“Derivatives & Its Applications”

A Project Submitted to
University of Mumbai for partial completion of the degree of
Bachelor in commerce (Banking and Insurance)
Under the Faculty of Commerce

By
Mr. Mohd Saqlain
Roll No:112

Under the guidance of

Mr. NandKumar Tiwari

K. J. SOMAIYA COLLEGE OF ARTS & COMMERCE

Vidyavihar, Ghatkopar - 400077

Semester VI
2021-22

1
 K.J.Somaiya College of Arts and Commerce
(Autonomous)
Vidyavihar, Mumbai – 400 077

Certificate
This is to certify that Mr. Mohd Saqlain has worked and completed his
project work for the Degree of Bachelor in Commerce (Banking and
Insurance) under the faculty of commerce in the subject of Project in
Banking and Insurance and his project is entitled “Derivatives & Its
Applications” under my supervision. I further Certify that the entire
work has been done by the learner under my guidance and that no part of
it has been submitted previously for any degree diploma of any
University
It is his own work and fact reported by his personal findings and
investigation.
Date of Submission: 15 January, 2022
th

___________________ __________________
Mr. Milind Saraf
(BBI Coordinator) (External Guide)

Mr. Nandakumar Tiwari Dr.(Mrs.) Veena Sanekar

(Internal Guide) (I/c Principal)

2
 DECLARATION

I the undersigned Mr. Mohd Saqlain here by, declare that the work
embodied in this project work titled “Derivatives & Its Applications”
forms my own contribution to the research work carried out under
guidance of Mr. NandKumar Tiwari is a result of my own research
work and has not been previously submitted to any other University for
any other Degree / Diploma to this or any other University.
Whenever reference has been made to previous works of other, it has
been clearly indicated as such and included in the bibliography.
I, here by further declare that all information of his document has been
obtained and presented in accordance with academic rules and ethical
conduct.

Mr. Mohd Saqlain

Certified by
Mr. NandKumar Tiwari
Internal Guide

3
 ACKNOWLEDGEMENT

To list who all have helped me is difficult because they are so numerous and the depth
is so enormous.
I would like to acknowledge the following as being idealistic channels and fresh
dimensions in the completion of this project.
I take this opportunity to thank the University of Mumbai for giving me chance to do
this project.
I would like to thank my I/c Principal, Dr. (Mrs.) Veena Sanekar for providing the
necessary facilities required for completion of this project.
I take this opportunity to thank our Coordinator Mr. Milind saraf, for this moral
support and guidance.
I would also like to express my sincere gratitude towards my project guide Mr.
NandKumar Tiwari, whose guidance and the 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.
Lastly, I would like to thank each and every person who directly or indirectly helped
me in the completion of the project especially my Parents and Peers who supported
me throughout my project.

4
 INDEX
SR. CONTENTS PAGE
NO. NO.

1 Introduction 6

2 History& Development of Derivatives 19

3 Hedging strategies using futures 40

4 Hedging strategies using options 47

5 Option Greeks 62

6 Simulation 68

7 Taxation of derivatives in India 73

8 Data Analysis, Interpretation and Presentation 76

9 Conclusion 82

5
Chapter 1 INTRODUCTION
Last years, when the COVID wave hit us as an individual we learned the importance
of life and value of closed ones as well as we also understood the importance of risk
management, we have seen an enormous growth in terms people learning about the
personal finance & wealth management like topics, also we have witnessed significant
jump in the opening of new demat accounts, when all the businesses were closed due
to lock down people started trading and investing in stock market as well as other
asset classes such commodities& crypto currency. But also there we were people who
just got influenced with the screenshots of the profits and started trading in the stock
market specifically speaking F&O segment without having any prior knowledge of
the segment, risk involved and liabilities could occur due losses in the same. Some
might have got lucky and have made a good amount but most of the new bees failed.
As many reports suggests that 95% of the people failed while trading.

Here in this project report I have tried to depict that how an individual can apply the
theoretical knowledge of finance and derivatives into the real market scenario to earn
with proper risk management, position sizing and other mechanisms involved. My
main focus in this project will be trading in F&O segment of different asset classes
such as Index, stocks, currencies, commodities and emerging asset derivatives of
crypto currency. I will not only discuss about foresaid topics but will start from the
scratch with term derivatives and touching upon the Forward, swaps and other OTC
(over the counter) and ETD (Exchange traded derivatives) derivatives and lastly we
will learn the applications of so far what we have learned.

Meaning and Definitions of derivatives

The term “derivative” indicates that it has no independent value, i.e., its value is
entirely derived from the value of underlying asset. The underlying asset can be
securities, commodities, bullion, currency, live stock, or anything else. In other words,
derivative means forwards, futures, options or any other hybrid contract of
predetermined fixed duration, “linked for the purpose of contract fulfillment to the
value of specified real or financial asset or to an index of securities.

The securities Contract (Regulation) Act, 1956 defines “derivative” as under:

6
“Derivative” includes -

 Security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument or contract for differences or any other form of
security.
 A contract which derives its value from the prices, or index of prices, of
underlying securities.

The above definition conveys that:

1. The derivatives are financial products.

2. Derivative is derived from other financial instrument/contract called the
underlying. In the case of Nifty futures, Nifty index is the underlying. A
derivative derives its value from the underlying assets.

In the RBI Act-1934 as amended vide RBI (Amendment) Act, 2006; derivatives
have been defined in section 45(u) (a) as:

"derivative" means an instrument, to be settled at a future date, whose value is derived

from change in interest rate, foreign exchange rate, credit rating or credit index, price
of securities (also called "underlying"), or a combination of more than one of them
and includes interest rate swaps, forward rate agreements, foreign currency swaps,
foreign currency-rupee swaps, foreign currency options, foreign currency-rupee
options or such other instruments as may be specified by the Bank from time to time.

The derivative is also defined as:

 The derivatives are the financial product which derived from one or more
basic instruments which are called underlying assets/instruments.
 Derivative are financial instrument whose payoffs are derived from other,
more important financial variables, for example, a stock, commodity, an
exchange rate, interest rate, an index level etc.
 Derivative instruments are referred to those contracts/instruments whose
values are linked to the future value of an underlying instrument to which they
represent.

Features of Financial derivative

7
The basic feature of derivative instrument can be drawn from the general
definition of a derivative irrespective of its type. Derivative or derivative
securities are future contracts which are written between two-parties (counter-
parties) and whose value are derived from the value of underlying widely held and
easily marketable assets such as agricultural and other physical(tangible)
commodities, or short-term & long term financial instrument, or intangible things
like weather etc. Usually, the counter parties to such contracts are those other than
the original issuer (holder) of the underlying asset. In the light of this, the basic
features of a derivative may be stated as follows:

1. A derivative instrument relates to the future contract between two parties.

2. The derivative instruments have the value which is derived from the values
of other underlying assets which changes with the change in the
underlying assets, and sometimes, it may be nil or zero.
3. The counter parties have specified obligation under the derivative contract.
4. The derivative contracts can be undertaken directly between the two
parties (OTC) or through recognized exchanges such as NSE, NASDAQ,
and DOW Jones etc.
5. In general, the financial derivatives are carried off-balance sheet.
6. In derivative trading, usually the delivery of underlying assets is not
involved.
7. They are also known as deferred delivery or deferred payment instruments.
8. Derivatives are mostly used in secondary market & have little usefulness
for raising fresh capital; however, warrants and convertibles are exception
in this respect.
9. Although the standardized are evolving but still many privately negotiated
customized, OTC traded derivatives exist.
10. Derivative instrument sometimes because of their off-balance sheet nature
can be used to clear up the balance sheet.

8
Classification of Derivatives

9
Classification of derivatives on the basis of their nature
One form of classification of derivatives instrument is between commodity
derivatives and financial derivatives. The basic difference between these is the nature
of the underlying instrument or asset. In a commodity derivative, the underlying
instrument is a commodity which may be wheat, cotton, paper, sugar, jute, turmeric,
corn, soybeans, crude oil, natural gas, gold, silver, copper, and so on. In financial
derivatives, the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, gilt-edged securities, index etc. It is to be noted that financial derivative is
fairly standard and there is no quality issue where is in commodity derivative with the
quality maybe underlying matters. However, the distinction between these two forms
structure and functioning point of you view, both are almost similar in nature.

Another way of classifying the financial derivatives is into basic and complex
derivatives. In this, forward contracts, future contracts and option contracts are
included in the basic derivatives, whereas swaps and other complex derivatives are
included in the complex category because they are built up from either forwards and
futures or options contract, or both. In fact, such derivatives are effectively derivatives
of derivatives.

Classification of derivatives on the basis of Market Trading

On the basis of market trading, the financial derivatives can be classified into two
categories that are Exchange Traded Derivatives (ETD) and over-the-counter (OTC)
derivatives. Derivatives contracts that are traded and privately negotiated directly
between the two parties without going through an exchange are called OTC
derivatives whereas the derivatives which are traded on recognised stock exchange
are known as exchange traded derivatives ETD (exchange traded derivatives).

The OTC derivative market is the largest market for derivatives and largely
unregulated and directly executed by the parties themselves. The information relating
to some of these are not to disclose generally. On the other hand a derivative
exchange is a market where individuals trade in standardized contracts which have
been specified by the respective exchange. These exchanges act as an intermediary

10
 between the members through which transactions are initiated on behalf of their
clients. The trading mechanism in both the derivative markets differs in many
respects.

Distinction between ETD and OTC Derivative

S. Particulars ETD OTC

No.
1. Parties to the contract These are done through the These contracts are
recognized exchanges. These are privately placed. They
more than two parties in such are bilateral contracts,
contracts. which may be routed
directly or through
broker/agent.

