A Project Report On

Futures And Options- How The Mechanism Works

SUBMITTED TO

UNIVERSITY OF MUMBAI FOR PARTIAL COMPLETION OF

THE DEGREE OF MCOM (BANKING & FINANCE)

UNDER THE FACULTY OF COMMERCE

SEMESTER III

SUBBMITTTED BY

Preety Venkatesh Kshirsagar

4026

UNDER THE GUIDANCE OF

ASST. PROF. POURNIMA RELEKAR

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MAHARSHI DAYANAND COLLEGE OF ART, SCIENCE & COMMERCE

NAAC ACCREDITED-A 2021-2022

This is certify that (Preety Venkatesh kshirsagar) of B&F Semester III (Academic Year 2021-2022) has
successfully completed a research project on “Futures And Options- How The Mechanism Works”.
Under The Guidance Of Asst. Prof. Pournima Relekar.

Asst. Prof. POURNIMA RELEKAR Assoc. Prof. C.K. GHOGARE

(PROJECT GUIDE) (COURSE COORDINATOR)

DR.C.S. PANSE

(EXTERNAL EXAMINATION) (PRINCIPAL)

Place - Mumbai

Date -

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DECLARATION

I, Preety Venkatesh Kshirsagar, Student of B & F (Banking & Finance) Semester III (Academic Year
2021-2022) hereby declare that, I have completed the research project on-

“Futures And Options- How The Mechanism Works”

This information presented in this project is true and original to the best of my knowledge. This project is
previously not submitted to any university for any Degree or Diploma Course of this or any other University.

Preety Venkatesh Kshirsagar

4026

Place – Mumbai

Date-

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ACKNOWLEDGEMENT

I would like to thank the University of Mumbai, for introducing B & F (Banking & Finance) Semester III
course, thereby giving its student a platform to be abreast with changing business scenario, with the help of
theory as a base and Practical as a solution. I am indebted to our Principal Dr. C.S. PANSE for providing
necessary facilities required for completion of the project. I take this opportunity to thank our Coordinator
ASSOC. PROF. C.K. GHOGARE for his support and guidance.

I would sincerely like to thank him for all efforts. I would like to express my sincere gratitude towards my
project guide POURNIMA RELEKAR whose guidance and care made the project successful. I would like
to thank my college library for having provided various references books and magazines related to my
project. Last but not the least; I would like to thank my parents for giving the best education and for their
support and contribution without which this project would not have been possible.

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EXECUTIVE SUMMARY

The objective of the study is to analyze the mechanism of futures and options in derivative market. This
study includes derivative market and its operations, history of derivative market and the current scenario,
history of futures and options, evolution of futures and options, pricing models for futures and options,
measures taken by SEBI to prevent investors interest, client and broker relationship n derivative market. For
this questionnaire was prepared and provided to the respondents for their valuable inputs.

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INDEX

Chapter
Particulars Page No
No
Introduction
1 7

Futures
2 16
Options
3 26
Minimum Size Of Derivatives Contract
4 54
Measures Specified By SEBI To Protect The Rights Of Investor In
5 Derivatives Market
55
System Of Badla
6 56

7 Similarities In Futures And Badla 58

Client and Broker Relationship In Derivative Segment
8 61
Objectives of study
9 62

10 Scope And Limitations Of Study 63

11 Research Methodology 64
Review Of Literature
12 65

13 Data Analysis And Interpretation 67

Suggestions And Recommendations
14 78
Conclusion
15 79
Bibliography
16 81
Appendix
17 82

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Chapter No. 1

INTRODUCTION

Futures And Options – How The Mechanism Works

The term derivative refers to the class of financial instruments which mainly consists of futures and options.
These instruments derive their value from the price of an underlying asset. The price of an instrument is
totally reliable on underlying asset. Underlying assets are of many forms such as:

Commodities: Grains, pulses, coffee, tea.

Precious metals: gold, silver.

Foreign currencies, local currencies, bonds, shares, short term securities etc.

A derivative is a financial contract wherein the instrument’s value is derived from an underlying asset. An
asset is chosen as a benchmark value from which the derivates value is derived. It is a contract between two
parties, the value of derivative is derived mainly from fluctuations that occur in the price of underlying asset.
These assets are such as currencies, bonds, stocks, commodities or interest rates. Derivative trading involves
both buying and selling of these financial contracts in the stock market. A derivative is a contract between
two or more parties that can be traded on an exchange or over the counter. These contracts can be used to
trade any number of assets and carry their on risks. Prices for derivatives derive from fluctuations in an
underlying assets. These financial securities are commonly used to access certain markets and may be traded
to hedge against the risk

Financial derivative allow for free trading of risk components. This leads to improving market efficiency.
Generally, many of the investors invest in derivatives as it is an attractive instrument than any underlying
asset. Derivative has greater amount of liquidity in the market and it is associated with lower transaction cost
compared to the cost of trading in cash market. The most important application of derivatives is price
discovery. It discovers the future price as it is a legal contract which is made at a specified price of a
particular commodity at a specified date in future.

Many of the derivatives are traded in cash. Which means that the gain or loss in the trade is simply an
accounting cash flow to the trader’s brokerage account. Derivate trading is similar to regular buying and
selling process. Instead of paying whole amount, a trader pays only initial margin to stockbroker. In
derivative trading both buyer and seller have opposite estimation of the future trading price. Both the parties
have their focus on future value of underlying assets to make a profit.

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Chapter No. 1.1

History Of Derivatives Market In India

The origin of derivatives came by observing the need of farmers to protect themselves against fluctuations in
the price of their crop. It has been observed that farmers protect themselves from the loss by locking in asset
prices. Through the use of simple derivative products, it was possible for the farmer to partially or fully
transfer risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers
and were basically a means of reducing risk.

The area of existence of derivatives was in commodities, it was association by traders in Bombay which was
named as Bombay Cotton Trade Association (BCTA) in 1875 and started dealing with the futures contracts.
In 19th century India became the world’s largest future industry. The Indian Government banned cash
settlement and options trading. Thus, derivative trading shifted to informal forward market. In 1995, the
introduction of derivative trading in India was a declaration on options in securities market law. SEBI
granted permission to derivative trading in 2001. This approval was granted on the recommendations of L.C.
Gupta Committee. SEBI permitted the derivatives segments of two stocks i.e. BSE and NSE. Permission
was granted to their clearing house corporation to settle the trading. The problem of risk caused by
uncertainty and volatility in the underlying assets can be effectively solved by derivatives as it is the risk
management tool that help an organisation to transfer the risk. Starting from November 2001, the growth in
number of contracts traded at NSE were remarkable. An average compounded percentage was 5.1% a
month.

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Chapter No. 1.2

Growth Of Indian Derivatives Market

Few derivatives exchanges worldwide have obtained such a hectic pace of growth in the early years after
launch. In earlier times, market had new technique called futures and options. This idea of trading an index
was new. Share of index derivative went up to 80% of equity derivatives trading.

There has been a shift from a equity derivatives. At that time options and swaps were banned. Participants of
Foreign Institutional Investors (FII) and Non Resident Indians (NRI) were also banned.

Trading was permitted only in futures and options on Rupee- Dollar rate. Currency trading in India gained a
great prominence. NSE was rising to above 10% of overall NSE within 6 months.

Initially, Underlying asset was in a form of agricultural goods. After independence, derivative market came
through a full circle from prohibition of all sorts of derivative trades to their recent reintroduction.

Following are important factors contributing to the growth of derivative market in India:

1. Price Volatility:
The objects having value such as commodities, foreign currencies, local currencies has its own price.
The price is determined by forces of demand and supply. These factors are constantly interacting with
market causing changes in the price these changes in price is known as price volatility. This price
volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can
be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares
and bonds.
2. Globalization Of Market:
Globalization has increased the size of market and enhanced competition. Therefore it has a positive
effect on derivative market. Globalization of market led to increase the turnover of derivatives in the
market.
3. Technological Advancement:
The growth of derivative market has been driven from technological advancement. Technological
advancement increases volatility, risk management, communication. Technological advancement
facilitated rapid movement of information and spontaneous impact on market.

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Chapter No. 1.3

Advantages Of Derivative Trading

1. Low Transaction Cost:

Derivative contract plays an important role in reducing market transaction costs. Derivatives works
as risk management tools. Therefore the cost of transaction in derivative trading is lower as
compared to other securities like debentures and shares.
2. Used In Risk Management:
There is a direct relationship between price of an underlying asset and a derivative. Therefore,
derivatives are used to hedge the risks associated with changing price levels of underlying asset.
3. Market Efficiency:
Derivative contract involves arbitrage which plays a vital role in ensuring that the market reaches
equilibrium and the price of underlying assets are correct.
4. Risk Is Transferable:
Derivates allow investors, businesses and others to transfer the risk to other parties. This is beneficial
to those who can not bear risk.
5. Determines The Price Of An Underlying Asset:
Derivate contracts are used to ascertain the price of an underlying assets.

