ACKNOWLEDGEMENT

The Summer Training at Kotak Securities Ltd., Bareilly. It is my professional experience in both Financial and Marketing sector that enriched my knowledge about the marketing sector. Inspiration, motivation & encouragement are some essential ingredients for a research project to be undertaken. The numbers of people who have influenced, supported & guided me through this project are numerous to mention, but some merit special attention. I would like to take this opportunity to express my gratitude towards Mr. Atul Kumar agarwal, Branch Head,Kotak Securities ltd., Bareilly,for giving me an opportunity to work as a summer trainee. I am also thankful to my family, and my friends for their support and encouragement. In the end I extend my heart felt thanks to wonderful experience. respondents who helped in filling in my Questionnaires sincerely, thereby making my project a

Kratika purwar

PREFACE
Derivative Market serve as a link between the saving public and the capital markets in that they mobilize saving from investors and bring them to the borrowers in the capital markets. By the vary nature of their activities, and by virtue of being knowledgeable and informed investors, they influence the stock market and play an active role in promoting good corporate governance, investors protection and the health of capital markets. Derivative Market have imparted much needed liquidity into the financial system and challenged the hitherto dominant role of banking and financial institutions in the capital markets. In this project, my focus is on tracking down the changing requirements, needs of customers, preferences, and their changing perspective on the investment schemes with a special reference on Derivative Market in the

city Bareilly.

SUBJECT OF RESEARCH
The subject of research undertaken was to make an in depth and comprehensive study on Consumer Investment Pattren In Derivative Market.Kotak Mahindra is one of Indias leading financial institutions, offering complete financial solution that encompasses every sphere of life. Kotak Securities is one of the largest private sector in securities market in India .

OBJECTIVE OF STUDY
The objective of the study was to find answer of some of the questions, which are important to understand the present scenario in theDerivative Market. The study has given answers to the following questions.

About Derivative Market.

Understand the investment objective . Why do people invest in Derivative market? Source of information while making investment Whether the sample is risk averse or risk taker. Overall perception of investors about Derivative market.

RESEARCH METHODOLOGY
Place of Research
The study was primarily conducted in Bareilly. The market survey was done to have market perspective of Derivative Market in Bareilly. For this we used questionnaire as a tool for investor perception.

Sample Frame
The study conducted on the sample set, which included people who had enquired about the various investments plans, the brokers who regularly make investments on behalf of the investors and the employees of various organizations Viz. Public and Private & professionals Viz. Chartered Accountants and Doctors.

Sampling Design
The sample was picked randomly from the set of people who generally belong to High class. We may better say that the sample design is a systematic random sample because the focus was mainly on the people who were interested in investing some minimum amount of their income in one or the other avenue.

Sample Size
The sample size considered in our study is 50.

Sample Characteristics

The sample considered is a homogenous one; the characteristics of the respondents were more or less the same. The people generally belonged to high class strata. The results deduced can be projected on the high class population on a wider class.

Method of Data Collection

The research was conducted on the availability of information from Primary and Secondary sources.

Primary sources of Data

Interaction with the employees of various organizations Viz. Public and Private & professionals Viz. C.A.s and Doctors. Interaction with existing investors. Questionnaire.

Secondary Sources of Data

Journals, Magazines etc. Brochures/ Pamphlets of Various Mutual Fund companies. Internet. Other Documents.

Research Time
The time taken for the research study was nearly 6 weeks.

Research Limitations
There was a problem when the respondents were asked about what proportion of their saving is invested in which avenue. They were apprehensive in revealing details about their income and their investments.

Gathering various factors that play an important role in influencing buying decisions of any individual while purchasing an investment plan was quite difficult. Professionals were not always willing to cooperate and tell their preference. 20% of the respondents did not know about the Derivative Market & so it was not possible to carry out research study any further with them.

CORPORATE PROFILE

HISTORY OF THE GROUP

The Kotak Mahindra Group was born in 1985 as Kotak Capital Management A.A.Pinto and Kotak & Company, Industrialists Harish Mahindra And An and Mahindra took a stake in 1986, and thats when the company changed its name to Kotak Mahindra Finance Limited.

1986: Kotak Mahindra finance ltd. starts the activity of bill discounting. 1987: Kotak Mahindra finance ltd. Enters the lease and hire purchase
market.

1990: The Auto Finance division is started.

1991: The investment banking division is started. Takes over FICOM, one of Indias largest financial retail and marketing network

1992: Enters the Funds Syndication sector. 1995: Brokerage and Distribution business incorporated into a separate
company-Kotak Securites.Investment Banking, division incorporated into a separate company- Kotak Mahindra Capital Company.

