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PROJECT REPORTOn“Derivatives in Indian Market”Towards partial fulfillment ofMaster of Business Administration (MBA)School of Management, Graphic Era Hill University, DehradunSubmitted By: Submitted To:Saurabh Sharma Ms PunjIVth Semester Faculty Of ManagementRoll No-Graphic Era Hill University, Dehra...

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PROJECT REPO REPOR RT

On

“Derivatives in Indian Market” Towards partial fulfillment of Master of Business Administration (MBA) School of Management, Graphic Era Hill University, Dehradun

Submitted By: Saurabh Sharma IVth Semester Roll No-1105136

Submitted To: Ms.Divya Punj Faculty Of Management

Gra Graphic phic Er Era a Hill Univ University ersity ersity,, Dehr Dehradun adun Batch: 2018-2020

ACKNOWLEDGEMENT

Any accomplishment requires the effort of many people and this work is no different. First of all, I am grateful to the Almighty God for making me able to complete my project report. I wish to express my sincere thanks to School of

Management, GEHU, for

providing me with all the necessary facilities. I would like to express my sincere regards to Ms. Divya Punj ( Faculty MBA) for extending her valuable guidance and at the same time strictly adhering to high quality of my work I would like to express my gratitude to my parents, friends and all those persons for their contribution to this work.

EXECUTIVE SUMMARY

This project report comprises a study of Derivatives in Indian market. The study covers major markets in which the derivatives are traded. The commodities market study includes the agriculture and non- agro based commodities traded, the study of National Multi Commodity Exchange of India, Futures and forwards agreements , the trading and settlements in this market. The capital market study includes the equity derivatives and their importance, their working and most importantly the trading strategies and the volatility research. The money market study comprises the credit derivatives, currency swaps and interest rate swaps and their working. The foreign exchange markets study comprises the currency swaps , forward rate agreement and their working and their practicability in real business situations.

TABLE OF CONTENTS

Page No.

SL No. 1

CHAPTERS INTRODUCTION TO DERIVATIVES :

5

 Background of the study  Statement of Problem  Need and importance of study  Objectives of the Study 2

RESEARCH METHODOLOGY :   

22

Research Objectives Research Design Data Sources

3

DATA ANALYSIS AND INTERPRETATION

24

4

CONCLUSION/FINDINGS

53

5

RECOMMENDATION

67

6

BIBLOGRAPHY

71

CHAPTER 1 INTRODUCTION TO DERIVATIVES

INTRODUCTION Background of the Study: History of derivatives: The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments such as bond, currencies, stocks and stock indices have now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desai’s government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities were allowed to trade on exchanges. For example, now cotton and oil futures trade in Mumbai, soybean futures trade in Bhopal, pepper futures in Kochi, coffee futures in Bangalore etc. In June 2000, National Stock Exchange and Bombay Stock Exchange started trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. Currently there are 41 stocks trading on NSE Derivative and the list keeps growing. Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are

major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. Early forward contracts in the US addressed merchants’ concerns about ensuring that there were buyers and sellers for commodities. However “credit risk’ remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the “Chicago Board of Trade” (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivative contract in the US, these contracts were called future contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivative are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

Indian Derivative Markets: Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalization process and Reserve Bank of India's (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalization process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India the following table shows Chronology of instruments

1991

Liberalization process initiated

14-Dec-95

NSE asked SEBI for permission to trade index futures.

18-Nov-96 11-May-98 07-Jul-99

SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.

24-May-00

SIMEX chose Nifty for trading futures and options on an Indian index.

25-May-00

SEBI gave permission to NSE and BSE to do index futures trading.

09-Jun-00

Trading of BSE Sensex futures commenced at BSE.

12-Jun-00

Trading of Nifty futures commenced at NSE.

25-Sep-00

Nifty futures trading commenced at SGX.

02-Jun-01

Individual Stock Options & Derivatives

In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors' aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India's financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of India's efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.

