PROJECT REPORT ON

AN OVERVIEW OF DERIVATIVES- A CAPITAL MARKET FINANCIAL INSTRUMENT

For: DEGREE OF E-MASTER OF BUSINESS ADMINISTRATION

Submitted by: Abhishek Srivastava

Roll No 03110128 Year 2005

INSTITUTE OF MANAGEMENT TECHNOLOGY GHAZIABAD.

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ACKNOWLEDGEMENT

First I would like to express my heartfelt thanks to the professor Shri Sudhir Bajaj who guided me in this project. Though this topic looks to be a bit new in Indian context, but this is a sincere effort towards attaining new heights of knowledge. Further, I would like to thank all my friends who extended their cooperation in completing this project. No project can be said to be free from the limitations. The limitations which I faced during the completion of this project are as follows: Limitation of time. Inherent limitation in getting the secondary data. Reluctance informations. Even then I tried my level best to complete this project with my full and sincere efforts. In the end I would like to thank my parents who encouraged me and extended their cooperation in completion of this project. by persons responsible to give primary

Abhishek Srivastava.

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PREFACE
Derivatives are a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad". When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy. This project attempts to familiarize with financial derivatives, their use and the need to appreciate and manage risk. It is not a substitute, however, for seeking competent professional advice the knowledge of financial derivative will lead to the right direction for investment proposals.

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CONTENTS
Topics Introduction What is a derivative History of Derivatives Characteristics of derivatives Type of derivatives Forward contract Future contract Swaps Options Function of derivatives Advantages of Derivatives Disadvantages of derivatives Risks associated with derivatives Derivatives in Indian Market Trading Mechanism of Derivatives Trading Mechanism of Derivative in Indian Capital market Recommendations Annexures References Page No. 5 7 10 16 18-40 19 22 29 35 41 46 52 62 65-78 69 73 79-86 87-90 91

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INTRODUCTION
Over the past two decades, the financial markets have experienced an impressive expansion in terms of securities issued and traded on the secondary markets. In addition, financial markets have becomes more and more

interconnected allowing almost continuous trading in some precious metals, currencies and stocks traded on several exchanges. Financial innovation that led to the issuance and trading of derivative products has been perhaps one of the most important boost to the changes and development of

financial market. In the financial marketplace, some securities and some instruments are regarded as fundamental, while others are regarded as derivative. In a corporation, for example, the stock and bonds issued by the firm are fundamental

securities and form the bedrock of financial geology. Every corporation must have stock and stock ownership gives rights of ownership to the firm. In contrast with

fundamental securities such as stocks and bonds, there is an entirely distinct class of financial instruments called derivatives,. In finance, a derivative is financial instrument or security whose payoffs depend on a more primitive or fundamental good. For example a gold futures contract is a derivative instrument, because the value of the futures
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contract depends upon the value of the gold that underlies the futures contract. The value of the gold is the key since the value of a gold futures contract derives its value from the value of the underlying gold. Derivative products such as options, futures or swap

contracts have become a standard risk management tool that enables risk sharing and thus facilitates the efficient allocation of capital to productive investment opportunities. The word derivative has only been in common usage for about the last few years or so. Many practitioners in this markets will remember financial the terms, off-balance risk sheet

instruments,

products

management

instruments and financial engineering all meaning much the same thing and now all covered by the expression derivative. Unfortunately some market participants, not only the banks who provide a service in these instruments, but also some end users, have used these derivative products to speculate widely. Derivatives have been likened to aspirin: Taken as prescribed for a headache they will make the pain go away. If you take the whole bottle at once, you may kill yourself. The expression derivative covers any transaction where the is no movement of principal, and where the price performance commodity.
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of derivatives

is

driven

by

an

underlying

What is a Derivative? A derivative is a contractual relationship established by two (or more) parties where payment is based on (or derived from) some agreed-upon benchmark. Since individuals can create a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is list of derivative products. When one enters into a derivative product arrangement, the medium and rate of repayment are specified in detail. For instance, repayment may be in currency, securities or a physical commodity such as gold or silver. Similarly the amount of repayment may be tied to movement of interest rates, stock indexes or foreign currency. Derivatives, as the basic definition of the word implies, are a synthetic by-product created or derived from the value of the underlying asset, be it a real asset, such as gold wheat or oil, or a financial asset, such as a stock, stock index, bond or foreign currency. Exchange traded derivatives- Derivatives which trade on an exchange are called exchange traded derivatives. Trades on an exchange generally take place with anonymity.

Trades at an exchange generally go through the clearing corporation.

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OTC Derivative- A derivative contract which is privately negotiated is called an OTC derivative. OTC trades have no anonymity, and they generally do not go through a clearing corporation. Every derivative product can either trade OTC (i.e., through private negotiation), or on an exchange. The most important derivatives are-

Forwards
A forward contract, as it occurs in both forward and futures markets, always involves a contract initiated at one time; performance in accordance with the terms of the contract occurs at one time; performance in accordance with the terms of the contract occurs at a subsequent time. further, the type of forward contracting to be considered here always involves an exchange of one asset for another. The price at which the exchange occurs is set at the time of the initial contracting. Actual payment and delivery of the good occur later. So defined, almost everyone has engaged in some kind of forward contract.

Futures
A futures contract is a type of forward contract with highly standardized and closely specified contract terms. As in all forward contracts, a futures contract calls for the exchange of some good at a future date for cash, with the payment for the good to occur at that future date. The purchaser of a
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futures contract undertakes to receive delivery of the good and pay for it while the seller of a futures promises to deliver the good and receive payment. The price of the good is determined at the initial time of contracting.

Option
Option contracts confer the right but not the obligation to buy in the case of a call or sell, in the case of a put a specified quantity of an asset at a predetermined price on or before a specified future date option contract would expire if it is not in the best interest of the option owner to exercise.

Swaps
Swaps generally trade in the OTC market but there is monitoring of this market segment, which is now the largest segment of the derivatives market as provided by the international swap dealers associations (ISDA) and the Bank of international settlements (BIS) Swaps which are agreement between two parties to exchange cash flows in the future according to a prearranged formula. In case of popular interest rate swap, one party agrees to pay a series of fixed cash flows in exchange for a sequence of variable cost.

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HISTORY OF DERIVATIVES
Financial derivatives are not new; they have been around for years. A description of the first known options contract can be found in Aristotle a writings. He tells the story of Thales, a poor Philosopher from Miletus who developed a financial device which Thales said that his lack of wealth was proof that philosophy was useless occupation and of no practical value. But Thales knew what he was doing and made plans to prove to others his wisdom and intellect. Thales had great skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with Area Olives Press owners to deposit what little money he had with them to guarantee his exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one know whether the harvest would be plentiful or pathetic and because the olive-press owners ware willing to hedge against the possibility of a poor yield. Aristotle 1s story about Thales ends as one might guess: When the harvest time came and many presses were wanted all at once and of a sudden he let them out at any rate which he pleased and made a quantity of money. Thus he showed the world that philosophers can sort. So Thales exercised the first known options contracts some 25,000
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years ago. He was not obliged to exercise the options. If the olive harvest had not been good, Thales could have let the option contracts expire unused and limited his loss to the original price paid for the options. But as it turned out, bumper crop came in, so Thales exercised the options and sold his claims on these olive presses at a high profit. Options are just one type of derivative instrument,

Derivatives as their name implies are contracts that are based on or derived from some underlying asset, reference rate, or index Most common financial derivatives, described later, can be classified as one or a combination of four types swaps, forwards, futures and options that are based on interest rates or currencies. Most financial derivatives traded today are the plain

vanilla variety the simplest form of a financial instrument. But variants on the basic structures have given way to more sophisticated and complex financial derivatives that are much more difficult to measure manage and understand for those instruments, the measurement and control of risks can be far more complicated creating the increased

possibility of unforeseen losses. Wall Streets stock-scientists are continually creating new complex sophisticated financial derivative products.

However those products are all built on the foundation of the four basic types of derivatives. Most of the newest
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innovations are designed to hedge complex risks in an effort to reduce future uncertainties and manage risks more effectively. But the newest innovations require a firm

understanding of the trade off of risks and rewards. To what and derivatives users should establish a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities. Those

principles should focus on the role of senior management valuation and market and risk management credit risk

measurement

management

enforceability

operating

systems and controls and accounting and disclosure of risk management positions. Banks have long been involved in the purchase and sale of derivatives products such as futures options and swaps. Before the 1980s such activities were only of moderate interest to bank regulators. Generally speaking the use of derivatives by banks was expected to be limited to the management of interest rate and exchange rate risks associated with banking operations the derivatives were limited to instruments for which the underlying asset was an asset that was permissible for direct purchase by a bank. But the 1980s saw a dramatic change in the nature and extent of bank participation in the derivatives market. Banks became increasingly involved in: i. Trading activities that were not necessarily related to the management of risk and
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ii.

Dealing in derivative instruments where the underlying asset was not necessarily one that banks could buy or sell.

Furthermore, banks became active participants in the OTC derivatives market during the explosive growth of the swaps market during this period. It seems that commercial banks have suddenly become the primary (if not the

principal) participants in both domestic and international swaps, futures, options and other derivatives markets. The following table shows the instruments traded in the global derivatives industry and outstanding contracts in $billion.