2. Exchange These are traded on the recognized These are traded over
exchanges. the counters of the
respective exchanges.
3. Specifications These contracts are standardized in These contracts are
terms of quantity, quality of asset, made on the basis of
maturity, etc. Such standards are the requirements of
decided by the concerned the parties. Terms and
exchanges. conditions of the
contracts are decided
by the parties
themselves.
4. Delivery date These contracts are offset or The delivery date of
delivered on the specified date as these contracts is
per the exchange notifications. settled by parties
themselves.
5. Settlement These contracts settled through These contracts are
clearing houses. self-regulatory

11
 contracts.

6. Margin Margins are required by both the No such margin is

parties as decided by the exchange. required.
7. Daily Adjustment MTM is followed in these These contracts are
contracts. settled on expiry.

8. Credit risk There’s no risk as they are settled There’s counter party
through clearing houses. risk involved.

Example: Some important examples of these derivatives traded at OTC

and exchanges are stated blow:

OTC Derivatives Exchange Traded Derivatives

Forward contracts on equity shares, foreign Futures contracts on equity shares, stock
exchange, commodities, forward rate index, foreign currencies, commodities.
agreements.

Option contracts on stocks, foreign Options contract on equity shares, stock

exchange, commodities. index, foreign currencies and commodities.

Interest rate swaps, currency swaps, caps, Interest rate (both short term & long term),
floors, swaption, caption, floortion, exotic swap, note future, warrants and convertible
derivatives. securities.

12
 Basics of Financial derivatives

Forward Contracts

A forward contract is a simple customized contract between two parties to buy or sell
an asset at a certain time in the future for a certain prize unlike futures contracts they
are not traded on an exchange traded in the over the counter market usually between
two Financial Institutions or between a financial institution and one of its client is a
bilateral contracts and their negotiated directly between the buyers and sellers and all
the terms of the contract are decided by themselves.

Example: An Indian company buys Automobile parts from the USA with payment of
1 million dollar due in 90 days the important does is short of dollar that is it US dollar
for future delivery. Suppose present price of the dollar is 63 rupees. Over the next 90
days, however, dollar rise against 63. The importer can help this exchange raised by
negotiating a 90 days forward contract with a bank at a price of rupees 65. According
to the forward contract in 90 days the bank will give the important 1 million dollar
and the imported will pay the bank 65 million hedging future payment with forward
contract. On that due date the important will make a payment of rupees 65 million and
the bank will pay 1 million dollar to importer, whatever rate of the Dollar is after 90
days. So, this is the example of simple forward contract in foreign currency.

Basic feature of forward contract are given in brief here as under:

1. Forward contracts bilateral contracts and hence they are exposed to counterparty risk.
There is risk of non performance of obligation either of the parties so these are riskier
then to futures contracts.

2. Each contract is custom designed, and hence, is unique in terms of contract size,
expiration date, the Asset type quality etc.

3. In the forward contract, one of the parties take a long position by agreeing to buy the
Asset at certain specified future date. The other party assumes a short position by
agreeing to sell the same as at the same date for the same specified price. A party with
no application of setting the forward contract to have an open position. A party with a
closed position is sometimes called a hedger.

13
4. The specified price in a forward contract is referred to as delivery price. Forward
price for a particular contract at a particular time is the delivery price that would apply
if the contract were entered into at that time. It is important to differentiate between
the forward price and the delivery price. Both are equal at the time the contract is
entered into. However, as the time passes, the forward price is likely to change, where
the delivery price is remains the same.

5. In the forward contract, derivative acids can often be contracted from the combination
of underlying assets, such assets are often known as synthetic assets in the Forward
Market.

6. In Forward Market, the contract has to be settled by delivery of the asset on expiration
date. Enter the party wishes to reverse the contract, it has to compulsorily go to the
same counter party, which may dominate and command the price it wants as being in
a Monopoly situation.

7. In Forward Market, covered parity for cost of carry relations are relation between the
prices of forward and underlying asset. Such relations for the assist in determining the
arbitrage based forward asset prices.

8. Forward contract are very popular in foreign exchange market as well as interest rate
wearing instruments. Most of the large and international banks quoted the forward
rate through their 'forward desk' lying within their foreign exchange trading room.
Forward foreign exchange quotes by these banks are displayed with the spot rates.

9. As per the Indian forward contract act 1952, different kinds of Forward contracts can
be done like hedge contracts, Transferable specific delivery contract and non
Transferable specific delivery contract. Hedge contract are freely Transferable and do
not specify, any particular lot, consignment or variety for delivery. Enable specific
delivery contracts are though free Transferable from one party to another, find me the
specific and free determined consignment. Delivery is mandatory. Non Transferable
specific delivery contract, as the name indicate, are not transferable at all, and as such,
they are highly specific.

14
In brief, a forward contract is an agreement between the parties to buy or sell a
specified quantity of an asset at a specified price, with delivery at a specified time and
place. These contracts are not standardized; one is usually being customized to its
owner’s specifications.

1. FUTURES -

A future contract is an agreement between two parties to buy or sell an

asset at a certain time the future at the certain price. Futures contracts are the special
types of forward contracts in the sense that are standardized exchange-traded
contracts.

Equities, bonds, hybrid securities and currencies are the

commodities of the investment business. They are traded on organised exchanges
in which a clearing house interposes itself between buyer and seller and
guarantees all transactions, so that the identity of the buyer or the seller is a matter
of indifference to the opposite party. Futures contract protect those who use these
commodities in their business.

Futures trading are to enter into contracts to buy or sell financial

instruments, dealing in commodities or other financial instruments for forward
delivery or settlement on standardised terms. The futures market facilitates stock
holding and shifting of risk. They act as a mechanism for collection and distribution
of information and then perform a forward pricing function. The futures trading can
be performed when there is variation in the price of the actual commodity and there
exists economic agents with commitments in the actual market. There must be a
possibility to specify a standard grade of the commodity and to measure deviations
from this grade. A futures market is established specifically to meet purely
speculative demands is possible but is not known. Conditions which are thought of
necessary for the establishment of futures trading are the presence of speculative
capital and financial facilities for payment of margins and contract settlement. In

15
addition, a strong infrastructure is required, including financial, legal and
communication systems.

2. OPTIONS -

A derivative transaction that gives the option holder the right but
not the obligation to buy or sell the underlying asset at a price, called the strike
price, during a period or on a specific date in exchange for payment of a premium
is known as ‘option’. Underlying asset refers to any asset that is traded. The price
at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION AND PUT OPTION.

a. CALL OPTION :

A contract that gives its owner the right but not the obligation
to buy an underlying asset-stock or any financial asset, at a specified price
on or before a specified date is known as a ‘Call option’. The owner
makes a profit provided he sells at a higher current price and buys at a
lower future price.

b. PUT OPTION :

A contract that gives its owner the right but not the obligation
to sell an underlying asset-stock or any financial asset, at a specified price
on or before a specified date is known as a ‘Put option’. The owner makes
a profit provided he buys at a lower current price and sells at a higher
future price. Hence, no option will be exercised if the future price does not
increase.

16
 Put and calls are almost always written on equities, although
occasionally preference shares, bonds and warrants become the subject of options.

4. SWAPS -

Swaps are transactions which obligates the two parties to the contract
to exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A contract
whereby two parties agree to exchange (swap) payments, based on some notional
principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are
exchanged and not the principle amount. The two commonly used swaps are:

a. INTEREST RATE SWAPS :

Interest rate swaps is an arrangement by which one party

agrees to exchange his series of fixed rate interest payments to a party in
exchange for his variable rate interest payments. The fixed rate payer takes
a short position in the forward contract whereas, the floating rate payer
takes a long position in the forward contract.

b. CURRENCY SWAPS :

Currency swaps is an arrangement in which both the principle

amount and the interest on loan in one currency are swapped for the
principle and the interest payments on loan in another currency. The
parties to the swap contract of currency generally hail from two different
countries. This arrangement allows the counter parties to borrow easily
and cheaply in their home currencies. Under a currency swap, cash flows
to be exchanged are determined at the spot rate at a time when swap is
done. Such cash flows are supposed to remain unaffected by subsequent
changes in the exchange rates.

17
c. FINANCIAL SWAP :

Financial swaps constitute a funding technique which permit

a borrower to access one market and then exchange the liability for another
type of liability. It also allows the investors to exchange one type of asset
for another type of asset with a preferred income stream.

The other kind of derivatives, which are not, much popular are as
follows :

5. BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index

Options are most popular form of baskets.

6. LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years. These
long-term option contracts are popularly known as Leaps or Long term Equity
Anticipation Securities.

7. 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.

18
8. SWAPTIONS -

Swaption 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 swaption market has receiver swaption and payer swaption. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption
is an option to pay fixed and receive floating.

19
Chapter – 2 HISTORY OF DERIVATIVES
The history of derivatives is quite colorful and surprisingly a lot
longer than most people think. Forward delivery contracts, stating what is to be
delivered for a fixed price at a specified place on a specified date, existed in
ancient Greece and Rome. Roman emperors entered forward contracts to provide
the masses with their supply of Egyptian grain. These contracts were also
undertaken between farmers and merchants to eliminate risk arising out of
uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.

The first organized commodity exchange came into existence in the

early 1700’s in Japan. The first formal commodities exchange, the Chicago
Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem
of ‘credit risk’ and to provide centralised location to negotiate forward contracts.
From ‘forward’ trading in commodities emerged the commodity ‘futures’. The
first type of futures contract was called ‘to arrive at’. Trading in futures began on
the CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’
derivatives contract, known as the futures contracts. Futures trading grew out of
the need for hedging the price risk involved in many commercial operations. The
Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in
1919, though it did exist before in 1874 under the names of ‘Chicago Produce
Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first
financial futures to emerge were the currency in 1972 in the US. The first foreign
currency futures were traded on May 16, 1972, on International Monetary
Market (IMM), a division of CME. The currency futures traded on the IMM are
the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the
German Mark, the Australian Dollar, and the Euro dollar. Currency futures were
followed soon by interest rate futures. Interest rate futures contracts were traded
for the first time on the CBOT on October 20, 1975. Stock index futures and
options emerged in 1982. The first stock index futures contracts were traded on
Kansas City Board of Trade on February 24, 1982.

