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TRANSCRIPT
AProject Report
On
“COMPARATIVE STUDY ON DERIVATIVE MARKET”
At
Sharekhan Limited
Dissertation Submitted
In The Partial Fulfillment for the Award of the Degree
“MASTERS PROGRAMME IN INTERNATIONAL BUSINESS”
In Finance
Submitted By
Under the guidance of
Mr. K. P. Singh
----------Designation--------
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CERTIFICATE
This is to certify that the Project Work entitled “COMPARATIVE STUDY ON
DERIVATIVE MARKET” in Sharekhan Limited, Ameerpet, is a bonafied work
of in partial fulfillment of the requirements for the award of the degree of
“MASTERS PROGRAMME IN INTERNATIONAL BUSINESS”.
Mr. K. P. Singh
(Internal Project Guide) (External Examination) (Department of Management Studies)
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DECLARATION
I hereby declare that the project report titled “COMPARATIVE STUDY ON DERIVATIVE
MARKET” submitted in partial fulfillment of the requirements for the POST GRADUATION
of “MASTERS PROGRAMME IN INTERNATIONAL BUSINESS”, from is a bonafide
work carried out by me under the guidance of Mr. K. P. Singh, ------designation-----,
Further, the project report work is the result of my own efforts and is not submitted to
any other University for the award of any other Degree, Diploma, Fellowship or prizes.
Date:
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ACKNOWLEDGEMENT
I take this opportunity to acknowledge, all the people who rendered their valuable advice and
support in bringing the project to function.
As part of cirriculum at “”. The project enables us to enhance our skills, expand our knowledge
by applying various theories, concepts and laws to real life scenario which would further
prepare us to face the extremely “Competitive Corporate World” in the near future.
I express my sincere gratitude to the staff of Hyderabad. I specially thank “THE
MANAGEMENT AND STAFF OF SHAREKHAN LIMITED” for creating out the study
and for their guidance and encouragement that made the project very effective and easy.
I sincerely express my gratitude to MR. K. P. SINGH----desgnation------- – SHAREKHAN
LIMITED, for his valuable guidance and cooperation throughout my project work.
I would like to thank Mr. K. P. Singh and Mr. Ajay , for guiding and directing me in the
process of making this project report and for all the support and encouragement.
I am grateful to our Internal Faculty for his support and assistance in my project work.
I have tried my level best to put my experience and analysis in making this report. I am grateful
to Sharekhan Limited as an organization and its various employees for helping me to learn and
explore many fields.
Index
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INDUSTRY PROFILE
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INDUSTRY PROFILE
Following diagram gives the structure of Indian financial system:
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FINANCIAL MARKET:
Financial markets are helpful to provide liquidity in the system and for smooth functioning
of the system. These markets are the centers that provide facilities for buying and selling of
financial claims and services. The financial markets match the demands of investment with
the supply of capital from various sources.
According to functional basis financial markets are classified into two types.
They are:
Money markets (short-term)
Capital markets (long-term)
According to institutional basis again classified in to two types. They are
Organized financial market
Non-organized financial market.
The organized market comprises of official market represented by recognized institutions,
bank and government (SEBI) registered/controlled activities and intermediaries. The
unorganized market is composed of indigenous bankers, moneylenders, individual
professional and non-professionals.
MONEY MARKET:
Money market is a place where we can raise short-term capital.
Again the money market is classified in to
Inter bank call money market
Bill market and
Bank loan market Etc.
E.g.; treasury bills, commercial papers, CD's etc.
CAPITAL MARKET:
Capital market is a place where we can raise long-term capital.
Again the capital market is classified in to two types and they are
Primary market and
Secondary market.
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E.g.: Shares, Debentures, and Loans etc.
PRIMARY MARKET: Primary Market
Primary market is generally referred to the market of new issues or market for mobilization
of resources by the companies and government undertakings, for new projects as also for
expansion, modernization, addition, diversification and up gradation. Primary market is also
referred to as New Issue Market. Primary market operations include new issues of shares by
new and existing companies, further and right issues to existing shareholders, public offers,
and issue of debt instruments such as debentures, bonds, etc.
The primary market is regulated by the Securities and Exchange Board of India (SEBI), a
government regulated authority).
FUNCTION:
The main services of the primary market are origination, underwriting, and distribution.
Origination deals with the origin of the new issue. Underwriting contract make the shares
predictable and remove the element of uncertainty in the subscription. Distribution refers to
the sale of securities to the investors.
The following are the market intermediaries associated with the market:
1. Merchant banker/book building lead manager
2. Registrar and transfer agent
3. Underwriter/broker to the issue
4. Adviser to the issue
5. Banker to the issue
6. Depository
7. Depository participant
INVESTORS’ PROTECTION IN THE PRIMARY MARKET:
Investors’ Protection in the Primary Market
To ensure healthy growth of primary market, the investing public should be protected. The
term investor protection has a wider meaning in the primary market. The principal
ingredients of investors’ protection are:
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Provision of all the relevant information
Provision of accurate information and
Transparent allotment procedures without any bias.
SECONDARY MARKET
The primary market deals with the new issues of securities. Outstanding securities are traded
in the secondary market, which is commonly known as stock market or stock exchange.
“The secondary market is a market where scrip’s are traded”. It is a market place which
provides liquidity to the scrip’s issued in the primary market. Thus, the growth of secondary
market depends on the primary market. More the number of companies entering the primary
market, the greater are the volume of trade at the secondary market. Trading activities in the
secondary market are done through the recognized stock exchanges which are 23 in number
including Over the Counter Exchange of India (OTCE), National Stock Exchange of India
and Interconnected Stock Exchange of India.
Secondary market operations involve buying and selling of securities on the stock exchange
through its members. The companies hitting the primary market are mandatory to list their
shares on one or more stock exchanges in India. Listing of scrip’s provides liquidity and
offers an opportunity to the investors to buy or sell the scrip’s.
The following are the intermediaries in the secondary market:
1. Broker/member of stock exchange – buyers broker and sellers broker
2. Portfolio Manager
3. Investment advisor
4. Share transfer agent
5. Depository
6. Depository participants.
STOCK MARKETS IN INDIA:
Stock exchanges are the perfect type of market for securities whether of government and
semi-govt bodies or other public bodies as also for shares and debentures issued by the
joint-stock companies. In the stock market, purchases and sales of shares are affected in
conditions of free competition. Government securities are traded outside the trading ring in
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the form of over the counter sales or purchase. The bargains that are struck in the trading
ring by the members of the stock exchanges are at the fairest prices determined by the basic
laws of supply and demand.
Definition of a stock exchange:
“Stock exchange means any body or individuals whether incorporated or not, constituted for
the purpose of assisting, regulating or controlling the business of buying, selling or dealing
in securities.” The securities include:
Shares of public company.
Government securities.
Bonds
HISTORY OF STOCK EXCHANGES:
The only stock exchanges operating in the 19th century were those of Mumbai setup in 1875
and Ahmedabad set up in 1894. These were organized as voluntary non-profit-marking
associations of brokers to regulate and protect their interests. Before the control on securities
under the constitution in 1950, it was a state subject and the Bombay securities contracts
(control) act of 1925 used to regulate trading in securities. Under this act, the Mumbai stock
exchange was recognized in 1927 and Ahmedabad in 1937. During the war boom, a number
of stock exchanges were organized. Soon after it became a central subject, central legislation
was proposed and a committee headed by A.D.Gorwala went into the bill for securities
regulation. On the basis of the committee’s recommendations and public discussion, the
securities contract (regulation) act became law in 1956.
FUNCTIONS OF STOCK EXCHANGES:
Stock exchanges provide liquidity to the listed companies. By giving quotations to the listed
companies, they help trading and raise funds from the market. Over the hundred and twenty
years during which the stock exchanges have existed in this country and through their
medium, the central and state government have raised crores of rupees by floating public
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loans. Municipal corporations, trust and local bodies have obtained from the public their
financial requirements, and industry, trade and commerce- the backbone of the country’s
economy-have secured capital of crores or rupees through the issue of stocks, shares and
debentures for financing their day-to-day activities, organizing new ventures and completing
projects of expansion, diversification and modernization. By obtaining the listing and
trading facilities, public investment is increased and companies were able to raise more
funds. The quoted companies with wide public interest have enjoyed some benefits and
assets valuation has become easier for tax and other purposes.
VARIOUS STOCK EXCHANGES IN INDIA:
At present there are 23 stock exchanges recognized under the securities contracts
(regulation), Act, 1956. Those are:
1. Ahmedabad Stock Exchange Association Ltd.
2. Bangalore Stock Exchange
3. Bhubaneshwar Stock Exchange Association
4. Calcutta Stock Exchange
5. Cochin Stock Exchange Ltd.
6. Coimbatore Stock Exchange
7. Delhi Stock Exchange Association
8. Guwahati Stock Exchange Ltd
9. Hyderabad Stock Exchange Ltd.
10. Jaipur Stock Exchange Ltd
11. Kanara Stock Exchange Ltd
12. Ludhiana Stock Exchange Association Ltd
13. Madras Stock Exchange
14. Madhya Pradesh Stock Exchange Ltd.
15. Magadh Stock Exchange Limited
16. Meerut Stock Exchange Ltd.
17. Mumbai Stock Exchange
18. National Stock Exchange of India
19. OTC Exchange of India
20. Pune Stock Exchange Ltd.
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21. Saurashtra Kutch Stock Exchange Ltd.
22. Uttar Pradesh Stock Exchange Association
23. Vadodara Stock Exchange Ltd.
Out of these the major stock exchanges were:
1. NSE (National Stock Exchage)
2. BSE (Bombay Stock Exchange)
NSE (National Stock Exchage):
The National Stock Exchange of India Limited has genesis in the report of the High
Powered Study Group on Establishment of New Stock Exchanges, which recommended
promotion of a National Stock Exchange by financial institutions (FI’s) to provide access to
investors from all across the country on an equal footing. Based on the recommendations,
NSE was promoted by leading Financial Institutions at the behest of the Government of
India and was incorporated in November 1992 as a tax-paying company unlike other stock
exchanges in the country. On its recognition as a stock exchange under the Securities
Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the
Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities)
segment commenced operations in November 1994 and operations in Derivatives segment
commenced in June 2000
NSE's mission is setting the agenda for change in the securities markets in India. The NSE
was set-up with the main objectives of:
Establishing a nation-wide trading facility for equities and debt instruments.
Ensuring equal access to investors all over the country through an appropriate
communication network.
Providing a fair, efficient and transparent securities market to investors using electronic
trading systems.
Enabling shorter settlement cycles and book entry settlements systems, and
Meeting the current international standards of securities markets.
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The standards set by NSE in terms of market practices and technology, have become
industry benchmarks and are being emulated by other market participants. NSE is more than
a mere market facilitator. It's that force which is guiding the industry towards new horizons
and greater opportunities.
BSE (Bombay Stock Exchange):
The Stock Exchange, Mumbai, popularly known as "BSE" was established in 1875 as "The
Native Share and Stock Brokers Association". It is the oldest one in Asia, even older than
the Tokyo Stock Exchange, which was established in 1878. It is a voluntary non-profit
making Association of Persons (AOP) and is currently engaged in the process of converting
itself into demutualised and corporate entity. It has evolved over the years into its present
status as the premier Stock Exchange in the country. It is the first Stock Exchange in the
Country to have obtained permanent recognition in 1956 from the Govt. of India under the
Securities Contracts (Regulation) Act 1956.The Exchange, while providing an efficient and
transparent market for trading in securities, debt and derivatives upholds the interests of the
investors and ensures redresses of their grievances whether against the companies or its own
member-brokers. It also strives to educate and enlighten the investors by conducting
investor education programmers and making available to them necessary informative inputs.
A Governing Board having 20 directors is the apex body, which decides the policies and
regulates the affairs of the Exchange. The Governing Board consists of 9 elected directors,
who are from the broking community (one third of them retire ever year by rotation), three
SEBI nominees, six public representatives and an Executive Director & Chief Executive
Officer and a Chief Operating Officer.
The Executive Director as the Chief Executive Officer is responsible for the day-to-day
administration of the Exchange and the Chief Operating Officer and other Heads of
Department assist him.
The Exchange has inserted new Rule No.126 A in its Rules, Byelaws pertaining to
constitution of the Executive Committee of the Exchange. Accordingly, an Executive
Committee, consisting of three elected directors, three SEBI nominees or public
representatives, Executive Director & CEO and Chief Operating Officer has been
constituted. The Committee considers judicial & quasi matters in which the Governing
Board has powers as an Appellate Authority, matters regarding annulment of transactions, 14 | P a g e
admission, continuance and suspension of member-brokers, declaration of a member-broker
as defaulter, norms, procedures and other matters relating to arbitration, fees, deposits,
margins and other monies payable by the member-brokers to the Exchange, etc.
REGULATORY FRAME WORK OF STOCK EXCHANGE
Regulatory Frame Work of Stock Exchange
A comprehensive legal framework was provided by the “Securities Contract Regulation Act,
1956” and “Securities Exchange Board of India 1952”. Three tier regulatory structure
comprising
Ministry of finance
The Securities And Exchange Board of India
Governing body
MEMBERS OF THE STOCK EXCHANGE:
Members of The Stock Exchange
The securities contract regulation act 1956 has provided uniform regulation for the
admission of members in the stock exchanges. The qualifications for becoming a member of
a recognized stock exchange are given below:
The minimum age prescribed for the members is 21 years.
