1.

Futures
Future, as the name indicates, is a trade whose settlement is going to take place in the future. However, before we take a look at futures, it will be beneficial for us to take a look at forward rate agreements

What is a forward rate agreement? A forward rate agreement is one in which a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date. An example for this is the exporters getting into forward rate agreements on currencies with banks.

But there is always a risk of one of the parties defaulting. The buyer may not pay up or the seller may not be able to deliver. There may not be any redressal for the aggrieved party as this is a negotiated contract between two parties.

What is a future? A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.

Futures Futures exchange are traded on a

Forwards stock Forwards are non tradable, negotiated instruments

Futures are contracts having standard Forwards are contracts customized by terms and conditions No the buyer and seller

default risk as the exchange High risk of default by either party

provides a counter guarantee Exit route is provided because of high No exit route for these contracts liquidity on the stock exchange Highly regulated with strong margining No such systems are present in a and surveillance systems forward market.

There are two kinds of futures traded in the market- index futures and stock futures. There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures depending on the tenure.

What are Index Futures?

Index futures are futures contract on the index itself. One can buy a 1, 2 or 3month index future. If someone wants to take a call on the index, then index futures are the ideal instruments for him. Let us try and understand what an index is. An index is a set of numbers that represent a change over a period of time.

A stock index is similarly a number that gives a relative measure of the stocks that constitute the index. Each stock will have a different weight in the index The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.

For example, Nifty was formed in 1995 and given a base value of 1000. The value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000 was invested in the stocks that form in the index, in the same proportion in
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which they are weighted in the index, then Rs 1000 would have become Rs 1172 today.

There are two popular methods of computing the index. They are price weighted method like Dow Jones Industrial Average (DJIA) or the market capitalization method like Nifty or Sensex.

What the terminologies used in a Futures contract? The terminologies used in a futures contract are: Spot Price: The current market price of the scrip/index Future Price: The price at which the futures contract trades in the

futures market Tenure: The period for which the future is traded Expiry date: The date on which the futures contract will be settlec Basis : The difference between the spot price and the future price

Why are index futures more popular than stock futures? Globally, it has been observed that index futures are more popular as compared to stock futures. This is because the index future is a relatively low risk product compared to a stock future. It is easier to manipulate prices for individual stocks but very difficult to manipulate the whole index. Besides, the index is less volatile as compared to individual stocks and can be better predicted than individual stock.

How is the future price arrived at? Future price is nothing but the current market price plus the interest cost for the tenure of the future. This interest cost of the future is called as cost of carry.

If F is the future price, S is the spot price and C is the cost of carry or opportunity cost, then

F=S+C

F = S + Interest cost, since cost of carry for a finance is the interest cost

Thus, F=S (1+r)

Where r is the rate of interest and T is the tenure of the futures contract.The rate of interest is usually the risk free market rate.

Example 1.1: The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will be the price of one-month future?

Solution
T

The price of a future is F= S (1+r)

The one-month Reliance future would be the spot price plus the cost of carry. Since the bank rate is 10 %, we can take that as the market rate. This rate is an annualized rate and hence we recalculate it on a monthly basis.

1/12

300(1+0.10) F= Rs 302.39

Example 1.2: The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys is Rs 3100. The returns expected from the Gsec funds for the same period is 10 %. Is the future of Infosys overpriced or underpriced?

Solution
(1/12)

The 1 month Future of Infosys will be F= 3000(1+.0.10)

F= Rs 3023.90

But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs 76.

What happens if dividend is going to be declared? Dividend is an income to the seller of the future. It reduces his cost of carry to that extent. If dividend is going to be declared, the same has to be deducted from the cost of carry Thus the price of the future in this case becomes, F= S
T

(1+r-d) Where d is the dividend.

Example 1.3:

Since Reliance is paying 50 paise per share and the face value of reliance is Rs 10, the dividend rate is 5%. So while calculating futures, F=300(1+0.10(1/12)

0.05)

F= Rs. 301.22

What happens if dividend is declared after buying a future? If the dividend is declared after buying a one month future, the cost of carry will be reduced by a pro rata amount. For example, if there is a one month
th th

future ending June 30 and dividend is declared on June 15 , then dividend benefit will be reduced from the cost of carry for 15 days.