1996: The Auto Finance hived off into a separate company-Kotak

Mahindra Primus ltd. Kotak Mahindra takes a significant stake in Ford Credit Kotak Mahindra Ltd., for financing Ford Vehicles. The Launch if Matrix Information Services. Marks the groups entry into information distribution.

1998:Enters the Mutual fund market with the Kotak Mahindra Asset
Management Company.

2000:Kotak Mahindra ties up with Old Mutual plc. For the life insurance
business. Kotak Securities launches kkotakstreet.com-its online broking site. Formal commencement of private equity activity through setting up of Kotak Mahindra Venture Capital Fund. 2001:Matrix sold to Friday Corporation Launches Insurance Services.

2003:Mahindra Finance Ltd. Converts to bank. The first Indian company

to do so.

2004: Launches India Growth fund, a private equity fund. 2005: Kotak Group realigns joint Kotak Buys) and sells ford Mahindra
Prime (formerly known as Kotak Mahindra Primus Limited venture in ford Credit; Credit Kotak Mahindra.

KOTAK CORPORATE EDENTITY

The symbol of the Infinite Ka reflects our global Indian personality. The Ka is uniquely Indian while its curve forms the infinity sign, which is universal. One of the basic tenets of economics is that mans needs are unlimited. The Infinite Ka symbolizes that we have an infinite number of ways to meet those needs.

THE KOTAK MAHINDRA GROUP

Kotak Mahindra is one of Indias leading financial institutions, offering complete financial solution that encompass every sphere of life. From commercial banking, to investment banking, the group caters to the financial needs of individuals and corporate. The group has a net worth of over Rs.2500 crore, employs around 6700 people in its various business and has a distribution network of branches, franchisees, representative offices and satellite offices across 250 cities and towns in India and offices in New York, Landon, Dubai and Mauritius. The Group services over 1.6 million customer Accounts.

Kotak Mahindra has international partnerships with Goldman Sacra (one of the worlds largest investment banks and brokerage firms), Ford Credit (one of the worlds largest dedicated automobile financiers) and Old Mutual (a large insurance, banking and asset management conglomerate).

GROUP MANAGEMENT Mr. Uday Kotak

director Executive Vice Chairman & managing

Mr. Shivaji Darn Mr. C. Jayaram Mr. Dipak Gupta

POLICIES AND REGULATION APPLICABLE TO ALL SCHEMES

The Trustee reserves the right to change the benchmark for evaluation of performance of the respective Schemes from time to time in conformity with the investment objectives and appropriateness of the benchmark subject to, and other prevailing guidelines, if any. Investment in debt securities by the Schemes(except HSGF) will usually be in instruments which have been assessed as high investment grade by at least one credit rating agency authorized to carry out such activity under the applicable regulations. The AMC board and the Trustee shall approve the detailed parameters for such investments. The detail s of such investment would be communicated by the AMC to Trustee in their periodic reports. It would also be clearly mentioned in the reports, how the parameters have been compiled with. However, in case any unrated debt securities does fall under the parameters, the prior approval of Board of AMC and Trustee shall be sought.

Pursuant to the SEBI Regulations, each of the Schemes shall not make any investment in: Any unlisted security of an associate or group company of the Sponsors; or Any securities issued by way of private placement by an associate or group company of the Sponsors: or the listed securities of Group Company of the Sponsors which is in access of 25% of the net assets.

SWOT ANALYSIS
After conducting a consumer survey and analyzing the needs of consumer we further do the following SWOT Analysis.

STRENGTH
1. Large distribution network 2. Good fund management 3. High service standard 4. Ethics oriented fund house

WEAKNESSES
1. Less commission/ remuneration to distributors 2. much time in processing 3. A No. of legal formalities

OPPURTUNITY
1. Weakness of competitors become an opportunity for the Kotak . 2. Rules and regulation are in favour of Kotak .

THREAT

1. To become no. 1 house of India.

INTRODUCTION

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

DERIVATIVES
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, Rice 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 Rice which is the underlying.

EMERGENCE OF DERIVATIVES
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives visavis derivative products based on individual securities is another reason for their growing use. Recently all the futures lot in NSE Future cuts in to small for receiving more response of small Investors.

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

DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member 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 preconditions 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 Prof. J. R. Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade 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 segments of two stock 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 futures contracts based on S&P CNX Nifty and BSE-30 (Sen-sex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. The contract is expire on the last thrusday of the month.

