Financial Markets

Study Material on Financial Markets

Compiled by

Prof. Anil Suvarna

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Financial Markets

Syllabus
No. Contents
Section 1: Introduction to Equities 1.1 Indian Financial Markets: An Overview 1.2 1.3 1.4 1.5 Classification of Financial Markets Evolution of Stock Markets in India History of Stock Exchanges in India Management of Stock Markets

Section 2: Equities 2.1 Equities: History, Meaning and Definition 2.2 Types of Trading 2.3 Trading Mechanism and its Modernization 2.4 Clearing and Settlement Section 3: Derivatives 3.1 Derivatives: History, Meaning and Definition 3.2 Classification of Derivatives 3.3 Features, Types and Players in Derivatives 3.4 Forwards: Meaning, Definition & Limitations Section 4: Futures 4.1 Meaning 4.2 Terminologies 4.3 Payoff Profile 4.4 Numericals Section 5: Options 5.1 Meaning 5.2 Terminologies 5.3 Payoff Profile 5.4 Numericals

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Financial Markets

Section 1: Introduction to Equities

1.1 Financial Markets: An Overview

Financial markets are an integral part of the economy of any nation. They play a key role in the development of the economy. In simple words financial markets facilitate the reallocation of savings from savers to entrepreneurs. In India the financial markets and institutions have, in recent years, undergone significant changes keeping in pace with the changing needs of market participants. Also the market has gone through various stages of liberalization that has increased its degree of integration with the global markets.

In the financial markets savings are linked to investments by a variety of intermediaries through a range of complex financial products called securities. Securities are defined in the Securities Contracts (Regulation) Act, 1956 to include shares, bond, scrip, stocks, or other marketable securities of like nature in or of any incorporate company or body corporate, government securities, derivatives of securities, units of collective investment scheme, interest and rights in securities, security receipt or any other instruments so declared by the Central Government.

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1.2 Classification of Financial Markets

The Financial Market Comprises Of Two Broad Groups

Financial Market

Money Market

Capital Market

Gilt-edged Securities Market

Securities Market

Primary Market

Secondary Market

Money market The money market is concerned with the borrowing and lending of short- term funds. It deals with near substitutes for money like trade bills, promissory notes and government papers drawn for a short period not exceeding one year. These, short term instruments can be converted into cash readily without any loss and at low transaction cost. This market supplies funds for financing current business operations, working capital requirements, and short period requirements of the Government.

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Financial Markets Capital market Capital market is concerned with the borrowing and lending of long-term funds. The capital markets mobilize the savings of the households and of the industrial concerns, provide them with excellent investment opportunities thus facilitating capital formation in the country. The capital market makes available funds for various projects in the private sector as well as public sector. Also institutions raise funds for projects in the backward areas, which in turn lead to development of the backward areas. A healthy capital market is an indication of a tremendous economic growth and development of a country.

Evolution of capital markets In India the current structure of capital market has evolved over the years due to constant improvement measures and modifications. A major reason behind this is the growth of Stock Exchanges in India. Due to this it has become possible for many people to be a part of the capital market as they have a medium via which they can buy and sell the securities. The stock exchanges act as a connecting link between the potential demand and supply.

Setting up of the most important regulatory body in the context of a primary market, i.e. Securities and Exchange Board of India (SEBI) way back in the year 1988, definitely played a crucial role in the development of the capital market.

Besides these, the growth of financial institutions such as State Finance Corporations (SFC), Industrial Finance Corporation of India (IFCI), State Industrial Development Corporations (SIDC), a major spurt in the mutual funds industry, development of credit rating industries have also provided a boost to the capital market in India. These institutions actively participate in the securities market.

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Financial Markets As a result of these significant moves, today our market is rated third in the entire world. Absence of capital market acts as a deterrent factor to capital formation and economic growth. Resources would remain idle if finance is not funneled through capital market. Thus as mentioned earlier it is evident that capital market facilitates increase in production and productivity in the economy and thus enhances the economic welfare of the society.

Gilt-edged securities market This market deals with the securities such as bonds issued by Central Government, State Government, and All India Financial Institutions like IDBI, State Finance Corporations, SIDCs and other government bodies. The securities are issued in the forms of bonds and credit notes. The buyers of such securities are banks, insurance companies, employees provident funds, RBI and even individuals. These securities are fully backed by the Government.

Securities Market This market deals with equities, bonds and derivatives. The securities market has essentially three categories of participants, namely the issuer of securities, investors in securities and the intermediaries. The issuers and investors are consumers of services rendered by the intermediaries. While the investors are consumers of securities issued by the issuers as they subscribe for and trade in those securities. The Securities Market has two independent and inseparable segments: The Primary Market and The Secondary Market.

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Financial Markets Primary Market The primary market provides the channel for creation of new securities through issuance of financial instruments by public companies as well as Governments and Government agencies and bodies. This market provides both existing quoted companies and new companies with the facility for raising new capital. In India a secondary offering is also done in a primary market. The primary market issuance is done through: Public Issue Offer for sale Right Issues Private Placement

Secondary Market The secondary market is the place for sale and purchase of existing securities. It enables an investor to adjust his holdings of securities in response to changes in his assessment about risk and return. It also enables him to sell securities for cash to meet his liquidity needs. It essentially comprises of the stock exchanges which provide platform for trading of securities and a host of intermediaries who assist in trading of securities and clearing and settlement of trades. The securities are traded, cleared and settled as per prescribed regulatory framework under the supervision of the exchanges and the oversight of SEBI.

The secondary market has further two components, namely:

The Over-The-Counter (OTC) Market OTC is different from market place provided by the Over The Counter Exchange of India Limited (OTCEIL). OTC markets are essential informal markets where trade deals are negotiated. Most of the traders in government securities are in the OTC market. All the spot trades where securities are traded for immediate delivery and payment take place in OTC market.

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Financial Markets

The Exchange-Trade Market Trades taking place over a trading cycle, i.e., a day under a rolling settlement, are settled together after a certain time (currently 2 working days). All the 23 stock exchanges in the country provide facilities for trading of equities. Traders executed on the leading exchange (National Stock Exchange of India Limited (NSE) are cleared and settled by a clearing corporation that provides notations and settlement guarantee.

Alternative Sources of Finance The selection of alternative sources of capital depends on the urgency of the financial need, corporate and shareholder objectives, the amount of capital needed, the use to which the proceeds will be applied, and the relative size and maturity of the company.