Since the seller is holding the shares and will transfer the shares to the buyer only after a month, the dividend benefit goes to the seller. The seller will enjoy the benefit to the extent of interest on dividend.

Thus net cost of carry = cost of carry dividend benefits

Example 1.4: The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance declares a dividend of 5%. What will be the price of one-month future? Solution: The benefit accrued due to the dividend will be reduced from the cost of the
(1/12)

future. One month future will be priced at F= 300(1+0.10)

F = 302.39 Cost
(0.5/12)

of Carry= Rs 302.39-Rs 300 = Rs 2.39 The interest benefit of the dividend is available for 15 days, ie 0.5 months. Dividend for 15 days = 300(1+0.05) Dividend Benefit = Rs300.61- Rs 300= Rs0.61 Therefore, net cost of the carry is, Rs2.39-Rs0.61 = Rs 1.78 Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78 In practice, the market discounts the dividend and the prices are automatically adjusted. The exchange steps into the picture if the dividend declared is more than 10 % of the market price. In such cases, there is an official change in the price. In other cases, the market does the adjustment on its own.

What happens in case a bonus/ stock split is declared on the stock in which I have a futures position? If a bonus is declared, the settlement price is adjusted to reflect the bonus. For example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the position becomes 400 Reliance at Rs 150 so that the contract value is unaffected.

But is the Future really traded in this way in the market? What has been discussed above is the theoretical way of arriving at the future price. This can be used as a base for calculation future price

But the actual market price that we see on the trading screen depends on liquidity too. So the prices that we observe in real world are also a function of demand-supply position in that stock.

How do future prices behave compared to spot prices?

Future prices lead the spot prices. The spot prices move towards the future prices and the gap between the two is always closing with as the time to

settlement decreases. On the last day of the future settlement, the spot price equals the future price.

Is the futures price always higher than the spot price? The futures price can be lower than the spot price too. This depends on the fundamentals of the stock. If the stock is not expected to perform well and the market takes a bearish view on them, then the futures price can be lower than the spot price. Future prices can fall also due to declaration of dividend.

All that is okay in theory, but what happens in the real world? In the real world, derivatives are highly volatile instruments and there have been lot of losses in the various financial markets. The classic examples have been Long Term Capital Markets (LTCM) and Barings. We will examine what happened exactly at various places later in the book.

As a result, the regulators have decided that a minimum of Rs 2 lacs should be the contract size. This is done primarily to keep the small investors away from a volatile market till enough experience and understanding of the markets is acquired. So the initial players are institutions and high net worth individuals who have a risk taking capacity in these markets.

Because of this minimum amount, lots are decided on the market price such that the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in case of Sensex, 50.

Similarly minimum lots are decided for individual stocks too. Thus you will find different stock futures having different market lots. The lots decided for each stock was such that the contract value was Rs 2 lacs. This was at the point of introduction of these instruments. However the lot size has remained the same and has not been adjusted for the price changes. Hence the value of the contract may be slightly lower in case of certain stocks.

Trading, i.e. Buying and Selling take place in the same manner as the stock markets. There will be an F & O terminal with the broker and the dealer will enter the orders for you.
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Another fact of the real world is that, since the future is a standard instrument, you can close out your position at any point of time and need not hold till maturity.

How is the trading done on the exchange? Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in cash and is the difference between the futures price and the spot price prevailing at that time For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a cash loss of Rs 10. Thus futures market is a cash market.

In future, there is a possibility that the futures may result in delivery. In such a scenario, the future market will be merged with the spot market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock markets.

How does the mark to market mechanism work?

Market to market is a mechanism devised by the stock exchange to minimize risk. In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future.

2. Options
What are options? As seen earlier, futures are derivative instruments where one can take a position for an asset to be delivered at a future date. But there is also an obligation as the seller has to make delivery and buyer has to take delivery.

Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, index, currency or a commodity

But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that. This payment is called as premium. The party that had the option or the right to buy/sell enjoys low risk. The cost of this low risk is the premium amount that is paid to the other party.

Thus we have seen an option is a derivative that gives one party a right and the other party an obligation to buy /sell at a specified price for a specified quantity. The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The cost of this transaction is the premium.

