derivative project report

8/7/2019 DERIVATIVE PROJECT REPORT

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PROJECT REPORT

ON

HEDGING AND ARBITRAGE

USING INDEX FUTURES

IN DERIVATIVES MARKET

SUBMITTED BY:

JYOTI

Email: [email protected]


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TABLE OF CONTENTS

CHAPTER 1

INTRODUCTION TO STOCK MARKET FINANCIAL MARKETS

MONEY MARKET

CAPITAL MARKETS ABOUT CAPITAL MARKET STOCK EXCHANGE

ROLE OF STOCK EXCHANGE

VARIOUS STOCK EXCHANGES HISTORY OF STOCK EXCHANGE

CHAPTER 2

DERIVATIVES

CONCEPT HISTORY OF DERIVATIVE MARKET IN THE WORLD DEVELOPMENT OF DERIVATIVE MARKET IN INDIA

NEED BEHIND DERIVATIVES USAGE

PARTICIPITANTS

TYPES OF DERIVATIVES FACTORS BEHIND GROWTH OF FINANCIAL DERIVATIVES

ACCOUNTING and taxation OF DERIVATIVES

CHAPTER 3

WORKING OF FUTURES AND OPTIONS

TRADING STRATEGIES

CHAPTER 4

RESEARCH WORK INTRODUCTION TO RESEARCH TOPIC


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OBJECTIVES OF STUDY

RESEARCH METHODOLOGY

RESEARCH DESIGN

SAMPLING DESIGN

LIMITATIONS OF THE STUDY

DATA ANALYSIS RESULTS AND FINDINGS

SUGGESTIONS AND RECOMMENDATIONS

CHAPTER 5

ANNEXURE AND BIBLIOGRAPHY

INTRODUCTION TO STOCK MARKET

Every individual tries to plan and secure his future using variousavenues of investment. An individual invests money on account ofmultiple reasons. A few of them are as follows:

1.More and more returns

2.Planning or securing ones future.

3.Tax benefits

4.Saving for childrens education


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5.Safety

6.Hedging against devaluation

7.Possessing liquidity

The growth of economy and hence, development of nationdepends on the amount of resources that are readily available tovarious factors of production in the economy.Savings/investments of the inhabitants and others likenonresidents,foreigners,both individual play a key role. It is in thisregard that the financial markets help in channelising the savingand investments into the economy and makes it available to thefactors of production.

FINANCIAL MARKETS

IT COMPROMISES OF

1.MONEY MARKET

2.CAPITAL MARKET


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MONEY MARKET provides short-term capital to borrowers formeeting their short term working requirement.

CAPITAL MARKET is a market for long-term funds.

ABOUT CAPITAL MARKET

The major borrowers in this sector are corporate, agriculturesector and government. The corporate sector needs funds for

capital investment purposes like capital expansion, diversification,integration, mergers, and acquisitions. The government needsfunds for its various programs for infrastructure development likeroads, highways, power sanitation and water supply, etc. Thesupply of funds for the capital market comes from individualhouseholds, corporate banks, insurance companies, specializedfinancial agencies and the government.

Capital market is divided into debt market and equity market. Ingeneral, when we talk about the market we mean equity market

or stock market.

CAPITAL MARKET IS FURTHER DIVIDED INTO

PRIMARY MARKET: It is the market where the security is issued forthe first time.

SECONDARY MARKET: The secondary market is represented bystock exchange, which provides an organized place for investorsto trade in securities.

STOCK EXCHANGE

Stock exchange is a corporation or mutual organization whichprovides facilities for stock brokers and traders to tradecompany stocks and other securities. It refers to thatsegment of capital market where the securities issued by


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corporate entities are traded. It acts as a nervous system ofthe capital market.Stock exchanges also provide facilities forthe issue and redemption of securities, as well as, otherfinancial instruments and capital events including the

payment of income and dividends. The securities traded on astock exchange include: shares issued by companies, unittrusts and other pooled investment products and bonds. Tobe able to trade a security on a certain stock exchange, it hasto be listedthere. Usually there is a central location at leastfor recordkeeping, but trade is less and less linked to such aphysical place, as modern markets are electronic networks,which gives them advantages of speed and cost oftransactions. Trade on an exchange is by members only. Theinitial offering of stocks and bonds to investors is by definition

done in the primary market and subsequent trading is done inthe secondary market. A stock exchange is often the mostimportant component of a stock market. Supply and demandin stock markets are driven by various factors which, as in allfree market affect the prices of the stocks.

VARIOUS STOCK EXCHANGES IN THE WORLD


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Bombay Stock Exchange

Frankfurt Stock Exchange

New York Stock Exchange
http://en.wikipedia.org/wiki/Bombay_Stock_Exchangehttp://en.wikipedia.org/wiki/Frankfurt_Stock_Exchangehttp://en.wikipedia.org/wiki/New_York_Stock_Exchangehttp://en.wikipedia.org/wiki/Image:P1010237.jpghttp://en.wikipedia.org/wiki/Image:P1010237.jpghttp://en.wikipedia.org/wiki/Image:NYSESecurity.JPGhttp://en.wikipedia.org/wiki/Image:NYSESecurity.JPGhttp://en.wikipedia.org/wiki/Image:Boerse_Frankfurt_front.JPGhttp://en.wikipedia.org/wiki/Image:Boerse_Frankfurt_front.JPGhttp://en.wikipedia.org/wiki/Image:Bombay-Stock-Exchange.jpghttp://en.wikipedia.org/wiki/Image:Bombay-Stock-Exchange.jpghttp://en.wikipedia.org/wiki/Frankfurt_Stock_Exchangehttp://en.wikipedia.org/wiki/New_York_Stock_Exchangehttp://en.wikipedia.org/wiki/Bombay_Stock_Exchange


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So Paulo Stock Exchange

Singapore Stock Exchange

Tokyo Stock Exchange
http://en.wikipedia.org/wiki/S%C3%A3o_Paulo_Stock_Exchangehttp://en.wikipedia.org/wiki/Singapore_Stock_Exchangehttp://en.wikipedia.org/wiki/Tokyo_Stock_Exchangehttp://en.wikipedia.org/wiki/Image:Montr%C3%A9al_-_Tour_de_La_Bourse_-_20050310.jpghttp://en.wikipedia.org/wiki/Image:Zuerich_Boerse.jpghttp://en.wikipedia.org/wiki/Image:TokyoStockExchange1144.jpghttp://en.wikipedia.org/wiki/Image:TokyoStockExchange1144.jpghttp://en.wikipedia.org/wiki/Image:Sing019.jpghttp://en.wikipedia.org/wiki/Image:Sing019.jpghttp://en.wikipedia.org/wiki/S%C3%A3o_Paulo_Stock_Exchangehttp://en.wikipedia.org/wiki/Singapore_Stock_Exchangehttp://en.wikipedia.org/wiki/Tokyo_Stock_Exchange


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Tour de la Bourse,Montreal

Bolsa de Valores de Lima

[edit]

ROLE OF STOCK EXCHANGE

Raising capital for businesses

The Stock Exchange provides companies with the facility to raisecapital for expansion through selling shares to the investingpublic.

Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to amore rational allocation of resources because funds, which couldhave been consumed, or kept in idle deposits with banks, aremobilized and redirected to promote business activity withbenefits for several economic sectors such as agriculture,commerce and industry, resulting in a stronger economic growthand higher productivity levels.

Facilitate company growth
http://en.wikipedia.org/wiki/Tour_de_la_Boursehttp://en.wikipedia.org/wiki/Tour_de_la_Boursehttp://en.wikipedia.org/wiki/Montrealhttp://en.wikipedia.org/w/index.php?title=Stock_exchange&action=edit&section=3http://en.wikipedia.org/wiki/Company_(law)http://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Investinghttp://en.wikipedia.org/wiki/Deposit_accounthttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Agriculturehttp://en.wikipedia.org/wiki/Commercehttp://en.wikipedia.org/wiki/Industryhttp://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/Productivity_(economics)http://en.wikipedia.org/wiki/Image:Bolsa_de_Valores_de_Lima.jpghttp://en.wikipedia.org/wiki/Image:Bolsa_de_Valores_de_Lima.jpghttp://en.wikipedia.org/wiki/Image:Montr%C3%A9al_-_Tour_de_La_Bourse_-_20050310.jpghttp://en.wikipedia.org/wiki/Tour_de_la_Boursehttp://en.wikipedia.org/wiki/Montrealhttp://en.wikipedia.org/w/index.php?title=Stock_exchange&action=edit&section=3http://en.wikipedia.org/wiki/Company_(law)http://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Investinghttp://en.wikipedia.org/wiki/Deposit_accounthttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Agriculturehttp://en.wikipedia.org/wiki/Commercehttp://en.wikipedia.org/wiki/Industryhttp://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/Productivity_(economics)


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Companies view acquisitions as an opportunity to expand productlines, increase distribution channels, hedge against volatility,increase its market share, or acquire other necessary businessassets. A takeover bid or a merger agreement through the stock

market is the simplest and most common way to companygrowing by acquisition or fusion.

