivatives markets.
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RESEARCH METHODOLOGY
The following are the steps involved in the study.
Selection of the scrip:-
The scrip selection is done on a random and the scrip selected is
HINDUSTAN PETROLEUM LTD. The lot is 200. Profitability position of the futures buyers
and seller and also the option holder and option writers is studied.
Data Collection:-
The data of the HINDUSTAN PETROLEUM LTD has been collected from the internet site
www.nseindia.com. The data consist of the February-March Contract and period of Data
collection is from 29rd FEBRUARY 2011 27th MARCH 2011.
Analysis:-
The analysis consist of the tabulation of the data assessing the profitability Positions of the
futures buyers and sellers and also option holder and the option Writer, representing the data
with graphs and making the interpretation using Data.
The data for the present study is collected from primary and secondary sources.
PRIMARY SOURCES: The primary sources of data collection is done by personal discussions
with the assistant branch manager, relationship manager and assistant relationship manager and
also through the contacts with the other staff members of the organization of indiainfoline
Limited.
SECONDARY SOURCES: The secondary sources of the data is collected through the official
website of the National Stock Exchange of India www.nseindia.com, and through the articles
collected from various news papers, journals and magazines.
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LIMITATIONS OF THE STUDY
The following are the limitations of this study.
The scrip chosen for analysis is HINDUSTAN PETROLEUM LTD and the
contract taken is March 2011 ending one-month contract.
The data collected is completely restricted to the HINDUSTANPETROLEUM LTD of March 2011 hence this analysis is restricted only to
the selected company, and is not applicable to any other company of same
kind and nature.
As the futures and options are only taken for making the analysis and the
outcome may not be applicable to other components of derivatives.
A full study of the hedging strategies may not be overviewed
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REVIEW OF
LITERATURE
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Introduction
Derivatives are financial contracts whose values are derived from the value of an underlying
primary financial instrument, commodity or index, such as: interest rates, exchange rates,
commodities, and equities. The International Monetary Fund defines derivatives as "financial
instruments that are linked to a specific financial instrument or indicator or commodity and
through which specific financial risks can be traded in financial markets in their own right.
The value of financial derivatives derives from the price of an underlying item, such as assetor index. Unlike debt securities, no principal is advanced to be repaid and no investment
income accrues" While some derivatives instruments may have very complex structures, all
of them can be divided into basic building blocks of options, forward contracts or some
combination thereof. Derivatives allow financial institutions and other participants to
identify, isolate and manage separately the market risks in financial instruments and
commodities for the purpose of hedging, speculating, arbitraging the price differences of the
investments and adjusting portfolio risks.
The emergence of the market for derivatives products, most notable forwards, futures,
options and swaps can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. The
financial markets can be subject to a very high degree of volatility. Through the use of
derivative products, it is possible to partially or fully transfer price risks by locking-in asset
prices. As instruments of risk management, derivatives products generally do not influence
the fluctuations in the underlying asset prices. However, by locking-in asset prices,
derivatives products minimize the impact of fluctuations in asset prices on the profitability
and cash flow situation of risk-averse investors.
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The need for a derivatives market
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse
people in greater numbers5. They increase savings and investment in the long run
Meaning of Derivatives
The term "Derivative" indicates that it has no independent value, i.e. its value is entirely
"derived" from the value of the underlying asset. The underlying asset can be securities,
commodities, bullion, currency, live stock or anything else. In other words, Derivative means a
forward, future, option or any other hybrid contract of pre determined fixed duration, linked for
the purpose of contract fulfillment to the value of a specified real or financial asset or to an index
of securities.
Derivative is a product/contract which does not have any value on its own i.e. it derives its value
from some underlying. As the name suggests, derivative contracts are those contracts which
derives their value from the price of something else. Typically derivatives contracts derive their
value from underlying cash market
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Derivatives are the Investments that derive their value from underlying assets such as currencies,
treasury bills, and bonds or are linked to indices such as a stock market index that can be used to
speculate on market movements or to protect investments against major swings in market prices
Derivatives are the financial contracts that derive their value from an underlying asset or index,
such as an interest rate or foreign currency exchange rate which can be used to manage risk,
reduce cost and enhance returns
As the name suggests, derivative contracts are those contracts which derives their value from
the price of something else. Typically derivatives contracts derive their value from underlying
cash market for e.g. derivative of the Reliance, will derive its value from the cash market price of
Reliance.
DEFINITIONS OF DERIVATIVES
Derivatives are the Investments that derive their value from underlying assets such as
currencies, treasury bills, and bonds or are linked to indices such as a stock market index that can
be used to speculate on market movements or to protect investments against major swings in
market prices.
Derivatives are the financial contracts that derive their value from an underlying asset or index,
such as an interest rate or foreign currency exchange rate which can be used to manage risk,
reduce cost and enhance returns.
Derivatives are the Trades that are constructed or derived from another security (stock, bond,
currency, or commodity) that can be both exchange and non-exchange traded (known as Over
the Counter or OTC).
Derivatives are the financial contracts the value of which depends on the value of the underlying
instrument - commodity, bond, equity, currency or a combination.
Derivatives are financial instruments whose value changes in response to an underlying variable,
that require little or no net initial investment and are settled at a future date.
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With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the
definition of Securities. The term Derivative has been defined in Securities Contracts
(Regulations) Act, as:-
A Derivative includes: -
a. a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
b. a contract which derives its value from the prices, or index of prices, of
underlying securities;
Futures Contract
Futures Contract means a legally binding agreement to buy or sell the underlying
security on a future date. Future contracts are the organized/standardized contracts in terms of
quantity, quality (in case of commodities), delivery time and place for settlement on any date in
future. The contract expires on a pre-specified date which is called the expiry date of the
contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash
settlement enables the settlement of obligations arising out of the future/option contract in cash.
An Option contract
Options Contract is a type of Derivatives Contract which gives the buyer/holder
of the contract the right (but not the obligation) to buy/sell the underlying asset at apredetermined price within or at end of a specified period. The buyer / holder of the option
purchase the right from the seller/writer for a consideration which is called the premium. The
seller/writer of an option is obligated to settle the option as per the terms of the contract when the
buyer/holder exercises his right. The underlying asset could include securities, an index of prices
of securities etc.
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Under Securities Contracts (Regulations) Act, 1956 options on securities has been
defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell,
or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a
put, a call or a put and call in securities;
NOTE: An Option to buy is called Call option and option to sell is calledPutoption.
As in the case of futures contracts, option contracts can be also be settled by delivery of the
underlying asset or cash. However, unlike futures cash settlement in option contract entails
paying/receiving the difference between the strike price/exercise price and the price of the
underlying asset either at the time of expiry of the contract or at the time of exercise / assignment
of the option contract.
The Index Futures and Index Option Contracts
Futures contract based on an index i.e. the underlying asset is the index, are known as Index
Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These
contracts derive their value from the value of the underlying index.
Similarly, the options contracts, which are based on some index, are known as Index options
contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right
but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are
generally European Style options i.e. they can be exercised / assigned only on the expiry date.
An index in turn derives its value from the prices of securities that constitute the index and is
created to represent the sentiments of the market as a whole or of a particular sector of the
economy. Indices that represent the whole market are broad based indices and those that
represent a particular sector are sectoral indices.
In the beginning futures and options were permitted only on S&P Nifty and BSE
Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to
fulfilling the eligibility criteria.
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Derivative contracts may be permitted on an index if 80% of the index
constituents are individually eligible for derivatives trading. The index is required to fulfill the
eligibility criteria even after derivatives trading on the index have begun. If the index does not
fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be
discontinued.By its very nature, index cannot be delivered on maturity of the Index futures or
Index option contracts therefore, these contracts are essentially cash settled on Expiry.
