comparative analysis of equity and derivative market
TRANSCRIPT
A PROJECT REPORTON
“COMPARATIVE ANALYSIS OF EQUITY & DERIVATIVE MARKEY”
SUBMITTED TOMAEER’s MIT SCHOOL OF BUSINESS
BY
LUCY CHATTERJEERoll No. 260247
26th Batch
IN PARTIAL FULFILLMENT OFPOST GRADUATE DIMPLOMA IN MANAGEMENT
(PGDM)
December, 2009
MAEER’s MIT SCHOOL OF BUSINESS PUNE
CONTENTS
Chapter No. Title Page No.Declaration from student III
Certificate from organisation
IV
Certificate from Guide VAcknowledgement VI
List of Tables VIIList of Graphs VIIList of charts VII
List if abbreviations IXExecutive summary X
1 Introduction
1.1 Background of the study 11.2 Company Profile
Company History 6 Top management 11
Competitive advantage of
Religare
11
1.3 Need of the Study 131.4 Objective of the Study 131.5 Methodology of the Study 131.6 Limitation of the Study 14
2 Data Processing & Analysis
2.1 Equity 16 Benefits from
equity16
Risk in equity investment
18
How to overcome from risk
18
Process of diversification
18
Selection of shares 19 When to buy/sell
shares19
Types of cash market margin
25
2.2 Derivatives 28 Factors driving the
growth of derivative
29
Types of derivatives
29
Types of trades I derivative
41
Types of F& O margin
43
2.3 Comparative analysis
47
3 Findings Practical situation 52
Comparative analysis of the
traded values in the F & O segment
with Cash segment
54
4 Conclusions 55
5 Recommendations 56
6 Bibliography 57
DECLARATION
I, Ms. Lucy Chatterjee
hereby declare that this project report is the record of authentic work
carried out by me during the period from 2008 to 2010 and has not been
submitted to any other University or Institute for the award of any
degree / diploma etc.
Name of the student: Lucy ChatterjeeDate:
iii
Acknowledgement
It gives me an immense pleasure to present this project report, for the partial fulfillment of the
course. This project has been made possible through the direct and indirect co-operation of so
many people for whom by profound through appreciation the gratitude remains.
First of all. I would like to thanks to Mrs. Priya Venkatraman, Senior Relationship Management
for her valuable suggestions and constructive criticisms that have acted as a guiding light for me.
I also acknowledge the help given to me by the people of the organization whose valuable inputs
were the driving force behind this project. Last not but the least. I take this opportunity to
express my gratitude to Prof. (Gp. Capt.) D. P. Apte.
I am also grateful to my guide Prof. P. Krishnan who guided me to complete this project
successfully on time and other faculty members of MITSOB for the knowledge, which I am
imbibed throughout the two years of my PGDM course.
My deepest regards to my parents who have been always immense of inspiration & support to
me forever. I would like to dedicate this work to my parents without whose co-operation this task
would have remained unachieved.
vi
List of Table
Table No. Title Page No.1 Performance of sensex
from 19913
2 Client interface 123 Distinction between
futures and forward33
4 Distinction between future and option
41
5 Comparative analysis 466 Comparative analysis in
the F & O segment with cash segment
54
List of Graph
Graph No. Title Page no.1 Sensex performance 42 Exchange traded
derivatives “Forward”31
3 Payoff from forward contract
32
4 Exchange traded in derivative “Option”
35
5 Payoff from option 33
vii
List of Charts
Chart No. Title Page No.1 An overview of a REL 72 Religare Financial service
group overview 8
3 REL vision and mission 94 REL & its subsidiaries 10
viii
List of Abbreviations
Abbreviation Full FormBSE Bombay stock Exchange
CDSL Central depository services limitedDP Depository ParticipantEPS Earnings per share
EWMA Exponentially weighted moving averageFII’s Foreign institutional investors
F & O Futures & OptionsIPO Initial Public OfferingLN Natural log
MTM Mark to marketNAV Net asset valueNSDL National securities depository limited
P/E ratio Price per earnings ratioRBI Reserve bank of India
SCRA Securities contract regulation actSEBI Securities & Exchange board of IndiaSRO Self-regulatory organizationVaR Value at Risk
FICCI Federation of Indian Chambers of Commerce and Industry
ix
EXECUTIVE SUMMARY
The project is about the study of brand awareness of RELIGARE SECURIRTIES LIMITED
among investors. It gives the knowledge of market position of the company. I studied as to how
this company proves to an option for the investors, by studying the performance of investing in
equity & derivative for few months considering their analysis. I selected area of COMPARITIVE
ANALYSIS OF EQUITY & DERIVATIVE, which attract different kinds of investors to invest
in equity derivative and to face high risk and get high returns. The major findings of the project
are to overview of the comparison of equity cash segment and equity derivative segment,
overview of the equity and F & O segment from May 2009 to June 2009. The methodology of
the project here is to analyze the Equity & Derivative performance based on NAV, EPS and
other things. In this project I also included my practical situation during the project internship,
that how the market goes up and down and why it happens.
The methodology of the project here is to analyze the investment opportunities available for
those investors & study the returns & risk involved in various investment opportunities and also
study of investment management & risk management. So for that we have to study & analyze the
performance of Equity & Derivative in the market. We know that there is a high risk, high return
in equity but in a long time only. While in derivative there is a high risk, high return in the short
term, because derivative contract is for short time for 1/2/3 months only. So this project included
different types of returns, margin & risk involved in equity, and types, need, use & margin
involved in the derivatives market and also participants & terms use in derivative market.
X
1. INTRODUCTION
1.1Background of the study:
The oldest stock exchange in Asia (established in 1875) and the first in the country to be granted
permanent recognition under the Securities Contract Regulation Act, 1956, Bombay Stock
Exchange Limited (BSE) has had an interesting rise to prominence over the past 133 years. A lot
has changed since 1875 when 318 persons became members of what today is called “Bombay
Stock Exchange Limited” paying a princely amount of Re 1. In 2002, the name "The Stock
Exchange, Mumbai" was changed to Bombay Stock Exchange. Subsequently on August 19,
2005, the exchange turned into a corporate entity from an Association of Persons (AoP) and
renamed as Bombay Stock Exchange Limited.
BSE, which had introduced securities trading in India, replaced its open outcry system of trading
in 1995, with the totally automated trading through the BSE Online trading (BOLT) system. The
BOLT network was expanded nationwide in 1997.
Since then, the stock market in the country has passed through both good and bad periods. The
journey in the 20th century has not been an easy one. Till the decade of eighties, there was no
measure or scale that could precisely measure the various ups and downs in the Indian stock
market. Bombay stock Exchange Limited (BSE) in 1986 came out with a stock Index that
subsequently became the barometer of the Indian Stock Market.
SENSEX first compiled in 1986 was calculated on a “Market Capitalization Weighted”
methodology of 30 component stocks representing a sample of large, well established and
financially sound companies. The base year of SENSEX is 1978-79. The index is widely
reported in both domestic and international markets through prints as well as electronic media.