Redistribution of wealth

By giving a wide spectrum of people a chance to buy shares andtherefore, become part-owners (shareholders) of profitableenterprises, the stock market helps to reduce large incomeinequalities. Both casual and professional stock investors throughstock price rise and dividends get a chance to share in the profits

of promising business that were set up by other people.

Corporate governance

By having a wide and varied scope of owners, companiesgenerally tend to improve on their management standards andefficiency in order to satisfy the demands of these shareholdersand the more stringent rules for public corporations by publicstock exchanges and the government. Consequently, it is allegedthat public companies (companies that are owned by

shareholders who are members of the general public and tradeshares on public exchanges) tend to have better managementrecords than privately-held companies (those companies whereshares are not publicly traded, often owned by the companyfounders and/or their families and heirs, or otherwise by a smallgroup of investors). However, some well-documented cases areknown where it is alleged that there has been considerableslippage in corporate governance on the part of some publiccompanies (e.g. Enron Corporation, MCI WorldCom, Pets.com,

Webvan, or Parmalat).

Creates investment opportunities for small investors
http://en.wikipedia.org/wiki/Product_linehttp://en.wikipedia.org/wiki/Product_linehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Takeoverhttp://en.wikipedia.org/wiki/Mergers_and_acquisitionshttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Shareholderhttp://en.wikipedia.org/wiki/Profithttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Stock_pricehttp://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Managementhttp://en.wikipedia.org/wiki/Efficiency_(economics)http://en.wikipedia.org/wiki/Public_companieshttp://en.wikipedia.org/wiki/Privately-held_companyhttp://en.wikipedia.org/wiki/Corporate_governancehttp://en.wikipedia.org/wiki/E.g.http://en.wikipedia.org/wiki/Enron_Corporationhttp://en.wikipedia.org/wiki/MCI_WorldComhttp://en.wikipedia.org/wiki/Pets.comhttp://en.wikipedia.org/wiki/Webvanhttp://en.wikipedia.org/wiki/Parmalathttp://en.wikipedia.org/wiki/Product_linehttp://en.wikipedia.org/wiki/Product_linehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Takeoverhttp://en.wikipedia.org/wiki/Mergers_and_acquisitionshttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Shareholderhttp://en.wikipedia.org/wiki/Profithttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Stock_pricehttp://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Managementhttp://en.wikipedia.org/wiki/Efficiency_(economics)http://en.wikipedia.org/wiki/Public_companieshttp://en.wikipedia.org/wiki/Privately-held_companyhttp://en.wikipedia.org/wiki/Corporate_governancehttp://en.wikipedia.org/wiki/E.g.http://en.wikipedia.org/wiki/Enron_Corporationhttp://en.wikipedia.org/wiki/MCI_WorldComhttp://en.wikipedia.org/wiki/Pets.comhttp://en.wikipedia.org/wiki/Webvanhttp://en.wikipedia.org/wiki/Parmalat


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As opposed to other businesses that require huge capital outlay,investing in shares is open to both the large and small stockinvestors because a person buys the number of shares he/she canafford. Therefore, the Stock Exchange provides an extra source of

income to small savers.

Government raises capital for development projects

The Government and even local authorities like municipalitiesmay decide to borrow money in order to finance huge

infrastructure projects such as sewerage and water treatmentworks or housing estates by selling another category ofsecuritiesknown as bonds. These bonds can be raised through the StockExchange whereby members of the public buy them. When theGovernment or Municipal Council gets this alternative source offunds, it no longer has the need to overtax the people in order tofinance development.

Barometer of the economy

At the stock exchange, share prices rise and fall depending,largely, on market forces. Share prices tend to rise or remainstable when companies and the economy in general show signs ofstability and growth. An economic recession, depression, orfinancial crisis could eventually lead to a stock market crash.Therefore the movement of share prices and in general of thestock indexes can be an indicator of the general trend in theeconomy.
http://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Market_(economics)http://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Economic_recessionhttp://en.wikipedia.org/wiki/Financial_crisishttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Stock_indexhttp://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Stock_investorhttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Market_(economics)http://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Economic_recessionhttp://en.wikipedia.org/wiki/Financial_crisishttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Stock_index


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HISTORY OF STOCK EXCHANGE

More than 200 years ago in front of Trinity church in EastManhattan in U.S, the oldest stock exchange called New York

Stock Exchange emerged. At that point, there was no papermoney changing hands nor people had any idea of what stockmeant, people traded silver for papers saying they owned sharesin cargo .The trade flourished. During American Revolution, thecolonial government needed money to fund its wartimeoperations. They did this by selling bonds. Bonds are pieces ofpaper a person buys for a set price, knowing that after a certainperiod of time; they can exchange their bonds for a profit. Alongwith bonds, the first of the nations bank started to sell parts orshares of their own company to people in order to raise money.Thus, they sell the part of the company to whoever wanted to buyit. This led to the emergence of the modern day stock market.

The concept of stock markets came to India in 1875, whenBombay Stock Exchange (BSE) was established as The NativeShare and Stockbrokers Association', a voluntary non-profitmaking association. BSE is the oldest in Asia. Presently, India hasabout 10,000 listed companies, the largest number of listedcompanies in the world. Stock exchanges in India can be

categorized as: 1)Voluntary Associations such as Bombay, Indoreand Ahmadabad, 2) Public limited companies such as Calcuttaand Delhi, and 3) Guarantee companies such as Hyderabad,Madras and Bangalore. Besides BSE, India's other major stockexchange is National Stock Exchange (NSE) that was promoted byleading financial institutions and was established in April 1993.Today, these global stock exchanges have become premierinstitutions and are highly efficient, computerized organizationsthat have fostered the growth of an open, global securities

market. There are various products which are traded in the stockmarket such as bonds, shares and debentures.

In this part of my analysis, I have dealt with Derivativescommonly known as futures and options.


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Derivatives are one of the options available to the investor wherehe can invest in share market.

Let us move on to understand concept of derivatives.


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Concept ofderivativesThe word Derivatives is used in our life in many contexts. From

the viewpoint of an English teacher, quickly is a derivative ofquick. From the point of chemist, chloroform is a derivative ofmethane. In mathematics, change of function is a derivative i.e., akey concept of calculus.

The word 'derivative' has its origin from mathematics andRefers to a variable, which has been derived from anothervariable. Derivatives are so called because they have no value oftheir own. They derive their value from the value of some otherasset, which is known as the underlying.

Derivatives are financial instruments that have no intrinsic value,but derive their value from something else. They hedge the risk ofowning things that are subject to unexpected price fluctuations,e.g. foreign currencies, bushels of wheat, stocks and governmentbonds.

The primary objectives of any investor are to maximize returnsand minimize risks. Derivatives are contracts that originated fromthe need to minimize risk. For example, a derivative of the sharesof Infosys (underlying), will derive its value from the share price(value) of Infosys. Similarly, a derivative contract on soybeandepends on the price of soybean.

Derivatives are specialised contracts which signify an agreementor an option to buy or sell the underlying asset of the derivate up


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to a certain time in the future at a prearranged price, the exerciseprice.

The contract also has a fixed expiry period mostly in the range of3 to 12 months from the date of commencement of the contract.

The value of the contract depends on the expiry period and alsoon the price of the underlying asset.For example, a farmer fearsthat the price of soybean (underlying), when his crop is ready fordelivery will be lower than his cost of production.

Let's say the cost of production is Rs 8,000 per ton. In order toovercome this uncertainty in the selling price of his crop, heenters into a contract (derivative) with a merchant, who agrees tobuy the crop at a certain price (exercise price), when the crop is

ready in three months time (expiry period).In this case, say the merchant agrees to buy the crop at Rs 9,000per ton. Now, the value of this derivative contract will increase asthe price of soybean decreases and vice-a-versa.

If the selling price of soybean goes down to Rs 7,000 per ton, thederivative contract will be more valuable for the farmer, and if theprice of soybean goes down to Rs 6,000, the contract becomeseven more valuable.

This is because the farmer can sell the soybean he has producedat Rs .9000 per tonne even though the market price is much less.If the underlying asset of the derivative contract is coffee, wheat,pepper, cotton, gold, silver, precious stone or for that matter evenweather, then the derivative is known as a commodity derivative.

If the underlying is a financial asset like debt instruments,currency, share price index, equity shares, etc., the derivative isknown as a financial derivative.

Derivative contracts can be standardized and traded on the stockexchange. Such derivatives are called exchange-tradedderivatives. Or they can be customized as per the needs of theuser by negotiating with the other party involved.


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Such derivatives are called over-the-counter (OTC) derivativesThus, the value of the derivative is dependent on the value of theunderlying.

