No. Particulars No. Introduction To Derivatives

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CONTENTS
Chapter Particulars Page
No.
No.
1 Introduction to Derivatives
 Derivatives Defined……………………………………………………………. 3
 The participants in a derivative market ……………………………………….. 5
 Types of Derivatives…………………………………………………………... 5
 History of Derivatives…………………………………………………………. 8
 Derivative Market in India…………………………………………………….. 11
 Introduction to Forward Contract……………………………………………… 14
 Introduction to Futures………………………………………………………… 16
 Introduction to Option…………………………………………………………. 19
 Pricing of futures ……………………………………………………………… 22
 Pricing of Options……………………………………………………………... 22
2 Clearing & Settlement
 Clearing Banks………………………………………………………………… 24
 Clearing Members…………………………………………………………....... 24
 Clearing Mechanism………………………………………………………… 25
 Settlement Schedule…………………………………………………………… 27
 Settlement Price………………………………………………………………... 27
 Settlement Mechanism………………………………………………………… 28
 Settlement Procedure…………………………………………………………... 32
3 Basic Pay-offs
 Pay-off for Buyer of Call option………………………………………………. 32

 Pay-off for Writer of Call option………………………………………………. 32
 Pay-off for Buyer of Put option………………………………………………... 33
 Pay-off for Writer of Put option……………………………………………...... 34
 Pay-off for Buyer of Nifty Future……………………………………………... 35
 Pay-off for Seller of Nifty Future……………………………………………… 35
4 Trading in Derivative
 Future and Option trading System ……………………………………………. 37
 Entities in trading System……………………………………………………... 37
 Corporate hierarchy……………………………………………………………. 38
 Order types and condition……………………………………………………... 39
5 The Risk Management System of Derivatives
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Shri S.V. Patel College of Computer Science & Business Management

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INTRODUCTION
The term "Derivative" indicates the value which is entirely "derived" from the value of the assets
such as securities, commodities, bullion, currency, live stock or anything else. In other words,
Derivative means a forward, future, option or any other hybrid contract of pre determined fixed
duration, linked for the purpose of contract fulfillment to the value of a specified real or financial
asset or to an index of securities.
Derivatives have been included in the definition of Securities in The Securities Contracts
(Regulations) Act, as 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.

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Derivatives include options and futures. Certain options are short-term in nature and are issued
by investors. These options may be long-term in nature and are issued by companies in the
process of financing their activities. The trading in derivatives are things of US origin and in US
the Organized exchanges began trading in options on equities in 1973 and on debt from 1982.
‘Derivatives’ initially, had its reference to the bank transaction when banks created deposits out
of primary deposits. The primary deposit is received by banks and the same is lent on book
credit. The bank does not give cash to the borrower but provides him with a cheque book and
allows him to draw for payment. When these cheques presented in the bank, they create deposits
and they were referred to as the derivatives. In a similar fashion, the stocks are traded in
exchanges either as spot – delivery against payment or on forward market – delivery on future
payment. This may or may not happen, but the purpose is to prevent any fall in price of stocks
which is insurance the risk of volatility in prices. The derivatives market consists of forward
contract, futures contract, options trading and swaps market.
Derivatives Defined
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases underlying asset, index, or reference rate, in a contractual manner, the underlying
asset can be equity, fore, commodity or any other asset. 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 derivatives. The price of this derivative is driven by the spot price of
wheat which is the “underlying”.
In the Indian context the Securities Contracts Regulation Act, 1956(SCRA) defines
“derivative’ to include”-
1. A security derived from a debt instrument, share, and loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
2. A contract, which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives are securities under the SCRA and hence the regulatory framework under the SCRA
governs the trading of derivatives.

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Structure of Derivative Markets
Derivative trading in India takes place either on a separate and independent Derivative Exchange
or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function
as a Self-Regulatory Organization (SRO) and SEBI acts as the oversight regulator. The
clearing & settlement of all trades on the Derivative Exchange/Segment would have to be
through a Clearing Corporation/House, which is independent in governance and membership
from the Derivative Exchange/Segment.
Economic functions of a derivatives market:
The derivatives market performs a number of economic functions:
1. It helps in transferring risks from risk averse people to risk oriented people.
2. It helps in the discovery of future as well as current prices.
3. It catalyzes entrepreneurial activity.
4. It increase the volume traded in markets because of participation of risk averse people in
greater number.
5. It increases savings and investment in the long run.
The participants in a derivative market
Hedgers
Use futures or options markets to reduce or eliminate the risk associated with price of an asset.
Speculators

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Use futures and options contracts to get extra leverage in betting on future movements in the
price of an asset. They can increase both the potential gains and potential losses by usage of
derivatives in a speculative venture.
Arbitragers
Arbitragers are in business to take advantage of a discrepancy between prices in two different
markets. If, for example, they see the futures price of an asset getting out of line with the cash
price, they will take offsetting positions in the two markets to lock in a profit.
Types of Derivatives
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.
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
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.
Warrant
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.

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LEAPS
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of up to three years.
Baskets
Basket options are options on portfolios of underlying assets. The underlying asset is usually a
moving average or a basket of assets. Equity index options are a form of basket options.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
There are two types of Swaps: Interest rate swaps & Currency swaps.
1. Interest rate swaps
These entail swapping only the interest related cash flows between the parties in the same
currency.
2. Currency swaps
These entail swapping both principal and interest between the parties, with the cash flows in one
direction being in a different currency than those in the opposite direction.
Swaptions
Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

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Types of Derivatives
Derivatives
FORWARD OPTIONS FUTURE SWAP
CALL PUT CURRENCY INTEREST RATE
History of Derivatives
The history of derivatives is quite colorful and surprisingly a lot longer than most people think.
Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place
on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward
contracts to provide the masses with their supply of Egyptian grain. These contracts were also
undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices
of grains. Thus, forward contracts have existed for centuries for hedging price risk.

