Sunteți pe pagina 1din 94

A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial institutions, banks and their corporate clients in what are termed as over-the- counter markets – in other words, there is no single market place organized exchanges.

Different investment avenues are available to investors. Stock market also offers good investment opportunities to the investor alike all investments, they also carry certain risks. The investor should compare the risk and expected yields after adjustment of tax on various instruments while taking investment decision the investor may seek advice from expert and consultancy include stock brokers and analysts while making investment decisions. The objective here is to make the investor aware of the functioning of the derivatives.

A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The
A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The

1.1 NEED OF THE STUDY

1. INTRODUCTION

Page 1

Derivatives act as a risk hedging tool for the investors. The objective if is to help the investor in selecting the appropriate derivates instrument to attain maximum risk and to construct the portfolio in such a manner to meet the investor should decide how best to reach the goals from the securities available.

The study is limited to the analysis made for types of instruments of derivates each strategy is analyzed according to its risk and return characteristics and derivatives performance against the profit and policies of the company.

The study is limited to “Derivatives” with special reference to futures and options in the Indian context; the study is not based on the international perspective of derivative markets.

The developed and the improved strategies in the investment policy formulated. They will help the selection of asset classes and securities in each class depending up on their risk return attributes.

To identity investor objective constraints and performance, which help formulate the investment policy?

Derivatives act as a risk hedging tool for the investors. The objective if is to help
Derivatives act as a risk hedging tool for the investors. The objective if is to help

1.2 SCOPE OF THE STUDY

Page 2

The subject of derivates if vast it requires extensive study and research to understand the depth of the various instrument operating in the market only a recent phenomenon

There are various other factors also which define the risk and return preferences of an investor. However the study was only contained towards the risk maximization and profit maximization objective of the investor.

The derivative market is a dynamic one premiums, contract rates strike price fluctuate on demand and supply basis. Therefore data related to last few trading months was only considered and interpreted.

The subject of derivates if vast it requires extensive study and research to understand the depth

1.3 LIMITATION OF THE STUDY

The subject of derivates if vast it requires extensive study and research to understand the depth

Page 3

Share khan is one of India's largest and leading financial services companies. It is an online stock trading company of SSKI Group (S.S. Kantilal Ishwarlal Securities Limited) which has been a provider of India-based investment banking and corporate financial service for over 80 years.

SSKI caters to most of the prominent financial institutions, foreign and domestic, investing in Indian equities. It has been valued for its strong research- led investment ideas, superior client servicing track record and exceptional execution skills.

Share khan is one of India's largest and leadin <a href=g financial services companies. It is an online stock trading company of SSKI Group (S.S. Kantilal Ishwarlal Securities Limited) which has been a provider of India-based investment banking and corporate financial service for over 80 years. SSKI caters to most of the prominent financial institutions, foreign and domestic, investing in Indian equities. It has been valued for its strong research- led investment ideas, superior client servicing track record and exceptional execution skills.  You get freedom from paperwork.  There are instant credit and money transfer facilities. The key features of Sharekhan are as follows: 2. COMPANY PROFILE 2.1 SHAREKHAN Page 4 " id="pdf-obj-3-12" src="pdf-obj-3-12.jpg">

You get freedom from paperwork. There are instant credit and money transfer facilities.

Share khan is one of India's largest and leadin <a href=g financial services companies. It is an online stock trading company of SSKI Group (S.S. Kantilal Ishwarlal Securities Limited) which has been a provider of India-based investment banking and corporate financial service for over 80 years. SSKI caters to most of the prominent financial institutions, foreign and domestic, investing in Indian equities. It has been valued for its strong research- led investment ideas, superior client servicing track record and exceptional execution skills.  You get freedom from paperwork.  There are instant credit and money transfer facilities. The key features of Sharekhan are as follows: 2. COMPANY PROFILE 2.1 SHAREKHAN Page 4 " id="pdf-obj-3-19" src="pdf-obj-3-19.jpg">

The key features of Sharekhan are as follows:

Share khan is one of India's largest and leadin <a href=g financial services companies. It is an online stock trading company of SSKI Group (S.S. Kantilal Ishwarlal Securities Limited) which has been a provider of India-based investment banking and corporate financial service for over 80 years. SSKI caters to most of the prominent financial institutions, foreign and domestic, investing in Indian equities. It has been valued for its strong research- led investment ideas, superior client servicing track record and exceptional execution skills.  You get freedom from paperwork.  There are instant credit and money transfer facilities. The key features of Sharekhan are as follows: 2. COMPANY PROFILE 2.1 SHAREKHAN Page 4 " id="pdf-obj-3-23" src="pdf-obj-3-23.jpg">

2. COMPANY PROFILE

2.1 SHAREKHAN

Page 4

You can trade from any net enabled PC. After hour orders facilities. You can go for online orders over the phone. Timely advice and research reports Real-time Portfolio tracking. Information and Price alerts. Sharekhan provides assistance and the advice like no one else could. It has created special information tools to help answer any queries. Sharekhan’s first step program, built specifically for new investors, is testament to of its commitment to being your guide throughout your investing life cycle.

The tag line of Sharekhan says that it is your guide to the financial jungle.” As per the tag line there are many amazing services that Sharekhan offers like technical research, fundamental research, share shops, portfolio management, dial-n-trade, commodities trade, online services, depository services, equity and derivatives trading (including currency trading). With Sharekhan’s online trading account, you can buy and sell shares at anytime and from anywhere you like.

 You can trade from any net enabled PC.  After hour orders facilities.  You
 You can trade from any net enabled PC.  After hour orders facilities.  You

2.2 SHAREKHAN SERVICES:

Page 5

 Online BSE and NSE executions (through BOLT & NEAT terminals)  Free access to investment

Online BSE and NSE executions (through BOLT & NEAT terminals) Free access to investment advice from Sharekhan's Research team Sharekhan Value Line (a monthly publication with reviews of recommendations, stocks to watch out for etc) Daily research reports and market review (High Noon & Eagle Eye) Pre-market Report (Morning Cuppa) Daily trading calls based on Technical Analysis

With a physical presence in over 400 cities of India through more than 1200 "Share Shops" with more than 3000 employees, and an online presence through Sharekhan.com, India's premier, it reaches out to more than 8, 00,000 trading customers.

A Sharekhan outlet online destination offers the following services:

 Online BSE and NSE executions (through BOLT & NEAT terminals)  Free access to investment
 Online BSE and NSE executions (through BOLT & NEAT terminals)  Free access to investment

Page 6

Cool trading products (Daring Derivatives and Market Strategy) Personalized Advice Live Market Information Depository Services: Demat Transactions Derivatives Trading (Futures and Options) Commodities Trading IPOs & Mutual Funds Distribution Internet-based Online Trading: Speed Trade

Sharekhan has one of the best state-of-art web portals providing fundamental and statistical information across equity, mutual funds and IPOs. Surfing can be done across 5,500 companies for in-depth information, details about more than 1,500 mutual fund schemes and IPO data. Other market related details such as board meetings, result announcements, FII transactions, buying/selling by mutual funds and much more can also be accessed.

In a business where the right information at the right time can translate into direct profits, investors get access to a wide range of information on the content- rich portal, www.sharekhan.com. Investors will also get a useful set of knowledge-based tools that will empower them to take informed decisions

It provides a complete life-cycle of investment solution in Equities, Derivatives, Commodities, IPO, Mutual Funds, Depository Services, Portfolio Management Services and Insurance. It also offers personalized wealth management services for High Net worth individuals.