Commercial Lenders and Lessors Strategic Partnerships Government Loans and Guarantees Venture Capitalists Sale or Merger Initial Public Offering

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1.3 Evolution of Stock Market in India

India has a two hundred year old trading in securities. Infact, the first Indian stock exchange established in Bombay is the oldest exchange in Asia. The pace of growth of stock exchanges was slow till 80s. After that, there was a capital market revolution in the country. This was due to gradual liberalization of economic and industrial policies. The shift from command economy to a market economy brought the importance of stock exchanges into limelight.

The origin of stock market in India can be traced to the later part of the eighteenth century. The earliest security dealings were transactions in loans securities of the East India Company, the dominant institute of those days. Corporate shares came into the picture by 1830s, and assumed significance with the enactment of the Companies Act in 1850. The introduction of limited liability marked the beginning of the era of the modern joint stock enterprises. This was followed by the American civil war in 1860 1865. However, the bubble burst with the end of the civil war and a disastrous slump followed. It lasted for a long time. It also resulted in complete ostracism of the broker community.

The tremendous social pressure on the brokers led to their forming an informal association which later gave birth to, The Native Share and Stock Brokers Association, (now known as the Bombay stock exchange) in 1887. . This stock exchange played a major role during the phase of recovery from the seven year depression. It continued to grow in stature and the size of operations and became the nerve centre of all financial activity and the first to be recognized by the government of India. This was followed by the formation of association/exchanges in:Ahmedabad Calcutta Madras (1894) (1908) (1937)

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Financial Markets The Second World War resulted in a sharp boom and growth in the number stock exchanges. However, most of the stock exchanges languished till 1956, when the government came out with a comprehensive legislation called The Securities Contract (Regulation) Act, to regulate the functioning of stock exchanges and to check the performance and promote a more orderly development of the stock market. This legislation made it mandatory on the part of the stock exchanges to secure recognition from central government. Only the established stock exchanges were recognised under the act. Under this legislation it is mandatory on the part of stock exchanges to seek governmental recognition.

After this the trading on the stock exchanges in India used to take place without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient and also imposed limits on trading volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced a nation-wide online fully automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. This allowed faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets.

Owing to development of stock markets in India, this attracted the various foreign players to invest in the Indian stock market. Various FIIs came to India and got them registered themselves with SEBI and started investing in Indian stock market. During that time market also had a variety of deferral products like modified carry forward system, which encouraged leveraged trading by enabling postponement of settlement. The deferral products have been banned and in their place came the existence of Derivative trading in securities though at the beginning it dint take of well because there was no suitable regulatory framework to govern the trades.

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Financial Markets So SCRA was amended in December 1999 to expand the definition of securities to include derivatives so that the whole regulatory framework governing trading of securities could e applied to derivatives also. Then derivative trading took of in June 2000 on two exchanges. Now in all there are 23 stock exchange in the country where trading in equities is carried. This all changes have led to development of stock market in India.

1.4 History of Stock Exchanges in India In 1860, the exchange flourished with 60 brokers. In fact the 'Share Mania' in India began when the American Civil War broke and the cotton supply from the US to Europe stopped. Further the brokers increased to 250. At the end of the war in 1874, the market found a place in a street (now called Dalal Street). In 1887, "Native Share and Stock Brokers' Association" was established. In 1895, the exchange acquired a premise in the street which was inaugurated in 1899.

The stock exchanges are the exclusive centres for trading of securities. Stock exchange means anybody or individual whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. It is an association of member brokers for the purpose of self-regulation and protecting the interest of the members. It can operate only if it is registered under the Securities Contracts (Regulation) Act 1956.

The SCRA was made in order to regulate certain matters of stock exchanges which include opening / closing of the stock exchanges, timing of trading, regulation of bank transfers, regulation of badla or carry over business, control of the settlement and other activities of the stock exchange like: -

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Financial Markets Margin regulation, regulation of brokers, broker charges, trading rules on the exchange and settlement and clearing of the trading, at the end March 2003, there were 23 operative stock exchanges with 9,413 securities listed. On the same date, there were 9,519 registered brokers and 13,291 registered sub brokers trading on these exchanges in the listed companies.

Functions of the Stock Exchange:

To Ensure A Measure of Safe Dealing: - The stock exchange operates under a regulatory framework which favours them heavily by almost banning trading of securities outside exchanges resulting to protect the interest of the investors. The rules, regulations of a stock exchange approved by the government are made to ensure that a reasonable measure of safety is provided to investors and transactions take place in competitive conditions and no malpractices are to be involved.

Directing the Flow of Capital in The Most Profitable Channels: - Companies which have more profitable investment opportunities are normally able to generate more funds through this market, whereas companies which do not have such opportunities are not able to do so. In this way stock exchange facilitates the direction of flow of capital in most profitable channels.

Motivates The Company To Raise Its Standard Of Performance: - When the company is listed on the stock exchange, the performance of the company is reflected in the market price of the equity stock, which is readily available for public consumption. When the companies make profit then the public will invest in the shares of that company resulting to profitability of that company. Such a public exposure induces companies to raise their standard of performance.

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Financial Markets Providing Liquidity To The Listed Companies: - The stock exchange helps the companies in raising their funds. The savings of investors flow in the stock exchange there by resulting in trading in securities. This provides liquidity to the listed companies.

Recognized Stock Exchanges of India No. Name Of Exchange Date Of Initial Recognition
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. The Bombay Stock Exchange The Ahmedabad Stock Exchange The Calcutta Stock Exchange The Madras Stock Exchange The Delhi Stock Exchange The Hyderabad Stock Exchange The Madhya Pradesh Stock Exchange The Banglore Stock Exchange The Cochin Stock Exchange The Uttar Pradesh Stock Exchange The Pune Stock Exchange The Ludhiana Stock Exchange The Gauhati Stock Exchange The Kanara Stock Exchange The Magadha Stock Exchange The Jaipur Stock Exchange The Bhubaneswar Stock Exchange The Saurashtra Kutch Stock Exchange The Vadodra Stock Exchange The Coimbatore Stock Exchange The Meerut Stock Exchange The National Stock Exchange Over The Counter Exchange of India 31.03.1957 16.09.1957 10.10.1957 15.10.1957 09.1.1957 29.09.1958 24.12.1958 16.02.1963 10.05.1979 03..6.1982 02.09.1982 29.04.1983 01.05.1984 09.09.1985 11.12.1980 09.01.1989 05.06.1989 10.07.1989 05.01.1990 18.09.1991 20.09.1991 26.04.1993 23.08.1994

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Financial Markets 1.5 Management of Stock Exchanges

The Indian stock exchanges are regulated by the Ministry of Finance, The Securities and Exchange Board of India (SEBI), and the governing boards of the stock exchanges within the legal framework provided by the securities contracts (Regulations) Act, 1956, and the Securities and Exchange Board of India Act, 1992. The internal governance of the stock exchange is done through the framework of Rules, Bye-laws and Regulations, duly approved by the government of India.