1986 Exchange Traded Interest futures Interest options Currency futures Currency options 39 10 rate 146 rate 370 583

1990 2292

1993 7839

1994 8838

1454

4960

5757

600

2362

2623

16

30

33

56

81

55

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Stock futures Stock options Some of

index 15

70

119

128

index 3

96

286

242

the 500

3450

7777

11200

OTC industry Interest swaps Currency swaps Caps, collars, 100 578 561 900 700 915 1470 rate 400 2312 6177 8815

floors,Swaptions Total 1083 5742 16616 20038

Development of financial derivatives 1972 1973 Foreign Currency Futures Equity Futures: Futures on Mortgage-backed Bonds 1973 1975 1977 1979 1980 1981 Equity Futures Treasury bill Futures on Mortage backed Bonds Treasury bond future Over the Counter Currency Options Currency Swaps Equity Futures Index Bank Futures; CD Options on T bond

Futures,

T-note

futures,
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Eurodollar Futures; interest-rate Swaps. 1983 Interest-rate Caps and Floor; Options on: T note, future; Currency Futures; Equity Index Futures. 1985 Eurodollar Options: Swaptions: Futures on US Dollar and Municipal Bond Indices 1987 Average options Commodity Swaps Bond

Futures and Options Compound Options 1989 Three-month Euro-DM Futures Captions ECU Interest-rate futures on interest rate Swaps 1990 1991 1992 Equity Index Swaps Portfolio Swaps Differential Swaps

Source: Phillips, K. Arrogant Capital (Boston: Mass, 1994)

CHARACTERISTICS OF DERIVATIVES:
Derivatives have increased in popularity because they offer four distinct characteristics, which are not readily found in any one asset or a combination of assets. The most important is the close relationship between

the value of the derivative and its underlying assets, which can be readily used to speculate or hedge. In a speculative transaction the investor can lever his

investment through the purchase of the derivative asset which sells for a fraction of the underlying asset, but
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exhibits

almost

identical

profit

potential

in

absolute

dollar value with greater percentage gains. Secondly the existence of derivatives allows an investor to readily acquire a short position in an asset. For example, assume that an investor holds a bond

dominated in a foreign currency and will be obliged to take position of that currency when the bond matures (long position). Assume further that he is concerned that the foreign currency may depreciate against his own prior to maturity. In order to offset this risk he

undertakes to short himself by entering into a forward agreement wherein he sells the currency at

predetermined rate guaranteed by the bank, thereby eliminating the risk inherent in currency movements. It is generally easier to take short position in derivative assets than in the underlying asset. Thirdly, exchange-traded derivatives can readily he

more liquid and exhibit lower transactions costs than a variety of other assets. They exhibit increased liquidity owing to their standardized terms and low credit risk. As well, transactions costs and margin requirements tend to be low. Lastly, the investor can use derivatives through financial engineering to construct portfolios which are highly specific to the needs of the portfolio objectives, such as
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portfolio

insurance

techniques

(e.g.,

purchasing

protective puts on individual stocks or stock indices) to limit downside risk.

TYPES OF DERIVATIVES
One of the most misunderstood and maligned investment, today is the derivative. A Derivative is a security or

contract whose market value is derived from an underlying index, interest rate or asset including other securities. There are several kind of derivatives of which the following are the most important : 1. Forward Contracts 2. Future Contracts
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3. Swaps 4. Options

FORWARD CONTRACTS
In the forward market currencies are brought and sold at prices agreed now but for future delivery at an agreed date. Not only is delivery made in the future, but payment is also made at the future date. The main participants in the market are companies and individuals, commercial banks, central banks and brokers. Companies and individuals need foreign currency for

business or travel reasons. Commercial banks are the source for which companies and individuals obtain their foreign currency.

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There are also foreign exchange brokers who bring buyers, sellers and banks together and receive commissions on deals arranged. The other main player operating in the market is the central bank, the main part of whose foreign exchange activities involves the buying and selling of the home currency or foreign currencies with a view to ensuring that the exchange rate moves in line with established targets set for it by the government. Not only are there numerous foreign exchange market centres around the world, but dealers in different locations can communicate with one another via the telephone, telex and computers. The overlapping of time zones means that apart from weekends, there is always one centre that is open. A foreign exchange rate is the price of one currency in terms of another. Foreign exchange dealers quote two prices, one for selling, one for buying. The first area of mystique in foreign exchange quotations arises from the fact that there are two ways of quoting rates: the direct quote and the indirect quote. The former gives the

quotation in terms of the number of units of home currency to buy one unit of foreign currency. The latter gives the quotation in terms of the number to buy one unit of foreign currency. The latter gives the quotation in terms of the number of units of foreign currency bought with one unit of home currency.
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The rate at which the exchange is to be made the delivery date and the amounts involved are fixed at the time of the agreement. Premium or discount on the forward trade One of the major problems that newcomers to foreign exchange markets have is understanding how the forward premium and discount works and how foreign exchange dealers quote for forward delivery. Assume that a quoted currency is more expensive in the future than it is now in terms of the base currency. The quoted currency is then said to stand at a premium in the forward market relative to the base currency. Conversely, the base currency is said to stand at a discount relative to the quoted currency. If a foreign currency stands at premium in the forward market it shows that the currency is 'stronger' than the home currency in that forward market. By contrast, if a foreign currency stands at discount in the forward market, it shows that the currency is 'weaker' than the home currency in that forward market. The forward premium or discount is always calculated as the annualized percentage difference between the spot and forward rates as a

proportion of the spot rate - that is :

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f -S 0 0 x 12 x 100% S n 0 Non - deliverable forward contracts A new type of forward contract called non-deliverable

forward contracts (NDFs) is frequently used for currencies in emerging markets. Like a regular forward contract, an NDF represents an agreement regarding a position in a specified amount of a specified currency a specified

exchange rate and a specified future settlement date. However, an NDF does not result in an actual exchange of the currencies at the future date. That is there is no delivery. Instead a payment is made by one party in the agreement to the other party based on the exchange rate at the future date.

FUTURE CONTRACT
A futures contract is a type of forward contract with highly standardized and closely specified contract terms. As in all forward contracts, a future contract calls for the exchange of some good at a future date for cash, with the payment for the good to occur at that future date. The purchaser of a future contract undertakes to receive delivery of the good and pay for it while the seller of a futures promises to deliver the good and receive payment. The price of the good is determined at the initial time of contracting.
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It is important to understand how futures contracts differ from other forms of forward contracts. Comparison of the forward and future market. Forward Size of contract Tailored individual needs Delivery date Tailored individual needs Participants Banks, and brokers Banks, brokers to Standardized Futures to Standardized

multinational and

multinational

companies. speculation encouraged

Public companies. not Qualified speculation encouraged public

Security deposit

None as such, but Small compensating bank lines balances of or

security

deposit required.

credit

required Clearing operation Handling contingent individual and brokers. No separate Handled on exchange banks clearinghouse. Daily to settlements the market by

clearinghouse

price.
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function Marketplace Over the telephone Central worldwide. floor worldwide communications Regulation Self-regulating Commodity futures trading commission; National association Liquidation Most actual settled by Most by few offset, by futures exchange with

delivery. very

Some by offset at delivery. a cost Transaction costs Set by "spread" Negotiated bank's brokerage free

between

buy and sell prices Source : Reprinted with the permission of the Chicago Mercantile Exchange Note : Clearing House Future contracts trade in a smoothly functioning market, each futures exchange has an associated clearinghouse. The clearinghouse may be constituted as a separate corporation or it may be part of the futures exchange, but each

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exchange

is

closely

associated

with

particular

clearinghouse. In addition the clearinghouse, there are other safeguards for the futures for market. margin Chief and the among daily these are the

requirements trading a

settlement. trade

Before must

futures

contract

prospective

deposit funds with a broker. These funds serve as a good faith deposit by the trader and are referred to as margin. The main purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations. The function of the clearinghouse in future market Obligations without a clearinghouse Goods Buyer Funds Obligations with a Clearinghouse Goods Buyer Funds Clearinghouse Goods Funds Seller Seller

Types of Future contracts The types of futures contracts that are traded fall into four fundamentally different categories. The underlying good

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traded may be a physical commodity, a foreign currency, an interest earning asset or an index, usually a stock index. Agricultural and metallurgical contracts : In the

agricultural area, contracts are traded in grains (corn, oats, and wheat), oil and meal (soybeans, soyameal, and soyaoil, and sunflower seed and oil), live-stock (live hogs, cattle, and pork bellies), forest products (lumber and plywood), textiles (cotton), and foodstuffs (coca, coffee, orange juice, rice and sugar). For many of these commodities, several different contracts are available for different grades or types of the commodity. For most of the goods, there are also a number of months for delivery. The months chosen for delivery of the seasonal crops generally fit their harvest patterns. The number of contract months available for each commodity also depends on the level of trading activity. Interest - Earning Assets: Futures trading on interestbearing assets started only in 1975, but the growth of this market has been tremendous. Contracts are traded now on Treasury bills notes, and bonds, on Eurodollar deposits, and on municipal bonds. The existing contracts span almost the entire yield curve, so it is possible to trade instruments with virtually every maturity. Foreign Currencies : Active futures trading of foreign currencies dates back to the inception of freely floating exchange rates in the early 1970s. contracts trade on the
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British pound, the Canadian dollar, the Japanese yen, the franc, and the German mark. Contracts are also listed on French francs, Dutch guilders, and the Mexican peso, but these have met with only limited success and are no longer traded. Indexes : The last major group of futures contracts is for indexes. Most but not all of these contracts are for stock indexes. Beginning only in 1982, these contracts have been quite successful, with trading on market indexes in full swing. One of the most striking things about these stock index contracts is that they do not admit the possibility of actual delivery. A trader's obligation must be fulfilled by a

reversing trade or a cash settlement at the end of trading. Closing a future position There are three ways to get out of a futures position once you take it. You can satisfy the contract by delivering the goods. This is called delivery. Depending on the wording of the contract, delivery may be made by physically delivering the goods to the designated location or by making a cash settlement of any gain or losses. You may make a reverse, or offsetting, trade in the future market. Since the other side of your position is held by the
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clearinghouse,

if

you

make

an

exact

opposite

trade

(maturity, quantity and good) to your current position the clearinghouse will net your positions out, leaving you with a zero balance. A position may also be settled through an exchange for physicals (EFP). Here, you find a trade with an opposite position to your own and deliver the goods and settle up between yourselves off the floor of the exchange (Called an ex-pit transaction. Purpose of future market Futures market have been recognized as meeting the need of three groups of futures market users: those who wish to discover information about future price of commodities those who wish to speculate and those who wish to hedge. Thus, there are two main social functions of futures markets - price discovery and hedging.

