A

PROJECT REPORT

ON COMPARATIVE STUDY ON DERIVATIVE MARKET

AT

SHAREKHAN LIMITD Hyderabad

Submitted by Kavita Jain (H.No. 200627577)

Symbiosis Centre for Distance Learning (SCDL) In partial fulfillment of the requirements for the award of

MASTERS OF BUSINESS ADMINISTRATION (2009-2010)

PGDHRM PUNE

DECLARATION

I hereby declare that the project report titled COMPARATIVE STUDY ON DERIVATIVE MARKET submitted in partial fulfillment of the requirements for the POST GRADUATION OF MASTERS IN BUSINESS ADMINISTRATION, from fromSymbiosis Centre for Distance Learning (SCDL) PUNE, is my original work and not submitted for the award of any other Degree, Diploma, Fellowship or prizes.

DATE: PLACE:HYDERABAD

KAVITA JAIN (HT.NO. 200627577)

CERTIFICATE

This is to certify that the project report entitled COMPARATIVE STUDY ON DERIVATIVE MARKET carried at SHAREKHAN LIMITED is a bonafide work done by Miss.Kavita jain, bearing Roll No. 200627577 a student of MBA (Finance) of Symbiosis Centre for Distance Learning (SCDL) and submitted the same in partial fulfillment for the award of the degree of MASTER OF BUSINESS ADMINISTRATION affiliated to PUNE UNIVERCITY for the scholastic year 2009-10.

We found the work carried out by her to be good. We wish her success in all future endeavors.

Mr.xxxxxx. (Internal Project Guide) LECTURE IN FINANCE

EXTERNAL (Examiner)

(Mr.xxxxxxxxxxxxxxx) (Principal)

ACKNOWLEDGEMENT

I take this opportunity to express my sincere gratitude to the staff of Symbiosis Centre for Distance Learning (SCDL). I specially thank THE MANAGEMENT AND STAFF OF SHAREKHAN LIMITED for creating out the study and for their guidance and encouragement that made the project very effective and easy. I sincerely express my gratitude to Mr.Ajay Sharma, SHAREKHAN LIMITED, for his guidance and support throughout my project.

I would like to thank Mr.Ajay Sharma for guiding and directing me in the process of making this project report and for all the support and encouragement.

INDUSTRY PROFILE

COMPANY PROFILE

ABOUT SHAREKHAN LIMITED Sharekhan Limited is one of the fastest growing financial services providers with a focus on equities, derivatives and commodities brokerage execution on the National Stock Exchange of India Ltd. (NSE), Bombay Stock Exchange Ltd. (BSE), National Commodity and Derivatives Exchange India (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX). Sharekhan provides trade execution services through multiple channels - an Internet platform, telephone and retail outlets and is present in 280 cities through a network of 704 locations. The company was awarded the 2005 Most Preferred Stock Broking Brand by Awwaz Consumer Vote.

ORIGIN Sharekhan traces its lineage to SSKI, an organization with more than decades of trust and credibility in the stock market. Pioneers of online trading in India- Sharekhan.com was launched in 2000 and is now the second most visited broking site in India. Has one of the largest networks of Share shops in the country. SHAREHOLDING PATTERN SHAREHOLDERS CITI Venture Capital and other Private Equity Firm IDFC Employees MANAGRMENT TEAM CONSISTS OFHOLDINGS 81% 9% 10%

NAME Tarun Shah Mr. Pathik Gandotra Mr. Rishi Kohli Jaideep Arora Shankar Vailaya

POST Chief Executive Officer Head Of Research Vice President Of Equity Derivative Director- Products And Technology Director- Operation

Sharekhan Limited offers blend of tradition and technology like Share shops, dial-ntrade and online trading- where there is choice of three trading interfaces which are speed trade exe for active trader, web based classic interface for investor, web based applet- fast trade for investor. Sharekhan Limited was formerly known as SSKI Investor Services Private Limited. The company is based in Mumbai, India and its address is- A-206 Phoenix House, 2nd Floor Senapati Bapat Marg, Lower Parel Mumbai, 400 013. India Phone: 91 22 24982000 Fax: 91 22 24982626

www.sharekhan.com Advanced Technology Used By Sharekhan Sharekhan selected Aspect EnsemblePro from the Aspect Software Unified IP Contact Center product line, a unified contact centre solution delivering advanced multichannel contact capabilities, because it provided the best total value over other solutions evaluated. It enabled Sharekhan to meet customer service needs for inbound call handling, voice self service, predictive outbound dialing, call blending, call monitoring and recording, and creating outbound marketing campaigns, among other capabilities. This helps them to

 Increased agent efficiency and productivity. Enabled company to execute proactive customer service calls and expand services offered to customers. Enhanced call monitoring for improved service quality Financial services are a highly competitive and volume-driven industry which demands high standards of customer service, effective consultation and quick deliverables. This is something Sharekhan Limited, a financial services provider based in India, understands. The company offers several user-friendly services for customers to manage their stock portfolios, including online capabilities linked to an information database to help customers confidently invest, and inbound customer services using voice self-service technology and customer service agents handling telephone orders from clients. With a customer base of more than 500000, and a employee of 3100 Sharekhan continues to grow at a fast pace. Customer satisfaction is a top priority in Sharekhans agenda.

Its primary objective Is to help and support its customers in managing their portfolio in the best possible manner through quality advice, innovative product and superior service. Scheme which are provided by Sharekhan cover almost every segment of the customer-

SCHEME First Step Classic Speed Trade Platinum Circle

INVESTOR New Comer Trade Occasionally Day Trader High Net Worth Individuals

DERIVATIVES

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INTRODUCTION

Derivatives are products whose value is derived from one or more variables called bases. These bases can be underling asset such as foreign currency, stock or commodity, bases or reference rates such as LIBOR or US treasury rate etc. Example, an Indian exporter in anticipation of the riceipt of dollar denominated export proceeds may wish to sell dollars at a future date to eliminate the risk of exchange rate volatility by the data. Such transactions are called derivatives, with the spot price of dollar being the underling asset.

