A STUDY ON

“DERIVATIVES”

With reference to
INDIA INFOLINE LIMITED

A project report submitted for the partial fulfillment of the requirements

for the award of the degree of

MASTER OF BUSINESS ADMINISTRATION

By
DEEPAK LAKOTIA
(HT-NO-10241E0013)

Under the guidance of

Mr. K.V.S. Raju
Head of the Department

GOKARAJU RANGARAJU COLLEGE OF

ENGINEERING AND TECHNOLOGY,
DEPARTMENT OF MANAGEMENT STUDIES
Bachupally, Hyderabad.
(Affiliated to JNT University, Hyderabad)
 2

DECLARATION

I here by declare that the project report entitled “A STUDY ON

DERIVATIVES” Special Reference with “INDIA INFOLINE LTD” is the
original bonafide work done by me under the able guidance of Mr. K.V.S Raju,
Head Of The Department,in partial fulfillment of the award of the degree of
Master of Business Administration by JNT University, Hyderabad.

The project work has not been submitted either in part of or in full for
the award of any other degree or diploma in any other university or board.

Place: Deepak Lakhotia

Date: 10241E0013
 3

ACKNOWLEDGEMENT

The ideal way to begin documenting this research work would be to extend my
heartfelt gratitude to everyone who has encouraged and guided me all through the
project.

I convey my heartfelt thanks to the management of Gokaraju Rangaraju College

of Engineering And Technology, Department Of Management Studies, Bachupally,

Hyderabad, our respected Principal , Course Director and Head Of The

Department Mr. K.V.S Raju for giving me this opportunity to undertake the project

work.

I am deeply indebted to my internal guide Mrs. Indira whose help, stimulating

suggestions and encouragement at all levels helped me to complete my project

successfully.

I specially thank Mr. Kishore, Branch Manager, INDIA INFOLINE LIMITED,

Hyderabad and Mr. Venkatesh, Relationship Manager for their suggestions and the help

extended to me when I approached them and the valuable discussion that I had with them

during the course of my project.

Deepak Lakotia
(10241E0013)
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TABLE OF CONTENTS

CHAPTER PAGE NUMBER

1. INTRODUCTION…………………………………………... 05
1.1 INTRODUCTION TO DERIVATIVES………………………… 06
1.2 OBJECTIVES OF THE STUDY ……………………………….. 07
1.3 SCOPE OF THE STUDY ………………………………………. 08
1.4 RESEARCH METHODOLOGY AND LIMITATIONS ………. 09

2. COMPANY PROFILE.............................................................. 10

3. THEORITICAL CONCEPTS ON DERIVATIVES ................ 18

3.1 DERIVATIVES ……………………..……………………….. 19
3.2 FORWARDS ………………………………………………… 30
3.3 FUTURES …………………………………………………… 33
3.4 OPTIONS …………………………………………………….. 46
3.5 SWAPS ……….……………………………………………… 62

4. ANALYSIS ………………...………………..….. …………...71

5. CONCLUSIONS …………………….…..... ………………....79

6. SUGGESTIONS ........................................................................80

BIBLIOGRAPHY………..………………………………..…81

GLOSSARY ………………………………………………... 82
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1.1 INTRODUCTION TO DERIVATIVES

A derivative security is a security whose value depends on the value of together

more basic underlying variable. These are also known as contingent claims. Derivatives
securities have been very successful in innovation in capital markets.

The emergence of the market for derivative products most notably forwards,
futures and options can be traced back to the willingness of risk -averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. By their very nature, financial markets are markets by a very high degree of
volatility. Through the use of derivative products, it is possible to partially or fully
transfer price risks by locking – in asset prices. As instruments of risk management
these generally don’t influence the fluctuations in the underlying asset prices.

However, by locking-in asset prices, derivative products minimize the impact of

fluctuations in asset prices on the profitability and cash-flow situation of risk-averse
investor.

Derivatives are risk management instruments which derives their value from an
underlying asset. Underlying asset can be Bullion, Index, Share, Currency, Bonds,
Interest, etc.
 7

1.2 OBJECTIVES OF THE STUDY:

To understand the concept of the Financial Derivatives such as Forwards,

Futures and Options and swaps

To find out profit/loss position of the option writer and option holder

To study various trends in derivatives market

To study the role of derivatives in India financial market

To study in detail the role of futures and options

To examine the advantages and the disadvantages of different

strategies along with situations

To study the different ways of buying and selling of Options
 8

1.3 SCOPE OF THE STUDY:

The study is limited to “Derivatives” With special reference to Futures and

Options in the Indian context and the IIFL has been taken as representative sample for
the study.

The study cannot be said as totally perfect, any alteration may come. The study
has only made humble attempt at evaluating Derivatives markets only in Indian context.
The study is not based on the International perspective of the Derivatives markets.
 9

1.4 RESEARCH METHODOLOGY:

The data had been collected through primary and secondary source.

Primary data:
The data had been collected through IIFL staff.

Secondary data:
The data had been collected through Journals, News papers, and Internet.

LIMITATIONS:

The study does not take any Nifty Index Futures and Options and International

Markets into the consideration.

This is a study conducted within a period of 45 days.

During this limited period of study, the study may not be a detailed, Full –

fledged and utilitarian one in all aspects.

The study contains some assumptions based on the demands of the analysis.

The study does not provide any predictions or forecast of the selected scripts.

The study was conducted in Hyderabad only.

As the time was limited, study was confined to conceptual understanding of
Derivatives market in India.
10
 11

THE INDIA INFOLINE LIMITED

PROFILE OF IIFL INVESTMENT SOLUTIONS

India Infoline has been founded with the aim of providing world class investing
experience to hitherto underserved investor community. India Infoline is currently
providing broking services on the NSE, BSE, derivative market and commodity
exchange. India Infoline allows individual investors too conveniently, comfortably and
cost-efficiently place trades online and offline. While offering the service they also give
the added assurance of 92 branch offices. The company, created to provide premium
service with reasonable commissions, currently maintains more than 25000 individual
accounts.

Mission:
To create long term value by empowering individual investors through superior
financial services supported by culture based on highest level of teamwork, efficiency
and integrity.

Team:
Founder & CEO : Mr.
Co-founder & president : Mr.
Chief operating officer : Mr.
Chief financial officer : Mr.

Products and services:

India Infoline customers have the advantage of trading in all the market segments
together in the same window, as they understand the need of transactions to be executed
with high speed and reduced time. At the same time, they have the advantage of having
 12

all kind of insurance and investment advisory services for life insurance, general
insurance, mutual funds, and IPO’s also.

Key product offerings are as follows:

 Equity trading
 Commodity trading
 NRI services
 Mutual fund
 Life insurance
 General insurance
 Depository services
 Portfolio tracker
 Back office.

Mode of Operation in Commodities at IIFL:

 On line trading through the existing mode of connectivity available in the

branch or can be arranged immediately at client’s location after the MOU. To
restore the connectivity an alternative arrangement is always provided to ensure
ongoing uninterrupted trading.
 All open contracts not intended for delivery and in non-deliverable positions
are automatically settled by the exchange on expiry.
 All contracts materializing in to deliveries would be settled in the electronic
mode in a period of 2 to 7 days after the expiry or the exact settlement day/date
as specified by the exchange.
 Price quoted for the futures contracts would be ex-warehouse and exclusive of
sales tax.
 Margin as specified by the concerned exchange for each traded commodity is
required to be paid as per day-to-day outstanding position of the contract to
facilitate the trading.
 The mark to market loss /profit to be settled on daily basis.
 13

1.3 PROFILE OF NATIONAL COMMODITIES AND DERIVATIVE

EXCHANGE (NCDEX):
National commodity & derivatives exchange limited (NCDEX) is a
professionally managed on-line multi commodity exchange in the country promoted by
national level institutions. NCDEX is a public limited company incorporated on April
23, 2003 under the companies act, 1956. It obtained its certificate for commencement
of business on May 9, 2003. It commenced its operations on December 15, 2003.

NCDEX is regulated by forward markets commission. It is subjected to various

laws of the land like the forward contracts (regulation) act, ccmpanies act, stamp act,
contract act and various other legislations. NCDEX is located in Mumbai and offers
facilities to its members about 550 centers throughout India. NCDEX currently
facilitates trading of 57 commodities.

Agriculture:
Barley, Cashew, Castor Seed, Chana, Chilli, Coffee - Arabica, Coffee - Robusta, Crude
Palm Oil, Cotton Seed Oilcake, Expeller Mustard Oil, Groundnut (In Shell), Groundnut
Expeller Oil, Guar Gum, Guar Seeds, Gur, Jeera, Jute Sacking Bags, Indian Parboiled
Rice, Indian Pusa Basmati Rice, Indian Traditional Basmati Rice, Indian Raw Rice,
Indian 28.5 Mm Cotton, Indian 31 Mm Cotton, Masoor Grain Bold, Medium Staple
Cotton, Mentha Oil, Mulberry Green Cocoons, Mulberry Raw Silk, Mustard Seed,
Pepper, Potato, Raw Jute, Rapeseed-Mustard Seed Oilcake, Rbd Palmolein, Refined
Soy Oil, Rubber, Sesame Seeds, Soybean, Sugar, Yellow Soybean Meal, Tur,
Turmeric, Uri, V-797 Kapas, Wheat, Yellow Peas And Yellow Red Maize.

Metals:
Aluminum Ingot, Electrolytic Copper Cathode, Gold, Mild Steel Ingots, Nickel
Cathode, Silver, Sponge Iron and Zinc Ingot.
Energy:
Brent Crude Oil and Furnace Oil.
 14

Board of Directors:
The governance of NCDEX vests with the 12 board of directors.
Mr. R. Ramaseshan is the Managing Director and Chief Executive Officer

Shareholders of NCDEX:

Equity shareholding pattern as on 18th April, 2012

Source: www.ncdex.com
 15

2.1 NEED FOR THE STUDY:

Derivative market in Indian scenario is still believed to be at infant stage

disturbing the macro level parameters for eg: forward trading in cereals & pulses and
metals segments is believed to be the prime culprit of core sector inflation being faced
by India now.

