SYLLABUS IFS SEM IV

Serial Modules/Units
No.
1 MONEY MARKET

Components of organized money market – Call and Notice Market, Treasury Bills
Market, Commercial Bills Market, Market for Certificate of Deposits, Market for
Commercial Papers, Discount Market and Market for Collateralized Borrowing and
Lending Obligations - Features of Indian Money Market-
Reforms in Indian money market.
2 CAPITAL MARKET & FOREIGN EXCHANGE MARKET

Capital Market: Structure of the Indian Capital Market –Recent Developments in the
Primary Market and the Secondary Market - Overview of Debt Market in India – Role
of SEBI - Foreign Exchange Market: components and functions.

3 DERIVATIVES MARKET IN INDIA

Meaning of derivatives – Participants in the derivative markets (Hedgers, Arbitragers

and Speculators)
–– Significance of derivative markets – types and functioning of financial derivatives:
Forwards, Futures, Options and Swaps - Derivatives trading in India.

4 FINANCIAL SERVICES

Merchant Banking-Functions & Role, Credit Rating-Concept & Types, Functions &
Limitations, Leasing Companies, Venture Capital Funds, Micro Finance.
 MODULE III

DERIVATIVES MARKET IN INDIA

Meaning of derivatives – Participants in the derivative markets (Hedgers, Arbitragers and

Speculators)
–– Significance of derivative markets – types and functioning of financial derivatives: Forwards,
Futures, Options and Swaps - Derivatives trading in India.

Meaning of Derivative Market

A Derivatives Market is a financial marketplace where financial instruments, such as options
and futures, and other derivative instruments are traded. Different types of investors take part
in this market with varying objectives. For instance, some want to earn a profit, some speculate,
while some enter the market to hedge their risk.
Types of Derivatives Market
1. Exchange- Traded derivatives: This includes the contracts that are managed and
regulated by the market. Such contracts are standardized futures or options contracts,
thus trading on a recognized exchange. These contracts have less risk (default) for the
investor. The parties need to deposit an initial payment at the time of entering the
contract.
2. Over The Counter (OTC) : There are private agreements between investors. The
provisions of the agreement remain private. Such contracts do not trade on any
exchange, nor do they have any intermediaries. These are not standardized contracts.
And therefore, parties can easily modify and customize the terms of the contract.

Instruments in Derivatives Market

1. Options : It gives the buyer the right (not an obligation) to buy or sell the underlying
asset at a specific price and at a specific date. On the basis of when the buyer executes
the contract, an option could either be American, European, or Bermudan. Options
involve buying put or call options.
2. Futures : Like options, futures are the standard agreements between the parties. And
these contracts give a right to the holder to buy or sell the underlying asset at an agreed
price and at a future date. However, unlike options, a futures contract is both a right and
an obligation to execute the agreement on or before the specified date, as per the
provisions. Since these are standard agreements, they trade on the exchange market.
3. Forwards: These are the same as the futures contract, with the only difference being
they are over-the-counter products. This means they are not standardized contracts and
are not regulated, nor do they trade on any exchange. The parties are free to customize
the contracts as per their requirements.
 4. Swaps : These contracts allow parties to swap or exchange their financial obligations.
Such contracts are also OTC and do not trade on any exchange market. These swaps
are available for currency, interest rate, commodity, etc. However, the most popular
and widely used swaps are interest rate swaps.
Advantages of Derivatives Market
 They ensure a ready market for the derivative financial tools.
 They offer investors lucrative returns. In fact, in the derivative market, one can
trade with limited capital, and profit potential is huge as compared to the
investments in the primary securities. However, these investments in the
derivatives market also carry higher risk in case of adverse movement than the
normal stock market investments. But, the higher returns that this market offers
to lure the investors towards it.
 It allows investors to hedge their risk and save themselves and their capital from
unchartered or high swings.
 An investor can choose to invest in OTC or exchange-traded derivate depending
on their risk profile and need.

Features of Derivatives Market

 It is a massive market with traders all around the globe. Its volume and traded
value are almost greater than 3 to 15 times the routine market volumes and
values.
 The OTC trades are more popular, with a total market value of about $600
trillion.
 The derivative market attracts many speculators and hedgers, as they can earn
higher profits with lesser capital investments.
 Trading in a derivative market requires the participant to know the market and
the economy well.
Participants in Derivatives Market

Hedgers
These are the investors who enter the derivative market to reduce their risk or hedge their risk.
In fact, hedging is the biggest motive that drives investors to the derivative market. The option
route is preferred by the hedgers to reduce their risks.

Speculators
It is the most common market activity in any financial market. This basically involves betting
against the future price movement and taking positions accordingly. It is a risky activity
involving buying the underlying asset and then betting on its price. Earning a big profit is the
driving force for speculative activities.

For example, an investor expects the price of a share to drop going ahead. Thus, to profit from
this, the investor will short sell the share now and buy later when the price drops.

Arbitrageurs
Arbitrage is also a profit-making activity by taking advantage of the price volatility in the
different financial markets. Arbitrageurs earn a profit using the price difference resulting in
investment between the two markets. Or, we can say they buy an asset at less price in one
market and sell it in another at a higher price. For example, buying a share for $100 in the cash
market and selling it at $102 in the future market.

Margin traders
Another derivative market participant is margin traders. The margin is the initial deposit that
an investor makes at the time of entering into a contract.