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SWAPS
A swap is an agreement between two or more parties to exchange a sequence of cash flows over a period in the future. For example, Party A might agree to pay a fixed rate of interest on $1 million each year for five year to Party B. In return, Party B might pay a floating rate of interest on $1 million each year for five years. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or to the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps. The swaps market For purposes of comparison, we begin by summarizing some of the key features of futures and options markets. Against this background, we focus on the most important features of the swap product. On futures and options exchange major financial institutions are readily identifiable. For

example in a futures pit, traders can discern the activity of particularly firms, because traders know who represents which firm. Therefore exchange trading necessarily involves a certain loss of privacy. In the swaps market, by contrast only the counterparties know that the swap takes place. Thus the swaps market affords a privacy that cannot be obtained in exchange trading.
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We have noted that futures and options exchanges are subject to considerable government regulation. By contrast, the swaps market has virtually no government regulation. As we will see later swaps are similar to futures. The swaps market feared that the commodity futures trading

commission might attempt to assert regulatory authority over the swaps market on the grounds that swaps are really futures. However the commodity futures trading

commission has formally announced that it will not seek jurisdiction over the swaps market. This means that the swaps market is likely to remain free of deferral regulation for the foreseeable future. For the most part, participants in the swaps market are thankful to avoid regulation. The international swaps and derivatives association inc. (ISDA) is an industry organization that provides standard

documentation for swap agreements and keeps records of swap activity. Bankers are in the business of taking deposits in various currencies on the basis of a fixed or floating interest rate. At the same time banks offer to make loans in various currencies on a fixed or on a floating interest rate basis. The fact that banks are prepared to take deposits on a floating basis and to lend on a fixed basis-and vice versa in a particular currency gives the essential rationale for the interest rate swap market. The fact that banks will take deposits in one currency on a fixed or floating basis and
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also make loans to customers in a different currency on a fixed or floating basis provides an underpinning to the currency swap market. Interest rate swaps A swap- whether an interest rate swap or a currency swap can simply be described as the transformation of one stream of future cash flows into another stream of future cash flows with different features. An interest rate swap is an exchange between two counterparties of interest

obligations (payments of interest) or receipts (investment income) in the same currency on an agreed amount of notional principal for an agreed period of time. the agreed amount is called notional principal because, since it is not a loan or investment the principal amount is not initially exchanged or repaid at maturity. An exchange of interest obligations is called a liability swap; an exchange of interest receipts is called an asset swap. Interest streams are exchanged according to predetermined rules and are based upon the underlying notional principal amount. There are two main types of interest rate swap - the coupon swap and the basis swap. Coupon swaps convert interest flows from a fixed rate to a floating rate basis or the reverse, in the same currency. A simple example is shown in figure 1. In the figure the arrows refer to interest payment flows.
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Basis swaps convert interest flows from a floating rate calculated according to one formula to a floating rate calculated according to another. For example, one set of interest flows might be set against six-month dollar LIBOR, while the other set of flows might be based upon another floating rate such as US commercial paper, US Treasure Bill Rate or LIBOR based upon one-or three-month maturities. Figure 2, givens an example of a basis swap. Figure 1 Coupon Swap Fixed rate 12% Company X Floating rate based upon 6-month LIBOR? Bank

Figure 2 Basis Swap Floating rate -6month $ LIBOR Bank Floating rate - US Commercial paper

Company X

Currency swaps Fixed rate currency fixed rate swap involves in one counterparty currency A

exchanging

interest

with

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counterparty B in return for fixed rate interest in another currency. Currency swaps usually involve three basic steps: Initial exchange of principal Ongoing exchange of interest Re-exchange of principal amounts on maturity.

The initial exchange of principal works as follows. At the outset, the counterparties exchange the principal amounts of the swap at an agreed rate of exchange. This rate is usually based on the spot exchange rate, but a forward rate set in advance of the swap commencement date may also be used. This initial exchange can be on a notional basis that is, with no physical exchange of principal amounts - or alternatively on a physical exchange basis. Whether the initial exchange is on a physical or notional basis, its importance is solely to establish the reference point of the principal amounts for the purpose of calculating first, the ongoing payments of interest and, secondly the re-

exchange of principal amounts under the swap. The ongoing exchange of interest is the second key step in the currency swap. Having established the principal amounts, the

counterparties exchange interest payments on agreed dates based on the outstanding principal amounts at fixed interest rates agreed at the outset of the transaction. The third step in the currency swap involves the ultimate re-exchange of principal amounts at maturity.

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Currency coupon swap Essentially this is a combination of interest rate swap and fixed rate currency swap. The transaction follows the three basic steps described for the fixed rate currency swap. The transaction follows the three basic steps described for the fixed rate currency swap except that fixed rate interest in one currency is exchanged for floating rate interest in another currency. Imagine a borrower which is in a relatively favourable position, for example to raise long-term fixed rate US dollar funding but in fact wants floating rate yen. The currency swap market enables it to marry its requirements with another borrower of relatively high standing in the yen market but which does not have similar access to long-term fixed rate dollars. The gain accrues by each corporation swapping liabilities raised in those markets which each can readily access; the effect is to broaden the access of borrowers to international lending markets Clearly, the currency swap enables the treasurer to alter the denomination of his or her liabilities and assets. Swap transactions may be set up with great speed, and their documentation and formalities are generally much less detailed than in other large financial deals swap documentation is normally shorter and simpler than that relating to term loan agreements. Transaction costs are relatively low too. And swaps can be unwound easily.

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OPTIONS

Everyone has options. When buying a car, we can add more equipment to the automobile that is "optional at extra cost." In this sense an option is a choice. This book examines options in financial markets. These are a very specific types of option - an option created through a financial contract. Options have played a role in security markets for many years, although no one can be certain how long. Initially, options were created by individualized contracts between two parties. However, until recently there was no organized exchange for trading options. The development of option exchanges stimulated greater interest and more active trading of options. The development of option exchanges stimulated greater interest and more active trading of options. In many respects the recent history of option trading can be regarded as an option revolution. Every option is either a call option or a put option. The owner of a call option has the right to purchase the underlying good at a specific price, and this right lasts until a specific date. In short the owner of a call option can call the underlying good away from someone else.

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Likewise, the owner of a put option can put the good to someone else by making the opposite party buy the

good.To acquire these rights, owners of options buy them from other traders by paying the price, or premium, to seller. Options are created only by buying and selling. Therefore for every owner of an option, there is a seller. The seller of an option is also known as an option writer. The seller receives payment for an option from the purchaser. In exchange for the payment received, the seller confers rights to the option owner. The seller of a call option receives payment and in exchange, gives the owner of a call option the right to purchase the underlying good at a specific price, with this right lasting for a specific time. the seller of a put option receives payment from the purchaser and promises to buy the underlying good at a specific price for a specific time, it the owner of the put option chooses. In these agreements all rights lie with the owner of the option. In purchasing an option the buyer makes payments and receives rights to buy or sell the underlying good on specific terms. In selling an option the seller receives payment and receives rights to buy or sell the underlying

good on specific terms. In selling an option the seller receives payment and promises to sell or purchase the underlying good on specific terms - at the discretion of the option owner. With put and call options and buyers and
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sellers, four basic positions are possible. Notice that the owner of an option has all the rights. After all that is what the owner purchases. The seller of an option has all the obligations, because the seller undertakes obligations in exchange for payment. Let us now see some of the commonly adopted strategies using hybrid options combinations:Strategies Straddle- Straddle is a strategy which involves buying or selling (writing) both a call and a put on the same stock with both the options having the same exercise price. Strip- Buying two put options and one call options of the same stock at the same exercise price and for the same period, such a strategy is called a Strip. This strategy may be used when there is a strong

possibility of declining value of stock. Strap- A Strap is buying two calls and one put when the buyer feels that the stock is more likely to rise steeply than to fall, i.e. a possibility skewed in the direction opposite to the one assumed in the case of a strip. Spreads- A spread involves the purchase of one option and sale of another (i.e.), writing) on the same sock.
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It is important to note that spreads comprise either all calls or all puts and not a combination of the two, as in a straddle, strip or a strap. Option spreads having different exercise prices but the same expiration date are called vertical spreads and are listed in a separate block in the quotation lists. On the other hand if the exercise prices are the same and the expiration dates are different such combinations are called horizontal spreads. These are listed in horizontal rows in the quotation lists. Time spreads and calendar spreads are forms of horizontal spreads. Mixtures of vertical and horizontal spreads comprising

options with different expiration dates and exercise prices are called diagonal spreads. Price of an Option Options are generally traded on different types of strike prices. At the money, in the money and out of money.e.g. If the call option is traded at a strike price equal to that of underlying spot price of the equity, then it is called At the money. If the strike price is lesser than the underlying spot price, it is called In the money and similarly if the strike price is greater than the underlying spot price it is called Out of Money.