Therefore this project finds it necessary the assess the impact of forward trading
on spot prices of commodities. It is also necessary to establish a mechanical
relationship between forward prices of one time lag and spot prices of its immediate
time lag.

Accordingly this project is constructed to find whether forward trading

influences the core areas of wholesale price index.

2.2 OBJECTIVES OF THE STUDY:

 To understand the basics of derivatives trading.

 To understand the regulatory framework of forward trading in Indian markets.
 To find the impact of forward prices on the spot price trend of its immediate
time lag.
 To find the limitations of forward trading.

2.3 SCOPE OF THE STUDY:

This study has got the limited scope of single underlying assest silver and a
limited time period of one year. Nevertheless the scope is extended to through scrutiny
and understanding of regulatory framework of derivatives, technicalities and influence
of forward trading on spot prices. This study is purely executed with secondary data
sources, although impact of forward trading can be measured through primary sources
as well.
16
 17

3.1 DERIVATIVES:

The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. By their very nature, the financial markets are marked by a very high degree of
volatility. Through the use of derivative products, it is possible to partially or fully
transfer price risks by locking –in asset prices. As instruments of risk management,
these generally do not influence the fluctuations underlying prices. However, by
locking –in asset prices, derivative products minimizes the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk–averse investors.

3.1.1 DEFINITION:
Understanding the word itself, Derivatives is a key to mastery of the topic. The
word originates in mathematics and refers to a variable, which has been derived from
another variable. For example, a measure of weight in pound could be derived from a
measure of weight in kilograms by multiplying by two.
In financial sense, these are contracts that derive their value from some
underlying asset. Without the underlying product and market it would have no
independent existence. Underlying asset can be a Stock, Bond, Currency, Index or a
Commodity. Some one may take an interest in the derivative products without having
an interest in the underlying product market, but the two are always related and may
therefore interact with each other.

The term Derivative has been defined in Securities Contracts (Regulation) Act 1956, as:

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

or unsecured, risk instrument or contract for differences or any other
form of security.
B. A contract, which derives its value from the prices, or index of prices,
of underlying securities.
 18

3.1.2 IMPORTANCE OF DERIVATIVES:

Derivatives are becoming increasingly important in world markets as a tool for

risk management. Derivatives instruments can be used to minimize risk. Derivatives are
used to separate risks and transfer them to parties willing to bear these risks. The kind
of hedging that can be obtained by using derivatives is cheaper and more convenient
than what could be obtained by using cash instruments. It is so because, when we use
derivatives for hedging, actual delivery of the underlying asset is not at all essential for
settlement purposes.

Moreover, derivatives would not create any risk. They simply manipulate the
risks and transfer to those who are willing to bear these risks.
For example,

Mr. A owns a bike If he does not take insurance, he runs a big risk. Suppose he
buys insurance [a derivative instrument on the bike] he reduces his risk. Thus, having
an insurance policy reduces the risk of owing a bike. Similarly, hedging through
derivatives reduces the risk of owing a specified asset, which may be a share, currency,
etc.
 19

3.1.3 RATIONALE BEHIND THE DEVELOPMENT OF

DERIVATIVES:

Holding portfolio of securities is associated with the risk of the possibility that the
investor may realize his returns, which would be much lesser than what he expected to
get. There are various influences, which affect the returns.

1. Price or dividend (interest).

2. Sum are internal to the firm like:

Industry policy

Management capabilities

Consumer’s preference

Labour strike, etc.

These forces are to a large extent controllable and are termed as “Non-systematic
Risks”. An investor can easily manage such non- systematic risks by having a well-
diversified portfolio spread across the companies, industries and groups so that a loss in
one may easily be compensated with a gain in other.

There are other types of influences, which are external to the firm, cannot be
controlled, and they are termed as “systematic risks”. Those are
• Economic
• Political
• Sociological changes are sources of Systematic Risk

Their effect is to cause the prices of nearly all individual stocks to move together in
the same manner. We therefore quite often find stock prices falling from time to time in
spite of company’s earnings rising and vice –versa.
Rational behind the development of derivatives market is to manage this systematic
risk, liquidity. Liquidity means, being able to buy & sell relatively large amounts
quickly without substantial price concessions.
 20

In debt market, a much larger portion of the total risk of securities is systematic.
Debt instruments are also finite life securities with limited marketability due to their
small size relative to many common stocks. These factors favor for the purpose of both
portfolio hedging and speculation.

India has vibrant securities market with strong retail participation that has
evolved over the years. It was until recently a cash market with facility to carry forward
positions in actively traded “A” group scripts from one settlement to another by paying
the required margins and borrowing money and securities in a separate carry forward
sessions held for this purpose. However, a need was felt to introduce financial products
like other financial markets in the world.

3.1.4 CHARACTERISTICS OF DERIVATIVES:

1. Their value is derived from an underlying instrument such as stock index,

currency, etc.
2. They are vehicles for transferring risk.
3. They are leveraged instruments.
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3.1.5 MAJOR PLAYERS IN DERIVATIVE MARKET:

There are three major players in the derivatives trading.

1. Hedgers
2. Speculators
3. Arbitrageurs

Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek to
protect themselves against price changes in a commodity in which they have an
interest.
Speculators: 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.
Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be
making money even with out putting their own money in, and such opportunities often
come up in the market but last for very short time frames. They are specialized in
making purchases and sales in different markets at the same time and profits by the
difference in prices between the two centers.
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3.1.6 TYPES OF DERIVATIVES:

Most commonly used derivative contracts are:

Forwards: A forward contract is a customized contract between two entities where
settlement takes place on a specific date in the futures at today’s pre-agreed price.
Forward contracts offer tremendous flexibility to the party’s to design the contract in
terms of the price, quantity, quality, delivery, time and place. Liquidity and default risk
are very high.
Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense, that the former are standardized exchange traded
contracts.
Options: Options are two types - Calls and Puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset at a given price on or
before a given future date. Puts give the buyer the right but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.
Warrants: Longer – dated options are called warrants and are generally traded over –
the – counter. Options generally have life up to one year, the majority of options traded
on options exchanges having a maximum maturity of nine months.
LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These
are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form
of basket options
Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a pre-arranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are: -
Interest rare swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
 23

Currency swaps: These entail swapping both the principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in
opposite direction.

3.1.7 RISKS INVOLVED IN DERIVATIVES:

Derivatives are used to separate risks from traditional instruments and transfer these
risks to parties willing to bear these risks. The fundamental risks involved in derivative
business includes

A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation
as per the contract. Also known as default or counterparty risk, it differs with
different instruments.
B. Market Risk: Market risk is a risk of financial loss as a result of adverse
movements of prices of the underlying asset/instrument.
C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing
market prices is termed as liquidity risk. A firm faces two types of liquidity
risks:

Related to liquidity of separate products.

Related to the funding of activities of the firm including derivatives.
D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal
aspects associated with the deal should be looked into carefully.
 24

3.1.8 DERIVATIVES IN INDIA:

Indian capital markets hope derivatives will boost the nation’s economic
prospects. Fifty years ago, around the time India became independent men in Mumbai
gambled on the price of cotton in New York. They bet on the last one or two digits of
the closing price on the New York cotton exchange. If they guessed the last number,
they got Rs.7/- for every Rupee layout. If they matched the last two digits they got
Rs.72/- Gamblers preferred using the New York cotton price because the cotton market
at home was less liquid and could easily be manipulated.
Now, India is about to acquire own market for risk. The country, emerging from a
long history of stock market and foreign exchange controls, is one of the vast major
economies in Asia, to refashion its capital market to attract western investment. A
hybrid over the counter, derivatives market is expected to develop along side. Over the
last couple of years the National Stock Exchange has pushed derivatives trading, by
using fully automated screen based exchange, which was established by India's leading
institutional investors in 1994 in the wake of numerous financial & stock market
scandals.

Derivatives Segments in NSE & BSE

On June 9, 2000 BSE and NSE became the first exchanges in India to introduce
trading in exchange traded derivative products, with the launch of index Futures on
Sensex and Nifty futures respectively. Index Options was launched in June 2001, stock
options in July 2001, and stock futures in November 2001.
NIFTY is the underlying asset of the index futures at the futures and options
segment of NSE with a market lot of 50 and Sensex is the underlying stock index in
BSE with a market lot of 30. This difference of market lot arises due to a minimum
specification of a contract value of Rs.2 Lakhs by Securities and Exchange Board of
India. For example Sensex is 18000 then the contract value of a futures index having
Sensex as underlying asset will 30x18000 = 540000. Similarly, If Nifty is 5200 its
futures contract value will be 50x5200=260000. Every transaction shall be in multiples
 25

of market lot. Thus, index futures at NSE shall be traded in multiples of 50 and a BSE
in multiples of 30.

Contract Periods:

At any point of time there will be always be available nearly 3months contract
periods in Indian Markets.
These were
1) Near Month
2) Next Month
3) Far Month

For example in the month of September 2007 one can enter into September
futures contract or October futures contract or November futures contract. The last
Thursday of the month specified in the contract shall be the final settlement date for the
contract at both NSE as well as BSE; it is also known as Expiry Date.

Settlement:
The settlement of all derivative contracts 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 asset.

Margins:
There are two types of margins collected on the open position, viz., initial
margin which is collected upfront which is named as “SPAN MARGIN” and mark to
market margin, which is to be paid on next day. As per SEBI guidelines it is mandatory
 26

for clients to give margins, failing in which the outstanding positions are required to be
closed out.

Members of F&O segment:

There are three types of members in the futures and options segment. They are
trading members, trading cum clearing members and professional clearing members.
Trading members are the members of the derivatives segment and carrying on the
transactions on the respective exchange.
The clearing members are the members of the clearing corporation who deal with
payments of margin as well as final settlements.
The professional clearing member is a clearing member who is not a trading member.
Typically, banks and custodians become professional clearing members.
It is mandatory for every member of the derivatives segment to have approved users
who passed SEBI approved derivatives certification test, to spread awareness among
investors.