SENSEX is not only scientifically designed but also based on globally accepted construction and
review methodology. From September 2003, the SENSEX is calculated on a free-float market
capitalization methodology. The “free-float Market Capitalization-Weighted” methodology is a
widely followed index construction methodology on which majority of global equity benchmarks
are based.
The growth of equity markets in India has been phenomenal in the decade gone by Right from
early nineties the stock market witnessed heightened activity in terms of various bull and bear
runs. The SENSEX captured all these happenings in the most judicial manner. One can identify
the booms and bust of the Indian equity market through SENSEX.
The Exchange also disseminates the Price-Earnings Ratio, the Price to Book Value Ratio and the
Dividend Yield Percentage on day-to-day basis of all its major indices.
The value of all BSE indices are every 15 seconds during the market hours and displayed
through the BOLT system. BSE website and news wire agencies.
All BSE-Indices are reviewed periodically by the “Index Committee” of the Exchange. The
Committee frames the broad policy guidelines for the development and maintenance of all BSE
indices. Department of BSE Indices of the exchange carries out the day to day maintenance of all
indices and conducts research on development of new indices.
Institutional investors, money managers and small investors all refer to the Sensex for their
specific purposes The Sensex is in effect the substitute for the Indian stock markets. The
country's first derivative product i.e. Index-Futures was launched on SENSEX.
PERFORMANCE
OF SENSEX FROM
1991
*As of 30/June/2009
Year Open high low close1991
1,027.38
1,955.29
947.141
1,908.85
1992
1,957.33
4,546.58
1,945.48
2,615.37
1993
2,617.78
3,459.07
980.06
3,346.06
1994
3,436.87
4,643.31
3,405.88
3,926.90
1995
3,910.16
3,943.66
2,891.45
3,110.49
1996
3,114.08
4,131.22
2,713.12
3,085.20
1997
3,096.65
4,605.41
3,096.65
3,658.98
1998
3,658.34 4,322
2,741.22
3,055.41
1999
3,064.95
5,150.99
3,042.25
5,005.82
2000
5,209.54
6,150.69
3,491.55
3,972.12
2001
3,990.65
4,462.11
2,594.87
3,262.33
2002
3,262.01
3,758.27
2,828.48
3,377.28
2003
3,383.85
5,920.76
2,904.44
5,838.96
2004
5,872.48
6,617.15
4,227.50
6,602.69
2005
6,626.49
9,442.98
6,069.33
9,397.93
2006
9,422.49
14,035.30
8,799.01
13,786.91
2007
13,827.77
20,498.11
12,316.10
20,286.99
2008
20,325.27
21,206.77
7,697.39
9,647.31
GRAPH SHOWING SENSEX PERFORMANCE
1.2COMPANY’S PROFILE
Company’s History
Religare is one of the leading integrated financial services institutions od India. Religare is
promoted by the promotion of Ranbaxy Laboratories Limited. The comapn offers large and
diverse bouuet of services ranging from equties, derivatives, commodities, insurance
broking, to wealth advisory, portfolio managemnt services, personal finacial services
Investment banking and institutuonal broking services. The services are broadly clubbed
across three key business verticals- Retail, wealth mangement and the institutional specturm.
Religare retail network spreads across the length and the breadth of the country with it
presence through more than 1,217 locations across more than 392 cities and towns. The
company has a represenattive office in London. Having spread itself fairly well across the
country and with the promises of not resting on its laurels, it has also aggresively started
eyeing global geographies.
An Overview of a Religare Enterprise Limited
Religare Enterprise Limited Fortis healthcare Limited
Super Religare Laborataries Limited Religare Wellness Limited (formerly SRL Ranbaxy) (formerly Fortis Healthworld)
Religare Technova Limited
Religare Voyages Limited
Healthcare
Religare Financial Services Group Overview:-
Religare Enterprise Limited
Their Joint Ventures
Life Insurance Business Asset management business(Aegon as a Partner) (Aegon as a Partner)
Private Wealth Business India’s First SEBI approved Film (Macquire, Australian Financial Services Major Fund (Vistaar as a Partner) As a partner)
REL Vision and Mission
To build Religare as a globally trusted brand in the financial services domain and present it as the “Investment Gateway of India.”
VISION
Religare is driven by ethical and dynamic processes for wealth creation.
Providing financial care driven by the core values of diligence and transparency.MISSION
BRAND ESSENCE
REL & its subsidiaries
Structurally, all businesses are operated through various subsidiaries of the holding company, Religare Enterprises Limited.
Top Management Team
Mr. Sunil Godhwani- CEO & Managing Director, Religare Enterprises Limited. Mr. Shacindra Nath- Group Chief operating Officer, Religare Enterprises Limited.Mr. Anil Saxena- Group Chief Operating Officer, Religare Enterprises Lmited.
Competitive advantage of ReligareLowest BrokerageOnline Money Transfer.Daily Confirmation Calls.Daily Contract Notes.Different Kinds of Accounts like, R-Ally, R-Ally Lite, R-Ally Pro etc.Providing Funding Facility.
Client Interface:
Retail Spectrum Institutional Spectrum Wealth Spectrum
Positioning
Leverage reach and offer integrated product and service portfolio
Leverage relationship with growing SME segment spread across India
To be a client centric wealth management advisory firm for the high net worth individuals (HNIs)
Products and Services
Equity Trading
Commodity Trading
Online Investment portal
Personal Financial Services
- Investment Solutions
- Insurance
- Loans
Consumer Finance
Insurance Solutions
- Life Insurance
- Non-Life Insurance
Institutional Broking
Investment Banking
Insurance Advisory
Portfolio Management Services
Premier Client Group Services
Arts Initiative
International Advisory Fund Management Service (AFMS)
1.3NEED OF THE STUDY
Different kinds of investors to invest in equity & derivative and to face high risk and get high returns.
Company proves to an option for the investors.
Studying the performance of investing equity & derivative for few months considering their analysis.
1.4 OBJECTIVE OF THE STUDY
Any investor’s vision is a long term investment ad short term investment and gets high
returns by bearing high risk. For that objective need to be climbed successfully an so
objectives of this project are,
1) To find the RIGHT SCRIPT to buy and sell at the RIGHT TIME
2) To get good return.
3) To know how derivatives can be use for hedging.
4) To know the outcome of Equity and Derivative.
5) How to achieve Capital appreciations.
1.5METHODOLOGY OF THE PROJECT
Defining objective won’t suffice unless and until a proper methodology is to achieve the
objectives.
1) Analyzing and observing the investment opportunities.
2) Analyzing the performance of Equity and Derivative market with the help of NAV,
EPS, P/E ratio etc.
1.6LIMITATIONS OF THE STUDY
This project was restricted for two months; hence exhaustive data is not available upon
which conclusions can be relied.
1) Investment in Securities carry risk so investment in Equity & Derivative is also
carrying risk on the basis of the market.
2) Factors affecting the Market Price of Investment may be due to Market forces,
performance of the companies is not possible, and so all the data is not available.
2. DATA PROCESSING & ANALYSIS
2.1 Equity
Total equity capital of a company is divided into equal units of small denominations, each called
a share.
