CHAPTER-2

INSTRUMENTS, CONCEPTS
AND TERMINOLOGIES USED
IN CAPITAL MARKET

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2.1 INTRODUCTION
To have a basic idea on Capital Market, it is very much essential to
know various important instruments, concepts as well as terminologies
used in Primary and Secondary segments of Capital Market. Capital
Market Instruments are of two types - (1) Direct instruments and (2)
Indirect instruments. The Direct instruments are: (a) Equity/Ordinary
Shares (b) Preference Shares (c) Debentures/Bonds/Notes and (d)
Innovative Debt Instruments. Among these, securities like Equity and
Preference Shares are ownership instruments while Debentures/Bonds
/Notes and Innovative Debt instruments are. creditor-ship securities.
Derivative instruments are the indirect instruments. The present chapter
~contains discussions on various instruments, concepts and terminologies
relating to the Indian Capital Market. At first, various instruments of
capital market have been discussed. Then the various concepts and
terminologies now in use relating to issuance of shares have been
discussed. At the end, some important concepts and terminologies
relating to derivatives trading on Indian bourses have been discussed.

2.2 INSTRUMENTS OF CAPITAL MARKET

2.2.1 Equity/Ordinary Shares
The capital of a company is divided into a number of indivisible
units of a fixed amount. These units are known as shares. Thus, if the
share capital of a company is Rs 5 lakh divided into 50,000 units of Rs
10, each unit ofRs 10 shall be called a share of the company. Section 82
of the Indian Companies Act, 1956 describes a 'share certificate' to mean
a certificate, under the common seal of the company, specifying the
number of shares held by a member. Section 84 further suggests that a
share certificate shall be a prima facie evidence of title of the member to
such shares. Thus, whereas 'share' represents property (movable), 'share
certificate' is an evidence (prima facie) of the title of the member to such
property.
As per Section 85 (2) of the Indian Companies Act, 1956 equity
shares are those shares which are not preference shares. In other words,
shares which do not enjoy any preferential right in the matter of payment

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of dividend or repayment of capital are known as equity shares. After

satisfying the rights of preference shares, the equity shares shall be
entitled to share in the remaining amount of distributable net profits of the
company. The dividend on equity shares is not fixed and may vary from
year to year depending upon the amount of net profit available. The rate
of dividend is recommended by the Board of Directors of the company
and declared by the shareholders in the Annual General Meeting.
Equity shareholders have a right to vote on every resolution placed in
the meeting or passed through postal ballot voting and such voting rights
shall be in proportion to the paid-up equity capital.
Ordinary shares typically have a par/face value and the most popular
denomination is Rs. 10. However, companies are permitted to issue
shares of any par value of not less than Re.l and in multiples of Re.l. The
price at which the equity shares are issued is the issue price. The issue
price for new companies particularly without any profit track-record is
generally equal to the face value. It may be higher for existing profit
making companies, the difference/excess being the share premium.
Though now-a-days, under Book Building process, subject to fulfillment
of certain conditions, companies without having previous profit trackrecord can also issue shares at high premium. The book value of ordinary
shares refers to the paid up capital plus reserves and surplus (net worth)
divided by the number of outstanding shares. The price at which equity
shares are traded in the stock market is their marker value. However, the
market value of unlisted/rarely traded shares is not available.

2.2.2 Preference Shares

Preference Share/Capital is a unique type of long-term capital market
instrument, and it combines some of the features of equity shares as well
as some of debentures. As a hybrid security/form of financing/instrument,
it is similar to debentures in so far as it: (i) carries a fixed/stated rate of
dividend (ii) ranks higher than equity as a claimant to the income/assets
(iii) normally does not have voting rights and (iv) does not have a share in
residual earnings/assets. It also partakes some of the attributes of equity
capital, namely, (i) dividend on preference capital is paid out of

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divisible/after tax profit, that is, it. is not tax deductible (ii) payment of
preference dividend depends on the discretion of the management, that is,
it is not an obligatory payment, and non-payment does not force
insolvency/liquidation and (iii) irredeemable types of preference shares
have no fixed maturity date.

2.2.3 Debentures/Bonds/Notes
Akin to a promissory note, debentures/bonds represent creditorship securities and debenture-holders are long term creditors of the
company. As a secured instrument, it is a promise to pay interest and
repay principal at stipulated times. In contrast to equity capital, which is
a variable income security (i.e. in respect of dividend), the debentures/
notes are fixed income (i.e. in respect of interest) security.

2.2.4 Innovative Debt Instruments/Securities

In order to improve the attractiveness of fixed income securities,
namely- bonds and debentures, some new features have been added. As a
result, a wide range of innovative debt securities have emerged in India,
particularly, after the early nineties. This section describes some
important innovative debt instruments.

* Convertible Debentures/Bonds: Features

Convertible debentures give the holders the right (option) to
convert them into equity shares on certain terms. They are entitled
to a fixed income till the conversion option is exercised and would
share the benefits associated with equity shares after the
conversion. At present the operational features of convertible
debentures in India are as follows.
All the details about conversion terms, namely, conversion ratio,
conversion premium/price and conversion timing are specified in the
offer document/prospectus. Companies can issue Fully Convertible
Debentures (FCDs) or Party Convertible Debentures (PCDs ). At the end
of specified time, ordinary shares are issued in lieu of each convertible
debenture in a pre-determined ratio. The conversion price is the price paid
for the ordinary shares at the time of conversion. Thus, conversion ratio
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equals the par value of convertible debentures divided by the conversion

price. The conversion time refers to the period from the date of allotment
of convertible debentures after which the option to convert can be
exercised. If the conversion is to take place between 18-36 months, the
holder will have the option to exercise his rights in full or part. A
conversion period exceeding 36 month is not permitted without Put and
Call Options. The Call Option gives the issuer the right to redeem the
debentures/bonds prematurely, on the stated terms. In addition,
compulsory credit rating is necessary for fully convertible debentures.
* Callable/Puttable Bonds/Debentures

Beginning from 1992, when the Industrial Development Bank of

Iqdia issued bonds with call features, several callable/puttable bonds have
emerged in the country in the recent years. Call provisions provide
flexibility to the company to redeem them prematurely. Generally, firms
issue bonds at a presumably lower rate of interest when JJ?.arket conditions
are favorable to redeem such bonds.
*Warrants

A warrant entitles its holders to subscribe to the equity capital of a

company during a specified period at a stated/particular/certain price. The
holder acquires only the right (option) but he has no obligation to acquire
the equity shares. Warrants are generally issued in conjunction with/tied
to other instruments, for example, attached to (i) Secured Premium Notes
and (ii) Debentures.
Features of Warrant: The important features ofwarrants are as follows:
Exercise Price- It is the price at which the holder of a warrant is entitled
to acquire the ordinary shares of the company.
Exercise Ratio- It refers the number of shares that can be acquired per
warrant. Typically, the ratio is 1:1, which implies that one equity share
can be allotted against each warrant.

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Expiry Date- It means the date after which the option to buy shares
expires, that is, the life of the warrant. Usually, the life of warrants is 5 to
10 years.

Types- Warrants can be (i) detachable and (ii) non-detachable. A

detachable warrant can be sold separately to take advantage of price
increase and in that case the holder can continue to retain the instrument
to which the warrant was tied. In the cases of non-detachable warrants,
separate sale of warrants (i.e. independent of the instrument) is not
possible. Detachable warrants are listed on stock exchanges and tradable
but non-detachable warrants are not.

Difference between Warrants and Convertible Debentures

Warrants are akin to convertible debentures to the extent that both
give the holder the option/right to buy ordinary shares but there are
differences between the two. While the debenture and conversion option
:are inseparable, warrants can be detached. Similarly the conversion
. option is tied to the debenture but warrants can be offered independently
also. Warrants are typically exercisable for cash.

*Zero Interest Bonds (ZIBs)/Debentures

Also known as Zero Coupon Bonds (ZCBs) or Zero Interest
Debentures (ZIDs), the instruments do not carry any explicit/coupon rate
of interest. They are sold at a discount from their maturity value. The
difference between the face value of the bond and the acquisition cost is
the gain/return to the investors. The implicit rate of return/interest on such
bonds can be computed by the equation:
Acquiring price = Maturity (Face) Value I (l+it where, i = rate of
interest per rupee per year and n = Maturity Period (year~).