Drawbacks
Following are the drawbacks of a derivative market:

 Over the years, many have criticized the market for being too risky for investors.
Those who criticize this market cite the role of CDS, a derivative tool, in
triggering the 2008 financial meltdown.
 The derivative market also sees a high level of volatility, enough to erase the
full investment of an investor. Also, the financial instruments in the derivatives
market are extremely sensitive to even small changes in the interest rate,
maturity, any political, medical, or economy-related issues, and more.
 Financial instruments in the derivatives market are not as simple as the ones you
will see in the primary and secondary markets. Because of this, new and
occasional investors avoid this market. They, however, have an option to take
the services of brokers and trading agents to invest in the derivatives market.
  Another criticism against the market is that their activities are similar to
gambling but legal. This is because the activities in the derivative markets are
similar in nature to gambling.
Differences – Cash vs. Derivative Market
The key differences between the cash and derivative markets are as follows:

 In the cash market, investors can buy in any quantity, while in a derivative
market, the buying and selling are in pre-fixed lots.
 Only tangible assets trade in the cash market. In the derivative market, both
tangible and intangible assets trade.
 Investors use the cash market to invest, while traders use the derivative market
for hedging, arbitrage, or speculation.
 The investor needs to have a trading and Demat account to trade in a cash
market. For investing in futures, an investor needs only a future trading account.
 In the cash market, all funds are invested upfront. However, only the margin
money is paid in advance in the futures market. Balance money instead the
difference money is paid on exiting or expiry, only if the trade goes negative.
Otherwise, no more money needs to be paid if it is favorable.
 When an investor buys a share in the cash market, they own a part of that firm.
However, as derivatives are based on some underlying asset, the investor or
holder of the derivative instrument has no ownership. Need to note that even the
right or obligation or option bought or sold has a maturity/expiry. Therefore, it
is a very short-term trading contract only and does not give ownership rights
even on expiry or maturity.
 In the cash market, the investor may get dividends, but there are no such things
as a dividend in the derivative market.

Derivatives trading in India

The risk associated with derivatives trading in India

You should understand that derivatives trading carries an element of risk in it. The following
points are self-explanatory.

 Derivatives product requires a large number of funds. So it is not for you if you have
limited resources. Limited resources mean limited funds and low-risk appetite.

 Trading derivatives need expert knowledge. A high trading expertise and experience is
mandatory with high-risk tolerance.

 As a derivatives trader, you must therefore carefully consider its suitability depending
upon your financial position.

 You should accept the fact that you can lose profits. Even you can incur the loss with
the execution of derivatives trade.
  It is invariably desirable to refer carefully Model Risk Disclosure Document before
beginning the derivative trade. You can ask for this document from your broker. Also,
before signing it you should read and understand its implications. This document clearly
mentions all risk associated with derivatives trading.

 Read the sample SEBI Model Risk Document and also the same document
for NSE derivatives trading for having an understanding of risk.

How future contracts improved derivatives trading in India?

Future contracts are similar to the forward contracts with some improvements. Forward
contract derives the values from the underlying spot prices. Under these contracts, two parties
enter into an agreement to trade at some point in future. They agree to trade at pre-specified
price and time. Also, there is no exchange of money during the time of entering the agreement.
Future and forward contracts are derivatives market instruments in India.

However, trading with the forward contracts have deep limitations like –

1. There is lack of any centralized trading mechanism,

2. No predefined settlement procedure,
3. Liquidity was always a concern, and
4. Counterparty risk is always there.
Future contracts, however, overcome all these forward contract limitations. All future contracts
are standardized. Trading in the future contract is centralized. Stocks exchanges facilitate
centralized trading mechanism in this derivatives instrument. Further, there is no counterparty
risk involved with future contracts. There is always clearing corporations behind every side of
a transaction.

At present, there are five clearing corporations operational in India, namely –

1. India International Clearing Corporation (IFSC) Limited

2. Indian Clearing Corporation Ltd
3. Metropolitan Clearing Corporation of India Ltd
4. National Securities Clearing Corporation Ltd
5. NSE IFSC Clearing Corporation Limited
The other features that differentiate future from the forward contracts are –
 1. The increased time to expiration does not increase the counterparty risk in future
contracts, and
2. Future contract markets are highly liquid in comparison to forward markets.
There are various participants in the derivatives trading in India. Learn about the derivatives
market participants such as hedgers, arbitrageurs, and speculators in the blog.

Indian derivatives trading instruments and its type

In order to understand instruments for the derivatives market, let us concentrate over NSE
platform. Mainly two types of derivatives instruments, namely futures and options.

All future contracts have cash settlement over NSE. Any future contract is always made
between two persons. But clear corporation always takes opposite position against any order.
Thus, there is always an opposite party by default in each trade. Unlike forward contracts, in
future contract money transfer takes place during the time of entering the contract.

Similarly, while entering an option contract, the buyer of an option pays the premium. With
this payment, the buyer gets the right to exercise his option to buy at the expiration date. On
the other hand, the seller of options receives the premium. Due to this he/she is obliged to
sell/buy the asset in the situation when buyer exercises his right.

In general, options are of two types. call options and put options. All options at NSE also
settle at cash. When you buy a call option, you receive the right but not obligation to buy the
asset at predefined price and quantity at or on the future date. On the other hand, if you buy put
options you get the right but not obligation to sell the asset at predefined price and quantity at
or on the future date.

Similarly, you can also write options. When you sell a call or put options we call it as writing
options. One thing you must remember that while writing an option you receive the premium
and when you buy options you will need to pay the premium. Get yourself acquainted
with equity derivatives trading strategies for NSE with Rmoney India market intelligence.