20
 The first of the several networks, which offered a trading link
between two exchanges, was formed between the Singapore International
Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to

ancient Greece and Rome. Options are very popular with speculators in the tulip
craze of seventeenth century Holland. Tulips, the brightly colored flowers, were a
symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch
growers and dealers traded in tulip bulb options. There was so much speculation
that people even mortgaged their homes and businesses. These speculators were
wiped out when the tulip craze collapsed in 1637 as there was no mechanism to
guarantee the performance of the option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the counter.
Agricultural commodities options were traded in the nineteenth century in
England and the US. Options on shares were available in the US on the over the
counter (OTC) market only until 1973 without much knowledge of valuation. A
group of firms known as Put and Call brokers and Dealers’ Association was set up
in early 1900’s to provide a mechanism for bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE)

was set up at CBOT for the purpose of trading stock options. It was in 1973 again
that black, Merton, and Scholes invented the famous Black-Scholes Option
Formula. This model helped in assessing the fair price of an option which led to
an increased interest in trading of options. With the options markets becoming
increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia
Stock Exchange (PHLX) began trading in options in 1975.

The market for futures and options grew at a rapid pace in the
eighties and nineties. The collapse of the Bretton Woods regime of fixed parties
and the introduction of floating rates for currencies in the international financial

21
 markets paved the way for development of a number of financial derivatives
which served as effective risk management tools to cope with market
uncertainties.

The CBOT and the CME are two largest financial exchanges in the
world on which futures contracts are traded. The CBOT now offers 48 futures and
option contracts (with the annual volume at more than 211 million in 2001).The
CBOE is the largest exchange for trading stock options. The CBOE trades options
on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange
is the premier exchange for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the NASDAQ 100, and the Nikkei 225. The US indices and
the Nikkei 225 trade almost round the clock. The N225 is also traded on the
Chicago Mercantile Exchange.

1.4 DERIVATIVES IN INDIA :

India has started the innovations in financial markets very late.

Some of the recent developments initiated by the regulatory authorities are very
important in this respect. Futures trading have been permitted in certain
commodity exchanges. Mumbai Stock Exchange has started futures trading in
cottonseed and cotton under the BOOE and under the East India Cotton
Association. Necessary infrastructure has been created by the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock
index futures and the commencement of operations in selected scripts. Liberalised
exchange rate management system has been introduced in the year 1992 for
regulating the flow of foreign exchange. A committee headed by S.S.Tarapore
was constituted to go into the merits of full convertibility on capital accounts. RBI
has initiated measures for freeing the interest rate structure. It has also envisioned
Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank
Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest

22
Rates and Forex. Badla transactions have been banned in all 23 stock exchanges
from July 2001. NSE has started trading in index options based on the NIFTY and
certain Stocks.

A.} EQUITY DERIVATIVES IN INDIA –

In the decade of 1990’s revolutionary changes took place in the institutional

infrastructure in India’s equity market. It has led to wholly new ideas in market
design that has come to dominate the market. These new institutional
arrangements, coupled with the widespread knowledge and orientation towards
equity investment and speculation, have combined to provide an environment
where the equity spot market is now India’s most sophisticated financial market.
One aspect of the sophistication of the equity market is seen in the levels of
market liquidity that are now visible. The market impact cost of doing program
trades of Rs.5 million at the NIFTY index is around 0.2%. This state of liquidity
on the equity spot market does well for the market efficiency, which will be
observed if the index futures market when trading commences. India’s equity spot
market is dominated by a new practice called ‘Futures – Style settlement’ or
account period settlement. In its present scene, trades on the largest stock
exchange (NSE) are netted from Wednesday morning till Tuesday evening, and
only the net open position as of Tuesday evening is settled. The future style
settlement has proved to be an ideal launching pad for the skills that are required
for futures trading.

Stock trading is widely prevalent in India, hence it seems easy to think that
derivatives based on individual securities could be very important. The index is
the counter piece of portfolio analysis in modern financial economies. Index
fluctuations affect all portfolios. The index is much harder to manipulate. This is
particularly important given the weaknesses of Law Enforcement in India, which
have made numerous manipulative episodes possible. The market capitalisation of
the NSE-50 index is Rs.2.6 trillion. This is six times larger than the market
capitalisation of the largest stock and 500 times larger than stocks such as Sterlite,

23
 BPL and Videocon. If market manipulation is used to artificially obtain 10%
move in the price of a stock with a 10% weight in the NIFTY, this yields a 1% in
the NIFTY. Cash settlements, which is universally used with index derivatives,
also helps in terms of reducing the vulnerability to market manipulation, in so far
as the ‘short-squeeze’ is not a problem. Thus, index derivatives are inherently less
vulnerable to market manipulation.

A good index is a sound trade of between diversification and liquidity. In India the
traditional index- the BSE – sensitive index was created by a committee of
stockbrokers in 1986. It predates a modern understanding of issues in index
construction and recognition of the pivotal role of the market index in modern
finance. The flows of this index and the importance of the market index in modern
finance, motivated the development of the NSE-50 index in late 1995. Many
mutual funds have now adopted the NIFTY as the benchmark for their
performance evaluation efforts. If the stock derivatives have to come about, the
should restricted to the most liquid stocks. Membership in the NSE-50 index
appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly
the most liquid stocks in India.

The choice of Futures vs. Options is often debated. The difference between these
instruments is smaller than, commonly imagined, for a futures position is identical
to an appropriately chosen long call and short put position. Hence, futures position
can always be created once options exist. Individuals or firms can choose to
employ positions where their downside and exposure is capped by using options.
Risk management of the futures clearing is more complex when options are in the
picture. When portfolios contain options, the calculation of initial price requires
greater skill and more powerful computers. The skills required for pricing options
are greater than those required in pricing futures.

B.} COMMODITY DERIVATIVES TRADING IN INDIA –

In India, the futures market for commodities evolved by the setting up of the
“Bombay Cotton Trade Association Ltd.”, in 1875. A separate association by the
24
name "Bombay Cotton Exchange Ltd” was established following widespread
discontent amongst leading cotton mill owners and merchants over the functioning
of the Bombay Cotton Trade Association. With the setting up of the ‘Gujarati
Vyapari Mandali” in 1900, the futures trading in oilseed began. Commodities like
groundnut, castor seed and cotton etc began to be exchanged.

Raw jute and jute goods began to be traded in Calcutta with the establishment of
the “Calcutta Hessian Exchange Ltd.” in 1919. The most notable centres for
existence of futures market for wheat were the Chamber of Commerce at Hapur,
which was established in 1913. Other markets were located at Amritsar, Moga,
Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and
Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad
and Barielly in U.P. The Bullion Futures market began in Bombay in 1990. After
the economic reforms in 1991 and the trade liberalization, the Govt. of India
appointed in June 1993 one more committee on Forward Markets under
Chairmanship of Prof. K.N. Kabra. The Committee recommended that futures
trading be introduced in basmati rice, cotton, raw jute and jute goods, groundnut,
rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed,
copra and soybean, and oils and oilcakes of all of them, rice bran oil, castor oil
and its oilcake, linseed, silver and onions. All over the world commodity trade
forms the major backbone of the economy. In India, trading volumes in the
commodity market have also seen a steady rise - to Rs 5,71,000 crore in FY05
from Rs 1,29,000 crore in FY04. In the current fiscal year, trading volumes in the
commodity market have already crossed Rs 3,50,000 crore in the first four months
of trading. Some of the commodities traded in India include Agricultural
Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute, Rubber,
Spices, Cotton, Precious Metals like Gold & Silver, Base Metals like Iron Ore,
Aluminum, Nickel, Lead, Zinc and Energy Commodities like crude oil, coal.
Commodities form around 50% of the Indian GDP. Though there are no
institutions or banks in commodity exchanges, as yet, the market for commodities
is bigger than the market for securities. Commodities market is estimated to be
around Rs 44,00,000 Crores in future. Assuming a future trading multiple is about

25
 4 times the physical market, in many countries it is much higher at around 10
times.

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA :

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew
the prohibition on options in securities. The market for derivatives, however, did not
take off, as there was no regulatory framework to govern trading of derivatives. SEBI
set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on
November 18, 1996 to develop appropriate regulatory framework for derivatives
trading in India. The committee submitted its report on March 17, 1998 prescribing
necessary pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‘securities’ so that
regulatory framework applicable to trading of ‘securities’ could also govern trading of
securities. SEBI also set up a group in June 1998 under the Chairmanship of
Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in
India. The report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker net
worth, deposit requirement and real–time monitoring requirements. The Securities
Contract Regulation Act (SCRA) was amended in December 1999 to include
derivatives within the ambit of ‘securities’ and the regulatory framework was
developed for governing derivatives trading. The act also made it clear that
derivatives shall be legal and valid only if such contracts are traded on a recognized
stock exchange, thus precluding OTC derivatives. The government also rescinded in
March 2000, the three decade old notification, which prohibited forward trading in
securities. Derivatives trading commenced in India in June 2000 after SEBI granted
the final approval to this effect in May 2001. SEBI permitted the derivative segments
of two stock exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts. To begin with,
SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–
30 (Sense) index. This was followed by approval for trading in options based on these
two indexes and options on individual securities.

26
 The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001. The derivatives trading on
NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The
trading in index options commenced on June 4, 2001 and trading in options on
individual securities commenced on July 2, 2001. Single stock futures were
launched on November 9, 2001. The index futures and options contract on NSE
are based on S&P CNX Trading and settlement in derivative contracts is done in
accordance with the rules, byelaws, and regulations of the respective exchanges
and their clearing house/corporation duly approved by SEBI and notified in the
official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all
Exchange traded derivative products.