Factors driving the growth of derivatives: Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the

world. Some of the factors of driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets 2. Increased integration of national financial markets with the international markets 3. Marked improvement in communication facilities and sharp decline in their costs 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies 5. Innovation in the derivatives markets, which optionally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

Prerequisites for derivatives market: There are five essential prerequisites for derivatives market to flourish in a country: a) Large market capitalization: At a market capitalization of near $1.5 trillion, India is well ahead of many other countries where derivatives markets have succeeded. b) Liquidity in the underlying: A few years ago, the total trading volume in India used to be around Rs300crores a day. Today, daily trading volume in India is around Rs-15000crores a day. This implies a degree of liquidity, which is around six times superior to the earlier conditions. There is empirical evidence to suggest that there are many financial instruments in the country today, which have adequate to support derivative market. c) Clearing house that guarantees trades: Counter party risk is one of the major factors recognized as essential for starting a strong and healthy derivatives market. Trade guarantee therefore becomes imperative before a derivatives market could start. The first clearinghouse corporation guarantees trades have become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCC). NSCC is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. Other exchanges

are also moving towards setting up separate and well-funded clearing corporations for providing trade guarantees. d) Physical infrastructure: India’s equity markets are all moving towards satellite connectivity, which allows investors and traders anywhere in the country to buy liquidity services from anywhere else. This telecommunications infrastructure, India’s capabilities in computer hardware and software, will enable the establishment of computer system for creation of derivatives markets. Setting up of automated trading system as an experience with various prospective exchanges will also be beneficial while setting up the derivative market. e) Risk-taking capability and Analytical skills: India’s investors are very strong in their risk-bearing capacity and can cope with the risk that derivatives pose. Evidence of the volumes traded on the capital markets, which are akin to a futures market, is indicative of this capacity. In contrast, in some other countries, investors simply lack the risk-bearing capacity to sustain the growth of even the equity market. It is expected that such a barrier will not appear in India. On the subject of analytical skills, derivatives require a high degree of analytical capability for many subtle trading strategies to pricing. India has an enormous pool of mathematically literate finance professionals, who would excel in this field. Lastly, an obvious advantage for the Indian market is that we have enormous experience with futures markets through the settlement cycle oriented equity which is not truly a spot market but a futures market (including concepts like market-to-market margin, low delivery ratios, and last-day-of settlement abnormalities in prices). We also have active futures markets on six commodities. With this state of development of the capital markets it is felt that there is no major hurdle left for the creation of development of the capital markets. Hence on July 2, 1996 the SEBI board gave an in principal approval for the launch of derivatives markets in India.

Myths and Realities about Derivatives: In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? What is the underlying truth behind such myths? The myths and the realities behind them are:

1. Derivatives increase speculation and do not serve any economic purpose: Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without

selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance.

2. Indian Market is not ready for derivative trading: Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the prerequisites, which are needed for the introduction of derivatives and how Indian market

fares: Large market Capitalization - India is one of the largest market-

capitalized countries in Asia with a market capitalization of more than Rs.765000crores. High Liquidity in the underlying - The daily average traded volume in Indian capital market today is around 7500crores. Which means on an average every month 14% of the country's Market capitalization gets traded. These are clear indicators of high liquidity in the underlying. Trade guarantee - The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. A Strong Depository - National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionized the security settlement in our country. A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

3. Disasters prove that derivatives are very risky and highly

leveraged instruments: Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines. Some of the reasons behind disasters related to derivatives are: 1. Lack of independent risk management 2. Improper internal control mechanisms 3. Problems in external monitoring done by Exchanges and Regulators 4. Trader taking unauthorized positions 5. Lack of transparency in the entire process

4. Derivatives are complex and exotic instruments that Indian

investors will have difficulty in understanding: Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading. Forward Markets Commission has allowed trading in Commodity Forwards on Commodities Exchanges, which are, called Futures in international markets. Commodities futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals to hedge the user's exposure in international markets. Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in

1912. Bullion futures market was set up in Mumbai in 1920.

History and existence of marke...