kotak securities ltd

8/4/2019 Kotak Securities Ltd.

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ACKNOWLEDGEMENT

The Summer Training at Kotak Securities Ltd., Bareilly. It is my professional

experience in both Financial and Marketing sector that enriched my knowledge

about the marketing sector.

Inspiration, motivation & encouragement are some essential ingredients for a

research project to be undertaken. The numbers of people who have influenced,

supported & guided me through this project are numerous to mention, but some

merit special attention.

I would like to take this opportunity to express my gratitude towards Mr. Atul

Kumar agarwal, Branch Head,Kotak Securities ltd., Bareilly,for giving me an

opportunity to work as a summer trainee.

I am also thankful to my family, and my friends for their support and

encouragement. In the end I extend my heart felt thanks to respondents who

helped in filling in my Questionnaires sincerely, thereby making my project a

wonderful experience.

Kratika purwar


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PREFACE

Derivative Market serve as a link between the saving public and the capital

markets in that they mobilize saving from investors and bring them to the

borrowers in the capital markets.

By the vary nature of their activities, and by virtue of being knowledgeable and

informed investors, they influence the stock market and play an active role in

promoting good corporate governance, investors protection and the health of

capital markets.

Derivative Market have imparted much needed liquidity into the financial system

and challenged the hitherto dominant role of banking and financial institutions in

the capital markets.

In this project, my focus is on tracking down the changing requirements,needs of customers, preferences, and their changing perspective on the

investment schemes with a special reference on Derivative Market in the

city Bareilly.


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SUBJECT OF RESEARCH

The subject of research undertaken was to make an in depth and

comprehensive study on Consumer Investment Pattren In Derivative

Market.Kotak Mahindra is one of Indias leading financial institutions,

offering complete financial solution that encompasses every sphere of life.

Kotak Securities is one of the largest private sector in securities market in

India .


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OBJECTIVE OF STUDY

The objective of the study was to find answer of some of the questions,

which are important to understand the present scenario in theDerivative

Market. The study has given answers to the following questions.

About Derivative Market.

Understand the investment objective .

Why do people invest in Derivative market?

Source of information while making investment

Whether the sample is risk averse or risk taker.

Overall perception of investors about Derivative market.


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RESEARCH METHODOLOGY

Place of Research

The study was primarily conducted in Bareilly. The market survey was

done to have market perspective of Derivative Market in Bareilly. For this

we used questionnaire as a tool for investor perception.

Sample FrameThe study conducted on the sample set, which included people who had

enquired about the various investments plans, the brokers who regularly

make investments on behalf of the investors and the employees of various

organizations Viz. Public and Private& professionals Viz. Chartered

Accountants and Doctors.

Sampling Design

The sample was picked randomly from the set of people who generally

belong to High class. We may better say that the sample design is a

systematic random sample because the focus was mainly on the people

who were interested in investing some minimum amount of their income in

one or the other avenue.

Sample Size

The sample size considered in our study is 50.

Sample Characteristics


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The sample considered is a homogenous one; the characteristics of the

respondents were more or less the same. The people generally belonged

to high class strata. The results deduced can be projected on the high

class population on a wider class.

Method of Data Collection

The research was conducted on the availability of information from

Primary and Secondary sources.

Primary sources of Data

Interaction with the employees of various organizations Viz. Public andPrivate & professionals Viz. C.A.s and Doctors.

Interaction with existing investors.

Questionnaire.

Secondary Sources of Data

Journals, Magazines etc.

Brochures/ Pamphlets of Various Mutual Fund companies.

Internet.

Other Documents.

Research Time

The time taken for the research study was nearly 6 weeks.

Research LimitationsThere was a problem when the respondents were asked about what

proportion of their saving is invested in which avenue.

They were apprehensive in revealing details about their income and their

investments.


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Gathering various factors that play an important role in influencing buying

decisions of any individual while purchasing an investment plan was quite

difficult.

Professionals were not always willing to cooperate and tell their

preference.

20% of the respondents did not know about the Derivative Market

& so it was not possible to carry out research study any further with them.

CORPORATE PROFILE


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HISTORY OF THEGROUP

The Kotak Mahindra Group was born in 1985 as Kotak Capital

Management A.A.Pinto and Kotak & Company, Industrialists Harish

Mahindra And An and Mahindra took a stake in 1986, and thats when the

company changed its name to Kotak Mahindra Finance Limited.

1986: Kotak Mahindra finance ltd. starts the activity of bill discounting.

1987: Kotak Mahindra finance ltd. Enters the lease and hire purchase

market.

1990:The Auto Finance division is started.


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1991: The investment banking division is started. Takes over FICOM, one

ofIndias largest financial retail and marketing network

1992: Enters the Funds Syndication sector.

1995: Brokerage and Distribution business incorporated into a separate

company-Kotak Securites.Investment Banking, divisionincorporated into a

separate company- Kotak Mahindra Capital Company.

1996: The Auto Finance hived off into a separate company-KotakMahindraPrimus ltd. Kotak Mahindra takes a significant stake in Ford

Credit Kotak Mahindra Ltd., for financing Ford Vehicles. The Launch if

Matrix Information Services. Marks the groups entry into information

distribution.

1998:Enters the Mutual fund market with the Kotak Mahindra Asset

Management Company.

2000:Kotak Mahindra ties up with Old Mutual plc. For the life insurance

business. Kotak Securities launches kkotakstreet.com-its online broking

site. Formal commencement of private equity activity through setting up of

Kotak Mahindra Venture Capital Fund.

2001:Matrix sold to Friday Corporation Launches Insurance Services.

2003:Mahindra Finance Ltd. Converts to bank. The first Indian company

to do so.


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2004:Launches India Growth fund, a private equity fund.

2005:Kotak Group realigns joint Kotak Buys) and sells fordMahindra

Prime (formerly known as Kotak Mahindra Primus Limited venture in fordCredit;Credit Kotak Mahindra.

KOTAK CORPORATE EDENTITY


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The symbol of the Infinite Ka reflects our global Indian personality. The

Ka is uniquely Indian while its curve forms the infinity sign, which is

universal. One of the basic tenets of economics is that mans needs are

unlimited. The Infinite Ka symbolizes that we have an infinite number of

ways to meet those needs.

THE KOTAK MAHINDRA GROUP

Kotak Mahindra is one of Indias leading financial institutions, offering

complete financial solution that encompass every sphere of life. From

commercial banking, to investment banking, the group caters to the

financial needs of individuals and corporate.

The group has a net worth of over Rs.2500 crore, employs around 6700

people in its various business and has a distribution network of branches,

franchisees, representative offices and satellite offices across 250 cities

and towns in India and offices in New York, Landon, Dubai and Mauritius.

The Group services over 1.6 million customer Accounts.


