Chapter 1: INTRODUCTION 1.1: Background of The Study:: Equity and Derivatives

Equity and Derivatives
Chapter 1: INTRODUCTION 1.1: Background of the study: The oldest stock exchange in Asia (established in 1875) and the first in the country to be granted permanent recognition under the Securities Contract Regulation Act, 1956, Bombay Stock Exchange Limited (BSE) has had an interesting rise to prominence over the past 133 years. A lothas changed since 1875 when 318 persons became members of what today is called Bombay Stock Exchange Limited paying a princely amount of Re 1. In 2002, the name "The Stock Exchange, Mumbai" was changed to Bombay Stock Exchange. Subsequently on August 19, 2005, the exchange turned into a corporate entity from an Association of Persons (AoP) and renamed as Bombay Stock Exchange Limited. BSE, which had introduced securities trading in India, replaced its open outcry system of trading in 1995, with the totally automated trading through the BSE Online trading (BOLT) system. The BOLT network was expanded nationwide in 1997. Since then, the stock market in the country has passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no measure or scale that could precisely measure the various ups and downs in the Indian stock market. Bombay stock Exchange Limited (BSE) in 1986 came out with a stock Index that subsequently became the barometer of the Indian Stock Market. SENSEX first compiled in 1986 was calculated on a Market Capitalization Weighted methodology of 30 component stocks representing a sample of large, well established and financially sound companies. The base year of SENSEX is 1978-79. The index is widely reported in both domestic and international markets through prints as well as electronic media. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. From September 2003, the SENSEX is calculated on a freefloat market capitalization methodology. The free-float Market CapitalizationWeighted methodology is a widely followed index construction methodology on which majority of global equity benchmarks are based. The growth of equity markets in India has been phenomenal in the decade gone by Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The SENSEX captured all these happenings in the most judicial manner. One can identify the booms and bust of the Indian equity market through SENSEX. The Exchange also disseminates the Price-Earnings Ratio, the Price to
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Book Value Ratio and the Dividend Yield Percentage on day-to-day basis of all its major indices. The value of all BSE indices are every 15 seconds during the market hours and displayed through the BOLT system. BSE website and news wire agencies. All BSE-Indices are reviewed periodically by the Index Committee of the Exchange. The Committee frames the broad policy guidelines for the development and maintenance of all BSE indices. Department of BSE Indices of the exchange carries out the day to day maintenance of all indices and conducts research on development of new indices. Institutional investors, money managers and small investors all refer to the Sensex for their specific purposes The Sensex is in effect the substitute for the Indian stock markets. The country's first derivative product i.e. Index-Futures was launched on SENSEX.
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1.2: NEED OF THE STUDY Different kinds of investors to invest in equity & derivative and to face high risk and get high returns. Company proves to an option for the investors. Studying the performance of investing equity & derivative for few months considering their analysis. 1.3: OBJECTIVE OF THE STUDY Any investors vision is a long term investment and short term investment and gets high returns by bearing high risk. For that objective need to be climbed successfully and so objectives of this project are: 1) To find the RIGHT SCRIPT to buy and sell at the RIGHT TIME 2) To get good return. 3) To know how derivatives can be use for hedging. 4) To know the outcome of Equity and Derivative. 5) How to achieve Capital appreciations.
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1.4: METHODOLOGY OF THE PROJECT Defining objective wont suffice unless and until a proper methodology is to achieve the objectives. 1) Analyzing and observing the investment opportunities. 2) Analyzing the performance of Equity and Derivative market with the help of NAV, EPS, P/E ratio etc.
1.5: LIMITATIONS OF THE STUDY This project was restricted for two months; hence exhaustive data is not available upon which conclusions can be relied. 1) Investment in Securities carry risk so investment in Equity & Derivative is also carrying risk on the basis of the market. 2) Factors affecting the Market Price of Investment may be due to the Market forces, performance of the companies is not possible, and so all the data is not available.
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Chapter 2: Equity Chapter 2.1: Introduction on Equity What Does Equity Capital Market - ECM Mean? A market that exists between companies and financial institutions that is used to raise equity capital for the companies. Some activities that companies operate in the equity capital markets include: overall marketing, distribution and allocation of new issues; initial public offerings, special warrants, and private placements. Along with stocks, the equity capital markets deal with derivative instruments such as futures, options and swaps. Total equity capital of a company is divided into equal units of small denominations, each called a share. It is a stock or any other security representing an ownership interest. It proves the ownership interest of stock holders in a company.
For example:In a company the total equity capital of Rs 2, 00, 00,000 is divided into 20, 00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to have 20, 00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights.
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2.2: Benefits from Equity The benefits distributed by the company to its shareholders can be: 1) Monetary Benefits 2) Non-monetary Benefits.
Benefits from Equity
Monetary Benefits
NonMonetary Benefits
Dividend
Capital Appreciation
Bonus
Right Issue
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1. Monetary Benefits: A. Dividend: An equity shareholder has a right on the profits generated by the company. Profits are distributed in part or in full in the form of dividends. Dividend is an earning on the investment made in shares, just like interest in case of bonds or debentures. A company can issue dividend in two forms: a) Interim Dividend: A dividend payment made before a company's AGM and final financial statements. This declared dividend usually accompanies the company's interim financial statements. b) Final Dividend: While final dividend is distributed only after closing of financial year; companies at times declare an interim dividend during a financial year. Hence if X Ltd. earns a profit of Rs 40 core and decides to distribute Rs 2 to each shareholder, a holding of 200 shares of X Ltd. Would entitle you to Rs 400 as dividend. This is a return that you shall earn as a result of the investment made by you by subscribing to the shares of X Ltd. B. Capital Appreciation: A shareholder also benefits from capital appreciation. Simply put, this means an increase in the value of the company usually reflected in its share price. Companies generally do not distribute all their profits as dividend. As the companies grow, profits are re-invested in the business. This means an increase in net worth, which results in appreciation in the value of shares. Hence, if you purchase 200 shares of X Ltd at Rs 20 per share and hold the same for two years, after which the value of each share is Rs 35. This means that your capital has appreciated by Rs 3000.
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2. Non-Monetary Benefits: Apart from dividends and capital appreciation, investments in shares also fetch some type of non-monetary benefits to a shareholder. Bonuses and rights issues are two such noticeable benefits. A. Bonus: An issue of bonus shares is the distribution free of cost to the shareholders usually made when a company capitalizes on profits made over a period of time. Rather than paying dividends, companies give additional shares in a pre-defined ratio. Prima facie, it does not affect the wealth of shareholders. However, in practice, bonuses carry certain latent advantages such as tax benefits, better future growth potential, and an increase in the floating stock of the company, etc. Hence if X Ltd decides to issue bonus shares in a ration of 1:1, every existing shareholder of X Ltd would receive one additional share free for each share held by him. Of course, taking the bonus into account, the share price would also ideally fall by 50 percent post bonus. However, depending upon market expectations, the share price may rise or fall on the bonus announcement. B. Rights Issue: A rights issue involves selling of ordinary shares to the existing shareholders of the company. A company wishing to increase its subscribed capital by allotment of further shares should first offer them to its existing shareholders. The benefit of a rights issue is that existing shareholders maintain control of the company. Also, this results in an expanded capital base, after which the company is able to perform better. This gets reflected in the appreciation of share value.
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2.3: Risks In equity investment: Although an equity investment is the most rewarding in terms of returns generated, certain risks are essential to understand before venturing into the world of equity. Market/ Economy Risk. Industry Risk. Management Risk. Business Risk. Financial Risk Exchange Rate Risk. Inflation Risk. Interest Rate Risk.
How to overcome risks: Most risks associated with investments in shares can be reduced by using the tool of diversification. Purchasing shares of different companies and creating a diversified portfolio has proven to be one of the most reliable tools of risk reduction. The process of Diversification: When you hold shares in a single company, you run the risk of a large magnitude. As your portfolio expands to include shares of more companies, the company specific risk reduces. The benefits of creating a well diversified portfolio can be gauged from the fact that as you add more shares to your portfolio, the weight age of each companys share gets reduced. Hence any adverse event related to any one company would not expose you to immense risk. The same logic can be extended to a sector or an industry. In fact, diversifying across sectors and industries reaps the real benefits of diversification. Sector specific risks get minimized when shares of other sectors are added to the portfolio. This is because a recession or a downtrend is not seen in all sectors together at the same time.
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However all risks cannot be reduced: Though it is possible to reduce risk, the process of equity investing itself comes with certain inherent risks, which cannot be reduced by strategies such as diversification. These risks are called systematic risk as they arise from the system, such as interest rate risk and inflation risk. As these risks cannot be diversified, theoretically, investors are rewarded for taking systematic risks for equity investment.
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2.4: Selection of Shares:
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Proper selections of shares are of two types:1. Fundamental analysis: It involves in depth study and analysis of the prospective company whose shares we want to buy, the industry it operates in and the overall market scenario. It can be done by reading and assessing the companys annual reports, research reports published by equity research houses, research analysis published by the media and discussions with the companys management or the other experienced investors. 2. Technical analysis: It involves studying the prices movement of the stock over an extended period of time in the past to judge the trend of the future price movement. It can be done by software programs, which generate stock prices charts indicating upward. Downward and sideways movements of the stock price over the stipulated time period.
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2.5: When to buy & sell shares: With high volatility prevailing in the market, major price fluctuations in equities are not uncommon. Therefore, apart from ascertaining which stock to buy or sell, it becomes equally important to consider when to buy or sell. Any investor should be aware of the fact where all the investor is following i.e., Buy Low. Sell High. That means we should buy stocks at a low price and sell them at a high price. When to buy Three ways by which we can figure that out what it is about this stock that makes it hot. 1. Earnings per Share (EPS): How well the company is doing EPS is the total earning or profits made by company (during a given period of time) calculated on per share basis. It aims to give an exact evaluation of the returns that the company can deliver. Example: Company XYZ Ltd. Capital: Rs 100 crore (Rs 1 billion). Capital is the amount the owner has in the business. As the business grows and makes profits, it adds to its capital. This capital is subdivided into shares (or stocks). The capital is divided into 100 million shares of Rs 10 each. Net Profit in 2003-04: Rs 20 crore (Rs 200 million). EPS is the net profit divided by the total number of shares.
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EPS = net profit/ number of shares EPS = Rs 20 crore (Rs 200 million)/ 10 crore (100 million) shares = Rs 2 per share Lesson to be learnt 1. If a company's EPS has grown over the years, it means the company is doing well, and the price of the share will go up. If the EPS declines, that's a bad sign, and the stock price falls. 2. Companies are required to publish their quarterly results. Keep an eye out for these results; check for the trend in their EPS.
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2. Price earnings ratio (PE ratio): How other investors view this share An indicator of how highly a share is valued in the market. It arrived at by dividing the closing price of a share on a particular day by EPS. The ratio tends to be high in the case of highly rated shares. The average PE ratio for companies in an industry group is often given in investment journal. Two stocks may have the same EPS. But they may have different market prices. That's because, for some reason, the market places a greater value on that stock. PE ratio is the market price of the stock divided by its EPS. PE = market price/ EPS Lets take an example of two companies. Company KMS Ltd Market price = Rs 100 EPS = Rs 2 PE ratio = 100/ 2 = 50 Company KMJ Ltd Market price = Rs 200 EPS = Rs 2 PE ratio = 200/ 2 = 100 In the above cases, both companies have the same EPS. But because their market price is different, the PE ratio is different. Lesson to be learnt In the case of EPS, it is not so much a high or low EPS that matters as the growth in the EPS. The company's PE reflects investors' expectations of future growth in the EPS. A high PE company is one where investors have hopes that earnings will rise, which is why they buy the share.
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3. Forward PE: Looking ahead The stock market is not nostalgic. It is forward looking. For instance, it sometimes happens that a sick company, that has made losses for several years, gets a rehabilitation package from its bank and a new CEO. As a consequence, the company's stock shoots up. Because investors think the company will do better in the future because of the package and new leadership, and its earnings will go up. And we think it is a good time to buy the shares of the company now. Suddenly, the demand for the shares has gone up. Because stock prices are based on expectations of future earnings, analysts usually estimate the future earnings per share of a company. This is known as the forward PE. Forward PE is the current market price divided by the estimated EPS, usually for the next financial year. Forward PE = Current market price/ estimate EPS for the next financial year. To illustrate what we have been talking about, let's take the example of Infosys Technologies. Trailing 12-month EPS = Rs 56.82 (EPS of the last four quarters) Closing price on January 6 = Rs 2043.15 PE = Price/EPS = 2043.15/ 56.82 = 35.95 Estimated EPS for 2004-05 = Rs 67 Estimated EPS for 2005-06 = Rs 90 These figures are according to brokers' consensus estimates. Forward PE = current market price/ estimated EPS for next financial year Forward PE for 2004-05 = 2043.15/ 67 = 30.49 Forward PE for 2005-06 = 2043.15/ 90 = 22.70
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With an EPS growth of over 30%, a forward PE of 22.7 is not high, indicating that there is scope to be optimistic about the stock's price. Lesson to be learnt Sometimes, investors look out for a low PE stock, expecting that its price will rise in the future. But sometimes, low PE stocks may remain low PE stocks for ages, because the market doesn't fancy them. Keep tab on the business news to check out the company's prospects in the future
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When to sell Stock Reaches Fair Value or Target Price This is the easiest part of selling. We should sell when a stock reaches its fair value. It is the main reason why we chose to buy it on the first place. The target price can be computed by assessing the companys estimated financial performance over the next 3 to 5 years, computing its EPS and using an acceptable P/E ratio to compute the future market price. Based on this future estimated price and our required return on our investment, compute our target price. When the prices reaches Stop loss It is advisable to always consider the possibility of a loss before making our investment. We should decide how much loss we are willing to book in the stock. The lower price i.e., the price at which we are willing curtail our loss, is called Stop Loss. Need the money The generally happens due to improper planning. However, things happen. Even the most carefully planned strategy may not work. Catastrophic events may force investors to sell an investment if his household is affected by it. The book is unclean When management left their post abruptly or when the SEBI conduct a criminal investigation on a company, it may be time to sell. Our assumption may be inaccurate as a lot of fair value calculation is based on the company's balance sheet, cash flow or other financial statement published by management. Takeover news When one of your stock holding is getting bought by other companies, it may be time to sell. Sure, you might like the acquiring company but you still need to figure out the fair value of the common stock of the acquiring company. If the acquiring company is overvalued, then it is best to sell.