PARTICIPANTS
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants

Hedgers
Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk

Speculators
Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

Arbitrageurs
Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

FUNCTIONS
The derivatives market performs a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets

TYPES OF DERIVATIVES
The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used.

Forwards
A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchangetraded contracts.

Options
Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants
Options generally have lives of upto one year, the majority of options traded on options Exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-thecounter.

LEAPS
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.

Baskets
Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

Swaps
Swaps are private agreements between two parties to exchange cash flows in the future according in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps

These entail swapping only the interest related cash flows between the parties in the same currency.

Currency swap
These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions
Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

INTRODUCTION TO FUTURES AND OPTIONS

In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market.

FUTURES
Futures markets were designed to solve the problems that exist 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 futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in 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. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change _Location of settlement

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

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

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

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

Contract size
The amount of asset that has to be delivered under one contract. For instance, the contract size on NSEs futures market is 200 Nifties. A lot size of 100 Nifties is going to be introduced shortly.

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

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

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.

Marking-to-market
In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket.

Maintenance margin
This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

OPTIONS
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

OPTIONAL TERMENLOGY

Index options
These options have the index as the underlying. Some options are European while others are American. Like indexing futures contracts, indexing options contracts are also cash settled.

Stock options
Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

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 call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options options.

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.

Put option
A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price
Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date
The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price
The price specified in the options contract is known as the strike price or the exercise price.

American options
American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.

European options
European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option
An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option
An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option
An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Time value of an option

The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.

CONCLUSION
Derivatives - Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. The price of this derivative is driven by the spot price of Rice which is the underlying. Futures and Options are the most commonly used equity derivative instruments. Derivatives market has been in existence for years in an unorganized manner. In India we are yet to see the full-fledged derivatives trading. As per the global standards, derivatives trading volumes are generally 4-5 times the cash market volumes. Whereas, in India the derivatives volumes are 2-3 times the cash market volumes Derivatives are used for three categories of participants :Hedgers - Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk Speculators - Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture Arbitragers - Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Derivatives market reflects the perception of the market player about the market. They help in discovery of future as well as current prices. They transfer risk from

those who have it but may not like to have them to those who have a appetite for it. Transfer of risk enables market participants to expand their volume of activity

TERM RELATED TO DERIVATED MARKET

RISK TRANSFER
One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy. This can be viewed as being like insurance; with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance. A risk averse person buys insurance; a riskseeking person sells insurance. On an options market, an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way. In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk. In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).

EFFECT OF DERIVATING TRADING ON SPOT MARKET

The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once derivatives trading comes about. Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities, and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency. From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market. Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market. A liquid derivatives market tends to become the focus of speculation and price discovery. When news breaks, the derivative market reacts first. The information propagates

USEFULLNESS OF FORWARD CONTRACTING

Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because (a) the costs of taking or making delivery of wheat is avoided, and (b) funds are not blocked for the purpose of speculation.

LEVERAGE
Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is leverage of 20 times. This example involves a forward market. More generally, all derivatives involve lever-age. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.

POOR LIQUIDITY OF FORWARD CONTRACT

One basic problem of forward markets is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form customdesigned contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation; this can make the contracts non-tradable since others might not find those specific terms useful. In addition, forward markets are like the real estate market in that buyers and sellers find each other using telephones. This is inefficient and timeconsuming. Every user faces the risk of not trading at the best price available in the country. Forward markets often turn into small clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by users, i.e. it makes the forward market illiquid from the user perspective.

FUTURE MARKET SOLVES THE PROBLEMS OF FORWARD MARKET

Futures markets feature a series of innovations in how trading is organized: Futures contracts trade at an exchange with pricetime priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a nontransparent club market (based on telephones) to an anonymous, electronic exchange, which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation. Futures contracts are standardized all buyers or sellers are constrained to only choose from a small list of tradable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customization of forward contracts. A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk.

. Novation at the clearing corporation makes it possible to have safe trading

between strangers. This is what enables largescale participation into the futures market in contrast with small clubs, which trade by telephone, and makes futures markets liquid.

CASH SETTLEMENT
The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2004, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use cash settlement. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Nov 2004. Suppose we come to the expiration date, i.e. 31 Dec 2004, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable.

WHEN WOULD ONE USE OPTIONS INSTEAD OF FUTURES

Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from a futures: which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating guaranteed return products. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer nonlinear payoffs whereas futures only have linear payoffs. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.

