May/June 2012

PART-A
1. Derivatives are instruments whose value is derived from one or more underlying financial asset. The
underlying instrument could be a financial security, a securities indexes or some combination of securities,
indexes and commodities.
2. A forward contract is a customized contract between two entities, where settle takes place on a specific
date in the future at today's pre-agreed price. Forward are generally traded on OTC.
3. A futures contract is an agreement between two parties to buy or sell an asset certain time in the future at a
certain price. Futures contracts are special types of forward. Contracts in the sense that the former are
standardized exchange-traded contracts. Unlike forward contracts, the counterparty to a futures contract
corporation on the appropriate exchange.
4. In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's
gain or loss depending upon the futures closing price. This is called marking-to-market.
5. An option represents the right (but not the obligation) to buy or sell a security or other asset during a given
time for a specified price (the "strike" price). Options are of two types:

a. Call Option
b. Put Option
6. The intrinsic value of a call is the amount the option is ITM. If the call is OTM, its intrinsic value is zero.
Putting it another way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic value of a
call is the greater of 0 or (St - K). Similarly, the intrinsic value of a put is Max[0, K St],i.e. the greater of
0 or (K St). K is the strike price and St is the spot price
7. Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. Swaps generally are traded OTC
through swap dealers, which generally consist of large financial institution, or other large brokerage houses.
8. A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one
currency for another and, after a specified period of time, to give back the original amounts swapped.
9. Stock index future is an index derivative that draws its value from an underlying stock index like Nifty or
Sensex. Because it is very inconvenient to deliver the index, stock index futures contracts are settled by a
cash amount which is equal to the difference between the contracted futures price and the final index value
times a multiplier that scales the contract size.
10. Commodity futures contract involves obligations of both parties to perform in the future -the buyer (long)
to purchase the asset underlying the future and the seller (short) to deliver the asset

PART-B
11. A) The basic features of a derivative can be explained as follows:
1) Contract between Two Parties: A derivative instrument relates to the future contract between two parties. It
means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The
future period may be short or long depending upon the nature of contract, for example, short-term interest rate
futures and long-term interest rate futures contract.
2) Value of Underlying Assets: Normally, the derivative instruments have the value which derived from the
values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets,
etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the
changes in the underlying assets and sometimes, it may be nil or zero. Hence, they are closely related.
3) Specified Obligation: In general, the counter-parties have specified obligation under the derivative contract.
Obviously, the nature of the obligation would be different as per the type of the instrument o f a derivative.
For example, the obligation of the counter-parties, under the different derivatives, such as forward contract,
future 'contract, option contract and swap contract would be different.
4) Types of Trading: The derivatives contracts can be undertaken directly between the tow parties or through
the particular exchange like financial futures contracts. The exchange-traded derivates are quite liquid and
have low transaction costs in comparison to tailor-made contracts. Examples of exchange traded derivatives

5)

6)

7)

8)
9)

are Dow Jons, S&P 500, Nikkei 225, NIFTY option, S&P Junior that are traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
Notional Amount: In general, the financial derivatives are carried off-balance sheet. The size of the
derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the
pay-off. For example, in the option contract, the potential loss and potential pay-off, both may be. different
from the value of underlying shares, because the pay-off of derivative products differs from the pay-off that
their estimated amount might suggest.
No Physical Delivery: Usually, in derivatives trading, the taking or making of delivery of underlying assets is
not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of
underlying assets.
Deferred Payment Instrument: Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or
securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to
financial engineering.
Secondary Market Instruments: Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are
exception in this respect.
Standardized And Customized: Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many privately negotiated customized,
Over-the-Counter(OTC) traded derivatives are in existence. They expose the trading parties to operational
risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of
such derivatives.

10) Off-Balance Sheet: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature,
can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking
particular currency can buy a structured note whose coupon is tied to the performance of a particular currency
pair.
b)
Parameters

Future

Forward

Market
Nature of Contract
Margin

Organized
Standardized
Margin payment

OTC
Customized
No Margin

Counter-party

Clearing House

Known bank or client

Valuation

Marked to
everyday

Regulation

By organized market

Self-regulation

Counter-Party Risk

Absent

Settlement

Clearing House

Depend on counterparty
Dependent on terms of
contract

Gain/Loss

Unlimited

market

No special method of
valuation

Unlimited

Option
OTC
Organized
OTC
Standardized
Customized
Standardized
Upfront premium payable by
Buyer
Known bank Clearing
or client
House
No
special Marked
to
method
of market every
valuation
day
Self-regulation By organized
market
Depend
on Absent
counter-party
Dependent on Clearing
terms
of House
contract
Gain unlimited/loss to the extent
premium paid upfront

1) A) Spot Price: The price at which an asset trades in the spot market.
2) Futures Price: The price at which the futures contract trades in the futures market.
3) Contract Cycle: The period over which a contract trades. The index futures contracts on the NSE have
one-month, two-months and three-month expiry cycles which expire on the last Thursday of the

7)
8)
9)
10)
11)

month. Thus, a January expiration contract expires on the last Thursday of January and a February
expiration contract ceases trading on the last Thursday of February. On the Friday following the last
Thursday, a new contract having a three-month expiry is introduced for trading.
4) Expiry Date: It is the date specified in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
5) Contract Size: The amount of asset that has to be delivered less than one contract. For example, the
contract size on NSE's futures market is 50 Nifties.
6) Long and Short Position
i) Long Position: In simple terms, long position is a net bought position.
ii) Short Position: Short position is net sold position.
Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There
will be a different basis for each delivery month for each contract. In a normal market, basis will be positive.
This reflects that futures prices normally exceed spot prices.
Cost of Carry: The relationship between futures prices and spot prices can be summarized in terms of what is
known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less
the income earned on the asset.
Initial Margin: The amount that must be deposited in the margin account at the time a futures contract is first
entered into is known as initial margin.
Marking-to-Market: In the futures market, at the end of each trading day, the margin account is adjusted to
reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.
Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in
the margin account never becomes negative. If the balance in the margin account falls below the maintenance
margin, the investor receives a margin call and is expected to top up the margin account to the initial margin
level before trading commences on the next day.
b)

13 a) Participants in the Options Market

There are four types of participants in options markets depending on the position they take. People who buy options
are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions,
and sellers are said to have short positions.
Important distinctions between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or
sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers), however, are
obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell,
whenever the option buyer exercises his option.
1) Buyer of Call Option: The buyer of an equity call option has purchased the right, but not the obligation, to buy
100 shares of the underlying stock at the stated exercise price at any time before the option expires. Once the
option is purchased, the buyer is then "long" the call contract, and to purchase 100 underlying shares he notifies
his brokerage firm of his intent to exercise the call contract.
For example, the buyer of one XYZ June 60 call option has the right to purchase 100 shares of XYZ stock at 60
per share up until the June expiration.
Potential Profit: Unlimited as the underlying stock price increases.
Potential Loss: Limited to premium paid for call option.
2)
Writer (Seller) of Call Option: An investor who sells an option contract that he does not already own is
known as the option "writer", and is then "short" the contract. The writer of an equity call option, commonly referred
to as the "seller", has the obligation to sell 100 shares of the underlying stock at the stated exercise price if assigned
an exercise notice at any time before the option expires.
For example, the writer of an XYZ June 75 call option has the obligation to sell 100 shares of XYZ stock at ?75 per
share if assigned at any time until June expiration.
Potential Profit: Limited to premium received from call's initial sale.
Potential Loss: Unlimited as the underlying stock price increases.
3) Buyer of Put Option: A put option gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of
the stock will fall before the option expires.
The buyer of an equity put option has purchased the right, but not the obligation, to sell 100 shares of the
underlying stock at the stated exercise price at any time before the option expires. Once the option is purchased

the buyer is then "long" the put contract, and to sell 100 underlying shares he notifies his brokerage firm of his
intent to exercise the put contract.
For example, the buyer of one XYZ June 70 put option has the right to sell 100 shares of XYZ stock at 70 per
share up until the June expiration.
Potential Profit: Substantial and increases as the underlying stock price decreases to zero.
Potential Loss: Limited to premium paid for put.
4) Writer (Seller) of Put Option: An investor who sells an option contract that he does not already own is known
as the option "writer" and is then "short" the contract. The writer of equity put option, commonly referred to as
the "seller", has the obligation to purchase 100 shares of the underlying stock at the stated exercise price if
assigned an exercise notice at any time before the option expires.
For example, the writer of an XYZ June 80 put option has the obligation to purchase 100 shares of XYZ stock
at 80 per share if assigned at any time until June expiration. v
Potential Profit: Limited to premium received from put's initial sale.
Potential Loss: Substantial and increases as the underlying stock price decreases to zero.
b) There are two models for option valuation as in figure below:
Option Pricing Models

Black-Scholes Model

Binomial Option Pricing Model

Black-Scholes Model
Option pricing theory - also called Black-Scholes theory or derivatives pricing theory traces its roots to Bachelier
who invented Brownian motion to model options on French government bonds. This work anticipated Einstein's
independent use of the Brownian motion in physics by five years.
The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the
option) using the five key determinants of an option's price; stock price strike price, volatility, time to expiration, and
short-term (risk free) interest rate. I
The original formula for calculating the theoretical Option Price (OP) is as follows:
C = SN(d1) Ee

Where, d1 =

-rt

N(d2)

()[

1 2
I n S + r+
2
E

( ES )+[r 12 ]
2

and d2 =

The variables are:

S = Stock Price.
E = Strike Price.
t = Time remaining until expiration, expressed as a per cent of a year,
r = Current continuously compounded risk-free interest rate,
= Annual volatility of stock price (the standard deviation of the short-term returnsover one year),
In = Natural logarithm,
e = Exponential function.
The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks.
The key argument is that traders could risklessly hedge a long options position with a short position in the stock and
continuously adjust the hedge ratio (the delta valueone of the option sensitivities known as "greeks") as needed.
For example, the stock price follows a random walk, and using the methods of stochastic calculus, a price for the
option can be calculated where there is no arbitrage profit. This depends only on five factors: the current stock price,

the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price.
Eventually, the 1 was adapted to be able to price options on dividend paying stocks as well.

Assumptions of Black and Scholes Model

Following are the assumptions of Black and Scholes Model:
1) Stock Pays no Dividends during the Option's Life: Most companies pay dividends to their share holders, so
this might seem a serious limitation to the model considering the observation that higher dividend yields elicit
lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value
of a future dividend from the stock price.
2) European Exercise Terms are Used: European exercise terms dictate that the option can only be exercised on
the expiration date. American exercise term allow the option to be exercised at any time during the life of the
option, making American options more valuable due to their greater flexibility. This limitation is not a major
concern because very few calls are ever exercised before the last few days of their life. This is true because
when the investor exercise a call early; he forfeits the remaining time value on the call and collects the intrinsicvalue. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the
same.
3) Markets are Efficient: This assumption suggests that people cannot consistently predict the direction of the
market or an individual stock. The market operates continuously with share prices following a continuous
process.
4) No Commissions are Charged: Usually market participants do have to pay a commission to buy or sell
options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's
pays are more substantial and can often distort the output of the model.
5) Interest Rates remain Constant and Known: The Black and Scholes model uses the risk-free rate to represent
this constant and known rate. In reality, there is no such thing as the risk-free rate, but the discount rate on U.S.
Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of
rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the
assumptions of the model.
6) Returns are Log Normally Distributed: This assumption suggests, returns on the underlying stock are
normally distributed, which is reasonable for most assets that offer options.

Advantage of Black and Scholes Model

The main advantage of the Black-Scholes model is speed - it helps to calculate a very large number of option prices in a
very short time.