GENERAL STRUCTURE OF DERIVATIVES
(CHART 1.1)
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DERIVATIVES
FUTURESOPTIONS
Put Option
Call Option
FORWARDS
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DIFFERENT TYPES OF DERIVATIVES
The following are the various types of derivatives. They are:
FUTURES:
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Futures contracts are special types of forward contracts in the sense
that the former are standardized exchange-traded contracts.
OPTIONS:Options are of two types-calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.
FORWARDS:
A forward contract is a customized contract between two entities, where settlement takes placeon a specific date in the future at todays pre-agreed price.
WARRANTS:
Options generally have lives of upto one year; the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded Over-the-counter.
LEAPS:
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of upto three years.
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BASKETS:
Basket options are options on portfolio of underlying assets. The underlying asset is usually a
moving average of a basket of assets. Equity index options are a form of basket options.
SWAPS:
Swaps are private agreement between two parties to exchange cash flows in the future according
to a pre arranged formula. They can be regarded as portfolios of forward contracts. The two
commonly used swaps are:
Interest rate swaps:
The entail swapping only the interest related cash flows between the parties in the same
currency.
Currency swaps:
These entail swapping both principal and interest between the parties, with the cashflows in one
direction being in a different currency than those in the opposite direction.
Swaptions:
Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay fixed and received
floating.
Although there are many types of derivatives, in Indian stock market currently we have futures
and options.
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THE DERIVATIVES OFFERS THE FOLLOWING USAGES:
Speculation: One can take a view of the market and buy or sell derivatives accordingly at a
fraction of a total cost.
Hedging: It reduces the risk associated with market exposure by taking a counter position in the
derivatives market.
Arbitrage: It offers an opportunity to take an advantage of the price difference between the
derivatives market and the cash market.
EVOLUTION OF COMMODITIES DERIVATIVES MARKET IN INDIA
The Indian experience in commodity futures market dates back to thousands of years. References
to such markets in India appear in Kautialyas Arthasastra. The words, Teji, Mandi, Gali,
and Phatak have been commonly heard in Indian markets for centuries.
The first organized futures market was however established in 1875 under the aegis of the
Bombay Cotton Trade Association to trade in cotton contracts. Derivatives trading were
then spread to oilseeds, jute and food grains. The derivatives trading in India however did
not have uninterrupted legal approval. By the Second World War, i.e., between the 1920s
&1940s, futures trading in organized form had commenced in a number of commodities
such as cotton, groundnut, groundnut oil, raw jute, jute goods, castor seed, wheat, rice,
sugar, precious metals like gold and silver. During the Second World War futures trading
was prohibited under Defence of India Rules.
After independence, the subject of futures trading was placed in the Union list, and
Forward Contracts (Regulation) Act, 1952 was enacted. Futures trading in commodities
particularly, cotton, oilseeds and bullion, was at its peak during this period. However
following the scarcity in various commodities, futures trading in most commodities were
prohibited in mid-sixties. There was a time when trading was permitted only two minor
commodities, viz., pepper and turmeric.
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Deregulation and liberalization following the forex crisis in early 1990s, also triggered
policy changes leading to re-introduction of futures trading in commodities in India. The
growing realization of imminent globalization under the WTO regime and non-
sustainability of the Government support to commodity sector led the Government to
explore the alternative of market-based mechanism, viz., futures markets, to protect the
commodity sector from price-volatility. In April, 1999 the Government took a landmark
decision to remove all the commodities from the restrictive list. Food-grains, pulses and
bullion were not exceptions.
The long spell of prohibition had stunted growth and modernization of the surviving
traditional commodity exchanges. Therefore, along with liberalization of commodity
futures, the Government initiated steps to cajole and incentives the existing Exchanges tomodernize their systems and structures. Faced with the grudging reluctance to modernize
and slow pace of introduction of fair and transparent structures by the existing Exchanges,
Government allowed setting up of new modern, demutualised Nation-wide Multi-
commodity Exchanges with investment support by public and private institutions. National
Multi Commodity Exchange of India Ltd. (NMCE) was the first such exchange to be
granted permanent recognition by the Government
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STRUCTURE OF DERIVATIVE MARKETS IN INDIA
Derivative trading in India takes can place either on a separate and independent
Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative
Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as the
oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment
would have to be through a Clearing Corporation/House, which is independent in governance
and membership from the Derivative Exchange/Segment.
Everyone talks about derivatives these days. Derivative products have been around for a long
time. Derivatives first came from Japanese rice markets. As early as the 1650s, dealings
resembling present day derivative market transactions were seen in rice markets in Osaka, Japan.
The first leap towards an organized derivatives market came in 1848, when the Chicago Board of
Trade, the largest derivative exchange in the world, was established.
Derivatives markets broadly can be classified into two categories, those that are traded on the
exchange and they traded one to one or 'over the counter'. They are hence known as:
Exchange Traded Derivatives
OTC Derivatives (Over The Counter)
OTC Equity Derivatives
Traditionally equity derivatives have a long history in India in the OTC market. Options of
various kinds (called Teji and Mandi and Fatak) in un-organized markets were traded as early
as 1900 in Mumbai.The Securities Contract and Regulatory Authority (SCRA) however banned
all kind of options in 1956. The prohibition on options in SCRA was removed in 1995. Foreign
currency options in currency pairs other than Rupee were the first options permitted by RBI. The
Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk
reductions OTC derivative products.
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The term "Derivative" indicates that it has no independent value, i.e. its value is entirely
"derived" from the value of the underlying asset.
The underlying asset can be securities, commodities, bullion, currency, live stock or anything
else. In other words, Derivative means a forward, future, option or any other hybrid contract of
pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a
specified real or financial asset or to an index of securities.
Derivative trading in India takes can place either on a separate and independent Derivative
Exchange or on a separate segment of an existing Stock Exchange. Derivative
Exchange/Segment function as a Self-Regulatory Organisation and SEBI acts as the oversight
regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would
have to be through a Clearing Corporation/House, which is independent in governance and
membership from the Derivative Exchange/Segment.
With the amendment in the definition of 'securities' under SC(R)A (to include derivativecontracts in the definition of securities), derivatives trading takes place under the provisions of
the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India
Act, 1992..Dr. L.C Gupta Committee constituted by Sebi had laid down the regulatory
framework for derivative trading in India. SEBI has also framed suggestive bye-law for
Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the
provisions for trading and settlement of derivative contracts.
The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their
Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. Sebi has
also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing
Corporation/House.The eligibility conditions have been framed to ensure that Derivative
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Exchange/Segment & Clearing Corporation/House provide a transparent trading environment,
safety & integrity and provide facilities for redressal of investor grievances. Factors generally
attributed as the major driving force behind growth of financial derivatives are:
(a) Increased Volatility in asset prices in financial markets,
(b) Increased integration of national financial markets with the international markets,
(c) Marked improvement in communication facilities and sharp decline in their costs,
(d) Development of more sophisticated risk management tools, providing economic agents a
wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and returns over a
large number of financial assets, leading to higher returns, reduced risk as well as transaction
costs as compared to individual financial assets.
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THE COMPANYTHE COMPANY
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(THE FINANCIAL SERVICE INDUSTRY)(THE FINANCIAL SERVICE INDUSTRY)
Financial Services
The Indian financial sector is on a roll. Driven by a strong investor interest and an
expanding market, the Indian stock market rose to record levels, with the popular sensex crossing
21,000 points and Nifty crossing the 6,000 mark for the first time.
