1. Derivative Markets
Financial Derivatives - 2

2. Introduction:
• The market can be divided into two:
exchange-traded derivatives
over-the-counter derivatives
Difference in 
Legal nature of the products
the way they are traded
Similarity 
Market participants

3. Importance
• Volume of transactions
• Lower transaction cost
• Risks
• Increased liquidity to investors
• Faster execution of transactions
• Enhance price discovery
• Transfer of risk
• Increase saving and investments in economy

4. Participants :
• Major Participants 
1. Hedgers
2. Speculators
3. Arbitrageurs
4. Spreaders

5. Hedgers
• Traders, who wish to protect themselves from the risk involved in price
movements, participate in the derivatives market.
They try to hedge the price of their assets by undertaking an exact opposite trade
in the derivatives market. Thus, they pass on this risk to those who are willing to
bear it.
They are so keen to rid themselves of the uncertainty associated with price
movements that they may even be ready to do so at a predetermined cost.
• For example,
No.of shares 200
Buying price  90/-
Market price  110/-
Goal  Sell after 6 months
Minimum expectation  100/- AND Must get the benefit “IF” price increases
By paying a small price, you can purchase a derivative contract called an 'option'
that incorporates all your above requirements. This way, you reduce your losses,
and benefit, whether or not the share price falls. You are, thus, hedging your risks,
and transferring them to someone who is willing to take these risks.

6. Speculator
Some might be averse to risk, while some people embrace them. This is because, the basic market idea is
that risk and return always go hand in hand. Higher the risk, greater is the chance of high returns. Then
again, while you believe that the market will go up, there will be people who feel that it will fall. These
differences in risk profile and market views distinguish hedgers from speculators. Speculators, unlike
hedgers, look for opportunities to take on risk in the hope of making returns.
• Example:
No. Of shares  200 Will the price drop after 1 month?
In the derivative market, there will be a speculator who expects the market to rise. Accordingly, he will
enter into an agreement with you stating that he will buy shares from you at Rs. 100 if the price falls below
that amount. In return for giving you relief from this risk, he wants to be paid a small compensation. This
way, he earns the compensation even if the price does not fall and you wish to continue holding your stock.
Types:
• Scalpers are a type of short-term trader that may dart in and out of a stock or other asset class dozens, or in some
cases hundreds, of times per day.
• Day trader tries to take advantage of intra-day fluctuations in prices. All their trades are settled by undertaking an
opposite trade by the end of the day. They do not have any overnight exposure to the markets.
• Position traders greatly rely on news, tips and technical analysis – the science of predicting trends and prices, and
take a longer view, say a few weeks or a month in order to realize better profits. They take and carry position for
overnight or a long term.
• Margin traders: Many speculators trade using of the payment mechanism unique to the derivative markets. This is
called margin trading. When you trade in derivative products, you are not required to pay the total value of your
position up front. . Instead, you are only required to deposit only a fraction of the total sum called margin.[Settlement]

7. Arbitrageur
• Arbitrageurs exploit the imperfections and inefficiencies in two different
markets to their advantage. Arbitrage trade is a low-risk trade, where a
simultaneous purchase of securities is done in one market and a
corresponding sale is carried out in another market. These are done when
the same securities are being quoted at different prices in two markets.
• Example, suppose the cash market price is Rs. 1000 per share, but is
quoting at Rs. 1010 in the futures market. An arbitrageur would purchase
100 shares at Rs. 1000 in the cash market and simultaneously, sell 100
shares at Rs. 1010 per share in the futures market, thereby making a profit
of Rs. 10 per share

8. Spreaders
• A spread is defined as the sale of one or more futures contracts and
the purchase of one or more offsetting futures contracts. A spread
tracks the difference between the price of whatever it is you are long and
whatever it is you are short. Therefore the risk changes from that of price
fluctuation to that of the difference between the two sides of the spread.
• The spreader is a trader who positions himself between the speculator and
the hedger. Rather than take the risk of excessive price fluctuation, he
assumes the risk in the difference between two different trading months of
the same futures, the difference between two related futures contracts in
different markets etc.
• Believes in lower expected return at the reduced risk

