investors awareness regarding risk hedging instruments

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LOVELY PROFESSIONAL UNIVERSITY DEPARTMENT OF MANAGEMENT Report on DERRIVATIVES “Investor’s Awareness regarding Risk Hedging Instruments Submitted to Lovely Professional University In partial fulfillment of the Requirements for the award of Degree of Master of Business Administration SOFI OWAIS AHMAD 11112675 DEPARTMENT OF MANAGEMENT

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Page 1: Investors Awareness Regarding Risk Hedging Instruments

LOVELY PROFESSIONAL UNIVERSITYDEPARTMENT OF MANAGEMENT

Report on

DERRIVATIVES

“Investor’s Awareness regarding Risk Hedging Instruments ”

Submitted to Lovely Professional University

In partial fulfillment of theRequirements for the award of Degree of

Master of Business Administration

SOFI OWAIS AHMAD

11112675

DEPARTMENT OF MANAGEMENTLOVELY PROFESSIONAL UNIVERSITY

JALANDHAR-NEW DELHI GT ROADPHAGWARA

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PUNJAB

PREFACE

This project report pertains to the making of summer training project of M.B.A.

The purpose of this project is to make the students gain thorough knowledge of the topics given

to them. I learned a lot about the topic after putting in much hard work in collecting the

information regarding the topic allotted, which will be of a great use in future.

It cannot be said with certainty that full justification has been done to the topic in the few pages

presented here, but I have tried my best to cover as much as possible about “Derivatives:

Investors Awareness Regarding Risk Hedging Instruments” in this report.

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DECLARATION

I Sofi Owais Ahmad, here by declare that this is my Project Report on “Derivatives: Investors

Awareness Regarding Risk Hedging Instruments”, which is submitted in partial fulfillment of

the requirement of “Master of Business Administration” to Lovely Professional University.

This is my original work and not submitted for the award of any other degree, diploma,

fellowship or other similar titles. The assistance and help during the execution of the project has

been fully acknowledged.

Date_______________ Signature_______________

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Guide Certificate

This to certify that Sofi Owais Ahmad , a student of MBA, Lovely Professional University has

undertaken the project on “Investor’s Awareness Regarding Risk hedging Instruments”, and has

successfully completed this project under my guidance.

This project was commissioned only for academic purposes, and is certified to be a bona fide

work done by student.

Date:

Assistant Professor

Lovely School of Business and Applied Art

LPU

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ACKNOWLEDGEMENT

. Any research is never an individual effort. It is contributory effort of many hearts, hand and

heads. First I would like to express my gratitude to “LOVELY PROFESSIONAL

UNIVERSITY” who provided me an opportunity to do my summer training project in LSE for a

span of 45 days .I am highly indebted to those who have helped me in making this summer

training project a success and for providing their guidance and support in completing the project .

While, I take this opportunity to thanks all of them. They are too numerous to be mentioned in

this brief acknowledgement. This form of acknowledgement may not be sufficient to express the

feeling of gratitude towards people, who have helped me successfully completing my training.

It is my profound privilege to express my sincere thanks to Mr. Sadhu Ram, who gave

me an opportunity to pursue my training in their prestigious organization.

I would also like to thank Mrs. PoojaM.Kohli (executive director (offtg)) for giving her

expert guidance & co-operation whenever I approached her for help in carrying out my project

related to derivatives and also provided the valuable insights in understanding the basic

fundamental about stock markets and regulation throughout duration of my project.

I would like to express my thanks to all Faculty through which this learning was possible.

Last and above all, I am extremely thankful to Miss.Jatinder kaur , Faculty Guide LOVELY

PROFFESIONAL UNIVERSITY, for his timely guidance and support throughout the Final

Report work. It would not have been possible with out her support and guidance.

Sofi Owais Ahmad

11112675

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TABLE OF CONTENTS

TOPICS PAGE NO.

Acknowledgement………………………………………………..

Abstract…………………………………………………………..

CHAPTER:-1 (INTRODUCTION)

Introduction to Stock Exchange………………………………....

Introduction to LSE……………………………………………....

Operations of LSE………………………………………………..

CHAPTER:-2 (DERIVATIVES)

Introduction to derivatives……………………………………….

Types of Derivative………………………………………………

CHAPTER:-3 (REVIEW OF LITERATURE)

Literature Review………………………………………………..

CHAPTER:-4 (OBJECTIVES)

Objectives………………………………………………………

CHAPTER:-5 (RESEARCH METHODOLOGY)

Research Methodology…………………………………………..

Limitations of the Study…………………………………………..

CHAPTER:-6 (ANALYSIS & CONCLUSION)

Analysis…………………………………………………………..

Research Findings………………………………………………..

Recommendations………………………………………………..

Perception held by Investors about Derivatives…………………..

Conclusion…………………………………………………………

CHAPTER:-7 (BIBLIOGRAPHY)

Bibliography……………………………………………………….

(ANEXURE) Questionnaire…………………………………….

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EXECUTIVE SUMMARY

From the past few years financial markets have experienced an impresssive expansion in terms

of securities issued and traded on secondary markets. In addition financial markets have become

more interconnected allowing almost continous trading in some precious metals and currencies

and stocks traded onseveral exchanges.one of the most important boosts to the changes and

development of financial market is issuance and trading of derivatives.

Derivative is a prroduct whose value is derived from the value of one or more basic variables

called basis (underlying assets, index or any other assets) in a contractual manner.The underlying

asset can be equity ,for example commodity or any other asset .These are mostly used by

investors to hedge or balance risk involved in financial transactions or trading.

In this report I have tried to full fill my objective as investors awareness regarding risk hedging

instruments , perception held by investors about the financial derivatives. Moreover I have

focussed my study as how derivatives help to reduce the risk and how they provide hedge against

risk.I have covered in this project the brief and precise introduction of stock market ,an extensive

overview of financial derivatives .In order to know more about the subject matter a

comprehensive literature review has been carried out. Since my objective was to know about the

awareness of investors regarding risk hedging instruments , perception held by investors about

derivatives for being a risk hedging instrument and moreover experience of those investorswho

have dealt with derivatives , a well designed questionnaire was framed to gather the data.

Keeping in view the objectives and time span sample unit and size were decided .My sampling

unit was ludhiana stock exchange ,investors visiting stock exchange were taken as

population.After collecting all data modern IT tools were used to cover the research

methodology part like With the help of SPSS a software an analysis and interpretation was made

more clear and comprehensive.Since it is not possible to cover all those things in executive

summary which I have found during my analysis,however I believe that there is lack of

knowledge , difficulty in understanding the risk hedging instruments like derivatives among

investorswhich has keep them away from financial derivatives.The investors prefer

diversification of portfolio to reduce risk than use of derivatives.Another fear of most of the

investors is speculation . Thus need of the time is tocreate awareness among investors and to kill

all those wrong notions associated with derivatives.

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CHAPTER:-1

INTRODUCTION

INTRODUCTION TO STOCK EXCHANGE

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Stock markets refer to a market place where investors can buy and sell stocks. The price at which

each buying and selling transaction takes is determined by the market forces (i.e. demand and

supply for a particular stock).

Inorder to have better understanding as how market forces supply and demand determine price of

any stock ,what can be a best than this example. Shimar co. Ltd. enjoys high investor confidence

and there is an anticipation of an upward movement in its stock price. More and more people

would want to buy this stock (i.e. high demand) and very few people will want to sell this stock

at current market price (i.e. less supply). Therefore, buyers will have to bid a higher price for this

stock to match the ask price from the seller which will increase the stock price of Shimar co. Ltd.

On the contrary, if there are more sellers than buyers (i.e. high supply and low demand) for the

stock of shimar co. Ltd. in the market, its price will fall down.

Gone are the days when buyers would assemble at stock exchange to make a transaction ,now

with the advancement in IT , most of the operations are carried out electronically and the stock

markets have become almost paper less.Now investors can trade freely from their home or office

over the phone and internet.

HISTORY OF THE INDIAN STOCK MARKET-THE ORIGIN

One of the oldest stock market in Asia, the Indian Stock Markets has a 200 years old history

.

18th Century East India company was the dominant institution and by the end

of the century, business in its loan securities gained full

momentum.

1830’s Business on corporate stock and shares in bank and cotton presses

started in Bombay. Trading listed by the end of 1839 got broader.

1840’s Recognition from banks and merchants to about half a dozen

brokers.

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1850’s Rapid development of commercial enterprise saw brokerage

business attracting more people in the business.

1860’s The number of brokers increases to 60.

1860-61 The American civil war broke out which caused a stoppage of

cotton supply of united states of America; marking the beginning

of the “Share Mania” in India.

1862-63 The number if brokers increased to 200 to 250.

1865 A disastrous slump began at the end of American civil war (as an

example, bank of Bombay share which had touched Rs.2850

could only be sold at Rs.87.

Pre-Independence Scenario-Established of Different Stock Exchanges

1874 With the rapid development share trading business, brokers’

used to gather at a street (now well known as “Dalal Street”)

for the purpose of tractions business.

1875 “The Native Share and Stock Brokers’ Association” (also

known as “The Bombay Stock Exchange”) was established

in Bombay.

1880’s Development of cotton mills industry and set up of many

others.

1894 Establishment of “The Ahmadabad share and Stock Brokers’

Association”.

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1880-90’s Sharp increase in share prices of jute industries in 1870’s

was followed by a boom in tea stocks and coal.

1908 “The Calcutta Stock Exchange Association was formed.

1920 Madras witness was boom the business at “The Madras

Stock Exchange” was transacted with 100 brokers.

1923 When recession was followed, number of brokers came

down to 3 and the exchange was closed down.

1936 Merger of the Lahore Stock Exchange with the Punjab Stock

Exchange.

1937 Re-organization and set up of Madras Stock Exchange

Limited (Pvt.) led by improvement in stock market activities

in South India with establishment of new textile mills and

plantation companies.

1940 Uttar Pradesh Stock Exchange Limited and Nagpur Stock

Exchange Limited were established.

1944 Establishment of “The Hyderabad Stock Exchange was

Limited”.

1947 “Delhi Stock and Share Brokers’ Association Limited” and

“The Delhi Stocks and Shares Exchange Limited” were

establishment and later on merged into. “The Delhi Stock

Exchange Association Limited”.

POST INDEPENDENT SCENARIO

The depression witnessed after the independence led to closer of a lot of exchanges in the

country. Lahore stock exchange was closed down after the partition of India, and later on merged

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with the Delhi stock exchange. Bangalore stock exchange limited was registered in 1957 and got

recognition only by 1963. Most of the other exchanges were in a miserable state till 1957 when

they applied for recognition under securities contracts (Regulations) Act, 1956.

The exchanges that were recognized under the act were:

Indore * Ahmadabad

Bangalore * Madras

Hyderabad * Calcutta

Delhi * Bombay

Many more stock exchanges were established during 1980’s, names:

Meerut stock Exchange

Coimbatore stock exchange

Vadodara stock exchange limited(at baroda,1990)

Saurashtra Kutch stock exchange limited(at Rajkot,1989)

Bhubaneswar stock exchange association limited(1989)

Jaipur stock exchange limited(1989)

Magadh stock exchange association(at patna,1986)

Kanara stock exchange limited(at mangalore,1985)

Gauhati stock exchange limited(1984)

Ludhiana stock exchange association limited(1983)

Pune stock exchange limited(1982)

Uttar Pradesh stock exchange association limited(at Kanpur,1982)

Cochin stock exchange(1980)

The recent to join the list was Meerut Stock Exchange and Coimbatore Stock Exchange.

