General introduction

The liberalization of the Indian economy has ushered in an era of opportunities for the Indian corporate sector. however, these opportunities are accomplished by challenges. The corporate are now required to operate at global capacities to be able to reap the benefits of economies of scale and be competitive. To operate at global capacities, huge investments are called for and the main source of fund in the public at large. Therefore, the corporate now started tapping the capital market in a big way. The response is also encouraging. As the Indian nation integrates with world economy era, small tremors in the world market starts affecting the Indian economy. As an example, interest rates have been south bound in the world and the same has happened in the Indian market too. fixed income rates have fallen drastically due to fall in the real income of people. To overcome this fall , investors have been continuously seek to increase the yield of their of their investments. But, it is a time-tested fact that, the yields on investment in equity shares are maximum, the accompanying risks are also maximum. Therefore, it is absolutely essential that efforts should be made to reduce this factor. The reduction of risk can be achieved through the process of hedging using derivatives financial instrument. A hedge is any act that reduced the price risk of an existing or anticipated position in the cash market. Basically, there are two type of hedging with futures :long hedge and short hedge.

Financial derivatives are a kind of risk management instrument. A derivative's value depends on the price changes in some more fundamental underlying assets. Many forms of financial derivatives instruments exist in the financial markets. Among them, the three most fundamental financial derivatives instruments are: forward contracts, futures, and options. If the underlying assets are stocks, bonds, foreign exchange rates and commodities etc., then the corresponding risk management instruments are: stock futures (options), bond futures (options), currency futures (options) and commodity futures (options) etc. In risk management of the underlying assets using financial derivatives, the basic strategy is hedging, i.e., the trader holds two positions of equal amounts but opposite directions, one in the underlying markets, and the other in the derivatives markets, simultaneously. This risk management

strategy is based on the following reasoning: it is believed that under normal circumstances, prices of underlying assets and their derivatives change roughly in the same direction with basically the same magnitude; hence losses in the underlying assets (derivatives) markets can be offset by gains in the derivatives (underlying assets) markets; therefore losses can be prevented or reduced by combining the risks due to the price changes. The subject of this book is pricing of financial derivatives and risk management by hedging.

SCOPE OF THE STUDY

Introduction of derivatives in the Indian capital market is the beginning of a new era , which is truly exciting. Derivatives, worldwide are recognized risk management products. These products have a long history in India, in the unorganized sector , especially in currency and commodity markets. The availability of these products on organized exchanges ha provided the market participants with broad based risk management tools. This study mainly covers the area of hedging and speculation. The main aim of the study is to prove how risks in investing in equity shares can be reduced and how to make maximum return to the other investment.

IMPORTANCE OF THE STUDY

It helps the researcher to construct a diversified portfolio.

Provide an insight on return and risk analysis.

It helps to make a general study on derivatives.

It helps to identify and reduce by using hedging strategies and speculation.

OBJECTIVE OF THE STUDY Primary Objectives

To construct portfolio and analyses the risk return relationship.

To hedge the most profitable portfolio.

To construct a diversified portfolio and risk reduction by using index futures.

Secondary objective

To find out extant to which loss can be reduced by applying hedging strategies.

To determine whether the hedger enjoys better returns from the use of hedgers.

To identify how much reduction in risk is possible.

To find out the extend of loss due to misjudgment on index movements .

LIMITATION OF THE STUDY

A) While applying the strategies , transaction cost and impact cost are not taken into consideration.so,it will reflect in the profit calculation on each month of the study. B) data were collected only on the basis of NSE trading C) Hedging strategy is applied on historical data. so the direction of each trend in the stock market is known before hand for the period selected. As a result, some bias could have been done for the application of hedging strategy.

REVIEW OF LITURATURE

Financial derivatives are so effective in reducing risk because they enable financial Institutions to hedge that is, engage in a financial transaction that reduces or eliminates

risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a Future date, it is said to have taken a short position, and this can also expose the Institution to risk. Financial derivatives can be used to reduce risk by invoking the following basic principle of hedging :Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. In other words, if a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position)at a future date. We look at how this principle can be applied using forward and futures PARTICIPANTS OF DERIVATIVE There are three broad categories of participants hedgers, speculators and arbitrageurs. hedgers face risk associated with the price of an assets. They use futures or options markets to reduce or eliminate this risk. Speculates wish to bet on future movement in the price of an asset. features and options contracts cangue them an extra leverage;they can increase both the potential gains and losses in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. Derivative products initially emerged, as hedging devices against fluctuation in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. In recent years, the market for financial derivative has grown tremendously in terms of variety of instruments available. The emergence of the market for

derivative products, most notable forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices.

Though the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. as instrument of risk management , these generally do not influence the fluctuations in the underlying asset prices.

DEFINATIONS
According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else. With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b. contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.

FACTERS AFFECTING GROWTH OF DERIVATIVE

Growth of derivative is affected by a number of factors, some of the important factors are started below. 1. Increased volatility in asset prices in financial markets

Financial derivatives are so effective in reducing risk because they enable financial Institutions to hedge that is, engage in a financial transaction that reduces or eliminates risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a Future date, it is said to have taken a short position, and this can also expose the Institution to risk. Financial derivatives can be used to reduce risk by invoking the following basic principle of hedging :Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. In other words, if a financial institution has

bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position)at a future date. We look at how this principle can be applied using forward and futures PARTICIPANTS OF DERIVATIVE There are three broad categories of participants hedgers, speculators and arbitrageurs. hedgers face risk associated with the price of an assets. They use futures or options markets to reduce or eliminate this risk. Speculates wish to bet on future movement in the price of an asset. features and options contracts cangue them an extra leverage;they can increase both the potential gains and losses in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. Derivative products initially emerged, as hedging devices against fluctuation in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. In recent years, the market for financial derivative has grown tremendously in terms of variety of instruments available. The emergence of the market for

derivative products, most notable forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Though the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. as instrument of risk management , these generally do not influence the fluctuations in the underlying asset prices.

DEFINATIONS
According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else. With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b. contract which derives its value from the prices, or index of prices, of

underlying securities. Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.

FACTERS AFFECTING GROWTH OF DERIVATIVE

Growth of derivative is affected by a number of factors, some of the important factors are started below. 1. Increased volatility in asset prices in financial markets

2. Increased integration of national financial markets with the international markets. 3. Marked improvement in communication facilities and sharp decline in their costs. 4. Development of more sophisticated risk management tools, providing economic agents, a wider choice of risk management strategies. 5. Innovation in the derivative markets, which optimally combine the risk and returns, reduced risk as well as transaction costs as compared to individual financial assets.

TYPE OF DERIVATIVES
One of classifying derivatives is as,

COMMODITY DERIVATIVE
These deals with commodities like suger, gold, wheat, pepper etc..thus, futures or options on gold, suger,pepper, jute etc are commodity derivatives.