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Other Investment Opportunity Let us consider we bought stock A and it has risen to 10% below its fair value. Meanwhile, we noticed that stock B fallen to below 50% of our calculated fair value. This is an easy decision. We will sell our stock A and buy stock B. Our goal as an investor is to maximize our investment return. Sacrificing a 10% of return in order to earn a 50% return is a sensible way to do that. Inaccurate Fair Value Calculation As investors, we sometimes made errors in our fair value calculation. There are factors that we might not take into accounts when researching a particular company. For example: Satyam scandal. New Competitors with Better Products When new competitors sprung up, the company that you hold might have to spend more money in order to fend off competition. Recent example includes the emergence of pay-per click advertising by Google. Any advertising business such as newspapers or cable network, this new product by Google might hurt profit margins and eventually the fair value of the stock. Not having a valid reason to Buy When we don't know why we bought a particular stock, we won't know how much our potential return is or when we should sell it. This is the easiest way of losing money. When we have no valid reason to buy, we should sell immediately.
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2.6: Lets us now discuss about the Types of Cash market margin with its Examples: 1. Value at Risk (VaR) margin. 2. Extreme loss margin 3. Mark to market Margin
Value at Risk Margin
Extreme Loss Margin
Type of Cash Market
Mark to Market Margin
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1. Value at Risk ( VaR ) margin : VaR Margin is at the heart of margining system for the cash market segment. VaR is a technique used to estimate the probability of loss of value of an asset or group of assets (for example a share or a portfolio of a few shares), based on the statistical analysis of historical price trends and volatilities. A VaR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the question that VaR answers: With 99% confidence, what is the maximum value that an asset or portfolio may lose over the next day? Example:Suppose shares of a company bought by an investor. Its market value today is Rs.50 Lakh but its market value tomorrow is obviously not known. An investor holding these shares may, based on VaR methodology, say that 1-day VaR is Rs.4 lakhs at 99% confidence level. This implies that under normal trading conditions the investor can, with 99% confidence, say that the value of the shares would not go down by more than Rs.4 lakhs within next 1-day. In the stock exchange scenario, a VaR Margin is a margin intended to cover the largest loss (in %) that may be faced by an investor for his / her shares (both purchases and sales) on a single day with a 99% confidence level. The VaR margin is collected on an upfront basis (at the time of trade). How is VaR margin calculated? VaR is computed using exponentially weighted moving average (EWMA) methodology. Based on statistical analysis, 94% weight is given to volatility on T1 day and 6% weight is given to T day returns. To compute, volatility for January 1, 2008, first we need to compute days return for Jan 1, 2009 by using LN (close price on Jan 1, 2009 / close price on Dec 31, 2008).Take volatility computed as on December 31, 2008. Use the following formula to calculate volatility for January 1, 2009: Square root of [0.94*(Dec 31, 2008 volatility)*(Dec 31, 2008 volatility) + 0.06*(January 1, 2009LN return)*(January 1, 2009 LN return)]
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Example: Share of ABC Ltd Volatility on December 31, 2008 = 0.0314 Closing price on December 31, 2008 = Rs. 360 Closing price on January 1, 2009 = Rs. 330 January 1, 2009 volatility = Square root of [(0.94*(0.0314)*(0.0314) + 0.06 (0.08701)* (0.08701)] = 0.037 or 3.7%
How is the Extreme Loss Margin computed? The extreme loss margin aims at covering the losses that could occur outside the coverage of VaR margins. The Extreme loss margin for any stock is higher of 1.5 times the standard deviation of daily LN returns of the stock price in the last six months or 5% of the value of the position. This margin rate is fixed at the beginning of every month, by taking the price data on a rolling basis for the past six months. Example: In the Example given at question 10, the VaR margin rate for shares of ABC Ltd. was 13%. Suppose the 1.5 times standard deviation of daily LN returns is 3.1%. Then 5% (which is higher than 3.1%) will be taken as the Extreme Loss margin rate. Therefore, the total margin on the security would be 18% (13% VaR Margin + 5% Extreme Loss Margin). As such, total margin payable (VaR margin + extreme loss margin) on a trade of Rs.10 lakhs would be 1, 80,000/-
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How is Mark-to-Market (MTM) margin computed? MTM is calculated at the end of the day on all open positions by comparing transaction price with the closing price of the share for the day. Example: A buyer purchased 1000 shares @ Rs.100/- at 11 am on January 1, 2008. If close price of the shares on that day happens to be Rs.75/-, then the buyer faces a notional loss of Rs.25, 000/ - on his buy position. In technical terms this loss is called as MTM loss and is payable by January 2, 2008 (that is next day of the trade) before the trading begins. In case price of the share falls further by the end of January 2, 2008 to Rs. 70/-, then buy position would show a further loss of Rs.5,000/-. This MTM loss is payable. In case, on a given day, buy and sell quantity in a share are equal, that is net quantity position is zero, but there could still be a notional loss / gain (due to difference between the buy and sell values), such notional loss also is considered for calculating the MTM payable. MTM Profit/Loss = [(Total Buy Qty X Close price)] - Total Buy Value] [Total Sale Value - (Total Sale Qty X Close price)].
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Section I: Chapter 3: DEREVETIVES Chapter 3.1: INTRODUCTION ON DERIVATIVES Stock exchanges have almost always remained as lucrative investment destinations in Indian context since their beginning. There have been many structural and policy changes in the Indian stock exchanges from time to time as per the requirement. The removal of erstwhile Carry Forward system matched by introduction of Derivative Trading on Indian bourses was an unprecedented phenomenon. Especially, post-derivatives, the Indian Stock Exchanges will never be same again. Various products in the F & O (Futures & Options) traded at the NSE and the BSE provide the market participants with an elbow room for taking positions in individual stocks as well as in indices. The stock markets the world over are highly volatile. Now, as the derivatives are here, the market participants can immunize themselves against such wild volatility making permutations and combinations of various positions in the futures and options. However, it is not only the stock markets that have seen radical changes. Even the money and debt markets in India have seen sea changes thanks to the step of RBI permitting the introduction of Interest Rate Derivatives. The finance managers, or the Chief Financial Officers or more colloquially termed the bean-counters of India Inc., now have more sophisticated trading strategies for Interest Rate Risk Management which they were, hitherto, devoid of in the absence of any concrete measures on the part of the regulators. This change in the Indian Financial System will get them closer to their counterparts in the developed nations. The reason for us to choose the subject of Derivative Trading is that the subject per se is complex enough to pose a great challenge to anyone working on it. For a layman, the subject is so complicated that trying to understand the nitty-gritty of the derivatives leaves him much confused. There are so many regulatory issues involved, risk containment measures, payoff charts, the trading strategies, valuation models et al. This is just a tip of the ice-berg. The subject itself is so wide that one can even go for a thesis on the subject that would qualify for a Ph.D.
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In the pages that follow, we have made a humble effort to give justice to almost all the important issues involved in the derivatives. Section-1 deals with Futures & Options (F & O) segment of the capital markets, whereas Section-2 covers issues involving Interest Rate Swaps (IRSs) and Forward Rate Agreements (FRAs).
We hope that for the readers, this project-report would prove to be an authentic document on the subject to make reasonable conclusions and draw inferences from.
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3.2: FINANCIAL DERIVATIVES MARKET AND ITS DEVELOPMENT IN INDIA Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called basis. These bases can be underlying assets say: forex, equity, bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the wheat would be the underlying asset. Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
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The need for a derivatives market The derivatives market performs a number of economic functions: They help in transferring risks from risk averse people to risk oriented people. They help in the discovery of future as well as current prices. They catalyze entrepreneurial activity. They increase the volume traded in markets because of participation of risk averse people in greater numbers. They increase savings and investment in the long run. The participants in derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.
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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 exchangetraded 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. Warrants: Options generally have lives of up to one year, the majority of options tr5aded on options exchanges have 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 up to 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.
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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. Swaptions: Swaptions are options to buy or sell a swap that will become operative at an expiry of the options. Thus a swaption is an option on a forward swap, rather than having call 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.
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Table 1 The global derivatives industry: Outstanding contracts, (in $ billion) 1995 Exchange traded instrumen ts Interest rate futures and options Currency futures and options Stock index futures and options Some OTC instruments Interest rate swaps and options Currency swaps and options Other instruments Total 9283 1996 10018 1997 12403 1998 13932 1999 13522 2000 14302
8618
9257
11221
12643
11669
12626
154
171
161
81
59
96
511
591
1021
1208
1793
1580
17713 16515
25453 23894
29035 27211
80317 44259
88201 53316
95199 58244
1197
1560
1824
5948
4751
5532
30110
30134
31423
26996
35471
41438
94249
101723
10950 1
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Factors driving the growth of financial derivatives Increased volatility in asset prices in financial markets. Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs. Development of more sophisticated risk management tools, providing economic agents a wider choice or risk management strategies, and Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.
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Table 2 Turnover in derivatives contracts traded on exchanges, (in US$ trillion) 199 3 Interest rate futures Interest rate options Curren cy futures Curren cy options Stock market index futures Stock market index options Total 177. 3 32.8 199 4 271. 9 46.7 199 5 266. 4 43.3 199 6 253. 6 41 199 7 247. 8 48.6 199 8 296. 6 55.8 199 9 263. 8 45.6 2000
292.3
47.5
2.8
3.3
3.2
2.6
2.7
2.5
2.6
2.4
1.4
1.4
1.3
1.3
0.9
0.5
0.3
0.2
7.1
9.4
10.6
12.9
16.4
19.6
21.7
22.7
6.3
9.3
10.2
13.1
14.7
15.7
18.7
227. 7
340. 7
334. 1
321. 6
356. 5
389. 7
349. 7
383.8
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Development of derivatives market in India The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof. J.R.Varma, to recommend measures for risk containment in the derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, the operational details of marging system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognize4d stock exchange, thus precluding OTC derivatives.
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The government also rescinded in March 2000, the three-decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on the individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE and based on S&P CNX. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.
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The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles with the erstwhile Badla system. On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuables when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was nonexistent. Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day? If calls and puts are not looked as just substitutes for spot trading, the intraday stock price variations should not have a one-to-one impact on the option premiums.
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3.3: HISTORY OF FUTURE AND OPTION FUTURES- THE HISTORICAL BACKGROUND Futures contracts on commodities have been traded for long. In the USA, for instances, such contracts began trading on the CBOT in the 1860s. However, in the past three decades, financial futures contracts have been evolved. The financial futures, probably, are a very significant financial innovation. They encompass a variety of underlying assets-securities, stock indices, interest rates and so on. The beginnings of financial futures were made with the introduction of currency futures contracts on the International Monetary Markets (IMM) - a division of the Chicago Mercantile Exchange (CME) - in May 1972. Subsequently, interest rates futures- where the contract is on an asset whose price is dependent solely on the level of interest rates- were introduced on the CBOT in October 1975. Within a short span of time, CBOT made a headway and introduced the Government National Mortgage Association Contract (GNMA), and years 1976 and 1977 saw the launching by IMM, respectively, of the treasury bill futures and treasury bond futures. A futures contract in treasury bonds is one of the most actively traded futures contract in the world and it has, in particular, lent great impetus to the introduction of similar futures on many futures exchanges the world over. The Eurodollar time deposit futures contract (the Eurodollar is a dollar deposited in an American or foreign bank outside the USA), which started trading on the IMM in December 1981, was the first contract that was settled in Cash, involving no delivery of the underlying asset. An important development took place in the world of futures contracts in 1982 when stock index futures were introduced in the USA. Although some futures contracts on indices were traded in Europe in the 1970s; however, trading could not mature, as it was mainly done outside the exchanges.
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It was in America only that a formal beginning was made when the Kansas City Board of Trade (KCBT) introduced stock index futures contracts with the value line index serving as the underlying index. In the mean time, the CME tied up with S&P. In the August 1983, the CBOT developed its own stock index contract. A futures contract on a stock index has been a revolutionary and novel idea because it represents a contract based not on a readily deliverable physical commodity or currency or other negotiable instrument. It is instead based on the concept of a mathematically measurable index that is determined by the market movement of a predetermined set of equity stocks.
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OPTIONS- THE HISTORICAL BACKGROUND The concept of options is not a new one. In fact, options have been in use for centuries. The idea of an option existed in ancient Greece and Rome. The Romans wrote options on the cargoes that were transported by their ships. In the 17th century, there was an active options market in Holland. In fact, options were used in a large measure in the tulip bulb mania of that century. However, in the absence of mechanism to guarantee the performance of the contract, the refusal of many put option writers to take delivery of the tulip bulbs and pay the high prices of the bulbs they had originally agreed to, led to bursting of the bulb bubble during the winter of 1637. A number of speculators were wiped out in the process. Options were traded in the USA and UK during the 19th century but were mainly confined to the agricultural commodities. Earlier, they were declared illegal in the UK in 1733 and remained so until the Act declaring them illegal was repealed. They were again banned in the third decade of this century, albeit temporarily. In the USA, options on equity stocks of the companies were available on the OTC market only, until April 1973. They were not standardized and involved the intra-party risk. In India, options on stocks of companies, though illegal then, had been traded for many years, in a limited form. As such, this trading has been a very risky proposition to undertake. In spite of the long time that has elapsed since the inception of options, they were, until not very long ago, looked down upon as mere speculative tools and associated with corrupt practices. Things changed dramatically in the 1970s when options were transformed from relative obscurity to a systematically traded asset which is an integral part of financial portfolios.