At present, There are 23 recognized stock exchanges in India, including the Over the

Counter Exchange of India (OTCEI) for small and new companies and the National Stock

Exchange (NSE) which was set up as a model exchange to provide nation-wide services to

investors. NSE, which in the recent past has accounted for the largest trading volumes, has a

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fully automated screen based system that operates in the wholesale debt market segment as

well as the capital market segment.

Trading Pattern of the Indian Stock Market

Indian Stock Exchanges allow trading of securities of only those public limited companies

that are listed on the Exchange(s).

They are divided into two categories:

Types of Transactions

The flowchart below describes the types of transactions that can be carried out on the Indian

stock exchanges:

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Indian stock exchange allows a member broker to perform following activities:

1. Act as an agent,

2. Buy and sell securities for his clients and charge commission for the same,

3. Act as a trader or dealer as a principal,

Buy and sell securities on his own account and risk.

OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

Traditionally, trading in Stock Exchanges in India followed a conventional style where people

used to gather at the Exchange and bids and offers were made by open outcry.

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This age-old trading mechanism in the Indian stock markets used to create much

functional inefficiency. Lack of liquidity and transparency, long settlement periods and

transactions are a few examples that adversely affected investors. In order to overcome these

inefficiencies, OTCEI was incorporated in 1990 under the Companies Act 1956. OTCEI is the

first screen based nationwide stock exchange in India created by Unit Trust of India, Industrial

Credit and Investment Corporation of India, Industrial Development Bank of India, SBI Capital

Markets, Industrial Finance Corporation of India, General Insurance Corporation and its

subsidiaries and Can Bank Financial Services.

Advantages of OTCEI

1. Greater liquidity and lesser risk of intermediary charges due to widely spread trading

mechanism across India.

2. The screen-based script less trading ensures transparency and accuracy of prices.

3. Faster settlement and transfer process as compared to other exchanges.

4. Shorter allotment procedure (in case of a new issue) than other exchanges.

National Stock Exchange

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In order to lift the Indian stock market trading system on par with the international standards. On

the basis of the recommendations of high powered M J Pherwani Committee, the National Stock

Exchange was incorporated in 1992 by Industrial Development Bank of India, Industrial Credit

and Investment Corporation of India, Industrial Finance Corporation of India, all Insurance

Corporations, selected commercial banks and others.

NSE provides exposure to investors in two types of markets, namely:

1. Wholesale debt market

2. Capital market

Wholesale Debt Market - Similar to money market operations, debt market operations

institutional investors and corporate bodies entering into transactions of high value in financial

instruments like treasury bills, government securities, commercial papers etc.

Trading at NSE

1. Fully automated screen-based trading mechanism.

2. Strictly follows the principle of an order-driven market.

3. Trading members are linked through a communication network.

4. This network allows them to execute trade from their offices.

5. The prices at which the buyer and seller are willing to transact will appear on the screen.

6. When the prices match the transaction will be completed.

7. A confirmation slip will be printed at the office of the trading member.

Advantages of trading at NSE

1. Integrated network for trading in stock market of India.

2. Fully automated screen based system that provides higher degree of transparency.

3. Investors can transact from any part of the country at uniform prices.

Greater functional efficiency supported by totally computerized network.

ROLE OF STOCK EXCHANGE

“A stock exchange fulfills a vital function in the economic development of a nation. Its main

function is to ‘liquefy’ capital by enabling a person who has invested money in, say a factory or

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railway, to convert it into cash by disposing off his shares in the enterprise to someone else.

Investment in joint stock companies is attractive to public, because the value of the shares is

announced day after day in the stock exchanges, and shares quoted on the exchanges are capable

of almost immediate conversion into money .in modern days a company stands little chance of

inducing the public to subscribe to its capital, unless its shares are quoted in an approved stock

exchange. All public companies are anxious to obtain permission from reputed exchanges for

securing quotations of their shares and the management of a company is anxious to inform the

investing public that the shares of the company will be quoted on the stock exchange”.

FUNCTIONS OF STOCK EXCHANGE

The stock exchange is really an essential pillar of the private sector corporate economy. It

discharges three essential functions:

First, the stock exchange provides a market place for purchase and sale of securities viz.

shares, bonds, debentures etc. it therefore ensures the free transferability of securities

which is the essential basis for the joint stock enterprises system.

Secondly, the stock exchange provides the linkage between the savings in the household

sector and the investment in the corporate economy. It mobilizes savings, channelizes

them as securities into these enterprises which are favored by the investors on the basis of

such criteria as future growth prospects, good return and appreciation of capital.

Thirdly, by providing a market quotation of the prices of shares and bonds- a short of

collective judgment simultaneously reached by many buyers and sellers in the market-

the stock exchange serves the role of a barometer, not only of the state of health of

individual companies, but also of the nation’s economy as the whole.

LUDHIANA STOCK EXCHANGE SECURITIES LIMITED

LSE Securities Ltd. was incorporated in January, 2000 with a view to receive the capital market

in the region and for taking full advantage of the emerging opportunities being provided by

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expansion of bigger stock exchange like NSE and BSE. The company since its inception has

marched forward rapidly and has maintained consistent growth record.

LSE Securities Limited is a subsidiary of the Ludhiana Stock Exchange has presence at various

locations to effectively service its large base of individual clients. The clients of the company

greatly benefit from strong research capability, which encompasses fundamentals as well as

technical’s of LSE Securities Ltd, besides it wide reach in this part of the country.

LUDHIANA STOCK EXCHANGE PROFILE

The Ludhiana Stock Exchange Limited was established in 1981, by Sh. S.P. Oswal of Vardhman

Group and Sh. B.M. Lal Munjal of Hero Group, leading industrial luminaries, to fulfill a vital

need of having a Stock Exchange in the region of Punjab, Himachal Pradesh, Jammu & Kashmir

and Union Territory of Chandigarh. Since its inception, the Stock Exchange has grown

phenomenally.

The Stock Exchange has played an important role in channelizing savings into capital for the

various industrial and commercial units of the State of Punjab and other parts of the country. The

Exchange has facilitated the mobilization of funds by entrepreneurs from the public and thereby

contributed in the overall, economic, industrial and social development of the States under its

jurisdiction.

Ludhiana Stock Exchange is one of the leading Regional Stock Exchange and has been in the

forefront of other Stock Exchange in every spheres, whether it is formation of subsidiary for

providing the platform of trading to investors, for brokers etc. in the era of Screen based trading

introduced by National Stock Exchange and Bombay Stock Exchange, entering into the field of

Commodities trading or imparting education to the Public at large by way of starting

Certification Programs in Capital Market.

The vision and mission of stock Exchange is:

VISION

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“Reaching small investors by providing services relating to Capital market including Trading

Depository operations etc and creating Mass Awareness by way of education and training in the

field of Capital market”.

MISSION

“To create educated investors and fulfilling the gap of skilled work force in the domain in

Capital Market.”

Further, the exchange has 295 members out of which 171 are registered with national Stock

exchange as Sub- broker and 124 with Bombay Stock exchange as sub- brokers through our

subsidiary.

DETAILS OF PRESIDENTS AND VICE PRESIDENTS

PRESIDENT/CHAIRMEN

VICE PRESIDENT/VICE CHAIRMEN

PRESIDENTS/CHAIRMEN

Sr.

No.

Name of the person Tenure

1 Sh. S.P. Oswal 16.08.1983 to 27.07.1986

2 Sh. B.M. Lal Munjal 28.07.1986 to 15.10.1989

3 Sh. V.N. Dhiri 16.10.1989 to 30.10.1992

30.09.1998 to 04.10.2000

4 Sh. G.S. Dhodi 31.10.1992 to 22.12.1993

5 Sh. Jaspal Singh 01.10.1996 to 29.09.1998

06.10.2001 to 01.07.2002

6 Sh. M.S. Gandhi 06.10.1995 to 30.09.1996

7 Sh. R.C. Singal 05.10.2000 to 05.10.2001

8 Dr. B. B. Tandon, Chairman 25.06.2007 to 10.12.2007

9 Sh. S.P. Sharma, Chairman 15.07.2007 to 23.09.2008

10 Sh. Jagmohan Krishan 23.09.2008 to 29.09.2009

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11 Prof  Padam Parkash Kansal 30.09.2009 to till date

VICE PRESIDENTS/ VICE CHIRMAN

Sr. No. Name of the person Tenure

1 Sh. Rajinder Verma 14.07.1984 to 08.08.1987

2 Sh. B.K. Arora 09.08.1987 to 15.10.1989

31.10.1992 to 22.12.1993

3 Sh. G.S. Dhodi 28.10.1991 to 30.10.1992

4 Sh. B.S. Sidhu 16.10.1989 to 27.10.1991

23.12.1993 to 05.10.1995

5 Sh. D.P. Gandhi 06.10.1995 to 26.09.1997

06 Sh. M. S. Sarna 27.09.1997 to 29.09.1998

7 Sh. T.S. Thapar 30.09.1998 to 04.10.2000

8 Sh. Tarvinder Dhingra 05.10.2000 to 05.10.2001

9 Dr. Rajiv Kalra 06.10.2001 to 01.07.2002

10 Sh. D.K. Malhotra, Vice

Chairman 025.06.2007 to 10.12.2007

11 Sh. Jagmohan Krishan, Vice

Chairman 15.07.2007 to 23.09.2008

12 Sh. Ravinder Nath Sethi 23.09.2008 to 08.10.2008

13 Prof  Padam Parkash Kansal 09.10.2008 to 29.09.2009

14 Sh. Joginder Kumar 30.09.2009 to till date

GOVERNANCE AND MANAGEMENT

Ludhiana Stock Exchange has a strong governance and administration, which encompasses a

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right balance of industry experts with highest level educational background, practicing

professional and independent experts in various filed of Financial Sector. The administration is

presently headed by Sr. General Manager-cum-company Secretary (holding additional charge of

Executive Director (Offtg.) and team of persons having indepth knowledge of secretarial, legal

and Educational Training. 

The Governing Board of our Exchange comprises of twelve members, out of which three are

Public Interest Directors, who are eminent persons in the fields of Finance and Accounts,

Education, Law, Capital Markets and other related fields, Six are Shareholder Directors, and

three are Broker Member Director and the Exchange has four Statutory Committees namely

Disciplinary Committee, Arbitration Committee, Defaults Committee and Investor Services

Committee. In addition, it has advisory and standing committees to assist the administration.

LSE has a Code of Conduct in place that governs the elected Board Members and the Senior

Management Team. The same is monitored through periodic disclosure procedures. The

Exchange has an Ethics Committee, which looks into any issue of conflict of interest and has in

place general code of conduct for the Senior Officials.

The composition of the Governing Board is as under:-

Sr. No. Name of Director Category

1 Prof. Padam Parkash Kansal Chairman (Shareholder Director)

2 Sh. Joginder Kumar Vice Chairman(Shareholder Director)

3 Sh. Rajinder Mohan Singla Shareholder Director

4 Sh. Satish Gupta Shareholder Director

5 Sh. Ashok Kumar Shareholder Director

6 Sh. Vikas Batra Shareholder Director

7 Dr. Raj Singh Registrar of Companies (Public Interest

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Director)

8 Sh. Ashwani Kumar Public Interest Director

9 Sh. V.P. Gaur Public Interest Director

10 Sh. Jaspal Singh Trading member Director

11 Sh. Sunil Gupta Trading Member Director

12 Sh. Sanjay Anand Trading member Director

STRENGHTS OF LSE GROUP

1. “LSE” brand is popular among masses. The brand image of LSE can be capitalized.