HISTORY OFDERIVATIVESMARKET IN

INDIA


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The history of derivatives is surprisingly longer than what mostpeople think. Some texts even find the existence of thecharacteristics of derivative contracts in incidents ofMahabharata. Traces of derivative contracts can even be found inincidents that date back to the ages before Jesus Christ.However, the advent of modern day derivative contracts is

attributed to the need for farmers to protect themselves from anydecline in the price of their crops due to delayed monsoon, oroverproduction.The first 'futures' contracts can be traced to the Yodoya ricemarket in Osaka, Japan around 1650. These were evidentlystandardised contracts, which made them much like today'sfutures.The Chicago Board of Trade (CBOT), the largest derivativeexchange in the world, was established in 1848 where forward

contracts on various commodities were standardised around1865. From then on, futures contracts have remained more orless in the same form, as we know them today.Derivatives have had a long presence in India. The commodityderivative market has been functioning in India since thenineteenth century with organized trading in cotton through theestablishment of Cotton Trade Association in 1875. Since then,contracts on various other commodities have been introduced aswell.Exchange traded financial derivatives (FUTURES AND OPTIONS)were introduced in India in June 2000 at the two major stockexchanges, NSE and BSE. There are various contracts currentlytraded on these exchanges.National Commodity & Derivatives Exchange Limited (NCDEX)started its operations in December 2003, to provide a platform forcommodities trading.


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The derivatives market in India has grown exponentially,especially at NSE. Stock Futures are the most highly tradedcontracts on NSE accounting for around 55% of the total turnoverof derivatives at NSE, as on April 13, 2005

Financial Derivativesmarket and its

development in IndiaThe first step towards introduction of derivatives trading in Indiawas the promulgation of the Securities Laws (Amendment)Ordinance, 1995, which withdrew the prohibition on options insecurities. The market for derivatives, however, did not take off,as there was no regulatory framework to govern trading ofderivatives. SEBI set up a 24member committee under theChairmanship of Dr.L.C.Gupta on November 18, 1996 to develop

appropriate regulatory framework for derivatives trading in India.The committee submittedits report on March 17, 1998 prescribing necessary preconditionsfor introduction of derivatives trading in India. The committeerecommended that Derivatives should be declared as securitiesso that regulatory framework applicable to trading of securitiescould also govern trading of securities. SEBI also set up a group inJune 1998 under the Chairmanship of Prof. J.R.Varma, torecommend measures for risk containment in derivative market in

India. The report, which was submitted in October 1998, workedout the operational details of margining system, methodology forcharging initial margins, broker net worth, deposit requirementand realtime monitoring requirements.


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The Securities Contract Regulation Act (SCRA) was amended inDecember 1999 to include Derivatives within the ambit ofsecurities and the regulatory framework was developed forgoverning derivatives trading. The act also made it clear that

derivatives shall be legal and valid only if such contracts aretraded on a recognized stock exchange. Thus, precluding OTCderivatives. The government also rescinded in March 2000, thethreedecade old notification, which prohibited forward trading insecurities.

Derivatives trading commenced in India in June 2000 after SEBIgranted the final approval to this effect in May 2001. SEBIpermitted the derivative segments of two stock exchanges, NSEand BSE, and their clearing house/corporation to commence

trading and settlement in approved derivatives contracts. Tobegin with, SEBI approved trading in index futures contractsbased on S&P CNX Nifty and BSE30(Sensex) index. This wasfollowed by approval for trading in options based on these twoindexes and options on individual securities.The trading in BSE Sensex options commenced on June 4, 2001and the trading in options on individual securities commenced inJuly 2001. Futures contracts on individualstocks were launched in November 2001. The derivatives trading

on NSE commenced with S&P CNX Nifty Index futures on June 12,2000. The trading in index options commencedon June 4, 2001 and trading in options on individual securitiescommenced on July 2, 2001.Single stock futures were launched on November 9, 2001. Theindex futures and options contracts on NSE are based on S&P CNXtrading. Settlement in derivative contracts is done in accordancewith the rules, byelaws, and regulations of the respectiveexchanges and their clearing house/corporations duly approvedby SEBI and notified in the official gazette. Foreign InstitutionalInvestors(FIIs) are permitted to trade in all exchange tradedderivative products.

The following are some observations based on the tradingstatistics provided in the NSEReport on the futures and options (F&O):


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Single-stock futures continue to account for a sizable proportionof the F&O segment. It constituted 70 per cent of the totalturnover during June 2002. A primary reason attributed to thisphenomenon is that traders are comfortable with single-stock

futures than equity options, as the former closely resembles theerstwhile Badla system On relative terms, volumes in the index options segmentcontinues to remain poor. This may be due to the low volatility ofthe spot index. Typically, options are considered more valuablewhen the volatility of the underlying (in this case, theIndex ) is high. A related issue is that brokers do not earn highcommissions by recommending index options to their clients,because low volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segmenthave increased since January 2002. The call-put volumes in indexoptions have decreased from 2.86 in January 2002 to 1.32 in June.The fall in call-put volumes ratio suggests that the traders areincreasingly becoming pessimistic about the market. Farther month futures contracts are still not actively traded.Trading in equity options on most stocks for even the next month

was non-existent.

Daily option price variations suggest that traders use the F&Osegment as a lessrisky alternative (read substitute) to generate profits from thestock price movements. The fact that the option premiums tailintra-day stock prices is an evidence to this. Calls on Satyam fall,while puts rise when Satyam falls intra-day.If calls and puts are not looked as just substitutes for spot trading,the intra-day stock price variations should not have a one-to-oneimpact on the option premiums.


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NEED BEHIND USAGE OF DERIVATESDerivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to

risk oriented people2. They help in the discovery of future as well as current

prices3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of

participation risk averse people in greater numbers5. They increase savings and investment in the long run .

The participants in a derivatives market

Hedgers use futures or options markets to reduce or eliminatethe risk associated with price of an asset. Speculators use futures and options contracts to get extra

leverage in betting on future movements in the price of an asset.


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They can increase both the potential Gains and potential lossesby usage of derivatives in a speculative venture.

Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets. If, forexample, they see the futures price of an asset gettingout of line with the cash price, they will take offsetting positions inthe two markets to lock in a profit.

Types of Derivatives

Forwards: A forward contract is a customized contract between

two entities, where settlement takes place on a specific date inthe future at todays pre-agreed price.

Futures: A futures contract is an agreement between two partiesto buy or sell an asset at a certain time in the future at a certainprice. Futures contracts are special types of forward contracts inthe sense that the former are standardized exchange-tradedcontracts

Options: Options are of two types - calls and puts. Calls give thebuyer the right but not the obligation to buy a given quantity ofthe underlying asset, at a given price on or before a given futuredate. Puts give the buyer the right, but not the obligation to sell agiven quantity of the underlying asset at a given price on orbefore a given date.WARRANTS: Options generally have life span of up to one year, themajority of options traded on options exchanges have a maximummaturity of nine months. Longer-dated optionscalled warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity AnticipationSecurities. These are options having a maturity of up to threeyears.


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Baskets: Basket options are options on portfolios of underlyingassets. An underlying asset is usually a moving average or abasket of assets. Equity index options are a form of Basketoptions

.Swaps: Swaps are private agreements between two parties toexchange cash flows in the Future according to a prearrangedformula. They can be regarded as portfolios of forwardContracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interestrelated cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal andinterest between the parties, with the cash flows in one direction

being in a different currency than those in the opposite direction.Swap: Swaptions are options to buy or sell a swap that willbecome operative at the expiry of the options. Thus a swaption isan option on a forward swap. Rather than haveCalls and puts, the swaptions market has receiver swaptions andpayer swaptions. A receiver swaption is an option to receive fixedand pay floating. A payer swaption is an option topay fixed and receive floating.

Factors driving the growth of financialderivatives

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 sharpdecline in their costs.

4. Development of more sophisticated risk management tools,providing economic agents a wider choice of riskmanagement strategies.

5. Innovations in the derivatives markets, which optimallycombine the risks and returns


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6. Over a large number of financial assets leading to higherreturns, reduced risk as well as low transaction costs ascompared to individual financial assets.

ACCOUNTING OF DERIVATIVES:

The Institute of Chartered Accountants of India (ICAI) has issuedguidance notes on accounting of index futures contracts from theviewpoint of parties who enter into suchfutures contracts as buyers or sellers. For other parties involved inthe trading process, like brokers, trading members, clearingmembers and clearing corporations, a trade in equityindex futures is similar to a trade in, say shares, and does notpose any peculiar accounting problems

Taxation

The Income Tax Act does not have any specific provisionregarding taxability from derivatives. The only provisions, whichhave an indirect bearing on derivative transactions are sections73(1) and 43(5). Section 73(1) provides that any loss, computedin respect of a speculative business carried on by the assessee,shall not be set off except against profits and gains, if any, of

speculative business. In the absence of a specific provision, it isapprehended that the derivatives contracts, particularly the indexfutures which are essentially cash-settled, may be construed asspeculative transactions and therefore, the losses, if any, will notbe eligible for set off against other income of the assessee andwill be carried forward and set off against speculative income onlyup to a maximum of eight years. As a result, an investors losses


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or profits out of derivatives even though they are of hedgingnature in real sense, are treated as speculative and can be set offonly against speculative income, that may exceed the costassociated with leaving a part of the production uncovered.

