1.

INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of
traded securities and stock, prices of gold or copper. Derivatives have
become increasingly important in the field of finance, Options and Futures
are traded actively on many exchanges, Forward contracts, Swap and
different types of options are regularly traded outside exchanges by financial
institutions, banks and their corporate clients in what are termed as over-thecounter markets in other words, there is no single market place organized
exchanges.

1.1 NEED OF THE STUDY

Different investment avenues are available to investors. Stock market

also offers good investment opportunities to the investor alike all
investments, they also carry certain risks. The investor should compare the
risk and expected yields after adjustment of tax on various instruments while
taking investment decision the investor may seek advice from expert and
consultancy include stock brokers and analysts while making investment
decisions. The objective here is to make the investor aware of the functioning
of the derivatives.

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Derivatives act as a risk hedging tool for the investors. The objective if is to
help the investor in selecting the appropriate derivates instrument to attain
maximum risk and to construct the portfolio in such a manner to meet the
investor should decide how best to reach the goals from the securities
available.
To identity investor objective constraints and performance, which help
formulate the investment policy?
The developed and the improved strategies in the investment policy
formulated. They will help the selection of asset classes and securities in each
class depending up on their risk return attributes.

1.2 SCOPE OF THE STUDY

The study is limited to Derivatives with special reference to futures
and options in the Indian context; the study is not based on the international
perspective of derivative markets.
The study is limited to the analysis made for types of instruments of
derivates each strategy is analyzed according to its risk and return
characteristics and derivatives performance against the profit and policies of the
company.

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1.3 LIMITATION OF THE STUDY

The subject of derivates if vast it requires extensive study and research to
understand the depth of the various instrument operating in the market only a
recent phenomenon
There are various other factors also which define the risk and return
preferences of an investor. However the study was only contained towards the
risk maximization and profit maximization objective of the investor.
The derivative market is a dynamic one premiums, contract rates strike
price fluctuate on demand and supply basis. Therefore data related to last few
trading months was only considered and interpreted.

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2. COMPANY PROFILE

2.1 SHAREKHAN
Share khan is one of India's largest and leading
financial services companies. It is an online stock trading company of SSKI
Group (S.S. Kantilal Ishwarlal Securities Limited) which has been a provider of
India-based investment banking and corporate financial service for over 80
years.
SSKI caters to most of the prominent financial institutions, foreign and
domestic, investing in Indian equities. It has been valued for its strong researchled investment ideas, superior client servicing track record and exceptional
execution skills.
The key features of Sharekhan are as follows:
You get freedom from paperwork.
There are instant credit and money transfer facilities.

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 You can trade from any net enabled PC.

After hour orders facilities.
You can go for online orders over the phone.
Timely advice and research reports
Real-time Portfolio tracking.
Information and Price alerts.
Sharekhan provides assistance and the advice like no one else could. It
has created special information tools to help answer any queries. Sharekhans
first step program, built specifically for new investors, is testament to of its
commitment to being your guide throughout your investing life cycle.

2.2 SHAREKHAN SERVICES:

The tag line of Sharekhan says that it is your guide to the financial
jungle. As per the tag line there are many amazing services that Sharekhan
offers like technical research, fundamental research, share shops, portfolio
management, dial-n-trade, commodities trade, online services, depository
services, equity and derivatives trading (including currency trading). With
Sharekhans online trading account, you can buy and sell shares at anytime and
from anywhere you like.

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With a physical presence in over 400 cities of India through more than
1200 "Share Shops" with more than 3000 employees, and an online presence
through Sharekhan.com, India's premier, it reaches out to more than 8, 00,000
trading customers.
A Sharekhan outlet online destination offers the following services:
Online BSE and NSE executions (through BOLT & NEAT terminals)
Free access to investment advice from Sharekhan's Research team
Sharekhan Value Line (a monthly publication with reviews of
recommendations, stocks to watch out for etc)
Daily research reports and market review (High Noon & Eagle Eye)
Pre-market Report (Morning Cuppa)
Daily trading calls based on Technical Analysis
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 Cool trading products (Daring Derivatives and Market Strategy)

Personalized Advice
Live Market Information
Depository Services: Demat Transactions
Derivatives Trading (Futures and Options)
Commodities Trading
IPOs & Mutual Funds Distribution
Internet-based Online Trading: Speed Trade

Sharekhan has one of the best state-of-art web portals providing

fundamental and statistical information across equity, mutual funds and IPOs.
Surfing can be done across 5,500 companies for in-depth information, details
about more than 1,500 mutual fund schemes and IPO data. Other market related
details such as board meetings, result announcements, FII transactions,
buying/selling by mutual funds and much more can also be accessed.
It provides a complete life-cycle of investment solution in Equities,
Derivatives, Commodities, IPO, Mutual Funds, Depository Services, Portfolio
Management Services and Insurance. It also offers personalized wealth
management services for High Net worth individuals.

Knowledge
In a business where the right information at the right time can translate into
direct profits, investors get access to a wide range of information on the contentrich portal, www.sharekhan.com. Investors will also get a useful set of
knowledge-based tools that will empower them to take informed decisions
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Investment Advice
Sharekhan has dedicated research teams of more than 30 people for
fundamental and technical research. Their analysts constantly track the pulse of
the market and provide timely investment advice to customer in the form of
daily research emails, online chat, printed reports etc

2.3 ONLINE SERVICES

The online trading account can be chosen as per trading habits and
preferences, that is the classic account for most investors and speed trade for
active day traders. Share khan also provides a free software called Trade tiger
to all its account holders.

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The Classic Account enables you to trade online for investing in Equities
and Derivatives on the NSE via sharekhan.com; it gives access to all the
research content and also comes with a free Dial-n-Trade service enabling to
buy shares using the telephone.
Its features are:
Streaming quotes (using the applet based system)
Multiple watch lists
Integrated Banking, Demat and digital contracts
Instant credit and transfer
Real-time portfolio tracking with price alerts and, of course, the
assurance of secure transactions

The Trade Tiger is a next-generation online trading product that brings

the power of the broker's terminal to your PC. It's the perfect trading platform
for active day traders.

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Its features are:

A single platform for multiple exchange BSE & NSE (Cash & F&O),
MCX, NCDEX, Mutual Funds, IPOs
Multiple Market Watch available on Single Screen
Multiple Charts with Tick by Tick Intraday and End of Day Charting
powered with various Studies
Graph Studies include Average, Band- Bollinger, Know Sure Thing,
MACD, RSI, etc
Apply studies such as Vertical, Horizontal, Trend, Retracement &
Free lines
User can save his own defined screen as well as graph template, that
is, saving the layout for future use
User-defined alert settings on an input Stock Price trigger
Tools available to gauge market such as Tick Query, Ticker, Market
Summary, Action Watch, Option Premium Calculator, Span Calculator
Shortcut key for FAST access to order placements & reports
Online fund transfer activated with 12 Banks

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 Sharekhan provides you the facility to trade in Commodities through

Sharekhan Commodities Pvt. Ltd. a wholly owned subsidiary of its
parent SSKI. It trades on two major commodity exchanges of the
country:
Multi Commodity Exchange of India Ltd, Mumbai (MCX) and
National Commodity and Derivative Exchange, Mumbai (NCDEX).
For trading in any commodity, initial margin of around 10% on any
commodity is to be maintained. Sharekhan has launched its own commodity
derivatives micro-site. The site is available through the Sharekhan home
page www.sharekhan.com. Along with the site Sharekhan has launched several
commodity derivatives products (both research and trading) too. The products
have been listed below:
Commodities Buzz: a daily view on precious metals and agro
commodities.
Commodities Beat: a summary of the days trading activity.
Traders Corner: Under commodity trading calls, there are two types of
trading calls:
Rapid Fire: (short-term calls for 1 day to 5 days updated
daily)
Medium-term Plays: (medium-term calls for 1 month to 3
months updated weekly or in between if needed)

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 Sharekhan Exclusive: the commodity research reports and analyses

(periodical).
Market Scan: the daily commodity market data and statistics (end of day).
All these products are both e-mailed as newsletters and published on the
commodity derivatives site
EXPOSURE
In Sharekhan one can get 4 times exposure on cash and on assets one can
gets 2 times.
Sharekhan gives money only for A group and B group companies.
Only Blue-chip companies get exposure and not for x group companies.

NOTES
In Sharekhan account opening is free.
First years maintenance charge is zero.
Second years maintenance is Rs 400/-

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Page 13

3. INTRODUCTION TO DERIVATIVES

The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was
sown to the time it was ready for harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
partially or fully transfer price risks by locking-in asset prices. These were
simple contracts developed to meet the needs of farmers and were basically a
means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he
would receive for his harvest in September. In years of scarcity, he would
probably obtain attractive prices. However, during times of oversupply, he
would have to dispose off his harvest at a very low price. Clearly this meant that
the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains

too would face a price risk that of having to pay exorbitant prices during dearth,
although favourable prices could be obtained during periods of oversupply.
Under such circumstances, it clearly made sense for the farmer and the
merchant to come together and enter into contract whereby the price of the grain
to be delivered in September could be decided earlier. What they would then

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negotiate happened to be futures-type contract, which would enable both parties

to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

farmers and merchants together. A group of traders got together and created the
to-arrive contract that permitted farmers to lock into price upfront and deliver
the grain later. These to-arrive contracts proved useful as a device for hedging
and speculation on price charges. These were eventually standardized, and in
1925 the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts
also exist on a lot of financial underlying like stocks, interest rate, exchange
rate, etc.