2. We have requisite infrastructure for the Capital Market activities which includes a

multi-stored, centrally air conditioned building situated in the financial hub of the city

i.e. Feroze Gandhi Mar0ket.

3. We have well experienced staff handling operations of Stock Exchange.

4. We have competent Board and professional management.

5. We have much needed networking of sub brokers in the entire region, who are having

rich experience in Stock Market operations for the last 25 years.

6. We have more than 40,000 clients spread across Punjab, Himachal Pradesh, Jammu &

Kashmir and adjoining areas of Haryana and Rajasthan.

7. The turnover of our subsidiary is the highest amongst all subsidiaries of Regional Stock

Exchanges in India

INFRASTRUCTURE AND ASSET BASE AT LSE

The Exchange building is situated at Feroz Gandhi Market, Ferozpur Road, Ludhiana.

It is a six storey building, which is centrally air-conditioned. The building has 262 rooms, which

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are located on various floors ranging from second to fifth. The first floor of the building houses

the administrative office and rooms from second to fifth floors have been leased out to brokers.

The first floor also has canteen and banking facilities. Investor Service Centre is also located at

first floor which houses a well-equipped library and view-terminals to provide “live” rates of

NSE and BSE to investors. Investors are also provided with Cable TV for the purpose of viewing

the latest happenings in the Capital Market and around. Basement of the building has air-

conditioning plant and Generators to provide air-conditioned environment and twenty-four hours

power back up. The Exchange has also an additional plot of land measuring 2333 sq. yards in the

prime location of city, to enhance its infrastructure and source of income.

STATUS OF OUR SUBSIDIARY I.E LSE SECURITIES LTD.

Due to Nation wide reach of bigger Stock Exchanges, the trading volumes at Ludhiana Stock

Exchange declined and ultimately, the trading stopped in February, 2002, but the Stock

Exchange converted the threat of bigger Exchanges into opportunities and acquired the corporate

membership of these exchanges through its subsidiary company i.e. LSE Securities Limited. We

have now been providing Trading Platforms of Bigger Stock Exchanges to the Investors of the

region. The vast network of Brokers of the Exchange is servicing millions of Investors. The

subsidiary company is also providing depository services in the State of Punjab and Himachal

Pradesh. The turnover of subsidiary is highest amongst all the subsidiaries of Regional Stock

Exchanges. The growth of subsidiary is swift and it has been providing a range of services to the

public at large such as Trading, Depository, IPO bidding collection Centre. The Company in its

continuous endevour to provide qualitative services to its valued clients has started e-broking

trading services for its clients, thereby increasing the geographical reach of the company.

LISTING OF SECURITIES OF A COMPANIES AT LUDHIANA STOCK EXCHANGE

At present, Ludhiana Stock Exchange has 324 listed companies, out of which 211 are regional

and 113 are Non-regional. The total listed capital of aforesaid companies is Rs. 3063.56 Crores

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appx. The market capitalization of the said companies is more than Rs. 1890.53 crores. The

Stock Exchange is covering the vast investor base through the listing of abovesaid companies,

which are situated in the region comprising of Punjab, Himachal Pardesh, Jammu & Kashmir,

Chandigarh.

Ludhiana Stock Exchange has facilitated the capital generation for agro based industries as

Punjab is a agricultural led economy. It will continue to do so, once it gets approval for a tie up

with bigger Exchanges for commencing trading operations.

INVESTOR RELATED SERVICES

The Exchange has been providing a variety of services for the benefit of investing public. The

services include Investor Service Centres, Investor Protection fund and Investor Educational

Seminars.

1) INVESTOR SERVICE CENTRES

The Exchange has set-up Investor Service Centre at LSE Building for providing information

relating to Capital Market to the general public. The Centres subscribe to leading economic,

financial dailies and periodicals. They also store the Annual Reports of the companies listed at

the Stock Exchange.

2) INVESTOR AWARENESS SEMINARS

The Exchange has been organizing Investor Awareness Seminars for the benefit of Investors of

the region comprising State of Punjab, Himachal Pradesh, Jammu & Kashmir, Chandigarh and

adjoining areas of Haryana and Rajasthan. This massive exercise of organizing Investor

Awareness Seminars has been launched as a part of Securities Market Awareness Campaign

launched by SEBI in January, 2003. The Exchange apprises the investors about Do’s and Don’ts

to be observed while dealing in Securities Market. During 2011-2012, till date, Exchange has

organized more than 83 workshops in the region mentioned above.

3) WEBSITE OF THE EXCHANGE

www.lse.co.in The Exchange has its own website with the domain name www.lse.co.in. The

website provides valuable information about the latest market commentary, research reports

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about companies, daily status of International markets, a separate module for Internet trading,

information about listed companies and brokers and sub-brokers of the Exchange and its

subsidiary. The website also contains many useful links on portfolio management, investor

education, frequently asked questions about various topics relating to Primary and Secondary

Market, information about Mutual Funds, Financials of the Company including Quarterly

Results, Share Prices, Profit and Loss Accounts, Balance Sheet and Many More. The website

also contains daily Technical Charts of various scrips being traded in BSE and NSE.

CHAPTER:-2

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DERIVATIVES

INTRODUCTION TO DERIVATIVES

Over the past two decades, the financial markets have experienced an impressive expansion in

terms of securities issued and traded on the secondary markets. In addition, financial markets

have become more and more interconnected allowing almost continuous trading in some

precious metals, currencies and stock traded on several exchanges.

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Financial innovation that led to the issuance and trading of derivative products has been perhaps

one of the most important boosts to the changes and development of financial market.

In the financial market place, some securities and some instruments are regarded as fundamental,

while others are regarded as derivative. In a corporation, for example the stock and bonds issued

by the firm are fundamental securities. With the fundamental securities such as stock and bonds,

there is entirely distinct class of financial instrument or securities whose payoffs depend on a

more primitive or a fundamental good. For example a gold future contract is a derivative

instrument, because the value of the future contract depends upon the value of the gold that

underlies the future contract.

DEFINITION OF DERIVATIVES

Derivative is a product whose value is derived from the value of one or more basic variables

called bases (underlying assets, index or any other assets), in a contractual manner. The

underlying assets can be equity, for ex commodity or any other assets. For example, wheat

farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices

by that date. Such a transaction is an example of a derivative. The price of this derivative is

driven by the spot price of wheat which is the underlying.

Definition under SEBI Act:

The terms “Derivatives” indicates that it has no independent value, i.e. its value is entirely

“derived” from the value of underlying assets. The underlying assets can be securities,

commodities, bullion, currency, live stock or anything else. In other words, derivative means a

forward future, options or any other hybrid contract of predetermined fixed duration, linked for

the purpose of contract fulfillment to the value of specified real or financial assets or to an index

of securities.

HISTORY OF DERIVATIVES

The History of derivatives is surprisingly longer then what most people think. Some texts even

find the existence of the characteristics of derivatives contracts even been found in incidents of

Mahabharata. The traces of derivative contract even are found in incidents that date to back to

the ages before Jesus Christ. However, the advent of modern day derivative contracts is

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attributed to the need for farmers to protect themselves from any decline in the price of their

crops due to delayed monsoon, or over production.

The first ‘future’ contracts can be traced to rice market in Osaka, Japan around 1650. These were

evidently standardized contracts, which made them much like today’s future.

The Chicago Board Of Trade (CBOT), the largest derivative exchange in the world, was

established in 1848 where forward contracts in 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.

INDIAN CONTEXT

Derivatives have had a long presence in India. The commonly derivative market has been

functioning in India since the 19th 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 trade financial derivatives were introduced

in India in June 2000 at the two major stock exchanges; NSE and BSE. There are various

contacts currently trade on these exchanges.

DERIVATIVES MARKET IN INDIA

The first step toward introduction of derivatives trading India was the promulgation of the

securities Laws Ordinance, 1995, which withdrew the prohibition on option in securities the

market for derivatives, however, did not take off as there was on regulatory framework to govern

the trading of derivatives. SEBI set up a 24-member committee under the chairmanship of Dr.

L.C gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives

trading in India. The committee submitted its report on March 17, 1998 prescribing necessary

per-conditions for introduction of derivatives trading in India. The committee recommended that

derivatives should be declared as” securities” so that regulatory framework applicable to trading

of “securities” could also govern trading of securities. SEBI also set up a group in June 1998

under the chairmanship of professor J R Verma to recommend measures for risk containment in

derivatives market in India. The report which was submitted in October 1998, worked out the

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operational details of margining system, methodology for charging initials margins, broker net

worth, Deposit requirement and real time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit of

“Securities” and the regulatory frame works were developed for governing derivatives trading.

The act also made it clear that derivatives shall be made legal and valid only if such contracts are

traded on a recognized stock exchange thus precluding OTC Derivatives. The government also

resigned in March 2000, the three decade old notification, which prohibited forward trading in

securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to

this effect in May 2000. SEBI permitted the derivative segment of two exchanges, NSE and

BSE, and their clearing house/corporation to commence trading and settlement in approved

derivatives contracts. To begin with, SEBI approved trading in index future contracts based on

S&P CNX Nifty and BSE-30(Sensex) index. This was followed by the approval of trading in

options commenced in June 2001 and the trading in the options on individual securities

commenced in July 2001. Futures contracts in individual stocks were launched in November

2001. Trading and settlement in derivatives contracts is done in accordance with the rules,

bylaws and regulations of the respective exchanges and their clearing house duly approved to

SBEI and notified in the official gazette.

DERIVATIVES MARKET AT NSE

The derivatives trading on the exchanged commenced with S&P CNC Nifty Index futures on

June 12, 2000. The trading in index options commenced on July 2, 2001. Single stock futures

were launched on November 9, 2001. The index futures and options contract on NSE are based

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on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month

expiration cycles. There contracts are available for trading. With 1 month, 2 month, 3 month

expiry. A new contract is introduced on the next trading day following the expiry of the near

month contract.

Risk Management Tools

Derivatives are powerful risk management tools. To illustrate, let’s take an example of an

investor who holds the stock of Infosys, which are currently trading at Rs.2, 756.30.

Example: Infosys options are traded on the National Stock Exchange of India, which gives the

owner the right to buy (call) shares of Infosys at Rs.2,920 each (exercise price), expiring on 30 th

September,2011. Now if the share price of Infosys remains less than or equal to Rs.2,920, the

contract would be worthless for the owner and he would lose the money he paid to buy the

option, known as premium.

However, the premium is the maximum amount that the owner of the contract can lose. Hence he

has limited his loss. On the other hand, if the share prices of Infosys goes above Rs.2,920, the

owner of the call option can exercise the contract, buy the share at Rs.2,920 and make profits by

selling the share at the market price of Infosys.

The upward gain can be unlimited. Say the share price of Infosys zooms to Rs.3, 300 by

September 2011; the owner of the call option can buy the shares at Rs.2, 920, the exercise price

of the option, and sell it in the market for Rs.3, 300.

Making the profit of Rs.380 less the premium that has been paid. If the premium paid to buy the

call option is say Rs.10, the profit would be Rs.370.

Turnover of Derivate Market at NSE

The trading volume of NSE’S derivatives market has seen an increase since the launch of the

first derivatives contract. The average daily turnover at NSE now exceeds at 14,000cr.