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Kotak Mahindra has international partnerships with Goldman Sacra (one

of the worlds largest investment banks and brokerage firms), Ford Credit

(one of the worlds largest dedicated automobile financiers) and Old

Mutual (a large insurance, banking and asset management

conglomerate).


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GROUP MANAGEMENT

Mr. Uday Kotak Executive Vice Chairman & managing

director

Mr. Shivaji Darn

Mr. C. Jayaram

Mr. Dipak Gupta


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POLICIES AND REGULATION APPLICABLE TO ALL

SCHEMES

The Trustee reserves the right to change the benchmark for evaluation of

performance of the respective Schemes from time to time in conformity

with the investment objectives and appropriateness of the benchmark

subject to, and other prevailing guidelines, if any.

Investment in debt securities by the Schemes(except HSGF) will usually

be in instruments which have been assessed as high investment grade

by at least one credit rating agency authorized to carry out such activityunder the applicable regulations. The AMC board and the Trustee shall

approve the detailed parameters for such investments. The detail s of

such investment would be communicated by the AMC to Trustee in their

periodic reports. It would also be clearly mentioned in the reports, how the

parameters have been compiled with. However, in case any unrated debt

securities does fall under the parameters, the prior approval of Board of

AMC and Trustee shall be sought.

Pursuant to the SEBI Regulations, each of the Schemes shall not

make any investment in:

Any unlisted security of an associate or group company of the Sponsors;

or

Any securities issued by way of private placement by an associate or

group company of the Sponsors: or

the listed securities of Group Company of the Sponsors which is in

access of 25% of the net assets.


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SWOT ANALYSIS

After conducting a consumer survey and analyzing the needs of consumer

we further do the following SWOT Analysis.

STRENGTH

1. Large distribution network

2. Good fund management

3. High service standard

4. Ethics oriented fund house

WEAKNESSES

1. Less commission/ remuneration to distributors

2. much time in processing

3. A No. of legal formalities

OPPURTUNITY

1. Weakness of competitors become an opportunity for the Kotak .

2. Rules and regulation are in favour of Kotak .

THREAT

1. To become no. 1 house of India.


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INTRODUCTION


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The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averse economic

agents to guard themselves against uncertainties arising out of fluctuations in

asset prices. By their very nature, the financial markets are marked by a very high

degree of volatility. Through the use of derivative products, it is possible to

partially or fully transfer price risks by lockingin asset prices. As instruments of

risk management, these generally do not influence the fluctuations in the

underlying asset prices. However, by locking-in asset prices, derivative products

minimize the impact of fluctuations in asset prices on the profitability and cash

flow situation of risk-averse investors.


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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, Rice 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 Rice which is the underlying.


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EMERGENCE OF DERIVATIVES

Derivative products initially emerged as hedging devices against fluctuations in

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

such products for almost three hundred years. Financial derivatives came into

spotlight in the post-1970 period due to growing instability in the financial

markets. However, since their emergence, these products have become very

popular and by 1990s, they accounted for about two-thirds of total transactions in

derivative products. In recent years, the market for financial derivatives has

grown tremendously in terms of variety of instruments available, their complexity

and also turnover. In the class of equity derivatives the world over, futures andoptions on stock indices have gained more popularity than on individual stocks,

especially among institutional investors, who are major users of index-linked

derivatives. Even small investors find these useful due to high correlation of the

popular indexes with various portfolios and ease of use. The lower costs

associated with index derivatives visavis derivative products based on

individual securities is another reason for their growing use. Recently all the

futures lot in NSE Future cuts in to small for receiving more response of small

Investors.


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HISTORY OF DERIVATIVES

Early forward contracts in the US addressed merchants concerns about ensuring

that there were buyers and sellers for commodities. However credit risk

remained a serious problem. To deal with this problem, a group of Chicago

businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary

intention of the CBOT was to provide a centralized location known in advance for

buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one

step further and listed the first exchange traded derivatives contract in the US,

these contracts were called futures contracts. In 1919, Chicago Butter and Egg

Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name

was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME

remain the two largest organized futures exchanges, indeed the two largest

financial exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of

Trade. Currently the most popular stock index futures contract in the world is

based on S&P 500 index, traded on Chicago Mercantile Exchange. During the

mid eighties, financial futures became the most active derivative instruments

generating volumes many times more than the commodity futures. Index futures,

futures on T-bills and Euro-Dollar futures are the three most popular futures

contracts traded today. Other popular international exchanges that trade

derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in

Japan, MATIF in France, Eurex etc.


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DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern trading

of derivatives. SEBI set up a 24member committee under the Chairmanship of

Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India. The committee submitted its report on

March 17, 1998 prescribing necessary preconditions for introduction of

derivatives trading in India. The committee recommended that derivatives should

be declared as securities so that regulatory framework applicable to trading of

securities could also govern trading of securities. SEBI also set up a group in

June 1998 under the Chairmanship of Prof. J. R. Varma, to recommend measures

for risk containment in derivatives market in India. The report, which was

submitted in October 1998, worked out the operational details of margining

system, methodology for charging initial margins, broker net worth, deposit

requirement and realtime monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the

ambit of securities and the regulatory framework was developed for governing

derivatives trading. The act also made it clear that derivatives shall be legal and

valid only if such contracts are traded on a recognized stock exchange, thus

precluding OTC derivatives. The government also rescinded in March 2000, thethreedecade old notification, which prohibited forward trading in securities.


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Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this effect in May 2000. SEBI permitted the derivative segments of

two stock exchanges, NSE and BSE, and their clearing house/corporation to

commence trading and settlement in approved derivatives contracts. To begin

with, SEBI approved trading in index futures contracts based on S&P CNX Nifty

and BSE-30 (Sen-sex) index. This was followed by approval for trading in

options based on these two indexes and options on individual securities. The

trading in index options commenced in June 2001 and the trading in options on

individual securities commenced in July 2001. Futures contracts on individual

stocks were launched in November 2001. Trading and settlement in derivative

contracts is done in accordance with the rules, byelaws, and regulations of the

respective exchanges and their clearing house/corporation duly approved by SEBI

and notified in the official gazette.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index

futures on June 12, 2000. The trading in index options commenced on June 4,

2001 and trading in options on individual securities commenced on July 2, 2001.

Single stock futures were launched on November 9, 2001. The index futures and

options contract on NSE are based on S&P CNX Nifty Index. Currently, the

futures contracts have a maximum of 3-month expiration cycles. Three contracts

are available for trading, with 1 month, 2 months and 3 months expiry. A new

contract is introduced on the next trading day following the expiry of the near

month contract. The contract is expire on the last thrusday of the month.


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PARTICIPANTS

Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. The following three broad categories of

participants

Hedgers

Hedgers face risk associated with the price of an asset. They use futures or

options markets to reduce or eliminate this risk

Speculators

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

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

increase both the potential gains and potential losses in a speculativeventure.

