1

PROJECT REPORT ON
ANALYSIS
OF investor’s perception
towards DERIVATIVES AS AN
INVESTMENT STRATEGY

Submitted in partial fulfillment of the requirement of the degree

course of Master of Business Administration (2011-2013) from Desh
Bhagat Institute Of Management affiliated to Punjabi University
Patiala

PROJECT GUIDE :- SUBMITTED BY:-

Mr. DAKSH BANSAL HARDEV SINGH

AWARDED AS THE BEST BROKERAGE FIRM IN INDIA FOR 2012

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ACKNOWLEDGEMENT
A project report is never the sole product of the person whose name appears on the cover. There
are always some people who guidance proves to be an immense help in giving its final shape so;
it become my first duty to express my gratitude towards all of them.

I am thankful to “MR.DAKSH BANSAL” (Manager Online) for giving me his kind

permission to carry out SUMMER TRANING in the organization. I feel especially privileged to
work under their kind supervision. He guided me at every step to make my project a real
masterpiece.

My heartfelt gratitude to my respected faculty without their continuous help the project would
not have been materialised in the present form. Their valuable suggestions helped me at every
step.

I am also grateful to our institute DESH BHAGAT for providing me a platform and opportunity
to do work in the field of management.
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PREFACE
Practical training constitutes an integral part of the management studies. Training gives
opportunities to the students to expose themselves to the industrial environment, which is quite
different from the classroom teaching.

One can not rely merely upon theoretical knowledge. It has to be coupled with practical for it to
be fruitful. Classroom lecture make the fundamentals concept of management clear but not their
application in actual practice. Positive and corrective results of classroom learning need realities
of practical situation. The training also enables the management students to themselves see the
working condition under which they have to work in future. It thus enables the students to
undergo those experiences, which will help them later when they join the organisation.

It is in this sense that practical training in the company has a significant role to play in the
subject of management for developing managerial and administrative skills in the future
managers and to enhance their analytical skills.

I received my training in KOTAK SECURITIES at Chandigarh. It was my fortune to get

training in a very healthy atmosphere. I learnt a lot of new things which I could never been learnt
from theory classes.
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CERTIFICATION OF COMPLITION
This is to certify that Mr. Hardev Singh, a student of Master of Business
Administration, Desh Bhagat Institute of Management, Mandi Gobindgarh
affiliated to Punjabi University; Patiala has worked under my Supervision to
complete his Project Report.

“Analysis of Investors Perception Towards Derivatives As An Investment

Strategy ”

The work done is original and out come of his sincere efforts. I am satisfied with the
work done by him and recommend the same to be forward for evaluation.

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Declaration
I hereby declare that the final Project Report “Analysis of Investor’s Perception
towards Derivatives as an Investment Strategy” submitted in partial fulfillment of
the award for the degree of Master of Business Administration (MBA) to Desh
bhagat Institute Of Management, Mandi Gobindgarh (Approved by A.I.C.T.E
New Delhi, Affiliated to Punjabi University, Patiala), is one of my original work and
not submitted to any other Degree/Diploma, fellowship or other similar title.

Name:- Hardev Singh

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CONTENTS

Serial No. Contents Page No

1 Introduction To Kotak Group 7 – 11
2 Introduction To Kotak 12 – 29

Securities
3 Introduction To Derivatives 30 – 51
4 Objectives Of Study 52
5 Rationale Of Study & 53 – 54

Research Methodology
6 Survey Of Literature 55 – 64
7 Analysis Of Study 65 – 88
8 Findings 89 – 90
9 Recommendations 91
10 Limitations 92
11 Conclusion 93
12 Bibliography 94
13 Questionnaire 95 – 96

INTRODUCTION
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TO

KOTAK GROUP

Kotak Mahindra is one of India’s leading banking and financial services institutions,
offering a wide range of financial services that encompass every sphere of life. From
commercial banking, to stock broking, to mutual funds, to life insurance, to
investment banking, the group caters to the diverse financial needs of individuals
and corporate sector.

The group has a net worth of over Rs. 100.6 billion and has a distribution network
of branches, frenchisees, representative offices and satellite offices across cities and
towns in India, and offices in New York, San Fransisco, London, Dubai, Mauritius
and Singapore servicing around 8 million customer accounts.

Kotak Group products and services:

. Bank
. Life Insurance
. Mutual Fund
. Car Finance

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. Securities
. Institutional Equities
. Investment Banking
. Kotak Mahindra International
. Kotak Private Equity
. Kotak Reality Fund

KOTAK MAHINDRA BANK

Kotak Mahindra Bank Ltd is a one stop shop for all banking needs. The bank offers
personal finance solutions of every kind from savings accounts to credit cards,
distribution of mutual funds to life insurance products. Kotak Mahindra Bank offers
transaction banking, operates lending verticals, manages IPOs and provides working
capital loans. Kotak has one of the largest and most respected Wealth Management
teams in India, providing the widest range of solutions to high net worth individuals,
entrepreneurs, business families and employed professionals.

KOTAK SECURITIES

Kotak Securities is one of the largest broking houses in India with a wide
geographical reach. Kotak Securities operations include stock broking and
distribution of various financial products including private and secondary placement
of debt, equity and mutual funds.

Kotak Securities operates in five main areas of business:

 Stock Broking
 Depository Services
 Portfolio Management Services
 Distribution of Mutual Funds
 Distribution of Kotak Mahindra Old Mutual Life Insurance Ltd Products.

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KOTAK MAHINDRA CAPITAL COMPANY

Kotak Investment Banking (KMCC) is a full-service investment bank in India

offering a wide suite of capital market and advisory solutions to leading domestic
and multinational corporations, banks, financial institutions and government
companies.

Our services encompass Equity & Debt Capital Markets, M&A Advisory, Private
Equity Advisory, Restructuring and Recapitalization services, Structured Finance
services and Infrastructure Advisory and Fund Mobilization.

KOTAK MAHINDRA ASSET MANAGEMENT COMPANY

Kotak Mahindra Asset Management Company offers a complete bouquet of asset

management products and services that are designed to suit the diverse risk return
profiles of each and every type of investor. KMAMC and Kotak Mahindra Bank are
the sponsors of Kotak Mahindra Pension Fund Ltd, which has been appointed as one
of six fund managers to manage pension funds under the new pension scheme.

KOTAK MAHINDRA PRIME LTD

Kotak Mahindra Prime Ltd is among India's largest dedicated passenger vehicle
finance companies. KMPL offers loans for the entire range of passenger cars, multi-
utility vehicles and pre-owned cars. Also on offer are inventory funding and
infrastructure funding to car dealers.

KOTAK PRIVATE EQUITY GROUP

Kotak Private Equity Group helps nurture emerging businesses and mid-size
enterprises to evolve into tomorrow's industry leaders. With a proven track record of
helping build companies, KPEG also offers expertise with a combination of equity
capital, strategic support and value added services. What differentiates KPEG is not

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merely funding companies, but also having a close involvement in their growth as
board members, advisors, strategists and fund raisers.

KOTAK INTERNATIONAL BUSINESS

Kotak International Business specialises in providing a range of services to overseas

customers seeking to invest in India. For institutions and high net worth individuals
outside India, Kotak International Business offers asset management through a range
of offshore funds with specific advisory and discretionary investment management
services.

KOTAK REALITY FUND

Kotak Realty Fund deals with equity investments covering sectors such as hotels, IT
parks, residential townships, shopping centres, industrial real estate, health care,
retail, education and property management. The investment focus here is on
development projects and enterprise level investments, both in real estate intensive
businesses.

KOTAK GROUP TEAM LEADERS

Mr. Uday S. kotak

Executive Vice Chairman and Managing Director

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Mr. C Jayaram
Joint Managing Director

Mr. Deepak Gupta

Joint Managing Director

KOTAK SECURITIES

Originally established in 1994, Kotak Securities is a subsidary of Kotak Mahindra

Bank, which services more than 7.4 lakh customers. The firm has a wide network of
more than 1400 branches, frenchisees, representatives offices, and satellite offices
across 448 cities in India and offices in New York, London, San Fransisco, Dubai,
Maritius and Singapore.

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We process more than 400000 trades a day which is much higher than some of the
other renowned international brokers.
The company is a corporate member of both The Bombay Stock Exchange (BSE)
and The National stock Exchange (NSE) of India. Our operations include stock
broking services for trading in stock markets through branches and internet and
distribution of various financial products including investments in IPO’s, Mutual
Funds and Currency Derivatives. Currently, Kotak Securities is one of the largest
broking houses in India with substential geographical reach to Asia Pecific, Europe,
Middle East and America.

Kotak Securities Limited has Rs. 1202 crores of Assets Under Management (AUM)
as of 31st Dec 2011.

INNOVATORS

We have been the pioneers in providing many products and services which have
now become industry standards for stock broking in India. Some of them include:
 Mobile stock trading application to keep track of your investments even on
the go.

 Facility of Margin Finance to the customers for online stock trading.

 Investing in IPOs and Mutual Funds on phone.

 SMS alerts before execution of depository transactions.

 Auto Invest- A systematic investing plan in equities and Mutual Funds.

 Provision of margin against securities automatically against shares in your

Demat account.

RESEARCH EXPERTISE:

We specialize in Fundamental and Technical analysis backed by a team of highly

trained and qualified individuals.

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Our full fledged research division is involved in Macro Economic studies, Sectorial
Research and Company Specific Equity Research which publishes in- depth stock
market analysis. This is combined with a strong and well networked sales force
which helps deliver current and upto date market information and news.

We are also a depository participant with National Securities Depositary Limited

(NSDL) and Central Depository Services Limited (CDSL). By being a stock broker
and depository participant, we provide dual benefit in our services wherein the
investors can avail our stock broking services for executing the transactions and the
depository services for settling them.

Our Portfolio Management Service comes as an answer to those who would like to
grow exponentially on the crest of the stock market, with the backing of an expert.

AWARDS:

 Best broker in India by FinanceAsia for 2010 & 2009.

 UTIMF- CNBC TV 18 Financial Advisor Awards- Best Performing Equity

Broker (National) for the year 2009.

 Best brokerage firm in India by Asiamoney in 2010, 2009, 2008, 2007 &
2006.

 Best Performing Equity Broker in India- CNBC Financial Advisor awards

2008.

 Avaya Customer Responsiveness Award (2008, 2007 & 2006) in Financial

Services Sector.

 The Leading Equity House in India in Thomson Extel Surveys Awards for
year 2007.

 Euromoney Award (2007 & 2006) – Best provider of Portfolio Management

Equities.

 Euromoney Award (2005) – Best Equity House in India.

 Finance Asia Award (2005) – Best Broker in India.

 Finance Asia Award (2004) – India’s Best Equity House.

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Most Recent Award

Kotak Securities is awarded as the Best Brokerage Firm of year 2012 by

FinanceAsia

Products And Services Offered By Kotak

Account types

• Account type package various products and tools based on service levels and
customer segments

• Account types distinguished between – “Self Reliant” and “Managed

Accounts”

• Service level differentiation which involves structuring and customising

offering products and tools as per customer/market segments

Benefits of being a kotak customer

• Enjoy convenience and ease while investing in IPO's - through Easy IPO.

• Trinity Account – Open Trading, Demat and Bank account through Kotak
Securities

• Consistent Award Winner

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• Our Research Reports on the economy, select industries and companies

help you make informed investment decisions while dealing in Equity.

• Buy and sell stocks on phone using Call & Trade.

• Access to 16+ mutual fund houses and over 650+ mutual fund schemes
through Easy Mutual Fund.