The following are some observations based on the trading statistics provided in
the NSE report on the futures and options (F&O):

 Single-stock futures continue to account for a sizable proportion of the F&O segment.
It constituted 70 per cent of the total turnover during June 2002. A primary reason
attributed to this phenomenon is that traders are comfortable with single-stock futures
than equity options, as the former closely resembles the erstwhile badla system.
 On relative terms, volumes in the index options segment continues to remain poor.
This may be due to the low volatility of the spot index. Typically, options are
considered more valuable when the volatility of the underlying (in this case, the
index) is high. A related issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility leads to higher
waiting time for round-trips.

 Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in
January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the
traders are increasingly becoming pessimistic on the market.

27
 Farther month futures contracts are still not actively traded. Trading in equity options
on most stocks for even the next month was non-existent.
 Daily option price variations suggest that traders use the F&O segment as a less risky
alternative (read substitute) to generate profits from the stock price movements. The
fact that the option premiums tail intra-day stock prices is evidence to this. If calls and
puts are not looked as just substitutes for spot trading, the intra-day stock price
variations should not have a one-to-one impact on the option premiums.

FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES :

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the
financial theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects having
value maybe commodities, local currency or foreign currencies. The concept of
price is clear to almost everybody when we discuss commodities. There is a price
to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays
for use of a unit of another person’s money is called interest rate. And the price
one pays in one’s own currency for a unit of another currency is called as an
exchange rate.

Prices are generally determined by market forces. In a market, consumers have

‘demand’ and producers or suppliers have ‘supply’, and the collective interaction
of demand and supply in the market determines the price. These factors are
constantly interacting in the market causing changes in the price over a short

28
period of time. Such changes in the price is known as ‘price volatility’. This has
three factors : the speed of price changes, the frequency of price changes and the
magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,
producing firms and governments to significant risks. The break down of the
BRETTON WOODS agreement brought and end to the stabilising role of fixed
exchange rates and the gold convertibility of the dollars. The globalisation of the
markets and rapid industrialisation of many underdeveloped countries brought a
new scale and dimension to the markets. Nations that were poor suddenly became
a major source of supply of goods. The Mexican crisis in the south east-Asian
currency crisis of 1990’s have also brought the price volatility factor on the
surface. The advent of telecommunication and data processing bought information
very quickly to the markets. Information which would have taken months to
impact the market earlier can now be obtained in matter of moments. Even equity
holders are exposed to price risk of corporate share fluctuates rapidly.

These 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.

B.} GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic concerns ; what happened
in other part of the world was mostly irrelevant. Now globalisation has increased
the size of markets and as greatly enhanced competition .it has benefited
consumers who cannot obtain better quality goods at a lower cost. It has also
exposed the modern business to significant risks and, in many cases, led to cut
profit margins

29
 In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis-à-vis depreciated currencies. Export of certain
goods from India declined because of this crisis. Steel industry in 1998 suffered its
worst set back due to cheap import of steel from south east asian countries.
Suddenly blue chip companies had turned in to red. The fear of china devaluing
its currency created instability in Indian exports. Thus, it is evident that
globalisation of industrial and financial activities necessitiates use of derivatives
to guard against future losses. This factor alone has contributed to the growth of
derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed
processors, network systems and enhanced method of data entry. Closely related
to advances in computer technology are advances in telecommunications.
Improvement in communications allow for instantaneous worldwide conferencing,
Data transmission by satellite. At the same time there were significant advances in
software programmes without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of information
and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a

whole resources are rapidly relocated to more productive use and better
rationed overtime the greater price volatility exposes producers and consumers
to greater price risk. The effect of this risk can easily destroy a business which is
otherwise well managed. Derivatives can help a firm manage the price risk
inherent in a market economy. To the extent the technological developments
increase volatility, derivatives and risk management products become that much
more important.

30
D.} ADVANCES IN FINANCIAL THEORIES –
Advances in financial theories gave birth to derivatives. Initially forward contracts in
its traditional form, was the only hedging tool available. Option pricing models
developed by Black and Scholes in 1973 were used to determine prices of call and
put options. In late 1970’s, work of Lewis Edeington extended the early work of
Johnson and started the hedging of financial price risks with financial futures. The
work of economic theorists gave rise to new products for risk management which led
to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives
instruments.

PARTICIPANTS IN THE DERIVATIVES MARKET :

The participants in the derivatives market are as follows:

A.} TRADING PARTICIPANTS :

1.] HEDGERS –

The process of managing the risk or risk management is called as

hedging. Hedgers are those individuals or firms who manage their risk with the

31
help of derivative products. Hedging does not mean maximising of return. The
main purpose for hedging is to reduce the volatility of a portfolio by reducing the
risk.

2.] SPECULATORS –

Speculators do not have any position on which they enter into

futures and options Market i.e., they take the positions in the futures market
without having position in the underlying cash market. They only have a
particular view about future price of a commodity, shares, stock index, interest
rates or currency. They consider various factors like demand and supply, market
positions, open interests, economic fundamentals, international events, etc. to
make predictions. They take risk in turn from high returns. Speculators are
essential in all markets – commodities, equity, interest rates and currency. They
help in providing the market the much desired volume and liquidity.

3.] ARBITRAGEURS –

Arbitrage is the simultaneous purchase and sale of the same

underlying in two different markets in an attempt to make profit from price
discrepancies between the two markets. Arbitrage involves activity on several
different instruments or assets simultaneously to take advantage of price
distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world. It is

the mechanism that keeps prices of futures contracts aligned properly with prices
of underlying assets. The objective is simply to make profits without risk, but the
complexity of arbitrage activity is such that it is reserved to particularly well-
informed and experienced professional traders, equipped with powerful
calculating and data processing tools. Arbitrage may not be as easy and costless as
presumed.

32
B.} INTERMEDIARY PARTICIPANTS :

4.] BROKERS –

For any purchase and sale, brokers perform an important function of bringing
buyers and sellers together. As a member in any futures exchanges, may be any
commodity or finance, one need not be a speculator, arbitrageur or hedger. By
virtue of a member of a commodity or financial futures exchange one get a right
to transact with other members of the same exchange. This transaction can be in
the pit of the trading hall or on online computer terminal. All persons hedging
their transaction exposures or speculating on price movement, need not be and for
that matter cannot be members of futures or options exchange. A non-member has
to deal in futures exchange through member only. This provides a member the
role of a broker. His existence as a broker takes the benefits of the futures and
options exchange to the entire economy all transactions are done in the name of
the member who is also responsible for final settlement and delivery. This activity
of a member is price risk free because he is not taking any position in his account,
but his other risk is clients default risk. He cannot default in his obligation to the
clearing house, even if client defaults. So, this risk premium is also inbuilt in
brokerage recharges. More and more involvement of non-members in hedging and
speculation in futures and options market will increase brokerage business for
member and more volume in turn reduces the brokerage. Thus more and more
participation of traders other than members gives liquidity and depth to the futures
and options market. Members can attract involvement of other by providing
efficient services at a reasonable cost. In the absence of well functioning broking
houses, the futures exchange can only function as a club.

5.] MARKET MAKERS AND JOBBERS –

Even in organised futures exchange, every deal cannot get the

counter party immediately. It is here the jobber or market maker plays his role.
They are the members of the exchange who takes the purchase or sale by other
members in their books and then square off on the same day or the next day. They

33
quote their bid-ask rate regularly. The difference between bid and ask is known as
bid-ask spread. When volatility in price is more, the spread increases since jobbers
price risk increases. In less volatile market, it is less. Generally, jobbers carry
limited risk. Even by incurring loss, they square off their position as early as
possible. Since they decide the market price considering the demand and supply of
the commodity or asset, they are also known as market makers. Their role is more
important in the exchange where outcry system of trading is present. A buyer or
seller of a particular futures or option contract can approach that particular jobbing
counter and quotes for executing deals. In automated screen based trading best
buy and sell rates are displayed on screen, so the role of jobber to some extent. In
any case, jobbers provide liquidity and volume to any futures and option market.

C.} INSTITUTIONAL FRAMEWORK :

6.] EXCHANGE –

Exchange provides buyers and sellers of futures and option

contract necessary infrastructure to trade. In outcry system, exchange has trading
pit where members and their representatives assemble during a fixed trading
period and execute transactions. In online trading system, exchange provide
access to members and make available real time information online and also allow
them to execute their orders. For derivative market to be successful exchange
plays a very important role, there may be separate exchange for financial
instruments and commodities or common exchange for both commodities and
financial assets.

7.] CLEARING HOUSE –

A clearing house performs clearing of transactions executed in futures and option

exchanges. Clearing house may be a separate company or it can be a division of
exchange. It guarantees the performance of the contracts and for this purpose
clearing house becomes counter party to each contract. Transactions are between

34
members and clearing house. Clearing house ensures solvency of the members by
putting various limits on him. Further, clearing house devises a good managing
system to ensure performance of contract even in volatile market. This provides
confidence of people in futures and option exchange. Therefore, it is an important
institution for futures and option market.

8.] CUSTODIAN / WARE HOUSE –

Futures and options contracts do not generally result into delivery but there has to
be smooth and standard delivery mechanism to ensure proper functioning of
market. In stock index futures and options which are cash settled contracts, the
issue of delivery may not arise, but it would be there in stock futures or options,
commodity futures and options and interest rates futures. In the absence of proper
custodian or warehouse mechanism, delivery of financial assets and commodities
will be a cumbersome task and futures prices will not reflect the equilibrium price
for convergence of cash price and futures price on maturity, custodian and
warehouse are very relevant.

9.] BANK FOR FUND MOVEMENTS –

Futures and options contracts are daily settled for which large fund movement
from members to clearing house and back is necessary. This can be smoothly
handled if a bank works in association with a clearing house. Bank can make daily
accounting entries in the accounts of members and facilitate daily settlement a
routine affair. This also reduces a possibility of any fraud or misappropriation of
fund by any market intermediary.

