A PROJECT REPORT ON

“Analytical study of derivatives in

futures”

Introduction

A Derivative is a financial instrument that derives its value from an underlying asset.
Derivative is an financial contract whose price/value is dependent upon price of one or more
basic underlying asset, these contracts are legally.

binding agreements made on trading screens of stock exchanges to buy or sell an asset in the
future. The most commonly used derivatives contracts are forwards, futures and options,
which we shall discuss in detail later. The main objective of the study is to analyse the
derivatives market in India and to analyse the operations of futures and options. Analysis is to
evaluate the profit/loss position futures and options. Derivate market is an innovation to cash
market. Approximately its daily turnover reaches to the equal stage of cash market.

In cash market the profit/loss of the investor depend the market price of the underlying asset.
Derivatives are mostly used for hedging purpose. In bullish market the call option writer
incurs more losses so the investor is suggested to go for a call option to hold, where as the put
option holder suffers in a bullish market, so he is suggested to write a put option. In bearish
market the call option holder will incur more losses so the investor is suggested to go for a
call option to write,where as the put option writer will get more losses, so he is suggested to
hold a put option.

REVIEW OFLITERATURE
Derivative

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The emergence of the market for derivative 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:

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 (SC(R) A) defines “derivative” to include – 1. 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.2. A contract which
derives its value from the prices, or index of prices, of underlying securities.

PARTICIPANTS:

The following three broad categories of participants in the derivatives market.

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.

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ARBITRAGEURS:

Arbitrageurs are in business to take advantage 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 positions in the two markets to lock in a profit.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by the derivatives markets. They
are:

 Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level.
 Derivatives market helps to transfer risks from those who have them but may not like
them to those who have an appetite for them.
 Derivative trading acts as a catalyst for new entrepreneurial activity.

TYPES OF DERIVATIVES:

The following are the various types of derivatives. They are:

FORWARDS:

A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s 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.

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 given 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:

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Options generally have lives of up to one year; the majority of options traded on 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 interest 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
one direction being in a different currency than those in the opposite Direction.

Swaptions:

Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a Swaptions is an option on a forward swap.

RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVES:

Holding portfolio of securities is associated with the risk of the possibility that the investor
may realize his returns, which would be much lesser than what he expected to get. There are
various factors, which affect the returns: 1. Price or dividend (interest).2.Some are internal to
the firm like –

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1. Industrial policy
2. Management capabilities
3. Consumer’s preference
4. Labour strike, etc.

These forces are to a large extent controllable and are termed as non-systematic risks. An
investor can easily manage such non-systematic by having a well – diversified portfolio
spread across the companies, industries and groups so that a loss in one may easily be
compensated with a gain in other. There are yet other types of influences which are
external to the firm, cannot be controlled and affect large number of securities. They are
termed as systematic risk. They are: 1.Economic2.Political3.Sociological changes are
sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause
prices of nearly all individual stocks to move together in the same manner. We therefore
quite often find stock prices falling from time to time in spite of company’s earnings
rising and vice versa.

Ducts in India. Derivative products allow the user to transfer this price risk by looking in
the asset price thereby minimizing the impact of fluctuations in the asset price on his
balance sheet and have assured cash flows. Derivatives are risk management instruments,
which derive their value from an underlying asset. The underlying asset can be bullion,
index, shares, bonds, currency etc.

ANY EXCHANGE FULFILLING THE DERIVATIVE SEGMENT ATNATIONAL

STOCK EXCHANGE:

The derivatives segment on the exchange commenced with S&P CNX Nifty Index futures
on June 12, 2000. The F&O segment of NSE provides trading facilities for the following
derivative segment:

1. Index Based Futures

2. Index Based Options

3. Individual Stock Options

4. Individual Stock Futures

REGULATORY FRAMEWORK:

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The trading of derivatives is governed by the provisions contained in the SC(R) A, the
SEBI Act and the regulations framed there under the rules and byelaws of stock
exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of Dr. L.C. Gupta develop the
appropriate regulatory framework for derivative trading in India. The sales practices of its
members and will obtain approval of SEBI before start of Trading in any derivative
contract.

The provisions in the SC (R) A govern the trading in the securities. The amendment of
the SC (R) A to include “DERIVATIVES” within the ambit of ‘Securities’ in the SC (R )
A made trading in Derivatives possible within the framework of the Act.

1.Eligibility criteria as prescribed in the L.C. Gupta committee report may apply to SEBI
for grant of recognition under Section 4 of the SC ( R ) A,1956 to start Derivatives
Trading. The derivatives exchange/segment should have a separate governing council and
representation of trading / clearing members shall be limited to maximum of 40% of the
total members of the governing council. The exchange shall regulate the sales practices of
its members and will obtain approval of SEBI before start of Trading in any derivative
contract.