FINANCIAL DERIVATIVE Futures or options or swaps on currencies, gift edged securities, stocks and shares, stock market indices, cost of living indices etc are financial derivatives. Another way of classifying derivatives. DERIVATIVES
COMMODITY FINANCIAL

BASIC DERIVATIVES They are forward /futures contracts and option contracts. COMPLEX DERIVATIVE
Other derivative, such as swaps are complex

Forward contract
An agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. A forward contract is an agreement to replace a risk with a certainty. The buyer in the contract is said to hold a long position, and the seller is said to hold a short position. The specified price in the contracts called the delivery price and the specified time is called maturity. Let K-delivery price, and T-maturity, then a forward contract's payoff VT at maturity is: VT = ST-K, (long position) VT = K -ST,(short position Where ST denotes the price of the underlying asset at maturity t = T.

LONG POSITION SHORT POSITION Forward Contracts are generally traded OTC (over-the-counter).

Future contract
Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. Futures have evolved from standardization of forward contracts. Futures differ from forward contracts in the following respects: a. Futures are generally traded on an exchange. b. A future contract contains standardized articles. c. The delivery price on a future contract is generally determined on an exchange, and depends on the market demands.

Options

Options-an agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the agreement according to the terms specified in the agreement. In an options contract, the specified price is called the exercise price or strike price, the specified date is called the expiration date, and the action to perform the buying or selling of the asset according to the option contract is called exercise. According to buying or selling an asset, options have the following types: call option:- is a contract to buy at a specified future time a certain amount of an underlying asset at a specified price. put option:-is a contract to sell at a specified future time a certain amount of an underlying asset at a specified price. According to terms on exercise in the contract, options have the following types: European options:- can be exercised only on the expiration date. American options:- can be exercised on or prior to the expiration date. Define K-strike price and T-expiration date, then an option's payoff (value) VT at expiration date is: VT = (ST-K)+, ( call option) VT = (K -ST)+, ( put option

K ST O K ST COMPLEX DERIVATIVE Using futures and option it is possible to build number of complex derivative. it is designed to suit the particular need and circumstances of a client. Example. SWAPS, Credit derivatives

Weather derivative
This is a new tool for risk management. This is a contract between 2 parties that stipulates how payment will be exchanged between parties depending on certain meteorological conditions

souring the contract period. They are based on data such as temperature, rainfall, snowfall etc, the primary objective of this derivative is to initiate the volume risks, which will influence the balance sheet and profit and loss figures.

FUCTION OF DERIVATIVES
1.Risk management: it involves structuring of financial contracts too produce grains or losses that counter balance the losses or gains arising from movements in financial prices. Thus risks are reduced and profit is increased of a financial enterprises. 2.Price discovery: this represents the ability to achieve and disseminate price information without price information investors ;consumers an producers cannot make decision. Derivatives are well suited for providing price information. 3.Transactional efficiency: transitional efficiency is the product of liquidity. Inadequate liquidity results in high transaction costs. These incases investment and causes

According to buying or selling an asset, options have the following types: call option:- is a contract to buy at a specified future time a certain amount of an underlying asset at a specified price. put option:-is a contract to sell at a specified future time a certain amount of an underlying asset at a specified price. According to terms on exercise in the contract, options have the following types: European options:- can be exercised only on the expiration date. American options:- can be exercised on or prior to the expiration date. Define K-strike price and T-expiration date, then an option's payoff (value) VT at expiration date is:

VT = (ST-K)+, ( call option) VT = (K -ST)+, ( put option) Where ST denotes the price of the underlying asset at the expiration date t =T VT VT 0 K ST O K ST COMPLEX DERIVATIVE Using futures and option it is possible to build number of complex derivative. it is designed to suit the particular need and circumstances of a client. Example. SWAPS, Credit derivatives

Weather derivative
This is a new tool for risk management. This is a contract between 2 parties that stipulates how payment will be exchanged between parties depending on certain meteorological conditions souring the contract period. They are based on data such as temperature, rainfall, snowfall etc, the primary objective of this derivative is to initiate the volume risks, which will influence the balance sheet and profit and loss figures.

FUCTION OF DERIVATIVES
1.Risk management: it involves structuring of financial contracts too produce grains or losses that counter balance the losses or gains arising from movements in financial prices. Thus risks are reduced and profit is increased of a financial enterprises. 2.Price discovery: this represents the ability to achieve and disseminate price information without price information investors ;consumers an producers cannot make decision. Derivatives are well suited for providing price information. 3.Transactional efficiency: transitional efficiency is the product of liquidity. Inadequate liquidity results in high transaction costs. These incases investment and causes

accumulation of capital. Derivatives increases market liquidity, as a result transitional costs are lowered, and the efficiency in doing business is increased.

RISK OF DERIVATIVE
Any comment about derivative would be inadequate without a word of caution. there are 4 inherent risk associated with derivatives. These risk should clearly understood before establishing position in derivatives market. A) Credit risk: the exposure to the possibility of loss resulting from a counter partys failure to meet its financial obligation B) Market risk :adverse movement in the price of a financial asset or commodity. C) Legal risk: an auction by a court or by a regulatory body that could invalidate a financial contract. D) Operational risk: inadequate controls, human error system failure or fraud.

Industries profile;-

Limitation of the techniques used The varies techniques used for the study involves projective technique involving of thematic appreciation test, sentence completion test etcattitude test, linkert scale etc The various limitation of the techniques used are, lack of practical experience for the thematic and

Attitude test lack of proper support from the respondents The limitation of techniques itself. STUDY PLAN. The study plan was for a period of only 45 days.

CHAPTER 4
INDUSTRY PROFILE
Introduction
In general, the financial market divided into two parts, Money market and capital market. Securities market is an important, organized capital market where transaction of capital is facilitated by means of direct financing using securities as a commodity. Securities market can be divided into a primary market and secondary market. PRIMARY MARKET

The primary market is an intermittent and discrete market where the initially listed shares are traded first time, changing hands from the listed company to the investors. It refers to the process through which the companies, the issuers of stocks, acquire capital by offering their stocks to investors who supply the capital. In other words primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is called an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus. SECONDARY MARKET The secondary market is an on-going market, which is equipped and organized with a place, facilities and other resources required for trading securities after their initial offering. It refers to a specific place where securities transaction among many and unspecified persons is carried out through intermediation of the securities firms, i.e., a licensed broker, and the exchanges, a specialized trading organization, in accordance with the rules and regulations established by the exchanges. A bit about history of stock exchange they say it was under a tree that it all started in 1875.Bombay Stock Exchange (BSE) was the major exchange in India till 1994.National Stock Exchange (NSE) started operations in 1994. NSE was floated by major banks and financial institutions. It came as a result of Harshad Mehta scam of 1992. Contrary to popular belief the scam was more of a banking scam than a stock market scam. The old methods of trading in BSE were people assembling on what as called a ring in the BSE building. They had a unique sign language to communicate apart from all the shouting. Investors weren't allowed access and the system was opaque and misused by brokers. The shares were in physical form and prone to duplication and fraud. NSE was the first to introduce electronic screen based trading. BSE was forced to follow suit. The present day trading platform is transparent and gives investors prices on a real time basis. With the introduction of depository and mandatory dematerialization of shares chances of fraud reduced further. The trading screen gives you top 5 buy and sell quotes on every scrip. A typical trading day starts at 10 ending at 3.30. Monday to Friday. BSE has 30 stocks which make up the Sensex .NSE has 50 stocks in its index called Nifty. FII s Banks, financial institutions mutual funds are biggest players in the market. Then there are the retail investors and