The industry is also becoming more vibrant, with new types of products and services
being offered to meet the needs of the booming economy. For example, in the derivatives
market, the notional principal amount outstanding has more than trebled between March 2005
and June 2007 to US$ 24.09 billion from US$ 6.836 billion.
The rise in the economy is also estimated to lead to a four-fold increase in India's
investable wealth from US$ 250 billion in 2007 to US$ 1 trillion. Simultaneously, according to a
report by Celent, an international consultancy firm, India's wealth management will rise to an
estimated 42 million by 2012 from about 13 million in 2007.
Clearly, there is huge potential in this segment. Significantly, wealth management
revenues are expected to account for 32-37 per cent of the total full-service financial institutions
by 2012. The market is also expected to undergo a structural transformation with organized
players increasing their market share.
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Stock Markets
The year 2007 saw Indian stock markets scaling new peaks. It has emerged as the third
best performing market in the world with a dollar return of 71.23 per cent. The popular Bombay
Stock Exchange (BSE) benchmark index, sensex, also posted its highest ever absolute gain of
6500 points in over two decades.
This performance of Indian stock markets has led to the total investor wealth of Bombay
Stock Exchange (BSE) surging to a record high of over US$ 1.7 trillion, with an average increase
of over US$ 10.18 million in every minute of trading during 2007. At the end of 2006, the total
market capitalisation stood at US$ 812 billion. Simultaneously, the National Stock Exchange
(NSE) has climbed to the top spot in stock futures contracts and number-two slot in the index
futures segment in the world.
According to Ernst & Young, India was also the fifth largest market in terms of number
of IPOs and seventh largest in terms of the proceeds for the year. Indian companies raised a
whopping US$ 11.48 billion through public issues in 2007, which is 83 per cent higher than US$
6.28 billion mobilized in 2006.
The robust performance of the Indian stock markets can also be seen in the huge increasein the funds mobilised by the corporate India. During 2007-08, India Inc mobilised a whopping
US$ 8.13 billion through issue of shares on rights issue, which is almost an eight-fold increase
over US$ 926.32 million raised in 2006-07. In fact, the mobilisation of the funds in 2007-08 was
more than the combined mobilisation of the preceding 12 years.
Simultaneously, a whopping US$ 13.07 billion has been raised through by India Inc
through public issues, according to data compiled by Prime Database. This is almost twice that
of US$ 6.25 billion mobilised in 2006-07 and the highest ever in the last six years. While initial
public offerings mobilised US$ 10.34 billion (about 79.14 per cent), follow-on public issues
mobilised US$ 2.53 billion.
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Private Equity
The year 2007 was a watershed for private equity market, which has emerged as the most
preferred mode of fund mobilization for India Inc. The capital mobilised through this route was
higher than the funds mobilized through IPOs, follow-on issues and qualified institutional
placements put together.
India, in fact, topped the Asia private equity chart for the first time in 2007 in terms of
aggregate deal value. According to Grant Thornton, a total of US$ 17.14 billion was mobilised
through 386 deals by India Inc in 2007, compared to US$ 7.8 billion in 2006. Real estate,
infrastructure, banking and financial services were the dominant sectors attracting about 55 per
cent of the total private equity investments.
The growth continues apace in 2008. During January-March 2008, private equity firms
invested about US$ 3.3 billion across 97 billion, which was 22.22 per cent higher than the US$
2.7 billion clocked in the corresponding period last year.
A study by global consulting firm Boston Analytics, the average deal size has increased
from US$ 8.4 billion in 2003 to US$ 36.8 billion in 2007. And driven by the robust economic
growth and attractive market valuations, private equity investments are estimated to continue
strongly through 2011.
Structured Finance
India has emerged as the fastest growing market in the Asia-Pacific region for structured
finance, a process of arranging funds by banks and other entities through partly selling their loan
books. It was also the second largest market for domestic issuance in the structured finance
market.
Within this market, Asset Backed Securities (ABS) market has been the dominant
segment than Residentially Market Backed Securities (RMBS). This market has been growing at
a frenetic pace ever since the RBI issued revised guidelines on securitisation in 2006.
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Mutual Funds
India is also one of the fastest growing market for mutual funds industry attracting a host
of global players. The combination of increasing number of fund houses (along with new
schemes) and increase in the number of people parking their savings in mutual funds has resulted
in total funds mobilisation increasing at a whopping 124.93 per cent during 2007-08 to stand at
US$ 1.11 trillion as against US$ 485.13 billion in 2006-07.
The average assets under management (AUM) of the mutual fund industry for March
2008 stood at US$ 134.76 billion as against US$ 89.86 billion at the end of 2006, representing a
year on year growth of 49.96 per cent.
With accelerating investor interest shown in mutual fund segment, the number of investor
folios of the MFs increased to 43.7 million at the end of March 2008, from 27.9 million at the
end of January 2007 (a growth rate of 54 per cent). Simultaneously, there has been an increase in
the number of distributors to 72,108 (excluding 107 banks) till March 2008 from 54,000 in
January 2007.
Continuing the growth, the Indian mutual funds industry is expected to grow at a CAGR
of 30 per cent in the next three years to become a US$ 241.79 billion industry by 2011 from US$
118.85 billion in July 2007. This would be on the back of 25 per cent growth rate between 1999
and 2007. Consequently, market penetration in the MF industry would more than double by 2011
from about 4 per cent in 2007.
Banking
The burgeoning economy, surging foreign investment, financial sector reforms and a
favourable demographic profile has led to the Indian banking industry emerging as one of the
fastest growing in the world. The industry's business grew at a CAGR of 20 per cent from US$
471.11 billion as of March 2002 to US$ 1175.61 billion by March 2007. Significantly, the newly
licensed private sector business has grown almost twice (1.75 times) as that of banking industry
as a whole, leading to their share in total banking business increasing from 9 per cent in 2001-02
to 16 per cent in 2006-07.
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This boom in the banking industry has propelled nine Indian banks to the list of top 50
Asian Banks, as per this year's Asian Banker 300 report. Similarly, seven Indian microfinance
institutions find place in Forbes list of World's Top 50 Microfinance Institutions. Despite such
impressive performance, the potential for further growth is huge considering the fact that India
has second largest financially excluded households (about 135 million) in the world. In fact,
according to Boston Consulting Group, India is the fastest growing incremental revenue pool in
the world.
Insurance
The liberalisation of the rules for the entry of domestic and foreign players has had a
favourable impact on this sector, leading to premium collections growing by 19.9 per cent in
2006-07, compared to the world average of 2.9 per cent. Consequently India became the 15th
largest insurance market from 19th in 2005.
This growth looks particularly impressive when seen against the fact that the combined
penetration of both life and non-life is less than 2 per cent of the GDP compared to world
average of 7.52 per cent. Clearly, the scope for growth is enormous.
With increasing per capita income, insurance penetration and entry of new players, the
Indian insurance industry is estimated to grow to US$ 50.9 billion by 2011 from around US$
12.72 billion in 2007. The private players are likely to see a growth rate of 140 per cent during
this period.
Debt Market
While the Indian financial sector was dominated by the stellar performance of the stock
markets, the Indian debt market had its own share of excitement. India Inc increased its
collections through the debt market by as much as 53.84 per cent to US$ 20 billion in 2007 from
US$ 13 billion in 2006.
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FINANCIAL SERVICES (BANKING AND NON-BANKING)
Promising sub-sectors
Capital markets Venture banking
Consumer financing Mutual funds
Infrastructure financing
(Table3.1)
India has one of the most developed financial markets in the developing world.