Exposure limit:
The national value of gross open positions at any point in time for index futures
and short index option contract shall not exceed 33.33 times the liquid net worth of a
clearing member. In case of futures and options contract on stocks the notional value of
futures contracts and short option position any time shall not exceed 20 times the liquid
net worth of the member. Therefore, 3 percent notional value of gross open position in
index futures and short index options contracts, and 5 percent of notional value of
futures and short option position in stocks is additionally adjusted from the liquid net
worth of a clearing member on a real time basis.

Position limit:
It refers to the maximum no of derivatives contracts on the same underlying
security that one can hold or control. Position limits are imposed with a view to detect
concentration of position and market manipulation. The position limits are applicable
on the cumulative combined position in all the derivatives contracts on the same
 27

underlying at an exchange. Position limits are imposed at the customer level, clearing
member level and market levels are different.

Regulatory Framework:

Considering the constraints in infrastructure facilities the existing stock

exchanges are permitted to trade derivatives subject to the following conditions:
• Trading should take place through an online screen based trading system
• An independent clearing corporation should do the clearing of the
derivative market
• The exchange must have an online surveillance capability, which
monitors positions, price and volumes in real time so as to detect market
manipulations. Position limits be used for improving market quality
• Information about traded quantities and quotes should be disseminated
by the exchange in the real time over at least two information-vending
networks, which are accessible to the investors in the country
• The exchange should have at least 50 members to start derivatives
trading
• The derivatives trading should be done in a separate segment with a
separate membership. The members of an existing segment of the
exchange will not automatically become the members of derivatives
segment
• The derivatives market should have a separate governing council and
representation of trading/clearing members shall be limited to maximum
of 40% of total members of the governing council
• 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 and
dealing on any exchange during his tenure
28
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3.2 Forwards

Forwards are the simplest and basic form of derivative contracts. These are
instruments are basically used by traders/investors in order to hedge their future risks. It
is an agreement to buy/sell an asset at certain in future for a certain price. They are
private agreements mainly between the financial institutions or between the financial
institutions and corporate clients.

One of the parties in a forward contract assumes a long position i.e. agrees to
buy the underlying asset on a specified future date at a specified future price. The other
party assumes short position i.e. agrees to sell the asset on the same date at the same
price. This specified price referred to as the delivery price. This delivery price is
choosen so that the value of the forward contract is equal to zero for both the parties. In
other words, it costs nothing to the either party to hold the long/short position.

A forward contract is settled at maturity. The holder of the short position

delivers the asset to the holder of the long position in return for cash at the agreed upon
rate. Therefore, a key determinate of the value of the contract is the market price of the
underlying asset. A forward contract can therefore, assume a positive/negative value
depending on the movements of the price of the asset. For example, if the price of the
asset rises sharply after the two parties entered into the contract, the party holding the
long position stands to benefit, that is the value of the contract is positive for him.
Conversely the value of the contract becomes negative for the party holding the short
position.

The concept of forward price is also important. The forward price for a certain
contract is defined as that delivery price which would make the value of the contract
zero. To explain further, the forward price and the delivery price are equal on the day
that the contract is entered into. Over the duration of the contract, the forward price is
liable to change while the delivery price remains the same.
 30

3.2.1 Essential features of Forward Contracts:

• A forward contract is a Bi-party contract, to be performed in the future, with the
terms decided today
• Forward contracts offer tremendous flexibility to the parties to design the
contract in terms of the price, quantity, quality, delivery time and place
• Forward contracts suffer from poor liquidity and default risk
• Contract price is generally not available in public domain
• On the expiration date the contract will settle by delivery of the asset
• If the party wishes to reverse the contract, it is compulsorily to go to the same
counter party, which often results high prices

3.2.2 Forward Trading in Securities:

The Securities Contract (amendment) Act of 1999 has allowed the trading in
derivative products in India. As a further step to widen and deepen the securities market
the government has notified that with effect from March 1st 2000 the ban on forward
trading in shares and securities is lifted to facilitate trading in forwards and futures.
It may be recalled that the ban on forward trading in securities was imposed in 1986 to
curb certain unhealthy trade practices and trends in the securities market. During the
past few years, thanks to the economic and financial reforms, there have been many
healthy developments in the securities markets.

The lifting of ban on forward deals in securities will help to develop index
futures and other types of derivatives and futures on stocks. This is a step in the right
direction to promote the sophisticated market segments as in the western countries.
31
 32

3.3 FUTURES

The future contract is an agreement between two parties to buy or sell an asset
at a certain specified time in future for certain specified price. In this, it is similar to a
forward contract. A futures contract is a more organized form of a forward contract;
these are traded on organized exchanges. However, there are a number of differences
between forwards and futures. These relate to the contractual futures, the way the
markets are organized, profiles of gains and losses, kind of participants in the markets
and the ways they use the two instruments.

Futures contracts in physical commodities such as wheat, cotton, gold, silver,

cattle, etc. have existed for a long time. Futures in financial assets, currencies, and
interest bearing instruments like treasury bills and bonds and other innovations like
futures contracts in stock indexes are relatively new developments.

The futures market described as continuous auction markets and exchanges

providing the latest information about supply and demand with respect to individual
commodities, financial instruments and currencies, etc. Futures exchanges are where
buyers and sellers of an expanding list of commodities; financial instruments and
currencies come together to trade. Trading has also been initiated in options on futures
contracts. Thus, option buyers participate in futures markets with different risk. The
option buyer knows the exact risk, which is unknown to the futures trader.

3.3.1 FEATURES OF FUTURES CONTRACTS:

The principal features of the contract are as follows.

Organized Exchanges: Unlike forward contracts which are traded in an over- the-
counter market, futures are traded on organized exchanges with a designated physical
location where trading takes place. This provides a ready, liquid market which futures
can be bought and sold at any time like in a stock market.
 33

Standardization: In the case of forward contracts the amount of commodities to be

delivered and the maturity date are negotiated between the buyer and seller and can be
Tailor made to buyer’s requirement. In a futures contract both these are standardized by
the exchange on which the contract is traded.

Clearing House: The exchange acts a clearing house to all contracts struck on the
trading floor. For instance a contract is struck between capital A and B. Upon entering
into the records of the exchange, this is immediately replaced by two contracts, one
between A and the clearing house and another between B and the clearing house. In
other words the exchange interposes itself in every contract and deal, where it is a
buyer to seller, and seller to buyer. The advantage of this is that A and B do not have to
under take any exercise to investigate each other’s credit worthiness. It also guarantees
financial integrity of the market. This enforces the delivery for the delivery of contracts
held for until maturity and protects itself from default risk by imposing margin
requirements on traders and enforcing this through a system called marking – to –
market.

Actual delivery is rare: In most of the forward contracts, the commodity is

actually delivered by the seller and is accepted by the buyer. Forward contracts are
entered into for acquiring or disposing of a commodity in the future for a gain at a price
known today. In contrast to this, in most futures markets, actual delivery takes place in
less than one percent of the contracts traded. Futures are used as a device to hedge
against price risk and as a way of betting against price movements rather than a means
of physical acquisition of the underlying asset. To achieve this most of the contracts
entered into are nullified by the matching contract in the opposite direction before
maturity of the first.

Margins: In order to avoid unhealthy competition among clearing members in

reducing margins to attract customers, a mandatory minimum margins are obtained by
the members from the customers. Such a stop insures the market against serious
liquidity crisis arising out of possible defaults by the clearing members. The members
 34

collect margins from their clients as may be stipulated by the stock exchanges from
time to time and pass the margins to the clearing house on the net basis i.e. at a
stipulated percentage of the net purchase and sale position.
The stock exchange imposes margins as follows:
1. Initial margins on both the buyer as well as the seller.
2. The accounts of buyer and seller are marked to the market daily.

The concept of margin here is same as that of any other trade, i.e. to introduce a
financial stake of the client, to ensure performance of the contract and to cover day to
day adverse fluctuations in the prices of the securities.
The margin for future contracts has two components:
• Initial margin
• Marking to market

Initial margin: In futures contract both the buyer and seller are required to perform
the contract. Accordingly, both the buyers and the sellers are required to put in the
initial margins. The initial margin is also known as the “performance margin” and
usually 5% to 15% of the purchase price of the contract. The margin is set by the stock
exchange keeping in view the volume of business and size of transactions as well as
operative risks of the market in general.

The concept being used by NSE to compute initial margin on the futures
transactions is called “value- at –Risk” (VAR) where as the options market had SPAN
based margin system”.

Marking-to-Market: Marking to market means, debiting or crediting the client’s

equity accounts with the losses/profits of the day, based on which margins are sought.

It is important to note that through marking to market process, the clearinghouse

substitutes each existing futures contract with a new contract that has the settlement
 35

price or the base price. Base price shall be the previous day’s closing Nifty value.
Settlement price is the purchase price in the new contract for the next trading day.

3.3.2 FUTURES TERMINOLOGY:

Spot price: The price at which an asset is traded in spot market.
Futures price: The price at which the futures contract is traded in the futures market.
Expiry Date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract Size: The amount of asset that has to be delivered under one contract. For
instance contract size on NSE futures market is 100 Nifties.

Basis/Spread:
In the context of financial futures basis can be defined as the futures price minus
the spot price. There will be a different basis for each delivery month for each contract.
In formal market, basis will be positive. This reflects that futures prices normally
exceed spot prices.

Cost of Carry:
The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the
interest that is paid to finance the asset less the income earned on the asset.

Multiplier:
It is a pre-determined value, used to arrive at the contract size. It is the price per
index point.

Tick Size: It is the minimum price difference between two quotes of similar nature.
 36

Open Interest:
Total outstanding long/short positions in the market in any specific point of
time. As total long positions for market would be equal to total short positions for
calculation of open Interest, only one side of the contract is counted.
Long position: Outstanding/Unsettled purchase position at any point of time.
Short position: Out standing/unsettled sale position at any time point of time.

Index Futures:
Stock Index futures are most popular financial futures, which have been used to
hedge or manage systematic risk by the investors of the stock market. They are called
hedgers, who own portfolio of securities and are exposed to 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 traded on a regulated futures exchange for a
specified price at a specified time in future.

