A

PROJECT REPORT

ON

“COMPARATIVE STUDY ON DERIVATIVE MARKET”

AT

SHAREKHAN LIMITD

Hyderabad

Submitted by

Kavita Jain

(H.No. 200627577)

Symbiosis Centre for Distance Learning (SCDL) 

In partial fulfillment of the requirements for the award of

MASTERS OF BUSINESS ADMINISTRATION

(2009-2010)

1

PGDHRM

PUNE

DECLARATION

I hereby declare that the project report titled “COMPARATIVE STUDY ON

DERIVATIVE MARKET” submitted in partial fulfillment of the requirements for

the POST GRADUATION OF “MASTERS IN BUSINESS ADMINISTRATION”,

from fromSymbiosis Centre for Distance Learning (SCDL) PUNE, is my original

work and not submitted for the award of any other Degree, Diploma, Fellowship or

prizes.

DATE: KAVITA JAIN

PLACE:HYDERABAD (HT.NO. 200627577)

2

CERTIFICATE

This is to certify that the project report entitled “COMPARATIVE STUDY

ON DERIVATIVE MARKET” carried at SHAREKHAN LIMITED is a bonafide

work done by Miss.Kavita jain, bearing Roll No. 200627577 a student of MBA

(Finance) of Symbiosis Centre for Distance Learning (SCDL) and submitted the

same in partial fulfillment for the award of the degree of “MASTER OF BUSINESS

ADMINISTRATION” affiliated to PUNE UNIVERCITY for the scholastic year

2009-10.

We found the work carried out by her to be good. We wish her success in all

future endeavors.

Mr.xxxxxx. EXTERNAL (Mr.xxxxxxxxxxxxxxx)(Internal Project Guide) (Examiner) (Principal)LECTURE IN FINANCE

3

ACKNOWLEDGEMENT

I take this opportunity to express my sincere gratitude to the staff of

Symbiosis Centre for Distance Learning (SCDL). I specially thank “THE

MANAGEMENT AND STAFF OF SHAREKHAN LIMITED” for creating out

the study and for their guidance and encouragement that made the project very

effective and easy.

I sincerely express my gratitude to Mr.Ajay Sharma, – SHAREKHAN

LIMITED, for his guidance and support throughout my project.

I would like to thank Mr.Ajay Sharma for guiding and directing me in the

process of making this project report and for all the support and encouragement.

4

INDUSTRY PROFILE

5

6

COMPANY PROFILE

ABOUT SHAREKHAN LIMITED

Sharekhan Limited is one of the fastest growing financial services providers

with a focus on equities, derivatives and commodities brokerage execution on the

National Stock Exchange of India Ltd. (NSE), Bombay Stock Exchange Ltd. (BSE),

National Commodity and Derivatives Exchange India (NCDEX) and Multi

Commodity Exchange of India Ltd. (MCX). Sharekhan provides trade execution

services through multiple channels - an Internet platform, telephone and retail outlets

and is present in 280 cities through a network of 704 locations. The company was

awarded the 2005 Most Preferred Stock Broking Brand by Awwaz Consumer Vote.

ORIGIN

Sharekhan traces its lineage to SSKI, an organization with more than decades

of trust and credibility in the stock market.

7

Pioneers of online trading in India- Sharekhan.com was launched in 2000 and

is now the second most visited broking site in India.

Has one of the largest networks of Share shops in the country.

SHAREHOLDING PATTERN

SHAREHOLDERS HOLDINGS

CITI Venture Capital and other Private Equity Firm 81%

IDFC 9%

Employees 10%

MANAGRMENT TEAM CONSISTS OF-

NAME POST

Tarun Shah Chief Executive Officer

Mr. Pathik Gandotra Head Of Research

Mr. Rishi Kohli Vice President Of Equity Derivative

Jaideep Arora Director- Products And Technology

Shankar Vailaya Director- Operation

Sharekhan Limited offers blend of tradition and technology like Share shops, dial-n-

trade and online trading- where there is choice of three trading interfaces which are

speed trade exe for active trader, web based classic interface for investor, web based

applet- fast trade for investor. Sharekhan Limited was formerly known as SSKI

Investor Services Private Limited. The company is based in Mumbai, India and its

address is- A-206 Phoenix House, 2nd Floor

Senapati Bapat Marg, Lower Parel

Mumbai, 400 013. India

Phone: 91 22 24982000

8

Fax: 91 22 24982626

www.sharekhan.com

Advanced Technology Used By Sharekhan

Sharekhan selected Aspect® EnsemblePro™ from the Aspect Software Unified IP

Contact Center product line, a unified contact centre solution delivering advanced

multichannel contact capabilities, because it provided the best total value over other

solutions evaluated. It enabled Sharekhan to meet customer service needs for inbound

call handling, voice self service, predictive outbound dialing, call blending, call

monitoring and recording, and creating outbound marketing campaigns, among other

capabilities. This helps them to

Increased agent efficiency and productivity.

Enabled company to execute proactive customer service calls and expand

services offered to customers.

Enhanced call monitoring for improved service quality

Financial services are a highly competitive and volume-driven industry which

demands high standards of customer service, effective consultation and quick

deliverables. This is something Sharekhan Limited, a financial services provider

based in India, understands. The company offers several user-friendly services for

customers to manage their stock portfolios, including online capabilities linked to an

information database to help customers confidently invest, and inbound customer

services using voice self-service technology and customer service agents handling

telephone orders from clients.

With a customer base of more than 500000, and a employee of 3100 Sharekhan

continues to grow at a fast pace. Customer satisfaction is a top priority in Sharekhan’s

agenda.

Its primary objective

9

Is to help and support its customers in managing their portfolio in the best

possible manner through quality advice, innovative product and superior

service.

Scheme which are provided by Sharekhan cover almost every segment of the

customer-

SCHEME INVESTOR

First Step New Comer

Classic Trade Occasionally

Speed Trade Day Trader

Platinum Circle High Net Worth Individuals

10

DERIVATIVES

INTRODUCTION

Derivatives are products whose value is derived from one or more variables

called bases. These bases can be underling asset such as foreign currency, stock or

commodity, bases or reference rates such as LIBOR or US treasury rate etc. Example,

an Indian exporter in anticipation of the riceipt of dollar denominated export proceeds

11

may wish to sell dollars at a future date to eliminate the risk of exchange rate

volatility by the data. Such transactions are called derivatives, with the spot price of

dollar being the underling asset.

Derivatives thus have no value of their own but derive it from the asset that is

being dealt with under the derivative contract. A financial manager can hedge himself

from the risk of a loss in the price of a commodity or stock by buying a derivative

contract. Thus derivative contracts acquire their value from the spot price of the asset

that is covered by the contract.

The primary purposes of a derivative contract is to transfer “risk” from one

party to another i.e. risk in a financial sense is transfer from a party that is willing to

take it on. Here, the risk that is being dealt with is that of price risk. The transfer of

such a risk can therefore be speculative in nature or act as a hedge against price

movement in a current or anticipated physical position.

Derivatives or derivative securities are contracts which are written between

two parties (counterparties) and whose value is derived from the value of underlying

widely-held and easily marketable assets such as agricultural and other physical

(tangible) commodities or currencies or short term and long-term and long term

financial instruments or intangible things like commodities price index (inflation

rate), equity price index or bond piece index. The counterparties to such contracts are

those other than the original issuer (holder) of the underlying asset.

Derivatives are also known as “deferred delivery or deferred payment instruments”.

In a sense, they are similar to securitized assets, but unlike the latter, they are not the

obligations which are backed by the original issuer of the underlying asset or security.

It is easier to take a short position in derivatives than in other possible to combine

them to match specific requirements, i.e., they are more easily amenable to financial

engineering.

12

The values of derivatives and those of their underlying assets are closely

related. Usually, in trading derivatives, the taking or making of delivery of underlying

assets is not involved; the 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. Derivatives are

“off balance sheet” instruments, a fact that is said to obscure the leverage and

financial might they give to the party. They are mostly secondary market instruments

and have little usefulness in mobilizing fresh capital by the companies (warrants,

convertibles being the exceptions). Although the standardized, general, exchange-

traded derivatives are being contracts which are in vogue and which expose the users

to operational risk, counterparty risk, liquidity risk, and legal risk. There is also an

uncertainty about the regulatory status of such derivatives.

There are bewilderingly complex varieties of derivatives already in existence,

and the markets are innovating newer and newer ones continuously: plain, simple or

straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged,

customized or OTC-traded, standardized or organized-exchange traded. Although we

are not going to discuss all of them, the names of certain derivatives may be noted

here: futures, options, range forward and ratio range forward options, swaps,

warrants, convertible bonds, credit derivatives, captions, swaptions, futures options,

the ratio swaps, periodic floors, spread lock one and two, treasury-linked swaps,

wedding bands three and six, inverse floaters, index amortizing swaps, and so on;

because of their complexity, derivatives have become a continuing pain for the

accounting person and a true mind-bender for anyone trying to value them.

The turnover of the stock exchanges has been tremendously increasing from

last 10 years. The number of trades and the number of investors, who are

participating, have increased. The investors are willing to reduce their risk, so they

are seeking for the risk management tools. Mutual funds, FIIs and other investors who

are deprived of hedging (i.e. risk reducing) opportunities will now have a derivatives

market to bank on.

13

While derivatives markets flourished in the developed world, Indian markets

remain deprived of financial derivatives to the beginning of this millennium. While

the rest of the world progressed by leaps and bounds on the derivatives front, Indian

market lagged behind. Having emerged in the markets of the developed nations in the

1970s, derivatives markets grew from strength to strength. The trading volumes

nearly doubled in every three years making it a trillion-dollar business. They became

so ubiquitous that, now, one cannot think of the existence of financial markets

without derivatives.

Two broad approaches of SEBI is to integrate the securities market at the

national level, and to diversify the trading products, so the more number of traders

including banks, financial institutions, insurance companies, mutual funds, primary

dealers etc., choose to transact through the exchanges. In this context the introduction

of derivatives trading through Indian Stock Exchanges permitted by SEBI exchange

in the year 2000 is a real landmark.

Prior to SEBI abolishing the BADLA system, the investors had this system as

a source of reducing the risk, as it has many problems like no strong margining

system, unclear expiration date and generating counter party risk. In view of this

problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for a

hedging system, which could reduce their portfolio risk. SEBI thought the

introduction of the derivatives trading, as a first step it has set up a 24 member

committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate

regulatory framework for derivative trading in India, SEBI accepted the

recommendations of the committee on May 11, 1998 and approved the phased

introduction of the derivatives trading beginning with stock index futures. The Board

also approved the “suggestive bye-laws” recommended for regulation and control of

trading and settlement of derivatives contracts.

14

However the securities contracts (regulation) act, 1956 (SCRA) needed

amendment to include “derivatives” in the definition of securities to enable SEBI to

introduce trading in derivatives. The government in the year 1999 carried out the

necessary amendment. The securities Laws (Amendment) bill 1999 was introduced

to bring about the much needed changes. In December 1999 the new framework has

been approved derivatives have been accorded the status of ‘securities’. The ban

imposed on trading in derivatives way back in 1999 under a notification issued by the

central Government has been revoked. Thereafter SEBI formulated the necessary

regulations/bye-laws and started in India at NSE in the same year and BSE started in

the year 2001. In this module we are covering the different types of derivatives

products and their features, which are traded in the stock exchanges in India.