WHY HAVE INDEX DERIVATIVE PROVED TO BE MORE IMPORTANT THAN INDIVIDUAL STOCKS?
Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk management using index derivatives is of far more importance than riskmanagement using individual security options. This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is index-related. Hence investors are more interested in using indexbased derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks.

DELIVERY OF MARKET INDEX

On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price.

FAIR PRICE OF DERIVATIVE

The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this sense, arbitrage (and arbitrage alone) determines the fair price of a derivative: this is the price at which there are no profitable arbitrage opportunities.

FAIR PRICE OF INDEX FUTURE PRODUCT

The pricing of index futures depends upon the spot index, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, suppose the spot Nifty is at 2000 and suppose the onemonth interest rate is 1.5%. Then the fair price of an index futures contract that expires in a month is 2030.

BASIS & BASIS RISK

The difference between the spot and the futures price is called the basis. When a Nifty future trades at 2030 and the spot Nifty is at 2000, the basis is said to be Rs.15 or 1.5%.

BASIS RISK
Basis risk is the risk that users of the futures market suffer, owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates, and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations reduce the usefulness of the futures market for hedgers and speculators.

GOOD MARKET INDEX FOR USE IN AN INDEX FUTURES AND INDEX OPTIONS MARKET
Several issues play a role in terms of the choice of index.

Diversification
A stock market index should be welldiversified, thus ensuring that hedgers or speculators are not vulnerable to individual company or industry risk. This diversification is reflected in the Sharpes Ratio of the index.

Liquidity of the index

The index should be easy to trade on the cash market. This is partly related to the choice of stocks in the index. High liquidity of index components implies that the information in the index is less noisy.

Liquidity of the market

Index traders have a strong incentive to trade on the market, which supplies the prices, used in index calculations. This market should feature high liquidity and be well designed in the sense of supplying operational conveniences suited to the needs of index traders.

Operational issues
The index should be regularly maintained, with a steady evolution of securities in the index to keep pace with changes in the economy. The calculations involved in the index should be accurate and reliable. When a stock trades at multiple venues, index computation should be done using prices from the most liquid market.

LIQUIDITY IN MARKET INDEX

At one level a market index is used as a pure economic time-series. Liquidity affects this application via the problem of non-trading. If some securities in an index fail to trade today, then the level of the market index obtained reflects the valuation of the macro economy today (via securities which traded today), but is contaminated with the valuation of the macro economy yesterday (via securities which traded yesterday). This is the problem of stale prices. By this reasoning, securities with a high trading intensity are best suited for inclusion into a market index. As we go closer to applications of market indexes in the indexation industry (such as index funds, or sector-level active management, or index derivatives), the market index is not just an economic time-series, but also a portfolio, which is traded. The key difficulty faced here is again liquidity, or the transactions costs faced in buying or selling the entire index as a portfolio.

HEDGING STRATEGIES

HEDGING: LONG SECURITY, SHORT NIFTY FUTURES

Investors studying the market often come across a security which they believe is intrinsically undervalued. It may be the case that the profits and the quality of the company make it seem worth a lot more than what the market thinks. A stockpicker carefully purchases securities based on a sense that they are worth more than the market price. When doing so, he faces two kinds of risks: 1. His understanding can be wrong, and the company is really not worth more than the market price. OR 2. The entire market moves against him and generates losses even though the underlying idea was correct. The second outcome happens all the time. A person may buy SBI at Rs.670 thinking that it would announce good results and the security price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of SBI was correct. There is a peculiar problem here. Every buy position on a security is simultaneously a buy position on Nifty. This is because a LONG SBI position generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a LONG SBI position is not a focused play on the valuation of SBI. It carries a LONG NIFTY position along with it, as incidental baggage. The stock-picker may be thinking he wants to be LONG SBI, but a long position on SBI effectively forces him to be LONG SBI + LONG NIFTY.

There is a simple way out. Every time you adopt a long position on a security, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every longsecurity position. Once this is done, you will have a position, which is purely about the performance of the security. The position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI , without any extra risk from fluctuations of the market index. When this is done, the stockpicker has hedged away his index exposure. The basic point of this hedging strategy is that the stock-picker proceeds with his core skill, i.e. picking securities, at the cost of lower risk.