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The first organized commodity exchange came into existence in the early 1700’s in Japan. The
first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848
in the US to deal with the problem of ‘credit risk’ and to provide centralized location to negotiate
forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’.
The first type of futures contract was called ‘to arrive at’. Trading in futures began on the CBOT
in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as
the futures contracts. Futures trading grew out of the need for hedging the price risk involved in
many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT,
was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce
Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB).
The first financial futures to emerge were the currency in 1972 in the US. The first foreign
currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a
division of CME. The currency futures traded on the IMM are the British Pound, the Canadian
Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro
dollar. Currency futures were followed soon by interest rate futures. Interest rate futures
contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures
and options emerged in 1982. The first stock index futures contracts were traded on Kansas City
Board of Trade on February 24, 1982.The first of the several networks, which offered a trading
link between two exchanges, was formed between the Singapore International Monetary
Exchange (SIMEX) and the CME on September 7, 1984.
Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options
are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the
brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices
shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation
that people even mortgaged their homes and businesses. These speculators were wiped out when
the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the
option terms.

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The first call and put options were invented by an American financier, Russell Sage, in 1872.
These options were traded over the counter. Agricultural commodities options were traded in the
nineteenth century in England and the US. Options on shares were available in the US on the
over the counter (OTC) market only until 1973 without much knowledge of valuation. A group
of firms known as Put and Call brokers and Dealer’s Association was set up in early 1900’s to
provide a mechanism for bringing buyers and sellers together.
On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the
purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented
the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an
option which led to an increased interest in trading of options. With the options markets
becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia
Stock Exchange (PHLX) began trading in options in 1975.
The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse
of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies
in the international financial markets paved the way for development of a number of financial
derivatives which served as effective risk management tools to cope with market uncertainties.
The CBOT and the CME are two largest financial exchanges in the world on which futures
contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual
volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock
options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The
Philadelphia Stock Exchange is the premier exchange for trading foreign options.
The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq
100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The
N225 is also traded on the Chicago Mercantile Exchange.

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Derivative Market in India

The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws Ordinance, 1995, which withdrew the prohibition on options in securities. The
market for derivatives however did not take off as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr. L.C.
Gupta on November 18, 1996 to develop appropriate regulatory framework of derivatives trading
in India. The committee submitted its report on March 17, 1998 prescribing necessary pre
conditions for introduction of derivatives trading in India.

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The committee recommended that derivatives should be declared as “securities’ so that

regulatory framework applicable to trading of ‘securities’ could also govern trading of securities.
SEBI also set up a group in June 1998 under the Chairmanship of Prof J.R. Varma, to
recommend measures for risk containment in derivatives market in India. The report which was
submitted in October 1998, worked out the operational details of margining system methodology
for charging initial margins, broker net worth deposit requirement and real time monitoring
requirements.
The SCRA was amended in December 1999 to include derivatives within the ambit of
‘securities’ and the regulatory framework were developed for governing derivatives trading. The
act also made it clear that derivatives shall be legal and valid only if such contracts are traded on
a recognized stock exchange thus precluding OTC derivatives. The government also reclined in
March 2000 the three-decade-old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges NSE
and BSE and their clearing House Corporation to commence trading and settlement in approved
derivatives contracts to begin with SEBI approved trading in index futures contracts based on
S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading inn
options based on theses tow indexes options on individual securities. The trading in index
options commenced June 2001 and the trading in options on individual securities commenced in
July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and
settlement in derivative contract is done in accordance with the rules, bye laws and regulations of
the respective exchanges ands their clearing house corporation duly approved by SEBI and
notified in the official gazette.
1991 Liberalisation process initiated.
14 December 1995 NSE asked SEBI for permission to trade index

futures.

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18 November 1996 SEBI setup L.C.Gupta Committee to draft a

policy framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate

agreements (FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and

options on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do

index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at

BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
Recommendations of L.C.Gupta Committee on Derivatives
The committee was set up by SEBI in November 1996 to develop the appropriate regulatory
framework for the derivatives trading in India. The committee concern was with the financial
derivatives in general and in particular about the equity derivatives. The committee consisted of
24 members which were from various fields of financial sector. The following were the main
recommendations of the committee:
1. The committee strong favored the introduction of the derivatives trading in India with a view
to provide the hedging to the institutions and the general investors.

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2. The committee recommended that there should be two level of regulatory framework, one is
at the exchange level and the second level is that of the SEBI level.
3. The committee observed that the regulation of SEBI was of overlapping nature and that they
should be studied in detail and then made applicable to the derivatives segment.
4. The committee observed that Mutual funds which are the big players in the capital market
should be allowed to work in the derivatives segment but made it clear that they can use the
derivatives market only for the purpose of hedging and not for speculation.
5. The committee favored the introduction of the simple variants of the derivatives first so that
the market players can understand the product and then proceed with the gradual introduction
of the complex products of derivatives.
6. The committee further recommended that “derivatives” to be included in the definition of

securities under the Securities Contract Regulations Act (SCRA) to enable the trading in
derivatives in its products of options and futures.
Introduction to Forward Contract
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date for the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally by the parties to
the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are :

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 They are bilateral contracts and hence exposed to counter-party risk.
 Each contract is custom designed, and hence is unique in terms of contract size, expiration date
and the asset type and quality.
 The contract price is generally not available in public domain.
 On the expiration date, the contract has to be settled by delivery of the asset.
 If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party,
which often results in high prices being charged.
However forward contract in certain markets have become very standardized as in the case of
foreign exchange thereby reducing transaction costs and increasing transaction volume. This
process of standardization reaches its limit in the organized futures market.
Forward contract are very useful heeding and speculation. The classic hedging application would
be that of an exporter who expects to receive payment in dollar three months later. He is exposed
to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars
forward he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is
required to make a payment in dollars two months hence can reduce his exposure to exchange
rate fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price then he can go
long on the forward market instead of the cash market. The speculator would go long on the
forward, wait for the price to raise and then take a reversing transaction to book profits.
Speculators may well be required to deposit a margin upfront. Hoverer this is generally a
relatively small proportion of the value of the assets underlying the forward contract. The use of
forward markets here supplies leverage to the speculator.