NATURE OF THE PROBLEM:

The turnover of the stock exchanges has been tremendously increasing

from last 10 years. The number of trades and the number of investors, who are

participating, have increased. The investors are willing to reduce their risk, so they

are seeking for the risk management tools.

Prior to SEBI abolishing the BADLA system, the investors had this

system as a source of reducing the risk, as it has many problems like no strong

margining system, unclear expiration date and generating counter party risk. In view

of this problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for

a hedging system, which could reduce their portfolio risk. SEBI thought the

introduction of the derivatives trading, as a first step it has set up a 24 member

committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate

regulatory framework for derivative trading in India, SEBI accepted the

recommendations of the committee on May 11, 1998 and approved the phased

introduction of the derivatives trading beginning with stock index futures.

15

There are many investors who are willing to trade in the derivative

segment, because of its advantages like limited loss and unlimited profit by paying the

small premiums.

OBJECTIVES OF THE STUDY:

To analyze the derivatives market in India.

To analyze the operations of futures and options.

To find out the profit/loss position of the option writer and option holder.

To study about risk management with the help of derivatives.

SCOPE OF THE STUDY:

The study is limited to “Derivatives” with special reference to futures and

options in the Indian context and the Hyderabad stock exchange has been taken as a

representative sample for the study. The study can’t be said as totally perfect. Any

alteration may come. The study has only made a humble attempt at evaluating

derivatives market only in Indian context. The study is not based on the international

perspective of derivatives markets, which exists in NASDAQ, NYSE etc.

LIMITATIONS OF THE STUDY:

The following are the limitations of this study:

The scrip chosen for analysis is ONGC and the contract taken is August and

September 2005.

The data collected is completely restricted to the ONGC of August and

September 2005.

Hence this analysis cannot be taken as universal.

16

The term “Derivative” indicates that it has no independent value, i.e. its value is

entirely derived from the value of the underlying asset. The underlying asset can be

securities, commodities, bullion, currency, livestock or anything else. In other words,

derivative means a forward, future, option or any other hybrid contract of pre-

determined fixed duration, linked for the purpose of contract fulfillment to the value

of a specified real or financial asset or to an index of securities.

DEFINITION:

Derivative is a product whose value is derived from the value of an

underlying asset in a contractual manner. The underlying asset can be equity, forex,

commodity or any other asset.

Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to

include:-

1. A security derived from a debt instrument, share, and 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 above definition conveys:

i. That derivative is financial products and derives its value from the

underlying assets.

ii. Derivative is derived from another financial instrument/contract called

the underlying. In this case of nifty index is the underlying.

17

PARTICIPANTS/USES OF DERIVATIVES:

1. Hedgers use for protecting (risk-covering) against adverse movement.

Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives

are widely used for hedging. A hedge can help lock in existing profits. Its purpose is

to reduce the volatility of a portfolio, by reducing the risk.

2. Speculators to make quick fortune by anticipating/forecasting future

market movements. Speculators wish to bet on future movements in the price of an

asset. Futures and options contracts can give them an extra leverage; that is, they can

increase both the potential gains and potential losses in a speculative venture.

Speculators on the other hand arte those classes of investors who willingly take price

risks to profit from price changes in the underlying.

18

3. Arbitrageurs to earn risk-free profits by exploiting market imperfections.

Arbitrageurs profit from price differential existing in two markets by simultaneously

operating in the two different markets. Arbitrageurs are in business to take advantage

of a discrepancy between prices in two different markets.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by the derivatives markets.

They are:

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.

Derivatives market helps to transfer risks from those who have them but may not

like them to those who have an appetite for them.

Derivative trading acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

TYPES OF DERIVATIVES:

Derivative products initially emerged as hedging devices against fluctuations in

commodity prices, and commodity-linked derivatives remained the sole form of such

products for almost three hundred years. Financial derivatives came into spotlight in

the post-1970 period due to growing instability in the financial markets. However,

since their emergence, these products have become very popular and by 1990s, they

accounted for about two-thirds of total transactions in derivative products, in recent

years, the market for financial derives has grown tremendously in terms of variety of

instruments depending on their complexity and also turnover. In this class of equity

19

derivatives the world over, futures and options on stock indices have gained more

popularity than on individual stocks, especially among institutional investors, who are

maor users of index-linked derivatives. Even small investors find these useful due to

high correlation of the popular indices with various portfolios and ease of use. The

lower costs associated with index derivatives vis-à-vis derivative products based on

individual securities is another reason for their growing use.

The most commonly used derivatives contracts are forwards, futures and options.

Here we take a brief look at various derivatives contracts that have come to be used.

CLASSIFICATION OF DERIVATIVES:

1. ETF (Exchange Traded Fund)

2. OTF ( Out Side Traded Fund)

ETF (Exchange Traded Fund):

An exchange-traded fund (or ETF) is an investment vehicle traded on stock

exchanges, much like stocks. An ETF holds assets such as stocks or bonds and

trades at approximately the same price as the net asset value of its underlying

assets over the course of the trading day.

Futures

Options

OTF (Out Side Traded Fund):

Forwards

Swaps

20

Warrants

Leaps

Baskets

OTF(FORWARDS,SWAPS,WARRANTS,LESAPS,BASKETS)

FORWARDS:

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

FUTURES:

A futures contract is an agreement between two parties to buy or sell an asset at

a certain time in the future at a certain price. Futures contracts are special types of

forward contracts in the sense that the former are standardized exchanged-traded

contracts.

OPTIONS:

Options are of two types - calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price on or

before a given future date. Puts give the buyer the right, but not the obligation to sell a

given quantity of the underlying asset at a given price on or before a given date.

WARRANTS:

Options generally have lives of up to one year; the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-dated

options are called warrants and are generally traded over-the-counter.

21

LEAPS:

The acronym LEAPS means Long-Term Equity Anticipation Securities. These

are options having a maturity of up to three years.

BASKETS:

Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average of a basket of assets. Equity index options are a

form of basket options.

SWAPS:

Swaps are private agreements between two parties to exchange cash flows in

the future according to a prearranged formula. They can be regarded as portfolios of

forward contracts.

The two commonly used swaps are:

Interest rate swaps:

These entail swapping only the interest related cash flows between the

parties in the same currency.

Currency swaps:

These entail swapping both principal and interest between the parties, with the

cash flows in one direction being in a different currency than those in the opposite

Direction.

SWAPTIONS:

22

Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather

than have calls and puts, the swaptions market has receiver swaptions and payer

swaptions. A receiver swaption is an option to receive fixed and pay floating. A

payer swaption is an option to pay fixed and receive floating.

REGULATORY FRAMEWORK

23

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SCRA,

the SEBI Act, the rules and regulations framed there under and the rules and bye-

laws of stock exchanges.

Securities contracts Regulation Act, 1956

SCRA aims at preventing undesirable transactions in securities by regulating

the business of dealing therein and by providing for certain other matters

connected therewith. This is the principal Act, which governs the trading of

securities in India. The term “securities” has been defined in the SCRA. As per

section 2(h), the ‘securities’ include:

24

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable

securities of a like nature in or of any incorporated company or other body

corporate.

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to

the investors in such schemes

4. Government securities

5. Such other instruments as may be declared by the Central Government to be

securities

6. Rights or interests in securities.

“Derivative” is defined to include:

A security derived from a debt instrument, share and loan whether secured

or unsecured, risk instrument or contract for differences or any other form

of security.

A contract which derives its value from the prices or index of prices, of

underlying securities.

Section 18A provides that notwithstanding anything contained in any other

law for the time being in force, contracts in derivatives shall be legal and

valid if such contracts are:

Traded on a recognized stock exchange settled on the clearinghouse of the

recognized stock exchange, in accordance with the rules and byelaws of

such stock exchanges.

Securities and exchange board of India act, 1992

SEBI act, 1992 provides for establishment of securities and exchange board of

India (SEBI) with statutory powers for (a) protecting the interests of investors in

securities

25

(b) Promoting the development of the securities market and (c) regulating the

securities market. Its regulatory jurisdiction extends over corporates in the

issuance of capital and transfer of securities, in addition to all intermediaries and

persons associated with securities market. SEBI has been obligated to perform

the aforesaid functions by such measures as it thinks fit.

In particular, it has powers for:

Regulating the business in stock exchanges and any other securities markets.

Registering and regulating the working of stockbrokers, sub broker etc.

Promoting and regulating self-regulatory organizations.

Prohibiting and fraudulent and unfair trade practices.

Calling information from, undertaking inspection, conducting inquiries and

audits the stock exchanges, mutual funds and other persons associated with the

securities marker and intermediaries and self-regulatory organizations in the

securities market performing such functions and exercising according the

securities contracts (regulation) act, 1956, as may be delegated to it by the central

government.

SEBI (stock brokers and sub-brokers) regulations, 1992

In this we shall have a look at the regulations that apply to brokers under

the SEBI regulations.

Brokers:

A broker is an intermediary who arranges to buy and sell securities on

behalf of clients (the buyer and the seller). According to Section 2(e) of the SEBI

(stockbrokers and sub-brokers) rules 1992, s Stock Broker means a member of a

recognized stock exchange. NO stockbroker is allowed to buy, sell or deal in

securities, uses he or she holds a certificate of registration granted by SEBI

26

through a stock exchange of which he or she is admitted as a member. SEBI may

grant a certificate to a stock-broker (as per SEBI rules, 1992) subject to the

conditions that:

1. He holds the membership of any stock exchange:

2. He shall abide by the rules, regulations and byelaws of the stock exchange or

stock exchanges of which he is a member.

3. In case of any change in the status and condition, he shall contain prior

permission of SEBI to continue to buy, sell or deal in securities in any stock

exchange;

4. He shall pay the amount of fees for registration in the prescribed manner; and

5. HE shall take adequate steps for redress of grievances of the investors within

one month of the date of the complaint and keep SEBI informed about the

number, nature and other particulars of the complaints.

As per SEBI (stock brokers and sub-brokers) regulations, 1992, SEBI shall

take into account for considering the grant of a certificate all matters relating to

buying, selling, or dealing in securities and in particular the following, namely

whether the stockbroker-(a) is eligible to be admitted as a member of a stock

exchange; (b)has the necessary infrastructure like adequate office space,

equipment and man power to effectively discharge his activities; (c) has any past

experience in the business of buying selling or dealing in securities; (D) is

subjected to disciplinary proceedings under the rules, regulations and bye-laws of

a stock exchange with respect to his business as a stock-brokers involving either

himself or any of his partners, directors or employees.

Regulations for derivatives trading

SEBI set up a 24-member committee under the chairmanship of

Dr.L.C.Gupta to develop the appropriate regulatory framework for derivatives

trading in India. The committee submitted its report in March 1998. On May 11,

27

1998 SEBI accepted the recommendations of the committee and approved the

phased introduction of derivatives trading in India beginning with tock index

futures. SEBI also approved the “suggestive bye-laws” recommended by the

committee for regulation and “suggestive bye-laws” recommended by the

committee for regulation and control of trading and settlement of derivatives

contracts.

1. The provisions in the SC(R)A and regulatory framework developed

there under govern trading in securities.