He should be an Indian citizen.
He should be neither a bankrupt nor compound with the creditors.
He should not be convicted for fraud or dishonesty.
He should not be engaged in any other business connected with a company.
He should not be a defaulter of any other stock exchange.
The minimum required education is a pass in 12th standard examination.
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
The securities and exchange board of India was constituted in 1988 under a resolution of
government of India. It was later made statutory body by the SEBI act 1992.according to
this act, the SEBI shall constitute of a chairman and four other members appointed by the
central government.
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With the coming into effect of the securities and exchange board of India act, 1992 some of
the powers and functions exercised by the central government, in respect of the regulation of
stock exchange were transferred to the SEBI.
OBJECTIVES AND FUNCTIONS OF SEBI
To protect the interest of investors in securities.
Regulating the business in stock exchanges and any other securities market.
Registering and regulating the working of intermediaries associated with securities
market as well as working of mutual funds.
Promoting and regulating self-regulatory organizations.
Prohibiting insider trading in securities.
Regulating substantial acquisition of shares and take over of companies.
Performing such functions and exercising such powers under the provisions of
capital issues (control) act, 1947and the securities to it by the central government.
SEBI GUIDELINES TO SECONDARY MARKETS: STOCK EXCHANGES
Board of Directors of Stock Exchange has to be reconstituted so as to include non-
members, public representatives and government representatives to the extent of 50% of
total number of members.
Capital adequacy norms have been laid down for the members of various stock
exchanges depending upon their turnover of trade and other factors.
All recognized stock exchanges will have to inform about transactions within 24 hrs.
TYPES OF ORDERS:
Buy and sell orders placed with members of the stock exchange by the investors. The orders
are of different types.
LIMIT ORDERS:
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Orders are limited by a fixed price. E.g. ‘buy Reliance Petroleum at Rs.50.’Here, the
order has clearly indicated the price at which it has to be bought and the investor is not
willing to give more than Rs.50.
Best rate order: Here, the buyer or seller gives the freedom to the broker to execute the order
at the best possible rate quoted on the particular date for buying. It may be lowest rate for
buying and highest rate for selling.
Discretionary order: The investor gives the range of price for purchase and sale. The broker
can use his discretion to buy within the specified limit. Generally the approximation price is
fixed. The order stands as this “buy BRC 100 shares around Rs.40”.
STOP LOSS ORDER:
The orders are given to limit the loss due to unfavorable price movement in the market.
A particular limit is given for waiting. If the price falls below the limit, the broker is
authorized to sell the shares to prevent further loss. E.g. Sell BRC limited at Rs.24, stop loss
at Rs.22.
Buying and selling shares: To buy and sell the shares the investor has to locate register
broker or sub broker who render prompt and efficient service to him. The order to buy or
sell specifying the number of shares of the company of investors’ choice is placed with the
broker. The order may be of any type. After receiving the order the broker tries to execute
the order in his computer terminal. Once matching order is found, the order is executed. The
broker then delivers the contract note to the investor. It gives the details regarding the name
of the company, number of shares bought, price, brokerage, and the date of delivery of
share. In this physical trading form, once the broker gets the share certificate through the
clearing houses he delivers the share certificate along with transfer deed to the investor. The
investor has to fill the transfer deed and stamp it. The stamp duty is one of the percentage
considerations, the investor should lodge the share certificate and transfer deed to the
register or transfer agent of the company. If it is bought in the DEMAT form, the broker has
to give a matching instruction to his depository participant to transfer shares bought to the
investors account. The investor should be account holder in any of the depository
participant. In the case of sale of shares on receiving payment from the purchasing broker,
the broker effects the payment to the investor.
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Share groups: The scrips traded on the BSE have been classified into
‘A’,’B1’,’B2’,’C’,’F’ and ‘Z’ groups. The ‘A’ group represents those, which are in the carry
forward system. The ‘F’ group represents the debt market segment (fixed income securities).
The Z group scrips are of the blacklisted companies. The ‘C’ group covers the odd lot
securities in ‘A’, ‘B1’&’B2’ groups.
ROLLING SETTLEMENT SYSTEM:
Under rolling settlement system, the settlement takes place in days (usually 1, 2, 3 or
5days) after the trading day. The shares bought and sold are paid in for n days after the
trading day of the particular transaction. Share settlement is likely to be completed much
sooner after the transaction than under the fixed settlement system.
The rolling settlement system is noted by T+N i.e. the settlement period is n days after
the trading day. A rolling period which offers a large number of days negates the advantages
of the system. Generally longer settlement periods are shortened gradually.
SEBI made RS compulsory for trading in 10 securities selected on the basis of the
criteria that they were in compulsory demat list and had daily turnover of about Rs.1 crore
or more. Then it was extended to “A” stocks in Modified Carry Forward Scheme,
Automated Lending and Borrowing Mechanism (ALBM) and Borrowing and lending
Securities Scheme (BELSS) with effect from Dec 31, 2001.
SEBI has introduced T+5 rolling settlement in equity market from July 2001 and
subsequently shortened the cycle to T+3 from April 2002. After the T+3 rolling settlement
experience it was further reduced to T+2 to reduce the risk in the market and to protect the
interest of the investors from 1st April 2003.
Activities on T+1: conformation of the institutional trades by the custodian is sent to the
stock exchange by 11.00 am. A provision of an exception window would be available for
late confirmation. The time limit and the additional changes for the exception window are
dedicated by the exchange.
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The exchanges/clearing house/ clearing corporation would process and download the
obligation files to the broker’s terminals late by 1.30 p.m on T+1. Depository participants
accept the instructions for pay in securities by investors in physical form upto 4 p.m and in
electronic form upto 6 p.m. the depositories accept from other DPs till 8p.m for same day
processing.
Activities on T+2: The depository permits the download of the paying in files of
securities and funds till 10.30 a.m on T+2 from the brokers’ pool accounts. The depository
processes the pay in requests and transfers the consolidated pay in files to clearing
House/clearing Corporation by 11.00am/on T+2. The exchange/clearing house/clearing
corporation executes the pay-out of securities and funds latest by 1.30 p.m on T+2 to the
depositories and clearing banks. In the demat mode net basis settlement is allowed. The buy
and sale positions in the same scrip can be settled and net quantity has to be settled.
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COMPANY PROFILE
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SHAREKHAN LIMITED
Introduction
Sharekhan Limited is one of the fastest growing financial services providers with a focus
on equities, derivatives and commodities brokerage execution on the National Stock Exchange
of India Ltd. (NSE), Bombay Stock Exchange Ltd. (BSE), National Commodity and Derivatives
Exchange India (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX). Sharekhan
provides trade execution services through multiple channels - an Internet platform, telephone
and retail outlets and is present in 280 cities through a network of 704 locations. The company
was awarded the 2005 Most Preferred Stock Broking Brand by Awwaz Consumer Vote.
Origin
Sharekhan traces its lineage to SSKI, an organization with more than decades of trust
and credibility in the stock market.
Pioneers of online trading in India- Sharekhan.com was launched in 2000 and is now the
second most visited broking site in India.
Has one of the largest networks of Share shops in the country.
Shareholding Pattern
SHAREHOLDERS HOLDINGS
CITI Venture Capital and other Private Equity Firm 81%
IDFC 9%
Employees 10%
Managrment Team
NAME POST
Tarun Shah Chief Executive Officer
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Mr. Pathik Gandotra Head Of Research
Mr. Rishi Kohli Vice President Of Equity Derivative
Jaideep Arora Director- Products And Technology
Shankar Vailaya Director- Operation
Sharekhan Limited offers blend of tradition and technology like Share shops, dial-n-trade and
online trading- where there is choice of three trading interfaces which are speed trade exe for
active trader, web based classic interface for investor, web based applet- fast trade for investor.
Sharekhan Limited was formerly known as SSKI Investor Services Private Limited. The
company is based in Mumbai, India and its address is:
A-206 Phoenix House, 2nd Floor
Senapati Bapat Marg, Lower Parel
Mumbai, 400 013. India
Phone: 91 22 24982000
Fax: 91 22 24982626
www.sharekhan.com
Advanced Technology Used By Sharekhan
Sharekhan selected Aspect® EnsemblePro™ from the Aspect Software Unified IP Contact
Center product line, a unified contact centre solution delivering advanced multichannel contact
capabilities, because it provided the best total value over other solutions evaluated. It enabled
Sharekhan to meet customer service needs for inbound call handling, voice self service,
predictive outbound dialing, call blending, call monitoring and recording, and creating outbound
marketing campaigns, among other capabilities. This helps them to
Increased agent efficiency and productivity.
Enabled company to execute proactive customer service calls and expand services
offered to customers.
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Enhanced call monitoring for improved service quality
Financial services are a highly competitive and volume-driven industry which demands high
standards of customer service, effective consultation and quick deliverables. This is something
Sharekhan Limited, a financial services provider based in India, understands. The company
offers several user-friendly services for customers to manage their stock portfolios, including
online capabilities linked to an information database to help customers confidently invest, and
inbound customer services using voice self-service technology and customer service agents
handling telephone orders from clients.
With a customer base of more than 500000, and a employee of 3100 Sharekhan continues to
grow at a fast pace. Customer satisfaction is a top priority in Sharekhan’s agenda.
Its primary objective
Is to help and support its customers in managing their portfolio in the best possible
manner through quality advice, innovative product and superior service.
Scheme which are provided by Sharekhan cover almost every segment of the customer-
SCHEME INVESTOR
First Step New Comer
Classic Trade Occasionally
Speed Trade Day Trader
Platinum Circle High Net Worth Individuals
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DERIVATIVES
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Introduction
Derivatives are products whose value is derived from one or more variables called bases.
These bases can be underling asset such as foreign currency, stock or commodity, bases or
reference rates such as LIBOR or US treasury rate etc. For example, an Indian exporter in
anticipation of the receipt of dollar denominated export proceeds may wish to sell dollars at a
future date to eliminate the risk of exchange rate volatility by the data. Such transactions are
called derivatives, with the spot price of dollar being the underling asset.
Derivatives thus have no value of their own but derive it from the asset that is being
dealt with under the derivative contract. A financial manager can hedge himself from the risk of
a loss in the price of a commodity or stock by buying a derivative contract. Thus derivative
contracts acquire their value from the spot price of the asset that is covered by the contract.
The primary purposes of a derivative contract is to transfer “risk” from one party to
another i.e. risk in a financial sense is transfer from a party that is willing to take it on. Here, the
risk that is being dealt with is that of price risk. The transfer of such a risk can therefore be
speculative in nature or act as a hedge against price movement in a current or anticipated
physical position.
Derivatives or derivative securities are contracts which are written between two parties
(counterparties) and whose value is derived from the value of underlying widely-held and easily
marketable assets such as agricultural and other physical (tangible) commodities or currencies
or short term and long-term and long term financial instruments or intangible things like
commodities price index (inflation rate), equity price index or bond piece index. The
counterparties to such contracts are those other than the original issuer (holder) of the
underlying asset.
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Derivatives are also known as “deferred delivery or deferred payment instruments”. In a sense,
they are similar to securitized assets, but unlike the latter, they are not the obligations which are
backed by the original issuer of the underlying asset or security. It is easier to take a short
position in derivatives than in other possible to combine them to match specific requirements,
i.e., they are more easily amenable to financial engineering.
The values of derivatives and those of their underlying assets are closely related.
Usually, in trading derivatives, the taking or making of delivery of underlying assets is not
involved; the transactions are mostly settled by taking offsetting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of claims which can be traded
in respect of underlying assets. Derivatives are “off balance sheet” instruments, a fact that is
said to obscure the leverage and financial might they give to the party. They are mostly
secondary market instruments and have little usefulness in mobilizing fresh capital by the
companies (warrants, convertibles being the exceptions). Although the standardized, general,
exchange-traded derivatives are being contracts which are in vogue and which expose the users
to operational risk, counterparty risk, liquidity risk, and legal risk. There is also an uncertainty
about the regulatory status of such derivatives.
There are bewilderingly complex varieties of derivatives already in existence, and the
markets are innovating newer and newer ones continuously: plain, simple or straightforward,
composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC-traded,
standardized or organized-exchange traded. Although we are not going to discuss all of them,
the names of certain derivatives may be noted here: futures, options, range forward and ratio
range forward options, swaps, warrants, convertible bonds, credit derivatives, captions,
swaptions, futures options, the ratio swaps, periodic floors, spread lock one and two, treasury-
linked swaps, wedding bands three and six, inverse floaters, index amortizing swaps, and so on;
because of their complexity, derivatives have become a continuing pain for the accounting
person and a true mind-bender for anyone trying to value them.
The turnover of the stock exchanges has been tremendously increasing from last 10
years. The number of trades and the number of investors, who are participating, have increased.
The investors are willing to reduce their risk, so they are seeking for the risk management tools.
Mutual funds, FIIs and other investors who are deprived of hedging (i.e. risk reducing)
opportunities will now have a derivatives market to bank on.