Stock index futures will require lower capital adequacy and margin requirement
as compared to margins on carry forward of individual scrip’s. The brokerage cost 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
incase 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 refer 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 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 contracts traded. 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
 37

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.

Example:
If NSE NIFTY is at 5800 and each point in the index equals to Rs.50, a contract
struck at this level could work Rs.290000 (5800x50). If at the expiration of the contract,
the NSE NIFTY is at 5900, a cash settlement of Rs.5000 is required (5900-5800) x50).

Stock Futures:
With the purchase of futures on a security, the holder essentially makes a legally
binding promise or obligation to buy the underlying security at same point in the future
(the expiration date of the contract). Security futures do not represent ownership in a
corporation and the holder is therefore not regarded as a shareholder.

A futures contract represents a promise to transact at same point in the future. In

this light, a promise to sell security is just as easy to make as a promise to buy security.
Selling security futures without previously owing them simply obligates the trader to
sell a certain amount of the underlying security at same point in the future. It can be
done just as easily as buying futures, which obligates the trader to buy a certain amount
of the underlying security at some point in future.

Example:
If the current price of the GMRINFRA share is Rs.170 per share. We believe
that in one month it will touch Rs.200 and we buy GMRINFRA shares. If the price
really increases to Rs.200, we made a profit of Rs.30 i.e. a return of 18%.

If we buy GMRINFRA futures instead, we get the same position as ACC in the cash
market, but we have to pay the margin not the entire amount. In the above example if
the margin is 20%, we would pay only Rs.34 per share initially to enter into the futures
 38

contract. If GMRINFRA share goes up to Rs.200 as expected, we still earn Rs.30 as

profit.

3.3.3 PAYOFF FOR FUTURES CONTRACTS:

Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of a futures contract are unlimited. These
linear payoffs are fascinating as they can be combined with options and the underlying
to generate various complex payoffs.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for
a person who holds an asset. He has a potentially unlimited upside as well as potentially
unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures
contract when Nifty stands at 4800. The underlying asset in this case is Nifty portfolio.
When the index moves up, the long futures position starts making profits, and when
index moves down it starts making losses.

Payoff for a buyer of Nifty futures

Profit

4800
0 Nifty

LOSS
 39

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has potentially unlimited upside as well as potentially
unlimited downside.

Payoff for a seller of Nifty futures

Profit

4800
0 Nifty

Loss

Take the case of a speculator who sells a two-month Nifty index futures
contract when the Nifty stands at 4800. The underlying asset in this case is the Nifty
portfolio. When the index moves down, the short futures position starts making profits,
and when index moves up, it starts making losses.
 40

3.3.4 PRICING FUTURES

Cost of Carry Model:

We use fair value calculation of futures to decide the no arbitrage limits on the
price of the futures contract. This is the basis for the cost-of-carry model where the
price of the contract is defined as follows.

F=S+C
Where
F - Futures
S - Spot price
C - Holding cost or Carry cost
This can also be expressed as
F = S (1+r) T
Where
r - Cost of financing
T - Time till expiration

Pricing index futures given expected dividend amount:

The pricing of index futures is also based on the cost of carry model where the
carrying cost is the cost of financing the purchase of the portfolio underlying the index,
minus the present value of the dividends obtained from the stocks in the index portfolio.

Example
Nifty futures trade on NSE as one, two and three month contracts. Money can be
borrowed at a rate of 15% per annum. What will be the price of a new two-month
futures contract on Nifty?
1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days of purchasing of contract.
2. Current value of Nifty is 1200 and Nifty trade with a multiplier of 200.
 41

3. Since Nifty is traded in multiples of 200 value of the contract is

200x1200=240000.
4. If ACC has weight of 7% in Nifty, its value in Nifty is Rs.16800 i.e.
(240000x0.07).
5. If the market price of ACC is Rs.140, then a traded unit of Nifty involves 120
shares of ACC i.e. (16800/140).
6. To calculate the futures price we need to reduce the cost of carry to the extent of
dividend received is Rs.1200 i.e. (120x10). The dividend is received 15 days
later and hence compounded only for the remainder of 45 days. To calculate the
futures price we need to compute the amount of dividend received for unit of
Nifty. Hence, we divided the compounded figure by 200.
7. Thus futures price
F = 1200(1.15) 60/365 – (120x10(1.15) 45/365)/200 = Rs.1221.80.

Pricing index futures given expected dividend yield

If the dividend flow through out the year is generally uniform, i.e. if there are few
historical cases of clustering of dividends in any particular month, it is useful to
calculate the annual dividend yield.
F = S (1+ r-q) T
Where
F- Futures price
S - Spot index value
r - Cost of financing
q - Expected dividend yield
T - Holding period
Example:
A two-month futures contract trades on the NSE. The cost of financing is 15% and the
dividend yield on Nifty is 2% annualized. The spot value of Nifty is 1200. What would
be the fair value of the futures contract?
Fair value = 1200(1+0.15-0.02) 60/365 = Rs.1224.35
 42

Pricing stock futures

A futures contract on a stock gives its owner the right and the obligation to buy
or sell the stocks. Like, index futures, stock futures are also cash settled: There is no
delivery of the underlying stock.

Pricing stock futures when no dividend is expected

The pricing of stock futures is also based on the cost of carry model, where the
carrying cost is the cost of financing the purchase of the stock, minus the present value
of the dividends obtained from the stock. If no dividends are expected during the life of
the contract, pricing futures on that stock is very simple. It simply involves the
multiplying the spot price by the cost of carry.

Example:
SBI futures trade on NSE as one, two and three month contracts. Money can be
borrowed at 15% per annum. What will be the price of a unit of new two-month futures
contract on SBI if no dividends are expected during the period?
1. Assume that the spot price of SBI is Rs.228.
2. Thus, futures price F = 228(1.15) 60/365 = Rs.223.30.

Pricing stock futures when dividends are expected

When dividends are expected during the life of futures contract, pricing involves
reducing the cost of carrying to the extent of the dividends. The net carrying cost is the
cost of financing the purchase of the stock, minus the present value of the dividends
obtained from the stock.

Example:
ACC futures trade on NSE as one, two and three month contracts.
What will be the price of a unit of new two-month futures contract on ACC if dividends
are expected during the period?
 43

1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days pf purchasing contract.
2. Assume that the market price of ACC is Rs.140/-
3. To calculate the futures price, we need to reduce the cost of carrying to the
extent of dividend received. The amount of dividend received is Rs.10/-. The
dividend is received 15 days later and hence, compounded only for the
remaining 45 days.
4. Thus, the futures price
F = 140 (1.15) 60/365 – 10(1.15) 45/365 = Rs.133.08.
44
 45

3.4 OPTIONS

An option is a derivative instrument since its value is derived from the

underlying asset. It is essentially a right, but not an obligation to buy or sell an asset.
Options can be a call option (right to buy) or a put option (right to sell). An option is
valuable if and only if the prices are varying.

An option by definition has a fixed period of life, usually three to six months.
An option is a wasting asset in the sense that the value of an option diminishes as the
date of maturity approaches and on the date of maturity it is equal to zero.
An investor in options has four choices before him. Firstly, he can buy a call option
meaning a right to buy an asset after a certain period of time. Secondly, he can buy a
put option meaning a right to sell an asset after a certain period of time. Thirdly, he can
write a call option meaning he can sell the right to buy an asset to another investor.
Lastly, he can write a put option meaning he can sell a right to sell to another investor.
Out of the above four cases in the first two cases the investor has to pay an option
premium while in the last two cases the investors receives an option premium.

3.4.1 DEFINITION:
An option is a derivative i.e. its value is derived from something else. In the
case of the stock option its value is based on the underlying stock (equity). In the case
of the index option, its value is based on the underlying index.

Options clearing corporation

The Options Clearing Corporation (OCC) is guarantor of all exchange-traded
options once an option transaction has been completed. Once a seller has written an
option and a buyer has purchased that option, the OCC takes over it. It is the
responsibility of the OCC who over sees the obligations to fulfill the exercises. If I
want to exercise an ACC November 100-call option, I notify my broker. My broker
notifies the OCC, the OCC then randomly selects a brokerage firm, which is short of
 46

one ACC stock. That brokerage firm then notifies one of its customers who have
written one ACC November 100 call option and exercises it. The brokerage firm
customer can be chosen in two ways. He can be chosen at random or FIFO basis.
Because, OCC has a certain risk that the seller of the option can’t fulfill the contract,
strict margin requirement are imposed on sellers. This margin requirements acts as a
performance Bond. It assures that OCC will get its money.

3.4.2 OPTIONS TERMINOLOGY:

Call Option:
A call option gives the holder the right but not the obligation to buy an asset by
a certain date for a certain price.

Put option:
A put option gives the holder the right but the not the obligation to sell an asset
by a certain date for a certain price.

Option price:
Option price is the price, which the option buyer pays to the option seller. It is
also referred to as the option premium.

Expiration date:
The date specified in the option contract is known as the expiration date, the
exercise date, the straight date or the maturity date.

Strike Price:
The price specified in the option contract is known as the strike price or the
exercise price.
 47

American options:
American options are the options that the can be exercised at any time up to the
expiration date. Most exchange-traded options are American.

European options:
European options are the options that can be exercised only on the expiration
date itself. European options are easier to analyze than the American options and
properties of an American option are frequently deduced from those of its European
counter part.

In-the-money option:
An in-the-money option (ITM) is an option that would lead to a positive cash
flow to the holder if it were exercised immediately. A call option in the index is said to
be in the money when the current index stands at higher level that the strike price (i.e.
spot price > strike price). If the index is much higher than the strike price the call is said
to be deep in the money. In the case of a put option, the put is in the money if the index
is below the strike price.

At-the-money option:
An At-the-money option (ATM) is an option that would lead to zero cash flow
if it exercised immediately. An option on the index is at the money when the current
index equals the strike price (I.e. spot price = strike price).