Arbitrageurs

Arbitrageurs are in business to take advantage of a discrepancy between

prices in two different markets. If, for example, they see the futures price of anasset getting out of line with the cash price, they will take offsetting positions in

the two markets to lock in a profit.


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FUNCTIONS

The derivatives market performs a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the

perceived future level. The prices of derivatives converge with the prices

of the underlying at the expiration of the derivative contract. Thus

derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them

but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash

markets. With the introduction of derivatives, the underlying market

witnesses higher trading volumes because of participation by more players

who would not otherwise participate for lack of an arrangement to transfer

risk.

4. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators

trade in the underlying cash markets. Margining, monitoring and

surveillance of the activities of various participants become extremely

difficult in these kind of mixed markets


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TYPES OF DERIVATIVES

The most commonly used derivatives contracts are forwards, futures and

options which we shall discuss in detail later. Here we take a brief look at various

derivatives contracts that have come to be used.

Forwards

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

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

FuturesA futures contract is an agreement between two parties to buy or sell an

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

types of forward contracts in the sense that the former are standardized exchange-

traded contracts.

Options

Options are of two types - calls and puts. Calls give the buyer the right butnot the obligation to buy a given quantity of the underlying asset, at a given price

on or before a given future date. Puts give the buyer the right, but not the

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

before a given date.

Warrants

Options generally have lives of upto one year, the majority of optionstraded on options Exchanges having a maximum maturity of nine months.

Longer-dated options are called warrants and are generally traded over-the-

counter.


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LEAPS

The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of upto three years.

Baskets

Basket options are options on portfolios of underlying assets. The

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

options are a form of basket options.

Swaps

Swaps are private agreements between two parties to exchange cash flows

in the future according in the future according to a prearranged formula. They can

be regarded as portfolios of forward contracts. The two commonly used swaps

are:

Interest rate swaps

These entail swapping only the interest related cash flows between the

parties in the same currency.

Currency swap

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

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

opposite direction.


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Swaptions

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

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

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

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

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


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INTRODUCTION TO FUTURES AND OPTIONS

In recent years, derivatives have become increasingly important in the field of

finance. While futures and options are now actively traded on many exchanges,

forward contracts are popular on the OTC market.

FUTURES

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 liquidityin 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


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FUTURES 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-months 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 under one contract. For instance, the

contract size on NSEs futures market is 200 Nifties. A lot size of 100 Nifties is

going to be introduced shortly.


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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 investors gain or loss depending upon the futures closing

price. This is called markingtomarket.

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.


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OPTIONS

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 upfront payment.


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OPTIONAL TERMENLOGY

Index options

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

others are American. Like indexing futures contracts, indexing options contracts

are also cash settled.

Stock options

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

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

or sell shares at the specified price.

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. There

are two basic types of options, call options 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.


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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.

Option price

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.


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In-the-money option

An in-the-money (ITM) option is an option that would lead to a positive

cashflow to the holder if it were exercised immediately. A call option on the indexis 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 cashflow 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 thestrike 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.

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 options time

value, all else equal. At expiration, an option should have no time value.


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CONCLUSION

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. The price of this derivative is driven by the spot price of Rice

which is the underlying.

Futures and Options are the most commonly used equity derivative instruments.

Derivatives market has been in existence for years in an unorganized manner. In

India we are yet to see the full-fledged derivatives trading. As per the global

standards, derivatives trading volumes are generally 4-5 times the cash market

volumes. Whereas, in India the derivatives volumes are 2-3 times the cash market

volumes

Derivatives are used for three categories of participants :-

Hedgers - Hedgers face risk associated with the price of an asset. They use futures

or options markets to reduce or eliminate this risk

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

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

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

Arbitragers - Arbitrageurs are in business to take advantage of a discrepancy

between prices in two different markets. If, for example, they see the futures price

of an asset getting out of line with the cash price, they will take offsetting

positions in the two markets to lock in a profit.

Derivatives market reflects the perception of the market player about the market.

They help in discovery of future as well as current prices. They transfer risk from


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those who have it but may not like to have them to those who have a appetite for

it. Transfer of risk enables market participants to expand their volume of activity


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TERM RELATED TO DERIVATED MARKET


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RISK TRANSFER

One key motivation for derivatives is to enable the transfer of risk between

individuals and firms in the economy. This can be viewed as being like insurance;

with the difference that anyone in the economy (and not just insurance

companies) would be able to sell insurance. A risk averse person buys insurance;

a riskseeking person sells insurance.

On an options market, an investor who tries to protect himself against a drop in

the index buys put options on the index, and a risk-taker sells him these options.

One special motivation which drives some (but not all) trades is mutual insurance

between two persons, both exposed to the same risk, in an opposite way. In the

context of currency fluctuations, exporters face losses if the rupee appreciates and

importers face losses if the rupee depreciates. By forward contracting in the

dollar-rupee forward market, they supply insurance to each other and reduce risk.

This is a situation where both parties in the transaction seek to avoid risk.

In these ways, derivatives supply a method for people to do hedging and reduce

their risks. As compared with an economy lacking these facilities, this is a

considerable gain. The largest derivatives markets in the world are on government

bonds (to help control interest rate risk), the market index (to help control risk that

is associated with fluctuations in the stock market) and on exchange rates (to cope

with currency risk).


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EFFECT OF DERIVATING TRADING ON SPOT MARKET

The empirical evidence broadly suggests that market efficiency and liquidity on

the spot market improve once derivatives trading comes about.

Speculators generally prefer implementing their positions using derivatives rather

than using a sequence of trades on the underlying spot market. Hence, access to

derivatives increases the rate of return on information gathering, research and

forecasting activities, and thus serves to spur investments into information

gathering and forecasting. This helps improve market efficiency.

From a market microstructure perspective, derivatives markets may reduce the

extent to which informed speculators are found on the spot market, thus reducing

the adverse selection on the spot market. Derivatives also help reduce the risksfaced by liquidity providers on the spot market, by giving them avenues for

hedging. These effects help improve liquidity on the spot market.

A liquid derivatives market tends to become the focus of speculation and price

discovery. When news breaks, the derivative market reacts first. The information

propagates


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USEFULLNESS OF FORWARD CONTRACTING

Forward contracting is valuable in hedging and speculation.

The classic hedging application is that of a wheat farmer forward-selling his

harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread

factory could buy wheat forward in order to assist production planning without

the risk of price fluctuations.

If a speculator has information or analysis which forecasts an upturn in a price,

then she can adopt a buy position (go long) on the forwardmarket instead of the

cash market. The speculator would wait for the price to rise, and then close out

the position on the forward market (by selling off the forward contracts). This is a

good alternative to speculation using the spot market, which involves buying

wheat, storing it for a while, and then selling it off. A speculator prefers

transactions involving a forward market because (a) the costs of taking or making

delivery of wheat is avoided, and (b) funds are not blocked for

the purpose of speculation.