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Thus, if the buyer of an option is making a profit/loss than the option is In the money/Out of money respectively. An option writer charges an upfront premium from the buyer for selling a right. The premium charged consists of two parts 1) the intrinsic value and 2) time value. The intrinsic value of a put option is the difference between the strike price and the spot price, whereas the intrinsic value of a call option is the difference between the spot price and the strike price. Time value of an option is the price the buyer of an option has to pay to the writer of an option because of the risk the writer of the option takes. This is over and above the intrinsic value of that an option holder pays. Generally, the premium charged by the writer of an option is equal to the sum of both the intrinsic value and the time value. The factors affecting the price of an option The various factors affecting the price of an option include the price of the underlying asset, the strike price of the option, the volatility of the underlying stock, the expiration time and interest rate in the country. Factors like the rate of interest at which the writer is investing the money and the type of option whether American or European also effects the price of an option.

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Why trade options? 1. Options can be used to speculate on price movements Call option are always cheaper than the underlying stock. Put options are almost always cheaper than the

underlying stocks price. Options prices are more volatile than the underlying stock's price 2. Option can be used to reduce risk exposure Options can be used to adjust the risk return

characteristics of a portfolio. Options can be used to eliminate risk altogether Options can be combined with stocks to a perform like risk free bonds. 3. Options can be used to reduce transaction costs. 4. Options can be used to avoid tax exposure 5. Options can be used to avoid market restrictions. There are restrictions on short selling that can be avoided by buying puts.

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FUNCTIONS OF DERIVATIVES
The three basic functions of financial institutions and financial markets naturally also apply to the wide area of derivatives. Three functions are discussed in more detail: Risk sharing and market completion; Implementation of asset allocation decisions; Information gathering.

Trivially derivative transactions appear to be zero-sum games (transaction costs and other costs neglected). Why should zero-sum games be economically beneficial? As a matter of fact, derivatives are at best monetary zero-sum games, i.e., with respect to the involved cash flow. But the economic nature of derivatives cannot be understood by an isolated analysis of the resulting cash flows stemming from derivative transactions. If instead, derivatives are analyzed in an economic setting where for example, risk allocation and imperfect information are relevant structural

characteristics of the financial system and the economy, derivatives turn out to have strong welfare effects. As such they are not zero-sum games in allocative terms.

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Risk Sharing The major economic function of derivatives is typically seen in risk sharing derivatives provide a more efficient

allocation of economic risks. Examples of risk management, which have already been mentioned are illustrative but they do not address the question why derivatives are necessary to attain a better social allocation of risks. A systematic analysis of this question is provided by the state-preference to attain a better social allocation of risk. A systematic analysis of this question is provided by the state-preference model developed by Arrow (1953, 1964) and Debreu

(1959). Within this framework, it can be shown that options have a tremendous power to complete the capital markets. The principal characteristic of a complete market is that the entire set of state securities can be constructed with

portfolios of existing assets. The economic implication of complete markets is straightforward. in the state If there is then

unconstrained

trading

securities

individuals are able to achieve any desired risk allocation pattern in terms of payoff distributions across states. This implies an unconstrained Pareto efficient allocation of risk. This approach was taken by Ross (1976) and Hakansson (1978) to demonstrate the welfare effects of options in incomplete markets.

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Implementation of strategies Portfolio strategies can be classified as either static or dynamic. One of the most attractive features of options is that they enable a static strategy to achieve the same payoffs as dynamic strategies relying on stocks and bonds. Static strategies represent buy-and-hold investments in stocks, bonds options, futures, and other securities. In order to enhance the full risk-return investment spectrum, static strategies require cheap diversification and leverage opportunities. Derivatives significantly reduce the cost of diversification opportunities. Derivatives are available on many aggregate economic risk factors such as global bond and stock portfolios. With many futures contacts, global risk positions and portfolios can be traded as a single financial product. While for example, it is difficult to trade baskets of securities at stock exchanges stock index options and futures offer opportunities to trade aggregate stock market risks for as much as 1/10 or 1/20 of the costs of an equivalent cash market transactional. Derivatives also facilitate diversification because, given and provides for heavy leverage

amount of capital across several assets. Finally, if more risk can be diversified the systematic risk exposure of the economy decreases which lowers the overall cost of risk capital for firms. Further leverage opportunities are often expensive and complicated to implement for many investors
- 42 -

in the cash market or are simply not feasible. However, options and futures represent (highly) levered investment in the underlying cash instruments and require only a small fraction of the investment in the underlying securities. The availability of a specific, highly levered instrument

facilitates to take a risk exposure which exactly matches the risk preference of the investor, and which exactly matches the risk preference of the investor and which cannot be achieved through (static) positions in stocks and cash. Information gathering In a perfect market with no transactions costs no frictions would and no no informational stemming asymmetries, from the there of

be

benefit

use

derivative instruments. However, in the presence of trading costs and market illiquidity, portfolio

strategies are often implemented or supplemented with derivatives at substantial lower costs compared to cash market transactions. In this respect the

welfare effect of derivative instruments results from a reduction in transaction costs. But this is only a part of the real economic benefit of derivatives. If risk allocation is the major function of these instruments, and because risk is also also related affect to the information, information
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derivative

markets

structure of the financial system. The information

structure of the financial system. The information structure is a major determinant of the dynamics and the stability of the economic system. The information on aggregate economic factors (interest rates stock indices oil price, etc.) is more efficiently processed and reflected in futures (and options) markets and supports their price discovery role. Thus with respect to the information flow, it is the cash market, which should be regarded as the derivative with respect to the futures (and options) market! Empirical evidence often demonstrates that mature futures markets

systematically lead the underlying cash market. Investors use derivatives for four basic purposes : To hedge risk; To speculate and profit from anticipated market

movements; To adjust portfolios quickly and cheaply; To arbitrage price discrepancies in financial markets.

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ADVANTAGES AND DISADVANTAGES

Financial innovation that led to the issuance and trading of derivative products has been an important boost to the development of financial markets. Derivative product such as options, futures or swap contracts have become a standard risk management tool that enables risk sharing and thus facilitates the efficient allocation of capital to productive investment opportunities. While the benefits stemming from the economic functions performed by

derivative securities have been discussed and proven by academics, there is increasing concern within the financial community that the growth of the derivatives marketswhether standardized or not-destabilizes the economy. In particular, one often hears that the widespread use of derivatives has reduced long term investments since it concentrates capital in short term speculative transaction. In this study, we have tried to look at the various pros and cons that the derivative trading pose.

BENEFITS OF DERIVATIVES
The recent studies of derivatives activity have led to a broad consensus, both in the private and public sectors, that derivatives provide numerous and substantial benefits to end-users.

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Derivatives as means of hedging

Derivatives provide a low-cost, effective method for end users to hedge and manage their exposures to interest rates commodity prices or exchange rates. Interest rate futures and swaps, for example, help banks of all sizes better manager the re-pricing mismatches in funding long term assets, such as mortgages, with short term liabilities such as the certificates of deposit. Agricultural futures and options help farmers and processors hedge against

commodity price risk. Similarly, airlines and oil refiners can use commodity derivatives to hedge their exposures to fluctuating fuel and oil prices. Finally multinational

corporations can hedge against currency risk using foreign exchange forwards, futures or options. Derivatives also allow corporations, and institutional

investors to more effectively manage their portfolios of assets and liabilities. An equity fund for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. Corporate borrowers and governmental entities can

effectively manage their liability structure the ratio of fixed to floating rate debt and the currency composition of that debt using interest rate and currency futures and swaps.

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Improves market efficiency and liquidity

Well functioning derivatives improves the market efficiency and liquidity of the cash market. The launch of derivatives has been associated with substantial improvement in the market qualify on the underlying equity market. This

happens because of the low transaction costs involved and arbitrageurs will face low costs when they are eliminating the mispricings. Traders in individual stocks who supply liquidity to these stocks use index futures to offset their index exposure and hence able to function at lower levels of risk.

Allows institutions to raise capital at lower costs

Corporations, governmental entities and financial

institutions also benefit from derivatives through lower funding costs and more diversified funding sources.

Currency and interest rate derivatives provide the ability to borrow in the cheapest capital market, domestic or foreign, without regard or can to the currency in in which the debt is is

denominated Derivatives

the

form

which foreign

interest borrowing

paid. into a

convert

the

synthetic domestic currency financing with either fixed-or floating-rate interest institutional investors and portfolio managers may enhance asset, yields, diversify their

portfolios, and protect the value of illiquid securities by using derivatives.