Out-of-the-money option:
An out of the money (OTM) option is an option that would lead to a negative
cash flow if it were exercised immediately. A call option on the index is out of the
money when the current index stands at a level, which is less than the strike price (i.e.
spot price < strike price). If the index is much lower than the strike price the call is said
to be deep OTM. In the case of a put, the put is OTM if the index is above the strike
price.
 48

Intrinsic value of an option:

It is one of the components of option premium. The intrinsic value of a call is
the amount the option is in the money, if it is in the money. If the call is out of the
money, its intrinsic value is Zero. For example X, take that ABC November-call option.
If ABC is trading at 102 and the call option is priced at 2, the intrinsic value is 2. If
ABC November-100 put is trading at 97 the intrinsic value of the put option is 3. If
ABC stock was trading at 99 an ABC November call would have no intrinsic value and
conversely if ABC stock was trading at 101 an ABC November-100 put option would
have no intrinsic value. An option must be in the money to have intrinsic value.

Time value of an option:

The value of an option is the difference between its premium and its intrinsic
value. Both calls and puts have time value. An option that is OTM or ATM has only
time value. Usually, the maximum time value exists when the option is ATM. The
longer the time to expiration, the greater is an options time value. At expiration an
option should have no time value.

3.4.3 CHARACTERISTICS OF OPTIONS:

The following are the main characteristics of options:
1. Options holders do not receive any dividend or interest.
2. Options holders receive only capital gains.
3. Options holder can enjoy a tax advantage.
4. Options are traded at O.T.C and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying asset.
6. Options create the possibility of gaining a windfall profit.
7. Options holders can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable the investors to gain a better return with a limited amount of
investment.
 49

3.4.4 Call Option:

An option that grants the buyer the right to purchase a desired instrument is
called a call option. A call option is contract that gives its owner the right but not the
obligation, to buy a specified asset at specified prices on or before a specified date.

An American call option can be exercised on or before the specified date. But, a
European option can be exercised on the specified date only.

The writer of the call option may not own the shares for which the call is
written. If he owns the shares it is a ‘Covered Call’ and if he des not owns the shares it
is a ‘Naked call’.

Strategies:
The following are the strategies adopted by the parties of a call option.
Assuming that brokerage, commission, margins, premium, transaction costs and taxes
are ignored.

A call option buyer’s profit/loss can be defined as follows:

• At all points where spot price < exercise price, there will be a loss.
• At all points where spot prices > exercise price, there will be a profit.
• Call Option buyer’s losses are limited and profits are unlimited.

Conversely, the call option writer’s profits/loss will be as follows:

• At all points where spot prices < exercise price, there will be a profit
• At all points where spot prices > exercise price, there will be a loss
• Call Option writer’s profits are limited and losses are unlimited.
 50

Following is the table, which explains In the-money, Out-of-the-money and At-the-

money position for a Call option.

Exercise call option Spot price>Exercise price In-The-Money

Do not exercise Spot price<Exercise price Out-of the-Money
Exercise/Do not exercise Spot price=Exercise price At-The-Money

Example:
The current price of NTPC share is Rs.260. Holder expect that price in a three
month period will go up to Rs.300 but, holder do fear that the price may fall down
below Rs.260.

To reduce the chance of holder risk and at the same time, to have an opportunity
of making profit, instead of buying the share, the holder can buy a three-month call
option on NTPC share at an agreed exercise price of Rs.250.

1. If the price of the share is Rs.300. then holder will exercise the option since
he get a share worth Rs.300. by paying a exercise price of Rs.250. holder
will gain Rs.50. Holder’s call option is In-The-Money at maturity.
2. If the price of the share is Rs.220. then holder will not exercise the option.
Holder will gain nothing. It is Out-of-the-Money at maturity.

Payoff for buyer of call option: Long call

The profit/loss that the buyer makes on the option depends on the spot price of
the underlying asset. If upon expiration, the spot price exceeds the strike price, he
makes a profit. Higher the spot price more is the profit he makes. If the spot price of the
underlying asset is less than the strike price, he lets his option un-exercise. His loss in
this case is the premium he paid for buying the option.
 51

Payoff for buyer of call option

Profit

4850
0 Nifty

86.
Loss

The figure shows the profit. The profits/losses for the buyer of the three-month Nifty
4850(underlying) call option are shown above. As can be seen, as the spot nifty rises,
the call option is In-The-money. If upon expiration Nifty closes above the strike of
4850, the buyer would exercise his option and profit to the extent of the difference
between the Nifty-close and strike price. However, if Nifty falls below the strike of
4850, he lets the option expire and his losses are limited to the premium he paid i.e.
86.60.

Payoff for writer of call option: Short call

For selling the option, the writer of the option charges premium. Whatever is the
buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike
price, the buyer will exercise the option on the writer. Hence as the spot price increases
the writer of the option starts making losses. Higher the spot price more is the loss he
makes. If upon expiration the spot price is less than the strike price, the buyer lets his
option un-exercised and the writer gets to keep the premium.
 52

Payoff for writer of call option

Profit

86.60
4850
0 Nifty

Loss

The figure shows the profits/losses for the seller of a three-month Nifty 4850
call option. If upon expiration Nifty closes above the strike of 4850, the buyer would
exercise his option on the writer would suffer a loss to the extent of the difference
between the Nifty-close and the strike price. This loss that can be incurred by the writer
of the option is potentially unlimited. The maximum profit is limited to the extent of
up-front option premium Rs.86.60.

3.4.5 Put option:

An option that gives the seller the right to sell a designated instrument is
called put option. A put option is a contract that gives the owner the right, but not the
obligation to sell a specified number of shares at a specified price on or before a
specified date.

An American put option can be exercised on or before the specified date. But,
a European put option can be exercised on the specified date only.
 53

The following are the strategies adopted by the parties of a put option.
• A put option buyer’s profit/loss can be defined as follows:
At all points where spot price<exercise price, there will be a gain.
At all points where spot price>exercise price, there will be a loss.
• Conversely, the put option writer’s profit/loss will be as follows:
At all points where spot price<exercise price, there will be a loss.
At all points where spot price>exercise price, there will be a profit.

Following is the table, which explains In-the-money, Out-of-the Money and At-the-
money positions for a Put option.

Exercise put option Spot price<Exercise price In-The-Money

Do not Exercise Spot price>Exercise price Out-of-The-Money
Exercise/Do not Exercise Spot price=Exercise price At-The-Money

Example:
The current price of RPL share is Rs.250. Holder by a three month put option at
exercise price of Rs.260. (Holder will Exercise his option only if the market price/ spot
price is less than the exercise price).
If the market/Spot price of the NTPC share is Rs.245. then the holder will exercise the
option. Means put option holder will buy the share for Rs.245. In the market and
deliver it to the option writer for Rs.260. the holder will gain Rs.15 from the contract.

Payoff for buyer of put option: Long put.

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon the expiration, the spot price is below the
strike price, he makes a profit. Lower the spot price more is the profit he makes. If the
spot price of the underlying asset is higher than the strike price, he lets his option expire
un-exercised.
 54

Payoff for buyer of put option

Profit

4850
0
61.70 Nifty

Loss

The figure shows the profits/losses for the buyer of a three-month Nifty 4850
put option. As can be seen, as the spot Nifty falls, the put option is In-The-Money. If
upon expiration, Nifty closes below the strike of 4850, the buyer would exercise his
option and make a profit to the extent of the difference between the strike price and
Nifty-close. The profits possible on this option can be as high as the strike price.
However, if Nifty rises above the strike of 1250, he lets the option expire. His losses are
limited to the extent of the premium he paid.

Payoff for writer of put option: Short put

The figure below shows the profit/losses for the seller/writer of a three-month
put option. As the spot Nifty falls, the put option is In-The-Money and the writer starts
making losses. If upon expiration, Nifty closes below the strike of 4850, the buyer
would exercise his option on writer who would suffer losses to the extent of the
difference between the strike price and Nifty-close.
 55

Payoff for writer of put option

Profit

61.70
4850
0 Nifty

Loss

The loss that can be incurred by the writer of the option is to a maximum
extent of strike price. Maximum profit is limited to premium charged by him.

3.4.6 Pricing Options:

Factors determining options value:
Exercise price and Share price:
If the share price is more than the exercise price then the holder of the call
option will get more net payoff, means the value of the call option is more. If the share
price is less than the exercise price then the holder of the put option will get more net
pay-off.

Interest Rate:
The present value of the exercise price will depend on the interest rate. The
value of the call option will increase with the rise in interest rates. Since, the present
value of the exercise price will fall; the effect is reversed in the case of a put option.
The buyer of a put option receives exercise price and therefore as the interest increases,
the value of the put option will decrease.
 56

Time to Expiration:
The present value of the exercise price also depends on the time to expiration
of the option. The present value of the exercise price will be less if the time to
expiration is longer and consequently value of the option will be higher. Longer the
time to expiration higher is the possibility of the option to be more in the money.

Volatility:
The volatility part of the pricing model is used to measure fluctuations
expected in the value of the underlying security or period of time. The more volatile the
underlying security, the greater is the price of the option. There are two different kinds
of volatility.
They are Historical Volatility and Implied Volatility. Historical volatility
estimates volatility based on past prices. Implied volatility starts with the option price
as a given, and works backward to ascertain the theoretical value of volatility which is
equal to the market price minus any intrinsic value.

