Project Hedging 01

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General introduction

The liberalization of the Indian economy has ushered in an era of opportunities for the

Indian corporate sector. however, these opportunities are accomplished by challenges. The corporate are

now required to operate at global capacities to be able to reap the benefits of economies of scale and be

competitive. To operate at global capacities, huge investments are called for and the main source of fund

in the public at large. Therefore, the corporate now started tapping the capital market in a big way. The

response is also encouraging.

As the Indian nation integrates with world economy era, small tremors in the world market

starts affecting the Indian economy. As an example, interest rates have been south bound in the world

and the same has happened in the Indian market too. fixed income rates have fallen drastically due to fall

in the real income of people. To overcome this fall , investors have been continuously seek to increase

the yield of their of their investments. But, it is a time-tested fact that, the yields on investment in equity

shares are maximum, the accompanying risks are also maximum. Therefore, it is absolutely essential that

efforts should be made to reduce this factor.

The reduction of risk can be achieved through the process of hedging using

derivatives financial instrument. A hedge is any act that reduced the price risk of an existing or

anticipated position in the cash market. Basically, there are two type of hedging with futures :long hedge

and short hedge.

Financial derivatives are a kind of risk management instrument. A derivative's value

depends on the price changes in some more fundamental underlying assets. Many forms of financial

derivatives instruments exist in the financial markets. Among them, the three most fundamental financial

derivatives instruments are: forward contracts, futures, and options. If the underlying assets are stocks,

bonds, foreign exchange rates and commodities etc., then the corresponding risk management

instruments are: stock futures (options), bond futures (options), currency futures (options) and commodity

futures (options) etc. In risk management of the underlying assets using financial derivatives, the basic

strategy is hedging, i.e., the trader holds two positions of equal amounts but opposite directions, one in

the underlying markets, and the other in the derivatives markets, simultaneously. This risk management


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strategy is based on the following reasoning: it is believed that under normal circumstances,

prices of underlying assets and their derivatives change roughly in the same direction with

basically the same magnitude; hence losses in the underlying assets (derivatives) markets can be

offset by gains

in the derivatives (underlying assets) markets; therefore losses can be prevented or reduced by

combining the risks due to the price changes. The subject of this book is pricing of financial

derivatives and risk management by hedging.

SCOPE OF THE STUDY

Introduction of derivatives in the Indian capital market is the beginning of a new era , which is

truly exciting. Derivatives, worldwide are recognized risk management products. These products have a

long history in India, in the unorganized sector , especially in currency and commodity markets. The

availability of these products on organized exchanges ha provided the market participants with broad

based risk management tools.

This study mainly covers the area of hedging and speculation. The main aim of the study is

to prove how risks in investing in equity shares can be reduced and how to make maximum return to the

other investment.

IMPORTANCE OF THE STUDYIt helps the researcher to construct a diversified portfolio.

Provide an insight on return and risk analysis.

It helps to make a general study on derivatives.

It helps to identify and reduce by using hedging strategies and speculation.

OBJECTIVE OF THE STUDY

Primary Objectives

To construct portfolio and analyses the risk return relationship.

To hedge the most profitable portfolio.

To construct a diversified portfolio and risk reduction by using index futures.Secondary objective

To find out extant to which loss can be reduced by applying hedging strategies.

To determine whether the hedger enjoys better returns from the use of hedgers.

To identify how much reduction in risk is possible.

To find out the extend of loss due to misjudgment on index movements .

LIMITATION OF THE STUDY


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A) While applying the strategies , transaction cost and impact cost are not taken into

consideration.so,it will reflect in the profit calculation on each month of the study.

B) data were collected only on the basis of NSE trading

C) Hedging strategy is applied on historical data. so the direction of each trend in the stock market is known

before hand for the period selected. As a result, some bias could have been done for the application of

hedging strategy.

REVIEW OF LITURATURE

Financial derivatives are so effective in reducing risk because they enable financial

Institutions to hedge that is, engage in a financial transaction that reduces or eliminates


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risk. When a financial institution has bought an asset, it is said to have taken a

long position, and this exposes the institution to risk if the returns on the asset are

uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a

Future date, it is said to have taken a short position, and this can also expose the

Institution to risk. Financial derivatives can be used to reduce risk by invoking the following

basic principle of hedging :Hedging risk involves engaging in a financial transaction

that offsets a long position by taking an additional short position, or offsets a short

position by taking an additional long position. In other words, if a financial institution has

bought a security and has therefore taken a long position, it conducts a hedge by

contracting to sell that security (take a short position) at some future date. Alternatively,

if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts

a hedge by contracting to buy that security (take a long position)at a future date. We look at how this

principle can be applied using forward and futuresPARTICIPANTS OF DERIVATIVE

There are three broad categories of participants hedgers, speculators and

arbitrageurs. hedgers face risk associated with the price of an assets. They use futures or options

markets to reduce or eliminate this risk. Speculates wish to bet on future movement in the price of an

asset. features and options contracts cangue them an extra leverage;they can increase both the potential

gains and losses in a speculative venture. Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets.

Derivative products initially emerged, as hedging devices against fluctuation in

commodity prices and commodity-linked derivatives remained the sole form of such products for almost

three hundred years. In recent years, the market for financial derivative has grown tremendously in terms

of variety of instruments available. The emergence of the market for

derivative products, most notable forwards, futures and options, can be traced back to the willingness of

risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset

prices.


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Though the use of derivative products, it is possible to partially or fully transfer price risks

by locking in asset prices. as instrument of risk management , these generally do not influence the

fluctuations in the underlying asset prices.

DEFINATIONSAccording to JOHN C. HUL A derivatives can be defined as a financial instrument whosevalue depends on (or derives from) the values of other, more basic underlying variables.

According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply

an agreement between two people) which has a value determined by the price of something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of

Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-A Derivative includes: -

a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk

instrument or contract for differences or any other form of security;

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

underlying

securities.

Derivatives were developed primarily to manage, offset or hedge against risk but some were

developed primarily to provide the potential for high returns.

FACTERS AFFECTING GROWTH OF DERIVATIVEGrowth of derivative is affected by a number of factors, some of the important factors are

started below.