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TYPES OF DERIVATIVES

The most commonly used derivatives contracts are forwards, futures and options which shall be

discuss in details in later. Here we take a brief look at various derivatives contracts that have

come to be used

Forwards : a forward contract is customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: a future contract is an agreement between two parties to buy or sell an asset at

a certain time in the future at a certain price. Future contracts are special types of forward

contract 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 an underlying asset at a given price on or before

a given future date. Puts gives the buyer the right, but not the obligation to sell a given

price on or before a given date.

Warrants: options generally have live 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 are generally traded over the counter.

Leaps: ‘Leaps’ means long term equity anticipation securities. The options having

maturity of up to three years.

Baskets: they are options on portfolio of the underlying assets. The underlying asset is

usually a moving average of 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 pre arranged formula. They can be regarded as portfolios of forward

contracts. The two commonly swaps used are:

Interest Rate Swaps : these entail swapping only the interest related cash flows between

the parties in the same currency.

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Currency Swaps : the entail swapping both principal is interest between the parties with

the cash flows in one direction being in a different currency than those in opposite

direction.

PARTICIPATION OF DERIVATIVE MARKET

There three board categories of participants are:

Hedgers: People who attempt to reduce or eliminate their risk. They are in the position

where they face risk associated with the price of an asset. They use derivatives to reduce

or eliminate risk. For example, a farmer may use futures or options to establish the price

of his crop long before his harvest it. Various factors affect the supply and demand for

that crop, causing prices to rise and fall over the growing season. The farmer can watch

the prices discovered in trading at the CBOT and, when they reflect the price he wants,

will sell futures contracts to assure him of a fixed price of his crop.

Speculators: They wish to bet on future movement in price of an asset. Future and option

contracts can give them an extra leverage; that is they can increase both the potential

gains and potential losses in a speculative venture.

Arbitragers: People who aim at profits by taking advantage of difference in prices in

same products among different markets .for example, they see the future price of an asset

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PARTICIPANTS

HEDGERS SPECULATORS ARBITRAGER

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getting out of line with the cash price, they will take offsetting in the two markets to lock

in a profit.

FUNCTIONS OF DERIVATIVE MARKET

The derivatives market performs a number of economic functions. They are:

Price is an organized derivatives market reflects the perception of market participants

about the future and leads the prices of underlying to the perceived future level. The

prices of the derivatives converge with the prices of the underlying expiration of the

derivative contract. Thus derivatives help in discovery of future as well as current prices.

The derivatives market help to transfer risks from those who have them but may not like

them to those who have an appetite for them.

Derivatives, due to their inherent nature are linked to the underlying cash markets. With

the introduction of derivative 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.

The derivative has a history of attracting many bright people with an entrepreneurial

attitude.

Derivatives market helps increase savings and investment in the long run. Transfer of risk

enables market participants to expand their volume of activity.

TYPES

OTC and Exchange-Traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished

by the way that they are traded in the market:

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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, product rate agreements.

Exchange-traded derivatives are those derivatives products that are traded via

specialized derivatives exchanged or other exchanges. Derivative exchanges acts as

an intermediary to all related transactions, and take initial margin from both sides of

the trade to act as a guarantee.

There are number of financial instruments that are categorized as derivatives, but

futures, forwards, options and swaps are by far the most common.

A) Forward contracts

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. Thus, the trade date and delivery date are

separated. One party agrees to buy, the other sell, from a forward price agreed in advance.

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DERIVATIVES

OVER THE COUNTER

DERIVATIVES

EXCHANGE TRADED

DERIVATIVES

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In a forward transaction, no actual cash changes hands. If the transaction is collaterised exchange

of margin will take place according to a pre-agreed rule. Otherwise no asset of any kind actually

changes hands, until the maturity of contract.

A forward contract is one to one bi-partite contract, to be performed in the future, at

the terms decided today. (E.g. forward currency market in India).

Forward contracts offer tremendous flexibility to the parties to design the contracts in

terms of the price, quantity, quality (in case of commodities), delivery time and place.

Forward contracts suffer from poor liquidity and default risk.

Example of how forward contract work

Suppose that B wants to buy a house in one year’s time. At the same time, suppose that A

currently owns a house that he wishes to sell in one year’s time. Both parties could enter into a

forward contract with each other. Suppose that they agree on the sale price in one year’s time of

Rs.1, 04,000. A and B have entered into a forward contract . B, because he is buying the

underlying, is said to have entered a long forward contract. Conversely, A will have the short

forward contract.

At the end of one year, suppose that the current market valuation of A house is Rs.1, 10,000.

Then, because A is obliged to sell to B for only Rs.1, 04,000, B will make a profit of Rs.6, 000.

To see why this is so, one need only to recognize that B can buy from A for Rs.104, 000 and

immediately sells to the market for Rs, 110,000. B has made the difference in profit. In contrast,

A has made a loss of Rs.6, 000. To see why this is so, one needs only recognize that A could

have sold to the open market Rs.110, 000 rather than B for Rs.104, 000. Unfortunately for A, he

is legally obliged to sell to B at the lower price.

B) Future Contracts

Future market was designed to solve the problem that exists in forward markets. 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. But unlike forward contracts, the future contracts are standardized and

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exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain

standard feature of the contract. It is a standardized contract with the standard underlying

instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or

which can be used in reference purpose for settlement) and a standard timing of such settlement.

A futures contract may be offset prior to maturity by entering into an equal and opposite

transaction.

Future contracts are organized / standardized contracts, which are traded on the

exchanges

These contracts, being standardized and traded on the exchanges are very liquid in

nature.

In futures market, clearing corporation/house provides the settlement guarantee

Every futures contract is a forward contract. They:

Are entered into through exchange, traded on exchange and clearing corporation/

house provides the settlement guarantee for trades.

Are of standard quantity: standard quality (in case of commodities).

Have standard delivery time and place.

Futures terminology

Spot price: The price at which an asset trades in the spot market or price which is

prevailed in cash market.

Futures price: The prices at which the futures contract trades in the futures market or

price of contract in future.

Contract cycle: The period over which a contract trades. The index futures contracts on

the NSE have one-month, three-month expiry cycles which expire on the last Thursday of

the month.

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Contract size : the amount of asset that has to be delivered under one contract and which

is fixed by SEBI.

Basis : It can be defined as the future price minus the spot price. There will be a different

basis for each basis for each delivery month for each contract.

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.

Initial margin : The amount that must be deposited in the margin account at the time a

futures contract is first entered into is known as initial margin.

(Different Products of derivatives in India)

INDEX FUTURE

Index futures are futures contract where the underlying asset is the index. The index futures

provide a hedge against price fluctuations of the securities and hedgers are using it as an

insurance tool. A stock index future contract is an obligation to deliver at settlement an amount

of cash equal to the difference between the stock index value at the close of the last trading day

of the contact and price at which the futures contract was originally struck. For instance, if the

SENSEX index is at 3000 and a lot size of contract is equal to 50, a contract struck at this level

could be worth Rs.1,50,000(3000*50). If at the expiration of the contract, the SENSEX stock

index is at 3100, a cash settlement of Rs.5000 is required {(3100-3000)*50}. In stock index

futures, no physical delivery of stock is made.

In India, the BSE was the first stock exchange to introduce index futures on 9 June, 2000 on

SENSEX. In NSE, the trading of index futures commenced on 12June, 2000 on the S&P CNX

NIFTY. The stock index futures are traded on the F&O segment of the both exchanges.

Both buyers and sellers are required to deposit margin at the time of contract. The margin

amount is based volatility if market index. In India the initial margin is expected to be around 8-

10%. The margin is kept in a way that it covers prices movement more than 99% of the time.

Usually key sigma (standard deviation) is used for this measurement. This technique is also

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called value at risk (VAR). In futures market at the end of the each trading day, the margin

account is adjusted to reflect the investor’s gain or loss depending upon the futures closing prices

and variation may be required or released. This is known as mark to market (MAM).

STOCK FUTURE

Stock futures are the contract where the underlying asset is the individual securities or stock.

Stock Future contract is an agreement to buy or sell a specified quantity of underlying equity

share for a future date at a price agreed upon between the buyer and seller. The contracts have

standardized specifications like market lot, expiry day, and unit of price quotation, tick size and

method of settlement.

In stock futures, the investor also require to deposit initial margin is decided by the exchange

(on the basis of four time change in security prices in a day) on the volatility of individual stock.

Beside this exposure margin is also required by the stock exchange, it can be 5 % (6% or 7% at

specific securities) of all 41 individual securities. In India settlement of future on individual

stock is settled in cash only.

Contract Specification

Underlying Index S&P CNX NIFTY

Exchange of Trading NSE

Security Descriptor N FUSTK

Contract size 100 or multiple thereof (minimum value of

Rs.2 lakh)

Trading Cycle The future contract will have maximum of

the three month trading cycle. The near

month (one), the next month (two), and the

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far month (three). New contract will be

introduced on the next trading day

following the expiry of the near month

contract.

Expiry Day The last Thursday of the expiry month of

the previous trading day if the last

Thursday is the trading holiday

Settlement Basis Mark to market & final settlement will be

cash settled on T+1 basis

Forward / Futures Contracts

Features Forward contract Future contract

Operational

Mechanism

Not traded on exchange or

traded between two parties

Traded on exchange

Contract

Specification

Differ from trade to trade. Contracts are standardized

contract

Counterparty Risk Exist Exists, but assumed by

clearing corporation/house

Liquidation Profile Poor Liquidity as contract are

tailor maid contract

Very high liquidity as contract

are standardized contracts.

Price Discovery Not Efficient. Highly Efficient

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C) Options

Options: Is it just Another Derivative

Option on stock was first traded on an organized stock exchange in 1973. Since then there has

been extensive work on these instruments and manifold growth in the field has taken the world

market by storm. This financial innovation is present in case of stock, stock indices, foreign

currencies, depth instruments, commodities, and futures contracts.

An option gives the holder of the option the right to do something. The holder does not has to

exercise this right. In contrast, in forward or futures contract, the two parties have committed

themselves to do something. Whereas it cost nothing (except margin requirements) to enter into a

futures contract, the purchase of an option require an up-front payment.

Options are instruments whereby the right is given by the option seller to the option buyer to buy

or sell a specific asset at a specific price on or before a specific date.

Option Terminology

Index options: These options have the index as underlying. Some option are European

while other are American. Like index futures contracts, index option contracts are also

cash settled.

Stock options: Stock option are option on individual stocks

Buyer of an option: the buyer of an option is the one who by paying the option premium

buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: the writer of a option is the one who receives the one who receives

the option premium and is thereby obliged to see/buy the asset if the buyer exercise on

him

Call option: A call option gives the holder the right but not the obligation to buy an asset

by a certain date for a certain price.

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Put option: Holder has the right to sell and not the obligation.

Option prices: it is the price which the option buyer pays to the option seller. It is also

referred to as option premium.

Expiration date: The date specified in the option contract is known as expiration date.

Strike price: The price specified in the option contact is known as the strike price or the

exercise price.

American options: they are option can be exercised at any time up to the expiration date

European options: They are option that can be exercised only on the expiration date.

In-the-money option: It is an option that would lead to a positive cash flow to the holder

if it were exercised immediately.

At-the-money option: it is an option that would lead to zero cash flow if it were

exercised immediately.