 Cool trading products (Daring Derivatives and Market Strategy)  Personalized Advice  Live Market Information
 Cool trading products (Daring Derivatives and Market Strategy)  Personalized Advice  Live Market Information

Knowledge

Page 7

Sharekhan has dedicated research teams of more than 30 people for fundamental and technical research. Their analysts constantly track the pulse of the market and provide timely investment advice to customer in the form of daily research emails, online chat, printed reports etc

The online trading account can be chosen as per trading habits and preferences, that is the classic account for most investors and speed trade for active day traders. Share khan also provides a free software called “Trade tiger” to all its account holders.

Sharekhan has dedicated research teams of more than 30 people for fundamental and technical research. Their
Sharekhan has dedicated research teams of more than 30 people for fundamental and technical research. Their

2.3 ONLINE SERVICES

Investment Advice

Page 8

Streaming quotes (using the applet based system) Multiple watch lists Integrated Banking, Demat and digital contracts Instant credit and transfer Real-time portfolio tracking with price alerts and, of course, the assurance of secure transactions

The Classic Account enables you to trade online for investing in Equities and Derivatives on the NSE via sharekhan.com; it gives access to all the research content and also comes with a free Dial-n-Trade service enabling to buy shares using the telephone.

The Trade Tiger is a next-generation online trading product that brings the power of the broker's terminal to your PC. It's the perfect trading platform for active day traders.

 Streaming quotes (using the applet based system)  Multiple watch lists  Integrated Banking, Demat
 Streaming quotes (using the applet based system)  Multiple watch lists  Integrated Banking, Demat

Its features are:

Page 9

is, saving the layout for future use  User-defined alert settings on an input Stock Price

is, saving the layout for future use User-defined alert settings on an input Stock Price trigger Tools available to gauge market such as Tick Query, Ticker, Market

MCX, NCDEX, Mutual Funds, IPO’s Multiple Market Watch available on Single Screen Multiple Charts with Tick by Tick Intraday and End of Day Charting

Summary, Action Watch, Option Premium Calculator, Span Calculator Shortcut key for FAST access to order placements & reports Online fund transfer activated with 12 Banks

Free lines User can save his own defined screen as well as graph template, that

powered with various Studies Graph Studies include Average, Band- Bollinger, Know Sure Thing,

MACD, RSI, etc Apply studies such as Vertical, Horizontal, Trend, Retracement &

A single platform for multiple exchange BSE & NSE (Cash & F&O),

is, saving the layout for future use  User-defined alert settings on an input Stock Price
is, saving the layout for future use  User-defined alert settings on an input Stock Price

Its features are:

Page 10

Commodities Buzz: a

For trading in any commodity, initial margin of around 10% on any commodity is to be maintained. Sharekhan has launched its own commodity derivatives micro-site. The site is available through the Sharekhan home page www.sharekhan.com. Along with the site Sharekhan has launched several commodity derivatives products (both research and trading) too. The products have been listed below:

commodities. Commodities Beat: a summary of the day’s trading activity. Traders Corner: Under commodity trading calls, there are two types of trading calls:

Rapid Fire:

(short-term calls for 1 day

to

5 days updated

daily)

Medium-term Plays: (medium-term calls for 1 month to 3 months updated weekly or in between if needed)

Sharekhan provides you the facility to trade in Commodities through Sharekhan Commodities Pvt. Ltd. a wholly owned subsidiary of its parent SSKI. It trades on two major commodity exchanges of the country:

National Commodity and Derivative Exchange, Mumbai (NCDEX).

Multi Commodity Exchange of India Ltd, Mumbai (MCX) and

 Commodities Buzz: a For trading in any commodity, initial margin of around 10% on anywww.sharekhan.com . Along with the site Sharekhan has launched several commodity derivatives products (both research and trading) too. The products have been listed below: commodities.  Commodities Beat: a summary of the day’s trading activity.  Traders Corner: Under commodity trading calls, there are two types of trading calls:  Rapid Fire: (short-term calls for 1 day to 5 days updated daily)  Medium-term Plays: (medium-term calls for 1 month to 3 months updated weekly or in between if needed)  Sharekhan provides you the facility to trade in Commodities through Sharekhan Commodities Pvt. Ltd. a wholly owned subsidiary of its parent SSKI. It trades on two major commodity exchanges of the country:  National Commodity and Derivative Exchange, Mumbai (NCDEX).  Multi Commodity Exchange of India Ltd, Mumbai (MCX) and on precious Page 11 metals daily view agro and " id="pdf-obj-10-52" src="pdf-obj-10-52.jpg">
 Commodities Buzz: a For trading in any commodity, initial margin of around 10% on anywww.sharekhan.com . Along with the site Sharekhan has launched several commodity derivatives products (both research and trading) too. The products have been listed below: commodities.  Commodities Beat: a summary of the day’s trading activity.  Traders Corner: Under commodity trading calls, there are two types of trading calls:  Rapid Fire: (short-term calls for 1 day to 5 days updated daily)  Medium-term Plays: (medium-term calls for 1 month to 3 months updated weekly or in between if needed)  Sharekhan provides you the facility to trade in Commodities through Sharekhan Commodities Pvt. Ltd. a wholly owned subsidiary of its parent SSKI. It trades on two major commodity exchanges of the country:  National Commodity and Derivative Exchange, Mumbai (NCDEX).  Multi Commodity Exchange of India Ltd, Mumbai (MCX) and on precious Page 11 metals daily view agro and " id="pdf-obj-10-54" src="pdf-obj-10-54.jpg">

on

precious

Page 11

metals

daily

view

agro

and

In Sharekhan one can get 4 times exposure on cash and on assets one can

gets 2 times. Sharekhan gives money only for A group and B group companies.

Only Blue-chip companies get exposure and not for x group companies.

NOTES

In Sharekhan account opening is free.

First year’s maintenance charge is zero.

Second year’s maintenance is Rs 400/-

All these products are both e-mailed as newsletters and published on the commodity derivatives site

Market Scan: the daily commodity market data and statistics (end of day).

analyses reports and
analyses
reports
and

Sharekhan (periodical).

 In Sharekhan one can get 4 times exposure on cash and on assets one can

commodity

Exclusive: the

EXPOSURE

research

Page 12

Page 13
Page 13
Page 13

Page 13

The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.

On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then

A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.

The origin of derivatives can be traced back to the need of farmers to protect themselves

3. INTRODUCTION TO DERIVATIVES

The origin of derivatives can be traced back to the need of farmers to protect themselves

Page 14

A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the ‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk.

A derivative is a product whose value is derived from the value of one or more
A derivative is a product whose value is derived from the value of one or more

3.1 DERIVATIVES DEFINED

Page 15

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-

A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As

A contract which underlying securities

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As

index of prices, of

derives its value

prices, or

from the

Page 16

3.2 TYPES OF DERIVATIVES MARKET Exchange Traded Derivatives Over The Counter Derivatives National Stock Exchange Bombay
3.2 TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives
Over The Counter Derivatives
National Stock Exchange
Bombay Stock Exchange
National Commodity & Derivative
exchange
Index Future
Index option
Stock option
Stock future
Interest
Rate Futures
Derivativ
3.3 TYPES OF DERIVATIVES
es
Page 17
Future
Option
Forward
Swaps

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

The history of derivatives is quite colourful 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
The first organized commodity exchange came into existence in the early 1700’s in Japan. The first

3.4 HISTORY OF DERIVATIVES:

Page 18

commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

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

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

commercial operations. The Chicago Mercantile Exchange (CME) , a spin-off of CBOT, was formed in 1919,
commercial operations. The Chicago Mercantile Exchange (CME) , a spin-off of CBOT, was formed in 1919,

Page 19

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 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.