10.] REGULATORY FRAMEWORK –

A regulator creates confidence in the market besides providing

Level playing field to all concerned, for foreign exchange and money market, RBI
is the regulatory authority so it can take initiative in starting futures and options
trade in currency and interest rates. For capital market, SEBI is playing a lead
role, along with physical market in stocks, it will also regulate the stock index
35
 futures to be started very soon in India. The approach and outlook of regulator
directly affects the strength and volume in the market. For commodities, Forward
Market Commission is working for settling up national National Commodity
Exchange.

3.2 ROLE OF DERIVATIVES :

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –

Futures and options contract can be used for altering the risk of
investing in spot market. For instance, consider an investor who owns an asset. He
will always be worried that the price may fall before he can sell the asset. He can
protect himself by selling a futures contract, or by buying a Put option. If the spot
price falls, the short hedgers will gain in the futures market, as you will see later.
This will help offset their losses in the spot market. Similarly, if the spot price
falls below the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A

person who wants to reduce risk, can transfer some of that risk to a person who
wants to take more risk. Consider a risk-averse individual. He can obviously
reduce risk by hedging. When he does so, the opposite position in the market may
be taken by a speculator who wishes to take more risk. Since people can alter their
risk exposure using futures and options, derivatives markets help in the raising of
capital. As an investor, you can always invest in an asset and then change its risk
to a level that is more acceptable to you by using derivatives.

2.] PRICE DISCOVERY –

Price discovery refers to the markets ability to determine true

equilibrium prices. Futures prices are believed to contain information about future

36
spot prices and help in disseminating such information. As we have seen, futures
markets provide a low cost trading mechanism. Thus information pertaining to
supply and demand easily percolates into such markets. Accurate prices are
essential for ensuring the correct allocation of resources in a free market economy.
Options markets provide information about the volatility or risk of the underlying
asset.

3.] OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower

transaction costs. Secondly, they offer greater liquidity. Large spot transactions
can often lead to significant price changes. However, futures markets tend to be
more liquid than spot markets, because herein you can take large positions by
depositing relatively small margins. Consequently, a large position in derivatives
markets is relatively easier to take and has less of a price impact as opposed to a
transaction of the same magnitude in the spot market. Finally, it is easier to take a
short position in derivatives markets than it is to sell short in spot markets.

4.] MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot,

futures and options markets are inextricably linked. Since it is easier and cheaper
to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and
to keep prices in alignment. Hence these markets help to ensure that prices reflect
true values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative

to engaging in spot transactions. Also, the amount of capital required to take a
comparable position is less in this case. This is important because facilitation of
37
 speculation is critical for ensuring free and fair markets. Speculators always take
calculated risks. A speculator will accept a level of risk only if he is convinced
that the associated expected return, is commensurate with the risk that he is
taking.

HOW BANKS USE DERIVATIVES :

ASSET LIABILITY MANAGEMENT -

Banks have traditionally taken deposits from their customers and put those
deposits to work as loans. Because the deposits and the loans are dominated in the
same currency, this activity has no associated foreign exchange risk. But it does
limit banks to lending to customers which need to borrow in the currencies which
the banks have available on deposits.

If a bank is asked to lend to a customer in a currency other than one of those it has
on deposits it creates a currency exposure for the bank. Suppose a customer wants
to borrow EUROS from a US Bank for 5 years and that the US bank has no
natural source of EUROS. It is possible for the banks to cover this exposure in the
forward market by selling EUROS forwards and buying US dollars. The
transaction costs associated with this, in particular the bid / offer spread in the
medium term foreign exchange forward market, would make the resultant cost of
the loan prohibitively expensive for the borrower.

Currency swaps provide an economic alternative to this problem for banks. In

order to cover the exposure created by a loan to a customer in EUROS funded by
a bank’s deposit in US dollar, a bank could receive fixed rate US dollars in a
currency swap and pay fixed rate EUROS.

38
One of the consequences of the development of the currency swap market is that
banks now often make much more competitive medium term forward foreign
exchange prices than they used to. Most banks quote forward foreign exchange
and currency swap prices from the same desk and increases liquidity in the latter
has improved liquidity in the former. Banks therefore, need no longer restrict
their lending activities to the currencies in which they have natural deposits. They
are free to fund themselves in the most competitively priced currency and to lend
to their customers in the currency of the customer’s preference, using a currency
swap as an asset and liability matching tool

The “Normal yield curve”, reflects that it is much easier for banks to borrow at the
short end of the curve than the long end. This means that banks can fund
themselves much more effectively in the inter bank market in maturities such as
the overnight, tom / next (overnight from tomorrow, or tomorrow to the next day),
spot / next, one week, one month, three months and six months than they can in
maturities such as five years or 20 years.

With the development of the swaps market it is possible for banks to satisfy their
customers demands for fixed rate funding while ensuring that the banks assets and
liabilities are matched. Suppose a bank has a customer who needs 5 years fixed
rate funds. Let us say that the bank finances in this loan in the interbank market at
3 month LIBOR. The bank now has a 3 month liability and a 5 year asset (Figure
1).

39
The bank is short floating rate interest at 3 month LIBOR and long fixed rate interest
at the rate at which it lends to its customer. This is called the asset liability mismatch.
So in order to hedge its position the banks needs to match its exposure to 3 month
LIBOR by receiving on a floating rate basis in an interest rate swap, and match its
exposure on a fixed rate basis by paying a fixed rate in a interest rate swap. This is a
hedge which is ideally suited to an interest rate swap which the bank receives a
floating rare of interest and pays a fixed rare (Figure 2).

This structure has the benefit for the bank that it eliminates the bank’s exposure to
interest rate risk. The bank can no longer profit from a fall in interest rates but it
cannot lose money on its asset and liability mismatch as a result of an increase in
rates. The bank will make or lose money based on its pricing of the credit risk in
the transaction and its overall loan exposure rather than on its ability to forecast
interest rates. Hence the interest rate swaps provide banks with an opportunity to
change their risks from interest rate to credit.

40
41
Chapter - 3 Hedging strategies Using Futures
Today, the corporate units operate in a complex business environment. Managers
often find that the profitability of their organisation heavily depend upon on such
factors which are beyond their control. Important among these are external influences
like commodity prices, stock prices, interest rate, exchange rate, etc.

As a result, modern business has become more Complex, uncertain and risky. So, it is
essential for the executives of the forms to control such uncertainty and rest so that
the business can run successfully. Important function of futures market is to permit
managers to reduce or control dress by transferring it to others who are willing to bear
the risk. In other words, futures market can provide the managers certain tools to
reduce and control their price risks. So the activity of trading features with the
objective of reducing or controlling risk is called hedging.

In this chapter, we will discuss the nature of hedging, fundamental of hedging and
how futures Hedges can be tailored to the need of the hedger. In other words, we will
consider the different issues associated with the way the headers are set up. When is a
short future position appropriate? When is long features position appropriate? Which
futures contract should be used? Optimal size of the features position appropriate?

Example 1 Firm A is a manufacturer of automobile cars of different edition. A

requires of automobile parts which imports from USA. A is of the view that the prices
of imported parts will increase in future thereby increasing the cost of cars, which
effect on the profit profile of this firm. There is a considerable risk that prices will
raise in future. Frequently the firm wants to avoid such risk which Aform increasing
the price of imported parts. He wants to head this race in future by entering into
derivatives market today for futures prices of the imported parts and can held the risk
which he bears.

Basic Strategies Using Futures While the use of short and long hedges can reduce (or
eliminate in some cases - as below) both downside and upside risk. The reduction of
upside risk is certainly a limitation of using futures to hedge.

42
Short Hedges

A short hedge is one where a short position is taken on a futures contract. It is

typically appropriate for a hedger to use when an asset is expected to be sold in the
future. Alternatively, it can be used by a speculator who anticipates that the price of a
contract will decrease. 1. For example, assume a cattle rancher plans to sell a pen of
feeder cattle in March based on the spot prices at that time. The rancher can hedge in
the following manner. Currently,

• A March futures contract is purchases for a price of $150

• For simplicity, assume the rancher antipates (and does sell) selling

50,000 pounds (1 contract)

• Spot prices are currently $155

• What happens when the spot price is March decreases to $140?

– Rancher loses $10 per 100 pounds on the sale from the decreased

price

– Rancher gains $10 by selling the futures contract for $150 and

immediately buying (to close out) for $140

– Effective price of the sale is $150

• What happens when the spot price is March increases to $160?

– Rancher gains $10 per 100 pounds on the sale from the increased

price

– Rancher loses $10 by buying the futures contract for $150 and

immediately selling (to close out) for $160

– Effective price of the sale is $150

• The seller has effectively locked in on the price prior to the sale by

offsetting gains/losses

43
2. Now assume the same for a speculator who takes a short position on a

March futures contract at $150

• If the price falls to $140, the speculator sells for $150 and immediately

buys for $140, leading to a gain of $10 per 100 pounds [$5,000 gain

in value for one contract]

• If the price increases to $160, the speculator loses $5,000

Example of Short Future Hedge using Call option

Long Hedges

A long hedge is one where a long position is taken on a futures contract. It is

typically appropriate for a hedger to use when an asset is expected to be bought

in the future. Alternatively, it can be used by a speculator who anticipates that

the price of a contract will increase.

1. For example, assume an oil producer plans on purchasing 2,000 barrels of

crude oil in August for a price equal to the spot price at the time. The

44
producer can hedge in the following manner by using crude oil futures

from the NYMEX. Currently,

• An August oil futures contract is purchases for a price of $59 per

barrel

• Spot prices are currently $60

• What happens when the spot price in August decreases to $55?

– Producer gains $4 per barrel on the purchase from the decreased

price

– Producer loses $4 by buying the futures contract for $59 and

immediately selling (to close out) for $55

– Effective price of the sale is $59

• What happens when the spot price in August increases to $65?

