A

Project report
On
Derivatives a risk management tool

In partial fulfilment of the requirements of

Masters in Management Studies
Conducted by
Rizvi Institute of Management Studies and Research

Under the guidance of

Prof. Subhash Raje

Submitted by
Zainab Yusuf Fanaswalla
MMS
Batch 2016-18
 CERTIFICATE

This is to certify that Ms. Zainab Yusuf Fanaswalla, a student of Rizvi Institute of
Management Studies and Research, of MMS bearing Roll no M-87 and specializing in
Finance has successfully completed the project titled

Derivatives a risk management tool

Under the guidance of Prof. Subhash Raje in partial fulfilment of the requirement of Post
Graduate Diploma in Business Management conducted by Rizvi Institute of Management
Studies and Research for the academic year 2016-18.

_____________
Prof. Subhash Raje
Project Guide

_____________ _____________
Prof. Umar Farooq Dr. Kalim Khan
Academic Coordinator Director
 ACKNOWLEDGEMENT

In the earnest attempt to prepare this report, Prof. Subhash Raje has played pivotal role
and has provided constant motivation as a guide. I am truly obliged and indebted to her for
the time and focus she provided.
Further, I would like to extend my acknowledgement to Dr. Kalim Khan for providing
the environment and infrastructure needed to accomplish the task. As a director in charge
of the institute, he has truly helped and guided at each and every step of this process.
Above all I am very thankful to all people directly or indirectly have played an important
role to be beneficial in completing the project.
Last but not the least, I am grateful to our institute, Rizvi College of Management Studies
and Research, including all their members and participants for providing such excellent
infrastructure equipped with ultra-modern facilities which served as great source of
convenience and information.

______________
Zainab Yusuf Fanaswalla
Rizvi Institute of Management Studies and Research

2
 Table of Contents

Sr. No Topic Page No

1 Executive Summary
2 Introduction to derivatives
3 Participants in derivative market
4 Risk in derivatives contract
5 Type of derivatives contract
(i) - Forwards
((i)(i)(ii) -Futures
(iii)
(ii) ((ii) -Options
(iii) 6 Basic option transactions
7 Effect of premium on pay-off profile
8 Swaps
(i) - Characteristics and Limitations
(i) (ii) - Interest rate swaps
(ii) (iii) - Illustrations on interest rate swaps
(iii) (iv) - Currency Swaps
(iv) (v) - Basis Swaps
(v) 9 Forward rate agreements
(i) - Illustrations of FRAs
10 Primary Analysis
11 Bibliography

2
EXECUTIVE SUMMARY
Business like life is inherently risky. Firms convert inputs such as labour, raw materials, and
machines, into goods and services. A firm is profitable if the cost of what it produces exceeds
the cost of the inputs. Prices can change, however, and what appears to be a profitable activity
today may not be profitable tomorrow. Many instruments are available which permit firms to
hedge various risks, ranging from commodity prices to weather. A firm which actively uses
derivatives and other techniques to alter its risk and protect its profitability is engaging in risk
management.

Derivatives and its various types are now traded on exchanges throughout the world. In
addition, huge volumes in all types of underlying assets are being traded in the over-the-counter
market. A growing understanding and acceptance among potential users suggests that growth
will be sustained for the foreseeable future.

Derivatives in finance work on the same principle. They are financial instruments whose
promised payoffs are derived from the value of something else, generally called the underlying.
The underlying is often a financial asset, but it does not have to be.

Derivatives are not only useful to manage risks that corporations have already taken. They
enable firms to change what they do, to think of new profitable strategies. As derivatives are
risk-shifting devices, it is important to identify and fully comprehend the risks being assumed,
evaluate those risks and continuously monitor and manage those risks. Each party to a derivative
contract should be able to identify all the risks that are being assumed (interest rate, currency
exchange, stock index, long or short-term bond rates, etc.) before entering into a derivative
contract.

Part of the risk identification process is a determination of the monetary exposure of the parties
under the terms of the derivative instrument. As money usually is not due until the specified
date of performance of the parties' obligations, the lack of an up-front commitment of cash may
obscure the eventual monetary significance of the parties' obligations.

While investors and markets traditionally have looked to commercial rating services for an
evaluation of the credit and investment risk of issuers of debt securities lately, some commercial
firms have begun issuing ratings on a company's securities which reflect an evaluation of that
company's exposure to derivative financial instruments to which it is a party. For instance, the
degree of risk which one party was willing to assume initially could change greatly due to
intervening and unexpected events.

Each party to the derivative contract should monitor continuously the commitments represented
by the derivative product. If an individual is charged with this responsibility, this person should
be held accountable for placing the party on notice when conditions change dramatically.
Financial derivative instruments that have leveraging features demand closer, even daily or
hourly monitoring and management. The creditworthiness of each party to a derivative
instrument must be evaluated independently by each counter party. In a derivative situation,
performance of the other party's obligations is highly dependent on the strength of its balance

3
sheet. Therefore, a complete financial investigation of a proposed counter party to a derivative
instrument is imperative.

Options, futures, and swaps are examples of derivatives. A derivative is simply a financial
instrument (or even more simply, an agreement between two people) which has a value
determined by the price of something else. This project enables us to understand various types
of derivative instruments like forwards; futures; options; swaps and forward rate arrangements
(FRAs). It also helps us to understand and gives a brief insight in few of the strategies used in
options. For example, if a corporate has issued long term debt with an interest rate of 7 % and
current interest rates are 5 %, the corporate treasurer may choose to exchange (i.e., Swap),
interest rate payments on the long term debt for a floating interest rate, without disturbing the
underlying principal amount of the debt itself.

In short, the following are the benefits of derivative instruments

Derivatives unbundled the risk and pass the risk from parties not willing to take the risk
to parties more willing to take it.
Help to lock in price for future transaction.
Instruments for hedging risk.
Price discovery.
Derivatives market helps to increase the savings and investments in the long run.

4
INTRODUCTION TO DERIVATIVES

A Derivative is an instrument whose value is derived from the value of one or more underlying.
The underlying may be:
Precious metals
Foreign exchange rate
Bonds
Loans
Stocks
Stock indices etc.
Financial derivatives have crept into the nations popular economic vocabulary on a wave of
recent publicity about serious financial losses suffered by municipal governments, well-known
corporations, banks and mutual funds that have invested in these products.

Derivatives however remain a type of financial instrument that few understand and fewer still
fully appreciate. The value of these instruments changes in response to the change in specified
interest rates, security prices, commodity prices or rates, or similar variables.
Financial derivatives have changed the face of finance by creating new ways to understand,
measure, and manage risks. Financial derivatives should be considered part of any firm's risk-
management strategy to ensure that value-enhancing investment opportunities are pursued. The
freedom to manage risk effectively must not be taken away.