Online account types

• Gateway
• AutoInvest
• Advance Fee Schemes
• Kotak Privileged Circle
• Kotak Trader - Saxo Capital Markets Singapore is our business Associate for
this Product

Gateway

If Customer Needs a

“Simple Online Trading account”

Product Offering

• Online Trading in Equities, derivatives

• Invest in IPO, Mutual Funds and Debt securities
• Research Reports , Trading Strategies, customer Service Etc.
• Sebi Margin Finance

Product Positioning

• Main/Staple Product Offering of Kotak Securities

• Self Reliant Service

Gateway Pricing

Gateway Pricing has two variants:

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Normal Gateway

• Turnover Based brokerage Rate – From 0.59% to 0.18% for delivery

Gateway Flat

• Gateway Flat - Flat rate of 0.49% for Delivery irrespective of T/O

Note

• Both variants come under the Gateway Umbrella Brand

• Services offered are the same
• Account opening Fee of Rs 750/-
• Call n Trade – First 20 calls free, Rs 20 from the 21st call onwards

Auto invest

If Customer Needs a

“I need assistance for my investments on Regular basis”

Product Offering

• Regular portfolio construction and rebalancing – Hence the term

“Autoinvest”
• Asset classes recommended extend to mutual funds and Gold (ETFs)
• Tele Sales Individual would advise and churn the customer portfolio based
on a model portfolio
• Model Portfolio suggested post Customer Risk profiling

Product Positioning

• Assisted/Managed Account service

• Systematic investing

Product Target Group

• Salaried class who regularly invest in stock markets

• Mutual Fund SIP customers

• Assistance in trading and advisory

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• Risk averse investors that seek diversification to Gold

• Buy and Hold clients

Product Pricing

• 2% for every Trade

• Account opening Fee of Rs 750

Note – Trades are not placed automatically - Customer consent is required for every
execution

Advance fee schemes

If Customer Needs a

“Simple Online Trading account” + “lower brokerage fee than existing account
Types”

What are Advance Fee Schemes?

• Customer pays an advance amount upfront

• Lower brokerage rate is assigned to the customer based on his Chosen period
and brokerage rate
• Brokerage generated during the validity period is reversible up to a
maximum of the advance fee

• Suppose under Plan A acustomers generates a brokerage of Rs 800 during

the validity period, then Rs 800 would be reversed to your account.
• If the brokerage generated is Rs 4000, then only Rs 1000 is reversible as the
Maximum amount reversible is the advance fee.
• If no brokerage is generated during the validity period the advance fee will
not be reversed.

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Positioning

Product Genesis – Business Advantages

• Advance fee is collected upfront acts as an assurance of income from the

customer

Why Advance Fee Plans? - Sales Pitch Points

• No Account opening Fee

• Identify customer Trading potential i.e. existing turnover , brokerage rate
and cash outflow capacity
• Suggest Product based on customer’s Existing Turnover

Ex – Rs 2500 product is ideal for a customer with a T/O of at least Rs 8.33 lacs
during the validity period

Advance fee variants

Important :-

• Advance fee variants can be customized based on potential revenue

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• Advance Fee variants are automatically renewed at the end of the Validity
period
• Offline and Online have different start date billing cycles. Please read Form
for more details
• %age Incentive is paid to RM on the advance fee collected. So larger the
advance fee, the better is the incentive!

Kotak privileged circle

If Customer Needs a

“Pampered Service” plus is the customer brings in a Margin of Rs 10,00,000

Product Positioning

• Premium service offering

Product Offering – Same as Gateway except

• KEAT PRO free

• Unlimited call and Trade
• Brokerage Rate starts from 0.18% and then moves as per Gateway Slab

Kotak trader

If Customer Needs a

“I want to trade in International Markets”

Product Offering

• Trade in 24 stock exchanges across the world

• Advance Trading platform

Product Positioning

• Niche service offering

• Diversification benefit

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Product Pricing

• Brokerage rate 0.75% for every Trade each side .However there is a
minimum brokerage which differs from exchange to exchange. Hence on any
given trade the brokerage would be either the minimum brokerage rate or .75
which ever is higher.

• Account opening Fee of Rs 750

• Minimum Margin to open an Account is $10,000USD

• Maximum of remittance of $ 200,000 per annum as per RBI guidelines

Account opening process

• The client can fill in his details on Kotak Securities website, by which he
will be contacted by the local RM who will deliver the account opening form
to him.

• The forms will then be sent to account opening team who will carry out the
due diligence and then scan the documents to Saxo Singapore.

• Saxo will then conduct the due diligence and will give the final approval.

• Saxo contacts the client directly once the account is opened and ready to be
funded

• The account opening team will send the approved original document in
batches once every fortnight to Saxo.

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Product Matrix- online

NRI Account

• You can do online delivery based trading through our NRI-Trinity Account.
This account links your Banking, Demat and Trading account, thus providing
you a seamless platform to trade efficiently and conveniently.

• Avail top class research from our dedicated Research Team that gives you
valid, fact based and reliable research inputs on industry trends, sector news,
which company scrips to buy, sell or hold and more.

• You also get detailed reports on Daily Morning Briefs, Stock Ideas, special
Reports and access to Kotak Securities News Channel.

• You can now avail 80% margin against your executed & unbilled delivery
marked trades.

• You also have the facility to trade on both- NSE and BSE. MF and IPO is
currently unavailable for NRI's

• Equip yourself with useful information through the Kotak Securities News
Channel. Get detailed news on the Indian stock markets, the Indian

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Charges

Eligibility

All Non Resident Indians - NRI / PIO (except minors) residing in Gulf Co-operation
Council (GCC) countries of United Arab Emirates, Saudi Arabia, Bahrain,
Kuwait, Oman and Qatar can avail of our NRI account services.

CURRENCY DERIVATIVES

Exchange Traded Currency Derivatives In India

Exchange Traded Currency Derivatives were Launched in August 2009 after

consultation with SEBI and RBI. Exchange allows retail participation in the new
segment and hence provides first time access to retail investor in the new asset class.
There is no need for underlying exposure to participate in the market. Also there is
much higher accessibility, price transparency and liquidity compared to OTC
market. In exchange traded Currency Derivatives, standard agreements and
processes makes investment hassle free and simple. In Exchange Traded currency
Derivatives, higher participation provides better liquidity to the clients

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Why Currency Derivatives ?

Directional Views

Positioning for INR appreciation or depreciation

Hedging current exposure

Importers and exporters can hedge future payables & receivables

Borrowers can hedge FCY loans for interest or principal payments

Hedge for offshore investment for Resident Indians

FIIs and NRIs hedge their investments in India

Trade & Capital Flows

Remittances for trade or services and capital transactions

Arbitrage

Arbitrage opportunity for entities who can access onshore and non
deliverable forward markets

What are Exchange Traded Currency Derivatives ?

Underlying of contract is rate of exchange between the currency and INR

12 near calendar month contracts available on the market

Order driven market similar to equity derivative segment

Fixed expiry on the last business day of any month

Minimum price fluctuation of 0.25 paise or INR 0.0025

Cash settlement in INR at relevant RBI reference rate of exchange between the
currency and INR

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Market timing from 0900 hours to 1700 hours

Contract fixing two days prior to Contract Expiration date and settlement on contract
expiry date

Currencies Available

USD – INR (Contract size USD 1000)

EUR – INR (Contract size EUR 1000)

GBP – INR (Contract size GBP 1000)

JPY – INR (Contract size JPY 100,000)

Why Exchange Traded Currency Derivatives ?

Access to a new asset class which was earlier not allowed for trading to all Indian
residents

Higher participation in market increases higher liquidity for structured contracts

Permitting NRIs and FIIs at a future date may shift a substantial portion of NDF
business to exchanges

Potential arbitrage opportunity in OTC vs. Futures market could increase volumes in
both the markets

How to Get Started ?

New Clients

Account opening form with currency derivative segment agreements

Required KYC proofs

Existing Clients

Additional Currency derivative application form including model currency

derivative agreement, model currency derivative RDD & additional annexure

Mandatory KYC proofs required by exchanges

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SUPER TOOLS

KEAT and KEAT Premium

are two trading tools that enable you to view unlimited scrips, Intraday and

Historical charts for scrips, use most of the charting tools, view the graphs type you
want to, see Derivative chains, see online order and trade

confirmations, view dynamic net positions, dynamic profit and loss, select
indices/sectors or business groups and lots more.

• KEAT Premium runs faster than KEAT Pro as it runs on a separate server
and has Scrip Alerts
•
• Charges for KEAT Premium are Rs 500

Super Multiple In Cash Management

Kotaksecurities.com has launched Super Multiple, a service that offers you up to 12

times exposure against your margin, on specified scrips.

For e.g., if you have a margin of Rs. 1,00,000/-, you will get up to 12 times exposure
on your Super Multiple orders, i.e. Rs. 12,00,000/-.

Super Multiple In Futures Segment

Kotaksecurities.com has launched Super Multiple, a service that offers you up to 12

times exposure against your margin, on specified scrips.

For e.g., if you have a margin of Rs. 1,00,000/-, you will get up to 12 times exposure
on your Super Multiple orders, i.e. Rs. 12,00,000/-.

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COMPETITORS OF KOTAK SECURITIES

• India Bulls
• Share Khan/SSKI
• Motilal Oswal
• Angel Stock Broking
• KR Choksey
• Anand Rathi
• ICICI Direct.com (Online)
• R - Trade (New entrant)
• Prabhudas Liladhar
• India Infoline
• Karvy
• Magnum Securities
• SBI Capital
• L K P Shares & Securities
• Geojit Financial
• Man Financial
• Religare Securities
• IL & FS
• Emkay Share & Stock Broking
• Enam Financial
• HDFC Securities
• Edelwise Capital
• UTI Securities
• Ambit Capital
• Ventura Capital

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OFFLINE ACCOUNT

Normal Account

• Normal Account – It is a simple trading account

• The clients DP ( Depository Participant ) or Demat Account can be with
Kotak or with any other DP
• Delivery Based Trading is done under Normal account
• Shares are bought, sold and transferred electronically
• The client can buy / sell shares, he can transfer his shares from one DP
account to another
• A unique code is generated for each clientAfter completing all the
formalities of opening the normal account, the account will open in 3
working days
• The client will receive a Welcome letter and Trading code

Security Margin Account

● Security Margin Account – The Client will compulsorily will have to have
the DP with Kotak.
● The Client will sign the POA – Power of Attorney, where by Kotak has the
right to sell off clients shares if the settlement is not done by Friday or on T
+ 2 days i.e. Trading + 2 days. Either the client will have to square off or pay
to retain the shares in his DP account.
● The clients who would like Kotak to handle their DP.
● Big Traders are major clients for this kind of account.
● Stock holding in the DP is used as margin.
● Limit – To purchase
– The Limit for delivery will be 4 times of the DP amount
– The Limit for Intra Day will be 7 times of the DP amount

● Advantages –
– No Need to sign the transaction slip for buy or sell of shares
– Hassle free trading
– Position can be known at any moment
– Special features like phone / sms facility which enables the clients to
do trading from any corner of the world.

● Disadvantage –
– The shares cannot be transferred from one DP to another.
– The broker has the right to sell the shares if not settled on time.

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SEBI Margin Funding

SEBI margin funding – The Client will have to compulsorily open a DP and sign a
POA to Kotak Securities Margin Funding is upto 50% in specific Scripts – around
600 scripts approved by SEBI

Clients – Positional Traders and People who need some Leverage.

Advantages –

The interest will be charged to client only on upto 50% funding taken by the client
from Kotak Securities.

Eg: if the client buys shares of Rs.1 lac under SEBI margin account, he will have to
pay interest only on 50% amount paid by Kotak Sec on his behalf.

If the Position is +ve

The client can sell the shares and books his profits after paying the brokerage and
the interest or can hold for longer period.

If the position is – ve

Say the share value is dropped rs.10000, then the client is asked to pay the Top-Up /
Mark to Margin ( M to M ) of the above said amount.

Disadvantages –

– When the stocks are down, the client has to immediately pay the
difference.
– In SEBI Funding Margins, stock volumes are not considered and is
strictly operated in cash.
– After 2 lac the stock category comes into picture, A category stocks
are normally funded upto 50%, B, C and D category stocks will be
funded upto 50% but will be according to the Haircut.

Eg: If a B category stock is of Rs.100 and has a hair cut of 10% then the funding
will happen as below –

Rs.100 – 10% = Rs.90

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So here Kotak sec will fund 50% on Rs.90 and not on Rs.100. So the ratio will be
Kotak sec : Rs.45 and Client will Pay Rs.55. The client cannot watch the before-said
division in his ledger.

The client cannot get the Position on day to day basis Only chosen scripts are
funded.