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Allows exchanges to offer differentiated products

In spot market, the ability for the exchanges to

differentiate their products is limited by the fact that they are trading the same paper. In contrast, in the case of derivatives there are numerous avenues for product

differentiation. Each exchange trading index option has to take major decisions like choice of index choice of contract size, choice of expiration dates, American Vs European options, rules governing strike price etc. Thus in derivatives area, it is easier for exchanges to differentiate themselves and find subsets of the user population which require different features in the product thus making the market place competitive. Participating in derivatives activity benefits derivatives

dealers by increasing both the average credit quality and the diversity of credit risk to which they are exposed. This activity provides a profitable and stable earnings stream that helps to build capital and diversify sources of earnings. Finally as banking supervisors have rightly emphasized, improvements in risk management techniques that were first applied to derivatives are now spilling over into and improving the management of risks in other more

traditional business banks taking deposits and making loans, securities firms purchasing and financing securities positions. Or corporations managing their treasury function.
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These improvements in risk management, in turn enhance the safety and profitability of these institutions.

Assists in Capital formation in the economy

By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. It improves the markets ability to carefully direct resources towards the projects and industries where the rate of return is the highest. This improves the allocative efficiency of the market and thus a given stock of inevitable funds will be better used in procuring the highest possible GDP growth for the country. By providing domestic firms with new and more effective tools to manage their inherent risk exposures, derivatives reduce the likelihood that these firms will face financial distress, helping to stabilize employment. Moreover with these incidental risk exposures under control, management can focus on its core business strategy-improving the quality and lowering the cost of its product. The growth in derivatives activities yields substantial

benefits to the economy and by facilitating the access of the domestic companies to international capital markets and enabling them to lower their cost of funds and diversify
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their funding sources, derivatives improve the position of domestic economy. firms in an expanding competitive global

Improved ROI (IN the books) for institutions

Derivatives are basically off-balance trading in that no transfer of principal sum occurs and no posting in the balance sheet will be required. Consequently a fund that corresponds to the principal sum in traditional financial transactions (on -alance trading) is unnecessary, thus substantially improving the return on investment. Looking at the restriction on the ratio of net worth, on the other hand, the risk ratio of assets that form the basis for calculating the net worth in off-balance trading is assumed to be lower than that in the traditional on balance trading. In practice calculated by multiplying the assumed amount of principal of an off-balance trading by a risk-to-value ratio is to be weighted by the creditworthiness of the other party. Eventually the impact of the restriction on the ratio of net worth in derivative transactions is relatively lower than in the case of traditional financial transactions. This is a quite important aspect when utilizing a limited amount of available capital to the best of its advantage. Derivatives have strengthened the important linkages

between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance.
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DISADVANTAGES OF DERIVATIVES
Many stories have invaded the non-academic financial press with attention generating headlines which may actually mislead many readers. To be fair to the popular press,

many of the stories written present a more balanced picture than the images conjured up by the attention glabbing headlines. For example in The Devils in the Derivatives. It is revealed that one investor, who had suffered derivative losses through an investment fund, had not closely

examined that fund prior to investing when he did examine its structure but only after incurring the loses he discovered that it was a hedge fund, intended to protect against falling interest rates.This unfortunate investor , however, had been lured to the fund by impressive past performance and was not looking to hedge another position. As investor became an unwitting speculator. Still the reporting of the workings of derivatives markets has been slanted, and several unproven or misleading a result this

claims have been promoted. These range from the simple claim that they are risky investment, to the charge that speculation in derivatives has superseded traditional

investing, and the arguments are: Derivative securities are risky Derivative securities create risk.
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Derivative securities generate volatility Derivative securities are speculative investments Derivative securities have caused speculation to

displace investment.

Derivative Securities are Risky

This is the most common claim made against derivatives apparently based on the magnitude of the losses which the popular press has reported .Several; important points must be considered in this regard. The first is that risk is often a relative (as opposed to absolute) measure in the same way that hot and cold are relative. It is improper to

categorically state that any particular security

is risky, as

all securities even the risk free government bonds have some level or form of risk associated with them . The level of risk must be referenced to that of another security: for example, a stock entails more risk than a government bond. This relative risk is also dependent upon the perception of the individual, as each person has differing level of risk tolerance. That is, two people many examine the same situation and while one may assess the risk as excessive the other could view the associated risk as minimal This difference is highly dependent upon the level of knowledge and experience of the individual. To most people, walking on a high wire would be viewed as very risky. For the

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trained and practiced tightrope artist who might perform such a feat daily , the level of risk is not perceived to be significantly different than the average person views going to work each day. Thus a financial manager charged with dealings in foreign currencies would not likely view currency derivative contracts to be as risky as a casual investor would. Risky level is also situation specific . Generally the more significant the loss resulting from an unfavorable outcome, the greater the person while risk one associates with the venture. If a

hiking the woods, came upon a small stream

where the only way across was a narrow log suspended between the banks. The hiker would cross the stream. The unfavorable probably use it to out come facing the

hiker is losing his or her balance and falling off the log, But, the associated loss is likely to be only a very wet pair of same log is suspended

feet. The situation changes if that

across a deep gorge. The unfavorable outcome is the same loosing balance and falling off the from that event would not log. But now the fallout hiker

could be the loss of life and the

likely attempt the crossing. For

the investor,

more risk is associated with an investment where total loss would have a greater effect (such as bankruptcy than one which would represent an insignificant fraction of total wealth.

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Any investor must analyze the level of risk

he is willing to

accept, and invest accordingly. For Procter & Gamble which lost U.S.$ 157 million in derivatives, the investments made were not part of its investment strategy and were in fact in violation of corporate policy. Once invested, the investor must also watch the situation because it can change

(markets are dynamic) and the strategy must be adjusted accordingly. This may have been Orange Country Treasurer the trap that caught Citron. He had

Robert

successfully pursued a strategy (which had been agreed to) for several years but when interest rates initially began to rise that strategy should have been reassessed It does not appear that it was instead of cutting the loses short, they kept mounting Within a relatively short period(about nine months from the first rate increase) losses mounted to approximately U S $ 1.5 billion.

Derivative Securities Create Risk

Which came first the chicken or the egg.? There are many seemingly simple question which have frustrated great minds, since the beginning of time . Derivatives were created as a means of reducing risks experienced with traditional securities through hedging . But does their existence create or increase financial risk. As derivative securities and skills in risk management have evolved. It

has become apparent that many businesses are actually

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exposed to form of risk that in a superficial examination one would not expect to encounter. The principles of risk management quickly became relatively complex as did derivatives the

used to manage the risks. It may be that as

these risks have been identified as the risk management techniques evolve one could get the impression that they are new risks hence, the creation of risk. These risks have always existed however they just were not considered to

be there or were inadequately measured or understood. One argument against the creation of risk is that the

hedging function of derivatives is achieved through risk transference. This means that through the derivative a risk that one person, the hedger, it is not willing to take is new or

transferred to someone, the speculator who is No

additional risk is created in this scenario Just the bearer of the risk changes. The investment risk that arises with a derivative contract(in a non-hedging role) is the result of future unpredictability. At the point in time that the

contract is derived a spot price exists in the market. The contract specifies a price (or rate) that the agreed

transaction will be performed

at in the future. That future

price is therefore , an estimate or prediction of the spot price at the future point in time. The future price set each day and the spot price must converge as the contract

expiry date approaches becoming equal on the final day or settlement of the contract. The risk to the non hedging
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investor is that the spot price in the future does not equal the estimated price made now.

Derivative Securities Generate Volatility

This claim is linked to the assertion that derivatives create risk, as volatility is the most accepted measure for

assessing relative risk. To understand how volatility is used to measure risk one must full appreciate a basic tenet of

market price movement know as the Random Walk theory. The hypothesis states that market prices of a security will fluctuate randomly about its intrinsic value and that its

basic intrinsic value will not change without new input(s) This means that any specific price movement it completely unrelated subsequent to the previous move which price moves are further means that Volatility is

unrelated

insensitive to direction

and only reflects the magnitude of

problem movements. Following any price movement the subsequent price move has equal either upwards or down wards. Volatility is linked to risk in this manner. A security with a higher volatility than another has a higher probability of a large, random price movement. Since it is just as likely that the price move would be down as up there is a greater probability of large drop in price for this security than for probability of being

the one with lower volatility: hence the more volatile security carries grater risk.
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The popular perception is that volatility is undesirable and this is not unreasonable given the way it is used to quantify risk However, volatility which is more specifically a measure of how quickly a security price may change is necessary for one to profit. If a security completely stable with volatility

of zero its price would be unchanging an no profit would be possible. When markets advance steadily as they did

through 1993, they

are considered to be stable when,in

fact, they change continually, they must be volatile. There is no link which shows that the use of derivatives has increased market volatilities .