1. Increased volatility in asset prices in financial markets

Financial derivatives are so effective in reducing risk because they enable financial

Institutions to hedge that is, engage in a financial transaction that reduces or eliminates

risk. When a financial institution has bought an asset, it is said to have taken a

long position, and this exposes the institution to risk if the returns on the asset are

uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a

Future date, it is said to have taken a short position, and this can also expose the

Institution to risk. Financial derivatives can be used to reduce risk by invoking the following

basic principle of hedging :Hedging risk involves engaging in a financial transaction

that offsets a long position by taking an additional short position, or offsets a short

position by taking an additional long position. In other words, if a financial institution has


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bought a security and has therefore taken a long position, it conducts a hedge by

contracting to sell that security (take a short position) at some future date. Alternatively,

if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts

a hedge by contracting to buy that security (take a long position)at a future date. We look at how this

principle can be applied using forward and futuresPARTICIPANTS OF DERIVATIVE

There are three broad categories of participants hedgers, speculators and

arbitrageurs. hedgers face risk associated with the price of an assets. They use futures or options

markets to reduce or eliminate this risk. Speculates wish to bet on future movement in the price of an

asset. features and options contracts cangue them an extra leverage;they can increase both the potential

gains and losses in a speculative venture. Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets.

Derivative products initially emerged, as hedging devices against fluctuation in

commodity prices and commodity-linked derivatives remained the sole form of such products for almost

three hundred years. In recent years, the market for financial derivative has grown tremendously in terms

of variety of instruments available. The emergence of the market for

derivative products, most notable forwards, futures and options, can be traced back to the willingness of

risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset

prices.

Though the use of derivative products, it is possible to partially or fully transfer price risks

by locking in asset prices. as instrument of risk management , these generally do not influence the

fluctuations in the underlying asset prices.

DEFINATIONSAccording to JOHN C. HUL A derivatives can be defined as a financial instrument whose

value depends on (or derives from) the values of other, more basic underlying variables.According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply

an agreement between two people) which has a value determined by the price of something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of

Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-A Derivative includes: -

a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk

instrument or contract for differences or any other form of security;

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


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underlying

securities.

Derivatives were developed primarily to manage, offset or hedge against risk but some were

developed primarily to provide the potential for high returns.

FACTERS AFFECTING GROWTH OF DERIVATIVEGrowth of derivative is affected by a number of factors, some of the important factors are

started below.1. Increased volatility in asset prices in financial markets

2. Increased integration of national financial markets with the international markets.

3. Marked improvement in communication facilities and sharp decline in their costs.

4. Development of more sophisticated risk management tools, providing economic agents,

a wider choice of risk management strategies.

5. Innovation in the derivative markets, which optimally combine the risk and returns,

reduced risk as well as transaction costs as compared to individual financial assets.

TYPE OF DERIVATIVESOne of classifying derivatives is as,

COMMODITY DERIVATIVEThese deals with commodities like suger, gold, wheat, pepper etc..thus, futures or options

on gold, suger,pepper, jute etc are commodity derivatives.

FINANCIAL DERIVATIVE

Futures or options or swaps on currencies, gift edged securities, stocks and shares,

stock market indices, cost of living indices etc are financial derivatives.

Another way of classifying derivatives.DERIVATIVESCOMMODITYFINANCIAL


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BASIC DERIVATIVES

They are forward /futures contracts and option contracts.

COMPLEX DERIVATIVEOther derivative, such as swaps are complex


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Forward contract

An agreement to buy or sell at a specified future time a certain amount of an underlying

asset at a specified price. A forward contract is an agreement to replace a risk with a certainty.

The buyer in the contract is said to hold a long position, and the seller is said to hold a short

position. The specified price in the contracts called the delivery price and the specified time is

called maturity. Let K-delivery price, and T-maturity, then a forward contract's payoff VT at

maturity is:VT = ST-K, (long position)

VT = K -ST,(short position

Where ST denotes the price of the underlying asset at maturity t = T.


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LONG POSITION

SHORT POSITION

Forward Contracts are generally traded OTC (over-the-counter).

Future contract

Future same as a forward contract, an agreement to buy or sell at a specified future time a

certain amount of an underlying asset at a specified price. Futures have evolved from

standardization of forward contracts. Futures differ from forward contracts in the following

respects:

a. Futures are generally traded on an exchange.

b. A future contract contains standardized articles.

c. The delivery price on a future contract is generally determined on anexchange, and depends on the market demands.

Options


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Options-an agreement that the holder can buy from, or sell to, the seller of the option at

a specified future time a certain amount of an underlying asset at a specified price. But the holder

is under no obligation to exercise the contract. The holder of an option has the right, but not the

obligation, to carry out the agreement according to the terms specified in the agreement. In an

options contract, the specified price is called the exercise price or strike price, the specified date

is called the expiration date, and the action to perform the buying or selling of the asset

according to the option contract is called exercise.

According to buying or selling an asset, options have the following types:

call option:- is a contract to buy at a specified future time a certain amount of an underlying

asset at a specified price.

put option:-is a contract to sell at a specified future time a certain amount of an underlying


According to terms on exercise in the contract, options have the following types:

European options:- can be exercised only on the expiration date.

American options:- can be exercised on or prior to the expiration date.

Define K-strike price and T-expiration date, then an option's

payoff (value) VT at expiration date is:

VT = (ST-K)+, ( call option)

VT = (K -ST)+, ( put option


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K

ST

O

K

ST

COMPLEX DERIVATIVE

Using futures and option it is possible to build number of complex derivative. it is designed to

suit the particular need and circumstances of a client.

Example. SWAPS, Credit derivatives

Weather derivative

This is a new tool for risk management. This is a contract between 2 parties that stipulates how

payment will be exchanged between parties depending on certain meteorological conditions


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souring the contract period. They are based on data such as temperature, rainfall, snowfall etc,

the primary objective of this derivative is to initiate the volume risks, which will influence thebalance sheet and profit and loss figures.

FUCTION OF DERIVATIVES

1.Risk management: it involves structuring of financial contracts too produce grains or

losses that counter balance the losses or gains arising from movements in financial prices.