COMMERCIALS

• Trading Account Opening – Rs. 750

• Only Demat Account – Rs. 500
• Brokerage – Delivery – 0.5% (Max 2.5%)
• Intra-day & Derivatives – 0.10% (On Options – Premium Only)
• Service Tax – 10.30% of brokerage
• STT – Delivery buy – 0.125%
• Delivery sale – 0.125%
• Cash market sq up – 0.025% (seller)
• Derivatives – 0.017% (seller)
• Stamp Duty – Cash Market – 0.01%
• Derivatives – 0.002%

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INTRODUCTION

TO

DERIVATIVES

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Derivatives are financial instruments whose value is derived from the value of
something else. They generally take the form of contracts under which the parties
agree to payments between them based upon the value of an underlying asset or
other data at a particular point in time. The main types of derivatives are futures,
forwards, options, and swaps.

The main use of derivatives is to reduce risk for one party while offering the
potential for a high return (at increased risk) to another. The diverse range of
potential underlying assets and payoff alternatives leads to a huge range of
derivatives contracts available to be traded in the market. Derivatives can be based
on different types of assets such as commodities, equities (stocks), bonds, interest
rates, exchange rates, or indexes (such as a stock market index, consumer price
index (CPI) — see inflation derivatives — or even an index of weather conditions,
or other derivatives). Their performance can determine both the amount and the
timing of the payoffs.

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.

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;

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b. A contract which derives its value from the prices, or index of prices,
of underlying securities.

1.1.2 History of derivatives

The history of derivatives is surprisingly longer than what most people think. Some
texts even find the existence of the characteristics of derivative contracts in incidents
of Mahabharata. Traces of derivative contracts can even be found in incidents that
date back to the ages before Jesus Christ. However, the advent of modern day
derivative contracts is attributed to the need for farmers to protect themselves from
any decline in the price of their crops due to delayed monsoon, or overproduction.
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan
around 1650. These were evidently standardized contracts, which made them much
like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world,
was established in 1848 where forward contracts on various commodities were
standardized around 1865. From then on, futures contracts have remained more or
less in the same form, as we know them today. Derivatives have had a long presence
in India. The commodity derivative market has been functioning in India since the
nineteenth century with organized trading in cotton through the establishment of
Cotton Trade Association in 1875. Since then contracts on various other
commodities have been introduced as well.

Exchange traded financial derivatives were introduced in India in June 2000 at the
two major stock exchanges, NSE and BSE. There are various contracts currently
traded on these exchanges. National Commodity & Derivatives Exchange Limited
(NCDEX) started its operations in December 2003, to provide a platform for
commodities trading. The derivatives market in India has grown exponentially,
especially at NSE. Stock Futures are the most highly traded contracts on NSE
accounting for around 55% of the total turnover of derivatives at NSE, as on April
13, 2005.

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1.1.3 Types of Derivatives

 Over-the-counter (OTC) derivatives are contracts that are traded (and

privately negotiated) directly between two parties, without going through an
exchange or other intermediary. Products such as swaps, forward rate
agreements, and exotic options are almost always traded in this way. The
OTC derivatives market is huge. According to the Bank for International
Settlements, the total outstanding notional amount is USD 516 trillion (as of
June 2007).
 Exchange-traded derivatives (ETD) are those derivatives products that are
traded via specialized Derivatives exchanges or other exchanges. A
derivatives exchange acts as an intermediary to all related transactions, and
takes Initial margin from both sides of the trade to act as a guarantee. The
world's largest derivatives exchanges (by number of transactions) are the
Korea Exchange (which lists KOSPI Index Futures & Options), Eurex
(which lists a wide range of European products such as interest rate & index
products), and CME Group (made up of the 2007 merger of the Chicago
Mercantile Exchange and the Chicago Board of Trade). According to BIS,
the combined turnover in the world's derivatives exchanges totaled USD 344
trillion during Q4 2005. Some types of derivative instruments also may trade
on traditional exchanges. For instance, hybrid instruments such as
convertible bonds and/or convertible preferred may be listed on stock or
bond exchanges. Also, warrants (or "rights") may be listed on equity
exchanges. Performance Rights, Cash xPRTs(tm) and various other
instruments that essentially consist of a complex set of options bundled into a
simple package are routinely listed on equity exchanges. Like other
derivatives, these publicly traded derivatives provide investors access to
risk/reward and volatility characteristics that, while related to an underlying
commodity, nonetheless are distinctive.

1.1.4 Types of Derivative contracts

1. Forward Contract: A forward contract is an agreement between two parties to

buy or sell an asset (which can be of any kind) at a pre-agreed future point in time.
Therefore, the trade date and delivery date are separated. It is used to control and

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hedge risk, for example currency exposure risk (e.g., forward contracts on USD or
EUR) or commodity prices (e.g., forward contracts on oil). One party agrees
(obligated) to sell, the other to buy, for a forward price agreed in advance. In a
forward transaction, no actual cash changes hands. If the transaction is
collateralized, exchange of margin will take place according to a pre-agreed rule or
schedule. Otherwise no asset of any kind actually changes hands, until the maturity
of the contract. The forward price of such a contract is commonly contrasted with
the spot price, which is the price at which the asset changes hands (on the spot date,
usually two business days). The difference between the spot and the forward price is
the forward premium or forward discount. A standardized forward contract that is
traded on an exchange is called a futures contract.

2. Futures Contract : A futures contract is a standardized contract, traded on a

futures exchange, to buy or sell a certain underlying instrument at a certain date in
the future, at a specified price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price. A futures
contract gives the holder the obligation to buy or sell, which differs from an options
contract, which gives the holder the right, but not the obligation. In other words, the
owner of an options contract may exercise the contract, but both parties of a "futures
contract" must fulfill the contract on the settlement date. The seller delivers the
commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from
the futures trader who sustained a loss to the one who made a profit. To exit the
commitment prior to the settlement date, the holder of a futures position has to offset
their position by either selling a long position or buying back a short position,
effectively closing out the futures position and its contract obligations. Futures
contracts, or simply futures, are exchange traded derivatives. The exchange's
clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
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

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of the underlying asset or cash. Cash settlement enables the settlement of obligations
arising out of the future/option contract in cash.

3. Option contract: The right, but not the obligation, to buy (for a call option) or
sell (for a put option) a specific amount of a given stock, commodity, currency,
index, or debt, at a specified price (the strike price) during a specified period of time.
For stock options, the amount is usually 100 shares. Each option contract has a
buyer, called the holder, and a seller, known as the writer. If the option contract is
exercised, the writer is responsible for fulfilling the terms of the contract by
delivering the shares to the appropriate party. In the case of a security that cannot be
delivered such as an index, the contract is settled in cash. For the holder, the
potential loss is limited to the price paid to acquire the option. When an option is not
exercised, it expires. No shares change hands and the money spent to purchase the
option is lost. For the buyer, the upside is unlimited. Option contracts, like stocks,
are therefore said to have an asymmetrical payoff pattern. For the writer, the
potential loss is unlimited unless the contract is covered, meaning that the writer
already owns the security underlying the option. Option contracts are most
frequently as either leverage or protection. As leverage, options allow the holder to
control equity in a limited capacity for a fraction of what the shares would cost. The
difference can be invested elsewhere until the option is exercised. As protection,
options can guard against price fluctuations in the near term because they provide
the right acquire the underlying stock at a fixed price for a limited time. risk is
limited to the option premium (except when writing options for a security that is not
already owned). However, the costs of trading options (including both commissions
and the bid/ask spread) is higher on a percentage basis than trading the underlying
stock. In addition, options are very complex and require a great deal of observation
and maintenance.

4. Warrants & convertible: Warrants & convertible are other important categories
of financial derivatives, which are frequently traded in the market. Warrants are just
like an option contract where the holder has the right to buy shares of a specified
company at a certain price during the given time period. In the other words the
holder of a warrant has the right to purchase a specific number of shares at a fixed
price in a fixed period from a issuing company. Convertible are hybrid securities

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which combine the basic attributes of fixed interest and variable return securities.
These are mostly convertible bonds, convertible debentures, and convertible
preference shares. These are also called equity derivative securities. They can be
fully or partially converted in to equity shares of the issuing company at the
predetermined specified terms with regards to conversion ratio and conversion price.

5. Swap Contracts: These are agreements between two parties to exchange cash
flows in the future under the swap agreement various terms like the dates. When the
cash flows are to be paid, the currency in which to be paid & the mode of payment
are finalized by the parties. The most popular type of swap contracts is given below:

a) Interest rate swaps contracts: A contract entered into by an issuer or obligor

with a swap provider to exchange periodic interest payments. Typically, one party
agrees to make payments to the other based upon a fixed rate of interest in exchange
for payments based upon a variable rate. Interest rate swap contracts typically are
used as hedges against interest rate risk or to provide fixed debt service payments to
an issuer or conduit borrower dependent on a specified revenue stream for payment
of such debt. For example, an issuer may issue variable rate debt and
simultaneously enter into an interest rate swap contract. The swap contract may
provide that the issuer will pay to the swap counter-party a fixed rate of interest in
exchange for the counter-party making variable payments equal to the amount
payable on the variable rate debt.

b) Currency swaps: A currency swaps (or cross currency swap) is a foreign

exchange agreement between two parties to exchange a given amount of one
currency for another and, after a specified period of time, to give back the original
amounts swapped. Currency swaps can be negotiated for a variety of maturities up
to 30 years. Unlike a back-to-back loan, a currency swap is not considered to be a
loan by United States accounting laws and thus it is not reflected on a company's
balance sheet. A swap is considered to be a foreign exchange transaction (short leg)
plus an obligation to close the swap (far leg) being a forward contract. Currency
swaps are often combined with interest rate swaps. For example, one company
would seek to swap a cash flow for their fixed rate debt denominated in US dollars
for a floating-rate debt denominated in Euro. This is especially common in Europe

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where companies "shop" for the cheapest debt regardless of its denomination and
then seek to exchange it for the debt in desired currency.

Commodity Derivatives:

Futures contracts in pepper, turmeric, gur (jaggery), Hessian (jute fabric), jute
sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are
traded in 18 commodity exchanges located in various parts of the country. Futures
trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in
futures in the new commodities, especially in edible oils, is expected to commence
in the near future. The sugar industry is exploring the merits of trading sugar futures
contracts. The policy initiatives and the modernization programme include extensive
training, structuring a reliable clearinghouse, establishment of a system of
warehouse receipts, and the thrust towards the establishment of a national
commodity exchange. The Government of India has constituted a committee to
explore and evaluate issues pertinent to the establishment and funding of the
proposed national commodity exchange for the nationwide trading of commodity
futures contracts, and the other institutions and institutional processes such as
warehousing and clearinghouses. With commodity futures, delivery is best affected
using warehouse receipts (which are like dematerialized securities). Warehousing
functions have enabled viable exchanges to augment their strengths in contract
design and trading. The viability of the national commodity exchange is predicated
on the reliability of the warehousing functions. The programme for establishing a
system of warehouse receipts is in progress. The Coffee Futures Exchange India
(COFEI) has operated a system of warehouse receipts since 1998.

1.1.5 Uses of derivatives:

Derivatives are supposed to provide the following services:

1. One of the most important services provided by the derivatives is to

control, avoid, shift and manage efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc. derivatives assist the holders to
shift or modify suitably the risk characteristics of their portfolios. These are

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specifically useful in highly volatile market conditions like erratic trading, highly
flexible interest rates, and volatile exchange rates.
2. Derivatives serve as barometers of the future trends in prices which in
the discovery of new prices both on the spot and futures markets.
Further they help in disseminating different information regarding the
futures markets trading of various commodities and securities to the
society which discover or form suitable or correct true equilibrium
prices in the markets.
3. As we see that in derivatives trading no immediate full amount of the
transaction is required since most of them are based on the margin
trading. As a result, large number of traders, speculators arbitrageurs
operates in such markets. So, derivatives trading enhance liquidity and
reduce transactions costs in the markets for underlying assets.
4. The derivatives assist the investors, traders and managers of large pools
of funds to devise such strategies so that they may make proper asset
allocation increase their yields and achieve other investment goals.
5. It has been observed from the derivatives trading in the market that in
the market that the derivatives have smoothen out price fluctuations,
squeeze the price spread, integrate price structure different points of
time and remove shortages in the market.
6. The derivatives trading encourage the competitive trading in the
markets, different risk taking preference of the market operators like
speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in
trading volume in the country. They also attract young investors,
professionals and other experts who will act as catalysts to growth of
financial markets.

