A PROJECT REPORT ON RISK MANGEMENT

K.P.PATEL SCHOOL FOR MANAGEMENT &COMPUTER STUDIES IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF THE AWARD FOR THE DEGREE OF MASTER OF BUSINESS ASMINISTRATION In Gujarat Technological University UNDER THE GUIDANCE OF Varsha Mam (Asst.Professor) Submitted by Sumit Patel MBA SEMESTER IV K. P.PATEL SCHOOL FOR MANAGEMENT &COMPUTER STUDIES MBA PROGRAMME Affiliated to Gujarat Technological University Ahmadabad 2010-2012

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PARTICULAR INTRODUCTION TO DERIVATIVES MARKET

PAGE NO. 3

TYPES OF TRADERS IN DERIVATIVE MARKET

3. 3

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA 6 INSRUMENTS AVAILABLE IN INDIA 7

PROCEDURE FOR OPENING TRADING ACCOUNT

DERIVATIVES TRADING STRATEGIES USING OPTIONS CONCLUSION

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INTRODUCTION TO DERIVATIVES MARKET

MEANING OF DERIVATIVE Derivatives are contracts, whose value is "derived" from the price of something else, typically, cash market investments such as stocks, bonds, money market instruments or commodities. An equity derivative, for example, might give you the right to buy a particular share at a stated price up to a given date. And in these circumstances the value of that right will be directly related to the price of the "underlying" share: if the share price moves up, then the right to buy at a fixed price becomes more valuable; if it moves down, the right to buy at a fixed price becomes less valuable.

This is but one example of a particular kind of derivative contract. However, the close relationship between the value of a derivative contract and the value of the underlying asset is a common feature of all derivatives. There are many different types of derivative contract, based on lot of different financial instruments; share prices, foreign exchange, interest rates, the difference between two different prices, or even derivatives of derivatives. The possible combinations of products are almost limitless. What then are derivatives used for?

The main instruments under the derivatives are: 1. Forward contract 2. Future contract

3. Options 4. Swap

1. Forward Contract:
A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions or between a financial institution and one of its corporate clients. It is not normally traded on an exchange.

2. Futures Contract:
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contract are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract.

3. Options:
An option is a contract, which gives the buyer the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be commodities like wheat/rice/ cotton/ gold/ oil/ or financial instruments like equity stocks/ stock index/ bonds etc.

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

5. Warrants:
Options generally have lives of unto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

Types of Traders in Derivatives Market:

1. Hedgers Hedgers are interested in reducing a risk that they already face. The purpose of hedging is to make the outcome more certain. It does not necessarily improve the outcome. 2. Speculators Whereas hedgers want to eliminate an exposure to movements in the price of assets, speculators wish to take a position in the market. 3. Arbitrageurs They are a third important group of participants in derivatives market. Arbitrage involves locking in a riskless profit by entering simultaneously into transactions in two or more markets.

DEVELOPMENT OF 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. Measures specified by SEBI to protect the rights of investor in the Derivative Market: 1. Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. 2. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. 3. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member. 4. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member

Instruments available in India

The National stock Exchange (NSE) has the following derivative products:
Options on Individ ual Securit ies 30 securities stipula ted by SEBI American

Index Futures Products Index Options

Futures on Individual Securities 30 securities stipulated by SEBI

Underlying Instru ment Type

S&P CNX Nifty

S&P CNX Nifty European

Trading Cycle

maximum of 3-month trading cycle. At any point in time, there will be 3 contracts available : 1) near month, 2) mid month & 3) far month duration

Same as index future s

Same as index futures

Same as index futures

Expiry Day

Last Thursday of the expiry month

Same as index future s

Same as index futures

Same as index futures As stipulated by NSE (not less than Rs.2 lacs)

Contract Size

Permitted lot size is 200 & multiples thereof

Same as index future s

As stipulated by NSE (not less than Rs.2 lacs)

PROCEDURE FOR OPENING TRADING ACCOUNT

Subject of the Agreement The subject of this Agreement is providing brokerage services to the Customer by the Bank and stipulating of general conditions for these services. The Bank, acting according to instructions of the Customer and acting on Customers account and at Customers risk, accepts Customers Orders and places Orders with the Banks Brokers and Counterparts. The Bank conducting actions as per c. 2.1. of this Agreement receives from the Customer Commissions set by the Tariff. The Bank provides accounting and settlements of the Deals executed under this Agreement.

Deal execution conditions The Bank provides the Customer with facility to conclude the Deals with the Instruments as follows: Forex Spot Forex forward Forex Option Gold and silver Stocks CFD on stocks CFD on Exchanges indices Exchange traded CFD (CFD DMA) Futures Bonds

The Bank reserves the right at its sole discretion to impose a limitation or a ban on execution of Customers Deals with complex Instruments, if the Bank is on the opinion, that Customers qualification is insufficient for trading with such Instruments. According to the provisions of clause 1.1.2 of this Agreement, status has been assigned to the Customer, any amendments to which can be made exclusively on bases of mutual agreement between the Parties within the terms and conditions, stipulated in this Agreement.