Thus risks are reduced and profit is increased of a financial enterprises.

2.Price discovery: this represents the ability to achieve and disseminate price information

without price information investors ;consumers an producers cannot make decision.

Derivatives are well suited for providing price information.3.Transactional efficiency: transitional efficiency is the product of liquidity. Inadequate

liquidity results in high transaction costs. These incases investment and causes


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According to buying or selling an asset, options have the following types:

call option:- is a contract to buy at a specified future time a certain amount of an underlying


put option:-is a contract to sell at a specified future time a certain amount of an underlying


According to terms on exercise in the contract, options have the following types:

European options:- can be exercised only on the expiration date.

American options:- can be exercised on or prior to the expiration date.

Define K-strike price and T-expiration date, then an option's

payoff (value) VT at expiration date is:


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VT = (ST-K)+, ( call option)

VT = (K -ST)+, ( put option)Where ST denotes the price of the underlying asset at the expiration date

t =TVT

VT

0

K

ST

O

K

ST

COMPLEX DERIVATIVE

Using futures and option it is possible to build number of complex derivative. it is designed to

suit the particular need and circumstances of a client.

Example. SWAPS, Credit derivativesWeather derivative

This is a new tool for risk management. This is a contract between 2 parties that stipulates how

payment will be exchanged between parties depending on certain meteorological conditions

souring the contract period. They are based on data such as temperature, rainfall, snowfall etc,

the primary objective of this derivative is to initiate the volume risks, which will influence thebalance sheet and profit and loss figures.

FUCTION OF DERIVATIVES

1.Risk management: it involves structuring of financial contracts too produce grains or

losses that counter balance the losses or gains arising from movements in financial prices.

Thus risks are reduced and profit is increased of a financial enterprises.

2.Price discovery: this represents the ability to achieve and disseminate price information

without price information investors ;consumers an producers cannot make decision.

Derivatives are well suited for providing price information.3.Transactional efficiency: transitional efficiency is the product of liquidity. Inadequate

liquidity results in high transaction costs. These incases investment and causes


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accumulation of capital. Derivatives increases market liquidity, as a result transitional

costs are lowered, and the efficiency in doing business is increased.

RISK OF DERIVATIVEAny comment about derivative would be inadequate without a word of caution.

there are 4 inherent risk associated with derivatives. These risk should clearly understood before

establishing position in derivatives market.

A) Credit risk: the exposure to the possibility of loss resulting from a counter partys failureto meet its financial obligation

B) Market risk :adverse movement in the price of a financial asset or commodity.

C) Legal risk: an auction by a court or by a regulatory body that could invalidate a financial

contract.

D) Operational risk: inadequate controls, human error system failure or fraud.

Industries profile;-

Limitation of the techniques used

The varies techniques used for the study involves projective technique involvingof thematic appreciation test, sentence completion test etcattitude test, linkert scale etc

The various limitation of the techniques used are,

lack of practical experience for the thematic and


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Attitude test

lack of proper support from the respondents

The limitation of techniques itself.STUDY PLAN.

The study plan was for a period of only 45 days.

CHAPTER4INDUSTRY PROFILE

Introduction

In general, the financial market divided into two parts, Money market and capital market.

Securities market is an important, organized capital market where transaction of capital is

facilitated by means of direct financing using securities as a commodity. Securities market can

be divided into a primary market and secondary market.PRIMARY MARKET


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The primary market is an intermittent and discrete market where the initially listed shares are

traded first time, changing hands from the listed company to the investors. It refers to the process

through which the companies, the issuers of stocks, acquire capital by offering their stocks to

investors who supply the capital. In other words primary market is that part of the capital

markets that deals with the issuance of new securities. Companies, governments or public sector

institutions can obtain funding through the sale of a new stock or bond issue. This is typically

done through a syndicate of securities dealers. The process of selling new issues to investors is

called underwriting. In the case of a new stock issue, this sale is called an initial public offering

(IPO). Dealers earn a commission that is built into the price of the security offering, though it

can be found in the prospectus.SECONDARY MARKET

The secondary market is an on-going market, which is equipped and organized with a

place, facilities and other resources required for trading securities after their initial offering. It

refers to a specific place where securities transaction among many and unspecified persons is

carried out through intermediation of the securities firms, i.e., a licensed broker, and the

exchanges, a specialized trading organization, in accordance with the rules and regulations

established by the exchanges.

A bit about history of stock exchange they say it was under a tree that it all started in

1875.Bombay Stock Exchange (BSE) was the major exchange in India till 1994.National Stock

Exchange (NSE) started operations in 1994.

NSE was floated by major banks and financial institutions. It came as a result of Harshad Mehta

scam of 1992. Contrary to popular belief the scam was more of a banking scam than a stock

market scam. The old methods of trading in BSE were people assembling on what as called a

ring in the BSE building. They had a unique sign language to communicate apart from all the

shouting. Investors weren't allowed access and the system was opaque and misused by brokers.

The shares were in physical form and prone to duplication and fraud.

NSE was the first to introduce electronic screen based trading. BSE was forced to follow suit.The present day trading platform is transparent and gives investors prices on a real time basis.

With the introduction of depository and mandatory dematerialization of shares chances of fraud

reduced further. The trading screen gives you top 5 buy and sell quotes on every scrip.

A typical trading day starts at 10 ending at 3.30. Monday to Friday. BSE has 30 stocks which

make up the Sensex .NSE has 50 stocks in its index called Nifty. FII s Banks, financial

institutions mutual funds are biggest players in the market. Then there are the retail investors and

speculators. The last ones are the ones who follow the market morning to evening; Market can be

very addictive like blogging though stakes are higher in the former.

ORIGIN OF INDIAN STOCK MARKET

The origin of the stock market in India goes back to the end of the eighteenth century when long-

term negotiable securities were first issued. However, for all practical purposes, the real

beginning occurred in the middle of the nineteenth century after the enactment of the companies

Act in 1850, which introduced the features of limited liability and generated investor interest in

corporate securities.

An important early event in the development of the stock market in India was the formation of

the native share and stock brokers 'Association at Bombay in 1875, the precursor of the present


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day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in

Ahmedabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of

ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during

depressing times subsequently.

Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life. Without a

stock exchange, the saving of the community- the sinews of economic progress and productive

efficiency- would remain underutilized. The task of mobilization and allocation of savings could

be attempted in the old days by a much less specialized institution than the stock exchanges. But

as business and industry expanded and the economy assumed more complex nature, the need for

'permanent finance' arose. Entrepreneurs needed money for long term whereas investors

demanded liquidity the facility to convert their investment into cash at any given time. The

answer was a ready market for investments and this was how the stock exchange came into

being.

Stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose

of regulating or controlling the business of buying, selling or dealing in securities. These securities

include:(i) Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like nature in

or of any incorporated company or other body corporate;

(ii) Government securities; and

(iii) Rights or interest in securities.

The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are

the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges.

However, the BSE and NSE have established themselves as the two leading exchanges and

account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equalin size in terms of daily traded volume. The average daily turnover at the exchanges has

increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further to Rs 2,273

crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a total market

capitalization of around Rs 9, 21,500 crore.

The BSE has over 6000 stocks listed and has a market capitalization of around Rs 9, 68,000

crore. Most key stocks are traded on both the exchanges and hence the investor could buy them

on either exchange. Both exchanges have a different settlement cycle, which allows investors to

shift their positions on the bourses. The primary index of BSE is BSE Sensex comprising 30

stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex

is the older and more widely followed index.


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Both these indices are calculated on the basis of market capitalization and contain the heavily

traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the

exchanges have switched over from the open outcry trading system to a fully automated

computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National

Exchange Automated Trading) System.

It facilitates more efficient processing, automatic order matching, faster execution of trades and

transparency; the scrip's traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z'

groups. The 'A' group shares represent those, which are in the carry forward system(Badla). The

'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrip's are

the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups

and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories,

Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and

primary market is the Securities and Exchange Board of India (SEBI) Ltd.Brief History of Stock Exchanges

Do you know that the world's foremost marketplace New York Stock Exchange

(NYSE), started its trading under a tree (now known as 68 Wall Street) over 200 years ago?

Similarly, India's premier stock exchange Bombay Stock Exchange (BSE) can also trace back its

origin to as far as 125 years when it started as a voluntary non-profit making association.

News on the stock market appears in different media every day. You hear about it any time it

reaches a new high or a new low, and you also hear about it daily in statements like 'The BSE

Sensitive Index rose 5% today'. Obviously, stocks and stock markets are important. Stocks of

public limited companies are bought and sold at a stock exchange. But what really are stock

exchanges? Known also as the stock market or bourse, a stock exchange is an organized

marketplace for securities (like stocks, bonds, options) featured by the centralization of supply

and demand for the transaction of orders by member brokers, for institutional and individual

investors.

The exchange makes buying and selling easy. For example, you don't have to actually go to astock exchange, say, BSE - you can contact a broker, who does business with the BSE, and he or

she will buy or sell your stock on your behalf.Market Basics

Electronic trading

Electronic trading eliminates the need for physical trading floors. Brokers can trade from their

offices, using fully automated screen-based processes. Their workstations are connected to a

Stock Exchange's central computer via satellite using Very Small Aperture Terminus(V SA Ts ).

The orders placed by brokers reach the Exchange's central computer and are matched

electronically.Exchanges in India

The Stock Exchange, Mumbai(BSE) and the National Stock Exchange(N SE) are the country'stwo leading Exchanges. There are 20 other regional Exchanges, connected via the Inter-

Connected Stock Exchange(I C SE). The BSE and NSE allow nationwide trading via their VSAT

systems.

Index

An Index is a comprehensive measure of market trends, intended for investors who are

concerned with general stock market price movements. An Index comprises stocks that have


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large liquidity and market capitalization. Each stock is given a weight age in the Index equivalent

to its market capitalization. At the NSE, the capitalization of NIFTY (fifty selected stocks) is

taken as a base capitalization, with the value set at 1000. Similarly, BSE Sensitive Index or

Sensex comprises 30 selected stocks. The Index value compares the day's market capitalization

vis--vis base capitalization and indicates how prices in general have moved over a period of

time.Execute an order

Select a broker of your choice and enter into a broker-client agreement and fill in the client

registration form. Place your order with your broker preferably in writing. Get a trade

confirmation slip on the day the trade is executed and ask for the contract note at the end of the

trade date.Need a broker

As per SEBI (Securities and Exchange Board of India.) regulations, only registered members can

operate in the stock market. One can trade by executing a deal only through a registered broker

of a recognized Stock Exchange or through a SEBI-registered sub-broker.Contract note

A contract note describes the rate, date, time at which the trade was transacted and the brokeragerate. A contract note issued in the prescribed format establishes a legally enforceable relationship

between the client and the member in respect of trades stated in the contract note. These are

made in duplicate and the member and the client both keep a copy each. A client should receive

the contract note within 24 hours of the executed trade. Corporate Benefits/Action.Split

A Split is book entry wherein the face value of the share is altered to create a greater number of

shares outstanding without calling for fresh capital or altering the share capital account. For

example, if a company announces a two-way split, it means that a share of the face value of Rs

10 is split into two shares of face value of Rs 5 each and a person holding one share now holds

two shares.

Buy Back

As the name suggests, it is a process by which a company can buy back its shares from

shareholders. A company may buy back its shares in various ways: from existing shareholders on

a proportionate basis; through a tender offer from open market; through a book-building process;

from the Stock Exchange; or from odd lot holders.A company cannot buy back through negotiated deals on or off the Stock Exchange, through spot

transactions or through any private arrangement.

Settlement cycle

The accounting period for the securities traded on the Exchange. On the NSE, the cycle begins

on Wednesday and ends on the following Tuesday, and on the BSE the cycle commences on

Monday and ends on Friday. At the end of this period, the obligations of each broker are

calculated and the brokers settle their respective obligations as per the rules, bye-laws and

regulations of the Clearing Corporation. If a transaction is entered on the first day of the

settlement, the same will be settled on the eighth working day excluding the day of transaction.

However, if the same is done on the last day of the settlement, it will be settled on the fourth

working day excluding the day of transaction.