Disadvantage of Black and Scholes Model

The Black-Scholes model has one major limitation'; it cannot be used to accurately price options with an American-style
exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the
way where there could be i the possibility of early exercise of an American option. As all exchange traded equity options
have American-style exercise (i.e., they can be exercised at any time as opposed to European Options which can only be
exercised at expiration) this is a significant limitation.

Binomial Options Pricing Model (BOPM)

In finance, the binomial options pricing model provides a generalizable numerical method for the valuation of options.
The binomial model was first proposed by Cox, Ross and Rubinstein. This model is an important technique of pricing a
stock option by constructing a binomial tree. The binomial tree represents different possible paths that that be followed
by the stock price over the life of the option. At the end of the tree, i.e., at the expiration of the option, the final possible
stock prices are simply equal to their intrinsic values. This model will consider the time to expiry of an option as being
one period, two periods and multiple periods.
The binomial model is used by the help of probabilities of a stock moving up or down; the risk-free rate and the time
interval of each step (in the binomial tree) till expiry. By use of these probabilities, a binomial tree is to be constructed
and evaluated to finally find the price of a call option.
Essentially, the model uses a "discrete-time" model of the varying price over time of the underlying financial instrument.
Option valuation is then through the application of the risk neutrality assumption over the life of the option, as the price
of the underlying instrument evolves.
Assumptions of Binomial Options Pricing Model
The assumptions of Binomial Options Pricing Model are as follows:

1) The current selling price of the stock (S) can only take two possible values, i.e., an upper value (Su) and a lower
value (Sd).
2) A perfect and competitive market involve the followings:
i) There are no transaction costs, taxes or margin requirements.
ii) The investors can lend or borrow at the risk-less rate of interest, r, which is the only interest rate prevailing.
iii) The securities are tradable in fractions, i.e., they are divisible infinitely.
iv) The interest rate (r) and the upswings/downswings in the stock prices are predictable.
3) The value of (1+r) is greater than d, but smaller than u, i.e., u<l + r<d. This condition or assumption ensures that
there is no arbitrage opportunity.
4) The investors are prone to wealth maximization and lose no time in exploiting the arbitrage opportunities.
14 a) Features of Swaps
The following are the important features of a swap:
1) Basically a Forward: A swap is nothing but a combination of forwards. So, it has all the properties of forward
contract.
2) Double Coincidence of Wants: Swap requires that two parties with equal and opposite needs must come into
contact with each other, i.e., rate of interest differs from market to market and within the market itself.
3) Comparative Credit Advantage: Borrowers enjoying comparative credit advantage in floating rate debts will
enter into a swap agreement to exchange floating rate interest with the borrowers enjoying comparative
advantage in fixed interest rate debt, like bonds. In the bond market, lending is done at a fixed rate for a long
duration, and therefore, the lenders do not have the opportunity to adjust the interest rate according to the
situation prevailing in the market.
4) Flexibility: In short term market, the lenders have the flexibility to adjust the floating interest rate (short term
rate) according to the conditions prevailing in the market as well as the current financial position of the
borrower.
5) Necessity of an Intermediary: Swap requires the existence of two counterparties with opposite but matching
needs. This has created a necessity for an intermediary to cancel both the parties.
6) Settlements: Though a specified principal amount is mentioned in the swap agreement; there is no exchange of
principal. On the other hand, a stream of fixed rate interest is exchanged for a floating rate of interest, and thus,
there are streams of cash flows rather than single payment.
7) Long Term Agreement: Generally, forwards are arranged for short period only. Long dated forward rate
contracts are not preferred because they involve more risks, for example, risk of default, risk of interest rate
fluctuations, etc.
b. Meaning of Interest Rate Swaps
An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a series of interest
payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to
pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the "notional
principal"; the second party promises to pay to the first at the same intervals a floating amount of interest on the
notional principle calculated according to a floating-rate index.
The first party in a fixed/floating rate swap, that which pays the fixed amount of interest, is known as the fixed-rate
payer, while the second party, that which pays the fixed amount of interest, is known as the floating-rate payer. The
notional principal is simply a reference amount against which the interest is calculated
Interest rate swaps can be used to take on fresh interest rate risk as well as to manage existing interest rate risk.
Interest Rate swaps without offsetting underlying create interest rate risk. Each counter party in an interest rate swap
is committed to pay a stream of interest payments and receive a different stream of interest payments. A payer of
fixed interest rate payments is exposed to the risk of falling interest rates, while a payer of floating interest rate
payments is exposed to the risk of rising interest rates. Similarly, a receiver of fixed interest rate payments is
exposed to the risk of rising interest rates, while the receiver of floating interest payments is exposed to the risk of
falling interest rates. In conclusion, interest rate swaps create an exposure to interest rate movements, if not offset by
an underlying exposure.

Mechanics of Interest Rate Swaps

Upon determining that an interest rate swap would be a prudent financial decision, an entity employs a swap dealer
to arrange the terms of the swap. The party with the outstanding floating rate debt seeks the lowest possible fixed

rate. Other factors, such as the financial strength of the dealer and the counterparty, also are considered at this time.
The counterpartys floating rate usually is determined using an index.
Once these parties agree to the terms arranged by the swap dealer, they must enter into a International Swap Dealer
Association (ISDA) Master Agreement and Certification.
This certification assures that the entity has the legal authority to enter into the swap. The length of the swap is also
determined at this time and is usually one to ten years. After agreement upon the terms, the parties are ready to
enter into an interest rate swap. Interest payments and determined on a monthly, semi-annual, or annual basis.
FR + 2%

Fin A

Swap
Dealer 12%

Swap
Dealer

12%

FR +

Fin B
12%

12%

FRHouse
+
Building
Societies

FR + 1%

Deposito

Borrowe

Part III: Joining the two parts - The Combined Swap

Deposito

Fin A
FR + 12%

Swap
Dealer

Fin B
FR +

12%

FR + 1%

House
Building
Societies

Deposito

FR +

12%

Borrowe

Deposito

Future 4.2: Mechanics of Interest Rate Swap

In this Swap there is: I) Ensured Profit to Fin A = 1%, II) Ensured Profit to Fin B = 0.10%,
III) Ensured Profit to Swap Dealer = 0.15%

Currency Swaps
Currency swaps are derivative products that help to manage exchange rate and interest rate exposure on long-term
liabilities. A currency swap involves exchange of interest payments denominated in two different currencies for a
specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed rate, or a
floating rate indexed to some reference rate, like the LIBOR.
In a typical currency swap, counterparties will perform the following:
1) Exchange equal initial principal amounts of two currencies at the spot exchange rate,
2) Exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period
of the swap, and then,
3) Re-exchange the principal amount at maturity at the initial spot exchange rate.

The currency swap provides a mechanism for shifting a loan from one currency to another, or shifting the currency
of an asset. It can be used, for example, to enable a company to borrow in a currency different from the currency it
needs for its operations, and to receive protection from exchange rate changes with respect to the loan.
1) Commodity Swaps: In commodity swaps, the cash flows to be exchanged are linked to commodity prices.
Commodities are physical assets such as metals, energy stores and food including cattle. For example, in a
commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.
Commodity swaps are used for hedging against:
i) Fluctuations in commodity prices, or
ii) Fluctuations in spreads between final product and raw material prices e.g., cracking spread, which indicates the
spread between crude prices and refined product prices, significantly affect the margins of oil refineries).
A company that uses commodities as input may find its profits becoming very volatile if the commodity prices
become volatile. This is particularly so when the output prices may not change as frequently as the commodity
prices change. In such cases, the company would enter into a swapj whereby it receives payment linked to
commodity prices and pays a fixed fate in exchange. A producer of a commodity may want to reduce the
variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to uie commodity
prices.
2) Equity Swaps: Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to
buy it back at market price at a future date. However, he retains a voting right on the shares.
In equity swap atleast one of the two streams of cash flows is determined by a stock price^ the value of a
stock portfolio, or the level of a stock index. The other stream of cash flows can be a fixed rate, a floating
rate such as LIBOR, or it can be determined by the value of another stock, stock portfolio, or stock index.
In this manner, an equity swap can substitute for trading in an individual stock, stock portfolio, or stock
index.
Equity swaps are certainly similar to interest rate and currency swaps, but they also differ notably. One
difference is that the swap payment is determined by the return on the stock. Since stock returns can be
negative, the swap payment can be negative, for example, party A agrees to pay party B the return on the
underlying stock. If at a given payment date, the return on the stock is negative. Then party A effectively
owes a" negative return. This means that party B would have to pay the return to party A. unless party B
also owes a negative return; party B will end-up making both payments.
Another way in which equity swaps differ from interest rate and currency swaps is the fact that the
upcoming equity payment is never known.
3) Basis Rate Swaps: A fast developing area in the international swap markets is the basis rate swap. The
structure of the basis rate swap is the same as the straight interest rate swap, with the exception that floating
interest calculated on one basis is exchanged for floating interest calculated on a different basis.
4) Differential Swaps: A differential swap is an interest rate swap based on the interest rates in two countries
but where the payments are made in a single currency. For example, a U.S. firm might be concerned that
German interest rates will increase relative to U.S. rates. It could hedge this position by purchasing a eurodenominated floating-rate note and selling a dollar-denominated floating-rate note. This would, however,
be assuming unwanted currency risk. Alternatively, it could enter into a diff swap in which it receives the
German interest rate and pays the U.S. interest rate, with all payments made in dollars. Thus, if German
interest rates rise relative to U.S. interest rates, the swap will result in a net payment in dollars to the firm.
Obviously the dealer in such a swap would incur the currency risk and would probably pass on to the party,
the cost of hedging that risk, but presumably the dealer could do it much cheaper.
It should be apparent that this swap is simply a currency-hedged basis swap. If the interest rates of one
country are consistently higher than those in the other country, there would be a spread similar to that in a
basis swap negotiated up front.
7) Credit Default Swaps: A Credit Default Swap (CDS) is a swap contract in which the buyer of the CDS
makes a series of payments to the seller and, in exchange, receives a pay-off if a credit instrument ,typically
a bond or loan, goes into default (fails to pay). Less commonly, the credit event that triggers the pay-off can
be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS
contracts have been compared with insurance, because the buyer pays a premium and, in return, receive a
sum of money if one of the events specified in the contract occur.