1.1.6 Demerits of Derivatives:

1. Speculative and gambling motives: one of the most important arguments

against the derivatives is that they promote speculative activities in the
market. It is witnessed from the financial markets throughout the world that
the trading volumes in derivatives have increased in multiples of the value of
the underlying assets. As such speculation has become the primary purpose

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of the birth, existence and growth of derivatives. Sometimes these

speculative buying and selling by professionals have adversely affect the
genuine producers and distributors.
2. Increase in risk: The derivatives are supposed to be efficient tool of risk
management in the market. In fact this is also one sided argument. It has
been observed that the derivatives market-especially OTC markets, as
particularly customized, privately managed and negotiated and thus they are
highly risky. Empirical studies in this respect have shown that derivatives
used by the banks have not resulted in the reduction in risk, and rather these
have raised new types of risks.
3. Instability of financial system: it is argued that derivatives have increased
the risk not only for their users but also for the whole financial system. The
fears of micro and macro financial crisis have caused to unchecked growth of
derivatives which have turned many market players into big losers. The
malpractices, desperate behavior and fraud by users of derivatives have
threatened the stability of the financial markets and the financial system.
4. Price instability: Some experts argue in favor of the derivatives that their
major contribution is forward contribution is toward price stability and price
discovery in the market whereas some others have doubt about this. Rather
they argue that derivatives have caused wild fluctuations in asset prices and
moreover they widened the range of such fluctuations in the prices. The
derivatives may be helpful in the price stabilization only if there exist a
properly organized, competitive and well regulated market. Further the
traders behave and function in professional manner and follow standard code
of conduct. Unfortunately all these are not so frequently practiced in the
market and hence the derivatives sometimes cause to price instability rather
than stability.
5. Displacement effect: There is another doubt about the growth of the
derivatives that they will reduce the volume of the business in the primary or
new issue market specifically for new and small corporate units. it is
apprehension that most of investors will divert to derivatives markets,
raisings fresh capital by such units will be difficult and hence this will create
displacement effect in the financial market. However it is not so strong

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argument because there is no such rigid segmentation of investors and

investors behave rationally in market.

1.1.7 Users of Derivatives:

The participants in the derivatives markets can be classified into three broad
categories. These are the arbitrageurs, the speculators and the hedgers.

Arbitrageurs:
These are an important category as the principles underlying the valuation of
derivatives are based on the assumption that capital markets are efficient and
opportunities for arbitrage are inexistent. Arbitrage can be defined as the ability to
make a risk-less profit from market anomalies.

Speculators:

Speculators are traders who aim to make profits from favorable market movements.
In other words speculators are investors that are after capital gains. Traders using
derivatives take leveraged positions and hence the market risk of the underlying
assets is amplified.

Hedgers:

Before discussing how derivatives can be used in mitigating risk, it is essential to

understand risk and the implications of hedging. Hedging does not imply avoiding
losses but reducing uncertainty i.e. risk. Higher risks could result in higher returns
and therefore hedging against risks entails reducing the likelihood of excessive gains
as well as excessive losses. For example, the appreciation of the euro against the
US$ during 2003 shaved US$ 1.25 billion from Volkswagen operating income for
that year. Hedging would have reduced this loss but if the euro weakened instead of
strengthening, Volkswagen would have forfeited the opportunity to make an
exceptional gain. The decision on whether to hedge or not depends primarily on the
extent to which a business can pass on adverse market movements to consumers. If
one refers to the local market, competition has intensified and it is very difficult for
local businesses to pass on adverse movements in say interest rates, exchange rates
and commodity prices to consumers. A counter argument to this is that if hedging is

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not the norm then all market suppliers are in the same position and therefore at the
end of the day adverse market fluctuations are borne by consumers. Nonetheless, not
all market suppliers are equally sensitive to market fluctuations so such argument
may not hold in practice.

1.1.8 Derivatives Markets:

Derivatives are either traded ‘over-the-counter’ or on specialized exchanges. Over-

the-counter (OTC) derivatives are entered into between two parties directly. One
party would normally be a bank or an investment bank, while the counterparty is
likely to be a corporate or an institutional investor. On the other hand exchange
traded derivatives are traded, to a certain extent, similarly to listed equities and
bonds. The main difference is that while OTC derivatives are specifically engineered
according to the needs of the parties involved, exchange traded derivatives are
standardized contracts. Normally, OTC derivatives are offered by banks and each
bank will have an agreement which governs the relationship between the bank and
counterparty vis-à-vis the derivative contract. This agreement would be based on the
International Swaps Dealers Association (ISDA) master agreement but can be
slightly modified particularly for exotic contracts. Needless to say, it is important
that financial controllers that are considering the use of OTC derivatives, with the
assistance of their company’s lawyers, understand the contents of these agreements.
Exchange traded derivatives are standardized and the terms and conditions of each
contract are set out by the exchange where they are traded. The fact that these are
traded on an exchange and due to their standardized nature makes these contracts
highly liquid. However, their liquidity declines with the duration of the contract, i.e.
generally the longer the duration of the contract, the lower the volume of
transactions in that contract. Liquidity also depends on the popularity of the contract
in terms of willing buyers and sellers. Standardization helps to keep the transaction
costs involved in trading these instruments low. The exchange guarantees that the
contract will be honoured and to ensure fulfillment every exchange uses what is
termed as a margining system. When a contract is bought or sold, the buyer/seller is
bound to make a deposit with the clearing house of the exchange. This deposit
would be a percentage of the contracted amount. This deposit is referred to as the
initial margin. Derivative trading in India takes can place either on a separate and

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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.

1.1.9 The regulatory framework of Derivatives markets in India

With the amendment in the definition of 'securities' under SC(R)A (to include
derivative contracts 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 Exchange/Segment & Clearing Corporation/House provide a
transparent trading environment, safety & integrity and provide facilities for
redressal of investor grievances. Some of the important eligibility conditions are-

o Derivative trading to take place through an on-line screen based

Trading System.
o The Derivatives Exchange/Segment shall have on-line surveillance
capability to monitor positions, prices, and volumes on a real time
basis so as to deter market manipulation.
o The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a
real time basis through at least two information vending networks,
which are easily accessible to investors across the country.

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o The Derivatives Exchange/Segment should have arbitration and

investor grievances redressal mechanism operative from all the four
areas / regions of the country.
o The Derivatives Exchange/Segment should have satisfactory system
of monitoring investor complaints and preventing irregularities in
trading.
o The Derivative Segment of the Exchange would have a separate
Investor Protection Fund.
o The Clearing Corporation/House shall perform full novation, i.e., the
Clearing Corporation/House shall interpose itself between both legs
of every trade, becoming the legal counterparty to both or
alternatively should provide an unconditional guarantee for
settlement of all trades.
o The Clearing Corporation/House shall have the capacity to monitor
the overall position of Members across both derivatives market and
the underlying securities market for those Members who are
participating in both.
o The level of initial margin on Index Futures Contracts shall be related
to the risk of loss on the position. The concept of value-at-risk shall
be used in calculating required level of initial margins. The initial
margins should be large enough to cover the one-day loss that can be
encountered on the position on 99% of the days.
o The Clearing Corporation/House shall establish facilities for
electronic funds transfer (EFT) for swift movement of margin
payments.
o In the event of a Member defaulting in meeting its liabilities, the
Clearing Corporation/House shall transfer client positions and assets
to another solvent Member or close-out all open positions.
o The Clearing Corporation/House should have capabilities to
segregate initial margins deposited by Clearing Members for trades
on their own account and on account of his client. The Clearing
Corporation/House shall hold the clients’ margin money in trust for

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the client purposes only and should not allow its diversion for any
other purpose.
o The Clearing Corporation/House shall have a separate Trade
Guarantee Fund for the trades executed on Derivative Exchange /
Segment.

Presently, SEBI has permitted Derivative Trading on the Derivative

Segment of BSE and the F&O Segment of NSE.

1.1.10 Eligibility criteria for stocks on which derivatives trading is permitted:

A stock on which stock option and single stock future contracts are
proposed to be introduced is required to fulfill the following broad
eligibility criteria:-

o The stock shall be chosen from amongst the top 500 stock in terms of
average daily market capitalization and average daily traded value in
the previous six month on a rolling basis.
o The stock’s median quarter-sigma order size over the last six months
shall be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is
the mean order size (in value terms) required to cause a change in the
stock price equal to one-quarter of a standard deviation.
o The market wide position limit in the stock shall not be less than
Rs.50 crores.

A stock can be included for derivatives trading as soon as it becomes

eligible. However, if the stock does not fulfill the eligibility criteria
for 3 consecutive months after being admitted to derivatives trading,
then derivative contracts on such a stock would be discontinued.

1.1.11 Minimum contract size:

The Standing Committee on Finance, a Parliamentary Committee, at the time of

recommending amendment to Securities Contract (Regulation) Act, 1956 had
recommended that the minimum contract size of derivative contracts traded in the
Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this

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recommendation SEBI has specified that the value of a derivative contract should
not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In
February 2004, the Exchanges were advised to re-align the contracts sizes of
existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were
authorized to align the contracts sizes as and when required in line with the
methodology prescribed by SEBI.

1.1.2 Lot size of a contract:

Lot size refers to number of underlying securities in one contract. The lot size is
determined keeping in mind the minimum contract size requirement at the time of
introduction of derivative contracts on a particular underlying.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum
contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be
200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

1.1.13 Derivatives and Risk:

Derivatives help to manage risk in new ways--an important economic function. Yet
the risks involved in derivatives activities are neither new nor unique. They are the
same kinds of risks found in traditional financial products: market, credit, legal, and
operational risks.

Because over-the-counter derivatives are customized transactions, they often

assemble risks in complex ways. This can make the measurement and control of
these risks more difficult and create the possibility of unexpected loss. Banking
supervisors have conducted several studies into the implications of derivatives for
the financial system. None of these studies concluded that derivatives significantly
increase systemic risk, but neither did they find cause for complacency.

For derivatives activity to grow and prosper, those who take part in it--whether as
dealers, end-users, or both--should continue laying a strong foundation of good
management practice. They also should provide the public with information that will
allay unjustified fears by demystifying this activity. And participants should discuss

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openly with legislators, supervisors, and regulators, ways to further strengthen the
current institutional framework.

These steps are both appropriate and sufficient to address the systemic and other
concerns about derivatives activity. Without minimizing the significance of these
concerns, this Study does not conclude that any fundamental changes in the current
regulatory framework, such as separate regulation of this activity, are needed.

Separate regulation of global derivatives would be at cross-purposes with the

existing framework of supervision, with its focus on the common risks contained in
derivatives and traditional instruments. There is also a danger in imposing regulatory
formulas that inhibit new product innovation or discourage firms from developing
the individualized, robust risk management systems on which they should rely. The
Various types of risks in derivatives are given below:

Credit Risk: It is also called default risk. The risk that a counter party will default
on its obligations is called credit risk. Most of the derivatives transactions are
executed through over the counter and recognized exchanges. An exchange traded
futures contracts is likely to have significantly less counter party risk in comparison
to OTC driver contracts. The major factors influencing the credit risk are such as
rating system, scope for credit enhancements, sophistication of users, measurement
approach, need for diversified client bases, product characteristics, valuation data,
barriers to entry, etc. The credit analysis includes the techniques which are used to
measure the ongoing credit risk that the firm is bearing. The major technique
include: using risk adjusted return calculations applying options theory to credit
default analysis; using efficient portfolio and aggregating risks into a single
measurement by the statistical correlation between individual credit risks. After
analyzing the credit risk of counter party next step is to control credit risk. Various
methods have been suggested like collateral agreements, netting agreements, credit
guarantees, credit triggers, mutual termination options, etc.

Market Risk: This risk relates to adverse changes in the market price of a
derivative. In other words, market risk exposes a firm to uncertainty due to changes
in various market factors like foreign exchange rates, commodity prices, equity
prices, volatility related to options positions, market interest rates etc. in fact market

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risk arises due to market factors, which is beyond the control of counter party. Such
risk is to be estimated and then steps are taken to mange the same. There are three
important aspects relating to market risk: ‘tools’ necessary to carry out timely and
accurate measurement, technique of risk analysis and monitoring and strong and
effective lines of communication to senior management. In order to develop a sound
market risk approach, an organization and culture, executives skill, theoretical
underpinnings, systems architecture, procedure and control, portfolio characteristics,
management information etc.