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Rolling settlement

The rolling settlement ensures that each day's trade is settled by keeping a fixed gap of a

specified number of working days between a trade and its settlement. At present, this gap is five

working days after the trading day. The waiting period is uniform for all trades. In a Rolling

Settlement, all trades outstanding at end of the day have to be settled, which means that the buyer

has to make payments for securities purchased and seller has to deliver the securities sold. InIndia, we have adopted the T+5 settlement cycle, which means that a transaction entered into on

Day 1 has to be settled on the Day 1 + 5 working days, when funds pay in or securities pay out

takes place.The Advantages Of Rolling Settlements

As mentioned earlier, this is the system practiced in developed countries. Pay outs are

quicker than in weekly settlements, and investors will benefit from increased liquidity. The other

benefit of the modified system is that it keeps cash and forward markets separate. In the current

system, the trader has five days to square off his transaction which leads to a high level of

speculation as people even without funds tend to "play" the market. During volatile markets,

especially in a bearish market, this often leads to a payment problem which has dogged the

Indian stock exchanges for a long time. It provides for a higher degree of safety, and once

mechanisms such as futures and stock-lending become popular, it would result in quality

speculation and genuine investor interest.When does one deliver the shares and pay the money to broker

As a seller, in order to ensure smooth settlement you should deliver the shares to your broker

immediately after getting the contract note for sale but in any case before the pay-in day.

Similarly, as a buyer, one should pay immediately on the receipt of the contract note for purchase

but in any case before the pay-in day.Short selling

Short selling is a legitimate trading strategy. It is a sale of a security that the seller does not own,

or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers

take the risk that they will be able to buy the stock at a more favorable price than the price at

which they "sold short."

The selling of a security that the seller does not own, or any sale that is completed by the

delivery of a security borrowed by the seller, Short sellers assume that they will be able to buy

the stock at a lower amount than the price at which they sold short.Auction

An auction is conducted for those securities that members fail to deliver/short deliver during pay-

in. Three factors primarily give rise to an auction: short deliveries, un-rectified bad deliveries,

and un-rectified company objectionsSeparate market for auctions

The buy/sell auction for a capital market security is managed through the auction market. As

opposed to the normal market where trade matching is an on-going process, the trade matching

process for auction starts after the auction period is over.If the shares are not bought in the auction

If the shares are not bought at the auction i.e. if the shares are not offered for sale, the Exchange

squares up the transaction as per SEBI guidelines. The transaction is squared up at the highest

price from the relevant trading period till the auction day or at 20 per cent above the last


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available Closing price whichever is higher. The pay-in and pay-out of funds for auction square

up is held along with the pay-out for the relevant auction.Bad Delivery

SEBI has formulated uniform guidelines for good and bad delivery of documents. Bad delivery may

pertain to a transfer deed being torn, mutilated, overwritten, defaced, or if there are spelling mistakes in

the name of the company or the transfer. Bad delivery exists only when shares are transferred physically.In "Demat" bad delivery does not exist.Stock & Exchange Board of India

REGULATION OF BUSINESS IN THE STOCK EXCHANGES

Under the SEBI Act, 1992, the SEBI has been empowered to conduct inspection of stock

exchanges. The SEBI has been inspecting the stock exchanges once every year since 1995-96.

During these inspections, a review of the market operations, organizational structure and

administrative control of the exchange is made to ascertain whether:

the exchange provides a fair, equitable and growing market to investors

the exchange's organization, systems and practices are in accordance with the Securities

Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under

the exchange has implemented the directions, guidelines and instructions issued by the

SEBI from time to time

The exchange has complied with the conditions, if any, imposed on it at the time of

renewal/ grant of its recognition under section 4 of the SC(R) Act, 1956.

During the year 1997-98, inspection of stock exchanges was carried out with a special focus on

the measures taken by the stock exchanges for investor's protection. Stock exchanges were,

through inspection reports, advised to effectively follow-up and redress the investors' complaints

against members/listed companies. The stock exchanges were also advised to expedite the

disposal of arbitration cases within four months from the date of filing.

During the earlier years' inspections, common deficiencies observed in the functioning of the

exchanges were delays in post trading settlement, frequent clubbing of settlements, delay inconducting auctions, inadequate monitoring of payment of margins by brokers, non-adherence to

Capital Adequacy Norms etc. It was observed during the inspections conducted in 1997-98 that

there has been considerable improvement in most of the areas, especially in trading, settlement,

collection of margins etc.Dematerialization

Dematerialization in short called as 'demat' is the process by which an investor can get physical

certificates converted into electronic form maintained in an account with the Depository

Participant. The investors can dematerialize only those share certificates that are already

registered in their name and belong to the list of securities admitted for dematerialization at the

depositories.

Depository: The organization responsible to maintain investor's securities in the electronic form

is called the depository. In other words, a depository can therefore be conceived of as a "Bank" for

securities. In India there are two such organizations viz. NSDL and CDSL. The depository concept is

similar to the Banking system with the exception that banks handle funds whereas a depository handles


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securities of the investors. An investor wishing to utilize the services offered by a depository has to open

an account with the depository through Depository Participant.Depository Participant: The market intermediary through whom the depository services can be

availed by the investors is called a Depository Participant (DP). As per SEBI regulations, DP

could be organizations involved in the business of providing financial services like banks,

brokers, custodians and financial institutions. This system of using the existing distributionchannel (mainly constituting DPs) helps the depository to reach a wide cross section of investors

spread across a large geographical area at a minimum cost. The admission of the DPs involves a

detailed evaluation by the depository of their capability to meet with the strict service standards

and a further evaluation and approval from SEBI. Realizing the potential, all the custodians in

India and a number of banks, financial institutions and major brokers have already joined as DPs

to provide services in a number of cities.Advantages of a depository services:

Trading indemat segment completely eliminates the risk of bad deliveries. In case of

transfer of electronic shares, you save 0.5% in stamp duty. Avoids the cost of courier/

notarization/ the need for further follow-up with your broker for shares returned for company

objection No loss of certificates in transit and saves substantial expenses involved in obtaining

duplicate certificates, when the original share certificates become mutilated or misplaced.