WORKING OF FUTURES ANDOPTIONS

WORKING OF FUTURES

A futures contract is a type of derivative or financial contract, inwhich two parties agree to transact a set of financial instrumentsor physical commodities for future delivery at a particular price.For instance, A, a farmer, is expecting a good harvest of wheatbut fears that the prevailing price of wheat may decline in thefuture. To hedge against this risk of price fluctuation, A entersinto a contract with B in January 2005 to deliver, at a later date,50 Kgs of wheat at the present market price. The contractbetween A and B is a futures contract and B (buyer) is said to go

long the contract whereas A (seller) is said to go short. The priceagreed to, between the parties, for delivery of 50 Kgs of wheat iscalled the settlement price. Now, if the prices were to actuallydecline, the farmer would walk away with a profit but if the priceswere to go up instead, he would end up making a loss.Futures can be traded either over-the-counter (OTC) or over anexchange. Futures traded OTC are also called forwards. While an


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OTC future remains open to counter party risk, there is no suchrisk in an exchange. This is because in an exchange both theparties transact only through the exchange and thus, theexchange is substituted as one of the parties to the contract. In

other words, the exchange plays the role of a guarantor to boththe parties to the contract. This eliminates the possibility ofcounter-party risk.Let us take a closer look at the working of an exchange tradedfutures contract.

Working of futures: The clauses of a futures contract, traded onthe exchange, are generally standardized in respect of thefollowing items:

Quantity of the underlying asset

Quality of the underlying asset(not required in financialfutures)

Date and month of delivery

The units of price quotation (not the price itself) and theminimum change in price (tick-size)

Location of settlement

The settlement price is agreed to between the parties.When a futures contract is opened, the exchange prescribes aminimum amount of money to be deposited by both the parties to

the contract with the exchange. This original deposit of money isreferred to as the initial margin. The exchange also prescribes amaintenance margin, which is the lowest amount an account canreach before being replenished again. This must be distinguishedfrom initial margin, which is merely the minimum deposit requiredto enter into a futures contract. When the margin amount fallsbelow the maintenance margin, a margin call is made requesting


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inducement of additional funds so as to bring up the level back tothe initial margin. Lets say that the initial margin was Rs.1000and the maintenance margin Rs.500. A series of losses reducedthe amount to Rs. 400. A margin call may be made requiring

inducement of additional funds.To understand how futures trade, let us consider the followingillustration.Illustration: A enters into a contract with B for sale of 100 Kgs ofrice at Rs. 10 /kg at a later date. The settlement price for thisfuture is, therefore, Rs. 1000. Lets assume the initial marginrequirement to be Rs. 100 (at 10%). Therefore, on the first day oftrading, both A and B will have Rs. 100 each in their accounts.Now A has taken the short position because he thinks that theprice of rice would decline whereas B has gone long fearing the

prices to rise.Mark-to-Market: On the next day, if the price of rice were to riseto Rs.11, A, would suffer a loss (and B a corresponding gain) ofRs. 100. In other words, Rs. 100 would be deducted form Asaccount and the same amount credited to Bs account. On theother hand, if the price of rice were to decline, As account wouldbe credited with Rs. 100 and Bs account deducted by the sameamount. Therefore, all profits and losses are settled on a dailybasis. This is known as the mark-to-market system.

Liquidation: If either of the parties wants to liquidate his positionin the futures contract, he can do so by entering into an equal andopposite transaction to the one that opened the position. This iscalled an offsetting transaction. Consider the above example.Lets say the settlement price dipped to Rs. 900 and the farmermade a profit of Rs. 100 in the process. Now he wants to liquidatehis position so that he retains the profits already made withoutincurring any further risks of loss. He can do so by entering intoan identical and opposite transaction to achieve the same.Consider the following flow chart:

A BSettlement Price 1 = Rs. 1000(Original)Settlement Price 2 = Rs. 900(after price decline)


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After a decline in the cost of rice, As account would be creditedwith Rs. 100 and Bs account debited with the same amount.

A B+100 -100

As profit = 1000-900 = Rs. 100Now, if A wants to liquidate his position, he would have to enterinto an equal and opposite transaction. In other words, instead ofgoing short, he would have to go long on a contract with the sameexpiry date and underlying asset, etc.

C ASettlement Price = Rs. 900Now, lets take a situation where the price rose to Rs. 1200 afterthe previous days decline. Under ordinary circumstances, Awould stand to lose Rs. 300 on his short position. However, afterthe offsetting transaction with C, as elucidated above, this losswould be offset by the gains made on his long position in thiscontract. In this case, As position is said to be closed out as itdoes not reap any profits or losses.

A B+100 300 -100 + 300

C A-300 +300As Net Profit = Rs. 100

Similarly, B can also liquidate his position by going short on anidentical contract.Settlement: A futures contract that is not liquidated before itsexpiry may be settled in either of the following ways:1. Physical Delivery: This involves the delivery of theunderlying asset by the seller to the buyer in accordance with therules of the Exchange. However, the exchange generallydiscourages such physical delivery through the exchange as itmakes the exchange vulnerable to arbitration in case of default

by either of the parties.2. Cash Settlement: Cash settlement is an importantadvance and has broadened the reach of derivatives to productslike stock indices where physical delivery is not possible. In cashsettlement, the underlying asset is not physically delivered on theexpiration of the contract. Instead all open positions are settled


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by payment of cash based on the difference between the finalsettlement price and the previous days settlement price.Theoretically the final price of the futures contract and the spotmarket price of the underlying commodity must converge and be

the same. However, this rarely happens and many exchanges areknown to deem the final settlement price of a futures contract tobe equal to the spot market price. In other words, the terminalsettlement price is assumed to be equal to the prevailing spotmarket price and cash settlement is effected by computing thedifference between the prevailing spot market price and theprevious days settlement price.Theoretical Pricing of Futures: The price of a future is derivedfrom the price of the underlying asset of the futures contract. Inother words, the settlement price of the futures contract is the

same as its settlement price.As explained above, the settlement price in a futures contract isnever standardized but is agreed to between the parties. Thistakes place by way of an offer bid system. However, atheoretical way of determining the value of a futures contractmay be summed up in the following formula:Futures Price = Spot Market Price + Cost of CarryCost of carry is the sum of all costs incurred if a similar position istaken in the cash market and carried to the expiry of the futures

contract, less any revenue that may arise out of holding theasset. The cost typically includes interest cost in case of financialfutures (insurance and storage costs are also considered in caseof commodity futures).Market Participants: The following are the broad category ofmarket participants in futures trading:1. Hedgers: Hedging is a sophisticated mechanism that providesthe necessary immunity to the above interests in the marketing ofcommodities from the risk of price fluctuations. It basicallyinvolves the purchase or sale of a futures contract to reduce oroffset the risk of a position in the underlying asset. A hedger givesup the potential to profit from a favorable price change in theposition being hedged in order to minimize the risk of loss from anadverse price change.A hedge may be either short or long. A short hedge involves ashort position in futures contracts. It is appropriate when the


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hedger already owns an asset and expects to sell it at some timein the future or even when an asset is not owned right now butwill be owned some time in the future. Take, for instance, afarmer who expects a harvest only after 6 months and is unsure

about the price fluctuations. To hedge this risk, the farmer canenter into a futures contract for sale of rice, 6 months from now,at the prevailing market price.Hedges that involve taking a long position in a futures contractare known as long hedges. A long hedge is appropriate when acompany / individual knows it will have to purchase a certainasset in the future and wants to lock in a price now. Taking thesame example as above, if a consumer is uncertain about theprice movements of rice, he can hedge his risk by going long afutures contract at the prevailing market price. This would

neutralize his position in case of inflation. Though hedgingprotects from price risk, a hedged position often suffers frombasis risk.2. Speculators: Hedging on futures markets cannot be practicedunless there are operators willing to assume the risk of adverseprice fluctuations, which the hedgers desire to transfer. Theseoperators are called speculators. Their presence in the futuresmarket is inevitable as they provide liquidity to the markets.Unlike hedgers, speculators aim to benefit from the inherently

risky nature of the futures market. They do not seek to actuallyown the commodity in question. Rather, a speculator enters themarket to make profits by offsetting rising and declining pricesthrough the buying and selling of contracts. The basic distinctionbetween a hedge and a speculative transaction on a futuresmarket is that in case of a hedge there is a correspondingtransaction in the ready market, which is absent in case ofspeculation. In general, a speculator takes a view on the marketand plays accordingly. If one is bullish, one can buy futures and ifone is bearish one can sell futures. For e.g. a person who expectsthe price of Reliance stock to increase by March can buy a MarchReliance security futures contract. If the price of the stock rises,he will make a profit on the futures and can liquidate his positionto freeze his profits.3. Arbitrageurs: Arbitrage is the simultaneous purchase and saleof similar commodities or securities, such as derivatives, in