*Deep Discount Bond (DDB)

A Deep Discount Bond is a form of Zero Interest Bond (ZIB). It is
issued at a deep/steep discount over its face value. It implies that the
interest (coupon) rate is far less than the yield to maturity. The DDB
appreciates to its face value over the maturity period.
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DDBs are being issued by the public financial institutions in India,

namely- IDBI, SIDBI and so on. For instance, in 1992, IDBI sold a DDB
with a face value of Rs 1 lakh at a deep discount price of Rs. 2, 700 with a
maturity period of 25 years. If the investor could hold the DDB for 25
years, the annualized rate of return would work out to 15.54 %. A second
series ofDDBs was issued by the IDBI in 1996 with a face value ofRs.2
lakh and a maturity period of 25 years, the deep discount issue price
being Rs 5,300.

*Secured Premium Notes (SPNs)

The SPN is a secured debenture, redeemable at a premium over the
face value/purchase price. It resembles a ZIB. There is a lock-in-period
for SPN, during which no interest is paid. The holder has the option to
sell the SPN back to the issuing company, at par, after the lock-in-period.
The redemption is made in installments. The SPN is a tradable
instrument.
Although the SPN is akin to a ZIB to the extent it has no coupon rate
of interest (where the interest payment and principa~ repayment are
spread over a period of some years), whereas in case of ZIBs the entire
payment is made in lump sum on maturity.

* Floating Rate Bond,s (FRBs)

The interest on such bonds is not fixed. It is floating and is linked to
a benchmark rate such as interest on treasury bills, bank rate and
maximum rate on term deposits. It is typically a certain percentage point
higher than the benchmark rate. The price of FRBs tends to be fairly
stable and close to par value in comparison to fixed interest bonds. They
provide protection against inflation risk to investors, particularly in
comparison to interest rates provided by banks and financial institutions.

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2.3 CONCEPTS AND TERMINOLOGIES RELATING

TO ISSUANCE OF SHARES
2.3.1 DIFFERENT KINDS OF ISSUES
Primarily, issues can be classified as a Public, Rights or Preferential
issues (also known as private placements). While public and rights issues
involve a detailed procedure, private placements or preferential issues are
relatively simpler. The classification of issues is illustrated below:

Initial Public
Offering

Further Public
Offering

Public issues can be further classified into Initial Public Offerings and
Further Public Offerings. In a public offering, the issuer makes an offer
for new investors to enter its shareholding family. The issuer company
makes detailed disclosures as per the DIP guidelines of SEBI in its offer
document and offers it for subscription. The significant features are
illustrated below:
Initial Public Offering (IPO) is an issue when an unlisted company
makes either a fresh issue of securities or an offer for sale of its existing
securities or both for the first time to the public. This paves way for
listing and trading of the issuer's securities.

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A Further Public Offering (FPO) is an issue when an already listed

company makes either a fresh issue of securities to the public or an offer
for sale to the public, through an offer document. An offer for sale in such
scenario is allowed only if it is made to satisfy listing or continuous
listing obligations.

Rights Issue (RI) is an issue when a listed company which proposes

to issue fresh securities to its existing shareholders as on a record date.
The rights are normally offered in a particular ratio to the number of
securities held prior to the issue. This route is best suited for companies
who would like to raise capital without diluting stake of its existing
shareholders unless they do not intend to subscribe to their entitlements.
A Preferential Issue is an issue of shares or of convertible securities
by listed companies to a select group of persons under Section 81 of the
companies Act, 1956 which is neither a rights issue nor a public issue.
This is a faster way for a company to raise equity capital. The issuer
company has to comply with the companies Act and the requirements
contained in the Chapter pertaining to preferential allotment in SEBI
(DIP) guidelines which inter alia include pricing, disclosures in notice
etc.
2.3.2 SEBI'S ROLE IN AN ISSUE
Any company making a public issue or a listed company making a
rights issue of value of more than Rs.50 lakh is required to file a draft
. offer document with SEBI for its observations. The company can proceed
further on the issue only after getting observations from SEBI. The
validity period of SEBI's observation letter is three months only i.e. the
company has to open its issue within three months period.
SEBI does not recommend any issue nor does take any
responsibility either for the financial soundness of any scheme or the
project for which the issue is proposed to be made or for the correctness
of the statements made or opinions expressed in the offer document.
It is to be distinctly understood that submission of offer document to
SEBI should not in any way be deemed or construed that the same has
37

been cleared or approved by SEBI. The lead manager certifies that the
disclosures made in the offer document are generally adequate and are in
conformity with SEBI guidelines for disclosures and investor protection
in: force for the time being. This requirement is to facilitate investors to
take an informed decision for making investment in the proposed issue.
The investors should make an informed decision purely by themselves
based on the contents disclosed in the offer documents. SEBI does not
associate itself with any issue/issuer and should in no way be construed as
a guarantee for the funds that the investors propose to invest through the
issue. However, the investors are generally advised to study all the
material facts pertaining to the issue including the risk factors before
considering any investment. They are strongly warned against any 'tips'
or news through unofficial means.

2.3.3 DISCLOSURE & INVESTOR PROTECTION GUIDELINES

The primary issuances are governed by SEBI in terms of SEBI
(Disclosures and Investor Protection) Guidelines. SEBI framed its DIP
guidelines in 1992. Many amendments have been carried out in the same
in line with the market dynamics and requirements. In 2000, SEBI issued
"Securities and Exchange Board of India (Disclosure and Investor
Protection) Guidelines, 2000" which is compilation of all circulars
organized in chapter forms. These guidelines and amendments thereon
are issued by SEBI under section 11 of the Securities and Exchange
Board of India Act, 1992. SEBI (Disclosure and investor Protection)
Guidelines, 2000 are in short called DIP guidelines. It provides a
comprehensive framework for issuances by the companies.

2.3.4 SEBI'S ROLE ENSURING COMPLIANCE WITH DIP

The Merchant Bankers are the specialized intermediaries who are
required to do due diligence and ensure that all the requirements of DIP
guidelines are complied with while submitting the draft offer document to
SEBI. Any non-compliance on their part, attract penal action from SEBI,
in terms of SEBI (Merchant Bankers) Regulations. The draft offer
document filed by Merchant Banker is also placed on the website for
public comments. Officials of SEBI at various levels examine the

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compliance with DIP guidelines and ensure that all necessary material
information is disclosed in the draft offer document.
2.3.5 SOME IMPORTANT TERMS - OFFER DOCUMENT,
DRAFT OFFER DOCUMENT, RED HERRING
PROSPECTUS AND ABRIDGED PROSPECTUS
I

Offer Document means Prospectus in case of a public issue or offer

for sale and Letter of Offer in case of a rights issue, which is filed with
Registrar of Companies (ROC) and Stock Exchanges (SEs ). An offer
document covers all the relevant information to help an investor to make
his/her investment decision.
Draft Offer Document means the offer document in -draft stage. The
draft offer documents are filed with SEBI, at least 21 days prior to the
filing of the Offer Document with ROC/SEs. SEBI may specify changes,
if any, in the Draft Offer Document and the issuer or the lead merchant
banker shall carry out such changes in the draft offer document before
filing the Offer Document with ROC/SEs. The Draft Offer Document is
available on the SEBI website for public comments for a period of 21
days from the date of filing of the Draft Offer Document with SEBI.
Red Herring Prospectus is a prospectus which does not have details of
either price or number of shares being offered or the amount of issue.
this is used in book building issues only. In the case of book built issues,
it is a process of price discovery and the price cannot be determined until
~he bidding process is completed. Hence, such details are not shown in
the Red Herring Prospectus filed with ROC in terms of the provisions of
the companies Act. Only.: on completion of the bidding process, the details
of the final price are included in the offer document. The offer document
filed thereafter with ROC is called a Prospectus.
Abridged Prospectus means the memorandum as prescribed in Form 2A
. under Sub-section (3) of Section 56 of the Companies Act, 1956. It
contains all the salient features of a prospectus. It accompanies the
application form for public issues.