Derivatives thus have no value of their own but derive it from the asset that is being dealt with under the derivative contract. A financial manager can hedge himself from the risk of a loss in the price of a commodity or stock by buying a derivative contract. Thus derivative contracts acquire their value from the spot price of the asset that is covered by the contract. The primary purposes of a derivative contract is to transfer risk from one party to another i.e. risk in a financial sense is transfer from a party that is willing to take it on. Here, the risk that is being dealt with is that of price risk. The transfer of such a risk can therefore be speculative in nature or act as a hedge against price movement in a current or anticipated physical position.

Derivatives or derivative securities are contracts which are written between two parties (counterparties) and whose value is derived from the value of underlying widely-held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short term and long-term and long term 11

financial instruments or intangible things like commodities price index (inflation rate), equity price index or bond piece index. The counterparties to such contracts are those other than the original issuer (holder) of the underlying asset. Derivatives are also known as deferred delivery or deferred payment instruments. In a sense, they are similar to securitized assets, but unlike the latter, they are not the obligations which are backed by the original issuer of the underlying asset or security. It is easier to take a short position in derivatives than in other possible to combine them to match specific requirements, i.e., they are more easily amenable to financial engineering.

The values of derivatives and those of their underlying assets are closely related. Usually, in trading derivatives, the taking or making of delivery of underlying assets is not involved; the transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims which can be traded in respect of underlying assets. Derivatives are off balance sheet instruments, a fact that is said to obscure the leverage and financial might they give to the party. They are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the companies (warrants, convertibles being the exceptions). Although the standardized, general, exchange-traded derivatives are being contracts which are in vogue and which expose the users to operational risk, counterparty risk, liquidity risk, and legal risk. There is also an uncertainty about the regulatory status of such derivatives.

There are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously: plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC-traded, standardized or organized-exchange traded. Although we are not going to discuss all of them, the names of certain derivatives may be noted here: futures, options, range forward and ratio range forward options, swaps, warrants, convertible bonds, credit derivatives, captions, swaptions, futures options, the ratio swaps, periodic floors, spread lock one and two, treasury-linked swaps, wedding bands three and six, inverse floaters, index amortizing swaps, and so on; because of

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their complexity, derivatives have become a continuing pain for the accounting person and a true mind-bender for anyone trying to value them.

The turnover of the stock exchanges has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Mutual funds, FIIs and other investors who are deprived of hedging (i.e. risk reducing) opportunities will now have a derivatives market to bank on.

While derivatives markets flourished in the developed world, Indian markets remain deprived of financial derivatives to the beginning of this millennium. While the rest of the world progressed by leaps and bounds on the derivatives front, Indian market lagged behind. Having emerged in the markets of the developed nations in the 1970s, derivatives markets grew from strength to strength. The trading volumes nearly doubled in every three years making it a trillion-dollar business. They became so ubiquitous that, now, one cannot think of the existence of financial markets without derivatives.

Two broad approaches of SEBI is to integrate the securities market at the national level, and to diversify the trading products, so the more number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc., choose to transact through the exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI exchange in the year 2000 is a real landmark.

Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk. In view of this problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the 13

introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivative trading in India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the phased introduction of the derivatives trading beginning with stock index futures. The Board also approved the suggestive bye-laws recommended for regulation and control of trading and settlement of derivatives contracts. However the securities contracts (regulation) act, 1956 (SCRA) needed amendment to include derivatives in the definition of securities to enable SEBI to introduce trading in derivatives. The government in the year 1999 carried out the necessary amendment. The securities Laws (Amendment) bill 1999 was introduced to bring about the much needed changes. In December 1999 the new framework has been approved derivatives have been accorded the status of securities. The ban imposed on trading in derivatives way back in 1999 under a notification issued by the central Government has been revoked. Thereafter SEBI formulated the necessary regulations/bye-laws and started in India at NSE in the same year and BSE started in the year 2001. In this module we are covering the different types of derivatives products and their features, which are traded in the stock exchanges in India.

NATURE OF THE PROBLEM:

The turnover of the stock exchanges has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools.

Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk. In view of this problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. 14 SEBI thought the

introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivative trading in India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the phased introduction of the derivatives trading beginning with stock index futures.

There are many investors who are willing to trade in the derivative segment, because of its advantages like limited loss and unlimited profit by paying the small premiums.

OBJECTIVES OF THE STUDY: To analyze the derivatives market in India. To analyze the operations of futures and options. To find out the profit/loss position of the option writer and option holder. To study about risk management with the help of derivatives.

SCOPE OF THE STUDY: The study is limited to Derivatives with special reference to futures and options in the Indian context and the Hyderabad stock exchange has been taken as a representative sample for the study. The study cant be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluating derivatives market only in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, NYSE etc.

LIMITATIONS OF THE STUDY:

The following are the limitations of this study: The scrip chosen for analysis is ONGC and the contract taken is August and September 2005. 15

 The data collected is completely restricted to the ONGC of August and September 2005. Hence this analysis cannot be taken as universal. The term Derivative indicates that it has no independent value, i.e. its value is entirely derived from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In other words, derivative means a forward, future, option or any other hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

DEFINITION:

Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include:1. A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract, which derives its value from the prices, or index of prices, of underlying securities.

The above definition conveys:

i. underlying ii.