Tremendous scope exists for both banking and non-banking financial institutions from other
countries. The insurance sector, nationalised suinmce 1971, has been opened up according to an
announcenebt made in November 1998. A legislation to to this effect is expected by early 1999.
Top companies from the United Kingdom and the United States among others are
already active in India's financial markets. markets. Some of the big names are: Merrill Lynch,
Oppenheimer, J.P. Morgan, Morgan Stanley, Grindlays, Standard Chartered, Hong Kong and
Shanghai Banking Corporation among others.
Foreign institutional investors (FIIs) have been allowed to invest in the stocks and
securities markets with rights of full repatriation and withdrawal. Their presence has added a
new dynamism to the market
India already has foreign exchange reserves of US$27 billion which is considered very
comfortable, but the country needs to use foreign skills and networks to be able to manage the
huge sums for its development needs.
Local financial Institutions such as the Industrial Development Bank of India (IDBI),
Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation
of India, Unit Trust of India and the Shipping Credit and Investment Corporation of India have
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raised billions through the most sophisticated financial instruments including Deep Discount
Bonds.
Indian firms are showing increasing liking for Global Depository Receipts (GDR) listed
in London. American institutions are trying to promote American Depository Receipts (ADR)
listed in New York.
After much dithering, India has finally opened up the insurance sector to private and
foreign investors.
VOLUTION OF BROKERAGE HOUSES IN INDIA
Early Years
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The equity brokerage industry in India is one of the oldest in the Asia region. India had
an active stock market for about 150 years that played a significant role in developing risk
markets as also promoting enterprise and supporting the growth of industry.
The roots of a stock market in India began in the 1860s during the American Civil War
that led to a sudden surge in the demand for cotton from India resulting in setting up of a
number of joint stock companies that issued securities to raise finance. This trend was a kin to
the rapid growth of securities markets in Europe and the North America in the background of
expansion of railroads and exploration of natural resources and land development.
Historical records show that as early as 1864, there were about 1,000 brokers with the
stock markets functioning from three places in Mumbai; between 9 am to 7 pm at the junction
of Meadows Street and Rampart Row, from day break till 9 am and from 7 pm to early hours of
next morning at Bazargate, Bombay.
Share prices rose sharply even at that time. A share of Colaba Land Company during the
boom period of the 1860s rose from Rs 10,000 at par to Rs 1,20,000 and that of Backbay Shares
went up from Rs 2,000 to Rs 54,000. Bombay, at that time, was a major financial centre having
housed 31 banks, 20 insurance companies and 62 joint stock companies.
Reports on stock markets around that time indicate that an ordinary broker in 1864
earned about Rs 200 per day, a huge sum in those days. The boom period came to an abrupt end
in 1865. In Jul 1865, what was then used to be called the share mania ended with burst of the
stock market bubble. Never Investors witnessed in any place a run so widely distributed nor
such distress followed so quickly on the heels of such prosperity An interesting aspect is that
despite the collapse of the stock market, most of the brokers met their payment commitments.
In the aftermath of the crash, banks, on whose building steps share brokers used to gather
to seek stock tips and share news, disallowed them to gather there, thus forcing them to find a
place of their own, which later turned into the Dalal Street. A group of about 300 brokers
formed the stock exchange in Jul 1875, which led to the formation of a trust in 1887 known as
the Native Share and Stock Brokers Association.
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A unique feature of the stock market development in India was that that it was entirely
driven by local enterprise, unlike the banks which during the pre-independence period were
owned and run by the British. Following the establishment of the first stock exchange in
Mumbai, other stock exchanges came into being in major cities in India, namely Ahmedabad
(1894), Calcutta (1908), Madras (1937), Uttar Pradesh and Nagpur (1940) and Hyderabad
(1944). The stock markets gained from surge and boom in several industries such as jute
(1870s), tea (1880s and 1890s), coal (1904 and 1908) etc, at different points of time.
Beginning of a new equity culture
A new phase in the Indian stock markets began in the 1970s, with the introduction of
Foreign Exchange Regulation Act (FERA) that led to divestment of foreign equity by the
multinational companies, which created a surge in retail investing. The early 1980s witnessed
another surge in stock markets when major companies such as Reliance accessed equity markets
for resource mobilisation that evinced huge interest from retail investors.
A new set of economic and financial sector reforms that began in the early 1990s gave
further impetus to the growth of the stock markets in India. As a part of the reform process, it
became imperative to strengthen the role of the capital markets that could play an important role
in efficient mobilization and allocation of financial resources to the real economy. Towards thisend, several measures were taken to streamline the processes and systems including setting up
an efficient market infrastructure to enable Indian finance to grow further and mature. The
importance of an efficient micro market infrastructure came into focus following the incidence
of market abuses in securities and banking markets in 1991 and 2001 that led to extensive
investigations by two respective Joint Parliamentary Committees.
The Securities and Exchange Board of India (SEBI), which was set up in 1988 as an
administrative arrangement, was given statutory powers with the enactment of the SEBI Act,
1992. The broad objectives of the SEBI include
To protect the interests of the investors in securities
To promote the development of securities markets and to regulate the securities
markets
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The scope and functioning of the SEBI has greatly expanded with the rapid growth of
securities markets in India in the last fifteen years.
Following the recommendations of the High Powered Study Group on Establishment of
New Stock Exchanges, the National Stock Exchange of India (NSE) was promoted by financial
institutions with an aim to provide access to investors all over the country. NSE was
incorporated in Nov 1992 as a tax paying company, the first of such stock exchanges in India,
since stock exchanges earlier were trusts, being run on no-profit basis.
NSE was recognized as a stock exchange under the Securities Contracts (Regulations) Act
1956 in Apr 1993. It commenced operations in wholesale debt segment in Jun 1994 and capital
market segment (equities) in Nov 1994. The setting up of the National Stock Exchange brought
to Indian capital markets several innovations and modern practices and procedures such as
nationwide trading network, electronic trading, greater transparency in price discovery and
process driven operations that had significant bearing on further growth of the stock markets in
India.
Faster and efficient securities settlement system is an important ingredient of a successful
stock market. To speed the securities settlement process, The Depositories Act 1996 was passed
that allowed for dematerialisation (and rematerialisation) of securities in depositories and thetransfer of securities through electronic book entry.
The National Securities Depository Limited (NSDL) set up by leading financial institutions,
commenced operations in Oct 1996. Regulations governing selection of various types of market
intermediaries as depository participations were made. Subsequently, Central Depository
Services (India) Limited promoted by Bombay Stock Exchange and other financial institutions
came into being.
Rapid Growth
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The last decade has been exceptionally good for the stock markets in India. In the back
of wide ranging reforms in regulation and market practice as also the growing participation of
foreign institutional investment, stock markets in India have showed phenomenal growth in the
early 1990s. The stock market capitalization in mid-2007 is nearly the same size as that of the
gross domestic product as compared to about 25 percent of the latter in the early 2000s. Investor
base continued to grow from domestic and international markets.
The value of share trading witnessed a sharp jump too. Foreign institutional investment
in Indian stock markets showed continuous rise reaching about USD10 billion in each of these
years between FY04 to FY06. Stock markets became intensely technology and process driven,
giving little scope for manual intervention that has been the source of market abuse in the past.
Electronic trading, digital certification, straight through processing, electronic contract notes,online broking have emerged as major trends in technology.