INDEX OPTION

Index option are the contract between two parties that give the right, but not the obligation to buy

or sell underlying at a stated date & a stated price to buyer of the contract. In index option, the

underlying is share price index and all contracts are based upon it. In index option, the buyer

requires to pay a sum for the buying the contract that is called ‘premium’. The premium is

decided by the market force and not by the stock exchange. All index option are cash settled and

physical delivery is not applicable.

Beside the premium the seller of the contract is required to pay 3% margin on contract value to

the exchange to eliminate the risk that is called exposure margin. In India the option on index

started by the BSE & NSE on their SENSEX and S&P CNX NIFITY respectively. Trading on

S&P CNX NIFTY commenced at NSE on 2 June, 2001.

In index option the investor can hedge their risk and make profits. In index option the loss is

limited to premium paid and profit is unlimited of the buyer, On the other hand the profit to

premium received of the writer is limited and loss is unlimited.

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Contact Specification

Call Option

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Underlying Index S&P CNX NIFTY

Exchange of Trading NSE

Security Descriptor N OPTIDX NIFTY

Contract size Permitted lot size shall 200 & multiple

thereof (minimum value of Rs.2lakh)

Trading Cycle The future contract will have maximum

of the three month trading cycle. The near

month (one), the next month (two), and

the far month (three). New contract will

be introduced on the next trading day

following the expiry of the near month

contract.

Expiry Day The last Thursday of the expiry month of

the previous trading day if the last

Thursday is the trading holiday.

Settlement Basis Cash settled on T+1 basis

Style of option European

Strike price Rs.20

Daily settlement price Premium value (net)

Final settlement price Closing value of the index on the trading

day

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The following example would clarify the basics on Call Option

Illustration1:

An investor buys one European Call option on one share of Reliance Petroleum at a premium of

Rs.2 per share on 31 July. The strike prices Rs.60 and the contract matures on 30 September. The

payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the

payoff table (Table 1). It may be clear from the graph that even in the worst case scenario; the

investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium.

The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call

option buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share

would be made on the premium payment by the buyer

Payoff from Call Buying/long (Rs.)

S Xt C Payoff Net Profit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -2

60 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

65 60 2 5 3

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66 60 2 6 4

A European call option gives the following payoff to the investor: max (S – Xt, 0).

The seller gets a payoff: max (S – Xt, 0) or min (Xt – s, 0).

Notes:

S – Stock price

Xt – exercise Price at time‘t’

C – European Call Option Premium

Payoff – Max(S – Xt, 0)

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Net profit- Payoff minus ‘c’

Exercising the Call Option and what are its implication for the Buyer and the Seller

The Call option gives the buyer a right to buy the requisite shares on a specific date price. This

put the seller under the obligation to sell the shares on that specific date and specific price. The

Call buyer exercises his option only when he/she feels it is profitable. This process is called

“Exercising the option”. This leads us to the fact that if the spot prices is lower than the strike

price then it might be profitable for the investor to buy the share in the open market and the

premium paid.

The implication for a buyer is that it is his/her decision whether to exercise the option or not. In

case the investor expect price to rise far above the strike price in the future then he/she would

surely be interested in buying call options. On the other hand, if the seller feel that his are not

given the desire return and they are not going to perform any better in the future, a premium can

be charged or return from selling the call option can be used to make up.

For the desired returns. At the end of the options contract there is an exchange of the underlying

asset. In the real world, most of the deals are closed with another counter or reverse deal. There

is no requirement to exchange the underlying assets then as the investigator gets out of the

contract just before its expiry.

Put Options

The European Put Option is the reverse of the call option deal. Here’s, there is a contract to sell a

particular number of underlying assets on a particular date at a specific price.

Illustration 2:

An investor buys one European Put Option on one share of Reliance Petroleum at a premium of

Rs. 2 per on 31 July. The strike price is Rs. 60 and the contract matures on 30 September. The

payoff table shows the fluctuations of net profit with a change in the spot price.

Payoff from Put Buying/Long (Rs.)

S Xt P Payoff Net Profit

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55 60 2 5 3

56 60 2 4 2

57 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -2

63 60 2 0 -2

The payoff for the put buyer is max (Xt – S, 0)

The payoff for a put writer is max (Xt – S, 0) or min S – Xt, 0)

Graph

Payoff from Put buying / long

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These are the two basic options that form the whole gamut of transactions in the Options trading.

These in combination with other derivatives create a whole world of instruments to choose form

depending on the kind of requirement and the kind of market expectations. Exotic Options are

often mistaken to be another kind of option. They are nothing But non-standard derivatives and

are not a third type of option.

STOCK OPTION

Stock options are the contract on the individual scripts means where underlying are Individual

scripts. A privilege, sold by one party to another, that gives the buyer the right, but not the

obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on

a specific date. The buyer is requires to pay some money at the time of the purchases of the

contract to seller of the contract that is called 'premium'. And seller requires paying exposure

Margin to exchange that is 5% (6% and 7% on specific securities) on the contract value. At

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present in India 41 individual scripts are approved by the SEBI for stock option. The trading on

the stock commenced at NSE on 2 July, 2001. These contracts are Available at BSE & NSE on

highly liquid and price band free 41 scripts.

Contract Specification

Underlying Index Individual Securities

Exchange of Trading NSE

Security Descriptor N OPTSTK

Contract size 100 or multiple thereof (minimum value of

Rs.2lakh)

Trading Cycle The future contract will have maximum of

the three months trading cycle. The near

month (one), the next month(two), and the

far month (three). New contracts will be

introduced on the next trading day

following the expiry of the near month

contract.

Expiry Day The last Thursday of the expiry month of

the previous trading day if the last Thursday

is the trading holiday

Settlement Basis Daily settlement on T+1 basis & final

option exercise settlement on T+2 basis.

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Style of option American

Strike price interval Between Rs. 2.5 & Rs. 100 depending on

the

price of underlying

Daily settlement price Premium value (net)

Final settlement price Closing value of the index on the trading

day

Buying options can be compared to buying insurance. For example to cover the risk of burglary,

fire etc. you by insurance and pay premium in the event of any untoward happening, the

insurance cover expires after the specific period of time.

What is 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.

2,00,000 . Based on this recommendation SEBI has specified that the value of a derivative

contract should not be less than Rs. 200,000 at the time of introducing the contract in the market.

What is 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 off to next higher multiple

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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. 200,000, then the lot size for that particular scrip stands to be 200000/ 1000 = 200 shares i.e.

one contract in XYZ Ltd. covers 200 shares.

OPTIONS PRICING

Prices of options are commonly depending upon five factors. Unlike futures which derives there

prices primarily from prices of the undertaking. Option's prices are far more complex. The table

below helps understands the affect of each of these factors and gives a broad picture of option

pricing keeping all other factors constant

IN- THE-MONEY, AT-THE-MONEY, OUT-OF-THE-MONEY

All equity option may be classified as being in-the-money, at-the-money, or out-of-the-money.

These terms refer to a particular option’s exercise price in relation to its current underlying stock

price.

A call is considered:

In-the-money when its exercise (or strike) price is less than the current underlying stock

price.

At-the-money when its exercise (or strike) price is the same as the current underlying

stock price.

Out-of-the-money when the strike price (or strike) is a greater than the current

underlying stock

A put is considered:

In-the-money when its exercise (or strike) price is greater than the current underlying

stock price.

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At-the-money when its exercise (or strike) price is the same as the current underlying

stock price.

Out-of-the-money when the strike price(or strike) is less than the current underlying

stock price

Let’s discuss the above terms in detail

a) In-The-Money Call Option

A call is considered in-the-money when its exercise (or strike) price is less than the current

underlying stock price.

Example

Consider an XYZ September 60 call option, with XYZ stock currently at Rs.65. Again, its owner

has the right to purchase 100 shares of XYZ stock at Rs.60 per share. Since the actual par value

of XYZ stock is Rs.65, it would be cheaper to exercise the call and purchase shares at Rs.60 than

to purchase shares outright at Rs.65 on a stock exchange. Under this condition, this call option is

in-the-money by Rs.5 (Rs.65 current share price – Rs.60 exercise price)

b) At-The-Money Call Option

A call is considered at-the-money when its exercise (or strike) price is the same as the current

underlying stock price.

Example

With a current XYZ stock price of 65.00,all calls and puts with an exercise price if 65 are exactly

at-the-money. While by definition such an option’s exercise price and underlying market should

be the same, you might see or hear reference to option whose exercise prices are close to the

price of the underlying stock as being at-the-money. For instant: “At-the-money options trade

more than in-the-money or out-of-the-money option.” In this context, the observer is nothing that

contracts that are approximately at-the-money give or take a few dollars might have more trading

volume than those that are considerably in-the-money or out-of-the-money.

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c) Out-Of-The-Money Call Option

A call is considered out-of-the-money when the strike price(or strike) is greater than the current

underlying stock price. Results in negative cash flow I.e. Current Price < Strike Price

Example

Consider an XYZ September 70 call option, with XYZ stock currently at Rs.65. Again, its owner

has the right to purchase 100 share of XYZ stock at Rs.70 per share. Since the actual market

value of XYZ stock is Rs.65, it would not make sense to exercise the call and purchase XYZ

shares at Rs.70 when the same shares could be purchase outright a Rs.65 on a stock exchange.

Under these conditions, this call option is out-of-the-money by Rs.5 (Rs.70 exercise price-Rs.65

current share price).

d) In-The-Money Put Option

A put considered in-the-money when exercise (or strike) price is greater than the current

underlying stock price

Example

Consider an XYZ September 70 put, with XYZ stock currently at Rs.65. Again, its owner has the

right to sell 100 shares of XYZ stock at Rs.70 per share. Since the actual market value of XYZ

stock is Rs.65, it would be more profitable to exercise the put and sell shares at Rs.70 than to sell

shares outright at Rs.65 on a stock exchange. Under these conditions, this put option is in-the-

money by Rs.5 (Rs.70 exercise price – Rs.65 current share price).

e) At-The-Money Put Option:

A put is consider at-the-money when its exercise (or stock) price is the same as the current

underlying stock price

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Example

With a current XYZ stock price of Rs.65.00 (as above), all calls and puts with an exercise price

if 65 are exactly at-the-money. While by definition such as option’s exercise price and

underlying market should be the same, you might see or hear reference to options whose exercise

prices are close to the price of the underlying stock as being at-the-money. For instant: “At-the-

money option trade more in-the-money or out-of-the-money options.” In this context, the

observer is nothing that contract that are approximately at-the-money give or takes a few dollars

might have more trading volume than those that are considerably in-the-money or out-of-the-

money.

f) At-The-Money Put option

A put is considered out-of-the-money when the strike price (or strike) is less than the current

underlying stock price.

Example

With a current XYZ stock price of 65.00(as above), all calls and puts with an exercise price if 65

are exactly at-the-money. While by definition such an option’s exercise price and underlying

market should be the same, you might see or hear reference to options whose exercise prices are

close to the price of the underlying stock as being at-the-money. For instance: “At-the-money

options trade more than in-the-money or out-of-the-money options.” In this context, the observer

is nothing that contract that are approximately at-the-money give or take a few dollars might

have more trading volume than that are considerably in-the-money or out-of-the-money.

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CHAPTER:-3

REVIEW OF LITERATURE

LITERATURE REVIEW

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From the past many years derivatives have emerged as an interesting subject to

researchers across the world. Here are few reviews of research papers .