The securities markets in India are governed under 4 main legislations: The Securities Contracts (Regulation) Act, 1956: - This prevents undesirable transaction in the securities by regulating the business of dealing in securities. The Companies Act, 1956: - Which is a uniform law relating to companies throughout India. The SEBI Act, 1992: - For protection of interest of investors and for promoting development of and regulating the securities market. The Depositories Act, 1996: - Which provides for electronic maintaince and transfer of ownership of dematerialised securities.

Besides, the Ministry of Finance, through the stock exchange division, administers the SCRA, 1956. It has the powers to apply the provisions of the said Act, provide licenses to dealers, grant recognition to the stock exchanges and regulate their operations.

Further, it has the appellate and supervisory powers over the SEBI. The Ministry of Finance has the power to nominate the Presidents and Vice-Presidents and also the approval on appointment of various representatives of the stock exchanges.

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Financial Markets SEBI - Securities and Exchange Board of India The Securities and Exchange Board of India (SEBI) was set up on April 12, 1988. To start with, SEBI was set up as a non-statutory body. It took almost four years for the government to bring about a separate legislation in the name of SEBI conferring statutory powers. The Act charged to SEBI with comprehensive powers over practically all aspects of capital market operations. SEBI has two Advisory Committees, one each for primary and secondary market. The committees are constituted from among the market players, recognized investor associations and eminent persons associated with the capital market. They provide advisory inputs in framing policies and regulations. These committees are non statutory in nature and SEBI is not bound by the committees. Objectives According to the preamble of the SEBI Act, the primary objective of the SEBI is to promote healthy and orderly growth of the securities market and secure investor protection. For this purpose, the SEBI monitors the activities of not only stock exchange but also merchant bankers etc. The objectives of SEBI are as follows: To protect the interest of investors so that there is a steady flow of savings into the capital market. To regulate the securities market and ensure fair practices by the issuers of securities so that they can raise resources at minimum cost. To promote efficient services by brokers, merchant bankers and other intermediaries so that they become competitive and professional. Simultaneously SEBI which came into existence in 1992 was regarded as the capital market regulator in India. SEBI was given the full authority and jurisdiction over the securities market under the act. Anil Suvarna 15

Financial Markets Roles The various roles of SEBI are as follows:To ensure better disclosure norms Introducing free pricing of Public Issues Establishing the new norms for issue of stock investment Framing rules for various market participants (bankers, portfolio managers and brokers) To protect the interest of the investors in the securities market, promoting the development of securities market and even regulating the stock market Setting up advisory panel for primary and secondary markets Registering brokers and levying appropriate fees to the brokers Framing rules for Foreign Institutional Investors (FIIs) Developing a specific code for mergers and takeovers To collect information and advise the government on matters relating to the stock and capital markets Developing norms for insider trading Powers: SEBI has been vested with the following powers: Power to call periodical returns from recognized stock exchanges Power to call any information or explanation from recognized stock exchanges or their members. Power to direct enquiries to be made in relation to affairs of stock exchanges or their members. Power to grant approval to byelaws of recognized stock exchanges. Power to make or amend byelaws of recognized stock exchanges. Power to compel listing of securities by public companies. Power to control and regulate stock exchanges. Anil Suvarna 16

Financial Markets Power to grant registration to market intermediaries. Power to levy fees or other charges for carrying out the purpose of regulation. Power to declare applicability of Sec 17 of Securities Contract (Regulation) Act in any state or area to grant licenses to dealers in securities. Operational Review of SEBI: I. The Securities and Exchange Board of India Act, 1992 provides for the establishment of the Board to: Protect the interest of the investors in securities Promote the development of, and Regulate the securities market and matters connected therewith or incidental to.

II.

The Securities and Exchange Board of India (SEBI) has chalked out a vision of becoming the "Most Dynamic and Respected Regulator-Globally".

III.

SEBI has drawn a comprehensive Strategic Action Plan in order to realize this vision. The Plan envisages achievement of strategic aims laid down for : Investors (Consumers): Investors are enabled to make informed choices and decisions and achieve fair deals in their financial dealings Firms (Corporate): Regulated firms and their senior management understand and meet their regulatory obligations Financial Markets (Exchanges, Intermediaries): Consumers and other participants have confidence that markets are efficient, orderly and clean Regulatory Regime: An appropriate, proportionate and effective regulatory regime is established in which all the stakeholders have confidence.

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Section 2: Equities

2.1 Equities: History, Meaning and Definition

History The Indian Equity Market is also the other name for Indian share market or Indian stock market. Indian Equity Market at present is a lucrative field for the investors and investing in Indian stocks are profitable for not only the long and medium-term investors, but also the position traders, short-term swing traders and also very short term intra-day traders. Foreign investment in general enjoys a majority share in the Indian Equity Market. Foreign Institutional Investors (FII) need to register themselves with the SEBI and the RBI for operating in Indian stock exchanges. In fact from the Indian equity market analysis it is known that in some specific industries foreigners can have even 100% shares. In the last few years with the facility of the Online Stock Market Trading in India, it has been very convenient for the FIIs to trade in the Indian equity market.

Thus, the growing financial capital markets of India being encouraged by domestic and foreign investments is becoming a profitable business more with each day.

Meaning The market in which shares are issued and traded, either through exchanges or over-thecounter markets equity market, also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. This market can be split into two main sectors: the primary and secondary market. The primary market is where new issues are first offered. Any subsequent trading takes place in the secondary market.

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Financial Markets Definition Equity market or stock market is a system through which company shares are traded. The equity market offers investors an opportunity to participate in a company's success through an increase in its stock price. With enhanced opportunity, however, the equity market usually carries greater risk than debt markets. The worldwide equity market benefited from freer markets, government privatizations, and companies seeking an alternative to debt.

2.2 Types of Trading, Types of Traders and Styles of Trading

Types of Trading can be divided into long term and short term. For long term trading we have delivery trading and for short term trading we have intra-day trading.