It is a stock or any other security representing an ownership interest.
It proves the ownership interest of stock holders in a company.
For example:-
In a company the total equity capital of Rs 2, 00, 00,000 is divided into 20, 00,000
units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to
have 20, 00,000 equity shares of Rs 10 each. The holders of such shares are members of the
company and have voting rights.
Benefits from Equity
The benefits distributed by the company to its shareholders can be: 1) Monetary Benefits and 2)
Non Monetary Benefits.
1. Monetary Benefits:
A. Dividend: An equity shareholder has a right on the profits generated by the
company. Profits are distributed in part or in full in the form of dividends.
Dividend is an earning on the investment made in shares, just like interest in case
of bonds or debentures. A company can issue dividend in two forms: a) Interim
Dividend and b) Final Dividend. While final dividend is distributed only after
closing of financial year; companies at times declare an interim dividend during a
financial year. Hence if X Ltd. earns a profit of Rs 40 crore and decides to
distribute Rs 2 to each shareholder, a holding of 200 shares of X Ltd. would
entitle you to Rs 400 as dividend. This is a return that you shall earn as a result of
the investment made by you by subscribing to the shares of X Ltd.
B. Capital Appreciation: A shareholder also benefits from capital appreciation.
Simply put, this means an increase in the value of the company usually reflected
in its share price. Companies generally do not distribute all their profits as
dividend. As the companies grow, profits are re-invested in the business. This
means an increase in net worth, which results in appreciation in the value of
shares. Hence, if you purchase 200 shares of X Ltd at Rs 20 per share and hold
the same for two years, after which the value of each share is Rs 35. This means
that your capital has appreciated by Rs 3000.
2. Non-Monetary Benefits: Apart from dividends and capital appreciation, investments in
shares also fetch some type of non-monetary benefits to a shareholder. Bonuses and
rights issues are two such noticeable benefits.
A. Bonus: An issue of bonus shares is the distribution free of cost to the shareholders
usually made when a company capitalizes on profits made over a period of time.
Rather than paying dividends, companies give additional shares in a pre-defined
ratio. Prima facie, it does not affect the wealth of shareholders. However, in
practice, bonuses carry certain latent advantages such as tax benefits, better future
growth potential, and an increase in the floating stock of the company, etc. Hence
if X Ltd decides to issue bonus shares in a ration of 1:1, every existing
shareholder of X Ltd would receive one additional share free for each share held
by him. Of course, taking the bonus into account, the share price would also
ideally fall by 50 percent post bonus. However, depending upon market
expectations, the share price may rise or fall on the bonus announcement.
B. Rights Issue: A rights issue involves selling of ordinary shares to the existing
shareholders of the company. A company wishing to increase its subscribed
capital by allotment of further shares should first offer them to its existing
shareholders. The benefit of a rights issue is that existing shareholders maintain
control of the company. Also, this results in an expanded capital base, after which
the company is able to perform better. This gets reflected in the appreciation of
share value.
Risks In equity investment:
Although an equity investment is the most rewarding in terms of returns generated, certain risks
are essential to understand before venturing into the world of equity.
Market/ Economy Risk.
Industry Risk.
Management Risk.
Business Risk.
Financial Risk
Exchange Rate Risk.
Inflation Risk.
Interest Rate Risk.
How to overcome risks:
Most risks associated with investments in shares can be reduced by using the tool of
diversification. Purchasing shares of different companies and creating a diversified portfolio has
proven to be one of the most reliable tools of risk reduction.
The process of Diversification:
When you hold shares in a single company, you run the risk of a large magnitude. As your
portfolio expands to include shares of more companies, the company specific risk reduces. The
benefits of creating a well diversified portfolio can be gauged from the fact that as you add more
shares to your portfolio, the weightage of each company’s share gets reduced. Hence any adverse
event related to any one company would not expose you to immense risk. The same logic can be
extended to a sector or an industry. In fact, diversifying across sectors and industries reaps the
real benefits of diversification. Sector specific risks get minimised when shares of other sectors
are added to the portfolio. This is because a recession or a downtrend is not seen in all sectors
together at the same time.
However all risks cannot be reduced:
Though it is possible to reduce risk, the process of equity investing itself comes with certain
inherent risks, which cannot be reduced by strategies such as diversification. These risks are
called systematic risk as they arise from the system, such as interest rate risk and inflation risk.
As these risks cannot be diversified, theoretically, investors are rewarded for taking systematic
risks for equity investment.
Selection of Shares:
Proper selections of shares are of two types:-
1. Fundamental analysis:
It involves in –depth study and analysis of the prospective company whose shares
we want to buy, the industry it operates in and the overall market scenario. It can be done
by reading and assessing the company’s annual reports, research reports published by
equity research houses, research analysis published by the media and discussions with the
company’s management or the other experienced investors.
2. Technical analysis :
It involves studying the prices movement of the stock over an extended period of
time in the past to judge the trend of the future price movement. It can be done by
software programs, which generate stock prices charts indicating upward. Downward and
sideways movements of the stock price over the stipulated time period.
When to buy & sell shares:
With high volatility prevailing in the market, major price fluctuations in equities
are not uncommon. Therefore, apart from ascertaining ‘which’ stock to buy or sell, it becomes
equally important to consider ‘when’ to buy or sell. Any investor should be aware of the fact
where all the investor is following i.e., Buy Low. Sell High.
That means we should buy stocks at a low price and sell them at a high price.
When to buy
Three ways by which we can figure that out what it is about this stock that makes it hot.
1. Earnings per Share (EPS): How well the company is doing
EPS is the total earning or profits made by company (during a given period of time) calculated
on per share basis. It aims to give an exact evaluation of the returns that the company can deliver.
Example:
Company XYZ Ltd. Capital: Rs 100 crore (Rs 1 billion).
Capital is the amount the owner has in the business. As the business grows and makes profits, it
adds to its capital. This capital is subdivided into shares (or stocks). The capital is divided into
100 million shares of Rs 10 each.
Net Profit in 2003-04: Rs 20 crore (Rs 200 million).
EPS is the net profit divided by the total number of shares.
EPS = net profit/ number of shares
EPS = Rs 20 crore (Rs 200 million)/ 10 crore (100 million) shares = Rs 2 per share
Lesson to be learnt
1. If a company's EPS has grown over the years, it means the company is doing well, and the
price of the share will go up. If the EPS declines, that's a bad sign, and the stock price falls.
2. Companies are required to publish their quarterly results. Keep an eye out for these results;
check for the trend in their EPS.
3. Price earnings ratio (PE ratio): How other investors view this share
An indicator of how highly a share is valued in the market. It arrived at by dividing the
closing price of a share on a particular day by EPS. The ratio tends to be high in the case of
highly rated shares. The average PE ratio for companies in an industry group is often given
in investment journal. Two stocks may have the same EPS. But they may have different
market prices. That's because, for some reason, the market places a greater value on that
stock. PE ratio is the market price of the stock divided by its EPS.
PE = market price/ EPS
let’s take an example of two companies.