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LEVERAGE

Suppose a user of a forward market adopts a position worth Rs.100. As mentioned

above, no money changes hands at the time the deal is signed. In practice, a good

faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using

Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is

leverage of 20 times.

This example involves a forward market. More generally, all derivatives involve

lever-age. Leverage makes derivatives useful; leverage is also the source of a host

of disasters, payments crises, and systemic risk on financial markets.

Understanding and controlling leverage is equivalent to understanding and

controlling derivatives.


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POOR LIQUIDITY OF FORWARD CONTRACT

One basic problem of forward markets is that of too much flexibility and

generality. The forward market is like the real estate market in that any two

consenting adults can form customdesigned contracts against each other. This

often makes them design terms of the deal, which are very convenient in that

specific situation; this can make the contracts non-tradable since others might not

find those specific terms useful.

In addition, forward markets are like the real estate market in that buyers and

sellers find each other using telephones. This is inefficient and timeconsuming.

Every user faces the risk of not trading at the best price available in the country.

Forward markets often turn into small clubs of dealers who earn elevated

intermediation fees. This elevates the fees paid by users, i.e. it makes the forward

market illiquid from the user perspective.


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FUTURE MARKET SOLVES THE PROBLEMS OF

FORWARD MARKET

Futures markets feature a series of innovations in how trading is organized:

Futures contracts trade at an exchangewith pricetime priority. All buyers

and sellers come to one exchange. This reduces search costs and improves

liquidity. This harnesses the gains that are commonly obtained in going from a

nontransparent club market (based on telephones) to an anonymous, electronic

exchange, which is open to participation. The anonymity of the exchange

environment largely eliminates cartel formation.

Futures contracts are standardized all buyers or sellers are constrained to

only choose from a small list of tradable contracts defined by the exchange. Thisavoids the illiquidity that goes along with the unlimited customization of forward

contracts.

A new credit enhancement institution, the clearing corporation, eliminates

counterparty risk on futures markets. The clearing corporation interposes itself

into every transaction, buying from the seller and selling to the buyer. This is

called novation. This insulates each from the credit risk of the other. In futures

markets, unlike in forward markets, increasing the time to expiration does not

increase the counterparty risk.

. Novation at the clearing corporation makes it possible to have safe trading

between strangers. This is what enables largescale participation into the futures

market in contrast with small clubs, which trade by telephone, and makes futures

markets liquid.


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CASH SETTLEMENT

The forward or futures contracts discussed so far involved physical settlement. On

31 Dec 2004, the seller was supposed to come up with 100 tolas of gold and the

buyer was supposed to pay for it.

In practice, settlement involves high transactions costs. This is particularly the

case for products such as the equity index, or an inter bank deposit, where

effecting settlement is extremely difficult or impossible.

In these cases, futures markets use cash settlement. Here, the terminal value of

the product is deemed to be equal to the price seen on the spot market. This is

used to determine cash transfers from the counterparties of the futures contract.

The cash transfer is treated as settlement.

Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on

31 Nov 2004. Suppose we come to the expiration date, i.e. 31 Dec 2004, and the

Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty

and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty

applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000.

Hence, the clearing corporation organises a payment of Rs.3,000 from S and a

payment of Rs.3,000 to L. This is called cash settlement.

Cash settlement was an important advance, which extended the reach of

derivatives into many products where physical settlement was unviable.


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WHEN WOULD ONE USE OPTIONS INSTEAD OF FUTURES

Options are different from futures in several interesting senses.

At a practical level, the option buyer faces an interesting situation. He pays for the

option in full at the time it is purchased. After this, he only has an upside. There is

no possibility of the options position generating any further losses to him (other

than the funds already paid for the option). This is different from a futures: which

is free to enter into, but can generate very large losses. This characteristic makes

options attractive to many occasional market participants, who cannot put in the

time to closely monitor their futures positions. Buying put options is buying

insurance. To buy a put option on Nifty is to buy insurance which reimburses the

full extent to which Nifty drops below the strike price of the put option. This is

attractive to many people, and to mutual funds creating guaranteed return

products.

The Nifty index fund industry will find it very useful to make a bundle of a Nifty

index fund and a Nifty put option to create a new kind of a Nifty index fund,

which gives the investor protection against extreme drops in Nifty.

Selling put options is selling insurance, so anyone who feels like earning revenues

by selling insurance can set himself up to do so on the index options market.

More generally, options offer nonlinear payoffs whereas futures only have

linear payoffs. By combining futures and options, a wide variety of innovative

and useful payoff structures can be created.


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WHY HAVE INDEX DERIVATIVE PROVED TO BE MORE

IMPORTANT THAN INDIVIDUAL STOCKS?

Security options are of limited interest because the pool of people who would be

interested (say) in options on ACC is limited. In contrast, every single personwith

any involvement in the equity market is affected by index fluctuations. Hence risk

management using index derivatives is of far more importance than risk-

management using individual security options. This goes back to a basic principle

of financial economics. Portfolio risk is dominated by the market index,

regardless of the composition of the portfolio. All portfolios of around ten stocks

or more have a pattern of risk where 70% or more of their risk is index-related.

Hence investors are more interested in using indexbased derivative products.

Index derivatives also present fewer regulatory headaches when compared to

leveraged trading on individual stocks. Internationally, this has led to regulatory

encouragement for index futures and discouragement against futures on individual

stocks.


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DELIVERY OF MARKET INDEX

On futures markets, open positions as of the expiration date are normally

supposed to turn into delivery by the seller and payment by the buyer.

It is not feasible to deliver the market index. Hence open positions are squared off

in cash on the expiration date, with respect to the spot Nifty. Specifically, on the

expiration date, the last mark to market margin is calculated with respect to the

spot Nifty instead of the futures price.


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FAIR PRICE OF DERIVATIVE

The fair price of a derivative is the price at which profitable arbitrage is

infeasible. In this sense, arbitrage (and arbitrage alone) determines the fair price

of a derivative: this is the price at which there are no profitable arbitrage

opportunities.

FAIR PRICE OF INDEX FUTURE PRODUCT

The pricing of index futures depends upon the spot index, the cost of carry, and

expected dividends. For simplicity, suppose no dividends are expected, suppose

the spot Nifty is at 2000 and suppose the onemonth interest rate is 1.5%. Then

the fair price of an index futures contract that expires in a month is 2030.

BASIS & BASIS RISK

The difference between the spot and the futures price is called the basis. When a

Nifty future trades at 2030 and the spot Nifty is at 2000, the basis is said to be

Rs.15 or 1.5%.

BASIS RISK

Basis risk is the risk that users of the futures market suffer, owing to unwanted

fluctuations of the basis. In the ideal futures market, the basis should reflect

interest rates, and interest rates alone. In reality, the basis fluctuates within a band.

These fluctuations reduce the usefulness of the futures market for hedgers and

speculators.


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GOOD MARKET INDEX FOR USE IN AN INDEX FUTURES

AND INDEX OPTIONS MARKET

Several issues play a role in terms of the choice of index.