Asani sarkar (2006) Rise of derivatives in India., The research paper focuses on the

rise of derivatives after the bretton wood system of fixed exchange rate was dismantled in year

1971.The paper further describes the evolution of Indian derivative markets, the popular

derivative instruments and the main users of derivatives in India. According to researcher In

terms of the growth of derivatives markets, and the variety of derivatives users, the Indian

market has equaled or exceeded many other regional markets.13 While the growth is being

spearheaded mainly by retail investors, private sector institutions and large corporations, smaller

companies and state-owned institutions are gradually getting into the act. Foreign brokers such

as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives.

The variety of derivatives instruments available for trading is also expanding.

There remain major areas of concern for Indian derivatives users. Large gaps exist in the rangeof

derivatives products that are traded actively. In equity derivatives, NSE figures show that almost

90% of activity is due to stock futures or index futures, whereas trading in options is limited to a

few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-

traded derivatives based on interest rates and currencies are virtually absent.

According to researcher Liquidity and transparency are important properties of any developed

market. Liquid markets require market makers who are willing to buy and sell, and be patient

while doing so. In India, market making is primarily the province of Indian private and foreign

Banks, with public sector banks lagging in this area (FitchRatings, 2004). A lack of market

liquidity may be responsible for inadequate trading in some markets. Transparency is achieved

partly through financial disclosure. Financial statements.

Sasidharan, k. and Mathews, Alex k, (Nov 11, 2005) A study on Indian derivative

market opportunities and challenges. This paper evaluates the growth of Indian stock

derivatives market and examines the opportunities and challenges ahead. The paper consists of

six parts covering Market and products, Turnover, Arbitrage opportunities, Challenges,

Participation, Conclusions. The researcher has used many statistical techniques to find out the

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frequency and level of return while arbitraging between index future with spot index, and to find

out the efficiency of index future market by finding out degree of arbitrage opportunities

available in Indian market .According to researcher one of the major factors to be considered

when doing cash and carry arbitrage (when futures are at premium)is the number of days to

expiry. When the days to expiry is high, the cost of carry of the borrowed funds (needed to buy

spot) is high and the net returns from arbitrage drops significantly even though there is a

considerable difference in prices .The paper further reads that the key reasons for the high return

in this segment is lack of institutional participation, high investment cost, poor IT infrastructure

to exploit the arbitrage opportunities and lack of knowledge about arbitrage by the retail

investors.

The study brings certain interesting facts, which are of highly useful to investors and derivative

traders. The futures market provides excellent arbitrage opportunity. The magnitude of the

arbitrage profits nullifies the impact of the losses. The investors can identify the best

opportunities available for arbitrage between the futures and spot in the stock market and

enhance their returns. The scope for high returns will create more arbitrage and can attract more

players to the market. As a result the depth of the market will increase providing better

opportunities for expanded trading activities. The current trend indicates that the Indian equity

derivatives market is poised for a big leap in the days to come.

Varma,Jayant, Rama,(Feb 2009) Risk management lessons from the Global

financial crisis for derivative exchanges. The research paper is a comprehensive

analysis of derivative exchanges with special reference to after math of global financial crisis of

2007 and 2008. The research paper reads that during the global financial crisis of 2007 and 2008

no major derivative clearing house encountered distress while many banks pushed to brink and

beyond.An important reason for this is that derivative exchanges have avoided using value at

risk, normal distributions and linear correlations. The global financial crisis has also taught us

that in risk management, robustness is more important than sophistication and that it is

dangerous to use models that are over calibrated to short time series of market prices. The paper

applies these lessons to the important exchange traded derivatives in India and recommends

major changes the current margining systems to improve their robustness. It also discusses

directions in which global best practices in exchange risk management could be improved to take

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advantage of recent advances in computing power and finance theory. The paper argues that risk

management should evolve towards explicit models based on coherent risk measures (like

expected shortfall), fat tailed distributions and non linear dependence structures.

According to researcher Derivative exchanges have fared much better banks during the global

financial crisis as their models were more robust even if they appeared crude in comparison to

the internal models of the large banks. This is an important lesson and risk managers must

continue to emphasize robustness in their models. Sophistication and market calibration should

neverbe pursued at the cost of robustness. However, it would be a mistake for exchanges to

become complacent about their margining systems. Risk management is a rapidly evolving field

with new methods being developed constantly. Growing computational power is also making

previously infeasible approaches increasingly practicable. Risk managers must be continually

striving to adopt the best models that are both robust and computationally tractable .Derivative

exchanges in India need to look carefully at their margining methodology and eliminate certain

elements that could contribute to the fragility of the risk management system. Specific

recommendations have been given in the paper about stock index futures and currency futures.

Similar analyses have to be performed about other derivative products as well.

Narain,(Aug 2011)After effects of global financial crisis on Indian derivative

market. This paper tries to analyse the impact of global financial crisis on the financial

derivatives market in India. It is found that the global financial crisis of 2008 has structurally

altered the composition of equity derivatives market in India. The predominance of single

stock futures as a derivative product has now been replaced by the predominance of

Index option as a favourite derivative product in India. The speculative nature of single stock

futures had been the prime reason for the dominance of this derivative product in the pre-

crisis period. However, the cautious risk-aversion on the part of the investor has now been the

reason for the dominance of Index options in the revised scenario. Such over domination of

particular derivative products is not a healthy sign for the derivatives market in India.

The global financial crisis has proved to be a structural break in the financial derivative segment

of Indian stock market. As has been reflected by the analysis, the turnover structure of National

Stock Exchange of India, the exchange with dominating position in India, has shown that

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the derivatives trading has been a substantial & significant component of Indian stock

market. Within this segment, the investors have been spotted with their obsession with

Single Stock Futures contracts in the pre global financial crisis period. This obsession has now

been altered in the post-crisis period. However, the obsession is now with the Index Option

contracts. However, with such preference for Index based derivative products, studies focusing

on the interaction of derivatives trading with spot market on aspects of lead-lag

relationship, impact on liquidity, transfer of trading, etc. can now be justified to come up

with robust conclusions. Such studies have been inconclusive so far in Indian contexts.

Nevertheless, such a skewed preference is not desirable situation for an emerging economy

like India. A reasonable mix of the derivative products should provide a better alternative

to the investors by supplementing the avenues for investment and risk management with the

growing maturity of India’s derivatives market.

Ahmad, Tabrez, Jaffrey, Reshma Sheerin, Sahoo, Sheetal and Chatterjee,

Aman(September 11, 2009) Trading Risks: Contracts and Regulatory Issues of Derivative

Transactions in India. The paper analyses market risk and counterparty credit risk and almost

exclusively focuses on risk as potential loss. The methods for measuring, in a specified context,

the potential loss of economic value of a portfolio of financial contracts are also described. The

context that needs to be specified includes the time frame over which the losses might occur, the

confidence level at which the potential losses are measured and the types of loss that would be

attributed to the risk being measured .This wider distribution of credit risks within the global

financial system should in principle limit risk concentrations and reduce the risk of a systemic

shock. Banks have fewer incentives to effectively screen and monitor borrowers. A systematic

deterioration in lending and collateral standards would of course entail losses greater than

historical experience of default and loss-given-default rates would indicate, and it is not clear

that current risk management practices make enough allowance for this. Further the gap between

the original borrower and the ultimate investors widened with a number of vehicles in between.

Secondly, events may force banks to re-assume risks they had assumed transferred to other

parties - either to preserve a bank’s reputation or to honour contingency liquidity/credit lines. 

The derivatives market in India has been expanding rapidly and will continue to grow. The

participation of private and public sector banks and corporates are dependent on development of

skills, adapting technology and developing sound risk management practices. While derivatives

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are very useful for hedging and risk transfer, and hence improve market efficiency, it is

necessary to keep in view the risks of excessive leverage, lack of transparency particularly in

complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden

systemic risk. Clearly there is need for greater transparency to capture the market, credit as well

as liquidity risks in off-balance sheet positions and providing capital therefore. From the

corporate point of view, understanding the product and inherent risks over the life of the product

is extremely important. Further development of the market will also hinge on adoption of

international accounting standards and disclosure practices by all market participants, including

corporates. The recent episode of financial turbulence has provoked debate about the

measurement, pricing and allocation of risk by way of derivatives, which can have important

lessonsfor India.

Varghese, John, (February 1, 2011) , Regulation of Financial Derivatives:

Some Policy Consideration. This paper tries to examine the various models of regulation

of financial derivatives from a purposive perspective. According to researcher Regulation of

Financial Derivatives has a chequered history. There were periods in history when the trading in

these instruments was banned. However like any prohibition, the prohibition of openly trading in

financial derivatives only led to evolution of a clandestine market for these instruments, and

innovative players in these markets created new types of instruments to bypass regulatory

restraints .The paper further provides an extensive over view of regulation of derivatives, role of

RBI,MCX , SEBI in the regulation of derivatives. In India derivatives trading is regulated by a

mixture of command control, franchising, contractual and self regulatory mechanism. The

researcher has provided certain suggestions to ameliorate the regulation of derivatives like there

is a need for a stricter regulatory regime for derivatives, in other words re-regulation and more

government involvement in the economy . There are also suggestions to have a central counter

party (CCP) for OTC derivatives especially for Credit Default Swaps (CDS) applicable to all

jurisdictions, which will help to ensure greater transparency and better reporting. It is also

imperative that there should be some international standard setting process for both product

design as well as approach towards risk of all forms so far as derivative products are concerned,

since in the current globalised economy, strict regulatory regime in some countries and lax

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standards in others would lead only to regulatory arbitrage. There is a need for creation of a net

work amongst regulators in various countries, as well as the different regulators in the same

jurisdiction, to ensure better regulatory cooperation, common regulatory standards and denial of

regulatory arbitrage opportunities to unscrupulous players in market. An international

regulatory framework arrangement, much like the BASEL guidelines for banks, should be

brought in place for derivative instruments and trading in derivatives market. Such a framework

should lay down standards of risk taking in derivative instruments and guidelines to derivative

product design and tighter control over structure of underlying securities, which will then help to

have a uniform standard across the world for such instruments. There should also be a proper

control mechanism to identify sufficiently early, mitigate and to cover up the various types of

risks involved in similar type of instruments. Such an approach would enable to retain the

derivatives products as good risk hedging tools for all investors, rather than an instrument to

satisfy the greed of a few investment bankers.

Shobna, solanki, abishek,dilip kumar and dash, mihir,(jan 20 2012).A study

on commodity market behaviour ,price discovery and its factors . This paper

provides an overview of the commodity market in India and its participants,and analyses

twelve commodities that are traded in MCX (Multi Commodity Exchange), in terms of

price discovery of the spot and futures markets using GARCH model. It also analyses the impact

of trading volume, inflation and other macroeconomic factors on spot and futures price

movements.

After studying the paper we came to know about the dynamic character of commodity market

thus offering the opportunity of forward contracting and hedging, and witnessing activity

almost eighteen times higher in volume as compared to the spot market. . However,

awareness of the commodity market is less when compared to the stock market. This is mainly

due to the huge investment that is required in order to hedge and trade, even though only a

small margin amount is required. Three multi-commodity exchanges have been set up in

India to facilitate commodity trading for the retail investors. They are the Multi-

Commodity Exchange (MCX), the National Commodity and Derivatives Exchange (NCDEX),

and the National Multi-Commodity Exchange (NMCE).The researcher has done comprehensive

analysis of long term volatility of each commodity ,to compare volatility between different

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commodity groups, to examine the effect of inflation and volume on the prices of the

commodities, and to understand the fundamental and technical factors affecting the price of each

commodity. The study explores commodity prices from several different angles. First, there is

the possibility of lead-lag relationships between commodity spot and futures prices, as seen

from the similarity of their trend patterns. Another area explored in the study is the

impact of trading volume and inflation on commodity price volatility for selected

commodities. While trading volume was found to have significant impact on volatility,

inflation was found to have significant impact on crude oil price volatility only.