2. The amendment of the SC(R)A to include derivatives within the

ambit of ‘securities’ in the securities in the SC(R)A made trading in

derivatives possible within the framework of that Act.

3. 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 huge a

separate governing council and representation of trading/clearing

members shall be limited to maximum of 40% of the total members

of the governing council. The exchange shall regulate the sales

practice of its members and will obtain prior approval of SEBI

before start of trading in any derivative contact.

4. The Exchange shall have minimum 50 members.

5. The members of an existing segment of the exchange will not

automatically become the members of the derivative segment need

to fulfill the eligibility conditions as laid down by the L.C.Gupta

committee.

6. The clearing and settlement of derivatives trades shall be through a

SEBI approved clearing corporation/house. Clearing

corporations/houses complying with the eligibility conditions a s

28

laid down by the committee have to apply SEBI for grant of

approval.

7. Derivative brokers/dealers and clearing members are required to

seek registration from SEBI. This is in addition to their registration

a brokers of existing stock exchanges. The minimum net worth for

clearing members of the derivatives clearing corporation/house shall

be Rs.300 lakhs. The net worth of the member shall be computed as

follows:

Capital+Free reserves

Less non-allowable assets viz,

(a) Fixed assets

(b) Pledged securities

(c) Member’s card

(d) Non-allowable securities (unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

6. The minimum contract value shall not be less than Rs.2 lakhs. 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

SEBI/Exchange shall prescribe margin demands related to the risk of loss on

the position from time to time.

8. The L.C.Gupta committee report requires strict enforcement of “Know you

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

29

trading by issuing to the client the Risk Disclosure Document and obtain a

copy of the same duly signed by the client.

9. The trading members are required to have qualified approved user and sales

person who have passed a certification programme approved by SEBI.

REGULATION FOR CLEARING AND SETTLEMENT

1) The L.C.Gupta committee has recommended that the clearing corporation

should interpose itself between both legs of every trade, becoming the legal

counter party to both or alternati9vely should provide an unconditional

guarantee for settlement of all trades.

2) The clearing corporation should ensure that none of the Board members has

trading interests.

3) The definition of net-worth as prescribed by SEBI needs to be incorporated in

the application/regulations of the clearing corporation

4) The regulations relating to arbitration need to be incorporated in the clearing

corporation’s regulations.

5) The clearing corporation in its regulations must incorporate specific

provision/chapter relating to declaration of default.

6) The regulations relating to investor protection fund for the derivatives market

must be included in the clearing corporation application/regulations.

7) The clearing corporation should have the capabilities to segregate upfront

initial margins deposited by clearing members for trades on their own account

and on account of his clients. The clearing corporation shall hold the clients’

margin money in trust for the clients’ purposes only and should not allow its

diversion for any other purpose. This condition must be incorporated in the

clearing corporation regulations

8) The clearing member shall collect margins from his constituents

(client/trading members). He shall clear and settle deals in derivative

contracts on behalf of the constituents only on the receipt of such minimum

margin.

30

9) Exposure limits based on the value at its risk concept will be used and the

exposure limits will be continuously monitored. These shall be within the

limits prescribed by SEBI from time to time.

10) The clearing corporation must lay down a procedure for periodic review of

the new worth of its members.

11) The clearing corporation must inform SEBI how it roposes to monitor the

exposure of its members in the underlying market.

12) Any changes in the byelaws, rules or regulations, which are covered under

the “suggestive bye-laws for regulations and control of trading and settlement

of derivatives contracts”, would require prior approval of SEBI.

Product specifications BSE-30 Sensex Futures

Contract Size -Rs.50 times the Index

Tick size – 0.1 points or Rs.5

Expiry day – last Thursday of the month

Settlement basis – cash settled

Contract cycle – 3 months

Active contracts – 3 nearest months

Product Specifications S&P CNX Nifty Futures

Contract Size – Rs.200 times the Index

Tick Size – 0.05 points or Rs.10

Expiry day – last Thursday of the month

Settlement basis – cash settled

Contract cycle - 3 month

Active contracts – 3 nearest months

Membership

31

Membership for the new segment in both the exchanges is not automatic

and has to be separately applied for:

Membership is currently open on both the exchanges.

All members will also have to be separately registered with SEBI before

they can be accepted.

Membership Criteria – National Stock Exchange (NSE)

Clearing Member (CM)

Net worth Rs.300 lakhs

Interest-Free Security Deposits – Rs.25 lakhs

Collateral Security Deposit – Rs.25 lakhs

In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs.

Trading Member (TM)

Net worth – Rs.100 lakhs

Interest-Free Security Deposit – Rs.8 lakhs

Annual Subscription fees – Rs.1 lakh

Membership Criteria – Mumbai Stock Exchange (BSE)

Clearing Member (CM)

Net worth – 300 lakhs

Interest-Free Security Deposit – Rs.25lakhs

Collateral Security Deposit – Rs.25 lakhs

Non-refundable Deposit – Rs.5 lakhs

Annual Subscription Fees – Rs.50,000.

In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs

with the following break-up.

i. Cash – Rs.25 lakhs

32

ii. Cash Equivalents – Rs.25 lakhs

iii. Collateral Security Deposit – Rs.5 lakhs

Trading Member (TM)

Net worth – Rs.50 lakhs

Non-refundable deposit – Rs.3 lakhs

Annual Subscription Fees – Rs.25 thousant

The Non-refundabel fee paid by the members is exclusive and will be a

total of Rs.8 lakhs if the member has both clearing and trading rights.

Trading systems

NSE’s trading system for its futures and options segment is called NEAT

F&O. It is bsed on the NEAT system for the cash segment.

BSE’s trading system for its derivatives segment is called DTs. It is built

on a platform different from the BOLT system though most of the features

are common.

Classification of derivatives:

Forwards (currencies, stocks, swaps etc.,)

Forward contract is different from a spot transaction, where payment of price and

delivery of commodity take place immediately the transaction is settled. In a

forward contract the sale/purchase transaction of an asset is settled including the

price payable not for deliver/settlement at spot, but at a specified future date.

India has a strong dollar-rupee forward market with contracts being traded for

one, two, Six-month expiration. Daily trading volume on this forward market is

around $500 million a day. Indian users of hedging services are also allowed to

buy derivatives involving other currencies on foreign markets.

33

Futures (Currencies, Stocks, Indices, Commodities):

A future contract has been defined as “a standardized exchange-traded agreement

specifying a quantity and price of a particular type of commodity (soyabeans,

gold, oil etc.,) to be purchased or sold at a pre-determined date in the future. On

contract date, delivery and physical possession take place unless the contract has

been closed out. Futures are also available on various financial products and

indices today. A future contract is thus a forward contract, which trades on an

exchange. S&P CNX Nifty futures are traded on National Stock ‘Exchange. This

provides them transparency, liquidity, anonymity of trades and also eliminates the

counter party risks due to the guarantee provided by national securities clearing

corporation Ltd.

Options (Currencies, Stocks, Indexes etc):

Options are the standardized financial contracts that allow the buyer (holder) of

the options, i.e., the right at the cost of option premium not the obligation, to buy

(call options) or sell (put options) a specified asset at a set price on or before a

specified date through exchanges under stringent financial security against

default.

Risk management in derivatives:

Derivatives are high-risk instruments and hence the exchanges have put a lot of

measures to control this risk. The most critical aspect of risk management is the daily

monitoring of price and position and the margining of those positions.

NSE used the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system

that has origins at the Chicago mercantile exchange, one of the oldest derivative

exchanges in the world.

34

The objective of SPAN is to monitor the positions and determine the maximum

loss that a stock can incur in a single day. This loss is covered by the exchange by

imposing mark to market margins.

SPAN evaluates risk scenarios, which are nothing but market conditions. The

specific set of market conditions evaluated, are called the risk scenarios, and these are

defined in terms of;

a) How much the price of the underlying instrument is expected to change

over one trading day, and

b) How much the volatility of that underlying price is expected to change

over one trading day.

Based on the SPAN measurement, margins are imposed and risk covered.

Apart from this, the exchange will have a minimum base capital of Rs.50 lakhs and

brokers need to pay additional base capital if they need margins about the permissible

limits.

35

FORWARD CONTRACTS

36

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date

for a specified price. One of the parties to the contract assumes along position agrees

to buy the underlying asset on a certain specified future date for a certain specified

price. The other party assumes a short position and agrees to sell the asset on the

same date for the same rice. Other contract details like delivery date, the parties to

the contract negotiate price and quantity bilaterally. The forward contracts are

normally traded outside the exchanges.

The salient features of forward contracts are:

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom-designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to the

same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized,

as in the case of foreign exchange, thereby reducing transaction cost and increasing

37

transaction volume. This process of standardization reaches its limit in the organized

futures market.

Forward contracts are very useful in hedging and speculation. The classic

hedging application would be that of an exporter who expects to receive payment in

dollars three months later. He is exposed to the risk of exchange rate fluctuations. By

using the currency forward market to sell dollars forward, he can lock on to rate today

and reduce his uncertainty. Similarly an importer who is required to make a payment

in dollars two months hence can reduce his exposure to exchange rate fluctuations by

buying dollars forward. If a speculator has information or analysis, which forecasts

an upturn in a price, then he can go long on the forward market instead of the cash

market. The speculator would go long the forward, wait for the price to raise, and

then take a reversing transaction to book profits. Speculators may well be required to

deposit a margin upfront. However, this is generally a relatively small proportion of

the value of the assets underlying the forward contract. The use of forward market

here supplies leverage to the speculator.

LIMITATIONS:

Forward markets worldwide are afflicted by several problems:

Lack of centralization of trading, liquidity and counter-party risk in the first two

of these, and the basic problem is that of too much flexibility and generality. The

forward market is like a real estate market in that any two consenting adults can form

contracts against each other. This often makes them design terms of the deal, which

are very convenient in that specific situation, but makes the contracts non-tradable.

Counter-party risk arises from the possibility of default by any one party to the

transaction. When one of the two sides to the transaction declare bankruptcy, the

other suffers. Even when forward markets trade standardized contracts, and hence

avoid the liquidity, still the counter-party risk remains a very serious issue.

38

FUTURES

39

FUTURES

INTRODUCTION:

Futures markets were designed to solve the problems that exist in forward

markets. Futures contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. But unlike forward contracts, futures

contracts are standardized and exchange traded. To facilitate liquidity in the futures

contracts, the exchange specifies certain standard features of the contract. It is a

standardized contract with standard underlying instrument, a standard quantity and

quality of the underlying instrument that can be delivered, (or which can be used for

reference purposes in settlement) and a standard timing of such settlement. A futures

contract may be offset prior to maturity by entering into an equal and opposite

transaction. More than 90 of futures transactions are offset this way.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and month of delivery

The units of price quotations and minimum price changes

40

Location of settlement

FUTURES MARKET:

The Chicago Board of Trade was the earliest one found, in 1848 and currently

is the largest futures exchange in the world. The method of trading futures in the

organized exchanges is similar in some ways to and different in other ways from the

way stocks are traded. As with the stocks and in other ways from the way stocks are

traded. As with the stocks and options, customers can pace market, limit and stop

orders. Further more once an order is transmitted to an exchange floor, it must be

taken to a destined spot for execution by a member of exchange, just as it is done for

stocks and options. This spot is known as pit because of its shape, which is circular

with a set of interior descending steps on which members stand.

