Derivatives on Equity

8/14/2019 Derivatives on Equity

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UNIVERSITY OF MUMBAI

PROJECT ON

EQUITY DERIVATIVES IN INDIA

SUBMITTED BY

LACHHANI NISHA M.

PROJECT GUIDE

Bhavdas sir

BACHELOR OF MANAGEMENT STUDIES

SEMESTER V

(2009-2010)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE,

SINDHI COLONY, CHEMBUR – 400071

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UNIVERSITY OF MUMBAI

PROJECT ON

_EQUITY DERIVATIVES IN INDIA

Submitted

In Partial Fulfillment of the requirementsFor the Award of the Degree of Bachelor of Management

By

LACHHANI NISHA M.

PROJECT GUIDE

MR. BHAVDAS SIR

BACHELOR OF MANAGEMENT STUDIES

SEMESTER V

(2009-10)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE,

SINDHI COLONY, CHEMBUR – 400071

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Declaration

I LACHHANI NISHA M. student of BMS – Semester V (2009-10) hereby declare that I have completed this project on

.

The information submitted is true & original to the best of my

knowledge.

Student’s Signature

Name of Student

LACHHANI NISHA M.

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C E R T I F I C A T E

This is to certify that Ms. LACHHANI NISHA Of TYBMS has

successfully completed the project on EQUITY

DERIVATIVES IN INDIA under the guidance of

MR.BHAVDAS SIR.

Project Guide Principal

Dr. (Mrs) J. K. PHADNIS

Course Co-ordinator

Mrs. A. MARTINA

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External Examiner

ACKNOWLEDGEMENT

This project took nearly 2months to complete the task. And this took a lot of

hard work from not just me but a lot of people who gave me not only their time

and attention but a true response as well.

I would like to thank the following people for their dedication and contribution

without which this project could have not been created.

Firstly, My Family members- my parents and sister for giving me space,

time and emotional support I needed to follow and complete what seemed like an

endless task.

Then to my project guide MR. BHAVDAS who helped me develop a proper

project plan, and being my professor showed me the right track to follow. He also

encouraged me a lot to take up this topic which seemed easier as I had his support.

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Financial market:-

Financial market is a mechanism that allows people to easily buy and sell (trade) financial

securities (such as stocks and bonds), commodities (such as precious metals or agricultural

goods), Financial markets have evolved significantly over several hundred years and are

undergoing constant innovation to improve liquidity.

A system that facilitates the exchange of money for financial assets. A security market such as

the National Stock Exchange is an example of a financial market.

Equity market:-

A equity market is a public market for the trading of company stock at an

agreed price; these are securities listed on a stock exchange as well as those only traded

privately.

Derivative market: -

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Financial

Equity Derivative

http://en.wikipedia.org/wiki/Market_system

http://en.wikipedia.org/wiki/Trade

http://en.wikipedia.org/wiki/Corporation

http://en.wikipedia.org/wiki/Stock

http://en.wikipedia.org/wiki/Security_(finance)

http://en.wikipedia.org/wiki/Stock_exchange

http://en.wikipedia.org/wiki/Market_system

http://en.wikipedia.org/wiki/Trade

http://en.wikipedia.org/wiki/Corporation

http://en.wikipedia.org/wiki/Stock

http://en.wikipedia.org/wiki/Security_(finance)

http://en.wikipedia.org/wiki/Stock_exchange



The derivatives markets are the financial markets for derivatives. The market can

be divided into two, that for exchange traded derivatives (ETD) and that for over-the-counter

derivatives(OTC).

Introduction of derivatives:-

The word “DERIVATIVES” is derived from the word itself derived of an underlying

asset. It is a future image or copy of an underlying asset which may be shares, stocks,

commodities, stock index, etc.

For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of

a change in prices by that date. Such a transaction is an example of a derivative. The price of this

derivative is driven by the spot price of wheat which is the "underlying".

Derivatives have become very important in the field finance. They are very important

financial instruments for risk management as they allow risks to be separated and traded.

Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each

party involved in the contract should be able to identify all the risks involved before the contract

is agreed.

It is also important to remember that derivatives are derived from an underlying asset.

This means that risks in trading derivatives may change depending on what happens to the

underlying asset. The underlying asset can be equity, forex, commodity or any other asset.

For example, if the settlement price of a derivative is based on the stock price of a stock for e.g.

Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on

a daily basis. This means that derivative risks and positions must be monitored constantly.

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http://en.wikipedia.org/wiki/Financial_market

http://en.wikipedia.org/wiki/Derivative_(finance)

http://en.wikipedia.org/wiki/Derivative_(finance)#Exchange_traded_derivatives

http://en.wikipedia.org/wiki/Derivative_(finance)#Over-the-counter_derivatives


http://en.wikipedia.org/wiki/Financial_market

http://en.wikipedia.org/wiki/Derivative_(finance)

http://en.wikipedia.org/wiki/Derivative_(finance)#Exchange_traded_derivatives





History of derivatives:-

Derivative products initially emerged as hedging devices against fluctuations in

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

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

post-1970 period due to growing instability in the financial markets.

