Chapter 1: Introduction

1.1 Introduction
The basic aim of all the financial management is to get as much as return
possible by applying risk as low as possible (i.e. maximizing returns and
minimizing risks). In todays time we can make a large amount of money by
investing into stock markets, commodity or currency trading and other such
products, provided we have a good knowledge about them. As we know that
large amount of profits come at a greater risk, the same is true with these options
as they involve a large amount of risk and thus they can also lead to devastating
scenarios. Derivatives are also one such instrument, they promise extraordinarily high returns but at the same time also attract some risk.

Indian people have been quite content in investing the fixed deposits, chit funds,
government instruments for investing their money and earing a fixed rate of
return on their investment. But the scenario changes in the early ninetys when
the investments in the stock markets increased and people started investing in
various stocks of the companies and we saw various IPOs hitting the Indian
markets. Derivative products are a step forward in this direction where one can
simply earn a large return by placing their bets right and predicting what the next
price movement would be like.

1.2 Purpose of the Study

This project report attempts to study the various derivatives products and to
examine their usage in the treasury branch of the Union Bank of India. The study
explores the various kinds of products available in the market, and also intends
to find out the scope for new products in the market and also intends to examine
the overall perception of the market participants towards this fast paced growing
area.

1.3 Derivatives
Derivatives can be simply defined as a financial instrument whose vale depends
on the value of an underlying asset. The underlying asset can be stock (share)
price, commodity (like oil, wheat etc.), currency exchange rates, interest rates
etc. There are four basic types of derivatives those are Forwards, Futures,
Swaps and Options. The basic purpose of derivatives is to hedge ones
position against the risks involved in the business due to the uncertainty. But they
also provide an opportunity to earn a large amount of profit by speculating or by
arbitrage in derivative products like futures and options.

The Evolution of Derivatives Markets around the world

Year
1972
1973
1975
1981
1982

Activity
Foreign currency futures
Equity options
Treasury bond futures
Currency swaps Eurodollar futures
Interest-rate swaps Equity index futures
Options on equity index Interest-rate caps and

1983
1985
1987
1989
1990
1991
1994
1996
1997
2001
2004

floors
Swaptions
Compound options Average options
Quanto options
Equity index swaps
Differential swaps
Credit default swaps
Electricity futures
Weather derivatives
Single-stock futures
Volatility index futures

Source: Philippe Jorion, Value at Risk- The new benchmark for managing
financial risk- 3rd edition, Tata Mcgraw Hill Edition 2009. (Chapter 1)

1.4 Classification of Derivative Markets

Derivative markets could be broadly classified into:

Over-the-counter (OTC) derivatives

Exchange traded derivatives.

Over-the-counter (OTC) derivatives:

The OTC reports very high volume trading. In OTC, trading is done on telephone
and computer networks which are linked to dealers. Trade between two financial

institutions is done with bid and offer prices being offered simultaneously by the
institutions. The OTC trading in India is carried out in currency and foreign
exchange.
The following products are permitted within the framework of RBI guidelines to be
traded Over-the-counter:

Forward Foreign Exchange Contracts

Cross Currency Options (not involving rupee)
Foreign Currency-INR Options
Foreign Currency-INR Swaps
Cost Reduction Structures
Cross Currency Swaps, Interest Rate Swaps, Coupon Swaps, Forward
Rate Agreement

In addition to generic derivative products, the bank offers structured derivatives

products to users as long as they do not contain any derivative instrument as
underlying and have been specifically permitted by RBI. Following is a list of
derivative instruments used to hedge an existing interest rate and forex
exposure.

Forex Forward Contracts

Forward Rate Agreement
Interest Rate caps and floors (plain vanilla only)
Plain Vanilla Options (call and put options)
Interest Rate Swaps
Currency Swaps including Cross Currency Swaps

Exchange Traded Derivatives:

In India we have, BSE, NSE, NCDEX, MCX and recently opened United Stock
Exchange for Banks (currency) dealing in derivatives instruments. United Stock
Exchange is an exchange to trade in currency and interest rate derivatives and it

has marked the beginning of a new era in the development of Indian financial
markets. In Exchange Traded Derivatives the sale and purchase of the
derivatives are done though an exchange and thus it provides a safe platform to
carry out the transactions and also is more reliable ad risk free than the OTC
trading. Currently 21 stock exchanges operate in India. Derivative trading in
equity pre-dominantly takes place in the National Stock Exchange (NSE).