Derivative Securities are Speculative Investments

In describing derivatives, the press has continually referred to them as bets on a movement in one direction or the other The connotation that this terms implies is decidedly unfair To address this clam. Consider a California lettuce farmer and a Canadian Supermarket chain while keeping in mind the idea of risk transference. In the spring when the farmer plants his crop the risk that arises is that at harvest time the price for the crop may be so low that the value of the crop will be less than what it cost of plant, care for harvest and deliver it If the farmer finds that in his view that the risk is exceedingly high he will want to hedge the position. To do so the farmer can enter into a forward sale contract ( a commodity derivative) to insure that the price
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received

at

harvest

will

provide

profit

Commodity

derivatives have long been accepted and such risks.

used to manage

The forward sale contract could be arranged between

the

farmer and the eventual purchaser. While the farmer faces the risk of a low price. the purchaser faces the risk of a high price One might assume that if the risk of a low price is high, then the risk of a high price would be low and the purchaser should not worry. However if the market price has been rising may view their and falling sharply and inconsistently both risk as too great, and each can address contract

their risk by arranging the forward commodity with each other with certainty:

fixing the future price of their transaction

Financial derivatives are used in exactly the same manner. If it is assumed that the forward commodity contract is denominated in U.S dollars the Canadian market will need to exchange Canadian for American currency at some point in time to pay for the crop becoming a seller of Canadian

Funds. The risk to the purchaser is that between now and the commodity sale the Canadian dollar may weaken

relative to the U.S. dollar making the transaction more costly . To manage this risk, the supermarket can use a financial derivative such as a currency option or futures contract to ascertain the cost of acquiring U.S. funds just
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as the

commodity derivative was used to fix the cost of

acquiring the commodity crop. Who is a speculator? Is a speculator someone who is willing to accept higher level of risk than the average person or is it someone who enters a situation without any consideration of the risk involved? If it is the former one encounters a problem since risk is a relative measure. How does one a

position a cross over point between an investor and

speculator on a sliding pace? If it is the latter type of person, it is very difficult to imagine someone who would

not have some preconceived notion of possible out comes. Who one person may think of as speculator, another may consider to be a very well informed investor. In general when speaking of speculators in the markets one is

referring to a person who has no desire or need to hedge a position in the underlying security but only wishes to profit in changes in its price. But also consider an investor in stock which has a clam on a company s assets. Most investors would have no desire to acquire those assets but only wish to profit in the stock . from changes

Speculator used only in differentiate one

from a hedger on a bi polar scale, may just be a rather unfortunate choice of label. The hedger is trying to protect an existing position from incurring losses, while the

speculator is establishing a position to potentially earn a profit.

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The financial press has claimed that the use of derivatives has led to speculation surpassing investment as the prime motive for transactions the majority in the financial markets. That is, are gambles, rather The as than in

of transactions

rationally arriving

assessed at this

investment assertion

strategies. to

logic

seems

go

follows

derivatives are speculative

Derivative markets have grown

faster than traditional markets and derivative volumes now exceed traditional volumes: Therefore speculation has

displaced investment. If one believes that derivatives do indeed open certain financial markets to a green population segment than it is logical should that market volumes would be high. The growth not be surprising been formal either considering longer that than while most

derivatives people

have

around

much

believe

organized

markets

for

financial

derivatives are relatively new. With new derivative products constantly being devised and the understanding of risk management increasing the industry could be as one would naturally expect in a growth phase of its life cycle. The growth rates may be impressive as present but one would expect moderation of the growth in the future.

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RISKS ASSOCIATED WITH DERIVATIVES The following seven categories of risk have been defined in the USA by the Senate Banking Committee, Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of Comptroller of the Currency: CREDIT RISK For derivatives where there is a firm commitment by the parties, credit exposure is measured not by the national amount of the contract, but by the cost to replace it in the market. Since most such contracts are made free or for a nominal fee, there is no immediate credit risk. The potential risk arises from movement of the underlying security that results in a positive value to the contract. The possibility of the counterpart reneging on the deal creates the credit exposure. Conversely, contracts that contain options have an immediate value to the seller due to the premium paid by the buyer. The buyer of these types of contracts carries the credit risk unless the value of the option is reduced to zero as a result of market movements. The seller has no credit risk. MARKET RISK As with all financial instruments, derivatives are subject to various price risks. The market risk of derivatives
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is

generally a function of the same risks facing the underlying security, although the extent varies considerably depending on the nature of the derivatives contract. Most institutions dealing in derivatives break market risk into its components (e.g., exchange rate risk, interest rate risk, raw material prices risk, etc.) OPERATING RISK When venturing into the derivatives market, organizations need sophisticated, high-tech dealing systems in order to maintain internal control. Without such systems.

Organizations are vulnerable to errors (both accidental and deliberate) that can result in substantial losses. Included in this type of risk is the need for senior management to understand the various method employed by their

treasurers. Similarly, treasurers need to be aware of the principles underlying senior managements risk-

management strategy. It was the lack of protection from this type of risk that resulted in the Sterling Pounds 860 million loss to barring PLC. SETTLEMENT RISK This risk is a function of the timing of payments. If one party of a contract delivers money or assets before

receiving retribution from the other party, they subject themselves to potential default by the other party.

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LEGAL RISK This type of risk arises when there is doubt as to the validity of a contract. This risk is greater if the contract involves international parties and is further complicated if one of the parties declares bankruptcy. Despite the work of the International Swap Dealers Association on this type of risk, there remains an unsettling degree of uncertainty. LIQUIDITY RISK The replacement value of most derivatives contracts is based on a liquid market. However, much larger losses

than anticipated can occur from a counterparty default if the markets become viscous or dry up. This can be

especially true in over-the-counter (OTC) markets. AGGREGATION RISK This is also known as interconnection or systematic risk. It results from derivatives contracts that involve several

markets and institutions. A default by one institution may lead to a domino effect that places the entire financial system in jeopardy. This type of risk is the basis for the world-wide financial collapse concerns of some analysts.

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DERIVATIVES IN THE INDIAN MARKET

As the mankind progressed and business and markets grew, the art of risk management grew from primitive stages to the modern day rocket science. While derivatives markets flourished in the developed world Indian markets remain deprived of financial derivatives to this day. The phase of waiting seems to be over. The statutory hassles have been cleared. Regulatory issues are being sorted out. Bourses are gearing up for derivatives trading. One the internet business portals are providing simulated trading games in index futures. Indian securities market is all set to the see derivatives trading in a few months from now. Derivatives are finally making their way to the Indian securities market. It has indeed been a long awaited

development. It took a decade of post-reform period to set the stage for the launch of derivatives trading. During the initial phases of financial sector reforms it appeared as if derivatives would foray into the Indian market just as easily as other things did. But it took a fairly long time for derivatives dream turn into reality. While the rest of the world progressed by leaps and bounds on the derivatives front. Indian market lagged behind. Emerged in the 1970s, derivatives market grew from

strength to strength. The trading volumes nearly doubled in every three years making it a trillion-dollar business. They
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became so ubiquitous that now one cannot think of the existence of financial markets without derivatives. While the Indian equity market is totally devoid of

derivatives, some varieties of them have been in existence in the money market. Last year derivatives based on interest rates have also been allowed. As for the debt market, less said the better. It offers a very narrow range of securities. Inspite of the efforts made by the NSE to -/create an exchange driven market the efforts have been in vain. Derivatives like options and futures do not exist. The existing debt market is small and inactive. It does not provide a wide range of investment choices to investors, to enabled them to design portfolios that match their riskreturn preferences. The reforms process began as a reactive rather than

proactive measure. Precarious economic conditions, which existed at that point of time, compelled India to reform itself. The improvements in the securities markets like capitalization, margining, establishment of clearing

corporations etc. reduced market and credit risks. Other major improvements are introduction of screen-based

trading systems, commendable progress on the demat from. While the reforms transformed the face of Indian securities market drastically, the absence of derivatives trading has been a lacuna in the Indian market. There have been statutory roadblocks to derivatives trading. Securities
- 65 -

contracts act banned option type of transactions. Moreover, regulatory framework for derivatives trading did not exist in India. The constitution of LC Gupta Committee by SEBI was intended to fill this gap. Another roadblock was the nonrecognition of derivatives as securities under securities contracts regulations act. It was in May 1998 made that by SEBI L C has accepted the

recommendations

Gupta

committee.

Subsequently SEBI has appointed J R Varma Committee to look into the operational aspects of derivatives markets. The securities Laws (Amendment) Bill, 1999 was introduced to bring about the much needed changes. In December 1999 the new framework has been accorded the status of 'Securities'. The ban imposed on trading in derivatives way back in 1969 under a notification issued by the central government has been revoked recently. With the onset of derivative market, Indian markets are all set to see the emergence three varieties of players in the derivatives market - hedgers, speculators and arbitrageurs. The introduction of derivatives trading is going to provide the much-needed market for risk. The derivatives market will provide a platform from hedgers to transfer their risks to speculators. In markets that lack derivatives trading like Indian, speculative trades take place in the market for
- 66 -

underlying securities. With the emergence of derivatives market they get transferred to the derivatives market. History of financial markets has evidence to suggest that when risk management avenues are provided by means of derivatives, markets attract higher volumes of investments from savers strengthening the markets in the process. It is precisely for this reason that the Parliamentary standing committee on Finance felt that introduction of derivatives market could revive the sagging state of Indian stock market.

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TRADING MECHANISM OF DERIVATIVES

Trading of derivatives Some derivative products are traded on national exchanges. Regulation responsibility of of national the US futures exchanges Futures is the

commodities

Trading

commission. National securities exchanges are regulated by the US securities and exchange commission (SEC). Certain financial derivative products like options traded on a

national securities exchange, have been standardized and are issued by a separate clearing corporation to

sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these

standardized options is guaranteed by the issuing clearing corporations. Both the exchange and the clearing

corporation are subject to SEC oversight. Other derivative products are traded over the counter (OTC) and represent between agreements parties. If that you are are individually considering

negotiated

becoming a party to an OTC derivative, it is very important to investigate first the creditworthiness of the parties

obligated

under the instrument so you have sufficient

assurance that the parties are financially responsible.