Lower interest charges for loans taken against demat shares as compared to the interest for loan

against physical shares. RBI has increased the limit of loans availed against dematerialized

securities as collateral to Rs 20 lakh per borrower as against Rs 10 lakh per borrower in case of

loans against physical securities. RBI has also reduced the minimum margin to 25% for loans

against dematerialized securities, as against 50% for loans against physical securities. Fill up the

account opening form, which is available with the DP. Sign the DP-client agreement, which

defines the rights and duties of the DP and the person wishing to open the account. Receive your

client account number (client ID).

This client id along with your DP id gives you a unique identification in the depository system.Fill up a dematerialization request form, which is available with your DP, Submit your share

certificates along with the form; write "surrendered for demat" on the face of the certificate

before submitting it for demat) Receive credit for the dematerialized shares into your account

within 15 days.

Derivatives

The term derivative instrument is generally accepted to mean a financial instrument with a

payoff structure determined by the value of an underlying security, commodity, interest rate, or index.

According to some notable surveys, over 80% of private sector corporations consider derivatives to be

important in implementing their financial policies. Derivatives have

also gained wide acceptance among national and local governments, government sponsored entities,

such as the Student Loan Marketing Association and the Federal Home Loan Mortgage Corporation, and

supranational, such as the World Bank.

Derivatives are used to lower funding costs by borrowers, to efficiently alter the proportions

of fixed to floating rate debt, to enhance the yield on assets, to quickly modify the assets payoff structure

to correspond to the firm's market view, to avoid taxes and skirt regulations, and perhaps most

importantly, to transfer market risk (hedge)- where the term market risk is used to connote the possibility


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of losses sustained due to an unforeseen price or volatility change. A firm may execute a derivative

transaction to alterits market risk profile by transferring to the trade's counter party a particular type of

risk. The price that the firm must pay for this risk transfer is the acceptance of another type of risk and/or

a cash payment to the counter party.

The term "derivative" indicates that it has no independent value, i.e. its value is entirely

"derived" from the value of the cash asset. A derivative contract or product, or simply derivative", is to be

sharply distinguished from the underlying cash asset, i.e. the asset brought / sold in the cash market on

normal delivery terms. A general definition of "derivative" may be suggested here as follows: "Derivative"

means forward, future or option contract of predetermined fixed duration, linked for the purpose of

contract fulfillment to the value of specified real or financial asset or to index of securities. Derivatives

offer organizations the opportunity to break financial risks into smaller components and then to buy and

sell those components to best meet specific risk management objectives.

As both forward contracts and futures contracts are used for hedging, it is important to

understand the distinction between the two and their relative merits. Forward contracts are private

bilateral contracts and have well established commercial usage. They are exposed to default risk by

counter-party. Each forward contract is unique in term of contract size, expiration date and the asset type/quality. The contract price is not transparent, as it is not publicly disclosed.Since the forward contract is

not typically tradable, it has to be settled by delivery of the asset on the expiration date. In contrast,

futures contracts are standardized tradable contracts. They are standardized in terms of size, expiration

date and all other features. They are traded on specially designed exchanges in a highly sophisticated

environment of stringent financial safeguards. They are liquid and transparent. Their market prices and

trading volumes are regularly reported. The futures trading system has effective safeguards against

defaults in the form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark to

market) to the accounts of trading members based on daily price change. Futures are far more cost-

efficient than forward contracts for hedging.

EVOLUTION OF DERIVATIVE

FORWARD TRADING

It is not clearly established when and where the first forward market came into existence. there are

reports that forward trade exited in India as for back as 2000 BC and in Roman times forward training is

believed to have been existence in the 12 th century in Japan.The first organized forward market came into existence in late 19th and early 20th century in

Kolkata(jute & jute goods)and in Mumbai (cotton)

FUTURES TRADING

The Dojima rice market can be considerd as the first future market in the sense of an

organized exchange.the first futures in the western hemisphere were developed in united states in

Chicago.first they were started as spot markets and gradually evolved into futures trading.

First stage was starting of agreements to buy grain in future a predetermined price with

the intention of actual delivery. Gradually these contracts become transferable and during.

American civil war, it become commonplace to sell and resell agreements instead of taking


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delivery of physical produce. Traders found that the agreements were easier to but and sell. This

is how modern futures contract came into being.

OPTION TRADING

Options trading are of more recent origin. It is estimated that they existing in Greece and Rome

as early as 400 BC. Option trading in agriculture products and shares came in us from the

1860s.chicago started the first option market board of trade (CBOT)in 1973.standard maturities ,

standard strike price, standard delivery arrangement were evolved. The risk of default laws

removed by introducing a clearing house and margin system. The introduction of trade option

opened the way for the evaluations of more complex derivative.

SWAP TRADINGThe first swap transaction took place between world bank and IBM (international business

machine) they were currency swaps. interest rates swap also commenced 1981

OTHER DERIVATIVEOther derivative like forward rate agreement (FRA).range forward contract and they like evolved

in second half of 1980s.

CONTENTS

Derivativesan overview

Futures contract Hedging in futures

Speculating in futures

Arbitrage in futures

Options

Options strategies

Derivatives products

Open interest

Futures price = spot price + cost of carry

DERIVATIVESThe word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks,

commodities, stock indices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing

(bank) does not have its value borrow the value from underlying asset/ basic variables.


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Derivatives is derived from the following products:

A. Shares

B. Debuntures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and other is

bearish in the market having opposite views regarding the market. There cannot be a derivatives having

same views about the market. In short it is like a INSURANCE market where investors cover their risk for

a particular position.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the

value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange

rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign

exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most

important aspect of derivatives and also its basic economic purpose. There has to be counter party tohedgers and they are speculators. Speculators dont look at derivatives as means of reducing risk but its

a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound

derivatives market, both hedgers and speculators are essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and

acceptance of market economy, that has really contributed towards the growing awareness of risk and

hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in

the local currency Interest Rate markets, which have not really developed, but with the gradual

acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their

balance sheet liabilities.The first product which was launched by BSE and NSE in the derivatives market was index

futures

BACKGROUND

Consider a hypothetical situation in which ABC trading company has to import a raw material for

manufacturing goods. But this raw material is required only after 3 months. However in 3 months the

prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time

it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with

fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage

charges. However, the availability of derivatives solves the problem of importer. He can buy currency

derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures

contract and vice versa. Hence the company can hedge its risk through the use of derivatives

INTRODUCTION TO FUTURE MARKETFutures markets were designed to solve the problems that exit in forward markets. A

f

utures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future

at a certain price. There is a multilateral contract between the buyer and seller for a underlying asset


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which may be financial instrument or physical commodities. But unlike forward contracts the future

contracts are standardized and exchange traded.