Company XYZ Ltd
Market price = Rs 100
EPS = Rs 2
PE ratio = 100/ 2 = 50
Company ABC Ltd
Market price = Rs 200
EPS = Rs 2
PE ratio = 200/ 2 = 100
In the above cases, both companies have the same EPS. But because their market price is
different, the PE ratio is different.
Lesson to be learnt
In the case of EPS, it is not so much a high or low EPS that matters as the growth in the
EPS. The company's PE reflects investors' expectations of future growth in the EPS. A
high PE company is one where investors have hopes that earnings will rise, which is why
they buy the share.
3. Forward PE: Looking ahead
The stock market is not nostalgic. It is forward looking. For instance, it sometimes happens that a
sick company, that has made losses for several years, gets a rehabilitation package from its bank
and a new CEO. As a consequence, the company's stock shoots up. Because investors think the
company will do better in the future because of the package and new leadership, and its earnings
will go up. And we think it is a good time to buy the shares of the company now.
Suddenly, the demand for the shares has gone up. Because stock prices are based on expectations
of future earnings, analysts usually estimate the future earnings per share of a company. This is
known as the forward PE. Forward PE is the current market price divided by the estimated EPS,
usually for the next financial year.
Forward PE = Current market price/ estimate EPS for the next financial year.
To illustrate what we have been talking about, let's take the example of Infosys Technologies.
Trailing 12-month EPS = Rs 56.82 (EPS of the last four quarters)
Closing price on January 6 = Rs 2043.15
PE = Price/EPS = 2043.15/ 56.82 = 35.95
Estimated EPS for 2004-05 = Rs 67
Estimated EPS for 2005-06 = Rs 90
these figures are according to brokers' consensus estimates.
Forward PE = current market price/ estimated EPS for next financial year
Forward PE for 2004-05 = 2043.15/ 67 = 30.49
Forward PE for 2005-06 = 2043.15/ 90 = 22.70
With an EPS growth of over 30%, a forward PE of 22.7 is not high, indicating that there is scope
to be optimistic about the stock's price.
Lesson to be learnt
Sometimes, investors look out for a low PE stock, expecting that its price will rise in the
future. But sometimes, low PE stocks may remain low PE stocks for ages, because the
market doesn't fancy them.
Keep tab on the business news to check out the company's prospects in the future
When to sell
Stock Reaches Fair Value or Target Price
This is the easiest part of selling. We should sell when a stock reaches its fair value. It is the
main reason why we chose to buy it on the first place.
The target price can be computed by assessing the company’s estimated financial performance
over the next 3 to 5 years, computing its EPS and using an acceptable P/E ratio to compute the
future market price. Based on this future estimated price and our required return on our
investment, compute our target price.
When the prices reaches Stop loss
It is advisable to always consider the possibility of a loss before making our investment. We
should decide how much loss we are willing to book in the stock. The lower price i.e., the price
at which we are willing curtail our loss, is called ‘Stop Loss’.
Need the money
The generally happens due to improper planning. However, things happen. Even the most
carefully planned strategy may not work. Catastrophic events may force investors to sell an
investment if his household is affected by it.
The book is unclean
When management left their post abruptly or when the SEBI conduct a criminal investigation on
a company, it may be time to sell. Our assumption may be inaccurate as a lot of fair value
calculation is based on the company's balance sheet, cash flow or other financial statement
published by management.
Takeover news
When one of your stock holding is getting bought by other companies, it may be time to sell.
Sure, you might like the acquiring company but you still need to figure out the fair value of the
common stock of the acquiring company. If the acquiring company is overvalued, then it is best
to sell.
Other Investment Opportunity
Let us consider we bought stock A and it has risen to 10% below its fair value. Meanwhile, we
noticed that stock B fallen to below 50% of our calculated fair value. This is an easy decision.
We will sell our stock A and buy stock B. Our goal as an investor is to maximize our investment
return. Sacrificing a 10% of return in order to earn a 50% return is a sensible way to do that.
Inaccurate Fair Value Calculation
As investors, we sometimes made errors in our fair value calculation. There are factors that we
might not take into accounts when researching a particular company. For example, satyam
scandal.
New Competitors with Better Products
When new competitors sprung up, the company that you hold might have to spend more money
in order to fend off competition. Recent example includes the emergence of pay-per click
advertising by Google. Any advertising business such as newspapers or cable network, this new
product by Google might hurt profit margins and eventually the fair value of the stock.
Not having a valid reason to Buy
When we don't know why we bought a particular stock, we won't know how much our potential
return is or when we should sell it. This is the easiest way of losing money. When we have no
valid reason to buy, we should sell immediately.
Types of Cash market margin
1. Value at Risk (VaR) margin.
2. Extreme loss margin
3. Mark to market Margin
1. Value at Risk (VaR) margin :
VaR Margin is at the heart of margining system for the cash market segment.
VaR is a technique used to estimate the probability of loss of value of an asset or group of
assets (for example a share or a portfolio of a few shares), based on the statistical analysis
of historical price trends and volatilities.
A VaR statistic has three components: a time period, a confidence level and a loss amount
(or loss percentage). Keep these three parts in mind as we give some examples of
variations of the question that VaR answers:
With 99% confidence, what is the maximum value that an asset or portfolio
may lose over the next day?
Example:-
Suppose shares of a company bought by an investor. Its market value today is Rs.50 lakhs but its
market value tomorrow is obviously not known. An investor holding these shares may, based on
VaR methodology, say that 1-day VaR is Rs.4 lakhs at 99% confidence level. This implies that
under normal trading conditions the investor can, with 99% confidence, say that the value of the
shares would not go down by more than Rs.4 lakhs within next 1-day.
In the stock exchange scenario, a VaR Margin is a margin intended to cover the largest loss (in
%) that may be faced by an investor for his / her shares (both purchases and sales) on a single
day with a 99% confidence level. The VaR margin is collected on an upfront basis (at the time of
trade).
How is VaR margin calculated?
VaR is computed using exponentially weighted moving average (EWMA) methodology. Based
on statistical analysis, 94% weight is given to volatility on ‘T-1’ day and 6% weight is given to
‘T’ day returns.
To compute, volatility for January 1, 2008, first we need to compute day’s return for Jan 1, 2009
by using LN (close price on Jan 1, 2009 / close price on Dec 31, 2008).
Take volatility computed as on December 31, 2008.
Use the following formula to calculate volatility for January 1, 2009:
Square root of [0.94*(Dec 31, 2008 volatility)*(Dec 31, 2008 volatility)+ 0.06*(January 1, 2009
LN return)*(January 1, 2009 LN return)]
Example:
Share of ABC Ltd
Volatility on December 31, 2008 = 0.0314
Closing price on December 31, 2008 = Rs. 360 Closing price on January 1, 2009 = Rs. 330
January 1, 2009 volatility =
Square root of [(0.94*(0.0314)*(0.0314) + 0.06 (0.08701)* (0.08701)] = 0.037 or 3.7%
How is the Extreme Loss Margin computed?
The extreme loss margin aims at covering the losses that could occur outside the coverage of
VaR margins.