However, since their emergence, these products have become very popular and by

1990s, they accounted for about two-thirds of total transactions in derivative products. In recent

years, the market for financial derivatives has grown tremendously in terms of variety of

instruments available, their complexity and also turnover.

In the class of equity derivatives the world over, futures and options on stock indices

have gained more popularity than on individual stocks, especially among institutional investors,

who are major users of index-linked derivatives. Even small investors find these useful due to

high correlation of the popular indexes with various portfolios and ease of use.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was

established in 1848 where forward contracts on various commodities were standardized around

1865. From then on, futures contracts have remained more or less in the same form, as we know

them today.

Exchange traded financial derivatives were introduced in India in June 2000 at the two

major stock exchanges, NSE and BSE. There are various contracts currently traded on these

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exchanges. The derivatives market in India has grown exponentially, especially at NSE. Stock

Futures are the most highly traded contracts on NSE accounting for around 55% of the total

turnover of derivatives at NSE, as on April 13, 2005.

CONCEPT OF BADLA SYSTEM

Badla is nothing but a carry forward system which means getting something in

return. The badla system was acceptable to be an important need for the investors in the stock market. Here in this system the investor feels that the price of a particular share is expected to go

up or down, without giving or taking the delivery he can participate in the possible fluctuation of

the share.

In the badla system, a position is carried forward, be it a short sale or a long purchase. In the

event of a long purchase, the market player may want to carry forward the transaction to the next

settlement cycle and for doing this he has to compensate the other party in the contract. While in

case of a short sale, the market player wants tom carry forward the transaction to the next

settlement cycle, he has to borrow the stocks to compensate the other party in the contract

THUS BADLA IS PURELY A MEANS OF CASH & SHARE FINANCING

ILLUSTRATION

The investor has purchased the 100shares of INFOSYS COMPANY for Rs.7000

which is trading at Rs. 7300. After this the investor expects to rise further. Therefore he wishes

to carry the contract forward to the next trading session by paying what are called badla charges.

In any badla transaction there are two key elements, the hawala rate and the bald

charge for the scrip. The badla charge is the interest payable by the investor for carrying forward

the position. It is fixed individually for each scrip by the exchange every Saturday and it is

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calculated on what is called the heal rate. The hawala rate is the price at which a share is squared

up in the current settlement and carried forward into the next settlement in the next trading

session. The existing position is squared up against the hawala rate fixed and carried forward

after factoring in the badla rate. The difference is paid to the broker (charges).

Thus if hawala rata Rs.7180 is lower than the initial margin the difference is paid to the broker.

The badla charges vary from broker to broker and proper relationship with the broker If broker

insists on a 25% margin, the investor get 400% leverage or four times the amount investor is

ready to deposit as margin. Thus At the end of each settlement, investor carry forward the

position at the hawala rate. This position will also be adjusted for badla. Thus investor can carry

forward the transactions for settlement

BADLA WAS BANNED ON 2nd JULY 2001

The badla was banned because more exposure was given to the speculation

and also the investor has to wait for 5days for the delivery of shares because the rolling

settlement was T+5 days. As badla system is a combination of lending and borrowing

mechanism of the stocks which further associated with risks. As badla was banned between the

intermediator was not the exchanges but the brokers. This system was time consuming because it

involves more Paper work. Thus if the broker becomes insolvent then they are not responsible

for the investors funds.

As carry forward were more a method of lending and borrowing of shares

and Funds. Here the borrower of shares or funds pays a fee or badla charges for the borrowing

and in the badla the futures prices were mixed up with the cash price.

The badla charges include a default risk premium because of the counterparty risk

inherent in the transaction. Further in the badla the position could break down if

borrowing/lending also proved infeasible. There is no expiration date in the badla system which

results into uncertainty. Finally in badla the net long (buy) positions would differ from the net

short (sell) positions.

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Aims and objectives of derivatives:-

1. To explore the derivative market in India.

2. To know what derivatives are available in India.

3. To know derivatives trading mechanism of exchanges.

4. To become aware of what strategies are followed by Indian Investors.

5. To know how derivatives are used in covering risk

6. To know how derivatives give a safe exposure.

Need for derivative market:-

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

2. They help in the discovery of future as well as current prices.

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3. They catalyze entrepreneurial activity.

4. They increase the volume traded in markets because of participation of risk adverse

people in greater numbers.

5. They increase savings and investment in the long run.

Purpose and benefits of derivative market;-

1. Today's sophisticated international markets have helped foster the rapid growth in

derivative instruments. In the hands of knowledgeable investors, derivatives can derive

profit from:

• Changes in interest rates and equity markets around the world.

• Changes in price of assets.

2. Help of hedge against inflation and deflation, and generate returns that are not correlated

with more traditional investments. The two most widely recognized benefits attributed to

derivative instruments are price discovery and risk management and others.

3. Price discovery: -

The kind of information and the way people absorb it constantly changes

the price of a commodity. This process is known as price discovery. the price of all future

contracts serve as prices that can be accepted by those who trade the contracts in lieu of

facing the risk of uncertain future prices.