3.1 DERIVATIVES DEFINED

A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can
be equity, forex, commodity or any other asset. In our earlier discussion, we saw
that wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of change in price by that date. Such a transaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat
which is the underlying in this case.

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The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward
Markets Commission (FMC) continues to have jurisdiction over commodity
futures contracts. However when derivatives trading in securities was
introduced in 2001, the term security in the Securities Contracts (Regulation)
Act, 1956 (SCRA), was amended to include derivative contracts in securities.
Consequently, regulation of derivatives came under the purview of Securities
Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of
derivatives is governed by the regulatory framework under the SCRA. The
Securities Contracts (Regulation) Act, 1956 defines derivative to include-

A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of
underlying securities

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3.2 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

National Stock Exchange

Over The Counter Derivatives

Bombay Stock Exchange

National Commodity & Derivative

exchange

Index Future

Index option

Stock option

Stock future
Rate Futures

Derivativ
es

3.3 TYPES OF DERIVATIVES

Future

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Option

Forward

Swaps

Interest

3.4 HISTORY OF DERIVATIVES:

The history of derivatives is quite colourful and surprisingly a lot longer than
most people think. Forward delivery contracts, stating what is to be delivered
for a fixed price at a specified place on a specified date, existed in ancient
Greece and Rome. Roman emperors entered forward contracts to provide the
masses with their supply of Egyptian grain. These contracts were also
undertaken between farmers and merchants to eliminate risk arising out of
uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into
existence in the early 1700s in Japan. The first formal commodities exchange,
the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal
with the problem of credit risk and to provide centralised location to negotiate
forward contracts. From forward trading in commodities emerged the
commodity futures. The first type of futures contract was called to arrive at.
Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the
first exchange traded derivatives contract, known as the futures contracts.
Futures trading grew out of the need for hedging the price risk involved in many
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commercial operations. The Chicago Mercantile Exchange (CME), a spin-off

of CBOT, was formed in 1919, though it did exist before in 1874 under the
names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter
Board (CEBB). The first financial futures to emerge were the currency in 1972
in the US. The first foreign currency futures were traded on May 16, 1972, on
International Monetary Market (IMM), a division of CME. The currency
futures traded on the IMM are the British Pound, the Canadian Dollar, the
Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the
Euro dollar. Currency futures were followed soon by interest rate futures.
Interest rate futures contracts were traded for the first time on the CBOT on
October 20, 1975. Stock index futures and options emerged in 1982. The first
stock index futures contracts were traded on Kansas City Board of Trade on
February 24, 1982.The first of the several networks, which offered a trading link
between two exchanges, was formed between the Singapore International
Monetary Exchange (SIMEX) and the CME on September 7, 1984.
Options are as old as futures. Their history also dates back to ancient Greece
and Rome. Options are very popular with speculators in the tulip craze of
seventeenth century Holland. Tulips, the brightly coloured flowers, were a
symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch
growers and dealers traded in tulip bulb options. There was so much speculation
that people even mortgaged their homes and businesses. These speculators were
wiped out when the tulip craze collapsed in 1637 as there was no mechanism to
guarantee the performance of the option terms.
The first call and put options were invented by an American
financier, Russell Sage, in 1872. These options were traded over the counter.
Agricultural commodities options were traded in the nineteenth century in
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England and the US. Options on shares were available in the US on the over the
counter (OTC) market only until 1973 without much knowledge of valuation. A
group of firms known as Put and Call brokers and Dealers Association were set
up in early 1900s to provide a mechanism for bringing buyers and sellers
together.
On April 26, 1973, the Chicago Board options Exchange
(CBOE) was set up at CBOT for the purpose of trading stock options. It was in
1973 again that black, Merton, and Scholes invented the famous Black-Scholes
Option Formula. This model helped in assessing the fair price of an option
which led to an increased interest in trading of options. With the options
markets becoming increasingly popular, the American Stock Exchange (AMEX)
and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975.
The market for futures and options grew at a rapid pace in the eighties and
nineties. The collapse of the Bretton Woods regime of fixed parties and the
introduction of floating rates for currencies in the international financial markets
paved the way for development of a number of financial derivatives which
served as effective risk management tools to cope with market uncertainties.
The CBOT and the CME are two largest financial exchanges in the world on
which futures contracts are traded. The CBOT now offers 48 futures and option
contracts (with the annual volume at more than 211 million in 2001).The CBOE
is the largest exchange for trading stock options. The CBOE trades options on
the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange
is the premier exchange for trading foreign options.
The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the

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Nikkei 225 trade almost round the clock. The N225 is also traded on the
Chicago Mercantile Exchange.

3.5 INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments in
India gained momentum in the last few years due to liberalisation process and
Reserve Bank of Indias (RBI) efforts in creating currency forward market.
Derivatives are an integral part of liberalisation process to manage risk. NSE
gauging the market requirements initiated the process of setting up derivative
markets in India. In July 1999, derivatives trading commenced in India
Table Chronology of instruments
1991

Liberalisation process initiated

14 December 1995

NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
index futures.
11 May 1998

L.C.Gupta Committee submitted report.

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7 July 1999

RBI gave permission for OTC forward rate agreements (FRAs) and
interest rate swaps.

24 May 2000

SIMEX chose Nifty for trading futures and options on an Indian

index.

25 May 2000

SEBI gave permission to NSE and BSE to do index futures trading.

9 June 2000

Trading of BSE Sensex futures commenced at BSE.

12 June 2000

Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

Individual Stock Options & Derivatives
2 June 2001

3.6 Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major part
of the world.
Until the advent of NSE, the Indian capital market had no access to the latest
trading methods and was using traditional out-dated methods of trading. There
was a huge gap between the investors aspirations of the markets and the
available means of trading. The opening of Indian economy has precipitated the
process of integration of Indias financial markets with the international
financial markets. Introduction of risk management instruments in India has
gained momentum in last few years thanks to Reserve Bank of Indias efforts in
allowing forward contracts, cross currency options etc. which have developed
into a very large market.

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3.7 Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Financial derivatives came
into the spotlight along with the rise in uncertainty of post-1970, when US
announced an end to the Bretton Woods System of fixed exchange rates leading
to introduction of currency derivatives followed by other innovations including
stock index futures. Today, derivatives have become part and parcel of the dayto-day life for ordinary people in major parts of the world. While this is true for
many countries, there are still apprehensions about the introduction of
derivatives. There are many myths about derivatives but the realities that are
different especially for Exchange traded derivatives, which are well regulated
with all the safety mechanisms in place.
What are these myths behind derivatives?
Derivatives increase speculation and do not serve any economic purpose
Indian Market is not ready for derivative trading
Disasters prove that derivatives are very risky and highly leveraged
instruments
Derivatives are complex and exotic instruments that Indian investors will
find difficulty in understanding
Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic purpose

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Numerous studies of derivatives activity have led to a broad consensus, both in

the private and public sectors that derivatives provide numerous and substantial
benefits to the users. Derivatives are a low-cost, effective method for users to
hedge and manage their exposures to interest rates, commodity prices or
exchange rates. The need for derivatives as hedging tool was felt first in the
commodities market. Agricultural futures and options helped farmers and
processors hedge against commodity price risk. After the fallout of Bretton
wood agreement, the financial markets in the world started undergoing radical
changes. This period is marked by remarkable innovations in the financial
markets such as introduction of floating rates for the currencies, increased
trading in variety of derivatives instruments, on-line trading in the capital
markets, etc. As the complexity of instruments increased many folds, the
accompanying risk factors grew in gigantic proportions. This situation led to
development derivatives as effective risk management tools for the market
participants.
Looking at the equity market, derivatives allow corporations and
institutional investors to effectively manage their portfolios of assets and
liabilities through instruments like stock index futures and options. An equity
fund, for example, can reduce its exposure to the stock market quickly and at a
relatively low cost without selling off part of its equity assets by using stock
index futures or index options.
By providing investors and issuers with a wider array of tools for
managing risks and raising capital, derivatives improve the allocation of credit
and the sharing of risk in the global economy, lowering the cost of capital
formation and stimulating economic growth. Now that world markets for trade
and finance have become more integrated, derivatives have strengthened these
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important linkages between global markets increasing market liquidity and

efficiency and facilitating the flow of trade and finance.

Is Indian Market is not ready for derivative trading?

Often the argument put forth against derivatives trading is that the Indian capital
market is not ready for derivatives trading. Here, we look into the pre-requisites,
which are needed for the introduction of derivative and how Indian market
fares:
PRE-REQUISITES

INDIAN SCENARIO

Large market Capitalisation

India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000
crores.

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The daily average traded volume in Indian capital market

High Liquidity in the
underlying

today is around 7500 crores. Which means on an average

every month 14% of the countrys Market capitalisation gets
traded. These are clear indicators of high liquidity in the
underlying.

Trade guarantee

The first clearing corporation guaranteeing trades has

become fully functional from July 1996 in the form of
National Securities Clearing Corporation (NSCCL). NSCCL
is responsible for guaranteeing all open positions on the
National Stock Exchange (NSE) for which it does the
clearing.