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 were set up in early 1900’s to provide a mechanism for bringing buyers and sellers together.

The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties.

The 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

On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for
On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for

Page 20

Page 21

May 1998

December 1995

November 1996

Table Chronology of instruments

Page 21 May 1998 December 1995 November 1996 Table Chronology of instruments 3.5 INDIAN DERIVATIVES MARKET

3.5 INDIAN DERIVATIVES MARKET

  • 1991 Liberalisation process initiated

    • 11 L.C.Gupta Committee submitted report.

    • 14 NSE asked SEBI for permission to trade index futures.

Page 21 May 1998 December 1995 November 1996 Table Chronology of instruments 3.5 INDIAN DERIVATIVES MARKET
  • 18 SEBI setup L.C.Gupta Committee to draft a policy framework for index futures.

Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India

Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors’ aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India’s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.

7

July 1999

RBI gave permission for OTC forward rate agreements (FRAs) and

24 May 2000

interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian

25 May 2000

index. SEBI gave permission to NSE and BSE to do index futures trading.

9

June 2000

Trading of BSE Sensex futures commenced at BSE.

12 June 2000 25 September 2000

Trading of Nifty futures commenced at NSE. Nifty futures trading commenced at SGX. Individual Stock Options & Derivatives

2

June 2001

In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading

3.6 Need for derivatives in India today

Until the advent of NSE, the Indian capital market had no access to the latest trading

Page 22

In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day- to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place.

Disasters prove that derivatives are very risky and highly leveraged instruments Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading

Derivatives increase speculation and do not serve any economic purpose

In less than three decades of their coming into vogue, derivatives markets have become the most

What are these myths behind derivatives?

3.7 Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become the most

Page 23

Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these

Numerous studies of derivatives activity have led to a broad consensus, both in the private and
Numerous studies of derivatives activity have led to a broad consensus, both in the private and

Page 24

Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivative and how Indian market fares:

important linkages between global markets increasing market liquidity and efficiency and facilitating the flow of trade and finance.

India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.

PRE-REQUISITES Large market Capitalisation

Often the argument put forth against derivatives trading is that the Indian capital market is not

Is Indian Market is not ready for derivative trading?

Often the argument put forth against derivatives trading is that the Indian capital market is not

INDIAN SCENARIO

Page 25

The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form

The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.

The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.

In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

The following three broad categories of participants who trade in the derivatives market:

The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form

started functioning in the year 1997 has revolutionalised the

4. PARTICIPANTS IN THE DERIVATIVES MARKET

High Liquidity in the underlying

Securities Depositories Limited (NSDL) which

National

security settlement in our country.

  • 2. Speculators and

A Good legal guardian

  • 3. Arbitrageurs

A Strong Depository

Trade guarantee

1. Hedgers

Page 26

Hedgers face risk associated with the price of an asset. The objective of these kinds of traders is to reduce/eliminate the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiraling oil prices have to be tamed using the security in derivative instruments.

Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one market and selling in another, buying two products in the same market are common. They could be making money even without putting their own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as the

Speculators wish to bet on future movements in the price of an asset. They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. Futures and Options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

Hedgers face risk associated with the price of an asset. The objective of these kinds of
Hedgers face risk associated with the price of an asset. The objective of these kinds of

Arbitrageurs:

Speculators:

Hedgers:

Page 27

exchange-traded derivatives:

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

For example, they see the futures price of an asset getting out of line with the cash price; they will take offsetting positions in the two markets to lock in a profit.

  • 2. There are no formal centralized limits on individual positions, leverage, or margining,

situation arises, arbitrageurs take advantage and demand-supply forces drive the markets back to normal.

1. The management of counter-party (credit) risk is decentralized and

exchange-traded derivatives: The OTC derivatives markets have witnessed rather sharp growth over the last few years,
  • 3. There are no formal rules for risk and burden-sharing,

Exchange-traded vs. OTC derivatives markets

located within individual institutions,

exchange-traded derivatives: The OTC derivatives markets have witnessed rather sharp growth over the last few years,

the

features compared to

following

derivatives

Page 28

markets

OTC

have

The

The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, which occur significantly, alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions.

  • 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

  • 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and

Some of the features of OTC derivatives markets embody risks to financial market stability.

The following features of OTC derivatives markets can give rise to instability in institutions, markets, and
The following features of OTC derivatives markets can give rise to instability in institutions, markets, and

Page 29

There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.

There has been some progress in addressing these risks and perceptions. However, the progress has been
There has been some progress in addressing these risks and perceptions. However, the progress has been

Page 30

A price is what one pays to acquire or use something of value. The objects which have value maybe commodities, local currency or foreign currency. 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 period of time. Such changes in the price are known as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes.

Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories.

The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals,

4.1 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

A price is what one pays to acquire or use something of value. The objects which

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects which

Page 31

producing firms and governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an 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 has 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.

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

These price volatility risks 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.

producing firms and governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an

B.} GLOBALISATION OF MARKETS –

producing firms and governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an

Page 32

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.

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 necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

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

A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area

Page 33

derivatives instruments

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.

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.

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

Futures and options contract can be used for altering the risk of investing in spot

derivatives instruments Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional

Derivative markets help investors in many different ways:

D.} ADVANCES IN FINANCIAL THEORIES

1.] RISK MANAGEMENT –

derivatives instruments Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional

4.2 BENEFITS OF DERIVATIVES

to

above factors in

combination of

growth of

lot many

Page 34

factors

The

led

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.

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.

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.

Price discovery refers to the market ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and

himself by selling a futures contract, or by buying a Put option. If the spot price

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity.

3.] OPERATIONAL ADVANTAGES –

4.] MARKET EFFICIENCY –

2.] PRICE DISCOVERY –

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity.

Page 35

1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. 2. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

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 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.

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.

The derivatives market performs a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants about the future

4.3 FUNCTIONS OF THE DERIVATIVES MARKET:

5.] EASE OF SPECULATION –

1. Prices in an organized derivatives market reflect the perception of market participants about the future

They are:

Page 36

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

  • 5. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

  • 3. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets.

  • 4. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

The first step towards introduction of derivatives trading in India was the promulgation of the Securities

5. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities

Page 37

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 were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also 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.

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

applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a
applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a

Page 38

Put volumes

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.

• On relative terms, volumes in the index options segment continue 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.

• 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.

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

increased since January 2002. The call-put volumes in index options have

Put volumes individual securities commenced on July 2, 2001. Single stock futures were launched on November

index options and equity options segment have

decreased from 2.86 in January

Put volumes individual securities commenced on July 2, 2001. Single stock futures were launched on November

fall in call-put

June. The

Page 39

2002

1.32

the

in

in

to

turnover of derivatives

• 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.

would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into rupees. However, since banks could not carry open positions the risk was allowed to be transferred to any other resident corporate. Normally such risks should be taken by corporate

but the derivative segment has also grown. In the derivative market foreign exchange swaps account for the largest share of the total

• Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.