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The year 1973 witnessed some major developments. Black and Scholes published a seminal paper explaining the basic principles of options pricing and hedging. In the same year, the Chicago Board of Options Exchange (CBOE) was created. It was first registered securities exchange dedicated to options trading. While trading in options existed for long, it experienced a gigantic growth with the creation of this exchange. The listing of options meant orderly and thicker markets for this kind of securities. Options trading is now undertaken widely in many countries besides the USA and UK. In fact, options have become an integral part of the large and developed financial markets. With full-fledge market for options trading here in India, the growth of the futures and options markets is unending.
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3.4: ADVANTAGES OF DERIVATIVES From an investors point of view, derivatives offer a huge number of opportunities, whether he is risk-taker or risk averse. Derivatives, especially index futures and stock options, through their n number of permutations and combinations, provide a great many number of trading strategies for the investors elaborated elsewhere the main advantages to an investor flowing from smart use of various derivative instruments are as discussed below: Power to leverage: Derivatives allow investor to take position of a large value by making a small investment. In futures, one takes a position by paying a margin in the range of 25-30%. In case of an option, one pays a premium that is a very small amount relative to the spot price and takes position in the markets. For example, Call Option of Satyam Computers with a strike price of Rs. 220, expiring October, is available at Rs. 5. The market lot of Satyam is 1200. This means by investing Rs. 6000 one can take a position of a contract valued at Rs. 2,64,000. Power to defer: The cash markets have a daily settlement mechanism. A speculator wanting to take a position in a stock has to either take delivery or square off his position the same day. Thus he is unable to take a position beyond a day. With futures, one can take a position on a stock today, while the settlement takes place at a Future date. In this aspect, Futures are similar to the erstwhile Badla system as it enables carry forward of positions.
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Power to lend or borrow from the markets: With futures, one can lend or borrow funds from the market. This will become more effective when actual deliveries are introduced in the derivatives markets. In case you need money for short-term requirements, you can sell your stocks in the cash market and buy Futures. You get the liquidity for some time and then you can get your stock back when the futures are settled. However, this is a profitable only when the particular stocks futures price is less than its theoretical price as given by Net Cost to Carry Model. For example: Spot price of Satyam is Rs. 200. Satyam one-month futures are quoting at Rs. 205. If one has funds, one can buy Satyam in spot market and sell it in Futures market. Effectively, one has lent Rs. 200 to the market and earned an interest of Rs. 5 for a one-month period.
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3.5: BENEFITS OF DERIVATIVES TO INDIAN CAPITAL MARKETS India's financial market system will strongly benefit from smoothly functioning index derivatives markets. The reasons in support of this statement are as follow: Internationally, the launch of derivatives has been associated with substantial improvements in market quality on the underlying equity market. Liquidity and market efficiency on India's equity market will improve once the derivatives commence trading. Many risks in the financial markets can be eliminated by diversification. Index derivatives are special insofar as they can be used by investors to protect themselves from the one risk in the equity market that cannot be diversified away, i.e. a fall in the market index. Once investors use index derivatives, they will suffer less when fluctuations in the market index take place. Foreign investors coming into India would be more comfortable if the hedging vehicles routinely used by them worldwide are available to them. So, the foreign funds inflow through FIIs in Indian capital markets will be more making it easier for the corporate to tap the funds at a cheaper rate. The launch of derivatives is a logical next step in the development of human capital in India. Skills in the financial sector have grown tremendously in the last few years, thanks to the structural changes in the market, and the economy is now ripe for derivatives as the next area for addition of skills. The launch of futures trading has been a milestone on Indian bourses although its full impact is yet not visible due to certain roadblocks. As the markets are becoming more volatile and complex, there is a need to hedge these risks and hence for instruments, which allow fund managers to manage risk, better. As our Indian market lacks infrastructure available, therefore our futures market is not perfect as it must be. For example, as we lack a system of electronic fund transfer in the banking sector and we don't even have the short term yield curve which can be used to calculate the fair price for the
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index future. As market becomes deep, the need for these deficiencies to go will be stronger. If the penetration of the equity cult among investors is any indication, we have a large investor population, one among the largest in the world. The Indian markets lack the kind of institutional presence, which is available in the developed countries, but now that too is becoming a matter of history. As our market is on retail basis therefore we require great protection against counter-party risk. It is the regulators that have nurtured the entire derivatives initiative and have played a very positive role. They may extend the support, guidance and advice while derivatives have been introduced. Even the regulatory framework, which has been designed, puts the Indian derivatives market best in the world. However, volumes in derivatives markets are still too small to have its comparison with developed countries capital markets. The derivatives market, which gives better price discovery, can have a positive impact on the cash market. It would increase the liquidity even in the cash market where arbitrage takes place between the futures and the cash market. Although introduction of derivatives implies better risk management and deeper market, we cannot mean that volatility decreases, as volatility is the growing phenomenon. Volatility in other instruments like interest rates, equities or foreign exchange has increased as compared to past levels. That is something, which we have to live with. Here, derivatives would no doubt increase the liquidity and depth. Within index futures Indian bourses would be launching sectoral index futures like Infotech or FMCG index. Among other products, we would like to bring futures on foreign exchange and fixed income instruments. So, in a nut-shell, the Indian capital markets, with the full-fledged derivatives market will never be the same as it used to be.
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3.6: MARKET PARTICIPANTS IN F & O MARKET The derivative instruments are used for various purposes. As indicated earlier, they are primarily used for purposes of managing risk by those managing funds. The trading of these instruments also allows the market participants the opportunities of making profits either by taking risk, i.e., speculation, or simultaneously taking opposite positions in the spot and futures market, or in the futures markets alone, to take advantage of price differentials, i.e., arbitrage. Accordingly, there are varied types of traders who trade in the futures and options markets. Hedgers, speculators, and arbitrageurs constitute three major classes of such traders. Hedgers: As already observed, hedging (covering against losses) is the prime reason which led to emergence of derivatives. The availability of derivatives allows the undertaking of many activities at a substantially lower risk. Hedgers, therefore, are an important constituent of the traders in the derivatives markets. Hedgers are the traders who want to eliminate the risk (of price change) to which they are already exposed. They may take a long position on, or short sell, a commodity and would, therefore, stand to lose should the prices move in the adverse direction. It will be instructive to illustrate hedging with some examples. To begin with, suppose a leading trader buys a large quantity of wheat that would take two weeks to reach him. Now, he fears that the wheat prices may fall in the coming two weeks and so wheat may have to be sold at lower prices. The trader can sell futures (or forward) contracts with matching price, to hedge.
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Thus, if wheat prices do fall, the trader would lose money on the inventory of wheat but will profit from the futures contract, which would balance the loss. Again, traders dealing in exports and imports are subject to fluctuations in the foreign exchange rates, called the forex risk. In the absence of any hedging instruments, they are bound to remain exposed to such risk and suffer in case of adverse changes in the exchange rates. However, the forex risk, an integral component of the foreign trade business, can be hedged with derivatives. For example, today, with the dollar-rupee forward contracts and with cross-currency options in India, it is possible to engage in foreign trade with a lesser degree of risk. As another example, consider a fund manager who believes in stock picking. However, at the same time, he has to live with the real risk that his analysis of securities may go awry. In such situations, the stock index derivatives may be employed in order to eliminate/ reduce the risk. It may be noted that hedging only makes an outcome more certain, it does not necessarily lead to an improved outcome. Suppose, todays dollar-rupee exchange rate is US $1 = Rs. 47.50, while the three-month forward rate is US $1 = Rs. 48.40. Suppose, an Indian firm has a commitment to pay $ 100,000, three months from now. The firm, being unsure of the way the dollar-rupee exchange rate would move in the three months time, decides to buy a forward contract and lock in the exchange rate. It involves no initial payment. With this, the firm knows for sure that it would need Rs. 48,40,000 to meet its obligation. Now, at the end of three months, if the rate becomes $1 = Rs. 49.20, then the firm would stand to gain Rs. 80,000. Without, the forward contract, the payment needed would have been Rs. 49,20,000. Similarly, if the exchange rate were $1 = Rs. 48.10, then the firm would regret having entered into forward contract, because it would have to pay Rs. 48,40,000 for something that could be bought for Rs. 48,10,000, without the contract.
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Of course, the firm may alternatively consider hedging through buying an options contract also. It would enable the firm to avoid the loss involved in buying US dollars if they become cheaper in terms of Indian rupees, and enjoy the profit if the movement in the exchange rate were favorable. Nevertheless, while a forward contract requires no payment, an options contract involves an initial cost: if the call is not exercised, the premium paid for it becomes a net loss while if it is exercised, the profit resulting from the call exercise would be reduced by this cost. Speculators: If hedgers are the people who wish to avoid the price risk, speculators are those who are willing to take such risk. These are the people who take positions in the market and assume risks to profit from fluctuations in prices. In fact, the speculators consume information, make forecasts about the prices and put their money in these forecasts. In this process, they feed information into prices and thus contribute to market efficiency. By taking positions, they are betting that a price would go up or they are betting that it would go down. Depending on their perceptions, they may take long or short positions on futures and/or options, or may hold spread positions (simultaneous long and short positions on the same derivative). In the absence of the derivatives, speculation activity would become very difficult as it might require huge funds to be invested. For example, if an investor believes that the price of a share is likely to rise substantially, then he would need a very large sum of money to buy the shares, keep them and sell them off when the price rises. With derivatives, however, it is much easier to do so because the derivatives are highly levered instruments. If the speculators prediction of direction and amount of price change is correct, huge profits can be realized. For example, suppose that a share is currently quoted at Rs. 32 and a speculator is strong on this share.
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Assume that a call option, with exercise price of Rs. 35 and due in one month, on this share is available in the market at 50 paise (per share). Buying this option would require Rs. 50 (a call is for 100 shares) only. Now, if the price of the share is either less than, or equal to, Rs. 35, the call shall not be exercised and the loss would be Rs. 50 or 100% of the investment. If, on the other hand, the price rules at Rs. 40, then a gain of 100*(Rs. 40-Rs. 35) = Rs. 500 would be made, which works out to be 900% of the investment! With no option or other derivative available, the investor would be required to invest Rs. 3200 (for 100 shares) and would make a profit of Rs. 800 i.e. only 24% of the amount invested. Not only that, much bigger losses would be incurred if the share price were to settle at less than Rs. 32. Obviously, therefore, the derivatives adequately address the needs of the speculators without threatening the market integrity in the process. The speculators in the derivatives markets may either be day traders or position traders. The day traders speculate on the price movements during one trading day, open and close positions many times a day and do not carry any position at the end of the day. Obviously, they monitor the prices continuously and generally attempt to make profit from just a few ticks per trade. On the other hand, the position traders also attempt to gain from price fluctuations but they keep their positions for longer durations- may be for a few days, weeks or even months. They use fundamental analysis and/or technical analysis as also any other information available to them to form their opinions on the likely price movements.
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Arbitrageurs: Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given commodity, or other item, that sells for different prices in different markets. The definition of arbitrage can be given in this manner: Simultaneous purchase of securities in one market where the price thereof is low and sale thereof in another market, where the price thereof is comparatively higher. These are done when the same securities are being quoted at different prices in the two markets, with a view to make a profit and carried on with the conceived intention to derive advantage from difference in prices of securities prevailing in the two markets. Thus, arbitrage involves making risk-less profit by simultaneously entering into transactions in two or more markets. If a certain share is quoted at a lower rate on the Delhi Stock Exchange (DSE) and at a higher rate on the Ahmedabad Stock Exchange (ASE), for example, then arbitrageur would profit by buying the share at DSE and selling it at ASE. This type of arbitrage is arbitrage over space. With the introduction of derivatives trading, the scope of arbitrageurs activities extends to arbitrage over time. For instance, if an arbitrageur feels that the futures are being quoted at a high level-considering the cost of carry-he could buy securities underlying an index today and sell the futures, maturing in a month or two hence. Similarly, since futures and options with various expiration dates are traded in the market, there are likely to be several arbitrage opportunities in trading. Thus, if a trader believes that the price differential between the futures contracts on the same underlying asset with differing maturities is more or less than what he/she perceives them to be, then appropriate positions, in them, may be taken to make profits.
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The existence of well-functioning derivatives markets alters the flow of information into the prices. This is because in a purely cash market, speculators, feed information into the sport prices. In contrast, the presence of a derivatives market, besides a cash market, ensures that a major part of the transformation of information into prices takes place at the derivatives market, due to lower transaction costs involved in such a market, and then it gets transmitted to the spot markets. It is here that the arbitrageurs provide a link between the derivatives market and the cash market by synchronizing the prices in the two. Thus, through their actions, the arbitrageurs provide a critical link between the cash and derivatives markets.
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3.7: PAY-OFF PROFILE OF F&O Payoff profile for a buyer of Futures: The payoff profile for Futures is linear. As the spot price increases, the profit from having bought a Future increases. Similarly, as spot price decreases, the profit from having sold Futures increases and is a mirror image of the profit from buying. The point where the spot price and the Futures price are same is the breakeven point.
Pay off profile for a buyer of Future s
profit
Strike price
loss
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Payoff profile for a buyer of Call Options: In Options, in case of a call, it is an Option to buy an asset at strike price. The maximum profit for the buyer of a Call Option is theoretically unlimited and maximum loss is limited to the extent of Option premium.
Payoff profile for a buyer of Call Options