 To execute a Deal with Instrument, the Customer shall submit a written Order to the Bank by one of the ways: - Through trading platform. - In hard copy according to c. 3.18. - Through Multinet system according to c. 3.18. The Customer is entitled to submit an Order to the Bank by phone, according t Requirements of the Bank. An Order given by phone must be confirmed by the customer in written not later than at 14:00 Latvian time on the next Business day after the day of Order execution. The Customer is entitled to submit an Order to the Bank by fax according to Appendix No.2. An Order given by fax must be confirmed by the Customer in written not later than at 14:00 Latvian time on the next Business day after the day of Order execution. Any Order submitted by the Customer through the Trading platform, including chat during Business day, shall be regarded as a written Order. The Bank shall accept any Customer Order given through the Trading platform, excluding chat, from 00:00 Monday till 24:00 Friday GMT. .The Bank shall accept Orders of the Customer by phone, fax, Multinet system and in chat on the Trading platform during Business day. The Bank has the right to reject Customers Order if: a. Order is incomplete or incorrect; b. The number of Instruments on Financial instruments account is not sufficient; c. The Account value is not sufficient to executing the Order and/or paying commissions; d. Orders conditions mismatch with market practice; e. Bank does not provide such service; f. There exist other obstacles for Deal execution. g. The Bank shall notify the Customer about reason of the Order rejection. The Customer has no right unilaterally to refuse execution of any Deal concluded in terms of this Agreement. The Bank starts execution of Customers Order immediately after Parties have agreed upon all basis conditions of the Order, according to c. 3.18. of this

Agreement. While executing Customers Order and acting in Customers interests The Bank shall place an Order with Brokers and/or Counterparts in any case choosing such Brokers and Counterparts at its own discretion. If Customer has submitted Market order to the Bank, such Order can not be canceled by Customer and the Bank does not accept and consider any Customers claims regarding price of Instrument, purchased or sold.

The Customer has the right to submit by Means of Communications a request on Order amendment or cancellation, excluding cases specified in c. 3.12. The Bank accepts such a request for execution if Order has not been executed by Broker or Counterpart. In regard of any Deal under this Agreement, excluding as specified in cc. 3.15, 8.1 and 12.1, the Bank shall conclude any Deal on the basis of a separate Customers Order submitted by the way stipulated in this Agreement. The Customer submits Orders to the Bank personally or through the Authorized person according to the preliminary submitted Power of attorney. By signing of this Agreement the Customer undertakes to close in due time all the Open positions. Within this Agreement the Customer authorizes the Bank to take independent decision about closing of Customers Open positions without the additional Order in following cases: If the next Business day is the last trading day of any Instrument, the Bank has the right to close Customers Open position in this Instrument and to notify the Customer about such actions by the message through Means of communications; If a Margin call situation arises on Customers Margin account the Customer authorizes the Bank to take an independent decisions about closing all or some Customers Open positions without any additional orders. The Customer is not allowed to open new positions before the Account value assuming the Unrealized financial result has been recovered at a value of Initial margin for Open positions. Closing of positions in terms of this Agreement is performed at the Customer expense. All telephone conversations of the Customer (Authorized person) with the Bank are registered with a recording device. The Customer recognizes that such records of telephone conversations and the messages transferred by fax are accepted as proofs at the settlements of disputable issues which can arise in terms of this Agreement.

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 When Submitting the Order to the Bank, or requesting any information in terms of this Agreement the Customer must spell his Voice password, his name, Customers name and number of the Financial instruments account. The Bank shall not bear the responsibility in cases when Customers Voice password has been used by unauthorized persons if the direct fault of the Bank in such using of the Voice password has not been proved. The Customer undertakes to immediately notify the Bank in written form for by using Means of Communications if the Voice password or its confidentiality has been lost by the Customer. The Order on Deal execution should be issued in the form of Appendix No.2 or in the free form with mandatory including following data: the name of the Customer, number of the Financial instruments account, number of the Margin account, a surname of the Authorized person submitting the Order, a kind of the Order (buy/sell Instruments), the Order type (Market, Limit, Stop, Stop limit), a name of the Instrument, a price, a quantity (amount), the Order term, the Order logical relations. If the Customer has used text reductions, abbreviations, financial slang and/or specific financial terms in his Order, the Bank holds the prevailing rights for Order interpretation and will not accept and consider any Customers claims in regard of Orders basis conditions after its execution. In case when currency of funds to be credited to Customers Margin account or those to be withdrawn from it is different from the base currency of this Margin account the Bank converts Customers funds at a Banks currency rate effective on that day. The Bank at any time has the right to change the size of commissions if it is connected with: Change of commissions of the Brokers, the Counterparts and depositaries; Change of the Brokers, the Counterparts and depositaries. The Bank has the right to change the size of a commission having notified the Customer about that within 5 (five) Working days before. The requirement about the notice is not valid for cases specified in c. 3.21.