Diversification

A stock market index should be welldiversified, thus ensuring that

hedgers or speculators are not vulnerable to individual company or industry

risk. This diversification is reflected in the Sharpes Ratio of the index.

Liquidity of the index

The index should be easy to trade on the cash market. This is partly related

to the choice of stocks in the index. High liquidity of index components implies

that the information in the index is less noisy.

Liquidity of the market

Index traders have a strong incentive to trade on the market, which

supplies the prices, used in index calculations. This market should feature high

liquidity and be well designed in the sense of supplying operational conveniences

suited to the needs of index traders.

Operational issues

The index should be regularly maintained, with a steady evolution of

securities in the index to keep pace with changes in the economy. The calculations

involved in the index should be accurate and reliable. When a stock trades at

multiple venues, index computation should be done using prices from the mostliquid market.


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LIQUIDITY IN MARKET INDEX

At one level a market index is used as a pure economic time-series. Liquidity

affects this application via the problem of non-trading. If some securities in an

index fail to trade today, then the level of the market index obtained reflects the

valuation of the macro economy today (via securities which traded today), but is

contaminated with the valuation of the macro economy yesterday (via securities

which traded yesterday). This is the problem ofstale prices. By this reasoning,

securities with a high trading intensity are best suited for inclusion into a market

index.

As we go closer to applications of market indexes in the indexation industry (such

as index funds, or sector-level active management, or index derivatives), the

market index is not just an economic time-series, but also a portfolio, which is

traded. The key difficulty faced here is again liquidity, or the transactions costs

faced in buying or selling the entire index as a portfolio.


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HEDGING STRATEGIES


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HEDGING: LONG SECURITY, SHORT NIFTY FUTURES

Investors studying the market often come across a security which they believe is

intrinsically undervalued. It may be the case that the profits and the quality of the

company make it seem worth a lot more than what the market thinks. A

stockpicker carefully purchases securities based on a sense that they are worth

more than the market price. When doing so, he faces two kinds of risks:

1. His understanding can be wrong, and the company is really not worth

more than the market price.

OR

2. The entire market moves against him and generates losses even thoughthe underlying idea was correct.

The second outcome happens all the time. A person may buy SBI at Rs.670

thinking that it would announce good results and the security price would rise. A

few days later, Niftydrops, so he makes losses, even if his understanding of SBI

was correct.

There is a peculiar problem here. Every buy position on a security is

simultaneously a buy position on Nifty. This is because a LONG SBI position

generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a

LONG SBI position is not a focused play on the valuation of SBI. It carries a

LONG NIFTY position along with it, as incidental baggage. The stock-picker

may be thinking he wants to be LONG SBI, but a long position on SBI effectively

forces him to be LONG SBI + LONG NIFTY.


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There is a simple way out. Every time you adopt a long position on a security, you

should sell some amount of Nifty futures. This offsets the hidden Nifty exposure

that is inside every longsecurity position. Once this is done, you will have a

position, which is purely about the performance of the security. The position

LONG SBI+ SHORT NIFTY is a pure play on the value of SBI , without any

extra risk from fluctuations of the market index. When this is done, the stock-

picker has hedged away his index exposure. The basic point of this hedging

strategy is that the stock-picker proceeds with his core skill, i.e. picking securities,

at the cost of lower risk.


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HEDGING: HAVE PORTFOLIO, SHORT NIFTY FUTURES

The only certainty about the capital market is that it fluctuates! A lot of investors

who own portfolios experience the feeling of discomfort about overall market

movements. Sometimes, they may have a view that security prices will fall in the

near future. At other times, they may see that the market is in for a few days or

weeks of massive volatility, and they do not have an appetite for this kind of

volatility. The union budget is a common and reliable source of such volatility:

market volatility is always enhanced for one week before and two weeks after a

budget. Many investors simply do not want the fluctuations of these three weeks.

This is particularly a problem if you need to sell shares in the near future, for

example, in order to finance a purchase of a house. This planning can go wrong if

by the time you sell shares, Nifty has dropped sharply.

When you have such anxieties, there are two alternatives:

Sell shares immediately. This sentiment generates panic selling which

is rarely optimal for the investor.

Do nothing, i.e. suffer the pain of the volatility. This leads to political

pressures for government to do something when security prices fall.

In addition, with the index futures market, a third and remarkable alternative

becomes available:

. Remove your exposure to index fluctuations temporarily using index futures.This allows rapid response to market conditions, without panic selling of

shares. It allows an investor to be in control of his risk, instead of doing

nothing and suffering the risk.


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The idea here is quite simple. Every portfolio contains a hidden index exposure.

This statement is true for all portfolios, whether a portfolio is composed of index

securities or not. In the case of portfolios, most of the portfolio risk is accounted

for by index fluctuations (unlike individual securities, where only 3060% of the

securities risk is accounted for by index fluctuations).Hence a position LONG

PORTFOLIO + SHORT NIFTY can often become onetenth as risky as the

LONG PORTFOLIO position!

Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a

complete hedge is obtained by selling Rs.1.25 million of Nifty futures.


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Methodology

1. We need to know the beta of the portfolio, i.e. the average impact of a

1% move in Nifty upon the portfolio. It is easy to calculate the portfolio

beta: it is the weighted average of securities betas. Suppose we have a

portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4

and Rs.2 million of Hindustan Lever, which has a beta of 0.8, then the

portfolio beta is (1 * 1.4 + 2 * 0.8)/3 or 1. If the beta of any securities is

not known, it is safe to assume that it is 1.

2. The complete hedge is obtained by adopting a position on the index

futures market, which completely removes the hidden Nifty exposure. In

the above case, the portfolio is Rs.3 million with a beta of 1, hence we

would need a position of Rs.3 million on the Nifty futures.

3. Suppose Nifty is 1250, and the market lot on the futures market is 200. Each

market lot of Nifty costs Rs.250,000. Hence we need to sell 12 market lots, i.e.2400 Nifties to get the position: LONG PORTFOLIO Rs.3,000,000 SHORT

NIFTY Rs.3,000,000.

This position will be essentially immune to fluctuations of Nifty. If Nifty goes up,

the portfolio gains and the futures lose. If Nifty goes down, the futures gain and

the portfolio loses. In either case, the investor has no risk from market

fluctuations when he is completely hedged. The investor should adopt this

strategy for the short periods of time where (a) the market volatility that he

anticipates makes him uncomfortable, or (b) when his financial planning involves

selling shares at a future date and would be affected if Nifty drops. It does not

make sense to use this strategy for long periods of time if a twoyear hedging is


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desired, it is better to sell the shares, invest the proceeds, and buy back shares

after two years. This strategy makes the most sense for rapid adjustments.