HEDGING: HAVE PORTFOLIO, SHORT NIFTY FUTURES

The only certainty about the capital market is that it fluctuates! A lot of investors who own portfolios experience the feeling of discomfort about overall market movements. Sometimes, they may have a view that security prices will fall in the near future. At other times, they may see that the market is in for a few days or weeks of massive volatility, and they do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply. When you have such anxieties, there are two alternatives: Sell shares immediately. This sentiment generates panic selling which is rarely optimal for the investor. Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to do something when security prices fall. In addition, with the index futures market, a third and remarkable alternative becomes available:

. Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without panic selling of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk.

The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations).Hence a position LONG PORTFOLIO + SHORT NIFTY can often become onetenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.

Methodology

1. We need to know the beta of the portfolio, i.e. the average impact of a 1% move in Nifty upon the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4 and Rs.2 million of Hindustan Lever, which has a beta of 0.8, then the portfolio beta is (1 * 1.4 + 2 * 0.8)/3 or 1. If the beta of any securities is not known, it is safe to assume that it is 1. 2. The complete hedge is obtained by adopting a position on the index futures market, which completely removes the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would need a position of Rs.3 million on the Nifty futures.

3. Suppose Nifty is 1250, and the market lot on the futures market is 200. Each market lot of Nifty costs Rs.250,000. Hence we need to sell 12 market lots, i.e. 2400 Nifties to get the position: LONG PORTFOLIO Rs.3,000,000 SHORT NIFTY Rs.3,000,000. This position will be essentially immune to fluctuations of Nifty. If Nifty goes up, the portfolio gains and the futures lose. If Nifty goes down, the futures gain and the portfolio loses. In either case, the investor has no risk from market fluctuations when he is completely hedged. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. It does not make sense to use this strategy for long periods of time if a twoyear hedging is

desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, twothirds of his portfolio is hedged and one third of the portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.

HEDGING: HAVE FUNDS, BUY NIFTY FUTURES

Have you ever been in a situation where you had funds, which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Some common occurrences of this include: _ A closed-end fund, which just finished its initial public offering, has cash, which is not yet invested. Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand. An open-ended fund has just sold fresh units and has received funds.

Getting invested in equity ought to be easy but there are three problems: 1. A person may need time to research securities, and carefully pick securities that are expected to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in securities. During this time, he is exposed to the risk of missing out if the overall market index goes up.

2.A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large impact costs. The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favorable prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up. 3.In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises.

So far, in India, we have had exactly two alternative strategies, which an investor can adopt: to buy liquid securities in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available: The investor would obtain the desired equity exposure by buying index futures, immediately. A person who expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs.5 million. Similarly, a closed-end fund, which has just finished its initial public offering and has cash, which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual securities so it is possible to take extremely large positions at a low impact cost. Later, the investor/closed-end fund can gradually acquire securities (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position correspondingly. No matter how slowly securities are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the securities market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing securities and placing aggressive limit orders.

Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty!

Methodology
1. Aman Agrawal obtained Rs.4.8 million on 13th March 2005. He made a list of 14 securities to buy, at 13 March prices, totaling Rs.4.8 million.

At that time Nifty was at 2000. He entered into a LONG NIFTY MARCH FUTURES position for 2400 Nifties, i.e. his long position was worth 4,80,000. 2. From 14 March 2005 to 25 March 2005 he gradually acquired the securities. On each day, he purchased one securities and sold off a corresponding amount of futures. 3. On each day, the securities purchased were at a changed price (as compared to the price prevalent on 13 March). On each day, he obtained or paid the marktomarket margin on his outstanding futures position, thus capturing the gains on the index. 4. By 25 Mar 2005 he had fully invested in all the shares that he wanted (as of 13 Mar) and had no futures position left.

CONCLUSION
Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk.

Consider a simple (perhaps the simplest) case. Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that any particular stock will fall too. So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position. There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) If you're trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following points.

The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index. If the market goes up, you may need to advance more margin to cover your short position, and will not be able to use your stocks to cover the margin calls.

ARBITRAGE STRATEGIES

Arbitrage: Have funds, lend them to the market

Most people would like to lend funds into the security market, without suffering the risk. Traditional methods of loaning money into the security market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk. The basic idea is simple. The lender buys all 50 securities of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counter party on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries.

Methodology
1. Calculate a portfolio, which buys all the 50 securities in Nifty in correct proportion, i.e. where the money invested in each security, is proportional to its market capitalization. 2. Round off the number of shares in each security. 3. Using the NEAT or BOLT software, a single keystroke can fire off these 50 orders in rapid succession into the NSE or BSE trading system. This gives you the buy position 4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you. 5. A few days later, you will have to take delivery of the 50 securities and pay for them. This is the point at which you are loaning money to the market. 6. Some days later (anytime you want), you will unwind the entire transaction. 7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 securities. 8. A moment later, reverse the futures position. Now your position is down to 0. 9. A few days later, you will have to make delivery of the 50 securities and receive money for them. This is the point at which your money is repaid to you.