Let S= Spot price, X= Strike price, P=Premium Profit
When S>(X+P) S=(X+P) K<S<(X+P) S<X Profit is S-(X+P) Breakeven Loss is P+(X-S) Loss is P Loss Premium (P) S> X + P Break Even Point
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Payoff profile for a buyer of Put Options: Put Option is an Option to sell an asset at the strike price. As with any long position, the loss is limited to the premium paid with an unlimited potential for profit. However, since spot prices cannot be negative, the unlimited gain would be limited to X, the strike price, since the maximum gain can be X when the spot price touches zero.
Payoff profile for a buyer of Put Options Let S= Spot price, X= Strike price, P=Premium When S< (X-P) S=(X-P ) (X-P)<S< X S< X Profit
Profit is X-(S+P) Breakeven Loss = P-(X-S ) Loss is P
S< X - P
Premium (P )
Loss
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TRADING STRATEGIES -USING OPTIONS We have seen the payoff structure for buying Call Options as well as Put Options. The payoff profile for the writer of the options, that is to say, for the person selling the Call or Put Options is exactly the mirror images of the payoff profile of the buyer of the respective option, Call or Put. Given the nature of payoff profiles of Call and Put Options for the buyer and the seller, no. Of permutations as well as combinations can be thought of involving Options, Futures (with same or different Exercise Prices) as well as underlying asset (that is to say, individual stock). The strategy being employed by an investor amply underlies his attitude towards risk-whether he is risk averse or risk taker, his expectation about future prices-whether he is bullish on the market or bearish. In the coming pages, we present some of the commonly adopted strategies using options. (1) Hedging: Long Stock Long Put Hedging represents a strategy by which an attempt is made to limit the losses in one position by simultaneously taking a second offsetting position. Typically, a hedge strategy strives to prevent large losses without significantly reducing the gains. Very often, options in equities are employed to hedge a long or short position in the underlying common stock. Such options are called covered options in contrast to the uncovered or naked options, discussed earlier. This strategy viz. Long Stock Long Put involves buying a stock and simultaneously buying a Put Option.
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An example will demystify the nitty-gritty. Consider an investor who buys a share for Rs 100. To guard against the risk of loss from a fall in its price, he buys a put for Rs 16 for an exercise price of, say, Rs 110. He would, obviously exercise the option only if the price of the share were to be less than Rs. 110. The following table gives the profit/ loss for some selected values of the share price on maturity of the option.
Share Price
Exercise Price 110 110 110 110 110 110 110 110
Profit on exercise (i) 24 14 4 -6 -16 -16 -16 -16
Profit/ loss on share held (ii) -30 -20 -10 0 10 20 30 40
Net Profit (i) + (ii) -6 -6 -6 -6 -6 4 14 24
70 80 90 100 110 120 130 140
For instance, at a share price of Rs. 80, the put will be exercised and the resulting profit would be Rs. 14, equal to Rs. 110 Rs. 80, or Rs. 30 minus the put premium of Rs. 16. With a loss of Rs. 20 incurred for the reason of holding the share, the net loss equals to Rs. 6.
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The profits resulting from the strategy of holding a long position in the stock and long put are shown in the following figure. In all the figures that follow now, the dashed lines depict the relationship between the profit and stock prices for the stock in question, on the one hand, and profit and the option on the other hand. The solid line in each case depicts the relationship between profit and stock prices for the whole portfolio. It may further be noted that the profit/ loss shown is on a per share basis.
Profit 50 40 30 20 10 E 0 Stock Price 10 20 30 40 Loss Hedging: Long Stock Long Put Profit/ loss on hedging Profit on exercise of Put Profit/ loss on Long Stock
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(2) Hedging: Short Stock Long Call Unlike an investor with a ling position in stock, a short seller of stock anticipates a decline in stock prices. By shorting the stock now and buying it at a later date at a lower price in the future, the investor intends to make a profit. Any price increase can bring losses because of an obligation to purchase at a later date. To minimize the risk involved, the investor can buy a call option with an exercise price equal to or close to the selling price of the stock. Let us take a hypothetical case of an investor who shorts a share at Rs. 100 and buys a call option for Rs. 4 with a strike price of Rs. 105. The conditional payoffs resulting from some selected prices of the share are shown in the next table.
Share Price
Exercise Price 105 105 105 105 105 105 105
Profit on exercise (i) -4 -4 -4 -4 1 6 11
Profit/ loss on share held (ii) 15 10 5 0 -5 -10 -15
Net Profit (i) + (ii) 11 6 1 -4 -4 -4 -4
90 95 100 105 110 115 120
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The following figure illustrates the strategy.
50 40 30 20 10 E 0 Stock Price 10 20 30 40 Hedging: Short Stock Long call Profit/ Loss in hedging Profit/ Loss on Call Option Profit/Loss on Short Stock
(3) Hedging: Long Stock Short Call In the previous two strategies, the investor takes Long positions in the Option- be it Call or Put. Hedging can also be undertaken by writing (taking a Short position) Call as well as Put Options in appropriate circumstances. One of such strategies is to write a covered call option when the investor has already taken a long position in the underlying individual stock. If the common stock is not expected to witness a significant change, either way, in the near future, then the strategies of writing calls and puts may be usefully employed to minimize the risk. The following paragraph shows-How?
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Take for an example, if an investor has bought a share for Rs. 100, he can employ this strategy by writing a call option with the strike price of, say Rs. 105, with the premium of Rs. 3. The profit/ loss occurring at some prices of the underlying share, is indicated in the following table.
Share Price
Exercise Price 105 105 105 105 105 105 105
Profit on exercise (i) 3 3 3 3 -2 -7 -12
Profit/ loss on share held (ii) -10 -5 0 5 10 15 20
Net Profit (i) + (ii) -7 -2 3 8 8 8 8
90 95 100 105 110 115 120
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The following chart explains the same phenomena graphically.
50 40 30 20 10 E 0 10 20 30 40 Hedging: Long Stock Short Call Profit/ Loss on hedging Stock Price Profit/ Loss on Call Option Profit/ Loss on Long Stock
(4) Hedging: Short Stock Short Put Exactly adverse strategy is to be adopted when the investor short sells the share. He can hedge by writing a Put Option. Thus, by undertaking to be a buyer, the investor hopes to reduce the magnitude of loss that would be from an increase in the stock price, by limiting the profit that could be made when the stock price declines. Suppose, an investor shorts a share at Rs. 100 and write a put option for Rs.3, having an exercise price of Rs. 100. Clearly, the buyer of the put will exercise the option only if the share price does not exceed the exercise price. The table giving conditional payoff is given below:
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Share Price
Exercise Price 100 100 100 100 100 100 100
Profit on exercise (i) -7 -2 3 3 3 3 3
Profit/ loss on share held (ii) 10 5 0 -5 -10 -15 -20
Net Profit (i) + (ii) 3 3 3 -2 -7 -12 -17
90 95 100 105 110 115 120
For the pictorial presentation of this strategy:
Profit 50 40 30 20 10 E 0 Stock Price 10 20 30 40 Loss Hedging: Short Stock Short Put Profit/ Loss on Hedging Profit/ Loss on Put Option Profit/ Loss on Short Stock
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(5) Bull Spread Using Calls Spread trading strategy involves taking a position in two or more options of the same type. This strategy viz. Bull Spread is undertaken when one is bullish about the future price movements in the stock prices. However, Bull Spread can be affected using Calls as well as Puts. The latter is explained in the next head of strategy. This strategy calls for buying a Call Option on a stock and writing the Call Option on the same stock with the same maturity date, but with a higher exercise price. It may be noted that in case of Call Options, premium on the Option with lower exercise price is greater than that on Option with higher exercise price. So, in a way, this strategy involves some initial cost as the premium receivable for writing a Call Option (with a higher exercise price) would be less than the premium payable on the Call Option bought (with a lower exercise price). If on the expiry, the stock price is less than the lower exercise price, both the Call Options would be Out-of-money and, hence, both would expire unexercised. In that case, net outflow would be initial cost as represented by the difference between the premium payable (which is higher) and premium receivable. If on the expiry, the stock price lies between the two exercise prices, then the Call with the lower exercise price (which the investor has bought) would be exercised and the Call with the higher exercise price (which the investor has sold) would expire unexercised. So, the net profit would be the difference between the stock price and the exercise price of bought option minus the initial spread cost, as represented by the difference between the premium payable and the premium receivable.
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If the last possibility i.e. the stock price being greater than the higher exercise price, happens, then, both the Call Options, being in-the-money, would be exercised. The resultant net profit would be the difference between the two exercise prices as reduced by the initial spread cost, as represented by the difference between the premium payable and the premium receivable. The payoff table for the Bull Spread (Using Calls) is as shown below:
Price of Stock S1 >= E2 E1 < S1 < E2 S1 <= E1
Payoff from Long Call S1 E1 S1 E1 O (Not Exercised)
Payoff from Short Call E2 S1 O (Not Exercised) O (Not Exercised)
Total Payoff E2 E1 S1 E1 0
The corresponding graphical presentation is as shown under:
Profit
E1
E2
Stock Price
Profit/ Loss of Long Call Loss Profit/ Loss on Short Call
Bull Spread (Using Calls)
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(6) Bull Spread Using Puts In this strategy, the investor purchases a Put Option on the underlying and writes a Put Option on the same underlying and with the same expiry date, but with a higher exercise price. Here also, there would be a difference between the premiums payable and premium receivable. The premium payable on the bought Put Option (with a lower exercise price) would be less as compared to the premium receivable on the sold Put Option (with a higher exercise price). Now, suppose, on the expiry, the price of the underlying is less than the lower exercise price, then both the Put Options would be exercised. The net result would be the difference between premium received and premium paid minus the loss on exercise prices of the two options (as represented by the difference between the two exercise prices). If, on the expiry, the price of the underlying is between the two exercise prices, then the Put Option with higher exercise price (which was sold by the investor) would be exercised and other Put Option would expire unexercised. The net payoff would be the difference between the premiums of both the options as reduced by the difference between the exercise price of the Put Option sold and the price of the underlying. The third possibility, that is to say, the price of the underlying being greater than the higher exercise price, happens, then both the options would expire unexercised, being out-of-money. In that case, our investor would end up earning the difference between the premium received on the written Put and the premium paid on the bought Put.
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Explained in the next table is the conditional payoff flowing from the strategy just discussed.
Price of Stock S1 <= E1 E1 < S1 < E2 S1 >= E2
Payoff from Long Call E1 S1 O (Not Exercised) O (Not Exercised)
Payoff from Short Call S1 E2 S1 E2 O (Not Exercised)
Total Payoff E1 E2 S1 E2 0
The same story is retold by this chart.
Profit
Profit/ Loss from Long Put
Profit/ Loss from Short Put
E1
E2
Stock Price
Loss
Bull Spread (Using Puts)
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(7) Bear Spread Using Calls This strategy is employed when the investor is bearish about the prices of the underlying. He, therefore, buys a Call Option on the underlying and writes a Call Option on the same underlying with the same maturity date, but with lower exercise price. Here, also the premium difference between Call Option written and the Call Option bought would be the Net Inflow for the investor. In case, the price of the underlying were entered, falls below the lower would expire unexercised. So, the between the premium received and options. stock for which the Option contracts exercise price, then both the options Net result would be the difference the premium paid on the respective
But, if turns out that the price of the underlying scrip is between the two exercise prices, then the Call Option with lower exercise price (which was sold) would be exercised and one with higher exercise price (which was bought) would not be exercised. The result would be the loss as represented by the difference between the stock price and the lower exercise price (relating to the Call Option written and exercised). Of course, this loss would be reduced by the net inflow of premium received minus premium paid. On the other hand, if the price of the underlying stock is higher than the higher exercise price, then both the Call Options would be exercised as they would both be in-the-money options under that situation. The loss to the investor would be the difference the exercise prices of the Call Options bought and sold. Here, also this loss would be reduced by the net premium income arrived at by deducting premium paid on Call bought from the premium received on Call sold.
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The tabular summary of this conditional payoff is given on the next page along with the pictorial presentation of the same.
Price of Stock S1 >= E2 E1 < S1 < E2 S1 >= E1
Payoff from Long Call S1 E2 O (Not Exercised) O (Not Exercised)
Payoff from Short Call E1 S1 E1 S1 O (Not Exercised)
Total Payoff E1 E2 E1 S1 0
Profit
Profit/ Loss from Short Call Profit/ Loss from Long Call
E1
E2
Stock Price
Loss
Bear Spread (Using Calls)
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(8) Bear Spread Using Puts Bear spreads, just like Bull spreads, can be created by using Put Options instead of Call Options. In such a case, the investor buys a Put Option with a high exercise price and sells one with a low exercise price. This would require an initial investment because the premium for put with a higher exercise price would be greater than the premium receivable for the put with lower exercise price, written by the investor. The payoffs from a bear spread created with put options are given in the next table wherein the E1 and E2 are the exercise prices of the options sold and purchased respectively.
Price of Stock S1 >= E2 E1 < S1 < E2 S1 <= E1
Payoff from Long Call O (Not Exercised) E2 S1 E2 S1
Payoff from Short Call O (Not Exercised) O (Not Exercised) S1 E1
Total Payoff E1 E2 E2 S1 0
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Following is the graphical presentation of the above mentioned table
Profit
Profit/ Loss from Long Put Profit/ Loss from Short Put
E1
E2
Stock Price
Loss
Bear Spread (Using Puts)
(9) Butterfly Spread Butterfly spread results from taking positions in options with three different strike prices. In this strategy, the investor buys one Call Option with relatively low strike price E1, also buys one Call Option with higher strike price E3 along with writing two Call Options with the strike price E2 which would be exactly half-way between the two strike prices E1 and E3. The price E2 would be usually close to the current market price of the underlying stock, with the result that a profit is pocketed if the stock price stays close to E2 and a small loss would be incurred if there is a significant price movement either way from it. The strategy caters to the need of the investor who feels that huge price variations are not round the corner. However, positions taken entail some cost by way of premium on the options purchased.
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The payoff structure is tabulated below encompassing various possibilities as relating to the price of the underlying stock.
Stock Price
Payoff Payoff form Payoff from Total Payoff from First Second Long Short Calls Long Call Call (E3) (E2) (E1) O (Not Exercised) S1 E1 S1 E1 S1 E1 O (Not Exercised) O (Not Exercised) O (Not Exercised) S1 E3 O (Not Exercised) O (Not Exercised) 2( E2 S1) 2( E2 S1) O (Not Exercised) S1 E1 E3 S1 0
S1 < E1 E1 <= S1 < E2 E2 < S1 < E3 S1 >= E3
The strategy can be more easily understood with the help of an example. Suppose, RIL share is currently selling at Rs. 372. An investor, who feels that a significant change in this price is unlikely, in the next three months, observes the market prices of 3-month calls as tabulated on the next page:
Exercise Price (Rs.) 365 370 375
Call Price (Rs.) 11 8 6
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The investor, here, decides to go long in two callsone each with exercise price Rs. 365 and Rs. 375- and writes two calls with an exercise price of Rs. 370. So, his decision leads to Butterfly Spread. Buying two calls involves a payment of Rs. 11 + Rs. 6 = Rs. 17, and writing two calls yields Rs. 8 * 2 = Rs. 16. Thus, cost involved with the package of options = Rs. 17 Rs. 16 = Re. 1. Payoffs from this Butterfly Spread are given in the next following table:
Stock Price
Payoff from First Long Call (E1 = 365) O (Not Exercised) S1 365 S1 365 S1 365
Payoff form Payoff from Total Payoff Second Long Short Calls Call (E3 = (E2 = 370) 375) O (Not Exercised) O (Not Exercised) O (Not Exercised) S1 375 O (Not Exercised) O (Not Exercised) 2( 370 S1) 2( 370 S1) O (Not Exercised) S1 365 375 S1 0
S1 < 365 365 <= S1 < 370 370 < S1 < 375 S1 >= 375
From the table, it is clear that when the price of an RIL share is less than Rs. 365 or greater than Rs. 375, the payoff will be nil, while if the price varied between Rs. 365 and Rs. 370, the payoff would be the price in excess of Rs. 365 and if it is in the range of Rs. 370 to Rs. 375, then the payoff is Rs. 375 minus the stock price.
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The following table gives the calculation of Net result for four different given prices. Price of RIL share 63 68 73 80 Total Payoff from Calls 0 3 2 0 Cost of Strategy (1) (1) (1) (1) Net Result (1) 2 1 (1)
Graphical presentation of the Butterfly strategy would be as under:
Profit
Profit/ Loss on two Short Calls Profit/ Loss from Long Call
Profit/ Loss from Long Call
E1
E2
E3
Stock Price
Loss
Butterfly Spread
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(10) Straddle Straddle involves buying both the Call as well as the Put Option with the same exercise price and date of expiration. Since this strategy requires buying both the options, it costs to buy a straddle and to that extent, a loss is incurred if the price does not move away from the exercise price since in that case none of these options would be exercised. Buying a straddle is an appropriate strategy to adopt when large price changes are expected in the price of the underlying stock- for lower prices put will be exercised and for the higher prices, the call option will be exercised. One practical example on the strategy would make things more clear. Straddle, as has been mentioned just above, is undertaken when significant price movements are expected in the prices of the underlying. Generally, this happens when an outcome of an event, having a bearing on the fate of the company and in turn its stock prices, is uncertain. So, straddle is a cushion against an event risk, not only that, it also provides a great opportunity to make a profit should the prices move either way from the exercise price by a great many ticks. For example, the market did not know the outcome of the Cabinet Committee on Disinvestment meeting when it was slated to be held on 7 September, 2002. The decision to delay disinvestment in HPCL and BPCL sent the stock prices plummeting. With a great deal of certainty, one can say that a decision in favor of disinvestment would have sent the stock prices soaring. There was uncertainty in which direction the stock prices would have moved, prior to the event. The best strategy to beat this uncertainty would have been to buy a straddle. The strategy would be beneficial if the increase or decrease is greater than the combined premium paid for Call as well as Put Options.
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Suppose, if one bought BPCL Call and Put Options for a strike price of Rs. 240 by paying a premium of Rs. 10 and Rs. 5 respectively and based on the news of disinvestment delay, the prices fell to Rs. 210, one would have made a profit of Rs. 15. On the other hand, had the disinvestment measures been announced and the stock would have gone to Rs. 260, one would have made a profit of Rs. 5. The chart showing the Net payoff as a function of the stock price of BPCL is shown below.
Profit
Straddle Payoff 225 230 235 240 245 250 255 BPCL Stock Price
5 10 Call Option Payoff Loss Straddle Put Option Payoff
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(11) Strip Like straddles, strips and straps also involve taking long or short positions in calls and puts. A strip results when a long position in one call is coupled with a long position in two puts, all with the same exercise price and date of expiration. Here the investor is expecting that a big price movement in the stock price will take place but a decrease in the stock price is more likely than an increase. Since a put option is profitable when a price decrease occurs, two puts are bought in this strategy. Accordingly, the profit function for the strategy, as shown in the following chart, is steeper in the lower than exercise price range and less steep in the region of higher prices.
profit
Payoff from Strip
Stock price
loss
Strip
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(12) Strap Strap is employed when the investor expects that a big price change would occur, but the probability of the stock price going up is far higher than that of stock price going down. In such a situation buying a Put Option is matched with buying two Call Options. As the investors sentiment about the likely price of the scrip on the expiry day is bullish, he would prefer taking a long position in Call Options to that in the Put Option. That is why he tends to buy two Call Options as against one Put Option, a tendency exactly opposite of one in Strip where he considered himself better off going long more in Put Options than in Call Options due to bearish sentiment then. The payoff profile is shown in the following chart:
Payoff from Strap
profit
Stock price
loss
Strap
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(13) Strangle Strangle results when the investor buys a Call and a Put on the underlying stock with the same expiry date, but with different exercise prices. The key difference between Straddle and Strangle is that in case of the former, the exercise price of both the options (Call and Put) are same whereas in the latters case, they are different. The exercise price of the Put Option bought is lower than the exercise price of the Call Option bought. So, Strangle is a suitable strategy for the investor who believes that a sharp movement in the price of the stock is in the offing. Suppose, E1 is the exercise price of the Put Option and E2 is the exercise price of the Call Option. The payoff table for this strangle is as follows:
Price of Stock S1 <= E1 E1 < S1< E2 S1 > E2
Payoff from Put E1 S1 O (Not Exercised) O (Not Exercised)
Payoff from Call O (Not Exercised) O (Not Exercised) S1 E2
Total Payoff E1 S1 O S1 E2
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This payoff table is diagrammed in the chart on the next following page.
Profit
Profit/ Loss from Put Options
Profit/ Loss from Call Option
E1
E2 Stock Price
Loss
Strangle
Evidently, a strangle is a strategy similar to straddle, as here as well, the investor is betting that a large price change would take place but is not sure as to the direction in which the change would occur. However, in a strangle, the stock price has to move farther, than in a straddle, in order that the investor makes a profit. Also, if the stock price happens to be between the two exercise prices, the downside risk is smaller with a strangle than it is with a straddle if the price is close to exercise price. This strangle is also termed as bottom vertical combination or long strangle. Similarly, a strangle may be sold. A short strangle is the choice of an investor who believes that large variations are unlikely. However, if they do occur, then larger amounts of losses are imminent.
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(14) Long Condor A condor, as an investment strategy, encompasses four call or four put options. A long condor involving call options is created by buying callsone with a very low exercise price E1 and another with a comparatively high exercise price E4- and selling two call options- one with the exercise price E2 higher than, and closer to, E1 and the other with the exercise price E3 which is lower than and closer to E4. E1, E2, E3 and E4 are chosen in such a way that E2 E1 = E4 E3, and E3 E1 = 2(E2 E1) A long condor can be created using put options also. Here, the investor buys one put with exercise price E1 and another one with an exercise price equal to E4, and selling two puts- with the exercise prices of E2 and E3. The prices of E1, E2, E3 and E4 are related to each other as in the case of a long condor with call options. Following is the picturesque presentation of the conditional payoff from the long condor using Call Options.
Profit Profit/ Loss from Short Calls
E1
E2
E3
E4 Stock Price
Profit/ Loss from Long Calls Loss Long Condor
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(15) Short Condor A short condor, on the other hand, results by reversing the preceding strategy, and involving selling two calls having exercise prices of E 1 and E4, and buying two calls with the exercise prices of E2 and E3. As compared to Strangle, profit/ loss in case of Condors is limited in case large deviations from exercise prices are observed in stock prices on expiry. The phenomenon of Short Condor is explained below through the help of the chart.
Profit
Profit/ Loss from Short Calls
E1
E2
E3
E4
Stock Price
Profit/ Loss from Long Calls Loss Short Condor
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3.8: OPTION VALUATION An option, like all other financial assets, involves cash flows, but with some complex pattern and that too based on the price movements of the underlying asset. This is very much clear as the option, being a derivative instrument, derives its value from some other asset. No doubt, then, that the value of the option is significantly influenced by the price movements in the underlying asset. Before quantifying the value of option-before assigning any concrete Rupee tag to the option, let us first see some qualitative aspects or characteristics of the options value vis--vis changes in certain parameters. What the price of a Call Option depends on?
1.
Increase in variables: If there is an increase in: The change in the Call Option price is:
Stock Price (P) Exercise Price (EX) Interest Rate (rf) Time to expiration (t) Volatility of Stock price ( 2. Other properties:
Positive Negative Positive* Positive Positive*
a. The option price is always less than the stock price. b. The option price never falls below the payoff to immediate exercise (P EX or zero, whichever is larger). c. If the stock is worthless, the option price approaches the stock.
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d. As the stock price becomes very large, the option price approaches the stock price less the present value of the exercise price. The direct effects of increases in rf or on option price are positive. There may also be indirect effects. For example, an increase in rf could reduce stock price P. this in turn can reduce option price. Given the complex and very much conditional payoff structure of options, it is very much difficult to value them. However, unlike other financial instruments, options cannot be valued using standard operating procedure of (1)forecasting expected cash flow and (2) discounting at the opportunity cost of capital. The first step is messy but feasible. Finding the opportunity cost of capital is impossible, because the risk of the option changes every time the stock price moves, and we know it will move along a random walk through the options lifetime. It also changes over time even with the stock price constant. When one buys a Call, he is actually taking a position in the stock but putting up less of his own money than if he had bought the stock directly. Thus, an option is always riskier than the underlying stock. It has a higher beta and a higher standard deviation of return. How much riskier the option is depends on the stock price relative to the exercise price. An option that is in the money (stock price greater than exercise price in case of a Call) is safer than one that is out of money (stock price less than the exercise price in case of a Call). Thus, a stock price increases raises the options price and its risk increases. That is why the expected rate of return investors demand from an option changes day by day, or hour by hour, every time the stock price moves. Having seen the complexity involved in the valuation of options, now we come to know why an option-valuation technique eluded many economists for so many years.
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However, an answer to this mystery came from two economists: Fisher Black and Myron Scholes. In their seminal contribution in the area of option valuation, they propounded a model to value the options, popularly known as Black and Scholes Model. This model was based on the earlier Binomial Model for option valuation. In fact, it would not be out of place to say that Black and Scholes Model was a refinement, or for that matter to say, an extension of Binomial Model. BLACK & SCHOLES MODEL FOR OPTION VALUATION Noted economists Fisher Black and Myron Scholes, in their celebrated contribution in the area of option-valuation came out with the formula meant for the purpose. The formula for the model is somewhat unpleasant, yet it is the most reliable of all the models around. With some modifications, the model can also be used to value other financial options like currency options, interest rate options and so on. According to the model, the value of a Call Option is calculated as follows: C = S0 N (d1) E e-rt N (d2) Where, ln (S0/E) + (r + 0.5 d1 = * sqrt (t) 2) t 2) t
______________________________________
ln (S0/E) + (r d2 =
______________________________________
* sqrt (t)
C r
= =
current value of the option continuously compounded risk-free rate of return