1. Delivery Trading: This type of trading is done by investors who want to invest their money from a long term perspective say for more than 1 year. Under delivery trading one actually becomes the owner of the share as he pays full amount for buying the same. The investor has full right on the share purchased and can hold it in his demat a/c forever, in-short he has got no obligations to be fulfilled once have bought the share. Settlement happens on T+2 days and one gets the actually delivery of shares in his demat a/c.

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Financial Markets 2. Intra-day Trading: This type of trading is done only by traders; one has complete his trading activities in the same trading day. Under intra-day trading one doesnt become the owner of the share as he pays only the margin amount for buying or selling the same. The trader has the obligation to square off the position before the closing bell as he is not allowed to carry forward the position under intra-day. Settlement has to be compulsorily done on the same trading day, since intraday is cash settled there is no delivery happening.

Types of Traders The stock market also provides opportunities for short-term traders. When the price starts to fall or rise, other investors will jump on the bandwagon, causing an even faster acceleration in price. Eventually the market will correct itself, but for savvy short-term traders who watch the market closely, these price changes can offer opportunities for profitable trading. Short term traders are divided into 3 categories: Position Traders, Swing Traders, and Day Traders. 1. Position Traders - Position trading is the longest term trading style of the three. Stocks could be held for a relatively long period of time compared with the other trading styles. Position traders expect to hold on to their stocks for anywhere from 5 days to 3 or 6 months. Position traders are watching for fundamental changes in value of a stock. This information can be gleaned from financial reports and industry analyses. Position trading does not require a great deal of time. An examination of daily reports is enough to plan trading strategies. This type of trading is ideal for those who invest in the stock market to supplement their income. The time needed to study the stock market can be as little as 30 minutes a day and can be done after regular work hours.

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Financial Markets 2. Swing Traders - Swing traders hold stocks for shorter periods than position traders - generally from one to five days. The swing trader is looking for changes in the market that are driven more by emotion than fundamental value. This type of trading requires more time than position trading but the payback is often greater. Swing traders usually spend about 2 hours a day researching stocks and executing orders. They need to be able to identify trends and pick out trading opportunities. They usually rely on daily and intraday charts to plot stock movements.

3. Day Traders - Day trading is commonly thought of as the most risky way to play the stock market. This may be true if the trader is uneducated, but those who know what they are doing know how to limit their risk and maximize their profit potential. Day trading refers to buying and selling stock in very short periods of time - less than a day but often as short as a few minutes. Day traders rely on information that can influence price moves and have to plot when to get in and out of a position. Day traders need to be rational and analytical. Emotional buyers will quickly lose money in this type of trading. Because of the close attention needed to market conditions, day trading is a full-time profession. Styles of Trading
1.

Scalping - The scalper is an individual who makes dozens or hundreds of trades per day, trying to "scalp" a small profit from each trade by exploiting the bid-ask spread.

2.

Momentum Trading - Momentum traders look to find stocks that are moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit.

3.

Technical Trading - Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.

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4.

Fundamental Trading - Fundamentalists trade companies based on fundamental analysis, which examines things like corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions.

5.

Swing Trading - Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.

2.3Trading Mechanism and its Modernization

Decision to Trade

Planning Order

Funds / Securities

Trade Execution

Settlement of Trades

Clearing of Trades

Securities Trading Cycle

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Financial Markets

The above figure is a conceptual model of securities trading cycle. A person holding / having some amount of securities / funds when either to meet his liquidity needs or to reshuffle his holdings in response to changes in his perception about risk and return of the assets, decides to buy / sell the securities. Therefore, the person also influenced by the marketing activity is influenced to make a decision to either increase or decrease his share holdings. Then on that basis he contacts the broker and communicates his order i.e. places his order. Then the order is executed by the broker at the price and quantity of shares quoted by the investor. The order when matches sell / buy order is converted to trade. The trades then have to be sent for clearing in order to determine the obligations of counter parties to deliver securities as per schedule. Next the necessary formalities are conducted. Finally, the buyer / seller delivers funds / securities and receives securities / funds and acquires ownership them. So, this was the core concept on which the entire trading system was based upon which has been evolved from the traditional method to the computerized method but the transaction cycle hasnt changed. In the following pages it may be noticed that with the use of technology how the ill effects of traditional trading methods has been warded off order to evolve computerized system of trading for facilitating efficient trading for investors.

Traditional Trading Mechanism The traditional trading method of stock exchanges dates back at the time of inception of the stock exchanges wherein, rudimentary techniques of trading were applied. The trading on stock exchanges in India use to take place through open outcry without the use of information technology for immediate matching / recording of trades. This type of trading was called Ring trading / Pit trading.

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Ring trading bares its name due to the brokers trading activities used to be conducted in a ring or pit. The broker use to shout and quote their prices. The entire transaction was verbal trading and was a community driven market, mainly dominated by the Gujurathis. Also the market in the old trading system was location specific i.e. the trading could be done only in the stock market / exchange. The entire market was not representative as it was manipulated by few individuals.

The main aspect in the traditional trading mechanism was that of the brokers wherein they delt with the stock markets as per their Whims and Fancies and many a times manipulated the prices for their own personal benefit. Hence, the traditional trading mechanism was time consuming, inefficient and not secure.

Modern Trading Mechanism As analyzed the traditional trading mechanism had become obsolete because of many reasons such as increased volume in trade, opening up trade and susceptibility of markets to scams and manipulations. Therefore, on 14th March, 1995 history was created by introducing the Screen Based Trading System (SBTS).

The screen based trading system gave in an accurate and timely statistics on market activity. Also host of electronic devices such as Tickers, Monitors, Boards and Computer Terminals had been provided. The endeavour was to set up right kind of user friendliness performance and functionality.

The main objective of Modern Trading Mechanism was: Lead to Transparent deals in the market Improvement in Liquidity in the market Increase the market depth through quote continuity Eliminate mismatches and mitigate settlement risks Anil Suvarna 24

Financial Markets Instantaneous dissemination of information through various data-feed channels Structured MIS reports for analysis Provide a robust and scalable trading system for growing volumes

The aim of the new system was to provide the accurate information at a faster rate for the benefit of the traders.