– Producer loses $6 per barrel on the purchase from the increased

price

– Producer gains $6 by selling the futures contract for $59 and

immediately buying (to close out) for $65

– Effective price of the sale is $59

• The producer has effectively locked in on the price prior to the sale

by offsetting gains/losses

2. Now assume the same for a speculator who takes a long position on a

March futures contract at $59

• If the price increases to $65, the speculator sells for $59 and immediately buys for
$65, leading to a gain of $6 per barrel [$12,000 gain

in value for five contracts]

• If the price increases to $55, the speculator loses $12,000

45
Example of long future hedge using put option

Basis Risk

In practice, hedges are often not as straightforward as has been assumed in this

course due to the following reasons

1. The asset to be hedged might not be exactly the same as the asset underlying the
futures contract

• actual commodity, weight, quality, or amount might differ

2. The hedger might not be exactly certain of the when the asset will be

bought or sold

3. Futures contract might need to be closed out before its delivery month

• many commodities do not have 12 deliery months

Basis is the difference between the cash price for the asset to be hedged and

the futures price. If the hedged asset is identical to the commodity underlying

the futures contract, the cash price and futures price should converge as delivery

nears. Changes in basis price do not impact the futures contract but do impact

46
the sales price for the producted to be hedged.

Cross-Hedging

In the case when an asset is looking to be hedged and there is not an exact

replication in the futures/options market, cross hedging can be employed.

For example, if an airline is concerned with hedging against the price of jet

fuel, but jet fuel futures are not actively traded, they might consider the use ofheating
oil futures contracts.

• Hedge ratio - The ratio of the size of a position in a hedging instrument

to the size of the position being hedged.

– When an asset to be hedged is exactly the same as the asset underlying the futures
contract, the hedge ratio is equal to 1.0

– The existence of basis risk often prevents this from happening

– It is not always optimal to cross hedge (not is it usually possible) to

hedge such that the hedge ratio equals 1.0

Trading Strategies Involving Options

• A long position in a futures contract plus a short position in a call option

(covered call) (a)

The long position “covers” the investor from the payoff on writing the short

call that becomes necessary if prices increase. Downside risk remains if

prices drop.

• A short position in a futures contract plus a long postiion in a call option (b)

47
• A long position in a futures contract plus a long position in a put option

(protective put) (c)

• A short position in a put option witha short position in a futures contract (d)

48
Chapter - 4 Options Hedging & Strategies
Basically, whether it is future or option whenever we sell a future or an option and
against that we buy a future or option it is called as hedging, but when it comes to
hedging of options there are plenty options of how to hedge & every hedge can give a
give different meaning on the basis of the view for underlying. These views are also
referred as option strategies in the market. Some of those are:-

• Bull Spreads - Long and Short positions on a call option where strike

price is higher on the short position (K2 > K1).

– Investor collects when prices increase somewhere between K1 and K2

– This strategy limits the investor’s upside and downside risk

– In return for giving up some upside risk, the investor sells a call

option

– Both options have the same expiration date

– The value of the option sold is always less than the value of

the option bought Note: Recall, a call price always decreases as

the strike price increases

– There are three types of bull spreads:

1. Both calls are initially out of the money (lowest cost, most aggressive)

2. Only One call is initially in the money

3. Both calls are initially in the money (highest cost, most conservative)

49
Bull Call Spread

Bull Put Spread

50
• Bear Spreads - An investor hoping that the price will decline may benefit

from a bear spread. Basic strategy is to buy and put with strike price (K1)

and sell another put with strike price (K2), where K1 > K2.

– In contrast, the strike price of the purchased put will cost more than

the option that is sold.

Bear Call Spread

Bear Put Spread

51
Combinations

• Straddle - Involves buying a call and put with the same strike price and

Expiration date

– The bundle leads to a loss when the price is close to the strike price

– The bundle leads to a gain when the price moves sufficiently in either

Direction

Short Straddle

Long Straddle

52
Strangles - A put and a call with the same expiration date and different

strike prices, with put strike price K1 and a call strike price K2, where

K2 > K1.

– Similar shape compared to straddle, however prices need to deviate

more in a strangle in order for gains to be found

– The farther apart the strike prices, the less the downside risk and the

farther the price has to move for a gain to be realized

Long Strangle

Short Strangle

53
Iron Butterfly Option

Definition: The Iron Butterfly Option strategy, also called Iron fly, is a combination
of four different kinds of option contracts, which together make one bull Call spread
and bear Put spread.

Together these spreads make a range to earn some profit with limited loss. Ironfly
belongs to the ‘wingspread’ options strategy group, which is defined as a limited risk
strategy with potential to earn limited profit. The strategy is considered when the
future outlook of a security is neutral, and there is low volatility in the market.

The user of the strategy combines four option contracts with three different strike
prices of the same expiry date, wherein he buys/sells higher strike price Put/Call
options along with lower strike price Call/Put options, both of which are out-of-the-
money, and also buys/sells another set of at-the-money Call/Put options at the middle
strike price.

Thus, an iron butterfly option strategy involves the following:

1)Buying and selling of Call/Put options (Bull Call spread& Bear Put spread
combination)

2)All options have the same underlying asset with same expiry date/expiration

3)It involves combining four option contracts

4)It involves three different strike prices; higher, middle and lower, where the
difference between the middle strike price and the lower strike price or the upper
strike price is the same. Two contracts have the same strike price.

Description: In Iron Butterfly, there is a higher probability of earning profit because

the way it is constructed by combining Calls and Puts or bear Put and bull Call
spread, it becomes different from a classic Butterfly option strategy, where the
strategy involves a combination of either bull spreads or bear spreads. The strategy
gives best result and maximum profit when it is near to expiry and at-the-money,
which means the underlying price is equal to the mid-strike price out of all strike
prices. In this strategy, a butterfly-like image is formed where the Call and Put options

54
of the mid-strike price form the ‘body’ and Call and Put options at higher and lower
strike prices form the ‘wings’.

Example: The Tata Motors stock is trading at Rs 378.10. Now a trader forms a long
iron butterfly strategy by buying one lot of December expiry Put option at a lower
strike price of Rs 360 and one lot of same expiry Call option at a higher strike price at
Rs 400 at values of Rs 1.25 (360 Put) and Rs 1.10 (400 Call) and then sells one lot
each in Call and Put options at same the strike price of Rs 380 for Rs 5.65 (380 Call)
& Rs 7.50 (380 Put).

Now, the trader’s profit at the entry of the trade would be Rs 10.80 = (Rs 5.65+Rs
7.50-(Rs 1.25+Rs 1.10)),

If the strategy fails, the maximum loss will be (Rs 400-Rs 380-Rs 10.80) = Rs 9.20
plus commissions

If Tata Motors trades at the same level of Rs 380 on expiry date in December end,
then the Call option at the higher strike price will expire worthless as out-of-the-
money (Strike price is more than the trading price), while the Put option at the lower
strike price will again expire worthless (strike price is less than trading price) and
there are two sold at-the-money Call and Put options, which expired worthless. So on
expiry, the payout of this strategy will be Rs 10.80 minus the trading costs, which will
be the actual profit/loss.

But if the trader decides to exit the strategy before expiry, when Tata Motors is
trading around Rs 375 in cash market, and the options are trading at Rs 1.5 (360 Put),
Rs 0.9 (400 Call), Rs 7.05 (380 Call) and Rs 6.5 (380 Put), the payout will be:

Call Option (Rs 400) – (Rs 0.9- Rs 1.10) = (-)Rs 0.2 (Loss)

Put Option (Rs 360) – (Rs 1.5- Rs 1.25) = Rs 0.25 (Profit)

Call Option (Rs 380) – (Rs 5.65- Rs 7.05) = (-)Rs 1.40 (Loss)

55
Put Option (Rs 380) – (Rs 7.50- Rs 6.50) = Rs 1 (Profit)

Net Profit & Loss = (-) Rs 0.35 plus commission and exchange taxes so in all loss

There are various risks to this strategy, which include:

1)High implied volatility or prices are very volatile

2)If cash price moves outside the strike price range, that can affect the delta of the
strategy

3)It has a long expiry time, as sentiments in the market can change

4)Out-of-the-money expiry in case of all Calls or Puts or delivery on the expiry date
can work in reverse way for this strategy

5)Higher trading costs, commissions and taxes

56
Long Iron Butterfly: This means buying one Call option at a higher strike price and
Put option at a lower strike price, and simultaneously selling Call and Put options at a
strike price near to cash price or the middle strike price of the same expiry and
underlying asset (index, commodity, currency, interest rates).

The maximum a trader may lose is the (Long Call option strike price – Short put
option strike price – net premium received + taxes paid), when the cash price is
beyond the range of high and low strike prices on expiry. It will generate the
maximum profit when the cash price is equal to middle strike price on the expiry day.
The breakeven points of this strategy are:

Upper Breakeven Point = Strike price short call option (Strike Price + Premium
received)

Lower Breakeven Point = Strike Price short put option (Strike Price - Premium
received)

Long Butter Fly

57
Short Iron Butterfly: This means selling one Call option at a higher strike price and
one Put option at a lower strike price and, simultaneously, buying Call and Put
options at a strike price near to cash price of the same expiry and underlying asset
(index, commodity, currency, interest rates). A trader may lose maximum of premium
paid plus taxes, which will occur when the cash price trades at same level. It will earn
maximum profit when the cash price is beyond the range of lower and higher strike
prices on the expiry day (Profit = (Short Call or Long Put) Strike Price – (Short Put or
Long Call) Strike Price - Premium Paid – Taxes).

The breakeven points of this strategy are:

Upper Breakeven Point = Higher strike price long call/put option (Strike Price -
Premium paid)

Lower Breakeven Point = Lower strike price long call/put option (Strike Price +
Premium paid)

Short Butter Fly

58
Iron Condor

Definition: Iron Condor is a non-directional option strategy, whereby an option trader

combines a Bull Put spread and Bear Call spread to generate profit. In this strategy,
there is a high probability of limited gain. An option trader resorts to this strategy if
he believes that the market is going to be range bound. The maximum profit in an Iron
Condor strategy is equal to the net premium received adjusted for commissions. The
maximum loss occurs when the price of the underlying security is higher than the
strike price of the Long Call or when the price of the underlying security is less than
the strike price of the Long Put.