That derivative is financial products and derives its value from the assets. Derivative is derived from another financial instrument/contract called

the underlying. In this case of nifty index is the underlying.

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PARTICIPANTS/USES OF DERIVATIVES:

1. Hedgers use for protecting (risk-covering) against adverse movement. Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.

2. Speculators to make quick fortune by anticipating/forecasting future market movements. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Speculators on the other hand arte those classes of investors who willingly take price risks to profit from price changes in the underlying.

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3. Arbitrageurs to earn risk-free profits by exploiting market imperfections. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in the two different markets. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by the derivatives markets. They are: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Derivative trading acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase savings and investment in the long run.

TYPES OF DERIVATIVES:

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products, in recent years, the market for financial derives has grown tremendously in terms of variety of instruments depending on their complexity and also turnover. In this class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are maor users of index-linked derivatives. Even small investors find these useful due to 18

high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis--vis derivative products based on individual securities is another reason for their growing use.

The most commonly used derivatives contracts are forwards, futures and options. Here we take a brief look at various derivatives contracts that have come to be used.

CLASSIFICATION OF DERIVATIVES: 1. ETF (Exchange Traded Fund) 2. OTF ( Out Side Traded Fund)

ETF (Exchange Traded Fund): An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Futures Options

OTF (Out Side Traded Fund):

Forwards Swaps Warrants Leaps Baskets

OTF(FORWARDS,SWAPS,WARRANTS,LESAPS,BASKETS) 19

FORWARDS:

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

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 exchanged-traded contracts.

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

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

BASKETS:

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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 prearranged formula. They can be regarded as portfolios of forward contracts.

The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

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

SWAPTIONS:

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

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REGULATORY FRAMEWORK

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REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SCRA, the SEBI Act, the rules and regulations framed there under and the rules and byelaws of stock exchanges.

Securities contracts Regulation Act, 1956 SCRA aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term securities has been defined in the SCRA. As per section 2(h), the securities include: 1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes 4. Government securities 5. Such other instruments as may be declared by the Central Government to be securities 6. Rights or interests in securities.

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Derivative is defined to include: A security derived from a debt instrument, share and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices or index of prices, of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are: Traded on a recognized stock exchange settled on the clearinghouse of the recognized stock exchange, in accordance with the rules and byelaws of such stock exchanges.

Securities and exchange board of India act, 1992 SEBI act, 1992 provides for establishment of securities and exchange board of India (SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) Promoting the development of the securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit.

In particular, it has powers for: Regulating the business in stock exchanges and any other securities markets. Registering and regulating the working of stockbrokers, sub broker etc. Promoting and regulating self-regulatory organizations. Prohibiting and fraudulent and unfair trade practices.

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Calling information from, undertaking inspection, conducting inquiries and audits the stock exchanges, mutual funds and other persons associated with the securities marker and intermediaries and self-regulatory organizations in the securities market performing such functions and exercising according the securities contracts (regulation) act, 1956, as may be delegated to it by the central government.

SEBI (stock brokers and sub-brokers) regulations, 1992 In this we shall have a look at the regulations that apply to brokers under the SEBI regulations. Brokers: A broker is an intermediary who arranges to buy and sell securities on behalf of clients (the buyer and the seller). According to Section 2(e) of the SEBI (stockbrokers and sub-brokers) rules 1992, s Stock Broker means a member of a recognized stock exchange. NO stockbroker is allowed to buy, sell or deal in securities, uses he or she holds a certificate of registration granted by SEBI through a stock exchange of which he or she is admitted as a member. SEBI may grant a certificate to a stock-broker (as per SEBI rules, 1992) subject to the conditions that: 1. He holds the membership of any stock exchange: 2. He shall abide by the rules, regulations and byelaws of the stock exchange or stock exchanges of which he is a member. 3. In case of any change in the status and condition, he shall contain prior permission of SEBI to continue to buy, sell or deal in securities in any stock exchange; 4. He shall pay the amount of fees for registration in the prescribed manner; and 5. HE shall take adequate steps for redress of grievances of the investors within one month of the date of the complaint and keep SEBI informed about the number, nature and other particulars of the complaints.

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As per SEBI (stock brokers and sub-brokers) regulations, 1992, SEBI shall take into account for considering the grant of a certificate all matters relating to buying, selling, or dealing in securities and in particular the following, namely whether the stockbroker-(a) is eligible to be admitted as a member of a stock exchange; (b)has the necessary infrastructure like adequate office space, equipment and man power to effectively discharge his activities; (c) has any past experience in the business of buying selling or dealing in securities; (D) is subjected to disciplinary proceedings under the rules, regulations and bye-laws of a stock exchange with respect to his business as a stock-brokers involving either himself or any of his partners, directors or employees.

Regulations for derivatives trading SEBI set up a 24-member committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with tock index futures. SEBI also approved the suggestive bye-laws recommended by the committee for regulation and suggestive bye-laws recommended by the committee for regulation and control of trading and settlement of derivatives contracts.