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Chapter No. 1.4

Disadvantages of Derivative Trading

1. Involves High Risk:

Derivative contracts are highly fluctuating in nature as the value of underlying assets keeps
changing rapidly. Therefore, some investors are scared of huge losses.
2. Counterparty Risk:
Some derivative contracts are traded on the exchanges like BSE and NSE are organized and
regulated. Some of the derivative contracts are traded over the counter. Hence, there is always
a risk of counterparty default.
3. Speculative In Nature:
Generally, derivative contracts are used as tools for speculation. Due to high risk and
unpredictable fluctuations and speculations derivatives often lead to huge losses.
4. Requires expertise:
In case of shares investor can manage with a limited knowledge. But in derivatives market it
is difficult to sustain in the market without expert knowledge in the field.
5. Contract Life:
Derivatives contracts are of limited life. As the time passes the value of derivatives will
decline. There are chances of losing completely with that agreed time line.

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Chapter No. 1.5

Participants in Derivatives Market

There are four participants involved in derivative trading.

Hedgers:

Hedgers are those participants who invest in derivatives market to eliminate the risk with future price
changes. Hedger could be any individual or firm that buys or sells the actual physical commodity.

There are 3 types of hedgers such as:

a. Buy-side hedgers: They are concerned about raising commodity prices.

b. Sell-side hedgers: They are concerned about falling commodity prices. III.
c. Merchandisers: They determine their profitability by the difference between purchase and selling
price.

1. Speculators:
Speculators are primary participants in future market. Speculator is any individual or firm that
accepts risk and make profit. Speculators predict future changes in the price of an underlying asset.
Based on these predictions they make profit.
There are two types of speculators such as:

a. Bullish speculators:
Bullish speculators expect the price of an underlying asset to rise. A bull is a speculator who buys
the speculators to sell them at higher price in future.

b. Bearish speculators:
Bearish speculator expects the price of securities to fall in future. A bearish speculator sells short
securities with the aim of earning profit after selling them at lower price in future.

2. Arbitrageurs:

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Arbitrage is simultaneous purchase and sale of same asset in different market in order to make profit.
Arbitrage can be used whenever any stock or commodity is purchased in one market at a particular
price and sold in another market at high price. This situation creates an opportunity for a risk free
profit for the trader.

Arbitrage include the following types:

a. Risk arbitrage:
This type of arbitrage is also called as merger arbitrage. This involves buying of stocks in the
process of merger and acquisition.

b. Convertible arbitrage:
Convertible arbitrage involves buying and selling of convertible securities.

c. Statistical arbitrage:
Statistical arbitrage technique that use complex statistical models to find trading opportunities in
financial instruments.

3. Margin Traders:
Margin trading is an act of borrowing funds from the stockbrokers with the aim of investing in
financial securities. The purchased security works as a collateral security for the loan. Margin traders
use various payment options to invest in more securities.

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Chapter No. 1.6

Uses of Derivatives

1. Assist Investors:
The derivatives assist investors to increase their returns and achieve their investment goals.
Derivatives help to make proper asset allocation.

2. Catalyse Growth Of Financial Market:

The derivative trading encourage growth of financial market by encouraging competitive trading
in the markets. It helps to encourage investment habit in general public.

3. Enhance Liquidity:
As derivative trading is based on margin trading, large number of traders, arbitrageurs,
speculators operate in market. Hence, derivative trading enhances liquidity and reduces cost of
transaction.

4. Risk Aversion Tool:

Derivative is known as risk aversion tool as it involves some techniques to transfer or avoid risk
such techniques are hedging, spreading, arbitraging etc.

5. Prediction Of Future Prices:

Derivatives serve as barometers of the future trends in prices which result in the discovery of new
prices both on the spot and futures markets. They help in giving different information regarding
the futures markets trading of various commodities and securities to the society which enable to
discover or form suitable or correct or true equilibrium prices in the markets. They assist in
appropriate and superior allocation of resources in the society.

6. Integration of price structure:

It has been observed from the derivatives trading in the market that the derivatives have
smoothen out price fluctuations, squeeze the price spread, integrate price structure at different
points of time and remove gluts and shortages in the markets.
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Chapter No. 1.7

Types Of Derivatives

There are different conditions for different types of derivatives. Derivatives can be of following types:

1. Futures:
A future contract is a legal agreement between two parties to buy and sell an underlying asset at a
predetermined future date and price. Future contract is made through organised exchange. These are
settled on a daily basis. The risk associated with a futures contract is low.
2. Forwards:
Forward contract is a contract to trade an asset, often currencies, at a future time and date for a
specified price. Forward contract is also a legal contract between buyer and seller. Forward contract
is not made through any organised exchange. No collateral is required for forwards. These contracts
are over the counter contracts therefore, they involve counter party risk.
3. Options:
Options are financial derivatives that give buyers the right to buy or sell, but not the obligation to buy
or sell an underlying asset at a predetermined price.
4. Swaps:
A swap is known as contractual agreement between two parties to exchange cash flows at a future
date on a pre-determined price. Similar to forward contract, Swaps are also traded on Over the
counter and they are not traded on exchanges.
5. Warrants:
Options generally have maturity of up to one year, the majority of options traded on options
exchanges having maximum maturity of 11 months. Longer-dated options are called warrants and are
generally traded over-the-counter.
6. Leaps:
LEAPS means long term equity anticipation securities. These are options having a maturity of up to
three years.
7. Baskets:
Basket options are options on portfolios of underlying assets. The index options are a form of basket
options.
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Chapter No. 2

Futures

Futures contract is an agreement between two parties to buy and sell an asset at certain time in future at a
particular price. Future contracts are standardised and traded in exchanges. An exchange has specified
certain standard features of futures to facilitate liquidity in futures contract. Futures contracts are special
types of forward contracts. It is the standard contract with standard underlying instrument. There are some
standards given to transact into future contract. They are as follows:

1. Quantity of underlying
2. Quality of underlying
3. Date and month of settlement
4. Price quotation
5. Location of settlement

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Chapter No. 2.1

History Of Futures

Merton Miller, in 1990 said that financial futures represent most significant financial
innovation of the last twenty years. Le o Me l am ed t h e ch ai rm an of t he C hi c ag o M er c ant i l e
Exchange was acknowledged as the “Father Of Financial Futures.” By the 1990s, many
exchanges were trading futures and options from Asian to American stock indexes to interest
rate swaps.
In the development of futures contracts the counterparty risk was eliminated. Futures contracts
are a significant improvement over forward contracts.
Following are the improvements made in future contracts over forward contracts:
1. Futures are traded on an organised exchange
2. It has standardised contract terms therefore it is more liquid
3. It requires margin payment
4. It follows daily settlement
5. The contracting parties need not pay any down payment
6. It facilitates hedging of price risk

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Chapter No. 2.2

Types Of Futures Contracts

On the basis of the underlying asset they derive, the futures are divided into following types:

1. Commodities Futures:
Commodities are tangible assets that investors can physically buy and sell. The most common
commodities in which investors buy futures contracts are oil, metals, natural gas, food grains, etc.
Commodities futures plays a vital role in management of price risk. Specially, a farmer can enter into
a future contract to sell is commodities at a particular price on a specified date in future. Similarly,
the buyer of commodities will also know in advance the price which he has to pay in future.
2. Currency Futures:
Currency futures deals on the exchange price of currencies. The parties to the contract fix an
exchange rate for the currencies on a specific date in the future. Such contracts help to minimize the
exchange rate risk that may arise in the case of international trade over a period of time. For example,
Mr A has an investment India which is due to mature in the month of December 2021. The current
exchange rate is One USD = 75 INR. Mr A can buy the currency futures and lock the exchange rate.
As a result, Mr A will receive the returns as per the pre-determined currency exchange rate.
3. Interest Rate Futures:
Interest rate future contract is a type of hedging against the risk that may arise due to fluctuations in
the rate of interest of a financial instrument at a future date. Usually interest rates futures are used
with a money market or bond market instruments such as government bonds, bills, etc. They are the
underlying assets for such futures contracts. An investor can sell interest rates futures contract when
the interest rates rise and the price of bonds fall. This will help them to overcome some of the losses
they will suffer by a fall in the price of the bonds.
4. Stock and Index Futures:
Stock and index futures are used as a tool for hedging against risk for trading. Stock futures help an
investor to hedge against future price of a stock. Whereas, Index futures track the movements of an
index. Stock futures contracts create an obligation to buy or sell a stock at a specified time. Stock
future plays an important role in covering risk position in case of an adverse stock price movement in
future. While, Index futures create an obligation to trade on the basis of an underlying index and its
movements. Investors use these contracts for speculative purpose as well as to make quick profits.