Description: Iron Condor options involve the use of both Call and Put options to
generate profit for the option trader. In a Call option trade, the two counter-parties
involved are Call Option writer and Call Option buyer. The two parties have counter-
views on the direction of the security price. The Call Option buyer believes that the
price of the underlying security is going to rise while the Call Option writer believes
that the price of the underlying security is going to fall.

Buying an option gives the buyer the right, but not the obligation, to acquire the
security at a fixed price, called the Strike Price, within a certain date called the expiry
date. If the Strike Price is less than the current market price of the underlying security,
then the option is said to have an intrinsic value. This means that the option buyer will
find it worthy to exercise his right. This scenario is also called in the money.

Scenario

1. Trade: Buy a Call

2. Option buyer’s outlook for the underlying security: Bullish

3. Risk: Limited

59
4. Reward: Unlimited

5. Break-even point: Strike price plus premium

Call Option

In a Put Option trade, the counterparties remain the same as Call Option trade. But
their views about the direction of the price of the underlying security change. The Put
Option buyer believes that the price of the security is going to fall while the Put
Option writer believes that the price of the underlying security is going to rise. If the
strike price is more than the current market price of the underlying, then the Put
Option is said to be in the money. This means it has some intrinsic value which
makes it worthy for the Put Option buyer to exercise his right.

Scenario
1. Trade: Buy a Put
2. Option buyer’s outlook for the underlying security: Bearish
3. Risk: Limited
4. Reward: Limited
5. Break-even point: Strike price minus premium

60
 Put Option

Iron Condor option strategy is a limited risk-limited reward option trading strategy
and can be seen as a combination of Bull Put spread and Bear Call spread. In a Bull
Put spread, the option trader sells a Put option and at the same time buys a Put option
at a lower strike price but with the same expiry. In this strategy, both risk and reward
is limited. Increase in volatility typically hurts the option trader.

In a Bear Call Spread, the option trader sells a Call option and at the same time buys
another Call option with a higher strike but with the same expiry. In this strategy, both
risk and reward is limited.

In an Iron Condor option strategy, an option trader sells a Call option while at the
same time buys another Call with a higher strike price. Simultaneously, he buys a Put
option and at the same time buys another Put option at a lower strike price, but both
expiring at the same time. Thus it’s a combination of both Bull Put spread and Bear
Call spread.

In this strategy, the option trader believes that the market is neutral or rangebound.
Both risk and reward in this strategy is limited. The maximum profit is attained when
the stock price is between the strike price of the Short Put and Short Call. Time decay
helps the options trader whereas an increase in volatility hurts position. Two break-
even points are created in an Iron Condor option strategy.

1. Strike price in Short Call plus net premium received

2. Strike price in Short Put minus net premium received

61
The payoff diagram for a Condor options strategy is shown below:

Let us take a scenario

Current market price of stock X: Rs 150

An option trader executes the following trades

1. Writes a Feb 2016 Call option at strike price Rs 160 and receives a premium of Rs
20

2. Buys a Feb 2016 Call option at strike price Rs 165 and earns a premium of Rs 20

3. Sells a Feb 2016 Put option at strike price Rs 140 and receives a premium of Rs 40

4. Buys a Feb 2016 Put option at strike price Rs 130 and earns a premium of Rs 30

The net premium received from the transaction

= 20-20+40-30 = 10

Assuming the stock trades at Rs 150 till the expiry of the option term, the maximum
profit that the trader earns is equal to the premium received from the transaction. In
this case, the maximum profit will be equal to Rs 10.

62
Now assuming that the stock price fell to Rs 130 before expiry, the option trader will
benefit from the trade.

The following are the trading scenarios:

So in the above strategy, there is only one situation where the option is in-the-money
or in other words, has an intrinsic value.

63
Chapter - 5 Option Greeks
In simplest terms, Greeks give traders a theoretical way to judge their exposure to

various options pricing inputs.

Delta – A measure of the rate of change in an options theoretical value for a one-unit

change in the price of the underlying security.

Gamma – A measure of the rate of change in an options delta for a one-unit change
in

the price of the underlying. In other words, the rate of change in delta. Measured

in Delta not dollars

Vega - A measure of the rate of change in an option’s theoretical value for a one-unit

change in implied volatility.

Theta - A measure of the rate of change in an option’s theoretical value for a one-unit

change in time to the option’s expiration date.

Rho - A measure of an option’s theoretical sensitivity to changes in the risk-free

interest rate.

Use of Greeks

Delta

There are 3 common ways traders may use Delta in options trading:

1. It can be used to tell you how much your option contract’s price will change

based on a dollar move in the underlying

2. It can give you share equivalency, i.e. how many shares of the underlying your

option contract is equivalent to

3. It can give you an approximation of the probability that the option contract will

expire in/out of the money

64
Example: A long call with a 50 Delta; should move approximately $0.50 with a $1

move in the underlying (all else being equal):

• This is the equivalent of being long 50 shares of the underlying, and has a 50%

chance of being in/out of the money at expiration

Gamma

Gamma tells you how much the Delta should change based on a $1 move in the

underlying.

Remember, Gamma is measured in Delta!!!

• All other Greeks are measured in dollars. Its “job” is to get the Delta to 0 or 100 at
expiration.

In other words, either the option will be worthless or the equivalent of 100 shares of
the

underlying at expiration.

What does this mean?

• Ex. If your At The Money call contract has 50 Delta & 10 Gamma, and the stock

moves up $1(all else being equal), your option should now have 60 Delta and a

lower Gamma ~7.

The Gamma will decrease in this example because now the Gamma doesn’t have to

work as hard to get Delta to 0 or 100 at expiration!

Theta

Theta tells you how much the option contract’s value should change based

on 1 day’s passage of time.

What does this mean?

65
• Ex. If you have Theta of .05, your option’s price will theoretically lose

~$0.05 of for one day’s time passage, all else being equal

Remember!!! Greeks are not static! $0.05 loss today could be significantly different

next day/week/month. At the Money options experience non-linear time decay,

and it’s decay accelerates around the last 30-45 days of the contract’s life!

Vega

Vega tells you how much the option contract’s value should change based on 1

percentage point change in Implied Volatility.

What does this mean?

• Ex. If you have Vega of .05, your option’s price should gain or lose $0.05 for a 1%

change in Implied Volatility, all else being equal.

Remember!!! Implied Volatility is the “X factor” in options pricing. If there is more

demand for an

option, IV should increase and therefore so will the option’s prices. If there is less
demand for

an option, IV should decrease and thus the options prices should decrease as well.
Again,

remember a change in IV should directly affect the options price, but it will also
impact all of

the Greeks.

Rho

Rho tells you how much the option contract’s value should change based on

1 percentage point change in Interest Rates.

66
What does this mean?

• Ex. If you have Rho of .10, your option’s price should gain or lose $0.10

for a 1% change in interest rates, all else being equal

Remember!!! Interest rates can move gradually, i.e. 0.25% per quarter, meaning that

it would take a full year of 0.25% rises to equal 1%. This is why LEAP option

traders are generally the most concerned with Rho.

It is important to understand that the Greeks do not work in a

vacuum. They are constantly changing, and a change in one

can affect all the other Greeks!

How can the Greeks help me plan a trade?

• The Greeks give you a way to measure the theoretical exposure of

an option or option strategy to the various risks it is exposed to.

Not only do Greeks help you understand these risks but they can

help you to tailor a trade to your outlook.

Example:

• You want to minimize your exposure to directional movement.

67
• What do you do?

How can the Greeks help me plan a trade?

Answer:

• You may consider using the Greek Delta to plan a trade with as close

to Zero Delta as possible.

• It can be very difficult, or even impossible, to completely neutralize

some exposures, but the Greeks can help you measure how much

theoretical exposure you will have.

How can the Greeks help me manage a trade?

• You can use the Greeks to help assess your theoretical exposure.

• If we continue with our last example, as time goes by we can see how

our directional exposure has changed by looking at what our Delta

has become. We can use that information to help you determine if

you may want to consider adjusting the trade(and therefore the

Delta), or leave it alone.

Let’s look at our previous example after the passage of some

time.

How can the Greeks help me manage a trade?

Original Delta Exposure:

68
You started with Positive 4.478 Delta, and now you are Negative 51.922 Delta!

Is this still a trade you want to be in?

Greeks

In Summary:

• The Greeks can help you examine your exposure to various option’s

centric risks.

• Greeks are dynamic and constantly changing.

• Greeks can help you plan your trades to take advantage of, or

avoid/minimize, the effects of these risks.

• Greeks can help you manage your trades by showing how the trade’s

various exposures have changed regarding:

• Time (Theta)

• Price (Delta/Gamma)

• Volatility (Vega)

• Interest Rates (Rho)

69
Chapter – 6 Simulations
So far what I have learnt on that basis I have used option strategy “Iron Condor” and
learned adjustments for the strategy I have made simple rules for the strategy in which
a capital of 4 lacs is used the maximum risk taken per trade is 15 thousand approx. but
we will exit it whenever MTM losses touches 2000, more rules are as follows:

1. Enter on every Tuesday at 3:20 PM

2. Don't take trade if Wednesday is a holiday, if, make it below 0.10 delta
3. All the mentioned will be as it as when the expiry is on Wednesday
4. Always choose CE strike with 0.20 or less delta
5. Choose PE strike equal to or slightly less than the premium of CE option
6. Always hedge on both sides
7. EXIT, whenever losses cross 2000 and done for the day even if it's Thursday
8. In the above mentioned case take trade next day(Thursday) at 9:30 on strikes
have delta 0.20 or less
9. Exit all the legs at 2 O’clock or put trailing SL (Better to exit either in
minimum profit or loss)
10. Put Trailing SL after 2500 on Expiry day
11. Don't adjust after 12:30 on Thursday
12. Exit all legs if there's 70% decay before expiry
13. If it's holiday on Tuesday, don’t take trade on Monday

With the mentioned rules the strategy is used upon past one year’s data and
following are the results:

70
71
72
Other Requirements:

Explanation:

Risk Reward:This strategy is called Iron condor, the capital requirement is 4 lac
and maximum risk we will take is 2% of capital that is 8 thousand, though
whenever we will enter the trade the risk will be higher that is approx. 15thousand
but whenever the MTM swings comes to 2 thousand we will exit all the legs and
our monthly target is 8000 which makes 2000thousand as our weekly target.