For example, a railway ticket is an option in daily life. Using the ticket, a passenger has an option to travel. In case he decides not to travel, he can cancel the ticket and get a refund. But he has to pay a cancellation fee, which is analogous to the premium paid in an option contract. The railways, on the other hand, have an obligation to carry the passenger if he decides to travel and refund his money if he decides not to travel. In case the passenger decides to travel, the railways get the ticket fare. In case he does not, they get the cancellation fee.
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The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In case the travel does not materialize, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.

There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.

a. Option holder : The buyer of the option who gets the right b. Option writer : The seller of the option who carries the obligation c. Premium: The consideration paid by the buyer for the right d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price. e. Call option: The option that gives the holder a right to buy f. Put option : The option that gives the holder a right to sell

g. Tenure: The period for which the option is issued h. Expiration date: The date on which the option is to be settled American option: These are options that can be exercised at any i. point till the expiration date j. European option: These are options that can be exercised only on the expiration date Covered option: An option that an option writer sells when he has the underlying shares with him. Naked option: An option that an option writer sells when he does not have the underlying shares with him

k.

l.

m In the money: An option is in the money if the option holder is . n. making a profit if the option was exercised immediately Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately

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How is money made in an option? The money made in an option is called as the option pay off. There can be two pay off for options, for put and call option

Call option: A call option gives the holder a right to buy shares. The option holder will make money if the spot price is higher than the strike price. The pay off assumes that the option holder will buy at the strike price and sell immediately at the spot price.

But if the spot price is lower than the strike price , the option holder can simply ignore the option. It will be cheaper to buy from the market. The option holder loss is to the extent of premium he has paid.

But if the spot price is than the strike price , the option holder can make wind profits. Thus ,the profits for an option holder in a call option is unlimited while losses are capped to the extent of the premium. Conversely, for the writer, the maximum profit he can make is the premium amount. But the losses he can make are unlimited.

Example 2.1: The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What will be the profit for the option holder if the spot price touches a) Rs. 350 b)337

Solution

a. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of Reliance is Rs 340. He can sell the same in the spot market for Rs 350. He makes a profit of Rs 10.

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b. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of Reliance is Rs 340. He can sell the same in the spot market for Rs 337 He makes a loss of Rs 3. But he has reduced his losses by exercising the option. Had he not exercised the option, he would have made a loss of Rs 10, which is the premium that he paid for the option.

Put option: The put option gives the right to sell. The option holder will make money if the spot price is lower than the strike price. The pay off assumes that the option holder will buy at spot price and sell at the strike price

But if the spot price is higher than the strike price, the option holder can simply ignore the option. It will be beneficial to sell to the market. The option holder loss is to the extent of premium he has paid. But if the spot price is lower than the strike price then he can make wind fall profits.

Thus the profit for an option holder in a put option is unlimited while losses are capped to the extent of the premium. This is a theoretical fallacy as the maximum fall a stock can have is till zero, and hence the profit of a option holder in a put option is capped.

So, in a call option for the option holder to make money, the spot price has to be more than the strike price plus the premium amount. If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but cannot make profits by exercising the option.

Similarly, for a put option, the option holder makes money if spot is less than the strike price less the premium amount. If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot make profits by exercising the option

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How is the premium of an option calculated?

In practice, it is the market that decides the premium at which an option is traded. There are mathematical models, which are used to calculate the premium of an option.

The simplest tool is the expected value concept. For example, for a stock that is quoting at Rs 95. There is a 20 % probability that it will become Rs 110. There is a 30 % probability that it will become Rs 105. There is 30% probability that the stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90. If the strike price of a call option is to be Rs 100, then the option will have value when the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs 90. If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively. The expected returns for the above distribution is 0.20*15+0.30*10=Rs 6.

Thus this the price that one can pay as a premium for a strike price of Rs 100 for a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the option holder this opportunity.

This is a very simple thumb calculation. Even then, one would require a lot of background data like variances and expected price movements.

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Trading Strategies using Futures and Options . How can use derivatives as a leverage? You can use the derivatives market to raise funds using your stocks. Conversely, you can also lend funds against stocks.

Does that mean derivatives are badla revisited? The derivative product that comes closest to Badla is futures. Futures is not badla, though a lot of people confuse it with badla. The fundamental difference is badla consisted of contango and backwardation (undha badla and vyaj badla) in the same market. Futures is a different market segment altogether. Hence derivatives is not the same as badla, though it is similar.

