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Deriii 3
Deriii 3
BANGALORE UNIVERSITY
Submitted By:
VIJAY KUMAR B
Register No: 06XQCM6119
STUDENT DECLARATION
Place: BANGALORE
Date:
VIJAY KUMAR B
(06XQCM6119)
GUIDE CERTIFICATE
PLACE: BANGALORE
DATE:
Prof. Sathyanarayana
MPBIM
PRINCIPAL’S CERTIFICATE
Dr.Nagesh.S.Malavalli
(Principal, MPBIM)
ACKNOWLEDGEMENT
The completion of the research would have been impossible without the
valuable contributions of people from the academics, family and friends. I
hereby wish to express my sincere gratitude to all those who supported me
throughout the study.
I also thank my family members and friends whose support and encourage
has meant a lot to me personally and also for the completion of the report.
VIJAY KUMAR B
(06XQCM6119)
TABLE OF CONTENTS
SL CHAPTERS Page
No. No.
1 RESEARCH EXRACT 1
2 INTRODUCTION TO DERIVATIVES : 3
• Background of the study
• Statement of Problem
• Need and importance of study
5 DERIVATIVES A DISCUSSION : 23
• Forward Contracts
• Future Contracts
• Option Contracts
6 ANALYSIS AND INTERPRETATION 37
8 BIBILIOGRAPHY 69
CHAPTER 1
RESEARCH EXTRACT
RESEARCH EXTRACT
The emergence of the market for derivative products, most probably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by locking-in asset prices.
This project tries to explain the in depth concepts, about the history, growth and pros
and cons in investing and dealing with the derivative instruments. And the analysis
part deals with choosing the best available option in terms of returns.
The main objective of the study is to give the knowledge of derivatives to the
investors who are uncomfortable about the equity market would enter if they were
given the alternative of buying derivatives, which controls their downside risk. This
would enhance the action of the savings of the country, which are routed through the
equity market.
The study also gives an overview of the derivative products and features and the
advantages in dealing with these financial derivatives more importantly derivatives as
one of the important hedging tools. The research also reveals the difference in trading
derivatives from those of the underlying spot.
CHAPTER 2
INTRODUCTION TO DERIVATIVES
INTRODUCTION
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments in India
gained momentum in the last few years due to liberalization process and Reserve Bank
of India's (RBI) efforts in creating currency forward market. Derivatives are an
integral part of liberalization process to manage risk. NSE gauging the market
requirements initiated the process of setting up derivative markets in India. In July
1999, derivatives trading commenced in India the following table shows Chronology
of instruments
RBI gave permission for OTC forward rate agreements (FRAs) and
07-Jul-99
interest rate swaps.
24-May-00 SIMEX chose Nifty for trading futures and options on an Indian index.
25-May-00 SEBI gave permission to NSE and BSE to do index futures trading.
In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Today, derivatives have become part
and parcel of the day-to-day life for ordinary people in major part of the world. Until
the advent of NSE, the Indian capital market had no access to the latest trading
methods and was using traditional out-dated methods of trading. There was a huge gap
between the investors' aspirations of the markets and the available means of trading.
The opening of Indian economy has precipitated the process of integration of India's
financial markets with the international financial markets. Introduction of risk
management instruments in India has gained momentum in last few years thanks to
Reserve Bank of India's efforts in allowing forward contracts, cross currency options
etc. which have developed into a very large market.
This implies a degree of liquidity, which is around six times superior to the earlier
conditions. There is empirical evidence to suggest that there are many financial
instruments in the country today, which have adequate to support derivative market.
c) Clearing house that guarantees trades:
Counter party risk is one of the major factors recognized as essential for starting a
strong and healthy derivatives market. Trade guarantee therefore becomes imperative
before a derivatives market could start. The first clearinghouse corporation guarantees
trades have become fully functional from July 1996 in the form of National Securities
Clearing Corporation (NSCC). NSCC is responsible for guaranteeing all open
positions on the National Stock Exchange (NSE) for which it does the clearing. Other
exchanges are also moving towards setting up separate and well-funded clearing
corporations for providing trade guarantees.
d) Physical infrastructure:
India’s equity markets are all moving towards satellite connectivity, which
allows investors and traders anywhere in the country to buy liquidity services from
anywhere else. This telecommunications infrastructure, India’s capabilities in
computer hardware and software, will enable the establishment of computer system
for creation of derivatives markets. Setting up of automated trading system as an
experience with various prospective exchanges will also be beneficial while setting up
the derivative market.
e) Risk-taking capability and Analytical skills:
India’s investors are very strong in their risk-bearing capacity and can cope with
the risk that derivatives pose. Evidence of the volumes traded on the capital markets,
which are akin to a futures market, is indicative of this capacity. In contrast, in some
other countries, investors simply lack the risk-bearing capacity to sustain the growth
of even the equity market. It is expected that such a barrier will not appear in India.
On the subject of analytical skills, derivatives require a high degree of analytical
capability for many subtle trading strategies to pricing. India has an enormous pool of
mathematically literate finance professionals, who would excel in this field. Lastly, an
obvious advantage for the Indian market is that we have enormous experience with
futures markets through the settlement cycle oriented equity which is not truly a spot
market but a futures market (including concepts like market-to-market margin, low
delivery ratios, and last-day-of settlement abnormalities in prices). We also have
active futures markets on six commodities. With this state of development of the
capital markets it is felt that there is no major hurdle left for the creation of
development of the capital markets. Hence on July 2, 1996 the SEBI board gave an in
principal approval for the launch of derivatives markets in India.
markets in the world started undergoing radical changes. This period is marked by
remarkable innovations in the financial markets such as introduction of floating
rates for the currencies, increased trading in variety of derivatives instruments, on-
line trading in the capital markets, etc. As the complexity of instruments increased
many folds, the accompanying risk factors grew in gigantic proportions. This
situation led to development derivatives as effective risk management tools for the
market participants.