The various benefits of Modern Trading Mechanism were: It makes trading accessible--anywhere and at anytime The pace of communication facilitates a fast response time Dissemination of data is done at a faster rate Technology also provides the freedom to create-new systems, new products It also facilitates transparency of information Provides global connectivity It increases awareness of market participants through provision of information

Screen Based Trading System (SBTS) The Screen Based Trading System provides seamless information flow of the various scrips which is available to everyone and anyone interested in the markets. The main aim of the technology was used to carry the trading platform from trading hall of stock exchanges to premises of broker / investor. The Screen Based Trading System operates on strict time, price and priority. The order that has been placed by the broker on behalf of investors via satellite through his computer is registered. The orders are started with best price order getting the first priority. The orders are matched automatically by the computer keeping the system transparent, objective and fair. Where an order doesnot find a match, it remains in the system and is displayed to the whole market, till a fresh order comes in or the earlier order is cancelled or modified. Also the trading provides tremendous flexibility to the users in terms of kinds of orders that can be placed on the system. Anil Suvarna 25

Financial Markets The SBTS has two terminals viz. 1. BOLT 2. NEAT

1. BOLT - BSE ON LINE TRADING SYSTEM BSE's On Line Trading System, popularly known as the BOLT system took its genesis in the year 1994, as part of the four phase computerization program to create an automated trading environment. BOLT system aimed at converting the Open Outcry system of trading to a screen-based trading system. BSE had the requisite knowledge base and by virtue of the 125 year track record in the capital markets, BSE embarked on the specified project in 1991 and seamlessly completed the fourth phase in March 1995.

With the interest of BOLT it helped the performance and response time increase to very extent. Also there was continuos availability for reliable and continuos information. The data integrity is restored which inturn guarantee the security of the distributed data enabling others to access it from anywhere in the network. With the creation of BOLT accurate and timely statistics was available. Through networking, software and hardware an open interface specification was available. Through this members had the flexibility to use their own developed application. BOTL also is interfaced with various information vendors including Bloomberg, Bridge, Reuters and others. Market information is fed to news agencies to in real time. BOLT plans to enhance the capabilities further to have an integrated two way information flow.

2. NEAT - National Exchange For Automated Trading The National Stock Exchange (NSE) is India's leading stock exchange covering 364 cities and towns across the country. NSE was set up by leading institutions to provide a modern, fully automated screen-based trading system with national reach. The Exchange has brought about unparalleled transparency, speed & efficiency, safety and market integrity. It has set up facilities that serve as a model for the securities industry in terms of systems, Anil Suvarna 26

Financial Markets practices and procedures. NSE introduced for the first time in India, fully automated screen based trading. It uses a modern, fully computerised trading system designed to offer investors across the length and breadth of the country a safe and easy way to invest. The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a fully automated screen based trading system, which adopts the principle of an order driven market. On Line Trading Mechanism: A Conceptual Model

Issuer

R & T Agent
VSAT Link

VSAT Link

Clearing Corporation House

NSDL
VSAT Link VSAT Link

Clearing Member

DP Investor

DP Investor

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Financial Markets Electronic Linkage Model The above figure is a conceptual model of trading of securities through electronic linkage. The main aspect that needs to be considered is that the entire process has to be electronically networked on every aspect. This electronic network helps in accurate and fast exchange of information and dealings in order to facilitate the investor. In the above figure the issuer registers his shares with Registrar & Transfer agent electronically, and then the DPs trade in the shares on behalf of the investors either by buying or selling of shares. DPs can be termed as small terminals of NSDL (National Securities Depositaries Limited) which have electronic link with NSDL and the exchanges. In this system the investor or the broker either places an order of buy / sell of shares. The NSDL then connects to the mainframe server of the exchanges and matches the orders with the best buy and best sell technique. Now lets get a brief perspective of NSDL.

2.4 Clearing and Settlement

Clearing and settlement is a post trade activity. Clearing Agencies ensures trading members meet their fund/security obligations. It acts as a legal counter party to all trades and guarantees settlement for all members. The original trade between the two parties is cancelled and clearing corporation acts as counter party to both the parties, thus manages risk and guarantees settlement to both the parties. This process is called novation. It determines fund/security obligations and arranges for pay-in of the same. It collects and maintains margins, processes for shortages in funds and securities. It takes help of clearing members, clearing banks, custodians and depositories to settle the trades. The settlement cycle in India is T+2 days i.e. Trade + 2 days. T+2 means the transactions done on the Trade day, will be settled by exchange of money and securities on the second business day (excluding Saturday, Sundays, Bank and Exchange Trading Holidays). Pay-in and Pay-out for securities settlement is done on a T+2 basis.

Anil Suvarna 28

Financial Markets The following is the summary of trading and settlement process in India. Investors place orders from their trading terminals. Broker houses validate the orders and routes them to the exchange (BSE or NSE depending on the clients choice) Order matching at the exchange. Trade confirmation to the investors through the brokers. Trade details are sent to Clearing Corporation from the Exchange. Clearing Corporation notifies the trade details to clearing Members/Custodians who confirm back. Based on the confirmation, Clearing Corporation determines obligations. Download of obligation and pay-in advice of funds/securities by Clearing Corporation. Clearing Corporation gives instructions to clearing banks to make funds available by pay-in time. Clearing Corporation gives instructions to depositories to make securities available by pay-in-time. Pay-in of securities: Clearing Corporation advises depository to debit pool account of custodians/Clearing members and credit its (Clearing Corporations) account and depository does the same. Pay-in of funds: Clearing Corporation advises Clearing Banks to debit account of Custodians/Clearing members and credit its account and clearing bank does the same. Payout of securities: Clearing Corporation advises depository to credit pool accounts of custodians/Clearing members and debit its account and depository does the same. Payout of funds: Clearing Corporation advises Clearing Banks to credit account of custodians/ Clearing members and debit its account and clearing bank does the same. Note: Clearing members for buy order and sell order are different and Clearing Corporation acts as a link here. Anil Suvarna 29

Financial Markets Depository informs custodians/Clearing members through Depository Participants about pay-in and pay-out of securities. Clearing Banks inform custodians/Clearing members about pay-in and pay-out of funds. In case of buy order by normal investors Clearing members instruct his DP to credit the clients account and debit its account. The money will be debited (Total settled amount - margins paid at the time of trade) from the clients account. In case of sell order by normal investors Clearing members instruct his DP to debit the clients account and credit its account. The money will be credited to the clients account.

BSE Settlement Cycle: Day Activity T Trading through BOLT (BSE Online Trading) System, downloading of statements showing details of transactions and margins at the end of the day. Downloading of provisional securities and funds obligation statements by memberbrokers. 6A/7A entry by the member-brokers/ confirmation by the custodians.