Risk management became robust reducing the recurrence of payment defaults. Product
expansion took place in a speedy manner. Indian equity markets now offer, in addition to
trading in equities, opportunities in trading of derivatives in futures and options in index and
stocks. Electronic Traded Funds(ETFs) are showing gradual growth. Within five years of
introduction of derivatives, Indian stock markets now are ranked first in stock futures and fourth
in index futures. Indian stock markets are transaction intensive and thus rank among the top five
markets in this regard. Stock exchange reforms brought in professional management separating
conflicts of interest between brokers as owners of the exchanges and traders/dealers.
The demutualisation and corporatisation of all stock exchanges is nearing completion
and the boards of the stock exchanges now have majority of independent directors. Foreign
institutions took stake in Indias two leading domestic stock exchanges. While NYSE Group led
consortium took stake in the National Stock Exchange, Deutsche Borse and Singapore Stock
Exchange bought equity in the Bombay Stock Exchange Ltd.
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Circa1995. A group of Professionals Formed Company called Probity Research & Service
Private Limited. The name was later changed to IndiaInfoline Limited. The objective was
to provide unbiased and independent information to market intermediaries and investors. The
quality of research soon caught the imagination of all major participants in the financial market.
In a span of two to three years the client list read like the who's who of Indian financial market.
The list included consulting firms like Mckinsey, companies like Hindustan Lever, Banks like
Citibank, Rating agencies like CRISIL, D&B, FIs, FIIs, foreign brokers as well as leading Indian
brokers. The going was smooth but not exciting!
One fine morning in early1999, a colleague of the company had a crazy idea that if the
company made all the research available free on the web, the number of users may well jump
from 250 to 2.5million! To make it true, the business required incarnation. It meant that the
company put up all the information on the web site and let go off all the revenues and profits.
Worse, if the new avatar failed, there would be no comebacks'.
Circa2001.The internet bubble started bursting faster than any body could have
imagined. The dot com suffix, which was the tail to any business name, suddenly became the
worst stigma to have. Funding disappeared completely, regardless of valuation, business model
or management depth. The company also had a crash landing and was forced to drop a number of
plans including one to set up a TV channel. IndiaInfoline Limited decided to narrow its focus
on business where it could leverage its core competencies to the maximum. The key business
lines that emerged were mutual funds, life insurance and E-Broking.
The company became heavily dependant on its E-broking business for survival. The odds
were against them. There was no money available for the private equity investors at any
valuation. All the competitors were backed by institutions or had abundant capital.
There was a core group who never lost hope. They cut all the possible costs and worked
on bare bone structure. They survived against all odds and started capturing market share. Not
broking alone mutual funds and life insurance business also grew strongly. The company rose
from strength to strength to become the leading corporate agent in life insurance and among the
top retail players in mutual fund and broking space.
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The Story took an interesting turn. The company raised capital by the way of Initial
Public Offerings (IPOs).In India, investment advisory is a sunrise industry, with tremendous
long term promise. The young 'Earning' and 'saving' class of population is growing very rapidly.
Falling interest rates are compelling people look around for advised investment. The industry is
consolidating as smaller players find it difficult to meet strict compliance standards and service
customers with research and technology understandably; competition is intense.
The land scape was changing every day and the road ahead is less travelled by. The India
Infoline Ltd. along with its subsidiaries is a unique one stop investment which offers every thing
from information and advice to execution and service to the retail customers for the entire gamut
of investment products from risk free RBI Bonds to high risk, high reward equities and also
mutual funds and life insurance. They also entered into portfolio management services and
commodities broking, again leveraging upon their core competencies in research and technology.
The company promises to continue to deliver high quality independent research and
maintain high standards of integrity and compliance. The management realizes that the business
is highly vulnerable to lapse in risk management. Over the years, it evolved a clear and logical
risk management system, which stood the trial by fire on May 17; 2004.There are a number of
opportunities on the horizon and with availability of horizon, temptations around. The
management is fully conscious of the fact that with public money it is in a crucial relationship
with heightened responsibilities to ensure optimum use of capital.
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THE PRODUCT LINES OF INDIAINFOLINE LIMITED
(CHART3.1)
A SEBI authorized Portfolio Manager; it offers Portfolio Management Services to clients.
These services are offered to clients as different schemes, which are based on differing
investment strategies made to reflect the varied risk-return preferences of clients.
INDIA INFOLINE MEDIA AND RESEARCH SERVICES LIMITED
The content services represent a strong support that drives the broking, commodities,
mutual fund and portfolio management services businesses. Revenue generation is through the
sale of content to financial and media houses, Indian as well as global.
It undertakes equities research which is acknowledged by none other than Forbes as 'Best
of the Web' and 'a must read for investors in Asia'. India Infoline's research is available not
just over the internet but also on international wire services like Bloomberg (Code: IILL),
Thomson First Call and Internet Securities where India Infoline is amongst the most read Indian
brokers.
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INDIA INFOLINE COMMODITIES LIMITED.
India Infoline Commodities Pvt Limited is engaged in the business of commodities
broking. Our experience in securities broking empowered us with the requisite skills and
technologies to allow us offer commodities broking as a contra-cyclical alternative to equities
broking. We enjoy memberships with the MCX and NCDEX, two leading Indian commodities
exchanges, and recently acquired membership of DGCX. We have a multi-channel delivery
model, making it among the select few to offer online as well as offline trading facilities.
INDIA INFOLINE MARKETING & SERVICES
India Infoline Marketing and Services Limited is the holding company of India Infoline
Insurance Services Limited and India Infoline Insurance Brokers Limited.
(a) India Infoline Insurance Services Limited is a registered Corporate Agent with the
Insurance Regulatory and Development Authority (IRDA). It is the largest
Corporate Agent for ICICI Prudential Life Insurance Co Limited, which is India's
largest private Life Insurance Company. India Infoline was the first corporate
agent to get licensed by IRDA in early 2001.
(b) India Infoline Insurance Brokers Limited India Infoline Insurance Brokers
Limited is a newly formed subsidiary which will carry out the business of
Insurance broking. We have applied to IRDA for the insurance broking licence
and the clearance for the same is awaited. Post the grant of license, we propose to
also commence the general insurance distribution business.
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INDIA INFOLINE INVESTMENT SERVICES LIMITED
Consolidated shareholdings of all the subsidiary companies engaged in loans and
financing activities under one subsidiary. Recently, Orient Global, a Singapore-based investment
institution invested USD 76.7 million for a 22.5% stake in India Infoline Investment Services.
This will help focused expansion and capital raising in the said subsidiaries for various lending
businesses like loans against securities, SME financing, distribution of retail loan products,
consumer finance business and housing finance business. India Infoline Investment Services
Private Limited consists of the following step-down subsidiaries.
a) India Infoline Distribution Company Limited (distribution of retail loan products)
(b)Moneyline Credit Limited (consumer finance)
(c) India Infoline Housing Finance Limited (housing finance)
IIFL (ASIA) PRIVATE LIMITED
IIFL (Asia) Private Limited is wholly owned subsidiary which has been incorporated in
Singapore to pursue financial sector activities in other Asian markets. Further to obtaining the
necessary regulatory approvals, the company has been initially capitalized at 1 million Singapore
dollars.
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KEY MILESTONES OF THE COMPANY
YEAR MILESTONE ACHIEVED
October 18, 1995 Incorporated as Probity Research and Services.
May, 1999 Launched Internet Portal www.Indiainfoline.com.
April2000 Commenced distribution on of personal financial products like
Mutual Funds and RBI Bonds in Launched Online trading inshares and securities branded as www.5paisa.com.
December, 2000 Started life insurance agency business in as a corporate agent of
ICICI Prudential Life Insurance.