Looking at the equity market, derivatives allow corporations and institutional
investors to effectively manage their portfolios of assets and liabilities through
instruments like stock index futures and options. An equity fund, for example, can
reduce its exposure to the stock market quickly and at a relatively low cost without
selling off part of its equity assets by using stock index futures or index options. By
providing investors and issuers with a wider array of tools for managing risks and
raising capital, derivatives improve the allocation of credit and the sharing of risk in
the global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating the flow of trade and
finance.
(NSCCL). NSCCL is responsible for guaranteeing all open positions on the National
Stock Exchange (NSE) for which it does the clearing.
A Strong Depository - National Securities Depositories Limited (NSDL) which started
functioning in the year 1997 has revolutionized the security settlement in our country.
A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of
India) today the Indian capital market enjoys a strong, independent, and innovative
legal guardian who is helping the market to evolve to a healthier place for trade
practices.
3. Disasters prove that derivatives are very risky and highly leveraged
instruments:
Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
headlines. Some of the reasons behind disasters related to derivatives are:
1. Lack of independent risk management
2. Improper internal control mechanisms
3. Problems in external monitoring done by Exchanges and Regulators
4. Trader taking unauthorized positions
5. Lack of transparency in the entire process
4. Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding:
Trading in standard derivatives such as forwards, futures and options is already
prevalent in India and has a long history. Reserve Bank of India allows forward
trading in Rupee-Dollar forward contracts, which has become a liquid market. Reserve
Bank of India also allows Cross Currency options trading. Forward Markets
Commission has allowed trading in Commodity Forwards on Commodities
World over, the spot markets in equities are operated on a principle of rolling
settlement. In this kind of trading, if you trade on a particular day (T), you have to
settle these trades on the third working day from the date of trading (T+3).
Futures market allow you to trade for a period of say 1 month or 3 months and
allow you to net the transaction taken place during the period for the settlement at the
end of the period. In India, most of the stock exchanges allow the participants to trade
during one-week period for settlement in the following week. The trades are netted for
the settlement for the entire one-week period. In that sense, the Indian markets are
already operating the futures style settlement rather than cash markets prevalent
internationally.
In this system, additionally, many exchanges also allow the forward trading called
badla in Gujarati and Contango in English, which was prevalent in UK. This system is
prevalent currently in France in their monthly settlement markets. It allowed one to
even further increase the time to settle for almost 3 months under the earlier
regulations. This way, a curious mix of futures style settlement with facility to carry
the settlement obligations forward creates discrepancies. The more efficient way from
the regulatory perspective will be to separate out the derivatives from the cash market
i.e. introduce rolling settlement in all exchanges and at the same time allow futures
and options to trade. This way, the regulators will also be able to regulate both the
markets easily and it will provide more flexibility to the market participants.
In addition, the existing system although futures style, does not ask for any
margins from the clients Given the volatility of the equities market in India, this
system has become quite prone to systemic collapse. This was evident in the MS
Shoes scandal. At the time of default taking place on the BSE, the defaulting member
of the BSE Mr.Zaveri had a position close to Rs.18crores. However, due to the
default, BSE had to stop trading for a period of three days. At the same time, the
Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of
more than US $ 20 billion (more than Rs.84,000crores) with a loss of approximately
US $ 900 million (around Rs.3,800crores).
Statement of Problem:
Derivatives are the financial instruments which gives appreciable returns with the
transfer of risk and hedging. But many of the investors have lack of knowledge in
derivative instruments hence the research study reveals the significance of derivative
products, how they can hedge with these products and guides in choosing the best
derivative instrument.
CHAPTER 3
REVIEW OF LITERATURE
Review of Literature
Derivatives Defined:
Derivative is a product whose value is derived from the value of one or more basic
variables called bases (underlying assets) in a contractual manner. The underlying
asset can be equity, forex, precious metals, commodity, or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of a change in prices by that date. Such a transaction is an example of derivatives.
A derivative instrument by itself does not constitute ownership. It is, instead, a
promise to convey ownership.
¾ A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.
¾ A contract, which derives its value from the prices or index of prices of
underlying securities.
Derivative contracts has several variants namely forwards, futures,
options, swaps, warrants, LEAPS, Baskets, Swaptions. The participants in derivative
markets are Hedgers, Speculators, and Arbitragers.
Types of Derivatives:
The most commonly used derivatives contracts are forwards, futures and options,
which we shall discuss in detail later. Here we take a brief look at various derivatives
contracts that have come to be used.
Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
Options: Options are of two types - calls and puts. Calls give the buyer the right but
not the obligation to buy a given quantity of the underlying asset, at a given price on
or before a given future date. Puts give the buyer the right, but not the obligation to
sell a given quantity of the underlying asset at a given price on or before a given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.
Warrants: Options generally have lives of up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a
form of basket options.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus a swaption is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer swaptions.
A receiver swaption is an option to receive fixed and pay floating. A payer swaption is
an option to pay fixed and receive floating.
getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.
The derivative market performs a number of economic functions. First, prices in
an organized derivatives market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of derivative
contract. Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those who have them but
may not like them to those who have appetite for them. Third, derivatives, due to their
inherent nature, are linked to the underlying cash markets. With the introduction of
derivatives, the underlying market witnesses’ higher trading volumes because of
participation by more players who would not otherwise participate for lack of an
arrangement to transfer risk Fourth, speculative trades shift to a more controlled
environment of derivatives market.