8) Other Variations: There are different variations on the vanilla swap structure, which are limited only by
the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic
structures. These variations are as follows:
i) Total Return Swap: A total return swap is a swap in which party A pays the total return of an asset, and
party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or
dividend payments. If the total return is negative, then party A receives this amount from party B. The
parties have exposure to the return of the underlying stock or index, without having to hold the underlying
assets. The profit or loss of party B is the same for him as actually owning the underlying asset.
ii) Swaption: An option on a swap is called a swaption. These provide one party with the right but not the
obligation at a future time to enter into a swap.
iii) Variance Swap: A variance swap is an over-the-counter instrument that allows one to speculate on or
hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an
exchange rate, interest rate, or stock index.
iv) Constant Maturity Swap: A Constant Maturity Swap, also known as a CMS, is a swap that allows the
purchaser to fix the duration of received flows on a swap.
v) Amortizing Swap: An amortizing swap is usually an interest rate swap in which the notional principal for
the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a
mortgage or to an interest rate benchmark such as LIBOR.
15 a) Evolution of Derivatives Market in India
Derivatives markets in India have been in existence in one form or the other for a long time. In the area of
commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the
Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards
markets. In recent years, government policy has shifted in favor of an increased role of market-based pricing and
less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was
the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition
on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many
commodities! Around the same period, national electronic commodity exchanges were also set-up.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 20
on the recommendation of L.C. Gupta Committee. Securities and Exchange Board of India (SEBI) permitted the
derivative segments of two stock exchanges, NSE3 and BSE4, and their clearing house/corporation to commence
trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts
based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based trading was
permitted in options as well as individual securities.
Table 5.l: Derivatives in India: A Chronology

Date
14 December, 1995
18 November, 1996
11 May, 1998
7 July, 1999
24 May, 2000
25 May, 2000
9 June, 2000
12 June, 2000
31 August, 2000
June, 2001
July, 2001
9 November, 2002
June, 2003
13 September. 2004
1 January, 2008
1 January, 2008
29 August, 2008
2 October, 2008

Progress
NSE asked SEBI for permission to trade index futures.
SEBI setup L. C. Gupta Committee to draft a policy framework for index futures.
L.C. Gupta Committee submitted report.
RBI gave permission for OTC Forward Rate Agreements (FRAs) and interest rate
swaps.
SIMEX chose Nifty for trading futures and options on an Indian index.
SEBI gave permission to NSE and BSE to do index futures trading.
Trading of BSE Sensex futures commenced at BSE.
Trading of Nifty futures commenced at NSE.
Trading of futures and options on Nifty to commence at SIMEX.
Trading of Equity Index Options at NSE.
Trading of Stock Options at NSE.
Trading of Single Stock futures at BSE.
Trading of Single Stock futures at BSE.
Weekly Options at BSE.
Trading of Chhotav (Mini) Sensex at BSE.
Trading of Mini Index Futures & Options at NSE.
Trading of Currency Futures at NSE.
Trading of Currency Futures at BSE.

Growth of Derivative Markets

The derivative market growth for different derivative market instruments may be discussed under the following
heads:
1) Derivative Market Growth for the Exchange-Traded-Derivatives: The derivative market growth for equity
reached $114.1 trillion. The open interest in the futures and options market grew by 38% while the interest rate
futures grew by 42%. Hence the derivative market size for the futures and the options market was $49 trillion.
2) Derivative Market Growth for the Global Over-the-Counter Derivatives: The contracts traded through
Over-the-Counter market witnessed a 24% increase in its face value and the over-the-counter derivative market
size reached $70,000 billion. This shows that the face value of the derivative contracts has multiplied 30 times
the size of the U.S. economy. Notable increases were recorded for foreign exchange, interest rate, equity and
commodity-based derivative following an increase in the size of the Over-the-Counter derivative market.
The derivative market growth does not necessitate an increase in the risk taken by the different investors. Even
then, the overshoot in the face value of the derivative contracts shows that these derivative instruments played a
pivotal role in the financial market of today.
3) Derivative Market Growth for the Credit Derivatives: The credit derivatives grew from $4.5 trillion to $0.7
trillion in 2001. This derivative market growth is attributed to the increase in the trading in the synthetic
collateral debt obligations and also to the electronic trading systems that have come into existence. The Bank of
International Settlements measures the size and the growth of the derivative market. According to BIS, the
derivative market growth in the over the counter derivative market witnessed a slump in the second half of
2006. Although the credit derivative market grew at a rapid pace, such growth was made offset by a slump
somewhere else. The notional amount of the Credit Default Swap witnessed a growth of 42%. Credit derivatives
grew by 54%. The single name contracts grew by 36%. The interest derivatives grew by 11%. The OTC foreign
exchange derivatives slowed by 5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also
experienced crawling growth pattern.
b) Contract Specifications for Stock Futures
Trading in stock futures commenced on the NSE from November 2001. These contracts are cash settled on a T + 1
basis. The expiration cycle for stock futures is the same as for index futures, index options, and stock options. A new
contract is introduced on the trading day following the expiry of the near month contract. Table 5.5 gives the
contract specifications for stock futures:
Table 5.5: Contract Specification - Stock Futures

Underlying index
Exchange if trading
Security descriptor
Contract size
Price steps
Price bands
Trading cycle
Expiry day
Settlement basis
Settlement price

Individual securities
National Stock Exchange of India Limited
N FUTSTK
100 or multiple there of (minimum value 2 lac)
0.05
Not applicable
The futures contracts have a maximum of a three month trading cycle -the near month
(one), the next month (two), and the far month (three). A new contract is introduced on
the next trading day following the expiry of near month contract.
The last Thursday of the expiry month or the previous trading day if the last Thursday is
a trading holiday.
Mark to market and final settlement on T + 1 basis
The daily settlement price will be closing price of the future contracts for the trading day
and the final settlement price shall be the closing price of the underlying security on the
last trading day

Contract Specifications for Index Futures

The NSE trades Nifty futures contracts having one month, two month, and three month expiry cycles. All contracts
expire on the last Thursday of-every month. Thus, a January expiration contract would expire on the last Thursday
of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three month expiry would be introduced for trading. Thus, as
shown in figure 5.2, at any point in time, three contracts would be available for trading, with the first contract
expiring on the last Thursday of that month.
The figure shows the contract cycle for futures contracts on NSE's derivatives market. As can be seen, at any given
point of time, three contracts are available for trading - a near month, a middle month, and a far month. As the
January contract expires on the last Thursday of the month, a new three month contract starts trading from the
following day, once more making available three index futures contracts for trading.

Jan FebMarApr
Time
Jan 30 contract
Feb 27 contract
Mar 27 contract
Apr 24 contract
May 29 contract
Jun 26 contract

Figure 5.2: Contract Cycle

Depending on the time period for which one wants to take an exposure in index futures contracts, one can place buy
and sell orders in the respective contracts. All index futures contracts on, the NSE's futures trading system are coded.
The Instruments type refers to Futures contract on index", the contract symbol - NIFTY - denotes a "Futures contract
on the Nifty Index" and the Expiry date represents the last date on which the contract will be available for trading.
Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of pricetime priority and trades take place at the passive order price (similar to the existing capital market trading system).
The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas
the best sell order will be the order to sell the index at the lowest index level.

Trading is for a minimum lot size of 200 units. Thus, if the index level is around 1000, then the appropriate value of
a single index futures contract would be 2,00,000. The minimum tick size for an index future contract is 0.05 units.
Thus, a single move in the index value would imply a resultant gain or loss of 10 (i.e., 0.05 x 200 units) on an open
position of 200 units. Table 5.6 gives the contract specifications for Nifty futures.
Table 5.6: Contract Specification - Index Futures
Underlying index
Exchange of trading
Security descriptor
Contract size
Price steps
Price bands
Trading cycle
Expiry day
Settlement basis
Settlement price

S&P CNX Nifty

National Stock Exchange of India Limited.
N FUTIDX NIFTY
Permitted lot size 200 and multiplies thereof (minimum value 2 lac)
0.05
Not applicable
The futures contracts have a maximum of a three month trading cycle -the near month
(one), the next month (two), and the far month (three). A new contract is introduced on
the next trading day following the expiry of near month contract.
The last Thursday of the expiry month or the previous trading day if the last Thursday
is a trading holiday.
Mark to market and final settlement on T + 1 basis
The daily settlement price will be closing price of the future contracts for the trading
day and the final settlement price shall be the closing price of the underlying security
on the last trading day

Nov/Dec 2012
PART-A
1. Hedgers are those traders who wish to eliminate price risk associated with the underlying security being
traded. The objective of these kinds of traders is to safeguard their existing positions by reducing the risk.
They are not in the derivatives market to make profits
Speculators are traders with a view and objective of making profits. These are people who take positions
(either long or short positions) and assume risks to profit from fluctuations in prices. They are willing to
take risks and they bet upon whether the markets would go up or come down.
2. OTC traded instruments-forward contracts, swaps
Exchange traded instruments-future contracts, option contracts
3. A futures contract is an agreement between two parties to buy or sell an asset certain time in the future at a
certain price. Futures contracts are special types of forward. Contracts in the sense that the former are
standardized exchange-traded contracts. Unlike forward contracts, the counterparty to a futures contract
corporation on the appropriate exchange
4. Minimum variance hedge
5. A call option gives the buyer the right but not the obligation to buy a given quantity of the underlying asset,
at a given price on or before a given future date
Put option gives the buyer the right, but not the obligation to sell a given quantity of the underlying asset at
a given price on or before a given date
6. One persons loss is another persons gain
7. To be filled
8. A currency swap involves exchange of interest payments denominated in two different currencies for a
specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed
rate, or a floating rate indexed to some reference rate, like the LIBOR.
9. Stock Futures, Stock Options, Index Futures, Index Options, Interest Rate Futures, Commodity Futures,
Currency Futures
10. Delta is the rate of change of option price with respect to the price of the underlying asset & Gamma is the
rate of change of the options Delta with respect to the price of the underlying asset

1)
2)
3)
4)
5)
6)

11 A) In the Indian context the Securities Contracts (Regulation) Act, 1956 defines "derivative" to include:
1) A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or
contract for differences or any other form of security.
2) A contract which derives its value from the prices or index of prices, of underlying securities.
The underlying securities for derivatives are:
Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes).
Precious Metals (Gold, Silver).
Short-Term Debt Securities (Treasury Bills).
Interest Rate.
Common Shares/Stock.
Stock Index Value (NSE Nifty).

Features of Derivatives
The basic features of a derivative can be explained as follows:
1) Contract between Two Parties: A derivative instrument relates to the future contract between two parties. It
means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The
future period may be short or long depending upon the nature of contract, for example, short-term interest rate
futures and long-term interest rate futures contract.
2) Value of Underlying Assets: Normally, the derivative instruments have the value which derived from the
values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets,
etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the
changes in the underlying assets and sometimes, it may be nil or zero. Hence, they are closely related.
3) Specified Obligation: In general, the counter-parties have specified obligation under the derivative contract.
Obviously, the nature of the obligation would be different as per the type of the instrument o f a derivative.
For example, the obligation of the counter-parties, under the different derivatives, such as forward contract,

future 'contract, option contract and swap contract would be different.

4) Types of Trading: The derivatives contracts can be undertaken directly between the tow parties or through
the particular exchange like financial futures contracts. The exchange-traded derivates are quite liquid and
have low transaction costs in comparison to tailor-made contracts. Examples of exchange traded derivatives
are Dow Jons, S&P 500, Nikkei 225, NIFTY option, S&P Junior that are traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
5) Notional Amount: In general, the financial derivatives are carried off-balance sheet. The size of the
derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the
pay-off. For example, in the option contract, the potential loss and potential pay-off, both may be. different
from the value of underlying shares, because the pay-off of derivative products differs from the pay-off that
their estimated amount might suggest.
6) No Physical Delivery: Usually, in derivatives trading, the taking or making of delivery of underlying assets is
not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of
underlying assets.
7) Deferred Payment Instrument: Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or
securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to
financial engineering.
8) Secondary Market Instruments: Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are
exception in this respect.
9) Standardized And Customized: Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many privately negotiated customized,
Over-the-Counter(OTC) traded derivatives are in existence. They expose the trading parties to operational
risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of
such derivatives.
10) Off-Balance Sheet: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature,
can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking
particular currency can buy a structured note whose coupon is tied to the performance of a particular currency
pair.
b) Advantages of Derivatives
The advantages of derivatives are as follows:
1) Reflect Perception of Market Participants: Prices in an organized derivatives market reflect the perception of
market participants about the future and lead the prices of underlying to the perceived future level. The prices
of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus,
derivatives help in discovery of future as well as: current prices.
2) Helps to Transfer Risks: The derivatives market helps to transfer risks from those who have them but may not
like them to those who have an appetite for them.
3) Higher Trading Volumes: Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witnesses higher trading volumes because of
participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
4) Controlled Environment: Speculative trades shift to a more controlled environment of derivatives market. In
the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining,
monitoring and surveillance of the activities of various participants become extremely difficult in these kinds
of mixed markets.
5) Attract Entrepreneurial: An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative,
well-educated people with an entrepreneurial attitude. They often energize others to create new businesses,
new products and new employment opportunities, the benefit of which are immense.
In a nutshell, derivatives markets help increase savings and investment in the long-run. Transfer of risk enables
market participants to expand their volume of activity.