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4. Risk management: -

This could be the most important purpose of the derivatives market.

Risk management is the process of identifying the desired level of risk, identifying the

actual level of risk and altering the latter to equal the former. This process can fall into

the categories of hedging and speculation.

5. Derivatives help in transferring risks from risk-averse people to risk-oriented people.

6. By allowing transfer of unwanted risks, derivatives can promote more efficient allocation

of capital across the economy and thus, increasing productivity in the economy.

7. Derivatives increase the volume traded in markets because of participation of risk-averse

people in greater numbers.

Factors driving the growth of derivatives:-

Over the last three decades, the derivatives market has seen a

phenomenal growth. A large variety of derivative contracts have been launched at

exchanges across the world. Some of the factors driving the growth of financial

derivatives are:

1. Increased volatility in asset prices in financial markets,

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

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

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

agents a wider choice of risk management strategies, and

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

over a large number of financial assets leading to higher returns, reduced risk as well

as transactions costs as compared to individual financial assets.

Derivative market is divided in two markets:-

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Derivative market

Over the counter

(OTC)

Exchange

traded



Over the counter:-

Over the counter derivatives are contracts that are traded (and

privately negotiated) directly between two parties, without going through an exchange or other

intermediary. Products such as swaps and forward rate agreements are almost always traded in

this way. The OTC derivative market is the largest market for derivatives, and is largely

unregulated with respect to disclosure of information between the parties, since the OTC market

is made up of banks and other highly sophisticated parties.

Because OTC derivatives are not traded on an exchange, there is no

central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract,

since each counter party relies on the other to perform.

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http://en.wikipedia.org/wiki/Swap_(finance)

http://en.wikipedia.org/wiki/Forward_rate_agreement



http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Contract

http://en.wikipedia.org/wiki/Swap_(finance)


http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Contract



• Features of over the counter derivatives:-

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions.

2. There are no formal centralized limits on individual positions, leverage, or margining.

3. There are no formal rules for risk and burden-sharing.

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and

for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the

exchange's self-regulatory organization.

6. When asset prices change rapidly, the size and configuration of counter-party exposures

can become unsustainably large and provoke a rapid unwinding of positions.

Exchange traded derivatives:-

They are standardized ones where the exchange sets the

standards for trading by providing the contract specifications and the clearing corporation provides the trade guarantee and the settlement activities. Futures and Options are the

derivatives. Products like futures and options are traded in this way.

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In the exchange traded derivatives is the largest market for derivatives. In

this type of derivatives a highly regulated exchange is involved which is Security Exchange

Board of India (SEBI).

• Features of Exchange Traded Derivatives:-

1. The management of counter party risk is centralized and located with high

institutions.

2. There are formal centralized limits on individual positions, leverage, or margining

3. There are formal rules for risk and burden-sharing.

4. There are formal rules or mechanisms for ensuring market stability and integrity,

and for safeguarding the collective interests of market participants, and

5. The exchange traded contracts are generally regulated by a regulatory authority.

Types of derivatives:-

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Derivative contracts have several types. The most common variants are forwards, futures,

options and swaps.

1. Forwards:

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.

2. 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 exchange-traded contracts.

3. 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.

4. 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.

5. LEAPS:

The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of up to three years.

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6. 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.

7. 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:

These entail swapping only the interest related cash flow 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.

8. 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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Forward contract:-

It is an agreement between two parties to buy or sell an asset on a specified date

for a specified price. A forward contract is a simple derivative. It is a type of market where buyer

and seller predict the future for the underlying asset which may be stocks, currency, interest rate

etc. One of the parties to the contract assumes a long position which agrees to buy underlying

asset for a certain specified price. The other Party assumes a short position and agrees to sell at

the same price. Forward contract can be 30days, 90days and 180days

The contract is usually between two financial institutions or between a financialinstitution and its corporate client. A forward contract is not normally traded on an exchange. It

is traded on the OTC (over the counter) derivatives where the intermediator or exchange has no

role to play and contract is smoothly settled by the parties or normally traded outside the

exchanges.

At delivery, ownership of the good is transferred and payment is made. In other

words, whereas the forward contract is executed today, and the price is agreed upon today, the

actual transaction in which the underlying asset is traded does not take place until a later date.

Typically, no money changes hands on the origination date of a forward contract.

Forward contracts are not standardized unlike futures contracts. They are

customized and each contract is unique in terms of contract size, expiration date and the asset

type and quality. Terms of Forward contracts are negotiated between buyer and seller. As there is

no exchange involved in it there is chance of default of either party.

Forward contracts are very useful in hedging and speculation. Here the

importer and exporter can hedge their risk exposure with respect to exchange rate fluctuations

while entering into the currency forward market.

The first formal commodities exchange in the United States for spot and

forward contracting was formatted in 1848: the Chicago Board of Trade (CBOT).