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The Ten Commandments Before considering a derivative transaction. Forecast Have a view on the markets, build a credible market scenario compare it with market consensus curves. Analyze Work out your cash flows and you risks under various scenarios Determine your target cash flows if you are right and how much you are willing to lose if your are wrong. Reviewing the derivative transaction Replicate Reverse engineer it the its transaction basic by for example implied forward

decomposing

into

building

blocks. De-leverage it if necessary. Understand its employed trading strategy. Understand greater which on variables the have of the the

impact

value

transaction. Simulate Compute the transactions break even and its evolution with the passage time and under different over scenario and compute under the

leverage

time

changing
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scenarios. Scale Determine the optional size and leverage of the transaction. Commit Tie your dealer down to a maximum bid/ask spread frequency and dealing size. What does his price represents dealing price or a theoretical mid market valuation. Check his pricing methodology, his credit standing and check privies with other

market makers. Approving the derivative transaction. Authorize Who can commit the firm to a transaction, what and how much can he commit to, and with whom. Under what conditions can be commit the firm to a transaction, especially new structures with which the firm is not familiar. Limit Determine the acceptable overall risk

profiles over time. for market risk, this includes risk limits for the Greeks' i.e., wpeparate limits for delia, gamma, vega. For credit risk, and there should bee limits,

counterparty

concentration

collateral triggers and other sorts of credit enhancements in place.

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Establish

Ensure

that

the

appropriate

systems,

procedures, accounting documentation and people are in place and able to keep abreast with the changing dynamic of a derivative transaction. Entering into the derivative transaction. Monitor Set individual adjustment points in advance: for e.g., stop loss limits or profit lock ins which trigger an automatic close out of a transaction once they are breached.

Establish procedures and the people who have authority to override these automatic close out triggers.

TRADING MECHANISM OF DERIVATIVES IN INDIAN CAPITAL MARKET

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Lord Bagri, Chairman of the London Metal exchange in his address to the Indian Merchants Chamber had remarked "You have today some exceedingly bright people, who are constantly trying to construct new ways of adding value through financial instruments, often, by means of highly sophisticated methods. We use the term derivatives for these instruments" World over Index futures and Stock options are the most popular Equity Derivatives. Of these Index futures are set to make a debut in Indian capital markets, a few months from now. Hence we shall limit the scope of this paper to Index futures. MARKET STRUCTURE 3 essential classes of players drive the markets 1. Hedgers seek to eliminate or reduce price risk to which they are already exposed. They provide the economic substance to any financial market and without them, markets would lose their very purpose and become mere tools of gambling. 2. Speculators willingly take price risks to profit from price changes. Speculators provide the necessary liquidity and depth to the market. 3. Arbitrageurs strive to make risk-less profit by

simultaneously transacting in two markets to capitalize on the price differential between them. The derivatives market perform a number of useful economic functions : Price discovery
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Transfer of risk Market completion

Looking at Indian markets - on one hand, local variants of call/put options like teji, mandi, fatak & nazrana, being illegal are soon going to make way for equity derivatives. On the other hand, we have the indigenous badla or carry forward financing system, often misunderstood to be a derivative. Essentially 2 mechanisms of badla work in the market: seedha badla, where the buyer can postpone payment of money (by paying contango or financing charges to the vyajbadlawala) and undha badla, where the seller postpones delivery of shares (by paying backward charges to the malbadlawala). In the light of the role of badla, it is essential to dispel a myth doing the rounds - that futures & options will eventually replace badla. What people fail to understand is that badla & futures are fundamentally different concepts in themselves and are not even remotely comparable. Badla is purely a means of cash & share financing By enabling the investor to trade in two settlement cycles, badla helps in building a seamless bridge across settlements. The high degree of leverage provided by badla encourages even retail investors to speculate on stocks, thus providing depth & width to the market. Thus, to put it in a nutshell, for any equity market to function, it does need all of its vital constituents - the cash, the futures,
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and the stock and money lending markets. What the BSEs badla or the NSEs ALBM (Automated Lending & Borrowing Mechanism) does, is that it integrates the cash, the stock & the money lending markets, which, the equity markets just cannot do without. Trading, Settlement And Risks The regulatory and operational framework for equity derivatives in India is contained in the LC Gupta Committee & J R Varma Committee reports. Contract Specification The first series planned for launch are based on NSEs Nifty & BSEs Sensex. A matter of concern is by applying a tick size (of 0.05) and a multiplier of Rs. 50 for the BSE, the Sensex at 5000 would translate into a minimum contract value of Rs. 250,000 which is well beyond the reach of retail investors. Derivative Exchange Apex level SEBI regulation is a contentious issue - interestingly in the US, the SEC, inspite of being an extremely efficient regulator, restricts its itself to cash trading in securities and options on securities alone while futures trading falls under the Commodities Futures Trading Commission. The need for a separate exchange also remains a debatable issue - while the NYSE and Nasdaq are inarguably the largest cash markets for securities in the US, its future markets like the Chicago Mercantile Exchange and Chicago Board of Trade that walk away with the honours.

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Memberships on offer would broadly be of two kinds clearing members proprietary (with and discriminating client abilities and to settle trades on account) non-clearing members

(essentially satellite dealers). Trading A trade would bear two flags a Buy/Sell based on a long / short position being taken and an Open/Close depending on whether a fresh position is being taken or an existing one being squared up. This concept is important because margins are levied on net open positions not on the value of outstanding contracts alone. Clearing House A clearing house performs full novation for all contracts. By acting as a counterparty to each buy or sell, it assumes responsibility for guaranteeing settlement of all open positions. An important function of a clearing house is the fixation and enforcement of margin maintenance and default resolution by "shifting of positions" or "closing out." Concept of Margin A margin comprises "Initial" margin (cover against largest potential loss) and "Variation" margin (increase or decrease on margin account arising out of daily mark to market valuation of open positions). The JR Varma Committee has recommended margin fixation based on a 99% Value at Risk model. Risk Containment Even an accurate 99% VaR model could lead to margin shortfall once in every six months so a payment crisis threat hangs like a
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Damocles sword over the exchange. A second level of defence must necessarily be built by means of capital adequacy norms. And the last mechanism is by way of position limits. OPPORTUNITIES For Brokers, the product presents yet another revenue

opportunity as clearing members or non-clearing members (as a network of satellite dealers spread all over the country). With index futures, Mutual Funds could now hedge their portfolios and vary equity exposure freely. Index futures could also help reduce tracking error risk for index funds and mitigate impact cost while fulfilling redemption commitments. Banks, can operate as clearing banks and carrying large floats in the bargain. Guarantees on behalf of members (in lieu of margins) and extension of lines of credit are good business opportunities, further supplemented by advisory or custodial services. Corporates, Insurers or Institutions can take the advantage of calendar spreads, allowing them to earn risk free return with no credit risk. This promises to be an effective substitute for ICDs. Financial Institutions with large portfolios would be able to insulate their holdings from adverse market movements. A few enablers for the derivatives markets to kick off are needed: Inclusion of "derivatives" under the definition of securities under SCRA; Modification of SEBI (FII) and SEBI (Mutual Fund) Guidelines
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to permit them to trade in exchange listed derivatives; ICAI guidelines for accounting treatment of derivatives; CBDT guidelines for tax treatment of gains/losses on index futures usage: Exemption from stamp duty.

The Challenges ahead for derivatives to be successful : Broad-basing the Carry forward system to allow institutional participation Acceleration arbitrages Improvement in banking infrastructure and EFT Buoyancy of money markets Public awareness and education Political will of the dematerialisation drive to facilitate

It is necessary to end on a note of caution by continuing Lord Bagris quote "An attempt to add value to something that is already arbitrarily valued can easily compound a mistake So an instrument, created to control risk can itself turn into a major risk"

RECOMMENDATIONS
From this project we conclude that derivatives instrument are akin to a double -edged sword. They can be employed as risk
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management tools as well as risk profiting tools. Hence we make the following recommendations so that derivative does not become a wild beast which like Frankenstein's monster creates havoc in the financial market. The role of senior management Dealers and end-users should use derivatives in a manner consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market circumstances change. Policies governing derivatives use should be clearly defined, including the purposes for which these transactions are to be undertaken. Senior management should approve procedures and controls to implement these policies, and management at all levels should enforce them. Marketing to Market Dealers should mark their derivatives positions to market, on at least a daily basis, for risk management purposes. Market Valuation Methods Derivatives portfolios of dealers should values based on midmarket levels less specific adjustments or on appropriate bid or offer levels. Mid-market valuation adjustments should allow for expected future costs such as unearned credit spread, close-out costs, investing and funding costs, and administrative costs. Identifying Revenue Sources

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Dealers should use a consistent measure to calculate daily the market risk of their derivatives positions and compare it to market risk limits. Measuring Market Risk Dealers should use a consistent measure to calculate daily the market risk of their derivatives positions and compare it to market risk limits. Market risk is best measured as value at risk using probability analysis based upon a common confidence interval (e.g. two standard deviations) and time horizon (e.g., a oneday exposure). Components of market risk that should be considered across the term structure include: absolute price or rate change (delta); convexity (gamma): volatility (vega): time decay (theta): basis or correlation; and discounts rate (rho).

Stress Simulations
Dealers should regularly perform simulations to determine how their portfolios would perform under stress conditions.

Investing and Funding Forecasts

Dealers should periodically forecast the cash investing

requirements arising from their derivatives portfolios.

Independent Market Risk Management.