Disadvantages of Derivatives
The disadvantages of derivatives are as follows:
1) Speculative and Gambling Motives: One of most important arguments against the v derivatives is that they
promote speculative activities in the market. It is witnessed 2 from the financial markets throughout the world
that the trading volume in ; derivatives have increased in multiples of the value of the underlying assets and '
hardly one to two per cent derivatives are settled by the actual delivery of the underlying assets. As such
speculation has become the primary purpose of die birth, existence and growth of derivatives. Sometimes, these
speculative buying and selling by professionals and amateurs adversely affect the genuine producers and
distributors.
2) Increase in Risk: The derivatives are supposed to be efficient tool of risk management in the market. In fact this
is also one-sided argument. It has been observed that the derivatives market - especially OTC markets, as
particularly customized, privately managed and negotiated and thus, they are highly risky.
Derivatives used by the banks have not resulted in the reduction in risk and rather these have risen of new types
of risk. They are powerful leveraged mechanism used to create risk.
3) Instability of Financial System: It is argued that derivatives have increased risk not only for their users
but also for the whole financial system. The fears of micro and macro financial crisis have caused to the
unchecked growth of derivatives which have turned many market players into big losers. The
malpractices, desperate behavior and fraud by the users of derivatives have threatened the stability of the
financial markets and the financial system.
4) Price Instability: Some experts argue in favor of the derivatives that their major contribution is toward
price stability and price discovery in the market whereas some others have doubt about this. Rather they
argue that derivatives have caused wild fluctuations in asset prices and moreover, they have widened the
range of such fluctuations in the prices. The derivatives may be helpful in price stabilization only if there
existed a properly organized, competitive and well-regulated market. Further, the traders behave and
function in professional manner and foHow standard code of conduct. Unfortunately, all these are not so
frequently practiced in the market and hence, the derivatives sometimes cause to price instability rather
than stability.
5) Displacement Effect: There is another doubt about the growth of the derivatives that they will reduce the
volume of the business in the primary or new issue market specifically for the new and small corporate
units. It is apprehension that most of investors will divert to the derivatives markets, raising fresh capital
by such units will be difficult and hence, this will create displacement effect in the financial market.
However, it is not so strong argument because there is no such rigid segmentation of investors and
investors behave rationally in the market.
6) Increased Regulatory Burden: Derivatives create instability in the financial system as a result; there will
be more burdens on the government or regulatory authorities to control the activities of the traders in
financial derivatives.
12 a) A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at
a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized
exchange-traded contracts.
Future contract can be broadly classified into:

Types of Futures Contract

Financial Futures

Securities/Stock Future
Stock Index Futures
Currencies Futures

Commodity Futures

Interest Rate Futures

1) Financial Futures: A financial futures contract is a standardized agreement to deliver or receive a specified
amount of a specified financial instrument at a specified price and date. The buyer of a financial futures
contract buys the financial instrument, while the seller of a financial futures contract delivers the instrument
for the specified price. Financial futures contracts are traded on organized exchanges, which establish and
enforce rules for such trading. Futures exchanges provide an organized marketplace where futures contracts
can be traded. They clear, settle, and guarantee all transactions that occur on their exchanges.
Financial futures are of the following types:
i) Individual Stock Future: Stock futures are agreements to buy or sell a specified stock, i.e., the equity share
of a specified company, in the future at a specified price.
ii) Stock Index Futures: Stock-index futures offer the investor a medium for expressing an opinion on the
general course of the market.
iii) Currencies Futures: These financial futures, as the name indicates, trade in the foreign currencies, thus,
also known as exchange rate futures. A currency futures contract provides a simultaneous right and
obligation to buy and sell a particular currency at a specified future date, a specified price and a standard
quantity. In other words, in currency futures market, the different currencies are sold and purchased at the
specified future date, at predetermined price and of specified quantity on a particular recognized exchange.
iv) Interest Rate Future: An interest rate future contract is an agreement between two parties to buy or sell a
fixed income security such as Treasury bill or a Treasury bond at a given time in the future for a
predetermined price.
2) Commodity Futures: Commodity futures are agreements of contracts that are utilized to purchase or sell a
specified amount of a given commodity.

Difference between Forwards & Futures

Basis of Difference
1) Trading

Forwards
Traded by telephones or telex
(OTC).
Decided between buyer and seller.

Futures
Traded in a competitive arena
(recognized exchange).
Standardized in each futures market.

3) Price of Contract
4) Mark to Market
2) Margin

Remains fixed till maturity.

Not done.
No margin required.

6) Counter Party Risk

7) Number of
Contracts in a Year
8) Frequency of Delivery

Present.
There can be any number 0f
contracts. '
90% of all forward contracts are
settled by actual delivery
These are tailor-made for specific
date and quantity. $0 jt is perfect.

Changes everyday.
Marked to market everyday.
Margins are to be paid by both buyers
and sellers.
Not present.
Number of contracts in a year is fixed.

1) Size of Contracts

9) Hedging
10) Liquidity
11) Nature of Market
12) Mode of Delivery
13) Transaction Costs

b) Marking

No liquidity.
Over the counter.
Specifically decided. Most of the
contracts result in delivery
Costs are based on bid-ask spread

to the Market

Very few futures contracts are settled by

actual delivery.
Hedging is by nearest month and
quantity contracts. So, it is not perfect.
Highly liquid.
Exchange traded.
Standardized. Most of the contracts
are cash-settled.
Include brokerage fees for buy and sell
orders.

While forward contracts are settled on the maturity date, futures contracts are 'marked market' on a periodic basis.
This means that the profits and losses on futures contracts are settled on a periodic basis. The marking-to-market
feature of a futures contract may be illustrated with an example.
Suppose on Monday morning David take a long position in a futures contract that matures on Friday afternoon, but
is marked to market on a daily basis. The agreed upon price is, say, 100. At the close of trading on Monday, the
futures price rises to 105. Now the marking-to- market feature means that three things would occur. First, he will
receive a cash profit of 5. Second, the existing futures contract with a price of 100 would be cancelled. Third, he will
receive a new futures contract at 105. In essence, the making-to-market feature implies that the value of the futures
contract is set to zero at the end of each trading day.
The settlement margins are always collected in cash. Funds for settlement are automatically debited and credited to
the respective accounts of the clearing members. Each clearing member must open an account with one of the
clearing banks and .sufficient funds must be available for the process of settlements and margins - at the risk of
default proceedings.
The basic purpose of the mark-to-marking is that the futures contracts should be daily marked or settled and not at
the end of its life/Everyday, the trader's team (loss) is added or (subtracted), the margin on the case may be. This
brings the value of the contract back to zero. In other words, a futures contract is closed out and rewritten at a new
price everyday.
13 a) Option Greeks
b) Refer previous question paper
14 a) refer previous question paper
b) Valuation of swap
15 a) Growth of Derivative Markets
The derivative market growth for different derivative market instruments may be discussed under the following
heads:
3) Derivative Market Growth for the Exchange-Traded-Derivatives: The derivative market growth for equity
reached $114.1 trillion. The open interest in the futures and options market grew by 38% while the interest rate
futures grew by 42%. Hence the derivative market size for the futures and the options market was $49 trillion.
4) Derivative Market Growth for the Global Over-the-Counter Derivatives: The contracts traded through
Over-the-Counter market witnessed a 24% increase in its face value and the over-the-counter derivative market
size reached $70,000 billion. This shows that the face value of the derivative contracts has multiplied 30 times
the size of the U.S. economy. Notable increases were recorded for foreign exchange, interest rate, equity and
commodity-based derivative following an increase in the size of the Over-the-Counter derivative market.
The derivative market growth does not necessitate an increase in the risk taken by the different investors. Even
then, the overshoot in the face value of the derivative contracts shows that these derivative instruments played a
pivotal role in the financial market of today.
4) Derivative Market Growth for the Credit Derivatives: The credit derivatives grew from $4.5 trillion to $0.7
trillion in 2001. This derivative market growth is attributed to the increase in the trading in the synthetic
collateral debt obligations and also to the electronic trading systems that have come into existence. The Bank of
International Settlements measures the size and the growth of the derivative market. According to BIS, the
derivative market growth in the over the counter derivative market witnessed a slump in the second half of
2006. Although the credit derivative market grew at a rapid pace, such growth was made offset by a slump
somewhere else. The notional amount of the Credit Default Swap witnessed a growth of 42%. Credit derivatives
grew by 54%. The single name contracts grew by 36%. The interest derivatives grew by 11%. The OTC foreign
exchange derivatives slowed by 5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also
experienced crawling growth pattern.

SEBI Guidelines for Derivative Trading

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

2) The exchange shall have minimum 50 members.

3) The members of an existing segment of the exchange will not automatically became the members of derivative
segment. The members of the derivative segment need to fulfill the eligibility conditions as laid down by the
L.C. Gupta committee.
4) The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house.
5) Derivative brokers/dealers and clearing members are required to seek registry SEBI. This is in addition to their
registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the
derivatives clearing corporation/house shall be 300 lakh. The networth of the member shall be computed as
follows:
Capital + Free reserves - non-allowable assets
non allowable assets are as follows:
i) Fixed assets;
ii) Pledged securities;
iii) Member's card;
iv) Non-allowable securities (unlisted securities);
v) Bad deliveries;
vi) Doubtful debts and advances;
vii) Prepaid expenses;
viii) Intangible assets;
ix) 30% marketable securities.
6) The minimum contract value shall not be less than 2 lakh. Exchanges should also submit details of the
futures contract they propose to introduce.
7) The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to
the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.
8) The L.C.Gupta committee report requires strict enforcement of "Know your customer" rule and requires
that every client shall be registered with the derivatives broker. The members of the derivatives segment
are also required to make their clients aware of the risks involved in derivatives trading by issuing to the
client the Risk Disclosure Document and obtain a copy of the same duly signed by the client.
9) Derivative trading to take place through an online screen-based Trading System.
10) The Derivatives Exchange/Segment shall have online surveillance capability to monitor positions, prices,
and volumes on a real-time basis so as to deter market manipulation.
11) The Derivatives Exchange/Segment should have arrangements for dissemination of information about
trades, quantities, and quotes oh a real-time basis through atleast two information vending networks, which
are easily accessible to investors across the country.
12) The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism
operative from all the four areas/regions of the country.
13) The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and
preventing irregularities in trading.
14) The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
15) The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall
interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should
provide an unconditional guarantee for settlement of all trades.
16) The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both
derivatives market and the underlying securities market for those Members who are participating in both.
17) The level of initial margin on Index Futures Contracts shall be related to the risk of loss on me position.
The concept of level of initial margins. The initial margins should be large enough to cover the one-day loss that
can be encountered on the position on 99% of the day s.
18) The Clearing Corporation/House shall establish facilities for Electronic Funds Transfer (EFT) for swift
movement of margin payments.
19) In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer
client positions and assets to another solvent Member or close-out all open positions.
20) The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing
Members for trades on their own account and on account of his client. The Clearing Corporation/House shall

hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any
other purpose.
21) The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on
Derivative Exchange/Segment.
20) Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of
NSE.
15 B) refer previous question paper

April/My 2011
PART-A
1.
2.