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2.3.6 CONCEPT OF "LOCK-IN" FOR PROMOTERS' SHARES

Lock-in indicates a freeze on the shares. SEBI (DIP) Guidelines have

stipulated lock-in requirements on shares of promoters mainly to ensure
that the promoters or main persons, who are controlling the company,
shall continue to hold some minimum percentage of shares in the
company after the public issue.
2.3.7 INVESTORS ELIGIBLE TO BID
In the case of an issue of equity shares through Book Building
Procedure the following categories of different types of investors are
eligible to bid.
I. Persons eligible to invest under all applicable laws, rules,
regulations and guidelines ;
2. Indian nationals resident in India who are majors, in single or
joint names (not more than three) ;
3. Hindu Undivided Families or HUFs in the individual name of
the Karta;
4. Eligible NRis on a repatriation basis or a non-repatriation basis,
subject to applicable laws. Non-Residents can bid for partly
paid up equity shares only if they have obtained the approval of
the Reserve Bank of India to subscribe to partly paid up equity
shares and the said approval is submitted along with the Bidcum-Application Form;
5. Fils registered with SEBI on a repatriation basis or a nonrepatriation basis, subject to compliance with applicable laws,
rules, regulations, guidelines and approvals in the issue ;
6. State Industrial Development Corporations ;
7. Insurance companies registered with the Insurance Regulatory
and Development Authority, India;
8. Provident funds with minimum corpus of Rs. 250 million and
who are authorized under their constitution to invest in equity
shares;
9. Pension funds with a minimum corpus of Rs. 250 million and
who are authorized under their constitution to invest in equity
shares;

40

10.Companies and corporate bodies registered under the applicable

laws in India and authorized to invest in equity shares ;
11. Venture Capital Funds registered with SEBI ;
12. Foreign Venture Capital Investors registered with SEBI;
13. Indian Mutual Funds registered with SEBI ;
14. Indian financial institutions, scheduled commercial banks
(excluding foreign banks), regional rural banks, co-operative
banks (subject to the RBI regulations and the SEBI guidelines
and regulations, as applicable) ;
15. Multilateral and bilateral development financial institutions ;
16. Trusts registered under the Societies Registration Act_, 1860, as
amended, or under any other law relating to trusts and who are
authorized under their constitution to hold and invest in equity
shares; and
17. Scientific and/or industrial research organizations in India
under their constitution to invest in equity shares.
2.3.8 PRICING OF AN ISSUE
Indian primary market ushered in an era of free pricing in 1992.
Following this, the SEBI guidelines have provided that the issuer in
consultation with Merchant Banker shall decide the price. There is no
price formula stipulated by SEBI. SEBI does not play any role in price
fixation. The company and merchant banker are however required to give
full disclosures of the parameters which they had considered while
deciding the issue price. There are two types of issues- one, where the
company and the Book Running Lead Manager (BRLM) fix a price
(called fixed price) and the other, where the company and the BRLM
stipulate a floor price or a price band and leave it to market forces to
determine the final price (price discovery through book building process).
An issuer company is allowed to price the issue freely. The basis of
issue price is disclosed in the offer document where the issuer discloses in
detail about the qualitative and quantitative factors justifying the issue
price. In the case of an issue through Book Building Process, the issuer
company can mention a price band of 20% (cap in the price band should
not be, more than 20% of the floor price) in the Draft Offer Document

41

filed with SEBI and actual price can be determined at a later date before
filing of the final offer document with SEBI/ROCs.
2.3.9 PRICE DISCOVERY THROUGH BOOK BUILDING
PROCESS
Book Building means a process undertaken by which a demand for
the securities proposed to be issued by a body corporate is elicited and
built up and the price for the securities is assessed on the basis of the bids
obtained for the quantum of securities offered for subscription by the
issuer. This method provides an opportunity to the market to discover
price for securities.
2.3.10 PRICE BAND
In the case of book building process the red herring prospectus may
contain either the floor price for the securities or a price band within
which the investors can bid. The spread between the floor and the cap of
the price band shall not be more than 20%. In other words, it means that
the cap price should not be more than 120% of the floor price. The price
band can have a revision and such a revision in the price band shall be
widely disseminated by informing the stock exchanges, by issuing press
release and also by indicating the change on the relevant website and the
terminals of the syndicate members. In case the price band is revised, the
bidding period shall be extended for a further period of three days,
subject to the total bidding period not exceeding ten working days. The
company decides the price or the price band, in consultation with
Merchant Bankers.
2.3.11 FIRM ALLOTMENT CATEGORY OF SHARES
A company making an issue to public can reserve some shares on
allotment on firm basis for some categories as specified in DIP
guidelines. Allotment on firm basis indicates that allotment to the
particular investor group is on firm basis. DIP guidelines provide for
maximum percentage of shares which can be reserved on firm basis. The
shares to be allotted on firm allotment category can be issued at a price
different from the price at which the net offer to the public is made

42

provided that the price at which the security is being offered to the
applicants in firm allotment category is higher than the price at which
securities are offered to public.
2.3.12 PREFERENCE WIDLE DOING THE ALLOTMENT
The allotment to the Qualified Institutional Buyers (QIBs) is done on
a discretionary basis. The discretion is left to the Merchant Bankers who
first disclose the parameters of judgment in the Red Herring Prospectus.
The Merchant Bankers are free to set their criteria and mention the same
in the Red Herring Prospectus.
2.3.13 PARTICIPATION OF RETAIL INVESTORS IN BID
PROCESS
Retail Individual investor means an investor who applies or bids for
securities for a value up to a particular amount. Currently this investment
limit is Rs.l, 00,000 (Rupees One Lakh). Earlier this limit was Rs 50,000.
A retail investor can bid in a book-built issue for the aforesaid amount of
investment limit. Any person who bids in excess of this limit will be
considered as a High Net worth Individual (HNI) and his category is
different.
2.3.14 AVAILABILITY OF FORMS FOR APPLYING/BIDDING
FOR THE SHARES
The forms for applying/bidding for shares are available with all
syndicate members, collection centers, the brokers to the issue and the
bankers to the issue.
2.3.15 EXTENT OF FAITH THAT AN INVESTOR CAN LAY ON
THE CONTENTS OF THE OFFER DOCUMENT
The offer document is prepared by an independent specialized
agency called Merchant Banker, which is registered with SEBI. They are
required to do due diligence while preparing an offer document. The draft
offer document submitted to SEBI is put on website for public comments.
In case, an investor has any information about the issuer or its directors or
43

any other aspect of the issue, which in his view is not factually reflected,
he may send his complaint to the Lead Manager to the issue or to the
SEBI, Division of Issues and Listing.
2.3.16 REQUIREMENT OF DEMAT ACCOUNT FOR AN
INVESTOR
As per the requirement, all the public issues of size in excess of Rs.
10 Crore, are to make compulsorily in the demat form. Thus, if an
investor chooses to apply for an issue that is being made in a compulsory
demat mode, he has to have a demat account and has the responsibility to
put the correct DP ID and Client ID details in the bid/ application forms.
2.3.17 DURATION OF A PUBLIC ISSUE
As per Clause 8.8.1 of SEBI Guidelines, the subscription list for
public issues shall be kept open for at least 3 working days and not more
than 10 working days. In case of Book built issues, the period may be
extended by a further 3 days. The public issue made by an infrastructure
company, satisfying the requirements in Clause 2.4.1 (iii) of Chapter II
may be kept open for a maximum period of 21 working days. As per
Clause 8.8.2, Rights issues shall be kept open for at least 30 days and not
more than 60 days.
2.3.18 CHANGE/REVISION OF BID BY AN INVESTOR
The investor can change or revise the quantity or price in the bid by
using the bid-revision form that is available along with the main
application form. However, the entire process of changing or revising the
bids shall be completed within the date of closure of the issue.
2.3.19 A BIDDER'S PROOF FOR ENTERING BIDS
The Syndicate member returns to the applicant the counterfoil of the
Bid-cum-Application form with the signature, date and stamp of the
syndicate member. This counterfoil part duly authenticated by the
Syndicate member is called Transaction Registration Slip (TRS). The
investor can retain this document as a sufficient proof that his bid has
been taken into account. When a bidder revises his bid, he has to
44