Lodha, Kalpit Rajkumar,(feb 2008) Derivatives in Indian Financial Market - 'Structure &

Financial Concerns' an Indian Perspective .The research paper focuses on various types of

risks associated with financial instruments or other trade practices ,and how to hedge the

risks .As the concept of derivatives came into frame to reduce the price related risks .The paper

further examines the Indian derivative market .A complete history of introduction of derivatives

in Indian market after the liberalisation process has been given. Until the advent of NSE, the

Indian capital market had no access to the latest trading methods and was using traditional out-

dated methods of trading. There was a huge gap between the investors’ aspirations of the markets

and the available means of trading.8 The opening of Indian economy has precipitated the process

of integration of India’s financial markets with the international financial markets. Introduction

of risk management instruments in India has gained momentum in last few years thanks to

Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which

have developed into a very large market. The author has termed derivatives as a boon to Indian

financial markets.Since the constant risks have forced the investors to manage it through various

risk management tools.The author terms derivatives as an integral part of capital market of

developed as well as emerging market economies. Many benefits of derivative products have

been enumerated in paper viz it helps in transferring the risk from risk averse people to risk

oriented people. Derivatives assist business growth by disseminating effective price signals

concerning exchange rates, indices and reference rates or other assets and thereby, render both

cash and derivatives markets more efficient. Derivatives catalyze entrepreneurial activities.

By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of

capital across the economy and thus, increasing productivity in the economy. List is unending.

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In reply to a popular notion that derivatives are weapons of mass destruction, the author says that

derivatives if judiciously used , with the sole intention of mitigating underlying exposures can

act as a boon , but if used for speculative purposes can have a disastrous results..

Agarwal, Ravi Kumar, Amaresan, Shiva Kumar, Mukhtar, Wasif and Abar, Hemanth

January 16, 2009), Impact of Derivatives on Stock Market . The research paper throws light

on the impact of derivatives on Indian stock market, the author has done a comprehensive

analysis of impact of derivatives on stock market.The paper reads that many empirical and

theoretical studies have been carried out to assess the impact of derivatives on Indian stock

market. Two main bodies of theory about the impact of derivatives trading on the spot

market are prevailing in the literature and both are contradicting each other. One school of

thought argues that the introduction of futures trading increases the spot market volatility and

thereby, destabilizes the market. They are the proponents of ‘Destabilizing forces’

hypothesis. (Lockwood and Linn, 1990)) They explain that derivatives market provides an

additional channel by which information can be transmitted to the cash markets. Frequent

arrival and rapid processing of information might lead to increased volatility in the

underlying spot market. They also attribute increased volatility to highly speculative alevered

participants. Others argue that the introduction of futures actually reduces the spot market and

volatility and thereby, stabilises the market. They are the proponents of ‘Market

completion’ hypothesis. (Satya Swaroop Debasish, 2007). Kumar et al (1995) argued that

derivatives trading helps in price discovery, improve the overall market depth, enhance market

efficiency, augment market liquidity, reduce asymmetric information and thereby reduce

volatility of the cash market. The impact that the derivatives market has on the

underlying spot market remains an issue debated again and again with arguments both in

favour and against them. This study seeks to examine the volatility of the spot market due

to the derivatives market. Whether the volatility of the spot market has increased,

decreased or remained the same. If increased then, what extent it is due to futures market.

Yong chen,(Aug 2011) Derivatives Use and Risk Taking: Evidence from the

Hedge Fund Industry. This paper examines the use of derivatives and its relation with risk

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taking in the hedgefund industry. In a large sample of hedge funds, 71% of the funds trade

derivatives. Af-ter controlling for fund strategies and characteristics, derivatives users on average

exhibitlower fund risks (e.g., market risk, downside risk, and event risk), such risk reduction

isespecially pronounced for directional-style funds. Further, derivatives users engage lessin risk

shifting and are less likely to liquidate in a poor market state. However, the flow-performance

relation suggests that investors do not differentiate derivatives users whenmaking investing

decisions. This paper assesses the link between derivatives use and risk taking by exam-ining 3

essential aspects of hedge fund risk profiles. First, I compare several riskmeasures between

derivatives users and nonusers. Risk-management-motivateduse of derivatives should be

associated with lower risk. But if derivatives aremainly traded by funds with better information,

they can enhance fund perfor-mance through leverage and transaction-cost savings. In the

sample, derivativesuse in hedge funds is on average associated with a lower level of fund risks

(e.g.return volatility, market risk, downside risk, and extreme event risk). The neg-ative relation

between derivatives use and fund risks is both economically andstatistically significant for most

of the risk measures. For example, from a regres-sion model that controls various fund

characteristics and investment strategiesthe derivatives-use dummy variable is associated with a

reduction of market betaby –0.053, indicating that derivatives users on average have market risk

about 27% lower than an average hedge fund whose market beta is 0.20. More strik-\ingly,

derivatives users on average bear downside and event risks over 80% lower than nonusers. Such

evidence is robust to correcting data biases (e.g., survivor-ship bias and backfilling bias), to

controlling fund characteristics, to using bothnet-of-fee and pre-fee fund returns, to examining a

subperiod, and to applying2-stage least squares (2SLS) regressions with fund managers’ prior

expertise inderivatives trading as an instrumental variable .

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CHAPTER:-4

OBJECTIVES

Need of the study

Stock markets have experienced a comprehensive change from the last few years , with the

invent of new financial instruments their issuance and trade it has become worthy to study .

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Moreover the wrong notion and the perception held by investors about derivatives, their being a

risk hedging instrument has further opened the ways to study it more. Since the risk creates

staganacy ,economic instability thus arises a need to study what can be the safe investment for

investors.Below are mentioned some points with regard to need of study.

1) To know about different kinds of derivatives and the derivative market in india.

2) To know about the occurrence of risk of various investments of investors in stock market.

3) To provide knowledge to investors regarding various kinds of derivatives and to construct a

portfolio in such a manner which could balance the risk.

Objectives of study

A successful completion of any project is based on certain objectives, following are the

objectives of my project.

1.) To study the awareness of investors about risk hedging instruments.

2) To know about the perception held by investors about the financial derivatives.

3) To study the perception of investors towards diversification

4) To know experience of investors with derivatives till date.

:

.

CHAPTER:-565

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RESEARCH

METHODOLOGY

METHODOLOGY

Source of data

The primary data is collected with the help of questionnaire to study the individual investors

perception regarding the risk hedging instruments. And secondary data collected from journals,

internet, articles and other publications.

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Research design

Sampling: primary data is collected to study investors awareness through a well designed

questionnaire.

Sample design

Sampling unit: Ludhiana stock exchange investors

Type of sampling: convenient

Sample size: 50

LIMITATIONS OF THE STUDY

1) Small Sample Size: In order to complete any study one should have a diversified sample,

since my time and resources did not allow me to increase my sample size ,so research can

be biased also.

2) Time Constraints: Period of 45 days was not enough to collect all the data .

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3) Area Restriction: The survey carried out was confined to one unit i,e ludhiana stock

exchange ,so there are very high chances of variation from one unit to another unit.

4) Method of sampling: Method of sampling is convenient so biasness cannot be ruled out.

5) Secondary Data: The secondary data taken from a source might be wrong or twisted to

serve the purpose of a person or organization concerned.

6) Human Errors: “to err is human”, as Questionnaires have been filled by human beings,

so they are prone to error knowingly or unknowingly.

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ANALYSIS & CONCLUSION

Analysis

Q.NO.1

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As is evident from the above chart majority of the people who were surveyed fall in the

age group of 35-45 i.e. 36.73%. 16.33% fall within the age group below 25. In the age

group of 25-35 are 30.61% .While as 16.33% are above 45.

Q.NO.2

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Majority of the investors who were surveyed are retired i.e 46% as compared to those who

are either self employed or in service. 30% of respondents are self employed, 22% in

service and only 2% fall within the category of students.

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Q.NO.3

As is evident from the above bar chart majority of the investors investing in stock

market are day traders that is 40%. While short term investors precede them with

34%. Long term investors are found to be 26%.

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Q.NO .4

The above graph shows that majority of the investors are aware about the risk hedging

instruments i.e., 48%. 26% respondents are not aware about risk hedging instruments.,and

26% are neutral.

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Q.NO .5

As is evident from the above graph that 44% strongly agree that derivatives can be termed as

risk hedging instruments. 48% of people surveyed are neutral ,6% disagree and only 2%

strongly disagree.

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Q.NO .7

As is evident from the above bar chart majority of the buy and sell risk hedging instruments

with a sole purpose to take a position in stocks and derivative segment to minimize the loses.,

which is 50%. 32% of people surveyed have purpose to earn profit. Only 18% of the people

surveyed consider to purchase and sell the regular income bonds , government securities.

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Q.NO .8

The above mentioned graph shows that 52% repondents hold the choice that best option as

risk hedging instruments is entering into future contract. 48% of the investors hold the choice

that entering into option contract as best choice.

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Q.NO .9

The above bar chart shows that 32% people consider futures as most important , 12% people

surveyed consider it important, mean while 34% respondents consider it least important.

Only 10% consider it not important.

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Q.NO .9

As is evident from the above graph that majority of people surveyed prefer options as risk

hedging instruments i.e,44% . 26% respondents consider it important , 10% neutral and 20%

not important.

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Q.NO .10

Majority of people surveyed have been trading in derivatives from less than one year

i.e,48%. 28% people surveyed are trading from one year . people who are trading from more

than one year are 24% .

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Q.NO .11

The above graph shows that majority i.e, 50% of the investors have found their experience

with derivatives as profitable. Respondents who consider it not profitable are 32% and those

who consider equities better than derivatives are 18% .

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Q.NO .12

The above graph shows that majority of the people surveyed are of the opinion that it is lack of

knowledge and difficulty in understanding the derivatives that keeps it away from using

derivatives i.e, 48% .34% of people surveyed consider increasing speculation as reason that

keeps away people from derivatives. Respondents who consider it very risky and highly

leveraged instrument are 8% .while as 10% consider counter party risk as reason.

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Q.NO .13

The above graph shows that 32% people surveyed strongly agree that diversification of portfolio is more effective than buying and selling risk hedging instruments. 34% agree, 16% are neutral . Only 8% disagree and 10% strongly disagree.

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Q.NO .14

As is evident from the above graph that 40% of the respondents consider diversification of

portfolio as highly effective in managing risk, 18% effective. 10% respondents are neutral while

16% consider it ineffective.

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Q.NO .15

The above bar chart shows that 60% of the people surveyed prefer brokerage houses to take

advice before investing in derivative market. 18% Consider research analysis, 14% prefer

website and only 8% prefer media.

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Q.NO .16

40% will prefer index future, 26% stock future and 14% of the respondents cant say however

18% will prefer both.

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Q.NO .17

As is evident from the bar chart that 22% of the respondents say frequently entering into

derivative agreements have lead you in speculative mode rather than that of hedger as absolutely

while 64% say some times and 14% say never.