In futures market, there are floor brokers. They execute customer’s orders. In

doing so they, (or their phone clerks) each keep a file of any stop or limit orders that

cannot be executed, alternatively, members can be floor traders (those with very short

holding periods, of less than a day, are known as locals or scalpers), they execute

orders for their own personal accounts in an attempt to make profits by “buying low

and selling high”.

CLEARING HOUSE:

Each futures exchange has an associated clearinghouse that becomes the

“seller’s buyer” and the “buyer’s seller” as the trade is concluded. The people

associated with futures set up specifically the Chicago Board Options Exchange).

Clearing house is in a risky position as there is a chance of not delivering to the seller

or not paying by the buyer as it is like a mediator between the both. The procedure

that protect the clearinghouse from such potential losses involving brokers

1) Impose initial margin requirements on both buyers and sellers

2) Mark to market the accounts of buyers and sellers everyday

3) Impose daily maintenance margin requirements of both buyers and sellers

41

Use no contracts are outstanding. Subsequently as people began to make transactions,

the open interest grows. At any time open interest equals the amount that those with

the short position (the seller) are currently obligated to deliver. It also equals the

amount that with the long positions (the buyer) are obligated to receive.

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. That is, both buyer

and seller are required to make security deposit that they are intended to guarantee

that they will be in fact be able to fulfill their obligations, accordingly initial margin is

referred to as performance margin. The amount of this margin is roughly 5% to 15%

of the total purchase price of the futures contract.

Marking-to-market: In the futures market, at the end of each trading day, the margin

account is adjusted to affect 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. According to

the maintenance margin requirement, the investor must keep the account’s equity

equal or greater than certain percentage of the amount deposited as initial margin.

Because this percentage is roughly 5%, the investor must have equal 65% or greater

than 65% of initial margin. If the requirement is not met the investor will receive a

call. This call is a request to for an additional deposit of cash known as variation

margin.

OPEN INTEREST:

The number of contracts, which are outstanding for execution, is called open

interest. When trading is first allowed in a contract, there is no open interest because

no contract because no contracts are outstanding. Subsequently as people began to

make transactions, the open interest grows. At any time open interest equals the

amount that those with the short position (the seller) are currently obligated to deliver.

42

It also equals the amount that with the long positions (the buyer) are obligated to

receive.

BASIS:

In the context of financial futures, basis can be defined as the difference

between the current spot price on an asset (that is the price of the asset for immediate

delivery) and the corresponding future price (that is the purchase price stated in the

contract) is known as basis.

Basis = current spot price – futures price.

A person with a short position in a futures contract and a long position on a

deliverable asset (means that he owns a asset) will profit if the basis is positive and

widens or is negative and narrow). This is because the futures price will be falling or

the spot price is rising (or both). A falling futures price benefits those who are short

futures and a rising spot price benefits those who own the asset. Using the same type

of reasoning it can be shown that this person will lose the basis is positive and narrow

(or is negative and widens).

SETTLEMENT OF FUTURES

Mark to market settlement:

There is a daily settlement for mark to market. The profits/losses are computed

as the difference between the trade price (or the previous day’s settlement price, as

the case may be) and the current day’s settlement price. The party who have suffered

a loss are required to pay the mark to market loss amount to exchange which is in turn

passed on to the party who has made a profit/. This is known as daily mark to market

settlement.

43

Theoretical daily settlement price for unexpired futures contracts, which are not

traded during the last half an hour on a day, is currently the price computed as per the

formula detailed below:

F = S*RT

Where:

F=theoretical futures price

S=value of the underlying index/stock

R=rate of interest (MIBOR – Mumbai I Inter Offer Rate)

T=time to expiration

Rate of interest may be the relevant MIBOR rate or such other rate as may be

specified. After daily settlement, all the open positions are reset to the daily

settlement price. the pay-in and payout of the mark-to-market settlement is on T+1

days (T = Trade day). The mark to market losses or profits are directly debited or

credited to the broker passes to the client account.

Final settlement:

On the expiry of the futures contracts, exchange marks all positions to the final

settlement price and the resulting profit / loss is settled in cash. The final settlement

of the futures contracts is similar to the daily settlement process except for the method

of computation of final settlement price. The final settlement profit/loss is computed

as the difference between trade price (or the previous day’s settlement price, as the

case may be), and the final settlement price of the relevant futures contract.

Final settlement loss/profit amount is debited/credited to the relevant broker’s

clearing bank account on T+1 day (T = expiry day). This is then passed on the client

from the broker. Open positions in futures contracts cease to exist after their

expiration day.

44

DISTINCTION BETWEEN FUTURES AND FORWARDS

Forward contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic functions of the

allocating risk in the presence of future price uncertainty. However futures are a

significant improvement over the forward contracts as they eliminate counter party

risk and offer more liquidity.

TERMS USED IN FUTURES CONTRACT:

Spot price: the price at which an asset trades in the spot market.

Futures price: the price at which the futures contract trades in the futures

market.

Contract cycle: the period over which a contract trades. The index

futures contracts on the NSE have one-month, tow-months ad three-month

expiry cycle, which expires on the last Thursday of the month. Thus a

January expiration contract expires on the last Thursday of January and a

February expiration contract ceases trading on the last Thursday of

February. On the Friday following the last Thursday, a new contract

having a three-month expiry is introduced for trading.

Expiry date: it is the date specified in the futures contract. This is the last

day on which the contract will be traded, at the end of which it will cease

to exist.

Contract size: the amount of asset that has to be delivered less than one

contract. For instance, the contract size on NSE’s futures market is 200

Nifties.

45

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.

46

OPTIONS

INTRODUCTION:

Options on stocks were first traded on an organized stock exchange in 1973.

Since then there has been extensive work on these instruments and manifold growth

in the field has taken the world markets by storm. This financial innovation is present

47

in cases of stocks, stock indices, foreign currencies, debt instruments, commodities,

and futures contracts.

An option is a type of contract between two people where one grants the other

party the right to buy a specific asset at specific priced within a specific time period.

Alternatively, the contract may grant the other person the right to sell a specific asset

at a specific price within a specific period of time.

The person who has received the right, and thus has a decision to make, is known as

the option buyer because he or she must pay for this right.

The person who has sold the right, and thus must respond to the buyer’s decision is

known as the option writer.

TYPES OF OPTION CONTRACT

The two most basic types of option contracts are call option and put option.

Currently such options are traded on many exchanges around the world. Furthermore,

many of these contracts are created privately (“that is off exchange” or “over the

counter”), typically involving institutions banking firms and their clients.

CALL OPTION:

The most prominent type of option contract is call option for stocks. It gives

the buyer the right to buy (“call away”) a specific number of shares of a specific

48

company from the option writer at a specific purchase price at any time up to and

including a specific date.

An investor buys a call options when he seems that the stock price moves upwards. A

call option gives the holder of the option the right but not the obligation to buy an

asset by a certain date for a certain price.

PUT OPTION:

A second type of option for stocks is the put option. It gives the buyer the right

to sell (“put away”) a specific number of shares of a specific company to the option

writer at a specific selling price at any time up to and including a specific date. An

investor buys a put option when he seems that the stock price moves downwards. A

put option gives the holder of the option right but not the obligation to sell an asset by

a certain date for a certain price.

Options clearing house:

The Options Clearing House (OCC), a company that is jointly owned by

several exchanges, generally facilitates trading in these options. It does so by

maintaining a computer system that keeps track of all those options by recording the

position of all those investors in each one. Although the mechanics are complex, the

principles are simple. As soon as a buyer and a writer decide to trade a particular

option contract and the buyer pass the agreed upon premium the OCC steps in

becoming the effective writer as buyer is concerned the effective buyer as far as the

seller is concerned. Thus at this time all directs links between original buyer and

seller is served.

TRADING ON EXCHANGES:

There are two types of exchanged-based mechanisms for trading options

contracts. The focal point for trading either involves specialists or market makers.

49

SPECIALISTS:

These people serve two functions, acting as both dealers and brokers. As

dealers they keep an inventory of the stocks that are assigned to them and buy and sell

from that inventory at bid and ask process, respectively. As brokers they keep limit

order book and execute the orders in it a market moves up and down. Some option

market such as American Stock Exchange, function in a similar manner. These

markets have specialists who assigned specific options contract, and these specialists

act as dealers and brokers in their assigned options. As with the stock exchanges,

there may be floor traders, who trade solely for themselves, hoping to buy low and

sell high, and floor brokers who handle orders from public.

MARKER MAKERS

Other option markets such as Chicago Board Options Exchange, do not involve

specialists, instead they involve market makers, who act solely as dealers and order

both officials (previously known as board brokers), who keep the limit order book.

The market makers must trade with floor brokers, who are the members of Exchange

that handle orders from the public. In doing so the market makers have an inventory

of options and quote bid and ask prices. Where as there in only one specialist

typically assigned to a stock, there usually is more than one market maker assigned to

the option on a given stock.

COMMISSIONS:

A commission must be paid to stockbroker whenever an option is either

written, bought, sold. The size of the commission has been reduced substantially

since the options began trading on organize exchanges in 1973. Furthermore this

typically smaller than the commission that would be paid if the underlying stock had

been purchased instead of option. This is probably because that clearing and

settlement are easier with the options than stock. However, the investor should be

aware that exercise an option will typically result in the buyer’s having to pay

50

commission equivalent to the commission that would be incurred if the stock itself

were being bought or sold.

MARGINS:

Margins are the deposits, which reduce counter party risk, arise in a futures

contract. These margins are collected in order to eliminate the counter party risk.

There are three types of margins:

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. That is, both buyer

and seller are required to make security deposit that they are intended to guarantee

that they will be in fact be able to fulfill their obligations, accordingly initial margin is

referred to as performance margin. The amount of this margin is roughly 5% to 15%

of the total purchase price of the futures contract.

Marking-to-market: In the futures market, at the end of each trading day, the margin

account is adjusted to affect 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. According to

the maintenance margin requirement, the investor must keep the account’s equity

equal or greater than certain percentage of the amount deposited as initial margin.

Because this percentage is roughly 5%, the investor must have equal 65% or greater

than 65% of initial margin. If the requirement is not met the investor will receive a

call. This call is a request to for an additional deposit of cash known as variation

margin.

In the case of a call, shares are to be delivered by the writer in return for the

exercise price. In case of a put, cash has to be delivered in return for shares. In either

51

case the net cost to the option writer will be the absolute difference the exercise price

and the stocks market value at the time of exercise. As the OCCs at risk if the writer

is unable to bear this cost, it is not surprising that the OCC would have a system in

place protecting itself from the actions of the write. This system is known margin.

PARTIES IN AN OPTION CONTRACT:

1. Buyer of the Option:

The buyer of an option is one who by paying option premium buys the

right but not the obligation to exercise his option on seller/writer.

2. Writer/Seller of the Option:

The writer of a call/put options is the one who receives the option

premium and is there by obligated to sell/buy the asset if the buyer exercises the

option on him.

SETTLEMENT OF OPTIONS

Daily premium settlement

Premium settlement is cash settled and settlement style is premium style. The

premium payable position and premium receivable positions are netted across all

option contracts for each broker at the client level to determine the net premium

payable or receivable amount, at the end of each day. The brokers who have a

premium payable position are required to pay the premium receivable position. This

is known as daily premium settlement. The brokers in turn would take this from their

clients. The pay-in and payout of the premium settlement is on T+1 days (T=Trade

Day). The premium payable amounts are directly debited or credited to the broker,

from where it is passed on to the client.