surrender the earlier TRS and get a revised TRS from the member of the
Syndicate.
2.3.. 20 CONFIRMATION OF ALLOTMENT OF SHARES
In case of fixed price issues, the investor is intimated about the
Confirmatory Allotment Note (CAN)/Refund Order within 30 days of
the closure of the issue. From such CAN the investor initially knows
about the allotment of shares in his favour. The investor is entitled to
receive a CAN in case he has been allotted shares. In case of book built
issues, if the investor has been allotted shares, he is entitled to receive
such CAN within 15 days from the date of closure of the issue. The
registrar of the issue then ensures that the demat credit or refund, as
applicable, is completed within 15 days of the closure of the issue.
2.3.21 DIFFERENT INTERMEDIARIES IN AN ISSUE
Merchant Bankers to the issue or Book Running Lead Managers
(BRLM), Syndicate Members, Registrar to the issue, Bankers to the issue,
Auditors of the company, Underwriters to the issue, Solicitors etc. are the
intermediaries to an issue. The issuer discloses the addresses,
telephone/fax numbers and e-mail addresses of these intermediaries.
2.3.22 ELIGIBILITY OF A BRLM
A Merchant banker possessing a valid SEBI registration in
accordance with the SEBI (Merchant Bankers) Regulations, 1992 is
eligible to act as a Book Running Lead Manager to an issue.
2.3.23 ROLE (PRE AND POST ISSUE) OF A LEAD MANAGER
In the pre-issue process, the Lead Manager (LM) takes up the due
diligence of company's operations/management/business plans/legal
procedures etc. Other activities of the LM include drafting and designing
of Offer Documents, Prospectus, Statutory Advertisements and
Memorandum containing salient features of the Prospectus. The BRLMs
shall ensure compliance with stipulated requirements and completion of
prescribed formalities with the Stock Exchange, ROC and SEBI including
finalization of Prospectus and filing of necessary documents with ROC.
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Appointment of other intermediaries, viz., Registrar(s), Printers,

Advertising Agency and Bankers to the Offer is also included in the preissue processes. The LM also draws up the various marketing strategies
for the issue.
The post issue activities including management of escrow accounts,
co-ordination of non-institutional allocation, intimation of allocation and
dispatch of refunds to bidders etc are performed by the LM. The post
offer activities for the offer will involve essential follow-up steps, which
include the finalization of trading and dealing of instruments and dispatch
of certificates and delivery of demat shares, with the yarious agencies
connected with the work such as the Registrar(s) to the Offer and Bankers
to the Offer and the Bank handling refund business. The Merchant
Banker shall be responsible for ensuring that these agencies fulfill their
functions and enable it to discharge this responsibility through suitable
agreements with the Company.
2.3.24 ROLE OF A REGISTRAR
The Registrar finalizes the list of eligible allottees after deleting the
invalid applications and ensure that the corporate action for crediting of
shares to the demat account of the successful applicants is done and the
necessary refund orders are sent to those who are entitled to receive the
same. The Lead Manager co-ordinates with the Registrar to ensure
follow up so that all these works are completed and the securities get
listed.
2.3.25 ROLE OF BANKERS TO THE ISSUE
Bankers to the issue, as the name suggests, carries out all the activities
of ensuring that the funds are collected and transferred to the Escrow
Accounts. The Lead Merchant Banker shall ensure that Bankers to the
Issue are appointed in all the mandatory collection centers as specified in
DIP Guidelines. The LM also ensures follow-up with bankers to the issue
to get quick estimates of collection and advising the issuer about closure
of the issue, based on the correct figures.

46

2.3.26. SOME NEW TERMS RELATING TO NEW ISSUES

Some new terms relating to new issues are explained below:

a) Green-Shoe Option: A Green-Shoe Option means an Option of

allocating shares in excess of the shares included in the public issue and
operating a post-listing price stabilizing mechanism for a period not
exceeding 30 days in accordance with the provisions of Chapter VIllA of
DIP Guidelines, which is granted to a company to be exercised through a
Stabilizing Agent. This is an arrangement wherein the issue would be
over- allotted to the extent of a maximum of 15% of the issue size. From
an investor's perspective, an issue with Green -Shoe Option .provides
more probability of getting shares and also that post listing price may
show relatively more stability as compared to market.

b) E-IPO: A company proposing to issue capital to public through the

on-line system of the stock exchange for offer of securities can do so
if it complies with the requirements under Chapter llA of DIP
Guidelines. The appointment of various intermediaries by the issuer
includes a prerequisite that such members/registrars have the required
facilities to accommodate such an online issue process.

c) Syndicate Member: The Book Runner(s) may appoint those

intermediaries who are registered with the Board and who are permitted
to carry on activity as an "Underwriter" as syndicate members. The
:syndicate members are mainly appointed to collect the entire bid forms in
:a book built issue.

d) Cut off Price: In Book Building Issue, the issuer is required to

indicate either the price band or a floor price in the red herring
prospectus. The actual discovered issue price can be any price in the price
band or any price above the floor price. This issue price is called Cut off
Price. This is decided by the issuer and LM after considering the book
and investors' appetite for the stock. SEBI (DIP) guidelines permit only
retail individual investors to have an option of applying for shares at cut
off price.

47

e) Differential pricing: Pricing of an issue where one category is offered

shares at a price different from the other category is called differential
pricing. In DIP Guidelines differential pricing is allowed only if the
securities to applicants in the firm allotment category are at a price higher
than the price at which the net offer to the public is made. The net offer to
the public means the offer made to the Indian public and does not include
firm allotments or reservations or promoters' contributions.
t) Basis of Allotment: After the closure of the issue, the bids received
are aggregated under different categories i.e., Firm Allotment, Qualified
Institutional Buyers (QIBs), Non-Institutional Buyers (NIBs), Retail
Investors etc. The oversubscription ratios are then calculated for each of
the categories as against the shares reserved for each of the categories in
the offer document. Within each of these categories, t~e bids are then
segregated into different buckets based on the number of shares applied
for. The oversubscription ratio is then applied to the number of shares
applied for, and the number of shares to be allotted to applicants in each
of the buckets is determined. Then, the number of successful allottees is
determined. This process is followed in case of proportionate allotment.
In case of allotment of shares to QIBs, it is subject to the discretion of the
post issue lead manager.

g) Qualified Institutional Buyers (QIBs): Qualified Institutional

Buyers are those institutional investors who are generally perceived to
possess expertise and financial muscle to evaluate and invest in the
capital markets.
In terms of clause 2.2.2B (V) of DIP Guidelines, a 'Qualified
Institutional Buyer' shall mean
(i) Public Financial Institutions as defined in section 4A of
the Companies Act, 1956;
(ii) Scheduled Commercial Banks;
(iii) Mutual Funds;
(iv) Foreign Institutional Investors registered with SEBI;
(v) Multilateral and bilateral Development Financial
Institutions;
(vi) Venture Capital Funds registered with SEBI;
(vii) Foreign Venture Capital Investors registered with SEBI;
48

viii) State Industrial Development Corporations;

ix) Insurance companies registered with the Insurance

Regulatory and Development Authority (IRDA);

x) Provident Funds with minimum corpus of Rs. 25 Crore;
and
xi) Pension Funds with minimum corpus of Rs. 25 Crore.
These entities are not required to be registered with SEBI as QIBs.
Any entities falling under the categories specified above are considered as
QJBs for the purpose of participating in primary issuance process.

2.4

SOME IMPORTANT CONCEPTS AND TERMINOLOGIES

RELATING TO DERIVATIVES TRADING ON INDIAN
BOURSES

Stock markets around the globe have witnessed tremendous

financial, technical and behavioral changes over the last two decades.
Among these radical adjustments and innovations is the arrival of
'Derivatives'. With due approvals from the Ministry of Finance, the
Reserve Bank of India and the Securities and Exchange Board of India
:(SEBI), derivatives trading was launched on 9th June, 2000 in the Stock
.'Exchange, Mumbai (BSE). Though a number of countries abroad have
introduced derivatives trading in Stock Exchanges much earlier, India
saw the fonmil introduction of financial derivatives on this day ( i.e. 9th
June, 2000) when BSE launched the trading of 'Stock Index Futures'
(Sensex Futures). Three days later, i.e. on 12th June, 2000, the National
Stock Exchange, Mumbai (NSE) also launched the trading of 'Stock
Index Futures' (i.e. Nifty Futures). Subsequently trading of some other
derivatives products were launched on these two stock exchanges. At
present, four types of derivatives products, namely Stock Index Futures,
Stock Futures (or Equity Futures), Stock Index Options and Stock
Options (or Equity Options) are traded on these two Stock Exchanges in
our country.
This part of the study includes the concepts and terminologies
relating to the trading in these four types of derivative products on BSE
andNSE.