Liquidity Risk: Liquidity risk refers to the fluctuation of derivative instruments

prices for not quickly sold or purchased in the market. Sometimes due to various
factors, a particular derivative may not be easily sold at a fair price. It is observed
that usually liquidity risk is higher at OTC market in of a comparison to exchange
traded derivatives. Two elements of liquidity risk arise due to relative ability of an
organization to transfer its assets into, and second the mismatch between the bank’s
cash inflows and outflows arising out of derivative activity. The transfer ability of a
derivative to be converted in to cash at fair value depends largely on the existence of
the secondary market. This depends upon three factors: a) transaction costs incurred
on liquidation determined largely by bid ask spread. b) cost of exposure of the
position maintained and c) the cost of hedging the exposure, where possible. Trade
off between the three components would determine the rate of liquidation.
Sometimes, large derivatives portfolios can be subject to sudden cash demands and
thus creating mismatch between a banks cash inflows and outflows. This position
may make liquidity management for off balance sheets products crucial. Sudden
liquidity changes can arise out cash flow risk, which the bank should monitor
considering the potential price and volatility changes in derivative instrument.

Legal Risk: Legal risk is the likelihood that the counterparty is not legally bound to
fulfill his obligations under the derivative contract or that the derivative contract
does not cover certain situations. This situation is similar to that where a person
takes insurance cover and later on he finds out that certain risks are not covered or
that the insurance contract is null and void. An example of legal risk involving
derivatives is that of the London borough of Fulham and Hammersmith. Between
1983 and 1989, this borough entered into derivative contracts with various banks.

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The derivative contracts were losing money and the borough defaulted from its
commitments. In 1991, the House of Lords declared that the borough did not have
the contractual capacity to enter into such contracts and therefore the contracts were
null and void. It is estimated that a number of banks, which were the counterparties
of the borough in question, made 400 million losses plus incurring 15 million in
legal fees.

Operational risk: This risk relates to that errors or frauds which may occur in
carrying out operations, placing orders, making payments, taking derivatives,
accounting for derivatives transactions. The main reason for this is that operational
risk is every where within an organization. Since derivative transaction decisions are
taken by senior management in the organization and implemented by the executory
functionaries through business line technologies; various sophisticated instruments
are used for placing the orders and then for cleaning them. Thus potential exposures
commonly associated with operations are diverse. These may relate to technology
choices: batch vs. real time processing, intra day settlement exposure, cross border
payment issue, reliance or manual controls, multilateral vs. bilateral payment
systems, timing of payment and delivery. Many of these issues even go beyond the
organization level. Operational risk is relevant to the entire value chain of an
organization technology and people. Manual and automated controls throughout the
organization all have a part to play in creating a secure operational environment.
Thus operational risk can be mitigated internally through proper controls and
procedures and a detailed understanding of all stages of the operational process.

The other types of risks linked to derivative products are:

Leverage: When an investor trades derivative products it must provide a deposit

and/or exchange (pay or receive) a premium. The amount provided as the deposit or
exchanged as a premium represents only a fraction of the derivative product's value.
Transactions in derivative products involve significant leverage as a relatively small
fluctuation in the price of the underlying instrument can have a proportionately
greater impact on the cash or on the value of any other guarantee deposited by the
investor. This can work for and against the client. If the market moves in an
unfavorable direction, the investor may not only lose more than the full amount of
the initial margin deposit, but also pay an additional margin and meet margin calls.

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To maintain the investor's position, new margin payments can be requested on very
short notice, occasionally during a market session. If the investor does not meet
margin calls within the required time limit, its position may be liquidated and the
investor will be liable for any debit balance on its account. Losses may therefore be
far greater than the margin initially deposited with the clearing house or than the
premium exchanged.
Liquidity and price fluctuations: Derivatives markets can be illiquid. If the market
is not sufficiently liquid, the investor may be unable to liquidate or even partially
close out a futures position at the desired time. In addition, the difference between
the bid price and the offer price of a given contract may be significant. Prices on
derivatives markets can fluctuate considerably, depending on a number of factors
that are difficult to forecast. The price and liquidity of any investment depends upon
the availability and value of the underlying asset, which can be affected by a number
of extrinsic factors including, but not limited to, political, environmental and
technical. Such factors can also affect the ability to settle or perform on time or at
all. The impact of these events on the liquidity and prices increases as the maturity
date is near.
Orders aimed at limiting a loss (stop-limit, stop-loss): Trading conditions on
futures markets allow investors to place orders with a stop-limit price and orders
with a trigger threshold, which are also referred to as “stop orders”. These orders
were designed to limit losses that could occur as a result of market fluctuations. The
use of such orders does not provide a guarantee that losses will be limited to the
intended amounts. Placing contingent orders, such as "stop-loss" or "stop-limit"
orders, will not necessarily limit its losses to the intended amounts, since market
conditions on the exchange where the order is placed may make it difficult or
impossible to execute such orders.
Commission, fees and taxes: All charges relating to a futures transaction reduce the
investor's profit or increase its loss. Commission, agreed upon between the broker
and investor, is paid in addition to the fees due to the markets and clearing houses.
Before concluding a transaction, investors must be informed of all fees and costs to
be paid. Any payments made or received in relation to any investment may be
subject to tax and the Client should seek professional advice in this respect.
Seller and buyer obligations: Transactions in derivative products involve the
obligation to make, or to take, delivery of the underlying asset of the contract at a

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future date, or in some cases to settle the position with cash, in accordance with the
applicable market conditions.
(a) Obligation to deliver: Unless it is able to offset its position before the
delivery date and thereby free itself from its obligation, the seller of a futures
contract or a call option may be required to deliver a predetermined quantity of
the underlying instrument, in accordance with the relevant market and clearing
house rules. The terms and conditions of trading require the seller to deliver the
underlying asset in accordance with the characteristics of the contract. If the
seller does not comply with this obligation, it may risk incurring additional costs
and penalties.
(b) Obligation to take delivery: Unless it is able to offset its position before the
delivery date and thereby free itself from its obligation, the buyer of a futures
contract or the seller of put option must accept delivery of and pay for the
underlying instrument, in accordance with the relevant market and clearing
house rules. It may have to pay an amount higher than the margin deposited with
the clearing house. For commodities, it may be required to agree to the necessary
storage, to organize transport and to take responsibility for any subsequent
related costs. If the buyer is not the end buyer of the commodity or a trader in
commodities of this type, it may encounter difficulties relating to storage or
sales, due to the fact that it cannot use the commodity in question. Furthermore,
there is a risk of loss if it decides to sell the commodity on the spot market. The
margin deposited by the buyer of a futures contract serves solely as a guarantee
and is not valid for the partial execution of its obligations.

Non-fungibility of contracts: As such, the orders we execute on behalf of our

clients are carried out on regulated markets and in some cases on over-the-counter
markets. Cases in which the same instrument can be traded on different markets, and
where two instruments are fungible, are exceptional. Before placing an order
relating to a product and prior to selecting a market, the client must assess the
market and its historical performance in order to take into account, in particular, its
liquidity. Where the Client is unable to transfer a particular instrument which it
holds, to exit its commitment under that instrument, the Client may have to offset its
position by either buying back a short position or selling a long position. Such an
offsetting transaction may have to be over the counter and the terms of such a

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contract may not match entirely those of the initial instrument. For example, the
price of such a contract may be more or less than the Client received or paid for the
sale or purchase of the initial instrument.
Foreign markets and emerging markets: Foreign markets will involve different
risks from the French markets. In some cases the risks will be greater. On request,
Calyon Financial will provide an explanation of the relevant risks and protections (if
any) which will operate in any foreign markets, including the extent to which it will
accept liability for any default of a foreign firm through whom it deals. The potential
for profit or loss from transactions on foreign markets or in foreign denominated
contracts will be affected by fluctuations in foreign exchange rates. Such
transactions may also be affected by exchange controls that could prevent or delay
performance
Risk of default or insolvency: insolvency or default, or that of any other brokers
involved with the Client’s transaction, may lead to positions being liquidated or
closed out without the Client’s consent. In certain circumstances, the Client may not
get back the actual assets which it lodged as collateral and the Client may have to
accept any available payments in cash.

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Section-2

1.2.1 Objectives of study:

In the present current scenario when derivatives are playing an important role it is
essential to study and analyze the perception of investors who actually deals in them
and also what they feels about these innovative financial instruments. The objectives
of the study are:
1. To study the customer perception regarding the derivatives
with reference to future and options.
2. To study the customer preference between the future and
options.
3. To study the risk factors affecting derivatives.

1.2.2 Null Hypothesis:

1. H0 = Preference of derivatives is independent to types of contracts

2. H0= Risk factor is not related to the return as factor of decision.
3. H0= Risk factor is not related to the safety as a factor of decision.
4. H0= Risk factor is not related to the liquidity as a factor of decision.
5. H0= Risk factor is not related to the tax saving as a factor of decision.
6. H0= Risk is not related to the speculation as a factor of decision.
7. H0= All the risks are not dependent on one another.

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1.2.3 Rationale of study:

In present current scenario when derivatives have taken the markets by sweep,
it is essential to study and analyze what the investor, who actually deals in
them, feels about these innovative financial instruments. The study intends to
have an insight into the expectations, apprehensions and interpretations of
these individual investors about this a new kind of the financial markets. The
study is also conducted to know the various risks involved in the derivatives.

1.2.4 Research Methodology:

1.2.4.1 Research Design: The research design carried out here is descriptive
research design.
1.2.4.2 Scope of Study: The scope of study is limited to the area of Chandigarh city.
1.2.4.3 Sample Size: Sample size of my study is 100 respondents or the investors of
Chandigarh.
1.2.4.4 Population: The sample size is 100 respondents or investors who invest in
the derivatives with respect to the future and options.
1.2.4.5 Sampling Technique: Convenience sampling is used as a technique of
sampling.
1.2.4.6 Data Collection Methods: The following methods are used for the purpose
of collection.
 Primary Method: The primary data is collected with the help of the
questionnaires in which both open ended and closed ended questionnaires
are asked from the investors related to derivatives with special reference to
future and options.
 Secondary Method: The secondary data is collected with the help of various
books related to the derivatives and from the various internet sites.
1.2.4.7 Tools of Data Analysis: Chi square and correlation are used as the tools of
data analysis and the data is classified with the help of bar diagrams and pie charts.

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References:
Gupta. S.L (2006), financial derivatives, 5th addition, prentice hall of India.

Websites:

http://en.wikipedia.org/wiki/Derivative_(finance)
http://www.edinformatics.com/investor_education/derivatives.html
http://www.reliancemoney.com/KB/Story.aspx?ArticleID=6ac0bbee-e465-4e97-
b882-59a1485bbdcc
http://www.investorbuddy.com.au/learning-centre/common-types-of-derivatives
http://finance.indiamart.com/markets/commodity/derivatives.html
http://www.sjsu.edu/faculty/watkins/deriv.html

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2.1 Survey of Literature

Brangers N, Schlag, C & Schneider E (2007) make a general equilibrium analysis

in a complete markets economy when the dividend is declared. The key output of
their analysis is the structure of the investors’ optimal portfolios and the volume and
direction of trading between them. It was found that trading in derivatives is
economically significant, with a value of traded contracts of up to twenty percent of
total market capitalization. In line with intuition, the less risk-averse investor holds
more pure stock price risk than the more risk-averse one. Volatility derivatives, on
the other hand, are special in the sense that the direction of trading depends on the
exact values for the levels of risk aversion of the individual investors, not just on
who is more and who is less risk-averse.

Handa (2006) summarized that in present current scenario when derivatives have
taken the markets by sweep, it is essential to study and analyze what the
investor, who actually deals in them, feels about these innovative financial
instruments. The study intends to have an insight into the expectations,
apprehensions and interpretations of these individual investors about this a
new kind of the financial markets. To effectuate the objectives a representative
sample of 70 investors was chosen, their responses recorded and analyzed
using various statistical techniques. The paper also traces the growth of the
derivatives markets since their inception on the Indian bourses. At the same
time, it also draws the attention towards the impediments on this seemingly
smoothes road which can make the journey ahead rather bumpy.