September, 2001 Became a depository participant of NSDL.
August, 2004 Launched portfolio management services.
May 17, 2005 Listed on NSE and BSE.
May, 2005 Acquired NBFC license.
December,2005 Acquired 100% equity of Marchmont Capital Advisors Pvt Ltd
through which the company had ventured into Merchant Banking.
December, 2005 DSP Merrill Lynch Capital subscribed to convertible bonds
aggregating Rs.80 crores .Their current stake in India Infoline is a
little over 14% as on 31st March 2007.
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December, 2005. Bennet Coleman &Co Ltd (BCCL) invested Rs.20 crores in India-
-infoline by way of preferential allotment.
June, 2006. The company became a depository participant of CSDL.
January, 2007 Merger of India Infoline securities Pvt Limited with India Infoline
Limited.
February, 2007 Entered into an alliance with Bank of Baroda e-trading.
April, 2007. Acquired IRDA license for Insurance Broking.
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THE MANAGEMENT TEAM OF THE COMPANY
Mr.Nirmal Jain (Chairman and managing Director)
Nirmal jain is the founder and Chairman of India Infoline Limited.
He holds an MBA degree from IIM Ahmedabad, and is a Chartered Accountant (All
India Rank2) and a cost Accountant.
He has an impeccable professional and academic track record.
He started his career in 1989 with Hindustan Lever Limited. During his stint with
Hindustan Lever Limited, he handled a variety of responsibilities, including exports and
trading in agro-commodities with Rs3bn annual turnover.
His work set new standards for equity research in India. In1995, he founded his own
independent financial research company, now known as India Infoline Ltd.
Mr.Venkatraman (Executive Director)
R Venkatraman is the co-promoter and Executive Director of India Infoline
Limited.
He holds a B.Tech degree in Electronics and Electrical Communications
Engineering from IIT Kharagpur and an MBA from IIM Bagalore.
He has held senior managerial positions in various divisions of ICICI Limited,
Including ICICI Securities Ltd, their investment banking joint venture with J P
Morgan of USA and with BZW and Taib Capital Corporation Limited.
He has also held the position of Assistant Vice President with G E Capital Services
India Limited in their private equity division.
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THE BOARD OF DIRECTORS
Mr. Sat Pal Khatter (Non Executive Director)
Mr Sat Pal Khatter joined the Board with effect from April20, 2001.
Mr Sat Pal Khattar is a lawyer by profession.
He was the founding partner of a firm of solicitiors in Singapore named Khattar
Wong and at present is a Consultant in the said firm.
He is also a director of a number of public companies in Singapore and India.
Mr. Sanjiv Ahuja (Independent Director)
Mr Sanjiv Ahuja joined the Board with effect from August 28,2002.
Mr Ahuja graduated from National University of Singapore with a degree in
Computer Science and is also a Certified Public Accountant.
He started his own investment advisory and consulting company in 2001, named
Centennial Management consultants Private Limited.
At present, he is also an Executive Director with Corporate Brokers International
Private Limited and also a board member of the Singapore Indian Chamber of
Commerce and Industry, a post he has held since 2002.
Mr. Nilesh Vikamsey (Independent Director)
Mr Nilesh Shivji Vikamsey joined the Board with effect from February 11, 2005.
Mr Vikamsey qualified as Chartered Accountant in 1985 and has been a member
of the Institute of Chartered Accountants of India since 1985.
In 1985, Mr Vikamsey was inducted as partner in M/s Khimji Kunverji& Co.,
Chartered Accountants and was in charge of the audit department till 1990 and
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thereafter also handles assignments related to financial services, consultancy,
investigations, mergers and acquisitions, valuations etc.
Mr. Kranti Sinha (Independent Director)
Mr Kranti Sinha joined the Board with effect from January 27, 2005.
Mr Sinha graduated from the Agra University with a masters degree.
He is currently the Managing Director of the Global Institute for Financial and
Eductaion Services (India) Private Limited (a sholly owned subsidiary of The
Global Institute, LLC, USA).
Mr Sinha is also on the Board of Directors of Hindustan Motors Limited, L& T
Limited & LICHFL Care Homes Limited.
INDIA INFOLINE TODAY
The company is a one stop investment shop where customers can meet all their advisory,
investing and borrowing needs under one roof. We provide advice, offer a wide range of
products to choose from, execute the orders and complete the value chain by providing constant
service to all our customers.
REGULATORS OF THE COMPANYREGULATORS OF THE COMPANY
Stock and Exchange Board of India (SEBI).
Reserve Bank of India (RBI).
Association of Mutual Funds in India (AMFI).
Insurance Regulatory Development Authority (IRDA).
Forward Market Commission (FMC).
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THE VISION OF THE COMPANYTHE VISION OF THE COMPANY
The companys vision is to be the most respected financial servicescompany in India.
Having a vision gives an organization a sense of direction. It helps all employees of the
organization to channelize their efforts in the same direction towards a common organizational
goal and acts as a cornerstone to resolve conflicts.
At India Infoline, they are convinced that even as a number of their peer companies are
focused on emerging as the biggest and the best in the financial services space in India, there is
an even more critical opportunity available in emerging as the most respected.
The company needs to be most respected by their stakeholders, their customers, their
employees and by society in general. Needless to emphasize, it is imperative for all of them to
align our personal goals and values to the organizations vision.
THE KEY COMPETITORS OF INDIAINFOLINE LIMITED
KARVY STOCK BROKERING LIMITED
SHAREKHAN SECURITIES LIMITED
INDIA BULLS SECURITIES LIMITED
MOTILAL OSWAL SECRITIES LIMITED
KOTAK SECURITIES LIMITED
ICICI DIRECT
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DATA ANALYSIS
&
INTERPRETATION
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FUTURES CONTRACT
Futures Contract means a legally binding agreement to buy or sell the underlying security
on a future date. Future contracts are the organized/standardized contracts in terms of quantity,
quality (in case of commodities), delivery time and place for settlement on any date in future.
The contract expires on a pre-specified date which is called the expiry date of the contract. On
expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables
the settlement of obligations arising out of the future/option contract in cash. A futures contract
is an agreement between two parties to buy or sell an asset at a certain time in the future at a
certain price. Futures contracts are special types of forward contracts in the sense that the former
are standardized exchange-traded contracts.
FUTURES FUNCTIONALITY
Futures are derivative contracts to buy or sell a specified quantity or underlying assets at
an agreed price, on or before a specified time. They are standardized forward contracts, whichare traded on the exchanges mainly BSE & NSE. Since they are traded on the exchange on
electronic platform, it provides them transparency, liquidity, anonymity of trades, and also
eliminates the counter party risk due to guarantee Provided by the exchange.
Derivative market is a leverage market since Investor/Trader has to pay only fraction of
total value of the contract as a margin to his broker, who in turn has to pay to the exchange, For
example if Rs. 100/- is required to be deployed in cash market for taking a delivery the same
stock if available in derivatives market can be bought by paying an average margin of
around15%.
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Currently in India we have three types of contracts available for trading i.e. for current
month, next month and far month. On last Thursday of each month these contracts expires and
then they are settled at a closing price of underlying cash market. In India contracts are settled in
cash. Further day to day mark to market difference is also debited/credited to the client and
brokers account by the Exchange.