Black Scholes pricing models:

The principle that options can completely eliminate market risk from a stock
portfolio is the basis of Black Scholes pricing model in 1973. Interestingly, before
Black and Scholes came up with their option pricing model, there was a wide spread
belief that the expected growth of the underlying asset ought to effect the option price.
Black and Scholes demonstrate that this is not true. The beauty of black and scholes
model is that like any good model, it tells us what is important and what is not. It
doesn’t promise to produce the exact prices that show up in the market, but certainly
does a remarkable job of pricing options within the framework of assumptions of the
model.
The following are the assumptions;
1. There are no transaction costs and taxes.
2. The risk from interest rate is constant.
3. The markets are always open and trading is continuous.
 57

4. The stock pays no dividend. During the option period the firm should not pay
any dividend.
5. The option must be European option.
6. There are no short selling constraints and investors get full use of short sale
proceeds.
The options price for a call computed as per the following Black Scholes formula:
VC =PS N (d1) - PX/ (e (RF) (T)) N (d2)
The value of Put option as per Black scholes formula:
VP=PX/(e (RF)(T)) N (-d2 )-PS N (-d1)
Where
d1= In [PS/PX] +T [RF+ (S.D) 2 / 2] / S.D (sqrt (T))
d2= d1-S.D (sqrt (T))
VC= value of call option
VP= value of put option
PS= current price of the share
PX= exercise price of the share
RF= Risk free rate of return
T= time period remaining to expiration
N (d1) = after calculation of d1, value normal distribution area is to be identified.
N (d2) = after calculation of d2, value normal distribution area is to be identified.
S.D= risk rate of the share
In = Natural log value of ratio of PS and PX

Pricing Index Option:

Under the assumptions of Black Scholes options pricing model, index options
should be valued in the way as ordinary options on common stock. The assumption is
that the investors can purchase the underlying stocks in the exact amount necessary to
replicate the index: i.e. stocks are infinitely divisible and that the index follows a
diffusion process such that the continuously compounded returns distribution of the
index is normally distributed. To use the black scholes formula for index options, we
must however, make adjustments for the dividend payments received on the index
 58

stocks. If the dividend payment is sufficiently smooth, this merely involves the
replacing the current index value S in the model with S/eqT where q is the annual
dividend and T is the time of expiration in years.

Pricing Stock Options:

The Black Scholes options pricing formula that we used to price European calls
and puts, with some adjustments can be used to price American calls and puts & stocks.
Pricing American options becomes a little difficult because, unlike European options,
American options can be exercised any time prior to expiration. When no dividends are
expected during the life of options the options can be valued simply by substituting the
values of the stock price, strike price, stock volatility, risk free rate and time to
expiration in the black scholes formula. However, when dividends are expected during
the life of the options, it is some times optimal to exercise the option just before the
underlying stock goes ex-dividend. Hence, when valuing options on dividend paying
stocks we should consider exercised possibilities in two situations. One-just before the
underlying stock goes Ex-dividend, two – at expiration of the options contract.
Therefore, owing an option on a dividend paying stock today is like owing to options
one in long maturity option with a time to maturity from today till the expiration date,
and other is a short maturity with a time to maturity from today till just before the stock
goes Ex-dividend.

3.4.7 Difference between the Futures and Options

Futures Options
1. Both the parties are obligated to 1. Only the seller (writer) is
perform. obligated to perform.
2. In futures either parties pay 2. In options the buyer pays the
premium. seller a premium.
3. The parties to the futures contract 3. The buyer of an options contract
must perform at the settlement can exercise the option at any
date only. They are obligated to time prior to expiration date.
 59
perform on the maturity date.
4. The holder of the contract is
exposed to the entire spectrum of
downside risk and had the
potential for all the upside return.
5. In futures margins are to be paid.
They are approximately 15% to
20% on the current stock price.
4. The buyer limits the downside
risk to the option premium but
retain the upside potential.
5. In options premium are to be paid.
But they are less as compare to
margin in futures.
60
 61

3.5 Swaps

Financial swaps are a funding technique, which permit a borrower to access

one market and then exchange the liability for another type of liability. Global financial
markets present borrowers and investors with a variety of financing and investment
vehicles in terms of currency and type of coupon – fixed or floating. It must be noted
that the swaps by themselves are not a funding instrument: They are devices to obtain
the desired form of financing indirectly. The borrower might otherwise as found this
too expensive or even inaccessible.

A common explanation for the popularity of swaps concerns the concept of

comparative advantage. The basis principle is that some companies have a comparative
advantage when borrowing in fixed markets while other companies have a comparative
advantage in floating markets. Swaps are used to transform the fixed rate loan into a
floating rate loan.

3.5.1 Types of swaps:

All Swaps involves exchange of a series of payments between two parties. A
swap transaction usually involves an intermediary who is a large international financial
institution. The two payment streams estimated to have identical present values at the
outset when discounted at the respective cost of funds in the relevant markets.
The most widely prevalent swaps are
1. Interest rate swaps.
2. Currency swaps.

Interest rate swaps

Interest rate swaps, as a name suggest involves an exchange of different
payment streams, which are fixed and floating in nature. Such an exchange is referred
to as an exchange of borrowings. For example, ‘B’ to pay the other party ‘A’ cash
flows equal to interest at a pre-determined fixed rate on a notional principal for a
number of years. At the same time, party ‘A’ agrees to pay ‘B’ cash flows equal to
 62

interest at a floating rate on the same notional principal for the same period of time. The
currencies of the two sets of interest cash flows are the same. The life of the swap can
range from two years to fifty years.

Usually two non-financial companies do not get in touch with each other to directly
arrange a swap. They each deal with a financial intermediary such as a bank.
At any given point of time, the swaps spreads are determined by supply and demand. If
no participants in the swaps market want to receive fixed rather than floating, Swap
spreads tend to fall. If the reverse is true, the swaps spread tend to rise. In real life, it is
difficult to envisage a situation where two companies contact a financial institution at a
exactly same with a proposal to take opposite positions in the same swap.

Currency Swaps
Currency swaps involves exchanging principal and fixed interest payments on
a loan in one currency for principal and fixed interest payments on an approximately
equivalent loan in another currency.

Example:
Suppose that a company ‘A’ and company ‘B’ are offered the fixed five years
rates of interest in US $ and Sterling. Also suppose that sterling rates are higher than
the dollar rates. Also, company ‘A’ a better credit worthiness then company ‘B’ as it is
offered better rates on both dollar and sterling. What is important to the trader who
structures the swap deal is that the difference in the rates offered to the companies on
both currencies is not same. Therefore, though company ‘A’ has a better deal. In both
the currency markets, company ‘B’ does enjoy a comparative lower disadvantage in
one of the markets. This creates an ideal situation for a currency swap. The deal could
be structured such that the company ‘B’ borrows in the market in which it has a lower
disadvantage and company ‘A’ in which it has a higher advantage. They swap to
achieve the desired currency to the benefit of all concerned.
A point to note is that the principal must be specified at the outset for each of the
currencies. The principal amounts are usually exchanged at the beginning and the end
 63

of the life of the swap. They are chosen such that they are equal at the exchange rate at
the beginning of the life of the swap.
Like interest swaps, currency swaps are frequently warehoused by financial institutions
that carefully monitor their exposure in various currencies so that they can hedge
currency risk.

CURRENTLY AVAILABLE FUTURES IN NSE

Span Margin:: Apr 09, 2012

Symbol Mlot TotMgn% TotMgnPerLt
LT 50 24.16 46531.63
LUPIN 350 47.75 86364.25
M&M 312 24.57 52743.8
WOCKPHARMA 600 33.98 73579.5
YESBANK 1100 23.82 63511.25
ZEEL 700 24.84 43057
BRIGADE 550 50.83 84899.38
MINIFTY 20 18.56 19568.55
EDELWEISS 250 57.35 144358
COLPAL 550 28.56 60401
BANKNIFTY 25 18.2 45020.6
CNX100 50 18.91 49145.13
CNXIT 50 19.33 36533.15
JUNIOR 25 25.01 65965.5
NFTYMCAP50 75 27.57 60157.13
NIFTY 50 18.54 48857.08
BAJAJAUTO 100 29.05 69763.75
BAJAJHIND 950 72.99 143518.26
BALRAMCHIN 2400 55.64 113916.24
BANKBARODA 700 29.73 90055
BANKINDIA 950 29.93 117013.14
BATAINDIA 1050 47.93 94497.88
BEL 275 37.78 175685.81
BEML 125 30.82 52850.81
BHARATFORG 1000 29.02 81487.5
BHARTIARTL 250 22.71 49283.13
BHEL 75 23.21 36348.5
BHUSANSTL 250 34.63 109680.79
BILT 1900 31 89889
 64

BINDALAGRO 4950 80.14 161261.3

BIOCON 450 30.37 55649.75
BIRLAJUTE 850 48.2 89260.63
BOMDYEING 300 40.96 95792.25
BONGAIREFN 2250 62.33 92911.22
BPCL 550 24.96 53713
BRFL 1150 30.73 103538.4
ESCORTS 2400 50.3 116255.66
ESSAROIL 5650 75.31 1004713.73
FEDERALBNK 851 30.24 84696.21
FINANTECH 150 28.68 93693.88
GAIL 750 31.72 104728.63
GDL 2500 41.26 118793.75
MAHLIFE 350 47.95 119007.8
GESHIP 600 45.21 110181
GLAXO 300 19.91 50760.75
GMRINFRA 1250 42.17 98870.72
GNFC 1475 32.11 86123.55
GRASIM 88 22.92 59727.76
GTL 750 21.77 42673.63
GUJALKALI 1400 46.77 110498.5
HAVELLS 400 41.64 92510
HCC 1400 42.64 112148.08
HCLTECH 650 25.5 40036.75
HDFC 75 19.91 41545.38
HDFCBANK 200 22.66 71799
HDIL 400 54.38 219148.88
IOC 600 38.43 114265.5
ITC 1125 24.48 54002.81
IVRCLINFRA 500 27.61 62955.54
IVRPRIME 400 141.03 146108
J&KBANK 300 30.62 73150.5
JETAIRWAYS 400 32.53 97787
JINDALSTEL 625 58.78 864736.43
JPASSOCIAT 750 40 113213.63
HINDZINC 250 38.04 53914.25
NIITLTD 1450 27.88 48236.29
JPHYDRO 3125 58.71 156408.89
REDINGTON 500 33.85 59234.75
NETWORK18 500 45.03 80485
NAUKRI 150 39.08 59415.16
MICO 50 29.14 56244.75
WWIL 3150 70.62 111684.51
KPIT 1650 48.75 70876.25
 65