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ILLUSTRATION

On 1st march 2004 Mukesh has entered into a forward contract with Anil In this Mukesh takes a

long position(buy) on the scrip and Anil takes a short position(short) on the scrip. Here Mukesh

agrees to purchase 100 shares of RELIANCE ENERGY from the Anil for a predetermined price

of Rs.400.The contract is three months forward. Thus on future Anil will deliver the shares to

Mukesh while in return Mukesh will pay the amount of Rs.40,000(400*100).

Suppose during the maturity date Mukesh may default for the transaction he refuse to

make the payment for the shares or Anil refuse to deliver the shares. Therefore in this there is a

counter party risk one party may default due to this other party suffers because there is no

standardized exchange between the parties and the contract is OTC in nature and also prices aredecided by the buyers and sellers.

Finally forward contract is settled at maturity. The holder of the short position delivers the asset

to the holder of the long position in return for cash at the agreed upon rate. Therefore, a key

determinant of the value of the contract is the market price of the underlying asset. A forward

contract can therefore, assume a positive or negative value depending on the movements of the price of the asset. For example, if the price of the asset rises sharply after the two parties have

entered into the contract, the party holding the long position stands to benefit, i.e. the value of the

contract is positive for her. Conversely, the value of the contract becomes negative for the party

holding the short position.

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Future contract:-

A future contract is similar to a forward contract. It is a standardizedforward contract that can be easily traded. In future contract default risk is lower on futures than

on forwards for several reasons:-

a) The counterparty to all futures trades is actually the clearing house of the futures

exchange, which guarantees that all payments will be made.

b) Future contracts are marked to market daily settled which means that any change in

the value of the contract is realized as a profit or loss every day.

c) Initial margin, which serves as a performance bond, is required when trading futures.

In contrast, because they are not marked to market, forward contracts can build up

large unrealized profits for one party and equally large unrealized losses for the other

party.

There is a multilateral contract between the buyer and seller for an

underlying asset which may be financial instrument or physical commodities. But unlike forward

contracts the future contracts are standardized and exchange traded.

The primary purpose of futures market is to provide an efficient and

effective mechanism for management of inherent risks, without counter-party risk. As it is a

future contract the buyer and seller has to pay the margin to trade in the futures market.

The standardized items in a futures contract are:

· Quantity of the underlying

· Quality of the underlying

· The date and the month of delivery

· The units of price quotation and minimum price change.

. Location of settlement.

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

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

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

purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of

Infosys is 300 shares.

Suppose the stock rises to 2200.

Profit

20

2200

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the buyer (Hitesh) = Rs.1, 65,000 [(2200-1650*3oo)] and notional profit for the buyer is 550.

Unlimited loss for the buyer because the buyer is bearish in the market

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Suppose the stock falls to Rs.1400

Profit

20

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

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

250.

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

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• History of future derivatives:-

Merton Miller, the 1990 Nobel laureate had said that 'financial futures

represent the most significant financial innovation of the last twenty years." The first exchange

that traded financial derivatives was launched in Chicago in the year 1972. A division of the

Chicago Mercantile Exchange, it was called the International Monetary Market (IMM) and

traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as

the 'father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange.

Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value wascounted in millions. By 1990, the underlying value of all contracts traded at the Chicago

Mercantile Exchange totaled 50 trillion dollar.

FUTURES TERMINOLOGY:-

a) Spot price: The price at which an asset trades in the spot market.

b) Futures price: The price at which the futures contract trades in the futures market.

c) Contract cycle: The period over which a contract trades. The index futures contracts

on the NSE have one- month, two-month and three months expiry cycles which

expire on the last Thursday of the month. Thus a January expiration contract expires

on the last Thursday of January and a February expiration contract ceases trading on

the last Thursday of February. On the Friday following the last Thursday, a new

contract having a three- month expiry is introduced for trading.

d) 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.

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e) Contract size: The amount of asset that has to be delivered under one contract. Also

called as lot size.

f) Basis: In the context of financial futures, basis can be defined as the futures price

minus the spot price. There will be a different basis for each delivery month for each

contract. In a normal market, basis will be positive. This reflects that futures prices

normally exceed spot prices.

g) 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.

h) 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.

i) Marking-to-market: In the futures market, at the end of each trading day, the margin

account is adjusted to reflect the investor's gain or loss depending upon the futures

closing price. This is called marking-to-market.

j) Maintenance margin: This is somewhat lower than the initial margin. This is set to

ensure that the balance in the margin account never becomes negative. If the balance

in the margin account falls below the maintenance margin, the investor receives a

margin call and is expected to top up the margin account to the initial margin level

before trading commences on the next day.

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Introduction to options:-

It is an interesting tool for small retail investors. An option is a contract, which

gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the

underlying assets, at a specific (strike) price on or before a specified time (expiration date). The

underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial

instruments like equity stocks/ stock index/ bonds etc.

Options are fundamentally different from forward and futures contracts. An

option gives the holder of the option the right to do something. The holder does not have to

exercise this right. In contrast, in a forward or futures contract, the two parties have committed

themselves to doing something. Whereas it costs nothing (except margin requirements) to enter

into a futures contract, the purchase of an option requires an up-front payment. The options are

also traded on stock exchange.