49

2.4.1 SENSEX: ITS COMPUTATION AND COMPOSITION

Sensex (abbreviated form ofBSE Sensitive Index) is the oldest stock
index in India. The Stock Exchange, Mumbai (BSE) in our country for
the first time in 1986 came out with a stock index (known as Sensex) that
subsequently became the barometer of Indian stock market.
Sensex is a Market Capitalization-Weighted Index of30 component
stocks representing a sample of large, well established and financially
sound companies. These stocks are taken from all significant sectors of
the economy. The base year ofSensex is 1978-79 (=100). In fact, Sensex
is considered as the pulse of Indian stock market. At present the
following stocks are included in the Sensex basket:
ACC, Ambuja Cements, Bajaj Auto, Bharti Airtel, BHEL, Cipla DLF,
Grasim Industries, HDFC, HDFC Bank, Hindalco, HUL, ICICI Bank,
Infosys Techno, lTC, Larsen & Toubro, Mahindra & Mahindra, Maruti
SuZUki, NTPC, ONGC, Rabaxy Labs, Reliance Communications,
Reliance Energy, Reliance Industries, Satyam Computer, SBI, Tata
Motors, Tata Steel, TCS and Wipro.
These 30 companies are not always the same. The history of stock
replacements in BSE Sensex shows that BSE authority makes some
changes in the component stocks by exclusion and inclusion of stock (s)
from time to time, depending on the need to do so.
2.4.2 UNDERLYING STOCKS OF NIFTY
Like Sensex on BSE, the stock index on NSE based on selected 50
important stocks representing major sectors of the economy is called
Nifty. From time to time the NSE authority makes some changes in the
component stocks of Nifty by inclusion and exclusion of stock(s),
depending on the need to do so. Currently the Nifty basket includes the
following 50 stocks: ABB, ACC, Ambuja Cement, Bajaj Auto, Bharti
Airtel, BHEL, BPCL, Cipla, Dr Reddys Labs, GAIL, Glaxosmith
Pharma, Grasim Industries, HCL Techno, HDFC, HDFC Bank, Hero
Honda, Hindalco, HPCL, HUL, ICICI Bank, Infosys Techno, ITC, Larsen
50

& Toubro, Mahindra & Mahindra, Maruti Suzuki, MTNL, National

Aluminium, NTPC, ONGC, PNB, Rabaxy Labs, Reliance

Communications, Reliance Energy, Reliance Industries, Reliance Petro,
SAIL, Satyam Computer, SBI, Siemens, Sterlite Industries, Sun Pharma,
Suzlon Energy, Tata Motors, Tata Power, Tata Steel, TCS, Unitech,
VSNL, Wipro and Zee Enter.
2.4.3 VARIOUS DERIVATIVE INSTRUMENTS

A derivative is an instrument whose value is derived from the value of

one or more underlying, which can be commodities, precious metals,
currency, bonds, stocks, stock indices, etc. Derivative instruments in
stock exchanges are Index Futures, Stock Futures, Options on Index and
Options on Individual Stocks. At present on NSE, different Index Futures
are: Nifty Future, Bank Nifty Future, and CNX IT Future, and different
Index Options are: Option on Nifty, Option on Bank Nifty and Option on
CNX IT. Besides these, Stock Futures on specified individual stocks on
NSE and on those specified stocks on NSE are allowed to trade.
2.4.4 INDEX FUTURES
Sensex Future and Nifty Future

Sensex Future is a financial derivative product enabling one to buy or

sell underlying Sensex on a future date at a price decided by the market
forces today. It is the first financial derivative products in India. On NSE,
the similar type of index-based future is Nifty Future.
Security name and Ticker Symbol of an Index Future

The security name used for Sensex Future is BSX. This security
name is also known as ticker symbol. Hence the ticker. symbol is BSX.
The security name and ticker symbol used for Nifty Future is NFUTIDX
NIFTY.
Main utility of Sensex Future and Nifty Future

Sensex Future is useful primarily for hedging one's Sensex-based

portfolios and also for expressing one's views on the market. Usefulness
51

of Nifty Future is also the same. That means, it is useful primarily for
hedging one's Nifty-based p01tfolios and also for expressing one's views
on the market.
Underlying for Sensex Futures and Nifty Futures

The underlying for the Sensex Futures is the BSE Sensitive Index of
30 scrips, popularly called the Sensex. The underlying for Nifty Futures
is Nifty, which is an important stock index based on 50 selected stocks on
NSE.
Contract multiplier for Index Futures on BSE and NSE

For Sensex Future, the contract multiplier is 50 times the Sensex. This
means that the Rupee notional value of a future contract would be 50
times the contracted value. In case of Nifty Future up to 31st March 2005,
the contract multiplier was 200 times the Nifty. With effect from 1st April
2005, the contract multiplier of Nifty Future has come down to 100. For
example, for July Nifty Future, if contract price of Nifty Future is 6150,
notional value of 1 lot (i.e. 100) of Nifty Future is Rs.6, 15,000. This
notional value is expressed in 'Rupees'.
. Maturity of the future contracts

Regulations permit introduction of Futures up to 12 months maturity.

Initially, however, Futures for the one month, two months and three
months maturity have been introduced. On 9th June 2000 on BSE, the
three Futures for June, July and August 2000 were started. These Futures
expired on 29th June, 2ih July and 31st August, 2000 respectively. This is
because the expiry date has been fixed as the last Thursday of the month
for each contract. On the day after the expiry, a new Future would come
into existence. For example in the year 2008, on 1st February, Friday (i.e.
on the day after the expiry of January Future on 31stJanuary, Thursday)
February Future would come into existence and this Febiuary Future will
expire on 28th February, Thursday. The expiry dates for various futures
contracts on NSE and BSE are the same.

52

Tick size for different Index Futures

For Sensex Futures, the tick size is '0.1 point'. This means that the
minimum price fluctuation in the value of a future can be only 0.1. In
Rupee terms, this translates to minimum price fluctuation of Rs. 5 (Tick
size x Contract Multiplier = 0.1 x Rs. 50). For Nifty futures, tick
size/price step is Rs. 0.05 but here the condition of minimum price
fluctuation is not applicable.

Determination of Final Settlement Price

The closing value of Sensex in the cash market is taken as the final
settlement price of the Sensex Futures contract on the last trading day of
the contract for settlement purpose. In the cases of Nifty Futures
contracts, the final settlement price is calculated on the basis of closing
value of Nifty in the cash market as on the last trading day of the relevant
contract.

Concept of Margin Money

There are different types of margins like Initial Margin,
Variation Margin and Additional Margin.
Margin money is like a security deposit or insurance against a
possible future loss of value. It is required to pay up front initial margin on
daily basis .Margin money is required to be paid to the exchange through
the broker by the person who makes contract for Future Trading (either in
Stock Future or in Index Future). Generally, such margin money ranges
from, 30% to 60% of the contract value. Such margin money is not the
same for all time and the Stock Exchange, from time to time, increases or
decreases the margin money depending on the need to do so, after
considering the market volatility and some other factors.
The aim of margin money is to minimize the risk of default by either
counter party. The payment of margin ensures that the risk is limited to
the previous day's price movement on each outstanding position.

53

The basic aim of Initial Margin is to cover the largest potential loss on
one day. Both buyer and seller have to deposit margins. The Initial
Margin is deposited before the opening of the position in the Futures
transaction. This margin is calculated by SPAN by considering the worst
case scenario.
All daily losses must be met by depositing of further collateral,
known as variation margin, which is required by the close of business, the
foltowing day. Any profits on the contract are credited to the client's
Variation Margin Account.

Concept of Long/Short positions

In simple terms, long and short positions indicate whether one has a
net over-bought position (long) or over-sold position (short).

Concept of Pricing Index Future

: The theoretical way of pricing any Future is to factor in the current
price and holding costs or cost of carry. In general, the Futures Price =
Spot Price + Cost of Carry. Cost of Carry is the sum of all costs incurred
. if a similar position is taken in cash market and carried to maturity of the
futures contract less any revenue which may result in this period. The
costs typically include interest in case of financial futures. The revenue
may be dividends in case of index futures.
. Apart from the theoretical value, the actual value may vary
depending on demand and supply of the underlying at present and
expectations about the future. In general, the Futures price is greater than
the spot price. In special cases, when cost of carry is negative, the Futures
price may be lower than Spot price.