1. The provisions in the SC(R)A and regulatory framework developed there under govern trading in securities. 2. The amendment of the SC(R)A to include derivatives within the ambit of securities in the securities in the SC(R)A made trading in derivatives possible within the framework of that Act. 3. Any Exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee report may apply to SEBI for grant of recognition under section 4 of the SC(R) A, 1956 to start trading derivatives. The derivatives exchange/segment should huge a 26

separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practice of its members and will obtain prior approval of SEBI before start of trading in any derivative contact. 4. The Exchange shall have minimum 50 members. 5. The members of an existing segment of the exchange will not automatically become the members of the derivative segment need to fulfill the eligibility conditions as laid down by the L.C.Gupta committee. 6. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house. Clearing

corporations/houses complying with the eligibility conditions a s laid down by the committee have to apply SEBI for grant of approval. 7. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration a brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 lakhs. The net worth of the member shall be computed as follows:

Capital+Free reserves Less non-allowable assets viz, (a) Fixed assets (b) Pledged securities (c) Members card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets

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(i) 30% marketable securities

6. The minimum contract value shall not be less than Rs.2 lakhs. Exchanges should also submit details of the futures contract they propose to introduce. 7. The initial margin requirement exposure limits linked to capital adequacy and SEBI/Exchange shall prescribe margin demands related to the risk of loss on the position from time to time. 8. The L.C.Gupta committee report requires strict enforcement of Know you customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

REGULATION FOR CLEARING AND SETTLEMENT 1) The L.C.Gupta committee has recommended that the clearing corporation should interpose itself between both legs of every trade, becoming the legal counter party to both or alternati9vely should provide an unconditional guarantee for settlement of all trades. 2) The clearing corporation should ensure that none of the Board members has trading interests. 3) The definition of net-worth as prescribed by SEBI needs to be incorporated in the application/regulations of the clearing corporation 4) The regulations relating to arbitration need to be incorporated in the clearing corporations regulations. 5) The clearing corporation in its regulations must incorporate specific provision/chapter relating to declaration of default. 6) The regulations relating to investor protection fund for the derivatives market must be included in the clearing corporation application/regulations.

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7) The clearing corporation should have the capabilities to segregate upfront initial margins deposited by clearing members for trades on their own account and on account of his clients. The clearing corporation shall hold the clients margin money in trust for the clients purposes only and should not allow its diversion for any other purpose. This condition must be incorporated in the clearing corporation regulations 8) The clearing member shall collect margins from his constituents (client/trading members). He shall clear and settle deals in derivative

contracts on behalf of the constituents only on the receipt of such minimum margin. 9) Exposure limits based on the value at its risk concept will be used and the exposure limits will be continuously monitored. These shall be within the limits prescribed by SEBI from time to time. 10) The clearing corporation must lay down a procedure for periodic review of the new worth of its members. 11) The clearing corporation must inform SEBI how it roposes to monitor the exposure of its members in the underlying market. 12) Any changes in the byelaws, rules or regulations, which are covered under the suggestive bye-laws for regulations and control of trading and settlement of derivatives contracts, would require prior approval of SEBI.

Product specifications BSE-30 Sensex Futures Contract Size -Rs.50 times the Index Tick size 0.1 points or Rs.5 Expiry day last Thursday of the month Settlement basis cash settled Contract cycle 3 months Active contracts 3 nearest months

Product Specifications S&P CNX Nifty Futures

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 Contract Size Rs.200 times the Index Tick Size 0.05 points or Rs.10 Expiry day last Thursday of the month Settlement basis cash settled Contract cycle - 3 month Active contracts 3 nearest months

Membership Membership for the new segment in both the exchanges is not automatic and has to be separately applied for: Membership is currently open on both the exchanges. All members will also have to be separately registered with SEBI before they can be accepted. Membership Criteria National Stock Exchange (NSE)

Clearing Member (CM) Net worth Rs.300 lakhs Interest-Free Security Deposits Rs.25 lakhs Collateral Security Deposit Rs.25 lakhs In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs.

Trading Member (TM) Net worth Rs.100 lakhs Interest-Free Security Deposit Rs.8 lakhs Annual Subscription fees Rs.1 lakh Membership Criteria Mumbai Stock Exchange (BSE)

Clearing Member (CM) Net worth 300 lakhs

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 Interest-Free Security Deposit Rs.25lakhs Collateral Security Deposit Rs.25 lakhs Non-refundable Deposit Rs.5 lakhs Annual Subscription Fees Rs.50,000. In addition for every TM he wishes to clear for the CM has to deposit Rs.10 lakhs with the following break-up. i. Cash Rs.25 lakhs ii. Cash Equivalents Rs.25 lakhs iii. Collateral Security Deposit Rs.5 lakhs

Trading Member (TM) Net worth Rs.50 lakhs Non-refundable deposit Rs.3 lakhs Annual Subscription Fees Rs.25 thousant The Non-refundabel fee paid by the members is exclusive and will be a total of Rs.8 lakhs if the member has both clearing and trading rights.

Trading systems NSEs trading system for its futures and options segment is called NEAT F&O. It is bsed on the NEAT system for the cash segment. BSEs trading system for its derivatives segment is called DTs. It is built on a platform different from the BOLT system though most of the features are common.

Classification of derivatives:

Forwards (currencies, stocks, swaps etc.,)

Forward contract is different from a spot transaction, where payment of price and delivery of commodity take place immediately the transaction is settled. In a

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forward contract the sale/purchase transaction of an asset is settled including the price payable not for deliver/settlement at spot, but at a specified future date. India has a strong dollar-rupee forward market with contracts being traded for one, two, Six-month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets.

Futures (Currencies, Stocks, Indices, Commodities): A future contract has been defined as a standardized exchange-traded agreement specifying a quantity and price of a particular type of commodity (soyabeans, gold, oil etc.,) to be purchased or sold at a pre-determined date in the future. On contract date, delivery and physical possession take place unless the contract has been closed out. Futures are also available on various financial products and indices today. A future contract is thus a forward contract, which trades on an exchange. S&P CNX Nifty futures are traded on National Stock Exchange. This provides them transparency, liquidity, anonymity of trades and also eliminates the counter party risks due to the guarantee provided by national securities clearing corporation Ltd.

Options (Currencies, Stocks, Indexes etc): Options are the standardized financial contracts that allow the buyer (holder) of the options, i.e., the right at the cost of option premium not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges under stringent financial security against default.