Terminologies of options:-

CALL OPTION

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

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

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

decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer

(seller) of the contract.

ILLUSTRATION

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

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

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

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1. CALL BUYER

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

exercised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will

earn profit once the share price crossed to Rs.625 (strike price + premium). Suppose the stock

has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip

from the seller at Rs.600 and sell in the market at Rs.660.

Profit

30

20

10

0 590 600 610 620 630 640

-10

-20

-30

Loss

Unlimited profit for the buyer = Rs.35{(spot price – strike price) – premium}

Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

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

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

Profit

30

20

10

0 590 600 610 620 630 640

-10

-20

-30

Loss

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

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

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the

lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

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

losses and have limited losses to the certain extent

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Thus call option indicates two positions as follows:

1) LONG POSITION

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

call option.

2) SHORT POSITION

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

call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right

to sell specified quantity of the underlying asset at the strike price on or before an expiry date.

The seller of the put option (one who is short put) however, has the obligation to buy the

underlying asset at the strike price if the buyer decides to exercise his option to sell.

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ILLUSTRATION

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

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

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.20.

1) PUT BUYER (Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will beexercised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer’s

breakeven point is Rs.780(Strike price – Premium paid). The buyer will earn profit once the

share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be

exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700 and sell to the

seller at Rs.800.

Profit

20

10

0 600 700 800 900 1000 1100

10

20

Loss

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

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

2) PUT SELLER (Amit):

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

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

rate.

Profit

20

10

0 600 700 800 900 1000 1100

10

20

Loss

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

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

Limited profit for the seller up to the premium received = 20

32



Thus Put option also indicates two positions as follows:

• LONG POSITION

If the investor expects price to fall i.e. bearish in

the market he takes a long position by buying Put option.

• SHORT POSITION

If the investor expects price to rise i.e. bullish in

the market he takes a short position by selling Put option.

CALL OPTIONS PUT OPTIONS

Option buyer or

option holder

Buys the right to buy

the underlying asset at

the specified price

Buys the right to sell the

underlying asset at the

specified price

Option seller or

option writer

Has the obligation to

sell the underlying asset

(to the option holder) at

the specified price

Has the obligation to

buy the underlying asset

(from the option holder)

at the specified price.

3) Index options:

33



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

European while others are American. Like index futures contracts, index options

contracts are also cash settled.

4) 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.

5) Buyer of an option:

The buyer of an option is the one who by paying the option

premium buys the right but not the obligation to exercise his option on the

seller/writer.

6) Writer of an option:

The writer of a call/put option is the one who receive the

option premium and is thereby obliged to sell/buy the asset if the buyer exercises on

him. There are two basic types of options, call options and put options.

7) Option price/premium:

Option price is the price which the option buyer pays to

the option seller. It is also referred to as the option premium.

8) Expiration date:

The date specified in the options contract is known as the

expiration date, the exercise date, the strike date or the maturity.

9) Strike price:

34



The price specified in the options contract is known as the strike

price or the exercise price.

10) American options:

American options are options that can be exercised at any

time up to the expiration date. Most exchange-traded options are American.

11) European options:

European options are options that can be exercised only on the

expiration date itself. European options are easier to analyze than American options,

and properties of an American option are frequently deduced from those of its

European counterpart.

12) In-the-money option:

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

positive cash flow to the holder if it were exercised immediately. A call option on the

index is said to be in-the-money when the current index stands at a level higher than

the strike price (i.e. spot price >strike price). If the index is much higher than the

strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the

index is below the strike price.

13) At-the-money option:

An at-the-money (ATM) option is an option that would lead to

zero cash flow if it were exercised immediately. An option on the index is at-the-

money when the current index equals the strike price

(i.e. spot price = strike price).

14) Out-of-the-money option:

35



An out-of-the-money (OTM) option is an option that would

lead to a negative cash flow if it were exercised immediately. A call option on the

index is out-of-the-money when the current index stands at a level which is less than

the strike price (i.e. spot price < strike price). If the index is much lower than the

strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if

the index is above the strike price.

15) Time value of an option:

Both calls and puts have time value. An option that

is OTM or ATM has only time value. Usually, the maximum time value exists when

the option is ATM. The longer the time to expiration, the greater is an option's time

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

FACTORS AFFECTING OPTION PREMIUM

36



THE PRICE OF THE UNDERLYING ASSET: (S)

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

price changes have opposite effects on calls and puts.

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

premium of a put will decrease. A decrease in the price of the underlying asset’s value will

generally have the opposite effect.

THE SRIKE PRICE: (K)

The strike price determines whether or not an option has any intrinsic value. An option’s

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

becomes more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an option’s time value, for puts and calls, decreases.

Volatility:

Volatility is simply a measure of risk (uncertainty), or variability of an option’s underlying.

Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying

price levels. This expectation generally results in higher option premiums for puts and calls alike,

and is most noticeable with at- the- money options.