GITANJALI 500 34.68 55199.53

GBN 250 39.41 100070.02
JSTAINLESS 1000 52.02 84402.5
JSWSTEEL 275 38.47 99491.86
KESORAMIND 500 39.35 90181.25
KOTAKBANK 275 34.11 101976.88
KTKBANK 1250 33.46 110718.75
LAXMIMACH 100 42.34 99031.25
LICHSGFIN 850 46.71 125403.27
LITL 425 59.42 136749.97
ORIENTBANK 1200 30.85 104184
ISPATIND 4150 67.59 127490.91
HINDOILEXP 1600 62.68 115232.3
PANTALOONR 500 29.24 94956.25
PARSVNATH 700 57.37 118758.5
GTOFFSHORE 250 41.53 82974.38
PATELENG 250 35.18 67252.47
DCB 1400 48.31 83605.98
JINDALSAW 250 43.18 98152.29
PATNI 650 34.23 58565
PENINLAND 2750 73.98 203059.51
PETRONET 2200 49.26 83836.5
PFC 1200 38.82 90924.05
PNB 600 30.19 123654
POLARIS 1400 126.22 153209
POWERGRID 1925 35.31 79465.17
PRAJIND 1100 47.17 83851.42
PUNJLLOYD 750 28.34 98700.35
PURVA 500 28.84 53158.75
RAJESHEXPO 1650 48.9 110055
RANBAXY 800 22.45 62964
RCOM 350 28.78 65033.5
REL 550 42.93 496514.63
RELCAPITAL 550 41.59 475616.09
RELIANCE 75 25.43 49085.69
SUNTV 500 74.6 124632.5
SUZLON 1000 26.94 85160
SYNDIBANK 1900 35.1 70808.25
TATACHEM 675 36.66 82285.88
TATAMOTORS 412 21.27 62665.91
TATAPOWER 200 37.66 96260.49
TATASTEEL 382 26.72 71268.67
TATATEA 275 35.52 76882.94
TCS 250 23.41 49917.38
 66

TECHM 200 33.83 48996.5

TITAN 206 33.59 84016.23
TRIVENI 1925 57.61 147068.69
TTML 5225 50.01 102842.22
TULIP 250 35.95 85200.5
TVSMOTOR 2950 39.51 50994.44
ULTRACEMCO 200 49.88 89206
UNIONBANK 2100 35.36 155817.1
UNIPHOS 700 29.72 71765.75
UNITECH 900 41.86 154479.88
VIJAYABANK 3450 42.26 103456.88
INFOTECH 1350 52.36 91550.25
ABAN 50 32.52 61735
ABB 250 24.08 72756.25
ABIRLANUVO 200 31.41 122529.5
ACC 375 25.75 77018.19
ADLABSFILM 225 61.58 160207.24
AIAENG 200 30.13 83456
AIRDECCAN 850 53.95 86339.68
ALBK 2450 38.18 113245.63
ALOKTEXT 3350 33.27 81162.19
AMBUJACEM 2062 17.33 41028.73
AMTEKAUTO 600 20.84 40933.5
ANDHRABANK 2300 37.98 83564.75
ANSALINFRA 650 107.95 197206.61
APIL 200 29.64 44457.5
APTECHT 650 54.2 89331.28
ARVINDMILL 4300 55.53 121540.06
ASHOKLEY 4775 41.88 73308.19
AUROPHARMA 350 62.92 79457
AXISBANK 225 27.29 69879.69
CAIRN 1250 28.93 69359.38
CANBK 800 39.51 94484
CENTRALBK 2000 35.7 80375
CENTURYTEX 425 40.65 171034.31
CESC 550 29.36 79321
CHAMBLFERT 3450 69.05 121034.23
CHENNPETRO 900 36.47 104580
CIPLA 1250 24.33 55834.88
CMC 200 48.95 80584
CORPBANK 600 25.44 54349.5
CROMPGREAV 500 27.29 49883.75
CUMMINSIND 475 23.34 34913.69
DABUR 2700 32.89 87399
 67

DENABANK 2625 51.81 100717.51

DIVISLAB 155 30.52 73007.55
DLF 400 27.94 99462
DRREDDY 400 26.01 58278
EDUCOMP 75 41.17 122344.16
EKC 1000 27.57 81609.2
HEROHONDA 400 22.76 63484
HINDALCO 1595 35.31 97901.55
HINDPETRO 1300 34.68 118995.5
HINDUJAVEN 250 90.94 135832.3
HINDUNILVR 1000 23.03 45597.5
HOTELEELA 3750 43.69 77659.33
HTMTGLOBAL 250 107.46 87540.61
I-FLEX 150 45.88 74038.13
ICICIBANK 175 25.85 57787.38
IDBI 1200 45.97 69708.89
IDEA 2700 27.64 82599.75
IDFC 1475 29.34 90955.54
IFCI 7875 55.29 266938.43
INDHOTEL 1750 31.91 78168.63
INDIACEM 725 35.09 52343.44
INDIAINFO 250 38.13 121979.66
INDIANB 1100 37.9 90795.6
INDUSINDBK 1925 47.65 91592.39
INFOSYSTCH 100 34.85 50579.5
IOB 1475 30.32 82836.5
MAHSEAMLES 600 44.05 112305
MARUTI 200 22.07 38176
MATRIXLABS 1250 48.3 97450.5
MCDOWELL-N 125 30.01 65615.83
MOSERBAER 825 32.07 59346.38
MPHASIS 800 27.5 52720
MRPL 2225 63.64 121365.34
MTNL 1600 39.67 83976
NAGARCONST 1000 27.25 78179.84
NAGARFERT 3500 67.31 97074.18
NATIONALUM 575 32.77 76297.94
NDTV 550 26.84 59554.5
NEYVELILIG 1475 68.04 144831.98
NICOLASPIR 1045 32.59 103512.78
NIITTECH 600 106.7 97092.72
NTPC 1625 35.2 121802.13
NUCLEUS 550 68.19 102542.5
OMAXE 650 70.97 146291.01
 68

ONGC 225 28.1 63338

ORCHIDCHEM 1050 37.53 95127.88
RENUKA 500 44.9 213297.5
RNRL 7150 62.37 645542.97
ROLTA 900 42.18 104604.75
RPL 1675 40.63 114850.31
SAIL 1350 37.39 109684.36
SASKEN 550 127.11 103614.5
SATYAMCOMP 600 21.04 50206.5
SBIN 132 20.3 61807.3
SCI 800 44.64 81218.64
SESAGOA 75 43 103348.19
SHREECEM 200 28.08 73499
SIEMENS 188 21.22 69590.66
SKUMARSYNF 1300 48.71 76157.25
SOBHA 350 37.4 99026.88
SRF 1500 52 90562.5
STAR 850 91.9 140337.13
STER 219 28.4 49428.33
STERLINBIO 1250 30.31 65203.13
STRTECH 1050 70.74 169434.47
SUNPHARMA 225 21.78 48561.69
VOLTAS 900 36.71 72581.79
VSNL 525 36.24 98082.13
WELGUJ 800 33.15 135900.47
WIPRO 600 20.12 48781.5
69
 70

4.1 FUTURES
Profit/Loss for a Future contract holder
Example:

On 7th Jan 2012 REL is trading at 2100 and REL Jan 2011 Contract is trading @ 2120.
We expect the share price to rise significantly and want to make a profit from the
increase.
Lot size of REL is 550
Span Margin for REL Future is 42.93% on the contract value

If an Investor bought 1 REL Future @ 2120 on 7th January 2012 and the closing price
of REL Future on 16th Jan 2012 is 2600. To make profit from this transaction the buyer
of the contract can sell the Future and book profit.
Span Margin Payable for buying REL Contract = 2120x550x42.93%=500563
Capital Invested on this contract is Rs.500563/-

On 16th Jan 2012 REL January Contract is trading @2600, If the investor sold the
contract then he would have gained profit of Rs.264000/-
Profit = (2600-2120) x 550 = Rs.264000/-

On 23rd Jan 2012 REL Jan Future closed @ 1600; if the investor holds the future till
date. His Mark to Market loss is as follows
Mark to Market Loss = (1600-2120) x 550 = Rs.286000/-

Investor has to pay/receive the margin with respect to the yesterday’s closing price and
to the today’s closing price.
Mark to Market margin payable/receivable = (Today’s Closing price – Yesterdays
Closing Price) x Lot Size
 71

4.2 BASIC OPTION STRATEGIES:

Buyer of the Call Option

Market View Bullish

Action Buy a call option
Profit Potential Unlimited
Loss Potential Limited

To make a profit from an expected increase in the price of an underlying share during
option’s life:
Case 1: On 30th Nov 2011, IOC is quoting at Rs.538. and the December Rs.560 (strike
price) Call costs Rs.32 (premium). We expect the share price to rise significantly and want
to make a profit from the increase.
Lot Size of IOC is 600
(i) IOC Dec 2011 CA 560 is trading @ 32 (Buying Out of Money Call Option):
Buy 1 IOC call at Rs.32, Market lot for IOC is 600. So, Net outlay is Rs.19200 (32x600). If
IOC shares go up, we can close the position either by selling the option back to the market
or exercising the right to buy the underlying shares at the exercise price.
On Expiry (27th Dec 2011) Market Price of IOC is Rs. 713/-
DATE Share Strike Call CALL OPTION VALUE
price Price Premiu
(Cash m
market)
30th Nov Rs.538 560 32 Buy 1 Dec 560 Call @ Rs.32
Cost = 19200
th
27 Dec Rs. 713 560 153 1. Sell 1 Dec contract (expiry)
Net gain Rs.153 (713--560)*600
= Rs.91800
Analysis Rises by 560 Gain:
Rs.175. Option sale = Rs.91800
Return Premium Paid = Rs.19200.
32.5% Net Profit = Rs.72600.
 72

Possible Outcome of IOC If the Spot price is not @ 713 on Expiry:

Share price Rs.713 Option worth Rs.91800. Closing the
position now will produce a net profit of
Rs.72600
Spot price < 560 Option expires worthless. The loss is
Rs.19200 (premium paid)
Share price >= 592 Net profit = Intrinsic value of (Break even
= 560+32) option i.e. by whatever amount
the share price exceeds Rs.592.