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While derivatives markets flourished in the developed world, Indian markets remain
deprived of financial derivatives to the beginning of this millennium. While the rest of the
world progressed by leaps and bounds on the derivatives front, Indian market lagged behind.
Having emerged in the markets of the developed nations in the 1970s, derivatives markets grew
from strength to strength. The trading volumes nearly doubled in every three years making it a
trillion-dollar business. They became so ubiquitous that, now, one cannot think of the existence
of financial markets without derivatives.
Two broad approaches of SEBI is to integrate the securities market at the national level,
and to diversify the trading products, so the more number of traders including banks, financial
institutions, insurance companies, mutual funds, primary dealers etc., choose to transact through
the exchanges. In this context the introduction of derivatives trading through Indian Stock
Exchanges permitted by SEBI exchange in the year 2000 is a real landmark.
Prior to SEBI abolishing the BADLA system, the investors had this system as a source
of reducing the risk, as it has many problems like no strong margining system, unclear
expiration date and generating counter party risk. In view of this problem SEBI abolished the
BADLA system.
After the abolition of the BADLA system, the investors are seeking for a hedging
system, which could reduce their portfolio risk. SEBI thought the introduction of the
derivatives trading, as a first step it has set up a 24 member committee under the chairmanship
of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivative trading in
India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the
phased introduction of the derivatives trading beginning with stock index futures. The Board
also approved the “suggestive bye-laws” recommended for regulation and control of trading and
settlement of derivatives contracts.
However the securities contracts (regulation) act, 1956 (SCRA) needed amendment to
include “derivatives” in the definition of securities to enable SEBI to introduce trading in
derivatives. The government in the year 1999 carried out the necessary amendment. The
securities Laws (Amendment) bill 1999 was introduced to bring about the much needed
changes. In December 1999 the new framework has been approved derivatives have been
accorded the status of ‘securities’. The ban imposed on trading in derivatives way back in 1999
27 | P a g e
under a notification issued by the central Government has been revoked. Thereafter SEBI
formulated the necessary regulations/bye-laws and started in India at NSE in the same year and
BSE started in the year 2001. In this module we are covering the different types of derivatives
products and their features, which are traded in the stock exchanges in India.
Nature of the problem
The turnover of the stock exchanges has been tremendously increasing from last
10 years. The number of trades and the number of investors, who are participating, have
increased. The investors are willing to reduce their risk, so they are seeking for the risk
management tools.
Prior to SEBI abolishing the BADLA system, the investors had this system as a
source of reducing the risk, as it has many problems like no strong margining system, unclear
expiration date and generating counter party risk. In view of this problem SEBI abolished the
BADLA system.
After the abolition of the BADLA system, the investors are seeking for a hedging
system, which could reduce their portfolio risk. SEBI thought the introduction of the
derivatives trading, as a first step it has set up a 24 member committee under the chairmanship
of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivative trading in
India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the
phased introduction of the derivatives trading beginning with stock index futures.
There are many investors who are willing to trade in the derivative segment,
because of its advantages like limited loss and unlimited profit by paying the small premiums.
Objectives of the Study
To analyze the derivatives market in India.
To analyze the operations of futures and options.
To find out the profit/loss position of the option writer and option holder.
To study about risk management with the help of derivatives.
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Scope of the Study
The study is limited to “Derivatives” with special reference to futures and options in the
Indian context and the Hyderabad stock exchange has been taken as a representative sample for
the study. The study can’t be said as totally perfect. Any alteration may come. The study has
only made a humble attempt at evaluating derivatives market only in Indian context. The study
is not based on the international perspective of derivatives markets, which exists in NASDAQ,
NYSE etc.
Limitations of the Study:
The following are the limitations of this study:
The scrip chosen for analysis is ONGC and the contract taken is August and September
2005.
The data collected is completely restricted to the ONGC of August and September 2005.
Hence this analysis cannot be taken as universal.
The term “Derivative” indicates that it has no independent value, i.e. its value is entirely
derived from the value of the underlying asset. The underlying asset can be securities,
commodities, bullion, currency, livestock or anything else. In other words, derivative means a
forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for
the purpose of contract fulfillment to the value of a specified real or financial asset or to an
index of securities.
Definition
Derivative is a product whose value is derived from the value of an underlying asset in a
contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to include:-
1. A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security.
29 | P a g e
2. A contract, which derives its value from the prices, or index of prices, of underlying
securities.
The above definition conveys:
i. That derivative is financial products and derives its value from the underlying
assets.
ii. Derivative is derived from another financial instrument/contract called the
underlying. In this case of nifty index is the underlying.
Participants/Uses of Derivatives:
1. Hedgers use for protecting (risk-covering) against adverse movement. Hedging is a
mechanism to reduce price risk inherent in open positions. Derivatives are widely used for
hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a
portfolio, by reducing the risk.
2. Speculators to make quick fortune by anticipating/forecasting future market
movements. Speculators wish to bet on future movements in the price of an asset. Futures and
options contracts can give them an extra leverage; that is, they can increase both the potential
gains and potential losses in a speculative venture. Speculators on the other hand arte those
classes of investors who willingly take price risks to profit from price changes in the
underlying.
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3. Arbitrageurs to earn risk-free profits by exploiting market imperfections.
Arbitrageurs profit from price differential existing in two markets by simultaneously operating
in the two different markets. Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets.
FUNCTIONS OF DERIVATIVES MARKET:
The following are the various functions that are performed by the derivatives markets. They
are:
Prices in an organized derivatives market reflect the perception of market participants about
the future and lead the prices of underlying to the perceived future level.
Derivatives market helps to transfer risks from those who have them but may not like them
to those who have an appetite for them.
Derivative trading acts as a catalyst for new entrepreneurial activity.
Derivatives markets help increase savings and investment in the long run.
TYPES OF DERIVATIVES:
Derivative products initially emerged as hedging devices against fluctuations in
commodity prices, and commodity-linked derivatives remained the sole form of such products
for almost three hundred years. Financial derivatives came into spotlight in the post-1970
period due to growing instability in the financial markets. However, since their emergence,
these products have become very popular and by 1990s, they accounted for about two-thirds of
total transactions in derivative products, in recent years, the market for financial derives has
grown tremendously in terms of variety of instruments depending on their complexity and also
turnover. In this class of equity derivatives the world over, futures and options on stock indices
have gained more popularity than on individual stocks, especially among institutional investors,
who are maor users of index-linked derivatives. Even small investors find these useful due to
high correlation of the popular indices with various portfolios and ease of use. The lower costs
associated with index derivatives vis-à-vis derivative products based on individual securities is
another reason for their growing use.
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The most commonly used derivatives contracts are forwards, futures and options. Here we take
a brief look at various derivatives contracts that have come to be used.
CLASSIFICATION OF DERIVATIVES:
1. ETF (Exchange Traded Fund)
2. OTF ( Out Side Traded Fund)
ETF (Exchange Traded Fund):
An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges,
much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately
the same price as the net asset value of its underlying assets over the course of the trading
day.
Futures
Options
OTF (Out Side Traded Fund):
Forwards
Swaps
Warrants
Leaps
Baskets
OTF (FORWARDS, SWAPS, WARRANTS, LESAPS, BASKETS)
FORWARDS:
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A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.
FUTURES:
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward contracts in
the sense that the former are standardized exchanged-traded contracts.
OPTIONS:
Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
WARRANTS:
Options generally have lives of up to one year; the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
LEAPS:
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of up to three years.
BASKETS:
Basket options are options on portfolios of underlying assets. The underlying asset is
usually a moving average of a basket of assets. Equity index options are a form of basket
options.
SWAPS:
Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
The two commonly used swaps are:
Interest rate swaps:
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These entail swapping only the interest related cash flows between the parties in the
same currency.
Currency swaps:
These entail swapping both principal and interest between the parties, with the cash flows in
one direction being in a different currency than those in the opposite Direction.
SWAPTIONS:
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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REGULATORY FRAMEWORK
REGULATORY FRAMEWORK
The trading of derivatives is governed by the provisions contained in the SCRA, the SEBI
Act, the rules and regulations framed there under and the rules and bye-laws of stock
exchanges.
Securities contracts Regulation Act, 1956
SCRA aims at preventing undesirable transactions in securities by regulating the
business of dealing therein and by providing for certain other matters connected therewith.
This is the principal Act, which governs the trading of securities in India. The term
“securities” has been defined in the SCRA. As per section 2(h), the ‘securities’ include:
1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate.
2. Derivative
3. Units or any other instrument issued by any collective investment scheme to the
investors in such schemes
4. Government securities
5. Such other instruments as may be declared by the Central Government to be securities
6. Rights or interests in securities.
“Derivative” is defined to include:
A security derived from a debt instrument, share and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security.
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A contract which derives its value from the prices or index of prices, of underlying
securities.
Section 18A provides that notwithstanding anything contained in any other law for
the time being in force, contracts in derivatives shall be legal and valid if such
contracts are:
Traded on a recognized stock exchange settled on the clearinghouse of the
recognized stock exchange, in accordance with the rules and byelaws of such stock
exchanges.
Securities and exchange board of India act, 1992
SEBI act, 1992 provides for establishment of securities and exchange board of India (SEBI)
with statutory powers for (a) protecting the interests of investors in securities
(b) Promoting the development of the securities market and (c) regulating the securities
market. Its regulatory jurisdiction extends over corporates in the issuance of capital and
transfer of securities, in addition to all intermediaries and persons associated with securities
market. SEBI has been obligated to perform the aforesaid functions by such measures as it
thinks fit.
In particular, it has powers for:
Regulating the business in stock exchanges and any other securities markets.
Registering and regulating the working of stockbrokers, sub broker etc.
Promoting and regulating self-regulatory organizations.
Prohibiting and fraudulent and unfair trade practices.
Calling information from, undertaking inspection, conducting inquiries and audits the
stock exchanges, mutual funds and other persons associated with the securities marker and
intermediaries and self-regulatory organizations in the securities market performing such
functions and exercising according the securities contracts (regulation) act, 1956, as may be
delegated to it by the central government.
SEBI (stock brokers and sub-brokers) regulations, 1992
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In this we shall have a look at the regulations that apply to brokers under the SEBI
regulations.
Brokers:
A broker is an intermediary who arranges to buy and sell securities on behalf of
clients (the buyer and the seller). According to Section 2(e) of the SEBI (stockbrokers and
sub-brokers) rules 1992, s Stock Broker means a member of a recognized stock exchange.
NO stockbroker is allowed to buy, sell or deal in securities, uses he or she holds a certificate
of registration granted by SEBI through a stock exchange of which he or she is admitted as a
member. SEBI may grant a certificate to a stock-broker (as per SEBI rules, 1992) subject to
the conditions that:
1. He holds the membership of any stock exchange:
2. He shall abide by the rules, regulations and byelaws of the stock exchange or stock
exchanges of which he is a member.
3. In case of any change in the status and condition, he shall contain prior permission of
SEBI to continue to buy, sell or deal in securities in any stock exchange;
4. He shall pay the amount of fees for registration in the prescribed manner; and
5. HE shall take adequate steps for redress of grievances of the investors within one month
of the date of the complaint and keep SEBI informed about the number, nature and
other particulars of the complaints.
As per SEBI (stock brokers and sub-brokers) regulations, 1992, SEBI shall take into
account for considering the grant of a certificate all matters relating to buying, selling, or
dealing in securities and in particular the following, namely whether the stockbroker-(a) is
eligible to be admitted as a member of a stock exchange; (b)has the necessary infrastructure
like adequate office space, equipment and man power to effectively discharge his activities;
(c) has any past experience in the business of buying selling or dealing in securities; (D) is
subjected to disciplinary proceedings under the rules, regulations and bye-laws of a stock
exchange with respect to his business as a stock-brokers involving either himself or any of
his partners, directors or employees.
Regulations for derivatives trading
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SEBI set up a 24-member committee under the chairmanship of Dr.L.C.Gupta to
develop the appropriate regulatory framework for derivatives trading in India. The
committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the
recommendations of the committee and approved the phased introduction of derivatives
trading in India beginning with tock index futures. SEBI also approved the “suggestive bye-
laws” recommended by the committee for regulation and “suggestive bye-laws”
recommended by the committee for regulation and control of trading and settlement of
derivatives contracts.
1. The provisions in the SC(R)A and regulatory framework developed there
under govern trading in securities.
2. The amendment of the SC(R)A to include derivatives within the ambit of
‘securities’ in the securities in the SC(R)A made trading in derivatives
possible within the framework of that Act.
3. Any Exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta
committee report may apply to SEBI for grant of recognition under section 4
of the SC(R) A, 1956 to start trading derivatives. The derivatives
exchange/segment should huge a separate governing council and
representation of trading/clearing members shall be limited to maximum of
40% of the total members of the governing council. The exchange shall
regulate the sales practice of its members and will obtain prior approval of
SEBI before start of trading in any derivative contact.
4. The Exchange shall have minimum 50 members.
5. The members of an existing segment of the exchange will not automatically
become the members of the derivative segment need to fulfill the eligibility
conditions as laid down by the L.C.Gupta committee.