A Strong Depository

National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised the
security settlement in our country.

A Good legal guardian

In the Institution of SEBI (Securities and Exchange Board of

India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping
the market to evolve to a healthier place for trade practices.

4. PARTICIPANTS IN THE DERIVATIVES MARKET

The following three broad categories of participants who trade in the derivatives
market:
1. Hedgers
2. Speculators and
3. Arbitrageurs

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Hedgers:
Hedgers face risk associated with the price of an asset. The objective
of these kinds of traders is to reduce/eliminate the risk. They are not in the
derivatives market to make profits. They are in it to safeguard their existing
positions. Apart from equity markets, hedging is common in the foreign
exchange markets where fluctuations in the exchange rate have to be taken care
of in the foreign currency transactions or could be in the commodities market
where spiraling oil prices have to be tamed using the security in derivative
instruments.

Speculators:
Speculators wish to bet on future movements in the price of an
asset. They are traders with a view and objective of making profits. They are
willing to take risks and they bet upon whether the markets would go up or
come down. Futures and Options contracts can give them an extra leverage; that
is, they can increase both the potential gains and potential losses in a speculative
venture.

Arbitrageurs:
Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. Riskless Profit Making is the prime
goal of Arbitrageurs. Buying in one market and selling in another, buying two
products in the same market are common. They could be making money even
without putting their own money in and such opportunities often come up in the
market but last for very short timeframes. This is because as soon as the

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situation arises, arbitrageurs take advantage and demand-supply forces drive the
markets back to normal.
For example, they see the futures price of an asset getting out of line with the
cash price; they will take offsetting positions in the two markets to lock in a
profit.

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last
few years, which have accompanied the modernization of commercial and
investment banking and globalisation of financial activities. The recent
developments in information technology have contributed to a great extent to
these developments. While both exchange-traded and OTC derivative contracts
offer many benefits, the former have rigid structures compared to the latter. It
has been widely discussed that the highly leveraged institutions and their OTC
derivative positions were the main cause of turbulence in financial markets in
1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to
exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and
located within individual institutions,
2. There are no formal centralized limits on individual positions, leverage,
or margining,
3. There are no formal rules for risk and burden-sharing,

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4. There are no formal rules or mechanisms for ensuring market stability

and integrity, and for safeguarding the collective interests of market
participants, and
5. The OTC contracts are generally not regulated by a regulatory authority
and the exchanges self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic
nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of
OTC derivative activities on available aggregate credit; (iv) the high
concentration of OTC derivative activities in major institutions; and (v) the
central role of OTC derivatives markets in the global financial system.
Instability arises when shocks, such as counter-party credit events and sharp
movements in asset prices that underlie derivative contracts, which occur
significantly, alter the perceptions of current and potential future credit
exposures. When asset prices change rapidly, the size and configuration of
counter-party exposures can become unsustainably large and provoke a rapid
unwinding of positions.

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There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and OTC
derivatives markets continue to pose a threat to international financial stability.
The problem is more acute as heavy reliance on OTC derivatives creates the
possibility of systemic financial events, which fall outside the more formal
clearing house structures. Moreover, those who provide OTC derivative
products, hedge their risks through the use of exchange traded derivatives. In
view of the inherent risks associated with OTC derivatives, and their
dependence on exchange traded derivatives, Indian law considers them illegal.

Page 30

4.1 FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the
financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects
which have value maybe commodities, local currency or foreign currency. The
concept of price is clear to almost everybody when we discuss commodities.
There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.
the price one pays for use of a unit of another persons money is called interest
rate. And the price one pays in ones own currency for a unit of another
currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have
demand and producers or suppliers have supply, and the collective
interaction of demand and supply in the market determines the price. These
factors are constantly interacting in the market causing changes in the price over
a short period of time. Such changes in the price are known as price volatility.
This has three factors: the speed of price changes, the frequency of price
changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market
adjustments through price changes. These price changes expose individuals,
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producing firms and governments to significant risks. The breakdown of the

BRETTON WOODS agreement brought an end to the stabilising role of fixed
exchange rates and the gold convertibility of the dollars. The globalisation of
the markets and rapid industrialisation of many underdeveloped countries
brought a new scale and dimension to the markets. Nations that were poor
suddenly became a major source of supply of goods. The Mexican crisis in the
south east-Asian currency crisis of 1990s has also brought the price volatility
factor on the surface. The advent of telecommunication and data processing
bought information very quickly to the markets. Information which would have
taken months to impact the market earlier can now be obtained in matter of
moments. Even equity holders are exposed to price risk of corporate share
fluctuates rapidly.
These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against
adverse price changes in commodity, foreign exchange, equity shares and
bonds.

B.} GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened
in other part of the world was mostly irrelevant. Now globalisation has
increased the size of markets and as greatly enhanced competition .it has
benefited consumers who cannot obtain better quality goods at a lower cost. It
has also exposed the modern business to significant risks and, in many cases,
led to cut profit margins

Page 32

In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of
certain goods from India declined because of this crisis. Steel industry in 1998
suffered its worst set back due to cheap import of steel from south East Asian
countries. Suddenly blue chip companies had turned in to red. The fear of china
devaluing its currency created instability in Indian exports. Thus, it is evident
that globalisation of industrial and financial activities necessitates use of
derivatives to guard against future losses. This factor alone has contributed to
the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological
breakthrough. Advances in this area include the development of high speed
processors, network systems and enhanced method of data entry. Closely related
to advances in computer technology are advances in telecommunications.
Improvement

in

communications

allow

for

instantaneous

worldwide

conferencing, Data transmission by satellite. At the same time there were

significant advances in software programmes without which computer and
telecommunication advances would be meaningless. These facilitated the more
rapid movement of information and consequently its instantaneous impact on
market price.
Although price sensitivity to market forces is beneficial to the economy as a
whole resources are rapidly relocated to more productive use and better rationed
overtime the greater price volatility exposes producers and consumers to greater
price risk. The effect of this risk can easily destroy a business which is

Page 33

otherwise well managed. Derivatives can help a firm manage the price risk
inherent in a market economy. To the extent the technological developments
increase volatility, derivatives and risk management products become that much
more important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward
contracts in its traditional form, was the only hedging tool available. Option
pricing models developed by Black and Scholes in 1973 were used to
determine prices of call and put options. In late 1970s, work of Lewis
Edeington, extended the early work of Johnson and started the hedging of
financial price risks with financial futures. The work of economic theorists gave
rise to new products for risk management which led to the growth of derivatives
in financial markets.
The above factors in combination of lot many factors led to growth of
derivatives instruments

4.2 BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:
1.] RISK MANAGEMENT
Futures and options contract can be used for altering the risk of investing in spot
market. For instance, consider an investor who owns an asset. He will always be
worried that the price may fall before he can sell the asset. He can protect

Page 34

himself by selling a futures contract, or by buying a Put option. If the spot price
falls, the short hedgers will gain in the futures market, as you will see later. This
will help offset their losses in the spot market. Similarly, if the spot price falls
below the exercise price, the put option can always be exercised.
2.]

PRICE DISCOVERY

Price discovery refers to the market ability to determine true equilibrium prices.
Futures prices are believed to contain information about future spot prices and
help in disseminating such information. As we have seen, futures markets
provide a low cost trading mechanism. Thus information pertaining to supply
and demand easily percolates into such markets. Accurate prices are essential
for ensuring the correct allocation of resources in a free market economy.
Options markets provide information about the volatility or risk of the
underlying asset.
3.]

OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction

costs. Secondly, they offer greater liquidity. Large spot transactions can often
lead to significant price changes. However, futures markets tend to be more
liquid than spot markets, because herein you can take large positions by
depositing relatively small margins. Consequently, a large position in
derivatives markets is relatively easier to take and has less of a price impact as
opposed to a transaction of the same magnitude in the spot market. Finally, it is
easier to take a short position in derivatives markets than it is to sell short in
spot markets.
4.]

MARKET EFFICIENCY

Page 35

The availability of derivatives makes markets more efficient; spot, futures and
options markets are inextricably linked. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage opportunities quickly and to keep
prices in alignment. Hence these markets help to ensure that prices reflect true
values.
5.]

EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable
position is less in this case. This is important because facilitation of speculation
is critical for ensuring free and fair markets. Speculators always take calculated
risks. A speculator will accept a level of risk only if he is convinced that the
associated expected return is commensurate with the risk that he is taking.

4.3 FUNCTIONS OF THE DERIVATIVES MARKET:

The derivatives market performs a number of economic functions.
They are:
1. Prices in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the
perceived future level.
2. Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players
who would not otherwise participate for lack of an arrangement to transfer
risk.
Page 36

3. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators trade
in the underlying cash markets.
4. An important incidental benefit that flows from derivatives trading is that it
acts as a catalyst for new entrepreneurial activity.
5. Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of
activity.

5. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24member committee under the
Chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee submitted
its report on March 17, 1998 prescribing necessary preconditions for
introduction of derivatives trading in India. The committee recommended that
derivatives should be declared as securities so that regulatory framework
Page 37

applicable to trading of securities could also govern trading of securities. SEBI

also set up a group in June 1998 under the Chairmanship of Prof. J.R. Varma, to
recommend measures for risk containment in derivatives market in India. The
report, which was submitted in October 1998, worked out the operational details
of margining system, methodology for charging initial margins, broker net
worth, deposit requirement and realtime monitoring requirements. The
Securities Contract Regulation Act (SCRA) was amended in December 1999 to
include derivatives within the ambit of securities and the regulatory
framework were developed for governing derivatives trading. The act also made
it clear that derivatives shall be legal and valid only if such contracts are traded
on a recognized stock exchange, thus precluding OTC derivatives. The
government also rescinded in March 2000, the three decade old notification,
which prohibited forward trading in securities. Derivatives trading commenced
in India in June 2000 after SEBI granted the final approval to this effect in May
2001. SEBI permitted the derivative segments of two stock exchanges, NSE and
BSE, and their clearing house/corporation to commence trading and settlement
in approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE30 (Sense) index.
This was followed by approval for trading in options based on these two
indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading
in options on individual securities commenced in July 2001. Futures contracts
on individual stocks were launched in November 2001. The derivatives trading
on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The
trading in index options commenced on June 4, 2001 and trading in options on
Page 38

individual securities commenced on July 2, 2001. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE
are based on S&P CNX Trading and settlement in derivative contracts is done in
accordance with the rules, byelaws, and regulations of the respective exchanges
and their clearing house/corporation duly approved by SEBI and notified in the
official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all
Exchange traded derivative products.

The following are some observations based on the trading statistics provided in
the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the

F&O segment. It constituted 70 per cent of the total turnover during June 2002.
A primary reason attributed to this phenomenon is that traders are comfortable
with single-stock futures than equity options, as the former closely resembles
the erstwhile badla system.

On relative terms, volumes in the index options segment continue to

remain poor. This may be due to the low volatility of the spot index. Typically,
options are considered more valuable when the volatility of the underlying (in
this case, the index) is high. A related issue is that brokers do not earn high
commissions by recommending index options to their clients, because low
volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have
decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put
Page 39

volumes ratio suggests that the traders are increasingly becoming pessimistic on
the market.

Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as

a less risky alternative (read substitute) to generate profits from the stock price
movements. The fact that the option premiums tail intra-day stock prices is
evidence to this. If calls and puts are not looked as just substitutes for spot
trading, the intra-day stock price variations should not have a one-to-one impact
on the option premiums.

The spot foreign exchange market remains the most important segment
but the derivative segment has also grown.

In the derivative

market

foreign exchange swaps account for the largest share of the total
turnover of derivatives in India followed by forwards and options.
Significant milestones in the development of derivatives market
been

(i) permission

have

to banks to undertake cross currency derivative

transactions subject to certain conditions (1996) (ii) allowing corporate to

undertake long term foreign currency swaps that contributed to the
development of the term currency swap market (1997) (iii) allowing dollar
rupee options (2003) and (iv) introduction of currency futures (2008). I
would like to emphasise that currency swaps allowed companies with ECBs
to swap their foreign currency liabilities into rupees. However, since banks
could not carry open positions the risk was allowed to be transferred to any
other resident corporate. Normally such risks should be taken by corporate
who have natural hedge or have potential foreign exchange earnings.

Page 40

But

often corporate assume these risks due to interest rate differentials and views
on currencies.
This period has also witnessed several relaxations in regulations relating to
forex markets and also greater liberalisation in capital account regulations
leading to greater integration with the global economy.
Cash settled exchange traded currency futures have made foreign currency a
separate asset class that can be traded without any underlying need or
exposure a n d on a leveraged basis on the recognized stock exchanges with
credit risks being assumed by the central counterparty
Since the commencement of trading of currency futures in all the three
exchanges, the value of the trades has gone up steadily from Rs 17, 429
crores in October 2008 to Rs 45, 803 crores in December 2008. The average
daily turnover in all the exchanges has also increased from Rs871 crores to
Rs 2,181 crores during the same period.

The turnover in the currency

futures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 3 per cent.

5.1 National Exchanges

In enhancing the institutional capabilities for futures trading the idea of
setting up of National Commodity Exchange(s) has been pursued since 1999.
Page 41

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

(NMCE),

Ahmedabad,

National

Commodity

&

Derivatives

Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX),

Mumbai have become operational.

National Status implies that these

exchanges would be automatically permitted to conduct futures trading in all

commodities subject to clearance of byelaws and contract specifications by the
FMC. While the NMCE, Ahmedabad commenced futures trading in November
2002, MCX and NCDEX, Mumbai commenced operations in October/
December 2003 respectively.

MCX
MCX (Multi Commodity Exchange of India Ltd.) an independent and
de-mutualised multi commodity exchange has permanent recognition from
Government of India for facilitating online trading, clearing and settlement
operations for commodity futures markets across the country. Key shareholders
of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC
Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra,
SBI Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of
Baroda, Canara Bank, Corporation Bank.
Headquartered in Mumbai, MCX is led by an expert management team
with deep domain knowledge of the commodity futures markets. Today MCX is
offering spectacular growth opportunities and advantages to a large cross
section of the participants including Producers / Processors, Traders, Corporate,
Regional Trading Canters, Importers, Exporters, Cooperatives, Industry
Associations, amongst others MCX being nation-wide commodity exchange,

Page 42

offering multiple commodities for trading with wide reach and penetration and
robust infrastructure.

MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-ofthe-art nationwide, digital Exchange, facilitates online trading, clearing and
settlement operations for a commodities futures trading.

NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was
promoted by Central Warehousing Corporation (CWC), National Agricultural
Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries
Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board
(GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune
Overseas Limited (NOL). While various integral aspects of commodity
economy, viz., warehousing, cooperatives, private and public sector marketing
of agricultural commodities, research and training were adequately addressed in
structuring the Exchange, finance was still a vital missing link. Punjab National
Bank (PNB) took equity of the Exchange to establish that linkage. Even today,
NMCE is the only Exchange in India to have such investment and technical
support from the commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by
CMC. It has robust delivery mechanism making it the most suitable for the
Page 43

participants in the physical commodity markets. It has also established fair and
transparent rule-based procedures and demonstrated total commitment towards
eliminating any conflicts of interest. It is the only Commodity Exchange in the
world to have received ISO 9001:2000 certification from British Standard
Institutions (BSI). NMCE was the first commodity exchange to provide trading
facility through internet, through Virtual Private Network (VPN).
NMCE follows best international risk management practices. The
contracts are marked to market on daily basis. The system of upfront margining
based on Value at Risk is followed to ensure financial security of the market. In
the event of high volatility in the prices, special intra-day clearing and
settlement is held. NMCE was the first to initiate process of dematerialization
and electronic transfer of warehoused commodity stocks. The unique strength of
NMCE is its settlements via a Delivery Backed System, an imperative in the
commodity trading business. These deliveries are executed through a sound and
reliable Warehouse Receipt System, leading to guaranteed clearing and
settlement.
NCDEX
National Commodity and Derivatives Exchange Ltd (NCDEX) is a
technology driven commodity exchange. It is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies,
Maharashtra in Mumbai on April 23, 2003. It has an independent Board of
Directors and professionals not having any vested interest in commodity
markets. It has been launched to provide a world-class commodity exchange
platform for market participants to trade in a wide spectrum of commodity
derivatives driven by best global practices, professionalism and transparency.

Page 44

Forward Markets Commission regulates NCDEX in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the
land like the Companies Act, Stamp Act, Contracts Act, Forward Commission
(Regulation) Act and various other legislations, which impinge on its working.
It is located in Mumbai and offers facilities to its members in more than 390
centres throughout India. The reach will gradually be expanded to more
centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil,
Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags,
Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw
Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy
Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red
Maize & Yellow soyabean meal.

5.2 DERIVATIVES SEGMENT IN BSE & NSE

On June 9, 2000 BSE & NSE became the first exchanges in India to
introduce trading in exchange traded derivative product with the launch of index
futures on sense and Nifty futures respectively.
Index futures was follows by launch of index options in June 2001, stock
options in July 2001 and stock futures in Nov 2001.Presently stock futures and
options available on 41 well-capitalized and actively traded scripts mandated by
SEBI.

Page 45

Nifty is the underlying asset of the Index Futures at the Futures & Options
segment of NSE with a market lot of 200 and the BSE 30 Sensex is the
underlying stock index with the market lot of 50. This difference of market lot
arises due to a minimum specification of a contract value of Rs. 2 lakhs by
Securities Exchange Board of India. A contract value is contracting Index laid
by its market lot. For e.g. If Sensex is 4730 then the contract value of a futures
Index having Sensex as underlying asset will

be 50 x 4730 = Rs. 2, 36,500.

Similarly if Nifty is 1462.7, its futures contract value will be 200 x 1462.7 =
Rs.2, 92,540/-.
Every transaction shall be in multiple of market lot. Thus, Index futures at
NSE shall be traded in multiples of 200 and at BSE in multiples of 50

5.3 CONTRACT PERIODS:

At any point of time there will always be available near three months
contract periods. For e.g. in the month of June 2009 one can enter into either
June Futures contract or July Futures contract or August Futures Contract. The
last Thursday of the month specified in the contract shall be the final settlement
date for that contract at both NSE as well BSE. Thus June 29, July 27 and
August 31 shall be the last trading day or the final settlement date for June
Futures contract, July Futures Contract and August Futures Contract
respectively.
When one futures contract gets expired, a new futures contract will get
introduced automatically. For instance, on 30th June, June futures contract
becomes invalidated and a September Futures Contract gets activated.