speculators. The last ones are the ones who follow the market morning to evening; Market can be very addictive like blogging though stakes are higher in the former. ORIGIN OF INDIAN STOCK MARKET The origin of the stock market in India goes back to the end of the eighteenth century when longterm negotiable securities were first issued. However, for all practical purposes, the real beginning occurred in the middle of the nineteenth century after the enactment of the companies Act in 1850, which introduced the features of limited liability and generated investor interest in corporate securities. An important early event in the development of the stock market in India was the formation of the native share and stock brokers 'Association at Bombay in 1875, the precursor of the present

day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in Ahmedabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during depressing times subsequently. Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life. Without a stock exchange, the saving of the community- the sinews of economic progress and productive efficiency- would remain underutilized. The task of mobilization and allocation of savings could be attempted in the old days by a much less specialized institution than the stock exchanges. But as business and industry expanded and the economy assumed more complex nature, the need for 'permanent finance' arose. Entrepreneurs needed money for long term whereas investors demanded liquidity the facility to convert their investment into cash at any given time. The answer was a ready market for investments and this was how the stock exchange came into being. Stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of regulating or controlling the business of buying, selling or dealing in securities. These securities include: (i) Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; (ii) Government securities; and (iii) Rights or interest in securities. The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges. However, the BSE and NSE have established themselves as the two leading exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equal in size in terms of daily traded volume. The average daily turnover at the exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further to Rs 2,273 crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a total market capitalization of around Rs 9, 21,500 crore. The BSE has over 6000 stocks listed and has a market capitalization of around Rs 9, 68,000 crore. Most key stocks are traded on both the exchanges and hence the investor could buy them on either exchange. Both exchanges have a different settlement cycle, which allows investors to shift their positions on the bourses. The primary index of BSE is BSE Sensex comprising 30

stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed index.

Both these indices are calculated on the basis of market capitalization and contain the heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the exchanges have switched over from the open outcry trading system to a fully automated computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National Exchange Automated Trading) System. It facilitates more efficient processing, automatic order matching, faster execution of trades and transparency; the scrip's traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which are in the carry forward system(Badla). The 'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrip's are the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and primary market is the Securities and Exchange Board of India (SEBI) Ltd. Brief History of Stock Exchanges Do you know that the world's foremost marketplace New York Stock Exchange (NYSE), started its trading under a tree (now known as 68 Wall Street) over 200 years ago? Similarly, India's premier stock exchange Bombay Stock Exchange (BSE) can also trace back its origin to as far as 125 years when it started as a voluntary non-profit making association. News on the stock market appears in different media every day. You hear about it any time it reaches a new high or a new low, and you also hear about it daily in statements like 'The BSE Sensitive Index rose 5% today'. Obviously, stocks and stock markets are important. Stocks of public limited companies are bought and sold at a stock exchange. But what really are stock exchanges? Known also as the stock market or bourse, a stock exchange is an organized marketplace for securities (like stocks, bonds, options) featured by the centralization of supply and demand for the transaction of orders by member brokers, for institutional and individual investors. The exchange makes buying and selling easy. For example, you don't have to actually go to a stock exchange, say, BSE - you can contact a broker, who does business with the BSE, and he or she will buy or sell your stock on your behalf. Market Basics Electronic trading Electronic trading eliminates the need for physical trading floors. Brokers can trade from their offices, using fully automated screen-based processes. Their workstations are connected to a Stock Exchange's central computer via satellite using Very Small Aperture Terminus(V SA Ts ). The orders placed by brokers reach the Exchange's central computer and are matched electronically. Exchanges in India The Stock Exchange, Mumbai(BSE) and the National Stock Exchange(N SE) are the country's two leading Exchanges. There are 20 other regional Exchanges, connected via the InterConnected Stock Exchange(I C SE). The BSE and NSE allow nationwide trading via their VSAT systems. Index An Index is a comprehensive measure of market trends, intended for investors who are concerned with general stock market price movements. An Index comprises stocks that have

large liquidity and market capitalization. Each stock is given a weight age in the Index equivalent to its market capitalization. At the NSE, the capitalization of NIFTY (fifty selected stocks) is taken as a base capitalization, with the value set at 1000. Similarly, BSE Sensitive Index or Sensex comprises 30 selected stocks. The Index value compares the day's market capitalization vis--vis base capitalization and indicates how prices in general have moved over a period of time. Execute an order Select a broker of your choice and enter into a broker-client agreement and fill in the client registration form. Place your order with your broker preferably in writing. Get a trade confirmation slip on the day the trade is executed and ask for the contract note at the end of the trade date. Need a broker As per SEBI (Securities and Exchange Board of India.) regulations, only registered members can operate in the stock market. One can trade by executing a deal only through a registered broker of a recognized Stock Exchange or through a SEBI-registered sub-broker. Contract note A contract note describes the rate, date, time at which the trade was transacted and the brokerage rate. A contract note issued in the prescribed format establishes a legally enforceable relationship between the client and the member in respect of trades stated in the contract note. These are made in duplicate and the member and the client both keep a copy each. A client should receive the contract note within 24 hours of the executed trade. Corporate Benefits/Action. Split A Split is book entry wherein the face value of the share is altered to create a greater number of shares outstanding without calling for fresh capital or altering the share capital account. For example, if a company announces a two-way split, it means that a share of the face value of Rs 10 is split into two shares of face value of Rs 5 each and a person holding one share now holds two shares. Buy Back As the name suggests, it is a process by which a company can buy back its shares from shareholders. A company may buy back its shares in various ways: from existing shareholders on a proportionate basis; through a tender offer from open market; through a book-building process; from the Stock Exchange; or from odd lot holders. A company cannot buy back through negotiated deals on or off the Stock Exchange, through spot transactions or through any private arrangement. Settlement cycle The accounting period for the securities traded on the Exchange. On the NSE, the cycle begins on Wednesday and ends on the following Tuesday, and on the BSE the cycle commences on Monday and ends on Friday. At the end of this period, the obligations of each broker are calculated and the brokers settle their respective obligations as per the rules, bye-laws and regulations of the Clearing Corporation. If a transaction is entered on the first day of the

settlement, the same will be settled on the eighth working day excluding the day of transaction. However, if the same is done on the last day of the settlement, it will be settled on the fourth working day excluding the day of transaction.