6. The clearing and settlement of derivatives trades shall be through a SEBI
approved clearing corporation/house. Clearing corporations/houses complying
with the eligibility conditions a s laid down by the committee have to apply
SEBI for grant of approval.
7. Derivative brokers/dealers and clearing members are required to seek
registration from SEBI. This is in addition to their registration a brokers of
existing stock exchanges. The minimum net worth for clearing members of
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the derivatives clearing corporation/house shall be Rs.300 lakhs. The net
worth of the member shall be computed as follows:
Capital+Free reserves
Less non-allowable assets viz,
(a) Fixed assets
(b) Pledged securities
(c) Member’s card
(d) Non-allowable securities (unlisted securities)
(e) Bad deliveries
(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities
6. The minimum contract value shall not be less than Rs.2 lakhs. Exchanges should also
submit details of the futures contract they propose to introduce.
7. The initial margin requirement exposure limits linked to capital adequacy and
SEBI/Exchange shall prescribe margin demands related to the risk of loss on the
position from time to time.
8. The L.C.Gupta committee report requires strict enforcement of “Know you customer”
rule and requires that every client shall be registered with the derivatives broker. The
members of the derivatives segment are also required to make their clients aware of the
risks involved in derivatives trading by issuing to the client the Risk Disclosure
Document and obtain a copy of the same duly signed by the client.
9. The trading members are required to have qualified approved user and sales person
who have passed a certification programme approved by SEBI.
REGULATION FOR CLEARING AND SETTLEMENT
1) The L.C.Gupta committee has recommended that the clearing corporation should
interpose itself between both legs of every trade, becoming the legal counter party to
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both or alternati9vely should provide an unconditional guarantee for settlement of all
trades.
2) The clearing corporation should ensure that none of the Board members has trading
interests.
3) The definition of net-worth as prescribed by SEBI needs to be incorporated in the
application/regulations of the clearing corporation
4) The regulations relating to arbitration need to be incorporated in the clearing
corporation’s regulations.
5) The clearing corporation in its regulations must incorporate specific provision/chapter
relating to declaration of default.
6) The regulations relating to investor protection fund for the derivatives market must be
included in the clearing corporation application/regulations.
7) The clearing corporation should have the capabilities to segregate upfront initial
margins deposited by clearing members for trades on their own account and on account
of his clients. The clearing corporation shall hold the clients’ margin money in trust for
the clients’ purposes only and should not allow its diversion for any other purpose.
This condition must be incorporated in the clearing corporation regulations
8) The clearing member shall collect margins from his constituents (client/trading
members). He shall clear and settle deals in derivative contracts on behalf of the
constituents only on the receipt of such minimum margin.
9) Exposure limits based on the value at its risk concept will be used and the exposure
limits will be continuously monitored. These shall be within the limits prescribed by
SEBI from time to time.
10) The clearing corporation must lay down a procedure for periodic review of the new
worth of its members.
11) The clearing corporation must inform SEBI how it roposes to monitor the exposure of
its members in the underlying market.
12) Any changes in the byelaws, rules or regulations, which are covered under the
“suggestive bye-laws for regulations and control of trading and settlement of
derivatives contracts”, would require prior approval of SEBI.
Product specifications BSE-30 Sensex Futures
Contract Size -Rs.50 times the Index
Tick size – 0.1 points or Rs.540 | P a g e
Expiry day – last Thursday of the month
Settlement basis – cash settled
Contract cycle – 3 months
Active contracts – 3 nearest months
Product Specifications S&P CNX Nifty Futures
Contract Size – Rs.200 times the Index
Tick Size – 0.05 points or Rs.10
Expiry day – last Thursday of the month
Settlement basis – cash settled
Contract cycle - 3 month
Active contracts – 3 nearest months
Membership
Membership for the new segment in both the exchanges is not automatic and has to
be separately applied for:
Membership is currently open on both the exchanges.
All members will also have to be separately registered with SEBI before they can be
accepted.
Membership Criteria – National Stock Exchange (NSE)
Clearing Member (CM)
Net worth Rs.300 lakhs
Interest-Free Security Deposits – Rs.25 lakhs
Collateral Security Deposit – Rs.25 lakhs
In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs.
Trading Member (TM)
Net worth – Rs.100 lakhs
Interest-Free Security Deposit – Rs.8 lakhs
Annual Subscription fees – Rs.1 lakh
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Membership Criteria – Mumbai Stock Exchange (BSE)
Clearing Member (CM)
Net worth – 300 lakhs
Interest-Free Security Deposit – Rs.25lakhs
Collateral Security Deposit – Rs.25 lakhs
Non-refundable Deposit – Rs.5 lakhs
Annual Subscription Fees – Rs.50,000.
In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs with the
following break-up.
i. Cash – Rs.25 lakhs
ii. Cash Equivalents – Rs.25 lakhs
iii. Collateral Security Deposit – Rs.5 lakhs
Trading Member (TM)
Net worth – Rs.50 lakhs
Non-refundable deposit – Rs.3 lakhs
Annual Subscription Fees – Rs.25 thousant
The Non-refundabel fee paid by the members is exclusive and will be a total of
Rs.8 lakhs if the member has both clearing and trading rights.
Trading systems
NSE’s trading system for its futures and options segment is called NEAT F&O. It
is bsed on the NEAT system for the cash segment.
BSE’s trading system for its derivatives segment is called DTs. It is built on a
platform different from the BOLT system though most of the features are common.
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Classification of derivatives:
Forwards (currencies, stocks, swaps etc.,)
Forward contract is different from a spot transaction, where payment of price and delivery
of commodity take place immediately the transaction is settled. In a forward contract the
sale/purchase transaction of an asset is settled including the price payable not for
deliver/settlement at spot, but at a specified future date. India has a strong dollar-rupee
forward market with contracts being traded for one, two, Six-month expiration. Daily
trading volume on this forward market is around $500 million a day. Indian users of
hedging services are also allowed to buy derivatives involving other currencies on foreign
markets.
Futures (Currencies, Stocks, Indices, Commodities):
A future contract has been defined as “a standardized exchange-traded agreement specifying
a quantity and price of a particular type of commodity (soyabeans, gold, oil etc.,) to be
purchased or sold at a pre-determined date in the future. On contract date, delivery and
physical possession take place unless the contract has been closed out. Futures are also
available on various financial products and indices today. A future contract is thus a
forward contract, which trades on an exchange. S&P CNX Nifty futures are traded on
National Stock ‘Exchange. This provides them transparency, liquidity, anonymity of trades
and also eliminates the counter party risks due to the guarantee provided by national
securities clearing corporation Ltd.
Options (Currencies, Stocks, Indexes etc):
Options are the standardized financial contracts that allow the buyer (holder) of the options,
i.e., the right at the cost of option premium not the obligation, to buy (call options) or sell
(put options) a specified asset at a set price on or before a specified date through exchanges
under stringent financial security against default.
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Risk management in derivatives:
Derivatives are high-risk instruments and hence the exchanges have put a lot of measures
to control this risk. The most critical aspect of risk management is the daily monitoring of price
and position and the margining of those positions.
NSE used the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that has
origins at the Chicago mercantile exchange, one of the oldest derivative exchanges in the world.
The objective of SPAN is to monitor the positions and determine the maximum loss that a
stock can incur in a single day. This loss is covered by the exchange by imposing mark to
market margins.
SPAN evaluates risk scenarios, which are nothing but market conditions. The specific set
of market conditions evaluated, are called the risk scenarios, and these are defined in terms of;
a) How much the price of the underlying instrument is expected to change over one
trading day, and
b) How much the volatility of that underlying price is expected to change over one
trading day.
Based on the SPAN measurement, margins are imposed and risk covered. Apart from
this, the exchange will have a minimum base capital of Rs.50 lakhs and brokers need to pay
additional base capital if they need margins about the permissible limits.
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FORWARD CONTRACTS
FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes along position agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date for the same price. Other
45 | P a g e
contract details like delivery date, the parties to the contract negotiate price and quantity
bilaterally. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom-designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the
case of foreign exchange, thereby reducing transaction cost and increasing transaction volume.
This process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging
application would be that of an exporter who expects to receive payment in dollars three months
later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward
market to sell dollars forward, he can lock on to rate today and reduce his uncertainty.
Similarly an importer who is required to make a payment in dollars two months hence can
reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has
information or analysis, which forecasts an upturn in a price, then he can go long on the forward
market instead of the cash market. The speculator would go long the forward, wait for the price
to raise, and then take a reversing transaction to book profits. Speculators may well be required
to deposit a margin upfront. However, this is generally a relatively small proportion of the
value of the assets underlying the forward contract. The use of forward market here supplies
leverage to the speculator.
LIMITATIONS:
Forward markets worldwide are afflicted by several problems:
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Lack of centralization of trading, liquidity and counter-party risk in the first two of these,
and the basic problem is that of too much flexibility and generality. The forward market is like
a real estate market in that any two consenting adults can form contracts against each other.
This often makes them design terms of the deal, which are very convenient in that specific
situation, but makes the contracts non-tradable. Counter-party risk arises from the possibility of
default by any one party to the transaction. When one of the two sides to the transaction declare
bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and
hence avoid the liquidity, still the counter-party risk remains a very serious issue.
FUTURES
INTRODUCTION:
Futures markets were designed to solve the problems that exist in forward markets.
Futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. But unlike forward contracts, futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain
standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,
(or which can be used for reference purposes in settlement) and a standard timing of such
settlement. A futures contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 90 of futures transactions are offset this way.
The standardized items in a futures contract are:
47 | P a g e
Quantity of the underlying
Quality of the underlying
The date and month of delivery
The units of price quotations and minimum price changes
Location of settlement
FUTURES MARKET:
The Chicago Board of Trade was the earliest one found, in 1848 and currently is the
largest futures exchange in the world. The method of trading futures in the organized
exchanges is similar in some ways to and different in other ways from the way stocks are
traded. As with the stocks and in other ways from the way stocks are traded. As with the stocks
and options, customers can pace market, limit and stop orders. Further more once an order is
transmitted to an exchange floor, it must be taken to a destined spot for execution by a member
of exchange, just as it is done for stocks and options. This spot is known as pit because of its
shape, which is circular with a set of interior descending steps on which members stand.
In futures market, there are floor brokers. They execute customer’s orders. In doing so
they, (or their phone clerks) each keep a file of any stop or limit orders that cannot be executed,
alternatively, members can be floor traders (those with very short holding periods, of less than a
day, are known as locals or scalpers), they execute orders for their own personal accounts in an
attempt to make profits by “buying low and selling high”.
CLEARING HOUSE:
Each futures exchange has an associated clearinghouse that becomes the “seller’s buyer”
and the “buyer’s seller” as the trade is concluded. The people associated with futures set up
specifically the Chicago Board Options Exchange). Clearing house is in a risky position as
there is a chance of not delivering to the seller or not paying by the buyer as it is like a mediator
between the both. The procedure that protect the clearinghouse from such potential losses
involving brokers
1) Impose initial margin requirements on both buyers and sellers
2) Mark to market the accounts of buyers and sellers everyday
3) Impose daily maintenance margin requirements of both buyers and sellers
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Use no contracts are outstanding. Subsequently as people began to make transactions, the open
interest grows. At any time open interest equals the amount that those with the short position
(the seller) are currently obligated to deliver. It also equals the amount that with the long
positions (the buyer) are obligated to receive.
Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin. That is, both buyer and seller are
required to make security deposit that they are intended to guarantee that they will be in fact be
able to fulfill their obligations, accordingly initial margin is referred to as performance margin.
The amount of this margin is roughly 5% to 15% of the total purchase price of the futures
contract.
Marking-to-market: In the futures market, at the end of each trading day, the margin account
is adjusted to affect the investor’s gain or loss depending upon the futures closing price. This is
called marking to market.
Maintenance margin: This is somewhat lower than the initial margin. According to the
maintenance margin requirement, the investor must keep the account’s equity equal or greater
than certain percentage of the amount deposited as initial margin. Because this percentage is
roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the
requirement is not met the investor will receive a call. This call is a request to for an additional
deposit of cash known as variation margin.
OPEN INTEREST:
The number of contracts, which are outstanding for execution, is called open interest.
When trading is first allowed in a contract, there is no open interest because no contract because
no contracts are outstanding. Subsequently as people began to make transactions, the open
interest grows. At any time open interest equals the amount that those with the short position
(the seller) are currently obligated to deliver. It also equals the amount that with the long
positions (the buyer) are obligated to receive.
BASIS:
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In the context of financial futures, basis can be defined as the difference between the
current spot price on an asset (that is the price of the asset for immediate delivery) and the
corresponding future price (that is the purchase price stated in the contract) is known as basis.
Basis = current spot price – futures price.
A person with a short position in a futures contract and a long position on a deliverable
asset (means that he owns a asset) will profit if the basis is positive and widens or is negative
and narrow). This is because the futures price will be falling or the spot price is rising (or both).
A falling futures price benefits those who are short futures and a rising spot price benefits those
who own the asset. Using the same type of reasoning it can be shown that this person will lose
the basis is positive and narrow (or is negative and widens).