In the absence of an organized derivatives market, speculators trade in the underlying
cash markets. Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kind of mixed markets. Fifth, an
important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity.
The derivatives have a history of attracting many bright, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are
immense. Sixth, derivatives markets help increase savings and investment in the long
run. Transfer of risk enables market participants to expand their volume of activity.
Derivatives thus promote economic development to the extent the later depends on the
rate of savings and investment.
contracts was to lessen the possibility that large swings would inhibit marketing the
commodity after a harvest. As the word suggests, derivatives that trade on an
exchange are called exchange traded derivatives, whereas privately negotiated
derivative contracts are called OTC contracts.
The OTC derivatives markets have witnessed rather sharp growth over the last
few years, which have accomplished the modernization of commercial and investment
banking and globalization of financial activities. The recent developments in
information technology have contributed to a great extent to these developments.
While both exchange traded and OTC derivative contracts offer many benefits, the
former have rigid structures compared to the latter. It has been widely discussed that
the highly leveraged institutions and their OTC derivative positions were the main
cause of turbulence in financial markets in 1998. These episodes of turbulence
revealed the risks posed to market stability originating in feature of OTC derivative
instruments and markets.
The OTC derivatives markets have the following features compared to
exchangetraded derivatives:
1. The management of counter-party (credit) risk is decentralized and located
within individual institutions
2. There are no formal centralized limits on individual positions, leverage or
margining
3. There are no formal rules for risk and burden-sharing
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants
5. The OTC contracts are generally not regulated by a regulatory authority and
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability. The following features of OTC derivatives markets can give rise to
instability in institutions, markets, and the international financial system: (i) the
dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the
effects of OTC derivative activities on available aggregate credit; (iv) the high
concentration of OTC derivative activities in major institutions; and (v) the central
role of OTC derivatives markets in the global financial system. Instability arises when
shocks, such as counter-party credit events and sharp movements in asset prices that
underlie derivative contracts occur, which significantly alter the perceptions of current
and potential future credit exposures. When asset prices change rapidly, the size and
configuration of counter-party exposures can become unsustainably large and provoke
a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk management,
including counter-party, liquidity and operational risks, and OTC derivative markets
continue to pose a threat to international financial stability. The problem is more acute
as heavy reliance on OTC derivatives creates the possibility of systemic financial
events, which fall outside the more formal clearing house the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives, and their
dependence on exchange traded derivatives, Indian law considers them illegal.
CHAPTER 4
RESEARCH METHODOLOGY
Research Methodology:
The type of research conducted in the study is a Descriptive research with a
little bit analysis in choosing the alternate financial instruments of derivative products.
And the data collected for conducting the research study is only secondary data and no
primary data is collected from any of the companies or corporate. Hence the study is a
micro study to guide the investors about the products offered in derivative markets.
Secondary Data:
The data related to the study is collected only through secondary sources such
as internet, bulletins, magazines and tutorials.
¾ Market price: The price at which traders are willing to buy or sell the contracts
¾ Risk free profits made by trading in these derivative contracts
¾ Cost-of-carry model: Used for pricing futures
¾ Black-Scholes model: A mathematical model that allows investors to
determine option prices.
Formulas used:
The tools used in the analysis part of the study are:
1. Formula used for calculating returns is:
Returns = Spot Price – Futures price * 100
Futures price
F = Se r T
Where S = spot price of underlying
e = 2.718
r = cost of financing (using continuously compounded interest rate)
T = time till expiration in years
CHAPTER 5
DERIVATIVES A DISCUSSION
Derivatives a Discussion
1. Forward Contracts:
A forward contract is a n agreement to buy or sell an asset on a specified date
for a specified price. One of the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain specified future date for a certain
specified price. The other party assumes a short position and agrees to sell the asset on
the same date for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward contracts
are normally traded outside the exchanges.
transactions volume. This process of standardization reaches its limit in the organized
futures market.
Forward contracts are very useful in hedging and speculation. The classic
hedging application would be that of an exporter who expects to receive payment in
dollars three months later. He is exposed to the risk of exchange rate fluctuations. By
using the currency forward market to sell dollars forward, he can lock on to a rate
today and reduce his uncertainty. Similarly an importer who is required to make a
payment in dollars two months hence can reduce his exposure to exchange rate
fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price,
then he can go long on the forward market instead of the cash market. The speculator
would go long on the forward, wait for the price to rise, and then take a reversing
transactions to book profits. Speculators may well be required to deposit a margin
upfront. However, this is generally a relatively small proportion of the value of the
assets underlying the forward contract. The use of forward markets here supplies
leverage to the speculator.
Liquidity
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generally.
The forward market is like a real estate market in that any two consenting adults can
form contracts against each other. This often makes them design terms of the deal
which are very convenient in that specific situation, but makes the contracts
nontradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the
other suffers. Even when forward markets trade standardized contracts, and hence
avoid the problem of illiquidity, still the counterparty remains a very serious issue.
2. Futures Contract:
A futures contract is a type of derivative instrument, or financial contract, in
which two parties agree to transact a set of financial instruments or physical
commodities for future delivery at a particular price. If you buy a futures contract, you
are basically agreeing to buy something that a seller has not yet produced for a set
price. But participating in the futures market does not necessarily mean that you will
be responsible for receiving or delivering large inventories of physical commodities -
remember, buyers and sellers in the futures market primarily enter into futures
contracts to hedge risk or speculate rather than to exchange physical goods (which is
the primary activity of the cash/spot market). That is why futures are used as financial
instruments by not only producers and consumers but also speculators.