52

Interim Exercise Settlement for Options on Individual Securities:

Interim exercise settlement for Option contracts on Individual Securities is

effected for valid exercised option positions at in the money strike prices, at the close

of the trading hours, on the day of exercise. Valid exercised option contracts are

assigned to short positions in option contracts with the same series, on a random

basis. The interim exercise settlement value is the difference between the strike price

and the settlement price of the relevant option contract. Exercise settlement value is

debited/credited to the relevant broker account in T+3 days (T=exercise date). From

there it is passed on to the clients.

Final Exercise Settlement:

Final Exercise Settlement is affected for option positions at in-the-money strike

prices existing at the close of trading hours, on the expiration day of an option

contract. Long positions at in-the-money strike prices are automatically assigned to

short positions in option contracts with the same series, on a random basis. For index

options contracts, exercise style is European style, while for options contracts on

individual securities, exercise style is American style. Final Exercise is automatic on

expiry of the option contracts.

Exercise Settlement is cash settled by debiting/crediting of the clearing

accounts of the relevant broker with the respective clearing bank, from where it is

passed to the client. Final settlement profit/loss amount for option contracts on Index

is debited/credited to the relevant broker clearing bank account on T+1 day (T=expiry

day), from where it is passed Final Settlement profit/loss amount for option contracts

on individual Securities is debited/credited to the relevant broker clearing bank

account on T=3 day (T=expiry day), from where it is passed open positions, in option

contracts, cease to exist after their expiration day.

53

Payoffs for an option buyer:

The following example would clarify the basics on Call Options:

Illustration 1:

An investor buys one European Call option on one share of Reliance Petroleum at a

premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract

matures on 30 September. The payoffs for the investor on the basis of fluctuating spot

prices at any time are shown by the payoff table (Table 1). It may be clear form the

graph that even in the worst-case scenario, the investor would only lose a maximum

of Rs.2 per share which he/she had paid for the premium. The upside to it has an

unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely

reverse of the call options buyer. The maximum loss that he can have is unlimited

though the buyer would make a profit of Rs.2 per share on the premium payment.

Payoff from Call Buying/Long (Rs.) S Xt c Payoff Net Profit57 60 2 0 -258 60 2 0 -259 60 2 0 -260 60 2 0 -261 60 2 1 -162 60 2 2 063 60 2 3 164 60 2 4 265 60 2 5 366 60 2 6 4

54

A European call option gives the following payoff to the investor: max (S - Xt, 0).

The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).

Notes:

S - Stock Price

Xt - Exercise Price at time 't'

C - European Call Option Premium

Payoff - Max (S - Xt, O )

Payoffs from a put buying:

Put Options

The European Put Option is the reverse of the call option deal. Here, there is a

contract to sell a particular number of underlying assets on a particular date at a

specific price. An example would help understand the situation a little better:

Illustration 2:

An investor buys one European Put Option on one share of Reliance Petroleum at a

premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract

matures on 30 September. The payoff table shows the fluctuations of net profit with a

change in the spot price

55

Payoff from Put Buying/Long (Rs.) S Xt p Payoff Net Profit55 60 2 5 356 60 2 4 257 60 2 3 158 60 2 2 059 60 2 1 -160 60 2 0 -261 60 2 0 -262 60 2 0 -263 60 2 0 -264 60 2 0 -2

The payoff for the put buyer is: max (Xt - S, 0)

The payoff for a put writer is: -max(Xt - S, 0) or min(S - Xt, 0)

These are the two basic options that form the whole gamut of transactions in the

options trading. These in combination with other derivatives create a whole world of

instruments to choose form depending on the kind of requirement and the kind of

market expectations.

Factors affecting the price of an option:

56

The following are the various factors that affect the price of an option. They

are:

Stock price:

The pay-off from a call option is the amount by which the stock price exceeds

the strike price. Call options therefore become more valuable as the stock price

increases and vice versa. The pay-off from a put option is the amount; by which the

strike price exceeds the stock price. Put options therefore become more valuable as

the stock price increases and vice versa.

Strike price:

In the case of a call, as the strike price increases, the stock price has to make a

larger upward move for the option to go in-the –money. Therefore, for a call, as the

strike price increases, options become less valuable and as strike price decreases,

options become more valuable.

Time to expiration:

Both Put and Call American options become more valuable as the time to

expiration increases.

Volatility:

The volatility of n a stock price is a measure of uncertain about future stock

price movements. As volatility increases, the chance that the stock will do very well

or very poor increases. The value of both Calls and Puts therefore increase as

volatility increase.

Risk-free interest rate:

The put option prices decline as the risk – free rate increases where as the

prices of calls always increase as the risk – free interest rate increases.

Dividends:

57

Dividends have the effect of reducing the stock price on the ex dividend date.

This has a negative effect on the value of call options and a positive affect on the

value of put options.

OPTION VALUATION USING BLACK AND SCHOLES:

The Black and Scholes Option Pricing Model didn’t appear overnight, in fact,

Fisher Black started out working to create a valuation model for stock warrants. This

work involved calculating a derivative to measure the discount rate of a warrant

varies with time and stock price. The result of this calculation held a striking

resemblance to a well known the transfer equation. Soon after this discovery, Myron

Scholes joined Black and the result of their work is a startling accurate option-pricing

model. Black and Scholes can’t take all credit for their work; in fact their model is

actually an improved version of a previous model developed by A.James Boness in

Ph.D dissertation at the University of Chicago. Black and Scholes’ improvement son

the Boness model come in the form of a proof that the risk-free interest rate is the

correct discount factor and with the absence of assumptions regarding investor’s risk

preferences.

THE MODEL:

C=SN (d1)-Ke (-r t) N (d2)

C=theoretical call premium

S=current stock price

T=time until option expiration

K=option striking price

R=risk free interest rate

N=cumulative standard normal distribution

E=exponentil terms (2.1783)

d1=in(s/k) + (r + s2/2) T

D2=d1 – St

58

In order to understand the model itself, we divide it into two parts. The first

part SN (d1) derives the expected benefit from acquiring a stock outright. This is

found by multiplying stock price(s) by the change in the call premium with respect to

a change in the underlined stock price [N (d1)]. The second part of the model, ke (-r t)

N (d2), gives the resent value of paying the exercise price on the expiration day. The

fair market value of the call option is then calculated by taking the difference between

these two parts.

Assumptions of the Black and Scholes model:

1) The stock pays no dividend to option’s life: most companies pay dividends

to their shareholders, so this might seem a serious limitations to the model

considering the observation that higher dividend is elicit lower call premiums.

A common way of adjusting the model for this situation is to subtract the

discounted value of a future dividend form the stock price.

2) European exercise terms are used: European exercise terms dictate thbat 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 the 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 you exercise a

call early, you forfeit the remaining time value on the call and collect the

intrinsic value 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 it process.

59

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 investors pay is 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 US

government treasury bills with 30 days left until maturity is usually used to

represent it. During periods of rapidly changing interest rates, these 30 days

rates are often subject to change. There by violating one of the assumptions of

the model.

SOME TERMS USED IN OPTIONS CONTRACT

Index options:

These options have the index as the underlined. Some options are European while

others are American. Like index, futures contracts, index options. Contracts are

also cash settled.

Stock options:

Stock options are options on individual stocks. Options currently trade on over

500 stocks in the United States. A contract gives the holder the right to buy or

sell shares at the specified price.

American options:

60

American options are options that can be exercised any time up to the expiration

date. Most exchange traded options are American.

European options:

European options are options that can be exercised only on the expiration date

itself. European options are easier to analyze that American option are frequently

deduced from those of its European counterpart.

In-the-money options:

An in-the-money option is an option that would lead to a positive cash flow to the

holder if it were exercised immediately. A call option on the index is said to be in

the money when the current index stands at a level higher than the strike price. If

the index is much higher than the strike price the call is said to be deep in the

money.

At-the-money option:

An at-the-money option is an option that would lead to zero cash flow if it were

exercised immediately. An option in the index is at the money when the current

index equal that strike price (i.e. spot price=strike price)

Out-of-the-money option:

An out-of-the-money option is an option that would lead to a negative cash flow. A

call option on the index is out of the money when the current index stands at a level,

which is less than the strike price (i.e. spot price-strike price).

Effect of increase in the relevant parameter on Option Prices:

61

European Options Buying American Options Buying

Parameters Call Put Call Put

Spot price (S) ↑ ↓ ? ↓

Strike price (Xt) ↓ ? ↓ ?

Time to expiration (T)

? ? ↑ ↑

Volatility ↑ ↑ ↑ ↑

Risk free interest rates ®

↑ ↓ ↑ ↓

Dividends (D) ↓ ↑ ↓ ↑

↑-Favorable

↓-Unfavorable

62

TRADING STRATEGIES USING FUTURES AND OPTIONS

TRADING STRATEGIES USING FUTURES AND OPTIONS

There are a lot of practical uses of derivatives. As we have seen derivatives can

be used for profits and hedging. We can use derivatives as a leverage tool too.

Using speculation to make profits:

63

When you speculate you normally take a view on the market, either bullish or

bearish. When you take a bullish view on the market, you can always sell futures and

buy in the spot market. Similarly, in the options market if you are a bullish you

Should buy call options? If you are bearish, you should buy put options of

conversely, if you are bullish, you should write put options. This is so because, in a

bull market, there are lower chances of the put option being exercised and you can

profit from the premium of you are bearish, you should write call options. This is so

because, in a bear market, there are lower chances of the call options being exercised

and you can profit from the premium.

Using arbitrage to make money in derivatives market:

Arbitrage is making money on price differentials in different markets. For

Example, future is nothing but the future value of the spot price. This future value is

obtained by factoring the interest rate. But if there are differences in the money

Market and the interest rate changes then the future price should correct itself to

factor the change in making money an arbitrage opportunity.

Let us take an example:

Example:

64

A stock us quoting for Rs.1000. The one-month future of this stock is at Rs.1005.

The risk free rate is 12%. The trading strategy is:

Solution:

The strategy for trading should be – Sell Spot and Buy Futures sell the stock for

Rs.1000. Buy the future at Rs.1005. Invest the Rs.1000 at12%. The interest earned

on this stock will be 1000(1+0.12)(1/2)=1009.

So net gain the above strategy is Rs.1009-Rs.1005=Rs.4.

Thus one can make risk less profit of Rs.4 because of arbitrage. But an important

point is that this opportunity was available due to mispricing and the market not

correcting itself. Normally, the time taken for the market to adjust to corrections is

very less. S, the time available for arbitrage is also less. As everyone rushes to cash

in on the arbitrage, the market corrects itself.

Using future to hedge position:

One can hedge one’s position by taking an opposite position in the futures

market. For example, if you are buying in the spot price, the risk you carry is that of

prices falling in the future. You can lock this by selling in the futures price.

Even if the stock continues falling, you position is hedged as you have formed

the price at which you are selling. Similarly, you want to buy a stock at a later date

but face the risk of prices rising. You can hedge against this rise by buying futures.