SETTLEMENT OF FUTURES
Mark to market settlement:
There is a daily settlement for mark to market. The profits/losses are computed as the
difference between the trade price (or the previous day’s settlement price, as the case may be)
and the current day’s settlement price. The party who have suffered a loss are required to pay
the mark to market loss amount to exchange which is in turn passed on to the party who has
made a profit/. This is known as daily mark to market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not traded during
the last half an hour on a day, is currently the price computed as per the formula detailed below:
F = S*RT
Where:
F=theoretical futures price
S=value of the underlying index/stock
R=rate of interest (MIBOR – Mumbai I Inter Offer Rate)
T=time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After
daily settlement, all the open positions are reset to the daily settlement price. the pay-in and
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payout of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market
losses or profits are directly debited or credited to the broker passes to the client account.
Final settlement:
On the expiry of the futures contracts, exchange marks all positions to the final settlement
price and the resulting profit / loss is settled in cash. The final settlement of the futures
contracts is similar to the daily settlement process except for the method of computation of final
settlement price. The final settlement profit/loss is computed as the difference between trade
price (or the previous day’s settlement price, as the case may be), and the final settlement price
of the relevant futures contract.
Final settlement loss/profit amount is debited/credited to the relevant broker’s clearing bank
account on T+1 day (T = expiry day). This is then passed on the client from the broker. Open
positions in futures contracts cease to exist after their expiration day.
DISTINCTION BETWEEN FUTURES AND FORWARDS Forward contracts are often confused with futures contracts. The confusion is primarily
because both serve essentially the same economic functions of the allocating risk in the
presence of future price uncertainty. However futures are a significant improvement over the
forward contracts as they eliminate counter party risk and offer more liquidity.
TERMS USED IN FUTURES CONTRACT:
Spot price: the price at which an asset trades in the spot market.
Futures price: the price at which the futures contract trades in the futures market.
Contract cycle: the period over which a contract trades. The index futures contracts
on the NSE have one-month, tow-months ad three-month expiry cycle, which
expires on the last Thursday of the month. Thus a January expiration contract
expires on the last Thursday of January and a February expiration contract ceases
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trading on the last Thursday of February. On the Friday following the last Thursday,
a new contract having a three-month expiry is introduced for trading.
Expiry date: it is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract size: the amount of asset that has to be delivered less than one contract.
For instance, the contract size on NSE’s futures market is 200 Nifties.
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.
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OPTIONS
INTRODUCTION:
Options on stocks were first traded on an organized stock exchange in 1973. Since then
there has been extensive work on these instruments and manifold growth in the field has taken
the world markets by storm. This financial innovation is present in cases of stocks, stock
indices, foreign currencies, debt instruments, commodities, and futures contracts.
An option is a type of contract between two people where one grants the other party the
right to buy a specific asset at specific priced within a specific time period. Alternatively, the
contract may grant the other person the right to sell a specific asset at a specific price within a
specific period of time.
The person who has received the right, and thus has a decision to make, is known as the option
buyer because he or she must pay for this right.
The person who has sold the right, and thus must respond to the buyer’s decision is known as
the option writer.
TYPES OF OPTION CONTRACT
The two most basic types of option contracts are call option and put option. Currently
such options are traded on many exchanges around the world. Furthermore, many of these
contracts are created privately (“that is off exchange” or “over the counter”), typically involving
institutions banking firms and their clients.
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CALL OPTION:
The most prominent type of option contract is call option for stocks. It gives the buyer
the right to buy (“call away”) a specific number of shares of a specific company from the option
writer at a specific purchase price at any time up to and including a specific date.
An investor buys a call options when he seems that the stock price moves upwards. A call
option gives the holder of the option the right but not the obligation to buy an asset by a certain
date for a certain price.
PUT OPTION:
A second type of option for stocks is the put option. It gives the buyer the right to sell
(“put away”) a specific number of shares of a specific company to the option writer at a specific
selling price at any time up to and including a specific date. An investor buys a put option when
he seems that the stock price moves downwards. A put option gives the holder of the option
right but not the obligation to sell an asset by a certain date for a certain price.
Options clearing house:
The Options Clearing House (OCC), a company that is jointly owned by several
exchanges, generally facilitates trading in these options. It does so by maintaining a computer
system that keeps track of all those options by recording the position of all those investors in
each one. Although the mechanics are complex, the principles are simple. As soon as a buyer
and a writer decide to trade a particular option contract and the buyer pass the agreed upon
premium the OCC steps in becoming the effective writer as buyer is concerned the effective
buyer as far as the seller is concerned. Thus at this time all directs links between original buyer
and seller is served.
TRADING ON EXCHANGES:
There are two types of exchanged-based mechanisms for trading options contracts. The
focal point for trading either involves specialists or market makers.
SPECIALISTS:
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These people serve two functions, acting as both dealers and brokers. As dealers they
keep an inventory of the stocks that are assigned to them and buy and sell from that inventory at
bid and ask process, respectively. As brokers they keep limit order book and execute the orders
in it a market moves up and down. Some option market such as American Stock Exchange,
function in a similar manner. These markets have specialists who assigned specific options
contract, and these specialists act as dealers and brokers in their assigned options. As with the
stock exchanges, there may be floor traders, who trade solely for themselves, hoping to buy low
and sell high, and floor brokers who handle orders from public.
MARKER MAKERS
Other option markets such as Chicago Board Options Exchange, do not involve
specialists, instead they involve market makers, who act solely as dealers and order both
officials (previously known as board brokers), who keep the limit order book. The market
makers must trade with floor brokers, who are the members of Exchange that handle orders
from the public. In doing so the market makers have an inventory of options and quote bid and
ask prices. Where as there in only one specialist typically assigned to a stock, there usually is
more than one market maker assigned to the option on a given stock.
COMMISSIONS:
A commission must be paid to stockbroker whenever an option is either written, bought,
sold. The size of the commission has been reduced substantially since the options began trading
on organize exchanges in 1973. Furthermore, this is typically smaller than the commission that
would be paid if the underlying stock had been purchased instead of option. This is probably
because that clearing and settlement are easier with the options than stock. However, the
investor should be aware that exercise an option will typically result in the buyer’s having to
pay commission equivalent to the commission that would be incurred if the stock itself were
being bought or sold.
MARGINS:
Margins are the deposits, which reduce counter party risk, arise in a futures contract.
These margins are collected in order to eliminate the counter party risk. There are three types of
margins:
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Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin. That is, both buyer and seller are
required to make security deposit that they are intended to guarantee that they will be in fact be
able to fulfill their obligations, accordingly initial margin is referred to as performance margin.
The amount of this margin is roughly 5% to 15% of the total purchase price of the futures
contract.
Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to affect the investor’s gain or loss depending upon the futures closing price. This is
called marking to market.
Maintenance margin: This is somewhat lower than the initial margin. According to the
maintenance margin requirement, the investor must keep the account’s equity equal or greater
than certain percentage of the amount deposited as initial margin. Because this percentage is
roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the
requirement is not met the investor will receive a call. This call is a request to for an additional
deposit of cash known as variation margin.
In the case of a call, shares are to be delivered by the writer in return for the exercise
price. In case of a put, cash has to be delivered in return for shares. In either case the net cost
to the option writer will be the absolute difference the exercise price and the stocks market
value at the time of exercise. As the OCCs at risk if the writer is unable to bear this cost, it is
not surprising that the OCC would have a system in place protecting itself from the actions of
the write. This system is known margin.
PARTIES IN AN OPTION CONTRACT:
1. Buyer of the Option:
The buyer of an option is one who by paying option premium buys the right but
not the obligation to exercise his option on seller/writer.
2. Writer/Seller of the Option:
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The writer of a call/put options is the one who receives the option premium and
is there by obligated to sell/buy the asset if the buyer exercises the option on him.
SETTLEMENT OF OPTIONS
Daily premium settlement
Premium settlement is cash settled and settlement style is premium style. The premium
payable position and premium receivable positions are netted across all option contracts for
each broker at the client level to determine the net premium payable or receivable amount, at the
end of each day. The brokers who have a premium payable position are required to pay the
premium receivable position. This is known as daily premium settlement. The brokers in turn
would take this from their clients. The pay-in and payout of the premium settlement is on T+1
days (T=Trade Day). The premium payable amounts are directly debited or credited to the
broker, from where it is passed on to the client.
Interim Exercise Settlement for Options on Individual Securities:
Interim exercise settlement for Option contracts on Individual Securities is effected for
valid exercised option positions at in the money strike prices, at the close of the trading hours,
on the day of exercise. Valid exercised option contracts are assigned to short positions in option
contracts with the same series, on a random basis. The interim exercise settlement value is the
difference between the strike price and the settlement price of the relevant option contract.
Exercise settlement value is debited/credited to the relevant broker account in T+3 days
(T=exercise date). From there it is passed on to the clients.
Final Exercise Settlement:
Final Exercise Settlement is affected for option positions at in-the-money strike prices
existing at the close of trading hours, on the expiration day of an option contract. Long
positions at in-the-money strike prices are automatically assigned to short positions in option
contracts with the same series, on a random basis. For index options contracts, exercise style is
European style, while for options contracts on individual securities, exercise style is American
style. Final Exercise is automatic on expiry of the option contracts.57 | P a g e
Exercise Settlement is cash settled by debiting/crediting of the clearing accounts of the
relevant broker with the respective clearing bank, from where it is passed to the client. Final
settlement profit/loss amount for option contracts on Index is debited/credited to the relevant
broker clearing bank account on T+1 day (T=expiry day), from where it is passed Final
Settlement profit/loss amount for option contracts on individual Securities is debited/credited to
the relevant broker clearing bank account on T=3 day (T=expiry day), from where it is passed
open positions, in option contracts, cease to exist after their expiration day.
Payoffs for an option buyer:
The following example would clarify the basics on Call Options:
Illustration 1:
An investor buys one European Call option on one share of Reliance Petroleum at a premium
of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30
September. The payoffs for the investor on the basis of fluctuating spot prices at any time are
shown by the payoff table (Table 1). It may be clear form the graph that even in the worst-case
scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for
the premium. The upside to it has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart completely reverse of the
call options buyer. The maximum loss that he can have is unlimited though the buyer would
make a profit of Rs.2 per share on the premium payment.
Payoff from Call Buying/Long (Rs.) S Xt c Payoff Net Profit57 60 2 0 -258 60 2 0 -259 60 2 0 -260 60 2 0 -261 60 2 1 -162 60 2 2 063 60 2 3 164 60 2 4 2
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65 60 2 5 366 60 2 6 4
A European call option gives the following payoff to the investor: max (S - Xt, 0).
The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at time 't'
C - European Call Option Premium
Payoff - Max (S - Xt, O )
Payoffs from a put buying:
Put Options
The European Put Option is the reverse of the call option deal. Here, there is a contract to sell a
particular number of underlying assets on a particular date at a specific price. An example
would help understand the situation a little better:
Illustration 2:
An investor buys one European Put Option on one share of Reliance Petroleum at a premium of
Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September.
The payoff table shows the fluctuations of net profit with a change in the spot price
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Payoff from Put Buying/Long (Rs.) S Xt p Payoff Net Profit55 60 2 5 356 60 2 4 257 60 2 3 158 60 2 2 059 60 2 1 -160 60 2 0 -261 60 2 0 -262 60 2 0 -263 60 2 0 -264 60 2 0 -2
The payoff for the put buyer is: max (Xt - S, 0)
The payoff for a put writer is: -max(Xt - S, 0) or min(S - Xt, 0)
These are the two basic options that form the whole gamut of transactions in the options trading.
These in combination with other derivatives create a whole world of instruments to choose form
depending on the kind of requirement and the kind of market expectations.
Factors affecting the price of an option:
The following are the various factors that affect the price of an option. They are:
Stock price:
The pay-off from a call option is the amount by which the stock price exceeds the strike
price. Call options therefore become more valuable as the stock price increases and vice versa.
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The pay-off from a put option is the amount; by which the strike price exceeds the stock price.
Put options therefore become more valuable as the stock price increases and vice versa.
Strike price:
In the case of a call, as the strike price increases, the stock price has to make a larger
upward move for the option to go in-the –money. Therefore, for a call, as the strike price
increases, options become less valuable and as strike price decreases, options become more
valuable.
Time to expiration:
Both Put and Call American options become more valuable as the time to expiration
increases.
Volatility:
The volatility of n a stock price is a measure of uncertain about future stock price
movements. As volatility increases, the chance that the stock will do very well or very poor
increases. The value of both Calls and Puts therefore increase as volatility increase.
Risk-free interest rate:
The put option prices decline as the risk – free rate increases where as the prices of calls
always increase as the risk – free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the ex dividend date. This has a
negative effect on the value of call options and a positive affect on the value of put options.
OPTION VALUATION USING BLACK AND SCHOLES:
The Black and Scholes Option Pricing Model didn’t appear overnight, in fact, Fisher
Black started out working to create a valuation model for stock warrants. This work involved
calculating a derivative to measure the discount rate of a warrant varies with time and stock
price. The result of this calculation held a striking resemblance to a well known the transfer
equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is
a startling accurate option-pricing model. Black and Scholes can’t take all credit for their work;
in fact their model is actually an improved version of a previous model developed by A.James
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Boness in Ph.D dissertation at the University of Chicago. Black and Scholes’ improvement son
the Boness model come in the form of a proof that the risk-free interest rate is the correct
discount factor and with the absence of assumptions regarding investor’s risk preferences.