Concept of Basis
The difference between Spot price and Future price is known as
Basis. Although the spot price and Future price generally move in line
with each other, the Basis is not constant. In some cases Future price may
be less, though spot price is high or vise versa. Generally basis will

54

decrease with time. And on expiry~ the basis is zero and Futures price
equals Spot price.

Profits and Losses in case of a Future's position

The profits and losses would depend upon the difference. between the
price at which the position is opened and the price at which it is closed.

Other costs of trading

There would be funding cost/transaction cost in providing.the security.
This cost must be added to one's total transaction costs to arrive at the
true picture. Other items in transaction costs would include brokerage,
stamp duty, security transaction tax etc.

Price Quotations for Sensex Futures and Nifty Futures

Sensex point is the Price Quotation for Sensex Futures and in the case
of Nifty futures the stock index point ofNifty is the Price Quotation.

Last Trading Day

It is the last Thursday of the contract month. If it is a holiday, the
immediately preceding business day would be the last trading day. For all
types of derivatives products on both the BSE and the NSE the last
trading day is always the last Thursday of the contract month. This day is
also called as Expiration Day.

Calculation of Daily Settlement Price

Daily settlement price is the closing price of Futures Contract Price
computed on the basis of weighted average of the trades of last 5 (five)
minutes, or if the number of trades in the last 5 minutes are less than 5,
then on the basis of weighted average of the last 5 trades.

55

Concept of Spread Position

A Calendar spread is created by takmg simultaneously two positions

1. A long position in a futures series expiring in an calendar month;
2. A short position in the same futures as stated above (under Sl No.
1) but for a series expiring in any month other than 1 above.
Examples of Calendar Spreads:
Long June Nifty Futures - Short July Nifty Futures
Short July Nifty Futures - Long August Nifty Futures
A spread position must be closed by reversing both the legs
simultaneously. The reversal of 1 above would be a sale of June Nifty
Futures while simultaneously buying the July Nifty Futures.

2.4.5 STOCK FUTURES

Stocks allowed for Stock Futures

Stock Future is a financial derivative product where the underlying

asset is an individual stock. It is also called equity Future. This derivative
product enables one to buy or sell the underlying stock on a future date at
a price decided by the market forces today. On NSE up to 19th April,
2005 trading on Stock Futures were allowed on 53 individual stocks
approved by SEBI. The list was expanded to include 34 more stocks with
effect from April20, 2005. Another 21 stocks were included in the list on
and from May 12, 2005. On May 27, 2005 ten (10) niore stocks were
permitted for future trading. Currently the list has been extended to about
200 selected stocks.
The price quotation for a Stock Future is Rupees along with per share.
Pricing of Stock Futures

The theoretical price of a Future contract is sum of the current spot

price and cost of carry. However, the actual price of Futures contract very
much depends upon the demand and supply of the underlying stock.
Generally, the Futures prices are higher than the spot prices of the
underlying stocks. Futures Price= Spot price+ Cost of Carry. Cost of

56

Carry is the interest cost of a similar position in cash market and carried
to maturity of the Futures contract less any dividend expected till the
expiry of the contract.

Example: Spot Price oflnfosys = Rs. 2000; Interest Rate= 12% p.a.
Futures Price of 1 month contract = Rs. 2,000 + Rs. (2,000 x 0.12 x
30/365) = Rs. (2,000+20) = Rs. 2,020.
Difference between Stock Futures and Stock Options
In Stock Options, the Option buyer has the right and not the
obligation, to buy or sell the underlying share. In case of Stock Futures,
both the buyer and the seller are obliged to buy or sell the underlying
share. Risk return profile is symmetric in case of single- Stock Futures
whereas in case of Stock Options pay off is asymmetric. Also, the price
of Stock Futures is affected mainly by the price of the underlying stock
whereas in case of Stock Options, volatility of the underlying stock
affects the price along with the price of the underlying stock.

Various opportunities offered by Stock Futures

Stock Futures offer a variety of usage to the investors. Some of the
key usages are mentioned below:
a) Investors can take long-term view on the underlying stock
using Stock Futures.
b) Stock Futures offer high leverage. This means that one can
take large position with less capital. For example, paying 40%
initial margin one can take position for 100%, i.e., 2.5 times the
cash outflow.
c) Futures may look overpriced or underpriced compared to the
spot price and can offer opportunities to arbitrage and earn riskless profit. Single- Stock Futures offer arbitrage opportunity
between Stock Futures and the underlying cash market.
d) When used efficiently, single-Stock Futures can be an
effective risk management tool. For instance, an investor with
position in cash segment can minimize either market risk or price
risk of the underlying stock by taking reverse position in an
appropriate futures contract.
57

Settlement of Stock Futures

Up to March 31, 2002, Stock Futures were settled in cash. The final
settlement price is the closing price of the underlying stock. From April
2002; Stock Futures are settled by delivery, i.e. by merging derivatives
positions into cash segment.
Concept of Squaring Up of an investor's position

The investor can square up his position at any time till the expiry. The
investor can first buy and then sell Stock Futures to square up or can first
sell and then buy Stock Futures to square up his position. For example, a
long (buy) position in July lTC futures, can be squared up by selling July
lTC futures.
Timing of paying initial margin to the broker

The initial margin needs to be paid to the broker on an up-front basis

before taking the position.
Necessity of paying mark-to-market margin by an investor

The outstanding positions in Stock Futures are marked to market daily.

The closing price of the respective futures contract is considered for
marking to market. The notional loss/profit arising out of mark is
paid/received on T+1 basis.
Profits and Losses in case of Squaring up of a Stock Future

The profits and losses would depend upon the difference between the
price at which the position is opened and the price at which it is closed.
Let an investor has a long position of one August HCPL Futures @ Rs.
330. If the investor squares up his position by selling August HCPL
Futures @ Rs. 350, the profit would be Rs. 20 per share. In case, the
investor squares up his position by selling August HCPL Futures@ Rs.
300, the loss would be Rs. 30 per share.

58

Market Lot for Stock Futures

For each Stock Future, there is a particular market lot. For example,
currently the market lot for HPCL Stock Future is 1300 and the market
lot for lTC Stock Future is 1125.
The market lot is different for various Stock Futures contracts. It may
be noted that the permissible stocks and their market lots change from
time to time by virtue of directives from the concerned Stock Exchange
and SEBI.
According to L. C. Gupta Committee Report on Derivatives, a
minimum contract value should be Rs. 2 lakh. So market lots are so
arranged that contract value for one lot becomes Rs. 2 lakh or more. If
such calculated contract value is less than Rs. 2 lakh, it is assumed to be
Rs. 2 lakh for the purpose of calculating the required a~ount of margin
money.

Different contract months available for trading

At present 1, 2 and 3 months contracts are available for trading.

Concept of Spread Trading

One can trade in spread contracts on the Derivative Segment of BSE
or NSE. Spreads are the contracts for different price. This means that in
case a person wants to buy a July contract and to sell June contract, he
can enter an order for Buy June-July stating the difference he wants to
pay. Similarly, one can enter an order to Sell June-July stating the
difference he wants to receive.

Opening of trading in Derivatives before cash market

The trading timings for the Derivative Segment of BSE are from 9.30
a.m. to 3.30 p.m. and that of NSE is from 9.55 a.m. to 3.30 p.m. The
investors can take advantage of expressing their views in the market
before opening of cash market.

59

Collateral to be submitted by an investor to the broker

He can pay initial margin in non-cash (bank guarantee, securities etc.)
form also. This is an arrangement between the client and his broker.
However, the mark-to-market loss has to be settled in cash.
Investor's strategy of using Stock Futures when he has the
underlying stock and he anticipates a short-term fall in stock price
The holder of the physical stock can sell a Future to avoid incurring a
loss without having to sell the shares. Any loss caused by the fall in the
price of the stock is offset by gains made on. the position.
Concept of pair trading
This trading strategy involves taking a position on the relative
performance of two stocks. It is achieved by buying Fut~res on the stock
expected to perform well and selling Futures on the stock anticipated to
perform poorly. The overall gain or loss depends on the relative
performance of the two stocks. Similarly, it is possible to take a position
in the relative performance of a stock versus a market index.