The Extreme loss margin for any stock is higher of 1.5 times the standard deviation of daily LN
returns of the stock price in the last six months or 5% of the value of the position.
This margin rate is fixed at the beginning of every month, by taking the price data on a rolling
basis for the past six months.
Example:
In the Example given at question 10, the VaR margin rate for shares of ABC Ltd. was 13%.
Suppose the 1.5 times standard deviation of daily LN returns is 3.1%. Then 5% (which is higher
than 3.1%) will be taken as the Extreme Loss margin rate.
Therefore, the total margin on the security would be 18% (13% VaR Margin + 5% Extreme Loss
Margin). As such, total margin payable (VaR margin + extreme loss margin) on a trade of Rs.10
lakhs would be 1, 80,000/-
How is Mark-to-Market (MTM) margin computed?
MTM is calculated at the end of the day on all open positions by comparing transaction price
with the closing price of the share for the day.
Example:
A buyer purchased 1000 shares @ Rs.100/- at 11 am on January 1, 2008. If close price of the
shares on that day happens to be Rs.75/-, then the buyer faces a notional loss of Rs.25, 000/ - on
his buy position. In technical terms this loss is called as MTM loss and is payable by January 2,
2008 (that is next day of the trade) before the trading begins.
In case price of the share falls further by the end of January 2, 2008 to Rs. 70/-, then buy position
would show a further loss of Rs.5,000/-. This MTM loss is payable.
In case, on a given day, buy and sell quantity in a share are equal, that is net quantity position is
zero, but there could still be a notional loss / gain (due to difference between the buy and sell
values), such notional loss also is considered for calculating the MTM payable.
MTM Profit/Loss = [(Total Buy Qty X Close price)] - Total Buy Value] - [Total Sale Value -
(Total Sale Qty X Close price)]
2.2 Derivatives
Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, forex, commodity or any other asset. For example, wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices
by that date. Such a transaction is an example of a derivative. The price of this derivative is
driven by the spot price of wheat which is the "underlying".
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines
"derivative" to include-
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by
the regulatory framework under the SC(R)A.
Factors driving the growth of derivatives
Over the last three decades, the derivatives market has seen a phenomenal growth. A large
variety of derivative contracts have been launched at exchanges across the world. Some of the
factors driving the growth of financial derivatives are:
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, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a
large number of financial assets leading to higher returns, reduced risk as well as transactions
costs as compared to individual financial assets.
Types of derivatives:
1. Forward Contract:
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 a long position and 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 price. Other contract
details like delivery date, price and quantity are negotiated bilaterally by the parties to the
contract. 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.
Limitations of Forward Contract
Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
In the first two of these, 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.
Counterparty risk arises from the possibility of default by any one party to the transaction. When
one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward
markets trade standardized contracts, and hence avoid the problem of illiquidity, still the
counterparty risk remains a very serious issue.
interest rate futures stock index futures currency futures0
1000
2000
3000
4000
5000
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7000
Exchange Traded Derivative" Forward"
Types
amou
nt in
bil
lion
of $
2. Future Contracts:
Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the 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 99% 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 the month of delivery
The units of price quotation and minimum price change
Location of settlement
The payoff from a long position in a forward contract is
P = S - X,
where S is a spot price of the security at time of contract maturity, X is the delivery price.
Similarly, the payoff from a short position is
P = X - S.
For example, let's say the current price of the stock is $80.00 and we entered in forward contract
to buy this stock in 3 months time for $81.00 (that means we hope that price will not fall lower
than $81.00). If after three months price is more than $81.00, let's say $83.00, than we can buy
the same stock for $81.00 (as stated by forward contract) and after reselling it on the market our
payoff will be
P = $83.00 - $81.00 = $2.00
If at forward maturity the stock price falls to $78.00, than our loss will be
P = $81.00 - $78.00 = $3.00
The graphs above illustrate the forward contract payoff patterns for long and short positions.
Distinction between futures and forwards
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
hence more liquid hence less liquid
Follows daily settlement Settlement happens at end of period
Future terminology
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, two-month and three months expiry cycles which expire 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. Also called as
lot size.
Basis: In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest that
is paid to finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is
called marking-to-market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. If the balance in the margin account
falls below the maintenance margin, the investor receives a margin call and is expected to top up
the margin account to the initial margin level before trading commences on the next day.
3. Option Contracts
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right. In
contrast, in a forward or futures contract, the two parties have committed themselves to doing
something. Whereas it costs nothing (except margin requirements) to enter into a futures
contract, the purchase of an option requires an up-front payment.
individal
stock
options
stock
index options
curre
ncy options
interset
rate
options0
1000
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Exchange Traded Derivatives "options"
In billions of $
type
s
Option Terminology
Index options: These options have the index as the underlying. 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 stoc ks. 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.
· Buyer of an option: The buyer of an option is the one who by paying the option premium buys
the right but not the obligation to exercise his option on the seller/writer.
· Writer of an option: The writer of a call/put option is the one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer exercises on him.
Option price/premium: Option price is the price which the option buyer pays to the option seller.
It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.
American options: American options are options that can be exercised at any time upto 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 than American options, and properties of an
American option are frequently deduced from those of its European counterpart.
In-the-money option: An in-the-money (ITM) 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 (i.e. spot price
>strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In
the case of a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-money when the current
index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a
negative cash flow if it were exercised immediately. 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). If the index is much lower than the strike price, the call is said to be deep OTM.
In the case of a put, the put is OTM if the index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two components -
intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it
is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of
a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St —
K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is
the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its premium and
its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only
time value. Usually, the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is an option's time value, all else equal. At expiration, an option
should have no time value.
There are two basic types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
i) Long a call:- person buys the right (a contract) to buy an asset at a certain price. We
feel that the price in the future will exceed the strike price. This is a bullish position.
ii) Short a call:- person sells the right ( a contract) to someone that allows them to buy to
buy an asset at a certain price. The writer feels that asset will devaluate over the time
period of the contract. This person is bearish on that asset.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.
i) Long a put:- Buy the right to sell an asset at a pre-determined price. We feel that the
asset will devalue over the time of the contract. Therefore we can sell the asset at a
higher price than is the current market value. This is a bearish position.
ii) Short a put:- sell the right to someone else. This will allow them to sell the asset at a
specific price. We feel the price will go down and we do not. This is a bullish
position.
Profit / payoff in Option
The payoff to a derivative portfolio is the market value of the portfolio at expiration.
(Also gross payoff).
The profit on a derivative portfolio is the payoff less the cost of acquisition or
assembling the portfolio. (Net profit).
We will be looking at a number of option strategies and combinations.
The (gross) payoff is the value (positive or negative) of the option or portfolio at
maturity.
The payoff does not include the initial cost (or the initial cash inflow) at the time the
portfolio was set up.
Net profit= (gross) Payoff- cost of buying options or other securities+ premium
received for selling options or other securities.