Refer previous question paper

Position traders: A type of

stock trader who holds a position for the long term (from
months to years). Long-term traders are not concerned with short-term fluctuations
because they believe that their long-term investment horizons will smooth these out.
overnight traders: The buying or selling of currencies between 9pm and 8am local time.
This type of transaction occurs when an investor takes a position at the end of the
trading day in a foreign market that will be open while the local market is closed. The
trade will be executed sometime that evening or early morning.

3.

Parameters

Future

Forward

Market

Organized

OTC

Nature of Contract

Standardized

Customized

4. Hedge Ratio is the ratio of the size of the position taken in future contracts to the size of the exposure
5. American options are options that can be exercised at any time up to the expiration date.
European options are options that can be exercised only on the expiration date itself.

6. The intrinsic value of an option is the/difference between the actual price of the underlying security
and the strike price of the option

7. A swap is a private agreement between two parties in which both parties are obligated to exchange
some specified cash flows at periodic intervals for a fixed period of time

8. An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a series
of interest payments without exchanging the underlying debt

9. Unlimited loss
10. Interest Rate swaps without offsetting underlying create interest rate risk. Each counter party in an
interest rate swap is committed to pay a stream of interest payments and receive a different stream of
interest payments. A payer of fixed interest rate payments is exposed to the risk of falling interest rates,
while a payer of floating interest rate payments is exposed to the risk of rising interest rates. Similarly,
a receiver of fixed interest rate payments is exposed to the risk of rising interest rates, while the
receiver of floating interest payments is exposed to the risk of falling interest rates. In conclusion,
interest rate swaps create an exposure to interest rate movements, if not offset by an underlying
exposure
PART-B

11.
A) Risks in Derivatives
The derivative has following risks as shown in figure below:
Risks in Derivatives

Lack of Transparency

Operational Risks

Counterparty Risk

Systemic Risk

1) Lack of Transparency: It has been highlighted as a key risk in the OTC derivatives market. Market
participants were unaware of overall market positions and build-ups in risk. This lack of transparency in
relation to overall exposures can lead to an unwillingness to trade in a falling market and so reduce market
liquidity. J.P. Morgan noted that the lack of information available to supervisors prevented proper
supervision taking place. The lack of transparency means' that supervisors are not able to monitor or
mitigate systemic risks effectively.
2) Counterparty Risk: The other main risk associated with derivatives contracts is counterparty risk, i.e., the
risk that a counterparty in a derivatives contract will not satisfy its obligations under the contract. For
example, by failing to supply goods in a futures contract. This could cause major problems to a
counterparty that would be left suddenly without a derivatives contract and no longer receiving payments
under the contract. The Managed Funds Association (MFA) explained that in practice large market
participants use various techniques, including the posting of collateral either through mark-to-market
margins (variation margin) and upfront margins (initial margin), to reduce counterparty risk to which they
are exposed.
3) Operational Risks: Risks those occur from human error or the failure of control systems. The MFA
considered that the elimination of large backlogs of unconfirmed derivatives, standardized contract terms
for OTC derivatives, improved processes, and procedures for the physical settlement of underlying assets,
and procedures for addressing valuation disputes have helped to reduce operational risks.
4) Systemic Risk: It describes the risk to the financial system posed by the default of a major player in the
derivatives market. Interlinkages in the market created by the large number of derivatives contracts, means
that the default of one party can have far-reaching implications for the creditworthiness of its
counterparties The Investment Management Association (IMA) referred to the "domino effect" caused
"financial firms connected through non-transparent OTC derivatives contracts". Unmitigated, this can lead
to systemic risk. This is clearly affected by the size of the counterparty-the larger the counterparty, the
greater effect its default causes on the market as a whole.

b)

Uses of Derivatives

1) Derivatives Used by Companies: Most of the companies use derivative instruments to manage and hedge their
risks more effectively. The companies using derivatives are located in 26 countries around the world and
represent a broad variety of industries, ranging from aerospace to wholesalers of office and electronic
equipment.
Of the companies using derivatives, 92% use them to help to manage interest rate risk. This represents 85% of
the total sample. 85% of the companies (78% of the total) use derivatives to help to manage currency risk, 25%
(23.5% of the total) to help to manage commodity price risk and 12% ( 11 % of the total ) to help to manage
equity price risk.
2) Derivatives Used by Mutual Fund and Investment Institutions: Derivatives like futures and options are
used by mutual funds for hedging their portfolio to manage the risk, for speculation to clock profits and for
arbitrage to earn risk-free profits. Derivatives are used by investors to:
i) Provide leverage or gearing, such that a small movement in the underlying value can cause a large
difference in the value of the derivative.
ii) Speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves
in a given direction, stays in or out of a specified range, reaches a certain level).
iii) Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the
opposite direction to their underlying position and cancels part or all of it out.
iv) Obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives).
v) Create optionability where the value of the derivative is linked to a specific condition or event (e.g., the
underlying reaching a specific price level).
3) Derivatives Used by Financial Institutions and Banks: Financial institutions, such as banks, have assets and
liabilities of different maturities and in different currencies, and are exposed to different risks of default from
their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to
manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this
affects their incentives to use derivatives. Indian insurance regulators, e.g., are yet to issue guidelines relating to
the use of derivatives by insurance companies. Derivatives are used by banking organizations both as risk
management tools and as a source of revenue. From a risk management perspective, they allow financial
institutions and other participants to identify, isolate, and manage separately the market risks in financial
instruments and commodities. When used prudently, derivatives can offer managers efficient and effective

methods for reducing certain risks through hedging. Derivatives may also be used to reduce financing costs and
to increase the yield of certain assets. For a growing number of banking organizations, derivatives activities are
becoming a direct source of revenue through "market-making" functions, position-taking, and risk arbitrage.
4) Derivatives Used by Individuals: Derivatives allow individuals to hedge risks. This means that they make it
more likely that risks are borne by those best able to bear them. This makes it possible for individuals to take on
more risky projects - with higher promised returns - and hence create more wealth by hedging those risks that
can be hedged. Non-financial firms are most likely to do so to hedge interest rate and currency risks. This leads
to a more productive economy - and to greater economic welfare.

12 a) MTM has to be subtracted from Initial margin, when margin reaches

maintenance margin level, margin call has to be raised.
b) F=Se(r-q)T

13 a ) Call

Options Payoff

The call option payoff are classified into:

Call Options Payof
Payoff of Call Options at Expiration
Payoff of Call Options before Expiration

Payoff of Call Options at Expiration

Since an option buyer is not obliged to exercise an option, when the market price is not favorable to the strike price,
the option buyer does not exercise the contract. However, the option premium that was paid at the time of entering
into the contract will be a loss to the option buyer. Thus, the premium paid becomes the maximum loss that can be
incurred by the option buyer. Theoretically, there is no upper limit to the share price and hence the buyer's profit
potential becomes unlimited. The following figure 3.4 shows the profit/loss profile of a call option at expiry.
Call options
Profit/Loss
Strike Price Break-even price
0

Stock Price

Premium

Figure 3.4: Profit/Loss Profile of a

Call Option at Expiry
At expiry, when an option results in a gross profit, it is said to be 'in-the-money'. In a call option, the gross profit
(intrinsic value) for the share will exist when the strike price is less than the market price. An option contract, for
which there is no gross profit or situations when the option will not be exercised, is said to be 'out of-the-money'. In
a call option, the 'out of-the-money' situation arises when the strike price is greater than the market price. Option
contracts are 'at-the-money' when the market price, is equal to the strike price.

Payoff of Call Options before Expiration

When the option contract expires, its price (premium) is expected to be equal to its intrinsic value (gross profit) if
not for the time value of money. Usually, hence, the premium before expiry will include the intrinsic value and the
time value. The excess of the price of the option over the intrinsic value is known as the time value. When an option

is exercised on the expiry date, only the intrinsic value is realized. Before the expiry date, the seller of an option
obtains a price/ (premium) that incorporates the intrinsic and time value (see Figure 3.5)

Premium

S2 ES) Stock price

(OTM) (ATM)
(ITM)
Figure 3.5
Before the expiry date, when the market price is less than the strike price, the entire premium will be the time value
of money. Time value is at its highest when the option is 'at-the-money'. Time value declines as the option moves
either 'in' or 'out-of-the money' and will approach zero as the market price of the share diverges substantially from
the exercise (strike) price.
Market prices below the exercise price leads to a premium that consists of only time value. However, market value
above the exercise price consists of both time and intrinsic value. This leads to the increase in the premium paid as
market prices rise above the strike price. However, the premium component is mostly the intrinsic value and not the
time value. This is because the buyer of the call option is likely to exercise the calls immediately. The change in the
option premium relative to the change in the market price is called as the gradient and is also known as the option
delta. The delta approaches zero as the option becomes deeply 'out-of-the-money' (extremely low market price) and
approaches one when it is deep 'in-the-money' (extremely high market price). The delta is approximately 0.5 when
the option is 'at-the-money' (equal to the market price).
Explanation with Example
Suppose an investor purchases a call option, with a strike price of $75, and an expiration date in three months. To
acquire this option, the investor pays a premium of $8. When the option expires, what will it be worth? If the
underlying stock price is less than $75 on the expiration date, the option will be worthless. No one would pay
anything for the right to buy this stock for $75 when they can easily buy it for less in the market. What if the stock
price equals $76 on the expiration date? In that case, owning the right to buy the stock at $75 is worth $1, the
difference between the stock's market price and the options exercise price. Ignoring transactions costs, an investor
who owns the option can buy the stock for $75 and immediately sell it in the market for $76, earning a $1 payoff. In
general, the payoff of this option will equal the greater of:
1) So, if the stock price is less than $75 at expiration, or
2) The difference between the stock price and $75, if the stock price is more than $75 at expiration.
The top line in figure 3.6 shows a payoff diagram for the option buyer, or the long position. This picture is a classic
in finance, known as the hockey-stick diagram. It shows that the option, at worst, will be worth $0, and at best, the
options value is unlimited. The lower line in the figure represents the investor's-net payoff. The net payoff line
appears $8 lower than the solid line, reflecting the $8 premium the investor paid to acquire the option. On a net
basis, the holder of the call option makes a profit when the price of the stock exceeds $83.
Call Payoff ($)
75
Payoff
50
Net Payoff
25
0
-8
Stock Price on Expiration Date ($)
2550
Figure 3.6:
Payoff 75100125
of a Call Option83
with X = $75
Option premium

Call Payoff ($)

8
0
25

83
Option Premium
50
75100125

50
75

25

Stock Price on Expiration Pate ($)

Payoff
Net Payoff

The top graph illustrates, from the option buyers' point of view, how a call option's payoff varies as the underlying
stock price changes. The lower graph shows the seller's perspective. The payoff line shows that a call option, with a
strike price of $75, will be worthless on the expiration date, if the stock price is $75, or less. For the buyer, the call's
value rises dollar for dollar with the stock price, as long as the stock is worth more than $75. For the seller, the
payoff fells as the stock price rises above $75. For the seller, the payoff fells as the stock price rises above $75. The
net payoff line reflects the $8 option premium that the call buyer must pay (or that the seller receives). The buyer
and seller break-even when the stock price is $83. At higher stock prices, the buyer earns a net gain at the seller's
expense. At stock prices below $83, the seller realizes a net gain, at me buyer's expense.

b) Put Options Payoff

The put option payoff are classified into:
Put Options Payof
Payoff of Put Options at Expiration
Payoff of Put Options before Expiration

Payoff of Put Options at Expiration

The premium is paid by the buyer of the put option at the time the option is purchased from Profit/Loss the writer.
As with the call option, the buyer of put option is also not obliged to exercise the right to sell the option contract
when the market price is not favorable. When the contract is not enforced, the premium is the
maximum toss the buyer of the option will incur.
The maximum profit is limited for a put option holder since the price cannot be
less than zero. Theoretically, if it is assumed that the market price of the stock falls to
zero, then the gross profit to the put option holder will be the strike price minus zero,

i.e., the strike price. This can never happen in the market. The net gain for the option
holder is the strike price minus the premium paid.
Figure 3.7 explains this situation. When the market price is higher than the strike price, the put option holder incurs
a consistent loss to the extent of the premium paid on the contract. When the market price is below this break-even
price, the put option holder makes a net profit from the trade.
Profit/Loss

Strike Price

Break-even

Stock price

Price
Figure 3.7: Profit Loss at Expiry

Payoff of Put Options before Expiration

At expiry, the put option has only intrinsic value, However, when put options are traded before expiry; the price of
the put option includes the intrinsic value and the time value.
Figure 3.8 includes the profit/loss position of the put holder before the expiry date (dot and dash line). Since
intrinsic value is the gross profit to be made from exercising the put option, it will be zero at or above the strike
price. This is because the put option will not be exercised at or above the strike price. When the market value is
below the strike price the intrinsic value of the put option will be equal to the difference between the stock price and
the strike price. Prior to expiry, the price of an option will tend to differ from its intrinsic value because of the time
value.
As the expiry date nears, the prior-to-expiry profits will tend to move closer to the at-expiry profits. This reflects the
tendency for the time value of an option to decline with the passage of time, i.e., as the expiry date nears.
When the share price exceeds the strike price, the put option is said to be out-of-the-money since the contract will
not be exercised. A better price can be obtained by selling the shares in the market than by exercising the option. The
out of-the-money put contract will reflect only the time value of the option. The time value declines as the option
moves further deep,out-of-the-money (extreme rise in market price). This reflects the decreasing likelihood of the
market price declining at a steeper rate to cause the exercise of the option to become profitable.

