1) Distinguish between futures and forwards.

Futures and forwards are financial contracts which are very similar in nature but there
exist a few important differences:
Forwards Contract:
A forward contract is the simplest of the Derivative products. It is a mutual agreement
between two parties, in which the buyer agrees to buy a quantity of an asset at a specific
price from the seller at a future date. The Price of the contract does not change before
delivery. These type of contracts are binding, which means both the buyer and seller must
stay committed to the contract. This means they are bound to deliver or take delivery of
the product on which the forward contract was agreed upon. Forwards contracts are very
useful in hedging.
Important Characteristics of Forwards Contracts:
They are over the counter (OTC) contracts
Both the buyer and seller are bound by the contractual terms
The Price remains fixed
Limitations of Forwards contracts:
Lack of centralized trading. Any two individuals can enter into a forwards
contract
Lack of Liquidity
Counterparty risk - The case wherein either the buyer or seller does not
honour his end of the contract.

Futures Contract:
A futures contract is an agreement to buy or sell an asset at a certain time in
the future at a specific price. The Contractual terms of the futures contracts
are very clear. The Futures market was designed to solve the shortcomings in
the forwards contracts. Unlike forwards, futures are traded in organized
exchanges. They also use a clearing house that provides the necessary
protection to both the buyer and the seller. The price of the futures contract
can change prior to delivery. Hence, both participants must settle daily price
changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of
Steel at Rs. 10000/- per tonne at some date say in December 2008. If no
interim payments are made and if the price of Steel moves violently, a
considerable credit risk could build up. To avoid this a margin system is used
by the exchanges. As per the margin system, both parties must deposit a small
sum with the exchange. This amount will be a small percentage of the total
contract. This amount is called the initial margin. As the steel value changes,
the contract value also changes. If the contract value changes, the margin
must be topped up by an amount corresponding to the change in price of steel.
The margin money is the property of the person who deposits it and would be
returned to them if the contract gets cancelled/completed.

Characteristics of Futures contract:
They are traded in organized exchanges
Credit risk is eliminated with the margin system. Both parties deposit a
portion of the contract with the clearing house.
Both the buyer and seller are bound by the contract terms and are expected to
honour their end of the contract.


2) What are the determinants of option price?




3) Discuss the function of forward Market commission.
The functions of the Forward Markets Commission are as follows:
To advise the Central Government in respect of the recognition or the withdrawal
of recognition from any association or in respect of any other matter arising out of
the administration of the Forward Contracts (Regulation) Act 1952.
To keep forward markets under observation and to take such action in relation to
them, as it may consider necessary, in exercise of the powers assigned to it by or
under the Act.
To collect and whenever the Commission thinks it necessary, to publish
information regarding the trading conditions in respect of goods to which any of
the provisions of the Act is made applicable, including information regarding
supply, demand and prices, and to submit to the Central Government, periodical
reports on the working of forward markets relating to such goods;
To make recommendations generally with a view to improving the organization
and working of forward markets;
To undertake the inspection of the accounts and other documents of any
recognized association or registered association or any member of such
association whenever it considers it necessary.