If S is a final price of the option underlying security, X is a strike price and OP is an option price,
than the profit is
Long Call: P = S - X - OP
Short Call: P = X - S + OP
Long Put: P = X - S - OP
Short Put: P = S - X + OP
For example, let's say the stock price is $50.00, we bought European call option with strike
$53.00 and paid $2.00 for this option. If option price is less than $53.00, we will not exercise the
option to buy the stock, because it doesn't make sense to buy security for higher price than it
costs on the market. In this case we lose all initial investment equal to the option price $2.00. If
stock price is more than $53.00, we will exercise the option. For example if the stock price is
$56.00, after exercising the option and immediately reselling the acquired stock our profit will
be:
P = $56.00 - $53.00 - $2.00 = $1.00
if the stock price is $54.00, than the profit is:
P = $54.00 - $53.00 - $2.00 = - $1.00
As we see in latter case we lose money. The reason is that increase of stock price just by $1.00
above the strike ($53.00) doesn't cover our initial investment of $2.00, although we still exercise
the option to recover at least $1.00 of initial investment. If the stock price at exercise time is
$55.00 than we exercise the option to cover our initial expenses(equal to option price):
P = $55.00 - $53.00 - $2.00 = $0.00
This latter case corresponds to option graph intersection point with horizontal axis on the
drawing above.
Distinction between futures and options
Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
Types of traders in derivative market
1. Hedgers:- Hedgers are those who protect themselves from the risk associated with the
price of an asset by using derivatives. A person keeps a close watch upon the prices
discovered in trading and when the comfortable price is reflected according to his wants,
he sells futures contracts. In this way he gets an assured fixed price of his produce.
In general, hedgers use futures for protection against adverse future price movements in
the underlying cash commodity. Hedgers are often businesses, or individuals, who at one
point or another deal in the underlying cash commodity.
Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices go
up. For protection against higher prices of the produce, he hedges the risk exposure by
buying enough future contracts of the produce to cover the amount of produce he expects
to buy. Since cash and futures prices do tend to move in tandem, the futures position will
profit if the price of the produce raise enough to offset cash loss on the produce.
2. Speculators:
Speculators are somewhat like a middle man. They are never interested in actual owing
the commodity. They will just buy from one end and sell it to the other in anticipation of
future price movements. They actually bet on the future movement in the price of an
asset.
They are the second major group of futures players. These participants include
independent floor traders and investors. They handle trades for their personal clients or
brokerage firms
.
Buying a futures contract in anticipation of price increases is known as ‘going long’. Selling a
futures contract in anticipation of a price decrease is known as ‘going short’. Speculative
participation in futures trading has increased with the availability of alternative methods of
participation.
Speculators have certain advantages over other investments they are as follows:
If the trader’s judgment is good, he can make more money in the futures market
faster because prices tend, on average, to change more quickly than real estate or
stock prices.
Futures are highly leveraged investments. The trader puts up a small fraction of the
value of the underlying contract as margin, yet he can ride on the full value of the
contract as it moves up and down. The money he puts up is not a down payment on
the underlying contract, but a performance bond. The actual value of the contract is
only exchanged on those rare occasions when delivery takes place.
3. Arbitrators:
According to dictionary definition, a person who has been officially chosen to make a
decision between two people or groups who do not agree is known as Arbitrator. In
commodity market Arbitrators are the person who takes the advantage of a discrepancy
between prices in two different markets. If he finds future prices of a commodity edging
out with the cash price, he will take offsetting positions in both the markets to lock in a
profit. Moreover the commodity future investor is not charged interest on the difference
between margin and the full contract value.
Types of Futures and Options Margins
Margins on Futures and Options segment comprise of the following:
1) Initial Margin
2) Exposure margin
In addition to these margins, in respect of options contracts the following additional margins are
collected
1) Premium Margin
2) Assignment Margin
How is Initial Margin Computed?
Initial margin for F&O segment is calculated on the basis of a portfolio (a collection of futures
and option positions) based approach. The margin calculation is carried out using software called
- SPAN® (Standard Portfolio Analysis of Risk). It is a product developed by Chicago Mercantile
Exchange (CME) and is extensively used by leading stock exchanges of the world.
SPAN® uses scenario based approach to arrive at margins. It generates a range of scenarios and
highest loss scenario is used to calculate the initial margin. The margin is monitored and
collected at the time of placing the buy / sell order.
The SPAN® margins are revised 6 times in a day - once at the beginning of the day, 4 times
during market hours and finally at the end of the day.
Obviously, higher the volatility, higher the margins.
How is exposure margin computed?
In addition to initial / SPAN® margin, exposure margin is also collected.
Exposure margins in respect of index futures and index option sell positions have been currently
specified as 3% of the notional value.
For futures on individual securities and sell positions in options on individual securities, the
exposure margin is higher of 5% or 1.5 standard deviation of the LN returns of the security (in
the underlying cash market) over the last 6 months period and is applied on the notional value of
position.
How is Premium and Assignment margins computed?
In addition to Initial Margin, a Premium Margin is charged to trading members trading in Option
contracts.
The premium margin is paid by the buyers of the Options contracts and is equal to the value of
the options premium multiplied by the quantity of Options purchased.
For example, if 1000 call options on ABC Ltd are purchased at Rs. 20/-, and the investor has no
other positions, then the premium margin is Rs. 20,000.
The margin is to be paid at the time trade.
Assignment Margin is collected on assignment from the sellers of the contracts.
How Marked to Market Margins are computed?
1. Future contracts:- The open positions (gross against clients and net of proprietary/ self
trading) in the futures contracts for each member are marked to market to the daily
settlement price at the end of each day is the weighted average price of the last half an
hour of the futures contract. The profits/losses arising from the different between the
trading price and the settlement price are collected/ given to all clearing members.
2. Option contracts:- the marked o market for option contracts is computed and collected
as part of the Initial Margin in the form of Net Option Values. The Initial Margin is
collected on an online real time basis based on the data feeds given to the system at
discrete time intervals.
How Client Margins are computed?
Client Members and Trading Member are required to collect initial margins from all their
clients. The collection of margins at client level in the derivatives markets is essential as
derivatives are leveraged products and non-collection of margins at the client level would
provide zero cost leverage. In the derivative markets all money paid by the client towards
margins is kept in trust with the Clearing House/ Clearing Corporation and in the event of default
of the Trading or Clearing Member the amounts paid by the client towards margins are
segregated and not utilized towards the dues of the defaulting member.
Therefore, Clearing members are required to report on a daily basis details in respect of such
margin amounts due and collected from their Trading members/ clients clearing and settling
through them. Trading members are also required to report on a daily basis details of the amount
due and collected from their clients. The reporting of the collection of the margins by the clients
is done electronically through the system at the end of each trading day. The reporting of
collection of client level margins plays a crucial role not only in ensuring that members collect
margin from clients but it also provides the clearing corporation with a record of the quantum of
funds it has to keep in trust for the clients.
2.3 Comparative Analysis
Basis Equity Derivative
Return Capital appreciation
Dividend Income
Capital gain
Price Fluctuation
Risk Company Specified
Sector specified
Global risk
General Market Risk
Market risk
Credit risk
Liquidity risk
Settlement risk
Types of margin VaR
Extreme Loss
Mark to market
Initial margin
Exposure margin
Premium margin
Duration Generally Long term
(more than 1 yr)
Short term
(Max. 3 months)
Participants Long term Investors
Hedgers
Safe Investors
Speculations
Arbitragers
Hedgers
Expiry Date of contract No such things Last Thursday of any month
Comparative analysis is easy to understand when we are analysis with the example of the real
market situation.