Difference between exchange traded and OTC derivatives

Sr. No. Exchange Traded
Derivatives traded on a
1

2
3
4

6
7

competitive floor, and

electronically
Standardized and published

OTC
Derivatives traded on a private basis
and individually negotiated
No standardized and published

contract specifications
contract specifications
Prices are transparent and easily Prices are less transparent and not
available
Market players not known to

easily available
Market players are known to each

each other

other
Commoditized vanilla contracts trade

Trading hours are published and 24 hours a day while less liquid and
exchange rules must be kept

customized one- time deals trade

Positions can easily be traded

during local hours

Positions are not easily closed or

out
transferred
Few contracts result in expiry or Majority of contracts result in expiry or
delivery

delivery

Source: John Wiley & Sons (Asia) Pte. Ltd. The Reuters Financial Training
Series, "An introduction to Derivatives" (1999)

1.5 Market Makers and Market Participants

Derivatives market comprises of the following participants in one of the three
roles either as Hedger, Arbitrageurs or Speculators:

Banks
Insurance Companies
Corporates
Traders
Exporters and Importers
Government
Individuals

1.5.1 Hedgers
Hedgers are the people who enter into a derivative contract to compensate for
the risk associated with their business transaction. For example there is an
exporter of pens, exporting pens to U.S. from India and is uncertain about the
currency exchange rate, which may vary over a period of time due to several
reasons. Similarly the importer of pens in U.S. would also be uncertain about the
currency exchange (USD/INR) rate in the future. So, both the exporter and
importer would enter into a forward contract where the exporter agrees to sell
pens to importer at a pre-determined price. The exporter is expecting that the
exchange rate would fall in future when the contract is to be honored and the
importer is expecting that the price would increase. Hence both the parties face
price risk. Thus the forward contract would eliminate the price risk for both the

parties. This is process called hedging and the participants are called hedgers.
The contract is concluded when the underlying is delivered at the agreed time
and at the pre-determined price.

1.5.2 Speculators
Speculators are the people who enter into a derivatives contract to make profit by
assuming risk. They have their own view of future price behavior of the
underlined asset and thus they take appropriate position in derivatives with the
intention of making profit. For example, the forward price in US dollars for a
contract maturing in two months is Rs. 64. If the speculator believes that two
months later the price of US dollar would be Rs. 66, s/he would buy forward
today and sell later. On the contrary if he believes that US dollar would
depreciate to Rs. 62 in one month, he would sell now and buy later. The intention
here is not to take the delivery of the underlying but to gain from the difference in
price, instead.

1.5.3 Arbitrageurs
Arbitrageurs are the ones who attempts to make profit from the inefficiencies in
the price of same underlying in different markets, by simultaneously buying and
selling the assets and thus gaining from the price discrepancies in the markets.
Arbitrageurs constantly monitor the prices of different assets in different markets
and identify opportunities to make profit that arise from mispricing of the products

in the different markets. Unlike hedgers and speculators, arbitrageurs take

riskless position and yet earn profit.
For example if the share price of Maruti Suzuki India is Rs. 3798 in National
Stock Exchange and Rs. 3796 in Bombay Stock Exchange the arbitrageurs will
sell at NSE and buy at BSE simultaneously and pocket the difference of Rs. 2
per share.
Arbitrageurs paly a very important role in the capital markets operations, as their
exploitation of price inefficiencies are the reason behind the accuracy of prices in
different markets.

1.6 Regulators
Independent regulators in various sectors like banking, insurance, capital
markets, and various services sectors regulate the Indian financial system. The
regulators come under the control of the Central Government. Regulation of the
markets is required so as to keep a check on the participants in the market and
thus keep an eye so as to prevent the disaster like the 2007 U.S. market crash,
Herstatt crisis; which can be devastating for the whole economy.
Market Segments and Corresponding Regulators in India are as follows:
Market Segment
Equity and Equity Derivatives

Regulator
Securities and Exchange Board of

India (SEBI)
Currency and Currency Derivatives Reserve Bank of India (RBI)
(Both Indian and Cross Currency)
Interest Rate and Fixed Income Reserve Bank of India (RBI)
Derivatives
Commodity Trading and Commodity Forward Market Commission