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Chapter No. 2.3

Parties In Futures Contract

There are two parties in futures contract, the buyer and the seller. The buyer of the futures contract is on the
long position of the futures contract and the seller of the futures contract is on the short position of the
futures contract.

Long Position In Future Contract:

Investors can enter into long future contract to hedge against adverse price movements. This position helps
to lock the price of an investment.

Short Position In Future Contract:

Short position in futures is used by a producer to lock in a price of commodity that he is going to sell in the
future. There is no maximum profit for short futures position. If the price of an underlying asset rises
dramatically there are chances of heavy loss.

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Chapter No. 2.4

Margins In Futures Contract

Margins are the deposits which help to reduce the counterparty risk arise in future contract. These margins
are collected in order to eliminate the counterparty risk. Following are the types of margins in futures
contract:

1. Initial Margins:
Whenever a future contract is signed, both buyer and seller are required to post these margins. They
are required to make security deposits as a guarantee that they will fulfil their obligation.
2. Mark To Market Margin:
This is the process of adjusting the equity in an investor’s account in order to reflect the change in
the settlement price of future contract is known as mark to market margin.
3. Maintenance Margin:
The investor must keep the futures account equal or greater than certain percentage of the amount
deposited as initial margin. Investors are required to maintain certain percentage of their

investment.

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Chapter No. 2.5

Pricing Of Futures

Pricing of futures contract is termed as simple pricing model. Using cost of carry model, the fair value of a
futures contract is calculated. Generally, the observed price derivates from the fair value. Arbitrageur would
enter into a trade to earn arbitrage profit. This will lead to push the future price back to its fair value. The
cost of carry model for pricing futures is as follow

F=S(1+r-q)t

Where, F= Futures price

S= Spot price of an underlying asset

r= Interest rate

q= expected dividend yield

t= Holding period

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Chapter No. 2.6

Futures Terminology

Following are the terms used in futures contract

1. Spot Price:
The price at which assets traded in the spot market.
2. Futures Price:
The price at which the futures contract are traded in the future market.
3. Contract cycle:
Contract cycle is a period which a contract trades. The index futures contracts on the NSE have one
month and three month expiry cycles which expires on the last Thursday of the month.
4. Expiry date:
It is the date specified in the future contract. This is the last day on which the contract will be traded.
At the expiry date of the contract, contract will be ceased to exist.
5. Contract size:
Contract size refers to the amount of asset that has to delivered under one contract. For example, the
contract size of NSE’s future market is 200 Nifties.
6. Basis:
In financial futures contracts, basis are defined as the futures price minus spot price. Normally,
futures prices exceed spot prices.
7. Cost of carry model:
Cost of carry referred as the relationship between futures prices and spot prices. Cost of carry model
measures the storage cost plus the interest that is paid to finance the asset less the income earned on
asset.

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Chapter No. 2.7

Functions Of Futures Contract

Initially futures were devised as instruments to fight against the risk of future price movements and
volatility. Apart from the various features of different futures contracts and trading, futures markets play a
significant role in managing the financial risk.

The important functions of futures market are described as follows:

1. Hedging Function:
The primary function of the futures market is the hedging function which is also known as price
insurance, risk shifting. Futures markets provide a vehicle through which the traders or participants
can hedge their risks or protect themselves from the adverse price movements in the underlying
assets in which they deal. For example, a farmer bears the risk at the planting time associated with
the uncertain harvest price his crop will command. He may use the futures market to hedge this risk
by selling a futures contract.

2. Price discovery function:

Another important function of futures market is the price discovery which reveals information about
futures cash market prices through the futures market. Price discovery function of the futures market
also leads to the inter temporal inventory allocation function. According to this, the traders can
compare the spot and futures prices and will be able to decide the optimum allocation of their
quantity of underlying asset between the immediate sale and futures sale.

3. Financing function:
Another function of a futures market is to raise finance against the stock of assets or commodities.
Since futures contracts are standardized contracts, so, it is easier for the lenders to ensure quantity,
quality and liquidity of the underlying asset.

4. Liquidity function:
The main function of the futures market deals with such transactions which are matured on a future
date. They are operated on the basis of margins. When there is a futures contract between two parties,
future exchanges required some money to be deposited by these parties called margins. Each futures
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exchange is responsible for setting minimum initial margin requirements for all futures contracts.
The trader has to deposit and maintain this initial margin into an account as trading account.

5. Price stabilization function:

The function of a futures market is to keep a stabilizing influence on spot prices by reducing the
amplitude of short term of fluctuations. There is less default risk in case of future contract because
the change in the value of a future contract results in a cash flow every day. The daily change in the
value of a futures contract must be exchanged, so that if one party defaults, the maximum loss that
will be realized is just one day’s change in value. Thus the incentive for default in futures is greater
than in forwards.

6. Disseminating information:
One of the important functions of the futures markets like risk-transference (hedging), price
discovery, price stabilization, liquidity, and financing, this market is very much useful to the
economy too. In futures market, futures traders’ positions are marked to market on daily basis, which
is known as daily resettlements. All the profits that increase the margin account balance above the
initial balance margin can be withdrawn and vice-versa. Futures markets disseminate information
quickly, effectively and inexpensively, and, as a result, reducing the monopolistic tendency in the
market. Thus investors are aware of their latest position of equity in transparent and efficient manner.

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Chapter No. 2.8

T-Bonds and T-notes Futures Contracts

The treasury bond market consists of treasury bond and treasury notes which have maturity from 10 years to
30 years. There are some features of T- bonds and T- notes futures in US.

1. T- bonds are issued by the US government.

2. A fixed rate of interest per period is paid on them.
3. The time period of this contract is usually six months.
4. These can be definitely redeemed at the maturity.
5. The CBOT (Chicago Board of Trade) futures contract permits the delivery of any US T-bond that are
not callable for at least 15 years from the first day of the delivery month.
6. They have a maturity of at least 15 years from the first day of the delivery month.
7. The seller of the futures contract has the option of choosing any bond to delivery having the same
coupon and maturity date.
8. These bonds can be traded in secondary market by authorized dealers like banks, stock broking firms
and institutions etc.
9. Over-the-counter quotations are based on transactions of $ 1 million or more and all yields to
maturity and are based on the asked quotes.
10. The first day is called intention day or position day.
11. The second day is called notice day. On the second day the CBOT clearing corporation finds the
oldest long position.
12. The third day is called the delivery day when the short must deliver the T-bonds to the long and the
long pays the invoice amount.

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Chapter No. 3

Options

Option is a type of contract between two persons where one gives the other the right to buy an asset at a
particular price within a specified time period. Similarly, the contracts may give the other person to sell an
asset at a particular price within a specified time period. Options are fundamentally different from futures
contracts. Options are of two types that are call option and put option. Calls give the buyer the right to but
not the obligation to buy a given quantity of an underlying asset on a particular date in future. Puts give the
buyers the right but not the obligation to sell a given underlying asset on a particular date in future. The
assets on which option can be derived are stocks, commodities, indexes etc. If an underlying asset is the
financial asset, then options would be stock options, currency options, commodities options, index options
etc.

Properties Of Options

Options have several unique properties that set them apart from other securities.

Following are the properties of options

1. Limited loss
2. High leverage potential
3. Limited life

Parties In An Options Contract

1. Buyer Of The Options:

The buyer of an option is the person who buys the right but not the obligation to exercise his option
on seller. The buyer pays option premium to buy the right.
2. Writer Or Seller Of The Options:
The writer of an option is the person who receives the option premium paid by the buyer. The writer
or seller is obligated to sell the asset if the buyer exercises the option on him.

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Chapter No. 3.1

Types of options

Types of options

On the basis of On the basis of On the basis of

an underlying market exercise of option
asset movements

Call Put
Index Stock Options Options American European
option Option Options Options
s

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The options are divided into various types on the basis of various classifications. The above diagram shows
different types under different classifications of options contracts. These types are explained as follows:

A. On The Basis Of An Underlying Asset:

There are two types of options which falls under this category are as follows
a. Index Options:
An index option is a financial derivative that gives the holder the right to buy or sell the value
of an underlying asset. Index options are always cash settled. Index options settle only on the
date of maturity. This type of options have no provision for early exercise.
b. Stock Options:
Stock option gives the buyer the right to buy or sell at a particular price on a specified date in
future. A seller of the stock option is called an option writer, where the seller is paid a
premium from the contract purchased by the buyer.