To establish a maximum cost at which to purchase shares at a lesser date if funds are not
available immediately:
(ii) IOC Dec 2011 CA 520 is trading @ 47 (Buying In the Money Call Option):
Buy 1 Dec 2011 IOC 520 call option at Rs.47 for total outlay of Rs.28200 on 30th Nov.
On Expiry 27th Dec 2011 Price of IOC is 713

DATE Share price Strike Call CALL OPTION VALUE

(Cash Price Premiu
market) m
30th Nov Rs.538 520 47 Buy 1 Dec 520 Call @ Rs.47
Cost = 28200
27th Dec Rs. 713 520 193 1. Sell 1 Dec contract (expiry)
Net gain Rs.193 (713-520)*600 =
Rs.115800
Analysis Rises by 520 Gain:
Rs.175. Return Option sale = Rs.115800
32.5% Premium Paid = Rs.28200.
Net Profit = Rs.87600.
 73

Possible outcomes at Expiry:

Share price Rs.713 Option worth Rs.115800. Closing the

position now will produce a net profit of
Rs.87600
Spot price < 520 Option expires worthless. The loss is
Rs.28200 (premium paid)
Share price >= 567 Net profit = Intrinsic value of (Break even
= 520+47) option i.e. by whatever amount
the share price exceeds Rs.567.

Writing a Call Option :

To earn additional income from a static shareholding, over and above any dividend
earnings, in terms of premium received on writing the option (Covered short call).

Market View Bearish/Neutral

Action: Sell call against an existing shareholding
Profit Potential Limited
Loss Potential Limited

Situation: On 30th Nov GMRINFRA share is trading at Rs.245. An investor holds 5000
shares of GMRINFRA. He does not expect its price to move very much in the next few
months. So, he decides to write a call option against this shareholding.

Action: The Dec 260 call is trading at Rs.15 and investor sells 5 contracts (one contract =
1000 shares). He received an option premium of Rs.75000 and takes on the obligation to
deliver 5000 shares at Rs.260 each if the holder exercises the option
 74

Date Share price

(Cash market) Option market
30th Nov Rs.245 Sell 5 Dec 260 calls @
Rs.15
Income = Rs.75000
(15x5000).
27th Dec Rs.248 Option expires worthless
Analysis No change in shareholding Profit = Rs.75000
(Option Premium received)

Possible Outcomes at Expiry:

Share > Rs.260 The holder will exercise his option.

Share price < 260
Share Price = 260
The investor as a writer will sell shares
originally purchased for Rs.245 at Rs.275
(260+15).
The option expires worthless.
Option won’t be exercised as there is no
price difference.
 75

Buyer of a Put Option

Market View Bearish
Action Buy a Put option
Profit Potential Unlimited
Loss Potential Limited

To make profit, from a fall in value of share price:

Situation: Current price of NTPC is @ Rs.280 on 14th Nov 2011. An investor thinks that
NTPC is overvalued and may fall substantially. He therefore decides to buy Put option to
gain exposure to its anticipated fall.
Action: Buy 1 NTPC NOV Rs.270 Put at Rs.10 for a total consideration of Rs.16250.
Share price
(Cash market) Option market
14th Nov Rs.280 Buy 1 NTPC NOV put at
Rs.10.
Total outlay = Rs.16250.
29th Nov Rs.235 Sell 1 July contract.
Net gain = Rs.56875
[Rs.35(270-235)x1625]
Analysis Fall of share price Rs.45. Option purchase =
Rs.16250
Option sale = Rs.56875.
Net profit = Rs.40625.
Possible Outcomes at Expiry: If NPTC is trading at diff. prices:

Share price = Rs.235 The put will be trading at Rs.35, which

gives a profit of Rs.25 (35-10)*1625, if the
position is closed out.
Share price is 260 Recover intrinsic value premium.
Share Price is between 260 to 270 Loss of Premium Varies from 1625 to
16250/-
Share Price is > 270 Loss of Premium Paid
 76

Writing a PUT Option:

Market View Bullish/neutral
Action Sell put option
Profit Potential Limited
Loss Potential Unlimited

To generate earnings on portfolio of shares:

Situation: An investor owns 5500 shares of REL and also has cash holding of around
Rs.10000000. In early April he feels that the share price of REL will either remain constant
or slightly rise.
Action: The investor decides to generate some additional income on his portfolio hence
writes 10 REL Rs.1800 puts. Thus he received a premium of Rs.220000 (40x5500 shares).

Possible Outcome at Expiry:

Share price > (or) = Rs.1800
Share price < Rs.1800
The investor’s expectation is correct and
the put will expire unexercised.
Profit = Rs.220000 (premium received).
The put option will be exercised and the
stock will have to be purchased for
Rs.7700000 (9900000-220000).
 77

CHAPTER-5
CONCLUSIONS

 Derivatives have existed and evolved over a long time, with roots in
commodities market. In the recent years advances in financial markets and the
technology have made derivatives easy for the investors.
 Derivatives market in India is growing rapidly unlike equity markets. Trading in
derivatives require more than average understanding of finance. Being new to
markets maximum number of investors have not yet understood the full
implications of the trading in derivatives. SEBI should take actions to create
awareness in investors about the derivative market.
 Introduction of derivatives implies better risk management. These markets can
give greater depth, stability and liquidity to Indian capital markets. Successful
risk management with derivatives requires a thorough understanding of
principles that govern the pricing of financial derivatives.
 In order to increase the derivatives market in India SEBI should revise some of
their regulation like contract size, participation of FII in the derivative market.
Contract size should be minimized because small investor cannot afford this
much of huge premiums.
 In cash market the profit/loss is limited but where in F& O an investor can enjoy
unlimited profits/loss.
 At present scenario the Derivatives market is increased to a great position. Its
daily turnover teaches to the equal stage of cash market.
 The derivatives are mainly used for hedging purpose.
 In cash market the investor has to pay the total money, but in derivatives the
investor has to pay premiums or margins, which are some percentage of total
oney.
 In derivative segment the profit/loss of the option holder/option writer is purely
depended on the fluctuations of the underlying asset.
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CHAPTER-6

Suggestions to Investors
The investors can minimize risk by investing in derivatives. The use of derivative
equips the investor to face the risk, which is uncertain. Though the use of derivatives
does not completely eliminate the risk, but it certainly lessens the risk.
It is advisable to the investor to invest in the derivatives market because of the greater
amount of liquidity offered by the financial derivatives and the lower transactions costs
associated with the trading of financial derivatives.
The derivatives products give the investor an option or choice whether to exercise the
contract or not. Options give the choice to the investor to either exercise his right or
not. If on expiry date the investor finds that the underlying asset in the option contract
is traded at a less price in the stock market then, he has the full liberty to get out of the
option contract and go ahead and buy the asset from the stock market. So in case of
high uncertainty the investor can go for options.
However, these instruments act as a powerful instrument for knowledgeable traders to
expose them to the properly calculated and well understood risks in pursuit of reward
i.e. profit.
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Bibliography
Books:-

Indian financial system - M.Y. Khan

Investment management - V.K. Bhalla

Publications of National Stock Exchange

News Papers:-

 The Financial Express

 Business World

 Economic Times

Websites
www.nseindia.org
www.bseindia.com
www.Unicon.com
www.sebi.gov.in
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GLOSSARY
Derivatives - Derivatives are instruments that derive their value and payoff from
another asset, called underlying asset.

Call Option – the option to buy an asset is known as a call option

Put option – the option to an asset is called a put option.
Exercise Prices – The price at which option can be exercised is called an exercise price
or a strike price.

European option – Where an option is allowed to be exercised only on the maturity

date, it is called a European option

American option – When the option can be exercised any time before its maturity, it is
called an American Option.

In-the-money option – A put or a call option is said to in-the-option when it is

advantageous for the investor to exercise it. In the case of in-the-money call option, the
exercise price is less than the current value of the underlying asset, while in the case of
the in-the-money put options; the exercise price is higher than the current value of stage
underlying asset.

Out-of-the money option – A put or call option is out-of-the-money if it is not

advantageous for the investor to exercise it. In the case of the out-of-the-money call
option, the exercise price is less than the current value of the underlying asset,

While in the case of the out – of-the-money put option, the exer4cise price is lower than
the current value of the underlying asset.

At-the-option – When the holder of a put or a call option does not lose of gain whether
of not he exercises his option, the option is said to be at-the-money. In the case of the
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out-of-the-money option the exercise price is equal to the current value of the
underlying asset.

Straddle – The investor can also create a portfolio of a call and a put with the same
exercise price. This is called a straddle.

Spread – If call and put with different exercise price are combined, it is called a spread.

Strip – A strips is a combination of two puts and one call with the same exercise price
and the expiration date.

Strap – A strap, on the other hand, entails combing two calls and one put.

Swaps – Swaps are similar to futures and forwards contracts in providing hedge against
financial risk. A swap is an agreement between two parties, called counterparties, to
trade cash flows over a period of time.

Currency Swaps – Currency swaps involves an exchange of payments in one currency

for cash payments in another currency.

Bullish spread – An investor may be expecting the price of an underlying share to rise.
But he may not like to take higher risk.

Bearish Spread – An investor, who is expecting a share of index to0 fall, may sell the
higher-*priced option and buy the lower-price option.

Index options – Index options are call or put options on the stock markets indices. In
India, there are options on the Bombay Stock Exchange, Sensex and the national Stock
Exchange, Nifty.

Premium – The price of an option contract, determined on the exchange which the
buyer of the option pays to the options writer for the fights to the option contract.
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Futures – Futures is a financial contract which derives its value for the underlying
asset.

Financial Futures – Futures are traded in a wide variety of commodities: wheat, sugar,
gold, silver, copper, oranges, coco, oil soybean etc.

Forward – In a forward contract, two parties agree to buy or sell some underlying
asset on some future date at a stated price and quantity.

Index futures – Index futures is one of the most successful financial innovation of the
financial market. In 1982, the stock index future was introduced.

Margin – Depending upon the nature of the buyer and seller the margin requirement to
deposit with the stock exchange is fixed.

Mark to Market – A process of valuing an open position on a futures market against

the ruling price of the contract at that time, in order to determine the size of the margin.

Hedging – Hedging is the term used for reducing risk by using derivatives.