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 The Customer pays a commission to the Bank according to the actual Tariff of the Bank, the commission of the Exchange, set by the corresponding Exchange, and other commissions according to the Instrument specification. The Customer gives to the Bank the right without obtaining any additional Customers consent to write off funds from Customers Margin account and other accounts of the Customer with the Bank in unconditional manner, if sufficient funds are not available on Margin account, to cover all the sums of the commissions and the sums of the incurred charges/losses in connection with execution of this Agreement. When there is lack of funds at Customers accounts, the Bank has the right to sell the necessary quantity of any Customers assets which are placed with the Bank and to apply the funds received from sales of these assets for covering of charges/losses of Bank. By the present chapter of the Agreement the Customer authorizes the Bank to perform all of the above-mentioned actions. When the Bank utilizes the rights given by the present clause of the Agreement all the actions executed by Bank are considered executed on behalf of the Customer. The Bank accrues interest on the funds plac 3.24. The Bank accrues interest on the funds placed on Margin account according to Tariff of Bank. The Bank deducts taxes and the duties related with Customers Deals with Instruments in terms of this Agreement.

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DERIVATIVES TRADING STRATEGIES USING OPTIONS

Basic Trading Strategies: Buying (Going Long) If Price Is Expected To Increase An investor expecting a futures price to increase may decide to go long. That is, purchase a futures contract. If the price of the contract rises the investor will profit. If the price of the contract declines, the investor will lose money. Selling (Going Short) If Price Is Expected To Decrease An investor who believes that the price of a commodity will decline will sell a futures contract. The mechanics of selling short are that first a futures contract is sold and then the profit is realized by buying an offsetting contract at a lower price. If the commodity declines in price the investor profits. If the contract increases in price the investor will have losses. An example of a profitable short trade would be to sell 1 July $3.65 corn and then close the trade by buying 1 July $3.60 corn to close. Spreads A futures spread involves buying one contract and selling another contract. The investor hopes to profit by any price discrepancy which develops between the two contracts. Assume there is a 10 cent difference between the January and March contracts. Analysis indicates that the difference between the two contracts will widen. The investor might want to sell the January contract and buy the March contract. Derivatives Trading Strategies can be classified under following heads: 1. Strategies involving a single options/Futures contract: Long Call buy a call option when one is bullish about the market. Short Call sell a call option when one is bearish about the market. Long Put buy a put option when one is bearish about the market. Short Put sell a put option when one is bullish about the market. Long Futures buy a futures contract when one is bullish about the market. Short Futures sell a futures contract when one is bearish about the market.

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2. Spreads: Bull Call Spread buy a call and sell a call with different strike price and same expiry date with sell call strike price higher than the buy call strike price. Bull Put Spread buy a put and sell a put with different strike price and same expiry date with sell put strike price higher than the buy put strike price. Bear Call Spread buy a call and sell a call with different strike price and same expiry date with sell call strike price lower than the buy call strike price. Bear put Spread buy a put and sell a put with different strike price and same expiry date with sell put strike price lower than the buy put strike price. Bullish Calendar Spread sell a near month option and buy a far month option with same strike price by choosing a higher strike price. Bearish Calendar Spread sell a near month option and buy a far month option with same strike price by choosing a lower strike price. Neutral Calendar Spread sell a near month option and buy a far month option with same strike price by choosing strike price close to spot price. Butterfly Spreads A butterfly spread involves positions in options with three different strike prices. It can be created by buying a call option with a relatively low strike price; buying a call option with a relatively high strike price; and selling two call options with a strike price halfway between lower and higher striker prices. Generally middle strike price should be close to the current stock price.

3. Combinations Long Straddle buy a call and buy a put with the same strike price and same expiry date when one is uncertain about the market but expects it to move in either direction sharply. Short Straddle sell a call and sell a put with the same strike price and same expiry date when prices are expected to be stable. Long Strangle buy a call (outthe-money) and buy a put (outthe-money) with same expiry date but different strike price, with the put strike price lower than the call strike price and when one is uncertain about the market but expects it to move in either direction sharply. Short Strangle sell a call (outthe-money) and sell a put (outthe-money) with same expiry date but different strike price, with the put strike price lower than the call strike price and when the prices are expected to be stable. 4. Other important strategies:

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Covered calls sell a call option and buy futures of the same scrip with same expiry date. Strips A Strip consists of a long position in one call and two puts with the same strike price and expiration date.

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