PURPOSEThe primary purpose of futures market is to provide an efficient and effective mechanism for

management of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are affected mainly by theprices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade

in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the settlement

day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the

gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here

both the parties face an equal amount of risk and are also required to pay upfront margins to the

exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in

cash unlike futures on individual stocks which are very rare and yet to be launched even in the US. Most

of the financial futures worldwide are index based and hence the buyer never comes to know who the

seller is, both due to the presence of the clearing corporation of the stock exchange in between and also

due to secrecy reasonsEXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is

bearish in the market. The initial margin is 10%. paid by the both parties.


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-10

-20

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is

250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some date in thefuture. Futures are often used by mutual funds and large institutions to hedge their positions when the

markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability to control a

sizable amount of an asset for a cash outlay, which is distantly small in proportion to the total value of

contractMARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the

margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk

of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract

value.PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on

their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin approximately

equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper

completion of all obligations associated with a traders futures position, the initial margin is returned to the

trader.

OBJECTIVEThe basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have

to deposit margins. The initial margin is deposited before the opening of the position in the Futures

transaction.MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than initial

margin. This is set to ensure that the balance in the margin account never becomes negative. If the

balance in the margin account falls below the maintenance margin, the investor receives a margin call to

top up the margin account to the initial level before trading commencing on the next level.ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty futures at1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%. The lot size of nifty

futures =200.suppose on MAY 16thThe price of futures settled at

Rs.1950. As the buyer is bullish and the seller is bearish in the

market. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)

Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)


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Suppose on may 17th nifty futures settled at 1400. Profit of buyer will be 10,000[(1450-1350)*200] Loss of

seller will be 10,000[(1350-1400)*200]Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)

Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600

While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.Loss for Buyer will be 2,000 [(1390-1400)*200]

Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)

Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to the settlement price

on a daily basis. Deficiencies in margin requirements are called for the broker, through margin calls. Till

now the concept of maintenance margin is not used in India.ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the exchange.

This is generally imposed when the exchange fears that the markets have become too volatile and may

result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent

breakdown.CROSS MARGINING:

This is a method of calculating margin after taking into account combined positions in Futures,

options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g.

Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script of SATYAM

falls then the investor is required to pay the mark-to-market margin also called as variation margin for

trading in the future contract


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HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already

exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their price

risk. Hedgers are those persons who dont want to take the risk therefore they hedge their risk while

taking position in the contract. In short it is a way of reducing risks when the investor has the underlying

security.

PURPOSE:TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK

Figure 1.1

HedgersExisting

SYSTEM

NewApproach

Peril &Prize

Approach

Peril &Prize1) Difficult to

1) No Leverage

1)Fix price today to buy

1) Additional

offload holding

available risk

latter by paying premium.

cost is only

during adverse


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reward dependant 2)For Long, buy ATM Put

premium.

market conditions

on market prices

Option. If market goes up,

as circuit filters

long position benefit else

limit to curtail losses.

exercise the option.

3)Sell deep OTM call option

with underlying shares, earn

premium + profit with increase prcie

Advantages

Availability of Leverage

STRATEGY:

The basic hedging strategy is to take an equal and opposite position in the futures market to the spot

market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor

hedge their risk by taking the short position in the Index futures


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HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and

hedging do not have have cost in cash but have opportunity cost. Hedging is implemented by adding anegatively and perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the

potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or,

alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group

of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets).ILLUSTRATION


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Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of

manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is

completed.COST

SELLING PRICE

PROFIT

4001000

600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the

contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if

Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.Shyam defaults

Shyam honors

400 (Initial Investment)

600 (Initial profit)

400 (penalty from Shyam

(-100) discount given to Shyam

- (No gain/loss)500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If

Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for

ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment.Now lets see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that the

market would go down due to some news. Then, to minimize your downside risk you could

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the

right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike)

price on or before a specified time (expiration date). The underlying may be physical commodities like

wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.MONTHLY OPTIONS :

The exchange trade option with one month maturity and the contract usually expires on last

Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as the

TYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the

underlying asset at the strike price on or before expiration date. The seller (one who is short call)

however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise

his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract.


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ILLUSTRATION

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the

market and other is Rakesh (call seller) who is bearish in the market.

The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised

once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit oncethe share price crossed to Rs.625(strike price + premium). Suppose the stock has crossed Rs.660 the

option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in

the market at Rs.660.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock

price fall to Rs.550 the buyer will choose not to exercise the option.

Profit for the Seller limited to the premium received = Rs.25

Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has thelost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimited

losses and have limited losses to the certain extent

Thus call option indicates two positions as follows:

LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying

call option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling

call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the

underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is

short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides

to exercise his option to sell.ILLUSTRATION

Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the

market and other is Amit(put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):


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Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be excerised

once the price went below 800. The premium paid by the buyer is Rs.20.The buyers breakeven point is

Rs.780(Strike price Premium paid). The buyer will earn profit once the share price crossed below to

Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the

RELIANCE scrip from the market at Rs.700and sell to the seller at Rs.800

Unlimited profit for the buyer = Rs.80 {(Strike pricespot price)premium}

Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option

will choose not to exercise his option to sell as he can sell in the market at a higher rate.profit

20

10

0600 700 800 900 1000 1100

-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for

the seller because the seller is bullish in the market = 780 - 750 = 30

Limited profit for the seller up to the premium received =


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Thus Put option also indicates two positions as follows:

LONG POSITION

If the investor expects price to fall i.e. bearish in the market he takes a long position by buying

Putoption.