Risk management in derivatives:

Derivatives are high-risk instruments and hence the exchanges have put a lot of measures to control this risk. The most critical aspect of risk management is the daily monitoring of price and position and the margining of those positions.

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

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

SPAN evaluates risk scenarios, which are nothing but market conditions. The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of; a) How much the price of the underlying instrument is expected to change over one trading day, and b) How much the volatility of that underlying price is expected to change over one trading day.

Based on the SPAN measurement, margins are imposed and risk covered. Apart from this, the exchange will have a minimum base capital of Rs.50 lakhs and brokers need to pay additional base capital if they need margins about the permissible limits.

33

FORWARD CONTRACTS

34

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes along position agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same rice. Other contract details like delivery date, the parties to the contract negotiate price and quantity bilaterally. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom-designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction cost and increasing transaction volume. This process of standardization reaches its limit in the organized futures market.

35

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long the forward, wait for the price to raise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward market here supplies leverage to the speculator.

LIMITATIONS:

Forward markets worldwide are afflicted by several problems:

Lack of centralization of trading, liquidity and counter-party risk in the first two of these, and the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable. Counter-party risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declare bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the liquidity, still the counter-party risk remains a very serious issue.

36

FUTURES

37

FUTURES

INTRODUCTION:

Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 90 of futures transactions are offset this way.

The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and month of delivery The units of price quotations and minimum price changes Location of settlement

FUTURES MARKET: The Chicago Board of Trade was the earliest one found, in 1848 and currently is the largest futures exchange in the world. The method of trading futures in the organized exchanges is similar in some ways to and different in other ways from the way stocks are traded. As with the stocks and in other ways from the way stocks are traded. As with the stocks and options, customers can pace market, limit and stop

38

orders. Further more once an order is transmitted to an exchange floor, it must be taken to a destined spot for execution by a member of exchange, just as it is done for stocks and options. This spot is known as pit because of its shape, which is circular with a set of interior descending steps on which members stand. In futures market, there are floor brokers. They execute customers orders. In doing so they, (or their phone clerks) each keep a file of any stop or limit orders that cannot be executed, alternatively, members can be floor traders (those with very short holding periods, of less than a day, are known as locals or scalpers), they execute orders for their own personal accounts in an attempt to make profits by buying low and selling high.

CLEARING HOUSE:

Each futures exchange has an associated clearinghouse that becomes the sellers buyer and the buyers seller as the trade is concluded. The people

associated with futures set up specifically the Chicago Board Options Exchange). Clearing house is in a risky position as there is a chance of not delivering to the seller or not paying by the buyer as it is like a mediator between the both. The procedure that protect the clearinghouse from such potential losses involving brokers 1) Impose initial margin requirements on both buyers and sellers 2) Mark to market the accounts of buyers and sellers everyday 3) Impose daily maintenance margin requirements of both buyers and sellers

Use no contracts are outstanding. Subsequently as people began to make transactions, the open interest grows. At any time open interest equals the amount that those with the short position (the seller) are currently obligated to deliver. It also equals the amount that with the long positions (the buyer) are obligated to receive. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. That is, both buyer and seller are required to make security deposit that they are intended to guarantee that they will be in fact be able to fulfill their obligations, accordingly initial margin is

39

referred to as performance margin. The amount of this margin is roughly 5% to 15% of the total purchase price of the futures contract.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to affect the investors gain or loss depending upon the futures closing price. This is called marking to market.

Maintenance margin: This is somewhat lower than the initial margin. According to the maintenance margin requirement, the investor must keep the accounts equity equal or greater than certain percentage of the amount deposited as initial margin. Because this percentage is roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the requirement is not met the investor will receive a call. This call is a request to for an additional deposit of cash known as variation margin.

OPEN INTEREST: The number of contracts, which are outstanding for execution, is called open interest. When trading is first allowed in a contract, there is no open interest because no contract because no contracts are outstanding. Subsequently as people began to make transactions, the open interest grows. At any time open interest equals the amount that those with the short position (the seller) are currently obligated to deliver. It also equals the amount that with the long positions (the buyer) are obligated to receive.

BASIS:

In the context of financial futures, basis can be defined as the difference between the current spot price on an asset (that is the price of the asset for immediate delivery) and the corresponding future price (that is the purchase price stated in the contract) is known as basis. Basis = current spot price futures price. A person with a short position in a futures contract and a long position on a deliverable asset (means that he owns a asset) will profit if the basis is positive and 40

widens or is negative and narrow). This is because the futures price will be falling or the spot price is rising (or both). A falling futures price benefits those who are short futures and a rising spot price benefits those who own the asset. Using the same type of reasoning it can be shown that this person will lose the basis is positive and narrow (or is negative and widens).

SETTLEMENT OF FUTURES

Mark to market settlement:

There is a daily settlement for mark to market. The profits/losses are computed as the difference between the trade price (or the previous days settlement price, as the case may be) and the current days settlement price. The party who have suffered a loss are required to pay the mark to market loss amount to exchange which is in turn passed on to the party who has made a profit/. This is known as daily mark to market settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below:

F = S*RT

Where: F=theoretical futures price S=value of the underlying index/stock R=rate of interest (MIBOR Mumbai I Inter Offer Rate) T=time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After daily settlement, all the open positions are reset to the daily

settlement price. the pay-in and payout of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the broker passes to the client account. 41

Final settlement:

On the expiry of the futures contracts, exchange marks all positions to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit/loss is computed as the difference between trade price (or the previous days settlement price, as the case may be), and the final settlement price of the relevant futures contract. Final settlement loss/profit amount is debited/credited to the relevant brokers clearing bank account on T+1 day (T = expiry day). This is then passed on the client from the broker. Open positions in futures contracts cease to exist after their expiration day.