B. On The Basis Of Market Movements:

On the basis of market movements the options are classified into two types
a. Call Option:
A call option is bought by an investor when he seems that stock price moves upwards. A call
option gives the holder of the option the right but not an obligation to buy an asset at certain price
on a particular date in future.
b. Put Option:
A put option is bought by an investor when he seems that the stock price falls down. A put
option gives the holder of option right but not an obligation to sell an asset at a particular price on
a particular date in future.

C. On The Basis Of Exercise Of Option:

On the basis of exercising of option there are two categories that are explained as follows:
a. American Options:
American option depends on the option holders’ right to exercise the option at their will or at pre-
determined date. An American call option allows the holder the right to ask for stock anytime
between the execution date and maturity date when the price rises beyond the strike price. In an
American call option, the strike price does not change.
American put option allows the holder the right to ask the buyer of the security of the stock
anytime between the execution date and maturity date when the price falls down the strike price.

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b. European Options:
European options gives the option holder the right to exercise the option only at a pre-determined
price and date. These options have a lower risk. European options holder easily use hedging
strategy as it is exercised only on the pre-determined date. European options are majorly traded
over the cover.

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Chapter No. 3.2

Features of options

Option may be defined as a contract between two parties where one gives the other the right to buy or sell an
underlying asset as a specified price within or on a specific time.

Following are the features of options contracts

1. Contract:
Option is an agreement to buy or sell an asset obligatory on the parties at a particular price on a
particular date.

2. Premium:
In case of option a premium in cash is to be paid by one party (buyer) to the other party (seller).

3. Pay off:
From an option in case of buyer is the loss in option price and the maximum profit a seller can have
in the options price.

4. Holder and writer:

Holder of an option is the buyer while the writer is known as seller of the option. The writer grants
the holder a right to buy or sell a particular underlying asset in exchange for a certain money for the
obligation taken by him in the option contract.

5. Exercise price:
There is call strike price or exercise price at which the option holder calls (buy) or puts (sell) an
underlying asset.

6. Variety of underlying asset:

The underlying asset traded as option may be variety of instruments such as commodities, metals,
stocks, stock indices, currencies etc.

7. Tool for risk management:

Options is a versatile and flexible risk management tools which can mitigate the risk arising from
interest rate, hedging of commodity price risk.
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Chapter No. 3.3

Pricing Of Options

Option pricing theory estimates a value of an option contract by assigning a price known as
premium. On the basis of calculated probability that contract will finish in the money at the maturity
date. Options pricing theory provides an evaluation of fair value of an option which traders
incorporate into their strategies.The primary goal of option pricing theory is to calculate the
probability that an option will be exercised. Options pricing theory also derives various risk factors
based on those inputs which are known as option’s Greek.
Models of option pricing are used to price options account for variables such as current market price,
strike price, volatility, interest rate and maturity period. Some commonly used options models to
value options are Black-scholes, Binomial option pricing and Monte- carlo simulation.
A put grants its owner the right to sell the underlying stock at a specified exercise price on or before
its expiration date. A put contract is similar to an insurance contract. For example, an owner of stock
may purchase a put contract ensuring that he can sell his stock for the exercise price given by the put
contract. The value of the put when exercised is equal to the amount by which the put exercise price
exceeds the underlying stock price (or zero if the put is never exercised).
The owner of the option contract may exercise his right to buy or sell; however, he is not obligated to
do so. Stock options are simply the contracts between two investors issued with the aid of a clearing
corporation, exchange, and broker which ensures that investors should honour their obligations. For
each owner of an option contract, there is a seller or ‘writer’ of the option who crates the contract,
sells it to a buyer, and must satisfy an obligation to the owner of the option contract.
The option writer sells (in the case of a call exercise) or buys (in the case of a put exercise) the stock
when the option owner exercises. The owner of a call is likely to profit if the stock underlying the
option increases in value over the exercise price of the option (he can buy the stock for less than its
market value); the owner of a put is likely to profit if the underlying stock declines in value below
the exercise price (he can sell stock for more than its market value).
Since the option owner’s right to exercise represents an obligation to the option writer, must be
purchased from the option writer; the option writer receives a ‘premium’ from the option purchaser
for assuming the risk of loss associated with enabling the option owner to exercise.

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Models Of Options Pricing

1. Black- Scholes Model:

Black- scholes model is commonly used option pricing model. This model was discovered in
1973 by economists Fisher Black and Myron Scholes. Black- Scholes model was developed
mainly for pricing European options. The model operates under certain assumptions according to
economic environment and stock price. The main variables used in Black- Scholes model are as
follows:
a. Price of underlying asset (S)
b. Strike Price (K)
c. Volatility (σ)
d. Time until expiration (T)
e. Interest rate (r)
f. Dividend Yield (δ)

In case the number of trials in a binomial distribution approaches to infinity (n Æ ∞), the
binomial distribution approaches the normal distribution. Black and Scholes provided a
derivation for an option pricing model based on the assumption that the natural log of stock price
relative will be normally distributed. The other assumptions of Black-Scholes option pricing
model are as follows:

Assumptions:

1. There exists no restriction on short sales of stock or writing of call options.

2. There are no taxes or transactions costs.
3. There exists continuous trading of stocks and options.
4. There exists a constant risk-free borrowing and lending rate.
5. The range of potential stock prices is continuous.
6. The underlying stock will pay no dividends during the life of the option.
7. The option can be exercised only on its expiration date; that is, it is a European option.
8. Shares of stock and option contracts are infinitely divisible.
9. Stock prices follow the process; that is, they follow a continuous time random walk in two-
dimensional continuous space.

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Investors’ behaviour is risk neutral. Investors price options as though they are risk neutral
because they can always construct riskless hedges comprising of options and their underlying
securities.
From an applications perspective, one of the most useful aspects of the Black-Scholes model
is that it only requires five inputs. With the exception of the variance of underlying stock
returns, all of these inputs are normally quite easily obtained:

1. The current stock price (S0). Use the most recent quote.
2. The variance of returns on the stock (σ2).
3. The exercise price of the option (X) given by the contract.
4. The time to maturity of the option (T) given by the contract.
5. The risk-free return rate (rf). Use a treasury issue rate with an appropriate term to
maturity.

It is important to note that the following less easily obtained factors are not required as model
inputs:

1. The expected or required return on the stock or option.

2. Investor attitudes toward risk.

2. Binomial Option pricing:

The simple method to price the options is Binomial pricing model. This model is based on
assumptions of perfectly efficient market. Binomial pricing model was developed in 1979. This
model uses repetitive procedure during the time span between valuation date and maturity date.
This model reduces possibility of price changes and decreases the possibility for arbitrage.
According to possible prices of an underlying asset, the payoff of the options is calculated.

a. Binomial Option Pricing: One Time Period:

The binomial option pricing model is based on the assumption that the underlying stock
follows a binomial return generating process. This means that for any period during the life of
the option, the stock’s value will change by one of two potential constant values.
The first step in determining the price of the call might be to determine α, the hedge ratio.
The hedge ratio defines the number of shares of stock that must be sold (or short sold) in
order to maintain a risk-free portfolio.
This riskless portfolio is comprised of one call option along with a short position in α shares
of stock (Short selling is selling of share without owing them. In other words, one party can
borrow the stock and sell it with the obligation of repurchasing of a later date). The hedge

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ratio is defined as α the number of shares to sell for every call purchased. This value is known
as a hedge ratio; by maintaining this hedge ratio, we maintain our hedged portfolio.

b. Binomial Option Pricing: Multiple Time Periods:

There are only two potential prices that the stock can assume at the expiry of the stock. Thus,
there are only two potential prices that the stock can assume at the expiration of the stock.
The binomial option pricing model can be further extended to cover as many potential
outcomes and time periods as necessary for a particular situation. The next step in the
development of a more realistic model is extension of the framework to two time periods.
One complication is that the hedge ratio only holds for the beginning of the first time period.
After this period, the hedge ratio must be adjusted to reflect price changes and movement
through time.

3. Monte- carlo simulation:

Monte- carlo simulation is one of the most important algorithms in quantitative finance. Monte-
carlo simulation can be utilised as an alternative tool for price options. This model is also used
for long term predictions due to its accuracy.

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Chapter No. 3.3

Factors Affecting Price Of Options

Following are the factors which affect the price of options they are as follow:

1. Stock Price:
Stock price is the last transaction price of the contract. The payoff from a call option is an amount by
which a stock price exceeds strike price. Therefore, call options become more valuable as the stock
price increases. Whereas, the payoff from the put option is an amount by which a strike price exceeds
stock price. Therefore, put options become more valuable as the strike price increases.