Now I would like to quote a real life example during my internship where I understood the actual
comparison of equity and derivative market.
Example:-
There was an investor Mr. Jaichand. He has Rs. 1, 00,000/- and he wants to invest it in share
market. Now he has two options either to invest in equity cash market or equity derivative
market (F&O).
Now suppose if he invest in equity cash market and buy shares of Rs. 1, 00, 000/- and diversified
risk so he buys different scrips. So he purchases 10 RIL shares of Rs. 2350/- each. 10 L&T
shares of Rs 800/- each, 15 Religare Enterprises Shares of Rs. 370/- each, 20 ICICI bank shares
of Rs. 800/- each, 10 Tata power shares of Rs. 1250 each and 10 BHEL shares of Rs. 1595/-
each. So for investing Rs. 1, 00,000/- in equity cash market he has to pay Rs. 1,00,000/- and gets
the delivery of the shares.
Now suppose if he invest in equity derivative market then he will able to purchase the shares
worth Rs. 5,00,000/- though he has capital of Rs. 1,00,00/- only, because of the margin payment.
But he has to purchase the share in a lot size. So he is able to purchase the 1 lot (100 shares) of
RIL at Rs. 2350/-, 1 lot (50 shares) of L&T at 2650/-, 2 lots (100 shares each) of Religare
Enterprises at Rs. 370/- and 1 lot (70 shares) of ICICI bank at Rs. 800/-. Here Mr. Jaichand has
to pay Rs. 1,00,000/- as a margin money and he is able to purchase a shares worth Rs. 5,00,000/-
But he has to pay the full amount of money at T+3 basis. So he has to pay the remaining amount
on the 3rd day of the trading if he wants the delivery.
I. Returns
Mr. Jaichand gets return on equity by two ways. One is when the share price of the
holding shares will increases in futures, called as capital appreciation. Second is by
getting a dividend income from the holding shares.
Mr. Jaichand gets return on equity derivative when the future prices of the shares are
increase in short term called as capital gain through price fluctuation or through
options premium.
II. Risk:
There are four types of risk involved in equity cash market.
1. Company Specified risk:- If company is not performing well than process of the
shares will declining and vice versa.
2. Sector specified risks: - If the sector is not performing well i.e. power sector,
metal sector, oil & gas sector, banking sector then prices of the shares will go
down and vice versa.
3. Global risk:- If global cues are positive then prices will increases but if global
cues are not good than prices of shares will go down.
4. General market risk:- General market risk is also affect the equity cash market
like inflation, banks interest rates etc.
So Mr. Jaichand has to consider all these risk factors while dealing in the equity
cash market.
There are four types of risk involved in equity derivative market.
1. Market risk:- In derivative market we have to calculate the market risk or mark to
market risk involved in the stocks or securities, that is the exposure to potential loss from
fluctuations in market prices (as opposed to changes in credit status). It is calculated on
the tradable assets i.e., stocks, currencies etc.
2. Credit risk: It may possible in derivative contract that the counterparty may be fail to
perform the contract or say defaulted then it is a risk for us. It is calculated on non-
tradable assets i.e., loans. So generally it is for long term purpose.
3. Liquidity Risk: - If Mr. Jaichand will not able to find a price( or a price within a
reasonable tolerance in terms of the deviation from prevailing or expected prices) for one
or more of its financial contracts in the secondary market. Consider the case of a
counterparty who buys a complex option on European interest rates. He is exposed to
liquidity risk because of the possibility that he cannot find anyone to make him a price in
the secondary market and because of the possibility that the price he obtains is very much
against him and the theoretical price for the product.
4. Settlement Risk: - The risk of non-payment of an obligation by a counterparty to a
transaction, exacerbated by mismatches in payment timings.
So, Mr. Jaichand has to consider all these factors while dealing in the equity derivative
market.
III. Margins:
Now Mr. Jaichand has also seen the margin paid in the equity cash segment.
1. Var Margin: - Now Mr. jaichand bought shares of a company. Its market value
today is Rs. 1, 00,000/- Obviously, we do not know what would be the market
value of these shares next day. Now Mr. Jaichand holding these shares may, based
on VaR methodology, say that 1-day Var is Rs. 1, 00,000/- at the 99% confidence
level. This implies that under normal trading conditions the investors can with
99% confidence, say that the value of shares would not go down by more than Rs.
1,00,000/- within next 1-day.
2. Extreme loss margin: - In the above situation, the VaR margin rate for shares of
RIL was 13%. Suppose that SD would be 1.5 x 3.1= 4.65. Then 5% (which is
higher than 4.65%) will be taken as the Extreme Loss margin rate.
Therefore, the total margin on the security would be 18% (13% VaR Margin +
5% Extreme Loss margin). As such, total margin payable( VaR margin + extreme
loss margin) on a trade of Rs. 23, 500/- woud be 4, 230/-
3. Mark to Market Margin:- Now Mr. Jaichand purchased 10 shares of RIL @
Rs. 2350/-, at 11 am on May 12, 2009. If close price of the shares on that
happened to be Rs. 2350, then the buyer faces a notional loss of Rs. 500/- on his
buy position. In technical term this loss is called as MTM loss and is payable by
May 13, 2009 (that is next day of the trade) before the trading begins.
In case, price of the shares falls further by the end of May 13 2009 to Rs. 2200/-,
then buy postion would show a further loss of Rs. 1, 000/-. This MTM loss is
payable by next day.
Now we will consider the margin payable under the equity derivatives segment.
i) Initial Margin: The initial margin required to be paid by the investor
would be equal to the highest loss the portfolio would suffer in any of the
scenarios considered. The margin is monitored and collected at the time of
placing the buy/ sell order. As higher the volatility, higher the initial
margin.
ii) Exposure Margin: - Exposure margins in respect of index futures and
index option sell position are 3% of the notional value.
iii) Premium margin: - If 1000 call option on RIL are purchased at Rs. 20/-
and Mr. Jaichand has no other positions, then the premium margin Rs.
20,000.
iv) Assignment Margin: - Assignment Margin is collected on assignment
from the sellers of the contract.
IV. Duration:
Generally equity market is a long term market and people invested in it for more than
one year and then only they get good return on equity. Generally any safe investors
can invest in it because here risk is comparatively low then derivative market.
While in derivative market investors are investing for less than one yea, generally for
2 months or 3 months. Here they get high returns on it because they are bringing high
risk.
V. Participants:
Generally any long term investors can invest in equity or hedgers are investing in the
equity, who wants to reduce their risk. Any person who wants to be safe investors and
wanted to earn a good amount of returns after a period of more than one year is also
invested in equity.
In derivative market mostly speculators and arbitragers are invested because they
wanted quick money in short time period and hedgers are also invested in derivative
market to reduce their risk.