37



Interest rate: (R1)

This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in case

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

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:-

Developmental institutions

Mutual Funds

Domestic & Foreign Institutional Investors

Brokers

Retail Participants

38



FUTURES V/S OPTIONS

RIGHT OR OBLIGATION :

Futures are agreements/contracts to buy or sell specified quantity of the

underlying assets at a price agreed upon by the buyer & seller, on or before

a specified time. Both the buyer and seller are obligated to buy/sell the

underlying asset. In case of options the buyer enjoys the right & not the

obligation, to buy or sell the underlying asset.

RISK:

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

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

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

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

the premium he has received from the buyer.

PRICES:

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

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

expiry of the contract & volatility of the underlying asset.

COST:

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

contract, termed as Premium.

39



STRIKE PRICE:

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

constant.

Liquidity:

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

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

dedicated trading and investors in the options contract.

Price behavior:

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

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

depends upon the price and volatility of the underlying.

PAY OFF:

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

While futures are more active has linear pay off.

FUTURES PAYOFFS

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits

for the buyer and the seller of a futures contract are unlimited. These linear payoffs are

fascinating as they can be combined with options and the underlying to generate various complex

payoffs.

40



Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who

holds an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who buys a two month Nifty index futures contract

when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When

the index moves up, the long futures position starts making profits, and when the index

moves down it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a

futures contract.

Payoff for a buyer of Nifty futures

The figure shows the profits/losses for a long futures position. The investor bought futures when

the index was at 2220. If the index goes up, his futures position starts making profit. If the index

falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who

shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty

stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves

41



down, the short futures position starts making profits, and when the index moves up, it starts

making losses. Figure shows the payoff diagram for the seller of a futures contract.

Payoff for a seller of Nifty futures

The figure shows the profits/losses for a short futures position. The investor sold futures when

the index was at 2220. If the index goes down, his futures position starts making profit. If the

index rises, his futures position starts showing losses.

OPTIONS PAYOFFS

42



The optionality characteristic of options results in a non-linear payoff for options. In simple

words, it means that the losses for the buyer of an option are limited; however the profits are

potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to

the option premium; however his losses are potentially unlimited. These non-linear payoffs are

fascinating as they lend themselves to be used to generate various payoffs by using combinations

of options and the underlying. We look here at the six basic payoffs.

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for

2220, and sells it at a future date at an unknown price, St. Once it is purchased, the

investor is said to be "long" the asset. Figure shows the payoff for a long position

on the Nifty.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 2220, and

buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be

"short" the asset. Figure shows the payoff for a short position on the Nifty.

Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in

the option. The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher

the spot price more is the profit he makes. If the spot price of the underlying is less than the

strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid

for buying the option. Figure 4.6 gives the payoff for the buyer of a three month call option

(often referred to as long call) with strike of 2250 bought at a premium of 86.60.

Payoff for investor who went Long Nifty at 2220

43



The figure shows the profits/losses from a long position on the index. The investor bought the

index at 2220. If the index goes up, he profits. If the index falls he looses.

Payoff for investor who went Short Nifty at 2220

44



The figure shows the profits/losses from a short position on the index. The investor sold the

index at 2220. If the index falls, he profits. If the index rises, he looses.

45



Payoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can

be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes

above the strike of 2250, the buyer would exercise his option and profit to the extent of the

difference between the Nifty-close and the strike price. The profits possible on this option are

potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire.

His losses are limited to the extent of the premium he paid for buying the option.

46



Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in

the option. For selling the option, the writer of the option charges a premium. The profit/loss that

the buyer makes on the option depends on the spot price of the underlying. Whatever is the

buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price,

the buyer will exercise the option on the writer. Hence as the spot price increases the writer of

the option starts making losses. Higher the spot price more is the loss he makes. If upon

expiration the spot price of the underlying is less than the strike price, the buyer lets his option

expire un-exercised and the writer gets to keep the premium. Figure gives the payoff for thewriter of a three month call option (often referred to as short call) with a strike of 2250 sold at a

premium of 86.60.

Payoff for writer of call option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the

spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon

expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the

writer who would suffer a loss to the extent of the difference between the Nifty -close and the

strike price. The loss that can be incurred by the writer of the option is potentially unlimited,

whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60

charged by him.

47



Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the option depends on the

spot price of the underlying. If upon expiration, the spot price is below the strike price, he

makes a profit. Lower the spot price more is the profit he makes. If the spot price of the

underlying is higher than the strike price, he lets his option expire un-exercised. His loss in

this case is the premium he paid for buying the option. Figure 4.8 gives the payoff for the

buyer of a three month put option (often referred to as long put) with a strike of 2250

bought at a premium of 61.70.

48



Payoff for buyer of put option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can

be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes

below the strike of 2250, the buyer would exercise his option and profit to the extent of the

difference between the strike price and Nifty-close. The profits possible on this option can be as

high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire.

His losses are limited to the extent of the premium he paid for buying the option.

49



o Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in

the option. For selling the option, the writer of the option charges a premium. The profit/loss that

the buyer makes on the option depends on the spot price of the underlying. Whatever is the

buyer's profit is the seller's loss.