5
NEED FOR DERIVATIVES

Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in
foreign exchange rates, interest rates, or stock indexes. For example, if an American company
expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative
contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will
be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the
other party is obligated to pay the company the amount due at the exchange rate in effect when
the derivative contract was executed. By using a derivative product, the company has shifted
the risk of exchange rate movement to another party.

More recently, derivatives have been used to segregate categories of investment risk that may
appeal to different investment strategies used by mutual fund managers, corporate treasurers or
pension fund administrators. These investment managers may decide that it is more beneficial
to assume a specific "risk" characteristic of a security.

The financial markets increasingly have become subject to greater "swings" in interest rate
movements than in past decades. As a result, financial derivatives have appealed to corporate
treasurers who wish to take advantage of favourable interest rates in the management of
corporate debt without the expense of issuing new debt securities.

For example, if a corporate has issued long term debt with an interest rate of 7 % and current
interest rates are 5 %, the corporate treasurer may choose to exchange (i.e., Swap), interest rate
payments on the long term debt for a floating interest rate, without disturbing the underlying
principal amount of the debt itself.

6
In short, the following are the benefits of derivative instruments
Derivatives unbundled the risk and pass the risk from parties not willing to take the risk
to parties more willing to take it.
Help to lock in price for future transaction.
Instruments for hedging risk.
Price discovery.
Derivatives market helps to increase the savings and investments in the long run.

7
PARTICIPANTS IN DERIVATIVE MARKETS

HEDGERS
Hedgers wish to eliminate or reduce the price risk to which they are already exposed.
Hedgers and investors provide the economic substance to any financial market. Without
them the markets would lose their purpose and become mere tools of gambling.

SPECULATORS
Speculators willingly take the price risks to profit from price changes. They provide
liquidity and depth to the markets.

ARBITRAGEURS
Arbitrageurs profit from price differential existing in two markets by simultaneously
operating in two different markets. They bring price uniformity and help price discovery.

8
RISKS IN DERIVATIVE CONTRACTS

As derivatives are risk-shifting devices, it is important to identify and fully comprehend the
risks being assumed, evaluate those risks and continuously monitor and manage those risks.
Each party to a derivative contract should be able to identify all the risks that are being assumed
(interest rate, currency exchange, stock index, long or short-term bond rates, etc.) before
entering into a derivative contract.

Part of the risk identification process is a determination of the monetary exposure of the parties
under the terms of the derivative instrument. As money usually is not due until the specified
date of performance of the parties' obligations, the lack of an up-front commitment of cash may
obscure the eventual monetary significance of the parties' obligations.

While investors and markets traditionally have looked to commercial rating services for an
evaluation of the credit and investment risk of issuers of debt securities lately, some commercial
firms have begun issuing ratings on a company's securities which reflect an evaluation of that
company's exposure to derivative financial instruments to which it is a party. , The
creditworthiness of each party to a derivative instrument must be evaluated independently by
each counter party. In a derivative situation, performance of the other party's obligations is
highly dependent on the strength of its balance sheet. Therefore, a complete financial
investigation of a proposed counter party to a derivative instrument is imperative.

An often overlooked, but very important aspect in the use of derivatives is the need for constant
monitoring and managing of the risks represented by the derivative instruments. Unlike the
purchase of an equity or debt security, one cannot enter into a derivative transaction, place the
paperwork in a drawer and forget it. The relationships established in the derivative instrument
require constant monitoring for signs of unacceptable change.

For instance, the degree of risk which one party was willing to assume initially could change
greatly due to intervening and unexpected events. Each party to the derivative contract should
monitor continuously the commitments represented by the derivative product. If an individual
is charged with this responsibility, this person should be held accountable for placing the party
on notice when conditions change dramatically. Financial derivative instruments that have
leveraging features demand closer, even daily or hourly monitoring and management.

9
TYPES OF DERIVATIVE CONTRACTS

FORWARDS
FUTURES
OPTIONS
SWAPS
FORWARD RATE AGREEMENTS

10
FORWARDS

A forward contract is an agreement to buy or sell a specified quantity of an asset at a specified

price, with delivery at a specified time and place.

Features of a forward contract

Tailor-made contracts:
Forward contracts are entered into on one-to-one basis, they are not exchange traded.

Bilateral contracts:

(i) Terms decided upfront: The terms and conditions are decided upfront on a one-
to-one basis.

(ii) Counter party risk: since forward contracts are not exchange traded there exists a
counter party risk of the opposite party not performing its obligations.

(iii) Each contract is unique: every forward contract is an independent contract in regards
its underlying, valuations terms and conditions, expiry date etc.
Settlement by delivery
At maturity a forward contract is settled by delivering the item specified in the contract,
such as a commodity a foreign currency or a financial instrument. Contract provisions may
also permit a net cash settlement.

Reversal is by mutual consent

In case if a counter party wishes to reverse the contract he can do so only by the consent of
the opposite party and a mutual agreement between the two as regards the reversal.

11
Purchasing or entering a forward contract

Forward contract may be entered into through an agreement without a cash payment provided
the forward rate is equal to the current
At-the-money forward market rate. They do not have cash flows during the contract term.

Pricing a forward contract

Calculating the forward price is the same as asking the question--- How much I should pay
to buy something in future.

A forward transaction can be replicated by purchasing the asset today and borrowing the
money to finance it.

The fair forward price indicates the price at which buyers and sellers are indifferent to
buying and selling the underlying asset today or in the future, based on the current market
cash price, cost of financing the asset and the expected return on the asset

The FAIR forward price is given by the cash price plus the net cost of financing the asset
over the term of the forward contract.

The interest cost tends to increase the forward price versus the cash price.

Any cash return on the asset over the term of the forward contract tends to decrease the
forward price versus the cash price.

12
FUTURES

A futures contract is an exchange-traded contract to buy or sell a predetermined quantity and

quality of an asset on a predetermined future date at a predetermined price.

An investor who buys the futures contract is termed to be at the

LONG POSITION

An investor who sells the futures contract is termed to be at the SHORT POSITION

Features of a futures contract

Exchange traded contracts

Futures contracts are traded on exchanges and hence have less credit risks than forward
contracts.

Standardized contract terms

The terms, quantity and quality of the contract are standardized through exchanges.

Unilateral reversal possible

Unlike forward contracts, unilateral reversal of the contract is possible without the consent
of opposite party.

Margin Accounts
The default in case of futures contract is controlled by margin accounts and the process is
known as MARK TO MARKET. It provides both parties with a daily accounting of their
financial obligations under the terms of Futures Contract.
Marking to market essentially mean that at the end of a trading session all outstanding
contracts are re-priced at the settlement price of that session. Margin accounts of those who
made losses are debited and of those who gained are credited.

