Study Notes on Derivatives

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This article provides a study note on Derivatives.

A derivative is a financial instrument whose value depends on underlying assets. The underlying assets could be
prices of traded securities of gold, copper, aluminum and may even cover prices of fruits and flowers. Derivatives
have become important in India since 1995, with the amendment of the Securities Contract Regulation Act of 1956.
Derivatives such as options and futures are traded actively on many exchanges. Forward contracts, swaps and
different types of options are regularly traded outside exchanges by financial institutions, banks and corporate clients
in over-the-counter markets. There is no single market place or an organized exchange.
Organized exchanges began trading in options on securities in 1973, whereas exchange traded debt options started
trading in 1982. On the other hand, fixed income futures began trading in 1975, but equity related futures started
trading in 1982. The reasons for debt options being stronger than futures are that stock exchanges tend to introduce
those instruments that they think will be successful in trading.
In the equity market, a relatively large proportion of the total risk of a security is unsystematic. At the same time,
many securities display a high degree of liquidity that can be expected to be maintained for long periods of time.
These to be successful, the underlying instruments have to be traded in large quantities and with some price
continuity so that the option related transactions need not create more than a minor disturbance in the market.
In the debt market, a large proportion of the total risk of the security is systematic in other words, the risk in debt
instruments cannot be diversified by investing in a number of securities. Debt instruments are smaller in size in
comparison to equity securities.
Derivatives can be classified as:
1. Commodities derivatives: These are derivatives on commodities like sugar, jute, paper, gur, castor seeds.
2. Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged securities.
3. Basic Derivatives: Futures and Options are basic derivatives.
4. Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives.
5. Exchange traded derivatives are standard contracts traded according to the rules and regulations of a stock
exchange. Only members can trade in exchange traded derivatives and they are guaranteed against counter-party
default. Contracts are settled daily.
6. OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts in foreign exchange are usually
OTC derivatives and have a high risk of default.
Participants in Derivatives Market:
Participants of derivatives market consists of the following:
1. Hedgers are those who try to minimize loses of both the parties entering into a derivative contract. At the same
time, they protect themselves against price changes in the products that they deal in. They use options and futures
and hedge in both financial derivatives and commodities derivatives.

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2. Speculators participate in futures and options. They take high risks for potential gains. Their gains are unlimited
but they can take positions and minimize their losses. They trade mainly in futures. They are the major players of the
derivatives market.
3. Arbitrageurs enter into two transactions into two different stock markets. They are able to make a profit through
the difference in price of the asset in different markets. They make a risk less profit but they have to analyse the
market with speed to ensure profitability.
Distinction between Futures and Options:
In a futures contract, both parties are obligated to perform. In the case of options, only the seller (writer) is obligated
to perform.
In an options contract, the buyer pays the seller (writer) a premium. In the case of futures, neither party pays a
premium.
In the case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and has the
potential for all the returns. In the case of options, the buyer is able to limit the downside risk to the option premium
but retains the upside potential.
The parties to a future contract must perform at the settlement date. They are, however, not obligated to perform
before the settlement date. The buyers of an options contract can exercise their right any time prior to that expiration
date.
Options:
Options or directions come with equity stock. They are usually speculative in nature and are an indirect way of
selling in stocks. Options are in the form of puts, calls, straddle, strap. Put is the right to sell at a specified time
and specified price, call is the right to buy in a similar fashion and has to be for a specified price at a specified time.
The buyer and seller of options is called writer. The attracting price is called the option price. Straddle is a
combination of a put and a call and is generally contracted by those who trade on both sides of the market.
A strap means two calls plus 1 put or 2 puts and one call. The buyer of options is interested in speculation and has
inherited both the return and the risk of trading through options. The basic reason for dealing in options is to control
stocks through a small investment. This may also be termed as leverage. The person who buys pays excess amount
in premium and in this manner is able to make the claim for a particular period of time.
Options may necessarily not be used and used only if they are rated and may be sold at either a higher or a lower
price in the next fortnight or the next month. If the option is not used it expires and the premium is lost. Option buying
is a risk and is made for a future expectation of price change in the associated stock price. Option buyer usually
knows that if he exercises options he may also be at a risk of loss.
In fact, the risk of loss is higher than the risk of gain. The writer of option can both sell and buy on a stock exchange.
The put and call options may be sold at a particular strap. If the price of that stock rises and the stock which is held
is called away, the option buyer may call and exercise his option to buy.
The person who writes the option makes a profit. If the stock price falls, a public option is made and the writer is
able to get an additional share of a particular stock. Sometimes, the price of stock remains neutral and does not rise
or fall. The writer of options can hold the stock and may make further contracts and right on them.
The price of an option in the form of premium generally rises:
(a) If the stock is held for a longer time as this is a higher risk to the writer;