Sharma and Gupta (2006) abstracted the impact of derivatives on the Indian
capital market. It is necessary to understand and measure the impact of various
factors on derivatives is necessary since it stirred the micro structures of
Indian capital market in general stock exchanges in particular. Derivatives
derive their values from the underlying instruments. An attempt is therefore,
made to study and analyze the impact of underlying instruments on the price
of futures on the selected companies of NSE on which future trading is
permitted. Changes in the price of equity stock and index value are expected to

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cause changes in the price of equity stock futures and nifty index futures
respectively. The study confirms this belief on the basis of regression analysis
of the selected companies.

Arnoldi (2006) the article is concerned with problems of 'framing' in electronic

derivatives markets. Traders in any given trading environment 'frame' or interpret
information about the market by drawing on a range of other information,
knowledge and heuristics. Such framing reduces uncertainty. In an open outcry
market environment, framing information would be flowing in the social networks
of that market environment. In electronic markets, traders do not interact with their
counterparts and are generally disembedded from the social networks of the open
outcry environment. Other ways of framing therefore have to be found. The article
examines various ways in which this happens. The article also suggests, however,
that framing in an electronic market environment remains difficult and that
electronic trading therefore creates incentives to do other forms of trading as well,
such as block trading, where there is more personal interaction, and where frames
can therefore be re-established more easily.

Acharya (2005) summarized that insider trading in the credit derivatives market has
become a significant concern for regulators and participants. This paper attempts to
quantify the problem. Using news reflected in the stock market as a benchmark for
public information, we report evidence of significant incremental information
revelation in the credit default swap (CDS) market under circumstances consistent
with the use of non-public information by informed banks. Specifically, the
information revelation occurs only for negative credit news and for entities that
subsequently experience adverse shocks. Moreover the degree of advance
information revelation increases with the number of banks that have
lending/monitoring relations with a given firm, and this effect is robust to controls
for non-informational trade. We find no evidence, however, that the degree of
asymmetric information adversely affects prices or liquidity in either the equity or
credit markets. If anything, with regard to liquidity, the reverse appears to be true.

Nasakkala (2004) concluded the derivative markets from a view point of an

electricity producer. The traditionally used asset pricing methods, based on the
no arbitrage principle, are extended to take into account electricity specific

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features: the non storability of electricity and the variability in the load
process. The sources of uncertainty include electricity forward curve, prices of
resources used to generate electricity, and the size of the future production.
Also the effects of competitors' actions are considered. The thesis illustrates
how the information in the derivative prices can be used in investment and
production planning. In addition, the use of derivatives as a tool to stabilize
electricity dependent cash flows is considered. The results indicate that the
information about future electricity prices and their uncertainty, obtained from
derivative markets, is important in investment analysis and production
planning.

Gupta (2004) discusses the introduction and growth of the derivatives market in
India. It describes in detail the reasons that led to the introduction of derivatives
trading in India and why it faced opposition by a section of industry analysts and
media. The case then describes the issues that still remain to be addressed by the
regulatory authorities to accelerate the long-term growth of the derivatives market.
Finally, the case mentions a few steps taken by the concerned authorities in early
2004. Main objectives and reasons for the introduction of derivatives trading in
India; and the factors that can accelerate/suppress the growth of the derivatives
market in a country.

Garcia, P., Leuthold, R. M. (2003) summarized the development of intertemporal

price relationships; hedging and basis relationships; price behavior; and institutional
issues related to futures markets. In each case the recent contributions are
recognized. Using this base of information as background, future research directions
are discussed with respect to the following topics: risk management and marketing
strategies; price and volatility behavior; electronic trading, price discovery and
trading funds; and exchange behavior.

Tehran and Kaur (2003) viewed as the negative image of crisis created by
derivatives overwhelms any positive publicity on the use of derivatives. It is
not cleared whether derivatives enable us to mange risk or just magnify it.
This paper is an attempt to explore the scope of derivatives transactions in
emerging markets, the policy developments regarding risk containment

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measures for stock options and for stock futures, the need and regulations for
risk management and the relevance of derivatives in India.

Streltchenko (2003) abstracted in derivative research that why investors trade in the
derivatives at a specified price. Here a model is developed that explicitly
incorporates a motivation to trade into the mathematical model describing the
investment problem. This motivation lies in investors' pre-existing liabilities. By
showing the equivalence, via a duality argument, of portfolio optimization and
derivatives pricing operator (measure) calibration, we are also able to explore (using
the same model) derivative valuation by investors in light of their individual
portfolio properties. It is conducted a simulation of a market populated with
investors whose decision support was based on this microeconomic model, and
observed various trading patterns depending on investors' individual properties.

Mahajan(2003) abstracted that in this dynamic environment financial innovation is

the word of the day as the tool of risk management. It is crucial to introduce
innovative risk reducing and risk transferring instruments to maintain the market
efficiency i.e. risk return trade off while increasing the liquidity at mass level and to
protect the operating profits of market participants from volatility and uncontrollable
risk at class level. The integration of financial markets and free mobility of capital
has multiplied risk due to complex nature of financial structuring and multiple
currency transactions. The information technology has contributed by eliminating
the geographical and time disparities and increased market efficiency. This dynamic
global financial environment creates the need for a shift from financial innovation to
financial engineering. Financial derivatives are the latest and modern type of
financial engll1eenng derivatives. They have been very successful risk management
tool in the world capital market. This paper discusses about the history of derivatives
which goes back to more than 100 yrs. It also discusses about various types of
derivatives with special reference to futures and options it also throws some light on
the working of the derivatives market. It also highlights the current scenario and
future of the derivative market.

Liang T. (2001) said that transactions are notoriously subject to a variety of risks
such as credit or counterparty risk, market risk, settlement risk, operational risk

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(remember Nick Lesson), liquidity risk, systemic risk and legal risk. There are a
variety of legal risks (which is beyond the scope of this article) and not least of all,
documentation risk. It is hoped that the above discussion will have given some
indication how such documentation risk in relation to derivatives can arise.

Bichler M. (2000) examined that Derivative instruments have become increasingly

important to financial institutions, institutional investors, traders and private
individuals throughout the world, both as risk-management tools and as a source of
revenue. The volume of over-the-counter (OTC) traded derivatives has increased
enormously over the past decade, because institutional investors have often had a
need for special derivative products which are not traded on organized exchanges.
An important feature of OTC trading is the bargaining on multiple attributes of a
contract such as price, strike price and contract maturity. Negotiation on multiple
attributes of a deal is currently not supported by electronic trading floors. In this
paper we describe an approach of how to automate the multi-attribute multilateral
negotiations using a Web-based trading system. First, we will give an overview of
various approaches to supporting or automating negotiations on multiple attributes.
Then we will introduce multi-attribute auctions, an extension of single-sided auction
theory and analyze preliminary game-theoretic results. Finally, we will show a Web-
based electronic trading system for OTC derivatives, based on multi-attribute
auctions.

Fatemi A. & Glaum M. (2000) Identifies some gaps in corporate risk management
research and presents a study of risk management practices in large, non-financial
German firms. Compares the perceived relevance of different types of risk with the
intensity of their management and reports that no respondents admitted major
difficulty in developing a risk management system. Finds that firm survival is rated
as the top goal of risk management, that respondents are closer to risk-neutral than
risk-averse for financial risks, that around half centralize treasury management and
88 per cent use derivatives. Ranks the types of derivatives used and the importance
of associated problems; shows how foreign exchange risk, US $ exposure and
interest rate risk are managed; and assesses attitudes towards foreign exchange and
interest rate risk management. Considers consistency with other research and calls
for more.

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Dixon R & Bhandari K. (1997) summarized that an extraordinary increase in the

use of financial derivatives in the capital markets. Consequently derivative
instruments can have a significant impact on financial institutions, individual
investors and even national economies. This relatively recent change in the status of
derivatives has led to calls for regulation. Fears that using derivatives to hedge
against risk carries in itself a new risk was brought sharply into focus by the collapse
of Barings Bank in 1995. The principal concerns of regulators about how legislation
may meet those concerns are the subject of current debate between the finance
industry and the regulators. Recommendations have been made and reviewed by
some of the key players in the capital markets at national and global levels. There is
a clear call for international harmonization and its recognition by both traders and
regulators. There are calls also for a new international body to be set up to ensure
that derivatives, while remaining an effective tool of risk management, carry a
minimum risk to investors, institutions and national/global economies. Having
reviewed derivatives and how they work, proceeds to examine regulation. Finds that
calls for regulation through increased legislation are not universally welcome,
whereas the regulators’ main concern is that the stability of international markets
could be severely undermined without greater regulation. Considers the expanding
role of banks and securities houses in the light of their sharp reactions to increases in
interest rates and the effect their presence in the derivatives market may have on
market volatility. Includes the reaction of some 30 dealers and users to the
recommendations of the G-30 report and looks at some key factors in overcoming
potential market volatility.

Figlewski (1997) reviewed that derivative instruments have been traded for a long
time, the enormous growth in the volume and variety of futures, options, swaps, and
more exotic types of contracts in recent years has been without precedent. Concern
about the risks of trading in these instruments is also not new, but it too has grown
along with the markets. In the last couple of years, a series of widely publicized
losses related to derivatives activities has focused public attention (once again) on
derivatives risks. Through derivatives, major classes of risk that in the past were
mostly borne by specialized financial institutions, with limited risk bearing capacity,

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can now be shared more broadly. For example, derivatives based on mortgages
allow home buyers to acquire funds from the bond market rather than having to rely
on the ability of savings and loans and similar financial institutions to attract
deposits. Recent innovations in derivatives based on catastrophic risks like
hurricanes and earthquakes are beginning to make it possible for insurance
companies to share risk exposure more broadly with outside investors. Derivatives
with option features allow investors to restructure risk exposures to provide
preferred patterns. For the public, this often means allowing an investor to control
the risk of a loss from an adverse price change without eliminating the possibility of
profiting from a favorable market move.

Okamoto (1996) found a system and method for creating a limited risk derivative
based on a realized variance of an underlying equity is disclosed. In one
implementation, a limited risk derivative product includes a capped value for a
statistical property reflecting a variance of the underlying equity is calculated based
on a pari-mutuel action. The capped value comprises a dynamic value and a cap.
The dynamic value reflects an average volatility of prices returns of the underlying
equity over a predefined period of time and the cap reflects a maximum value of the
dynamic value. The limited risk derivative product additionally includes an average
of a summation of each squared daily return of the underlying equity included in the
value for the statistical property reflecting the variance of the underlying equity.

Porterfield, Laura J. (1994) summarized growing size and complexity of the

derivatives market has prompted calls for improved reporting of information about
derivative activities. Derivatives, such as swaps, forwards, futures, calls, floors,
collars and puts, are financial instruments that derive their values from an
underlying asset, reference rate or index. They are often used by government
entities, corporations, financial institutions, institutional investors and nonprofit
organizations to manage exposures stemming from their asset and liability mix in
response to rising public concern about these very complex products, the FASB has
embarked on a limited-scope project on derivative activity disclosures. As part of
this project, the Board has issued the exposure draft, 'Disclosure about Derivative
Financial Instruments and Fair Value of Financial Instruments,' to enhance such
disclosures and make technical improvements to the disclosures in time for 1994

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year-end reporting. Derivative financial instruments, puts, calls, futures, et al, are in
the news and people are concerned. The FASB has issued an exposure draft that
proposes additional disclosures for these financial instruments in financial
statements for this year end. Swaps, forwards, futures, puts, calls, swaptions, caps,
floors, collars, captions--the rapid growth of these useful but complex and poorly
understood financial instruments, known collectively as derivatives, has propelled
them into the spotlight as one of today's hottest financial topics. Accountants--
prepares, auditors, and standard-setters--are struggling to keep pace with this
innovative and increasingly important market.