If upon expiration, the spot price happens to be below the strike

price, the buyer will exercise the option on the writer. If upon expiration the spot price of the

underlying is more than the strike price, the buyer lets his option unexercised and the writer gets

to keep the premium. Figure 4.9 gives the payoff for the writer of a three month put option (often

referred to as short put) with a strike of 2250 sold at a premium of 61.70.

o Payoff for writer of put option

The figure shows the profits/losses for the seller of a three-

month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the

writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer

would exercise his option on the writer who would suffer a loss to the extent of the difference

between the strike price and Nifty-close. The loss that can be incurred by the writer of the option

is a maximum extent of the strike price (Since the worst that can happen is that the asset price

can fall to zero) whereas the maximum profit is limited to the extent of the up-front option

premium of Rs.61.70 charged by him.

50



APPLICATION OF OPTIONS

Since the index is nothing but a security whose price or level is a weighted average of securities

constituting the index, all strategies that can be implemented using stock futures can also be

implemented using index options.

o Hedging: Have underlying buy puts

Owners of stocks or equity portfolios often experience discomfort

about the overall stock market movement. As an owner of stocks or an equity portfolio,

sometimes you may have a view that stock prices will fall in the near future. At other times you

may see that the market is in for a few days or weeks of massive volatility, and you do not have

an appetite for this kind of volatility.

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

volatility is always enhanced for one week before and two weeks after a budget. Many investors

simply do not want the fluctuations of these three weeks. One way to protect your portfolio from

potential downside due to a market drop is to buy insurance using put options.

Index and stock options are a cheap and easily implementable way of seeking this insurance. The

idea is simple. To protect the value of your portfolio from falling below a particular level, buy

the right number of put options with the right strike price. If you are only concerned about the

value of a particular stock that you hold, buy put options on that stock.

If you are concerned about the overall portfolio, buy put options on the

index. When the stock price falls your stock will lose value and the put options bought by you

will gain, effectively ensuring that the total value of your stock plus put does not fall below a

particular level. This level depends on the strike price of the stock options chosen by you.Similarly when the index falls, your portfolio will lose value and the put options bought by you

will gain, effectively ensuring that the value of your portfolio does not fall below a particular

level. This level depends on the strike price of the index options chosen by you.

51



Portfolio insurance using put options is of particular interest to mutual funds who already own

well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market

fall.

Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise.

For instance, after a good budget, or good corporate results, or the onset of a stable government.

How does one implement a trading strategy to benefit from an upward movement in the

underlying security? Using options there are two ways one can do this:

1. Buy call options; or

2. Sell put options

We have already seen the payoff of a call option. The downside to the

buyer of the call option is limited to the option premium he pays for buying the option. His

upside however is potentially unlimited. Suppose you have a hunch that the price of a particular

security is going to rise in a months time. Your hunch proves correct and the price does indeed

rise, it is this upside that you cash in on.

However, if your hunch proves to be wrong and the security price plunges

down, what you lose is only the option premium. Having decided to buy a call, which one should

you buy? Table 4.1 gives the premium for one month calls and puts with different strikes. Given

that there are a number of one-month calls trading, each with a different strike price, the obvious

question is: which strike should you choose? Let us take a look at call options with different

strike prices. Assume that the current price level is 1250, risk-free rate is 12% per year and

volatility of the underlying security is 30%.

The following options are available:

1. A one month calls with a strike of 1200.

2. A one month call with a strike of 1225.



52




Which of these options you choose largely depends on how strongly you feel

about the likelihood of the upward movement in the price, and how much you are willing to lose

should this upward movement not come about. There are five one-month calls and five one-

month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence

trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low

premium.

The call with a strike of 1300 is deep-out-of-money. Its execution depends on

the unlikely event that the underlying will rise by more than 50 points on the expiration date.

Hence buying this call is basically like buying a lottery. There is a small probability that it may

be in-the-money by expiration, in which case the buyer will make profits. In the more likely

event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of

Rs.27.50.

As a person who wants to speculate on the hunch that prices may rise, you can

also do so by selling or writing puts. As the writer of puts, you face a limited upside and an

unlimited downside. If prices do rise, the buyer of the put will let the option expire and you will

earn the premium. If however your hunch about an upward movement proves to be wrong and

prices actually fall, then your losses directly increase with the falling price level. If for instance

the price of the underlying falls to 1230 and you've sold a put with an exercise of 1300, the buyer

Of the put will exercise the option and you'll end up losing Rs.70. Taking into account the

premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.

Having decided to write a put, which one should you write? Given that there are a number of

one-month puts trading, each with a different strike price, the obvious question is: which strike

should you choose? This largely depends on how strongly you feel about the likelihood of the

upward movement in the prices of the underlying. If you write an at-the-money put, the option

premium earned by you will be higher than if you write an out-of-the-money put. However the

chances of an at-the-money put being exercised on you are higher as well.