2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically become
the members of the derivative segment. The members of the derivative segment need to
fulfil the eligibility conditions as lay down by the L.C. Gupta Committee.

4. The clearing and settlement of derivate trades shall be through a SEBI approved
Clearing Corporation / Clearing house. Clearing Corporation / Clearing House complying
with the eligibility conditions as lay down by the committee have to apply to SEBI for
grant of approval.

5. Derivatives broker/dealers and Clearing members are required to seek registration from
SEBI.

6. The Minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also
submit details of the futures contract they purpose to introduce.

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 7. The trading members are required to have qualified approved user and sales person
who have passed a certification programmed approved by SEBI.

Futures
DEFINITION

A Futures contract is an agreement between two parties to buy or sell anasset at a certain time
in the future at a certain price. To facilitate liquidity in thefutures contract, the exchange
specifies certain standard features of the contract.The standardized items on a futures contract
are:

 Quantity of the underlying

 Quality of the underlying
 The date and the month of delivery
 The units of price quotations and minimum price change
 Locations of settlement

Types of futures:

On the basis of the underlying asset they derive, the futures are divided into two types:

 Stock futures:

The stock futures are the futures that have the underlying asset as the individual securities.
The settlement of the stock futures is of cash settlement and the settlement price of the future
is the closing price of the underlying security.

 Index futures:

Index futures are the futures, which have the underlying asset as an Index. The Index futures
are also cash settled. The settlement price of the Index futures shall be the closing value of
the underlying index on the expiry date of the contract.

PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller. The buyer of the futures
contract is one who is

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LONG on the futures contract and the seller of the futures contract is one who is

SHORT on the futures contract.

The payoff for the buyer and the seller of the futures contract are as follows.

PAYOFF FOR A BUYER OF FUTURES:

CASE 1:

The buyer bought the future contract at (F); if the futures price goes to E1then the buyer gets
the profit of (FP).

CASE 2:

The buyer gets loss when the future price goes less than (F), if the futures price goes to E2
then the buyer gets the loss of (FL).

PAYOFF FOR A SELLER OF FUTURES:

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F – FUTURES PRICEE1, E2 – SETTLEMENT PRICE.

CASE 1:

The Seller sold the future contract at (f); if the futures price goes to E1 then the Seller gets the
profit of (FP).

CASE 2:

The Seller gets loss when the future price goes greater than (F), if the futures price goes to E2
then the Seller gets the loss of (FL).

MARGINS:

Margins are the deposits, which reduce counter party risk, arise in a futures contract. These
margins are collected in order to eliminate the counter party risk. There are three types of
margins:

INITIAL MARGIN:

Whenever a futures contract is signed, both buyer and seller are required to post initial
margin. Both buyer and seller are required to make security deposits that are intended to
guarantee that they will in fact be able to fulfil their obligation. These deposits are Initial
margins and they are often referred as performance margins. The amount of margin is
roughly 5% to 15% of total purchase price of futures contract.

MARKING TO MARKET MARGIN

The process of adjusting the equity in an investor’s account in order to reflect the change in
the settlement price of futures contract is known as MT Margin.

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MAINTENANCE MARGIN:

The investor must keep the futures account equity equal to or greater than certain percentage
of the amount deposited as Initial Margin. If the equity goes less than that percentage of
Initial margin, then the investor receives a call for an additional deposit of cash known as
Maintenance Margin to bring the equity up to the Initial margin.

ROLE OF MARGINS:

The role of margins in the futures contract is explained in the following example .S sold a
Satyam June futures contract to B at Rs.300; the following table shows the effect of margins
on the contract. The contract size of Satyam is 1200.The initial margin amount is say
Rs.20000, the maintenance margin is 65% of Initial margin

The fair value of the futures contract is derived from a model known as the Cost of Carry
model. This model gives the fair value of the futures contract.

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Cost of Carry Model:

F=S (1+r-q)t

Where

F – Futures Prices

S– Spot price of the Underlying

C– Cost of Financing

E – Expected Dividend Yield

T– Holding Period.

Futures terminology:

Spot price:

The price at which an asset trades in the spot market.

Futures price:

The price at which the futures contract trades in the futures market.

Contract cycle:

The period over which a contract trades. The index futures contracts on the NSE have one-
month, two-months and three-month expiry cycles which expire on the last Thursday of the
month. Thus a January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three-month expiry is introduced for
trading.