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S0 E
= =
current price of the stock exercise price of the option
t = time remaining before the expiration date (expressed as a fraction of a year) ln d. Now, we see the assumptions underlying Black and Scholes Model: = Std. deviation of the continuously compounded annual rate of return = natural logarithm value of the cumulative normal distribution evaluated at
N (d) =
The option being valued is a European style option, with no possibility of an early exercise. There are no transaction costs and there are no taxes. The risk-free interest rate is known and constant over the life of the option. The volatility of the underlying instrument (may be the equity share or the index) is known and constant over the life of the option. The distribution of the possible share prices (or index levels) at the end of a period of time is log normal or, in other words, a shares continuously compounded rate of return follows a normal distribution. Essentially, this means that the share (or index) in question is ratio, with the added implication that the share prices (or indices) cannot become negative. Now, we see one real life practical example of how Black and Scholes Model is used to find out the value of an option.
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We have taken data of weekly closing prices of BPCL share for last 40 weeks starting from 7th June, 2002 to 13th March, 2003. Table showing weekly closing prices of BPCL share at NSE and other relevant calculation Closing Price of BPCL share (Rs.) 251.3 290.9 263.75 267.3 284.65 288.55 300.15 302.4 291.35 289.9 287.75 293.5 274.8 253.5 206.05 193.8 1.1576 0.9067 1.0135 1.0649 1.0137 1.0402 1.0075 0.9635 0.9950 0.9926 1.0200 0.9363 0.9225 0.8128 0.9405 0.1463 -0.0980 0.0134 0.0629 0.0136 0.0394 0.0075 -0.0372 -0.0050 -0.0074 0.0198 -0.0658 -0.0807 -0.2072 -0.0613
Date 7-Jun-02 14-Jun-02 21-Jun-02 28-Jun-02 5-Jul-02 12-Jul-02 19-Jul-02 26-Jul-02 2-Aug-02 9-Aug-02 16-Aug-02 23-Aug-02 30-Aug-02 6-Sep-02 13-Sep-02 20-Sep-02
Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Price Relative
ln PR = X
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27-Sep-02 4-Oct-02 11-Oct-02 18-Oct-02 25-Oct-02 1-Nov-02 8-Nov-02 15-Nov-02 22-Nov-02 29-Nov-02 6-Dec-02 13-Dec-02 20-Dec-02 27-Dec-02 3-Jan-03 10-Jan-03 17-Jan-03 24-Jan-03 31-Jan-03 7-Feb-03 14-Feb-03 21-Feb-03
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17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38
186.55 182.1 204.8 193.9 189 193.8 187.75 185.65 184.65 190.65 216.55 219.2 210.65 218.8 231 230.15 227.9 214.45 192 203.25 206.3 222.85
0.9626 0.9761 1.1247 0.9468 0.9747 1.0254 0.9688 0.9888 0.9946 1.0325 1.1359 1.0122 0.9610 1.0387 1.0558 0.9963 0.9902 0.9410 0.8953 1.0586 1.0150 1.0802
-0.0381 -0.0241 0.1175 -0.0547 -0.0256 0.0251 -0.0317 -0.0112 -0.0054 0.0320 0.1274 0.0122 -0.0398 0.0380 0.0543 -0.0037 -0.0098 -0.0608 -0.1106 0.0569 0.0149 0.0772
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28-Feb-03 7-Mar-03 13-Mar-03
39 40 41
223.8 215.1 209.15
1.0043 0.9611 0.9723
0.0043 -0.0396 -0.0281
Price Relative means current weeks closing price plus dividends, divided by previous weeks closing price. For the sake of simplicity, here it has been assumed that no dividends have been paid out during the period covered.
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3.9: PUTS ARE CALLS, CALLS ARE PUTS Bizarre as it might sound, the title is truer than anything else. Actually, this is what Put Call Parity Theorem says. As we know Puts and Calls represent basic options. They serve as building blocks for developing more complex options. Put Call Parity Theorem does just that. The theorem involves a complex combination that consists of buying a stock, buying a put option on that stock, and borrowing an amount equal to the exercise price. The payoff from this combination is identical to the payoff from buying a call option. The algebra of this equivalence is shown as follows: Constituents of the combination Buy the equity stock Buy a put option Borrow an amount equal to the exercise price TOTAL Payoff before expiration if S1 < E S1 E - S1 -E Payoff before expiration if S1 >= E S1 0 -E
S1 - E
The payoff from the individual components and the combination are shown in the next page:
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Value of Stock Position
Buy stock Value of Put Position (P1) E Stock Price (S1) Buy a put (P1) E Combination (Buy a Call) (C1 = S1 + P1 E) Stock Price (S1) Buy Put
Value of Borrowed Position E Stock Price (S1) -E -E Put-Call Parity Theorem Buy a stock
Stock Price (S1) Borrow (-E)
If C1 is the terminal value of the Call Option (for a call option, C 1 = Max (S1E, 0), P1 the terminal value of the put option (for a put option, P1 = Max (ES1, 0), S1 the price of the stock, and E the amount borrowed, we know from the preceding analysis that: C1 = S1 + P1 E This is nothing but what Put-Call Parity Theorem seeks to explain.
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3.10: TAXABILITY OF DERIVATIVE INSTRUMENTS An investor is always concerned with the taxability of an investment avenue, apart from the payoff arising out of it. He always weighs various investment avenues keeping in mind the implications they may have on his tax-bill. Therefore, we make an attempt here as to the tax treatment of the gains arising out of transactions in the derivative segments. An interesting point to note here is that the Government has not come up with any direct provisions as regards the profits/ losses that result from the derivative instruments like Index Futures, Index Options, or for that matter, to say, any derivative instrument. In the absence of any direct provision concerning this matter, we have to rely more on circulars or clarifications from CBDT. Though circulars can always be challenged in the court of law, for the time being, they provide invaluable insight into the subject-matter at hand. While dealing with the taxability of such derivative transactions where settlement is done through Cash instead of actual delivery of ownership of the underlying asset, first section that comes into the picture is Section 73. For the perusal of the reader, we have given under the verbatim of Section 73 of the Income Tax Act, 1961. SECTION 73 Losses in speculation business 1. Any loss, computed in respect of a speculation business carried on by the assessee, shall not be set off except against profits and gains, if any, of another speculation business. 2. Where for any assessment year any loss computed in respect of a speculation business has not been wholly set off under sub-section (1), so much of the loss as is not so set off or the whole loss where the assessee had no income from any other speculation business, shall, subject to the other provisions of this chapter, be carried forward to the following assessment year, And:
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It shall be set off against the profit and gains, if any, of any speculation business carried forward to the following assessment year; and ii. If the loss cannot be wholly set off, the amount of the loss not so set off shall be carried forward to the following assessment year and so on. 1. In respect of allowance on account of depreciation or capital expenditure on scientific research, the provisions of sub-section (2) of section 72 shall apply in relation to speculation business as they apply in relation to any other business. 2. No loss shall be carried forward under this section for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed. Explanation. Where any part of the business of a company (other than a company whose gross total income consists mainly of income which is chargeable under the heads Interest on securities, Income from house property, Capital gains and Income from other sources or a company the principal business of which is the business of banking or the granting of loans and advances) consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares. The crux of this section is that losses arising out of speculation can be set off against the profits, if any, of the other speculation business of the assesssee. However, if, in the instant year, the assessee does not have sufficient profits from other speculation business, he can carry forward the said losses to the next years to be set off against the profits of the speculation business subject, of course, to the maximum of eight years. Given this limited framework incorporated in the Act, we have to see what, according to the Act or CBDT, amounts to a speculative transaction. Section 43(5) defines speculative transactions as those which are periodically or ultimately settled otherwise than by actual delivery or transfer. By this definition, all index futures transactions will qualify prima facie as speculative transactions, as delivery of such futures is not possible.
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Exceptions are provided to this definition to cover cases where contracts are entered into in respect of stocks and shares by a dealer or investor to guard against losses in holdings of stocks and shares through price fluctuations. Another exception is provided for contracts entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against losses, which may arise in the ordinary course of his business as such member. The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The important provisions of this Circular are summarized below: Hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the ready stock. Hedging transactions in connected, though not the same, commodities should not be treated as speculative transactions. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions outside his holdings. By this interpretation, transactions in index futures will not be covered under the definition of hedging. Speculation loss, if any carried forward from earlier years, should first be adjusted against speculation profits of the particular year before allowing any other loss to be adjusted against those profits. The Explanation to Section 73 provides for the additional ground for the deemed speculation. It provides that where any part of the business of a company consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this Section, be deemed to be carrying on a speculation business to the extent to which the business consists of purchase and sale of such shares. However, the said explanation has kept the following out of the ambit of the deemed speculation: Company whose Gross Total Income consists mainly of Income chargeable under the heads Interest on Securities, Income from House Property, Capital Gains and Income from Other Sources Company whose principal business is Banking and Company whose principal business is granting of loans and advances.
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So, most brokers and dealers are currently caught within the mischief of this Explanation, especially after the wave of corporatization of brokers businesses. The Explanation, however, does not cover index futures. In the light of the above-mentioned status quo, it is highly possible that the Income-Tax Department can take a stand whereby the index futures are considered as Speculation business and taxed accordingly. Another possible view (as far as non-business assessees are concerned) could be that gains and losses from index futures be treated as short term capital gains. This view can gain support from the fact that such assessees are not covered within the ambit of Sections 43 and 73 referred to above. However, the assessee can refute the said contention of the Department unless and until there is no direct provision that deem the index futures as a speculation transaction. The grounds of denial can be: 1. Section 43(5) speaks of purchase and sale of any commodity, including shares and stocks. Index futures are not commodities. Further, index futures are also not stocks and shares. Hence, section 43(5) does not apply to futures transactions. The question of examining the provisos (exceptions) does not arise. 2. Exceptions to speculative transactions as provided in Section 43(5) also include hedging transactions undertaken in respect of stocks and shares. Proviso (b) to Section 43(5) states a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations. It however remains to be seen whether index futures can be covered under stocks and shares. We hold the contention that if index futures are considered to be part of stocks and shares as per the wording of Section 43(5), then the proviso will also become applicable and hence hedging contracts through the mechanism of index futures will not be considered speculative. On the other hand, if index futures are not part of stocks and shares, then neither Section 43(5) nor the proviso apply and hence the entire gamut of index futures transactions will remain out of the purview of speculative transactions.
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3. Explanation to Section 73 speaks of purchase and sale of shares of other companies. Index futures are not shares. Hence, this Explanation does not apply to futures transactions. It is believed and understood that foreign exchange forward transactions are currently not being caught within the mischief of Sections 43 and 73. This lends more comfort to the possibility of index futures also being left out of this net, though only experience will indicate the stand the Income tax department will take as the Income-Tax Department is like a wife- you never know which way it will turn!
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Section II 3.11: INTERST AND OTHER DERIVETIVES 3.12: FORWARD RATE AGREEMENTS A Forward Rate Agreement (FRA) is notionally an agreement between two parties in which one of them (the seller of the FRA), contracts to lend to the other (the buyer), a specified amount of funds, in a specific currency, for a specified period starting at a specified future date, at an interest rate fixed at the time of agreement.
It is notional because in practice, actual lending or borrowing of the underlying principal does not take place but only the interest rate is locked in. the buyer of the FRA in turn agrees to borrow (again notionally), funds for a specified duration, starting at a specified future date, at a rate fixed at the time the FRA is bought. A typical FRA quote from a bank might look like this: USD 6/9 months: 7.507.60 % p.a. This quote can be interpreted as follows: The bank is ready to accept a US dollar deposit at a date six months far from now for a period of three months, maturing nine months from now, at an interest rate of 7.50%p.a. This is called bid rate. The bank is also offering a three-month loan after six months from now at a rate of 7.60%p.a. This is termed as ask rate. The following figure gives out the schematic presentation of an FRA, contracted at t = 0, applicable for the period between t = S and t = L. DS and DL are actual number of days from t = 0 to t = S and from t = 0 to t = L respectively. The period from t = S to t = L is the contract period, t = S is the settlement date, and DF is the number of days in the contract period.
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t=o
t=S
t=L
DS
DF
DL
Forward Rate Agreement
The important point to note is that there is no exchange of principal amount. If the settlement rate on the settlement date is above the contract rate, the seller compensates the buyer for the difference in interest on the agreed upon principal amount for the duration of the period in the contract. Conversely, if the settlement rate is below the contract rate, the buyer compensates the seller. The compensation is paid up front on the settlement day and therefore has to be suitably discounted since interest payment on short-term loans is at maturity of the loan. One of the following two formulas is used for calculating settlement payment from the seller to the buyer: P = [(LR) * DF * A]/ [(B * 100) + (DF * L)]
P = [(RL) * DF * A]/ [(B * 100) + (DF * L)]
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Here the notation is L R DF A B = = = = = The settlement rate (%) The contract rate (%) The number of days in a contract period The notional principal Day count basis (360 or 365)
The first formula is used when L > R, and the payment P is from the FRA seller to the FRA buyer, the second formula is used when L < R and the payment is from the buyer to the seller. In effect, if the settlement rate is higher, the FRA seller compensates the buyer for the extra interest; if the settlement rate is lower, the buyer surrenders the interest saving to the seller. An example along this line would render more clarity on the concept. Suppose a bank quote for an FRA is as below: USD 6/9 months: 7.207.30% p.a. A company which intends to take a loan for a period of 3 months starting from the end of the sixth months from now wishes to lock in its borrowing rate. It buys the FRA from the bank which is giving the above FRA quotes, at the banks ask rate of 7.30% for an underlying notional principal of USD 5 million. Suppose on settlement date, the reference rate, for instance, 3month USD LIBOR is pegged at 8.5%. The number of days in the contract period is 91 and the basis is 360 days. The bank will have to pay the company = USD [(8.507.30)(91)(50,00,000)]/[(36000)+(91*8.50)] = USD 14847.65