2. Strike Price:
In case of call option, as the strike price increases stock price needs to make an upward move to go in
the money. Therefore, for a call option, as the strike price increases option becomes less valuable and
as strike price decreases option becomes more valuable.

3. Time To Expiration:
Time to expiration is the precise date at which contracts are ceased to trade any right or obligation
due or expire. Both put and call options become more valuable as the time to expiration increases.

4. Volatility:
The volatility of a stock price is measured for uncertain future stock price movements. As the
volatility increases, the chance of high performance of stock or low performance of a stock also
increases. The value of call as well as put options increases as the volatility increases.

5. Dividends:
Dividends have the effect of reducing the stock price. This has negative effect on value of call
options and positive effect on value on put options.

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Chapter No. 3.4

Options Terminology

Options terminology refers to the terms used to transact in market.

Followings are the terms that are generally being used while transacting in options market.

1. Strike Price:
The price specified in the option contracts is known as strike price or exercise price.

2. Options Premium:
Options premium is the price paid by the options buyer to options seller.

3. Expiration Date:
The date mentioned in the options contract is known as expiration date.

4. In-The-Money Option:
In-the-money option is an option that would lead to positive cash flows to the holder if it is exercised
immediately.

5. At-The-Money Option:
At-the-money option is an option that would lead to zero cash flow to the holder if it is exercised
immediately.

6. Out-The-Money Option:
Out-the-money option is an option that would lead to negative cash flows to the holder if it is
exercised immediately.

7. Intrinsic Value Of Money:

Intrinsic value of an option is ITM(In-The-Money), If option is ITM. Whereas, if the option is
OTM(Out-The-Money) than its intrinsic value is zero.

8. Time Value Of An Option:

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The time value of an option is the difference between its premium and its intrinsic value.

Chapter No. 3.5

Valuing Of An Options

The value of option can be determined by taking the difference between two or if it is not exercised then the
value is zero. The valuation of option contract has two components: intrinsic value and time value of
options.

a. Intrinsic value of option

The intrinsic value of an option is called fundamental or underlying value. It is the difference
between the market/spot/current price and the strike price of the underlying asset. There is no
negative value of a put because the writer will not exercise his right to sell an underlying if the
exercise price is less than the market price. Further an option is said to be in-the-money if the
holder (writer) gets the profit if the option is immediately exercised. The option is said to be out
of the money if it gives loss when exercised immediately. If the current/spot price is equal to the
strike price the option becomes at-the-money.

b. Time value of an option

An American option can be exercised any time before the expiration date, there lies a probability
that the stock price will fluctuate during this period. It is the time at which the option holder
should exercise the option. The time value of an option is the difference between its premium and
its intrinsic value. The maximum time value exists when the option is At the Money (ATM). The
longer the time to expiry, the greater is an option’s time value. At expiration date of an option, it
has no time value.
There are various factors which affect the time value as follows:
1. Stock price volatility
2. The time remaining to the expiration date
3. The degree to which the option is in-the-money or out of the money.

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38
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Chapter No. 3.6

Strategies Involving Options

There are different trading strategies involving a single option on a stock and the stock. There are two main
types of strategies that are the dotted lines show the relationship between profit and the stock price for the
individual securities constituting the portfolio. While the solid lines show the relationship between profit and
the stock price for whole portfolio.

1. Positions in Options
a. Long Position In Stock In Call

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b. Short Position In Stock In Call

40
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2. Pay-off for options

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the
option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the
spot 9 price, more is the profit he makes. If the spot price of the underlying is less than the strike
price, he lets his option expire un-exercised.

a. Payoff for buyer of call options: Long call

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b. Payoff for writer or call options: short call

c. Bullish put vertical option spread:

In this spread, there is a buying a put with a low strike price and selling a put with a high strike
price, both having the same date of expiration. In this strategy, the premium paid to buy the lower
strike put option will always be less than the premium received from the sale of the higher strike
put so that the net option premium generates a cash inflow.
Maximum loss will be where the stock price is less than the lower of the two-strike prices. In this
situation both put will be exercised leading to maximum loss.

Bullish call vertical option spread

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Bullish put vertical option spread

d. Bearish vertical option strategy:

Bearish vertical option spread yields profit in case of decline in the price of the underlying assets.
In this strategy the investor buys an option with higher strike price and sells at relatively lower
strike price, both with same expiration date.
Bearish vertical option spreads are of two types: Bearish vertical call spread and Bearish vertical
put spread. In bearish vertical call spread, the investor purchases the call option with higher strike
price and sells at a lower strike price, both having the same expiration dates.
If the stock price is less than the lower strike price, both the options will be out of the money.

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Chapter No. 3.7

Currency options

Foreign currency options are used by different market participants e.g. exporters, importers, speculators,
arbitrageurs, bankers, traders and financial institutions. Currency options are devised to protect the investors
against unfavourable movements/fluctuations in foreign exchange rates. Like other option instruments,
currency options are also financial instruments which give the option holder the right not the obligation to
buy or sell a particular currency at a specific exchange rate (price) on or before an expiration date.

Following are the features of currency options

1. Right But Not The Obligation:

The currency options give the holder to buy or sell a currency right not obligation at a fixed price
(exchange rate) for a specified time period. A call currency option gives the holder to buy a currency
at a fixed rate at a specified time and a put currency option gives the owner the right to sell a
currency at a fixed price at a specified time. the buyer is known as holder and seller is called writer
of currency option. . The writer gets the premium from the holder for obligation undertaken in the
contract.

2. Two Parties:
There are two parties in the contract. The buyer (holder) and the seller (writer). In other words, a yen
call option gives the holder the right to buy yen against rupee, is also a rupee put option.

3. Premium:
The premium is the cost or price or value of the option itself.

4. Spot Exchange Rate:

Spot exchange rate is the current rate of exchange.

5. Option Premium:
Option premium is paid in advance by the buyer to the seller which lapses irrespective of whether the
option is exercised or not. In Over The Counter market the premium is quoted as percentage of the
transaction amount, whereas in domestic currency amount per unit of foreign currency in the
exchange traded options.

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6. Over The Counter (OTC):

Currency options can be traded on over the counter (OTC) market as well as exchange traded. OTC
currency options are customer tailored and have two categories: retailer and wholesale markets. The
retail segment of currency option markets are influenced by participants such as- traders, financial
institutions and portfolio managers. The wholesale currency options market is participated by big
commercial banks, financial institutions and investment banking firms for speculation or arbitrage
purposes.

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Chapter No. 3.8

Strategies Used in currency option

The strategies for the options trading have been discussed in lesson 8. To give a small view of the strategies
in a currency options, the following strategies can be used:

a. Buying A Call Currency Option

The above diagram shows profit/loss of buyer of a call currency option.

b. Buying A Put Currency Option

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The above diagram shows profit/loss of buyer of a put currency option.

Following strategies can be used currency options investors in the market. These strategies are explained as
follows:

1. Spread strategies:
In these strategies both call or puts are purchased or sold simultaneously. There may be bull spread,
bear spread, butterfly spreads, calendar spread and diagonal spreads etc.

2. Straddle strategies:
A straddle of currency options is created by buying or selling a call and put with similar strike rate
and expiration date. These strategies involve simultaneous buying a call and selling a put with same
strike price and expiration date. There are two types of straddles: Long straddle and short straddle. A
long straddle involve buying an equal number of calls and puts with the same stock, at the same
strike price and for the same expiration date. In case of price movement in any direction, the investor
is not aware of the movement, therefore if the stock price falls, the put option will be used and if the
price rises, the call option will be used.

Profit

K
St

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3. Strangle strategies:
Like in straddle, strangle has the same strategy but for the difference in strike prices of call and the
put. It is different from a straddle only in term of strike price. A strangle is a combination (portfolio)
of a put and a call with the same expiration date but with different strike prices. The investor
combines an out-of-the-money call with an out-of-the-money put. He will buy a call with strike price
higher than the underlying stock’s current price and a put with a strike price lower than the
underlying stock’s current price. When a strangle position is bought, it is called as long strangle and
when it is sold, it will become short strangle. A strangle can either be created by in-the-money-call
and in-the-money put or with one option being in-the-money and the other be out-of-the-money.