What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the return to the moneylender, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 March 2005, if the Nifty spot is 2100, and the Nifty March 2005 futures are at 2142 then the difference (2% for 30 days) is the return that the moneylender obtains.

Example
On 1 August, Nifty is at 2400. A futures contract is trading with 27th August expiration for 2460. Ashish wants to earn this return (60/2400 for 27 days). 1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 2407. 2. He sells Rs.3 million of the futures at 2460. The futures market is extremely liquid so the market order for Rs.3 million goes through at nearzero impact cost. He takes delivery of the shares and waits. 3. While waiting, a few dividends come into his hands. The dividends work out to Rs.14,000. 4. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 2420 and his sell orders (which suffer impact cost) goes through at 2413. 5. The futures position spontaneously expires on 27 August at 2420 (the value of the futures on the last day is always equal to the Nifty spot). 6. Ashish has gained Rs.6 (0.25%) on the spot Nifty and Rs.40 (1.63%) on the futures for a return of near 1.88% In addition, he has gained Rs.14000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free. It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 2460/2400 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days.

ARBITRAGE: HAVE SECURITIES, LEND THEM TO THE MARKET

Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues from stocklending. However, stocklending schemes that are widely accessible do not exist in India. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and contract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL). The basic idea is quite simple. You would sell off all 50 securities in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money, as you like until the futures expiration. On this date, you would buy back your shares, and pay for them.

Methodology
Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization). 1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software. 2. Buy index futures of an equal value at a future date. 3. A few days later, you will receive money and have to make delivery of the 50 shares. 4. Invest this money at the riskless interest rate. 5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio. 6. A few days later, you will need to pay in the money and get back your shares. When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spotfutures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stocklending could be profitable It is easy to approximate the return obtained in stocklending. To do this, we assume that transactions costs account for 0.4%. Suppose the spotfutures basis is

X% and suppose the rate at which funds can be invested is Y % Then the total return is (Y - X% - 0.4%) over the time that the position is held. This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spotfutures basis is somewhat wider.

Example
Suppose the Nifty spot is 1100 and the twomonth futures are trading at 1110. Hence the spot futures basis (10/1100) is 0.9%. Assume that the transactions costs are 0.4%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the twomonth period. Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4 million of the Nifty portfolio, which he would like to lend to the market. 1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098. 2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged. 3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100). 4. Suppose Akash lends this out at 1% per month for two months. At the end of two months, he get back Rs.40,70,199. Translated in terms of Nifty, this is 1098* or 1120. 5. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract.

6. When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25,400.

ARBITRAGE: OVERPRICED FUTURES: BUY SPOT, SELL FUTURES

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn risk less profits? Say for instance, ABB trades at Rs.1000. Onemonth ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions. 1. On day one, borrow funds; buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.1015. Sell the security. 6. Futures position expires with profit of Rs.10. 7. The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position. 8. Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cashandcarry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.

ARBITRAGE: UNDER PRICED FUTURES: BUY FUTURES, SELL SPOT

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem under priced. How can you cash in on this opportunity to earn risk less profits? Say for instance, ABB trades at Rs.1000. Onemonth ABB futures trade at Rs.965/- and seem under priced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions. 1. On day one, sell the security in the cash/spot market at 1000. 2. Make delivery of the security. 3. Simultaneously, buy the futures on the security at 965. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.975. Buy back the security. 6. The futures position expires with a profit of Rs.10. 7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.

If the returns you get by investing in riskless instruments is less than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reversecashandcarry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the costofcarry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cashandcarry and reverse cashandcarry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

CONCLUSION
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. A combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur. Arbitrage is the safest way to make money in the market. However, the scope for making money is diminutive. With the help of the arbitrage strategies discussed above, we can exploit the market condition and earn risk-free return. Arbitrage is game of strategy and also funds. A participant with ample funds can easily earn risk-free returns. On the other hand, a strategist can make risk-less profits by making use of mis-pricing in the market. Arbitrage could be inter-exchange, NSE and BSE. Arbitrage could also be between two segments of the market, Cash and F&O. Borrowing and lending is a common practice in arbitrage transaction, therefore, bank and financial institution are very active in arbitrage activities. The above states strategies cover all the types of arbitrage possibilities using equity derivatives.