The consensus in the investment world is that the futures market is a major
financial hub, providing an outlet for intense competition among buyers and sellers
and, more importantly, providing a center to manage price risks. The futures market is
extremely liquid, risky and complex by nature, but it can be understood if we break
down how it functions. While futures are not for the risk-averse, they are useful for a
wide range of people.
The futures market is a centralized marketplace for buyers and sellers from
around the world who meet and enter into futures contracts. Pricing can be based on
an open cry system, or bids and offers can be matched electronically. The futures
contract will state the price that will be paid and the date of delivery. But don't worry,
almost all futures contracts end without the actual physical delivery of the commodity.
Futures Terminology:
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures
contracts on the NSE have one-month, two-months & three-month expiry cycles
which expire on the last Thursday of the month. Thus a January expiration
contract expires on the last Thursday of January and a February expiration contract
ceases trading on the last Thursday of February. On the Friday following the last
Thursday, a new contract having a tree-month expiry is introduced for trading.
Expiry Date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract Size: The amount of asset that has to be delivered under one contract. For
instance, the contract size on NSE’s futures market is 200 Nifties.
Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for
each contract. In a normal market, basis will be positive. This reflects that futures
prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid up to finance the asset less the income
earned on the asset.
Initial Margin: The amount that must be deposited in the margin account at the
time a futures contract is first entered into is known as initial margin.
Marking-to-Market: In the future market at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures
closing price this is called Marking-to-market
Maintenance Margin: This is somewhat lower than the initial margin. This is set to
ensure that the balance in the margin account never becomes negative. If the
balance in the margin account falls below the maintenance margin the investor
receives a margin call and is expected to top up the margin account to the initial
margin level before trading commences on the next day.
Pricing Futures:
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate
the fare value of a futures contract. Every time the observed price deviates from the
fair value, arbitragers would enter into trades to capture the arbitrage profit. This in
turn would push the futures price back to its fair value. The cost-of-carry model used
for pricing futures is given below:
F = Se r T
3. Options Contract:
An option is a contract that gives the buyer the right, but not the obligation, to
buy or sell an underlying asset at a specific price on or before a certain date. An
option, just like a stock or bond, is a security. It is also a binding contract with strictly
defined terms and properties.
Say, for example, that you discover a house that you'd love to purchase.
Unfortunately, you won't have the cash to buy it for another three months. You talk to
the owner and negotiate a deal that gives you an option to buy the house in three
months for a price of Rs.200,000. The owner agrees, but for this option, you pay a
price of Rs.3,000.
Now, consider two theoretical situations that might arise:
1. It is discovered that the house is actually the true birthplace of some great
person. As a result, the market value of the house skyrockets to Rs.1 million. Because
the owner sold you the option, he is obligated to sell you the house for Rs.200,000. In
the end, you stand to make a profit of Rs.797,000 (Rs.1 million – Rs.200,000 –
Rs.3,000).
2. While touring the house, you discover not only that the walls are chock-full of
asbestos, but also the ghost haunts the master bedroom; furthermore, families of
superintelligent rats have built a fortress in the basement. Though you originally
thought you had found the house of your dreams, you now consider it worthless. On
the upside, because you bought an option, you are under no obligation to go through
with the sale. Of course, you still lose the Rs.3,000 price of the option.
This example demonstrates two very important points. First, when you buy an
option, you have a right but not an obligation to do something. You can always let the
expiration date go by, at which point the option becomes worthless. If this happens,
you lose 100% of your investment, which is the money you used to pay for the option.
Second, an option is merely a contract that deals with an underlying asset. For this
reason, options are called derivatives, which mean an option derives its value from
something else. In our example, the house is the underlying asset. Most of the time,
the underlying asset is a stock or an index.
Calls and Puts: The two types of options are calls and puts:
Call Option: A call gives the holder the right to buy an asset at a certain price within
a specific period of time. Calls are similar to having a long position on a stock. Buyers
of calls hope that the stock will increase substantially before the option expires.
Put Option: A put gives the holder the right to sell an asset at a certain price within a
specific period of time. Puts are very similar to having a short position on a stock.
Buyers of puts hope that the price of the stock will fall before the option expires.
People who buy options are called holders and those who sell options are called
writers; furthermore, buyers are said to have long positions, and sellers are said to
have short positions.
¾ Call holders and put holders (buyers) are not obligated to buy or sell. They have
the choice to exercise their rights if they choose.
¾ Call writers and put writers (sellers), however, are obligated to buy or sell. This
means that a seller may be required to make good on a promise to buy or sell.
Option Terminology:
Index Options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.
Stock Options: Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the right
to buy or sell shares at the specified price.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right not the obligation to exercise his option on the
seller/writer.
Writer of an option: The writer of a call/option put option is the one receives the
option premium and is thereby obligated to sell/buy the asset if he buyer exercises
on him.
Call Option: A call option gives the holder the right but not the obligation to buy
an asset by a certain date for a certain price.
Put Option: A put option gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price.
Option price/Premium: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration Date: The date specified in the option Contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike Price: The price specified in the options contract is known as the strike price
or the exercise price.
American Options: American options are options that can be exercised at any time
up to the expiration date. Most exchange-traded options are American.
European Options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American
options, and properties of an American option are frequently deduced from those
of its European counter parts.