THE MODEL:
C=SN (d1)-Ke (-r t) N (d2)
C=theoretical call premium
S=current stock price
T=time until option expiration
K=option striking price
R=risk free interest rate
N=cumulative standard normal distribution
E=exponentil terms (2.1783)
d1=in(s/k) + (r + s2/2) T
D2=d1 – St
In order to understand the model itself, we divide it into two parts. The first part SN (d 1)
derives the expected benefit from acquiring a stock outright. This is found by multiplying stock
price(s) by the change in the call premium with respect to a change in the underlined stock price
[N (d1)]. The second part of the model, ke (-r t) N (d2), gives the resent value of paying the
exercise price on the expiration day. The fair market value of the call option is then calculated
by taking the difference between these two parts.
Assumptions of the Black and Scholes model:
1) The stock pays no dividend to option’s life: most companies pay dividends to their
shareholders, so this might seem a serious limitations to the model considering the
observation that higher dividend is elicit lower call premiums. A common way of
adjusting the model for this situation is to subtract the discounted value of a future
dividend form the stock price.
2) European exercise terms are used: European exercise terms dictate thbat the option
can only be exercised on the expiration date. American exercise term allow the option
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to be exercised at any time during the life of the option,, making American options more
valuable due to the greater flexibility. This limitation is not a major concern because
very few calls are ever exercised before the last few days of their life. This is true
because when you exercise a call early, you forfeit the remaining time value on the call
and collect the intrinsic value towards the end of the life of a call, the remaining time
value is very small, but the intrinsic value is the same.
3) Markets are efficient: this assumption suggests that people cannot consistently
predict the direction of the market or an individual stock. The market operates
continuously with share prices following a continuous it process.
4) No commissions are charged: usually market participants do have to pay a commission
to buy or sell options. Even floor traders pay some kind of fee, but it is usually very
small. The fees that individual investors pay is more substantial and can often distort the
output of the model.
5) Interest rates remain constant and known: The Black and Scholes model uses the risk
free rate to represent this constant and known rate. In reality there is no such thing as
the risk free rate, but the discount rate on US government treasury bills with 30 days left
until maturity is usually used to represent it. During periods of rapidly changing interest
rates, these 30 days rates are often subject to change. There by violating one of the
assumptions of the model.
SOME TERMS USED IN OPTIONS CONTRACT
Index options:
These options have the index as the underlined. Some options are European while others
are American. Like index, futures contracts, index options. Contracts are also cash settled.
Stock options:
Stock options are options on individual stocks. Options currently trade on over 500 stocks
in the United States. A contract gives the holder the right to buy or sell shares at the
specified price.
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American options:
American options are options that can be exercised any time up to the expiration date.
Most exchange traded options are American.
European options:
European options are options that can be exercised only on the expiration date itself.
European options are easier to analyze that American option are frequently deduced from
those of its European counterpart.
In-the-money options:
An in-the-money option is an option that would lead to a positive cash flow to the holder if
it were exercised immediately. A call option on the index is said to be in the money when
the current index stands at a level higher than the strike price. If the index is much higher
than the strike price the call is said to be deep in the money.
At-the-money option:
An at-the-money option is an option that would lead to zero cash flow if it were exercised
immediately. An option in the index is at the money when the current index equal that
strike price (i.e. spot price=strike price)
Out-of-the-money option:
An out-of-the-money option is an option that would lead to a negative cash flow. A call option
on the index is out of the money when the current index stands at a level, which is less than the
strike price (i.e. spot price-strike price).
Effect of increase in the relevant parameter on Option Prices:
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European Options Buying American Options Buying
Parameters Call Put Call Put
Spot price (S) ↑ ↓ ? ↓
Strike price (Xt) ↓ ? ↓ ?
Time to expiration (T)
? ? ↑ ↑
Volatility ↑ ↑ ↑ ↑
Risk free interest rates ®
↑ ↓ ↑ ↓
Dividends (D) ↓ ↑ ↓ ↑
↑-Favorable
↓-Unfavorable
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TRADING STRATEGIES USING FUTURES AND OPTIONS
TRADING STRATEGIES USING FUTURES AND OPTIONS
There are a lot of practical uses of derivatives. As we have seen derivatives can be used
for profits and hedging. We can use derivatives as a leverage tool too.
Using speculation to make profits:
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When you speculate you normally take a view on the market, either bullish or bearish.
When you take a bullish view on the market, you can always sell futures and buy in the spot
market. Similarly, in the options market if you are a bullish you
Should buy call options? If you are bearish, you should buy put options of conversely, if you
are bullish, you should write put options. This is so because, in a bull market, there are lower
chances of the put option being exercised and you can profit from the premium of you are
bearish, you should write call options. This is so because, in a bear market, there are lower
chances of the call options being exercised and you can profit from the premium.
Using arbitrage to make money in derivatives market:
Arbitrage is making money on price differentials in different markets. For
Example, future is nothing but the future value of the spot price. This future value is obtained
by factoring the interest rate. But if there are differences in the money
Market and the interest rate changes then the future price should correct itself to factor the
change in making money an arbitrage opportunity.
Let us take an example:
Example:
A stock us quoting for Rs.1000. The one-month future of this stock is at Rs.1005. The risk free
rate is 12%. The trading strategy is:
Solution:
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The strategy for trading should be – Sell Spot and Buy Futures sell the stock for Rs.1000. Buy
the future at Rs.1005. Invest the Rs.1000 at12%. The interest earned on this stock will be
1000(1+0.12)(1/2)=1009.
So net gain the above strategy is Rs.1009-Rs.1005=Rs.4.
Thus one can make risk less profit of Rs.4 because of arbitrage. But an important point is that
this opportunity was available due to mispricing and the market not correcting itself. Normally,
the time taken for the market to adjust to corrections is very less. S, the time available for
arbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.
Using future to hedge position:
One can hedge one’s position by taking an opposite position in the futures market. For
example, if you are buying in the spot price, the risk you carry is that of prices falling in the
future. You can lock this by selling in the futures price.
Even if the stock continues falling, you position is hedged as you have formed the price at
which you are selling. Similarly, you want to buy a stock at a later date but face the risk of
prices rising. You can hedge against this rise by buying futures.
You can use a combination of futures too to hedge yourself. There is always a correlation
between the index and individual stocks. This correlation may be negative or positive, but there
is a correlation. This is given by the beta of the stock. In simple terms, beta indicates the
change in the price of a stock to every change in index.
For example, if beta of a stock is 0.18, it means that if the index goes up by when the index
falls, a negative beta means that the price of the stock falls when the index rises. So, if you
have a position in a stock, you can hedge the same by buying the index at times the value of the
stock.
Example:
The beta of HPCL is 0.8 the Nifty is at 1000. If there is a stock of Rs.10, 000 worth of HPCL,
hedging of position can be done by selling 8000 of Nifty. That is there is a sale.
Scenario 1
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If index rises by 10% the value of the index becomes 8800 i.e. a loss of Rs.800. The value of
the stock however goes up by 8 i.e. it becomes Rs.10, 800 i.e. a gain of Rs.800.
Thus the net position is zero and there is a perfect hedging.
Scenario 2
If index falls by 10%, the value of the index becomes Rs.7, 200 a gain of Rs.800. But the value
of the stock also falls by 8%. The value of this stock becomes Rs.9, 200 a loss of Rs.800. thus
the net position is zero and it is hedged.
But again, beta is predicted value based on regression models. Regression is nothing but
analysis of past data. So there is a chance that the above position may not be fully hedged if the
beta does not behave as per the predicted value.
Using options in trading strategy:
Options are a great tool to use for trading. If traders feel the market will go up. He
should buy a call option at a level lower than what he expects the market tot go up. If he thinks
that the market will fall, you should buy a put option at a level higher than the level to which he
expect the market fall. When we say market, we mean the index. The same strategy can be
used for individual stocks also.
A combination of futures and options can be used too, to make profits.
Strategy for an option writer to cover himself:
An option writer can use a combination strategy of futures and options to protect his
position. The risk for an option writer arises only when the options exercised. This will be very
clear with an example.
Supposing I sell a call option on satyam at a strike price of Rs.300/- for a premium of
Rs.20/-, the risk arises only when the option is exercised. The option will be exercised when the
price exceeds rs.300/-. I start making a loss only after the price exceeds Rs.32/- (strike price
plus premium).
More importantly, I have to deliver the stock to the opposite party. So to enable me to
deliver the stock to the other party and also makes entire profit on premium, I buy a future of
Satyam at Rs.300/-.
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This is just one leg of the risk. The earlier risk was of the call being exercised. The risk
now is that of the call not being exercised. In case the call is not exercised, I will have to take
delivery as I have bought a future.
So minimize this risk, I buy a put option on Satyam at Rs.300. but I also need to pay a
premium for buying the option. I pay a premium of Rs.10/-. Now I am covered and my net
cash flow would be
Premium earned from selling call option: Rs.20
Premium paid to buy put option: Rs.10
Net cash flow: Rs.10/-
But the above pay off will be possible only when the premium I am paying for the put
option is lower than the premium that I get for writing the call. Similarly, we can arrive at a
covered position for writing a put option too, another interesting observation is that the above
strategy in itself presents an opportunity to make money. This is so because of the premium
differential in the put and the call option. So if one tracks the derivative markets on a
continuous basis, one can chance upon almost risk less moneymaking opportunities.
LOT SIZES OF DIFFERENT COMPANIES
CODE LOT SIZE COMPANY NAMEACC 1500 ASSOCIATES CEMENT COS LTDANDHRA BANK 4600 ANDHRA BANKARVIND MILLS 4300 ARVIND MILLS LTDBAJAJ AUTO 400 BAJAJ AUTOMOBILES LTDBANKBARODA 1400 BANK OF BARODABANKINDIA 3800 BANK OF INDIABEL 550 BHARAT ELECTRICALS LTDBHEL 600 BHARAT HEAVY ELECTRICALS LTDBPCL 550 BHARAT PETROL CORPORATION LTDCANBK 1600 CANARA BANKCIPLA 200 CIPLA LTDCNXIT 10 IT INDEXDIGITALEQUIP 400 DIGITAL GLOBAL LTDDRREDDY 200 DR. REDDY’S LABORATORIES LTDGAIL 1500 GAS AUTHOURITY OF INDIAGRASIM 350 GRASIM INDUSTRIES LTD
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GUJAMBCEMENT 110 GUJARAT AMBUJA CEMENT LTDHCL TECH 1300 HINDUSTAN CORPORATION LTDHDFC 600 HOUSING DEDVELOPMENT FINANCE
CORPORATIONHDFC BANK 800 HDFC BANKHEROHONDA 400 HERO HONDA MOTORS LTDHINDALCO 300 HINDUSTAN ALUMINIUM COMPANYHINDLEVER 2000 HINDUSTAN LEVER LTDHINDPETROL 650 HINDUSTAN PETROLEUM CORPORATIONI-FLEX 300 I-FLEXICICIBANK 1400 ICICI BANKING CORPORATION LTDINFOSYSTECH 50 INFOSYS TECHNOLOGIES LTDIOC 600 INDIAN OIL CORPORATIONIPCL 1100 INDIAN PETROLEUM CHEMICALS LTDITC 300 INDIAN TOBACCO COMPANYL&T 500 LARSEN AND TURBOM&M 625 MAHENDRA AND MAHENDRA LTDMARUTI 400 MARUTI UDYOG LTDMASTEK 1600 MASTEKMTNL 1600 MAHANAGAR TELECOM NIGAM LTDNATIONALALAM 1150 NATIONAL ALUMINIUM COMPANYNIFTY 200 NATIONAL INDEX FOR FIFTY STOCKSNIIT 1500 NATIONAL INSTITUTE OF INFORMATION
TECHNOLOGYONGC 300 OIL AND NATURAL GAS CORPORATIONORIENT BANK 1200 ORIENTAL BANKPNB 1200 PUNJAB NATIONAL BANKPOLARIS 1400 POLARIS SOFTWARE COMPANY LTD.
RANBAXY 400 RANBAXY LABORATORIES LTDRELIANCE 550 RELIANCE INDUSTRIES LTDREL 600 RELIANCE COMPUTERS SERVICES LTDSATYAMCOMPU 1200 SATYAM COMPUTERS LTDSBI 500 STATE BANK OF INDIASCI 1600 SHIPPPING CORPORATION OF INDIASYNDIBANK 7600 SYNDICATE BANKTATAMOTORS 825 TATA MOTORSTATAPOWER 50 TATA POWER COMPANY LTDTATA TEA 900 TATA TEA LTDTISCO 4200 TATA IRON&STEEL COMPANY LTDUNION BANK 200 UNION BANK OF INDIAWIPRO 800 WESTERN INDIA-VEG PRODUCTS LTD
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DESCRIPTION OF THE METHOD:
DESCRIPTION OF THE METHOD:
The following are the steps involved in the study.
1. Selection of the scrip:
The scrip selection is done on a random basis and the scrip selected is ONGC.
The lot size of the scrip is 500. Profitability position of the option holder and option writer is
studied.