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Limitations of Forward Markets
 Lack of centralization of trading

 Liquidity and
 Counter party risk.
In the first two of these the basic problem is that of too much flexibility and generally. The
forward markets like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient
that specific situation, but makes the contract non tradable.
Counter party risk arises from the possibility of default by nay on party to the transactions. When
one of the two sides to the transaction declares bankruptcy the other suffers. Even when forward
markets trade standardized contracts and hence avoid the problem of illiquidity, still the counter
party risk remains a very serious issue.
Introduction to Futures
Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the future
at a certain price. But unlike forward contracts the futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain
standard features of the contract. It is a standardized contract with standard underlying
instrument a standard quantity and quality of the underlying instrument that can be delivered,
(which can be used for reference purposes in settlement) and a standard timing of such

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settlement. A futures contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in futures contract are;

 Quantity of the underlying
 Quality of the underlying
The first exchange that traded financial derivatives was launched in Chicago in the year1972. A
division if the Chicago Mercantile exchanges 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.
Future Terminology
Spot price: The price at which an asset trades in the spot market.
Future price: The price at which the future contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contacts on the NSE
have one month, two months and three months expiry cycle s, which expire on the last Thursday
of the month. Thus a January expiration contract expires on the last Thursday of January and
February expiration contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday a new contract having a three-month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under on contract. For instance, the
contract size on NSE’s futures markets is 200 Nifties.

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Basis: In the context of financial futures, basis can be defined as the futures price minus the spot
price. The will be d different basis for each delivery month for each contract. In a normal market,
basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest that
is paid to finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a future a
contract is first entered into is known as initial margin.
Mark to market: In the futures market at the end of each trading day the margin account
adjusted to reflect the investor gain or loss depending upon the futures closing price. This is
called mark to market.
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.
Distinction between Futures and Forwards Contracts

FEATURES FORWARD CONTRACT FUTURE CONTRACT
Operational Mechanism Traded directly between two Traded on the exchanges.
parties (not traded on the
exchanges).
Contract Specifications Differ from trade to trade. Contracts are standardized
contracts.
Counter-party risk Exists. Exists. However, assumed by the

clearing corp., which becomes

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the counter party to all the

trades or unconditionally
guarantees their settlement.
Liquidation Profile Low, as contracts are tailor High, as contracts are
made contracts catering to the standardized exchange traded
needs of the needs of the contracts.
parties.
Price discovery Not efficient, as markets are Efficient, as markets are
scattered. centralized and all buyers and
sellers come to a common
platform to discover the price.
Examples Currency market in India. Commodities, futures, Index
Futures and Individual stock
Futures in India
Introduction to Options
A derivative transaction that gives the option holder the right but not the obligation to buy or sell
the underlying asset at a price, called the strike price, during a period or on a specific date in
exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset
that is traded. The price at which the underlying is traded is called the ‘strike price’.
There are two types of options i.e., CALL OPTION & PUT OPTION.
Call Option
A contract that gives its owner the right but not the obligation to buy an underlying asset- stock
or any financial asset, at a specified price on or before a specified date is known as a ‘Call
option’. The owner makes a profit provided he sells at a higher current price and buys at a lower
future price.
Put Option

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A contract that gives its owner the right but not the obligation to sell an underlying asset- stock
or any financial asset, at a specified price on or before a specified date is known as a ‘Put
option’. The owner makes a profit provided he buys at a lower current price and sells at a higher
future price. Hence, no option will be exercised if the future price does not increase.
Put and calls are almost always written on equities, although occasionally preference shares,
bonds and warrants become the subject of options.
Option Terminology
Index options: Theses options have the index as the underlying some options are European
while others are American like index futures contract index options contracts are also cash
settled.
Stock options: Stock options are options on individual stock. Options currently trade on over
500 stocks in Untied States. A contract gives the holder the right to buy or sell shares at the
specified price.
Buyer of an option: The buyer of an option is the one who by paying the options premium buys
the right but not the obligation to exercise his options on the seller writers.
Writer of an option: The writer of a call put options is the one who receives the options
premium ands is there by obliged to sell buy the asset if the buyer exercises on him.
Option price: Option price is the price, which the option buyer pays to the option seller. It is
also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date the
exercise date, the strike date or the maturity
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.

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American options: American options are options that can be exercised at any time up to the
expiration date most exchange-traded options are American.
European options: European options are options that can be exercised only on the expiration
date itself. Index options are European options.
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 the were exercised immediately a call option on the index is said to be
in the money when the current index stand at la level higher than the strike price is spot price
strike price. If the index is much higher than the strike price, the call is said to be deep ITM. In
the case of a put, the put is ITM if the index is below the strike price.
At The Money option: An At the Money (ATM) option is an option that would lead to zero
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).
Out of The Money option: An Out of The Money (OTM) option is an option that would lead to
a negative cash flow it was 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.
Intrinsic value of an option: The option premium can be broken down into two components
intrinsic value a time value. The intrinsic value of a call is the mount the option is ITM if it is
ITM. If the call is OTM, its intrinsic value is zero. Putting it another way the intrinsic value of a
call is Max (O, St-K), which means the intrinsic value of call is the greater of O or (St) K is the
strike priced St is the spot price.
Time value of an option: The time value of an option is the difference between its premium
and its intrinsic value. Both calls and puts have time value an option OTM or ATM has only time

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value. Usually the maximum time value exists when the options Atm. The longer the time to
expiration the greater is an options time value alleles’ equal at expiration an option should have
no time value.
Pricing of futures
Pricing of a future contract is very simple. Using the cost-of-carry logic, we calculate the fair
value of the future contract. Every time the observed price deviates from the fair value,
arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the
future price back to its fair value. The cost of carry model used for pricing future given below:
F = S * e rt
Where: F = theoretical futures price
S = value of the underlying index
r = Cost of financing (using continuously compounded interest rate)
t = time till expiration in year
e =2.71828
Example:

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Security XYZ Ltd. Trades in the spot market at Rs. 1150. Money can be invested 11% p.a. the
fair value of one-month future contract on XYZ is calculated as follows:
F = S * e rt
= 1150*e0.11*1/12
= 1160
Pricing of Options
An option gives the buyer a right but not an obligation to exercise on the seller. The worst that
can happen to a buyer is the loss of the premium paid by him. His down side is limited to this
premium, but his upside is potentially unlimited. This optionality is precious and has a value,
which is expressed in term of an option price. Just like in order free market, it is the supply and
demand in the secondary market that drives the price of an option.
There are various models which help us get close to the true price of an option. Most of these are
variants of the celebrated Black-Scholes model for pricing European options. Today most
calculators and spread-sheets come with a built-in Black-Scholes options pricing formula.
The Black-Scholes formulas for the prices of European calls and puts on a non-dividend paying
stock are:
C = SN (d1) - Xe-rT N (d2)
P = Xe-rT N (-d2) - SN (-d1)
Where d1 = ln S/X + (r + 2 /2) T
d2 = d1 - T
 The Black-Scholes equation is done in continuous time. This required continuous

compounding. Example: if the interest rate per annum is 12 %, you need to use ln 1.12.
 N () is the cumulative normal distribution. N(d1) is called the delta of the option which is a
measure of change in option price with respect to change in the price of the underlying
assets.

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  a measure of volatility is the annualized standard deviation of continuously compounded

returns on the underlying. When daily sigma is given, that need to be converted into
annualized sigma.
 Sigmaannual = Sigmadaily *  Number of trading days per year. On an average there are 250
trading days in a year.
 X is the exercise price, S the spot price and T the time to expiration measured in a year.
Clearing & Settlement
National Securities Corporation Limited (NSCCL) undertakes clearing and settlement of all
trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal
counter party to all trades on the F&O segment and guarantees their financial settlement.
1. Clearing Banks
NSCCL has empanelled 13 clearing banks namely Axis Bank Ltd., Bank of India, Canara Bank,
Citibank N.A, HDFC Bank, Hongkong & Shanghai Banking Corporation Ltd., ICICI Bank, IDBI
Bank, IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank of India and
Union Bank of India.
Every Clearing Member is required to maintain and operate clearing accounts with any of the

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empanelled clearing banks at the designated clearing bank branches. The clearing accounts are to
be used exclusively for clearing & settlement operations.
2. Clearing Members
A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all
deals executed by Trading Members (TM) on NSE, who clear and settle such deals through
them. Primarily, the CM performs the following functions:
Clearing: Computing obligations of all his TM's i.e. determining positions to settle.
Settlement: Performing actual settlement. Only funds settlement is allowed at present in Index
as well as Stock futures and options contracts
Risk Management: Setting position limits based on upfront deposits / margins for each TM and
monitoring positions on a continuous basis.
Types of Clearing Members
 Trading Member-Clearing Member (TM-CM)
A Clearing Member who is also a TM. Such CMs may clear and settle their own proprietary
trades, their clients’ trades as well as trades of other TM’s & Custodial Participants.
 Professional Clearing Member (PCM)
A CM who is not a TM. Typically banks or custodians could become a PCM and clear and settle
for TM’s as well as of the Custodial Participants
 Self Clearing Member (SCM)
A Clearing Member who is also a TM. Such CMs may clear and settle only their own proprietary
trades and their clients’ trades but cannot clear and settle trades of other TM’s.

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Clearing Member Eligibility Norms
 Net worth of at least Rs.300 lakhs. The net worth requirement for a CM who clears and
settles only deals executed by him is Rs. 100 lakhs.
 Deposit of Rs. 50 lakhs to NSCCL which forms part of the security deposit of the CM.
 Additional incremental deposits of Rs.10 lakhs to NSCCL for each additional TM in case the
CM undertakes to clear and settle deals for other TMs.
3. Clearing Mechanism
The clearing mechanism essentially involves working out open positions and obligations of
clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is
considered for exposure and daily margin purpose. The open positions of CMs are arrived at by
aggregating the open positions of all the TMs and all custodial participants clearing through him,
in contracts in which they have traded. A TMs open position is arrived at as the summation of his
proprietary open position and clients open positions in the contracts in which he has traded.
While entering orders on the trading system, TMs are required to identity the orders, whether
proprietary (if they are their own trades) or client (if entered on behalf of clients) through
‘Pro/Cli’ indicator provided in the order entry screen. Proprietary positions are calculated on the
basis (buy-sell) for each contract. Clients’ positions are arrived a by summing together net (buy –
sell) positions of each individual client. A TMs open position is the sum of proprietary open
position, client open long position and client open short position.
1. Proprietary position of trading member Madanbhai on day 1

Trading member Madanbhai trades in the futures & options segment for himself and two of his
clients. The table shows his proprietary position.
Note: A buy position ‘200@1000’ means 200 units bought at the rate of Rs.1000.
Trading member Madanbhai
Buy Sell
Proprietary positions 200@1000 400@1010

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2. Client position of trading member Madanbhai on day 1

Trading member Madanbhai trades in the futures & options segment for himself and two of his
clients. The table shows his clients positions.
Buy Open Sell Close Sell Open Buy Close
Client position
Client A 400@1109 200@1000
Client B 600@1100 200@1099
3. Proprietary position of trading member Madanbhai on Day 2

Assume that the position on Day 1 is carried forward to the next trading day and the following
trades are also executed.
Buy Sell
Proprietary positions 200@1000 400@1010
4. Client position of trading member Madanbhai on day 2

Trading member Madanbhai trades in the futures and options segment for himself and two of his
clients. The table shows his client position on Day 2
Buy Open Sell Close Sell Open Buy Close
Client position
Client A 400@1109 200@1000
Client B 600@1100 400@1099

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The proprietary open position on day 1 is simply = Buy – Sell = 200- 400 = 200 short. The
open position for client A = Buy (O) – Sell (C) = 400 –200 = 200 long, i.e. he has a long
position of 200 units. The open position for Client B = shell (O) – Buy (C) = 600-200 = 400
short, i.e. he has a short position of 400 units. Now the total open position of the trading member
Madanbhai at end on day 1 is 200 (his proprietary open position on net basis) plus 600 (the
Client open positions on gross basis) i.e. 800.
The proprietary open position at end of day 1 is 200 short. The end of day open position for
proprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position at
the end of day 2 is 400 short. Similarly, Client A’s open position at the end of day 1 is 200 long.
The end of day open position for trades done by Client A on day2 is 200 long. Hence the net
open position for Client A at the end of day 2 is 400 long. Client B’s open position at the end of
day 1 is 400 short. The end of day open position for trades done by Client B on day 2 is 200
short. Hence the net open position for Client B at the end of day 2 is 600 short. The net open
position for the trading member at the end of day 2 is sum of the proprietary open position and
client open positions. It worked out to be 400 +400+ 600, i.e. 1400.
4. Settlement Schedule
The settlement of trades is on T+1 working day basis.
Members with a funds pay-in obligation are required to have clear funds in their primary clearing
account on or before 10.30 a.m. on the settlement day. The payout of funds is credited to the
primary clearing account of the members thereafter.
5. Settlement Price
Product Settlement Schedule