Example: say an investor has a bullish view on Reliance and hence buys a Reliance in a
futures market at a start of current month at Rs.750/- wherein price in cash market is Rs.747/-.He
has to pay 15% margin on Rs.750/- i.e. approx 112.5 per share to his broker as a margin, unlike
entire Rs.747/- for buying the same share in cash market. Now say for e.g. on the next day the
price of the Reliance in the futures market moves uptoRs.760/- then he will be credited Rs.10/- in
his account (760-750). Supposing next day price falls by Rs.5/- to Rs.755/-he will be debited by
Rs.5/- in his account. Thus, on a daily basis his account will be debited/credited to the extent of
difference in price compared to previous day. On the last day of the contract the difference will
be settled bytaking the closing price in the cash market for Reliance.In the similar manner if
investor has a bearish view on Reliance he can short sell in futures market unlike in cash market
where he can sell only if he has shares in his hand.
ARRIVAL OF FUTURE PRICE
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward contracts in
the sense that the former are standardized exchange-traded contracts.
The pricing of the futures depends on cash market price and the cost of carry. The Cost of
carry is the sum of all costs incurred if a similar position is taken in cash market and carried tomaturity of the futures contract less any revenue which may result in this period. Generally the
cost comprises interest while revenue comprises of dividend. Say for e.g. the interstate is 12%
and the dividend declared by the company is say0.50ps. on the stock that is quoting at Rs.100/-
in cash market then the theoretical value of this stock in the futures market should be 100 + 1
0.50 = 100.50.
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Although generally by definition futures prices should be higher than the cash prices to
the extent of the interest element (assuming no dividend). However, many a times it is not so and
it may be significantly higher or lower than the cash price because of built-in market
expectations for that stock in futures prices.
BASIS
The difference between spot price and futures price is known as basis. Although the spot
price and futures price generally move in line with each other, the basis is never constant. It
gradually decreases with time and on expiry since futures and cash prices becomes equal basis
becomes zero.
AN OPTION CONTRACT
Options Contract is a type of Derivatives Contract which gives the buyer/holder
of the contract the right (but not the obligation) to buy/sell the underlying asset at a
predetermined price within or at end of a specified period. The buyer / holder of the option
purchase the right from the seller/writer for a consideration which is called the premium. The
seller/writer of an option is obligated to settle the option as per the terms of the contract when the
buyer/holder exercises his right. The underlying asset could include securities, an index of prices
of securities etc.
Options are of two types-calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
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OPTIONS AND THEIR FUNCTIONS
Options are derivative contracts where the person gets aright (but not obligation) to buy
or sell a specified quantity of the underlying asset at an agreed price (strike price) on or before
the specified future date (expiration date) at an agreed Price (premium).
Example
Suppose an investor is bullish on Reliance at the start of the current month when the price
is Rs.750/- say for e.g. he is expecting a price of Rs.850/- by end of the month. Although he is
expecting an upward price movement, he wants to limit his downside risk and hence he buys an
option contract of Rs.750/- (strike price) for a price of say Rs.30/- (premium)By paying Rs.30/-
what he gets is right (not an obligation) to buy Reliance at any time before the month end at
Rs.750/-only, irrespective of cash market price. Obviously he will exercise his right if cash
market price is higher than Rs.750/- any time before expiry of the contract.
Since he has already incurred Rs.30/- as a cost for buying this right his break even point
is Rs.780/- so if Reliance moves to Rs.850/- he makes Rs.80/- (850-750-30) on an investment of
Rs.30/- (cost of buying an option). Now suppose that Reliance moves down to Rs. 650/- in this
case since it makes more sense to buy Reliance from the cash market, he will not exercise his
right to buy at Rs.750/- and hence he loses the premium amount of Rs.30/-. At the same time he
avoids the downside risk of Rs.100/- which otherwise he would have taken had he bought the
Reliance from the cash market at Rs.750/-.
Thus, options in a way, are like an insurance contract whereby paying certain premium,
option buyer passes on his risks to option seller. The risk of option buyer is limited while that of
an option seller is unlimited. In a similar manner, option buyer has unlimited gain potentials
while option seller has a limited income potential to the extent of premium income only.
The different types of Options
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There are basically two types of option contracts.
(a) Call Options
(b) Put Options
CALL OPTIONS:
A call option gives the holder (option buyer), the right to buy a specified quantity of the
underlying asset at a strike price on or before expiration date. The seller however, has the
obligation to sell the underlying asset if the buyer of the call option decides to exercise his option
to buy.
PUT OPTIONS:
A Put Option gives the holder (i.e. the buyer), the right to sell a specified quantity of the
underlying asset at a strike price on or before an expiry date. The seller of the put option
however has the obligation to buy the underlying asset at the strike price if the buyer decides to
exercise his option to sell.
The different style of Options
Broadly there are two styles of options, namely American style option and European style
option. An American style option is one, which can be exercised by the buyer on or before the
expiration date, i.e anytime between the time of purchase and the time of its expiry. The
European kind of option is one, which can be exercised by the buyer on the expiration day only
and not anytime before that. In India, stock options are of the American style while index options
are of the European style.
FACTORS THAT DETERMINE OPTION PRICES (PREMIUM)
There are two types of factors that affect the value of the option (premium):
Quantifiable factors, they are strike price, underlying asset price, the volatility of the underlying
asset, the time to expiration and the risk free interest rate:
Non-quantifiable factors, they are market participants varying estimates of the
underlying assets future volatility and future performance.
Difference between Futures and Options
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The significant differences between them are as under:
In case of futures, both the parties have an obligation to buy/sell the underlying asset.
Whereas in the case of options the buyer enjoys the right and not the obligation, to buy or sell
the underlying asset. In case of Futures the risk/return profile of both buyers and sellers is equal
whereas in case of options the buyer has limited risk and unlimited gain potential and seller of
the option has a unlimited risk and limited gain potential. Future prices are mainly affected by
the prices of underlying asset while option prices are affected by not only the prices of
underlying asset, but also by volatility and time to expiry.
Trading of Futures & Option before the expiry date
Once the position is taken in futures, it can be squared off by taking a reverse position
any time before the expiry of the contract. Similarly once the position is taken in the option
contract; it can be squared off by taking a reverse position any time before the expiry.
Various derivative Strategies and their utilization
Option strategies are various combinations of futures and options in such a manner that it
offers optimal risk to reward ratio based on the view of a market player for e.g. an investor
having a moderately bullish view on a market can buy a stock or futures and correspondingly sell
call of higher price at some premium and thus not only participate in rally but also earn some
premium income. This is called a covered call writing. Bullish and bearish option spread,
Strangle, straddle are few of other option strategies which can be utilized bythe market players.
Index Futures and its utilization
Index futures are the futures on index. Currently on NSE we have 3 types of index
futures. They are Nifty futures, CNX IT futures and Bank Nifty futures. While Nifty future is
future on cash Nifty CNX IT and Bank Nifty are futures on IT and bank index respectively. An
investor can utilize these futures as a hedging tool or for a trading based on his view about that
index.
The Uses/Advantages of Derivatives
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Versatility: The major advantage of derivatives is their versatility. An investor can use
derivative in a most
Conservative to most risky manner as his risk profile dictates.
High Leverage: Derivative contracts enable the investor to take an exposure to the full
value of underlying shares for a fraction of its value in the form of margin.
High Liquidity: Derivative contracts offers very high liquidity compared to cash market.
CONCEPTOFBASISIN FUTURES MARKET
BASIS: The difference between spot price and futures price is known as basis. Although the spot
price and futures price generally move in line with each other, the basis is never constant. It
gradually decreases with time and on expiry since futures and cash prices becomes equal basis
becomes zero.
Basis is defined as the difference between cash and futures prices:
Basis = Cash prices - Future prices. Basis can be either positive or negative (in Index futures, basis generally is negative).
Basis may change its sign several times during the life of the contract.