2.4.6 INDEX OPTIONS AND STOCK OPTIONS

Concept of Stock Index Option
It is a financial derivative product where the underlying asset is the
stock index of a particular stock exchange. This financial derivative
product enables one to buy or sell Call Option or Put Option (to be
exercised at a future date) on the underlying asset (i.e. Stock Index) at a
premium decided by the market forces today. On NSE, currently among
various Stock Index Options available for trading, Options on Nifty and
Options on Nifty Junior are very popular. On BSE, the most commonly
used Stock Index Option is Option on Sensex. A Stock Index Option
gives an investor the right to buy or sell the value of an index which
represents a group of stocks. Such Index Options are quoted with Strike
Price and Premium per Option in Rupees along with paise.

60

Concept of Stock Option

It is a financial derivative product enabling one to buy or sell Call or

Put Option (to be exercised at a future date) on the underlying individual
stock (equity) at a premium decided by the market forces today. On NSE,
up to 19th April, 2005 Stock Options were available on 53 individual
stocks. The stock Option list was expanded to include 34 more stocks
beginning April 20, 2005. Another 21 stocks were included in the list
with effect from May 12, 2005. Further on May 27, 2005 the Stock
Option list was expanded to 118 by permitting 10 more stocks to trade.
Prices for Options on individual stocks are quoted in terms of premium
per share in Rupees (including, if any) along with the Strike Price
although each contract is invariably for a larger number of shares (i.e. for
market lot of shares).
Some important terminologies in Options
Important terminologies used in Option trading are as follows:
Option Premium: Premium is the price paid by the buyer to the seller to
acquire the right to buy or sell.
Strike Price or Exercise Price: The strike or exercise price of an Option
is the specified/pre-determined price of the underlying asset at which the
same can be bought or sold if the Option buyer exercises his right to
buy/sell on or before the expiration day.
Expiration Date: The date on which the Option expires is known as
Expiration Date. On expiration date, either the Option is exercised or it
expires worthless.
Exercise Date: This is the date on which the Option is actually exercised.
In case of European Option the exercise date is same as the expiration
date while in case of American Options, the Options contract may be
exercised any day between the purchase of the contract and its expiration
date. In India, Options on Sensex are of European style, whereas Options
on stocks are of American style.

61

Open Interest: The total number of Options contracts outstanding in the

market at any given point of time is called Open Interest.
Option Holder: An Option holder is one who buys an Option which can
be a Call or a Put Option. He enjoys the right to buy or sell the underlying
asset at a specified price on or before specified time. His upside potential
is unlimited while losses are limited to the premium paid by him to the
Option writer.
Option Seller/Writer: This is one who is obligated to buy (in case of Put
Option) or to sell (in case of Call Option) the underlying asset in case the
buyer of the Option decides to exercise his Option. His profits are limited
to the premium received from the buyer while downside is unlimited.
Option Series: An Option series consists of all the Options of a given
class with the same expiration date and strike price. For example, BSXC
19600 July is an Option series which includes all Sensex Call Options
that are traded with Strike Price of 19600 & Expiry in July (i.e., on last
Thursday of July).
[Here BSX stands for BSE Sensex (underlying index), C stands for Call
Option, July is expiry month & strike price is 19600]
Concept of Assignment
When a holder of an Option exercises his right to buy/sell, a
randomly selected Option seller is assigned the obligation to honour the
underlying contract, and this process is termed as Assignment.
Concept of European & American Style of Options
An American style of Option is the one which can be exercised by
the buyer till the expiration date, i.e., anytime between the day of
purchase of the Option and the day of its expiry. The European style of
Option is the one which can be exercised by the buyer on the expiration
day only and not anytime before that.

62

Concept of 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 in case of American style of Option. 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.

Example: An investor buys One European Call Option of Infosys at the

strike price of Rs. 2,000 at a premium of Rs. 100. If the market price of
Infosys on the day of expiry is more than Rs. 2,000, the Option will be
exercised. The investor will earn profits once the share price crosses Rs.
2,100 (, i.e., strike Price Rs. 2,000 + Premium Rs. 100). Suppose stock
price on the expiry date is Rs. 2,300, the Option will be exercised and the
investor will buy 1 share of Infosys from the seller of the Option at Rs.
2,000 and sell it in the market at Rs. 2,300 making a profit of Rs. 200
{(Spot price - Strike price) - Premium}. In another scenario, if at the
time of expiry, stock price falls below Rs. 2,000, suppose it touches Rs.
1,800, the buyer of the Call Option will choose not to exercise his Option.
In this case the investor loses the premium paid (i.e., Rs. 100), which
shall be the profit earned by the seller of the Call Option.
Concept of 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 the expiry date (in case of American style Option). 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.
Example: An investor buys one European Put Option of HPCL at the
strike price of Rs. 300, at a premium of Rs. 25. If the market price of
HPCL, on the day of expiry is less than Rs. 300, the Option can be
exercised as it is 'in the money'. The investor's Break Even Point (i.e.,
no profit no loss situation) is Rs. 275 (Strike Price- Premium paid). The
investor will earn profit if the market falls below Rs. 275. Suppose stock

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price is Rs. 260, the buyer of the Put Option immediately buys HPCL
share in the market @ Rs. 260 and exercises his Option, selling the HPCL
share at Rs. 300 to the Option writer thus making a net profit of Rs. 15
{(St~ike price - Spot price) - Premium paid}. In another scenario, if at
the time of expiry, market price of HPCL is Rs. 320, 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. In this case the investor loses the premium paid
(i.e. Rs. 25), which shall be the profit earned by the seller of the Put
Option.
The different situations are shown in below in tabular form:
Persons
Option buyer or
Option holder

seller
Option
Option writer

Call Options
Buys the right to buy
the underlying asset at
the specified price.
or Has the obligation to
sell the underlying
asset (to the Option
holder) at the specified
price.

Put Options
Buys the right to sell
underlying asset at the
specified_price.
Has the obligation to
buy the underlying
asset (from the Option
holder) at the specified
price.

An Option is said to be at the money when the Option's strike price

is equal to the underlying asset price. This is true for both Puts and Calls.
A Call Option is said to be in the money when the strike price of the
Option is less than the underlying asset price. For example, a Nifty Call
Option with strike price of 6,100 is in the money, when the spot Nifty is
at 6, 150, as the Call Option has a value. The Call Option holder has the
right to buy a Nifty at 6,1 00, no matter by what amount the spot price
exceeded the strike price. With the spot price at 6,200, by selling Nifty at
this higher price he can make a profit.
On the other hand, a Call Option is said to be out of the money when
the strike price is greater than the underlying asset price. Using the earlier
example of Nifty Call Option, if the Nifty falls to 6,020, the Call Option
no longer has positive exercise value. The Call Option holder will not
exercise the Option to buy Nifty at 6, 100 when the current price is at
6,020 and allow his Option right to lapse.

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The aforesaid different situations of Options are shown below in a

tabular form at a glance:

Call Options
Strike price < Spot price
of underlying asset
At the Money
Strike Price = Spot price
of underlying asset
Out of the Strike price > Spot price
of underlying asset
Money
Situations
In the Money

Put Options
Strike price > Spot price
of underlying asset
Strike price = Spot price
of underlying asset
Strike price < Spot price
of underlying asset.

A Put Option is in the money when the strike price of the Option is
greater than the spot price of the underlying asset. For example, a Nifty
Put at strike of 6,400 is in the money when the Nifty is at 6,100. When
,this is the case, the Put Option has a value because the Put Option holder
can sell the Nifty at 6,400, i.e. at an amount greater than the current Nifty
of 6, I 00. Likewise, a Put Option is out of the money when the strike
price is less than the spot price of underlying asset. In the above example,
.: the buyer of Nifty Put Option won't exercise the Option when the spot
price is at 5,900. The Put no longer has positive exercise value and
therefore in this scenario, the Put Option holder will allow his Option
right to lapse.

Concept of the Intrinsic Value of an Option

The intrinsic value of an Option is defined as the amount by which an
Option is in the money or the immediate exercise value of the Option
when the underlying position is mark-to-market.
For a Call Option: Intrinsic Value= Spot price- Strike price
For a Put Option: Intrinsic Value = Strike price - Spot price
The intrinsic value of an Option must be a positive number or 0 (zero).
It can't be negative.

Concept of Time Value with reference to Options

Time value is the amount Option buyers are willing to pay for the
possibility that the Option may become profitable prior to expiration date

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due to favorable change in the price. of the underlying. An Option loses its
time value as its expiration date nears. Time value cannot be negative.