DISTINCTION BETWEEN FUTURES AND FORWARDS Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of the allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more liquidity.

TERMS USED IN FUTURES CONTRACT: Spot price: the price at which an asset trades in the spot market. Futures price: the price at which the futures contract trades in the futures market. Contract cycle: the period over which a contract trades.

The index

futures contracts on the NSE have one-month, tow-months ad three-month expiry cycle, which expires on the last Thursday of the month. Thus a

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January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. 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 less than one contract. For instance, the contract size on NSEs futures market is 200 Nifties. 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.

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OPTIONS

44

INTRODUCTION:

Options on stocks were first traded on an organized stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts.

An option is a type of contract between two people where one grants the other party the right to buy a specific asset at specific priced within a specific time period. Alternatively, the contract may grant the other person the right to sell a specific asset at a specific price within a specific period of time. The person who has received the right, and thus has a decision to make, is known as the option buyer because he or she must pay for this right. The person who has sold the right, and thus must respond to the buyers decision is known as the option writer.

TYPES OF OPTION CONTRACT The two most basic types of option contracts are call option and put option. Currently such options are traded on many exchanges around the world. Furthermore,

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many of these contracts are created privately (that is off exchange or over the counter), typically involving institutions banking firms and their clients.

CALL OPTION: The most prominent type of option contract is call option for stocks. It gives the buyer the right to buy (call away) a specific number of shares of a specific company from the option writer at a specific purchase price at any time up to and including a specific date. An investor buys a call options when he seems that the stock price moves upwards. A call option gives the holder of the option the right but not the obligation to buy an asset by a certain date for a certain price.

PUT OPTION: A second type of option for stocks is the put option. It gives the buyer the right to sell (put away) a specific number of shares of a specific company to the option writer at a specific selling price at any time up to and including a specific date. An investor buys a put option when he seems that the stock price moves downwards. A put option gives the holder of the option right but not the obligation to sell an asset by a certain date for a certain price.

Options clearing house:

The Options Clearing House (OCC), a company that is jointly owned by several exchanges, generally facilitates trading in these options. It does so by

maintaining a computer system that keeps track of all those options by recording the position of all those investors in each one. Although the mechanics are complex, the principles are simple. As soon as a buyer and a writer decide to trade a particular option contract and the buyer pass the agreed upon premium the OCC steps in becoming the effective writer as buyer is concerned the effective buyer as far as the

46

seller is concerned. Thus at this time all directs links between original buyer and seller is served.

TRADING ON EXCHANGES:

There are two types of exchanged-based mechanisms for trading options contracts. The focal point for trading either involves specialists or market makers.

SPECIALISTS:

These people serve two functions, acting as both dealers and brokers. As dealers they keep an inventory of the stocks that are assigned to them and buy and sell from that inventory at bid and ask process, respectively. As brokers they keep limit order book and execute the orders in it a market moves up and down. Some option market such as American Stock Exchange, function in a similar manner. These markets have specialists who assigned specific options contract, and these specialists act as dealers and brokers in their assigned options. As with the stock exchanges, there may be floor traders, who trade solely for themselves, hoping to buy low and sell high, and floor brokers who handle orders from public.

MARKER MAKERS Other option markets such as Chicago Board Options Exchange, do not involve specialists, instead they involve market makers, who act solely as dealers and order both officials (previously known as board brokers), who keep the limit order book. The market makers must trade with floor brokers, who are the members of Exchange that handle orders from the public. In doing so the market makers have an inventory of options and quote bid and ask prices. Where as there in only one specialist typically assigned to a stock, there usually is more than one market maker assigned to the option on a given stock.

COMMISSIONS: A commission must be paid to stockbroker whenever an option is either written, bought, sold. The size of the commission has been reduced substantially 47

since the options began trading on organize exchanges in 1973. Furthermore this typically smaller than the commission that would be paid if the underlying stock had been purchased instead of option. This is probably because that clearing and

settlement are easier with the options than stock. However, the investor should be aware that exercise an option will typically result in the buyers having to pay commission equivalent to the commission that would be incurred if the stock itself were being bought or sold.

MARGINS:

Margins are the deposits, which reduce counter party risk, arise in a futures contract. These margins are collected in order to eliminate the counter party risk. There are three types of margins:

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. That is, both buyer and seller are required to make security deposit that they are intended to guarantee that they will be in fact be able to fulfill their obligations, accordingly initial margin is referred to as performance margin. The amount of this margin is roughly 5% to 15% of the total purchase price of the futures contract.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to affect the investors gain or loss depending upon the futures closing price. This is called marking to market.

Maintenance margin: This is somewhat lower than the initial margin. According to the maintenance margin requirement, the investor must keep the accounts equity equal or greater than certain percentage of the amount deposited as initial margin. Because this percentage is roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the requirement is not met the investor will receive a call. This call is a request to for an additional deposit of cash known as variation margin. 48

In the case of a call, shares are to be delivered by the writer in return for the exercise price. In case of a put, cash has to be delivered in return for shares. In either case the net cost to the option writer will be the absolute difference the exercise price and the stocks market value at the time of exercise. As the OCCs at risk if the writer is unable to bear this cost, it is not surprising that the OCC would have a system in place protecting itself from the actions of the write. This system is known margin.

PARTIES IN AN OPTION CONTRACT:

1. Buyer of the Option: The buyer of an option is one who by paying option premium buys the right but not the obligation to exercise his option on seller/writer.

2. Writer/Seller of the Option: The writer of a call/put options is the one who receives the option premium and is there by obligated to sell/buy the asset if the buyer exercises the option on him.