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(b) If the rate of fluctuations on the stock is higher than premium;

(c) When the stocks have a very low face value they usually have a higher premium because even the price is lower
in the stock market but higher price stock receives less premium.
Options are usually exercised or struck as a cover on the premium paid for an option. It should also cover the cost
of transactions; the consideration of tax should also be made before exercising an option. Options are also used for
hedging.
An investor simultaneously buys 100 shares of a stock and puts on the stock. If stock appreciates after twelve
months, this loss has gone. The loss on this would be only in the matter of commissions and premiums. Puts are
also used for tax planning. Even if the stock prices fluctuate, the gains and losses on the assured and long stock
offset judging.
An options 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 for a specified price within a specified period of time.
The writer grants this right to the buyer for a certain sum of money called the option premium. An option that grants
the buyer the right to buy some instrument is called a call option. An option that grants the buyer to sell an
instrument is called a put option. The price at which the buyer can exercise his option is called the exercise price;
strike price or the striking price.
Options are available on a large variety of underlying assets like common stock, currencies, debt instruments and
commodities. Options are also traded on stock indices and futures contracts where the underlying asset is a futures
contract or futures style options.
Options are a versatile and flexible tool for risk management individually as well as in combination with other
instruments. Options help the individual investors with limited capital to speculate on the movements of stock prices,
exchange rates and commodity prices.
The main advantage of options is the feature of limited loss. The underlying asset for options could be a spot
commodity or a futures contract on a commodity or the futures style option.
An option on spot foreign exchange gives the option buyer the right to buy or sell a currency at a stated price (in
terms of another currency). If the option is exercised, the option seller must deliver or take delivery of currency.
An option on currency futures gives the option buyer the right to establish a long or short position in a currency
futures contract at a specified price. If the option is exercised, the seller must take the opposite position in the
relevant futures contract. For example, suppose you had an option to buy a December DM contract on the IMM at a
price of $0.58/DM.
You exercise the option when December futures are trading at $ 0.5895. You can close out your position at this price
and take a profit of $ 0.0095 per DM or, meet futures margin requirements and carry a long position with $ 0.0095
per DM being credited to your margin account. The option seller automatically gets a short position in December
futures.
Futures style options:
Like futures contracts, they represent a bet on a price. The price being betted on is the price of an option on spot
foreign exchange. The buyer of the option has to pay a price to the seller of the option, i.e., the premium or the price
of the option. In a futures style option, you are betting on the changes in this price, which, in turn depends on
several factors including the spot exchange rate of the currency involved.
For example a trader feels that the premium on a particular option is going to increase. He buys a future style call

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option. The seller of this call option is betting that the premium will go down. Unlike the option on the spot, the
buyer does not pay the premium to the seller. Instead, they both post margins related to the value of the call on spot.
Types of Options:
An option contract is an agreement between two parties representing the option buyer and the option seller. The
option seller receives a premium on the price of the option and grants the right to someone lese to buy or sell. He is
also called the option writer. The option buyer pays a price in the form of premium to the options seller for writing the
option.
When options are traded in a stock exchange, as in the case of futures, once the agreement is reached between two
traders, the clearing house (stock exchange) interposes itself between the two parties becoming buyer to every
seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. There are
two types of options. These are Call options and Put options.
A call option gives the option buyer the right to purchase currency Y against currency X, at a stated price X/Y, on or
before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y.
The writer of a call option must deliver the currency if the option buyer chooses to exercise his options.
A put option gives the option buyer the right to sell a currency Y against currency X at a specified price on or before
a specified date. The writer of a put option must take delivery if the option is exercised.
Strike Price is also called exercise price. If the striking price is high, the call option price will be low and the gain will
be limited.
The price is specified in the option contract at which the option buyer can purchase the currency (call) or sell the
currency (put) Y against X.
The date on which the option contract expires is the maturity date. Exchange traded options have standardized
maturity dates.
Options can be either American or European:
An American Option is an option, call or put, that can be exercised by the buyer on any business day from initiation
to maturity. A European option is an option that can be exercised only on maturity date.
Features of Options:
A Premium (Option price, Option value) is the fee that the option buyer must pay the option writer at the time the
contract is initiated. If the buyer does not exercise the option, he stands to lose this amount. The intrinsic value of an
option is the gain to the holder on immediate exercise of the option.
In order words, for a call option, it is defined as Max [(S-X), 0], where s is the current spot rate and X is the strike
rate. If S is greater than X, the intrinsic value is positive and if S is less than X, the intrinsic value will be zero. For a
put option, the intrinsic value is Max [(X-S), 0]. In the case of European options, the concept of intrinsic value is
notional as these options are exercised only on maturity.
The value of an American option, prior to expiration, must be at least equal to its intrinsic value. Normally, it will be
greater than the intrinsic value. This is because there is some possibility that the spot price will move further in
favour of the option holder. The difference between the value of option at any time t and its intrinsic value is called
the time value of the option.
A call option is said to be at-the-money if S = X, i.e., the spot price is equal to the exercise price. It is in-the- money if
S > X and out-of-the-money if S < X. Conversely, a put option is at-the-money if S < X, in-the-money if S < X and