13
 Settlement in cash or cash equivalents
There are two ways to close a futures position:

(i) Completion through delivery of the underlying.

(ii) Completion through and offset or via a reversing trade, which by far is the most
prevalent practice.

The settlement is not essentially through the delivery of the underlying but can also be
through cash or its equivalents.

14
A Typical Order Flow in Futures Contract

Clearing
Mark to Market Corporation Mark to Market

Confirmation

Trading System
Confirmation
Gains credited to Order Margins
Loss Debited to
Investors A/c
Investors Account
BROKER

Confirmation

Margins
Investor Withdraws Order Investor Deposits
Additional Margin Additional Margin
Investor
Marked to market Marked To Market

15
 FORWARDS v/s FUTURES

CRITERION FUTURES FORWARDS

Buyer-seller interaction Via exchange Direct

Contract terms Standardized Can be tailored

Unilateral reversal Possible Not possible

Default risk borne by Exchange Individual parties

Default controlled by Margin accounts Collateral

16
OPTIONS

An option is a contract, which gives the holder, the right but not the obligation to buy or sell,
an agreed amount of financial instrument on or before an agreed future date, at an agreed price.

CALL OPTIONS:
Call options provide the holder with the right to acquire an underlying at an exercise or strike
price. The holder pays a premium for the right to benefit from the appreciation in the underlying.

PUT OPTIONS:
Put options provide the holder with the right to sell the underlying at an exercise price or strike
price throughout the option term. The holder gains as the market price of the underlying falls
below the strike price.

OPTION PREMIUM
Option premium is the price that the buyer of the option, whether call or put pays to the writer
of the option for the rights conveyed by the option.

17
OPTIONS TYPES
AMERICAN OPTIONthe option can be exercised any time on or before the expiry date.

EUROPEAN OPTION the option can be exercised only on the expiry date.

Because an American option gives its owner all the rights and privileges of an European option
plus the additional right to exercise any time before expiration, the former would be worth at
least as much as the latter before the expiration date is reached and in some cases it is worth
more.

OPTIONS PAY-OFF

OTM: Out-of-the-Money options are those where the strike price is worse than the market
price. It is not profitable for the option holder to exercise the right.

ITM: In-the-Money options are those where the strike price is better than the market price. It
is profitable for the option holder to exercise the right.

ATM: At-the-Money options are those where strike price and market price are the same.

18
BASIC OPTION TRANSACTIONS
Buy a call (acquire the right to buy an underlying asset)
Sell a call (sell the right to buy an underlying asset)
Buy a put (acquire the right to sell an underlying asset)
Sell a put (sell the right to sell an underlying asset)

PAYOFF DIAGRAM-PROFIT / LOSS PROFILE

A payoff diagram is a graph that depicts the profit and loss profile for one party to an option
contract over a range of prices or rates on the underlying.
In Figures through, assume that the underlying asset is a bond, and that the bonds price will
vary with changes in market interest rates, specifically a change in the interest rate over the
tenor of the bond.

We will use the following notation in our analysis:

P / L = Profit or loss (vertical axis)
B = Bond price (horizontal axis)
X = Exercise price
Pm = Premium

VALUE AT EXPIRATION
To illustrate the four transaction types, we will consider the value at expiration of a European-
style option on the bond.

BUYING A CALL DECISION TO EXERCISE OR WALK AWAY

In our example, buying a European call is buying the right to buy the bond on the options
maturity date. The price of the underlying determines whether the holder exercises the option
or walks away from it. If, at expiration, the bond price is less than the exercise price, the option
is worthless (because it is possible to buy the bond in the market for less than the exercise price).
Therefore, the option will not be exercised.
If the bond price is greater than the exercise price at expiration, the value of the option is equal
to the difference between the bond price and the exercise price (intrinsic value). The call holder
will exercise the option, buying the bond for price X and selling it in the market for price B,
generating a profit of B-X.

19
P/L

B
X

20
EFFECT OF PREMIUM ON PAYOFF PROFILE
Notice that, in this case, the payoff line crosses the horizontal (bond price) line at X + Pm
(exercise price plus call premium). This is
The call holders break-even point. Note that the holder will exercise the option whenever the
bond price is greater than the exercise price even when the price is less than the break-even
because the loss will be less than if the option is not exercised.

P/L

Pm {
X
_
X+Pm

SELLING A CALL
The payoff for selling a call is the opposite of buying a call. The writer collects the premium,
Pm. If the price of the bond moves beyond the exercise price, the call holder will exercise the
option; so the writers payoff line turns downward at a 45o angle and crosses the bond price
line at X + Pm (exercise plus call premium). The crossing point is the call writers break-even
point. If the bond price moves beyond this point, the writer incurs a loss. This short call position
(position of the writer who has sold the call) is shown in Figure

21
 P/L

Pm { B

X
_
X+Pm

Buying a Put
Buying a put is buying the right to sell. The payoff for buying a put is the reverse of buying a
call. Notice that in Figure below, the payoff line crosses the bond price axis at X - Pm (exercise
price minus the put premium) and continues downward until it breaks into a horizontal line at
the exercise price (X). This tells us that the put holder profits if the bonds value goes below
the break-even point.

P/L

Pm {
_

22
Selling a Put
What will the payoff diagram look like if the writer sells the right to sell the bond? the payoff
for selling a put is the reverse of buying a put. The payoff line crosses the bond price axis at X
- Pm (exercise price minus the put premium) and continues upward until it breaks into a
horizontal line at the exercise price (X). Here, we see that the put writer profits if the bonds
value goes above the break-even point.

P/L
X-Pm
+

Pm {
_

23
OPTION PAYOFFS
Option combinations are useful as both hedging instruments and trading instruments. In this
section, we discuss the impact of combining a bond position with an option and combining an
option with another option. Understanding the effects of option combinations will help
understand the flexibility of the option product.

Diagram notation
Again, we will use payoff diagrams to illustrate net positions. In our diagrams, we indicate a
long position with a plus (+) sign and a short position with a minus (-) sign. The notations for
the four basic option transactions and the two possible underlying positions are as follows:

Buy a call = +C
Sell a call = C
Buy a put = +P
Sell a put = P
Long the bond = +B
Short the bond = B

Equivalent payoff profiles

Now, lets consider the payoff profiles for option combinations. It is possible to generate payoff
profiles that are identical to the basic payoff position shown using the combination of an
underlying position and an option, or the underlying position with more than one option
position.
An example will help illustrate this point.
An investor with a long bond position (+B) wishes to protect his / her investment against rising
interest rates by buying a put (+P) on the bond at the par (face value) price. The price of the put

24
is 2.00% of the notional value of the bond. What is the net effect of being long the bond and
long a put at the par price of 100?
To answer this question, we first calculate the payoffs for the
(1) Long bond position,
(2) Long put position, and
(3) Combination position, at
Different bond prices at maturity.