In-the-money: An in-the money (ITM) option is an option that would lead to a
positive cash flow to the holder if it were exercised immediately. A call option on
the index is said to be In-the-money when the current index stands at a level higher
than the strike price (i.e., spot price > strike price). If the index is much higher
than the strike price, the call is to be deep ITM. In the case of a put, the put is ITM
if the index is below the strike price.
At-the-money: An At-the-money (ATM) option is an option that would lead to
zero cash flow if it were exercised immediately. An option on the index is At-the-
money when the current index equals the strike price (i.e., spot price = strike
price).
Out-of-the-money: An out-of-the-money (OTM) option is an option that would
lead to a negative cash flow if it were exercised immediately. A call option on the
index is out-of-the-money when the current index stands at a level which is less
than the strike price (i.e., spot price < strike price). If the index is much lower than
the strike price, the call is said to be deep OTM. In the case of a put, the put is
OTM if the index is above the strike price.
Intrinsic value of an option : the option premium can be broken down into two
components – intrinsic value and time value. The intrinsic value of a call is the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is
zero. Putting it another way, the intrinsic value of a call is max [0, (S t – K)] which
means the intrinsic value of a call is the greater of 0 or (S t – K). Similarly, the
intrinsic value of a put is max [0, K – S t], i.e., the greater of 0 or (K-S t). K is the
strike price and St is the spot price.
Time value of an option: the time value of an option is the difference between its
premium and intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is an option’s
time value, all else equal. At expiration, an option should have no time value.
Pricing Options:
Black–Scholes model: Robert C. Merton was the first to publish a paper expanding
our mathematical understanding of the options pricing model and coined the term
"Black-Scholes" options pricing model, by enhancing work that was published by
Fischer Black and Myron Scholes. It is somewhat unfair to Merton that the resulting
formula has ever since been known as Black-Scholes, but with another hyphen the
label would be unwieldy. The paper was first published in 1973. The foundation for
their research relied on work developed by scholars such as Louis Bachelier, A. James
Boness, Edward O. Thorp, and Paul Samuelson. The fundamental insight of
BlackScholes is that the option is implicitly priced if the stock is traded. Merton and
Scholes received the 1997 Nobel Prize in Economics for this and related work; Black
was ineligible, having passed away in 1995.
An option buyer has the right but not the obligation to exercise on the seller. The
worst that can happen to a buyer is the loss of the premium paid by him. His downside
is limited to this premium, but his upside is potentially unlimited. This optionality is
precious and has a value, which is expressed in terms of the option price. Just like in
other free markets, it is the supply and demand in the secondary market that drives the
price of an option.
There are various models which help us to the true price of an option. Most of
these are variants of the celebrated Black-Scholes model for pricing European options.
Today mast calculators and spread-sheets come with a built-in Black-Scholes options
pricing formula so to price options we don’t really need to memorize the formula. All
we need to know is the variables that go into the model.
The Black-Scholes formulas for the prices of European calls and puts on a
nondividend paying stock are:
Benefits that acquire to the Indian capital markets and the Indian economy
from derivatives are discussed here. Derivatives will make possible hedging which
otherwise is infeasible this is illustrated by the dollar-rupee forward market. Imports
and exports used to take place in the country under the presumption that importer and
exporters have to bear currency risk.
To the extent that importers and exporters are risk averse, the existence of this
risk would lead them to do international trade in smaller quantities than they have
liked to. Once the dollar-rupee forward market came about, importers and exporters
could hedge themselves against currency risk. Today the use of such hedging is
extremely common amongst companies that are exposed to currency risk. This
hedging facility has definitely helped importers and exporters do international trade in
larger quantities than before. The RBI’s permission for the dollar-rupee forward
market is therefore part of the explanation for the enormous growth in imports and
exports that has taken place in the last five years.
Similarly, on the equity market, many retail investors who are uncomfortable
about the equity market would enter if they were given the alternative of buying
insurance, which controls their downside risk. This would enhance the action of the
savings of the country, which are routed through the equity market. The same would
be the case with international investors, who would place limit orders. These
improvements in the quality of the underlying market have been observed across a
variety of research studies done on foreign markets, which have compared market
quality before introduction of derivatives as compared with after.
Comparison of the close prices of the NIFTY near month Futures contract of
the (F&O segment Oct2007 to March2008) with the underlying movement of the
NIFTY Index (Cash Segment), along with the daily traded value of the Future and
option segment.
Inference: In the Index Futures Segment in the last year the open interest (no. of
contracts) has been increased by 51.11% and the turnover has been increased by
75.20%.
Inference: In the Stock Futures Segment in the last year the open interest has been
increased by 51.45% and the turnover has been increased by 11.38%.
Inference: In the Index Options Segment in the last year the open interest has been
decreased by 6.5% and the turnover has been increased by 23.84%.
Inference: In the Stock Options Segment in the last year the open interest has been
decreased by 21.66% and the turnover has been decreased by 38.04%.
CHAPTER 6
ANALYSIS AND INTERPRETATION
Stock/Index Futures:
1 NIFTY 50
2 CNX 100 50
3 NIFTY MIDCAP 75
10 ISPAT 4150
11 ITC 1125
12 NTPC 1625
13 RPL 1675
14 TCS 250
The Future prices of these contracts of March month expiring contract which
expires on last Thursday of the month i.e. on 27 th March, 2008 are compared with that
of the spot price of the underlying asset on expiry. And the corresponding returns have
been calculated although the brokerage is not included. The following data gives you a
view of returns in buying these following Index Futures and Stock Futures contracts
and exercising them on expiry:
The formula used to calculate the returns is:
Index Futures:
Inference: In the index futures the NIFTY index futures achieves -1.3% returns,
NIFTY MIDCAP achieves -14.61% returns and CNX100 returns -3.82%. By
considering the above index returns we can conclude that the market is bearish and the
indexes and also most of the individual stocks results in declining the spot.