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References:

Acharya V. Viral, (2005) The Journal of Financial Economics, Vol. 84, No.pp.110-
141 http://www.defaultrisk.com/pp_crdrv_58.html

Fatemi Ali & Glaum, Risk management practices of German firms from the Journal
of Managerial Finance, 2000 Volume: 26, Issue: 3 Page:1 –
17,DOI:10.1108/03074350010766549,Barmarick Publications

Bichler M. (2000) Springer Publisher Volume 1, Number 4, April 2000, pp. 401-
414(14)http://www.ingentaconnect.com/content/klu/isfi/2000/00000001/00000004/0
0258707

Brangers N, Schlag, C & Schneider E (2007) available in the article of Derivatives

Trading in a General Equilibrium Model,
http://www.wiwi.unifrankfurt.de/schwerpunkte/finance/wp/1537.pdf

Dixon R & Bhandari K. (1997), Journal: International Journal of Bank Marketing,

Volume: 15 Issue: 3 Page: 91 – 98, DOI: 10.1108/02652329710166000,
http://www.emeraldinsight.com/10.1108/02652329710166000

Figlewski (1997) Article: Derivative risks old and new,

http://fic.wharton.upenn.edu/fic/papers/97/b4.html

Garcia, P., Leuthold, R. M. (2003)

http://www.urotoday.com/browse_category/bph_male_luts/luts_treatment_future_tr
eatment_options_abstracts.html

Gupta Vivek Gautam, (2004), ECCH Case Collection, published by ICFAI Center
for Management Research (ICMR),
http://www.asiacase.com/ecatalog/NO_FILTERS/page-EC_INDUS-648548.html

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Okamoto Karl Shumpei (1996) http://www.freshpatents.com/Method-and-system-

for-creating-and-trading-derivative-investment-products-based-on-a-statistical-
property-reflecting-the-variance-of-an-underlying-asset-
dt20070510ptan20070106583.php

Porterfield, Laura J. (1994) Article: Derivative financial instruments: time for better
disclosure, http://www.nysscpa.org/cpajournal/old/15611641.htm

Streltchenko Olga (2003) http://ebiquity.umbc.edu/paper/html/id/198/Exploring-

Trading-Dynamics-in-a-Derivative-Securities-Market-of-Heterogeneous-Agents

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3.1 Sample Break-up

 Sex:

Table 3.1
Sex No. of Respondents

Male 67

Female 33

Total 100

No. of Respondents

33%

Male Female

67%

Figure 3.1

From the sample selected of 100 investors, 67 were of the male and 33 were of
the female. Thus we can say that most of the males invest in the derivatives.

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Age:

Table 3.2
Age Frequency

Under 30 29
Between 30 to 40 35
Between 40 to 50 31

More than 50 5

Total 100

No. of respondents

5%

29%
31%
Under 30
Between 30 to 40
Between 40 to 50
More than 50
35%
Figure: 3.2

Out of the sample of 100 investors 29investors were of less than 30 years of age, 35
were from 30 years to 40 years, 31 were from 40 years to the 50 years and remaining
5 investors were of more than 50 years of age. So we can say that most of the
investors invest from the age of 30 to 40 years.

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Income:

Table 3.3
Income level No. of respondents

Under RS 50000 3

Between RS 50000 to RS 100000 11

Between RS 100000 to Rs 200000 32

More than RS 200000 54

Total 100

60

50

40

30
Income level
No. of respondents
20

10

Figure: 3.3

There are 3 respondents who are having the income of less than Rs. 50000, 11
respondents are from income of Rs. 50000 to Rs. 100000, 32 respondents fall in
the income level of between Rs. 100000 to Rs. 200000 and 54 fall in the income
of more than Rs. 200000. So we can say that most of the investors fall in the
income group of more than Rs. 200000.

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3.2 Which category do you belong to?

Table 3.4

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Category No. of respondents

Studies 14
Business 35
Service 25
Others 26
Total 100

No. of respondents

Studies 14%

Others 26%

Studies Business Service

Others

Business 35%

Service 25%

Figure 3.4
From the sample selected 14 respondents belong to the student category, 35
respondents to the business, 25 respondents to the service and 26 respondents to

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the other categories such as housewives, farmers, agents, brokers etc. so from the
above data collected it can be said that most of the business category invest in
the derivatives.
3.3 What kind if derivatives preferred by you?

Table 3.5
Types of derivatives No. of respondents

Over the counter derivatives 27

Exchange traded derivatives 73

Total 100

No. of respondents

Over the counter derivatives

27%
Over the counter derivatives
Exchange traded derivatives
Exchange traded derivatives 73%

Figure: 3.5

From the sample selected of 100 investors, the type of derivative contracts they
preferred was asked. 27 respondents prefer to deal in over the counter derivatives

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and 73 respondents deal with exchange traded derivatives. So here it can be

interpreted that most of the investors prefer to deal with exchange traded derivatives.

3.4 Which type of contracts under derivatives is preferred by you?

Table 3.6

Type of contracts No. of respondents

Futures 25
Options 29
Both a & b 46

Total 100

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No. of respondents

50
46
45

40

35
29
30
Futures
25
25 Options
20 Both a & b

15

10

5
0
No. of respondents

Figure: 3.6

It was interpreted that from the sample selected of 100 respondents, 25 of the
respondents deal in the futures, 29 deals with the options and remaining 46
respondents deal in both future and options. So it can be said that most of the
people deal in the both i.e. futures and options.

Hypothesis:
Ho = Preference of derivatives is independent to types of contracts
Ha = Preference of derivatives is dependent to types of contracts
The value of Chi square is 0.022989.
The tabulated value of chi square is 0
Here the calculated value of chi square is more than the tabulated value. So the
difference between the observed and expected frequencies is insignificant so the
hypothesis is rejected.

3.5 How much money do you invest in the future and options?
Table 3.7

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Amount invested No. of respondents

Less than Rs. 25000 42

Between Rs. 25000 to Rs. 50000 37

Between Rs. 50000 to Rs 100000 14

More than Rs. 100000 7
Total 100

No. of Respondents

45 42

40 37

35
Less than Rs. 25000
30
Between Rs. 25000 to Rs. 50000
25 Between Rs. 50000 to Rs 100000
More than Rs. 100000
20

15 14

10 7

0
No. of respondents

Figure 3.7

The respondents were asked about the average money invested in future and
options. 42 of the investors replied that they invest less than Rs. 25000, 37 of the

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respondents replied that they invest between RS. 25000 to Rs. 50000, 13
investors invest between Rs. 50000 to Rs. 100000 and 7 investors invest more
than RS. 100000 in the futures and options. So we can say that average
investment falls in the category of less than Rs. 25000.

3.6 What is your average investment period?

Table 3.8
Period No. of respondents

Less than 3 months 23

3 months to 9 months 20

9 months to 12 months 32

More than 12 months 25

Total 100

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No. of respondents

More than 12 months

25% Less than 3 months
23%

Less than 3 months

3 months to 9 months
9 months to 12 months More than 12 months

3 months to 9 months
20%

9 months to 12 months
32%

Figure 3.8
The respondents were asked about the average investment period in future and
options. 23 of the investors replied that they invest for less than 3 months, 20 of
the respondents replied that they invest between 3 months to 9 months, 32
investors invest between 9 months to 12 months and 25 investors invest for more
than 12 months in the future and options. So we can say that average investment
period is between 9 months to 12 months.

3.7 Who influences your investment decision?

Table 3.9

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Influence on investment decision No. of respondents

Broker 37
Family/friends 30
Media 25
Any other 8
Total 100

No. of Respondents

40
37

35
30
30
25
25
Broker Family/friends Media
Any other
20

15

10 8

0
No. of respondents

Figure: 3.9

The influence of the investment decision was asked from the investors. 37
respondent’s decision is being influenced by the brokers, 30 are influenced by
family or friends, 25 are influenced by media and 8 are influenced by any other
person’s decision and it basically includes self decision. so it can be interpreted
that the buying decision is mostly influenced by the broker’s opinion.

3.8 How much is your decision influenced by the above selected option?

Table 3.10

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Extent of influence No. of respondents

To great extent 48

To some extent 50

Very little 2

Total 100

No. of respondents

Very little
2%

To great extent To great extent To some extent

48% Very little
To some extent
50%

Figure 3.10
Here the extent of influence was asked 48 people are greatly influenced by the
selected people and 50 people’s decision influence is to some extent and 2
people have a very little effect. So it can be interpreted that sometimes decision
is more influential and sometimes it is less influential.

3.9 Why do you invest in the Future and Options?

a) Return

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Table 3.11
Ranks for Return No. of respondents

1st rank 59
2nd rank 25
3rd rank 7
4th rank 7
5th rank 2
6th rank 0
Total 100

70
59
60
1st rank 2nd rank 3rd rank 4th rank 5th rank
50
6th rank
40

30 25

20

10 7 7
2 0
0
No. of respondents

Figure 3.11
From the above diagram it is interpreted that out of the sample selected 59 of the
investors give their first preference to the return, 25 investors gave second
preference to return, 7 investors gave third preference to the return, 7 investors
gave return as fourth preference and 2 investors gave return as fifth preference.

Hypothesis:
H0= Risk factor is not related to the return as factor of decision.
Ha= Risk factor is related return as factor of decision.
Here the correlation between return and risk factor is -0.58844877. As we know
that the value of r lies between -1 to 1 so here the value of r = -0.5. In this there is a
negative correlation. So the hypothesis is accepted. So our hypothesis is accepted.

b) Safety

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Table 3.12
Ranks for Safety No of respondents

1st rank 20
2nd rank 20
3rd rank 25
4th rank 6
5th rank 19
6 rank
th
10
Total 100

30
25
25
20 20 1st rank 2nd rank 3rd rank 4th rank 5th rank
19 6th rank
20

15
10
10
6
5

0
No of respondents

Figure: 3.12
From the above diagram it is interpreted that out of the sample selected 20 of the
investors give their first preference to the safety, 20 investors gave second
preference to safety, 25 investors gave third preference to the safety, 6 investors
gave safety as fourth preference, 19 investors gave safety as fifth preference and 10
investors gave safety as the sixth preference.

Hypothesis:
H0= Risk factor is not related to the safety as a factor of decision.
Ha= Risk factor is related to the safety as a factor of decision.

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Here the correlation between return and risk factor is -0.54399373. As we know
that the value of r lies between -1 to 1 so here the value of r = -0.54. In this there is
a negative correlation. In this there is a negative correlation. So the hypothesis is
accepted.

c) Liquidity
Table 3.13
Preference for Liquidity No. of respondents

1st rank 3
2nd rank 21
3rd rank 21
4th rank 26
5th rank 15
6th rank 14
Total 100

30
26
25
21 21 1st rank 2nd rank 3rd rank 4th rank 5th ran
20 6th rank

15
14
15

10

5 3

0
No. of respondents

Figure 3.13

From the above diagram it is interpreted that out of the sample selected of 100
investors, 3 of the investors give their first preference to the liquidity, 21 investors
gave second preference to liquidity, 21 investors gave third preference to the
liquidity, 26 investors gave liquidity as fourth preference, 15 investors gave
liquidity as fifth preference and 14 investors gave liquidity as the sixth preference.

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Hypothesis:
H0= Risk factor is not related to the liquidity as a factor of decision.
Ha= Risk factor is related to the liquidity as a factor of decision.
Here the correlation between liquidity and risk factor is -0.08179367. As we know
that the value of r lies between -1 to 1 so here the value of r = -0.08. In this there is
a negative correlation. In this there is a negative correlation. So the hypothesis is
accepted.

d) Tax saving

Table 3.14
Preference for Tax savings No. of Respondents

1st rank 16
2nd rank 27
3rd rank 29
4th rank 21
5th rank 6
6th rank 1
Total 100

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35
29
30 27
1st rank 2nd rank 3rd rank 4th rank 5th
25
21 6th rank
20
16
15

10
6
5
1
0
No. of Respondents

Figure 3.14
From the above diagram it is interpreted that out of the sample selected of 100
investors, 16 of the investors give their first preference to the tax savings, 27
investors gave second preference to tax savings, 29 investors gave third preference
to the tax savings, 21 investors gave tax savings as fourth preference, 6 investors
gave tax savings as fifth preference and 1 investor gave tax savings as the sixth
preference.