The ultimate objective of using these strategies is to get the maximum net payoff. There are a number
of strategies involving buying and selling of two or more than two options having either same
exercise price or date or different strike price and dates. In spread strategy, there is simultaneous
buying of one option and selling of another option of the same type. This strategy is based on the
expectation of change in prices of the option and the payoff will be obtained by offsetting of the two
positions. Spreads are of three types- vertical, horizontal and diagonal spread.
In vertical spread involves the trading of option having different strike prices but same expiration
dates. The vertical options strategies have two categories: the Bullish vertical spread on both put and
call and bearish vertical spread on both put and call.
In horizontal spreads, the trading of options having same strike prices but different expiration date is
done. Diagonal spread has a combination of both vertical and horizontal spreads.
There are strategies for the investors who use both call and put on the same asset. Straddles,
strangles, strips and straps are such strategies. Straddle strategy involves simultaneous buying a call
and put with the same exercise price and expiration date. A long straddle is created by buying an
equal number of calls and puts with same stock at same exercise price same expiration date.
On the other hand a short straddle involves simultaneous sale of a call and put the same stock, at the
same strike price and exercise date. Strip strategy involves a long position with one call and two put
options with same exercise price and expiration date.
The investor buys a put and a call with the same expiration date but with different exercise price i.e.
the exercise price of put and call is different strangle may be of long and short strangles. Different
strategies have different profit patterns.

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Expiration
Strategy Share Call Option Put Option Strike Price
Date

Spread Same One One Different Same

Vertical
Same Buying/selling Buying/selling Different Same
spread
Calendar
Same Buying Selling/selling Same Different
spread
Buying Selling
Straddle Same Same Same
(combination) (combination)
Buying Selling
Strangle Same Different Same
(combination) (combination)

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Chapter No. 3.9

Futures and options 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 nationwide
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.

All quantity fields are in units and price in rupees. The lot size on the futures market is for 100 Nifties. The
exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time
to time.

It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not
find a match, the order becomes passive and goes and sits in the respective outstanding order book in the
system.

Following are the participants in Futures and options trading system. These are four entities in the trading
system. Trading members, clearing members, professional clearing members and participants.

1. 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. 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. This ID is common for all users of a particular trading member. It is the
responsibility of the trading memb3er to maintain adequate control over persons having access to the
firm’s user IDs.

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2. Clearing members:
Clearing members are members of NSCCL. They carry out risk management activities and
confirmation/inquiry of trades through the trading system. A professional clearing members is a
clearing member who is not a trading member. Generally, banks and custodians become professional
clearing members and clear and settle for their trading members.

3. Participants:
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.
4. Corporate Hierarchy:
In the Futures and Options 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. These are explained as follows:

a. 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 h 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.

b. 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.

c. Dealer:
Dealers are users at the lower most level of the hierarchy. A dealer can perform view order and
trade related activities only for oneself and does not have access to information on other dealers
under either the same branch or other branches.

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Chapter No. 3.10

Eligibility Of Indices And Stocks For Futures And Option Trading

In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently,
central indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria.
Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible
for derivatives trading. However, no single ineligible stock in the index shall have a weight age of more than
5% in the index. The index is required to fulfil the eligibility criteria even after derivatives trading on the
index have begun. If the index does not fulfil the criteria for 3 consecutive months, then derivative contracts
on such index would be discontinued. By its very nature, index cannot be delivered on maturity of the Index
futures or Index option contract, therefore, these contracts are essentially cash settled on Expiry.

A stock on which stock option and single stock future contracts can be introduced is required to fulfil the
following broad eligibility criteria:

1. The stock should be amongst the top 200 scrips , on the basis of average market capitalization during
the last six months and the average free float market capitalization should not be less than Rs.750
crore. The free float market capitalization means the non-promoters holding in the stock.
2. The stock should be amongst the top 200 scrips on the basis of average daily volume (in value
terms), during the last six months. Further, the average daily volume should not be less than Rs 5
crore in the underlying cash market.
3. The stock should be traded on at least 90% of the trading days in the last six months, with the
exception of cases in which a stock is unable to trade due to corporate actions like demergers etc.
4. The non-promoter holding in the company should be at least 30%
5. The ratio of the daily volatility of the stock vis-à-vis the daily volatility of the index (either BSE-30
Sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous six months.
For this purpose the volatility would be computed as per the exponentially weighted moving average
Exponentially Weighted Moving Average (EWMA) formula.
6. The stock on which option contracts are permitted to be traded on one derivative exchange/segment
would also be permitted to trade on other derivative exchanges/segments.

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A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does
not fulfil the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then
derivative contracts on such a stock would be discontinued.

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Chapter No. 4

Minimum Size Of Derivatives Contract

The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment
to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract size of
derivative contracts traded in the Indian markets should be pegged not below Rs. 2 Lakh.

Based on this recommendation SEBI has specified that the value of a derivative contract should not be less
than Rs. 2 Lakh at the time of introducing the contract in the market. In February 2004, the Exchanges were
advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakh. Subsequently, the
Exchanges were authorized to align the contracts sizes as and when required in line with the methodology
prescribed by SEBI.

As compared to the cash equity markets , potential risks for the investors in derivatives market are
considered to be much higher and therefore, the minimum investment size has been increased given rise in
the average income involves trading volumes of small investors, market experts.

SEBI said that the lot size for derivatives contracts in equity derivatives segment would be fixed in such a
manner that the contract value of the derivative on the day of review is within Rs 5 lakh and Rs 10 lakh. A
derivative is a security derived from a debt instrument, share, loan, whether secured or unsecured or any
other form of security. It also derives its value from the prices, or index of prices, of underlying securities.

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Chapter No. 5

Measures Specified By SEBI To Protect The Rights Of Investor In Derivatives Market

The measures specified by SEBI include:

1. Investor’s money has to be kept, separate at all levels and is permitted to be used only against the
liability of the investor and is not available to the trading member or clearing member or even any
other investor.
2. The Trading Member is required to provide every investor with a risk disclosure document that will
disclose the risks associated with the derivatives trading so that investors can take a conscious
decision to trade in derivatives. investor would get the contract note duly time stamped for receipt of
the order and execution of the order.
3. The order will be executed with the identity of the client and without client ID order will not be
accepted by the system. The investor could also demand the trade confirmation slip with his ID in
support of the contract note. This will protect him from the risk of price favour, if any, extended by
the Member.
4. In the derivative markets all money paid by the Investor towards margins on all open positions is
kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading
or Clearing Member the amounts paid by the client towards margins are segregated and not utilized
towards the default of the member.
5. However, in the event of a default of a member, losses suffered by the Investor, if any, on
settled/closed out position are compensated from the Investor Protection Fund, as per the rules, bye-
laws and regulations of the derivative segment of the exchanges. T
6. he Exchanges are required to set up arbitration and investor grievances redressal mechanism
operative from all the four areas/ regions of the country

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Chapter No. 6

System Of Badla

The Badla system as prevailed in the Indian capital market, prior to ban by SEBI in December 1993, was a
unique system. The term ‘Badla’ denotes the system whereby the buyers or sellers of shares may be allowed
to postpone the payment of money, or delivery of the shares, as the case may be, in return for paying or
receiving a certain amount of money. It is also known as carry forward trading.

For example, on January 2, A buys the share of company X at a price of Rs. 100/- A is required to pay Rs.
100 to take the delivery of share on the settlement day, i.e., 15th January. On that day, the price of the share
is still Rs. 100/-. Instead of paying Rs. 100, he informs his broker that he would like to carry forward the
transaction to the next settlement date ending on January 30. The broker locates a seller who is also willing
to carry forward the transaction, i.e., who does not want payment of the share price on the 15th. In return for
agreeing to postpone the receipt of money from January 15th till 30th, the seller levies charges on the buyer.
This charge is known as a Badla.

Under the Badla system if the share has appreciated, the seller has to pay the buyer the amount of
appreciation. Of course he would separately receive from the buyer the Badla charge.

Reintroduction Of Badla

Some of the new system of CARRY FORWARD (CF), introduced at the Bombay Stock Exchange in
January 1996,are:

1. Sale or purchase of transactions may be carried forward up to 75days.

2. Brokers are to classify the transactions, as to whether for delivery or CF, and report daily.
3. Badla sessions will be screen-based.
4. Strict monitoring of brokers’ positions with the imposition of
5. various margins: daily, mark-to-market and CF.

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The strength of Badla system are:

1. In India, there are restrictions on bank lending against shares. As a result, the liquidity of the stock
market is lower than in other countries where bank land liberally against the security of shares. In
such an environment, Badla provided a system of financing share transactions and thereby promoted
the flow of funds into the secondary market, making for better price discovery and lower transaction
costs.
2. It had the merit of providing liquidity with narrow spreads between the ‘buy’ and ‘sell’ quotes. This
difference was very narrow ranging from one fourth of one percent to two percent in comparison to
the scrips in which Badla facility was not available, where it varied between 5 to 10 percent.
3. It increased the volume of trading resulting in a decrease in the spread between buy-sell quotes.
4. It was well-established system; besides, the brokers and investors were well conversant with it.