SHORT POSITION

If the investor expects price to rise i.e. bullish in the market he takes a short position by selling

Put option

CALL OPTIONS

PUT OPTIONSOption buyer or

option holder

Buys the right to buy the underlying asset at the specified price

Buys the right to sell the underlying asset at the specified priceOption seller or

option writer

Has the obligation to sell the underlying asset (to the option holder) at the specified price

Has the obligation to buy the underlying asset (from the option holder) at the specified price.

FACTORS AFFECTING OPTION PREMIUMTHE PRICE OF THE UNDERLYING ASSET: (S)

Changes in the underlying asset price can increase or decrease the premium of an option. These

price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and the

premium of a put will decrease. A decrease in the price of the underlying assets value will generally have

the opposite effect

Premium of the

Premium of thePrice of theCALL


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Price of

CALL

Underlying

Underlying

asset

asset

Premium of thePremium of the

PUTPUT

THE SRIKE PRICE: (K)

The strike price determines whether or not an option has any intrinsic value. An options premium

generally increases as the option gets further in the money, and decreases as the option becomes more

deeply out of the money.

Time until expiration: (t)An expiration approaches, the level of an options time value, for puts and calls, decreases.

Volatility:

Volatility is simply a measure of risk (uncertainty), or variability of an options underlying. Higher volatility

estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This

expectation generally results in higher option premiums for puts and calls alike, and is most noticeable

with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of an

option seller or received from alternative investments in the case of an option buyer for the premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.PLAYERS IN THE OPTION MARKET:a) Developmental institutions

b) Mutual Funds

c) Domestic & Foreign Institutional Investors

d) Brokers

e) Retail Participants


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FUTURES V/S OPTIONS


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RIGHT OR OBLIGATION :

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price

agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated

to buy/sell the underlying asset.In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying

asset.

RISK

Futures Contracts have symmetric risk profile for both the buyer as well as the seller.

While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the

downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a

seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he

has received from the buyer.PRICES:

The Futures contracts prices are affected mainly by the prices of the underlying asset.

While the prices of options are however, affected by prices of the underlying asset, time

remaining for expiry of the contract & volatility of the underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options

contract, termed as Premium.

STRIKE PRICE:

In the Futures contract the strike price moves while in the option contract the strike price

remains constant .

Liquidity:

As Futures contract are more popular as compared to options. Also the premium charged is high in the

options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated

trading and investors in the options contract.Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of the

underlying only. While trading in option is two-dimensional as the price of the option depends upon the

price and volatility of the underlying.PAY OFF:

As options contract are less active as compared to futures which results into non linear pay off.

While futures are more active has linear pay off .

OPTION STRATAGIES:

1.BULL CALL SPREAD:This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread

consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month.

However, the total investment is usually far less than that required to purchase the stock.Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of

1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1490+10=1500Possible outcomes at expiration:

i. BREAK- EVEN- POINT:


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On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The

call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also

reduce the premium received.ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is

less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce theloss through receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep

in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless.

While 1510 call sold result in Rs.10 loss i.e. deep out the money.


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If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While

1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs.

10iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10

while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in

loss to the premium paid.

The pay-off table:

PATNI COMPUTERS

AT EXPIRATION

1485

(

1. BEAR PUT SPREAD:It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the

purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high

leverage over a limited range of stock prices. However, the total investment is usually far less than that

required to buy the stock shares.Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one

month put of 4490 (lower price) and receive 45 ticks per contract.



BREAK- EVEN- POINT= 5510-10 = 5500.

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:


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iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless.

While 1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While

1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs.

10iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10

while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in

loss to the premium paid.

The pay-off table:

PATNI COMPUTERS

AT EXPIRATION


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1485

(below

lower

price)1490

(At the

lowerprice)

1495

(Between

lower strike

&BEP

1500

(At BEP)

1510

Intrinsic value of 1490

long call at expiration (a)

0

0

510

20

Premium paid (b)

25

25

25

25

25

Intrinsic value of 1510 short call at expiration (c)0

0

0

00

Premium received (d)

15

15

15

15

15

profit/loss(a-c)-(b- d)

-10

-10

-5

0

10PATNI COMPUTERS

AT EXPIRATION

1495

(below

higher

price)1510

(At the


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higher

price)

1505

(Between

higher strike

&BEP

1500

(At BEP)

1520

(Above BEP

Intrinsic value of 1510 short call at expiration (a)0

0

0

0

10

Premium paid (b)

15

15

15

15

15


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Intrinsic value of 1490long call at expiration (c)

5

20

15

10

30

Premium received (d)

25


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25

25

25

25

profit/loss(c-a)-( d - b)

-5

10

5

0

10

Profit

20

10

01490 1500 1510 1520 1530 1540

-10-20

Loss

1. BEAR PUT SPREAD:It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the

purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high

leverage over a limited range of stock prices. However, the total investment is usually far less than that

required to buy the stock shares.Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one

month put of 4490 (lower price) and receive 45 ticks per contract.



BREAK- EVEN- POINT= 5510-10 = 5500.

Possible outcomes at expiration:i. BREAK- EVEN- POINT:


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On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put

purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option

sold will expire worthless and also reduce the premium received.ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is

less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the

loss of Rs.10 through receiving the net premium.

If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep

in the money While 4490 put option sold will have no intrinsic value the premium receive will generate

profit .iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While

4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received

If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put

sold will have no intrinsic value and expire worthless and profit is the premium received between thestrike price an premium paid.iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic

value. while the 4490 put option sold result in maximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic

value. while the 5510 put option sold result in the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and

4490 option sold will be assigned (strike pricepremium paid) = profit

3. BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market toprovide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling

a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited

downside risk.

The current price of RELIANCE CAPITAL is Rs.1290Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell


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one month put of 1310 (higher price) and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid- 15 received)


BREAK- EVEN- POINT= 1300-10 = 1290

Possible outcomes at expiration:i. BREAK- EVEN- POINT:

On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an

intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an

intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic

value and expire worthless, while the 1310 option sold will have an intrinsic value of 5.iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire

worthless. While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an int

Project Hedging 01

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