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out-of-the-money if S > X.
Relationship of intrinsic value and call option price:
The premium is the difference between the intrinsic value and market price of the call option. With an increase in the
stock price, the intrinsic value increases but the premium declines. This can be explained with the help of the Table
8.5.

Option Premium and Stock Price:

Option premium fluctuates as the stock price moves above or below the strike price. Generally, option premiums
rarely move point for point with the price of the underlying stock. This happens only at parity, when the exercise price
plus the premium equals the market price of the stock.
Before attaining parity, premiums tend to increase less than point per point with the stock price. One reason for this
is that point per point increase in premium would result in sharply reduced leverage for the option buyers reduced
leverage means reduced demand for the option. Also, a higher option premium will bring about increased capital
outlay and increased risk, thus reducing demand for the option.
If stock prices decline, it does not result in a point per point decrease in option premium. Even a steep decline in the
stock price in a span of few days has only a slight effect on the options time value. This term to maturity effect
exists, because the option is a wasting asset.
Call Options Profits:
A call option buyers profit can be defined as follows:
At all points where S < X, the payoff will be c
At all points where S > X, the payoff will S-X-c, where,
S = Spot price
X = Strike price or exercise price
C = Call option premium

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Conversely, the option writers profit will be as follows:

At all points where S < X, the payoff will be c
At all points where S > X, the payoff will be -(S-X-c)
Put Options Profits:
A put option buyers profit can be defined as follows:
At all points where S < X, the payoff will be X-S-p
At all points where S > X, the payoff will be -p, where,
S = Spot price
X = Strike price or exercise price
P = Put option premium
Conversely, the put option writers profit will as follows:
At all points where S < X, the payoff will be -(X-S-p)
At all points where S > X, the payoff will be p.
Profit and Pay-offs from Options :
On the expiration date of the option the profit of pay-off can be examined for example Mr. A has an option with a
strike price of Rs. 1000/- per share and option premium of Rs. 200/- per share.
The pay-off on the expiration date in different situations is discussed through the following analysis:
Buying a Call Option:
When an investor has a buying a call option he may or may not exercise his right to buy at the strike price. If he has
purchased a call option has a premium of Rs. 200/- as stated above and his strike price is of Rs. 1000/- he will
exercise his option when the market price is more than Rs. 1000/-. If it is less than Rs. 1000/ the investor would
be keen to buy the asset. If the market price is Rs. 1200/- the investor would break even.
Figure 8.3, shows that if the price in the market of the underlying asset is less than the strike price the call option
holder will have a constant loss of the premium amount that he has paid.
However, if the price increases and it is higher than the strike price his lost will be reduced and will become zero
when the price is equal to the strike price plus premium. Therefore, the investors loss is restricted if he is a call
option holder but he can make profits to any extent depending upon the rise in the market price on the maturity date.
Selling Call Option:
Figure 8.4 shows the position of the call option writer. The call option writer has the risk of unlimited losses that are
dependent on the market price of the underlying asset but his gain will be only Rs. 200/- as long as the price of the
asset remains at Rs. 1,000.
His price reduces when the price of the asset increases and is above Rs. 1000/-. He makes the limited profit of Rs.
200/- only when the asset is less than the strike price plus premium.