Page 46

5.4 SETTLEMENT:
Settlement of all Derivatives trades is in cash mode. There is Daily
as well as Final Settlement.
Outstanding positions of a contract can remain open till the last
Thursday of that month. As long as the position is open, the same will be
marked to Market at the Daily Settlement Price, the difference will be credited
or debited accordingly and the position shall be brought forward to the next day
at the daily settlement price. Any position which remains open at the end of the
final settlement day (i.e., last Thursday) shall be closed out by the Exchange at
the Final Settlement Price which will be the closing spot value of the underlying
(Nifty or Sensex, or respective stocks as the case may be).

5.5 Regulation for Derivatives Trading

SEBI set up a 24-member committee under Chairmanship of Dr.
L.C. Gupta to develop the appropriate regulatory framework for derivatives
trading in India. The committee submitted its report in March 1998. On May 11,
1998 SEBI accepted the recommendations of the committee and approved the
phased introduction of derivatives trading in India beginning with stock index
futures. SEBI also approved the suggestive bye-laws recommended by the
committee for regulation and control of trading and settlement of derivatives
contracts.
The provisions in the SC(R) A and the regulatory framework
developed there under govern trading in securities. The amendment of the

Page 47

SC(R) A to include derivatives within the ambit of securities in the SC(R) A,

made trading in derivatives possible within the framework of the Act.
1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta
committee report may apply to SEBI for grant of recognition under Section 4
of the SC(R) a, 1956 to start trading derivatives. The derivatives
exchange/segment should have a separate governing council and
representation of trading / clearing members shall be limited to maximum of
40% of the total members of the governing council. The exchange shall
regulate the sales practices of its members and will obtain approval of SEBI
before start of trading in any derivative contract
2. The exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not automatically
become the members of derivative segment. The members of the derivative
segment need to fulfil the eligibility conditions as laid down by the L C
Gupta committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI
approved clearing corporation / house. Clearing corporation / houses
complying with the eligibility conditions as laid down by the committee
have to apply to SEBI for grant of approval.
5. Derivative brokers/dealers and clearing members are required to seek
registration from SEBI.
6. The minimum contract value shall not be less than Rs. 2 Lakhs. Exchanges
should also submit details of the futures contract they propose to introduce.
7. The trading members are required to have qualified approved user and sales
person who have passed a certification programme approved by SEBI.

Page 48

While from the purely regulatory angle, a separate exchange for

trading would be a better arrangement. Considering the constraints in
infrastructure facilities, the existing stock (cash) exchanges may also be
permitted to trade derivatives subject to the following conditions.

I. Trading should take place through an on-line screen based trading system.
II. An independent clearing corporation should do the clearing of the
derivative market.
III. The exchange must have an online surveillance capability, which monitors
positions, price and volumes in real time so as to deter market manipulation
price and position limits should be used for improving market quality.
IV. Information about trades quantities, and quotes should be disseminated by
the exchange in the real time over at least two information-vending
networks, which are accessible to investors in the country.
V. The exchange should have at least 50 members to start derivatives trading.
VI. The derivatives trading should be done in a separate segment with separate
membership; That is, all members of the cash market would not
automatically become members of the derivatives market.
VII. The derivatives market should have a separate governing council which
should not have representation of trading by clearing members beyond
whatever percentage SEBI may prescribe after reviewing the working of
the present governance system of exchanges.
VIII. The chairman of the governing council of the derivative division /
exchange should be a member of the governing council. If the chairman is
broker / dealer, then he should not carry on any broking or dealing on any
exchange during his tenure.
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IX. No trading/clearing member should be allowed simultaneously to be on the

governing council both derivatives market and cash market.

6. TYPES OF DERIVATIVES
The most commonly used derivatives contracts are forwards,
futures and options. Here various derivatives contracts that have come to be
used are given briefly:
1. Forwards
2. Futures
3. Options
4. Warrants
5. LEAPS
6. Baskets
7. Swaps
8. Swaptions
Page 50

6.1Forward contracts
A forward contract is a customised contract between the buyer and the
seller where settlement takes place on a specific date in future at a price
agreed today. The rupee-dollar exchange

rate is a big forward contract

market in India with banks, financial institutions, corporate and exporters

being the market participants.

Features of a forward contract

The main features of a forward contract are:
It is a negotiated contract between two parties and hence exposed to
counter party risk. eg: Trade takes place between A&B@ 100 to buy & sell x
commodity. After 1 month it is trading at Rs.120. If A was he buyer he would
gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter
party Risk i.e. you will now entitled to your gains. In case of Future, the
exchange gives a counter guarantee even if the counter party defaults you
will receive Rs.20/- as a gain.
Each contract is custom designed and hence unique in terms of contract
size, expiration date, asset type, asset quality etc.

A contract has to be settled in delivery or cash on expiration date as

agreed upon at the time of entering into the contract. In case one of the
two parties wishes to reverse a contract, he has to compulsorily go to the
Page 51

other party. The counter party being in a monopoly situation can

command the price he wants.

6.2 FUTURES

Futures contract is a firm legal commitment between a buyer & seller in

which they agree to exchange something at a specified price at the end of a
designated period of time. The buyer agrees to take delivery of something and
the seller agrees to make delivery.

6.2.1 STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures,
which have been used to hedge or manage the systematic risk by the investors
of Stock Market. They are called hedgers who own portfolio of securities and
are exposed to the systematic risk. Stock Index is the apt hedging asset since the
rise or fall due to systematic risk is accurately shown in the Stock Index. Stock
index futures contract is an agreement to buy or sell a specified amount of an
underlying stock index traded on a regulated futures exchange for a specified
price for settlement at a specified time future.
Stock index futures will require lower capital adequacy and
margin requirements as compared to margins on carry forward of individual
scrip. The brokerage costs on index futures will be much lower.
Savings in cost is possible through reduced bid-ask spreads where
stocks are traded in packaged forms. The impact cost will be much lower in case
Page 52

of stock index futures as opposed to dealing in individual scrips. The market is

conditioned to think in terms of the index and therefore would prefer to trade in
stock index futures. Further, the chances of manipulation are much lesser.
The Stock index futures are expected to be extremely liquid given
the speculative nature of our markets and the overwhelming retail participation
expected to be fairly high. In the near future, stock index futures will definitely
see incredible volumes in India. It will be a blockbuster product and is pitched
to become the most liquid contract in the world in terms of number of contracts
traded if not in terms of notional value. The advantage to the equity or cash
market is in the fact that they would become less volatile as most of the
speculative activity would shift to stock index futures. The stock index futures
market should ideally have more depth, volumes and act as a stabilizing factor
for the cash market. However, it is too early to base any conclusions on the
volume or to form any firm trend.
The difference between stock index futures and most other
financial futures contracts is that settlement is made at the value of the index at
maturity of the contract.
6.2.2 FUTURES TERMINOLOGY

Contract Size
The value of the contract at a specific level of Index. It is Index
level * Multiplier.
Multiplier
It is a pre-determined value, used to arrive at the contract size. It
is the price per index point.
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 Tick Size
It is the minimum price difference between two quotes of similar
nature.
Contract Month
The month in which the contract will expire.
Expiry Day
The last day on which the contract is available for trading.
Open interest
Total outstanding long or short positions in the market at any
specific point in time. As total long positions for market would be equal
to total short positions, for calculation of open Interest, only one side of
the contracts is counted.
Volume
No. Of contracts traded during a specific period of time i.e.
during a day, during a week or during a month.
Long position
Outstanding/unsettled purchase position at any point of time.
Short position
Outstanding/ unsettled sales position at any point of time.
Open position
Outstanding/unsettled long or short position at any point of time.
Physical delivery

Page 54

Open position at the expiry of the contract is settled through

delivery of the underlying. In futures market, delivery is low.
Cash settlement
Open position at the expiry of the contract is settled in cash.
These contracts Alternative Delivery Procedure (ADP) - Open position at the
expiry of the contract is settled by two parties - one buyer and one seller, at
the terms other than defined by the exchange. Worldwide a significant
portion of the energy and energy related contracts (crude oil, heating and
gasoline oil) are settled through Alternative Delivery Procedure.

Theoretical way of pricing futures

The theoretical price of a futures contract is spot price of the underlying plus the
cost of carry (futures are not about predicting future prices of the underlying
assets).
In general, Futures Price = Spot Price + Cost of Carry
The Cost of Carry is the sum of all costs incurred if a similar position is taken in
cash market and carried to expiry of the futures contract less any revenue that
may arise out of holding the asset. The cost typically includes interest cost in
case of financial futures (insurance and storage costs are also considered in case
of commodity futures). Revenue may be in the form of dividend. Though one

Page 55

can calculate the theoretical price, the actual price may vary depending upon the
demand and supply of the underlying asset.
Example on how futures are priced
Suppose Reliance shares are quoting at Rs1500 in the cash market. The interest
rate is about 12% per annum. The cost of carry for one month would be about
Rs15.
As such a Reliance future contract with one-month maturity should quote at
nearly Rs1515. Similarly Nifty level in the cash market is about 4000. One
month Nifty future should quote at about 4040. However it has been observed
on several occasions that futures quote at a discount or premium to their
theoretical price, meaning below or above the theoretical price. This is due to
demand-supply pressures.
Every time a Stock Future trades over and above its cost of carry i.e. above Rs.
the arbitragers would step in and reduce the extra premium commanded by the
future due to demand. e.g.: would buy in the cash market and sell the equal
amount in the future, hence creating a risk free arbitrage, vice-versa for the
discount. It is also observed that index futures generally don't command a huge
premium as stocks, due to many reasons such as dividends in index stocks,
hedging and speculation etc which keeps the index premium under check.