Structure of Derivative Markets in India
Derivative trading in India takes can place either on a separate and independent Derivative Exchange or
on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-
Regulatory Organisation (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.
Regulatory Objectives
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We therefore
reproduce this paragraph of the LCGC Report:
"The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is
inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been
guided by the following objectives:
A. Investor Protection: Attention needs to be given to the following four aspects:
i. Fairness and Transparency:
The trading rules should ensure that trading is conducted in a fair and transparent manner.
Experience in other countries shows that in many cases, derivatives-brokers / dealers failed to
disclose potential risk to the clients. In this context, sales practices adopted by dealers for
derivatives would require specific regulation. In some of the most widely reported mishaps in the
derivatives market elsewhere, the underlying reason was inadequate internal control system at
the user-firm itself so that overall exposure was not controlled and the use of derivatives was for
speculation rather than for risk hedging. These experiences provide useful lessons for us for
designing regulations.
ii. Safeguard for clients' moneys:
Moneys and securities deposited by clients with the trading members should not only be kept in a
separate clients' account but should also not be attachable for meeting the broker's own debts. It
should be ensured that trading by dealers on own account is totally segregated from that for
clients.
iii. Competent and honest service:
The eligibility criteria for trading members should be designed to encourage competent and
qualified personnel so that investors/clients are served well. This makes it necessary to prescribe
qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of
a knowledge base.
iv. Market integrity:
The trading system should ensure that the market's integrity is safeguarded by minimising the
possibility of defaults. This requires framing appropriate rules about capital adequacy, margins,
clearing corporation,etc.
B. Quality of markets:
The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important
market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader
objective than market integrity.
C. Innovation:
While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is
the source of all economic progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology."
Derivatives Trading - Regulatory Framework
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
Market Regulation & Investor Protection
We have seen that pursuant to the recommendations of JR Verma Committee SEBI formulated and
approved guidelines to the stock exchanges (NSE/BSE) and permitted trading in Derivatives. We will now
discuss the regulatory measures as envisaged by SEBI.
1. Futures/ Options contracts in both index as well as stocks can be bought and sold through the
trading members of National Stock Exchange, or the BSE Mumbai Stock Exchange. Some of the
trading members also provide the internet facility to trade in the futures and options market.
2. The investor is required to open an account with one of the trading members and complete the
related formalities which include signing of member-constituent agreement, constituent
registration form and risk disclosure document.
3. The trading member will allot the investor an unique client identification number.
4. To begin trading, the investor must deposit cash and/or other collaterals with his trading member
as may be stipulated by him. SEBI has issued detailed guidelines for the benefit of the investor
trading in the derivatives exchanges. These may be viewed and studied.
5. Margins are computed and collected on-line, real time on a portfolio basis at the client level.
Members are required to collect the margin upfront from the client & report the same to the
Exchange.
6. All the Futures and Options contracts are settled in cash at the expiry or exercise of the
respective contracts as the case may, be. Members are not required to hold any stock of the
underlying for dealing in the Futures / Options market.
Important Eligibility/Regulatory Conditions Specified by SEBI
Derivative trading to take place through an on-line screen based Trading System.
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.
The Derivatives Exchange/ Segment should have arrangements for dissemination of information
about trades, quantities and quotes on a real time basis through atleast two information vending
networks, which are easily accessible to investors across the country.
The Derivatives Exchange/Segment should have arbitration and investor grievances redressal
mechanism operative from all the four areas / regions of the country.
The Derivatives Exchange/Segment should have satisfactory system of monitoring investor
complaints and preventing irregularities in trading.
The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
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.
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.
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.
The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for
swift movement of margin payments.
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.
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 the client purposes only and
should not allow its diversion for any other purpose.
The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades
executed on Derivative Exchange / Segment.
Measures Specified by SEBI to Enhance Protection of the Rights of Investors
in the Derivative Market
SEBI has also specified measures to ensure protection of the rights of investors. These measures are as
follows:
Investor's money has to be kept separate at all levels and is permitted to be used only against the
liability of the Investor and is not available to the trading member or clearing member or even any
other investor.
The Trading Member is required to provide every investor with a risk disclosure document which
will disclose the risks associated with the derivatives trading so that investors can take a
conscious decision to trade in derivatives.
Investor would get the contract note duly time stamped for receipt of the order and execution of
the order. The order will be executed with the identity of the client and without client ID order will
not be accepted by the system. The investor could also demand the trade confirmation slip with
his ID in support of the contract note. This will protect him from the risk of price favour, if any,
extended by the Member.
In the derivative markets all money paid by the Investor towards margins on all open positions is
kept in trust with the Clearing House /Clearing Corporation and in the event of default of the
Trading or Clearing Member the amounts paid by the client towards margins are segregated and
not utilised towards the default of the member. However, in the event of a default of a member,
losses suffered by the Investor, if any, on settled / closed out position are compensated from the
Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of
the exchanges.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O
Segment of NSE. Derivative products have been introduced in a phased manner starting with
Index Futures Contracts in June 2000, Index Options and Stock Options introduced in June 2001
and July 2001 followed by Stock Futures in November 2001.
Types of Derivative Contracts Permitted by SEBI
Derivative products have been introduced in a phased manner starting with Index Futures Contracts in
June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by
Stock Futures in November 2001.
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 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.
The Lot Size of a Contract
Lot size refers to number of underlying securities in one contract. Additionally, for stock specific derivative
contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of
100 and fractions, if any, should be rounded of to the next higher multiple of 100. This requirement of
SEBI coupled with the requirement of minimum contract size forms the basis of arriving at the lot size of a
contract
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.
SEBI Amendment to Stipulations on Lot Size
While the Legislative body stipulated the minimum contract size in terms of value (Rs.2 Lacs), the system
of standardising securities trade in Lots, had a multiplying effect, on the minimum value of a contract,
when the prices of the premium Scrips started appreciating over time. BSE Sensix Index which was less
than 3000 at that time swelled to nearly 6000 presently. As the value of individual scrips increased,
smaller number of such scrips would be sufficient to cover the minimum contract value of Rs.2.00 Lacs
prescribed by the Standing Committee of the Parliament. But stipulating a fixed number of shares as the
lot in many cases swelled the value of the contract to Rs.5 Lacs and even more in many cases. This
brought derivatives trading beyond he scope of the small investor.
Considering the fact SEBI revised its stipulations regarding Lot size, but retaining the minimum contract
value at Rs.2 Lacs and issued a press release on 07.01.2004 stating:
It has been noticed that in several derivative contracts the value has exceeded Rs. 2 lakh. In such cases
it has been decided to reduce the value of the contract to close to but not less than Rs. 2 lakh by using an
appropriate lot size / multiplier which could be half or 50%. The exchanges could determine any other lot
size / multipliers to keep the contract size of derivatives close to Rs. 2 lakh, but in any case not less than
Rs. 2 lakh. The exchanges would be able to reduce the contract size of a derivative contract by
submitting a detailed proposal to SEBI and after giving at least two weeks prior notice to the market.