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Any profit or loss of the call option holder is equal to the loss or profit of the call option writer. In a European option,
the position shown in figure 8.3 and 8.4 is possible only on the specified date but an American option the call option
holder can exercise the option at any time before the specified date whenever, he has the opportunity to do so
depending on the market conditions.

Buying a Put Option:

Figure 8.5 depicts the position of the put option holder. When the market price is less than Rs. 800/- if he exercises
his option he will make a profit. If the price rises, then the option holder should sell in the market and not exercise
his option because he would make losses. Therefore, the option writer has a right to sell at the specified price at the
strike price.

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Selling a Put Option:

Figure 8.6 depicts the position of the put option seller also called writer as long as the market price is Rs. 1000/- or
below it the put option will be exercised against the seller. The option writer can have a reduction in his loss when
the market price increases up to strike price minus premium that is Rs. 800/-.
Option Pricing The Black Scholes Model:
The theory of pricing the derivatives dates back to 1973 when Black and Scholes published a paper on the pricing of
options. This theory is based on certain assumptions.
Assumptions:
(i) The stock underlying the call option provides no dividends or other distributions during the life.
(ii) There are no transaction costs involved in buying or selling the option.
(iii) The risk free rate of interest is assumed to be constant during the life of the option.
(iv) The call option can be exercised only on its expiration date.
(v) The movement of the stock price is taken to be random.
The Black Scholes Option Pricing Model is based on the concept of riskless hedge, i.e., an investor by buying
shares of a stock can simultaneously enter into call option on the stock, where gains on the stock will exactly offset
losses on the option and vice versa.
Black Scholes Model:
The Black Scholes model is given below:
V = P{N(dl)}-eRTS(N(d 2)}
V = Current value of the option
P = Current price of the underlying share
N(d1), N(d2) = Areas under a standard normal function

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S = Risk free rate of interest

T = Option period
d1= In (P/S) + (R + 0.5 2)T/T
d2 = d1 + T
a = Standard deviation
e = Exponential function
This model is very complicated but it is of practical use in finance. It appeals to practitioners because of the
parameters of current stock price, exercise price, risk-free interest rate and length of time in years to expiration date
which are observable. These factors help to analyse the hedge position at no risk.
Warrants:
Warrants are just like call options and are used to purchase equity stock during a specified period and at a specified
time. Warrants we usually long-term options.
Warrant prices also fluctuate just like stock prices. The value of a warrant depends on the amount which the
investors are willing to pay for it. These are detachable and attachable and are usually issued with bonds. Warrants
are usually issued for a period above five years and may even be perpetual.
Those who hold warrants do not receive any dividends but this does not affect the price of a warrant. In India,
warrants are not issued. Warrants have the privilege of transfer and it is generally used for speculation. The value of
a warrant is the value of call to actual market price of common stock minus option price per share depending on the
number of times which warrant gives the right to purchase.
An important dimension that has been brought about as reforms in the stock market is the introduction of
derivatives. It is expected to bring development in the stock market with increased activity and liquidity and
minimum risk for the investors.
Forwards:
In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated price
and quantity. The forward contract does not involve any money transaction at the time of signing the deal.
If a farmer enters into the contract, forward contract safeguards and eliminates the risk of price at a future date. But
the forward market has the problem of lack of centralization of trading, difficulty in liquidity and counterparty risk, in
case of one of the parties declaring themselves insolvent or bankrupt.
Futures:
Futures are a financial contract which derives its value from the underlying asset. For example, mango, walnut,
apples, wheat or rice farmers may wish to make a contract to sell their harvest at a future date to eliminate the risk
of any negative change in price by that date.
Transactions take place through the forward or futures market. There are commodity futures and financial futures. In
the financial futures, there are foreign currencies, interest rate and market index futures. Market index futures are
directly related with the stock market. Futures markets are standardized contracts, involve centralized trading and
settlements are made through clearing houses. This reduces risk.
The following values determine the pricing of futures.

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1. Expected rate of return from investing in the asset.