6A/7A: A mechanism whereby the obligation of settling the transactions done by a member-broker on behalf of a client is passed on to a custodian based on confirmation of latter. The custodian can confirm the trades done by the memberbrokers on-line and up to 11 a.m. on the next trading day. The late confirmation of transactions by the custodian after 11:00 a.m. up to 12:15 p.m., on the next trading day is, however, permitted subject to Anil Suvarna 30

Financial Markets payment of charges for late confirmation @ 0.01% of the value of trades confirmed or Rs. 10,000/-, whichever is less. Confirmation of 6A/7A data by the Custodians up to 11:00 a.m. Downloading of final securities and funds obligation statements by members. T+2 - Pay-in of funds and securities by 11:00 a.m. and pay-out of funds and securities by 1:30 p.m. The memberbrokers are required to submit the pay-in instructions for funds and securities to banks and depositories respectively by 10: 30 a.m. Auction on BOLT at 11.00 a.m. Auction pay-in and pay-out of funds and securities by 12:00 noon and 1:30 p.m. respectively.

Day Activity T +1

Day Activity T +2

Day Activity T +3 Day Activity T +4

NSE Settlement Cycle: Day T T+1 working days T+1 working day T+2 working day T+2 working day T+2 working day T+3 working day T+4 working day T+5 working day T+6 working day T+8 working day T+9 working days Post Settlement Type of Activity Trading Clearing Settlement Activity Rolling Settlement Trading Custodial Confirmation Delivery Generation Securities and Funds pay in Securities and Funds pay out Valuation Debit Auction Bad Delivery Reporting Auction settlement Rectified bad delivery payin and pay-out Re-bad delivery reporting and pickup Close out of re-bad delivery and funds pay-in & pay-out

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Financial Markets Functions of Custodian and Depository Custodian: A custodian is an entity which holds the documentary evidence of the title to property belonging like share certificates, etc for safekeeping. In Clearing Corporation, custodian is a clearing member but not a trading member. He settles trades assigned to him by trading members. He is required to confirm whether he is going to settle a particular trade or not. If it is confirmed, the Clearing Corporation assigns that obligation to that custodian and the custodian is required to settle it on the settlement day. If the custodian rejects (if there are mismatches due to errors in the system) the trade, the obligation is assigned back to the trading member. Only on receipt of the rejection message, the broker shall cancel the rejected contract note and issue a fresh contract note bearing a new number. Depository: A depository is an entity where the securities of an investor are held in electronic form. Depositories help in the settlement of the dematerialized securities. Each custodian/clearing member is required to maintain a clearing pool account with the depository. He is required to make available the required securities in the designated account on settlement day. The depository runs an electronic file to transfer the securities from accounts of the custodians/clearing member to that of Clearing Corporation. As per the schedule of allocation of securities determined by the Clearing Corporation, the depositories transfer the securities on the payout day from the account of the Clearing Corporation to those of members/custodians. Every investor who wants to hold securities in dematerialized form must open an account with a depository participant (DP) of his choice. Usually this is done by your broker on behalf of you. Depository Participants (DPs) hold accounts with depositories.

Anil Suvarna 32

Financial Markets Just as one can hold funds in a bank account and transfer funds across accounts without actually handling cash; one can hold securities in a depository account and transfer securities across depository accounts without actually handling share certificates.

There are two main depositories in India. 1. National Securities Depository Ltd (NSDL) 2. Central Depository Services Ltd (CDSL)

Functions of Clearing Banks Clearing Bank acts as an important intermediary between clearing member and clearing corporation. Every clearing member needs to maintain an account with clearing bank. Its the clearing members function to make sure that the funds are available in his account with clearing bank on the day of pay-in to meet the obligations. In case of a pay-out clearing member receives the amount on pay-out day.

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Financial Markets

Section: 3 Derivatives
Introduction: Indian Financial Markets: Where does derivative fall?

From the above chart we can see that derivatives fall under secondary market channel.

3.1 Derivatives History, Meaning and Definition

History Derivatives have been a recent development in the Indian financial markets. But there have been derivatives in the commodities market. There are Cotton and Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in Bangalore etc. But the players in these markets are restricted to big farmers and industries, who need these as an input to protect themselves from the vagaries of agriculture sector.

Globally too, the first derivatives started with the commodities, way back in 1894. Financial derivatives are a relatively late development, coming into existence only in the 1970s. The first exchange where derivatives were traded is the Chicago Board of Trade Anil Suvarna 34

Financial Markets (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000. The first derivatives were index futures. The index used was Nifty. Option trading was started in June 2001, for index as well as stocks. In November 2001, futures on stocks were allowed. Currently, there are 275 stocks on which derivative trading are allowed.

Meaning Derivate Derives its value from an asset - What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance of the underlying. When we say an Infosys future or an Infosys option, these carry a value only because of the value of Infosys.

Definition A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, pseudo assets like stock indices.

3.2 Classification of Derivatives

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Financial Markets Financial Derivatives Financial derivatives are instruments that derive their value from financial assets. These assets can be stocks, bonds, currency etc. These derivatives can be forward rate agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures and options.

3.3 Features of Derivatives

Hedging: To minimize risk arising due to volatility of the market. Price Discovery: To have better price discovery in terms of huge no. of players. Liquidity Function: To infuse liquidity in the market by way of lot size trading. Trading Volumes: To generate huge trading volumes by way of mass trading.

Types of Derivatives The most commonly used derivatives contracts are forwards, futures and options. Lets take a brief look at various derivatives contracts that have come to be used.

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Anil Suvarna 36

Financial Markets Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Anil Suvarna 37

Financial Markets Players in Derivatives

Hedgers: Hedgers face risk associated with the price of an asset they own. They use derivatives to reduce or eliminate risk.

Speculators: Speculators bet on future movements in the prices of an asset. Derivatives give them an extra leverage, by which they can increase both the potential gains and losses.

Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two different markets.

Jobbers: Jobbers take advantage from the spread between the Bid and Ask price.

3.4 Forwards: Meaning, Definition, Features, Players & Limitations

Meaning A forward contract is a private contract between a buyer and a seller in which the buyer agrees to buy and the seller agrees to sell a specific quantity of a certain security or commodity (known as the underlying instrument) at the price specified in the contract. The difference between a forward contract and most other sales contracts is that with the forward contract, the delivery and payment of the underlying instrument occurs at a specified future date instead of immediately.

Definition A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today.

Anil Suvarna 38

Financial Markets Features of Forwards The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

Players in Forwards Hedgers: The one who intends to minimize this risk which respect to price fluctuations Speculators: The one who speculates / anticipates the price movement in order to make maximum profits.