Rolling settlement The rolling settlement ensures that each day's trade is settled by keeping a fixed gap of a specified number of working days between a trade and its settlement. At present, this gap is five working days after the trading day. The waiting period is uniform for all trades. In a Rolling Settlement, all trades outstanding at end of the day have to be settled, which means that the buyer has to make payments for securities purchased and seller has to deliver the securities sold. In India, we have adopted the T+5 settlement cycle, which means that a transaction entered into on Day 1 has to be settled on the Day 1 + 5 working days, when funds pay in or securities pay out takes place. The Advantages Of Rolling Settlements As mentioned earlier, this is the system practiced in developed countries. Pay outs are quicker than in weekly settlements, and investors will benefit from increased liquidity. The other benefit of the modified system is that it keeps cash and forward markets separate. In the current system, the trader has five days to square off his transaction which leads to a high level of speculation as people even without funds tend to "play" the market. During volatile markets, especially in a bearish market, this often leads to a payment problem which has dogged the Indian stock exchanges for a long time. It provides for a higher degree of safety, and once mechanisms such as futures and stock-lending become popular, it would result in quality speculation and genuine investor interest. When does one deliver the shares and pay the money to broker As a seller, in order to ensure smooth settlement you should deliver the shares to your broker immediately after getting the contract note for sale but in any case before the pay-in day. Similarly, as a buyer, one should pay immediately on the receipt of the contract note for purchase but in any case before the pay-in day. Short selling Short selling is a legitimate trading strategy. It is a sale of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers take the risk that they will be able to buy the stock at a more favorable price than the price at which they "sold short." The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller, Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. Auction An auction is conducted for those securities that members fail to deliver/short deliver during payin. Three factors primarily give rise to an auction: short deliveries, un-rectified bad deliveries, and un-rectified company objections Separate market for auctions

The buy/sell auction for a capital market security is managed through the auction market. As opposed to the normal market where trade matching is an on-going process, the trade matching process for auction starts after the auction period is over. If the shares are not bought in the auction If the shares are not bought at the auction i.e. if the shares are not offered for sale, the Exchange squares up the transaction as per SEBI guidelines. The transaction is squared up at the highest price from the relevant trading period till the auction day or at 20 per cent above the last

available Closing price whichever is higher. The pay-in and pay-out of funds for auction square up is held along with the pay-out for the relevant auction. Bad Delivery SEBI has formulated uniform guidelines for good and bad delivery of documents. Bad delivery may pertain to a transfer deed being torn, mutilated, overwritten, defaced, or if there are spelling mistakes in the name of the company or the transfer. Bad delivery exists only when shares are transferred physically. In "Demat" bad delivery does not exist. Stock & Exchange Board of India REGULATION OF BUSINESS IN THE STOCK EXCHANGES Under the SEBI Act, 1992, the SEBI has been empowered to conduct inspection of stock exchanges. The SEBI has been inspecting the stock exchanges once every year since 1995-96. During these inspections, a review of the market operations, organizational structure and administrative control of the exchange is made to ascertain whether:

the exchange provides a fair, equitable and growing market to investors

the exchange's organization, systems and practices are in accordance with the Securities Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under

the exchange has implemented the directions, guidelines and instructions issued by the SEBI from time to time

The exchange has complied with the conditions, if any, imposed on it at the time of renewal/ grant of its recognition under section 4 of the SC(R) Act, 1956. During the year 1997-98, inspection of stock exchanges was carried out with a special focus on the measures taken by the stock exchanges for investor's protection. Stock exchanges were, through inspection reports, advised to effectively follow-up and redress the investors' complaints against members/listed companies. The stock exchanges were also advised to expedite the disposal of arbitration cases within four months from the date of filing. During the earlier years' inspections, common deficiencies observed in the functioning of the exchanges were delays in post trading settlement, frequent clubbing of settlements, delay in conducting auctions, inadequate monitoring of payment of margins by brokers, non-adherence to Capital Adequacy Norms etc. It was observed during the inspections conducted in 1997-98 that there has been considerable improvement in most of the areas, especially in trading, settlement, collection of margins etc. Dematerialization Dematerialization in short called as 'demat' is the process by which an investor can get physical certificates converted into electronic form maintained in an account with the Depository Participant. The investors can dematerialize only those share certificates that are already

registered in their name and belong to the list of securities admitted for dematerialization at the depositories. Depository: The organization responsible to maintain investor's securities in the electronic form is called the depository. In other words, a depository can therefore be conceived of as a "Bank" for securities. In India there are two such organizations viz. NSDL and CDSL. The depository concept is similar to the Banking system with the exception that banks handle funds whereas a depository handles

securities of the investors. An investor wishing to utilize the services offered by a depository has to open an account with the depository through Depository Participant. Depository Participant: The market intermediary through whom the depository services can be availed by the investors is called a Depository Participant (DP). As per SEBI regulations, DP could be organizations involved in the business of providing financial services like banks, brokers, custodians and financial institutions. This system of using the existing distribution channel (mainly constituting DPs) helps the depository to reach a wide cross section of investors spread across a large geographical area at a minimum cost. The admission of the DPs involves a detailed evaluation by the depository of their capability to meet with the strict service standards and a further evaluation and approval from SEBI. Realizing the potential, all the custodians in India and a number of banks, financial institutions and major brokers have already joined as DPs to provide services in a number of cities. Advantages of a depository services: Trading indemat segment completely eliminates the risk of bad deliveries. In case of transfer of electronic shares, you save 0.5% in stamp duty. Avoids the cost of courier/ notarization/ the need for further follow-up with your broker for shares returned for company objection No loss of certificates in transit and saves substantial expenses involved in obtaining duplicate certificates, when the original share certificates become mutilated or misplaced. Lower interest charges for loans taken against demat shares as compared to the interest for loan against physical shares. RBI has increased the limit of loans availed against dematerialized securities as collateral to Rs 20 lakh per borrower as against Rs 10 lakh per borrower in case of loans against physical securities. RBI has also reduced the minimum margin to 25% for loans against dematerialized securities, as against 50% for loans against physical securities. Fill up the account opening form, which is available with the DP. Sign the DP-client agreement, which defines the rights and duties of the DP and the person wishing to open the account. Receive your client account number (client ID). This client id along with your DP id gives you a unique identification in the depository system. Fill up a dematerialization request form, which is available with your DP, Submit your share certificates along with the form; write "surrendered for demat" on the face of the certificate before submitting it for demat) Receive credit for the dematerialized shares into your account within 15 days.

Derivatives
The term derivative instrument is generally accepted to mean a financial instrument with a payoff structure determined by the value of an underlying security, commodity, interest rate, or index. According to some notable surveys, over 80% of private sector corporations consider derivatives to be important in implementing their financial policies. Derivatives have

also gained wide acceptance among national and local governments, government sponsored entities, such as the Student Loan Marketing Association and the Federal Home Loan Mortgage Corporation, and supranational, such as the World Bank. Derivatives are used to lower funding costs by borrowers, to efficiently alter the proportions of fixed to floating rate debt, to enhance the yield on assets, to quickly modify the assets payoff structure to correspond to the firm's market view, to avoid taxes and skirt regulations, and perhaps most importantly, to transfer market risk (hedge)- where the term market risk is used to connote the possibility

of losses sustained due to an unforeseen price or volatility change. A firm may execute a derivative transaction to alterits market risk profile by transferring to the trade's counter party a particular type of risk. The price that the firm must pay for this risk transfer is the acceptance of another type of risk and/or a cash payment to the counter party. The term "derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the cash asset. A derivative contract or product, or simply derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset brought / sold in the cash market on normal delivery terms. A general definition of "derivative" may be suggested here as follows: "Derivative" means forward, future or option contract of pre- determined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset or to index of securities. Derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to best meet specific risk management objectives. As both forward contracts and futures contracts are used for hedging, it is important to understand the distinction between the two and their relative merits. Forward contracts are private bilateral contracts and have well established commercial usage. They are exposed to default risk by counter-party. Each forward contract is unique in term of contract size, expiration date and the asset type/ quality. The contract price is not transparent, as it is not publicly disclosed.Since the forward contract is not typically tradable, it has to be settled by delivery of the asset on the expiration date. In contrast, futures contracts are standardized tradable contracts. They are standardized in terms of size, expiration date and all other features. They are traded on specially designed exchanges in a highly sophisticated environment of stringent financial safeguards. They are liquid and transparent. Their market prices and trading volumes are regularly reported. The futures trading system has effective safeguards against defaults in the form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark to market) to the accounts of trading members based on daily price change. Futures are far more costefficient than forward contracts for hedging.