SETTLEMENT OF OPTIONS Daily premium settlement Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each broker at the client level to determine the net premium payable or receivable amount, at the end of each day. The brokers who have a premium payable position are required to pay the premium receivable position. This is known as daily premium settlement. The brokers in turn would take this from their clients. The pay-in and payout of the premium settlement is on T+1 days (T=Trade Day). The premium payable amounts are directly debited or credited to the broker, from where it is passed on to the client.

49

Interim Exercise Settlement for Options on Individual Securities:

Interim exercise settlement for Option contracts on Individual Securities is effected for valid exercised option positions at in the money strike prices, at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in option contracts with the same series, on a random basis. The interim exercise settlement value is the difference between the strike price and the settlement price of the relevant option contract. Exercise settlement value is debited/credited to the relevant broker account in T+3 days (T=exercise date). From there it is passed on to the clients.

Final Exercise Settlement: Final Exercise Settlement is affected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the-money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts, exercise style is European style, while for options contracts on individual securities, exercise style is American style. Final Exercise is automatic on expiry of the option contracts.

Exercise Settlement is cash settled by debiting/crediting of the clearing accounts of the relevant broker with the respective clearing bank, from where it is passed to the client. Final settlement profit/loss amount for option contracts on Index is debited/credited to the relevant broker clearing bank account on T+1 day (T=expiry day), from where it is passed Final Settlement profit/loss amount for option contracts on individual Securities is debited/credited to the relevant broker clearing bank account on T=3 day (T=expiry day), from where it is passed open positions, in option contracts, cease to exist after their expiration day.

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Payoffs for an option buyer: The following example would clarify the basics on Call Options:

Illustration 1: An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear form the graph that even in the worst-case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though the buyer would make a profit of Rs.2 per share on the premium payment.

S 57 58 59 60 61 62 63 64 65 66

Payoff from Call Buying/Long (Rs.) Xt c Payoff Net Profit 60 2 0 -2 60 2 0 -2 60 2 0 -2 60 2 0 -2 60 2 1 -1 60 2 2 0 60 2 3 1 60 2 4 2 60 2 5 3 60 2 6 4

A European call option gives the following payoff to the investor: max (S - Xt, 0). The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0). Notes: S - Stock Price

51

Xt - Exercise Price at time 't' C - European Call Option Premium Payoff - Max (S - Xt, O )

Payoffs from a put buying:

Put Options The European Put Option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better:

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

S 55 56 57 58

Payoff from Put Buying/Long (Rs.) Xt p Payoff Net Profit 60 2 5 3 60 2 4 2 60 2 3 1 60 2 2 0 52

59 60 61 62 63 64

60 60 60 60 60 60

2 2 2 2 2 2

1 0 0 0 0 0

-1 -2 -2 -2 -2 -2

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

These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives create a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations.

Factors affecting the price of an option:

The following are the various factors that affect the price of an option. They are: Stock price: The pay-off from a call option is the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the

53

strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. Strike price: In the case of a call, as the strike price increases, the stock price has to make a larger upward move for the option to go in-the money. Therefore, for a call, as the strike price increases, options become less valuable and as strike price decreases, options become more valuable.

Time to expiration: Both Put and Call American options become more valuable as the time to expiration increases.

Volatility: The volatility of n a stock price is a measure of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. volatility increase. The value of both Calls and Puts therefore increase as

Risk-free interest rate: The put option prices decline as the risk free rate increases where as the prices of calls always increase as the risk free interest rate increases.

Dividends: Dividends have the effect of reducing the stock price on the ex dividend date. This has a negative effect on the value of call options and a positive affect on the value of put options.

OPTION VALUATION USING BLACK AND SCHOLES: The Black and Scholes Option Pricing Model didnt appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to 54

a well known the transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startling accurate option-pricing model. Black and Scholes cant take all credit for their work; in fact their model is actually an improved version of a previous model developed by A.James Boness in Ph.D dissertation at the University of Chicago. Black and Scholes improvement son the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor and with the absence of assumptions regarding investors risk preferences.

THE MODEL: C=SN (d1)-Ke (-r t) N (d2) C=theoretical call premium S=current stock price T=time until option expiration K=option striking price R=risk free interest rate N=cumulative standard normal distribution E=exponentil terms (2.1783) d1=in(s/k) + (r + s2/2) T D2=d1 St In order to understand the model itself, we divide it into two parts. The first part SN (d1) derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price(s) by the change in the call premium with respect to a change in the underlined stock price [N (d1)]. The second part of the model, ke (-r t) N (d2), gives the resent value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes model: 1) The stock pays no dividend to options life: most companies pay dividends to their shareholders, so this might seem a serious limitations to the model 55

considering the observation that higher dividend is elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend form the stock price.

2) European exercise terms are used: European exercise terms dictate thbat the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option,, making American options more valuable due to the greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient: this assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous it process.

4) No commissions are charged: usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that individual investors pay is more substantial and can often distort the output of the model.

5) Interest rates remain constant and known: The Black and Scholes model uses the risk free rate to represent this constant and known rate. In reality there is no such thing as the risk free rate, but the discount rate on US government treasury bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 days rates are often subject to change. There by violating one of the assumptions of the model.

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SOME TERMS USED IN OPTIONS CONTRACT

Index options: These options have the index as the underlined. Some options are European while others are American. Like index, futures contracts, index options. Contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

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

European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze that American option are frequently deduced from those of its European counterpart.

In-the-money options: An in-the-money option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in the money when the current index stands at a level higher than the strike price. If the index is much higher than the strike price the call is said to be deep in the money.