The payoffs are shown in Figure

POSITION LONG BOND LONG PUT COMBINATION

PAYOFF PAYOFF PAYOFF
+B +P +B & +P
PRICE/STRIKE 100 100
PREMIUM -2
94 -6 +4 -2
96 -4 +2 -2
98 -2 0 -2
100 0 +2 -2
102 +2 +2 0
104 +4 +2 +2
106 +6 +2 +4

25
+6 B

+4

+2 LONG BOND

0
96 98 100 102 104 106
-2

-4

-6

+6

+4
LONG PUT
+2

0
96 98 100 102 104 106
-2

-4

-6

26
 +6

+4

+2 COM

0
96 98 100 102 104 106
-2

-4

-6
Other combinations
We can apply the same approach to other combinations to determine payoff equivalents. In the
following examples (which exclude the table of payoff)

Short Put (+B and -C = -P)

An investor who is long a bond and sells a call against it is engaging in covered call writing to
enhance yield. The net result is equivalent to being short a put, as shown in Figure

+6 +B

+4

+2 -p

0
96 98 100 102 104 106
-2

-4 -C

-6

Long Put (-B and +C = +P)

A trader who is short a bond buys a call as a hedge in case the bond goes up in value (with a
decrease in interest rates). The net result is equivalent to being long a put

27
 +6

+4

+2

0
96 98 100 102 104 106
-2

-4

-6

Short Call (-B and -P = -C)

An investor has a short bond position, which means the investor has given up the yield. Selling
a put on top of this position is a way of generating a return. The result is equivalent to a short
call.

+6

+4

+2

0
96 98 100 102 104 106
-2

-4

-6

Synthetic long bond position (+C and -P = +B)

An investor may create a synthetic long bond position by buying a call and selling a put . The
reason that the investor may do this instead of buying the bond is leverage; that is, the synthetic
position may require a much smaller investment than buying the bond. Note that this applies
only to investors who are required to put up either a substantial margin or the entire amount
rather than borrowing to finance the bond, as in the case of large institutional investors. All

28
other factors being equal, there should be no financial advantage to creating the payoff profile
in one-way or another.
Otherwise, arbitrage would take place!

+6

+4

+2

0
96 98 100 102 104 106
-2

-4

-6

Synthetic short bond position (+P and -C = -B)

An investor creates a synthetic short position by buying a put and simultaneously selling a call
(Figure 3.8). The motivation may be leverage, arbitrage, or lack of access to a REPO market

29
 +6

+4

+2

0
96 98 100 102 104 106
-2

-4

-6

Advantages of an option to the Buyer & Seller

The purchaser of an option pays a premium to the writer to receive the right to profit if the price
of the underlying item moves in a certain direction while limiting the potential loss to the
amount of premium paid for the option. The writer of an option takes a risk that potentially may
result in a profit that is limited to the premium received.

The writers loss potential can be substantial (and is unlimited with a call option) because the
writer is obligated to settle at the exercise price if and when the option is exercised.

Principal difference between an OPTION CONTRACT and either a FUTURES or

FORWARD CONTRACT

The primary difference is that the purchaser will exercise the option only if exercise would be
favorable. However performance is mandatory under a futures or forward contract. Therefore,
options have asymmetric or one-sided return profiles.

30
SWAPS

Swaps are private agreements between two parties to exchange cash flows in the future,
according to a predetermined formula.

Swaps are of different types:

Interest rate swaps

Currency swaps
Vanilla
Cross-currency
Commodity swaps
Equity swaps
Basis swaps

Characteristics of swap market

Swap is contracts of exchanging the cash flows and is tailored to the needs of the counter
parties. Swaps can meet specific needs of the customers.

Exchange trading necessarily involves loss of some privacy, by contrast, in the swap market
the privacy exists and only the counter parties know the transaction.

Counter parties can select amounts, currencies, maturity dates, etc.

Future, Stock or Option exchanges are subject to considerable regulations. Till today, swap
market does not face much of the regulations.

31
Limitations of swap market

Each party must find a counter party, which wishes to take opposite position.

Since swap is an agreement between two parties, therefore it cannot be terminated at ones
instance. The termination also requires to be accepted by counter parties.

Future and option exchange is guarantors to the transactions, where as there is no such
guarantee with the swap.

Since swaps are bilateral agreements, therefore the problem of potential default exists.

32
INTEREST RATE SWAPS

An interest rate swap is a contractual agreement entered into between two counter parties under
which each agrees to make periodic payment to the other for an agreed period of time based
upon a notional amount of principal.

The principal amount is purely notional. There is no physical exchange of principal amounts.
It only facilitates interest calculations.

Features of Interest Rate Swaps

Participants
Banks, Financial Institutions and Primary Dealers.

Types of IRS
Plain vanilla, floating to floating

Benchmark rates
The benchmark rates should necessarily evolve on its own in the market and require market
acceptance. The parties are therefore, free to use any domestic money or debt market rate
as bench mark rate for entering into IRS, provided methodology of computing the rate is
objective, transparent and mutually acceptable to counter parties.

Size
There will be no restriction on the minimum or maximum size of notional principal
amounts of IRS.

33
Purpose of IRS

Reduce funding costs

Liability management

Speculative Position

Hedging Interest Rate exposure

Asset Management

Advantages of IRS

A Floating to Fixed swap increases the certainty of an issuers future obligations.

Swapping from fixed to floating rate may save the issuers money if interest rates decline.

Swapping allows issuers to revise their debt profile to take advantage of current or expected
future market conditions.

IRS is a financial tool that potentially can help issuers lower the amount of debt service.

34
ILLUSTRATION:

Consider this example of a plain vanilla interest rate swap.

Bank A is an AAA-rated international bank located in the U.K. who wishes to raise
$10,000,000 to finance floating-rate Eurodollar loans.

Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent.

It would make more sense for the bank to issue floating-rate notes at LIBOR to finance
floating-rate Eurodollar loans.

Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with

a five-year economic life.

Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent.

Firm B would prefer to borrow at a fixed rate.

The borrowing opportunities of the two firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed Rate 11.75% 10% 1.75%

Floating Rate LIBOR+0.5% LIBOR 0.5%

QSD= 1.25%

Clearly the cost of funds for Company B is higher than that for Bank A whether fixed or floating
rate is considered. However, in the fixed rate case Bs extra cost is 1.75% while in the floating
rate the extra cost is 0.5%.