Derivatives
Source: John C Hull, Pearson Education Inc., "Options, Futures and other
Derivatives (7th Edition) (2009)

1.6.1 Reserve Bank of India

Reserve Bank of India (RBI) was established in 1935 and is the Central bank in
India. RBI formulates monetary policy, prescribes foreign exchange control
norms and is the regulator for financial and banking system. RBI has been
authorised to regulate the banking sector in India by, the Banking Regulation Act,
1949 and the Reserve Bank of India Act, 1934. The Reserve Bank of India
regulates a large segment of financial institutions in India, which includes
commercial and cooperative banks, NBFCs and various financial markets.

1.6.2 Securities and Exchange Board of India

Securities and Exchange Board of India (SEBI), established under the Securities
and Exchange board of India Act, 1992 is the regulatory authority for capital
markets in India. SEBI regulates the securities market, institutions and
intermediaries such as stock exchanges, depositories, mutual funds and other
asset management companies, brokers, merchant bankers, credit rating
agencies and venture capital funds etc. The stock exchanges regulate the
activities of the derivative traders and clearing agents.
SEBI has been vested with the following powers:

To approve laws of the stock exchanges

To require stock exchanges to amend their laws
Inspect accounting books of the stock exchanges
Inspect accounting books of the financial intermediaries
Compel companies to list their stock on particular exchanges

Register brokers

1.6.3 Forward Markets Commission

Forward Market Commission is the regulator for the commodity futures market in
India. It was established in 1953 under the provision of the Forward Contract
(Regulation) Act, 1952. It was originally overseen by the Ministry of Consumer
Affairs and Food and Public Distribution (India), but has now moved to the
Ministry of Finance, as the futures trading have become a more of a financial
activity. The First organized futures market was established in 1875 in Mumbai to
trade in cotton derivative contracts under the name of Bombay Cotton Trade
Association. The commission regulates the market to protect the market integrity
by some measures like limiting the open position of an individual members as
well as client to prevent over trading; limiting price fluctuation (daily/weekly) to
prevent abrupt upswing or downswing in prices etc.

1.7 Options
An Option is a derivative contract that gives the buyer the right, but not the
obligation, to buy or to sell an underlying asset at a specific price on or before a
certain date.

The basic types of options are as follows:

Call Option: It gives the holder the right to buy (but not the obligation) an asset
at a certain price within a specific period of time.

Put Option: It gives the holder the right to sell (but not the obligation) an asset at
a certain price within a specific period of time.

American Option: An American option is the one, which can be exercised

anytime during its life, i.e. prior to or on the maturity date of the contract. They
are generally traded over the exchanges.
European Option: A European option is the one, which can only be exercised at
the end of its life, i.e. at its maturity date. They are generally traded over the
counter.

1.7.1 Terminology used in Options Trading

Strike Price: It is the fixed price at which the option holder can buy (for call) or
sell (for put) the underlying assets at the time of exercising the contract.

Premium: It is the price paid by the holder of an Option for right he gets to
exercise the Option.
Premium is made up of two components, i.e. Intrinsic Value and Time Value.

Intrinsic Value: It is the difference between the current trading price and the
stock price. Only in-the-money options have intrinsic value.

Time Value: Additional amount of premium over and above the intrinsic value is
the time value or extrinsic value of Option. At the Money and Out of Money
Options will only have the time value. Time Value decreases as the expiration
date approaches and is large for the large time in the expiry date, as there is
much more time for the Option to come into profit.

In the money: When an option has an intrinsic value for itself it is said to be Inthe-money. A Call option is in-the-money when the current stock price is greater
than the Strike price and a Put option is in-the-money when the current stock
price is less than the strike price.

At the money: An option is at-the-money when the current stock price is equal to
the strike price.

Out of the money: A call option is out of the money, if the current stock price is
less than the strike price. A put option is out of the money, if the current stock
price is greater than the strike price.

1.7.2 Factors influencing the Option Price

1. Underlying Price: One of the most influential factors that affect the
pricing of an option is the current market price of the underlying asset. As
the underlyings price increases the price of call option increases and the
price of put option decreases, and vice-versa.