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different but related markets, in the hope of gaining from theprice differential. Arbitrage opportunities arise when there is adifference between the spot and futures prices.Illustration: Suppose Reliance stock is trading at Rs. 500 in the

spot market and the futures price of Reliance stock is trading atRs.550. An arbitrageur in this case would buy (lets say) 100shares of Reliance in the spot market and sell an equal amount offutures. He will then hold his position till the expiration of thefutures contract to make a profit of Rs. 5000 (100 x (550 -500)).Here the arbitrageur is said to lend money in the spot marketwhen he buys the stock and is said to get his loan repaid when hesettles his futures obligation. The profits that he makes are saidto be the return on his loans.Leverage: Futures are highly leveraged instruments. Leverage

refers to having control over large cash amounts of commoditieswith small levels of capital. In other words, with a relatively smallamount of cash, you can enter into a futures contract that isworth much more than you initially have to pay. Initial marginsthat are set by the exchange are relatively small compared to thecash value of the contracts in question. The smaller the margin inrelation to the cash value of the futures, the higher the leverage.In other words, leverage allows exposure to a given quantity of anunderlying asset for a fraction of the investment needed to

purchase that quantity outright.Due to leverage, if the price of the futures contract moves upeven slightly, the profits made will be very large in comparison tothe initial margin. However, if the price moves downwards, thesame leverage can result in huge losses in comparison to theinitial margin.Illustration: Consider a futures contract for 100 kg of coffee atRs. 80 per kg. The total value of the contract would be Rs. 8000.Consider an initial margin of 10% on the value of the contract i.e.Rs. 800. A slight change in the price of coffee by 6.25% (i.e. to Rs.85) would result in a corresponding gain and loss of Rs. 500 forthe party going long and short respectively. This is a gain / loss of62.5% with respect to the initial margin deposited for the purposeof trading in the contract. Please note that the profit amountremains the same, what is different is the percentage of gain /loss.


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Price Discovery: Apart from the usual purpose of hedging, afutures contract also aids in the discovery of prices at the spotmarket level. Futures prices are a very good indicator of thedemand-supply levels for a particular commodity in a market. This

is because; futures prices are generally determined by therelative buying and selling interest on a regulated exchange.However, futures prices do not always lead spot prices.Studies have shown that when a commodity comes to the market,the spot market dominates the spot market in price discovery.Take for instance, a March futures contract for wheat. If wheat isharvested by March, obviously, consumers would look at thetrading prices in the spot market (assuming there is a pricedifference between the spot market and the futures market).However, for all other contracts, where the commodity has not

reached the market, the futures prices would lead the spotmarket prices.

WORKING OF OPTIONS

An option is a contract between two parties wherein the buyerreceives a privilege for which he pays a fee (premium) and theseller accepts an obligation for which he receives a fee. It gives

the option buyer the right but not the obligation to buy or sell anunderlying at a specific price on or before a certain date [19. Theunderlying asset can be stock, index, commodities, futures,interest rate, etc.Lets understand this with the help of an example. Lets say thereis a plot of land which Mr.A wishes to purchase but does not havesufficient cash to buy it for another one month. After negotiationswith the owner, a deal is struck whereby the owner gives Mr.A anoption to buy the plot in one months time for a price of Rs.10

lakhs. For buying this option, Mr.A does not have to pay Rs.10Lakhs but only a fraction of this amount, as agreed to betweenthe buyer and seller, lets say Rs.50, 000.The seller of an option is called an option writer, the buyer of anoption is called an option holder, the right to buy an option iscalled a call option, the price which the option holder pays forbuying the option is called the option price or the premium and


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the price at which the option is exercised is called the strike priceor the exercise price.After buying this option, either of the following two situations mayarise.

If the market value of the plot increases, Mr.A will exercise hisoption of buying the plot for the agreed price and then may sell itagain for making a profit by way of difference between the pricehe paid and the present market value of the plot. The optionholder has only the right and not the obligation to buy or sell theunderlying asset but the option writer is obligated to sell or buy, ifthe holder exercises the option.Or, if the market value of the plot shows a downslide, Mr. A willnot exercise his option of buying the plot, in which case his losswill be limited to the initial amount of

Rs.50, 000 paid by him, to the seller.

Thus, by using an option, Mr.A is able to limit his loss from futuredepreciation in value of the plot and is also able to profit from anyincrease in the value of the said plot.

Unlike futures where both the parties are required to maintain amargin as performance bond, in options only the buyersperformance bond is in the form of the premium paid to the seller.Seller is required to pay a margin as his performance bond.

Further, in options, the premium paid by the buyer is forfeitableunlike futures where the performance bonds of the parties aremaintained with the exchange and are not forfeitable. Options inIndia are traded over the exchange as well as OTC.

Kinds of options

1. Call option - A call option gives the option holder a right tobuy an asset at a certain price within a specified period of time. Acall option buyer is said to have a long position.

2. Put option - A put option gives the option holder a right to sell

an asset at a certain price within a specified period of time. A putoption holder is said to have a short position.

Illustration of Put Option


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A Farmer Wants To Sell Wheat In The Market After One Month ButIs Unsure Of The Market Prices Or Is Wary Of Falling Market PricesWhen His Crop Is Ready To Be Sold. If The Present Market ValueOf Wheat Is Rs.1,000 (For 100 Kgs) The Farmer Will Not Want To

Sell His Produce At A Lesser Price Nor Will He Like To Suffer ALoss By Selling At The Prevalent Price In Case The Price Of WheatIncreases In Future. In Such A Situation, Options Provide A ReadySolution To Him. He Can Buy A Put Option, For Lets Say Rs.100Where The Value Of The Underlying Is Rs.1, 000. In Other Words,He Would Have Bought Himself The Right To Sell His Produce ForRs.1,000 After A Month, By Paying Rs.100 As Premium.

der the Chairmanship of Dr.L.C.Gupta on November 18, 1996 todevelop appropriate regulatory framework for derivatives tradingin India. The committee submittedits report on March 17, 1998 prescribing necessary preconditionsfor introduction of derivatives trading in India. The committeerecommended that Derivatives should be declared as securitiesso that regulatory framework applicable to trading of securitiescould also govern trading of securities. SEBI also set up a group in

June 1998 under the Chairmanship of Prof. J.R.Varma, torecommend measures for risk containment in derivative market inIndia. The report, which was submitted in October 1998, workedout the operational details of margining system, methodology forcharging initial margins, broker net worth, deposit requirementand realtime monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended inDecember 1999 to include Derivatives within the ambit ofsecurities and the regulatory framework was developed forgoverning derivatives trading. The act also made it clear thatderivatives shall be legal and valid only if such contracts aretraded on a recognized stock exchange. Thus, precluding OTCderivatives. The government also rescinded in March 2000, the


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threedecade old notification, which prohibited forward trading insecurities.

November 2001. The derivatives trading on NSE commenced with

S&P CNX Nifty Index futures on June 12, 2000. The trading inindex options commencedOn June 4, 2001 and trading in options on individual securitiescommenced on July 2, 2001.Single stock futures were launched on November 9, 2001. Theindex futures and options contracts on NSE are based on S&P CNXtrading. Settlement in derivative contracts is done in accordancewith the rules, byelaws, and regulations of the respectiveexchanges and their clearing house/corporations duly approvedby SEBI and notified in the official gazette. Foreign Institutional

Investors(FIIs) are permitted to trade in all exchange tradedderivative products.

The following are some observations based on the tradingstatistics provided in the NSEReport on the futures and options (F&O): Single-stock futures continue to account for a sizable proportionof the F&O segment. It constituted 70 per cent of the totalturnover during June 2002. A primary reason attributed to this

phenomenon is that traders are comfortable with single-stockfutures than equity options, as the former closely resembles theerstwhile Badla system On relative terms, volumes in the index options segmentcontinues to remain poor. This may be due to the low volatility ofthe spot index. Typically, options are considered more valuablewhen the volatility of the underlying (in this case, theIndex ) is high. A related issue is that brokers do not earn highcommissions by recommending index options to their clients,because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segmenthave increased since January 2002. The call-put volumes in indexoptions have decreased from 2.86 in January 2002 to 1.32 in June.


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The fall in call-put volumes ratio suggests that the traders areincreasingly becoming pessimistic about the market. Farther month futures contracts are still not actively traded.