SPECULATION STRATEGIES

SPECULATION: BULLISH INDEX, LONG NIFTY FUTURES

Do you sometimes think that the market index is going to rise? Could you make a profit by adopting a position on the index? After a good budget, or good corporate results, or the onset of a stable government, many people feel that the index would go up. How does one implement a trading strategy to benefit from an upward movement in the index? Today, you have two choices: 1. Buy selected liquid securities which move with the index, and sell them at a later date: or, 2. Buy the entire index portfolio and then sell it at a later date. The first alternative is widely used a lot of the trading volume on liquid securities is based on using these liquid securities as an index proxy. However, these positions run the risk of making losses owing to companyspecific news; they are not purely focused upon the index. The second alternative is cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can buy or sell the entire index by trading on one single security. Once a person is LONG NIFTY using the futures market, he gains if the index rises and loses if the index falls.

Methodology
When you think the index will go up, buy the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000/-, the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000/-, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor. Longer dated futures go well with longterm forecasts about the movement of the index. Shorter dated futures tend to be more liquid.

Example
1. On 1 July 2001, Milan feels the index will rise. 2. He buys 200 Nifties with expiration date on 31st July 2001. 3. At this time, the Nifty July contract costs Rs.960 so his position is worth Rs.192,000/-. 4. On 14 July 2001, Nifty has risen to 967.35. 3. The Nifty July contract has risen to Rs.980/-. 4. Milan sells off his position at Rs.980/-. 5. His profits from the position are Rs.4000/-.

SPECULATION: BEARISH INDEX, SHORT NIFTY FUTURES

Do you sometimes think that the market index is going to fall? Could you make a profit by adopting a position on the index? After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index? Today, you have two choices: 1. Sell selected liquid securities which move with the index, and buy them at a later date: or, 2. Sell the entire index portfolio and then buy it at a later date. The first alternative is widely used a lot of the trading volume on liquid securities is based on using these securities as an index proxy. However, these positions run the risk of making losses owing to companyspecific news; they are not purely focused upon the index. The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can buy or sell the entire index by trading on one single security. Once a person is SHORT NIFTY using the futures market, he gains if the index falls and loses if the index rises.

Methodology
When you think the index will go down, sell the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor. Longer dated futures go well with longterm forecasts about the movement of the index. Shorter dated futures tend to be more liquid.

Example
1. On 1 June 2001, Milan feels the index will fall. 2. He sells 200 Nifties with a expiration date of 26th June 2001. 3. At this time, the Nifty June contract costs Rs.1,060 so his position is worth Rs.212,000/-. 4. On 10 June 2001, Nifty has fallen to 962.90. 5. The Nifty June contract has fallen to Rs.990/-. Milan squares off his position. 6. His profits from the position work out to be Rs.14,000/-

CONCLUSION
Speculation has a lot of risks involved. Specially speculation in derivates is even more riskier as the derivatives are leveraged instruments. Speculator is responsible for liquidity in the market. Major part of the market volumes come from speculation, be it cash market or the F&O segment. Market participants to speculate extensively use Index futures and stock futures. Index futures attract the maximum volumes in the derivatives segment. Speculation in option is not very common, because buying an option is highly leveraged transaction. Speculation in options is naked positions, which are very risky. Speculation in the market index is very common, index is less volatile and index movement is easy to analyze than the individual stock movements. Speculation in individual securities attracts highest risk, are individual securities are more volatile than the market index. The above-discussed strategies are responsible for liquidity in the Derivatives segment hence leading to volumes in the cash segment also.

CONCLUSION

After completing my research and after analyzing the primary data I arrived on the conclusion that there is lot of scope for derivatives in Bareilly but presently the derivative market in Bareilly is very weak but potential is there what is needed is great effort and in the right direction. Directionless effort is of no use. People in Bareilly are not aware about Derivative and those who are aware not having much knowledge. The people who are no it aware about derivate are our potential customers and we have to identified them an should try the to our front desk. We can educate them about derivative by conducting following activities: Seminars Workshops Distribution of pamphlets. Personal talks.

After analyzing the data one can say two following things: There is NO market of derivative in Bareilly. OR There is HUGE market of Derivatives.