Expiry date:

It is the date specified in the futures contract. This is the last day on which the contract will
be traded, at the end of which it will cease to exist.

Contract size:

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The amount of asset that has to be delivered under one contract. For instance,
the contract size on NSE’s futures market is 200 Nifties.

Basis:

In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for
each contract. In a normal market, basis will be positive. This reflects that
futures prices normally exceed spot prices.

Cost of carry:

The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus
the interest that is paid to finance the asset less the income earned on the asset.

Open Interest:

Total outstanding long or short positions in the market at any specific time. As
total long positions for market would be equal to short positions, for calculation
of open interest, only one side of the contract is counted.

Trading
TRADING INTRODUCTION

The futures & Options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen-based trading for Nifty futures
&options and stock futures & Options on a nationwide basis as well as an online
monitoring and surveillance mechanism. It supports an order driven market and
provides complete transparency of trading operations. It is similar to that of
trading of equities in the cash market segment.

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The software for the F&O market has been developed to facilitate efficient andtransparent
trading in futures and options instruments. Keeping in view thefamiliarity of trading members
with the current capital market trading system,modifications have been performed in the
existing capital market trading system soas to make it suitable for trading futures and
options.On starting NEAT (National Exchange for Automatic Trading) Application, thelog
on (Pass Word) Screen Appears with the Following Details.1)User ID2)Trading Member
ID3)Password – NEAT CM (default Pass word)4)New Pass Word

Note: -

1) User ID is a Unique

2) Trading Member ID is Unique & Function; it is Common for all user of the Trading
Member

3) New password – Minimum 6 Characteristic, Maximum 8 characteristics only 3 attempts

are accepted by the user to enter the password’ to open the Screen

4) If password is forgotten the User required informing the Exchange in writing to reset the
Password.

TRADING SYSTEM

Nationwide-online-fully Automated Screen Based Trading System (SBTS)

•Price priority

•Time Priority Note: -

1) NEAT system provides open electronic consolidated limit orders book (OECLOB)

2) Limit order means: Stated Quantity and stated price.

Before Opening the market

User allowed to set Up

1) Market Watch Screen

2) Inquiry Screens Only

Open phase (Open Period)

User allowed to

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1) Enquiry

2) Order Entry

3) Order Modification

4) Order Cancellation

5) Order Matching

Permanent sign off: - market not updates.

Temporary sign off:- market up date (temporary sign off, after 5 minutes Automatically
Activate)

Exit: -the user comes out sign off Screen.

Local Database

Local Database is used for all inquiries made by the user for Own Order/Trades Information.
It is used for corporate manger/ Branch Manager Makes inquiries for orders/ trades of any
branch manager /dealer of the trading firm, and then the inquiry is Serviced By the host. The
local database also includes message of security information.

Ticker Window

The ticker window displays information of All Trades in the system. The user has the option
of Selecting the Security, which should be appearing in the ticker window.

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Market watch Window

Title Bar: Title Bar Shows: NEAT, Date & Time

Market watch window felicitate to set only 500 Scrip’s, But the User set up a Maximum of 30
Securities in one Page.
MBP (Market by Price)
MBP (F6) Screen shows Total Outstanding Orders of a particular security, in the Market,
Aggregate at each price in order of Best 5 prices.
It Shows: - RL Order (Regular Lot Order)
SL Order (Stop Loss Order)
ST Order (Special Term Orders)
Buy Back Order with ‘*’ Symbol
P = indicate Pre Open Position
S = Indicate Security Suspend
Report Selection Window
It facilitates to print each copy of report at any time. These Reports are
1)Open order report :-
For details of out standing orders
2)Order log report:-
For details of orders placed, modified & cancelled
3)Trade Done-today report :-
For details of orders traded
4) Market Statistics report: -
For details of all securities traded Information in a Day
Internet Broking
1) NSE introduced internet trading system from February 20002)Client place the order
through brokers on order routing system
WAP (Wireless Application Protocol)
1) NSE.IT Launches the from November 2000
2)1stStep-getting the permission from exchange for WAP
3)2ndstep-Approved by the SEBI(SEBI Approved only for SEBI registered Members)
X.25 Address check

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X.25 Address check, is performed in the NEAT system, when the user log on intothe NEAT,
system & during report down load request.

FTP (File Transfer protocol)

NSE Provide for each member a separate directory (File) to know their trading DATA, clear
DATA, bill trade Report.2)NSE Provide in Addition a “Common” directory also, to know
circulars, NCFM & Bhava Copy information

3) FTP is connected to each member through VSAT, leased line and internet.
4) VSAT (FROM 4:15PM to 9:30AM), Internet (24 Hours).
Snap Shot Data Base
Snap shot data base provides Snap shot of the limit order book at many time points in a day.
Index Data Base
Index Data Base provides information about stock market indexes.
Trade Data Base
Trade Data Base provides a data base of every single traded order, take place in exchange.