35
A Swap bank comes and arranges for a swap.
The SWAP BANK makes this offer to Bank A:

SWAP
BANK
10 3/8 %

LIBOR-1/8 %

BANK
10% A

You pay LIBOR 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on
$10 million for 5 years

Bank A can borrow externally at 10% fixed and have a net borrowing position of
-10 3/8 + 10 + (LIBOR 1/8) =LIBOR %
Which is % better than they can borrow floating without a swap.

% of $10,000,000 =$50,000 cost savings per year for 5 yrs

36
The SWAP BANK makes this offer to Company B:

SWAP
BANK

10-%

LIBOR-1/4%

Company LIBOR +
B %

You pay us 10 % per year on $10 million for 5 years and we will pay you LIBOR % per
year on $10 million for 5 years.

Company B can borrow externally at LIBOR + % and have a net borrowing position of
10 + (LIBOR + ) - (LIBOR - ) = 11.25%
Which is % better than they can borrow floating without a swap

% of $10,000,000 =$50,000 cost savings per year for 5 yrs

A actually borrows 10 million pounds from a bank at LIBOR+0.5% and B borrows 10 million
pounds from a bank at 9%. As a separate transaction A, B, C agree as follows:

Bank A will pay the Swap Bank a floating rate of LIBOR1/8 %

Bank A will receive from Swap Bank a fixed rate of 10 3/8%

Company B will pay Swap Bank C a fixed rate of 10 %

Company B will receive from Swap Bank floating rate of 10 %

37
 The SWAP BANK makes money too ---

The cash flows for the Swap Bank are:

SWAP
BANK
10 3/8 %
10-%

LIBOR-1/8 % LIBOR-1/4%

10% BANK
A Company LIBOR +
B
%

Bank saves %

A saves % B saves %

LIBOR 1/8 + 10 [LIBOR ] - 10 3/8 = %

% of $10 million= $25,000 per year for 5 years

38
OVERNIGHT INDEX SWAP

A specific type of IRS, which has become quite popular in the Indian markets, is the
OVERNIGHT INDEX SWAP

An OIS entails the exchange of a fixed interest rate with a designated overnight floating
index interest rate.

Commonly used over-night index

NSE MIBID or MIBOR

Reuters MIBOR

3 months Reuters

CP Reference Rate

Overnight Rate is calculated on a daily compounding basis

39
CURRENCY SWAPS

A Currency swap is a contract in which two counter-parties exchange specific amounts of two
different currencies at the outset, exchange interest payments in the two currencies over the
term of the swap, and re-exchange principal at maturity.

The rationale for a currency swap is that one of the parties has a comparative advantage in
borrowing in one currency, another has an advantage in the other.

CURRENCY v/s INTEREST RATE SWAPS

Currency swaps exchange of payment in two currencies

Interest rate swaps no exchange of payment in two currencies

Currency swaps -- exchange of both interest and principal amounts

Interest rate swaps exchange only of interest rates

40
ILLUSTRATION:

Suppose a U.S. MNC wants to finance a 10million expansion of a British plant.

They could borrow dollars in the U.S. where they are well known and exchange dollars for
pounds.

This will give them exchange rate risk

They could borrow pounds in the international bond market, but pay a lot since they are not
as well-known abroad.

HOWEVER---

If they can find a British MNC with a mirror image financing need they may both benefit
from a swap.

If the exchange rate is S0($/) = $1.60/, the U.S. firm needs to find a British firm wanting
to finance dollar borrowing in the amount of $16,000,000.

Consider two firms A and B: firm A is a U.S.based multinational and firm B is a U.K.
based multinational.

Both firms wish to finance a project in each others country of the same size.

41
 Their borrowing opportunities are given in the table below.

COMPANY A 8% 11.6%

COMPANY B 10% 12%

SWAP
BANK

$8% $9.4%

12%
11%
$8% Company Company 12%
A
B

As net position is to borrow at 11% Bs net position is to borrow at $9.4%

A saves 0.6% B saves $ 0.6%

The SWAP BANK makes money too

1.4% of $16 million financed with 1% of 10 million per year for 5years
At Sn ($/) = $1.60/ that is a gain of $124,000 per year for 5 years.

Benefits from the swap:

First, the two companies get currency of its own choices. Secondly, the cost of borrowing gets
reduced which brings in gains to Company A as well as to Company B.

42
Cost to Company A

Cost of in absence of Swap 11.6%

Cost of after Swap 11.0%

As net position is to borrow at 11%

Thus Company A saves 0.6% by undergoing the swap.

Cost to Company B

Cost of $ without swap 10%

Cost of $ after Swap 9.4%

Bs net position is to borrow at $9.4%

Thus Company B saves 0.6% by undergoing the swap.

43
BASIS SWAP

A contractual agreement to exchange a series of cash flows over a period of time where each
swap leg is referenced to a floating rate index.

A Basis Swap is most commonly used when:

Liabilities are tied to one floating index and financial assets are tied to another floating
index. This mis-matched can be matched via a basis swap.

3m-LIBOR to 6m-LIBOR swap or

6m-MIBOR to Prime lending rate

BASIS SWAPS

6m-MIBOR

FI CORPORATE

PLR

44
FORWARD RATE AGREEMENTS

An agreement between two parties, developed to protect them against a future adverse
movement in interest rates. Counter parties agree an interest rate to be applied to a notional
deposit of an agreed principal amount for a specified period of time from a specified future date

There is no physical principal amount involved.

By transacting the FRA, one effectively fixes the interest rate for the period in question.

The only sums that change hands are those that compensate for the movement in an interest
rate.

CONVENTION OF FRA
3 x 6 month FRA, at 9.35% against 91-day-T Bill rate on a notional principal of RS.25 crores
3 x 6 implies specified period: start date & maturity dates
Fixed rate payer pays 9.35% for 3 months from start date to the maturity date.
Floating rate payer pays 91-day-T Bill rate which would be determined on the start date of
the swap
The net amount would be settled on the start date

Trade date Start date Maturity date

Specified period
t=0 t + 3m t + 6m

45
MECHANICS OF FRA:

On the trade date, buyer and seller agree to exchange cash, on a specified future date, called
the settlement date.

The basis for their exchange will be the prevailing interest rate on the settlement date, the
reference rate that will be used will be agreed upon today.

What is being traded today is the future interest rate, hence the name FRA.

The buyer of the FRA expects interest rates to go up; the seller expects the rate to fall.

On the settlement date, if the actual rate is higher than the agreed rate, seller pays the buyer.

On the settlement date, if the actual rate is lower, buyer pays the seller.
ILLUSTRATION:

A bank wishes to protect itself against an upward move in interest rates for a future period.