2. Risk free rate of interest.
3. Price of the underlying asset in the cash market.
Index Futures:
In 1982, the stock index futures were introduced. The stock index futures contracts are made on the major stock
market index. It is an obligation, the settlement value depends on the value of stock index and the price at which the
original contract is struck and on the specified times the difference between the index value at the last closing day of
the contract and original price of the contract.
The basis of the stock index futures is the specified stock market index. No physical delivery of stock is made.
Standard and Poor contract is the most popular stock index futures. Here the obligation is to deliver cash equal to
500 times the difference between stock index value at the close of last trading day of the contract and the price at
which the future contract was struck at the settlement date. For example, if the contract is struck at the S&P stock
index level at 500 and the stock index is 510 at the end of the settlement date, then the payment that has to be made
is equal to (510 500) x 500 = 5000.
Swaps:
Financial swaps are a funding technique, which permit a borrower to access one market and then exchange the
liability for another type of liability. The global financial markets present borrowers and investors with a wide variety
of financing and investment vehicles in terms of currency and type of coupon fixed or floating.
Floating rates are tied to an index, which could be the London Inter-bank Borrowing Rate (LIBOR), US Treasury bill
rate etc. This helps investors exchange one type of asset for another for a preferred stream of cash flows.
Swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing
indirectly. The borrower might otherwise have found this too expensive or even inaccessible. Swaps are used to
transform the fixed rate loan into a floating rate loan.
Swaps are popular because they work on the concept of comparative advantage. The basic principle is that some
companies have a comparative advantage when borrowing in fixed rate markets, while others have a comparative
advantage in floating rate markets. This may lead to some companies borrowing in fixed markets when the need is
of floating rate loan and vice versa.
Types of Swaps:
All swaps involve exchange of a series of periodic payments between two parties. A swap transaction usually
involves an intermediary who is a large international financial institution. The two payment streams are estimated to
have identical present values at the outset when discounted at the respective cost of funds in the relevant markets.
The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a combination
of the two to result in cross-currency interest rate swaps. Of course, a number of variations are possible under each
of these major types of swaps.
Interest Rate Swaps:
An interest rate swap involves an exchange of different payment streams, which are fixed and floating in nature.
Such an exchange is referred to as a exchange of borrowings or a coupon swap.

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In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on
a notional principal for a number of years. At the same time, party A agrees to pay Party B cash flows equal to
interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of
interest cash flows are the same.
The life of the swap can range from two years to over 15 years. This type of a standard fixed to floating rate swap is
popularly called a plain vanilla swap. London Inter-bank Offer Rate (LIBOR) is often the floating interest rate in many
of the interest rate swaps.
LIBOR is the interest rate offered by banks on deposits from other banks in the Eurocurrency markets, LIBOR is
determined by trading between banks and changes continuously as the economic conditions change. Just as the
Prime Lending Rate (PLR) is used as the benchmark or the peg for many Indian floating rate instruments, LIBOR is
the most frequently used reference rate in international markets.
Usually, two non-financial companies do not directly arrange a swap. They deal with a financial intermediary such as
a bank who then structures the plan vanilla swap in such a way so as to earn a margin or a spread.
In international markets, they earn about 3 basis points (0.03%) on a pair of offsetting transactions. Swap spreads
are determined by supply and demand. If more participants in the swap markets want to receive fixed rather floating
swap spreads tend to fall. If the reverse is true, the swap spreads tend to rise.
It is uncommon to find a situation where two companies contact a financial institution at exactly the same with a
proposal to make opposite positions in the same swaps.
Most large financial institutions are engaged in house interest rate swaps. This involves entering into a swap with a
counterparty, then hedging the interest rate risk until an opposite counterparty is found. Interest rate future contracts
are resorted to as a hedging tool in such cases.
Currency Swaps:
Currency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency for
principal and fixed rate interest payments on an approximately equivalent loan in another currency.
Suppose that a company A and B are offered the fixed five-year rates of interest in U.S. dollars and sterling. Also
suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys better
creditworthiness than company B as it is offered better rates on both dollar and sterling.
What is important to the trader who structures the swap deal is that difference in the rates offered to the companies
on both currencies is not the same. Therefore, though company A has better deal in both the currency markets,
company B does enjoy a comparatively lower disadvantage in one of the markets.
This creates an ideal situation for a currency swap. The deal could be structured such that company B borrows in
the market in which it has a lower disadvantage and company A in which it has a higher advantage. They swap to
achieve the desired currency to the benefit of all concerned.
The principal amount must be specified at the outset for each of the currencies. The principal amounts are usually
exchanged at the beginning and the end of the life of the swap.
They are selected in such a way that they are equal at the exchange rate at the beginning of the life of the swap.
Like interest rate swaps, currency swaps are frequently warehoused by financial institutions that carefully monitor
their exposure in various currencies so that they can hedge their currency risk.
Derivatives have been developed in India for the smooth flow of investments in the market and to attract foreign
capital. It is also expected the constant scams in the investment market will be reduced. The Harshad Mehta scam