10. Growth of
Derivatives -
Factors
• Price Volatility – Rapid changes – Speed,
Frequency, Magnitude - RISK
• Globalisation of markets – Increased market
size – Competition - RISK
• Technological development - Automation,
data visualisation, and AI -Increased efficiency,
Reduction of operational risks, Reduction of
costs, More transparency, Increased pricing
quality, Speed of services
• Advancement in financial theories
• Development of sophisticated risk
management tools

11. In India
• External Factors
- Price volatility
- Globalisation of markets
- Technological advances
- Regulatory changes
• Internal Factors
- Liquidity needs
- Risk aversion
- Risk executives

12. Stock market derivatives in India
• Index Futures
• Stock Futures
• Index Options
• Stock Options
- BSE and NSE
• Derivatives – Commodity, Interest rate, Currency, Credit, Weather

13. Regulatory
Framework for
Derivatives Trading
in India
• Securities Laws (Amendment) Ordinance 1995  Withdrew
prohibition on options in securities  No expected impact  No
regulatory framework to govern trading of derivatives
• SEBI 
• Dr. L.C. Gupta Committee (24 member)on 18 November 1996 
17 March 1998
- Declare derivatives as securities  Same rules for securities
• Prof. J.R.Sharma committee, June 1998  To recommend
measures for risk containment  October 1998
- Operational details  margin trading, Methodology for charging
initial margins, broker networth, deposit requirement, Real-time
monitoring requirements
• Amendment of SCRA on December 1999  Included derivatives
 Legal & valid only if traded on a recognised stock exchange
• Rescission of notification prohibiting forward trading on March
2000

14. • Commencement of derivative trading on June 2000
• NSE, BSE and their clearing houses
• Index futures, Index options (June 2001), Options on individual securities(July
2001), Futures on individual stocks (November 2001)
• Trading & settlement in derivatives contract  Rules, Bye-laws, Regulations
of respective stock exchange, clearing houses  Approval by SEBI (Notified
in official gazette)
Continued...

15. Major regulations for trading
of derivatives
1. Exchange
• Fulfil eligibility criteria
• Apply to SEBI for grant of recognition
• Separate exchange/segment with its own governing council Maximum 40% trading/clearing
members
• Regulate sales practices
• Trading in new derivative contracts  Prior approval of SEBI
2. No. of. Members  Minimum 50
3. No automatic membership(Exchange members)  Fulfil eligibility conditions(L.C.Gupta
Committee)
4. Clearing and settlement SEBI approved clearing house

16. Continued…
5. Clearing members
• Registration from SEBI
• Minimum net worth  Rs. 3 Crore
6. Minimum contract value  Rs. 2 Lakhs
Minimum contract size [No. of underlying securities in one contract]  multiples of 100
7. Initial margin requirements, exposure limits etc.  Prescribed by SEBI
8. KYC , Every client shall be registered with the derivative broker, Issue Risk
Disclosure Document, Get RDD signed by client

17. Eligibility conditions for Derivative Exchange
and its Clearing House/Corporation
1.Derivative trading to take place through an online screen based Trading System.
2.The Derivatives Exchange/Segment shall have online surveillance capability to monitor
positions, prices, and volumes on a real time basis to deter market manipulation.
3.The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through at least two
information vending networks, which are easily accessible to investors across the country.
4.The Derivatives Exchange/Segment should have arbitration and investor grievances redressal
mechanism operative from all the four areas / regions of the country.
5.The Derivatives Exchange/Segment should have satisfactory system of monitoring investor
complaints and preventing irregularities in trading.
6.The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
7.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.

18. Continued …
8.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.
9.The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the
position. The concept of value-at-risk shall be used in calculating required 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 days.
10.The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for
swift movement of margin payments.
11.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.
12.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.
13.The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades
executed on Derivative Exchange / Segment.

19. Investor
protection
in
Derivative
Market
• Investor’ money  Separate. Not
available to any investor or member
• Provide risk disclosure document
• Duly time stamped contract note 
Receipt & execution of order(with client
ID) AND Trade confirmation slip
• Margin money paid by investor – kept in
trust with Clearing House/ Corporation.
Member default  Investor
compensated from Investor Protection
Fund (rules, regulation, bye-laws)