The weaknesses of Badla system are:

1. Sometimes even investors with inadequate funds to pay or shares to deliver were attracted to
speculate, usually leading to speculation in the market; according to a study conducted by Capital
Market Research and Development (CMRD), the liquidity provided by the speculators involved in
Badla was not necessarily genuine liquidity.
2. On an average around 30-40 percent of the volume was accounted for by delivery and payment while
the rest was carried forward.
3. Unhealthy speculation sometimes leads to payment problems which were many times followed by
closure of the markets.
4. While Badla allows speculation, it does not perform the information function. Details regarding
volume, rates of Badla charges, open positions etc. were totally absent in the traditional Badla
system.
5. This made it susceptible to manipulation. The zero margin requirements also meant that trading
volume could be increased easily by manipulators having little or no capital base.
6. The revised carry forward system provided data on several parameters, but still didn’t publicize the
Badla charges, which may vary from seller to seller.

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Chapter No. 7

Similarities In Futures And Badla

A Badla transaction is identical to a spot market transaction in shares financed by lending against the
security of shares while the futures contracts are those contracts in which agreement is made today for a
transaction that will take place at a future date. The system was slanted in favour of short sellers who could,
in a normal market situation, earn interest even without owning the shares sold (it has been argued though,
that such short selling helps to check speculative and furious buying). Also, it was suspected that the
backward charges reportedly decided at the badla sessions were often untrue. Besides, it appears that the
limit of 70 days within which the carryovers were to be settled, was often exceeded.

Beside this, Badla system fell into disrepute because of its faulty implementation and lack of proper
monitoring by concerned stock exchange authorities. Particularly, the margins collected were low, allowing excess
leveraged trading and not having proper monitoring and surveillance.

Having established the precise nature of Badla, the comparison with futures trading can be made as follows:

a. Badla and futures, both allow speculation without paying the full price.
b. Badla and futures, both perform the liquidity function by enhancing the liquidity of the market, since
they attract speculative volume.

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Futures VS Badla

Badla
Futures

In Badla, the price ultimately paid, inclusive of

In futures trading, the price for future delivery is Badla charges, is indeterminate and becomes
defined in advance. known only when the transaction is fully
concluded.

In Badla, the period of transaction is undefined, as

In the futures trading system, the futures trade is for a transaction can be carried forward indefinitely
a specified period defined in advance. from settlement to settlement, provided a willing
counter party can be found.

In the Badla system, no margins were required and

In futures trading, there is inevitably a deposit on hence the scope for speculation was theoretically
margin requirement, usually ranging from 5 to 15 unlimited. In practice, the only limit on speculative
percent of the transaction value. volume was the risk perception of seller and broker
with respect to the buyer’s credit worthiness.

As the Badla system has an indeterminate final

in futures, the relationship between future and spot price. This means it is not possible to hedge using
price is certain, so it performs the hedging or price the Badla transactions since the relationship
stabilization function. between the spot price and the future price is
uncertain

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Options VS Badla

Options Badla
In the option contract, the positions at the end of In Badla, all net positions at the end of the
the settlement period can not be carried forward settlement period can be carried forward and
members pay or receive Badla charges while the
option contract enables the buyer to close his
position at any time till the maturity date but
carrying forward the position with same option
contract is not possible.

In the option contract, no such financing Badla financiers provide the finance to members
mechanism exists. with net bought positions; usually buyers pay the
Badla charges to short sellers.

Options contract can be used for hedging purposes Badla contracts can’t be used for hedging purposes.
even when the future cash flows are unknown to
the holder of the option because it gives the right to
holder to exercise the contract rather than
obligation

After analyzing the above points, it is clear that Badla only leads to speculation activities in the market while
the derivatives perform the function of price discovery and risk management. It is also true that our market
comes under the semi- efficient category with the introduction of depositories, on-line trading, increase in
mutual fund activity and foreign portfolio investors, but even then it seems that the stage was right for the
introduction of derivatives trading. Therefore, when derivatives had become the standardized key to
unbundling the risk in banking, investment, capital and insurance market around the world, it was Inevitable
that we would also need to established derivatives market in India.

It is clear that derivatives have been introduced in the Indian market in the place of Badla to continue its
advantages and to avoid its disadvantages. In the derivatives market, the major participants are hedgers;
speculators and arbitrageurs who bring efficiency and liquidity in the market. But it is not necessary that the
liquidity brought by speculators is genuine liquidity.

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Chapter No. 8

Client and Broker Relationship In Derivative Segment

A trading member must ensure compliance particularly with relation to the following while dealing with
clients:

1. Filling of ‘know your client’ form.

2. Execution of client broker agreement
3. Bring risk factors to the knowledge of client by getting acknowledgement of client on risk disclosure
document.
4. Timely execution of orders as per the instruction of clients in respective client codes.
5. Collection of adequate margins from the client.
6. Maintaining separate client bank account for the segregation of client money.
7. Timely issue of contract notes as per the prescribed format to the client.
8. Ensuring timely pay-in and pay-out of funds to and from the clients.
9. Resolving complaint of clients if any at the earliest.
10. Avoiding receipt and payment of cash and deal only through account payee cheques.
11. Sending the periodical statement of accounts to clients.
12. Not charging excess brokerage.
13. Maintaining unique client code as per the regulations.

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Chapter No. 9

Objectives of study

1. To study how the mechanism of future and options work.

2. To find out how derivatives like futures and options secure investor’s portfolio.

3. To study the difference between futures and options trading.

4. To find out how futures and options work as a risk management tool.

5. To find out how future price is determined.

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Chapter No 10

Scope And Limitations Of Study

Scope:

This study takes into consideration the derivatives market. This study helps to understand the operation of
futures and options. In this study the impact of futures and options on derivative market is explained. This
study helps us to understand how the derivative market came into existence. It covers the uses of derivatives.
This study involves the information of investors and their performance for price changes. It considers types
of futures and options, uses of futures and options, effect on market etc.

Limitations:

1. This study is based on limited respondents.

2. There may be data error as findings are totally based on respondents response
3. This study is focused on futures and options area in derivative market.

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Chapter No. 11

Research Methodology

Primary Data Collection

In this project the primary data collection method is used. I have collected primary data with the help

of structured questionnaire. Questionnaire was sent to respondents in the form of Google Form. 10

questions were included in the questionnaire.

Secondary data collection

This study includes secondary data also. The secondary data has been collected from the following

sources

1. Books
2. Research papers
3. Official websites
4. News papers

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Chapter No. 12

Review Of Literature

1. Dr. Premalata Shenbagaraman, Research Paper (NSE), in this research paper researcher has
concluded that, whether futures and options trading increase stock market volatility. This explores
the impact of the introduction of derivative trading on cash market volatility using data on stock index
futures and options contracts traded on the S & P CNX Nifty (India). The results suggest that futures
and options have affected the volatility of underlying stock exchange however, the nature of volatility
seems to have changed post-future.

2. Sahoo (2002), In research paper researcher has focused on the Derivatives commodities firstly
developed as hedging policies towards instability in product prices.

3. Lovric M.(2008), shown a explanation method of character depositor behaviour wherein funding
selections are relating to system of communications among depositor and funding surroundings.

4. D Agarwal (2015), in this research paper, researcher has concluded the effect of futures and options on
valuation, price efficiency and liquidity of stocks. It was found that derivative leads to add value to spot
market by increasing liquidity and enhancing price.

5. MS Pan (2003), researcher has concluded that how volatility and future risk influence demand relation
in speculation and hedging. There is a positive relationship between volatility and interest for hedgers
and speculators and also observed that speculators are more responsive to the changes than hedgers in
terms of demand in futures risk premium.

6. Nilesh P. Movalia (2015), In the research paper, “A Study on Stock Market Volatility: Futures &
Options V/S Cash Market” it is found that there is strong positive relationship between F&O and
Cash Market. After the introduction of derivatives has push the cash market at top level and it has made
Indian stock market more volatile.

7. Naresh, G. (2006), studied the dynamic growth of the Derivatives market, particularly Futures &
Options. Even though this market was initially regulated by various expert teams’ survey, regulatory

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framework, recommendations byelaws and rules there is a debate on the existing regulations such as
why is regulation needed.

8. Revathi Pandian (March 2015), Research paper, “A study on financial derivatives(futures and
options)” has presented the insight of evolution of financial derivative market which came into
existence to guard the risk- averse economic agents against the uncertainties that raised due to
fluctuation in prices which leads to many instruments such as forwards, futures and options.