Premium

(ITM)

(ATM)

(OTM) Figure 3.8

Similarly, the put option will be in-he-money when the market price is lower than the strike price prior to expiry.
The put option holder is likely to receive profits from exercising the contract at this market price. Here also, time
value declines as the put option reaches a deep in-the-money (market price is near zero) situation. This is because
there is a risk of losing the intrinsic value as time progresses.
The price of an in-the-money put option contains the intrinsic value of that option. The buyer of an in-the-money
option bears this risk, whereas the buyer of an at-the-money put option does not. The risk borne increases as the
option become deeper in-the-money. This risk is reflected in the time value. The buyer of an at-the-money option
pays a higher price for time value than the buyer of an in-the-money option, with the price paid for time value
declining as the option becomes deeper in-the-money.
The slope of the prior-to-expiry profit line is known as the delta and represents the ratio between the change in the
price of the put option and the change in the market price of the share. In the case of put options, deltas are negative.
The delta increases in absolute value as the option moves deeper-in-the-money (falling market price). This means
that the delta approaches -1 when a put option becomes very deep in-the-money.
Explanation with Example
Figure 3.9 shows payoffs for put option buyers (long) and sellers (short). It is maintain the assumption that the
strike price equals $75, but, in this figure, the option premium is $7. For an investor holding a put option, the payoff
rises as the stock price falls below the option's strike price. However, unlike a call option, a put option's potential
gains are limited by a stock price that cannot fall below zero (because the law provides limited
Payoff to Buyers
Put Payoff ($)
75
65

Payoff
Net Payoff

50
25

0
-7

75100125
2550150
68Option Premium

Stock Price on Expiration Date ($)

Figure 3.9: Payoff of a Put Option with x = $75
Payoff to Sellers
Put Payoff ($)
7
0
- 25
- 50
- 68
-75

68

255075100125150

Payoff
Net Payoff

Stock Price on Expiration Date ($)

The top graph illustrates, from the option buyers' point of view, how a put option's payoff varies as the underlying
stock price changes. The lower graph shows the seller's perspective. The payoff line shows that a put option, with a
strike price of $75, will be worthless on the expiration date, if the stock price is $75 or more. For the buyer, the put's
value rises as the stock price falls, as long as the stock is worth less than $75. For me seller, the payoff falls as the
stock price falls below $75. The net payoff fine reflects the $7 option premium that the put buyer must pay (or that
the seller receives). The buyer and seller break-even when the stock price is $68. At higher stock prices, the seller
earns a net gain at the buyer's expense. At stock prices below $68, the buyer realizes a net gain, at the seller's
expense.

14 . a)

Meaning of Interest Rate Swaps

An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a series of interest
payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to
pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the "notional
principal"; the second party promises to pay to the first at the same intervals a floating amount of interest on the
notional principle calculated according to a floating-rate index.
The first party in a fixed/floating rate swap, that which pays the fixed amount of interest, is known as the fixed-rate
payer, while the second party, that which pays the fixed amount of interest, is known as the floating-rate payer. The
notional principal is simply a reference amount against which the interest is calculated
Interest rate swaps can be used to take on fresh interest rate risk as well as to manage existing interest rate risk.
Interest Rate swaps without offsetting underlying create interest rate risk. Each counter party in an interest rate swap
is committed to pay a stream of interest payments and receive a different stream of interest payments. A payer of
fixed interest rate payments is exposed to the risk of falling interest rates, while a payer of floating interest rate
payments is exposed to the risk of rising interest rates. Similarly, a receiver of fixed interest rate payments is
exposed to the risk of rising interest rates, while the receiver of floating interest payments is exposed to the risk of
falling interest rates. In conclusion, interest rate swaps create an exposure to interest rate movements, if not offset by
an underlying exposure.

Types of Interest Rate Swaps

Following are the types of interest rate swaps:
Types of Interest Rate Swaps
Plain Vanilla Swap
Alternative Floating Rate
Forward Swap

Zero Coupons to Floating

Floating-to-Floating
Rate-Capped Swap

1) Plain Vanilla Swap: Plain vanilla swap is also known as fixed-for-floating swap. In this swap, one party
with a floating interest rate liability is exchanged with fixed rate liability. Usually swap period ranges from
2 years to over 15 years for a predetermined notional principal amount. Most of deals occur within four
years period.
2) Zero Coupons to Floating: The holders of zero-coupon bonds get the full amount of loan and interest
accrued at the maturity of the bond. Hence, in this swap, the fixed rate player makes a bullet payment at
the end and floating rate player makes the periodic payment throughout the swap period.

3) Alternative Floating Rate: In this type of swap, the floating reference can be switched to other
alternatives as per the requirement of the counter-party. These alternatives include three-month LIBOR,
one-month commercial paper (which refers to the Federal Reserve release), T-Bill rate, etc. In other words,
alternative floating interest rates are charged in order to meet the exposure of other party.
4) Floating-to-Floating: In this swap, one counter-party pays one floating rate, such as, LIBOR while the
other counter-party pays another, such as, prime for a specified time period. These swap deals are mainly
used by the non-US banks to manage their dollar exposure.
5) Forward Swap: this swap an exchange of interest rate payment that does not begin until a specified future
point in time. It is also kind of swap involving fixed for floating interest rate.
6) Rate-Capped Swap: in this type of swap, there is exchange of fixed rate payments for floating rate
payments, whereby the floating rate payments are capped. An upfront fee is paid by floating rate party to
fixed rate party for the cap.

Mechanics of Interest Rate Swaps

Upon determining that an interest rate swap would be a prudent financial decision, an entity employs a swap dealer
to arrange the terms of the swap. The party with the outstanding floating rate debt seeks the lowest possible fixed
rate. Other factors, such as the financial strength of the dealer and the counterparty, also are considered at this time.
The counterpartys floating rate usually is determined using an index.
Once these parties agree to the terms arranged by the swap dealer, they must enter into a International Swap Dealer
Association (ISDA) Master Agreement and Certification.
This certification assures that the entity has the legal authority to enter into the swap. The length of the swap is also
determined at this time and is usually one to ten years. After agreement upon the terms, the parties are ready to
enter into an interest rate swap. Interest payments and determined on a monthly, semi-annual, or annual basis.
FR + 2%

Fin A

Swap
Dealer 12%

FR +

Swap
Dealer

Fin B
12%

12%

12%

FRHouse
+
Building
Societies

FR + 1%

Deposito

Fin A

Borrowe

Part III: Joining the two parts - The Combined Swap

Deposito

Swap
Dealer
FR + 12%

12%

12%

Fin B
FR +

12%

FR + 1%

House
Building
Societies

Deposito

FR +

12%

Borrowe

Deposito

Future 4.2: Mechanics of Interest Rate Swap

In this Swap there is: I) Ensured Profit to Fin A = 1%, II) Ensured Profit to Fin B = 0.10%,
III) Ensured Profit to Swap Dealer = 0.15%

b)

Meaning of Currency Swaps

Currency swaps are derivative products that help to manage exchange rate and interest rate exposure on long-term
liabilities. A currency swap involves exchange of interest payments denominated in two different currencies for a
specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed rate, or a
floating rate indexed to some reference rate, like the LIBOR.
In a typical currency swap, counterparties will perform the following:
4) Exchange equal initial principal amounts of two currencies at the spot exchange rate,
5) Exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period
of the swap, and then,
6) Re-exchange the principal amount at maturity at the initial spot exchange rate.
The currency swap provides a mechanism for shifting a loan from one currency to another, or shifting the currency
of an asset. It can be used, for example, to enable a company to borrow in a currency different from the currency it
needs for its operations, and to receive protection from exchange rate changes with respect to the loan.

Types of Currency Swaps

Following are the types of currency swaps:

Types of Currency Swaps

Fixed Rate Currency Swap

Currency Coupon Swap

Diff Swap

1) Fixed Rate Currency Swap: A fixed rate currency swap consists of the exchange between two counter-parties of
fixed rate interest in one currency in return for fixed rate interest in another currency.
i) Fixed-to-Fixed Currency Swap: In this category, the currencies are exchanged at fixed rate. This swap
works like this. One firm raises a fixed rate liability in currency X, for example, US dollar ($) while the
other firm raises fixed rate funding in currency Y, for example, Pound (). The principal amounts are
equivalent at the current market rate of exchange. In swap deal, first party will get pound whereas the
second party gets dollars. Subsequently, the first party will make periodic (pound) payments to the second,
in turn gets dollars computed at interest at a fixed rate on the respective principal amount of both
currencies. At maturity, the dollar and pound principal are re-exchanged.
ii) Fixed-to-Floating Currency Swaps: This swap is a combination of a fixed-to-fixed currency swap and
floating swap. In this, one party makes the payment at a fixed rate in currency, for example, X while the
other party makes the payment at a floating rate in currency, for example, Y. Contracts without the
exchange and re-exchange of principals do exist. In most cases, a financial intermediary (a swap bank)
structures the swaps deal and routes the payments from one party to other party.
2) Currency Coupon Swap: The currency coupon swap is a combination of the interest rate swap and the
fixed-rate currency swap. Currency swap involves exchange of affixed rate obligation in one currency for a
floating rate obligation in another currency. This is known as 'Fixed to Floating Currency Swap', or
'Circus Swap', or 'Currency Coupon Swap'.
The most important currencies in the currency swap market are the US Dollar, the Swiss Franc, the Deutsche
Mark, the ECU, the Sterling Pound, the Canadian Dollar and the Japanese Yen. The currency swap is an
important tool to manage currency exposures and cost benefits at the same time. These are often used to provide
long-term financing in foreign currencies. This function is important because in many foreign countries, longterm capital and forward foreign exchange markets are notably absent or not well developed. However, if the

international financial markets were fully developed from all the angles then the incentive to swap would be not
so much due to availability of arbitrage opportunities.
3) Diff Swap: Another Variation of the swap family is the differential swap also commonly known as
differential swap or quanto swap. This product was first developed in the early nineties in order to suit
the needs of customers who had strong views on the spread between interest rates in different countries.
For example, the treasurer of company A, a US based company, gets today's market
data for US and Japan's yield curves. He thinks that due to the strong growth in the
US economy relative to Japan's, the US interest rates are likely to rise faster than
what the market suggests now, i.e. the spread between US interest rates and Japan
interest
rates
would
widen
even
further
than
today's
prediction.