How can raise funds from the derivatives market? This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You have shares lying with you and are in urgent need of liquidity. Instead of pledging your shares and borrowing from banks at a margin, you can sell the stock at Rs 3000. Suppose you need this liquidity only for a month and also do not want to part with Infosys. You can buy a 1 month future at Rs 3050. After a month you get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the financing cost for the liquidity.

The other beauty about this is you have already locked in your purchase cost at Rs 3050. This fixes your liquidity cost also and you are protected against further price losses.

Suppose people dont want to lend/borrow money. people want to speculate and make profits? When you speculate, you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market, you can always sell futures and buy in the spot market. If you take a bearish view on the market, you can buy futures and sell in the spot market.

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Similarly, in the options market, if you are bullish, you should buy call options. If you are bearish, you should buy put options

Conversely, if you are bullish, you should write put options. This is so because, in a bull market, there are lower chances of the put option being exercised and you can profit from the premium

If you are bearish, you should write call options. This is so because, in a bear market, there are lower chances of the call option being exercised and you can profit from the premium

How can arbitrage and make money in derivatives? Arbitrage is making money on price differentials in different markets. For example, future is nothing but the future value of the spot price. This future value is obtained by factoring the interest rate.

But if there are differences in the money market and the interest rates change then the future price should correct itself to factor the change in interest. But if there is no factoring of this change then it presents an opportunity to make money- an arbitrage opportunity. Example A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005. The risk free interest rate is 12%. What should be the trading strategy?

Solution: The strategy for trading should be : Sell Spot and Buy Futures Sell the stock for Rs 1000. Buy the future at Rs 1005. Invest the Rs1000 at 12 %. The
(1/12)

interest earned on this stock will be 1000(1+.012)

=1009 So net gain the

above strategy is Rs 1009- Rs 1005 = Rs 4 Thus one can make a risk less profit of Rs 4 because of arbitrage

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But an important point is that this opportunity was available due to mis-pricing and the market not correcting itself. Normally, the time taken for the market to adjust to corrections is very less. So the time available for arbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.

Types of instruments using derivatives?

Butter fly spread - It is the strategy of simultaneous buying of put and call Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used. Double option An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price Straddle The simultaneous purchase and sale of option of the same specification to different periods. Tandem Options A sequence of options of the same type, with variable strike price and period. Bermuda Option Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option can be exercisable only on predetermined dates

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RISK MANAGEMENT IN DERIVATIVES Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to control this risk.

The most critical aspect of risk management is the daily monitoring of price and position and the margining of those positions.

NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that has origins at the Chicago Mercantile Exchange, one of the oldest derivative exchanges in the world.

The objective of SPAN is to monitor the positions and determine the maximum loss that a stock can incur in a single day. This loss is covered by the exchange by imposing mark to market margins.

SPAN evaluates risk scenarios, which are nothing but market conditions. The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of: (a) how much the price of the underlying instrument is expected to change over one trading day, and (b) how much the volatility of that underlying price is expected to change over one trading day. Based on the SPAN measurement, margins are imposed and risk covered. Apart from this, the exchange will have a minimum base capital of Rs 50 lacs and brokers need to pay additional base capital if they need margins above the permissible limits.

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REGULATORY AND TAXATION ASPECTS OF DERIVATIVES : Since derivatives are a highly risky market, as experience world over has shown, there are tight regulatory controls in this market.

The same is true of India. In India, a committee was set up under Dr L C Gupta to study the introduction of the derivatives market in India.

This committee formulated the guidelines and framework for the derivatives market and paved the way for the derivatives market in India.

There other committee that has far reaching implications in the derivatives market is the J R Verma Committee. This committee has recommended norms for trading in the exchange. A lot of emphasis has been laid on margining and surveillance so as to provide a strong backbone in systems and processes and ensure stringent controls in a risky market.

As for the taxation aspect, the CBDT is treating gains from derivative transactions as profit from speculation. Similarly losses in derivative transactions can be treated as speculation losses for tax purpose.

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BIBILIOGRAPHY

1. Asani Sarkar (2006), Indian Derivatives Market, New Delhi, Oxford University press, p.3 2. Kannan, R. (2008), Onset of Derivatives Trading in Derivatives market, available at:www.geocities.com/kstability/content/derivatives/first.html

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