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Futures Contracts Daily Closing price of the futures contracts on the trading
on Index or Settlement day. (closing price for a futures contract shall be
Individual Security calculated on the basis of the last half an hour
weighted average price of such contract)
Un-expired illiquid Daily Theoretical Price computed as per formula F=S * ert
futures contracts Settlement
Futures Contracts Final Closing price of the relevant underlying index /
on Index or Settlement security in the Capital Market segment of NSE, on
Individual the last trading day of the futures contracts.
Securities
Options Contracts Final Exercise Closing price of such underlying security (or index)
on Index and Settlement on the last trading day of the options contract.
Individual
Securities
6. Settlement Mechanism
The entire future and option contract are cash settled, i.e. through exchange of cash. The
underlying for index future/option of the nifty index cannot be delivered. These contracts,
therefore, have to be settled in cash. Future and option on individual securities can be delivered
as in the spot market. However, it has been currently mandated that stock option and future
would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients,
with respect to their obligations on MTM, premium and exercise settlement.
Settlement of future contract

Future contract have two types of settlements, the MTM settlement which happen on a
continuous basis at the end of each day, and the final settlement which happens on the last
trading day of the future contract.
MTM settlement
All future contracts for each member are marked-to-market (MTM) to the daily settlement price
of the relevant futures contract at the end of each day. The profit or losses are computed as the
difference between:

29
1. The trade price and the day’s settlement price for contracts executed during the day but not
squared up.
2. The previous day’s settlement price and the current day’s settlement price for bought
forward contract.
3. The buy price and the sell price for contracts executed during the day and squared up.
F = S * e rt
Where: F = theoretical futures price
S = value of the underlying index
r = rate of interest (MIBOR)
t = time to expiration
e =2.71828
Final settlement for futures

On the expiry day of the future contracts, after the close of the trading hours, NSCCL marks all
positions of a CM to the final settlement price and the resulting profit or loss is settled in cash.
Final settlement profit or loss amount is debited or credited to the relevant CM’s clearing bank
account on the day following expiry day of the contract.
Settlement of future contract

Option contracts have three types of settlements, daily premium settlement, exercise settlement,
interim exercise settlement in case of option contracts on securities and final settlement.
Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him.
Similarly, the seller of an option is entitled to receive the premium for the option sold by him.
The premium payable amount and the premium receivable amount are netted to compute the net
premium payable or receivable amount for each client for each option contract.

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Exercise settlement
Although most option buyer and seller close out their options positions by an offsetting closing
transaction, an understanding of exercise can help an option buyer determine whether exercise
might be more advantageous than an offsetting sale of an option. There is always a possibility of
an option seller being assigned an exercise. Once an exercise of an option has been assigned to
an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash
settlement amount in the case of cash-settled option) even though he may not yet have been
notified of the assignment.
Interim exercise settlement

Interim exercise settlement takes place only for option contracts on securities. An investor can
exercise his in-the-money options at any time during trading hours, through his trading member.
Interim exercise settlement is effected for such options at the close of the trading hours, on the
day of exercise. Valid exercised option contract are assigned to short position in the option
contract with the same series (i.e. having the same underlying, same expiry date and same strike
price), on a random basis, at the client level. The CM who has exercised the option receives the
exercise settlement value per unit of the option from the CM who has been assigned the option
contract.
Final exercise settlement

Final exercise settlement is effected for all open long in-the-money strike price options existing
at the close of trading hours, on the expiration day of the option contract. All such long positions
are exercised and automatically assigned to short positions in option contract with the same
series, on a random basis. The investor who ha long in the money options on the expiry date will
receive the exercise settlement value per unit of the option from the investor who has been
assigned the option contract.
4. Settlement Procedure
Clearing members who opt to pay the Daily MTM settlement on a T+0 basis would compute
such settlement amounts on a daily basis and make the amount of funds available in their

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clearing account before the end of day on T+0 day. Failure to do so would tantamount to non
payment of daily MTM settlement on a T+0 bases. Further, partial payment of daily MTM
settlement would also be considered as non payment of daily MTM settlement on a T+0 basis.
These would be construed as non compliance and penalties applicable for fund shortages from
time to time would be levied.
A penalty of 0.07 % of the margin amount at end of day on T+0 would be levied on the clearing
members. Further, the benefit of scaled down margins shall not be available in case of non
payment of daily MTM settlement on a T+0 basis from the day of such default to the end of the
relevant quarter.
Basic Pay-off
Option pays-offs
1. Pay-off for Buyer of call option
Pay-off diagram below represents the effective pay-off of a long call position of an option at the
time of the expiry date. It looks at the option from the point of view of buyer.
Profit
200
6000 6100
Nifty
5950 6050
-200

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Loss
The figure shows the profits or losses for the buyer of the call option of Nifty at the strike of
6000. As can be seen, as the spot Nifty raises, the call option in in-the-money. It will generate
positive cash flow and the investor will get profit to the extent of the difference between the spot
and the strike price.
However if nifty falls below the strike price of 6000, he let the option expire. His losses are
limited to the extent of the premium he paid for buying the option.
2. Pay-off for writer of call option
Option seller has limited profit potential and potentially unlimited risk. Pay-off diagram below
represents the effective pay-off of a short call position of an option at the time of the expiry date.
It looks at the option from the point of view of seller.
Profit
200
5950 6050
Nifty
6000 6100
-200
Loss
The figure shows the profits or losses for the seller of Nifty 6000 call option. As the spot Nifty
rises, the call option is in-the-money and the writer starts making losses. If Nifty closes above the
strike of 6000, 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.