53



o One month calls and puts trading at different strikes

The spot price is 1250. There are five one-month calls and five one-month puts trading in the

market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher

premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The

call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that

the price of underlying will rise by more than 50 points on the expiration date. Hence buying this

call is basically like buying a lottery. There is a small probability that it may be in-the-money by

expiration in which case the buyer will profit. In the more likely event of the call expiring out-of-

the-money, the buyer simply loses the small premium amount of Rs. 27.50. Figure 4.10 shows

the payoffs from buying calls at different strikes. Similarly, the put with a strike of 1300 is deep

in-the-money and trades at a higher premium than the at-the-money put at a strike of 1250. The

put with a strike of 1200 is deep out-of-the-money and will only be exercised in the unlikely

event that underlying falls by 50 points on the expiration date.

Show the payoffs from writing puts at different strikes.

Underlying Strike price of

option

Call premium (Rs.) Put premium (Rs.)

1250 1200 80.10 18.15

1250 1225 63.65 26.50

1250 1250 49.45 37.00

1250 1275 37.50 49.80

1250 1300 27.50 64.80

At a price level of 1250, one option is in-the-money and one is out-of-the-money. As expected,

the in-the-money option fetches the highest premium of Rs.64.80 whereas the out-of-the-money

option has the lowest premium of Rs. 18.15.

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o Speculation: Bearish security, sell calls or buy puts

Do you sometimes think that the market is going to drop? That you could make a

profit by adopting a position on the market? Due to poor corporate results, or the instability of

the government, many people feel that the stocks prices would go down. How does one

implement a trading strategy to benefit from a downward movement in the market? Today, using

options, you have two choices:

1. Sell call options; or

2. Buy put options

We have already seen the payoff of a call option. The upside to the writer of the call

option is limited to the option premium he receives upright for writing the option. His downside

however is potentially unlimited. Suppose you have a hunch that the price of a particular security

is going to fall in a months time. Your hunch proves correct and it does indeed fall, it is this

downside that you cash in on. When the price falls, the buyer of the call lets the call expire and

you get to keep the premium. However, if your hunch proves to be wrong and the market soars

up instead, what you lose is directly proportional to the rise in the price of the security.

55



REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R)A,

the SEBI Act, the rules and regulations framed there under and the rules and bye–laws of stock

exchanges.

SECURITIES CONTRACTS (REGULATION) ACT, 1956

SC(R)A 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 SC(R)A. 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.

56



“Derivative” is defined to include:

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

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

·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 derivative shall be legal and valid if such contracts are:

Traded on a recognized stock exchange Settled on the clearing house of the recognized stock

exchange, in accordance with the rules and bye–laws 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 stock brokers, sub–brokers etc.

· promoting and regulating self-regulatory organizations.

· prohibiting fraudulent and unfair trade practices.

· calling for information from, undertaking inspection, conducting inquiries and audits of the

stock exchanges, mutual funds and other persons associated with the securities market and

intermediaries and self–regulatory organizations in the securities market.

· performing such functions and exercising according to Securities

Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

57



REGULATION FOR DERIVATIVES TRADING

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. On May 11,

1998 SEBI accepted the recommendations of the committee and approved the phased

introduction of derivatives trading in India beginning with stock index futures. The provisions in

the SC(R)A and the regulatory framework developed there under govern trading in securities.

The amendment of the SC(R)A to include derivatives within the ambit of ‘securities’ in the

SC(R)A made trading in derivatives possible within the framework of that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Guptacommittee report can 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 have 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 would have to regulate the sales practices of

its members and would have to obtain prior approval of SEBI before start of trading in any

derivative contract.

2. The Exchange should have minimum 50 members.

3. The members of an existing segment of the exchange would not automatically

become the members of derivative segment. The members of the derivative segment would

need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee.

4. The clearing and settlement of derivatives trades would be through a

SEBI approved clearing corporation/house. Clearing corporations/houses complying with the

eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.

58



5. Derivative brokers/dealers and clearing members are required to seek

registration from SEBI. This is in addition to their registration as brokers of existing stock

exchanges. The minimum net worth for clearing members of the derivatives clearing

corporation/house shall be Rs.300 Lakh. The networth 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 Lakh. Exchanges have to submit

details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy and

margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange

from time to time.

8. The L. C. Gupta committee report requires strict enforcement of “Know your

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.

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“CONCLUSION”

The World Financial Markets have undergone qualitative changes

in the last 3 decades due to phenomenal growth of Derivatives. An increasingly;

large number of organizations now consider derivatives to play a significant role in

implementing their financial policies. Derivatives are used for a variety of

purposes, but perhaps, the most important is hedging.

Hedging involves transfer of market risk- the possibility of

sustaining losses due to unforeseen unfavorable price changes. A derivatives

transaction allows a firm to alter its market risk profile by transferring to counter

party some type of risk for a price. Hedging is prime reason for the advent of

derivatives and continuous to be significant factor driving financial managers to

deal in derivatives. Markets in India have developed a lot day by day these

instruments are becoming the integral part of Investments

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Derivatives on Equity

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