Significant milestones in the development of derivatives market have been (i) permission to banks to undertake cross currency derivative

volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.

who have natural hedge or have potential foreign exchange earnings. But

undertake long term foreign currency swaps that contributed to the

The spot foreign exchange market remains the most important segment

of the term currency swap market (1997) (iii) allowing dollar

transactions subject to certain conditions (1996) (ii) allowing

turnover of derivatives • Daily option price variations suggest that traders use the F&O segment as

rupee options (2003) and (iv) introduction

turnover of derivatives • Daily option price variations suggest that traders use the F&O segment as

futures (2008). I

and options.

development

of currency

corporate

followed

forwards

Page 40

India

by

in

to

Cash settled exchange traded currency futures have made foreign currency a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recognized stock exchanges with credit risks being assumed by the central counterparty Since the commencement of trading of currency futures in all the three exchanges, the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same period. The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between 2 – 3 per cent.

often corporate assume these risks due to interest rate differentials and views on currencies. This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy.

In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999.

 Cash settled exchange traded currency futures have made foreign currency a separate asset class that
 Cash settled exchange traded currency futures have made foreign currency a separate asset class that

5.1 National Exchanges

Page 41

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. “National Status” implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively.

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-mutualised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of Baroda, Canara Bank, Corporation Bank.

Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange,

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives
Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives

Page 42

MCX

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions.

MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of- the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading.

NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the

offering multiple commodities for trading with wide reach and penetration and robust infrastructure.

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National

Page 43

NMCE

NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23, 2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The contracts are marked to market on daily basis.
NMCE follows best international risk management practices. The contracts are marked to market on daily basis.

NCDEX

Page 44

9,

NSE

became

Page 45

On June

2000 BSE &

9, NSE became Page 45 On June 2000 BSE & the first exchanges in India to

the first exchanges in India to

5.2 DERIVATIVES SEGMENT IN BSE & NSE

9, NSE became Page 45 On June 2000 BSE & the first exchanges in India to

introduce trading in exchange traded derivative product with the launch of index futures on sense and Nifty futures respectively.

Index futures was follows by launch of index options in June 2001, stock options in July 2001 and stock futures in Nov 2001.Presently stock futures and options available on 41 well-capitalized and actively traded scripts mandated by SEBI.

Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow soyabean meal.

Nifty is the underlying asset of the Index Futures at the Futures & Options segment of NSE with a market lot of 200 and the BSE 30 Sensex is the underlying stock index with the market lot of 50. This difference of market lot arises due to a minimum specification of a contract value of Rs. 2 lakhs by Securities Exchange Board of India. A contract value is contracting Index laid by its market lot. For e.g. If Sensex is 4730 then the contract value of a futures Index having Sensex as underlying asset will be 50 x 4730 = Rs. 2, 36,500. Similarly if Nifty is 1462.7, its futures contract value will be 200 x 1462.7 = Rs.2, 92,540/-.

At any point of time there will always be available near three months contract periods. For e.g. in the month of June 2009 one can enter into either June Futures contract or July Futures contract or August Futures Contract. The last Thursday of the month specified in the contract shall be the final settlement date for that contract at both NSE as well BSE. Thus June 29, July 27 and August 31 shall be the last trading day or the final settlement date for June Futures contract, July Futures Contract and August Futures Contract respectively.

When one futures contract gets expired, a new futures contract will get introduced automatically. For instance, on 30th June, June futures contract becomes invalidated and a September Futures Contract gets activated.

Every transaction shall be in multiple of market lot. Thus, Index futures at NSE shall be traded in multiples of 200 and at BSE in multiples of 50

Nifty is the underlying asset of the Index Futures at the Futures & Options segment of
Nifty is the underlying asset of the Index Futures at the Futures & Options segment of

5.3 CONTRACT PERIODS:

Page 46

Outstanding positions of a contract can remain open till the last Thursday of that month. As long as the position is open, the same will be marked to Market at the Daily Settlement Price, the difference will be credited or debited accordingly and the position shall be brought forward to the next day at the daily settlement price. Any position which remains open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the Exchange at the Final Settlement Price which will be the closing spot value of the underlying (Nifty or Sensex, or respective stocks as the case may be).

SEBI set up a 24-member committee under Chairmanship of Dr. L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the committee for regulation and control of trading and settlement of derivatives contracts.

The provisions in the SC(R) A and the regulatory framework developed there under govern trading in securities. The amendment of the

Settlement of all Derivatives trades is in cash mode. There is Daily as well as Final Settlement.

Outstanding positions of a contract can remain open till the last Thursday of that month. As
  • 5.5 Regulation for Derivatives Trading

Outstanding positions of a contract can remain open till the last Thursday of that month. As
  • 5.4 SETTLEMENT:

Page 47

  • 1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R) a, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading / clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain approval of SEBI before start of trading in any derivative contract

  • 4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation / house. Clearing corporation / houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.

  • 3. The members of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfil the eligibility conditions as laid down by the L C Gupta committee.

SC(R) A to include derivatives within the ambit of ‘securities’ in the SC(R) A, made trading in derivatives possible within the framework of the Act.

  • 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI.

  • 7. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

  • 6. The minimum contract value shall not be less than Rs. 2 Lakhs. Exchanges should also submit details of the futures contract they propose to introduce.

1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee report
  • 2. The exchange shall have minimum 50 members.

1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee report

Page 48

VI. The derivatives trading should be done in a separate segment with separate membership; That is, all members of the cash market would not automatically become members of the derivatives market. VII. The derivatives market should have a separate governing council which should not have representation of trading by clearing members beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. VIII. The chairman of the governing council of the derivative division / exchange should be a member of the governing council. If the chairman is broker / dealer, then he should not carry on any broking or dealing on any exchange during his tenure.

positions, price and volumes in real time so as to deter market manipulation price and position limits should be used for improving market quality. IV. Information about trades quantities, and quotes should be disseminated by the exchange in the real time over at least two information-vending networks, which are accessible to investors in the country.

While from the purely regulatory angle, a separate exchange for trading would be a better arrangement. Considering the constraints in infrastructure facilities, the existing stock (cash) exchanges may also be permitted to trade derivatives subject to the following conditions.

derivative market. III. The exchange must have an online surveillance capability, which monitors

  • I. Trading should take place through an on-line screen based trading system. II. An independent clearing corporation should do the clearing of the

  • V. The exchange should have at least 50 members to start derivatives trading.

VI. The derivatives trading should be done in a separate segment with separate membership; That is,
VI. The derivatives trading should be done in a separate segment with separate membership; That is,

Page 49

  • 7. Swaps

The most commonly used derivatives contracts are forwards, futures and options. Here various derivatives contracts that have come to be used are given briefly:

No trading/clearing member should be allowed simultaneously to be on the governing council both derivatives market and cash market.