2. Data collection:
The data of the ONGC has been collected from the “The Economic Times” and the
Internet. The data consists of the August contract and the period of data collection is from 3 rd
August 2005 to 3rd September 2005.
3. Analysis:
The analysis consists of the tabulation of the data assessing the profitability positions of
the option holder and the option writer, representing the data with graphs and making the
interpretations using the data.
LOT SIZES OF SELECTED COMPANIES FOR ANALYSIS
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CODE LOT SIZE COMPANY NAME
ACC 188 Associates Cement Co. Ltd.
INFOSYS 200Infosys Technologies Ltd.
HLL 1000Hindustan UniLever Ltd.
RANBAXY 800Ranbaxy laboratories Ltd.
SATYAM 600Satyam Computer services Ltd.
The following tables explain about the trades that took place in futures and options between
01/05/2008 and 13/05/2008. The table has various columns, which explains various factors
involves in derivatives trading.
Date – the day on which trading took place
Closing premium – premium for the day
Open interest – No. of Options that did not get exercised
Traded quantity – No. of futures and options traded on that day
N.O.C – No. of contacts traded on that day
Closing price – the price of the futures at the end of the trading day
FUTURES OF ‘ACC CEMENTS’
Datedd/mm/yyy
Open.Rs
HighRs.
LowRs.
CloseRs
Open Int(‘000’)
N.O.C
20/04/2008 795.95 809.40 791.35 794.5 3452 750219/04/2008 809.00 819.00 783.10 790.15 3943 1575918/04/2008 815.00 827.45 815.00 818.00 3810 773817/04/2008 791.00 816.70 785.00 809.95 4600 1726516/04/2008 756.00 793.95 756.00 789.15 4385 10335
FINDINGS:
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The price gradually rose from 789.15 on first day to 18th April, where it stood at 818.00 as
high. As the players in the market with an intention to short or correct the market, the
players showed a bearish attitude for the next day where the price fell to 790.15. Later the
players become a bullish.
At 809.95 the open interest stood at peak position of 4600000, but later the next day players
sold their futures as to gain. The total contracts traded at this price stood 17265 which is
higher than the week days
By the end of the trading week most of the players closed up their contracts to make loss. As
the price was high, the open interest was high and the no. of contracts trades rose to 7502.
There always exit an impact of price movements on open interest and contracts traded. The
futures market also influenced by cash market, Nifty index futures, and news related to the
underlying asset or sector (industry), FII’s involvement, national and international affairs
etc.
FUTURES OF ‘INFOSYS’
Datedd/mm/yyy
OpenRs.
HighRs.
LowRs.
CloseRs
Open. int(‘000’)
N.O.C
20/04/2008 2061.00 2082.00 2055.50 2061.75 3335 1084219/04/2008 2046.50 2060.50 2021.25 2045.95 3397 1304118/04/2008 2076.00 2090.00 2062.15 2070.30 3625 1188617/04/2008 2102.65 2110.00 2055.50 2073.90 4215 2653416/04/2008 2100.00 2125.00 2095.00 2118.80 3698 17017
FINDINGS:
After the market quite relived by the fall in the discount on the Nifty in the futures and the
options segment, which was used by the players to short the market shown appositive
upward movement in futures and options segment and cash market during the first day of
the week.
The futures of INFOSYS shown a bullish way till 17th of the April whose impact shown on
the open interest at 4215 with 26534 contracts traded. The players at this point did not sell
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or close up their contracts as a hope of increase or go up in the market for a next day. Even
the cash market was down on this day for this underlying at Rs. 2076.00.
The market for INFOSYS for last day of the trading week shown a decline in the opening
price Rs. 15.05 when compare with the week high price. The open interest closed at
3335000 with lowest 10842 contracts traded on the last trading day of the week.
FUTURES OF THE ‘HLL’
Datedd/mm/yyy
Open.Rs.
HighRs.
LowRs.
CloseRs
Open. int(‘000’)
N.O.C
20/04/2008 205.10 209.80 204.25 206.20 8742 256819/04/2008 203.55 205.50 201.10 204.15 9112 274018/04/2008 208.10 211.80 205.25 206.00 9143 202017/04/2008 211.50 212.85 208.35 208.75 9205 245416/04/2008 205.70 211.45 204.70 211.10 9232 3765
INTERPRETATION:
HLL contracts traded in the futures stood at peak for the week i.e. 3765. There was a good
buying in both the futures and options and cash market for this stock.
The last trading day of the week showed a high strike price or exercising price for the HLL
futures i.e. Rs. 206.20 because of the huge correction done by the FII flows.
FUTURES OF ‘RANBAXY’
Datedd/mm/yyy
OpenRs
HighRs.
LowRs.
CloseRs
Open. int(‘000’)
N.O.C
20/04/2008 345.00 345.50 342.05 344.10 5698 136619/04/2008 336.00 344.75 335.10 342.45 6578 305.418/04/2008 339.50 344.80 339.00 341.40 6731 300817/04/2008 341.80 342.00 337.25 338.00 6770 167916/04/2008 337.00 342.25 337.00 339.30 6731 2370
INTERPRETATION:
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The week showed a buy for RANBAXY stock futures. Since beginning of the trading day of
the week the figures has been representing a continuous bullish market for RANBAXY. The
pharmacy sector is considered to be one of the eye watches for investors for investing.
On the last but one, trading day the RANBAXY stock futures has rose to peak level where
the price stood at 451.35 an increase of 11.73% over the first trading day price 403.95. The
open interest rose 52.16% to 9512000 and the contract traded, 19314 from 7645 of week’s
beginning.
At the end of the week the price of the RANBAXY has rose to Rs.458.90 this is all time
record of that week at this stage open interest has also gone up to 9512000, this was great
boom in pharmacy sector, because FII’s were interested to invest in this sector.
FUTURES OF ‘SATYAM COMPUTERS’
Datedd/mm/yyy
OpenRs
HighRs.
LowRs.
CloseRs
Open. int(‘000’)
N.O.C
20/04/2008 463.00 477.00 461.35 474.75 6226 1648619/04/2008 450.00 462.00 445.55 449.50 8991 1128618/04/2008 462.00 468.80 460.10 462.95 11072 1198417/04/2008 474.55 483.00 456.00 457.95 13645 1574716/04/2008 487.90 494.50 476.90 480.95 13043 11543
FINDINGS:
The above table indicates decrease in the price from the 3 rd day about 23 Rs.
Call and Put Options of ‘ACC Cements’
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C C.P O.I.* N.CCA 700 89.80 17 7CA 720 66.35 17 21 91.35 17 12
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CA 740 45.90 44 87 71.80 37 91CA 760 35.40 64 161 50.50 57 88 59.00 58 11 34.00 56 23CA 780 22.95 25 69 39.00 17 63 47.00 15 16 20.10 28 60 19.40 28 35CA 800 13.65 38 114 22.85 49 177 27.50 42 52 10.95 79 241 10.25 77 192CA 820 7.50 2 7 14.10 29 136 15.10 45 151 6.35 83 204 4.50 85 81CA 840 8.50 6 21 7.30 15 49 4.05 23 61 3.00 23 14
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C C.P O.I.* N.CPA 720 2.05 13 10 1.00 14 7PA 740 3.35 17 24 2.85 17 15PA 760 7.50 13 45 7.50 14 31 2.45 18 6 4.35 26 33 2.90 27 14PA 780 16.20 7 20 13.25 24 95 6.85 14 11 11.20 23 63 5.10 27 21PA 800 8.40 26 36 21.55 33 107 15.65 34 19PA 820 17.45 26 98 39.00 26 47
C.P. = Close premium O.I = Open interest N.C. = No. of contracts
The following table of net payoff explains the profit/loss of option holder/writer of ACC for the week 16/04/2008-20/04/2008.
Profit/loss position of Call option buyer/writer of ACC
Spot Price Strike Price Premium Whether Exercised
BuyerGain/Loss
WritersGain/Loss
788 700 89.80 NO -562.5 562.5788 720 66.35 YES 618.75 -618.75788 740 45.90 YES 787.5 -787.5788 760 35.40 NO -2775 2775788 780 22.95 NO -8598.5 8598.5788 800 13.65 NO -9618.75 9618.75788 820 7.50 NO -14812.5 14812.5
Profit/Loss position of Put option buyer/writer of ACC
Spot Price Strike Price Premium Whether Exercised
BuyerGain/Loss
WritersGain/Loss
788 720 2.05 YES 24731.25 -24731.25788 740 3.35 YES 16743.75 -16743.75788 760 7.50 YES 7687.5 -7687.5788 780 16.20 NO -3075 3075
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Findings:
The Call Options 700, 760,780,800 and 820 were out-of-the-money option and the remaining 720 and 740 were in the money option.
The Put Options 720,740 and 760 were in-the-money option and the remaining i.e.780 was out-of-the-money option.
Profit of the holder = (spot price – strike price) – premium * 375 (lot size) in case of Call Option
Profit of the holder = (spot price – strike price) – premium * 375 (lot size) in case of Put Option
If it is a profit for the holder than obviously it is loss for the holder and vice-versa.
Call and Put Options of ‘INFOSYS’Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.CA 1950 176.50 8 7CA 1980 145.95 30 31 102.00 27 28 102.0 26 7 79.95 26 13 83.05 26 10CA 2010 117.95 267 351 76.55 251 319 71.25 249 101 55.20 242 334 56.70 242 117CA 2040 90.55 100 362 57.90 107 271 50.45 105 108 37.10 104 399 36.95 100 150CA 2070 65.10 63 189 39.25 63 193 33.90 65 109 22.45 69 208 20.95 73 193CA 2100 45.40 327 1092 24.80 340 1194 22.55 344 466 14.85 370 601 11.30 358 437CA 2130 29.25 81 205 13.65 86 193 12.15 86 88 8.36 87 66 4.45 87 54CA 2160 19.35 85 159 8.30 93 215 5.65 95 150 5.70 94 115 3.95 95 54CA 2190 12.30 66 67 6.30 68 83 3.60 69 19 3.90 66 25 2.50 66 47CA 2220 9.00 73 98 4.50 77 67 3.05 80 32 3.00 80 20 1.30 80 12CA 2250 6.20 33 29
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I. N.C C.P. O.I. N.C. C.P. O.I. N.C. C.P. O.I. N.C. C.P. O.I. N.C.
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* . * * * *PA 1830 3.15 80 25 3.10 79 15 2.90 77 37PA 1890 3.40 51 34 3.60 50 10 2.80 47 27 1.25 46 11PA 1920 5.20 141 116 4.55 137 89 4.30 134 41 4.90 125 113 2.25 123 24PA 1950 5.65 75 34 7.00 73 46 5.85 72 13 7.70 67 82 3.25 64 38PA 1980 6.75 94 126 9.05 91 48 7.85 87 80 12.75 81 123 3.30 74 90PA 2010 10.40 218 351 14.15 200 336 12.15 193 249 19.60 169 433 8.35 171 113PA 2040 14.45 69 211 25.40 67 168 20.60 65 77 28.50 55 313 17.0 55 67PA 2070 19.70 24 128 36.90 23 117 34.05 24 50 42.25 19 96 33.6 19 41PA 2100 30.45 44 297 52.20 31 285 52.60 28 72 65.75 27 76 45.0 26 12
The following pay-off for explain the profit/loss of option holder/writer of ‘INFOSYS’for the week 16/04/2008-20/04/2008..
Profit/Loss position of Call Option Buyer/Writer of ‘INFOSYS’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
2040 1950 176.50 NO -8650 86502040 1980 145.95 NO -8595 85952040 2010 117.95 NO -8795 87952040 2040 90.55 NO -9055 90552040 2070 65.10 NO -9510 95102040 2100 45.40 NO -10540 105402040 2130 29.25 NO -11925 119252040 2160 19.35 NO -13935 139352040 2190 12.30 NO -16230 162302040 2220 9.00 NO -18900 189002040 2250 6.20 NO -21620 21620
Profit/Loss position of Put Option Buyer/writer of ‘INFOSYS’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
2040 1830 3.15 YES 20685 -206852040 1890 3.40 YES 14660 -146602040 1920 5.20 YES 11480 -114802040 1950 5.65 YES 8435 -84352040 1980 6.75 YES 5325 -53252040 2010 10.40 YES 1960 -19602040 2040 14.45 NO -1445 14452040 2070 19.70 NO -4970 49702040 2100 30.45 NO -9045 9045
Findings:
The Call options all were in out-of-money option.
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The Put option1830, 1890,1920,1950,1980 and 2010 were in-the-money options and the
remaining 2040, 2070 and 2100 were out of option.
Profit of the holder = (spot price – strike price) – premium*100 (lot size) in case call option
Profit of the holder = (spot price-spot price)-premium*100 (lot Size) in case of put option.
If it is profit for the holder than obviously it will be loss for the holder and vice-versa.