Hypothesis:
H0= Risk factor is not related to the tax saving as a factor of decision.
Ha= Risk factor is related to the tax saving as a factor of decision.
Here the correlation between tax savings and risk factor is -0.88180567. As we
know that the value of r lies between -1 to 1 so here the value of r = -0.88. In this
there is a negative correlation. In this there is a negative correlation. So the
hypothesis is accepted.

e) Speculation
Table 3.15
Preference for Speculation No. of respondents

1st rank 2

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2nd rank 7
3rd rank 17
4th rank 27
5th rank 29
6th rank 18
Total 100

35
29
30 27
1st rank 2nd rank 3rd rank 4th rank 5th rank
25 6th rank

20 17 18

15

10 7

5 2

0
No. of respondents

Figure 3.15
From the above diagram it is interpreted that out of the sample selected of 100
investors, 2 of the investors give their first preference to the speculation, 7
investors gave second preference to speculation, 17 investors gave third preference
to the speculation, 27 investors gave speculation as fourth preference, 29 investors
gave speculation as fifth preference and 18 investors gave speculation as the sixth
preference.

Hypothesis:
H0= Risk is not related to the speculation as a factor of decision.
Ha= Risk is related to the speculation as a factor of decision.
Here the correlation between tax savings and risk factor is 0.467725073. As we
know that the value of r lies between -1 to 1 so here the value of r = 0.46. In this
there is a positive correlation. In this there is a negative correlation. So the
hypothesis is accepted.

f) Risk factors

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Table 3.16
Preference for Risk factors No. of respondents

1st rank 0
2nd rank 0
3rd rank 1
4th rank 13
5th rank 29
6th rank 57
Total 100

60 57

50
1st rank 2nd rank 3rd rank 4th rank 5th r
40 6th rank

30 29

20
13
10
0 0 1
0
No. of respondents

Figure3.16

From the above diagram it is interpreted that out of the sample selected of 100
investors, 1 investor gave third preference to the risk factors, 13 investors gave risk
factors as fourth preference, 29 investors gave risk factors as fifth preference and
57 investors gave risk factors as the sixth preference.

3.10 Rate the following risks related to derivatives?

a) Credit Risk

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Table3.17
Ratings for credit risk No. of Respondents
Very high 23

High 54

Moderate 16
Low 7
Very low 0

No. of Respondents

7% 0%
23%
16%
Very high High Moderate
Low
Very low

54%

Figure 3.17
From the above data collected it is interpreted that 23 investors are in favor that the
credit risk in the derivatives is very high, 54 considers that credit risk is high, 16
considers that credit risk is moderate in the derivatives, 7 considers that credit risk
is low.

Hypothesis:
H0= All the risks are not dependent on one another.
Ha= All the risks are dependent on one another.
The calculated value of Chi square is 1.46.
The tabulated value of the chi square is 28.3.

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The calculated value of chi square is less than the tabulated value so the hypothesis
is accepted here because the difference between observed and expected is
insignificant.

b) Market risk

Table 3.18
Ratings for market risk No. of Respondents

Very High 30
High 52
Moderate 17
Low 1
Very low 0

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No. of Respondents

10%
17%
30%

Very High High Moderate Lo

Very low

52%

Figure 3.18
From the above data collected it is interpreted that 1investor is in favor that the
market risk in the derivatives is very high, 30 considers that market risk is high, 52
considers that market risk is moderate in the derivatives, 17 considers that market
risk is low and 1 investor is in the favor that market risk is very low in the
derivatives

c) Legal risk:

Table 3.19

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Ratings for legal risk No. of Respondents

Very high 12
High 30
Moderate 42
Very low 8
Low 8
Total 100

No. of Respondents

6%
15%

Very high High Moderate Very low Low

50% Total

21%

4% 4%

Figure 3.19

From the above data collected it is interpreted that 12 investors are in favor that the
legal risk in the derivatives is very high, 30 considers that legal risk is high, 42
considers that legal risk is moderate in the derivatives, 8 considers that legal risk is
low and 8 investors are in the favor that legal risk is very low in the derivatives

d) Liquidity risk:

Table 3.20

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Ratings for Liquidity risk No. of respondents

Very high 10

High 33
Moderate 36

Low 17
Very low 4
Total 100

No. of respondents

4% 10%
17%
Very high High Moderate Low
Very low

33%

36%

Figure 3.20

From the above data collected it is interpreted that 10 investors are in favor that the
liquidity risk in the derivatives is very high, 33 considers that liquidity risk is high,
36 considers that liquidity risk is moderate in the derivatives, 17 considers that
liquidity risk is low and 4 investors are in the favor that liquidity risk is very low in
the derivatives.

3.11 Which is the most prominent factor related to derivatives?

Table3.21

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Most prominent factor Frequency

Reduction in the capital/amount invested 46

No return 18
Foreign exchange risk 36
Total 100

No. of Respondents

36% Reduction in the capital/amount invested

46% No return

Foreign exchange risk

18%

Figure 3.21

The investors were asked about the most prominent factors related to derivatives. 46
respondents were in favor of reduction in the capital or the amount invested, 18 were
in favor that they will not get any return on their investment and 36 replied that there
is a lot of foreign risk in the derivatives. So it can be interpreted that most of the
people consider that the most prominent risk factor is the reduction in the basic
amount invested.

3.12 Are you satisfied with your investment in derivatives?

Table 3.22

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Satisfaction No. of respondents

Yes 68
No 32
Total 100

No. of respondents

32%

Yes No
68%

Figure 3.22

The investors were also asked about their satisfaction with their investment. Out
of the sample selected of 100 respondents, 68 investors were fully satisfied with
their investment and 32 were not at all satisfied with their investment so it can be
interpreted that most of the people are satisfied.

4.1 Findings:

The findings of my study are given below:

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1. Most of the respondents of my study are the business class people who invest
in the derivatives with respect to future and options.
2. There are two types of the contracts. One is the over the counter derivatives
and other is the exchange traded derivatives. From the study it is found that
most of the respondents of my sample size invest in the exchange traded
derivatives.
3. Most of the respondents of my sample prefer to deal with the both futures
and options contracts basically. And if we see preference from futures and
options then the preference is for the options contracts.
4. Most of the respondents of my sample selected prefer to invest less than Rs.
25000 in the futures and options contracts.
5. The average investment period preferred by the investors is the period
ranging from the 9 months to the 12 months. It means that investors prefer to
deal in the long term contracts.
6. The investment decision of the investor is being influenced by the broker as
compared to the other persons.
7. The extent of the influence of the broker’s decision is to some extent even
though it is the broker whose decision is more influenced the investor’s
investment decision.
8. It is found that most of the people invest their money due to the return
purpose.
9. It is found that investors consider that in the derivatives credit risk and the
market risk are high. Both the legal risk and the liquidity risk are moderate.
10. It is found that the most prominent factor related to the derivatives is the
reduction in the basic amount or the capital invested by the investors.
11. Most of the investors are satisfied with their investment in the derivatives
even there are some investors who are not satisfied with their investment.
12. Out of the investors most of the respondents are male. It shows that male
invest more in the derivatives rather than the females.
13. Most of the people who fall in the age group of 30 to 40 invest in the
derivatives.
14. The people who fall in the income level of more than Rs. 200000 invest their
money in the derivatives contracts.

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15. It has also been analyzed that the preference of derivatives is dependant to
the type of contract.
16. It has also been analyzed that risk factor is not related to the return as a factor
of decision.
17. It has also been analyzed that risk factor is not related to the safety as a factor
of decision.
18. It has also been analyzed that risk factor is not related to the Liquidity as a
factor of decision.
19. It has also been analyzed that risk factor is not related to the tax saving as a
factor of decision.
20. It has also been analyzed that risk factor is not related to the speculation as a
factor of decision.
21. It is found that all the risks are not dependant on one another.

4.2 Recommendations:

 Most of the investor’s decision is influenced by the broker so that broker

should present the true and fair figure to the investor.

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 Broker should not misguide or cheat the investors because he is the

middleman between the shareholder and the company.
 There should be seminars, group discussions on the derivative trading which
can be conducted by the various stock exchanges to provide the knowledge
to the general public while investing they can take their self decisions.
 Insider trading should be banned so that It can not be misused by the
directors of the company
 SEBI should also take some steps to control the market. As we know that
there is lot of fluctuations in the market these days so it should be controlled
that will definitely increase in more satisfaction of the investor.
 There is a need to bring more stability in foreign exchange market also.
Because as we know that the domestic market is influenced by the foreign
market.
 Awareness programmes should be launched or introduced by SEBI for
providing the knowledge to the investors.

4.3 Limitations

 The data which is collected with the help of questionnaire may be biased.

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 The sample size of 100 respondents is small as it does not represent the
whole figure.
 Due to time and resource constraints the study was limited to the area of
Chandigarh.
 The scope of study was very limited to the Chandigarh only.

4.4 Conclusion:

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At the end it can be concluded that derivatives are now a days playing an important
role. Investors preferred to deal in the both futures and options contracts. They also
prefer the long term contracts rather than the short term contracts. As it is found that
the decision of the investor is being influenced by the brokers. Most of the investors
are satisfied still there are some investors who are not satisfied so efforts should be
made to satisfy all the investors. There is a need to provide the knowledge to the
investors about the derivatives so it can be done with the help of the various
seminars and group discussion programmes which can be conducted by the stock
exchanges and SEBI either singly or jointly.

5 BIBLIOGRAPHY

5.1 Books:

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Singh harpreet’research methodology,Kalyani publisher,printed in 2006.Singh

Singh Inderpal, singh Jaswinder, Kaur Raminder, Kalyani Publisher, reprinted in
2006
5.2 Websites
http://en.wikipedia.org/wiki/derivative_(finance)
http://www.sebi.gov.in/faq/derivativesfaq.html
http://www.futuresoptions.com
http://www.urotoday.com/browse_category/bph_male_luts/luts_treatment_future_tr
eatment_options_abstracts.html http://www.cababstractsplus.org/google/abstract.asp?
AcNo=20053017970

http://www.amazon.ca/Introduction-futures-options-markets-John/dp/0138891486
http://www.conceptvisionindia.com/derivatives/basics.asp

QUESTIONAIRE

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I am Hardev Singh doing MBA from Desh Bhagat Institute of Management

(Affiliated to Punjabi University, Patiala). I am conducting a project on “Investor’s
perception towards Derivatives as an investment strategy.”I would request you
to fill the below mentioned questionnaire:

1Q: Which category do you belong to?

a) Student b) Business
c) Service d) Others

2Q: What kind of derivatives is preferred by you?

a) Over the counter derivatives. b) Exchange traded derivatives.

3Q: Which type of contracts under derivatives is preferred by you?

a) Future b) Options c) Both a & b

4Q: How much money do you invest in the futures and options?
a) Less than Rs. 25000 b) Between Rs. 25000 to Rs.
50000
c) Between Rs. 50000 to Rs. 100000 d) More than Rs. 100000

5Q: Who influence your investment decision?

a) Broker b) Family members/Friends
c) Media d) Any other
(Pls.specify........................................)

6Q: How much your decision is influenced by the above selected option?
a) To great extent b) To some extent c) Very little

7Q: Why do you invest in future and options? (Give preferences)

a) Return ( )
b) Safety ( )
c) Capital appreciation ( )
d) Liquidity ( )
e) Tax Saving ( )
f) Speculation ( )
g) Any other (pls. Specify) ( )

8Q: why do you invest in future and options? (Give preferences)

5 (Very High) 4 3 2 1(very Low)
Risk factors
Credit Risk
Market Risk
Legal Risk
Liquidity Risk

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9Q: Which is the most prominent factor related to derivatives?

a) Reduction in the capital or amount invested
b) No return
c) Foreign Exchange Risk

10: Are you satisfied with your investment in derivatives?

a) Yes b) No

11 Q: What are the suggestions for the futures and options?

Ans: ……………………………………………………….

Personal Profile

Name: ………………………………………….
Phone No……………………………………….

Sex:
a) Male b) Female

Age:
a) Under 30 b) Between 30 to 40
c) Between 40 to 50 d) More than 50

Income (per annum):

a) Under Rs. 50000 b) Between Rs.50000 to Rs.100000
c) Between Rs.100000 to Rs.200000 d) More than Rs.200000

(Thanks)