Limitations of Forwards Lack of centralization of trading Illiquidity Counter party risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue. Anil Suvarna 39

Financial Markets

Section 4: Futures
4.1 Meaning
Future contracts is an agreement made and traded on the exchange between two parties to buy or sell a commodity at a particular time in the future for a pre-defined price. Since both the parties are unaware of each other, the exchange provides a mechanism to give the party assurance of honored contract. The exchange specifies standardized features of the contract. The risk to the holder is unlimited, and because the pay off pattern is symmetrical, the risk to the seller is unlimited as well. Money lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading are a zero-sum game. These are basically forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. These are regulated by overseeing agencies, and are guaranteed by clearing houses. Hedgers often trade futures for the purpose of keeping price risk in check. Future contracts are often used by commercial enterprises as hedging tools to reduce the risk of expected future purchases or sales of the underlying asset. If used to speculate, risk increases. So risk depends on the underlying instrument and the use of the future.

Advantages of Futures Contracts

If price moves are favourable, the producer realizes the greatest return with this marketing alternative.

No premium charge is associated with futures market contracts.

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Financial Markets Disadvantages of Future Contracts

Subject to margin calls Unable to take advantage of favourable price moves Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occur in future. But Options are contract on the underlying futures contract where as futures are either to accept or deliver the actual physical commodity. To make a decision between using a futures contract or an options contract, producers need to evaluate both alternatives.

4.2 Terminologies
Spot price: The price at which an asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-months and three- months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.

Anil Suvarna 41

Financial Markets Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

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Financial Markets

Propose of Futures

Hedging: Hedging is a mechanism to reduce price risk. Price Risk can be reduced by taking an opposite position in futures market. Hedging can be initiated by Selling Nifty Futures or a stock .hedge can be for 20%, 50% or 100% based on view. Ideally 25 35% hedge is kept at all times, then based on view, its increased or decreased.

Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two different markets. Eg. Buy L&T in cash market @ Rs. 800/- sell in future market @ Rs .840/- thereby profit Rs. 40/-

Jobbing: Jobbing is nothing but taking advantage from the spread between the Bid and Ask price. Eg. Powergrid

4.3 Payoff Profile

A payoff is the likely profit or loss that would accrue to a market participant with change in the price of the underlying asset Futures have a linear payoff, i.e. the losses as well as profits for the trader of futures contract are unlimited

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Financial Markets

Payoff for Futures Buyer

250

150

50

-50

1,0 00

1,100

1,200

1,300

1,400

1,500

-150

-250

Payoff for Futures Seller

250

150

50

1, 000 -50

1, 100

1, 200

1,300

1,400

1, 500

-150

-250

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Financial Markets

4.4 Numericals

Q.1. Krishna Seth sold a January Nifty futures contract for Rs.240,000 on 15th January. Each Nifty futures contract is for delivery of 100 Nifties. On 25th January, the index closed at 2350. How much profit/loss did she make? a. b. -7,000 -5,000

c. +5,000 d. +7,000

Solution: Krishna Seth sold one futures contract costing her Rs.240,000. At a market lot of 100, this works out to be Rs.2400 per Nifty future. On the futures expiration day, the futures price converges to the spot price. If the index closed at 2350, this must be the futures close price as well. Hence she will have made of profit of (2400 - 2350)*100. The correct answer is number 3.

Q.2. Santosh is bullish about Company XYZ and buys ten one- month XYZ futures contracts at Rs.2,96,000. On the last Thursday of the month, XYZ closes at Rs.271. He makes a ___ a. b. profit of Rs. 15000 profit of Rs.25000

c. loss of Rs.15000 d. loss of Rs.25000

Solution: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures, i.e. 2,96,000/(10 * 100). On expiration day the spot and futures converge. Therefore he makes a loss of (296 - 271) * 1000 = 25000. The correct answer is number 4.

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Financial Markets

Q.3. Rajiv is bearish about Company ABC and sells twenty one- month ABC futures contracts at Rs.3,04,000. On the last Thursday of the month, ABC closes at Rs.134. He makes a _____. a. b. c. profit of Rs. 18000 profit of Rs.36000 loss of Rs. 18000

d. loss of Rs.36000

Solution: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures, i.e. 3,04,000/(20 * 100). On expiration day the spot and futures converge. Therefore his profit is (152-134) * 2000 = 36000. The correct answer is number 2.

Q.4. Ms. Sweta is short on NTPC; the details of her position are as follows: Lot size: 1625 Shares Net Future Value: Rs. 2, 59,431.25/Initial Margin: 33.95% Span Margin / Maintenance Margin: 23.95%

At what price will she get the margin call and what is the Margin Amount she has to bring in if she gets a margin call from her broker? a. Price Rs. 172.55/- and Amount Rs. 22350.50/b. Price Rs. 175.62/- and Amount Rs. 25,943.13/c. Price Rs. 181.13/- and Amount Rs. 30,056.25/d. Price Rs. 180.00/- and Amount Rs. 29,596.50/-

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Financial Markets

Q.5. Mr. Ankit is long on BHEL, the details of her position are as follows: Lot size: 75 Shares Price: Rs. 1355/- per share Initial Margin: 34.26% Span Margin / Maintenance Margin: 24.26%

At what price will she get the margin call and what is the Margin Amount she has to bring in if she gets a margin call from her broker? a. Price Rs. 1219.50/- and Amount Rs. 10,162.50/b. Price Rs. 1220.50/- and Amount Rs. 10,262.50/c. Price Rs. 1221.50/- and Amount Rs. 10,362.50/d. Price Rs. 1222.50/- and Amount Rs. 10,462.50/-

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Financial Markets

Section 5: Options
5.1 Meaning
Options give the buyer the right not the obligation to buy or sell a specified underlying at a set price, on or before a specified date

5.2 Terminologies
Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Seller / Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Anil Suvarna 48

Financial Markets

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price.

American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

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Financial Markets At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

ITM-OTM-ATM Thumb Rule

Market Scenario Market Price > Strike Price Market Price < Strike Price Market Price = Strike Price Call Option ITM OTM ATM Put Option OTM ITM ATM

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Financial Markets

Trading Strategies

Strategy 1:

Strategy: 2

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Financial Markets

5.3 Payoff Profile

20 0

Payoff Profile of a Call Buyer: The maximum loss for a call option buyer is the premium paid by him, while maximum gains are unlimited.