7. Swaps The most commonly used derivatives contracts are forwards, futures and options. Here various derivatives
7. Swaps The most commonly used derivatives contracts are forwards, futures and options. Here various derivatives
  • 6. TYPES OF DERIVATIVES

  • 8. Swaptions

  • 3. Options

  • 1. Forwards

  • 4. Warrants

  • 6. Baskets

  • 5. LEAPS

  • 2. Futures

Page 50

IX.

a negotiated

A forward contract is a customised contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupee-dollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants.

party Risk i.e. you will now entitled to your gains. In case of Future, the exchange gives a counter guarantee even if the counter party defaults you will receive Rs.20/- as a gain.

counter party risk. eg: Trade takes place between A&B@ 100 to buy & sell x commodity. After 1 month it is trading at Rs.120. If A was he buyer he would gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter

A contract has to be settled in delivery or cash on expiration date as agreed upon at the time of entering into the contract. In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the

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

a negotiated A forward contract is a customised contract between the buyer and the seller where

The main features of a forward contract are:

a negotiated A forward contract is a customised contract between the buyer and the seller where

Features of a forward contract

6.1Forward contracts

It

exposed to

parties

between

Page 51

contract

hence

and

two

is

Stock Index futures are the most popular financial futures, which have been used to hedge or manage the systematic risk by the investors of Stock Market. They are called hedgers who own portfolio of securities and are exposed to the systematic risk. Stock Index is the apt hedging asset since the rise or fall due to systematic risk is accurately shown in the Stock Index. Stock index futures contract is an agreement to buy or sell a specified amount of an underlying stock index traded on a regulated futures exchange for a specified price for settlement at a specified time future.

Futures contract is a firm legal commitment between a buyer & seller in which they agree to exchange something at a specified price at the end of a designated period of time. The buyer agrees to take delivery of something and the seller agrees to make delivery.

Stock index futures will require lower capital adequacy and margin requirements as compared to margins on carry forward of individual scrip. The brokerage costs on index futures will be much lower.

Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower in case

other party. The counter party being in a monopoly situation can command the price he wants.

Stock Index futures are the most popular financial futures, which have been used to hedge or
Stock Index futures are the most popular financial futures, which have been used to hedge or

6.2.1 STOCK INDEX FUTURES

6.2 FUTURES

Page 52

The Stock index futures are expected to be extremely liquid given the speculative nature of our markets and the overwhelming retail participation expected to be fairly high. In the near future, stock index futures will definitely see incredible volumes in India. It will be a blockbuster product and is pitched to become the most liquid contract in the world in terms of number of contracts traded if not in terms of notional value. The advantage to the equity or cash market is in the fact that they would become less volatile as most of the speculative activity would shift to stock index futures. The stock index futures market should ideally have more depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to base any conclusions on the volume or to form any firm trend.

The difference between stock index futures and most other financial futures contracts is that settlement is made at the value of the index at maturity of the contract.

of stock index futures as opposed to dealing in individual scrips. The market is conditioned to think in terms of the index and therefore would prefer to trade in stock index futures. Further, the chances of manipulation are much lesser.

The value of the contract at a specific level of Index. It is Index level * Multiplier.

It is a pre-determined value, used to arrive at the contract size. It is the price per index point.

The Stock index futures are expected to be extremely liquid given the speculative nature of our
The Stock index futures are expected to be extremely liquid given the speculative nature of our

6.2.2 FUTURES TERMINOLOGY

Contract Size

Multiplier

Page 53

Tick Size

It is the minimum price difference between two quotes of similar

nature.

Contract Month

The month in which the contract will expire.

Expiry Day

The last day on which the contract is available for trading.

Open interest

Total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.

Volume

Long position

Outstanding/unsettled purchase position at any point of time.

Short position

Outstanding/ unsettled sales position at any point of time.

Open position

Outstanding/unsettled long or short position at any point of time.

Physical delivery

No. Of contracts traded during a specific period of time i.e. during a day, during a week or during a month.

 Tick Size It is the minimum price difference between two quotes of similar nature. 
 Tick Size It is the minimum price difference between two quotes of similar nature. 

Page 54

Cash settlement Open position at the expiry of the contract is settled in cash. These contracts Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled by two parties - one buyer and one seller, at the terms other than defined by the exchange. Worldwide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.

The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). Revenue may be in the form of dividend. Though one

The theoretical price of a futures contract is spot price of the underlying plus the cost of carry (futures are not about predicting future prices of the underlying assets).

Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low.

 Cash settlement Open position at the expiry of the contract is settled in cash. These

In general, Futures Price = Spot Price + Cost of Carry

Theoretical way of pricing futures

 Cash settlement Open position at the expiry of the contract is settled in cash. These

Page 55

Every time a Stock Future trades over and above its cost of carry i.e. above Rs. the arbitragers would step in and reduce the extra premium commanded by the future due to demand. e.g.: would buy in the cash market and sell the equal amount in the future, hence creating a risk free arbitrage, vice-versa for the discount. It is also observed that index futures generally don't command a huge premium as stocks, due to many reasons such as dividends in index stocks, hedging and speculation etc which keeps the index premium under check.

As such a Reliance future contract with one-month maturity should quote at nearly Rs1515. Similarly Nifty level in the cash market is about 4000. One month Nifty future should quote at about 4040. However it has been observed on several occasions that futures quote at a discount or premium to their theoretical price, meaning below or above the theoretical price. This is due to demand-supply pressures.

The biggest advantage of futures is that you can short sell without having stock and you can carry your position for a long time, which is not possible in the cash segment because of rolling settlement. Conversely you can buy futures and

can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset.

Suppose Reliance shares are quoting at Rs1500 in the cash market. The interest rate is about 12% per annum. The cost of carry for one month would be about

Every time a Stock Future trades over and above its cost of carry i.e. above Rs.

6.2.3 Advantages and risks of trading in futures over cash

Example on how futures are priced

Every time a Stock Future trades over and above its cost of carry i.e. above Rs.

Page 56

Rs15.

For example, you expect Rs100 stock to go up by Rs10. One way is to buy the stock in the cash segment by paying Rs100. You make Rs10 on investment of Rs100, giving about 10% returns. Alternatively you take futures position in the stock by paying about Rs30 toward initial and mark-to-market margin. You make Rs10 on investment of Rs30, i.e. about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.

After listening to the news and other happenings in the economy, we take a view that the market would go up. We substantiate our view after talking to our near and dear ones. When the market opens, we express our view by buying ABC stock. The whole market goes up as we expected but the price of ABC stock falls due to some bad news related to the company. This means that while our view was correct, its expression was wrong.

Using Nifty/Sensex futures we can express our view on the market as a whole. In this case, we take only market risk without exposing our self to any company specific risk. Though trading on Nifty or Sensex might not give us a very high return as trading in stock can, yet at the same time our risk is also limited as index movements are smooth, less volatile without unwarranted swings.

Further futures positions are leveraged positions, meaning you can take Rs100 position by paying Rs25 margin and daily mark-to-market loss, if any. This can enhance the return on capital deployed.

carry the position for a long time without taking delivery, unlike in the cash segment where you have to take delivery because of rolling settlement.

