Derivatives (Futures & Options)

CHAPTER-I INTRODUCTION

Derivatives (Futures & Options) INTRODUCTION OF DERIVATIVES The emergence of the market for derivatives products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc. Banks, Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future. DEFINITION OF DERIVATIVES Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. Securities Contracts (Regulation) Act, 1956 (SCR Act) defines debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of

underlying securities.

Derivatives (Futures & Options) HISTORY OF DERIVATIVES MARKETS Early forward contracts in the US addressed merchants concerns about ensuring that there were buyers and sellers for commodities. However credit risk remained a serious problem. To deal with this problem, a group of Chicago; businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivatives contract in the US; these contracts were called futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off CBOT was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 indexes, traded on Chicago Mercantile Exchange. During the Mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivates are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan MATIF in France, Eurex etc. THE GROWTH OF DERIVATIVES Over the last three decades, the derivatives markets have seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: Increased volatility in asset prices in financial markets.
3

Derivatives (Futures & Options) Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and Innovations in the derivates markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. TYPES OF DERIVATIVES The following are the various types of derivatives. FORWARDS: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. FUTURES: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange traded contracts. OPTIONS: Options are of two types-calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a give future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of up to one year; the majority of options traded on
4

Derivatives (Futures & Options) options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the counter. LEAPS: The acronym LEAPS means long-term Equity Anticipation securities. These are options having a maturity of up to three years. BASKETS: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. SWAPS: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used Swaps are: Interest rate Swaps: These entail swapping only the related cash flows between the parties in the same currency. Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in on direction being in a different currency than those in the opposite direction. SWAPTION: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has received swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and received floating.

Derivatives (Futures & Options)

PARTICIPANTS IN THE DERIVATIVE MARKETS The following three broad categories of participants: HEDGERS: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS: Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. ARBITRAGERS: Arbitrageurs are in business to take of a discrepancy between prices in two different markets, if, for, example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit. FUNCTION OF THE DERIVATIVE MARKETS In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the price of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivate contract. Thus derivatives help in discovery of future as well as current prices. Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
6

Derivatives (Futures & Options) Derivative due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, Monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, Well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Derivatives trading acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase saving and investment in long run. SCOPE OF THE STUDY The Study is limited to Derivatives with special reference to Futures and Option is the Indian context and the Inter-Connected Stock Exchange have been Taken as a representative sample for the study. The study cant be said as totally perfect. Any alteration may come. The study has only made a humble Attempt at evaluation derivatives market only in India context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, CBOT etc.

Derivatives (Futures & Options)

OBJECTIVES OF THE STUDY To analyze the derivatives market in India To analyze the operations of futures and options To find the profit/loss position of futures buyer and also the option writer and option holder. To study about risk management with the help of derivatives. LIMITATIONS OF THE STUDY The following are the limitation of this study.

The scrip chose for analysis is M/s. RELIANCE POWER and the contract

taken is January 2009. Ending one-month contract. The data collected is completely restricted to the M/s. RELIANCE

POWER of January 2009; hence this analysis cannot be taken universal. ]

Derivatives (Futures & Options)

CHAPTER-II INDUSTRY PROFILE & COMPANY PROFILE

Derivatives (Futures & Options)

Banking in India
Banking in India originated in the last decades of the 18th century. The oldest bank in existence in India is the State Bank of India, a government-owned bank that traces its origins back to June 1806 and that is the largest commercial bank in the country. Central banking is the responsibility of the Reserve Bank of India, which in 1935 formally took over these responsibilities from the then Imperial Bank of India, relegating it to commercial banking functions. After India's independence in 1947, the Reserve Bank was nationalized and given broader powers. In 1969 the government nationalized the 14 largest commercial banks; the government nationalized the six next largest in 1980. Currently, India has 96 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the Government of India holding a stake), 31 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively Early history Banking in India originated in the last decades of the 18th century. The first banks were The General Bank of India which started in 1786, and the Bank of Hindustan, both of which are now defunct. The oldest bank in existence in India is the State Bank of India, which originated in the Bank of Calcutta in June 1806, which almost immediately became the Bank of Bengal. This was one of the three presidency banks, the other two being the Bank of Bombay and the Bank of Madras, all three of which were established under charters from the British East India Company. For many years the Presidency banks acted as quasi-central banks, as did their successors. The three banks merged in 1921 to form the

10

Derivatives (Futures & Options)

Imperial Bank of India, which, upon India's independence, became the State Bank of India. Indian merchants in Calcutta established the Union Bank in 1839, but it failed in 1848 as a consequence of the economic crisis of 1848-49. The Allahabad Bank, established in 1865 and still functioning today, is the oldest Joint Stock bank in India. It was not the first though. That honor belongs to the Bank of Upper India, which was established in 1863, and which survived until 1913, when it failed, with some of its assets and liabilities being transferred to the Alliance Bank of Simla. When the American Civil War stopped the supply of cotton to Lancashire from the Confederate States, promoters opened banks to finance trading in Indian cotton. With large exposure to speculative ventures, most of the banks opened in India during that period failed. The depositors lost money and lost interest in keeping deposits with banks. Subsequently, banking in India remained the exclusive domain of Europeans for next several decades until the beginning of the 20th century. Foreign banks too started to arrive, particularly in Calcutta, in the 1860s. The Comptoire d'Escompte de Paris opened a branch in Calcutta in 1860, and another in Bombay in 1862; branches in Madras and Pondichery, then a French colony, followed. HSBC established itself in Bengal in 1869. Calcutta was the most active trading port in India, mainly due to the trade of the British Empire, and so became a banking center.