Stock Futures:
8 ITC 189.95 200.1 10.15 5.34 9 NTPC 185.9 197.2 11.3 6.08
Inference: As the markets are bearish many of the stock prices falls as shown in the
above table but some of the stocks have beaten the marked outperformed to be bullish
even though the markets are declining.
One Month Price Fluctuations of the Underlying Asset in the contract Period:
Arvind Mills 49.2 Bharti Airtel 826.25
Inference: Arvind Mills has been declined by 23.27% in the spot market and Bharti
Airtel has been increased by 0.09%.
Inference: Dr. Reddy’s has been decreased 0.094% and GMR INFRA has been
decreased by 14.04% in their spot markets.
Hero Honda 761.65 Infosys Tech 1548.2
Hero Honda 774.9 Infosys Tech 1467.9
Hero Honda 772.55 Infosys Tech 1419.05
Hero Honda 773.5 Infosys Tech 1478.8
Hero Honda 766.65 Infosys Tech 1430.55
Hero Honda 757.15 Infosys Tech 1431.1
Hero Honda 735.6 Infosys Tech 1426.35
Hero Honda 728.25 Infosys Tech 1385.15
Hero Honda 737.2 Infosys Tech 1337.7
Hero Honda 716.3 Infosys Tech 1370.2
Hero Honda 686.3 Infosys Tech 1337.8
Hero Honda 685.05 Infosys Tech 1314.6
Hero Honda 650.35 Infosys Tech 1343.7
Hero Honda 647.7 Infosys Tech 1360.45
Hero Honda 678.7 Infosys Tech 1492.3
Hero Honda 679.6 Infosys Tech 1449.5
Hero Honda 686.05 Infosys Tech 1441.75
Inference: Hero Honda has been decreased by 9.92% in the spot market and Infosys
Technologies has been decreased by 6.87% in the spot.
Inference: ISPAT has been decreased by 29.09% in the spot market and ITC has been
decreased by 1.30% in the spot.
Inference: NTPC has been decreased by 2.37% in the spot market and RPL has been
decreased by12.20% in the spot.
Inference: TCS has been decreased by 2.83% in the spot market and Vijaya Bank has
been decreased by 23.84% in the spot.
Inference: Nifty Index has been decreased by 7.52% in the spot market and the
CNX100 has been decreased by 8.967% in the spot.
Inference: The NIFTY MIDCAP INDEX has been decreased by 17.53% in the spot
price of the market.
Interpretation of results:
By looking at the above data it is clear that the market is bearish over the
contract period and the buyers of future contracts are incurring the above shown loses.
From the above furnished data analysis the buyers of index futures namely NIFTY,
CNX 100 and Nifty Midcap have incurred negative returns of -1.30, -14.61 and -3.82
respectively. And when it comes to stock futures as the market declines many of the
individual stocks also declines. In our study i.e. Arvind Mills, GMR Infrastructures,
Hero Honda Motors, Infosys Technologies, ISPAT Industries, RPL and Vijaya Bank
show a positive correlation with that of the market movements. But some of the stocks
like Bharti Airtel, Dr.Reddy’s laboratories; ITC, NTPC and TCS have overcome the
market and shows appreciable returns in buying those futures. From the above data the
highest positive returns are obtained by buying NTPC futures and highest negative
returns are obtained by buying ISPAT Futures. Although when it comes to the
percentage of declining no Index will have such declining returns when compared to
that of the individual stocks i.e. ISPAT in our study.
The reasons for this declining movement may be many like overpricing of the
underlying, economic activities, Foreign Institutional Investors withdrawing money
from our markets like this many of the reasons will lead the market to the bearish
state, so one should also consider such factors in buying future contracts along with
the past data analysis. Hence a person who is bullish about the market here expects the
underlying asset prices to rise and buys the future contracts and the market doesn’t
move as per his expectations and he incurs loses. Instead of buying such selling of
futures are profitable as the market is bearish and results futures price is greater than
the spot price on expiry.
F = SerT
Here ‘F’ is the Futures price for the next month contract, ‘S’ is the spot price of
the underlying asset as on March 27, 2008, ‘e’ is the exponential constant i.e. 2.718,
‘r’ is rate of interest @ 11% and ‘T’ is the period of expiry of contract i.e. one month.
Index Futures:
INDEX Spot Price Futures Price
Stock Futures:
futures he can minimize his price risk. All he needs to do is enter into offsetting stock
futures position, in this case, take on a short futures position. Assume that the spot
price of the security he holds is Rs.390. two-month futures cost him Rs.402. for this he
pays an initial margin. Now if the price of the security falls any further, he will suffer
losses profits he makes on his short futures position. Take for instance that the price of
his security falls to Rs.350 the fall in the price of the security will result in a fall in the
price of futures. Futures will now trade at a price lower than the price at which he
entered into a short futures position. Hence his short futures position will start making
profits. The loss of Rs.40 incurred on the security he holds, will be made up by the
profits made on his short futures position.
Index futures in particular can be very effectively used to get rid of the market
risk of a portfolio. Every portfolio contains a hidden index exposure or a market
exposure. This statement is true for all portfolios, whether a portfolio is composed of
index securities or not. In case of portfolios, most of the portfolio risk is accounted for
by index fluctuations (unlike individual securities, where only 30-60% of the
securities risk is accounted for by index fluctuations). Hence a position Long Portfolio
+ Short Nifty can often become one-tenth as risky as the Long Portfolio position.