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Dealers should have a market risk management function. With clear independence and authority, to ensure that the following responsibilities are carried out. The development of risk limit policies and the monitoring of transactions and positions for adherence to these policies. The design of stress scenarios to measure the impact of market conditions, however improbable, that might cause market conditions, however improbable, that might cause market gaps, volatility swings , or disruptions of major relationships, or might reduce liquidity in the face of unfavorable market linkages, concentrated market making or credit exhaustion. The design of value at risk. The monitoring of variance between the actual volatility of portfolio value and that predicted by the measure of market risk. The review and approval of pricing models and valuation systems used by front and back- office personnel , and the development of reconciliation procedures if different system are used. revenue reports quantifying the contribution of

various risk components, and of market risk measures such as

Practices by End -Users

As appropriate to the nature, size and complexity of their

derivatives activities, end users should adopt the same valuation and market risk man agreement practices that are recommended for dealers. Specifically, they should consider: regularly marking to market their derivatives transactions for risk management
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purposes: periodically forecasting the cash investing and funding requirements arising from their derivatives transactions; and establishing a clearly independent and authoritative function to design and assure adherence to prudent risk limits.

Measuring Credit Exposure

Dealers and end users should measure credit exposure on derivatives in two ways: Potential calculated exposure, using which is an estimate of the upon future broad

replacement cost of derivatives transactions. It should be probability analysis based confidence intervals (e.g. two standard deviations) over the remaining terms of the transactions.

Aggregating Credit Exposures

Credit exposures on derivatives, and all other credit exposures to a counterparty, should be aggregated taking into consideration enforceable netting arrangements. Credit exposures should be calculated regularly and compared to credit limits

Independent Credit Risk Management

Dealers and end users should have a credit risk management function with clear independence and authority and with analytical capabilities in derivatives, responsible for Approving credit exposure measurement standards Setting credit limits and monitoring their use.

Reviewing credits and concentrations of credit risk.

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Master Agreements
Dealers and end users are encouraged to use one master agreement as widely as possible with each counter party to document existing and future derivatives transactions, including foreign exchange forwards and options. Master agreements should provide for payments meeting and close netting and close out netting , using a full two way payments approach.

Credit Enhancement
Dealers and end users should assess both the benefits and costs of credit enhancement and related risk reduction arrangements Where it is proposed that credit downgrades would trigger early termination carefully or collateral requirements., participant should their own capacity and that of their consider

counterparties to meet the potentially substantial funding needs that might result.

Promoting Enforceability
Dealers and end users should work together on a continuing basis to identify and recommend solutions for issues of legal enforceability, both within and across jurisdictions as activities evolve and new types of transactions are developed .

Professional Expertise
Dealers and end users must ensure that their derivatives activities are undertaken by professionals specialization. transact and These professionals in sufficient number specialists who and with the appropriate experience, skill levels, and degrees of include manage the risks involved, their supervisors, and
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those responsible for processing , reporting , controlling, and auditing the activities. Systems Dealers and end users must ensure that adequate systems for data capture, processing, settlement and management reporting are in place so that derivatives transactions are conducted in an orderly and efficient manner in compliance with management policies. Dealers should have risk management systems that measure the risks incurred in their derivatives activities including market and credit risks. End users should have risk management systems that measure the risks incurred in their derivatives activities based upon their nature, size and complexity.

Authority
Management of dealers and end users should designate who is authorized to commit their institutions to derivatives transactions Accounting Practices International harmonization of accounting standardization for derivatives is desirable. Pending the adoption of harmonized standards, the following accounting practices are recommended. End users should account for derivatives used to manage risks so as to achieve a consistency of income recognition treatment between those instruments and the risks being managed. Thus if the risk being managed is accounted for at cost (or, in the case of an anticipatory hedge, not yet recognized, changed in the value of a qualifying risk management instrument should be deferred unity a gain or loss in recognized on the risk being managed. Or ,
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if the risk being managed is marked to market with changes. In value being taken to income a qualifying risk management instrument should be treated be treated in a comparable fashion. End user should account for derivatives not qualifying for risk management treatment on a mark to market basis. Amounts due to and from counter parties should only be off set when there is a legal right to set off or when enforceable netting arrangements are in place. Where local regulations prevent adoption of these practices, disclosure along these lines is nevertheless recommended

Disclosures
Financial statements of dealers and end user should contain sufficient information about their use of derivatives to provide an understanding of the purposes for which transactions are under taken, the extent of the transactions, the degree of risk involved and how the transactions have been accounted for . Pending the adoption of harmonized accounting standards, the following disclosures are recommended: Information about managements attitude to financial risks, how instruments controlled. are used, and how risks are monitored and

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Accounting policies Analysis of the credit risk inherent to those positions. For dealers only, additional information about the extent of their activities in financial instruments.

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Annexures
RECENT MISUSES OF DERIVATIVES
The BARINGS PLC most recent incident making the headlines was the

estimated Sterling Pound s 860 million loss incurred by the 233 year-old British investment bank Barings PLC in early 1995 a Barings derivatives trader, Nick Leeson, had positioned the bank to profit heavily if Japanese stock prices increased. As stock prices tell, Leeson attempted to recoup the losses by increasing the banks position on the direction of stock prices. This has achieved by purchasing additional futures contracts related to the performance of the Nikkei 225 index on the Singapore International Monetary Exchange. By 23, 1995 the futures contracts represented Sterling Pounds 4.3 billion worth of Japanese stock. The gamble did not pay off. The Nikkei 225 index continued to decline and Barings was faced with mounting margin calls. When the Bank of England was informed that Barings may not be able to handle its massive exposure, the British central bank attempted to organize a rescue package. However, since the extent of the losses was determined (i.e. Sterling Pounds 610 million in Tokyo. Sterling Pounds 160 million in Singapore, and STG Pounds 90 million in Osaka). Barings was sold to ING Bank of the Netherlands for Sterling Pound 1 on the condition that in addition to its assets, ING would be responsible for all of Barings liabilities.
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ORANGE COUNTRY

Orange County is California lost an estimated U.S. STG Pounds 1.7 billion in 1994. The loss represented 24 percent of the countys former U S $ 7 billion fund. The long time treasurer of the fund, Robert Citron, embarked on a series of relatively complex ventures involving derivatives that had a potential for very high yields if short-term interest rates remained stable or fell. When the Federal Reserve Board started increasing interest rates in February 1994, the countys fund experienced large losses that grew with each subsequent rate hike. The culmination of which was the December 6 announcement by the country Government that it was bankrupt. Although the county was involved in several sophisticated derivatives transactions, most of the losses were incurred through a simple financial arrangement known as a reverserepurchase agreement whereby securities that paid a fixed rate of return were purchased on credit. The cost of credit was based on short-term interest rates. As long as the cost of credit was lower than the fixed rate of return from the securities, the fund would prosper. This strategy had been quite successful for Mr. Citron in the two years prior to 1994. PROCTER & GAMBLE (P&G)

In late 1993 the treasure for P&G Raymond Mains, approached Bankers Trust New York Corporation wishing to take a position on both U.S. and German interest rates. Bankers Trust is considered among the most aggressive dealers in sophisticated derivatives. The bank gave P & G choices of instruments whose rates of return would be a function of the
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interaction of US and german interest rates. P&G chose the package that could deliver the greatest return: however, it also contained the greatest risk. This differential swap would profit P & G if the two countries three-year interest rates converged at a certain pace. Unfortunately for P&G, the rates converged faster than they had anticipated. This faster than anticipated convergence cost the company U.S. $ 400,000 for each basis point. Given that a basis point is 1/100 of one per cent, the effects were devastating. Another aspect of the agreement that turned out to be quite devastating to P&G was the put options that the company gave to Bankers Trust. The put options allowed the bank to sell P&G U.S. treasury bonds and German at a predetermined price in the future. If bond price remained constant or increased, these put options would be worthless. However, as interest rates increased and bond prices fell, P&G was forced to buy these bonds at prices significantly higher than the market price. By the time P&G closed out its position with the bank in March 1994, the losses from the diff swap and the bond purchase amounted to US $157 million. METALLGESELLSCHAFT (MG)

In 1992 Metallgesellschaft Refining and Marketing (MGRM), a New York subsidiary of the German commodities conglomerate MG, started negotiating long-term, fixed-price contracts to sell fuel to several gas stations and other small businesses. The agreed price for the sales was marginally higher than the current price of fuel. To hedge against the possibility of fuel prices rises (thereby obliging MGRM to buy fuel at a higher price than it had agreed to
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sell), the company purchased short-dated futures on the New York Mercantile Exchange (NYMEX). As oil prices feel sharply in late 1993, the value of these futures contracts plummeted leading to severl margin calls from NYMEX. MGRM requested that its parent company, MG supply the necessary funds to cover their position on the futures contracts, MG responded by replacing the management team and unwinding the futures positions. The cost of this venture into fuel derivatives is estimates at U.S. $ 1.4 billion.

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REFERENCES
References taken to complete this project report have been taken from various books, internet web sites, Journals etc. Ajay Shah and Susan Thomas- Equity Derivatives in India, the state of art. In Derivatives markets in India 2003 (editor) Susan Thomas Chapter1, pages 1-25. Tata McGraw Hill, 203b. Van Horne Financial Management. Vinod Kothari Credit Derivatives and Synthetic Securitisation. Khan and Jain Financial Management. I.M.Pandey Financial Management.

Website to be included for research work would be

www.google.co.in www.credit-deriv.com www.msn.com

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