EVOLUTION OF DERIVATIVE
FORWARD TRADING It is not clearly established when and where the first forward market came into existence. there are reports that forward trade exited in India as for back as 2000 BC and in Roman times forward training is believed to have been existence in the 12 th century in Japan. The first organized forward market came into existence in late 19th and early 20th century in Kolkata(jute & jute goods)and in Mumbai (cotton)

FUTURES TRADING
The Dojima rice market can be considerd as the first future market in the sense of an organized exchange.the first futures in the western hemisphere were developed in united states in Chicago.first they were started as spot markets and gradually evolved into futures trading. First stage was starting of agreements to buy grain in future a predetermined price with the intention of actual delivery. Gradually these contracts become transferable and during. American civil war, it become commonplace to sell and resell agreements instead of taking

delivery of physical produce. Traders found that the agreements were easier to but and sell. This is how modern futures contract came into being.

OPTION TRADING
Options trading are of more recent origin. It is estimated that they existing in Greece and Rome as early as 400 BC. Option trading in agriculture products and shares came in us from the 1860s.chicago started the first option market board of trade (CBOT)in 1973.standard maturities , standard strike price, standard delivery arrangement were evolved. The risk of default laws removed by introducing a clearing house and margin system. The introduction of trade option opened the way for the evaluations of more complex derivative.

SWAP TRADING
The first swap transaction took place between world bank and IBM (international business machine) they were currency swaps. interest rates swap also commenced 1981

OTHER DERIVATIVE
Other derivative like forward rate agreement (FRA).range forward contract and they like evolved in second half of 1980s.

CONTENTS

Derivatives an overview Futures contract Hedging in futures Speculating in futures Arbitrage in futures Options Options strategies Derivatives products Open interest Futures price = spot price + cost of carry

DERIVATIVESThe word DERIVATIVES is derived from the word itself derived of a

underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc. Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives is derived from the following products: A. Shares B. Debuntures C. Mutual funds D. Gold E. Steel F. Interest rate G. Currencies. Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivatives having same views about the market. In short it is like a INSURANCE market where investors cover their risk for a particular position. Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential. Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks. Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities. The first product which was launched by BSE and NSE in the derivatives market was index futures

BACKGROUND
Consider a hypothetical situation in which ABC trading company has to import a raw material for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk through the use of derivatives

INTRODUCTION TO FUTURE MARKET

Futures markets were designed to solve the problems that exit in forward markets. A f utures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. There is a multilateral contract between the buyer and seller for a underlying asset

which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.

PURPOSE
The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk. It is a derivative instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be launched even in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons EXAMPLE The current market price of INFOSYS COMPANY is Rs.1650. There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties.

purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares. Suppose the stock rises to 2200. Profit 20 2200 10 0 1400 1500 1600 1700 1800 1900 -10 -20 Loss Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the buyer is 500. Unlimited loss for the buyer because the buyer is bearish in the market Suppose the stock falls to Rs.1400 Profit 20 10 0 1400 1500 1600 1700 1800 1900

-10 -20 Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is 250. Unlimited loss for the seller because the seller is bullish in the market. Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some date in the future. Futures are often used by mutual funds and large institutions to hedge their positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in proportion to the total value of contract MARGIN Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract value. PURPOSE The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations. TYPES OF MARGIN INITIAL MARGIN: It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a traders futures position, the initial margin is returned to the trader. OBJECTIVE The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction. MAINTENANCE MARGIN: It is the minimum margin required to hold a position. Normally the maintenance is lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call to top up the margin account to the initial level before trading commencing on the next level. ILLUSTRATION On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%. The lot size of nifty futures =200.suppose on MAY 16th The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the market. The profit for the buyer will be 10,000 [(1350-1300)*200] Loss for the seller will be 10,000[(1300-1350)] Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer) Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th nifty futures settled at 1400. Profit of buyer will be 10,000[(1450-1350)*200] Loss of seller will be 10,000[(1350-1400)*200] Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer) Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller) As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600 While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call. Now the nifty futures settled at Rs.1390. Loss for Buyer will be 2,000 [(1390-1400)*200] Profit for Seller will be 2,000 [(1390-1400)*200] Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer) Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller) Therefore in this way each account each account is credited or debited according to the settlement price on a daily basis. Deficiencies in margin requirements are called for the broker, through margin calls. Till now the concept of maintenance margin is not used in India. ADDITIONAL MARGIN: In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown. CROSS MARGINING: This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges. MARK-TO-MARKET MARGIN: It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market margin also called as variation margin for trading in the future contract

HEDGERS : Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who dont want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security. PURPOSE: TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK Figure 1.1

Hedgers
Existing SYSTEM New Approach Peril &Prize Approach Peril &Prize
1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional offload holding available risk latter by paying premium. cost is only during adverse

reward dependant 2)For Long, buy ATM Put premium. market conditions on market prices Option. If market goes up, as circuit filters long position benefit else limit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages

Availability of Leverage

STRATEGY:
The basic hedging strategy is to take an equal and opposite position in the futures market to the spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging is implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets). ILLUSTRATION

Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is completed. COST SELLING PRICE PROFIT 400 1000 600 However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if Shyam honours the contract Ram will offer a discount of Rs 100 as incentive. Shyam defaults Shyam honors 400 (Initial Investment) 600 (Initial profit) 400 (penalty from Shyam (-100) discount given to Shyam - (No gain/loss) 500 (Net gain) Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment. Now lets see how investor hedge their risk in the market Example: Say you have bought 1000 shares of XYZ Company but in the short term you expect that the market would go down due to some news. Then, to minimize your downside risk you could

INTRODUCTION TO OPTIONS It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc. MONTHLY OPTIONS : The exchange trade option with one month maturity and the contract usually expires on last Thursday of every month. PROBLEMS WITH MONTHLY OPTIONS Investors often face a problem when hedging using the three-monthly cycle options as the TYPES OF OPTION: CALL OPTION A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract.

ILLUSTRATION Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market. The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25 1. CALL BUYER Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660. 2. CALL SELLER: In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit for the Seller limited to the premium received = Rs.25 Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30 Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610. Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent Thus call option indicates two positions as follows: LONG POSITION If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option. SHORT POSITION If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option. PUT OPTION A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. ILLUSTRATION Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put seller) who is bullish in the market. The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0 1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the seller at Rs.800 Unlimited profit for the buyer = Rs.80 {(Strike price spot price) premium} Loss limited for the buyer up to the premium paid = 20 2). PUT SELLER(Amit): In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. profit 20 10 0 600 700 800 900 1000 1100 -10 -20 Loss Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 - 750 = 30 Limited profit for the seller up to the premium received =

Thus Put option also indicates two positions as follows:

LONG POSITION If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Putoption. SHORT POSITION If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option CALL OPTIONS PUT OPTIONS Option buyer or option holder Buys the right to buy the underlying asset at the specified price Buys the right to sell the underlying asset at the specified price Option seller or option writer Has the obligation to sell the underlying asset (to the option holder) at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price.