Hedging does not always make money. The best that can be achieved using
hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged
position will make less profit than the un hedged position, half the time. One should
not enter into a hedging strategy hoping to make excess profits for sure; all that can
come out of hedging is reduced risk.
Today a speculator can take exactly the same position on the security by using
futures contracts. Let us see how this works, the security trades at Rs.1000 and the
twomonth futures trades at 1006. Just for the sake of comparison, assume that the
minimum contract value is 100000. He buys 100 security futures for which he pays a
margin of Rs.20000. two months later the security closes at 1010. On the day of
expiration, the futures price converges to the spot price and he makes a profit of
Rs.400 an investment of Rs,20000. This works out to an annual return of 12 percent.
Because of they provide, security futures form attractive option for speculators.
seem overpriced. As an arbitrageur, you can make risk less profit by entering into the
following set of transactions.
a) On day one, borrow funds; buy the security on the cash/spot market at 1000.
b) Simultaneously, sell the futures on the security at 1025.
c) Take delivery of the security purchased and hold the security for a month.
d) On the futures expiration date, the spot and the futures price converge. Now
unwind the position.
e) Say the security closes at Rs.1015. Sell the security.
f) Futures position expires with profit of Rs.10.
g) The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the
futures position.
h) Return the borrowed funds.
When does it make sense to enter into this arbitrage? If your cost of borrowing funds
to buy the security is less than the arbitrage profit possible, it makes sense for you to
arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that
exploiting an arbitrage opportunity involves trading on the spot and futures market. In
the real world, one has to build in the transactions costs into the arbitrage strategy.
If the returns you get by investing in risk less instruments are more than the return
from the arbitrage trades, it makes sense for you to arbitrage. This is termed as
reverse-cashand-carry arbitrage. It is this arbitrage activity that ensures that the spot
and futures prices stay in line with the cost-of-carry. As we can see, exploiting
arbitrage involves trading on the spot market. As more and more players in the market
develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry, we
will see increased volumes and lower spreads in both the cash as well as the
derivatives market.
Options Segment:
Here it is refereed to single stock futures, however since the index is nothing but
a security whose price or level is a weighted average of securities consisting an index,
all strategies that can be implemented using stock options can also be implemented
using index options.
common and reliable source of such volatility: market volatility is always enhanced
for one week before and two weeks after a budget. Many investors simply do not want
the fluctuations of these weeks. One way to protect your portfolio from potential
downside due to a market drop is to buy insurance using put options.
Index and stock options are a cheap and easily implemantable way of seeking
this insurance. This idea is simple to protect the value of your portfolio from failing
below a particular level, buy the right number of put options with the right strike price.
If you are only concerned about the value of a particular stock that you hold, buy put
options on that stock. If you are concerned about the overall portfolio, buy put options
on the index. When the stock price falls your stock will lose value and the put options
bought by you will gain, effectively ensuring that the total value of your stock plus put
does not fall below a particular level. This level depends on the strike price of the
stock options chosen by you. Similarly when the index falls, your portfolio will lose
value and the put options bought by you will gain, effectively ensuring that the value
of your portfolio does not fall below a particular level. This level depends on the strike
price of the index options chosen by you. Portfolio insurance using put options is of
particular interest to mutual funds who already own well-diversified portfolios. By
using puts, the fund can limit its downside in case of a market fall.
on. However, if your hunch proves to be wrong and the security price plunges down,
what you lose is only the option premium.
Having decided to buy a call, which one should you buy? The table gives the
premia for one month calls and puts with different strikes. Given that there are a
number of one-month calls trading, each with a different strike price, te obvious
questions is: which strike should you choose? Let us take a look at call options with
different strike prices. Assume that the current price level is 1250, risk-free rate is
12% per year and volatility of the underlying security is 30%.
The following options are available: o A
one month call with a strike of 1200 o A
one month call with a strike of 1225 o
A one month call with a strike of 1250 o
A one month call with a strike of 1275 o
A one month call with a strike of 1300
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the price, and how much you are willing to
loose should this upward movement not come about. There are five one-month calls
and five one-month puts trading in the market. The call with a strike of 120 is deep in-
the-money and hence trades at a higher premium. The call with a strike of 1275 is out-
of-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-
money. Its execution depends on the unlikely event that the underlying will rise by
more than 50 points on the expiration date. Hence buying this call is basically like
buying a lottery. There is a small probability that it may be in-the-money by
expiration, in which case the buyer will make profits. In the more likely event of the
call expiring out-of-the-money, the buyer simply loses the small premium amount of
Rs.27.50
As a person who wants to speculate on the hunch that prices may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited upside
and an unlimited downside. If prices do rise, the buyer of the put will let the option
expire and you will earn the premium. If however your hunch about an upward
movement proves to be wrong and prices actually fall, then your losses directly
increase with the falling price level. If for instance the price of the underlying falls to
1230 and you’ve sold a put with an exercise of 1300, the buyer of the put will exercise
the option and you’ll end up losing Rs.70 taking into account the premium earned by
you when you sold the put, the net loss on trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there
are a number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly
you feel about the likelihood of the upward movement in the prices of the underlying.
If you write an at-the-money put, the option premium earned by you will be higher
than if you write an out-the-money put. However the chances of an at-the-money put
being exercised on you are higher as well. In the example at a price level of 1250, one
option is in-the-money and one is out-the-money. As expected, the in-the-money
option fetches the highest premium of Rs.64.80 whereas the out-of-the-money option
has the lowest premium of Rs.18.15.