6.2.3 Advantages and risks of trading in futures over cash

The biggest advantage of futures is that you can short sell without having stock
and you can carry your position for a long time, which is not possible in the
cash segment because of rolling settlement. Conversely you can buy futures and

Page 56

carry the position for a long time without taking delivery, unlike in the cash
segment where you have to take delivery because of rolling settlement.
Further futures positions are leveraged positions, meaning you can take Rs100
position by paying Rs25 margin and daily mark-to-market loss, if any. This can
enhance the return on capital deployed.
For example, you expect Rs100 stock to go up by Rs10. One way is to buy the
stock in the cash segment by paying Rs100. You make Rs10 on investment of
Rs100, giving about 10% returns. Alternatively you take futures position in the
stock by paying about Rs30 toward initial and mark-to-market margin. You
make Rs10 on investment of Rs30, i.e. about 33% returns. Please note that
taking leveraged position is very risky, you can even lose your full capital in
case the price moves against your position.

Advantages of index futures

After listening to the news and other happenings in the economy, we take a
view that the market would go up. We substantiate our view after talking to our
near and dear ones. When the market opens, we express our view by buying
ABC stock. The whole market goes up as we expected but the price of ABC
stock falls due to some bad news related to the company. This means that while
our view was correct, its expression was wrong.
Using Nifty/Sensex futures we can express our view on the market as a whole.
In this case, we take only market risk without exposing our self to any company
specific risk. Though trading on Nifty or Sensex might not give us a very high
return as trading in stock can, yet at the same time our risk is also limited as
index movements are smooth, less volatile without unwarranted swings.
Page 57

Use of volume and open interest figures to predict the market movement
The total outstanding position in the market is called open interest. In case
volumes are rising and the open interest is also increasing, it suggests that more
and more market participants are keeping their positions outstanding. This
implies that the market participants are expecting a big move in the price of the
underlying. However to find in which direction this move would be, one needs
to take help of charts. In case the volumes are sluggish and the open interest is
almost constant, it suggests that a lot of day trading is taking place. This implies
sideways price movement in the underlying.
Hedging stock position using futures
Suppose we are holding a stock that has futures on it and for two to three weeks
the stock does not look good to you. We do not want to lose the stock but at the
same time we want to hedge against the expected adverse price movement of
the stock for two to three weeks. One option is to sell the stock and buy it back
after two to three weeks. This involves a heavy transaction cost and issue of
capital gain taxes. Alternatively, we can sell futures on the stock to hedge our
position in the stock. In case the stock price falls, we make profit out of our
short position in the futures. Using stock futures we would virtually sell our
stock and buy it back without losing it. This transaction is much more
economical as it does not involve cost of transferring the stock to and from
depository account. We might say that if the stock had moved up, we would
have made profit without hedging. However it is also true that in case of a fall,
you might have lost the value too without hedging. Please remember that a
hedge is not a device to maximise profits. It is a device to minimise losses. As
they say, a hedge does not result in a better outcome but in a predictable
outcome.
Page 58

Basis
The difference between the futures price and cash price is called basis.
Generally futures prices are higher than cash prices (positive basis) as we are
positive interest rate economy. However there are times when futures prices are
lower than cash prices (negative basis). Basis is also popularly termed spread by
the trading community.

6.2.4 Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market participant
with change in the price of the underlying asset. Futures contracts have linear
payoffs. In simple words, it means that the losses as well as profits, for the
buyer and the seller of futures contracts, are unlimited.

Pay off for Buyer of futures: (Long futures)

The pay offs for a person who buys a futures contract is similar to
the pay off for a person who holds an asset. He has potentially unlimited
upside as well as downside. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at 1220. The
underlying asset in this case is the Nifty portfolio. When the index moves up,
the long futures position starts making profits and when the index moves
down it starts making losses
.
Pay off for seller of futures: (short futures)

Page 59

The pay offs for a person who sells a futures contract is similar to
the pay off for a person who shorts an asset. He has potentially unlimited
upside as well as downside. Take the case of a speculator who sells a twomonth Nifty index futures contract when the Nifty stands at 1220. The
underlying asset in this case is the Nifty portfolio. When the index moves
down, the short futures position starts making profits and when the index
moves up it starts making losses.

Page 60

6.2.5 DISTINCTION BETWEEN FUTURES AND FORWARDS

CONTRACTS

FEATURES

FORWARD

FUTURE CONTRACT

CONTRACT
Operational

Traded directly between two Traded on the exchanges.

Mechanism

parties (not traded on the

exchanges).

Contract

Differ from trade to trade.

Contracts are standardized contracts.

Exists.

Exists.

Specifications
Counter-party
risk

However,

assumed

by

the

clearing corp., which becomes the

counter party to all the trades or
unconditionally

guarantees

their

settlement.

Liquidation

Low, as contracts are tailor High, as contracts are standardized

Profile

made contracts catering to the exchange traded contracts.

needs of the needs of the
parties.

Price discovery

Not efficient, as markets are Efficient, as markets are centralized and

scattered.

all buyers and sellers come to a common

platform to discover the price.

Examples

Currency market in India.

Commodities, futures, Index Futures and

Individual stock Futures in India.

Page 61

6.3 OPTIONS

An option agreement is a contract in which the writer of the option

grants the buyer of the option the right to purchase from or sell to the writer a
designated instrument at a specific price within a specified period of time.
Certain options are of short term in nature and are issued by investors
another group of options are long-term in nature and are issued by companies.

6.3.1 OPTIONS TERMINOLOGY:

Call option:
A call is an option contract giving the buyer the right to purchase
the stock.
Put option:
A put is an option contract giving the buyer the right to sell the
stock.
Expiration date:
It is the date on which the option contract expires.
Strike price:
It is the price at which the buyer of an option contract can
purchase or sell the stock during the life of the option
Premium:
Is the price the buyer pays the writer for an option contract.
Page 62

 Writer:
The term writer is synonymous to the seller of the option contract.
Holder:
The term holder is synonymous to the buyer of the option
contract.

Straddle:
A straddle is combination of put and calls giving the buyer the
right to either buy or sell stock at the exercise price.
Strip:
A strip is two puts and one call at the same period.

Strap:
A strap is two calls and one put at the same strike price for the
same period.

Spread:
A spread consists of a put and a call option on the same security

for the same time period at different exercise prices.

The option holder will exercise his option when doing so provides him a benefit
over buying or selling the underlying asset from the market at the prevailing
price. These are three possibilities.
1.

In the money:

An option is said to be in the money when it is

advantageous to exercise it.

Page 63

2. Out of the money: The option is out of money if it not advantageous to

exercise it.
3.

At the money: If the option holder does not lose or gain whether he

exercises his option or buys or sells the asset from the market, the option is
said to be at the money. The exchanges initially created three expiration cycles
for all listed options and each issue was assigned to one of these three cycles.
January, April, July, October.
February, March, August, November.
March, June, September, and December.

In India, all the F and O contracts whether on indices or individual stocks

are available for one or two or three months series and they expire on the
Thursday of the concerned month.
American style options
Option contracts which can be exercised on or before the expiry are called
American options. All stock option contracts are American style.
European style options
The options on Nifty and Sensex or any other index options are European style
options-meaning that buyer of these options can exercise his options only on the
expiry day. He cannot exercise them before expiry of the contract as is the case
with options on stocks. As such the buyer of index options needs to square up
his position to get out of the market.

Page 64

6.3.2 CALL OPTION:

An option that grants the buyer the right to purchase a designated
instrument is called a call option. A call option is a contract that gives its owner
the right, but not the obligation, to buy a specified price on or before a specified
date.
Example
An investor buys one European Call option on one share of Reliance Petroleum
at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. The payoffs for the investor on the basis of
fluctuating spot prices at any time are shown by the payoff table (Table 1). It
may be clear from the graph that even in the worst case scenario; the investor
would only lose a maximum of Rs.2 per share which he/she had paid for the
premium. The upside to it has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart completely
reverse of the call options buyer. The maximum loss that he can have is
unlimited though a profit of Rs.2 per share would be made on the premium
payment by the buyer.

S
57
58
59
60
61
62
63
64
65
66

Payoff from Call Buying/Long (Rs.)

Xt c
Payoff
Net Profit
60 2
0
-2
60 2
0
-2
60 2
0
-2
60 2
0
-2
60 2
1
-1
60 2
2
0
60 2
3
1
60 2
4
2
60 2
5
3
60 2
6
4
Page 65

A European call option gives the following payoff to the investor: max (S - Xt,
0).
The seller gets a payoff of: -max (S - Xt, 0) or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at timet
C - European Call Option Premium
Payoff - Max (S - Xt, O)
Graph

Net Profit - Payoff minus 'c'

6.3.3 PUT OPTION:

It is an option contract giving the owner the right, but not the
obligation, to sell a specified amount of an underlying security at a specified
price within a specified time. This is the opposite of a call option, which gives
the holder the right to buy shares.