FACTORS AFFECTING OPTION PREMIUM THE PRICE OF THE UNDERLYING ASSET: (S)
Changes in the underlying asset price can increase or decrease the premium of an option. These price changes have opposite effects on calls and puts. For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying assets value will generally have the opposite effect

Premium of the Premium of the Price of theCALL

Price of CALL Underlying Underlying asset asset

Premium of the
Premium of the

PUT
PUT

THE SRIKE PRICE: (K)

The strike price determines whether or not an option has any intrinsic value. An options premium generally increases as the option gets further in the money, and decreases as the option becomes more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value, for puts and calls, decreases.

Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an options underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid. Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:

a) Developmental institutions b) Mutual Funds c) Domestic & Foreign Institutional Investors d) Brokers e) Retail Participants

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION : Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset. RISK Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. PRICES: The Futures contracts prices are affected mainly by the prices of the underlying asset. While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset. COST: It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium. STRIKE PRICE: In the Futures contract the strike price moves while in the option contract the strike price remains constant . Liquidity: As Futures contract are more popular as compared to options. Also the premium charged is high in the options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated trading and investors in the options contract. Price behaviour: The trading in future contract is one-dimensional as the price of future depends upon the price of the underlying only. While trading in option is two-dimensional as the price of the option depends upon the price and volatility of the underlying. PAY OFF: As options contract are less active as compared to futures which results into non linear pay off. While futures are more active has linear pay off . OPTION STRATAGIES:
1.

BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month. However, the total investment is usually far less than that required to purchase the stock. Current price of PATNI COMPUTERS is Rs. 1500 Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of 1510 and receive 15 ticks per contract. Premium = 10 ticks per contract(25 paid- 15 received) Lot size = 600 shares BREAK- EVEN- POINT= 1490+10=1500 Possible outcomes at expiration: i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also reduce the premium received. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT : If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce the loss through receiving the net premium. If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE: If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10 iv. ABOVE HIGHER PRICE: IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid. v. BELOW PRICE: IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid. The pay-off table: PATNI COMPUTERS AT EXPIRATION 1485 (

1. BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares. Current price of INFOSYS TECHNOLOGIES is Rs. 4500 Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract. Premium = 10 ticks per contract(55 paid- 45 received) Lot size = 200 shares BREAK- EVEN- POINT= 5510-10 = 5500. Possible outcomes at expiration: i. BREAK- EVEN- POINT:

iii. AT STRIKE: If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money. If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10 iv. ABOVE HIGHER PRICE: IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid. v. BELOW PRICE: IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid. The pay-off table: PATNI COMPUTERS AT EXPIRATION

1485 (below lower price) 1490 (At the lower price) 1495 (Between lower strike &BEP 1500 (At BEP) 1510 Intrinsic value of 1490 long call at expiration (a) 0 0 5 10 20 Premium paid (b) 25 25 25 25 25 Intrinsic value of 1510 short call at expiration (c) 0 0 0 0 0 Premium received (d) 15 15 15 15 15 profit/loss(a-c)-(b- d) -10 -10 -5 0 10 PATNI COMPUTERS AT EXPIRATION 1495 (below higher price) 1510 (At the

higher price) 1505 (Between higher strike &BEP 1500 (At BEP) 1520 (Above BEP Intrinsic value of 1510 short call at expiration (a) 0 0 0 0 10 Premium paid (b) 15 15 15 15 15

Intrinsic value of 1490 long call at expiration (c) 5 20 15 10 30 Premium received (d) 25

25 25 25 25 profit/loss(c-a)-( d - b) -5 10 5 0 10 Profit 20 10 0 1490 1500 1510 1520 1530 1540 -10 -20 Loss

1. BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares. Current price of INFOSYS TECHNOLOGIES is Rs. 4500 Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract. Premium = 10 ticks per contract(55 paid- 45 received) Lot size = 200 shares BREAK- EVEN- POINT= 5510-10 = 5500. Possible outcomes at expiration: i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option sold will expire worthless and also reduce the premium received. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT : If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the loss of Rs.10 through receiving the net premium. If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium receive will generate profit . iii. AT STRIKE: If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium received between the strike price an premium paid. iv. ABOVE STRIKE PRICE: IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic value. while the 4490 put option sold result in maximum loss to the premium received. If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic value. while the 5510 put option sold result in the maximum profit strike price - premium v. BELOW STRIKE PRICE: IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490 option sold will be assigned (strike price premium paid) = profit

3. BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market to provide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell

one month put of 1310 (higher price) and receive 15 ticks per contract. Premium = 10 ticks per contract (25 paid- 15 received) Lot size = 600 shares BREAK- EVEN- POINT= 1300-10 = 1290 Possible outcomes at expiration: i. BREAK- EVEN- POINT: On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT: If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15 If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of 5. iii. AT STRIKE: If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless. While 1310 will have an intrinsic value of 10 If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t the premium received iv. ABOVE STRIKE PRICE: If the index is above1300 say 1310, the 1300 put option buyer has lost the premium while the 1310 put option seller receive premium to the limited profit If the index is above 1310, say 1320 the 1290 put option buyer will have maximum loss results in deep out the money while the 1310 put option will have the limited

v. BELOW STRIKE PRICE: If the index is below 1300 say (1290) , the 1300 put option buyer will have an intrinsic value of 10 while the 1310 put option sold receive only premium as the profit is limited for the seller. OPTION PAYOFF

Profit Loss

4.BEAR CALL SPREAD:

This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. Here the investor buys a higher strike call and sells a lower strike call with the same expiration dates. However, the total investment is usually far less than that required to buy the stock or futures contract. The strategy has both limited profit potential and limited downside risk. Current price of ACC is Rs. 1500 Here the investor buys one month call of 1510 at 25 ticks per contract and sell one month call of 1490 and receive 15 ticks per contract. Premium = 10 ticks per contract (25 paid - 15 received) Lot size = 600 shares BREAK- EVEN- POINT= 1510+10=1520 Possible outcomes at expiration: i. BREAK- EVEN- POINT: On expiration if the stock of PATNI COMPUTERS is 1520 then the option will close at Breakeven. The call of 1510 will have an intrinsic value of 10 while the 1490 call option sold will expire worthless and also reduce the premium with the premium outflow. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT

If the index is between 1490 and 1500 then the 1510 call option will have no intrinsic value and expire worthless, While 1490 call option sold will not expire which will reduce the loss through receiving the net premium. If the index is between 1500 and 1510 then the 1510 call option will have an intrinsic value of 0, while 1490 call option sold will have no intrinsic value the premium receive generate profit . iii. AT STRIKE:

If the index is at 1510 the 1510 call option will have no intrinsic value and expire worthless. While 1490 call sold receive only premium If the index is at 1490, the 1510 call option will have no intrinsic value result in deep out the money, While 1490 call sold will have no intrinsic value and expire worthless iv. ABOVE HIGHER PRICE : IF the underlying stock is above 1510 say 1520, the 1510 call option will be in the money of Rs.10 while the 1490 option will incur loss to the premium receive IF the underlying stock is above 1490 say Below1510, the 1510 call option will not be exercised while the 1490 option will incur loss to the premium receive because seller is bearish in the market.v. BELOW STRIKE PRICE : IF the underlying stock is below 1510, the 1510 call option will result in deep out the money and 1490 option sold result in loss to the premium paid. OPTION PAYOFF Profit Loss

5).STRADDLE:
In this strategy the investor purchase and sell the call as well as the put option of the same strike price, the same expiration date, and the same underlying. In this strategy the investor is neutral in the market. This strategy is often used by the SPECULATORS who believe that asset prices will move in one direction or other significantly or will remain fairly constant.