9. Volker (2004), have concluded that derivatives are financial instruments which can be traded on
various market. The most common usage relates to the trading of commodities futures and options
which are pre-determined contracts.

10. Bessembinder and Seguin (1992), have examined whether greater futures trading activity is associated
with greater equity volatility. These findings are consistent with the theories predicting that active
futures markets enhance the liquidity and depth of the equity markets.

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Chapter No. 13

Data Analysis And Interpretation

Graph 1

Explanation:

The above diagram shows the percentage of people who trade in financial market. According
to the diagram, 78.2% people are trading in financial market while, 21.8% people are not
trading in financial market.

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Graph 2

Explanation:

The above graph represents traders in financial derivatives. In the graph, it is shown that
41.8% respondents are trading in financial derivatives and 58.2% respondents are not trading
in financial derivatives.

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Graph 2

Explanation:

The above graph shows the percentage of respondents who trade in futures and options in derivative market.
37.3% of the respondents do not trade in futures and options whereas, 62.7% of the respondents trade in
futures and options.

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Graph 3

Explanation:

The above graph represents the volatility of Indian Stock Exchange after the introduction of derivatives.
According to the respondents 76.4% respondents state that stock exchange has became volatile. While,
23.6% respondents state that stock exchange has not became volatile.

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Graph 4

Explanation:

The above graph represents the volatility of Indian Stock Exchange after the introduction of derivatives.
According to the respondents 76.4% respondents state that stock exchange has became volatile. While,
23.6% respondents state that stock exchange has not became volatile.

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Graph 5

Explanation:

This graph shows the time period of respondents who are associated with the derivative market. The graph
shows that 47.3% of respondents are associated with the derivative market since less than a year. The
respondents who are trading in the market are less than compare to 1 or 3 years.

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Graph 6

Explanation:

The above diagram respresents the percentage of respondents who trade in futures and options. According to
the graph, 30.9% and 69.1% of the respondents are trading in futures and options respectively. People who
invest in futures are more than comapre tom people who invest in options.

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Graph 7

Explanation:

The above graph says about risky behaviour of futures and options. According to the resposes, 57.3%
respondents state that futures are more risky and 42.7% responmdensty state that options are more risky.
This data says futures are more risky than options.

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Graph 8

Explanation:

According to the above graph, 74.5% respondents feel investment in financial and derivative market is risky.
Whereas, 25.5% respondents feel that investment financial and derivative market is not risky.

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Graph 9

Explanation:

According to the above diagram, 80.9% respondents are agree with the statement that investing in deiavtives
amrket will giev more returns compare to bank savings. On the other side, 19.1% respondents feel that
investing in derivatives will not giive more returns than bank savings.

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Graph 10

Explanation:

The above graph represents that 86.4% respondents feel that derivatives market should provide more returns
to their investors to attract more investments. Whereas, 13.6% respondents feel that derivatives market
should provide more returns to their investors to attract more investments. According to the graph,
deriavtives market shoild provide more returns to it’s investors which will help them to attract more
investments.

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Chapter No. 14

Suggestions And Recommendations

Derivative market is newly started in India. It is not known by every small investor. Therefore, SEBI has to
take steps to create awareness among the investors about derivative market. The problem of risk caused by
uncertainty and volatility in the underlying assets can be effectively solved by derivatives as it is the risk
management tool that help an organisation to transfer the risk.

With the help derivative instruments risk can be transferred easily. As every small investor is attracted
towards less risk or where the can be minimised, derivative instruments are useful to them. Derivative
instruments need to be spread among those investors. Derivative contract includes huge premium and it may
not be affordable to small investors therefore, size of contract should be minimised.

Globalization of market leads to increase the turnover of derivative market in India. Derivative market
includes two main instruments that are futures and options. Futures and options are legal contract between
buyers and sellers. The settlement of the contracts is based on pre-determined price.

Therefore, low risk is associated and small investors who are desired to get more returns with less risk could
get benefits. If the futures and options market are known to all kind of investors in the market then volatility
in the market will increase and market will run more efficiently.

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Chapter No. 15

Conclusion

The term derivative refers to the class of financial instruments which mainly consists of futures and options.
The price of an instrument is totally reliable on underlying asset. Derivative trading involves both buying
and selling of these financial contracts in the stock market. A derivative is a contract between two or more
parties that can be traded on an exchange or over the counter.

Financial derivative allow for free trading of risk components. Prices for derivatives derive from fluctuations
in an underlying assets. Derivative has greater amount of liquidity in the market and it is associated with
lower transaction cost compared to the cost of trading in cash market. Instead of paying whole amount, a
trader pays only initial margin to stockbroker.

In derivative trading both buyer and seller have opposite estimation of the future trading price. Both the
parties have their focus on future value of underlying assets to make a profit. In 1995, the introduction of
derivative trading in India was a declaration on options in securities market law. SEBI granted permission to
derivative trading in 2001. From this study it has been concluded that the problem of risk caused by
uncertainty and volatility in the underlying assets can be effectively solved by derivatives as it is the risk
management tool that help an organisation to transfer the risk.

Initially, Underlying asset was in a form of agricultural goods. After independence, derivative market came
through a full circle from prohibition of all sorts of derivative trades to their recent reintroduction. This study
concludes that risk can be transferred to other parties. It has also been concluded that derivative contracts
need expert knowledge. The contract life is short. As the investor has to bear profit or loss within the short
time line.

It has been observed from the derivatives trading in the market that the derivatives have smoothen out price
fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts
and shortages in the markets. In present time options are of different varieties like- foreign exchange, bank
term deposits, treasury securities, stock indices, commodity, metal etc. Similarly the example can be
explained in case of selling right of an underlying asset.

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In India, commodity futures date back to 1875. However, forward trading was banned in the 1960s by the
government. However, the forward contract in the rupee-dollar exchange rates were allowed by the Reserve
Bank and used on a fairly large scale.

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Chapter No 16

Bibliography

1. https://www.sites.google.com/site/mbawithfun/home/mba-projects/mba-projects/a-study-on-
financial-derivatives-futures-options
2. https://www.angelone.in/knowledge-center/futures-and-options/what-are-futures-and-options
3. http://www.ddegjust.ac.in/studymaterial/mba/fm-407.pdf
4. https://www.slideshare.net/Mbaprojectfree/a-study-on-financial-derivatives-futures-options
5. https://faculty.ksu.edu.sa/sites/default/files/options_futures_and_other_derivatives_8th_ed_pa
rt1.pdf
6. https://vdocuments.mx/derivatives-futures-and-options-mba-project.html
7. http://ignited.in/I/a/150580( performance of option)
8. https://www.iosrjournals.org/iosr-jef/papers/vol3-issue3/D0332542.pdf(journal of economics)
9. https://www.gapinterdisciplinarities.org/res/articles/380-382.pdf
10. https://www.dhanistocks.com/blog/derivative-trading/everything-you-should-know-about-
derivative-market/
11. https://vdocuments.mx/derivatives-futures-and-options-mba-project.html
12. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/speculation/
13. https://rmoneyindia.com/research-blog-beginners/participants-derivatives-market/
14. https://www.investopedia.com/ask/answers/070615/what-difference-between-derivatives-
and-options.asp
15. https://groww.in/p/derivative-trading/

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Chapter No 17

Appendix

Futures And Options – How The Mechanism Works

This questionnaire is formed for the research purpose. You are requested to fill the questionnaire for a
more comprehensive analysis. The data collected would be used for academic purpose only.

1. Name of the respondent *

2. Do you trade in financial market? *

Mark only one oval.

Yes

No

3. Do you trade in financial derivatives? *

Mark only one oval.

Yes

No

4. Do you trade in futures and options? *

Mark only one oval.

Yes

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No

83
5. Do you think that after the introduction of derivatives, Indian Stock Exchange has
became more volatile? *

Mark only one oval.

Yes

No

6. How long have you been associated with derivative market? *

Mark only one oval.

a. Less than 1 year

b. 1 year

c. 3 years

d. 5 years

7. Which of the following financial derivative you trade in? *

Mark only one oval.

a. Futures

b. Options

8. Which of the following is more risky? *

Mark only one oval.

a. Futures

b. Options

9. Do you feel that investment in financial market and derivatives is risky? *

Mark only one oval.

Yes

No
z
10. Do you feel that investing in derivatives will give more returns compare to bank savings? *

Mark only one oval.

Yes

No

11. Do you think, Derivatives market should provide more returns to their investors to attract more
investments? *

Mark only one oval.

Yes

No