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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 is charged by him.
3. Pay-off for buyer of put option
Profit
200
5950
5800 Nifty
6000 6050
-200
Loss
The figure shows the profits or losses for the buyer of a Nifty 6000 put option. As can be seen, as
the spot Nifty falls, the put option in-the-money. If Nifty closes below the strike of 6000, the
buyer would exercise his option and profit to the extent of the difference between the strike price
and Nifty-close. The profit possible on this option can be high as the strike price.
However if nifty rises above the strike price of 6000, he let the option expire. His losses are
limited to the extent of the premium he paid for buying the option.
4. Pay-off for writer of put option
The figure shows the profits or losses for the seller of a Nifty 6000 put option. As can be seen,
as the spot Nifty falls, the put option in-the-money and the writer starts making losses. If Nifty
closes below the strike of 6000, 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.
Profit
200

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5950
5800 Nifty
6000 6050
-200
Loss
The loss can be incurred by the writer of the option is a maximum extent of the strike price
whereas the maximum profit is limited to the extent of the up-front option premium is charged
by him.
Future pay-offs
1. Payoff for a buyer of the Nifty future
Profit
5800
Nifty
Loss

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The figure shows the profit or loss for a long future position. The investors buy futures when the
index was at 5800. If the index goes up, his future position starts making profit. If index falls, his
future position starts showing losses.
2. Payoff for a Seller of the Nifty future
1111
Profit
5800 Nifty
Loss
The figure shows the profit or loss for a short future position. The investors sold futures when the
index was at 5800. If the index goes down, his future position starts making profit. If index rises,
his future position starts showing losses.

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Trading in Derivative
Future and Option trading system
The futures and options trading system of NSE, called NEAT-F&O trading system, provides a
fully automated screen based trading for Nifty futures and options and stock futures and options
on a nation wide basis as well as an online monitoring and surveillance mechanism. It supports
an order driven market and provides complete transparency of trading operations. It is similar to
that of trading of equities in the cash market segment.
The software for the F&O market has been developed to facilitate efficient and transparent
trading in futures and options instruments. Keeping in view the familiarity of trading members
with the current capital market trading system, modifications have been performed in the existing
capital market trading system so as to make it suitable for trading futures and options.

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Entities in the trading system
There are four entities in the trading system. Trading members, clearing members, professional
clearing members and participants.
5. Trading members
Trading members are members of NSE. They can trade either on their own account or on behalf
of their clients including participants. The exchange assigns a trading member ID to each
trading member. Each member can have more than one use. The number of users allowed for
each trading member is notified by the exchange from time to time. Each user of a trading
member must be registered with the exchange and is assigned a unique user ID. The unique
trading member ID functions as a reference for all orders, trades of different users. This ID is
common for all users of a particular trading member. It is the responsibility of the trading
member to maintain adequate control over persons having access to the firms User ID.
6. Clearing members
Clearing members are members of NSCCL. They carry out risk management activities and
confirmation inquiry of trades through the trading system.
7. Professional clearing members
A professional clearing members is a clearing member who is not a trading member. Typically
banks and custodian become professional clearing members and clear and settle for their trading
members.
8. Participants

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A participant is a client of trading members like financial institutions. These clients may trade
through multiple trading members but settle through a single clearing member.
Corporate hierarchy
In the F&O trading software, a trading member has the facility of defining a hierarchy amongst
users of the system. This hierarchy comprises corporate manager, branch manager and dealer.
1. Corporate manager
The term ‘Corporate manager’ is assigned to a user placed at the highest level in a trading firm.
Such a user can perform all the functions such as order and trade related activities, receiving
reports for all branches of the trading member firm and also all dealers of the firm. Additionally,
a corporate manager can define exposure limits for the branches of the firm. This facility is
available only to the corporate manager.
2. Branch manager
The branch manager is a term assigned to a user who is placed under the corporate manager.
Such a user can perform and view order and trade related activities for all dealers under that
branch.
3. Dealer
Dealers are users at the lower most level of the hierarchy. A Dealer can perform view order and
trade related activities only for one self and dose not have access to information on other dealers
under either the same branch or other branches.
Order types and conditions

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The system allows the trading members to enter orders with various conditions attached to them
as per their requirements. These conditions are broadly divided into the following categories;
1. Time conditions
2. Price conditions
3. Other conditions
Several combinations of the above are allowed thereby providing enormous flexibility to the
uses. The order types and conditions are given below.
1. Time conditions
Day order
A day order, as the name suggest is an order which is valid for the day on which it is entered. If
the order is not executed during the day, the system cancels the order automatically at the end of
the day.
Immediate or Cancel (IOC)
An IOC order allows the user to buy or sell a contract as soon as the order is released into the
system failing which the order is cancelled from the system. Partial match is possible for the
order, and the unmatched portion of the order is cancelled immediately.
2. Price conditions
Stop loss
This facility allows the user to release an order into the system, after the market price of the
security reaches or crosses a threshold price E. G. if for stop loss buy order, the trigger is
1027.00, the limit price is 1030.00, and the market last traded price is 1023.00, then this order is
released into the system once the market price reaches or exceeds 1027.00, This order is added to
the regular lot book with time or triggering as the time stamp as a limit order of 1030.00. For the
stop loss sell order the trigger price has to be greater than the limit price.

40
3. Other conditions
Market Price
Market orders are orders for which no price is specified at the time the order is entered {i.e. price
is market price} for such orders, the system determines the price.
Trigger price
Price at which an order gets triggered from the stop loss book.
Limit price
Price of the orders after triggering from stop loss book.
Pro
Pro means that the orders are entered on the trading member’s own account.
Cli
Cli means that the trading member enters the orders on behalf of a client.
Placing order on the trading system
For both the future and the option market, while entering orders on the trading system, members
are required to identify order as being proprietary or client order. Proprietary order should be
identified as ‘Pro’ and those of client should be identified as ‘Cli’. Apart from this, in the case of
‘Cli’ trades, the client account number should also be provided.