You can use a combination of futures too to hedge yourself. There is always a

correlation between the index and individual stocks. This correlation may be negative

or positive, but there is a correlation. This is given by the beta of the stock. In simple

terms, beta indicates the change in the price of a stock to every change in index.

For example, if beta of a stock is 0.18, it means that if the index goes up by when the

index falls, a negative beta means that the price of the stock falls when the index rises.

So, if you have a position in a stock, you can hedge the same by buying the index at

times the value of the stock.

65

Example:

The beta of HPCL is 0.8 the Nifty is at 1000. If there is a stock of Rs.10, 000 worth

of HPCL, hedging of position can be done by selling 8000 of Nifty. That is there is a

sale.

Scenario 1

If index rises by 10% the value of the index becomes 8800 i.e. a loss of Rs.800. The

value of the stock however goes up by 8 i.e. it becomes Rs.10, 800 i.e. a gain of

Rs.800.

Thus the net position is zero and there is a perfect hedging.

Scenario 2

If index falls by 10%, the value of the index becomes Rs.7, 200 a gain of Rs.800. But

the value of the stock also falls by 8%. The value of this stock becomes Rs.9, 200 a

loss of Rs.800. thus the net position is zero and it is hedged.

But again, beta is predicted value based on regression models. Regression is nothing

but analysis of past data. So there is a chance that the above position may not be fully

hedged if the beta does not behave as per the predicted value.

Using options in trading strategy:

Options are a great tool to use for trading. If traders feel the market will go up.

He should buy a call option at a level lower than what he expects the market tot go

up. If he thinks that the market will fall, you should buy a put option at a level higher

than the level to which he expect the market fall. When we say market, we mean the

index. The same strategy can be used for individual stocks also.

A combination of futures and options can be used too, to make profits.

66

Strategy for an option writer to cover himself:

An option writer can use a combination strategy of futures and options to

protect his position. The risk for an option writer arises only when the options

exercised. This will be very clear with an example.

Supposing I sell a call option on satyam at a strike price of Rs.300/- for a

premium of Rs.20/-, the risk arises only when the option is exercised. The option will

be exercised when the price exceeds rs.300/-. I start making a loss only after the price

exceeds Rs.32/- (strike price plus premium).

More importantly, I have to deliver the stock to the opposite party. So to

enable me to deliver the stock to the other party and also makes entire profit on

premium, I buy a future of Satyam at Rs.300/-.

This is just one leg of the risk. The earlier risk was of the call being exercised.

The risk now is that of the call not being exercised. In case the call is not exercised, I

will have to take delivery as I have bought a future.

So minimize this risk, I buy a put option on Satyam at Rs.300. but I also need

to pay a premium for buying the option. I pay a premium of Rs.10/-. Now I am

covered and my net cash flow would be

Premium earned from selling call option: Rs.20

Premium paid to buy put option: Rs.10

Net cash flow: Rs.10/-

But the above pay off will be possible only when the premium I am paying for

the put option is lower than the premium that I get for writing the call. Similarly, we

can arrive at a covered position for writing a put option too, another interesting

observation is that the above strategy in itself presents an opportunity to make money.

This is so because of the premium differential in the put and the call option. So if one

tracks the derivative markets on a continuous basis, one can chance upon almost risk

less moneymaking opportunities.

67

LOT SIZES OF DIFFERENT COMPANIES

CODE LOT SIZE COMPANY NAMEACC 1500 ASSOCIATES CEMENT COS LTDANDHRA BANK 4600 ANDHRA BANKARVIND MILLS 4300 ARVIND MILLS LTDBAJAJ AUTO 400 BAJAJ AUTOMOBILES LTDBANKBARODA 1400 BANK OF BARODABANKINDIA 3800 BANK OF INDIABEL 550 BHARAT ELECTRICALS LTDBHEL 600 BHARAT HEAVY ELECTRICALS LTDBPCL 550 BHARAT PETROL CORPORATION LTDCANBK 1600 CANARA BANKCIPLA 200 CIPLA LTDCNXIT 10 IT INDEXDIGITALEQUIP 400 DIGITAL GLOBAL LTDDRREDDY 200 DR. REDDY’S LABORATORIES LTDGAIL 1500 GAS AUTHOURITY OF INDIAGRASIM 350 GRASIM INDUSTRIES LTDGUJAMBCEMENT 110 GUJARAT AMBUJA CEMENT LTDHCL TECH 1300 HINDUSTAN CORPORATION LTDHDFC 600 HOUSING DEDVELOPMENT FINANCE

CORPORATIONHDFC BANK 800 HDFC BANKHEROHONDA 400 HERO HONDA MOTORS LTDHINDALCO 300 HINDUSTAN ALUMINIUM COMPANYHINDLEVER 2000 HINDUSTAN LEVER LTDHINDPETROL 650 HINDUSTAN PETROLEUM CORPORATIONI-FLEX 300 I-FLEXICICIBANK 1400 ICICI BANKING CORPORATION LTDINFOSYSTECH 50 INFOSYS TECHNOLOGIES LTDIOC 600 INDIAN OIL CORPORATIONIPCL 1100 INDIAN PETROLEUM CHEMICALS LTDITC 300 INDIAN TOBACCO COMPANYL&T 500 LARSEN AND TURBOM&M 625 MAHENDRA AND MAHENDRA LTDMARUTI 400 MARUTI UDYOG LTDMASTEK 1600 MASTEKMTNL 1600 MAHANAGAR TELECOM NIGAM LTD

68

NATIONALALAM 1150 NATIONAL ALUMINIUM COMPANYNIFTY 200 NATIONAL INDEX FOR FIFTY STOCKSNIIT 1500 NATIONAL INSTITUTE OF INFORMATION

TECHNOLOGYONGC 300 OIL AND NATURAL GAS CORPORATIONORIENT BANK 1200 ORIENTAL BANKPNB 1200 PUNJAB NATIONAL BANKPOLARIS 1400 POLARIS SOFTWARE COMPANY LTD.

RANBAXY 400 RANBAXY LABORATORIES LTDRELIANCE 550 RELIANCE INDUSTRIES LTDREL 600 RELIANCE COMPUTERS SERVICES LTDSATYAMCOMPU 1200 SATYAM COMPUTERS LTDSBI 500 STATE BANK OF INDIASCI 1600 SHIPPPING CORPORATION OF INDIASYNDIBANK 7600 SYNDICATE BANKTATAMOTORS 825 TATA MOTORSTATAPOWER 50 TATA POWER COMPANY LTDTATA TEA 900 TATA TEA LTDTISCO 4200 TATA IRON&STEEL COMPANY LTDUNION BANK 200 UNION BANK OF INDIAWIPRO 800 WESTERN INDIA-VEG PRODUCTS LTD

69

DESCRIPTION OF THE METHOD:

70

DESCRIPTION OF THE METHOD:

The following are the steps involved in the study.

1. Selection of the scrip:

The scrip selection is done on a random basis and the scrip selected is

ONGC. The lot size of the scrip is 500. Profitability position of the option holder and

option writer is studied.

2. Data collection:

The data of the ONGC has been collected from the “The Economic Times”

and the Internet. The data consists of the August contract and the period of data

collection is from 3rd August 2005 to 3rd September 2005.

3. Analysis:

The analysis consists of the tabulation of the data assessing the profitability

positions of the option holder and the option writer, representing the data with graphs

and making the interpretations using the data.

LOT SIZES OF SELECTED COMPANIES FOR ANALYSIS

71

CODE LOT SIZE COMPANY NAME

ACC 188 Associates Cement Co. Ltd.

INFOSYS 200Infosys Technologies Ltd.

HLL 1000Hindustan UniLever Ltd.

RANBAXY 800Ranbaxy laboratories Ltd.

SATYAM 600Satyam Computer services Ltd.

The following tables explain about the trades that took place in futures and options

between 01/05/2009 and 13/05/2009. The table has various columns, which explains

various factors involves in derivatives trading.

Date – the day on which trading took place

Closing premium – premium for the day

Open interest – No. of Options that did not get exercised

Traded quantity – No. of futures and options traded on that day

N.O.C – No. of contacts traded on that day

Closing price – the price of the futures at the end of the trading day

FUTURES OF ‘ACC CEMENTS’

Date Open. High Low Close Open Int N.O.C

72

dd/mm/yyy Rs Rs. Rs. Rs (‘000’)

20/04/2011 795.95 809.40 791.35 794.5 3452 750219/04/2011 809.00 819.00 783.10 790.15 3943 1575918/04/2011 815.00 827.45 815.00 818.00 3810 773817/04/2011 791.00 816.70 785.00 809.95 4600 1726516/04/2011 756.00 793.95 756.00 789.15 4385 10335

FINDINGS:

The price gradually rose from 789.15 on first day to 18th April, where it stood at

818.00 as high. As the players in the market with an intention to short or correct

the market, the players showed a bearish attitude for the next day where the price

fell to 790.15. Later the players become a bullish.

At 809.95 the open interest stood at peak position of 4600000, but later the next

day players sold their futures as to gain. The total contracts traded at this price

stood 17265 which is higher than the week days

By the end of the trading week most of the players closed up their contracts to

make loss. As the price was high, the open interest was high and the no. of

contracts trades rose to 7502.

There always exit an impact of price movements on open interest and contracts

traded. The futures market also influenced by cash market, Nifty index futures,

and news related to the underlying asset or sector (industry), FII’s involvement,

national and international affairs etc.

FUTURES OF ‘INFOSYS’

Datedd/mm/yyy

OpenRs.

HighRs.

LowRs.

CloseRs

Open. int(‘000’)

N.O.C

20/04/2011 2061.00 2082.00 2055.50 2061.75 3335 1084219/04/2011 2046.50 2060.50 2021.25 2045.95 3397 13041

73

18/04/2011 2076.00 2090.00 2062.15 2070.30 3625 1188617/04/2011 2102.65 2110.00 2055.50 2073.90 4215 2653416/04/2011 2100.00 2125.00 2095.00 2118.80 3698 17017

FINDINGS:

After the market quite relived by the fall in the discount on the Nifty in the futures

and the options segment, which was used by the players to short the market shown

appositive upward movement in futures and options segment and cash market

during the first day of the week.

The futures of INFOSYS shown a bullish way till 17th of the April whose impact

shown on the open interest at 4215 with 26534 contracts traded. The players at

this point did not sell or close up their contracts as a hope of increase or go up in

the market for a next day. Even the cash market was down on this day for this

underlying at Rs. 2076.00.

The market for INFOSYS for last day of the trading week shown a decline in the

opening price Rs. 15.05 when compare with the week high price. The open

interest closed at 3335000 with lowest 10842 contracts traded on the last trading

day of the week.

FUTURES OF THE ‘HLL’

Datedd/mm/yyy

Open.Rs.

HighRs.

LowRs.

CloseRs

Open. int(‘000’)

N.O.C

20/04/2011 205.10 209.80 204.25 206.20 8742 256819/04/2011 203.55 205.50 201.10 204.15 9112 274018/04/2011 208.10 211.80 205.25 206.00 9143 202017/04/2011 211.50 212.85 208.35 208.75 9205 245416/04/2011 205.70 211.45 204.70 211.10 9232 3765

INTERPRETATION:

74

HLL contracts traded in the futures stood at peak for the week i.e. 3765. There

was a good buying in both the futures and options and cash market for this stock.