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FRAs are traded in all convertible currencies. The minimum principal amount is around 5 million units of a currency. Like the forward exchange contract, FRAs are an over-the-counter product and therefore not standardized.
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3.13: SWAPS In all the history of financial markets, no markets have ever grown or evolved as rapidly as have the swap markets. This is a testament to the efficacy and flexibility of the instruments, the resourcefulness and the professionalism of the new breed of financial engineers, and the increased appreciation by financial managers of the importance of financial risk management in a volatile interest rate, exchange rate, and commodity price environment. Industrial corporations, financial corporations, thrifts, banks, insurance companies, world organizations, and sovereign governments now use swaps. Swaps are used to reduce the cost of capital, manage risks, exploit economies of scale, arbitrage the worlds capital markets, enter new markets, and create synthetic instruments. A new user, new uses, and new swap variants emerge almost daily. Most people with some exposure to swaps believe that swaps are exceedingly complex instruments. In reality, this seeming complexity is more in the extensive documentation needed to fully specify the contract terms and the myriad of specialty provisions that can be included to tailor the swap to some specific need. This chapter demystifies basic or plain vanilla swap in the form of cash flow diagrams. By visually depicting the pattern of cash flows associated with swaps and the ways that swaps meld with cash market transactions, one can easily see how a desired end result is achieved. The applicability of basic swaps are with respect to the following three different settings: (1) an interest rate swap to convert a fixed-rate obligation to a floating-rate obligations; (2) a currency swap to convert an obligation in one currency to an obligation in another currency; and (3) A commodity swap to convert a floating prices to a fixed price.
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Before presenting the swap model, however, a brief history of the swap product will put the instruments in perspective. History of the Swap Product The first currency swap was engineered in London in 1979. During the two years that followed the market remained small and obscure. This obscurity ended when, in 1981, Salomon Brothers put together what is now the landmark currency swap involving the World Bank and IBM. The stature of the parties gave long-term credibility to currency swaps. It was a short step from currency swaps to interest rate swaps. Like the currency swap, the first interest rate swap was engineered in London. This took place in 1981. The product was introduced to the United States the following year when the Student Loan Marketing Association (Salllie Mae) employed a fixed-forfloating interest rate swap to convert the interest-rate character of some of its liabilities. Once established, the market for currency and interest rate swaps grew rapidly. From under $5 billion in combined notional principal outstandings at the end of 1982, the market grew to over $2.5 trillion by the end of 1990. The financial institutions that originated the swap product first saw themselves in the role of brokers. That is, they would find the potential counterparties with matched needs and, for a commission, would assist the parties in the negotiation of a swap agreement. The brokering of swaps proved more difficult than originally envisioned because of the need to precisely match each individual contract provision. It wasnt long, however, before these institutions realized their portnetial as dealers. That is, they could make a more liquid market by playing the role of Counterparty. This was possible because of the existence of a large cash market for U.S. Treasury debt and well-developed futures markets in which the swap dealers could hedge their resultant exposures.
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By 1984, representatives from leading dealer banks (commercial banks and investment banks) began work on standardizing swap documentations. In 1985 this group organized itself into the International Swap Dealers Association (ISDA) and published the first standardized swap code. The code was revised in 1986. In 1987, the standardization efforts of the ISDA culminated in the publication of standard form agreements. These contracts are structured as master agreements. As such, all subsequent swaps entered by the same counterparties are treated as supplements to the original agreement. Standardization of documentation dramatically reduced both the time and the cost of originating a swap. Commodity swaps were the first engineered in 1986 by the Chase Manhattan Bank. But, no sooner was the mechanism for commodity swaps in place than the Commodity Futures Trading Commission (CFTC) cast a cloud over the product by questioning the legality of the contracts. The intervention of the CFTC brought that agency into direct conflict with ISDA and a lengthy battle ensued. At the same time, those banks involved in commodity swaps moved the bulk of their activity overseas. In July of 1989, the CFTC issued a favorable policy statement on commodity swaps. The agency decided to grant the contracts a safe harbor, provided that certain criteria were met. These criteria were of little consequence as, for the most part, they reflected current industry practice. By the end of 1989 the volume of commodity swap outstandings was nearly $8 billion. While still small in comparison to interest rate and currency swaps, there appears to be tremendous potential for this market.
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3.14:THE STRUCTURE OF A SWAP A Note on Rate Conventions Interest rate and currency swaps are often discussed together- in which case they are collectively called rate swaps. Since the inception of rate swaps, the floating-rate side has most often been tied to the London Interbank Offered Rate known by the acronym LIBOR. LIBOR is the rate of interest charged on interbank loans of Eurocurrency deposits. While it is rarely made explicit, LIBOR is understood to be a quote on dollar deposits (Eurodollars). But non dollar LIBORs are also quoted. Deutschemark LIBOR, for example, would be denoted DEM LIBOR. All references to LIBOR in this chapter are references to dollar LIBOR unless specifically indicated otherwise. LIBOR quotes are available for various terms including one-month deposits (1-M LIBOR), three-month deposits (3-M LIBOR), six-month deposits (6-M LIBOR), and one year deposits (1-Y LIBOR). Regardless of the length of the deposit, LIBOR, like all interest rates, is quoted on an annual basis. There are two complications, however, which we need to point out. To determine the effective annual rate corresponding to a given term deposit, we need to take into considerations the number of days in a sixmonth period and the number of compounding per year. LIBOR, by convention, is quoted actual over 360. That is, the interest rate is stated as though the year has 360 days, but interest is actually paid every day. The effect of this is to raise the effective rate of interest. For example, if 6-M LIBOR is quoted at 8.00 percent, we would expect that the six-month periodic rate is 4 percent. But, in fact, one would earn 182/360 * 8.00 percent rather than 0.5*8.00 percent. Thus, the periodic rate is 4.0444 percent. During the second half of the year, one would earn a periodic rate of 183/360*8.00 percent for a periodic rate of 4.0667 percent.
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The second complication stems from the fact that the interest earned during the first half of the year would itself earn interest during the second half of the year. That is, compounding raises the effective annual rate of interest. To get the effective annual rate, we must take the compounding into account. This is done below: ER=[(1.040444)*(1.040667)] 1 = 8.276 percent We see then that the effective annual rate corresponding to a 6-M LIBOR quote of 8 percent is about 8.276 percent. The reason that this is important is that the fixed-rate side of a rate swap, called the swap coupon, is most often quoted as bond equivalent (BEY) (also called a coupon equivalent yield). Bond equivalency yields are calculated on the basis of a 365-day year with quotes stated actual over 365.
This differing treatment implies that LIBOR rate differentials and swap coupon differentials are not directly comparable. In order to properly compare them, they must first be adjusted for the differing numbers of days on which the two rates are quoted. Most often, this adjustment takes the form of a simple multiplication of a rate differential 365/360 (when going from LIBOR to BEY) or 360/365 (when going from BEY to LIBOR). This adjustment is only correct, however, if the payment frequencies on the two sides (legs) of the swap are the same-i.e. They are both made quarterly, or both made semiannually or both made annually. The floating-rate side of a swap need not be tied to LIBOR. It can be tied to some other readily identifiable rate that is not easily manipulated by an interested party. The rate can and often is tied to a rate index or based on an average of observations on a short-term rate or a rate index.
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Frequently used rates include certificate of deposit, commercial paper, Tbill, Fed funds, and the Twelfth District cost of funds. Nevertheless, the floating-rate side of most rate swaps are LIBOR based. The Basic Structure of a Swap All swaps are built around the same basic structure. Two parties, called counterparties, agree to one or more exchanges of specified quantities of underlying assets. We call the quantities of underlying assets in a swap the notionals in order to distinguish them from physical exchanges in the cash markets, which are called actuals. A swap may involve one exchange of notionals, two exchanges of notionals, a series of exchanges of notionals, or no exchanges of notionals. Most often, a swap involves one exchange of notionals at the commencement of the swap and a reexchange upon the swaps termination. The notionals exchanged in a swap may be the same or different. Between the exchanges of notionals, the counterparties make payments to each other for the use of the underlying assets. The first Counterparty makes periodic payments at a fixed price for the use of the second counterpartys assets. This fixed price is called the swap coupon. At the same time, the second counterparty makes the periodic payments at a floating (market determined) price for the use of the first counterpartys assets. This is the basic or plain vanilla structure. By modifying the terms appropriately and/or adding specialty provisions, this simple structure can be converted to dozens of variants to suit specific end user needs. For purposes of illustrations, we shall call the first counterparty A and the second counterparty B.
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It is very difficult to arrange a swap directly between two end users. A much more efficient structure is to involve a financial intermediary that serves as counterparty to both end users. This Counterparty is called a swap dealer, a market maker, or a swap bank. The terms are used interchangeably. The swap dealer profits from the bidask spread it imposes on the swap coupon. The cash flows associated with a typical swap are illustrated in the following figures:
Swap: Initial Exchange of Notional s (Optional )
notionals Counterparty A notionals Swap Dealer
notionals Counterparty B notionals
Fig. 1
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Swap: Periodi c Usage or Purchase Paym ents (Required)
Fixed price Counterparty A Floating price Swap Dealer
Fixed price Counterparty B Floating price
Fig. 2
Swap: Reexchange of Notional s (Optional)
notionals Counterparty A notionals Swap Dealer
notionals Counterparty B notionals
Fig. 3
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The first figure depicts the initial exchange of notionals, which is optional in the sense that it is not required in all swaps; the second figure depicts the periodic usage payments; and the third figure depicts the reexchange of notionals, which, like the initial exchange of notions, is optional in the sense that it is not required in all swaps. A swap by itself would generally not make much sense. But swaps do not exist in isolation. They are used in conjunction with appropriate cash market positions or transactions. There are three basic transactions: (1) Obtain actuals from the cash market, (2) make (receive) payments to (from) the cash market, or (3) supply actuals to the cash market. These possibilities are summarized in the next figure. The cash markets depicted in the figure may be the same or different.
Cash Market Transactions
Cash Market A Cash Market B Actuals and/or payments
Actuals and/or payments
Counterparty A
Counterparty B
By combining the cash market transactions with an appropriately structured swap, we can engineer a great many different outcomes. The idea of interest rate swaps and currency swaps developed in the later chapters.
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3.15: INTERST RATE SWAPS In Interest-Rate Swaps, the exchangeable notionals take the form of quantities of money and are consequently called notional principals. In such a swap, the notional principals to be exchanged are identical in amount and involve the same currency. As such, they can be dispensed with-, which explains the origin of the term notional. Furthermore, since the periodic usage payments, called interest in this case, are also in the same currency, only the value differential needs to be exchanged on the periodic settlement dates. Interest rate swaps are often motivated by a desire to reduce the cost of financing. In these cases, one party has access to comparatively cheap fixedrate funding, but desires floating-rate funding while another party has access to comparatively cheap floating-rate funding but desires fixed-rate funding. By entering into swaps with a swap dealer, both parties can obtain the form of financing they desire and simultaneously exploit their comparative borrowing advantages. For example, suppose that Party A is in need of 10-year debt financing. Party A has access to comparatively cheap floating-rate financing but desires a fixed-rate obligation. For purposes of illustration, assume that Party A can borrow at a floating rate of LIBOR + 50 bps or at a semiannual (sa) fixed rate of 11.25 percent. As it happens, Party B is also in need of 10-year debt financing. Party B has access to comparatively cheap fixed-rate rate financing but desires a floating-rate obligation. For the purpose of illustration, assume that Party B can borrow fixed rate at a semiannual rate of 10.25 percent and can borrow floating rate as sixth-month LIBOR. As it happens, Party A desires fixed-rate funding and Party B desires floating-rate funding.
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The swap dealer stands ready to enter a swap as either fixed-rate payer (floating-rate receiver) or as floating-rate payer (fixed-rate receiver). In both cases, the dealers floating rate is six-month LIBOR. Under its present pricing, if the dealer is to be the fixed-rate payer, it will pay a swap coupon of 10.40 percent (sa). If the dealer is to be fixed-rate receiver, it requires a swap coupon of 10.50 percent (sa). The financial engineers working for a swap dealer suggest that Party A issue floating-rate debt and that Party B issue fixed-rate debt and that they both enter into swaps with the swap dealer. Party A, now called Counterparty A, enters a swap, with the swap dealer acting as a floating-rate payer; and Party B, now called Counterparty B, enters a swap, with the dealer acting as a fixed-rate payer. While there are no exchanges of notional principals in these swaps, there are still three types of exchanges if we include the borrowings in the cash market. The full set of cash flows is illustrated in the following figures:
Fig. 1
CAS H MARKET TRANSACTIONS