Call and Put Option of HLL
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.CA 200 13.80 238 120 11.55 231 45 8.50 148 67 6.95 173 107 7.45 108 57CA 205 9.20 108 65 6.25 105 34 4.65 98 18 3.90 116 44 3.80 112 33CA 210 4.80 396 263 3.70 385 213 2.65 417 152 1.75 475 109 1.80 470 113CA 215 2.65 78 62 2.15 108 68 1.40 126 44 1.00 129 13 0.55 122 19CA 220 1.60 255 97 1.25 284 66 0.75 287 31 0.60 286 11 0.40 278 13CA 225 0.75 32 25 0.80 37 7 .50 40 8 2.10 86 30 1.05 88 17
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.PA 200 1.35 85 34 1.35 90 16 1.80 90 18 2.10 86 30 1.05 88 17PA 205 2.70 11 11 2.20 16 9 3.20 18 10 4.00 17 14 2.70 32 29PA 210 4.50 9 12 5.05 17 26 8.55 14 5 5.90 26 13
The following table of net payoff explains the profit/loss of option holder/writer of
‘HLL’ for the week 16/04/2008-20/04/2008...
Profit/Loss position of Call Option Buyer/Writer of ‘HLL’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
207 200 13.80 NO -6800 6800207 205 9.20 NO -7200 7200207 210 4.80 NO -7800 7800207 215 2.65 NO -10650 10650207 220 1.60 NO -14600 14600207 225 0.75 NO -18750 18750
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Profit/Loss position of Put Option Buyer/Writer of ‘HLL’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
207 200 1.35 YES 5650 -5650207 205 2.70 NO -700 700
Findings:
The Call Options all were out-of-the-money options
The Put Options200 was in-the-money option and 205was out-of-the-money option.
Profit of the holder = (spot price-strike piece)-premium*1000(lot size) in case of Call
option.
Profit of the holder = (strike price-spot price) - premium*1000(lot size) in case of Put
option.
If it is profit for the holder then obviously it will be loss for the holder and vice-versa.
Call and Put Options of ‘RANBAXY’
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.CA 330 . 15.00 28 8 16.65 26 8CA 340 8.90 102 63 8.45 122 54 8.75 124 61 8.35 124 32 8.40 118 29CA 350 5.65 115 51 4.80 123 22 4.70 130 42 4.10 133 23 3.60 129 15CA 360 3.35 103 11 3.00 105 5 2.45 106 16 2.20 102 9 1.75 103 8CA 370 1.25 44 9 1.70 42 9CA 400 0.60 22 6
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.
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PA 330 4.60 22 6 2.60 24 9
The following tables of net payoff explain the following Profit/Loss of option
holder/writer of ‘RANBAXY’ for the week 16/04/2008-20/04/2008...
Profit/Loss position of Call Buyer/Writer of ‘RANBAXY’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
340 340 8.90 NO -7120 7120340 350 5.65 NO -12520 12520340 360 3.35 NO -18680 18680340 400 0.60 NO -48480 48480
Profit/Loss position of Put option Buyer/Writer of ‘RANBAXY’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
340 330 4.60 NO -4320 4320
Findings:
The Call options all were in the out-of-the-money options.
The Put option also was in the out-of-the-money options..
Profit of the holder = (spot price- strike price) – premium* 800 (lot size) in case of call
option.
Profit for the holder = (strike price-spot price) –premium* 800(lot size) in case of Put
option.
If it is a profit of the holder then obviously it will be loss for the holder and vice-versa.
Call and Put Option of the ‘SATYAM COMPUTERS’
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.*
N.C. C.P. O.I.*
N.C.
C.P. O.I.*
N.C.
C.P. O.I.*
N.C. C.P. O.I.*
N.C.
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CA 440 18.35 50 21 32.25 44 18CA 450 35.00 44 26 18.10 51 63 21.65 61 36 12.85 152 282 26.50 91 263CA 460 28.05 88 35 13.40 120 258 15.20 133 113 7.55 302 569 18.25 185 701CA 470 22.20 115 72 8.85 185 306 10.45 205 123 4.25 325 334 12.10 266 971CA 480 15.75 161 310 6.35 292 435 7.15 329 171 2.80 446 353 6.35 418 855CA 490 11.40 55 101 4.00 96 112 4.25 130 66 2.05 143 61 2.90 175 136CA 500 7.85 194 300 2.95 326 310 2.95 358 120 1.40 430 186 1.65 442 328CA 510 5.00 31 58 2.05 34 12 1.90 37 17 1.00 33 13 0.80 36 22CA 520 3.00 26 44 1.50 39 29 1.30 41 6 9.60 4 8 0.25 40 11
Date/Options
16/04/2008 17/04/2008 18/04/2008 19/04/2008 20/04/2008
C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C. C.P. O.I.* N.C.PA 420 2.25 10 6 4.10 14 11PA 430 6.30 13 12 0.50 12 6PA 440 3.75 38 13 6.55 44 38 6.00 48 17 8.30 64 80 1.40 59 46PA 450 5.15 60 73 10.10 58 82 8.05 58 30 13.30 56 77 2.25 149 282PA 460 6.85 104 78 15.10 92 183 12.65 100 57 18.45 97 159 3.60 149 282PA 470 10.50 36 42 19.55 22 45 20.15 21 9 7.15 52 137PA 480 14.85 35 189 28.40 28 41 11.25 73 130PA 490 17.05 11 25PA 500 24.90 9 13
The following table of net payoff explains profit/loss of option holder/writer of
‘SATYAM COMPUTERS’ for the week 16/04/2008-20/04/2008...
Profit/Loss position of Call Option Buyer/Writer of ‘SATYAM COMPUTERS’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
448 450 35.00 NO -22200 22200448 460 28.05 NO -24030 24030448 470 22.20 NO -26520 26520448 480 15.75 NO -28650 28650448 490 11.40 NO -32040 32040448 500 7.85 NO -35910 35910448 510 5.00 NO -40200 40200448 520 3.00 NO -22200 22200
Profit/Loss position of Put Option Buyer/Writer of ‘TATA CONSULTANCY SERVICES’
SPOT PRICE
STRIKE PRICE
PREMIUM WHETHER EXERCISED
BUYER GAIN/LOSS
WRITER GAIN/LOSS
448 440 3.75 YES 2550 -255084 | P a g e
448 450 5.15 NO -4290 4290448 460 6.85 NO -11310 11310448 470 10.50 NO -19500 19500448 480 14.85 NO -28110 28110448 490 17.05 NO -35430 35430448 500 24.90 NO -46140 46140
Findings:
The Call Options all were out-of-the-money option
All Put Option 440 was in-the-money option and remaining 450,460,470,480,490 and 500
were out-of-the-money options.
Profit of the holder = (spot price-strike price)-premium*600 (lot size) in case of Call Option.
Profit of the holder = (strike piece-spot price)-premium*600 (lot size) in case of Put Option.
If it is a profit for the holder then obviously it will be loss for the holder and vice-versa.
Conclusion and Suggestions:
The above analysis Futures and Options of ACC, INFOSYS, HLL, RANBAXY and
SATYAM COMPUTERS had shown a positive market in the week.
The major factors that will influence the futures and options market, FII involvement, News
related to the underlying asset, National and International markets, Researchers view etc.
In a bearish market it is suggested to an investor to opt for Put Option in order to minimize
losses.
In a bearish market it is suggested to an investor to opt for Call Option in order to minimize
profits.
In a cash market the profit/loss is limited but where in futures and options an investor can
enjoy unlimited profit/loss.
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It is recommended that SEBI should take measures in improving awareness about the
futures and options market as it is launched very recently.
It is suggested to an investor to keep in mind the time and expiry duration of futures and
options contracts before trading. The lengthy the time, the risk is low and profit making. The
fever time may be high risk and chances of loss making.
At present futures and options are traded on NSE. It is recommended to SEBI to take actions
in trading of futures and options in other regional exchanges.
At present scenario the derivatives market is increased to a great position. Its daily turnover
reaches to the equal stage of cash market. The average daily turnover of NSE in derivatives
market is 400000 (vol.).
The derivatives are mainly used for hedging purpose.
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Glossary
Arbitrage – The simultaneous purchase and sale of a commodity or financial
instrument in different markets to take advantage of a price or exchange rate
discrepancy.
Calendar Spread – An option strategy in which a short term option is sold and a longer term
option is bought both having the same striking price. Either puts or calls
may be used.
Call Option – An option that gives the buyer right to buy a future contract at a premium, at the
strike price.
Currency Swap – A Swap in which the counter parties exchange equal amounts of
two currencies at the spot exchange rate.
Derivative – A derivative is an instrument whose value derived from the value of one
or more underlying assets, which can be commodities, precious metals,
currency, bonds, stocks, stock indices, etc. derivatives involves the trading of
rights or obligations based on the underlying assets, but do not directly transfer
the property.
Double Option – An option that gives the buyer the right to buy and or sell a future
Contract, at a premium, at a strike price.
Futures Contract –A legally binding agreement for the purpose and a sell of a commodity,
index or financial instrument some time in the future.
Hedge Fund – A large pool of private money and asset managed aggressively and often riskily
on any future exchange, mostly for short term gain.
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In-the-money option – An option with intrinsic value, a Call option is in the money if its strike
price is below the current price of the underlying futures contract
and the put option is in the money if it is above the underlying.
Margin call – A demand from a clearing house to a clearing member or from a broker to a
customer bring deposits up to a required minimum level to guarantee
performance at ruling prices.
Option – it gives the buyer the right, but not the obligation, to buy or sell stock at a set. price
on or before a given date. Investors who purchase call options but the stock will be
worth more than the price set by the option (strike price), plus the price they paid for
the option itself. Buyer of put option bet the stock price will go down below the
price set by the option.
Out-of-the-money option – An option with no intrinsic value, a call option is out of
Money if its strike price is above the underlying and a put option is
so if it is below the underlying.
Premium – The price of an option contract, determined on the exchange, which the buyer of the
option pays to the option writer for the rights to the option contract.
Spread – The difference between the bid and asked prices in any market.
Stop loss orders – An order place in the market to buy or sell to close out an open position on
order to limit losses when market moves the wrong way.
Swap – An agreement to exchange on currency on index return for another, the exchange on
fixed interest payments for a floating rates payments or the exchange of an equity
index return for a floating interest rate.
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Underlying – The currency, commodity, security or any other instrument that forms the basis
of a future or a option contract.
Writer – The person who originates the option contract by promising to perform the
Certain obligation in return for the price of the option. Also known as the option
writer.
All or noting option – An option with a fixed, predetermined payoff if the underlying
instrument is at or beyond the strike price at expiration.
Average option – A path dependent option that calculates the average of the path traversed by
the asset, arithmetic or weighted. The payoff therefore the difference
between the average price of the underlying asset, over the life of option
and the exercise price of the option.
Basket option – A third party option covered warrant on a basket of underlying stocks,
Currencies or commodities.
Bermuda option – Like the location of the Bermudas, this option located somewhere
between a European style options, this can be exercised only at
Maturity and an American style option which can be exercised any
time.
Option holders choose – this option can be exercisable only on predetermined dates.
Compound options – This is simply an option on an existing option such as a call on a Call a
put on a put etc, a call on a put etc.
Cross-currency options – An out performance option stock at an exchange rate between.two
currency.
Digital options – These are options that can be structured as a “one touch” barrier, “double no
touch” barrier and: all nothing “call/puts”. The “one touch” digital provides
an immediate payoff if the currency hits your selected price barrier chosen
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at outset. The “double no touch” provides a payoff upon expiration if the
currency does not touch both the upper and lower price. Barrier selected at
the outset. The call/put “all or nothing” digital option provides a payoff
upon expiration if your option finishes in the money.
Knock-in-options – There are two kinds of known in options, 1) up and in, 2) down and. in.
with known in options, the buyer starts out without a vanilla option. If
the buyer has selected an upper price barrier and the currency hits that
level; it creates the vanilla option with maturity date and strike price
agreed upon at the outset. This would be called an up and in. the down
and in option is the same as the up and in, expect the currency has to
reach a lower barrier. Upon hitting the chosen lower price level, it
creates the vanilla option.
Multi-index option – An out performance option with a payoff determined by the
deference in performance of two or more indices.
Out performance option – An option with a payoff based on the amount by which one of two
underlying instruments or indices out performs the other.
Quantity adjusting option – This is an option design to eliminate the currency risk by fix
effectively hedging it. It evolves combining an equity option
and incorporating a predetermined rate.
Example: if the holder has in the money Nikkei index call option expiration, the quanto option
terms would trigger by covering the yen proceeds into dollar which was specified at
the out set in the quanto option contract. The rate is agreed upon at the beginning
without the quantity of course, since this is an unknown at the time.
Secondary currency option – An option with a payoff in a difference currency than the
underling’s trading currency.
Swaption – An option to enter into a Swap contract.
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Up-and-out-option – The call pays of early exercise price trigger is hit. The put expires.
Worthless if the market price of the underlying risks is above a
predetermined expiration price.
Zero strike price option – An option with an exercise price of zero, or close to zero,
Traded on exchanges were there is transfer tax, owner
Restriction or other obstacle to the transfer of the underlying.
TITLE AUTHOR PUBLICATION
Securities Analysis and
Portfolio Management R. Madhumati Pearson Education
Investments Schaum’s TATA McGraw-Hill
International Financial P.G.Apte TATA McGraw-Hill
Management
Financial Institutions and L.M.Bhole TATA McGraw-Hill
Markets
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Options, Futures and John C. hull Pearson Education
Other Derivatives
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