Another important choice for the investor is the degree of hedging. Complete

hedging eliminates all risk of gain or loss. Sometimes the investor may be willing

to tolerate some risk of loss so as to hang on to some risk of gain. In that case,

partial hedging is appropriate. The complete hedge may require selling Rs.3

million of the futures, but the investor may choose to only sell Rs.2 million of the

futures. In this case, twothirds of his portfolio is hedged and one third of the

portfolio is held unhedged. The exact degree of hedging chosen depends upon the

appetite for risk that the investor has.


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HEDGING: HAVE FUNDS, BUY NIFTY FUTURES

Have you ever been in a situation where you had funds, which needed to get

invested in equity? Or of expecting to obtain funds in the future which will get

invested in equity. Some common occurrences of this include:

_

A closed-end fund, which just finished its initial public offering, has cash,

which is not yet invested.

Suppose a person plans to sell land and buy shares. The land deal is slow

and takes weeks to complete. It takes several weeks from the date that it

becomes sure that the funds will come to the date that the funds actually

are in hand.

An open-ended fund has just sold fresh units and has received funds.

Getting invested in equity ought to be easy but there are three problems:

1. A person may need time to research securities, and carefully pick securities

that are expected to do well. This process takes time. For that time, the investor

is partly invested in cash and partly invested in securities. During this time, he is

exposed to the risk of missing out if the overall market index goes up.

2.A person may have made up his mind on what portfolio he seeks to buy, but

going to the market and placing market orders would generate large impact

costs. The execution would be improved substantially if he could instead place

limit orders and gradually accumulate the portfolio at favorable prices. This takes

time, and during this time, he is exposed to the risk of missing out if the Nifty

goes up.

3.In some cases, such as the land sale above, the person may simply not have

cash to immediately buy shares, hence he is forced to wait even if he feels that

Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises.


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So far, in India, we have had exactly two alternative strategies, which an investor

can adopt: to buy liquid securities in a hurry, or to suffer the risk of staying in

cash. With Nifty futures, a third alternative becomes available:

The investor would obtain the desired equity exposure by buying index

futures, immediately. A person who expects to obtain Rs.5 million by

selling land would immediately enter into a position LONG NIFTY

worth Rs.5 million. Similarly, a closed-end fund, which has just finished

its initial public offering and has cash, which is not yet invested, can

immediately enter into a LONG NIFTY to the extent it wants to be

invested in equity. The index futures market is likely to be more liquid

than individual securities so it is possible to take extremely large

positions at a low impact cost.

Later, the investor/closed-end fund can gradually acquire securities

(either based on detailed research and/or based on aggressive limit

orders). As and when shares are obtained, one would scale down the

LONG NIFTY position correspondingly. No matter how slowlysecurities are purchased, this strategy would fully capture a rise in Nifty,

so there is no risk of missing out on a broad rise in the securities market

while this process is taking place. Hence, this strategy allows the investor

to take more care and spend more time in choosing securities and placing

aggressive limit orders.


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Hedging is often thought of as a technique that is used in the context of equity

exposure. It is common for people to think that the owner of shares needs index

futures to hedge against a drop in Nifty. Holding money in hand, when you want

to be invested in shares, is a risk because Nifty may rise. Hence it is equally

important for the owner of money to use index futures to hedge against a rise in

Nifty!

Methodology

1. Aman Agrawal obtained Rs.4.8 million on 13th March 2005. He made a

list of 14 securities to buy, at 13 March prices, totaling Rs.4.8 million.


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At that time Nifty was at 2000. He entered into a LONG NIFTY MARCH

FUTURES position for 2400 Nifties, i.e. his long position was worth 4,80,000.

2. From 14 March 2005 to 25 March 2005 he gradually acquired the

securities. On each day, he purchased one securities and sold off a

corresponding amount of futures.

3. On each day, the securities purchased were at a changed price (as

compared to the price prevalent on 13 March). On each day, he obtained

or paid the marktomarket margin on his outstanding futures position,

thus capturing the gains on the index.

4. By 25 Mar 2005 he had fully invested in all the shares that he wanted (as

of 13 Mar) and had no futures position left.

CONCLUSION

Hedging is a way of reducing some of the risk involved in holding an investment.

There are many different risks against which one can hedge and many different

methods of hedging. When someone mentions hedging, think of insurance. A

hedge is just a way of insuring an investment against risk.


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Consider a simple (perhaps the simplest) case. Much of the risk in holding any

particular stock is market risk; i.e. if the market falls sharply, chances are that any

particular stock will fall too. So if you own a stock with good prospects but you

think the stock market in general is overpriced, you may be well advised to hedge

your position.

There are many ways of hedging against market risk. The simplest, but most

expensive method, is to buy a put option for the stock you own. (It's most

expensive because you're buying insurance not only against market risk but

against the risk of the specific security as well.)

If you're trying to hedge an entire portfolio, futures are probably the cheapest way

to do so. But keep in mind the following points.

The efficiency of the hedge is strongly dependent on your estimate of the

correlation between your high-beta portfolio and the broad market index.

If the market goes up, you may need to advance more margin to cover

your short position, and will not be able to use your stocks to cover the

margin calls.


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ARBITRAGE STRATEGIES


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Arbitrage: Have funds, lend them to the market

Most people would like to lend funds into the security market, without suffering

the risk. Traditional methods of loaning money into the security market suffer

from (a) price risk of shares and (b) credit risk of default of the counter-party.

What is new about the index futures market is that it supplies a technology to lend

money into the market without suffering any exposure to Nifty, and without

bearing any credit risk.

The basic idea is simple. The lender buys all 50 securities of Nifty on the cash

market, and simultaneously sells them at a future date on the futures market. It is

like a repo. There is no price risk since the position is perfectly hedged. There is

no credit risk since the counter party on both legs is the NSCCL which suppliesclearing services on NSE. It is an ideal lending vehicle for entities which are shy

of price risk and credit risk, such as traditional banks and the most conservative

corporate treasuries.


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Methodology

1. Calculate a portfolio, which buys all the 50 securities in Nifty in correct

proportion, i.e. where the money invested in each security, is proportional to its

market capitalization.

2. Round off the number of shares in each security.

3. Using the NEAT or BOLT software, a single keystroke can fire off these

50 orders in rapid succession into the NSE or BSE trading system. This gives

you the buy position

4. A moment later, sell Nifty futures of equal value. Now you are

completely hedged, so fluctuations in Nifty do not affect you.

5. A few days later, you will have to take delivery of the 50 securities and

pay for them. This is the point at which you are loaning money to the

market.

6. Some days later (anytime you want), you will unwind the entire

transaction.

7. At this point, use NEAT to send 50 sell orders in rapid succession to sell

off all the 50 securities.

8. A moment later, reverse the futures position. Now your position is down

to 0.

9. A few days later, you will have to make delivery of the 50 securities and

receive money for them. This is the point at which your money is repaid

to you.