Page 66

Illustration:
An investor buys one European Put Option on one share of Reliance Petroleum
at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. The payoff table shows the fluctuations of
net profit with a change in the spot price.

Payoff from Put Buying/Long (Rs.)

S

Xt

Payoff

Net Profit

55

60

56

60

57

60

58

60

59

60

-1

60

60

-2

61

60

-2

62

60

-2

63

60

-2

64

60

-2

The payoff for the put buyer is: max (Xt - S, 0)

The payoff for a put writer is: -max(Xt - S, 0) or min(S - Xt, 0)
Graph
Page 67

These are the two basic options that form the whole gamut of transactions in the
options trading. These in combination with other derivatives create a whole
world of instruments to choose form depending on the kind of requirement and
the kind of market expectations.
Exotic Options are often mistaken to be another kind of option. They are
nothing but non-standard derivatives and are not a third type of option.

6.3.4 FACTORS DETERMINIG OPTION VALUE:

Stock price
Strike price
Time to expiration
Volatility
Risk free interest rate
Dividend

Page 68

SPOT PRICES:
In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more
the Spot Price more is the payoff and it is favourable for the buyer. It is the
other way round for the seller, more the Spot Price higher is the chances of his
going into a loss.
In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore,
more the Spot Price more are the chances of going into a loss. It is the reverse
for Put Writing.

STRIKE PRICE:
In case of a call option the payoff for the buyer is shown above. As per this
relationship a higher strike price would reduce the profits for the holder of the
call option.
TIME TO EXPIRATION:
More the time to Expiration more favourable is the option. This can only exist
in case of American option as in case of European Options the Options Contract
matures only on the Date of Maturity.
VOLATILITY:
More the volatility, higher is the probability of the option generating higher
returns to the buyer. The downside in both the cases of call and put is fixed but
the gains can be unlimited. If the price falls heavily in case of a call buyer then
the maximum that he loses is the premium paid and nothing more than that.
Page 69

More so he/ she can buy the same shares form the spot market at a lower price.
Similar is the case of the put option buyer. The table show all effects on the
buyer side of the contract.
RISK FREE RATE OF INTEREST:
In reality the r and the stock market is inversely related. But theoretically
speaking, when all other variables are fixed and interest rate increases this leads
to a double effect: Increase in expected growth rate of stock prices discounting
factor increases making the price fall
In case of the put option both these factors increase and lead to a decline in the
put value. A higher expected growth leads to a higher price taking the buyer to
the position of loss in the payoff chart. The discounting factor increases and the
future value become lesser.
In case of a call option these effects work in the opposite direction. The first
effect is positive as at a higher value in the future the call option would be
exercised and would give a profit. The second affect is negative as is that of
discounting. The first effect is far more dominant than the second one, and the
overall effect is favourable on the call option.
DIVIDENDS:
When dividends are announced then the stock prices on ex-dividend are
reduced. This is favourable for the put option and unfavourable for the call
option.

Page 70

6.3.5 DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES

OPTIONS

1) Both the parties are obligated to 1)

perform.

Only the

seller

(writer)

is

obligated to perform.

2) With futures premium is paid by 2) With options, the buyer pays the
either party.

seller a premium.

3) The parties to futures contracts 3) The buyer of an options contract

must perform at the settlement

can exercise any time prior to

date

expiration date.

only.

They

are

not

obligated to perform before that

date.
4) The holder of the contract is 4) The buyer limits the downside
exposed to the entire spectrum risk to the option premium but retain
of downside risk and had the the upside potential.
potential for all upside return.
5) In futures margins to be paid.
They are approximate 15-20%
on the current stock price.

5) In options premiums to be paid.

But they are very less

Page 71

as

compared to the margins.

6.3.6 Advantages of option trading:

Risk management: put option allow investors holding shares to hedge

against a possible fall in their value. This can be considered similar to
taking out insurance against a fall in the share price.
Time to decide: By taking a call option the purchase price for the shares
is locked in. This gives the call option holder until the Expiry day to
decide whether or exercised the option and buys the shares. Likewise the
taker of a put option has time to decide whether
or not to sell the shares.
Speculations: The ease of trading in and out of option position makes it
possible to trade options with no intention of ever exercising them. If
investor expects the market to rise, they may decide to buy call options. If
expecting a fall, they may decide to buy put options. Either way the
holder can sell the option prior to expiry to take a profit or limit a loss.

Page 72

Trading options has a lower cost than shares, as there is no stamp duty
payable unless and until options are exercised.
Leverage: Leverage provides the potential to make a higher return from a
smaller initial outlay than investing directly however leverage usually
involves more risks than a direct investment in the underlying share.
Trading in options can allow investors to benefit from a change in the
price of the share without having to pay of the share.

6.3.7 TRADING STRATEGIES:

Single Option and Stock
These strategies involve using an option along with a position in a stock.
Strategy 1:
A Covered Call: A long position in stock and short position in a call option.
Illustration: An investor enters into writing a call option on one share of Rel.
Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity
date is two months from now and along with this option he/she buys a share of
Rel.Petrol in the spot market at Rs. 58 per share.
By this the investor covers the position that he got in on the call option contract
and if the investor has to fulfil his/her obligation on the call option then can
fulfil it using the Rel.Petrol share on which he/she entered into a long contract.
Page 73

The payoff table below shows the Net Profit the investor would make on such a
deal.

Writing a Covered Call Option

Xt

Profit from Net

writing call from

Profit Share

Profit

Call bought from

Writing

Total
Profit

stock

50

60

58

-8

-2

52

60

58

-6

54

60

58

-4

56

60

58

-2

58

60

58

60

60

58

62

60

-2

58

64

60

-4

58

66

60

-6

58

Page 74

68

60

-8

-2

58

10

70

60

-10

-4

58

12

Strategy 2:
Reverse of Covered Call: This strategy is the reverse of writing a covered call.
It is applied by taking a long position or buying a call option and selling the
stocks.
Illustration:
An investor enters into buying a call option on one share of Rel. Petrol. At a
strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two
months from now and along with this option he/she sells a share of Rel.Petrol in
the spot market at Rs. 58 per share.

Page 75

The payoff chart describes the payoff of buying the call option at the various
spot rates and the profit from selling the share at Rs.58 per share at various spot
prices. The net profit is shown by the thick line.

Buying a Covered Call Option

S

Xt

Profit from Net Profit from Spot Price of Profit from Total Profit
buying call Call Buying

Selling

option

stock

the stock

50

60

-6

-6

58

52

60

-6

-6

58

54

60

-6

-6

58

-2

56

60

-6

-6

58

-4

58

60

-6

-6

58

-6

60

60

-6

-6

58

-2

-8

62

60

-6

-4

58

-4

-8

64

60

-6

-2

58

-6

-8

66

60

-6

58

-8

-8

Page 76

68

60

-6

58

-10

-8

70

60

-6

10

58

-12

-8

Strategy 3:
Protective Put Strategy:
This strategy involves a long position in a stock and long position in a put. It is
a protective strategy reducing the downside heavily and much lower than the
premium paid to buy the put option. The upside is unlimited and arises after the
price rise high above the strike price.
Illustration 5:
An investor enters into buying a put option on one share of Rel. Petrol. At a
strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two

Page 77

months from now and along with this option he/she buys a share of Rel.Petrol in
the spot market at Rs. 58 per share.

Protective Put Strategy

S

Xt

Profit
buying

from Net

Profit Spot Price of Profit

put from Buying Buying

option

put option

stock

the stock

from Total
Profit

50

60

-6

10

58

-8

-4

52

60

-6

58

-6

-4

54

60

-6

58

-4

-4

56

60

-6

-2

58

-2

-4

58

60

-6

-4

58

-4

60

60

-6

-6

58

-4

62

60

-6

-6

58

-2

64

60

-6

-6

58

66

60

-6

-6

58

68

60

-6

-6

58

10

Page 78

70

60

-6

-6

58

12

Strategy 4:
Reverse of Protective Put
This strategy is just the reverse of the above and looks at the case of taking short
positions on the stock as well as on the put option.
Illustration 6:
An investor enters into selling a put option on one share of Rel. Petrol. At a
strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two
months from now and along with this option he/she sells a share of Rel.Petrol in
the spot market at Rs. 58 per share.

Reverse of Protective Put Strategy

S

Xt

Profit

from Net Profit from Spot Price of Profit

writing a put Put Writing

Selling

option

stock

stock

Total Profit

the from

50

60

-10

-4

58

52

60

-8

-2

58

54

60

-6

58

Page 79

56

60

-4

58

58

60

-2

58

60

60

58

-2

62

60

58

-4

64

60

58

-6

66

60

58

-8

-2

68

60

58

-10

-4

70

60

58

-12

-6

Page 80

All the four cases describe a single option with a position in a stock. Some of
these cases look similar to each other and these can be explained by Put-Call
Parity.
Put Call Parity
P + S = c + Xe-r(T-t) + D ---------------------- (1)
Or
S - c = Xe-r(T-t) + D - p ---------------------- (2)
The second equation shows that a long position in a stock and a short position in
a call is equivalent to the short put position and cash equivalent to Xe-r(T-t) + D.
The first equation shows a long position in a stock combined with long put
position is equivalent to a long call position plus cash equivalent to Xe-r(T-t) + D.