For example, you expect Rs100 stock to go up by Rs10. One way is to buy

Advantages of index futures

For example, you expect Rs100 stock to go up by Rs10. One way is to buy

Page 57

Suppose we are holding a stock that has futures on it and for two to three weeks the stock does not look good to you. We do not want to lose the stock but at the same time we want to hedge against the expected adverse price movement of the stock for two to three weeks. One option is to sell the stock and buy it back after two to three weeks. This involves a heavy transaction cost and issue of capital gain taxes. Alternatively, we can sell futures on the stock to hedge our position in the stock. In case the stock price falls, we make profit out of our short position in the futures. Using stock futures we would virtually sell our stock and buy it back without losing it. This transaction is much more economical as it does not involve cost of transferring the stock to and from depository account. We might say that if the stock had moved up, we would have made profit without hedging. However it is also true that in case of a fall, you might have lost the value too without hedging. Please remember that a hedge is not a device to maximise profits. It is a device to minimise losses. As they say, a hedge does not result in a better outcome but in a predictable outcome.

The total outstanding position in the market is called open interest. In case volumes are rising and the open interest is also increasing, it suggests that more and more market participants are keeping their positions outstanding. This implies that the market participants are expecting a big move in the price of the underlying. However to find in which direction this move would be, one needs to take help of charts. In case the volumes are sluggish and the open interest is almost constant, it suggests that a lot of day trading is taking place. This implies sideways price movement in the underlying.

Use of volume and open interest figures to predict the market movement

Suppose we are holding a stock that has futures on it and for two to three

Hedging stock position using futures

Suppose we are holding a stock that has futures on it and for two to three

Page 58

Pay off for Buyer of futures: (Long futures) The pay offs for a person who buys a futures contract is similar to the pay off for a person who holds an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who buys a two- month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits and when the index moves down it starts making losses

The difference between the futures price and cash price is called basis. Generally futures prices are higher than cash prices (positive basis) as we are positive interest rate economy. However there are times when futures prices are lower than cash prices (negative basis). Basis is also popularly termed spread by the trading community.

A Pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits, for the buyer and the seller of futures contracts, are unlimited.

 Pay off for Buyer of futures: (Long futures) The pay offs for a person who

Pay off for seller of futures: (short futures)

 Pay off for Buyer of futures: (Long futures) The pay offs for a person who

6.2.4 Pay off for futures:

Page 59

Basis

.

The pay offs for a person who sells a futures contract is similar to the pay off for a person who shorts an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who sells a two- month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits and when the index moves up it starts making losses.

The pay offs for a person who sells a futures contract is similar to the pay
The pay offs for a person who sells a futures contract is similar to the pay

Page 60

FEATURES

FORWARD

 

FUTURE CONTRACT

 

CONTRACT

 

Operational

Traded directly between two

Traded on the exchanges.

 

Mechanism

parties (not traded exchanges).

on

the

 

Contract

Differ from trade to trade.

 

Contracts are standardized contracts.

 

Specifications

   

Counter-party

Exists.

Exists.

However,

assumed

by

the

risk

clearing

corp.,

which

becomes

the

counter

party

to

all

trades

the

or

unconditionally

guarantees

their

settlement.

 

Liquidation

Low,

as

contracts

are

tailor

High, as contracts are standardized

Profile

made contracts catering to the

exchange traded contracts.

needs of the needs parties.

of the

Price discovery

Not efficient, as markets are scattered.

Efficient, as markets are centralized and all buyers and sellers come to a common platform to discover the price.

Examples

Currency market in India.

 

Commodities, futures, Index Futures and Individual stock Futures in India.

6.2.5 DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURES FORWARD FUTURE CONTRACT CONTRACT Operational Traded directly between two Traded on the exchanges. Mechanism parties
FEATURES FORWARD FUTURE CONTRACT CONTRACT Operational Traded directly between two Traded on the exchanges. Mechanism parties

Page 61

Call option:

A call is an option contract giving the buyer the right to purchase

the stock.

Put option:

A put is an option contract giving the buyer the right to sell the

stock.

Expiration date:

It is the date on which the option contract expires.

Strike price:

An option agreement is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time.

It is the price at which the buyer of an option contract can purchase or sell the stock during the life of the option

Certain options are of short term in nature and are issued by investors another group of options are long-term in nature and are issued by companies.

 Call option: A call is an option contract giving the buyer the right to purchase

Is the price the buyer pays the writer for an option contract.

 Call option: A call is an option contract giving the buyer the right to purchase

6.3.1 OPTIONS TERMINOLOGY:

6.3 OPTIONS

Premium:

Page 62

Page 63

 

Writer:

 

The term writer is synonymous to the seller of the option contract.

 

Holder:

 

The term holder is synonymous to the buyer of the option

contract.

Straddle:

A straddle is combination of put and calls giving the buyer the right to either buy or sell stock at the exercise price.

 

Strip:

 

A strip is two puts and one call at the same period.

Strap:

A strap is two calls and one put at the same strike price for the same period.

Spread:

The option holder will exercise his option when doing so provides him a benefit over buying or selling the underlying asset from the market at the prevailing price. These are three possibilities.

A spread consists of a put and a call option on the same security for the same time period at different exercise prices.

Page 63  Writer: The term writer is synonymous to the seller of the option contract.
Page 63  Writer: The term writer is synonymous to the seller of the option contract.

advantageous to exercise it.

In the money:

the money

option is

it

when

said

An

be

in

to

is

1.

The options on Nifty and Sensex or any other index options are European style options-meaning that buyer of these options can exercise his options only on the expiry day. He cannot exercise them before expiry of the contract as is the case with options on stocks. As such the buyer of index options needs to square up his position to get out of the market.

In India, all the F and O contracts whether on indices or individual stocks are available for one or two or three months series and they expire on the Thursday of the concerned month.

exercises his option or buys or sells the asset from the market, the option is said to be at the money. The exchanges initially created three expiration cycles for all listed options and each issue was assigned to one of these three cycles.

Option contracts which can be exercised on or before the expiry are called American options. All stock option contracts are American style.

January, April, July, October. February, March, August, November. March, June, September, and December.

2. Out of the money: The option is out of money if it not advantageous to exercise it.

  • 3. At the money: If the option holder does not lose or gain whether he

The options on Nifty and Sensex or any other index options are European style options-meaning that
The options on Nifty and Sensex or any other index options are European style options-meaning that

American style options

European style options

Page 64

An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear from the graph that even in the worst case scenario; the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

 

Payoff from Call Buying/Long (Rs.)

S

Xt

c

Payoff

Net Profit

  • 57 60

2

0

-2

  • 58 60

2

0

-2

  • 59 60

2

0

-2

  • 60 60

2

0

-2

  • 61 60

2

1

-1

  • 62 60

2

2

0

  • 63 60

2

3

1

  • 64 60

2

4

2

  • 65 60

2

5

3

  • 66 60

2

6

4

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

An option that grants the buyer the right to purchase a designated instrument is called a call option. A call option is a contract that gives its owner the right, but not the obligation, to buy a specified price on or before a specified date.

An investor buys one European Call option on one share of Reliance Petroleum at a premium
An investor buys one European Call option on one share of Reliance Petroleum at a premium

6.3.2 CALL OPTION:

Example

Page 65

It is an option contract giving the owner the right, but not the obligation, to sell

It is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares.

S - Stock Price Xt - Exercise Price at time’t’ C - European Call Option Premium Payoff - Max (S - Xt, O)

The seller gets a payoff of: -max (S - Xt, 0) or min (Xt - S, 0). Notes:

A European call option gives the following payoff to the investor: max (S - Xt,

It is an option contract giving the owner the right, but not the obligation, to sell
It is an option contract giving the owner the right, but not the obligation, to sell

Net Profit - Payoff minus 'c'

6.3.3 PUT OPTION:

Graph

Page 66

0).