Trading in equity options on most stocks for even the next monthwas non-existent.

Daily option price variations suggest that traders use the F&Osegment as a less Foreign Institutional Investors(FIIs) arepermitted to trade in all exchange traded derivative products.

The following are some observations based on the tradingstatistics provided in the NSEReport on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportionof the F&O segment. It constituted 70 per cent of the totalturnover during June 2002. A primary reason attributed to thisphenomenon is that traders are comfortable with single-stockfutures than equity options, as the former closely resembles theerstwhile Badla system On relative terms, volumes in the index options segmentcontinues to remain poor. This may be due to the low volatility of

the spot index. Typically, options are considered more valuablewhen the volatility of the underlying (in this case, theIndex ) is high. A related issue is that brokers do not earn highcommissions by recommending index options to their clients,because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segmenthave increased since January 2002. The call-put volumes in indexoptions have decreased from 2.86 in January 2002 to 1.32 in June.The fall in call-put volumes ratio suggests that the traders areincreasingly becoming pessimistic about the market. Farther month futures contracts are still not actively traded.Trading in equity options on most stocks for even the next monthwas non-existent.


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Daily option price variations suggest that traders use the F&Osegment as a lessrisky alternative (read substitute) to generate profits from thestock price movements. The fact that the option premiums tail

intra-day stock prices is an evidence to this. Calls on Satyam fall,while puts rise when Satyam falls intra-day.If calls and puts are not looked as just substitutes for spot trading,the intra-day stock price variations should not have a one-to-oneimpact on the option premiums.falls intra-day.

If calls and puts are not looked as just substitutes for spot trading,the intra-day stock price variations should not have a one-to-oneimpact on the option premiums.-

Daily option price variations suggest that traders use the F&Osegment as a lessRisky alternative (read substitute) to generate profits from thestock price movements. The fact that the option premiums tailintra-day stock prices is an evidence to this. Calls on Satyam fall,while puts rise when Satyam falls intra-day.If calls and puts are not looked as just substitutes for spot trading,the intra-day stock price variations should not have a one-to-one

impact on the option premiums.

-

If, after a month, the price of wheat increases to Rs.1500, thefarmer will choose not to exercise his option. In such a case, hisloss will be limited to the option price paid by him, which will beoffset against the profit that he makes by selling his produce inthe spot market at Rs.1,500. Here the option is said to be out-of-money.On the other hand, if the price of wheat falls to Rs.800after a month, the farmer will exercise his option thereby

protecting himself from selling his produce at a lower price in thespot market. Here the option is said to be in-the-money.

Leverage - As in futures, one of the biggest advantages of usingan option is the leverage it gives to the investor. By making aninvestment in the form of a small premium, the buyer controls amuch larger stake.


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Illustration - If the stock of Reliance is trading at Rs.1000, it wouldtake Rs.1,00,000 to buy 100 shares of the stock. Instead of buyingthe stock, Mr.A purchases a call option with a strike price of 100with expiration after one month. Lets say the premium he pays is

Rs.10 for a share, i.e. Rs.1000 for buying the right to buy 100shares. Thus, his total investment is Rs.1000.

Lets suppose that the stock rises to Rs.1, 100 after a month. If Mr.A had purchased 100 shares, the profit that he would have madeis Rs.10,000 (difference between Rs.1,10,000 (Rs.1, 100 x 100)and Rs.1,00,000), i.e. a profit of 10%. However, by virtue of thecall option bought by Mr. A, on exercising his option of buying thestock for Rs1, 00,000 and selling the same for Rs.1, 10,000, theprofit that he will be making will be Rs.9, 000 (difference between

investment of Rs.1000 and the profit from sale), i.e. a profit of900%.

Option Pricing: Option price is the price, which the option holderpays to the option writer for buying a particular option.Theoretically, it is the supply and demand in the secondarymarket, which drives the option price. Greater the demand for theunderlying higher will be the option price and vice versa. Tounderstand option pricing, it becomes necessary to define certainterms.

Intrinsic value of an option is the amount of money that couldcurrently be realized by exercising the option at its strike price.An option is said to have an intrinsic value when the option is inthe money. When an option is at-the-money, the intrinsic value iszero.

Time value is the amount of money, which the option holder iswilling to pay and the option writer is willing to accept, over andabove any intrinsic value of the option. Time value of an optiondeclines as the option approaches maturity because the volatility

in the price of the underlying reduces.Reducing option price to a formula, it can be said that:

Option price/premium = Intrinsic value + time value.

In addition to the intrinsic value and time value, price of an optiondepends on the price of the underlying, strike price, volatility inthe price of the underlying and risk free rate of interest.


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Working of Options

Illustration: On 1st Jan 2006, stock of Wipro is trading at Rs.50and the premium for a March 55 Call is Rs.5. This means that theexpiration date for the option is last Thursday of March and thestrike price is 55.

Lets say Mr.A has information that the market is bullish and hemakes a decision of buying a March 55 Call. The total price of theoption is Rs.500.

For an option holder to exercise his option, it must yield profit. Inother words, it must have crossed the break-even point. Break-even point for a call option is the point where the value of the

underlying has crossed a price, which is all inclusive of the optionpremium; strike price and the transaction costs. In this case, thebreakeven point will be Rs.60.

After buying the option, till its expiration, there are three thingsthat Mr.A can possibly do with the option.

1. Exercise the option - An option can be exercised any timebefore its expiration . In the above example, if on the day afterbuying the option the value of the stock rises to Rs.110, Mr.A mayexercise his option of buying the stock at Rs. 50, in which case, he

makes an immediate profit of Rs.600 (mark-to market) less thepremium paid by him (Rs.500). After exercising his option he mayeither continue to hold the stock in anticipation of further priceincrease or may sell it in order to make a further profit of Rs.6,000 (difference between the price paid to buy 100 shares, i.e.


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Rs. 5,000 and the price at which shares were sold in the market,i.e. Rs. 11,000).

2. Continue to hold the option till expiry - If a favorable pricechange has not occurred yet, Mr.A may continue to hold the

option till the expiry date still hoping for the anticipated change. Ifit does not occur till the last day of trading, the option will not beexercised and will expire worthless. Loss of Mr.A in not exercisingthe option will be limited to Rs.500 (the premium).

3. Offset the option - An option that has been previouslypurchased or written can generally be offset at any time prior toits expiration by making an offsetting sale or purchase. Mostoption investors choose to realize their profits or limit their lossthrough an offsetting sale or purchase. It must be remembered

that the market may not always be favourable for offsetting anoption position.

Offset of options position by buyer If the call option forstock of Reliance is selling at Rs.8, Mr.A is in a profitable position.He anticipates that the market will be bearish and, thereforedecides to offset his position.

Seller (A) Buyer-300 +300

With the option at Rs.11, Mr.A will make a profit of Rs.300. He canoffset his position by selling a call option on stock of Reliance(same expiry date) at Rs.8, to Mr.C.

(A) Buyer C

Offset at Rs.800

By offsetting his position, Mr.A realises a profit of Rs.300 alongwith the premium (paid by C) in case the stock price makes afavorable movement.

Offset of options position by seller - If the call option forstock of reliance is selling at Rs.3, the seller is in a profitableposition.

Seller (A) Buyer+200 -200


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If he anticipates that the prices will rise, he might want to realizehis profit by offsetting his position, by buying a call option at Rs.3.By offsetting his position, the seller gets to keep his profit ofRs.200 and is protected against any future losses in case the

stock price increases.Seller COffset at Rs.300

The offsetting procedure is slightly varied when the underlying inan option is a futures contract. In that case, the buyer or theseller may offset their options position by entering into an equaland identical contract. However, if the buyer exercises the option,the buyer and the seller acquire long and short positionsrespectively in the underlying futures. Positions acquired in thefutures can be offset in the manner already explained underfutures.

Market participants: Players operating in options are thesame as those in futures market.

Hedgers Like futures, options can also be used for hedging. Incase of an unfavourable movement in the value of the underlying,the maximum that a buyer can lose is the premium paid for the

option, although the profit he can make is unlimited.

Speculators Speculators use options to gain from themovement (either ways) in the value of the underlying. They arewilling to take risks in order to profit from price changes in theunderlying . A speculator will buy an option when the strike pricefor the option is less than the value of the underlying and willexercise such option in order to realise the profits because of thedifference between the two prices. Similarly he will sell an optionwhen the strike price for the option is higher than the value of the

underlying.

Arbitrageurs An Arbitrageur seek to make a profit from thedifference in the prices in two markets by making simultaneoustransactions in two different markets. For example, an arbitrageurwill buy in the spot market and sell an option or sell in the spotmarket and buy an option. If the price of sugar in spot market is


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Rs.15 per kg and the strike price for option in sugar is Rs.12 perkg, to make a profit, the arbitrageur will buy a call on sugar,exercise his option for buying the sugar at Rs.12 and then sell thesame in the spot market thereby realizing a profit of Rs.3 on

every kg of sugar sold.These three players increase the volatility in the market andmake it more conducive for trading in options.