It buys $ 5 million of a 6 x 12 FRA, i.e., covering a six-month period, starting in six months
time, at 9.78%

The following will show how the bank has succeeded in locking itself into an effective
borrowing rate of 9.78%

46
Under the following conditions--
Whether interest rates

RISE to 11%
FALL to 9%
RISE to 11%-- will receive from counter party

Amount to be settled on the settlement day of the FRA---

5,000,000 x 183 x (11-9.78) = 30,583.56

365 100

Amount is due after 3 months

Hence it is discounted to the Present Value

Receive from FRA settlement = 30583.56

[1 + (0.11 x 183/365)]

= 28,985.02

This amount invested at 11% = 1,598.54

for 183 days earns

The effective cost of borrowing for the bank will be

Borrowed $5million in market at 11%costs = 275,753.42

Less: Amount received on FRA settlement = 28,985.02

Amount received on investment = 1,598.54

NET COST = 245,169.86

47
48
 Fall to 9%--Will pay to counter party

Amount to be settled on the settlement day of the FRA---

5,000,000 x 183 x (9.78-9) = 19,553.42

365 100

Amount to be paid after 3 months

hence it is Discounted to the Present Value

Pay under FRA settlement = 19,553.42

[1 + (0.09 x 183/365)]

= 18,709.20

Fund at 9% for 183 days cost = 844.22

The effective cost of borrowing for the bank will be

Borrowed $5million in market at 9% costs = 275,753.42

Add: Amount paid on FRA settlement = 28,985.02

Amount paid for funding = 1,598.54

NET COST = 245,169.86

49
Primary
Analysis

50
SCOPE
Since a considerable time has passed (since year 2000) after the introduction of the derivative
Instruments in Indian financial system, this study attempts to gauge the effectiveness of the
regulatory
Structure of the Indian derivative markets and scope for overhauling.

Objectives
1. This research attempts to analyse the positive features as well as the negative features of the
derivatives market.
2. It also attempts to find ways and means of enhancing the effectiveness of derivative
markets.

Analysis of Questionnaire for Regulators:

51
1. On query of whether the institutions monitor derivative trading, the institutions
replied:

SEBI: The SEBI has separate surveillance department Market Intermediaries

Regulation and Supervision Department comprising of around 30 to 40 personnel,
which monitors derivatives trading.

MCX: MCX monitors derivatives trading in Commodity Futures.

NSE: NSE monitors derivative trading.

2. On query on the list of instruments allowed to trade in derivatives market,

SEBI responded:

SEBI: Stock option, stock future, index option, index future, currency future,
currency options and interest rates futures.

NSE: It has products like S&P CNX Nifty, Mini Derivative Contracts, CNXIT, Bank
Nifty, Nifty Midcap 50 and Individual securities.

3. How many audits do you perform in a year?

SEBI: All exchanges are inspected on a yearly basis.

MCX: MCX perform annual audits.

4. Do you train market participants in derivatives trading?

SEBI: No, training for the market participants in derivatives trading is carried out by
exchanges. However SEBI conducts periodic investors awareness programs and
programs for common people periodically.

52
 MCX: Yes
NSE: Yes

5. How do you train derivative traders?

MCX: They are engaged in training market participants in derivative trading through
classroom training and literature/ pamphlet distribution.

NSE: NSE trains market participants and has large number of modules to offer. They
have classroom training methodology along with online examination system, which
is an ongoing activity.

6. How frequently?

MCX: The periodicity of the training is monthly.

NSE: Its an ongoing activity.

7. How do you enforce regulation compliance?

SEBI: Market Intermediaries Regulation and Supervision Department enforces

compliance to regulations.

MCX: MCX enforce regulation compliance through periodic audits and collection
of compliance reports.

8. How many times do you carry out periodic

audits? MCX: MCX conduct the audit annually.

9. How many times in a year does a trader have to present a compliance report?

MCX: A trader at MCX has to submit a compliance report on an annual basis.

NSE: As an example the following Compliance Calendar has to be followed by

the members of the derivative segment.

53
10. How many surprise checks do you carry out in a year?

MCX: MCX do not conduct any surprise

checks/audits.

11. How many periodic meeting do you conduct with the traders and institutional
investors in a year?

SEBI: Meetings with the traders and institution investors are conducted whenever its
required and when they approach with issues which require SEBI intervention.

MCX: MCX meet traders and institutional investors once in a year.

12. What does the compliance report consist of?

SEBI: The compliance report mentions the volume of trading activity date and the
current positions.

MCX: The compliance report submitted by the trader includes compliance to

instructions and bye-laws as well as compliance to FMC circulars.

13. Does a trader have to be qualified for derivatives trading?

SEBI: A derivatives trader has to be qualified as per the exchanges compliance

exams. For example NCFM exams being conducted by National Stock Exchange.

54
 MCX: At MCX a trader need not be qualified for derivatives trading by may lose
permission to trade if his/her compliance is found not satisfactory.

14. How do you ensure compliance?

SEBI: Inputs are sort by different stake holders by way of suggestion, reviews. The
same if required to incorporated as regulation gets reviewed by the departmental
head, General Manager, Executive Director, Whole Time Member and then
Chairman. Once formulated the regulation is sent as a circular via letters and through
website information dissemination system.

15. How do you incorporate new regulations?

SEBI: Information is disseminated through the organizational official website. A

section disseminates all circulars which are to be made public

MCX: MCX incorporates new regulations through changes in the Bye-laws of the
exchange.

16. How do you ensure compliance on information dissemination?

MCX: Information dissemination is a voluntary activity by traders and is not

compelled.

17. How do you make investors aware of the risk involved in derivatives trading?

SEBI: Investors are provided with adequate literature on trading in various

instruments on the Stock Exchanges through pamphlets distribution, List of dos and
donts like signing on blank forms and applications and handing them to brokers
giving power of attorney to brokers etc.

MCX: MCX undertakes investor education and the KYC (Know Your Customer)
norms facilitate investors to understand the risk of investment and trading.

NSE: Professional Clearing Member (PCM)

55
 The following persons are eligible to become PCMs of NSCCL for Futures &
Options and/or Capital Market Segment provided they fulfil the prescribed criteria:

SEBI Registered Custodians; or

Banks recognised by NSEIL/NSCCL for issuance of bank guarantees

Other Eligibility Criteria

At any point of time the applicant has to ensure that either the proprietor/one
designated director/partner or the Compliance Officer of the applicant entity should
be successfully certified either in Securities Market (Basic) Module or Compliance
Officers (Brokers) Module or the relevant module pertaining to the segments wherein
membership of the Exchange has been sought .i.e.