Basis turns to zero at maturity of the futures contract i.e. both cash and future prices
converge at maturity.
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(Chart 4.1)
Life of the contract
Operators in the derivatives market
Hedgers - Operators, who want to transfer a risk component of their portfolio.
Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit
of profit and eliminate mis-pricing.
PRICING FUTURES
Cost and carry model of Futures pricing
Fair price = Spot price + Cost of carry - Inflows
FPtT = CPt + CPt * (RtT - DtT) * (T-t)/365
FPtT - Fair price of the asset at time t for time T.
CPt - Cash price of the asset.
RtT - Interest rate at time t for the period up to T.
DtT - Inflows in terms of dividend or interest between t and T.
Cost of carry = Financing cost, Storage cost and insurance cost.
If Futures price > Fair price; Buy in the cash market and simultaneously sell in the futures
market.
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If Futures price < Fair price; Sell in the cash market and simultaneously buy in the futures
market.
This arbitrage between Cash and Future markets will remain till prices in the Cash and
Future markets get aligned.
Set of assumptions
No seasonal demand and supply in the underlying asset.
Storability of the underlying asset is not a problem.
The underlying asset can be sold short.
No transaction cost; No taxes.
No margin requirements, and so the analysis relates to a forward contract, rather than a
futures contract.
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INDEX FUTURES AND COST AND CARRY MODEL
In the normal market, relationship between cash and future indices is described by the
cost and carry model of futures pricing.
Expectancy Model of Futures pricing
(Chart4.2)
S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.
Expectancy model says that many a times it is not the relationship between the fair price
and future price but the expected spot and future price which leads the market. This
happens mainly when underlying is not storable or may not be sold short. For instance in
commodities market.
E(S) can be above or below the current spot prices. (This reflects markets expectations)
Contagion market- Market when Future prices are above cash prices.
Backwardation market - Market when future prices are below cash prices.
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RELATIONSHIP BETWEEN FORWARD & FUTURE MARKETS
Analyze the different dimensions of Forward and Future Contracts:
(Risk; Liquidity; Leverage; Margining etc....)
Assign value to each factor to arrive at the contract price.
(Perception plays a crucial role in price determination)
o Any substantial difference in the Forward and Future prices will trigger arbitrage.
RISK MANAGEMENT THROUGH FUTURES
Risk managing through Futures
Basic objective of introduction of futures is to manage the price risk.
Index futures are used to manage the systemic risk, vested in the investment in securities.
SOME SPECIFIC USES OF INDEX FUTURESSOME SPECIFIC USES OF INDEX FUTURES
Portfolio Restructuring - An act of increasing or decreasing the equity exposure of a
portfolio, quickly, with the help of Index Futures.
Index Funds - These are the funds which imitate/replicate index with an objective to
generate the return equivalent to the Index. This is called Passive Investment Strategy.
SSPECULATIONPECULATIONININTHETHE FFUTURESUTURESMARKETMARKET
Speculation is all about taking position in the futures market without having the
underlying. Speculators operate in the market with motive to make money. They take:
o Naked positions - Position in any future contract.
o Spread positions - Opposite positions in two future contracts. This is a conservative
speculative strategy.
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Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the
price discovery in the market.
AARBITRAGEURSRBITRAGEURSININ FFUTURESUTURESMARKETMARKET
Arbitrageurs facilitate the alignment of prices among different markets through operating
in them simultaneously.
MMARGININGARGININGININ FFUTURESUTURESMARKETMARKET
Whole system dwells on margins:
o Daily Margins
o Initial Margins
Compulsory collection of margins from clients including institutions.
Collection of margins on the Portfolio basis not allowed by L. C. Gupta committee.
Daily Margins
Daily margins are collected to cover the losses which have already taken place on open
positions.
o Price for daily settlement - Closing price of futures index.
o Price for final settlement - Closing price of cash index.
Daily margins should be received by CC/CH and/or exchange from its members before
the market opens for the trading on the very next day.
Daily margins would be paid only in cash.
Initial Margins
Margins to cover the potential losses for one day.
To be collected on the basis of value at risk at 99% of the days.
Different initial margins on:
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o Naked long and short positions.
o Spread positions.
Naked positions
Short positions 100 [exp (3st) - 1]
Long positions 100 [1 - exp (3rd)]
Where (st)2 = l(st-1)2 + (1-l)(rt
2)
st is todays volatility estimates.
st-1 is the volatility estimates on the previous trading day.
l is decay factor which determines how rapidly volatility estimates change and is taken as
0.94 by Prof. J. R. Verma.
rt is the return on the trading day [log(It/It-1)]
Because volatility estimate st changes everyday, Initial margin on open position will
change every day.
(For first 6 months of futures trading, minimum initial margin on naked positions shall be
5%)
Spread positions
Flat rate of 0.5% per month of spread on the far month contract.
Min. margin of 1% and maximum margin of 3% on spread positions.
A calendar spread would be treated as open position in the far month contract as the near
month contract approaches maturity.
Over the last five days of trading of the near month contract, following percentages of the
spread shall be treated as naked position in the far month contract:
o 100% on the day of expiry
o 80% one day before the expiry
o 60% two days before the expiry
o 40% three days before the expiry
o 20% four days before the expiry
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Liquid assets and Brokers net worth
Liquid assets
o Cash, fixed deposits, bank guarantee, government securities and other approved
securities.
o 50% of Liquid assets must be cash or cash equivalents. Cash equivalents means cash,
fixed deposits, bank guarantee and government securities.
Liquid net-worth = Liquid asset - Initial margin
Continuous requirement for a clearing member:
o Minimum liquid net-worth of Rs. 50 Lacs.
o The mark to market value of gross open position shall not exceed 33.33 times of
members liquid net worth.
Basis for calculation of Gross Exposure:
For the purpose of the exposure limit, a calendar spread shall be regarded as an open
position of one third of the mark to market value of the far month contract.
As the near month contract approaches expiry, the spread shall be treated as a naked
position in the far month contract in the same manner.
Margining in Futures market
Initial Margin (Value at risk at 99% of the days)
Daily Margin
Special Margins
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(Chart4.3)
Striking an intelligent balance between safety and liquidity while determining margins
is a million dollar point.
Position limits in Index Futures
Customer level
No position limit. Disclosure to exchange, if position of people acting in concert is 15%
or more of open interest.
Trading member level
15% of open interest or 100 crore whichever is higher.
To be reviewed after 6 months of futures trading.
Clearing member level
No separate position limit. However, C.M. should ensure that his own positions (if C.M.
is a T.M. also) and the positions of the T.Ms. clearing through him are within the limits
specified above for T.M.
Market level
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No limit. To be reviewed after 6 months of trading in futures.
Expected advantages of derivatives to the cash market
Higher liquidity
o Availability of risk management products attracts more investors to the cash market.
o Arbitrage between cash and futures markets fetches additional business to cash market.
Improvement in delivery based business.
Lesser volatility
Improved price discovery.
Reasons for making a contract click
Risk in the underlying market.
Presence of both hedgers and speculators in the system.
Right product specifications.
Proper margining.
Futures
Multiple indices trading on the same exchange even the same index with different
contract designs
Dedicated funds -
o Future funds
o Options funds
o Hybrid funds
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CONTRACT SPECIFICATIONS FOR FUTURES & OPTIONS
(Table4.1)
Parameter Index
Futures
Index
Options
Futures
on
Individual
Securities
Options on
Individual
Securities
Mini Index
Futures
Mini Index
Options
Underlying 6 Indices 6 Indices 225securities
225securities
S&P CNXNifty