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and the Ketan Parekh scams have led to ensuring and bringing back discipline in the financial markets through new
aspects like eliminating the badla system and bringing about derivatives.
Derivatives market in India:
The derivatives market in India began to be developed after 2000. Equity derivatives were introduced with the
submission of the L.C. Gupta Committee report, which recommended derivatives for hedging facility to the investors.
Hedging in the stock market is important because it saves the investors from losses. It is like an insurance against
risk from variations in the prices in the stock market. Hedging also helps in bringing about efficiency and liquidity in
the capital market.
Derivatives were introduced in the Indian Capital Market in phases. In the first phase, Stock Index Futures, Stock
Index options, Index Stock options, and Index Stock Futures were adopted for trading in the stock market. SEBI
gave permission for Index futures contracts to be based on the S&P, CNX, NIFTY and the BSE SENSEX.
In 2003, Interest Rate Derivatives were introduced by SEBI. These are Exchange Traded Interest Rate Futures.
(IRF). These derivatives were to derive their value from a basket of dated Government Securities. The IRF protects
the buyers and sellers from the adverse effects of interest rate changes.
It is an example of a Futures Derivative. It is settled through a Clearing Corporation. The minimum size of the IRF is
2,00000 and it has a maximum maturity of one year or 12 months. NRIs and FIIs are allowed to trade in IRF
according to the guidelines issued by the Reserve Bank of India.
Derivatives trading and settlement issues were to be made through the rules and byelaws of stock exchanges,
Security Contracts Regulation Act as well as regulations and guidelines framed by SEBI.
The derivative products in India are being traded in two stock exchanges the National Stock Exchange (NSE) and
the Mumbai (Bombay) Stock Exchange (BSE). The NSE allows trading according to a prescribed set of provisions.
The trading members and clients dealing in the stock exchange have to trade under the norm and regulations
framed by NSE Futures and Options Regulations, 2001. National Stock Exchange allows trading in Nifty Futures,
Nifty options, Individual Stock Futures and Individual Stock Options.
Individuals have a choice of Stock Futures and Options in more than 50 shares. The trading system at NSE is called
NEAT F&O. It is an order driven market. Orders are matched according to price, time and quantity of the order. An
NSE member can make an active order by trading through his terminal and on-line monitor and generate a
transaction by finding out a matching order by another member.
At the Mumbai Stock Exchange, trading is active in BSE Sensex Futures, BSE Sensex Options, Individual Stock
Futures and individual Stock Options
The value of a derivative contract for individuals depends on the market value of the share, which is traded in and
the number of shares in one contract. A contract for Futures and Options should be of 200 units whether it is a Nifty
Index or Sensex and the minimum value of a contract should be Rs. 2,00,000.
In India, derivatives have the distinct feature of being European in nature in Index Option and American in Stock
Options. Both Futures and Options are available for 1, 2, or 3 months and contracts expire on the last Thursday of
every calendar month.
A March contract would expire on the last Thursday of March and April contract would expire on the last Thursday of
April. BSE offers trading even for very short periods like 1 or 2 weeks to allow shorter period maturity and liquidity in
the market.

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Settlement of Contracts:
Derivatives contracts have the feature of paying margins. SEBI allows the margins in contracts. Daily settlement
margin is also possible by payment in cash on T + 1 basis.
A Futures Contract is settled through Mark to Market Method (MTM). This is a method of daily settlement price of the
contract at the end of the day but carrying forward till the final settlement day of last Thursday of each month.
Example:
An investor purchases a futures contract in Nifty at 2,000. If Nifty closes at 1,900 at the end of the day, the investor
has made a loss of 100 x 200 = 20,000. He has to pay this margin money to the stock exchange and his contract
can be carried forward the next day.
The next day supposing Nifty increases to 2050, the investor has a gain of (2050-1950) 100 x 200 = 20,000. His
contract would be carried forward the next day at 2050 and this will continue till the last Thursday of the month which
is the final settlement day. It is not necessary to continue till the last day. The investor can square up or even take
counter-transaction on any day and close the contract.
An Options Contract is settled by paying the option premium upfront. His loss is limited to the premium. The gain or
loss has to be settled on a daily basis. Margins are not required to be paid by the option writers and the final gain or
loss is settled on the last Thursday of the month.

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