Up Cp and Up 1/Pp
(Where, Up= Underlyings Price; Cp= Call Price; Pp= Put Price)

2. Volatility in Underlyings price: Volatility is the uncertainty in the

movement of the underlyings price in either of the direction. In options,
both call and put, the downside position of the buyer is covered as the
maximum loss than can happen is the loss of premium. So, as the
volatility increases, the probability of change in magnitude of underlyings
price increases and thus the price of the option increases.
Up Volatility
3. Interest Rate: For Call Option the holder has to pays for the security if he
decides to exercise the option at a later date so he will have make a
payment in future. If the interest rate increases he will benefit from
investing the money in the risk free returns or would also lose a greater
amount if the money is borrowed from somewhere. So the price of call
option increases as the interest rate increases.
For put option holder, he/she will receive the money if s/he exercises the
put sometime in future, so if the interest rate increases present value of
the future cash flows that will be received by him will decline so the Put
Option will decline in value if the interest rate increase.
Cp Interest Rates and Pp 1/Interest Rates
4. Time Until Expiration: The longer the time of expiration of an option,
higher is the price of it. Its basically because of the fact that as the time to

expiration increases, so does the probability of the option going in the

money with it.
Cp , PP Expiry Time
5. Dividends expected during the life of an asset: As the dividends
reduces the price of the underlying assets. So, as the dividends increases
price for the call option would increase, but the price for the put option
would increase.
Cp 1/Dividends Paid and Pp Dividends Paid
6. Strike Price: Strike price determines that whether the option has any
intrinsic value or not, i.e. whether the option is in the money or not. So, the
price (premium) of the option increases if the option is in the money at the
strike price while drafting the contract.

1.7.3 Pricing of Options: Black-Scholes-Merton Model

This model was introduced in 1973 for the calculation of the option premium. It
calculates the theoretical price of the European option (both call and put).

Certain assumptions considered while using this method is as follows:

It assumes that the options being used are European in nature

It also assumes that during the life of the option, no dividends would be

paid.
Markets are efficient, i.e. the movement of the markets cannot be

predicted.
No commissions are considered while premium calculation.
The volatility and the risk free rate are known and are assumed to be
constant

It follows a lognormal distribution, i.e. returns on the underlying are

normally distributed.

Call Price/ Call Premium = C = SN(d1) N(d2) K.e-rt

Where,
d1 = ln(S/K) + (r+s2/2)t / s.t
d2= d1 s.t
Interpretation of the above model:
N(d1) = Change in Option price due to change in the Stock Price.(Delta).
Probability that the option will be in-the-money.
N (d2) = Probability that the Option will be exercised.
S = Current price of the underlying asset
t = Time until option is exercised
K = Strike Price
r = Risk free interest rate
N = Cumulative standard normal distribution
s = Standard deviation/ Volatility

Put Price/ Put Premium = C = N(-d2) K.e-rt SN(-d1)

1.7.4 Pricing of Options: Garman and Kohlhagen method

The Garman-Kohlhagen formula is an extension of the Black Scholes model and
allows it to calculate the premiums of options with two different interest rates, one
domestic and another foreign. This allows one to value options on a foreign
exchange rate.

Call Price/ Call Premium = C = S0N(d1).e-rft N(d2) K.e-rd t

Where,
d1 = ln(S0/K) + (rd-rf+s2/2)t / s.t
d2= d1 s.t

Interpretation of the above model:

N(d1) = Change in Option price due to change in the Stock Price.(Delta).
Probability that the option will be in-the-money.
N (d2) = Probability that the Option will be exercised.
S0 = SPOT rate
t = Time until option is exercised
K = Strike Price
rd = Domestic interest rate
rf = Foreign interest rate
N = Cumulative standard normal distribution
s = Standard deviation/ Volatility

Put Price/ Put Premium = C = N(-d2) K.e-rd t - S0N(-d1).e-rft

1.7.5 A brief overview of Greeks

Delta
It is the rate of change of price of the option with respect to its underlying
securitys price. It ranges from 0 to 1 for call options and from -1 to 0 for put
options.
It basically tells the Options sensitivity to a change in price of the underlying.
= Change in Option Price / Change in Stock Price

Theta
It is the rate of change of the value of portfolio with respect to the passage of
time while all else remaining the same. It is also known as the time decay value
of an option.
The value of theta decreases with the increasing time to maturity because for a
longer period of time the change in price per day would be lower.
Theta vale is directly proportional to the volatility as the change in price increases
with the increase in volatility.
At the money options are more adverse to theta, because their pricing has a
greater part of time value and a lesser part of the intrinsic value.