(Debt Market) Principal (floating rate) (Debt Market) (fixed rate)
Principal
Counterparty A
Swap Dealer
Counterparty B
Swap
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Fig. 2

(Debt Market) 6-M (LIBOR + 50bps) (floating rate) (Debt Market) (fixed rate)
10.25% (sa)
10.50% (sa) Counterparty A 6-M LIBOR Swap Swap Dealer
10.40% (sa) Counterparty B 6-M LIBOR
Fig. 3

(Debt Market) Principal (floating rate) (Debt Market) (fixed rate)
Principal
Counterparty A
Swap Dealer
Counterparty B
Swap
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The first figure depicts the initial borrowings in the cash markets; the second figure depicts debt service in the cash markets and the cash flows with the swap dealer; and the third figure depicts the repayment of principals in the cash market. Examine the second figure. Notice that Counterparty A pays LIBOR+ 50bps on its cash market obligation and receives LIBOR from the swap dealer. The LIBOR portions of these payments are, therefore, offsetting. The only remaining obligation of Counterparty A is to pay the swap dealer 10.50 percent. Thus, Counterparty As final cost is approximately 11.00 percent. This is an approximation because, as noted earlier, the 50 basis point differential is not directly comparable to the foxed rate. It must first be adjusted by multiplying by 365/360. After this adjustment, we see that the real cost to Counterparty A is closer to 11.01 percent. Since direct borrowing of fixed rate in the cash market would have cost Counterparty A 11.25 percent, it is clear that Counterparty A has been benefited by 24 bps by employing the swap. Counterparty B is paying a fixed rate of 10.25 percent on its cash market borrowing and receiving 10.40 percent from the swap dealer. Thus, the total cost of Counterparty B is ahead by 15 basis points. In addition, Counterparty B is paying the swap dealer LIBOR. Thus, the total cost of Counterparty Bs debt is approximately LIBOR- 15 bps (even after adjusting the differential by 360/365). Had Counterparty B borrowed floating rate directly, it would have paid LIBOR. Thus, we find that the swap has saved Counterparty B 15 bps. As a side point, notice that the swap dealer earns 10 bps for its services in making a liquid swap market. This 10bps is the difference between the swap coupon received from Counterparty A and the swap coupon paid to Counterparty B.
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3.16: CURRENCY SWAPS In a Currency Swap, the currencies in which the principals are denominated are different, and for this reason, usually (but not always) need to be exchanged. A currency swap is viable whenever one counterparty has comparatively cheaper access to one currency than it does to another. To illustrate, suppose that Counterparty A can borrow deutschemark for seven years at a fixed rate of 9.0 percent and can borrow seven-year dollars at a floating-rate of one-year LIBOR. Counterparty B, on the other hand, can borrow seven-year deutschemark at a rate of 10.1 percent and can borrow seven-year floating-rate dollars at a rate of one-year LIBOR. As it happens, Counterparty A needs floating-rate dollar financing and Counterparty B needs fixed-rate deutschemark financing. The financial engineers working for a swap dealer that makes deutschemarkfor-dollar currency swaps work out a solution. The dealer is currently prepared to pay a fixed rate of 9.45 percent on deutschemark against dollar LIBOR and it is prepared to pay dollar LIBOR against a fixed rate of 9.55 percent on deutschemarks. The counterparties borrow in their respective cash markets- Counterparty A borrows fixed rate deutschemarks and Counterparty B borrows floating-rate dollars- and then enter a swap. The first figure depicts just that and the initial exchange of notional principals at the commencement of the swap. The second figure depicts the debt service in the cash markets and exchanges of interest payments on the swap. The third figure depicts the re-exchange of notional principals upon the termination of the swap and the repayment of the cash market borrowings.
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Fig. 1: Currency Swap with Cash Market transactions (Initial borrowing and exchange of notional principals)
Fig. 1

(Debt Market) Deutschemark Principal Deutschemark (Debt Market) Dollars
Dollar Principal
Deutschemark Principal Counterparty A Dollar Principal Swap Swap Dealer
Deutschemark Principal Counterparty B Dollar Principal
Fig. 2: Currency Swap with Cash Market transactions (Debt service with swap payments)
Fig.2

(Debt Market) 9% Deutschemark (Debt Market) Dollars
Dollar Principal
9.45% Counterparty A LIBOR Swap Swap Dealer
9.55% Counterparty B LIBOR
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Fig. 3: Currency Swap with Cash Market transactions (Repayment of actuals and reexchange of notional principals)
Fig. 3