The last trading day of the week showed a high strike price or exercising price for

the HLL futures i.e. Rs. 206.20 because of the huge correction done by the FII

flows.

FUTURES OF ‘RANBAXY’

Datedd/mm/yyy

OpenRs

HighRs.

LowRs.

CloseRs

Open. int(‘000’)

N.O.C

20/04/2011 345.00 345.50 342.05 344.10 5698 136619/04/2011 336.00 344.75 335.10 342.45 6578 305.418/04/2011 339.50 344.80 339.00 341.40 6731 300817/04/2011 341.80 342.00 337.25 338.00 6770 167916/04/2011 337.00 342.25 337.00 339.30 6731 2370

INTERPRETATION:

The week showed a buy for RANBAXY stock futures. Since beginning of the

trading day of the week the figures has been representing a continuous bullish

market for RANBAXY. The pharmacy sector is considered to be one of the eye

watches for investors for investing.

On the last but one, trading day the RANBAXY stock futures has rose to peak

level where the price stood at 451.35 an increase of 11.73% over the first trading

day price 403.95. The open interest rose 52.16% to 9512000 and the contract

traded, 19314 from 7645 of week’s beginning.

At the end of the week the price of the RANBAXY has rose to Rs.458.90 this is

all time record of that week at this stage open interest has also gone up to

75

9512000, this was great boom in pharmacy sector, because FII’s were interested

to invest in this sector.

FUTURES OF ‘SATYAM COMPUTERS’

Datedd/mm/yyy

OpenRs

HighRs.

LowRs.

CloseRs

Open. int(‘000’)

N.O.C

20/04/2011 463.00 477.00 461.35 474.75 6226 1648619/04/2011 450.00 462.00 445.55 449.50 8991 1128618/04/2011 462.00 468.80 460.10 462.95 11072 1198417/04/2011 474.55 483.00 456.00 457.95 13645 1574716/04/2011 487.90 494.50 476.90 480.95 13043 11543

FINDINGS:

The above table indicates decrease in the price from the 3 rd day about 23 Rs.

Call and Put Options of ‘ACC Cements’

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C

C.P O.I.*

N.C

CA 700

89.80

17 7

CA 720

66.35

17 21 91.35

17 12

CA 740

45.90

44 87 71.80

37 91

CA 760

35.40

64 161 50.50

57 88 59.00

58 11 34.00

56 23

CA 780

22.95

25 69 39.00

17 63 47.00

15 16 20.10

28 60 19.40

28 35

CA 800

13.65

38 114 22.85

49 177 27.50

42 52 10.95

79 241 10.25

77 192

76

CA 820

7.50 2 7 14.10

29 136 15.10

45 151 6.35 83 204 4.50 85 81

CA 840

8.50 6 21 7.30 15 49 4.05 23 61 3.00 23 14

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C

C.P O.I.*

N.C

PA 720 2.05 13 10 1.00 14 7PA 740 3.35 17 24 2.85 17 15PA 760 7.50 13 45 7.50 14 31 2.45 18 6 4.35 26 33 2.90 27 14PA 780 16.2

07 20 13.2

524 95 6.85 14 11 11.2

023 63 5.10 27 21

PA 800 8.40 26 36 21.55

33 107 15.65

34 19

PA 820 17.45

26 98 39.00

26 47

C.P. = Close premium O.I = Open interest N.C. = No. of contracts

The following table of net payoff explains the profit/loss of option holder/writer of ACC for the week 16/04/2011-20/04/2011.

Profit/loss position of Call option buyer/writer of ACC

Spot Price Strike Price

Premium Whether Exercised

BuyerGain/Loss

WritersGain/Loss

788 700 89.80 NO -562.5 562.5788 720 66.35 YES 618.75 -618.75788 740 45.90 YES 787.5 -787.5788 760 35.40 NO -2775 2775788 780 22.95 NO -8598.5 8598.5788 800 13.65 NO -9618.75 9618.75788 820 7.50 NO -14812.5 14812.5

Profit/Loss position of Put option buyer/writer of ACC

77

Spot Price Strike Price

Premium Whether Exercised

BuyerGain/Loss

WritersGain/Loss

788 720 2.05 YES 24731.25 -24731.25788 740 3.35 YES 16743.75 -16743.75788 760 7.50 YES 7687.5 -7687.5788 780 16.20 NO -3075 3075

Findings:

The Call Options 700, 760,780,800 and 820 were out-of-the-money option and the remaining 720 and 740 were in the money option.

The Put Options 720,740 and 760 were in-the-money option and the remaining i.e.780 was out-of-the-money option.

Profit of the holder = (spot price – strike price) – premium * 375 (lot size) in case of Call Option

Profit of the holder = (spot price – strike price) – premium * 375 (lot size) in case of Put Option

If it is a profit for the holder than obviously it is loss for the holder and vice-versa.

Call and Put Options of ‘INFOSYS’Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.CA 1950 176.50 8 7CA 1980 145.95 30 31 102.00 27 28 102.0 26 7 79.95 26 13 83.05 26 10CA 2010 117.95 267 351 76.55 251 319 71.25 249 101 55.20 242 334 56.70 242 117CA 2040 90.55 100 362 57.90 107 271 50.45 105 108 37.10 104 399 36.95 100 150CA 2070 65.10 63 189 39.25 63 193 33.90 65 109 22.45 69 208 20.95 73 193CA 2100 45.40 327 1092 24.80 340 1194 22.55 344 466 14.85 370 601 11.30 358 437CA 2130 29.25 81 205 13.65 86 193 12.15 86 88 8.36 87 66 4.45 87 54CA 2160 19.35 85 159 8.30 93 215 5.65 95 150 5.70 94 115 3.95 95 54CA 2190 12.30 66 67 6.30 68 83 3.60 69 19 3.90 66 25 2.50 66 47CA 2220 9.00 73 98 4.50 77 67 3.05 80 32 3.00 80 20 1.30 80 12CA 2250 6.20 33 29

78

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.*

N.C.

C.P. O.I.*

N.C. C.P. O.I.*

N.C. C.P. O.I.*

N.C. C.P. O.I.*

PA 1830 3.15 80 25 3.10 79 15 2.90 77 37PA 1890 3.40 51 34 3.60 50 10 2.80 47 27 1.25 46PA 1920 5.20 141 116 4.55 137 89 4.30 134 41 4.90 125 113 2.25 123PA 1950 5.65 75 34 7.00 73 46 5.85 72 13 7.70 67 82 3.25 64PA 1980 6.75 94 126 9.05 91 48 7.85 87 80 12.75 81 123 3.30 74PA 2010 10.40 218 351 14.15 200 336 12.15 193 249 19.60 169 433 8.35 171PA 2040 14.45 69 211 25.40 67 168 20.60 65 77 28.50 55 313 17.0 55PA 2070 19.70 24 128 36.90 23 117 34.05 24 50 42.25 19 96 33.6 19PA 2100 30.45 44 297 52.20 31 285 52.60 28 72 65.75 27 76 45.0 26

The following pay-off for explain the profit/loss of option holder/writer of ‘INFOSYS’for the week 16/04/2011-20/04/2011..

Profit/Loss position of Call Option Buyer/Writer of ‘INFOSYS’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

2040 1950 176.50 NO -8650 86502040 1980 145.95 NO -8595 85952040 2010 117.95 NO -8795 87952040 2040 90.55 NO -9055 90552040 2070 65.10 NO -9510 95102040 2100 45.40 NO -10540 105402040 2130 29.25 NO -11925 119252040 2160 19.35 NO -13935 139352040 2190 12.30 NO -16230 162302040 2220 9.00 NO -18900 189002040 2250 6.20 NO -21620 21620

Profit/Loss position of Put Option Buyer/writer of ‘INFOSYS’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

2040 1830 3.15 YES 20685 -20685

79

2040 1890 3.40 YES 14660 -146602040 1920 5.20 YES 11480 -114802040 1950 5.65 YES 8435 -84352040 1980 6.75 YES 5325 -53252040 2010 10.40 YES 1960 -19602040 2040 14.45 NO -1445 14452040 2070 19.70 NO -4970 49702040 2100 30.45 NO -9045 9045

Findings:

The Call options all were in out-of-money option.

The Put option1830, 1890,1920,1950,1980 and 2010 were in-the-money options

and the remaining 2040, 2070 and 2100 were out of option.

Profit of the holder = (spot price – strike price) – premium*100 (lot size) in case

call option

Profit of the holder = (spot price-spot price)-premium*100 (lot Size) in case of

put option.

If it is profit for the holder than obviously it will be loss for the holder and vice-

versa.

Call and Put Option of HLL

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.

C.P. O.I.* N.C. C.P. O.I.* N.C.

CA 200 13.80 238 120 11.55 231 45 8.50 148 67 6.95 173 107 7.45 108 57CA 205 9.20 108 65 6.25 105 34 4.65 98 18 3.90 116 44 3.80 112 33CA 210 4.80 396 263 3.70 385 213 2.65 417 152 1.75 475 109 1.80 470 113CA 215 2.65 78 62 2.15 108 68 1.40 126 44 1.00 129 13 0.55 122 19CA 220 1.60 255 97 1.25 284 66 0.75 287 31 0.60 286 11 0.40 278 13CA 225 0.75 32 25 0.80 37 7 .50 40 8 2.10 86 30 1.05 88 17

80

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.PA 200 1.35 85 34 1.35 90 16 1.80 90 18 2.10 86 30 1.05 88 17PA 205 2.70 11 11 2.20 16 9 3.20 18 10 4.00 17 14 2.70 32 29PA 210 4.50 9 12 5.05 17 26 8.55 14 5 5.90 26 13

The following table of net payoff explains the profit/loss of option

holder/writer of ‘HLL’ for the week 16/04/2011-20/04/2011...

Profit/Loss position of Call Option Buyer/Writer of ‘HLL’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

207 200 13.80 NO -6800 6800207 205 9.20 NO -7200 7200207 210 4.80 NO -7800 7800207 215 2.65 NO -10650 10650207 220 1.60 NO -14600 14600207 225 0.75 NO -18750 18750

Profit/Loss position of Put Option Buyer/Writer of ‘HLL’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

207 200 1.35 YES 5650 -5650207 205 2.70 NO -700 700

Findings:

The Call Options all were out-of-the-money options

The Put Options200 was in-the-money option and 205was out-of-the-money

option.

Profit of the holder = (spot price-strike piece)-premium*1000(lot size) in case of

Call option.

81

Profit of the holder = (strike price-spot price) - premium*1000(lot size) in case of

Put option.

If it is profit for the holder then obviously it will be loss for the holder and vice-

versa.

Call and Put Options of ‘RANBAXY’

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.* N.C. C.P. O.I.* N.C.

C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.

CA 330 . 15.00 28 8 16.65

26 8

CA 340 8.90 102 63 8.45 122 54 8.75 124 61 8.35 124 32 8.40 118 29CA 350 5.65 115 51 4.80 123 22 4.70 130 42 4.10 133 23 3.60 129 15CA 360 3.35 103 11 3.00 105 5 2.45 106 16 2.20 102 9 1.75 103 8CA 370 1.25 44 9 1.70 42 9CA 400 0.60 22 6

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.* N.C. C.P. O.I.* N.C.

C.P. O.I.* N.C.