Vega
Vega represents the change in the amount of call / put prices with respect to the
one point change in the implied volatility.

Gamma
It gives the rate of change in delta with respect to the one point change in the
underlyings price. It is represent in the term of percentage. It peeks when it is
near the strike price and reduces as the option goes deeper into or out of money.

1.7.6 Some Option Strategies

Straddle
Straddle involves the simultaneous buying of a call and a put of the same
underlying asset, at same strike price and having the same expiration date.

The above graph represents a straddle with a strike price of Rs.40/This strategy ensures unlimited profit and limited loss.

Maximum loss = Net Premium Paid + Commissions paid

Max. loss will happen if the price of underlying remains same as the strike price
at the time of expiration of the contract.
Upper Break even point = Strike Price of long call + Net premium paid
Lower Break even point = Strike price of long put Net premium paid

Strangle
Strangle involves simultaneously buying of a slightly out of the money put and a
slightly out of the money call of the same underlying asset, having the same
expiration date. It also provides unlimited profit and limited loss.

The above graph represents a strangle where the strike price of the call option is
Rs. 70/- and the strike price of the put option is Rs. 50.
Maximum loss will occur when the price of the asset is between the strike prices
of call and put.
Max. Loss = Net Premium Paid + Commission paid
Upper Break even point = Strike price + Net premium paid

Lower Break even point = Strike Price Net premium paid

Condor
Condor involves simultaneously selling of an in the money call, buying one in the
money call (at a lower strike price than the ITM call sold), selling one out of the
money call and buying one out of the money call (at higher strike price than the
OTM call sold).

The above graph represents a condor.

Maximum loss will occur if the price fluctuates in a large amount on either side.
This strategy is used when the trader is certain that the price will not move by a
large extent and thus make money if his/her assumption is correct.
Max Loss = Net premium paid + Commission paid
Max Profit = Strike price (SP) of lower strike short call SP of lower strike long
call Net premium paid(NPP) commission paid
Upper Break even point = SP of high strike long call NPP
Lower Break even point = SP of low strike long call + NPP

Butterfly spread
Butterfly involves simultaneously selling of two at the money call, buying one in
the money call and buying one out of the money call. It is useful for the traders
which are of the view that large stock price moves are unlikely.

The above graph represents a butterfly spread, where we buy an OTM call at Rs
40/-, Sell two ATM calls at Rs. 60/- and buy an ITM call at Rs. 80/-.
Max Loss = Net premium paid + Commission paid
Max Profit = Strike price (SP) of short call + SP of lower strike long
call Net premium paid (NPP) commission paid
Upper Break even point = SP of high strike long call NPP
Lower Break even point = SP of low strike long call + NPP

1.8 Objectives

To study the various aspects of derivative products.

To study the trading mechanism of the derivative products.

To study the current state of derivative products in India market.

To gauge the perception of the traders towards the various derivative

products and the derivative market in general.

To analyse the scope of derivative products in Indian Market.

1.9 Brief Outline of Chapters

This report consists of five chapters in all focusing on different aspects.
Chapter 1 introduces the derivative products and markets; and describes its
importance and relevance. It further discusses the purpose and objective of this
report, followed by the explanation of various derivatives products seen during
the course of the project. It concludes with a brief outline of all chapters.
Chapter 2 explains the methodology adopted to analyze the usage of derivatives
products in the market, that is, various tools and methods used to conduct the
study. This section is constituted by the universe of study, the locale of the study
where the study has been conducted, Sample size chosen for the study, data
collection techniques used, analysis of the data collected and research
experience while conducting the study. Chapter 3 presents the literature review
which is divided into two parts reviewed literature on Derivatives by referring
various journals, articles and books, and origin/history and growth of the Union
Bank of India. This part makes use of secondary data that is already available.
Chapter 4 includes the content analysis i.e. the analysis of the data collected.
This part analyses the Questionnaire that was used to conduct the study. This
helps in determining the effectiveness of the current practices and scope for
improvements. Chapter 5 constitutes the terminal section of the report and

presents the findings from the study, suggestions for improvement, limitations of
the study and future scope of this study.