(Debt Market) Deutschemark Principal Deutschemark (Debt Market) Dollars
Dollar Principal
Deutschemark Principal Counterparty A Dollar Principal Swap Swap Dealer
Deutschemark Principal Counterparty B Dollar Principal
Notice that while Counterparty A borrows deutschemarks, the swap converts the deutschemarks to dollars. Notice also that these dollars have a floatingrate character with a net cost of approximately LIBOR45 bps. This represents a 45 bps savings over a direct borrowing of floating rate. Similarly, Counterparty B borrows dollars but uses the swap to convert the dollars to deutschemarks. These deutschemarks have a net cost of 9.55 percent. This represents a 55 bps savings over a direct borrowing of fixedrate deutschemarks. Thus, we see that a swap can be used with the appropriate cash market transactions to convert both the currency denomination of a financing and the character of the interest cost.
The plain vanilla currency swap described above is often called an exchange of borrowings. The reason for this terminology is readily evident from an examination of the cash flow diagrams. In particular,
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examine the first figure. Notice that each counterparty to the swap borrows funds in its respective market and then exchanges those borrowings for the borrowings of the other party-hence the name.
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Chapter 4: Comparative Analysis Basis Equity Derivative Return Capital appreciation Dividend Income Capital gain Price Fluctuation Risk Company Specified Sector specified Global risk General Market Risk Market risk Credit risk Liquidity risk Settlement risk Types of margin VaR Extreme Loss Mark to market Initial margin Exposure margin Premium margin Duration Generally Long term (more than 1 yr) Short term (Max. 3 months) Participants Long term Investors Hedgers Safe Investors Speculations Arbitragers
Expiry Date of contract No such things Last Thursday of any month
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Comparative analysis is easy to understand when we are analysis with the example of the real market situation. Now I would like to quote a real life example during my friend doing its internship and very nicely he explains me and recently I really understood the actual comparison of equity and derivative market. Example: There was an investor Mr. Jaichand. He has Rs. 1, 00,000/- and he wants to invest it in share market. Now he has two options either to invest in equity cash market or equity derivative market (F&O). Now suppose if he invest in equity cash market and buy shares of Rs. 1, 00, 000/- and diversified risk so he buys different scrips. So he purchases 10 RIL shares of Rs. 2350/- each. 10 L&T shares of Rs 800/- each, 15 Religare Enterprises Shares of Rs. 370/- each, 20 ICICI bank shares of Rs. 800/- each, 10 Tata power shares of Rs. 1250 each and 10 BHEL shares of Rs. 1595/- each. So for investing Rs. 1, 00,000/- in equity cash market he has to pay Rs. 1,00,000/- and gets the delivery of the shares. Now suppose if he invest in equity derivative market then he will able to purchase the shares worth Rs. 5,00,000/- though he has capital of Rs. 1,00,00/- only, because of the margin payment. But he has to purchase the share in a lot size. So he is able to purchase the 1 lot (100 shares) of RIL at Rs. 2350/-, 1 lot (50 shares) of L&T at 2650/-, 2 lots (100 shares each) of Religare Enterprises at Rs. 370/- and 1 lot (70 shares) of ICICI bank at Rs. 800/-. Here Mr. Jaichand has to pay Rs. 1,00,000/- as a margin money and he is able to purchase a shares worth Rs. 5,00,000/But he has to pay the full amount of money at T+3 basis. So he has to pay the remaining amount on the 3rd day of the trading if he wants the delivery.
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I. Returns Mr. Jaichand gets return on equity by two ways. One is when the share price of the holding shares will increases in futures, called as capital appreciation. Second is by getting a dividend income from the holding shares. Mr. Jaichand gets return on equity derivative when the future prices of the shares are increase in short term called as capital gain through price fluctuation or through options premium. II. Risk: There are four types of risk involved in equity cash market. 1. Company Specified risk: If company is not performing well than process of the shares will declining and vice versa. 2. Sector specified risks: If the sector is not performing well i.e. power sector, metal sector, oil & gas sector, banking sector then prices of the shares will go down and vice versa. 3. Global risk: If global cues are positive then prices will increases but if global cues are not good than prices of shares will go down. 4. General market risk : General market risk is also affect the equity cash market like inflation, banks interest rates etc. So, Mr. Jaichand has to consider all these risk factors while dealing in the equity cash market.
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There are four types of risk involved in equity derivative market: 1. Market risk: In derivative market we have to calculate the market risk or mark to market risk involved in the stocks or securities, that is the exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status). It is calculated on the tradable assets i.e., stocks, currencies etc. 2.Credit risk: It may possible in derivative contract that the counterparty may be fail to perform the contract or say defaulted then it is a risk for us. It is calculated on non-tradable assets i.e., loans. So generally it is for long term purpose. 3. Liquidity Risk: If Mr. Jaichand will not able to find a price( or a price within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market. Consider the case of a counterparty who buys a complex option on European interest rates. He is exposed to liquidity risk because of the possibility that he cannot find anyone to make him a price in the secondary market and because of the possibility that the price he obtains is very much against him and the theoretical price for the product. 4. Settlement Risk: The risk of non-payment of an obligation by a counterparty to a transaction, exacerbated by mismatches in payment timings. So, Mr. Jaichand has to consider all these factors while dealing in the equity derivative market.
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I. Margins: Now Mr. Jaichand has also seen the margin paid in the equity cash segment. 1. Var Margin: Now Mr. jaichand bought shares of a company. Its market value today is Rs. 1, 00,000/- Obviously, we do not know what would be the market value of these shares next day. Now Mr. Jaichand holding these shares may, based on VaR methodology, say that 1-day Var is Rs. 1, 00,000/- at the 99% confidence level. This implies that under normal trading conditions the investors can with 99% confidence, say that the value of shares would not go down by more than Rs.1,00,000/- within next 1-day. 2. Extreme loss margin: In the above situation, the VaR margin rate for shares of RIL was 13%. Suppose that SD would be 1.5 x 3.1= 4.65. Then 5% (which is higher than 4.65%) will be taken as the Extreme Loss margin rate. Therefore, the total margin on the security would be 18% (13% VaR Margin + 5% Extreme Loss margin). As such, total margin payable( VaR margin + extreme loss margin) on a trade of Rs. 23, 500/- would be 4, 230/3. Mark to Market Margin: Now Mr. Jaichand purchased 10 shares of RIL @Rs. 2350/-, at 11 am on May 12, 2009. If close price of the shares on that happened to be Rs. 2350, then the buyer faces a notional loss of Rs. 500/- on his buy position. In technical term this loss is called as MTM loss and is payable by May 13, 2009 (that is next day of the trade) before the trading begins. In case, price of the shares falls further by the end of May 13 2009 to Rs. 2200/then buy postion would show a further loss of Rs. 1, 000/-. This MTM loss is payable by next day.
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Now we will consider the margin payable under the equity derivatives segment. i) Initial Margin: The initial margin required to be paid by the investor would be equal to the highest loss the portfolio would suffer in any of the scenarios considered. The margin is monitored and collected at the time of placing the buy/ sell order. As higher the volatility, higher the initial margin. ii) Exposure Margin: Exposure margins in respect of index futures and index option sell position are 3% of the notional value. iii) Premium margin: If 1000 call option on RIL are purchased at Rs. 20/- and Mr. Jaichand has no other positions, then the premium margin Rs. 20,000. iv) Assignment Margin: Assignment Margin is collected on assignment from the sellers of the contract.
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I. Duration: Generally equity market is a long term market and people invested in it for more than one year and then only they get good return on equity. Generally any safe investors can invest in it because here risk is comparatively low then derivative market. While in derivative market investors are investing for less than one yea, generally for 2 months or 3 months. Here they get high returns on it because they are bringing high risk. II. Participants: Generally any long term investors can invest in equity or hedgers are investing in the equity, who wants to reduce their risk. Any person who wants to be safe investors and wanted to earn a good amount of returns after a period of more than one year is also invested in equity. In derivative market mostly speculators and arbitragers are invested because they wanted quick money in short time period and hedgers are also invested in derivative market to reduce their risk. III. Expiry date: Its a last Thursday of any month in case of a derivative market but no such things in case of an equity market.
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Chapter 5: FINDINGS Practical situation I had experience of real practical situation in the stock Market and in an Organization. End of June 2009 turned out to be favorable for Indian stock markets. The first few sessions saw optimism in the market on the hope that the government will make policy announcements in the budget. However, the market corrected soon after the announcement of budget due to absence of major policy announcements. The sentiments remained negative during following few sessions. However, the market picked momentum from mid of the month. This was helped by better-than expected corporate earnings, huge overseas inflows and encouraging global cues. The buoyancy in the market continued in the second half helping the BSE Sensex to touch highest in more than a year towards the month end. On the whole, the market closed on a strong note. Global stocks rallied over the month on encouraging economic data and earnings reports. The MSCI AC World Index gained 8.70%, where as the MSCI Emerging Markets Index climbed 10.86% during the month. The performance of Indian markets was in line with the global counterparts. The Sensex settled the month with a gain of 8.12%, while the Nifty registered a rise of 8.05%. The BSE Mid and Small caps performance was in line with their larger counterparts, gaining 9.74% and 8.11% respectively over the month.
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Sector Performance All the BSE Sectoral indices wrapped the month with gains except Capital Goods. Intense buying spree was seen in Auto, Realty, FMCG and IT indices, which posted gains of over 20%. Metal, Teck, Health Care and Consumer Durable indices were among other top gainers whereas Oil & Gas index posted a marginal rise over the month. Institutional Activities The FIIs flow remained positive in equities with net inflows of Rs 11,625 crores (USD 2.40 bn) during the month. The domestic MFs were also net buyers with inflows of Rs 1,825.50 crores (USD 381 mn) during the month. Major Corporate Events Infosys Technologies announced a 17.28% y-o-y rise in consolidated net profit for the quarter ended June 2009 to Rs 1,527 crores (USD 318.59 mn). Income from operations for the quarter climbed 12.73% y-o-y to Rs 5,472 crores (USD 1.14 bn). Reliance Industries reported a drop of 11.53% y-o-y in net profit for the quarter ended June 2009 to Rs 3,636 crores (USD 758.60 mn). Total income for the quarter slipped 21.64% y-o-y to Rs 32,757 crores (USD 6.83 bn). Steel Authority of India earmarked Rs 59,800 crores (USD 12.48 bn) capex plan. It includes ongoing modernization and expansion, value addition, technology upgradation and sustenance. Of the total capex plan, Rs 10,000 crores (USD 2.10 bn) will be spent during 200910. Punj Lloyd along with its group companies bagged orders worth Rs 10,250 crores (USD 2.14 bn) during the month. It reported a 27% y-o-y rise in consolidated profit after tax for the quarter ended June 2009 to Rs 125 crores (USD 26.1 mn). Consolidated revenues for the quarter climbed 12% y-o-y to Rs 2,658 crores (USD 554.56 mn).
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Key Macro Developments Industrial production continued to remain positive in May 2009, with a growth of 2.7%. Core sectors registered a growth of 6.5% for June 2009. Exports growth continued to drop for a ninth consecutive month. In dollar terms, exports plunged 27.70% to USD 12.81 billion, however, in rupee terms, it dropped 17.40% to Rs 61,217 crores during June 2009. Meanwhile, oil prices slipped marginally 0.63% over the month to USD 69.45 a barrel. Outlook On the international front, the markets will track developments and key economic data from US, China and Japan. The exit strategy of the central banks will also have bearing on the global markets. On the other hand, the Indian markets will be driven by the progress of monsoon, policy announcements from the government and key economic data. Overall quarterly corporate earnings performance was better than the market expectations. The market is now hoping for better earnings growth prospects for FY2010. The manufacturing growth has also started showing signs of improvement. Now, with signs of economic recovery in developed countries and improvement in risk appetite globally, the funds will flow in the emerging markets like India in search of higher growth. This coupled with encouraging earnings outlook for FY2010, provides good opportunity for investors to take active participation in the market and increase the equity allocation from long term perspective.
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Comparative analysis of the traded value in the F & O Segment with the cash segment F& O (turnover in crores) Jan 2009 Feb 2009 12, 00, 000 12,00, 000 Cash Segment (turnover in crores) 2, 00, 000 1,00, 000 5, 00, 000 4, 50, 000 6 00, 000 6, 50, 000
March 2009 14,00,000 April 2009 May 2009 June 2009 16, 00, 000 19,00,000 18,00,000
From this table we can see that in practical life though equity cash segment is better than the derivatives because it involves lesser risk more numbers of investors are trading in derivatives (F& O) segment. It is a major finding of the projects shows that by 60% to 70% investors are bear more risk and traded in derivatives market because they want to earn more profits by trading in derivatives.
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Chapter 6: CONCLUSIONS This project has covered several areas. Its main conclusions are: Derivatives market growth continues almost irrespective of equity cash market turnover growth. Since 2000. Cash equity turnover has fallen in the developed markets, but derivatives turnover continued to rise steeply and steadily. Equity derivatives businesses like interest derivatives are highly concentrated. Using notional value as the measure, the 2 main US markets and the 2 cross-border European markets accounted for about 75% of the total. This was most apparent in index derivatives, which make 99% of the notional value of equity derivatives. In single stock derivatives, other markets have established niches and the dominance of the gig four is less evident. Equity market volume and derivative market notional value are strongly correlated- with a ratio significant differences between individual markets. A number of cash equity markets- particularly in developing Asia- do not have equity derivatives markets. Comparison of their cash market volumes with those that do have derivative exchanges shows that the markets without derivatives are of similar size. I am not convinced that market or infrastructure differences explain this, but suspects that regularity barriers have effectively prevented the development, markets in several developing Asian countries.
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Chapter 7: RECOMMENDATIONS RBI should play a greater role in supporting Derivatives. Because nowadays derivatives market are increasing rapidly and it plays a major role in the whole securities market. Derivatives market should be developed in order to keep it at par with other derivative market in the world. Nowadays more number of investors are shows their interest in derivatives market because it includes high return by bearing high risk. Speculation should be discouraged because it affects the market conditions badly and new investors are reducing their interest in the market. There must be more derivatives instruments aimed at individual investors. SEBI should conduct seminars regarding the use of derivatives to educate individual investors There is a need to have a smaller contract size in F & O Market. We can review the size of the contract from Rs. Two lacs to On Lacs. In the FICCI survey, 73% of the respondents also held the same view.
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BIBLIORAPHY Books: Securities Laws and Regulations of Financial Markets National Securities Depository Limited Fundamentals of Futures & Options Markets- John C. Hull Financial Derivatives- S. L. Gupta
Websites: www.world-exchange.org www.nseindia.com www.bseindia.com www.religaresecurities.com www.moneycontrol.com www.indiamart.com www.finpipe.com
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Chapter 1: INTRODUCTION 1.1: Background of The Study:: Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives

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Benefits from Equity

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2.4: Selection of Shares:

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Equity and Derivatives

Value at Risk Margin

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Type of Cash Market

Mark to Market Margin

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Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives

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Equity and Derivatives