Capital Market (Dealers) Module

Derivatives Market (Dealers) Module
National Institute of Derivatives Certification Examination
Securities Markets (NISM) Series I Currency

The above norm is a continued admittance norm for membership of the Exchange.

An applicant must be in a position to pay the membership and other fees, deposits
etc, as applicable at the time of admission within three months of intimation to him
of admission as a Trading Member or as per the time schedule specified by the
Exchange.

The Exchange may specify such standards for investor service and infrastructure
with regard to any category of applicants as it may deem necessary, from time to
time.

18. How many companies approach SEBI for derivative trading?

SEBI: Companies approach exchanges for derivatives trading. All though final
approval is given by SEBI. Currently 202 companies are registered on NSE and 102
on BSE for trading in stock future and options.

56
57
How many listed companies (%) of the applied meet SEBI criteria in participating in derivatives
trading?

19. Do you collaborate with SEC?

SEBI: The SEBI collaborates with SEC and other international exchanges and other
security commissions through an association of regulators called as International
Organization of Securities Commissions (IOSCO).

MCX: The exchange does not collaborate with SEC or CFTC, but do track their
developments.

20. How much international exposure do you allow in derivatives trading?

SEBI: SEBI does not control international exposure of any trader in the international
markets. The same gets covered under FERA and FEMA which are governed by RBI.
There is no programmed interaction with RBI on these issues.

MCX: There is no exposure allowed in the derivative trades in the international

markets.

21. How is the red alert signaled?

MCX: The exchange ensures trading in stopped when a trader/investors approach

his/her position limit or prices start becoming volatile.

22. How do you monitor mark to market investors positions?

MCX: Positions of all traders are marked to market on a daily basis and accounts are
credited / debited accordingly.

23. How does SEBI monitor day to day trading pattern?

SEBI: Day to day trading patterns is monitored by the respective exchanges. SEBI
gets the report on the next day. There is a days lag in the same

58
 MCX: The Forwards Market Commission (FMC) has the power to monitor daily
trading patterns and take preventive / penal action if unusual volatility is noted in the
prices.

25. How do you penalize non- compliance?

SEBI: If after analysis SEBI finds and non compliance and unusual pattern in
trading, it ceases the demat accounts and terminals of the default traders also results
into blocking of trading and barring the person on entering the market. Along with
imposing monitory penalties if required.

MCX: Any non-compliance by the traders is penalized by issuing warnings or

cancelling the licenses to trade.

26. Do you think a separate exchange for derivative trading should be established?

SEBI: As far as the functioning of exchanges are proving to be satisfactory, a need

to open a separate exchange may not be desired.

MCX: MCX is not of the opinion to establish a separate derivative exchange.

27. If yes, why do you think so?

SEBI: The desire to open new derivative exchange would not arise if the functioning
between the cash market and derivatives market are realistic and efforts being
coordinated for creation of an efficient market system.

28. How frequently do you introduce new products in the Derivatives Market?

SEBI: Whenever there is a mandate to introduce a new derivative product SEBI

considers it and introduces it after due diligence. SEBI follows the conservative
approach regarding introducing new products.

59
 MCX: There is no fixed pattern of introduction of new products in the derivatives
market. It depends on the market demand.

29. Do you think Indian Financial System is matured enough to adapt to exotic products
in Derivatives?

SEBI: The Indian financial system is not matured enough to absorb exotic and
advance products in derivatives. The investors are not aware of the usage and
advantages of trading in these products. For example An interest rate future product
was introduced last year but finds no takers, there is no liquidity in the market and
the market is unable to understand its complexities. Derivatives trading in stocks are
not allowed to be traded in OTC but only in exchanges. Only interest rate and
currency rate derivatives trading is allowed under OTC which is governed by RBI.
The trading in same is very small in exchanges.

MCX: Though its of the opinion that Indian Financial System is matured enough to
adapt to exotic products in Derivatives under the guidance and strict monitoring by
the regulator.

30. Why?

SEBI: As stated question no. 29.

31. Has any trader/broker defaulted?

SEBI: There has been no default in the equity derivative segment.

MCX: There have been default cases by traders in MCX against whom action has
been taken.

32. Have you taken any action on the defaulted trader/

broker? NSE: Yes

33. If yes, then how many?

60
 MCX: The number of defaulters is not revealed due to non-disclosure norms of the
exchange.

34. On what grounds have the traders/ brokers defaulted?

NSE: There were 1035 active members during January 2011 in the Futures and
Options (F & O) Segment. There were 1116 active members during January 2011 in
the Cash segment. Following is the complaint status against F & O trading members
as on 3rd December 2010.
Non- Actionable: 13
Opted for Arbitration: 67
Resolved status: 428
Under Process- 6

Interestingly the exchange received complaints against almost 50% of the members. The
above status does confirm the efficient grievance redress mechanism of NSE. 98 % is
the resolved rate.
Following are the type of complaints:

Table 24: Number of complaints

Type of Number of
Complaints Complaints %
I & II 43 8.37
III 3 0.58
III & IV 2 0.39
IV 16 3.11
IV & VI 299 58.17
IX 86 16.73
V 61 11.87
V & VI 2 0.39
VI 2 0.39
Total 514 100.00

61
Figure 11: Number of complaints

Number of complaints
400
300
200
100 Number of complaints
0
I & II III III & IV IV & IX V V & VI VI
IV VI

62
 Table 25: Type of complaints

Type of Complaints

Type Description
I Non-receipt / delay in payment:

Ia Delay in payment

Ib Non-receipt of payment

Ic Delay in refund of margin payment

Id Non settlement of accounts

II Non-receipt / delay in securities:

II a Delay in delivery

II b Non-receipt of delivery

II c Delay in refund of margin deposit

II d Non settlement of accounts

III Non-receipt of documents:

III a Contract notes

III b Bills

III c Account statements

III d Agreement copies

IV Unauthorized trades / misappropriation:

IV a Unauthorized trades in client account

IV b Mis-appropriation of clients funds / securities

V Service related:

63
Va Excess brokerage

Vb Non-execution of order

Vc Wrong execution of order

Vd Connectivity / system related problem

Ve Non-receipt of corporate benefits

Vf Other service defaults

VI Closing out / squaring up:

VI a Closing off / squaring up position without consent

VI b Dispute in Auction value / close out value

VII Non implementation of arbitration award

VIII IPO related

IX Others

Table 26: Status of the complaints

Status

Type Description

I Non actionable

Ia Complaint incomplete

Ib Outside the scope of stock exchange

II Resolved

III Under Process

IV Referred to Arbitration

64
58% complaints are related to unauthorized trade and service related, of which 83% are
resolved, rest 1% is in process and 15% cases opt for arbitration. Which shows that the
exchange is quite efficient is handing disputes and has a control on the defaults by the
members.