The Bank of Bengal, which later became the State Bank of India. The first entirely Indian joint stock bank was the Oudh Commercial Bank, established in 1881 in Faizabad. It failed in 1958. The next was the Punjab National Bank, established in Lahore in 1895, which has survived to the present and is now one of the largest banks in India.

11

Derivatives (Futures & Options)

Around the turn of the 20th Century, the Indian economy was passing through a relative period of stability. Around five decades had elapsed since the Indian Mutiny, and the social, industrial and other infrastructure had improved. Indians had established small banks, most of which served particular ethnic and religious communities. The presidency banks dominated banking in India but there were also some exchange banks and a number of Indian joint stock banks. All these banks operated in different segments of the economy. The exchange banks, mostly owned by Europeans, concentrated on financing foreign trade. Indian joint stock banks were generally under capitalized and lacked the experience and maturity to compete with the presidency and exchange banks. This segmentation let Lord Curzon to observe, "In respect of banking it seems we are behind the times. We are like some old fashioned sailing ship, divided by solid wooden bulkheads into separate and cumbersome compartments." The period between 1906 and 1911, saw the establishment of banks inspired by the Swadeshi movement. The Swadeshi movement inspired local businessmen and political figures to found banks of and for the Indian community. A number of banks established then have survived to the present such as Bank of India, Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and Central Bank of India. The fervour of Swadeshi movement lead to establishing of many private banks in Dakshina Kannada and Udupi district which were unified earlier and known by the name South Canara ( South Kanara ) district. Four nationalised banks started in this district and also a leading private sector bank. Hence undivided Dakshina Kannada district is known as "Cradle of Indian Banking".

12

Derivatives (Futures & Options)

13

Derivatives (Futures & Options)

COMPANY PROFILE

14

Derivatives (Futures & Options)

Company Overview
The Kotak Mahindra Group was born in 1985 as Kotak Capital Management Finance Limited. Uday Kotak, Sidney A.A.Pinto and Kotak & Company promoted this company. Kotak Mahindra Finance Limited. Since then its been a steady and confident journey to growth and success. 1986: 1987: market. 1990: 1991: 1992: 1995: The Auto Finance Division is started. The Investment Banking Division is started. Enters the Funds Syndication sector. Brokerage and Distribution Businesses incorporated in to a separate company Kotak Mahindra Finance Limited starts the activity of Bill Discounting. Kotak Mahindra Finance Limited enters the lease and hire purchase Industrialists Harish Mahindra and Anand Mahindra took a stake in 1986, and thats when the company changes its name to

Kotak Securities Investment Banking Division incorporated Mahindra Capital Company. 1996: -

into a separate company Kotak

The Auto Finance Business is hired off into a separate company Kotak Securities investment Banking Division Incorporated into a separate company -

Kotak Mahindra Capital Company. 1998: Enters the Mutual Fund Marker with the launch of Kotak Mahindra asset Management Company. 2000: Kotak Mahindra tie up with old Mutual PIC for the life insurance business. Kotak Securities launches its on-line broking site ( www.kotak securities 15

.com )

Derivatives (Futures & Options)

2001: Matrix sold to Friday Corporation launches insurance Services

2003: 2004: 2005: -

Kotak Mahindra Finance Limited converts to a Commercial Bank The first Indian Company to do so. Launches India growth fund, a private equity fund. Kotak group realigns Joint Ventures in ford credit; Buys Kotak Mahindra prime and sells ford credit Kotak Mahindra. Launches a Real-estate Fund.

Group Management : Mr.Uday Kotak Executive Vice Chairman & Managing Director. Mr.Sivaji Dam Mr.C.Jayaram Mr.Dipak Gupta.

Kotak Mahindra Group

Kotak Mahindra is one of Indias leading financial institutions offering complete financial solutions 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 financial needs of individuals and corporate. The group has a net worth of around Rs.2000 crore and the AUM across the group is around 120 billion and employs over 6000 employees in its various businesses. With a presence in 216 cities in India and offices in New York, London, Dubai and Mauritius, it services a customer base of over 10.00,000. The group specializes in offering top class financial services catering to every segment of the industry. The various group companies include.

16

Derivatives (Futures & Options)

Kotak Mahindra Capital Limited Kotak Mahindra Securities Limited Kotak Mahindra Inc Kotak Mahindra (International) Limited Global Investments Opportunities Fund Limited Kotak Mahindra(UK) Limited Kotak Securities Limited Kotak Mahindra Old Mutual Life Insurance Company Limited Kotak Mahindra Asset Management Company Limited Kotak Mahindra Trustee Company Limited Kotak Mahindra Investments Limited Kotak Forex Brokerage Limited Kotak Mahindra Private-Equity Trustee Limited

Group Structure
Kotak Mahindra Bank

Kotak Mahindra Capital Company

Kotak Securities

Kotak Mahindra Investments

Kotak Mahindra Prime

Kotak Mahindra Asset Management Company

Kotak Mahindra Trust Company

Kotak Mahindra Securities

Kotak Mahindra (UK)

Kotak Mahindra ( International) Global Investment Opportunities Fund Kotak Mahindra Inc.

Kotak Securities Limited.

17

Derivatives (Futures & Options)

18