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Risk Management system of Derivative
Margin system adopted by Exchanges in India
The initial margin is required to be paid by the person taking the risk. However, an option buyer
risk is limited to the amount of the premium. Thus, as a rule, an option buyer does not pay the
margin. He only pays the premium to the options seller at the time of buying the option. Options
sellers, futures buyers and futures sellers have potentially unlimited risk and hence have to pay
the initial margin. Options traders trading in vertical spreads and time spreads have to pay a
much lower margin than normal options writers.
In India, NSE and BSE use the margin system called as the Standardized Portfolio Analysis
(SPAN) developed by the Chicago Mercantile Exchange (CME), Chicago, USA. The objective
of SPAN is to identify the overall risk in a portfolio of futures and options contracts for each
member. The system treats futures and options contracts uniformly, while recognizing the non-

42
linearity of the payoffs of options portfolios and the consequential unique exposures associated
with them. SPAN is used to determine margin requirements. Its main objective is to determine
the largest loss that a portfolio might reasonably suffer from one day to the next.
The underlying market price, the volatility of the underlying instrument and the time to
expiration are important factors that directly affect the value of options at a given point in time.
A change in these factors affects the value of the futures and options in a portfolio. This system
is scientific and takes into consideration traders total long and short positions. It takes into the
market price of the underlying asset, the volatility o f the underlying asset, and the time to
expiration of the contract entered into. It also considers whether it is a long or short position.
The options and futures portfolio is analyzed as a whole and the net risk taken by the trader is
considered. Thus a naked options seller will have to pay much more margin than a trader who
has short options positions and also long options positions of a different strike price.
The calculation process is definitely much more systematic than an arbitrary margin rate system.
Derivatives contracts of a more volatility underlying asset have larger margin requirements, and
a derivatives contract on the same underlying with more time to expiry will also have a higher
margin requirement. There are a series of complex steps and procedures for calculating the final
margin amount. However, CME PC-SPAN software makes the calculations of margins very
simple. All that the broker back office has to do is to feed in the investors’ position at the end of
the day into the computer and they can get the final net margin requirement of the trader with the
click of the button. Initial margin is also payable in the form of specified securities. The list of
such securities is approved by SEBI and is updated regularly. A haircut specified by the
regulatory authorities’ sis applied to the value of the securities. This is very beneficial as the
investor paying the margin in the form of money will not earn interest, whereas if he deposits
securities like the government bonds as margin he will keep earning interest on them.
NSCCL-SPAN
The objective of NSCCL-SPAN is to identify over all risk on a portfolio of all futures and
options contracts for each member. The system treats futures and options contracts uniformly,
while at the same time recognizing the unique exposures associated with options portfolios. Like

43
extremely deep out of the money short position and inter month risk. Its over riding objective is
to determine the largest loss that a portfolio might reasonably to expected to suffer from one day
to the next day based on 99% VaR methodology. SPAN considers uniqueness of option
portfolios. The following actors affect the value of an option.
The following factors affect the value of an option
 Underlying market price

 Strike price
 Volatility of underlying instrument
 Time to expiration
 Interest rate
As these factors change, the value of options maintained within a portfolio also changes. Thus,
SPAN constructs scenarios of probable changes underlying prices and volatilities in order to
identify the largest loss a portfolio might suffer fro one day to the next. It then sets the margin
requirement to cover his one-day loss. The complex calculations (e.g. the pricing of options) in
SPAN are executed by NSCCL. The results of these calculations are called risk arrays. Risk
arrays, and other necessary data inputs for margin calculation are provided to members daily in a
file called the SPAN risk parameter file. Member can apply the data contained in the risk
parameter files, to their specific portfolios of futures and options contracts, to determine their
SPAN margin requirements. Hence, members need not execute complex option pricing
calculations, which are performed by NSCCL. SPAN has the ability to estimate risk for
combined futures and options portfolios, and also re-value the same under various scenarios of
change in market conditions.
Margins
Derivatives segment uses margins as one of the important measures for the risk management
purpose. In order to control the trading activities and to prevent the speculative activities the
exchange imposes several types of margins to safe guard the interest of the genuine investors and

44
for the proper development of the overall market. The following types of margins are imposed
for the purpose of risk management:-
1. Initial margin
This is the amount of money taken first time to safe guard the interest of the trading member.
The initial margin is charged at the time of opening of account in the options and futures
segment. The usual practice followed by the investment solution providers is to charges
Rs.10,000 in case of opening of an options account and Rs. 50,000 in case of opening a futures
account.
2. Maintenance margin
This is the minimum amount of margin required in the client account at all the times. When the
margin in the client account goes beyond the maintenance margin a call is made to the client by
the broker that the margin needs to be brought back to the original level of initial margin and the
client is required to provide the required margin immediately to the broker otherwise the broker
will close the account of the client and will not allow him to operate him anymore. It is a usual
practice to charge 75 per cent of the initial margin as the maintenance margin. For example if the
initial margin is Rs. 10,000 then its 75 per cent i.e. Rs. 7500 is considered as the maintenance
margin and if the margin money goes below Rs. 7500 then the client is required to bring the
required amount of money.
3. Value at Risk Margin

This is the margin which the exchange calculates on the basis of the volatility of the stock price
movement and it is decided on the movement of the stock prices during a particular day. This
margin is sent by the file to all the brokers three times a day or five times a day depending upon
the volatility of the stock. The value at risk margin may vary from 15 per cent to say 25 per cent.
When there is high volatility in the stock prices the value at risk margin is also charged at a high
level. This margin is imposed to have control over the speculative activities and to prevent the
traders from the over trading.
4. Special margin

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This margin is charged when the exchanges observed some abnormal movement in the prices of
the stock prices. This type of margin is imposed by the exchange by giving notice in the
newspaper and by informing the clients through the file sent through the internet to the brokers.
Recently on 9th December 2003 the Bombay stock exchange and the National Stock Exchange
imposed at special margin of 10 per cent on 35 scripts of A group while 71 scripts of B1, B2 and
Z group has been imposed a margin 25 per cent.
5. Mark to Market margin