The spot price is 1250. There are five one-month calls and five one-month
puts trading in the market. The call with a strike of 1200 is deep in-the-money and
hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money
and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its
execution depends on the unlikely event that the price will raise by more than 50
points on the expiration date.
Hence writing this call is a fairly safe bet. There is a small probability that
it may be in-the-money by expiration in which case the buyer exercises and the writer
suffers losses to the extent that the price is above 1300. in the more likely event of the
call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. the
payoffs from writing calls at different strikes similarly, the put with a strike of 1300 is
deep in-the-money and trades at a higher premium than the at-the-money put at a
strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be
exercised in the unlikely event that the price falls by 50 points on the expiration date.
The choice of which put to buy depends upon how much the speculator expects the
market to fall. The table shows the payoffs from buying puts at different strikes.
Which of these options you write largely depends on how strongly you feel
about the likelihood of the downward movement of prices and how much you are
willing to lose should this downward movement not come about. There are five
onemonth calls and five one-month puts trading in the market. The call with a strike of
1200 is deep in-the-money and hence trades at a higher premium. The call with a
strike of 1275 is out-of-money. Its execution depends on the unlikely event that the
stock will raise by more than 50 points on the expiration date. Hence writing this call
is a fairly safe bet. There is small probability that it may be in-the-money by
expiration in which case the buyer exercises and the writer suffers losses to the extent
that the price is above 1300. in the more likely event of call expiring out-of-the-
money, the writer earns the premium amount of Rs.27.50
As a person who wants to speculate on the hunch that the market may fall, you
can also buy puts. As the buyer of puts you face an unlimited upside but a limited
downside. If the price does fall, you profit to the extent the price falls below the strike
of the put purchased by you. If however your hunch about a downward movement in
the market in the market proves to be wrong and the price actually rises, all you lose is
the option premium. If for instance the security price rises to 1300 and you’ve bought
a put with an exercise of 1250, you simply let the put expire. If however the price does
fall to say 1225 on expiration date, you make a neat profit of Rs.25. having decided to
buy a put, which one should you buy? Given that there are a number of one-month
puts trading, each with a different strike price, the obvious question is: which strike
should you choose? This largely depends on how strongly you feel about the
likelihood of the downward movement in the market. If you buy an at-the-money put,
the option premium paid by you will by higher than if you buy an out-of-the-money
put. However the chances of an at-the-money put expiring in-the-money are higher as
well.
Put Options:
Symbol Open Interest(no. of contracts) Percentage
NIFTY 477636 95.55%
RELIANCE 7174 1.44%
RPL 1389 0.28%
RNRL 873 0.17%
DLF 849 0.17%
OTHERS 11964 2.39%
TOTAL 499885 100%
CHAPTER 7
SUMMARY AND CONCLUSIONS
2. The players in the Derivatives market are hedgers and speculators. A hedger tries
to minimize risk by buying or selling now in an effort to avoid rising or declining
prices. Conversely, the speculator will try to profit from the risks by buying or
selling now in anticipation of rising or declining prices.
3. Buying and selling in the futures market can seem risky and complicated. Futures
and Options trading are not for everyone, but it works for a wide range of people.
The futures market is a global marketplace, initially created as a place for farmers
and merchants to buy and sell commodities for either spot or future delivery. This
was done to lessen the risk of both waste and scarcity.
4. Rather than trade in physical commodities, futures markets buy and sell futures
contracts, which state the price per unit, type, value, quality and quantity of the
commodity in question, as well as the month the contract expires.
5. The futures market is also characterized as being highly leveraged due to its
margins. Prices of derivative instruments converge with the prices of the
underlying at the expiration of the derivative contracts.
6. Always there will be three contracts available for trading with 1 month, 2 months
and 3 months which of those expires on the last Thursday of the respective month.
7. In forward contracts counterparty risk arises from the possibility of default by any
one of the party to the transaction wherein future contracts exchanges acts as a
counterparty and it is standardized contract with standard underlying instrument, a
standard quantity and quality of the underlying instrument that can be delivered at
a standard timing of such settlement.
8. In forward and future contracts both the parties are obligated to exercise the
contract at expiry wherein options the buyer of an option contract is not obligated
to exercise the contract it’s his wish to exercise or not on the expiry date.
9. Future contracts have linear payoffs; it means that the losses as well as profits for
the buyer and the seller of a futures contract are unlimited.
10. Whereas option contracts have non-linear payoffs; it means that the losses for the
buyer of an option are limited; however the profits are potentially unlimited. For a
writer the payoff is exactly the opposite his profits are limited to the option
premium; however his losses are potentially unlimited.
Suggestions:
1. So to deal with the Derivatives one should have a clear knowledge about the
products and specifications and he should know the upside and downside in
buying are selling the product and should have the ability to analyze its behavior
with that of the spot price of the underlying asset.
2. It is preferred to use the derivative products as hedging tool, if the buyers are risk
averse i.e. they can use these products as insurance to their asset price fluctuations
in the spot market.
3. There are numerous derivatives strategies, but the common thread is that they all
allow you to either buy or sell an investment without actually taking possession of
it, with the ultimate goal of allowing you to profit from a move in the underlying
asset in a specified amount of time. And because derivatives trade for a fraction of
the price of the underlying asset, you have the opportunity to spend less money to
control more of the asset.
CONCLUSION
BIBILIOGRAPHY
Websites:
www.nseindia.com
www.derivativesindia.com
www.sharekhan.com www.moneycontrol.com
www.investopedia.com
www.businessmapsofindia.com
www.finance.yahoo.com