Payoff from Put Buying/Long (Rs.)

 

Xt

P

S

Payoff

Net Profit

  • 55 5

60

2

3

  • 56 4

60

2

2

  • 57 3

60

2

1

  • 58 2

60

2

0

  • 59 1

60

2

-1

  • 60 0

60

2

-2

  • 61 0

60

2

-2

  • 62 0

60

2

-2

  • 63 0

60

2

-2

  • 64 0

60

2

-2

An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price.

Payoff from Put Buying/Long (Rs.) Xt P S Payoff Net Profit 55 5 60 2 3

The payoff for a put writer is: -max(Xt - S, 0) or min(S - Xt, 0)

The payoff for the put buyer is: max (Xt - S, 0)

Payoff from Put Buying/Long (Rs.) Xt P S Payoff Net Profit 55 5 60 2 3

Illustration:

Graph

Page 67

These are the two basic options that form the whole gamut of transactions in the options

These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives create a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations.

Exotic Options are often mistaken to be another kind of option. They are nothing but non-standard derivatives and are not a third type of option.

Volatility Risk free interest rate Dividend

Stock price

Strike price

Time to expiration

These are the two basic options that form the whole gamut of transactions in the options

6.3.4 FACTORS DETERMINIG OPTION VALUE:

These are the two basic options that form the whole gamut of transactions in the options

Page 68

In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favourable for the buyer. It is the other way round for the seller, more the Spot Price higher is the chances of his going into a loss. In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing.

More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that.

in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity.

In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the

More the time to Expiration more favourable is the option. This can only exist

In case of a call option the payoff for the buyer is max(S - Xt, 0)
In case of a call option the payoff for the buyer is max(S - Xt, 0)

TIME TO EXPIRATION:

STRIKE PRICE:

SPOT PRICES:

VOLATILITY:

call option.

Page 69

In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices discounting factor increases making the price fall In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value become lesser. In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favourable on the call option.

When dividends are announced then the stock prices on ex-dividend are reduced. This is favourable for the put option and unfavourable for the call option.

More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table show all effects on the buyer side of the contract.

In reality the r and the stock market is inversely related. But theoretically speaking, when all

RISK FREE RATE OF INTEREST:

In reality the r and the stock market is inversely related. But theoretically speaking, when all

DIVIDENDS:

Page 70

 

FUTURES

 

OPTIONS

 

1) Both the parties are obligated to

1)

Only

the

(writer)

seller

is

perform.

obligated to perform.

 

2) With futures premium is paid by either party.

2) With options, the buyer pays the seller a premium.

3) The parties to futures contracts must perform at the settlement

3) The buyer of an options contract can exercise any time prior to

 

date

only. They are not

expiration date.

obligated to perform before that

date.

4)

The

holder of the contract is

4) The buyer limits the downside

exposed to the entire spectrum of downside risk and had the

risk to the option premium but retain the upside potential.

potential for all upside return.

5)

They are approximate 15-20%

margins to be paid.

In futures

5) In options premiums to be paid.

on the current stock price.

 

But

they

very

are

less

as

FUTURES OPTIONS 1) Both the parties are obligated to 1) Only the (writer) seller is perform.

6.3.5 DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES OPTIONS 1) Both the parties are obligated to 1) Only the (writer) seller is perform.

Page 71

Risk management: put option allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry day to decide whether or exercised the option and buys the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.

Speculations: The ease of trading in and out of option position makes it possible to trade options with no intention of ever exercising them. If investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss.

 

compared to the margins.

 Risk management: put option allow investors holding shares to hedge against a possible fall in

6.3.6 Advantages of option trading:

 Risk management: put option allow investors holding shares to hedge against a possible fall in

Page 72

Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised. Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly however leverage usually involves more risks than a direct investment in the underlying share. Trading in options can allow investors to benefit from a change in the price of the share without having to pay of the share.

Illustration: An investor enters into writing a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she buys a share of Rel.Petrol in the spot market at Rs. 58 per share.

By this the investor covers the position that he got in on the call option contract and if the investor has to fulfil his/her obligation on the call option then can fulfil it using the Rel.Petrol share on which he/she entered into a long contract.

A Covered Call: A long position in stock and short position in a call option.

These strategies involve using an option along with a position in a stock.

Trading options has a lower cost than shares, as there is no stamp duty payable unless
Trading options has a lower cost than shares, as there is no stamp duty payable unless

6.3.7 TRADING STRATEGIES:

Single Option and Stock

Strategy 1:

Page 73

Writing a Covered Call Option

 

S

Xt

C

Profit

from

Net

Profit

Share

Profit

Total

writing call

from

Call

bought

from

Profit

Writing

stock

  • 50 0

60

6

 

6

58

-8

-2

  • 52 0

60

6

 

6

58

-6

0

  • 54 0

60

6

 

6

58

-4

2

  • 56 0

60

6

 

6

58

-2

4

  • 58 0

60

6

 

6

58

0

6

  • 60 0

60

6

 

6

58

2

8

  • 62 -2

60

6

 

4

58

4

8

  • 64 -4

60

6

 

2

58

6

8

  • 66 -6

60

6

 

0

58

8

8

The payoff table below shows the Net Profit the investor would make on such a deal.

Writing a Covered Call Option S Xt C Profit from Net Profit Share Profit Total writing
Writing a Covered Call Option S Xt C Profit from Net Profit Share Profit Total writing

Page 74

An investor enters into buying a call option on one share of Rel. Petrol. At a

An investor enters into buying a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she sells a share of Rel.Petrol in the spot market at Rs. 58 per share.

  • 68 60

6

-8

-2

58

10

8

  • 70 60

6

-10

-4

58

12

8

Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is applied by taking a long position or buying a call option and selling the stocks.

An investor enters into buying a call option on one share of Rel. Petrol. At a
An investor enters into buying a call option on one share of Rel. Petrol. At a

Strategy 2:

Illustration:

Page 75

Buying a Covered Call Option

 

S

Xt

c

Profit

from

Net Profit from

Spot

Price of

Profit from

Total Profit

buying

call

Call Buying

Selling

the

stock

option

stock

  • 50 0

60

-6

 

-6

58

8

2

  • 52 0

60

-6

 

-6

58

6

0

  • 54 0

60

-6

 

-6

58

4

-2

  • 56 0

60

-6

 

-6

58

2

-4

  • 58 0

60

-6

 

-6

58

0

-6

  • 60 0

60

-6

 

-6

58

-2

-8

  • 62 2

60

-6

 

-4

58

-4

-8

  • 64 4

60

-6

 

-2

58

-6

-8

  • 66 6

60

-6

 

0

58

-8

-8

The payoff chart describes the payoff of buying the call option at the various spot rates and the profit from selling the share at Rs.58 per share at various spot prices. The net profit is shown by the thick line.

Buying a Covered Call Option S Xt c Profit from Net Profit from Spot Price of
Buying a Covered Call Option S Xt c Profit from Net Profit from Spot Price of

Page 76

68 8 60 -6 2 58 -10 -8 70 10 60 -6 4 58 -12 -8
  • 68 8

60

-6

2

58

-10

-8

  • 70 10

60

-6

4

58

-12

-8

This strategy involves a long position in a stock and long position in a put. It is a protective strategy reducing the downside heavily and much lower than the premium paid to buy the put option. The upside is unlimited and arises after the price rise high above the strike price.