C.P. O.I.* N.C.

C.P. O.I.* N.C.

PA 330 4.60 22 6 2.60 24 9

The following tables of net payoff explain the following Profit/Loss of option

holder/writer of ‘RANBAXY’ for the week 16/04/2011-20/04/2011...

Profit/Loss position of Call Buyer/Writer of ‘RANBAXY’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

82

340 340 8.90 NO -7120 7120340 350 5.65 NO -12520 12520340 360 3.35 NO -18680 18680340 400 0.60 NO -48480 48480

Profit/Loss position of Put option Buyer/Writer of ‘RANBAXY’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

340 330 4.60 NO -4320 4320

Findings:

The Call options all were in the out-of-the-money options.

The Put option also was in the out-of-the-money options..

Profit of the holder = (spot price- strike price) – premium* 800 (lot size) in case

of call option.

Profit for the holder = (strike price-spot price) –premium* 800(lot size) in case of

Put option.

If it is a profit of the holder then obviously it will be loss for the holder and vice-

versa.

Call and Put Option of the ‘SATYAM COMPUTERS’

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.*

N.C. C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C. C.P. O.I.*

N.C.

CA 440 18.35 50 21 32.25 44 18CA 450 35.00 44 26 18.10 51 63 21.65 61 36 12.85 152 282 26.50 91 263CA 460 28.05 88 35 13.40 120 258 15.20 133 113 7.55 302 569 18.25 185 701CA 470 22.20 115 72 8.85 185 306 10.45 205 123 4.25 325 334 12.10 266 971

83

CA 480 15.75 161 310 6.35 292 435 7.15 329 171 2.80 446 353 6.35 418 855CA 490 11.40 55 101 4.00 96 112 4.25 130 66 2.05 143 61 2.90 175 136CA 500 7.85 194 300 2.95 326 310 2.95 358 120 1.40 430 186 1.65 442 328CA 510 5.00 31 58 2.05 34 12 1.90 37 17 1.00 33 13 0.80 36 22CA 520 3.00 26 44 1.50 39 29 1.30 41 6 9.60 4 8 0.25 40 11

Date/Options

16/04/2011 17/04/2011 18/04/2011 19/04/2011 20/04/2011

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

C.P. O.I.*

N.C.

PA 420 2.25 10 6 4.10 14 11PA 430 6.30 13 12 0.50 12 6PA 440 3.75 38 13 6.55 44 38 6.00 48 17 8.30 64 80 1.40 59 46PA 450 5.15 60 73 10.1

058 82 8.05 58 30 13.3

056 77 2.25 149 282

PA 460 6.85 104 78 15.10

92 183 12.65

100 57 18.45

97 159 3.60 149 282

PA 470 10.50

36 42 19.55

22 45 20.15

21 9 7.15 52 137

PA 480 14.85

35 189 28.40

28 41 11.25

73 130

PA 490 17.05

11 25

PA 500 24.90

9 13

The following table of net payoff explains profit/loss of option holder/writer

of ‘SATYAM COMPUTERS’ for the week 16/04/2011-20/04/2011...

Profit/Loss position of Call Option Buyer/Writer of ‘SATYAM COMPUTERS’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

448 450 35.00 NO -22200 22200448 460 28.05 NO -24030 24030448 470 22.20 NO -26520 26520448 480 15.75 NO -28650 28650448 490 11.40 NO -32040 32040448 500 7.85 NO -35910 35910

84

448 510 5.00 NO -40200 40200448 520 3.00 NO -22200 22200

Profit/Loss position of Put Option Buyer/Writer of ‘TATA CONSULTANCY SERVICES’

SPOT PRICE

STRIKE PRICE

PREMIUM WHETHER EXERCISED

BUYER GAIN/LOSS

WRITER GAIN/LOSS

448 440 3.75 YES 2550 -2550448 450 5.15 NO -4290 4290448 460 6.85 NO -11310 11310448 470 10.50 NO -19500 19500448 480 14.85 NO -28110 28110448 490 17.05 NO -35430 35430448 500 24.90 NO -46140 46140

Findings:

The Call Options all were out-of-the-money option

All Put Option 440 was in-the-money option and remaining 450,460,470,480,490

and 500 were out-of-the-money options.

Profit of the holder = (spot price-strike price)-premium*600 (lot size) in case of

Call Option.

Profit of the holder = (strike piece-spot price)-premium*600 (lot size) in case of

Put Option.

If it is a profit for the holder then obviously it will be loss for the holder and vice-

versa.

Conclusion and suggetions:

The above analysis Futures and Options of ACC, INFOSYS, HLL, RANBAXY

and SATYAM COMPUTERS had shown a positive market in the week.

85

The major factors that will influence the futures and options market, FII

involvement, News related to the underlying asset, National and International

markets, Researchers view etc.

In a bearish market it is suggested to an investor to opt for Put Option in order to

minimize losses.

In a bearish market it is suggested to an investor to opt for Call Option in order to

minimize profits.

In a cash market the profit/loss is limited but where in futures and options an

investor can enjoy unlimited profit/loss.

It is recommended that SEBI should take measures in improving awareness about

the futures and options market as it is launched very recently.

It is suggested to an investor to keep in mind the time and expiry duration of

futures and options contracts before trading. The lengthy the time, the risk is low

and profit making. The fever time may be high risk and chances of loss making.

At present futures and options are traded on NSE. It is recommended to SEBI to

take actions in trading of futures and options in other regional exchanges.

At present scenario the derivatives market is increased to a great position. Its daily

turnover reaches to the equal stage of cash market. The average daily turnover of

NSE in derivatives market is 400000 (vol.).

The derivatives are mainly used for hedging purpose.

86

Glossary

Arbitrage – The simultaneous purchase and sale of a commodity or financial

instrument in different markets to take advantage of a price or

exchange rate discrepancy.

87

Calendar Spread – An option strategy in which a short term option is sold and a

longer term option is bought both having the same striking

price. Either puts or calls may be used.

Call Option – An option that gives the buyer right to buy a future contract at a

premium, at the strike price.

Currency Swap – A Swap in which the counter parties exchange equal amounts of

two currencies at the spot exchange rate.

Derivative – A derivative is an instrument whose value derived from the value of one

or more underlying assets, which can be commodities, precious

metals, currency, bonds, stocks, stock indices, etc. derivatives involves

the trading of rights or obligations based on the underlying assets, but

do not directly transfer the property.

Double Option – An option that gives the buyer the right to buy and or sell a future

Contract, at a premium, at a strike price.

Futures Contract –A legally binding agreement for the purpose and a sell of a

commodity, index or financial instrument some time in the

future.

Hedge Fund – A large pool of private money and asset managed aggressively and

often riskily on any future exchange, mostly for short term gain.

In-the-money option – An option with intrinsic value, a Call option is in the money

if its strike price is below the current price of the

underlying futures contract and the put option is in the

money if it is above the underlying.

88

Margin call – A demand from a clearing house to a clearing member or from a

broker to a customer bring deposits up to a required minimum level

to guarantee performance at ruling prices.

Option – it gives the buyer the right, but not the obligation, to buy or sell stock at a

set. price on or before a given date. Investors who purchase call options

but the stock will be worth more than the price set by the option (strike

price), plus the price they paid for the option itself. Buyer of put option bet

the stock price will go down below the price set by the option.

Out-of-the-money option – An option with no intrinsic value, a call option is out of

Money if its strike price is above the underlying and a

put option is so if it is below the underlying.

Premium – The price of an option contract, determined on the exchange, which the

buyer of the option pays to the option writer for the rights to the option

contract.

Spread – The difference between the bid and asked prices in any market.

Stop loss orders – An order place in the market to buy or sell to close out an open

position on order to limit losses when market moves the wrong

way.

Swap – An agreement to exchange on currency on index return for another, the

exchange on fixed interest payments for a floating rates payments or the

exchange of an equity index return for a floating interest rate.

89

Underlying – The currency, commodity, security or any other instrument that forms

the basis of a future or a option contract.

Writer – The person who originates the option contract by promising to perform the

Certain obligation in return for the price of the option. Also known as the

option writer.

All or noting option – An option with a fixed, predetermined payoff if the underlying

instrument is at or beyond the strike price at expiration.

Average option – A path dependent option that calculates the average of the path

traversed by the asset, arithmetic or weighted. The payoff

therefore the difference between the average price of the

underlying asset, over the life of option and the exercise price

of the option.

Basket option – A third party option covered warrant on a basket of underlying

stocks, Currencies or commodities.

Bermuda option – Like the location of the Bermudas, this option located somewhere

between a European style options, this can be exercised only at

Maturity and an American style option which can be exercised

any time.

Option holders choose – this option can be exercisable only on predetermined dates.

Compound options – This is simply an option on an existing option such as a call on

a Call a put on a put etc, a call on a put etc.

Cross-currency options – An out performance option stock at an exchange rate

between.two currency.

90

Digital options – These are options that can be structured as a “one touch” barrier,

“double no touch” barrier and: all nothing “call/puts”. The “one

touch” digital provides an immediate payoff if the currency hits

your selected price barrier chosen at outset. The “double no

touch” provides a payoff upon expiration if the currency does not

touch both the upper and lower price. Barrier selected at the

outset. The call/put “all or nothing” digital option provides a

payoff upon expiration if your option finishes in the money.

Knock-in-options – There are two kinds of known in options, 1) up and in, 2) down

and. in. with known in options, the buyer starts out without a

vanilla option. If the buyer has selected an upper price barrier

and the currency hits that level; it creates the vanilla option

with maturity date and strike price agreed upon at the outset.

This would be called an up and in. the down and in option is

the same as the up and in, expect the currency has to reach a

lower barrier. Upon hitting the chosen lower price level, it

creates the vanilla option.

Multi-index option – An out performance option with a payoff determined by the

deference in performance of two or more indices.

Out performance option – An option with a payoff based on the amount by which

one of two underlying instruments or indices out

performs the other.

Quantity adjusting option – This is an option design to eliminate the currency risk

by fix effectively hedging it. It evolves combining

an equity option and incorporating a predetermined

rate.

91

Example: if the holder has in the money Nikkei index call option expiration, the

quanto option terms would trigger by covering the yen proceeds into dollar

which was specified at the out set in the quanto option contract. The rate is

agreed upon at the beginning without the quantity of course, since this is

an unknown at the time.

Secondary currency option – An option with a payoff in a difference currency than

the underling’s trading currency.

Swaption – An option to enter into a Swap contract.

Up-and-out-option – The call pays of early exercise price trigger is hit. The put

expires. Worthless if the market price of the underlying

risks is above a predetermined expiration price.

Zero strike price option – An option with an exercise price of zero, or close to zero,

Traded on exchanges were there is transfer tax, owner

Restriction or other obstacle to the transfer of the

underlying.

92

TITLE AUTHOR PUBLICATION

Securities Analysis and

Portfolio Management R. Madhumati Pearson Education

Investments Schaum’s TATA McGraw-Hill

International Financial P.G.Apte TATA McGraw-Hill

Management

Financial Institutions and L.M.Bhole TATA McGraw-Hill

Markets

Options, Futures and John C. hull Pearson Education

Other Derivatives

WEB SITES:

www.nseindia.com

www.bseindia.com

www.economictimes.com

www.sharekhan.com

www.hseindia.com

www.google.com

93