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What is the interest rate that you will receive? We will use one specific case,

where you will unwind the transaction on the expiration date of the futures. In this

case, the difference between the futures price and the cash Nifty is the return to

the moneylender, with two complications: the moneylender additionally earns any

dividends that the 50 shares pay while he has held them, and the moneylender

suffers transactions costs (impact cost, brokerage) in doing these trades. On 1

March 2005, if the Nifty spot is 2100, and the Nifty March 2005 futures are at

2142 then the difference (2% for 30 days) is the return that the moneylender

obtains.


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Example

On 1 August, Nifty is at 2400. A futures contract is trading with 27th August

expiration for 2460. Ashish wants to earn this return (60/2400 for 27 days).

1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places

50 market orders and ends up paying slightly more. His average cost of

purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 2407.

2. He sells Rs.3 million of the futures at 2460. The futures market is

extremely liquid so the market order for Rs.3 million goes through at

nearzero impact cost. He takes delivery of the shares and waits.

3. While waiting, a few dividends come into his hands. The dividends work

out to Rs.14,000.

4. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty

portfolio, putting 50 market orders to sell off all the shares. Nifty happens

to have closed at 2420 and his sell orders (which suffer impact cost) goes

through at 2413.

5. The futures position spontaneously expires on 27 August at 2420 (the

value of the futures on the last day is always equal to the Nifty spot).

6. Ashish has gained Rs.6 (0.25%) on the spot Nifty and Rs.40 (1.63%) on

the futures for a return of near 1.88% In addition, he has gained Rs.14000

or 0.23% owing to the dividends for a total return of 2.11% for 27 days,

risk free.

It is easier to make a rough calculation of the return. To do this, we ignore the

gain from dividends and we assume that transactions costs account for 0.4%. In

the above case, the return is roughly 2460/2400 or 2.5% for 27 days, and we

subtract 0.4% for transactions costs giving 2.1% for 27 days.


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.


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ARBITRAGE: HAVE SECURITIES, LEND THEM TO THE

MARKET

Owners of a portfolio of shares often think in terms of juicing up their returns by

earning revenues from stocklending. However, stocklending schemes that are

widely accessible do not exist in India.

The index futures market offers a riskless mechanism for (effectively)

loaning out shares and earning a positive return for them. It is like a repo; you

would sell off your certificates and contract to buy them back in the future at a

fixed price. There is no price risk (since you are perfectly hedged) and there is no

credit risk (since your counterparty on both legs of the transaction is the NSCCL).

The basic idea is quite simple. You would sell off all 50 securities in Nifty

and buy them back at a future date using the index futures. You would soon

receive money for the shares you have sold. You can deploy this money, as you

like until the futures expiration. On this date, you would buy back your shares,

and pay for them.


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Methodology

Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct

proportion, with each share being present in the portfolio with a weight that is

proportional to its market capitalization).

1. Sell off all 50 shares on the cash market. This can be done using a single

keystroke using the NEAT software.

2. Buy index futures of an equal value at a future date.

3. A few days later, you will receive money and have to make delivery of the

50 shares.

4. Invest this money at the riskless interest rate.

5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using

NEAT again) to buy the entire NSE-50 portfolio.

6. A few days later, you will need to pay in the money and get back your

shares.

When is this worthwhile? When the spot-futures basis (the difference between

spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you

can find in the economy. If the spotfutures basis is 2.5% per month and you are

loaning out the money at 1.5% per month, it is not profitable. Conversely, if the

spot-futures basis is 1% per month and you are loaning out money at 1.2% per

month, this stocklending could be profitable

It is easy to approximate the return obtained in stocklending. To do this, we

assume that transactions costs account for 0.4%. Suppose the spotfutures basis is


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X% and suppose the rate at which funds can be invested is Y % Then the total

return is (Y - X% - 0.4%) over the time that the position is held.

This can also be interpreted as a mechanism to obtain a cash loan using your

portfolio of Nifty shares as collateral. In this case, it may be worth doing even if

the spotfutures basis is somewhat wider.


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Example

Suppose the Nifty spot is 1100 and the twomonth futures are trading at

1110. Hence the spot futures basis (10/1100) is 0.9%. Assume that the

transactions costs are 0.4%. Suppose cash can be risklessly invested at 1% per

month. Over two months, funds invested at 1% per month yield 2.01%. Hence the

total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the

twomonth period. Let us make this concrete using a specific sequence of trades.

Suppose Akash has Rs.4 million of the Nifty portfolio, which he would like to

lend to the market.

1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in

NEAT to rapidly place 50 market orders in quick succession. The seller

always suffers impact cost; suppose he obtains an actual execution at

1098.

2. A moment later, Akash puts in a market order to buy Rs.4 million of the

Nifty futures. The order executes at 1110. At this point, he is completely

hedged.

3. A few days later, Akash makes delivery of shares and receives Rs.3.99

million (assuming an impact cost of 2/1100).

4. Suppose Akash lends this out at 1% per month for two months. At the end

of two months, he get back Rs.40,70,199. Translated in terms of Nifty, this

is 1098* or 1120.

5. On the expiration date of the futures, he puts in 50 orders, using NEAT,

placing market orders to buy back his Nifty portfolio. Suppose Nifty has

moved up to 1150 by this time. This makes shares are costlier in buying

back, but the difference is exactly offset by profits on the futures contract.


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6. When the market order is placed, suppose he ends up paying 1153 and not

1150, owing to impact cost. He has funds in hand of 1120, and the futures

contract pays 40 (1150-1110) so he ends up with a clean profit, on the

entire transaction, of 1120 + 40 - 1153 or

7. On a base of Rs.4 million, this is Rs.25,400.


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ARBITRAGE: OVERPRICED FUTURES: BUY SPOT, SELL

FUTURES

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune

with the spot price. Whenever the futures price deviates substantially from its fair

value, arbitrage opportunities arise.

If you notice that futures on a security that you have been observing seem

overpriced, how can you cash in on this opportunity to earn risk less profits? Say

for instance, ABB trades at Rs.1000. Onemonth ABB futures trade at Rs.1025 and

seem overpriced. As an arbitrageur, you can make risk less profit by entering into

the following set of transactions.

1. On day one, borrow funds; buy the security on the cash/spot market at

1000.

2. Simultaneously, sell the futures on the security at 1025.

3. Take delivery of the security purchased and hold the security for a

month.

4. On the futures expiration date, the spot and the futures price converge.

Now unwind the position.

5. Say the security closes at Rs.1015. Sell the security.

6. Futures position expires with profit of Rs.10.

7. The result is a risk less profit of Rs.15 on the spot position and Rs.10

on the futures position.

8. Return the borrowed funds.


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When does it make sense to enter into this arbitrage? If your cost of borrowing

funds to buy the security is less than the arbitrage profit possible, it makes sense

for you to arbitrage. This is termed as cashandcarry arbitrage. Remember

however, that exploiting an arbitrage opportunity involves trading on the spot and

futures market. In the real world, one has to build in the transactions costs into the

arbitrage strategy.