Trading strategies

Trading strategies - Participants in the market usedifferent strategies to maximize their profit or minimizetheir loss..

Strategies are specific game plans created by investor based on

idea of how the market will move. Strategies are generallycombinations of various products futures, calls and puts andenable you to realize unlimited profits, limited profits, unlimitedlosses or limited losses depending on your profit appetite and riskappetite.

The simplest starting point of a Strategy could be having a clearview about the market or a scrip. There could be strategies of anadvanced nature that are independent of views, but it would be

correct to say that most investors create strategies based onviews.

There could be four simple views: bullish view, bearish view,volatile view and neutral view. Bullish and bearish views are


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simple enough to comprehend. Volatile view is where onebelieves that the market or scrip could move rapidly, but he is notclear of the direction (whether up or down). He is however surethat the movement will be significant in one direction or the

other. Neutral view is the reverse of the Volatile view where youbelieve that the market or scrip in question will not move much inany direction.

The following strategies are possible if one has bullish view:

Buy a Future Buy a Call Option Sell a Put Option Create a Bull Spread using Calls

Create a Bull Spread using Puts.

If a person buy a Futures Contract, he will need to invest a smallmargin (generally 15 to 30% of the Contract value). If theunderlying index or scrip moves up, the associated Futures willalso move up. He can then gain the entire upward movement atthe investment of a small margin. For example, if you buy NiftyFutures at a price of 1,100 which moves up to 1,150 in say 10

days time, you gain 50 points. Now if you have invested only20%, i.e. 220, your gain is over 22% in 10 days time, which worksout an annualized return of over 700%.

The danger of the Futures value falling is very important. Oneshould have a clear stop loss strategy and if your Nifty Futures inthe above example were to fall from 1,100 to say 1,080, youshould sell out and book your losses before they mount.


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Thegraph of a Buy Futures Strategy appears below:

If one buy a Call Option, His Option Premium is his cost which hewill pay on the day of entering into the transaction. This is alsothe maximum loss that he can ever incur. If he buy a Satyam May260 Call Option for Rs 21, the maximum loss is Rs 21. If Satyamcloses above Rs 260 on the expiry day, he will be paid thedifference between the closing price and the strike price of Rs260. For example, if Satyam closes at Rs 300, he will get Rs 40.

After setting off the cost of Rs 21, his net profit is Rs 19.

The Call buyer has a limited loss, unlimited profit profile. Nomargins are applicable on the buyer. The premium will be paid incash upfront. If the Satyam scrip moves nowhere, the buyer isadversely impacted. As time passes, the value of the Option willfall. Thus if Satyam is currently at around Rs 260 and remainsaround that price till the end of May, the value of the Optionwhich is currently Rs 21 would have fallen to nearly zero by thattime. Thus time affects the Call buyer adversely.

The graph of a Buy Call position appears below:


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Another bullish strategy is to sell a Put Option. As a Put Seller, hewill receive Premium. For example, if he sell a Reliance May 300Put Option for Rs 18; he will earn an Income of Rs 18 on the dayof the transaction. You will however face a risk that you mighthave to pay the difference between 300 and the closing price ofReliance scrip on the last Thursday of May. For example, ifReliance were to close on that day at Rs 275, he will be asked topay Rs 25. After setting of the Premium received of Rs 18, the netloss will be Rs 7. If on the other hand, Reliance closes above Rs

300 (as per your bullish view), the entire income of Rs 18 wouldbelong to him.

As a Put Seller, one is required to put up Margins. These marginsare calculated by the exchange using a software program calledSpan. The margins are likely to be between 20 to 35% of theContract Value. As a Put Seller, you have a limited profit,unlimited loss profile which is a high risk strategy. If time passesand Reliance remains wherever it is (say Rs 300), he will be veryhappy. Passage of time helps the Sellers as value of the Option

declines over time.


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Theprofile of the Put Seller would appear as under:

Bull Spreads

First of all, Spreads are strategies which combine two or moreCalls (or alternatively two or more Puts). Another series ofStrategies goes by the name Combinations where Calls and Putsare combined.

Bull Spreads are those class of strategies that enable you benefit

from a bullish phase on the index or scrip in question. Bullspreads allow you to create a limited profit limited loss model ofpayoff, which you might be very comfortable with.

Creating Bull Spreads

Bull spreads can be created using Calls or using Puts. One need tobuy one Call with a lower strike price and sell another Call with ahigher strike price and a spread position is created. Interestingly,one can also buy a Put with a lower strike price and sell another

with a higher strike price to achieve a similar payoff profile.

various bearish strategies


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The following major choices are available:

Sell Scrip Futures Sell Index Futures Buy Put Option Sell Call Option Bear Spreads Combinations of Options and Futures

In the current Indian system, when one sell Scrip Futures, he isnot required to deliver the underlying scrip. One will be requiredto deposit a certain margin with the exchange on sale of Scrip

Futures. If the Scrip actually falls (as per your belief), one can buyback the Futures and make a profit. For example, Satyam Futuresare quoting at Rs 250 and one sell them today as you are bearish.One could buy them back after 10 days at say Rs 230 (if they fallas per your expectations), generating a profit of Rs 20. Questionof delivering Satyam does not arise in the present set up.

You will be required to place a margin with the exchange whichcould be around 25% (an illustrative percentage). If youaccordingly place a margin of Rs 62.50, a return of Rs 20 in 10

days time works out to a wonderful 30% plus return.

Obviously, if Satyam Futures move up (instead of down) He facean unlimited risk of losses. He should therefore operate with astop loss strategy and buy back Futures if they move in reversegear.

One could adopt the same strategy with Index Futures if you arebearish on the market as a whole. Similar returns and risks are

attached to this strategy.

Put Option help in a bearish framework.

The Put Option will rise in value as the scrip (or index) drops. IfOne buy a Put Option and the scrip falls (as one believe), he cansell it at a later date. The advantage of a Put Option (as against


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Futures) is that his losses are limited to the Premium he pay onpurchase of the Put Option.

For example, a Satyam 260 Put may quote at Rs 21 when Satyamis quoting at Rs 264. If Satyam falls to Rs 244 in 8 days, the Putwill move up to say Rs 31. He can make a profit of Rs 10 in theprocess.

No margins are applicable on you when one buy the Put. Oneneed to pay the Premium in cash at the time of purchase.

If one is moderately bearish (or neutral or bearish), he canconsider selling a Call. He will receive a Premium when he sell aCall. If the underlying Scrip (or Index) falls as he expect, the Call

value will also fall at which point he should buy it back.

For example, if Satyam is quoting at Rs 264 and the Satyam 260Call is quoting at Rs 18, you might well find that in 8 days whenSatyam falls to Rs 244, the Call might be quoting at Rs 7. Whenyou buy it back at Rs 7, you will make a profit of Rs 11.

However, if Satyam moves up instead of down, the Call will moveup in value. You might be required to buy it back at a loss. One isexposed to an unlimited loss, but ones profits are limited to the

Premium he collect on sale of the Call. He will receive thePremium on the date of sale of the Option. You will however berequired to keep a margin with the exchange. This margin canchange on a day-to-day basis depending on various factors,predominantly the price of the scrip itself.

One should be very careful while selling a Call as he is exposedto unlimited losses.

Use Bear Spreads

In a bear spread, One buy a Call with a high strike price and sell aCall with a lower strike price. For example, one could buy aSatyam 300 Call at say Rs 5 and sell a Satyam 260 Call at Rs 26.He will receive a Premium of Rs 26 and pay a Premium of Rs 5,thus earning a Net Premium of Rs 21.


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If Satyam falls to Rs 260 or lower, he will keep the entire Premiumof Rs 21. On the other hand if Satyam rises to Rs 300 (or above)he will have to pay Rs 40. After set off of the Income of Rs 21, hismaximum loss will be Rs 19.

The pay offprofile

appears as under:

In in a bear spread, ones profits and losses are both limited.Thus, one is safe from an unexpected rise in Satyam ascompared to a clean Option sale.

Combinations of Futures and Options

SatyamClosingPrice

Profiton 260StrikeCall(Gross)

Profiton 300StrikeCall(Gross)

PremiumReceived onDayOne

NetProfit

250 0 0 21 21255 0 0 21 21260 0 0 21 21

270 -10 0 21 11281 -21 0 21 0290 -30 0 21 -9300 -40 0 21 -19310 -50 10 21 -19


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If one sell Futures in a bearish framework, he run the risk ofunlimited losses in case the scrip (or index) rises. He can protectthis unlimited loss position by buying a Call. This combination willresult effectively in a payoff similar to that of buying a Put.