The profit or loss of the investor open position is calculated on a daily basis and the is called as
mark to market (MTM). The daily profit/loss is credited or debited to the investors account on a
daily basis. A penalty is levied by the exchange on the clearing member in case of non-collection
of the initial or MTM margin and the open position of the investor is closed, irrespective of
whether he makes a profit or loss. The penalty is charged even if the client brings in the margin
later. The clearing member collects these penalties levied by the exchange from such a client. To
avoid such situations, the investors generally pay 10 to 15 per cent more than the margin
requirement. This practice not only precludes the possibility of a penalty being levied but also
meets the possibility of an additional margin requirement in the case of an increase by the
clearing house or daily MTM requirement.
6. Exposure Margin
Exchanges may levy an exposure margin over and above the initial margin as a second line of
defense. This margin may vary from 5 per cent to 20 per cent depending on the stock. This may
be increased by the exchanges as and when necessary by giving notices to the clearing members.
The clearing members in turn have to collect the same from the trading members and the clients
and pass them on to the exchanges. The exchanges do take such actions in time of volatility. The
main purpose of such an exercise is to reduce any excessive speculation in the market. However,
the negative effect of increasing the margins is that it results in the forced liquidations of
positions, thereby bringing down the market, at least temporarily.
7. Ad hoc margin

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The exchanges may levy an adhoc margin on investors who have large positions in the
derivatives segment. The exchanges send notices to the clearing members to collect such margins
from these investors.
The above margins are collected upfront from the clients so that there is no excess position
taking by the clients and the liquidity of the members is also safeguarded. Whenever the market
wide limit on a particular stock touches 80 per cent of the total limit allowed on that particular
day then the margins are doubled that is if the margins comes to Rs. 25000 then it is doubled and
becomes Rs. 50,000. On 14th October 2003 the following scripts had touched 80 per cent market
wide limit and so the margins were doubled.
1. ACC (82%) 6. Nalco (91%)
2. Arvind Mills (98%) 7. NIIT (84%)
3. Digital Global (85%) 8. PNB (83%)
4. IPCL (84%) 9. Polaris (93%)
5. Mastek (100%) 10. SCI (96%)
POSITION LIMITS
Position limits have been specified by SEBI at the trading member, client, market and the FII
levels to prevent any manipulation and excess position taking.
Trading Member position limits

There is a position limit in derivative contracts on an index of 15 % of the open position or Rs.
100 crores whichever is higher. The position limit in derivative contracts on an individual stock
is 7.5 % of the open interest in that underlying on the exchange or Rs. 50 crores whichever is
higher.
Client level position limit

Any client either individually or in group with other investor if acquires more than 15 % of the
total open interest in all the futures and options contract taken together then he has to inform the
Clearing Corporation and if he does not do so then it would attract penalty in the form of fine.
Market wide position limits

47
The market wide limit of open position in terms of the number of units of underlying stock on all
the futures and options contract on particular stocks is lower of 30 times the average number of
shares traded daily, during the previous calendar month, in the capital market segment of the
exchange or 10 % of the number shares held by the non-promoters that is 10% of the free float in
terms of the number of shares of the company.
Position limit for FIIs

In case of the index related derivative products the position limit is 15% of open interest in all
futures and option contract or Rs. 100 crores whichever is higher. In case of stock related
derivative products the position limit is 7.5% of open interest in all the futures and options
contracts or Rs. 50 crores whichever is higher.
Margin collection and violations

Clearing members are provided with terminals of the futures and options segment to monitor the
trades of all the trading members and clients. Through this, clearing members can set the
exposure limits for trading members and clients; the trading facility is withdrawn whenever a
trading member exceeds exposure limits. The initial margin amount on the positions taken by the
clearing member is computed for the each trade. The initial margin amount is reduced from the
effective deposits of the clearing member with the Clearing Corporation. Once 70, 80 and 90 per
cent of the effective deposits are consumed; the member receives a warning message on his
terminal. The clearing facility is withdrawn the moment 100 per cent is consumed. The liquid net
worth of the clearing member at any point of time should not be less than Rs. 50 lakhs. The
withdrawal of the clearing facility in case of violations will apply to the trading facility of all
trading members clearing and settling through that clearing member.
The margin amount on the positions taken by the trading member is also computed on a real time
basis and compared with the trading member limit set by his clearing member. Here also the
initial margin amount is reduced from the trading member limit, set by the clearing member.

48
Having consumed 70 per cent, 80 per cent and 90 per cent of the limit, the member receives a
warning message on his terminal, and once 100 per cent is consumed the trading facility
provided to the trading member is withdrawn.

No. Particulars No. Introduction To Derivatives

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1

 Pay-off for Buyer of Call option………………………………………………. 32

Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

Structure of Derivative Markets

Economic functions of a derivatives market:

The derivatives market performs a number of economic functions:

2. It helps in the discovery of future as well as current prices.

3. It catalyzes entrepreneurial activity.

5. It increases savings and investment in the long run.

The participants in a derivative market

Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

1. Interest rate swaps

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FORWARD OPTIONS FUTURE SWAP

CALL PUT CURRENCY INTEREST RATE

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Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

Derivative Market in India

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The committee recommended that derivatives should be declared as “securities’ so that

1991 Liberalisation process initiated.

14 December 1995 NSE asked SEBI for permission to trade index

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18 November 1996 SEBI setup L.C.Gupta Committee to draft a

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate

24 May 2000 SIMEX chose Nifty for trading futures and

25 May 2000 SEBI gave permission to NSE and BSE to do

9 June 2000 Trading of BSE Sensex futures commenced at

25 September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

Recommendations of L.C.Gupta Committee on Derivatives

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6. The committee further recommended that “derivatives” to be included in the definition of

Introduction to Forward Contract

The salient features of forward contracts are :

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 They are bilateral contracts and hence exposed to counter-party risk.

 The contract price is generally not available in public domain.

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Limitations of Forward Markets

 Lack of centralization of trading

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The standardized items in futures contract are;

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Distinction between Futures and Forwards Contracts

Counter-party risk Exists. Exists. However, assumed by the

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the counter party to all the

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Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

Shri S.V. Patel College of Computer Science & Business Management

 The Black-Scholes equation is done in continuous time. This required continuous

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  a measure of volatility is the annualized standard deviation of continuously compounded

Clearing & Settlement

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