I personally say that there is HUGE market of Derivatives in Bareilly. I personally believe that market of Derivatives in Bareilly is still untapped and underestimated. Im personally very bullish on the prospects of derivative market in Bareilly. What is needed is just the extension of our limits. Hedging is the purpose for which derivative was introduced. Generally traders face huge losses due to speculation, which they do on their own. On 22 may2006 market falls 1100 points and closed for an hour and on such a fall

speculators are the persons who faces the maximum loss. This also has an indirect impact on long-term investors and new entarants.As they see that future and option players faces the maximum loss they decided to stay away from the derivative market and declare it highly risky. We should focus on such speculators and educate them about the purpose or objective for which derivative was introduced. This helps us in many ways Makes he market stable Turn speculators into Hedgers. Brings long-term investors and new entrants easily.

Awareness can created and misconception can be corrected so therefore All Share Brokers should take a stand and discourage speculation to bring stability in the market in turn new clients.

BIBLIOGRAPHY

LITERATURE
Aghion, Philippe and Patrick batton, 1992, An Incomplete Contract, Approach to Financial Contracting, Revuew of Economic Studies, vol. 59 Ail, Yacineand Sahalia, Nonparametric Pricing of Interest rate Derivative Securities, Econometrica, Vol.64 No. 3, May, 96 Altman, E.R., measuring corporate bond mortality and performance, journal of Finance, 1989, Vol. 44, pp. 902-22 Andersen, Torben, G., stochastic autoregression volatility: A framework for Volatily Modelling, Mathematical Finance, 1994, Vol.4, pp.75-102 Bailey, Warren and Rene Stulz, The pricing of Stock Index Options in a General Equilibrium Model, Journal of Financial & Quantative Analysis, Vol.24, pp. 112, 1989 Bakshi, Gurudip ,Charles Cao, and Zhiwi Chen, pricing and Hedging Long-term Options, 1997. Barone, Adesi, Giovanni and Robert Whaley, Efficient Analytic of Approximation of American Options Values, Journal of Finance, Vol. 42, pp. 301-320, 1987. Bates, David, Testing Options Pricing Model in G. S. Maddala & C. R. Raoeds, Handbook of statistics, Vol. 15, Statistical Method in Finance, North Holland, Amsterdam, 1996, pp. 567-611. Bates, David, Post-87, cash Fears in Sand P 500 Future Options, Working Paper, University of Towa, 1996. Black, F., and M, Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, Vol. 73 Bodurtha, G.P. Boyle and K. Newport, Valuation of Tanden Options, Working paper, University of Waterloo. Boylem P.P., Option : A Monte Carlo Application, Journal of Financial Economics, Vol. *, 1980. Boyle, P.P. and D. Emanvel, Mean Dependent Options, Working Paper, University of Waterloo, 1985 Chance, D., An Intro to Options and Futures, Orlando, Fla Dryden Press 1989.

WEB RESOURCES:
http://www.kotaksecurities.com/ http://www.bseindia.com http://www.nseindia.com http://www.indiainfoline.com http://finance.google.com/finance http://finance.yahoo.com/ http://money.cnn.com/ http://moneycentral.msn.com/ http://economictimes.indiatimes.com/ http://www.financeindia.org/fdatabase.htm http://budget2k7.moneycontrol.com/ http://en.wikipedia.org/wiki/Derivative_%28finance%29 http://www.fenews.com/fen41/teach_notes/teaching-notes.html

QUESTIONNAIRE

QUESTIONNAIRE
Dear Sir/maam We are conducting a survey to understand consumer behaviour on investment pattern. We seek information from you in this regard. We assure you full confidentiality of information share by you. 1. Do you aware about equity Market? Yes No 2. Do you Invest in Equity Market? Yes No 3. Do you aware about Derivative? Yes No 4. From which Source you came to know about Derivatives? Friends/ Relatives Trading Experience Formal Education Broker 5. Do You involve in Derivative trading? Yes No 6. Reason for not trading in Derivatives? Not aware Not interested Highly risky Others 7. If guided would you like to trade in Derivative? Yes No Cant say 8. According to you which instrument is more dominant in financial market? Equity(cash) Mutual fund Debenture Bank FD Life Insurance Others 9. Who is your Investment Advisor Self Broker Business magazine/ Dailies

10. Your purpose to trade in Derivative? Speculatation Hedging Arbitraging 11. What is your Investment Horizon? Shortterm Mediumterm Longterm 12. From which broking house do you deal with? Alankit Indiabulls Sher-khan Others Investor Profile Name:____________________________ Age:_____________________________ Occupation________________________ Address:__________________________ Contract No.:______________________

SUMMER TRAINING REPORT ON "CUSTOMER INESTMENT PATTERN IN DERIVATIVE MRKET" AT KOTAK SECURITIES