BASKET TRADING SYSTEM

1) Taking advantage for easy arbitration between future market and & cash market
difference, NSE introduce basket trading system by offsetting positions through off line-
order-entry facility.
2) Orders are created for a selected portfolio to the ratio of their market Capitalization from 1
lake to 30 corers.
3) Offline-order-entry facility: -
generate order file in as specified format outside the system & up load the order file in to the
system by invoking this facility in Basket trading system.

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TRADING NETWORK

Holding of Shares (Voting Right) disclosing obligation

1) Any person or Director or officer or the company

2) More than 5% share or voting Right

3) With in 4th day inform to company is necessary.

4) Company inform with in 5th day to stock exchange is compulsory

First Started

Future trading: Chicago Board of Trading 1848

Financial Future Trading: CME (Chicago Mercantile Exchange 1919)

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Stock Index Futures: Kansas City Board of trade

Option First Trade: Holland - Tulip Balabmania

BROKER (Trading Member)(Broker means a member in recognized stock exchange)

Eligibility:

21 tears, graduation, 2 years experience in stock market relative Affairs and

•30 Lakhs paid up capital

•100 lakhs net worth

•125 lakhs interest free security deposit

•25 lakhs collatery security deposit

•1 lakh annual business subscription.

BROKER & CLIENT RELATION SHIP

1) Fill the client Registration Application form (for all details of clients).

2) Agreement on non-judicial form (Specified by SEBI that form)

3) PAN, Pass Port, Driving License or voter Identity card (SEBI

Registration Number in case of FII’s) - Pan Cards is must to future and option trading.

4) And then Allot-Unique client code.

5)Take copy of instruction in writing before placing order, cancellation &modification.6)If

order values exceed 1 lakh maintain the client record for 7 years.7)On conformation any
order, issue contract note within 24 hours.8)Collect margin of 50,000 & multiple with 10,000.

NOTE: - PAN is compulsory if the transaction cost exceed Rs.1 lakh.

9) Issuing the “know your client “form is must.

For Continuing Membership-Trading Member Fulfil the following documents.

1) Audited two important Financial Statements (profit & Loss account, balance Sheet)

2) Net worth certificate (Certificate by CA)

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3) Details of Directors, shareholders (certificate by CA)

4)Renewal insurance covering proof.

SUB BROKER

1) Eligibility: - 21 years, 10+2 qualification and paid up capital 5 lakhs

2) Not convicted involving fraud and dishonesty.

3)Not debarred by SEBI previously.

4)51% of shares as dominant promoters his/her and his/her spouse.

5)First application to stock exchange-Stock exchange send his application to SEBI-SEBI

satisfied issued Certificate Registration.

6)A registered sub-broker, holding registration, granted by SEBI on the Recommendations of

a trading member, can transact through the member (broker) who had recommend his
application for registration.

7)Maximum Brokerage Commission 2%.

8)Purchase note and sales note issued by the sub broker with 24 hours.

Investor protection Fund

1) Investor protection fund setup under Bombay public trust Act 1950.

2) IPF maintained by NSE Exact name of this fund is NSE Investors Protection Fund Trust.

3) Any Member defaulted the IPF paid maximum 10 lakhs only to each investor.

4) Client against default member, customer have right to apply within 3 months from the date
of Publishing notice by a widely circulated minimum one daily Newspaper.

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 CONCLUSIONS

 The above analysis of Futures of B.H.E.L, O.N.G.C, RELCAPITAL, TATA STEEL

had shown a Flat market in the week.
 The major factors that influence the F&O market are the cash market, Full
involvement, News related to the underlying asset, National and International
markets, Researchers view etc.
 In bearish market it is suggested to an investor option for put option in order to
minimize losses.
 In a bullish market it is suggested to investors to option for call option in order to
maximize profit.
 In cash market the profit/loss is limited but where in F& O an investor can enjoy
unlimited profits/loss.
 It is recommended that SEBI should take measures in improving awareness about the
F&O market as it is launched very recently.
 It is suggested to an investor to keep in mind the time or expiry duration of F&O
contract before trading. The lengthy the time, the risk is low and profitmaking. The
fewer time may be high risk and chances of loss making.
 At present scenario the Derivatives market is increased to a great position. Its daily
turnover teaches to the equal stage of cash market.
 The derivatives are mainly used for hedging purpose.

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