6.3.8 SPREADS
The above strategies involved positions in a single option and squaring them off
in the spot market. The spreads are a little different. They involve using two or
more options of the same type in the transaction.
Strategy 1:
Bull Spread:

Page 81

The investor expects prices to increase in the future. This makes him
purchase a call option at X1 and sell a call option on the same stock at X2,
where X1<X2.
Using an illustration it would be clear how this is put to use.
Illustration
An investor purchases a call option on the BSE Sensex at premium of Rs.450
for a strike price at 4300. The investor squares this off with a sell call option at
Rs. 400 for a strike price at 4500. The contracts mature on the same date. The
payoff chart below describes the net profit that one earns on the buy call option,
sell call option and both contracts together.

Payoff From a Bull Spread

S

X1

X2

c1

c2

Profit from Net profit Profit form Net

Total

X1

Profit

from X1

X2

Profit
from X2

4200 4300 4500

-450

400

-450

400

-50

4250 4300 4500

-450

400

-450

400

-50

4300 4300 4500

-450

400

-450

400

-50

4350 4300 4500

-450

400

50

-400

400

4400 4300 4500

-450

400

100

-350

400

50

Page 82

4450 4300 4500

-450

400

150

-300

400

100

4500 4300 4500

-450

400

200

-250

400

150

4550 4300 4500

-450

400

250

-200

-50

350

150

4600 4300 4500

-450

400

300

-150

-100

300

150

4650 4300 4500

-450

400

350

-100

-150

250

150

4700 4300 4500

-450

400

400

-50

-200

200

150

4750 4300 4500

-450

400

450

-250

150

150

The premium on call with X1 would be more than the premium on call with X2.
This is because as the strike price rise the call option becomes unfavourable for
the buyer. The payoffs could be generalised as follows.

Page 83

Spot Rate

Profit on

Profit

long call

short call

on Total

Net Profit

Payoff

Which
option(s)
Exercised

S >= X2

S - X1

X2 - S

X2 - X1

X2 - X1 - c1 + c2

Both

X1 < S <= X2

S - X1

S - X1

S - X1 - c1 +c2

Option 1

S >= X1

c2 - c1

None

The features of the Bull Spread:

This requires an initial investment.

This reduces both the upside as well as the downside potential.

The spread could be in the money, on the money and out of money.
Another side of the Bull Spread is that on the Put Side. Buy at a low strike price
and sell the same stock put at a higher strike price.
This contract would involve initial cash inflows unlike the Bull Spread based on
the Call Options. The premium on the low strike put option would be lower than
the premium on the higher strike put option as more the strike price more is
favourability to buy the put option on the part of the buyer.

Page 84

Illustration
An investor purchases a put option on the BSE Sensex at premium of Rs.50 for
a strike price at 4300. The investor squares this off with a sell put option at Rs.
100 for a strike price at 4500. The contracts mature on the same date. The
payoff chart below describes the net profit that one earns on the buy put option,
sell put option and both contracts together.

Payoff From a Bull Spread (Put Options)

S

X1

X2

p1

p2

profit from Net profit Profit

X1

from X1

Net

from X2 Profit

Total
Profit

from X2

4200 4300 4500

-50

100

100

50

-300

-200

-150

4250 4300 4500

-50

100

50

-250

-150

-150

4300 4300 4500

-50

100

-50

-200

-100

-150

4350 4300 4500

-50

100

-50

-150

-50

-100

4400 4300 4500

-50

100

-50

-100

-50

4450 4300 4500

-50

100

-50

-50

50

4500 4300 4500

-50

100

-50

100

50

Page 85

4550 4300 4500

-50

100

-50

100

50

4600 4300 4500

-50

100

-50

100

50

4650 4300 4500

-50

100

-50

100

50

4700 4300 4500

-50

100

-50

100

50

4750 4300 4500

-50

100

-50

100

50

Spot Rate

Profit

on Profit

on Total Payoff Net Profit

Which

long put

short put

S >= X2

p2 - p1

None

X1 < S <= X2

S - X2

S - X2

S - X2 - p1 + p2

Option 2

S <= X1

X1 - S

S - X2

X1 - X2

X2 - X1 - p1 + p2 Both

option(s)

Exercised

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6.3.9 Summary of options

Call option buyer

Call option writer (seller)

Pays premium

Receives premium

Right to exercise and buy the

Obligation to sell shares if exercised

share

Profits from falling prices or remaining

Profits from rising prices

Limited

losses,

neutral

potentially

unlimited gain

Potentially unlimited losses, limited

gain

Put option buyer

Put option writer (seller)

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Pays premium

Receives premium

Right to exercise and sell shares

Obligation to buy shares if exercised

Profits from falling prices

Profits from rising prices or remaining

Limited

losses,

neutral

potentially

unlimited gain

Potentially unlimited losses, limited

gain

6.4. SWAPS:
Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a SWAP. In case of swap, only the
payment flows are exchanged and not the principle amount. The two commonly
used swaps are:
INTEREST RATE SWAPS:
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Interest rate swaps is an arrangement by which one party agrees to exchange his
series of fixed rate interest payments to a party in exchange for his variable rate
interest payments. The fixed rate payer takes a short position in the forward
contract whereas the floating rate payer takes a long position in the forward
contract.
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the
interest on loan in one currency are swapped for the principle and the interest
payments on loan in another currency. The parties to the swap contract of
currency generally hail from two different countries. This arrangement allows
the counter parties to borrow easily and cheaply in their home currencies. Under
a currency swap, cash flows to be exchanged are determined at the spot rate at a
time when swap is done. Such cash flows are supposed to remain unaffected by
subsequent changes in the exchange rates.

FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to
access one market and then exchange the liability for another type of liability. It
also allows the investors to exchange one type of asset for another type of asset
with a preferred income stream.

The other kind of derivatives, which are not, much popular are as follows:

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6.5. BASKETS:
Baskets options are option on portfolio of underlying asset. Equity Index
Options are most popular form of baskets.

6.6. LEAPS:
Normally option contracts are for a period of 1 to 12 months. However,
exchange may introduce option contracts with a maturity period of 2-3 years.
These long-term option contracts are popularly known as Leaps or Long term
Equity Anticipation Securities.
Example:
An option to sell 5000 shares of GMR after a period of 2 years from the date
of entering into contract can be termed as LEAPS. This is not different from an
option except the period of validity.

6.7. WARRANTS:
Options generally have lives of up to one year; the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.
Example:

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An option to buy 1000 shares of RIL after a period of 1 years from the date of
entering into contract can be termed as a Warrant. This is no way different from
an option except the period of validity.

6.8. SWAPTIONS:
Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather
than have calls and puts, the swaptions market has receiver swaptions and payer
swaptions. A receiver swaption is an option to receive fixed and pay floating. A
payer swaption is an option to pay fixed and receive floating.
Example:
A and B enter into a SWAP contract. A is swapping his fixed interest rate
against B. That B can receive fixed interest rate and now pay floating.
When c buys an option to buy this swap from B, it becomes a receiver swaption.

7. Experience at Sharekhan
We came to know about various products of Sharekhan along with its
features and advantages.
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 We also learnt about various competitors of Share khan like 5paisa.com,

Reliance Securities, Angel broking, HDFC securities, Kotak Securities,
Motilal Oswal etc.
We came to know about advantages of Sharekhan over its competitors.
Morning 9a.m.we used to sit next to Mr. Jikesh Vakharia (Dealer) and see
how trading is done.
He also used to share various research reports of Sharekhan and solve our
queries.
We had various training sessions with Mr. Ghanashyam Kale, one of the
topic was Derivative, wherein we learnt what are derivatives, how they
are traded, how research reports are important in derivative trading, etc.
We studied various research reports daily such as Pre-market report,
Investors Eye report, Eagles Eye report, Post-market report, Weekly
report etc.
We also learnt how to pitch various products of Sharekhan to the potential
clients like Trade Tiger, classic and fast trade with various advance
brokerage plans like Rs750, 1000, 2000 and 6000.
We made phone calls to various people from a few database.
We got a few clients from our personal contacts and some other from the
appointments we got from various phone calls we made.

8. Recommendations & Suggestions

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 There should be a separate cabin or a desk for trainees to work.

There should be more training sessions with professional trainers.
Trainees should be divided in groups according to location and should be
reporting to offices near their vicinity as after meeting clients we had to
report to Lower Parel office.
There should be only 5 trainees under a trainer.
There should also be training given on equity research and also on how
research reports are generated.
There should be more information available to individual investors about
derivatives.
There should be special seminars conducted by SEBI about creating
awareness about derivatives to individual investors.

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9. BIBLIOGRAPHY
Books referred:
NSEs Certification in Financial Markets: - Derivatives Core module

Reports:
Options report by Sharekhan

Websites visited:
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.google.com
www.derivativesindia.com
www.scribd.com
www.sharekhan.com

Search Engine:
www.google.com

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