Fixation of Option Premium and its calculation

Options Premium is not fixed by the exchange. The fair
value/theoretical price of an Option can be known with the help of pricing
models and then depending on market conditions, the price is determined
by competitive bids and offers in the trading environment. An Option's
premium/price is the sum of intrinsic value and time value (explained
above). If the price of the underlying stock is held constant, the intrinsic
value portion of an Option premium will remain constant as well.
Therefore, any change in the price of the Option will be entirely due to a
change in the Option's time value. The time value component of the
Option premium can change in response to a change in the volatility of
the underlying, the time to expiry, interest rate fluctuations, dividend
payments and the immediate effect of supply and demand for both the
underlying and its Option.

Use of Option Calculator for calculation of Option Price

An Option Calculator is a tool to calculate the price of an Option on
the basis of various influencing factors like the price of the underlying
and its volatility, time to expiry, risk-free interest rate, etc. It also helps
the user to understand how a change in any one of the factors or more,
will affect the Option price.

Different players in the Options market

Developmental Institutions, Mutual Funds, Domestic and Foreign
Institutional Investors, Brokers, Retail Participants are the likely players
in the Options Market.
Different benefits of Options
Besides offering flexibility to the buyer in the form of right to buy or
sell, the major advantage of Options is their versatility. They can be as
conservative or as speculative as one's investment strategy dictates. Some
of the benefits of Options are as under.

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a) High leverage as by investing small amount of capital (in the form of

premium), one can take exposure in the underlying asset of much
greater value.
b) Maximum Risk for an Option buyer is pre-known.
c) For an Option buyer there is a large profit potential and a limited risk.
d) One can protect his equity portfolio from a decline in the market by
way of buying a protective Put wherein one buys Puts against an existing
stock position. This Option position can supply the insurance needed to
overcome the uncertainty of the market place. Hence, by paying a
relatively small premium (compared to the market value of the stock), an
investor knows that no matter how far the stock drops, it can be sold at
the strike price of the Put anytime until the Put expires. For example, an
investor holding 1 share of Infosys at a market price of Rs. 2,500 thinks
that the stock is over-valued and therefore decides to buy a Put Option at
a strike price ofRs. 2,500 by paying a premium ofRs. 200. If the market
price of Infosys comes down to Rs. 2,1 00, he can still sell it at Rs. 2,500
by exercising his Put Option. Thus by paying a premium of Rs. 200, he
insured his position in the underlying stock.

An investor's strategy for using Options

If the investor anticipates a certain directional movement in the price

of a stock, the right to buy or sell that stock at a predetermined price, for a
specific duration of time can offer an attractive investment opportunity.
The decision as to what type of Option to buy is dependent on whether
the investor's outlook for the respective security is positive (bullish) or
negative (bearish). If his outlook is positive, buying a Call Option creates
the opportunity to share in the upside potential of a stock without having
to risk more than a fraction of its market value (premium paid).
Conversely, if the investor anticipates downward movement, buying a Put
Option will enable him to protect against downside risk without limiting
profit potential.

Different alternatives after buying an Option

Option is a contract, which has a market value like any other tradable
commodity. Once an Option is bought there are following alternatives
that an Option holder has:
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a) He can sell an Option of the same series as the one he had bought
and close out/square up his position in that Option at any . time on or
l;Jefore its expiration date.
b) He can exercise the Option on the expiration day in case of
European Option or on or before the expiration day in case of an
:American Option. In case the Option is 'Out of Money' at the time of
:expiry, one will not exercise his Option, not being profitable and
. therefore, it will lapse or expire worthless.

Risks for an Option Buyer and an Option Writer

The risk/loss of an Option buyer is limited to the premium that he has
paid. The risk of an Option writer is unlimited whereas his gains are
limited to the premiums earned. When an uncovered Call is exercised for
physical delivery, the Call writer will have to purchase the underlying
asset and his loss will be the excess of the purchase price over the
exercise price of the Call reduced by the premium received for writing the
call.
The writer of a Put Option bears a risk of loss if the value of the
underlying asset declines below the exercise price. The writer of a Put
Option bears the risk of a decline in the price of the underlying asset
potentially to zero. When the Put Option holder exercises his Option in
the falling market, the Put writer is bound to purchase the underlying at
strike price, even if the underlying is otherwise available in the spot at
lower price.

Taking care of risk by an Option Writer

Option writing is a specialized job which is suitable only for the
knowledgeable investor who understands the risks, has the financial
capacity and has sufficient liquid assets to meet applicable margin
requirements. The risk of an Option writer may be reduced by the
purchase of other Options on the same underlying asset and thereby
assuming a spread position or by acquiring other types of hedging
positions in the Options/Futures and other correlated markets.

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Different Writers of Options in Indian derivatives market

In the Indian derivatives market, the Securities and Exchange Board of
India (SEBI) has not created any particular category of Options writers.
Any market participant can write Options. However, the margin
requirements are stringent for Options writers.

Number of stocks on which Stock Options are allowed to trade on

Indian bourses
Only on some selected stocks, Options are allowed on BSE and NSE.
On NSE, at present Stock Options and Stock Futures are allowed on
about 200 stocks. It may be mentioned here that the list of stocks for
trading in Stock Options and Stock Futures is the same.

Market Lot of different Stock Option contracts

Each stock Option has a specific market lot. For a particular stock
the market lot for Stock Option and market lot for Stock Future is the
same. On NSE, for the current period, the market lots for some selected
Stock Options and Stock Futures are as under:
3-1 Info Tech (2700 ), Aban Offshore (200), ACC (188), Allahabad Bank
(2450), Alok Inds (3350), Andhra Bank (2300), Arvind Mills (4300),
Ashok Leyland (4775), Bajaj Auto (100), Bajaj Hind (950), Ballarpur
Ind (1900), Balarampur Chini (2400), Bank of India (1900), Bharat Forge
(1 000), Hart Airtel (500), BHEL (300), Bongaigaon Ref (4500), BPCL
(1100), Cairn India (2500), Canara Bank (1600), CBI (2000), Century
Textiles (425), CESC (550), Chambal Fert (6900), Cipla (1250), Colgate
(1050), Dabur (2700), Deccan Aviation (1700), Dena B~ (5250), DLF
(400), Dr Reddy's Lab (400), Escorts (2400), Essar Oil (5650), GAIL
(750), Gateway Distal (2500), GMR Infra (5000), GNFC (2950), Guj
Alkalies (1400), Guj AMB Chern (2062), HCC (1400), HCL Techno
(650), HDFC Bank(200), HDIL (400), Hindalco (1595), Hotel Leela
(3750), HPCL (1300), HUL (1000), ICICI Bank (175), IDBI (1200), Idea
Cellular (2700), IDFC (1475), IFCI{l970), India Cement (725), Indian
Bank (2200), Indian Hotel (1899), IOC (60q), Indusind Bank (1925),
Infosys Tech (200), lTC (1125), Jindal Stainless (2000), JP Hydro (3125),

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JSW Steel (550), L & T (50), LIC Shag Fin (1700), Mah & Mah (312),
Maruti Udyog (400), Moser Bayer (825), MRPL (8900), M1NL (1600),
Nagarjuna Fert (14000), Neyveli Lignite (5900), NTPC (1625), Omaxe
(650), ONGC (225), Orchid Chern (lOSO), Oswal Chern (4950), Petronet
LNG (4400), Polaris Software (1400), Power Finance (2400), Power
Grid (3850), Praj Ind (2200), Punj Lloyd (1500), Ranbaxy Lab (800),
RNR (7150), Rill Cap (550), Rei Communi (700), Rei Energy (550), Rei
lnd (150), Rel Petro (3350), SAIL (2700), Satyam Computer (600), SBI
(250), Shipping Corp (1600), Siemens (188), SRF (1500), Steer Biotech
(1250), Sterlite Ind (438), Suzlon Energy (200), Syndicate Bank (3800),
Tata Chern (1350), Tata Motors (412), Tata Power (400), Tata Steel
(675), Tata Tele (M) (10450), TCS (250), Triveni Engg (7700), TVS
Motor (2950), Union Bank (2100), Unitech (900), Vijaya Bank (6900),
Voltas (3600), VSNL (525), WELSP Guj Sr (800), Yes Bank (1100).
It may be mentioned here that the stock exchange authorities

change these market lots from time to time.

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