Using Currency Swap

Manage Currency Risk

Following are the ways by which currency risk is managed by currency swaps:
1) Using Currency Swaps to Lower Borrowing Costs in Foreign Country
2) Using Currency Swaps to Hedge against Risk of a Decline in Revenue
3) Using Currency Swaps to Hedge against the Risk of an Increase in Cost
4) Using Currency Swaps to Hedge against the Risk of a Decline in the Value of an Asset
5) Using Currency Swap to Hedge against the Risk of a Rise in the Value of Liability

Using Currency Swap to Manage Currency Risk

To Lower Borrowing Costs in Foreign Country

To Hedge against Risk of a Decline in Revenue
To Hedge against the Risk of an increase in Cost
To Hedge against the Risk of a Decline in the Value of an Asset

To Hedge against the Risk of a Rise in the Value of Liability

Using Currency Swaps to Lower Borrowing Costs in Foreign Country

Interest rate swaps can be mutually beneficial if there is a comparative advantage for the two parties in one market
over another. The rationale for currency swaps is similar: one party has a comparative advantage in borrowing in one
currency while another has an advantage in the other.
For example, suppose a prominent Indian company (say, TISCO) wants to raise funds in the USA. At the same
time, a prominent American company, say, Jacobs Engineering wants to borrow in Indian rupees for a project in
India. TISCO, though a blue chip in India, may not be well known in the US debt market and would therefore have
to pay a higher rate of interest than its credentials would otherwise warrant. Similarly, Jacobs Engineering may not
receive a rate of interest in India that truly reflects its credit rating because of the obscurity of the 'name' in India.
It would be beneficial to both companies if TISCO borrows in rupees, Jacobs in dollars and the two then swap the
liabilities.
Sometimes, comparative advantage could run in the opposite direction. A British company might have already
borrowed heavily in the sterling bond market. As a result, the market may demand a premium on further borrowings,
as they would not prefer a concentration of holdings in one company. On the other hand, say because it is a well
known multinational, it may be able to raise funds relatively cheap in the Indian rupee debt market because it has no
previous exposure.

Using Currency Swaps to Hedge against Risk of a Decline in Revenue

Consider U.S. Apple, a U.S.-based firm that exports apples and sells them for yen in Japan. An abbreviated form of
its income statement is:
Revenues = P * Q Expenses
=

Expense
Operating Income

Where,
P = Price, the firm receives for the apples it sells in Japan (),
Q = quantity of apples it sells in Japan, and expenses are in U.S. dollars.
The goal of U.S. Apple is to maximize its dollar profits - typical for a U.S.-based firm. U.S. Apple is exposed to the
risk that the $/ exchange rate will fall, If the $/ declines, the dollar value of the firm's yen revenues will be less,
and its dollar profits will be less.
U.S. Apple can use a fixed-for-fixed currency swap to hedge its risk exposure. It can estimate its yen-denominated
revenues for the next several years, and agree to pay fixed yen and receive fixed U.S. dollars in each of the next
several years.
U.S. Apple will still be exposed to the risk of fluctuation in the quantity of apples it sells in Japan. The number of
apples it can sell in Japan, will vary as its crop size (in the United States) varies, as the selling price of apples grown
and sold in Japan varies, as the prices of other competing fruits in Japan varies, as import/export laws change, and as
tastes change in Japan.

Using Currency Swaps to Hedge against the Risk of an Increase in Cost

Chocoswiss is a Swiss manufacturer of liqueur-filled chocolates. It must import all its liqueurs from France, and it
pays for the liqueurs in euros. However, it sells its product in Switzerland only Chocoswiss want to maximize its
profits, which are denominated in Swiss Francs (SFR). An abbreviated version of Chocoswiss' income statement is:
Revenues = (in SFR)
=

Expense (a signigicant portion iseuros)

Operation Income

Chocoswiss faces the risk that the SFR/ will rise. If the SFR/ rate rises, then the SFR cost of its imports will rise.
As costs rise (denominated in SFR), SFR-denominated profits for Chocoswiss will decline. To hedge its currency
risk exposure, Chocoswiss can use a fixed-for-fixed currency swap in which it pays SFR and receives euros. There is
no need to exchange principal amounts.

Using Currency Swaps to Hedge against the Risk of a Decline in the Value of an
Asset
Suppose a U.S. company has a three-year 50 million investment (an asset) that yields 7% annually (in GBP) and
pays interest twice per year. The current exchange rate is $1.60/. The U.S. corporate treasurer thinks that the dollar
will strengthen against the pound sterling. Equivalently, this means that the dollar value of the GBP will decline (the
$/ exchange rate will decline), which means that the dollar value of any GBP-denominated assets will decline.
If the treasurer is correct, each future interest inflow of 1,750,000 will purchase less than $2,800,000. For example,
if the exchange rate is $1.50/, the interest payment of 1,750,000 will purchase only $2,625,000. However, because
the current three-year interest rate in the United States is 7.40%, the treasurer does not want to swap each subsequent
interest payment 1,750,000 for only $2,800,000. Not only will the decline in the value of the GBP mean that the
value of the interest rates will be less, but the dollar value of the U.S. firm's investment decline, too.
The treasurer finds a swap dealer willing to swap interest payments each six month 1,750,000 for $2,940,000 over
the next three years. In addition, there will be a final swap of 50 million for $80 million. Under this swap, the U. S.
company has transformed its three-year 50 million investment that yields 7% into a three-year $80 million
investment that yields 7.35%.
For example, consider a Japanese company that owns some real estate in the United States; i.e., the Japanese
company has a dollar-denominated asset. If the /$ exchange rate declines, the value of this asset, in yen, will

decline. To hedge, the Japanese company car buy yen futures or forwards. Alternatively, the Japanese company can
enter into a swap paying dollars and receiving yen.

Using Currency Swap to Hedge against the Risk of a Rise in the Value of
Liability
If the value of a firm's liability rises and its asset values remain unchanged, it follows that the value of the firm's
stock must decline. This must be the case because:
Assets = Liabilities + Owners Equity.
Suppose a U.S. company has a two-year debt (a liability) of 100,000,000 at 7.7% annually and interest is paid
quarterly. The current exchange rate is 0.9720/$. The U.S. corporate treasurer's staff is predicting that the dollar
will weaken against the euro (i.e., the /$ exchange rate will fall). This is equivalent to predicting that the $/ rate
will rise. If the dollar price of the euro rises, then the dollar-denominated value of this firm's liability will rise.
If the staff is correct, each future interest payment of 1,925,000 will cost more than $1,980,453. For example, if
the exchange rate changes to 0.9400/$, the interest payment of 1,925,000 will cost the firm $2,047,872.
The treasurer finds a swap dealer willing to swap quarterly cash flows of 1,925,000 for $2,004,750 over the next
two years. In addition, there will be a final swap of 100,000,000 for $102,880,658. Under this swap, the U.S.
company has transformed its two-year 7.7% debt for 100,000,000 into a 2-year $102,880,658 debt with an interest
rate of 7.79%.

Valuation of Currency Swaps

The swap can be valued as the difference between the current values of two conventional bonds. The technique used
for valuation of currency swap is just synonymous to valuation of interest rate swap. Here, the value of a foreign
currency bond, and the corresponding value of a domestic currency bond would be taken into consideration which
are as under:
V = SBtCH(T)-St
Where,
V = Value of the swap,
S = Current exchange rate (expressed as number of units of domestic currency per unit offoreign currency),
BtCH (T) - Value in (foreign currency) of the foreign currency bond
St = Value of local currency bond underlying the swap.
In simple term, the Value of currency swap can be determined from the term structure of interest rates in domestic
currency, the term structure of interests in the foreign currency and the spot exchange rate.
Calculation of BtCH(T): The bond equivalent to the foreign currency interest flows has the value as shown in the
following equation:
n

CH
t

B (T)=

F
i i

K F er t
i=1

+Q

er

F
n n

where, KF = Constant foreign currency interest payment,

rFi = The foreign currency discount rate,
ti = Corresponding periods to the interest payments and
Q = The principal sum in foreign currency.
Calculation of St: The bond equivalent to the domestic currency cash flow is determined as shown in the following
equation:
n

St =

K
i=1

er

D
i i

+ S

er

D
n n

where, KD = Constant foreign currency interest payment,

riD = Discount rates for the various periods to cash flows,
ti = Length of those periods to cash flows,
S' = Exchange rate at the time that the swap was agreed and

Q = Foreign currency principal sum converted into the equivalent domestic currency principal sum.
15 a) refer previous question paper
b) SEBI set-up a 24-raember committee under the Chairmanship of Dr. L.C. Gupta to develop the appropriate
regulatory framework for derivatives trading in India. On May 11, 1998 SEBI accepted the recommendations of the
committee and approved the phased introduction of derivatives trading in India beginning with stock index futures.
The provisions in the SC(R)A and the regulatory framework developed thereunder govern trading in securities. The
amendment of the SC(R)A to include derivatives within the ambit of 'securities' in the SC(R)A made trading in
derivatives possible within the framework of that Act. .

Regulatory Framework of Derivative Market

The futures and options markets, like the securities markets, are essential to economic growth and prosperity of an
economy. These markets play a significant role in the efficient allocation of the resources of a country. No doubt,
therefore, futures and options exchanges (and over-the-counter derivatives markets) are integral parts of virtually all
economics which have reached an advanced stage of development. Due to the economic significance of the
derivatives markets, their integrity is a matter of public interest. It is imperative, therefore, that such markets be
properly regulated.
Market integrity and efficiency, financial safety and customer protection being vital to the success of any financial
market, the regulators should strive to make securities and derivatives markets fair, transparent and orderly to instill
investor's confidence into them. For this, it is necessary to regulate trading, devise controls to prohibit manipulative
or fraudulent conduct, establish high standards for market intermediaries, and to vigorously enforce rules and
regulations. A lack or inadequacy of measures against manipulation, fraud and improper activities is likely to lead to
market abuse resulting in inefficient markets, higher transactional and systemic costs, losses to investors* and loss
of investor confidence in the market. It is imperative, therefore, that such markets be properly regulated so that they
can be viewed by investors, present and potential, to be fair and transparent.
An effective regulatory framework calls for ensuring:
1) A mechanism for imposing responsibility and accountability on market operators and intermediaries like
exchanges, brokers, clearing, and settlement agents;
2) A mechanism for monitoring compliance with the laws and rules governing the transactions; and
3) An effective system for enforcing laws and regulations of the exchanges and other market intermediaries
governing operations in these markets.
To meet the desired goals of regulation, it is necessary to ensure the following:
1) The derivatives products to be traded should be carefully designed to meet the requirements of customers.
For example, while designing a contract on the stock index, consideration should be given to the method
of calculation of the index, the number of stocks to be included in the index, the variation in stock prices,
replacement of constituent stocks in the index, and the 'multiplier' to determine the value of a futures
contract.
2) The rules regarding fair and efficient execution of orders should be stated clearly and enforced consistently.
3) Constant scrutiny of trading should be done so as to identify any manipulative behavior.
4) The exchanges should develop enough capacity in terms of manpower and technology to take on large trade
volumes.
5) The exchanges should have enough powers to appropriately punish erring participants.
6) Appropriate capital adequacy norms should be set and implemented.
7) An adequate margining system should be in place, because it is the margins which underlie the safety provided
by the clearing house. Margins should neither be too high (making entering into derivatives trading too costly) nor
should they be too low (making the risk of default to be high). The marking-to-the-market of margins should be
done to ensure financial integrity.
8) Although marking-to-market margins provide protection of the financial integrity of the system against price
volatility, additional measures may sometimes be needed in the face of abnormal volatility or market disruption
characterized by rapid market declines that threaten to create panic or disorderly market conditions. To meet such
contingencies, adequate measures need to be taken. They include circuit breakers -trading halt in the cash market
and a corresponding halt in the derivatives market -and setting of price limits.
9) The rules establishing the priorities by which orders may be executed should be clearly laid and properly
enforced in order to ensure fairness and to prevent fraud.
10) Proper records must be kept for a sufficiently long period of time to enable checking, at any time, on whether
the proper execution rules have been followed.