An investor enters into buying a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two

68 8 60 -6 2 58 -10 -8 70 10 60 -6 4 58 -12 -8
68 8 60 -6 2 58 -10 -8 70 10 60 -6 4 58 -12 -8

Protective Put Strategy:

Strategy 3:

Illustration 5:

Page 77

Protective Put Strategy

 

S

Xt

p

Profit

from

Net

Profit

Spot Price of

Profit

from

Total

buying

put

from

Buying

Buying

the

stock

Profit

option

put option

stock

  • 50 10

60

-6

 

4

58

-8

-4

  • 52 8

60

-6

 

2

58

-6

-4

  • 54 6

60

-6

 

0

58

-4

-4

  • 56 4

60

-6

 

-2

58

-2

-4

  • 58 2

60

-6

 

-4

58

0

-4

  • 60 0

60

-6

 

-6

58

2

-4

  • 62 0

60

-6

 

-6

58

4

-2

  • 64 0

60

-6

 

-6

58

6

0

  • 66 0

60

-6

 

-6

58

8

2

  • 68 0

60

-6

 

-6

58

10

4

months from now and along with this option he/she buys a share of Rel.Petrol in the spot market at Rs. 58 per share.

Protective Put Strategy S Xt p Profit from Net Profit Spot Price of Profit from Total
Protective Put Strategy S Xt p Profit from Net Profit Spot Price of Profit from Total

Page 78

Reverse of Protective Put Strategy

 

S

Xt

p

Profit

from

Net Profit from

Spot

Price

of

Profit

Total Profit

writing

a

put

Put Writing

Selling

the

from

option

stock

stock

  • 50 -4

-10

60

6

 

58

8

4

  • 52 -2

60

-8

6

 

58

6

4

  • 54 0

60

-6

6

 

58

4

4

An investor enters into selling a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she sells a share of Rel.Petrol in the spot market at Rs. 58 per share.

  • 70 60

-6

0

-6

58

12

6

This strategy is just the reverse of the above and looks at the case of taking short positions on the stock as well as on the put option.

Reverse of Protective Put Strategy S Xt p Profit from Net Profit from Spot Price of
Reverse of Protective Put Strategy S Xt p Profit from Net Profit from Spot Price of

Reverse of Protective Put

Strategy 4:

Illustration 6:

Page 79

  • 56 60

6

-4

2

58

2

4

  • 58 60

6

-2

4

58

0

4

  • 60 60

6

0

6

58

-2

4

  • 62 60

6

0

6

58

-4

2

  • 64 60

6

0

6

58

-6

0

  • 66 60

6

0

6

58

-8

-2

  • 68 60

6

0

6

58

-10

-4

  • 70 60

6

0

6

58

-12

-6

56 60 6 -4 2 58 2 4 58 60 6 -2 4 58 0 4
56 60 6 -4 2 58 2 4 58 60 6 -2 4 58 0 4
56 60 6 -4 2 58 2 4 58 60 6 -2 4 58 0 4

Page 80

Or

Page 81

Strategy 1:

6.3.8 SPREADS

Bull Spread:

Put Call Parity

Or Page 81 Strategy 1: 6.3.8 SPREADS Bull Spread: Put Call Parity S - c =

S - c = Xe -r(T-t) + D - p ---------------------- (2)

P + S = c + Xe -r(T-t) + D ---------------------- (1)

Or Page 81 Strategy 1: 6.3.8 SPREADS Bull Spread: Put Call Parity S - c =

The second equation shows that a long position in a stock and a short position in a call is equivalent to the short put position and cash equivalent to Xe -r(T-t) + D.

The first equation shows a long position in a stock combined with long put position is equivalent to a long call position plus cash equivalent to Xe -r(T-t) + D.

The above strategies involved positions in a single option and squaring them off in the spot market. The spreads are a little different. They involve using two or more options of the same type in the transaction.

All the four cases describe a single option with a position in a stock. Some of these cases look similar to each other and these can be explained by Put-Call Parity.

Payoff From a Bull Spread

 

S

X1

X2

c1

c2

Profit

from

Net

profit

Profit form

Net

Total

X1

from X1

X2

Profit

Profit

from X2

  • 4200 4300

4500

-450

400

0

-450

0

400

-50

  • 4250 4300

4500

-450

400

0

-450

0

400

-50

  • 4300 4300

4500

-450

400

0

-450

0

400

-50

  • 4350 4300

4500

-450

400

50

-400

0

400

0

  • 4400 4300

4500

-450

400

100

-350

0

400

50

An investor purchases a call option on the BSE Sensex at premium of Rs.450 for a strike price at 4300. The investor squares this off with a sell call option at Rs. 400 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy call option, sell call option and both contracts together.

purchase a call option at X1 and sell a call option on the same stock at X2, where X1<X2.

Payoff From a Bull Spread S X1 X2 c1 c2 Profit from Net profit Profit form

The investor expects prices to increase in the future.

Using an illustration it would be clear how this is put to use.

Payoff From a Bull Spread S X1 X2 c1 c2 Profit from Net profit Profit form

This makes him

Illustration

Page 82

  • 4450 -450

4500

4300

400

150

-300

0

400

100

  • 4500 -450

4500

4300

400

200

-250

0

400

150

  • 4550 -450

4500

4300

400

250

-200

-50

350

150

  • 4600 -450

4500

4300

400

300

-150

-100

300

150

  • 4650 -450

4500

4300

400

350

-100

-150

250

150

  • 4700 -450

4500

4300

400

400

-50

-200

200

150

  • 4750 -450

4500

4300

400

450

0

-250

150

150

4450 -450 4500 4300 400 150 -300 0 400 100 4500 -450 4500 4300 400 200

The premium on call with X1 would be more than the premium on call with X2. This is because as the strike price rise the call option becomes unfavourable for the buyer. The payoffs could be generalised as follows.

4450 -450 4500 4300 400 150 -300 0 400 100 4500 -450 4500 4300 400 200
4450 -450 4500 4300 400 150 -300 0 400 100 4500 -450 4500 4300 400 200

Page 83

Spot Rate

Profit

on

Profit

on

Total

Net Profit

Which

long call

short call

Payoff

option(s)

Exercised

S >= X2

S - X1

X2 - S

X2 - X1

X2 - X1 - c1 + c2

Both

X1 < S <= X2

S - X1

  • 0 S - X1

 

S - X1 - c1 +c2

Option 1

S >= X1

0

 
  • 0 c2 - c1

0

 

None

This contract would involve initial cash inflows unlike the Bull Spread based on the Call Options. The premium on the low strike put option would be lower than the premium on the higher strike put option as more the strike price more is favourability to buy the put option on the part of the buyer.

This requires an initial investment.

This reduces both the upside as well as the downside potential.

Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell the same stock put at a higher strike price.

The spread could be in the money, on the money and out of money.

Spot Rate Profit on Profit on Total Net Profit Which long call short call Payoff option(s)

The features of the Bull Spread:

Spot Rate Profit on Profit on Total Net Profit Which long call short call Payoff option(s)

Page 84

Payoff From a Bull Spread (Put Options)

 

S

X1

X2

p1

p2

profit from

Net profit

Profit

Net

Total

X1

from X1

from X2

Profit

Profit

from X2