TYPES: LONG STRADDLE:

Here the investor takes a long position(buy) on the call and put with the same strike price and same expiration date. In this the investor is beneficial if the price of the underlying stock move substantially in either direction. If prices fall the put option will be profitable an if the prices rises the call option will give gains. Profit potential in this strategy is unlimited ,While the loss is limited up to the premium paid. This will occur if the spot price at expiration is same as the strike price of the options.

SHORT STRADDLE:
This strategy is reverse of long straddle. Here the investor write(sell) the call as well as the put in equal number for the same strike price an same expiration. This strategy is normally used when the prices of the underlying stock is stable but the investor start suffering losses if the market substantially moves in either direction . Detailed example of a long straddle Current market price ofBAJAJ AUTO is Rs.600 Here the investor buys one month call of strike price 600 at 20 ticks per contract and two month put of strike price 600 for 15 ticks per contract. Premium Paid = 35 ticks Lot size = 400 shares Lower Break- Even- Point = 600 35 = 565 Higher Break- Even- Point = 600 + 35 = 635 i. AT BREAK- EVEN- POINT: If the stock is at 565 or at 635, this option strategy will be at Break- Even- Point. At 565 the 600 call will have no intrinsic value an expire worthless but the 600 put will have an intrinsic value of 35. At 635 the 600 call will have an intrinsic value of 35, while the put 600 will expire worthless.

BELOW STRIKE PRICE AND BELOW LOWER BEP: If the stock price goes to 550 then the 600 call will have no intrinsic value and expire worthless while 600 put will have an intrinsic value of 50. iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP: If the stock price touches 650 the 600 call will have an intrinsic value of 50, while 600 put will have no intrinsic value an will expire worthless. iv.BETWEEN LOWER BEP AND HIGHER BEP: If the stock prices goes to 6oo then the both call and put option will expire worthless which results in the loss of 35(premium).
ii.

6. STRANGLE:
In this strategy the investor is neutral in the market which involves the purchase of a higher call and a lower put that are slightly out of the money with different strike price and with the different expiration date. The premiums are lower as compared to straddle also the risk is more involved as compare to straddle which not leads to the profit. TYPES

1) LONG STRANGLE
Here the investor purchases a higher call and a lower put with different strike price and with the different expiration date. A long strangle strategy is used to profit from a volatile price an loss from stable prices.

1) SHORT STRANGLE:
In this the investor sells a higher call and a lower put with different strike price and with the different expiration date. A short strangle strategy is used to profit from a stable prices an loss starts when price is volatile. Detailed example of a short strangle Current market price of BSE INDEX is Rs.4000 Here the investor sells a two month call of strike price 4050 for 20 ticks per contract and two month put of strike price 3950 for 15 ticks per contract. Premium Received = 35 ticks Lot size = 300 shares Lower Break- Even- Point = 3950 35 = 3915 Higher Break- Even- Point = 4050 + 35 = 4085 On Expiration: i. ATBREAK EVEN POINT: If the stock is at 3915 or at 4085, this option strategy will be at Break- Even- Point. At 3915 the 4050 call will have no intrinsic value and expire worthless but the 3950 put will have an intrinsic value of 35 At 4085 the 4050 call will have an intrinsic value of 35, while the put 400 will have no intrinsic value and expire worthless. ii.BELOW STRIKE PRICE AND BELOW LOWER BEP: If the stock price goes to 3900 then the 4050 call will have no intrinsic value and expire worthless while 3950 put will have an intrinsic value of 50. iii.ABOVE STRIKE PRICE AND ABOVE LOWER BEP: If the stock price touches 4100 the 4050 call will have an intrinsic value of 50, while 3950 put will have no intrinsic value and will expire worthless. iv.BETWEEN LOWER BEP AND HIGHER BEP: If the stock prices goes to 4000 then the both call and put option will expire worthless and

limited profit up to the premium received. v. AT STRIKE PRICE: If the price is settled at 4050 then 4050 call and 3950 put will have limited profit upto the premium received The pay-off Loss 7) COVERED CALL: Under this strategy investors buys the shares which shows that they are bullish in the market but suddenly they are scared about the market falls thus they sells the call option. Here the seller is usually negative or neutral on the direction of the underlying security. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. Thus if price rises he will not participate in the rally. However he has now reduced loss by the amount of premium received, if prices falls.Finally if prices remains unchanged obtains the maximum profit potential. EXAMPLE: Portfolio: 100 shares purchased at Rs.300 Components: Sell a two month Reliance call of 300 strike at 25 Net premium: 25 ticks Premium received: Rs.2500 (25*100, the multiplier) Break-even-point: Rs.275:Rs.300-25 (Premium received) Possible outcomes at expiration: If the stock closes at 300, the 300 call option will not exercised and seller will receive the premium. If the stock ends at 275, the 300 call option expires worthless equilant to the premium received results into no profit no loss. If the stock ends above 300, the 300 call option is exercised and call writer receives the premium results into the maximum profit potential. The payoff diagram of a covered call with long stock + short call = short put 8) COVERED PUT: Here the writer sell stock as well as put because he overall moderate bearish on the market and profit potential is limited to the premium received plus the difference between the original share price of the short position and strike price of the put. The potential loss on this position, however is substantial if price increases above the original share price of the short position. In this case the short stock will suffer losses which will be offset by the premium received. 9) UNCOVERED CALL: This strategy is reverse of the covered call. There is no opposite position in the naked call. A call option writer (seller) is uncovered if the shares of the underlying security represented by the option is not owned by the option writer. The object of an uncovered call writer is to realize income by writing (selling) option without committing capital to the ownership of the underlying shares. This shows that the seller has one sided position in the contract for this the seller must deposit and maintain sufficient margin with the broker to assure that the stock can be purchased for delivery if option is exercised. RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE AS FOLLOWS:

If the market price of the stock rises sharply the calls could be exercised, while as far as the obligation is concerned the seller must buy the stock more than the option strike price, which results in a substantial loss.