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RESEARCH FINDINGS:

Indian derivative market is experiencing a comprehensive change, issuance of new hedging

instruments has opened a new ways to trade in stock exchange .It is growing and attracting new

investors to exploit the price movements in commodities in stock market. Below are mentioned

the findings of research.

It has been found that majority of the people investing in derivatives fall in the age group

of 35-45, 36.73% of the respondents among the investors surveyed are dealing in risk

hedging instruments.

Among the people surveyed majority of them are retired, 46% of the respondents are

retired. Since retired people are more apprehensive about future and have a lot of savings

so they invest it in stock market.

Majority of the investors surveyed are day traders, it was found that 40% of the

respondents are day traders while as 34% are short term investors and 26% are long term

investors. Since investors investing in stock market want profits within a short span of

time so day trading provides them a good opportunity. As we know that how prices of

shares and stocks vary after every minute, so they can easily exploit the price changes to

make profit.

Among the people surveyed majority of the respondents are aware about risk hedging

instruments i.e 48% . Thus we can say that awareness regarding risk hedging instruments

is growing among the investors.

Majority of the respondents remained neutral when they were asked can derivatives be

termed as risk hedging instruments ?.This shows that ignorance among investors about

derivatives is still in its inception. 48% were neutral and only 44% strongly agree.

It has been found that majority of the investors buy and sell risk hedging instruments to

take a position in stocks and derivative segment to minimise the loses .

The research shows 52% of the investors prefer entering into future contracts as

compared to entering into option contract .Since futures are most popular derivative

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instruments and provide a better hedge in minimising the risks. Although it cannot be

ruled out that investors use options also to hedge their risks.

Most of the investors have found their experience with derivatives as profitable .

However many investors hold the opinion that diversification of portfolio is better than

buying and selling risk hedging instruments and is considered more effective in managing

the risk.

Investors mostly prefer brokerage houses operating in our country for taking advice prior

to investment .

Index futures are emerging as popular risk hedging instruments among the investors.

Sometimes frequently investing in derivative agreements have lead them to speculators

instead of hedgers.

SUGGESTIONS

More and more short term and long term investors should be wooed to use derivatives as

risk hedging instruments apart from day traders.

There is a dire need to make investors aware about the risk hedging instruments viza viz

derivatives.

Since lot of wrong notions are associated with derivatives, the ambiguity should be killed

and investors need to be made understand the benefits of using derivatives.

Investors should enter into option contract also apart from futures, as options provide an

opportunity to sell or buy the underlying assets at a given price on or before certain time.

Thus an investor can exploit the price fluctuations and make profits.

As customers are new and young in the derivative market and they don’t have

adequate knowledge about derivatives and found this market be risky but at the same

time they feel this market provide good returns so a broking firm must provide support

and time to time guidance to their customer while trading in the market so that they are

able to sustain for long time in the market so that customer is also able to know about

where their money is being invested and how safe it is.

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Investors should choose risk hedging instruments in accordance with their aim which can

be either profit maximization or risk minimization.

Before using any risk hedging instrument an investor should consult his broker or any

other expert to know whether it will b feasible for him or not.

Moreover an ardent investor should keep himself updated about the progress in derivative

segment through electronic and print media.

Apart from using the old tool of port folio diversification to reduce the risk , hedging

instruments should be also included to make safe investment

Perception held by customers on derivative

Myth Number 1: Derivatives Are New, Complex, High-tech Financial Product

Fact: Financial derivative are not new: they have been around for years.

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged Instruments

Fact: The explosive use of financial derivative products in recent years was brought about due to

the more volatile markets, deregulation, and new technologies.

From the simple forward agreements, financial future contract were developed. Future are

similar to forwards, except that future are standardized by exchange clearinghouses, which

facilitates anonymous trading in a more competitive and liquid market .in addition, futures

contract are marked to market daily, which greatly decreases counterparty risk-the risk the other

party to the transaction will be unable to meet its obligations on the maturity date

Myth Number 3: Financial Derivatives Are Simply The Latest Risk-Management Tool Fact:

Financial derivative are not the latest risk-management fad; they are important tools for helping

organization to better manage their risk exposures.

Financial derivative are important tools that can help organizations to meet their specific risk-

management objectives. As is the case with all tools, it is important that the user understand the

tool’s intended function and that the necessary safety precautions be taken before the tool is put

to use

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When used wisely, financial derivatives can increase shareholder value by providing a means to

better control a firm’s risk exposures and cash flows

Myth Number 4: Derivative Take Money Out Of Productive Processes and Never Put Anything

Back

Fact: Financial derivative by reducing uncertainties, make it possible for corporations to initiate

productive activities that might not otherwise be pursued.

Derivative used as a hedge can improve the management of cash flows at the individual firm

level

Myth Number 5: Only Risk-Seeking Organization Should Use Derivative

Fact: financial derivative can be used in two way; to hedge against unwanted risks or to

speculate by taking a position in anticipation of a market movement.

Organizations today can use financial derivative to actively seek out specific risk and speculate

on the direction of interest-rate or exchange-rate movements, or they can use derivatives to

hedge against unwanted risks. Hence, it is not true that only risk-seeking institution use

derivatives

Indeed, organization should use derivatives as part of their overall risk-management strategy for

keeping those risks that are comfortable managing and selling those that they do not want to

other who are more willing to accept them. Even conservatively managed institution can use

derivatives to improve their cash-flow management to ensure that the necessary fund are

available to meet broader corporate objectives.

Myth Number 6: The Risk Associated With Financial Derivative Are New And Unknown

Fact: The kinds of risk associated with derivative are no different from those associated with

traditional financial instruments, although they can far more complex. There are credit risks,

operating risks, market risks, and so on.

Risk from derivatives originates with the customer. With few exceptions, the risks are manmade,

that is, they do not readily appear in nature.

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CONCLUSION

After the comprehensive study of the project I have concluded that indian stock markets are

growing and are showing new path ways to trade in various financial instruments. Investors are

using risk hedging instruments to hedge their risks . Most of the investors are day traders and it

will be a profitable deal for them if they make use of derivatives , as they can exploit the price

fluctuations .Although investors use these hedging instruments to minimise risk but many

investors held an opinion that they have earned profit also from the use of these risk hedging

instruments.

Index futures are emerging as popular risk hedging instruments which investors will

prefer in future. Currently investors enter into future contracts to reduce risks and minimise

loses. Lack of knowledge and awareness regarding risk hedging instruments is a reason that

keeps most of the investors away from derivatives. Moreover increasing speculation also

prevents them to deal in derivatives. Since most of the investors prefer brokerage houses to take

advice prior to any investment so they need to provide them true and valuable guidance .Many

investors believe that increased use of derivatives lead them to be speculators.

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CHAPTER:-7

BIBLIOGRAPHY

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BIBLIOGRAPHY

https://docs.google.com/viewer?a=v&q=cache:TPO-N5f9CAgJ:www.newyorkfed.org/

research/economists/sarkar/

derivatives_in_india.pdf+derivatives+market&hl=en&gl=in&pid=bl&srcid=ADGEESj2

EzeG5PGuIsta2Bp9oLS_kchDgPPLVnf_YR3W4oX7CuiGzrirbmhDRhCLGtt8uTCKzM

fY0FOA5HOyssIvmL3sFn4oyJbNxwGYVEESA-dmcj3h4RqpJ7ktXafrVfU-

NmF7jvem&sig=AHIEtbTPULhCAJBc4zJ2av_hvE-Kpjq9XQ

Varma, Jayanth Rama, Risk Management Lessons from the Global Financial Crisis for

Derivative Exchanges (February 2009)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1376276

Narain, After Effects of Global Financial Crisis on Indian Derivatives Market (August 1,

2011).

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1904136

Sasidharan, K. and Mathews, Alex K., A Study on Indian Derivative Market-

Opportunities and Challenges (November 11, 2005)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1795750

Mishra, Dr. Sisira Kanti, Trends and Prospects of Derivative Markets in India (March 16,

2011)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1788024

Shobana, Solanki, Abhishek Dilipkumar and Dash, Mihir, A Study on Commodity

Market Behaviour, Price Discovery and Its Factors (January 20, 2012).

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1988812

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Varghese, John, Regulation of Financial Derivatives: Some Policy Considerations

(February 1, 2011).

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1753116

http://www.jvi.org/uploads/tx_abaeasydownloads/DERIV_INDA_2006_Indian

%20Commodity%20Derivatives%20Markets.pdf.

http://web.ebscohost.com/ehost/detail?vid=3&hid=108&sid=4199a03e-2b9c-4c00-981b-

bba4487f9aaf%40sessionmgr115&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d

%3d#db=bth&AN=65456695

Ahmad, Tabrez, Jaffrey, Reshma Sheerin, Sahoo, Sheetal and Chatterjee, Aman,

Trading Risks: Contracts and Regulatory Issues of Derivative Transactions in India

(September 11, 2009)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=14798

INTERNET SITES

www.google.co.in

www.lse.co.in

www.SSRN.COM

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ANNEXURE

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QUESTIONNAIRE

I Sofi owais Ahmad student of lovely professional university phagwara Punjab is conducting a

study on Derivatives: “Investors’ awareness regarding risk hedging instruments”. The response will be used solely for academic purpose and your personal information will not be disclosed. So kindly fill the questionnaire.

Personal Information:

Name: ………………………

1) Age

Below 25 25-35 35-45 Above 45

2) Occupation:

Self employed Service retired Student

3) Do you invest in stock market?

a) Yes b) No

4) what type of investor you are in a market?

a) Day trader

b) Short term investor

c) Long term investor

5) Are you aware about risk hedging instruments?

a) Yes b) No

6) Can derivatives be termed as risk hedging instruments?

a) strongly agree

b) Agree

c) Neutral

d) Disagree

e) Strongly disagree

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7) The purpose of buying and selling risk hedging instruments on regular basis “

a) To earn profit

b) To take a position in stocks and derivative segment to minimise the loses

c) To purchase and sell the regular income bonds/government securities

d) Other

8) As per your choice what is the best option as risk hedging instruments ?

a)Entering into forward contract

b) Entering into future contracts

c) Entering into option contracts

9) Which of the following products do you prefer for hedging risk?

Please give weight age as per your preference (1-5)

Futures ( ) Forwards ( )

Options ( ) SWAPs ( )

10) How long you have been trading in derivatives?

a) Less than one year

b) one year

c) More than one year.

11) How will you describe your experience with derivatives till date?

a) I find this Quite Profitable.

b) I don’t find Derivative can give profits.

c) I feel that Equities are better than Derivatives.

d) Any other………………………………………..

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12) What keeps people away from dealing in derivatives?

a) Lack of knowledge and difficulty in understanding.

b) Increasing Speculation

c) Very Risky and Highly Leveraged instrument.

d) Counter party Risk.

13) ” Diversification of portfolio is more effective rather than opting for buying and selling of risk hedging instruments”

a) Strongly agree b) agree c) neutral

d) Disagree e) strongly disagree

14) ” Diversification of portfolio is really effective in managing risk”

a)Highly effective b) Effective c)neutral d) ineffective

e) Highly ineffective

15) Whom you prefer to take advice before investing in derivative market.?

a) Brokerage houses

b) Research analysis

c) Website

d) Media

e) Others specify

16) In future what will you prefer?

a) Index future b) stock future c) can’t say d) both

17) Do you agree that frequently entering into Derivative agreements have lead you into speculative mode instead that of a Hedger?

a) Absolutely b) Sometimes c) Never

Thank you………………..

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