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ARBITRAGE: UNDER PRICED FUTURES: BUY FUTURES,

SELL SPOT

Whenever the futures price deviates substantially from its fair value, arbitrage

opportunities arise. It could be the case that you notice the futures on a security

you hold seem under priced. How can you cash in on this opportunity to earn risk

less profits? Say for instance, ABB trades at Rs.1000. Onemonth ABB futures

trade at Rs.965/- and seem under priced. As an arbitrageur, you can make risk less

profit by entering into the following set of transactions.

1. On day one, sell the security in the cash/spot market at 1000.

2. Make delivery of the security.

3. Simultaneously, buy the futures on the security at 965.

4. On the futures expiration date, the spot and the futures price converge.

Now unwind the position.

5. Say the security closes at Rs.975. Buy back the security.

6. The futures position expires with a profit of Rs.10.

7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on

the futures position.


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If the returns you get by investing in riskless instruments is less than the return

from the arbitrage trades, it makes sense for you to arbitrage. This is termed as

reversecashandcarry arbitrage. It is this arbitrage activity that ensures that the

spot and futures prices stay in line with the costofcarry. As we can see,

exploiting arbitrage involves trading on the spot market. As more and more

players in the market develop the knowledge and skills to do cashandcarry and

reverse cashandcarry, we will see increased volumes and lower spreads in both

the cash as well as the derivatives market.


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CONCLUSION

Arbitrage is the practice of taking advantage of a state of imbalance between two

(or possibly more) markets. A combination of matching deals are struck that

exploit the imbalance, the profit being the difference between the market prices. A

person who engages in arbitrage is called an arbitrageur.

Arbitrage is the safest way to make money in the market. However, the scope for

making money is diminutive. With the help of the arbitrage strategies discussed

above, we can exploit the market condition and earn risk-free return.

Arbitrage is game of strategy and also funds. A participant with ample funds can

easily earn risk-free returns. On the other hand, a strategist can make risk-less

profits by making use of mis-pricing in the market.

Arbitrage could be inter-exchange, NSE and BSE. Arbitrage could also be

between two segments of the market, Cash and F&O.

Borrowing and lending is a common practice in arbitrage transaction, therefore,

bank and financial institution are very active in arbitrage activities.

The above states strategies cover all the types of arbitrage possibilities using

equity derivatives.


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SPECULATION STRATEGIES


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SPECULATION: BULLISH INDEX, LONG NIFTY FUTURES

Do you sometimes think that the market index is going to rise? Could you make a

profit by adopting a position on the index? After a good budget, or good corporate

results, or the onset of a stable government, many people feel that the index would

go up. How does one implement a trading strategy to benefit from an upward

movement in the index? Today, you have two choices:

1. Buy selected liquid securities which move with the index, and sell them at

a later date: or,

2. Buy the entire index portfolio and then sell it at a later date.

The first alternative is widely used a lot of the trading volume on liquid

securities is based on using these liquid securities as an index proxy. However,

these positions run the risk of making losses owing to companyspecific news;

they are not purely focused upon the index. The second alternative is cumbersome

and expensive in terms of transactions costs.

Taking a position on the index is effortless using the index futures market. Usingindex futures, an investor can buy or sell the entire index by trading on one

single security. Once a person is LONG NIFTY using the futures market, he gains

if the index rises and loses if the index falls.


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Methodology

When you think the index will go up, buy the Nifty futures. The minimum

market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in

units of Rs.240,000. When the trade takes place, the investor is only required to

pay up the initial margin, which is something like Rs.20,000. Hence, by paying an

initial margin of Rs.20,000/-, the investor gets a claim on the index worth

Rs.240,000. Similarly, by paying up Rs.200,000/-, the investor gets a claim on

Nifty worth Rs.2.4 million.

Futures are available at several different expirations. The investor can

choose any of them to implement this position. The choice is basically about the

horizon of the investor. Longer dated futures go well with longterm forecasts

about the movement of the index. Shorter dated futures tend to be more liquid.


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Example

1. On 1 July 2001, Milan feels the index will rise.

2. He buys 200 Nifties with expiration date on 31st July 2001.

3. At this time, the Nifty July contract costs Rs.960 so his position is worth

Rs.192,000/-.

4. On 14 July 2001, Nifty has risen to 967.35.

3. The Nifty July contract has risen to Rs.980/-.

4. Milan sells off his position at Rs.980/-.

5. His profits from the position are Rs.4000/-.


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SPECULATION: BEARISH INDEX, SHORT NIFTY FUTURES

Do you sometimes think that the market index is going to fall? Could you make a

profit by adopting a position on the index? After a bad budget, or bad corporate

results, or the onset of a coalition government, many people feel that the index

would go down. How does one implement a trading strategy to benefit from a

downward movement in the index? Today, you have two choices:

1. Sell selected liquid securities which move with the index, and buy them at

a later date: or,

2. Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used a lot of the trading volume on liquid

securities is based on using these securities as an index proxy. However, these

positions run the risk of making losses owing to companyspecific news; they are

not purely focused upon the index.

The second alternative is hard to implement. This strategy is also cumbersome

and expensive in terms of transactions costs. Taking a position on the index is

effortless using the index futures market. Using index futures, an investor can

buy or sell the entire index by trading on one single security. Once a person is

SHORT NIFTY using the futures market, he gains if the index falls and loses if

the index rises.


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Methodology

When you think the index will go down, sell the Nifty futures. The

minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is

done in units of Rs.240,000. When the trade takes place, the investor is only

required to pay up the initial margin, which is something like Rs.20,000. Hence,

by paying an initial margin of Rs.20,000 the investor gets a claim on the index

worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim

on Nifty worth Rs.2.4 million.

Futures are available at several different expirations. The investor can

choose any of them to implement this position. The choice is basically about the

horizon of the investor. Longer dated futures go well with longterm forecasts

about the movement of the index. Shorter dated futures tend to be more liquid.


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Example

1. On 1 June 2001, Milan feels the index will fall.

2. He sells 200 Nifties with a expiration date of 26th June 2001.

3. At this time, the Nifty June contract costs Rs.1,060 so his position is worth

Rs.212,000/-.

4. On 10 June 2001, Nifty has fallen to 962.90.

5. The Nifty June contract has fallen to Rs.990/-. Milan squares off his

position.

6. His profits from the position work out to be Rs.14,000/-


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CONCLUSION

Speculation has a lot of risks involved. Specially speculation in derivates is even

more riskier as the derivatives are leveraged instruments.

Speculator is responsible for liquidity in the market. Major part of the market

volumes come from speculation, be it cash market or the F&O segment.

Market participants to speculate extensively use Index futures and stock futures.

Index futures attract the maximum volumes in the derivatives segment.

Speculation in option is not very common, because buying an option is highly

leveraged transaction.

Speculation in options is naked positions, which are very risky.

Speculation in the market i