11) Appropriate fora should be provided for customers to settle disputes, if any, in trading.

SEBI Guidelines for Derivative Trading

In India, following are the major SEBI regulations for trading of derivatives:
1) Any exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee report may apply to
SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives
exchange/segment should have a separate governing council and representation of trading/clearing members
shall be limited to a maximum of 40% of the total members of the governing council. The exchange shall
regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any
derivative contract.
2) The exchange shall have minimum 50 members.
3) The members of an existing segment of the exchange will not automatically became the members of derivative
segment. The members of the derivative segment need to fulfill the eligibility conditions as laid down by the
L.C. Gupta committee.
4) The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house.
5) Derivative brokers/dealers and clearing members are required to seek registry SEBI. This is in addition to their
registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the
derivatives clearing corporation/house shall be 300 lakh. The networth of the member shall be computed as
follows:
Capital + Free reserves - non-allowable assets
non allowable assets are as follows:
x) Fixed assets;
xi) Pledged securities;
xii) Member's card;
xiii) Non-allowable securities (unlisted securities);
xiv) Bad deliveries;
xv) Doubtful debts and advances;
xvi) Prepaid expenses;
xvii)
Intangible assets;
xviii) 30% marketable securities.
15) The minimum contract value shall not be less than 2 lakh. Exchanges should also submit details of the
futures contract they propose to introduce.
16) The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to
the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.
17) The L.C.Gupta committee report requires strict enforcement of "Know your customer" rule and requires
that every client shall be registered with the derivatives broker. The members of the derivatives segment
are also required to make their clients aware of the risks involved in derivatives trading by issuing to the
client the Risk Disclosure Document and obtain a copy of the same duly signed by the client.
18) Derivative trading to take place through an online screen-based Trading System.
19) The Derivatives Exchange/Segment shall have online surveillance capability to monitor positions, prices,
and volumes on a real-time basis so as to deter market manipulation.
20) The Derivatives Exchange/Segment should have arrangements for dissemination of information about
trades, quantities, and quotes oh a real-time basis through atleast two information vending networks, which
are easily accessible to investors across the country.
21) The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism
operative from all the four areas/regions of the country.
22) The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and
preventing irregularities in trading.
23) The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
22) The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall
interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should
provide an unconditional guarantee for settlement of all trades.
23) The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both
derivatives market and the underlying securities market for those Members who are participating in both.

24)

The level of initial margin on Index Futures Contracts shall be related to the risk of loss on me position.
The concept of level of initial margins. The initial margins should be large enough to cover the one-day loss that
can be encountered on the position on 99% of the day s.
25) The Clearing Corporation/House shall establish facilities for Electronic Funds Transfer (EFT) for swift
movement of margin payments.
26) In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer
client positions and assets to another solvent Member or close-out all open positions.
27) The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing
Members for trades on their own account and on account of his client. The Clearing Corporation/House shall
hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any
other purpose.
28) The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on
Derivative Exchange/Segment.
21) Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of
NSE.

RBI Guidelines for Derivative Trading

1)
2)
3)
4)
5)
6)
7)
8)

Reserve Bank of India set-up a committee under the Chairmanship of R.V. Gupta to review 'Hedging' through
International Commodity Exchanges and other related issues. The committee's main recommendations were as
follows:
All the Indian companies with genuine commodity price risk exposures be allowed to hedge through off shore
commodity futures and option markets.
The Central Government should grant permission for such hedging transactions and the RBI should grant the
necessary exchange control permission.
Only hedging contracts for genuine price exposure through international markets should be allowed and not the
speculative or profit seeking objectives.
OTC instruments like vanilla swaps would only be permitted where they have only efficient means of hedging.
Use of options would not be allowed.
The committee recommended a phased manner approach.
In Phase-1, the hedging should ordinarily be through exchange traded commodity futures.
Phase-I, would be a period of acclimatization. At this stage prior approval would be required:
i) To ensure existence of genuine underlying risk,
ii) The appropriateness of the hedging instrument, and
iii) Adequateness of risk management procedures.
9) In Phase-II, no prior approval, as recommended in Phased should be needed. Only periodic scrutiny of actual
transactions and auditor's certification adequacy of control are sufficient.
10) The committee further recommends that hedging should be allowed through foreign^ derivatives markets.
However, the futures markets experts observed that due to lack of experience of the Indian corporate sector
regarding the functioning of international commodity derivatives and inadequate experience amongst auditors, a
longer 'acclimatization' period of atleast three years is desirable instead of one year as recommended by the
committee.

Committees on Derivative Markets

The Government of India appointed various committees at various time to go into the regulatory framework of
futures trading in the country. In 1950, the Indian Government appointed the A.D. Shroff Committee whose report
formed the basis of the Forward Contracts (Regulations) Act, 1952. In 1966, the M.L. Dantwala Committee
reviewed the SCR Act and the functioning of the Forward Markets Commission and made certain recommendation.
In 1979, the A.M. Khusro Committee was set-up to further review the functioning of forward markets and FMC
Further, in 1993, the Indian Government constituted the committee named, K.N. Kabra Committee, which submitted
its report in September, 1994 with the following major recommendation:
1) Kabra Committee Recommendations (1994)
i) The commodity exchanges should enroll more members,
ii) Capital adequacy norms must be ensured for smooth functioning.
iii) The commodity exchanges should be computerized so that online trading be ensured.
iv) Internal vigilance mechanism of the exchanges should be strengthened.

v) Non-transferable specific delivery forward contracts should be freed from restrictions.

vi) Options and range forward contracts may be introduced. However, this was not agreed by the Chairman of the
committee.
vii) The exchange should be recognized on permanent basis.
viii)
The exchanges should be developed into self-regulatory organizations.
ix) The Forward Markets Commission should be strengthened with more powers.
x) More commodities should be included in futures trading like basmati rice, cotton seed, ground nut, rapeseed,
linseed, copra, sesame seed, mustard seed, soyabean, etc.
2) Sodhani Expert Group Recommendations (1994): The forward contracts and options on foreign exchange are
conducted through the Over-The-Counter (OTC) markets and regulated by the Reserve Bank of India. In
November, 1994, the RBI constituted a committee under the headship of O.P. Sodhani on foreign exchange
markets functioning. The committee's main recommendations were as follows:
i) The companies should be given permission to book, cancel, and re-book options on foreign currencies.
ii) Banks should offer range forward contracts. .
iii) There should be no withholding taxes on derivatives transactions.
iv) More liberty should be given to banks to use derivatives.
v) More derivative instruments like caps, dollars, floors, FRAs, swaps should be allowed to offer by the
banks to the traders without the approval of RBI.
vi) Different specific dealers should be allowed to offer derivative instruments.
vii) Proper documentation and market practices should be evolved for better functioning of the markets.
3) R.V. Gupta Committee's Recommendations (1997): Reserve Bank of India set-up a committee under the
Chairmanship of R.V. Gupta to review 'Hedging' through International Commodity Exchanges and other related
issues. The committee's main recommendations were as follows:
i) All the Indian companies with genuine commodity price risk exposures be allowed to hedge through off
shore commodity futures and option markets.
ii) The Central Government should grant permission for such hedging transactions and the RBI should grant
the necessary exchange control permission.
iii) Only hedging contracts for genuine price exposure through international markets should be allowed and
not the speculative or profit seeking objectives.
iv) OTC instruments like vanilla swaps would only be permitted where they have only efficient means of
hedging.
v) Use of options would not be allowed.
vi) The committee recommended a phased manner approach.
vi) In Phase-I, the hedging should ordinarily be through exchange traded commodity futures.
vii) Phase-l would be a period of acclimatization. At this stage prior approval would be required:
a) To ensure existence of genuine underlying risk,
b) The appropriateness of the hedging instrument, and
c) Adequateness of risk management procedures.
ix) In Phase-Il, no prior approval, as recommended in Phase-I should be needed. Only periodic scrutiny of
actual transactions and auditor's certification adequacy of control are sufficient.
x) The committee further recommends that hedging should be allowed through foreign derivatives markets.
However, the futures markets experts observed that due to lack of experience of the Indian corporate
sector regarding the functioning of international commodity derivatives and inadequate experience
amongst auditors, a longer 'acclimatization' period of atleast three years is desirable instead of one year as
recommended by the committee.
4) Dr. L.C. Gupta Committee Report (1998): In November, 1996 this SEBI set-up a committee under the
Chairmanship of Dr. L.C. Gupta to develop in appropriate regulatory framework for derivatives trading in India.
Subsequently, the SEBI appointed J R. Varma Committee to look into the operational aspects of derivative
markets. As a result in 2000, the SEBI allowed derivatives trading in India with certain regulatory requirements.

Forward Market Commission

Established in 1953 under the provisions of the Forward Contracts (Regulation) Act, 1952, it consists of two to four
members, ail appointed by the Indian Government! Currently, the Commission allows commodity trading in 22
exchanges in India, of which three are national.

Uniquely the FMC falls under the Ministry of Consumer Affairs, Food and Public Distribution and not the Finance
Ministry as in most countries. This is because futures, traded in India, are traditionally on food commodities.
However, this has been changing and there have been calls for change in the industry and in regulation. One
proposal is the merging the commodities derivatives and securities regulation by including the Forward Market
Commission within the Securities and Exchange Board of India (SEBI), the primary securities regulator in India.
However, as of2003 there is no clear consensus for this move.
This was set-up under the Forward Contracts (Regulation) Act, 1952. It is responsible for regulating and promoting
futures/forward trade in commodities. The forward markets commission's Head Quarters is located at Mumbai and
regional office at Kolkata.
Responsibilities and Functions
The functions of the forward markets commission are as follows:
1) To advice the Central Government in respect of the recognition or the withdrawal of recognition from any
association or in respect of any other matter arising out of the administration of the Forward Contracts
(Regulation) Act 1952.
2) To keep forward markets under observation and to take such action in relation to them, as it may consider
necessary, in exercise of the powers assigned to it by or under the Act.
3) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading
conditions in respect of goods to which any of the provisions of the Act is made applicable, including
information regarding supply, demand and prices, and to submit to the Central Government, periodical
reports on the working of forward markets relating to such goods.
4) To make recommendations generally with a view to improving the organization and working of forward
markets.
5) To undertake the inspection of the accounts and other documents of any recognized association or
registered association or any member of such association, whenever it considers it necessary.
It allows futures trading in 23 Fibers and Manufacturers, 15 spices, 44 edible oils, 6 pulses, 4 energy products, single
vegetable, 20 metal futures, and 33 others Futures. The Forward Markets Commission (FMC) is the chief regulator
of forwards and futures markets in India. As of March 2009, it regulates ?52 Trillion worth of commodity trade in
India. It is headquartered in Mumbai and is overseen by the Ministry of Consumer Affairs, Food and Public
Distribution, Government of India.