MCX: The defaults are due to Business and Market malpractices and delivery
defaults.

35. What actions do you normally take on the default by the traders/
brokers? SEBI: As per the gravity of the default.

65
 36. Do you have a mechanism to monitor high performance individuals/ traders/ brokers?

MCX: MCX has mechanism to monitor high performance individual / traders /

brokers which are monitored by positions relative to the market and open positions.

37. If yes, then how do you monitor high performance individuals/ traders / brokers?

38. Are there any regulatory concerns to be addressed in the near

future? SEBI: Yes

MCX: Yes

39. If yes, then what?

SEBI: Investors and market maturity is a prime concern for SEBI. Introducing new
products in the market and finding takers also is a concern which has to be addressed.

Separate membership for separate class of product has to be taken by the trade
members. For example separate membership for currency, equity and interest
derivatives trading has to be sought. The policy and regulations of SEBI are framed
in such a way that it ensures proper collection of margins and conservative approach
in introducing derivative products so that they are suitable for investors across the
sections included retail investors and they are introduced only if the markets are ready
to absorb them. SEBI also tries to ensure that their policies and regulations bring in
an overall efficiency in the market. Before launching a product adequate quantitative
analysis is done and theoretical simulations are conducted to ensure adequate
collection of margins and proposing desired margins and networth by the traders /
brokers / dealers.

SEBI does not have any control over exposure of Banks in foreign markets since they
come under the purview of RBI.

MCX: According to the exchange, there are regulatory concerns to be addressed in

66
the near future which are; that the market is governed by an archaic law which need to be
amended so that the regulator gets more power and autonomy, more products are permitted in
the market, more participants, such as financial institutions, which are currently disallowed, are
permitted in the market.

67
SUMMARY
After my primary analysis I can say that everything has it positives and negatives. So does the
derivatives markets. These are some of the positive as well as negatives.

Positives of the derivative markets

Derivative Markets are not overtly aggressive and are progressing conservatively.
Counter party risk and settlement mechanism is very strong.
Strong interference and regulatory controls by SEBI.
Healthy participation from foreign institutional investors (FII).
Protection of investors by regulating exotic options and privately structured OTC
options by SEBI.
RBI controlling Banks from designing complex options, which investors may not
fully understand.
Derivative Markets witness very high volumes except in interest rate derivatives in
equity index, currency, and commodities derivatives which greatly reduces impact
costs and promotes high volumes of trading.
Due to NIFTY futures trading in Singapore Stock Exchange and Chicago Mercantile
Exchange, where positions are taken in dollars, is greatly attracting foreign investors
to invest in NIFTY Futures.
Liquidity is extremely good. Good derivative market regulation.
Efficient risk management by exchanges. The transactions are faster, safer and
properly priced. Equity derivatives are efficient. Proper Margins are there. The
regulators keep revising it.
The regulators are alert for the client's protection while trading in the derivative
market.

So far the market has not heard of any fiasco.

The derivative market functions quite smoothly.
Price discovery for Options for every change in underlying is swift and promptly
reflected in price of options on screen.

68
 We have market participants playing different roles like arbitrageurs while some
acting as speculators and hedgers. Each of them indirectly serves the purpose of
others. Also margin money and MTM is required to be collected as per exchange
regulations. Compared to volume they are fairly regulated.
The Indian Markets are online, transparent and relatively well-regulated to the extent
of being a bit over-regulated. The price-discovery is quite realistic given that the
Rupee is still not fully convertible.

Some of the negatives of the derivative markets

There are limited market participants, understanding and volumes are also quite
weak, and this needs to improve for efficient (liquid & deep) derivatives market.
Need to focus on options for larger participation. Number of players are less, more
players needed.
No appetite and no tools for pricing and managing derivative instruments.
Derivatives are important to leverage capital and manage capital risks, in absence of
virtually zero exposure by Indian banks, funding the infrastructure would be a
challenge.
Indian Markets are not efficient so derivative markets cannot be efficient. Still we
don't have t+ 1 settlement. Now its t+2. Real time gross settlement for bigger ticket
size is there; its not for the smaller ticket size.
We need to create products which can be easily sold and marketed to the investors-
we only have maximum 3 months contracts in futures which is a pity....stock options
are mostly illiquid and the quantity of stocks in futures are very high and not all of
them are liquid and some of them are really pure speculative stocks.
Extreme regulation.
Very little exotic instruments.
Still a developing market. Still not sufficient liquidity in the market.
Lack of awareness of derivative products.
Lack of sufficient strength in the home currency. Limited gold back up.
Lack of awareness of derivative products, lack of sufficient strength in home
currency due to limited gold backup.

69
DERIVATIVES ---- A RISK MANAGEMENT TOOL

Lack of understanding of the product and market mob flocking mentality.

Derivatives trading is not broad based and penetration is limited.
Derivatives are more used for speculation purpose rather than hedging and
efficient price discovery system.
As an instrument of hedging, it has limited penetration in rural farmers etc.
Use of vanilla products only.
Restrictions/ Regulatory oversight.
The markets do not have depth.
Multiple regulators, multiple and different objectives among policy makers.
Turnover velocity of shares in Indian Market is much lower than the other
markets.
Lack of depth was a major issue in Indian Market. However, we are
witnessing great improvements in liquidity in the recent years. Participation
of larger number of Institutional Investors would improve the overall
liquidity.

1
DERIVATIVES ---- A RISK MANAGEMENT TOOL

Ways to improve the effectives of the derivative

market
Standardised lot size for derivative contracts on individual securities
Introduction of derivative contracts on volatility index
Introduction of index options with tenure up to five years
Physical settlement of stock derivatives
Self-clearing member in the currency derivatives segment
Revised exposure margin for exchange-traded equity derivatives

2
DERIVATIVES ---- A RISK MANAGEMENT TOOL

3
DERIVATIVES ---- A RISK MANAGEMENT TOOL

4
DERIVATIVES ---- A RISK MANAGEMENT TOOL

BIBLIOGRAPHY
BOOKS

Fundamentals of Futures and Options Markets by:-John C. Hull

Options, Futures and Other Derivative by:-John C. Hull

Valuation of fixed income security and derivatives by:-Frank K. Fabozzi

Valuation by Damodar

WEBSITES
http://www.iijournals.com/toc/jod/24/4
http://www.bseindia.com/markets/Derivatives/DeriReports/derimarketwatc
h.aspx
https://derivatives.euronext.com/en
https://www.totalderivatives.com/

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DERIVATIVES ---- A RISK MANAGEMENT TOOL