15 0

10 0

50

1, 000

1, 100

1, 200

1, 50 2

1 , 50 3

1 , 50 4

1 , 50 5

50 -

- 10 0

- 15 0

20 0

15 0

Payoff Profile of a Call Seller: The maximum gain for a seller of the call option is premium

10 0

5 0

0 1, 00 0 -5 0 1, 0 10 1 0 ,20 1 50 ,2 1,3 50 1,4 50 1, 5 50

-10 0 -15 0

-20 0

-25 0

2 00

Payoff Profile of a Put Buyer: The maximum loss for a buyer of the put option is the premium paid by him, while maximum gains are unlimited.

1 50

1 00

50

0 9 50 -50 10 50 11 50 12 50 13 50 14 50 15 50

-1 00

-1 50

200

150

Payoff Profile of a Put Seller: The maximum gain for a seller of the put option is premium.

100

50

0 950 -50 1050 1150 1 250 135 0 1450 1550

-100

-150

-200

-250

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Financial Markets

Payoff Profile for Options Thumb Rule

Profits unlimited Losses limited to the extend premium paid Profits limited to the extend premium received Losses unlimited Profits unlimited Losses limited to the extend premium paid Profits limited to the extend premium received Losses unlimited

Buyer

Call
Seller

Buyer

Put
Seller

PCR Put Call Ratio

Put Call Ratio means, the Volume of Put Options to the Volume of Call of Options. As you may know, Put option indicates, the Price of the Stock is going to fall and a Call Option buyer anticipates the Stock is going to rise.

When calls are more than Puts, means the anticipation of market moving up is more. (Bullish Sentiment) When puts are more than calls, means it is a sentiment of Bearish Market. At the end of the day, when Put to call ratio is taken; the overall market sentiment can be captured.

When Put - call ratio is Low, That means, Calls are more than Puts - BullIish Market Sentiment.

When Put - Call Ratio is high, that means, puts are more than calls, Bearish Market Sentiment.

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Financial Markets

PCR Thumb Rule

PCR Higher PCR Lower Puts Are More Than Calls Calls Are More Than Puts Bearish Bullish

Open Interest
Open Interest is the number of Outstanding Shares (yet to be settled), in the Futures and Options trading. If you buy 2 futures from me, the Open Interest is 2. If I in turn buy 4 futures from C, the open interest is 6. These are un-setlled contracts. Thus to analyse Open Interest, it needs to be analyzed along with Price of the Shares.

These are the 4 common analysis parameters:

Open Interest Analysis Thumb Rule

Contract Increases Contract Increases Contract Decreases Contract Decreases Price Increases Price Decreases Price Increases Price Decreases Bullish Bearish Bullish Bearish

Thus PCR needs to be studied in co-relation with Open Interest for a complete analysis.

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Financial Markets

5.4 Numericals
Q.1. Chetan is bullish about the index. Spot nifty stands at 2200. He decides to buy one 3 month nifty call option contract with a strike of 2260 @ Rs. 60 a call. Three months later the index closes at 2240. His payoff on the position is (Lot Size = 100) a. -7000 b. -4000 c. -12000 d. -6000
Solution: The call expires out of the money, so he simply loses the call premium he paid, i.e 60 * 100 = Rs.6, 000. The correct answer is d.

Q.2. On 1st April, Ms. Sapna has bought 400 calls (1 Lot) on Cipla at a strike price of Rs 200/- for a premium of Rs 20 per call. On expiry Cipla closes at Rs. 240/-. What is net payoff in terms of profit / loss? a. Profit of Rs. 16000 b. Profit of Rs. 8000 c. Loss of Rs. 16000 d. Loss of Rs. 8000
Solution: On the 400 calls sold by her, she receives a premium of Rs.8000. However on the calls assigned to her, she loses Rs. 16,000(400 * (240-200)). Her payin obligation is Rs.8000. The correct answer is b.

Q.3. Miss Manisha has sold 800 calls on Dr. Reddys Lab at a strike price of Rs. 882 at a premium of Rs 25 per call on Jan 1st. The closing price of equity shares on Dr. Reddys lab is Rs. 884 on that day. If the call option is assigned to her on that day, what is her net obligation on Jan 1st? a. Pay out of Rs. 18300 b. Pay in of Rs. 18300 c. Pay in of Rs 13800 d. Pay out of Rs. 18400 Solution: She will receive the premium amount of Rs. 20,000/- (i.e.800*25). Since she is an option writer her max. profit is Rs. 20,000/- wherein losses can be unlimited. Now if the price goes above 882 she stands to loose and if it remains @ 882 or goes below 882 she stands to gain Rs. 20,000/-. As prices move up from 882 to 884 i.e. diff of Rs.2/- she stands to loose Rs. 1600/- (800*2). Her profit amount has gone down by 1600, thus she will Anil Suvarna 55

Financial Markets receive the payout from the exchange of Rs. 18400/- instead of Rs. 20,000/-. The correct answer in d.

Q.4. Miss Shweta has sold 600 calls on DLF at a strike price of Rs. 1403 for a premium of Rs. 30 per call on March 1st. The closing price of equity shares of DLF is Rs. 1453 on that day. If the call option is assigned against her on that day, what is her net obligation on March 1st? a. Pay out of Rs. 21600 b. Pay in of Rs 15000 c. Pay out of Rs 13400 d. Pay in of Rs 12000 Solution: She will receive the premium amount of Rs. 18,000/- (i.e.600*30). Since she is an option writer her max. Profit is Rs. 18,000/- wherein losses can be unlimited. Now if the price goes above 1403 she stands to loose and if it remains @ 1403 or goes below 1403 she stands to gain Rs. 18,000/-. As prices move up from 1403 to 1453 i.e. diff of Rs.50/she stands to loose Rs. 30,000/- (600*50). Now over here her entire profit amount of Rs. 18,000/- has got eroded but on top of that she has made a loss of 12,000/- (i.e. 30000 18000) thus she will have to pay in Rs. 12000 to the exchange. The correct answer in d.

Q.5. The May futures contract on XYZ Ltd. closed at Rs.3940 yesterday. It closes today at Rs.3898.60. The spot closes at Rs.3800. Raju has a short position of 3000 in the May futures contract. He sells 2000 units of May expiring put options on XYZ with a strike price of Rs.3900 for a premium of Rs.110 per unit. What is his net obligation to/from the clearing corporation today? a. Payin of Rs.344200 b. Payout of Rs.640000 c. Payout of Rs.344200 d. Payin of Rs.95800 Solution: On the short position of 3000 May futures contract, he makes a profit of Rs.124200 (i.e. 3000 * (3940 - 3898.60)). He receives Rs.220000 on the put options sold by him. Therefore his net obligation from the clearing corporation is Rs.344200. The correct answer in c.

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