The rise of buying uncovered calls is similar to that of selling stock although, as an option writer, the risk is cushioned somewhat by the amount of premium received. ILLUSTRATION: Portfolio: Write reliance call of 65 strike Net premium: 6 Lot size: 100 shares Market action: price settled at 55 Therefore the option will not be assigned because the seller has no stock position and price decline has no effect on the profit of the premium received. Suppose the price settled at Rs.75 the option assigned and the seller has to cover the position at a net loss of Rs.400 [1000 (loss on covering call)- 600(premium income)] Finally the loss is unlimited to the increase in the stock price and profit is limited to the declining stable stock price. 10) PROTECTIVE PUT: Under this strategy the investor purchases the stock along with the put option because the investor is bearish in the market. This strategy enables the holder of the stock to gain protection from a surprise decline in the price as well as protect unrealized profits. Till the

option expires, no matter what the price of underlying is, the option buyer will be able to sell the stock at strike price of put option. SCENARIO Price of HLL: 200 Components: Buy a one-month put of strike 200 Net premium: 10 ticks per contract

Premium paid: 1000 (10*100 multiplier) Break-even-point: 210 (Rs.200+10, Premium paid) Here the investor pays an additional margin of Rs.10 along with the price of Rs.210 combining a share with a put option is referred as a Protective Put. Possible outcomes at expiration

AT BREAK-EVEN-POINT: Previously if the price rises to 200 the investor will gain but now the investor pays an margin of Rs.10. If price rises to Rs.210 then only the investor will gain.

BELOW STRIKE PRICE: In case of fall in the stock price the loss is limited to Rs.18. This means that he maximum loss that the investor would have to bear is limited to the extent of premium paid. If the price falls at 190 the investor will sell at 200.

ABOVE STRIKE PRICE : In case of rise in prices then the put option will expire worthless and the investor will benefit from rise in the stock price. Finally uncertainty is the biggest curse of the market and a protective put helps override the uncertainty in the markets. Protective put removes the uncertainty by limiting the investor loss at Rs.10. In this case no matter what happens to the investor is protected by the loss of Rs.10. The put option makes the investor life by telling the investor in advance how much it stands to loss. This is also referred to as PORTFOLIO INSURANCE because it helps the investor by insuring the value of investment just like any other asset for which the investor would purchase insurance. PRICING OF AN OPTION DELTA A measure of change in the premium of an option corresponding to a change in the price of the underlying asset.
Change in option premium Delta = -------------------------------Change in underlying price

FACTORS AFFECTING DELTA OPTION: Strike price Risk free interest rate Volatility Underlying price Time to maturity ILUSTRATION The investor has buys the call option in the future contract for the strike price of Rs.19. The premium charged for the strike price of 19 at 0.80 The delta for this option is 0.5.Here if the price of the option rises to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The
new option premium will be 0.80 + 0.50 = Rs 1.30.

Here in the money call option will increase the delta by 1.which will make the value more and expensive while at the money option have the delta to 0.5 and finally out the money call option will have the delta

very close to 0 as the change in underlying price is not likely to make them valuable or cheap and reverse for the put option Delta is positive for a bullish position (long call and short put) as the value of the p osition increases with rise in the price of the underlying. Delta is negative for a bearish position (short call and long put) as the value of the position decreases with rise in the price of the underlying. Delta varies from 0 to 1 for call options and from 1 to 0 for put options. Some people refer to delta as 0 to 100 numbers. ADVANTAGE The delta is advantageous for the option buyer because it can tell him much of an option and accordingly buyer can expect his short term movements by the underlying stock. This can help the option of an buyer which call/put option should be bought. GAMMA A measure of change in the delta that may occur corresponding to the rise or fall in the price of the underlying asset. Gamma = change in option delta __________________ change in underlying price The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying. For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased. suppose the delta changed to 0.5-0.04 = 0.46 thus the rate of premium will decreased . In simple terms if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying. Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices THETA: A measure of change in the value of an option corresponding to its time to maturity. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio. Change in an option premium Theta =-------------------------------------Change in time to expiry Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases. ILLUSTRATION Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs.4.5. ADVANTAGE

Theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.

DISADVANTAGE Theta is always negative for the buyer of an option, as the value of the option goes down each day if his view is not realized. In simple words theta tells how much value the option would lose after one day, with all the other parameters remaining the same. VEGA The extent of extent of change that may occur in the option premium, given a change in the volatility of the underlying instrument.
Change in an option premium Vega =--- --- --- --- --- --- --- --- --- --- --- --- --- -Change in volatility

ILLUSTRATION
Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatility of the underlying is 35%. As the volatility increases to 36%, the premium of the option would change upward to Rs15.6. Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put). ADVANTAGE Simply put, for the buyer it is advantageous if the volatility increases after he has bought the option.

DISADVANTAGE
For the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility. In simple words Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.

DERIVATIVES PRODUCTS OFFERED BY BSE SENSEX FUTURES A financial derivative product enabling the investor to buy or sell underlying sensex on a future date at a future price decided by the market forces First financial derivative product in India. Useful primarily for Hedging the index based portfolios and also for expressing the views on the market SENSEX OPTIONS: A financial derivative product enabling the investor to buy or sell call or put options (to be exercised on a future date) on the underlying sensex at a premium decided by the market forces Useful primarily for Hedging the Sensex based portfolios and also for expressing the views on the market. STOCK FUTURES: A financial derivative product enabling the investor to buy or sell underlying stock on a future date at a price decided by the market forces Available on____ individual stocks approved by SEBI Useful primarily for Hedging, Arbitrage and for expressing the views on the market. STOCK OPTIONS: A financial derivative product enabling the investor to buy or sell call options(to be exercised at a future date) on the underlying stock at a premium decided by the market forces

Available on____ individual stocks approved

Useful primarily for Hedging, Arbitrage and for expressing the views on the market. CONTRACT SPECIFICATIONS PARTICULARS SENSEX FUTURES AND OPTIONS STOCK FUTURES AND OPTIONS Underlying Asset Sensex Corresponding stock in the cash market Contract Multiplier 50 times the sensex (futures) 100 times the sensex (options) Stock specific E.g. market lot of RIL is 600, Infosys is 100 & so on Contract Months 3 nearest serial months (futures) 1, 2 and 3 months(options) 1, 2 and 3 months Tick size 0.1 point 0.01* Price Quotation Sensex point Rupees per share Trading Hours 9:30a.m. to 3:30p.m. 9:30a.m. to 3:30p.m. Settlement value In case of sensex options the closing value of the sensex on the expiry day In case of stock options the closing value of the respectative in the cash segment of BSE Exercise Notice Time In case of sensex options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant. In case of stock options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant. Last Trading Day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day Final Settlement

On the last trading day, the closing value of the Sensex would be the final settlement price of the The difference is settled in cash on the expiration day on the basis of the closing value of the respectative DERIVATIVES PRODUCTS OFFERED BY NSE INDEX FUTURES Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index future Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation. The S&P 500 futures products are the largest traded index futures product in the world. Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000
ADVANTAGES OF INDEX FUYTURES

The contracts are highly liquid Index Futures provide higher leverage than any other stocks It requires low initial capital requirement It has lower risk than buying and holding stocks Settled in cash and therefore all problems related to bad delivery,
forged, fake certificates, etc can be avoided.

INDEX OPTIONS
An index option provides the buyer of the option, the right but not the obligation to buy or sell the underlying index, at a pre-determined strike price on or before the date of expiration, depending on the type of option. Index option offer investors an opportunity to either capitalize on an expected market move or hedge price risk of the physical stock holdings against adverse market moves. NSE introduce index option in June 2001.

FUTURES ON INDIVIDUAL SECURITIES A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001. NSE defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.