VI. Expiry date:
It’s a last Thursday of any month in case of a derivative market but no such things in
case of an equity market.
3. FINDINGS
Practical situation
During my training internship I had experience of real practical situation in the stock Market and
in an Organization.
End of June 2009 turned out to be favorable for Indian stock markets. The first few sessions saw
optimism in the market on the hope that the government will make policy announcements in the
budget. However, the market corrected soon after the announcement of budget due to absence of
major policy announcements. The sentiments remained negative during following few sessions.
However, the market picked momentum from mid of the month. This was helped by better-than-
expected corporate earnings, huge overseas inflows and encouraging global cues. The buoyancy
in the market continued in the second half helping the BSE Sensex to touch highest in more than
a year towards the month end. On the whole, the market closed on a strong note.
Global stocks rallied over the month on encouraging economic data and earnings reports. The
MSCI AC World Index gained 8.70%, where as the MSCI Emerging Markets Index climbed
10.86% during the month. The performance of Indian markets was in line with the global
counterparts. The Sensex settled the month with a gain of 8.12%, while the Nifty registered a rise
of 8.05%. The BSE Mid and Small caps performance was in line with their larger counterparts,
gaining 9.74% and 8.11% respectively over the month.
Sector Performance
All the BSE Sectoral indices wrapped the month with gains except Capital Goods. Intense
buying spree was seen in Auto, Realty, FMCG and IT indices, which posted gains of over 20%.
Metal, Teck, Health Care and Consumer Durable indices were among other top gainers whereas
Oil & Gas index posted a marginal rise over the month.
Institutional Activities
The FIIs flow remained positive in equities with net inflows of Rs 11,625 crores (USD 2.40 bn)
during the month. The domestic MFs were also net buyers with inflows of Rs 1,825.50 crores
(USD 381 mn) during the month.
Major Corporate Events
Infosys Technologies announced a 17.28% y-o-y rise in • consolidated net profit for the quarter
ended June 2009 to Rs 1,527 crores (USD 318.59 mn). Income from operations for the quarter
climbed 12.73% y-o-y to Rs 5,472 crores (USD 1.14 bn).
Reliance Industries reported a drop of 11.53% y-o-y in • net profit for the quarter ended June
2009 to Rs 3,636 crores (USD 758.60 mn). Total income for the quarter slipped 21.64% y-o-y to
Rs 32,757 crores (USD 6.83 bn).
Steel Authority of India earmarked Rs 59,800 crores (USD • 12.48 bn) capex plan. It includes
ongoing modernization and expansion, value addition, technology up-gradation and sustenance.
Of the total capex plan, Rs 10,000 crores (USD 2.10 bn) will be spent during 2009-10.
Punj Lloyd along with its group companies bagged orders • worth Rs 10,250 crores (USD 2.14
bn) during the month. It reported a 27% y-o-y rise in consolidated profit after tax for the quarter
ended June 2009 to Rs 125 crores (USD 26.1 mn). Consolidated revenues for the quarter climbed
12% y-o-y to Rs 2,658 crores (USD 554.56 mn).
Key Macro Developments
Industrial production continued to remain positive in May 2009, with a growth of 2.7%. Core
sectors registered a growth of 6.5% for June 2009. Exports growth continued to drop for a ninth
consecutive month. In dollar terms, exports plunged 27.70% to USD 12.81 billion, however, in
rupee terms, it dropped 17.40% to Rs 61,217 crores during June 2009. Meanwhile, oil prices
slipped marginally 0.63% over the month to USD 69.45 a barrel.
Outlook
On the international front, the markets will track developments and key economic data from US,
China and Japan. The exit strategy of the central banks will also have bearing on the global
markets. On the other hand, the Indian markets will be driven by the progress of monsoon, policy
announcements from the government and key economic data. Overall quarterly corporate
earnings performance was better than the market expectations. The market is now hoping for
better earnings growth prospects for FY2010. The manufacturing growth has also started
showing signs of improvement.
Now, with signs of economic recovery in developed countries and improvement in risk appetite
globally, the funds will flow in the emerging markets like India in search of higher growth. This
coupled with encouraging earnings outlook for FY2010, provides good opportunity for investors
to take active participation in the market and increase the equity allocation from long term
perspective.
Comparative analysis of the traded value in the F & O Segment with
the cash segment
F& O( turnover in crores) Cash Segment( turnover in
crores)
Jan 2009 12, 00, 000 2, 00, 000
Feb 2009 12,00, 000 1,00, 000
March 2009 14,00,000 5, 00, 000
April 2009 16, 00, 000 4, 50, 000
May 2009 19,00,000 6 00, 000
June 2009 18,00,000 6, 50, 000
From this table we can see that in practical life though equity cash segment is better than the
derivatives because it involves lesser risk more numbers of investors are trading in derivatives
(F& O) segment. It is a major finding of the projects shows that by 60% to 70% investors are
bear more risk and traded in derivatives market because they want to earn more profits by trading
in derivatives.
4. CONCLUSIONS
This project has covered several areas. Its main conclusions are:
Derivatives market growth continues almost irrespective of equity cash market turnover
growth. Since 2000. Cash equity turnover has fallen in the developed markets, but
derivatives turnover continued to rise steeply and steadily.
Equity derivatives businesses like interest derivatives are highly concentrated. Using
notional value as the measure, the 2 main US markets and the 2 cross-border European
markets accounted for about 75% of the total. This was most apparent in index
derivatives, which make 99% of the notional value of equity derivatives. In single stock
derivatives, other markets have established niches and the dominance of the gig four is
less evident.
Equity market volume and derivative market notional value are strongly correlated- with
a ratio significant differences between individual markets.
A number of cash equity markets- particularly in developing Asia- do not have equity
derivatives markets. Comparison of their cash market volumes with those that do have
derivative exchanges shows that the markets without derivatives are of similar size. I
Am not convinced that market or infrastructure differences explain this, but suspects that
regularity barriers have effectively prevented the development, markets in several
developing Asian countries.
5. RECOMMENDATIONS
RBI should play a greater role in supporting Derivatives. Because nowadays
derivatives market are increasing rapidly and it plays a major role in the whole
securities market.
Derivatives market should be developed in order to keep it at par with other
derivative market in the world. Nowadays more number of investors are shows
their interest in derivatives market because it includes high return by bearing high
risk.
Speculation should be discouraged because it affects the market conditions badly
and new investors are reducing their interest in the market.
There must be more derivatives instruments aimed at individual investors.
SEBI should conduct seminars regarding the use of derivatives to educate
individual investors
There is a need to have a smaller contract size in F & O Market. We can review
the size of the contract from Rs. Two lacs to On Lacs. In the FICCI survey, 73%
of the respondents also held the same view.
6. BIBLIORAPHY
Books:-
Securities Laws and Regulations of Financial Markets
National Securities Depository Limited
Fundamentals of Futures & Options Markets- John C. Hull
Financial Derivatives- S. L. Gupta
Websites:-
www.world-exchange.org
www.nseindia.com
www.bseindia.com
www.religaresecurities.com
www.moneycontrol.com
www.indiamart.com
www.finpipe.com