Strike Selection:We will enter is strategy on Tuesdays at 3:20PM by selling a

higher premium call & put and buying a lower premium call & put for hedging
and margin requirement purposes, Call strike selection will be based on delta, we
will look a strike with 0.20 blow delta. This is basically how much risk you want
to take, if you wish for higher profit one can go with higher deltas as well but this
will not only increase the profit but losses also.

For Put option, we will sell the strike with premium less than equal to the
premium of the of Call sold and will hedge it with lower strike.

73
Adjustments: Whenever the premium of any side that CE/PE becomes nearly half we
have to book the winning position and again enter that side with less than equal to
premium of the other side, in put option always re-entre with less premium compared
to call premium.

Result: As tested from this strategy for almost last one year the max one-day loss
which we saw is 4,025 Rupees and the and on monthly basis it is 4023 whereas the
max one day & one-month profit is 5951 & 17919 respectively which is an
overall22.10%gross return.

74
Chapter – 7 Taxation of Derivatives in India
Tax treatment of derivative since, there is no transfer or delivery of the underlying
asset in case of futures, the income or loss from it cannot be taxed under the head
“capital gains. Therefore, depending upon the fact whether the assesse is a trader or an
investor, the head of income — that is, income from business and profession or
income from other sources (IFOS) — will be determined, but in either case the
income will be taxed on net basis at the rates of tax applicable to the assesse. The
option premium is an income for the writer of the option and a tax-deductible expense
in the hands of the buyer of the option. In case of a trader, the taxability of the gains
on exercise of the option is akin to that in the case of futures trading.

However, in case of an investor, since there is an extinguishment of a right, ”the gain

there from will be treated as a capital gain, rather than an IFOS, and the premium will
be allowed as the cost of acquisition. Open interest refers to a situation, wherein on
the date of the financial year end, there are outstanding derivatives contracts in the
hands of the market participants. Since, under the prudent accounting principles,
derivatives contracts are marked-to-market (MTM), there can be unrealised MTM
gains or losses prevailing as on March 31. Whether the assesse will be liable to tax on
the gains or take the benefit of the losses in such a case.

Only real income/loss attracts tax provisions and not the notional gains/losses.
However, in certain judicial decisions notional losses have also been allowed as a
deductible expense. Nevertheless, this is one area which can attract litigated exercise.

With the insertion of Section 43(5)(d), eligible transactions on notified stock

exchanges have been rendered non-speculative in nature. So far only BSE, NSE and
MCX-SX have been notified for this purpose. Therefore, trading in commodity and
equity derivatives traded on stock exchanges other than those mentioned above, is still
treated as speculative, the loss where from cannot be adjusted against any other
sources of income.

CALCULATION OF TURNOVER OF DERIVATIVE

75
For every trade, contract notes are issued which show the value of derivative bought
or sold. While for the recording purpose only the difference between is used. Take
this example:

Mr. A bought one lot of XYZ Ltd at 4 lakhs and sold it for 4.8 lakhs (Profit = Rs
80,000)

Mr. A bought one lot of ABC Ltd at 3.5 lakhs and sold it for 3 lakhs (Loss= Rs
50,000).

The turnover shall be calculated as Rs 80,000 + Rs 50,000 = Rs. 1.30 lakhs. Also, any
premium received when you’re writing an option must be added to the turnover value.

When Tax audit mandatory for Derivative Transactions (F&O

Trading)

An audit is required if you have a business income and if your business turnover is
more than Rs 1 crores. Audit is also required as per section 44AD in cases where
turnover is less than Rs. 2 Crores but profits are lesser than 8% (6%, if all trades are
digital) of the turnover and total income is above minimum exemption limit.

Therefore, the applicability of tax audit will be as follows in case of F&O

Trading:

In case of Profit from transactions of F&O Trading:

 In the case of profit from derivative transactions, tax audit will be applicable if
the turnover from such trading exceeds Rs. 1 crore.
 Tax audit u/s 44AB row’s. 44AD will also be applicable, if the net profit from
such transactions is less than 8% (6%, if all trades are digital) of the turnover
from such transactions.

In case of Loss from F&O Trading:

76
 In case of Loss from derivative trading, since profit (Loss in this case) is less
than 8% (6%, if all trades are digital) of the turnover, therefore Tax Audit will
be applicable u/s 44AB r.w.s. 44AD.

Treatment of adjustment for loss

Loss in respect of Non Speculative Business Income: As per the Section 71 of the
Income Tax Act, loss in respect of such business can be set off against any other
heads of income including income from speculative business but excluding
income under the head “salaries” of that year.

As per Section 72 of the Income Tax Act, if there is any such loss which is not set
off against the above said incomes, such losses are eligible to be carried forward
and set off against the other incomes excluding income from salary for a period of
8 subsequent assessments in the manner as specified in the above order of set off.

Loss in respect of Speculative Business Income:

As per the Section 73 of the Income Tax Act, loss in respect of speculative
business cannot be set off against any other heads of income i.e. it can be set off
only against other speculative incomes if any in that year.

If there is any such loss which is not set off, such losses are eligible to be carried
forward and set off only against speculative incomes for a period of only 4
subsequent assessment years.

77
Chapter – 8 Data Analysis, Interpretation and
Presentation
A survey was done using a Google form in which responses were taken from people
belonging to different fields and back ground, overall 60 responses got collected. The
questionnaire which was formed is as follows:-

Personal Information

Age

Gender

Educational Qualification

Questions

Q1. Do you trade in derivative market?

Q2. If no to previous question, reason for not trading into this segment. Also, move to
question number 7.

Q3. If yes to trading in derivative segment, which instrument do you trade?

Q4. Do you use any strategies while trading derivatives?
Q5. What return you expect from derivatives trading?
Q6. Are you happy with SEBIs margin rule?
Q7. Would you like to learn more & more about derivatives?
Q8. Do you know that you can buy insurance for you stock portfolio using derivatives?

To get a better understanding of the data collected, all the data have been sorted into bar
graph or pie chart according to the responses collected.

78
Age

Age
ABOVE 35 YEARS 1

31-35 YEARS 2

26-30 YEARS 4

20-25 YEARS 48

BELOW 20 5

0 10 20 30 40 50 60

Gender

Gender

3%
Male
47% Female
50%
Prefer not to say

Educational Qualification

Educational Qualififaction
OTHERS 2

PROFESSIONAL DEGREE 5

POST GRADUATE 13

UNDERGRADUATE 40

0 10 20 30 40 50

79
Do you trade in derivative market?

Do you trade in derivative market?

30%
Yes
No
70%

If no to previous question, reason for not trading in derivative market. Also, move to
question number 7.

If no to previous question, reason for

not trading in derivative market.
Also, move to question number 7.

HUGE INVESTMENT 4

RISK INVOLVED 5

LACK OF AWARENESS 30

LACK OF KNOWLEDGE 21

0 5 10 15 20 25 30 35

80
If yes to trading in derivative segment, which instrument do you trade?

If yes to trading in derivative segment,

which instrument do you trade?

CURRENCY DERIVATIVE 2

COMMODITY DERIVATIVE 0

INDEX FUTURE & OPTION 37

STOCK FUTURE & OPTIONS 1

0 5 10 15 20 25 30 35 40

Do you use any strategies while trading derivatives?

Do you use any strategies while trading

derivatives?

42% Yes
No
58%

81
What return you expect from derivatives trading?

What return you expect from derivatives

trading?

0%
2%

Less than 5%

42% 5%-10%

56% 10-%-15%
Above 20%

Are you happy with SEBIs margin rule?

Are you happy with SEBIs margin rule?

5%

Yes
No

95%

82
Would you like to learn more & more about derivatives?

Would you like to learn more & more

about derivatives?

28%
Yes
No

8% 64% May be

Do you know that you can buy insurance for you stock portfolio using derivatives?

Do you know that you can buy insurance

for you stock portfolio using derivatives?

22%

Yes
No

78%

83
Chapter – 9 Conclusions
After deeply studying the topic I got to know that derivative is a very deep subject and
at many a times it also becomes very complex due to various calculations involved
when calculating the Greeks, pricing an option or understanding the data.

Not only a very complex but also a very risky segment when trading, either buying or
selling an option or a future contract one is exposed to very risk which can even wipe
out the entire capital, that is why it becomes very necessary to hedge our positions
whenever entering a trade or result could be disastrous.

Also to tackle the risk involved and saving the interest of retail participants SEBI have
introduced a new rule called margin rule in which the traders are required to maintain
a 100% margin whenever entering into a trade also this rule coming in effect makes
clear that now brokers cannot give leverage to their clients, many of the traders did
not welcome the rule and did protest to take the rule back but SEBI is firm on its
verdict and hence traders are not able to take leverage when entering into a short
position as brokers are giving any leverage.

I would like to end on the note that trading any segment be it derivative or any other
asset class or instrument one should always do proper risk analysis and keeping a tight
stop loss and NEVER FIGHT THE MARKET, as MARKET IS SUPREME.

84
Bibliography
Financial Derivatives – Theory, Concepts & Problems – S.L. Gupta
Options, Futures and Other Derivatives – John C.Hull
NISM Series I
NISM Series VIII Equity Derivatives
NISM Series XVI Commodity Derivatives

Webliography
www.nseindia.com
www.sebi.gov.in
www.zerodha.com
web.sensibull.com/
https://opstra.definedge.com/
https://www.stockmock.in/#!/home

85