He can decide the strike price of the Call depending on hiscomfort level. For example, Satyam is quoting at Rs 264 currentlyand you are bearish. You sell Satyam Futures at say Rs 265. IfSatyam moves up, you will make losses. However, you do notwant unlimited loss. You could buy a Satyam 300 Call by paying asmall Premium of Rs 5. This will arrest your maximum loss to Rs35.

If Satyam moves up beyond the Rs 300 level, he will receive

compensation from the Call, which will offset your loss on Futures.For example, if Satyam moves to Rs 312, he will make a loss of Rs37 on Futures (312 265) but make a profit of Rs 12 on the Call(312 300). For this comfort, you shell out a small Premium of Rs5, which is a cost.

STRADDLES, STRANGLES AND BUTTERFLIES

STRADDLES AND STRANGLES

As a seller of these strategies, one is are to unlimited risk. Mostoption writers would prefer to sell strangles rather than straddles.As one is aware, a straddle sale comprises of a call and a put soldat the same strike price. For example, if you sell a Satyam 240Strike Straddle with Call and Put premium at Rs 11 and Rs 13respectively, you will receive Rs 24 as Income and the two break

even points will be Rs 216 and Rs 264 respectively.

If Satyam moves below Rs 216 or Rs 264, his losses are unlimited.

In a Strangle, the loss range becomes wider as the Call and Putare at different strike prices. For example, one could sell aSatyam 220 Strike Put at Rs 5 and a Satyam 260 Strike Call at Rs


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6. While he could earn lower premium of Rs 11 (as against Rs 24),his break-even points are much wider at Rs 209 and Rs 271respectively.

As a seller of options with a neutral view, one should sell stranglesrather than straddles this is a relatively lower risk lower returnstrategy.

As a buyer of volatility, one would rather buy straddles most ofthe time (rather than strangles) as he would expect to profitfaster in a straddle than the strangle. He would consider thepremium that it costs him to buy a straddle, but if that isreasonable then one would actively pursue this strategy.

The pay off diagrams of the straddle and strangle for the buyerand seller

STRADDLE BUYER


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STRADDLE SELLER

Butterfly

If one is a seller, He is exposed to unlimited losses in bothstraddles and strangles..

The butterfly strategy helps one to achieve this result. He wouldin this case, cut the wings of your straddle. To cut the wings,Hewould buy a Call with a higher strike price and buy another putwith a lower strike price than that of the Straddle.

Example:

One has sold a Straddle on Satyam with Strike Price 240 andgenerated an Income of Rs 24 (as above). He could buy a 260Strike Call for Rs 5 and buy a 220 Strike Put for Rs 6. This wouldcost you Rs 11, thus reducing your Net Income to Rs 13. It willhowever insure you from losses at both ends.


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The final payoff table will emerge as under:

SatyamClosingPrice

Profit on240 CallSold

Profit on260 CallBought

Profit on220 PutBought

Profit on240 PutSold

NetProfitIncludingInitialIncomeof Rs 13

200 0 0 20 -40 -7210 0 0 10 -30 -7220 0 0 0 -20 -7230 0 0 0 -10 3240 0 0 0 0 13250 -10 0 0 0 3

260 -20 0 0 0 -7270 -30 10 0 0 -7280 -40 20 0 0 -7

Thus, he will generate a maximum profit of Rs 13 if Satyamremains at your Straddle Strike price of Rs 240. his maximum lossis restricted to Rs 7 which happens when Satyam moves eitherbelow Rs 220 or above Rs 260. This loss is capped on both sides.

:

Conclusions:

Straddle, Strangle and Butterfly are very useful and practicalstrategies for neutral and volatile views on the market (index) oron individual stocks. You need to have a clear view and need topick underlying with good volumes and liquidity in order to

execute these strategies well. You also need to keep one eye onvolatility all the time.


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RESEARCH WORK

INTRODUCTION TO RESEARCH TOPIC

The study is based on findings how to minimize the risk that isinvolved in portfolio using index futures.What is the meaning of risk Risk is a concept which relates tohuman expectations. It denotes a potential negative impact to anasset or some characteristic of value that may arise from somepresent process or from some future event expected returns foran investor .For an investor it is often defined as the unexpected

variability or volatility of returns, and thus includes both potentialworse than expected as well as better than expected returns. Instock market an investor constructs a portfolio of stocks in whichhe puts his investments.In context of equity market portfolio an investor has stocks of

those companies in which he has invested his money. Shareprices are subject to fluctuations in share market. So investorinstead of putting his in one kind of stock diversify his investmentby investing in various different stocks. He does this to safe guardhimself from price fluctuations in stock prices. In case the price of

one stock in which he has invested falls in share market and priceof other stock rises in the market. At least he can minimize hisrisk by earning from that share whose prices have risen.

OBJECTIVES OF THE STUDY


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Every aspect of the research is done keeping in mind somedefinite objectives. The objectives of my study are as mentionedhere under:

Finding out relationship between stock prices and changes invalue of the index.

How hedging by way of index futures help us to minimize therisk.

Finding out how arbitrage opportunities exist between spotmarket and derivatives market.

Find out how far index prices are responsible for bringingfluctuations in share prices.

RESEARCH METHODOLOGY


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Research refers to search of knowledge.

RESEARCH DESIGN

The research design of my study HEDGING AND ARBITRAGE

THROUGH INDEX FUTURES is descriptive.

SAMPLING DESIGN

POPULATION : STOCKS OF NSE

SAMPLING TIME : 1st MAY 2006 TO 30th JUNE 2006

SAMPLING UNIT : NSE STOCKS

SAMPLING SIZE :10 STOCKS

SAMPLING TECHNIQUE : CONVENIENCE SAMPLING

DATA COLLECTION

ALL THE SOURCES OF DATA ARE SECONDARY IN NATURE. DATA IS

COLLECTED THROUGH VARIOUS SITES AVAILABLE ON NET.

LIMITATIONS OF THE STUDY

1.The main limitation of this study is that we have taken past

data to predict the future prices of stocks and performance in the

past does not predict the future with 100 percent accuracy.

2.It is not feasible to take into account stocks of all sectors

because the numbers of sectors are very large.

3.Another main limitation of this study is that HEDGING BY WAYOF INDEX FUTURES is not cent percent accurate. It can minimize

the risk but risk cannot be eliminated totally.


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Before going for data analysis one needs to

understand the following terms:

BETA:

A statistical measure of the relative volatility of a stock,

fund, or other security in comparison with the market as a

whole. The beta for the market is 1.00. Stocks with betas

above 1.0 are more responsive to the market, but are also

more risky investments. Stocks with a beta below 1.0 are

less responsive to the market. For example, if the market

moves 1%, a stock with a beta of 3.00 will move 3%; a

stock with a beta of .5 will move 5%.

INDEX FUTURES :

A future contract in which underlying asset is index in the

stock market is known as index futures. For each index

there may be a different multiple for determining the price

of the futures contract. For example, the S&P 500 index is

one of the most widely traded index futures contracts in the

U.S. Often stock portfolio managers who want to hedge risk

over a certain period of time will use the S&P 500 index

future to do so. By shorting these contracts, stock portfolio

managers can protect themselves from downside price risk

of the broader market. However, by using this hedging

strategy, if perfectlydone, the manager's portfolio will not

participate in any gains on the index; instead the portfolio


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will lock in gains equivalent to the risk-free rate interest.

Alternatively stock portfolio managers can use index

futures to increase their exposure to movements in a

particular index, essentially leveraging their portfolio. In our

study we have hedged our portfolio using Nifty Futures

(whose underlying index is S&P CNX Nifty) which is an

index futures contract traded on National Stock Exchange

with a minimum lot size of 100.

COFFICIENT OF CORELATION(r ):

It measures the degree of relationship between two

variables. The value of r greater than 0.75 indicates high

degree of correlation between two variables.

COEFFICIENT OF DETERMINATION (r 2) :

It is defined as the ratio of the explained variance to the

total variance. If cofficient of determination is 0.8, it means

that 80% of the variation in the dependent variable has

been explained by independent variable.


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HOW ONE CAN GAIN IN DERIVATIVES MARKET?

For Gaining In The Derivatives Market, One Will Have To TakePosition In Derivatives Market By Selling Index Futures Of Nifty.How Many Contracts One Needs To Sell Is A Big Problem SoThat One Can Cover The Risk Totally. For That Beta Of The

Portfolio Needs To Be Studied Which Is Computed ByRegressing The Historical Changes In The Value Of Portfolio OnThe Changes In The Prices Of Index.

WHAT IS HEDGING AND WHY IS IT REQUIRED ?

Protection against downside risk is known as hedging. To hedgesomething is to construct a protective fence around it. Appliedto financial markets, hedging means eliminating the risk in anasset or a liability. Applied to stock market, hedging meanseliminating the risk in an investment portfolio.

One hedges a portfolio because one wants its value

derivative project report

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