At-the-money option:

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An at-the-money option is an option that would lead to zero cash flow if it were exercised immediately. An option in the index is at the money when the current index equal that strike price (i.e. spot price=strike price)

Out-of-the-money option: An out-of-the-money option is an option that would lead to a negative cash flow. 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).

Effect of increase in the relevant parameter on Option Prices:

European Options Buying

American Options Buying

Parameters Spot price (S) Strike price (Xt)

Call

Put ? ?

Call ?

Put ?

Time to ? expiration (T) Volatility Risk free interest rates Dividends (D)

-Favorable -Unfavorable

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TRADING STRATEGIES USING FUTURES AND OPTIONS

59

TRADING STRATEGIES USING FUTURES AND OPTIONS

There are a lot of practical uses of derivatives. As we have seen derivatives can be used for profits and hedging. We can use derivatives as a leverage tool too.

Using speculation to make profits:

When you speculate you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market, you can always sell futures and buy in the spot market. Similarly, in the options market if you are a bullish you

Should buy call options?

If you are bearish, you should buy put options of

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

Using arbitrage to make money in derivatives market:

Arbitrage is making money on price differentials in different markets. For Example, future is nothing but the future value of the spot price. This future value is obtained by factoring the interest rate. But if there are differences in the money

Market and the interest rate changes then the future price should correct itself to factor the change in making money an arbitrage opportunity.

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Let us take an example:

Example: A stock us quoting for Rs.1000. The one-month future of this stock is at Rs.1005. The risk free rate is 12%. The trading strategy is: Solution: The strategy for trading should be Sell Spot and Buy Futures sell the stock for Rs.1000. Buy the future at Rs.1005. Invest the Rs.1000 at12%. The interest earned on this stock will be 1000(1+0.12)(1/2)=1009. So net gain the above strategy is Rs.1009-Rs.1005=Rs.4. Thus one can make risk less profit of Rs.4 because of arbitrage. But an important point is that this opportunity was available due to mispricing and the market not correcting itself. Normally, the time taken for the market to adjust to corrections is very less. S, the time available for arbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.

Using future to hedge position:

One can hedge ones position by taking an opposite position in the futures market. For example, if you are buying in the spot price, the risk you carry is that of prices falling in the future. You can lock this by selling in the futures price. Even if the stock continues falling, you position is hedged as you have formed the price at which you are selling. Similarly, you want to buy a stock at a later date but face the risk of prices rising. You can hedge against this rise by buying futures.

You can use a combination of futures too to hedge yourself. There is always a correlation between the index and individual stocks. This correlation may be negative

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or positive, but there is a correlation. This is given by the beta of the stock. In simple terms, beta indicates the change in the price of a stock to every change in index.

For example, if beta of a stock is 0.18, it means that if the index goes up by when the index falls, a negative beta means that the price of the stock falls when the index rises. So, if you have a position in a stock, you can hedge the same by buying the index at times the value of the stock.

Example: The beta of HPCL is 0.8 the Nifty is at 1000. If there is a stock of Rs.10, 000 worth of HPCL, hedging of position can be done by selling 8000 of Nifty. That is there is a sale.

Scenario 1 If index rises by 10% the value of the index becomes 8800 i.e. a loss of Rs.800. The value of the stock however goes up by 8 i.e. it becomes Rs.10, 800 i.e. a gain of Rs.800. Thus the net position is zero and there is a perfect hedging.

Scenario 2 If index falls by 10%, the value of the index becomes Rs.7, 200 a gain of Rs.800. But the value of the stock also falls by 8%. The value of this stock becomes Rs.9, 200 a loss of Rs.800. thus the net position is zero and it is hedged. But again, beta is predicted value based on regression models. Regression is nothing but analysis of past data. So there is a chance that the above position may not be fully hedged if the beta does not behave as per the predicted value.

Using options in trading strategy:

Options are a great tool to use for trading. If traders feel the market will go up. He should buy a call option at a level lower than what he expects the market tot go up. If he thinks that the market will fall, you should buy a put option at a level higher than

62

the level to which he expect the market fall. When we say market, we mean the index. The same strategy can be used for individual stocks also. A combination of futures and options can be used too, to make profits.

Strategy for an option writer to cover himself:

An option writer can use a combination strategy of futures and options to protect his position. The risk for an option writer arises only when the options exercised. This will be very clear with an example. Supposing I sell a call option on satyam at a strike price of Rs.300/- for a premium of Rs.20/-, the risk arises only when the option is exercised. The option will be exercised when the price exceeds rs.300/-. I start making a loss only after the price exceeds Rs.32/- (strike price plus premium). More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the stock to the other party and also makes entire profit on premium, I buy a future of Satyam at Rs.300/-. This is just one leg of the risk. The earlier risk was of the call being exercised. The risk now is that of the call not being exercised. In case the call is not exercised, I will have to take delivery as I have bought a future. So minimize this risk, I buy a put option on Satyam at Rs.300. but I also need to pay a premium for buying the option. I pay a premium of Rs.10/-. Now I am covered and my net cash flow would be Premium earned from selling call option: Rs.20 Premium paid to buy put option: Rs.10 Net cash flow: Rs.10/But the above pay off will be possible only when the premium I am paying for the put option is lower than the premium that I get for writing the call. Similarly, we can arrive at a covered position for writing a put option too, another interesting observation is that the above strategy in itself presents an opportunity to make money. This is so because of the premium differential in the put and the call option. So if one tracks the derivative markets on a continuous basis, one can chance upon almost risk less moneymaking opportunities. 63

LOT SIZES OF DIFFERENT COMPANIES

LOT SIZE ACC 1500 ANDHRA BANK 4600 ARVIND MILLS 4300 BAJAJ AUTO 400 BANKBARODA 1400 BANKINDIA 3800 BEL 550 BHEL 600 BPCL 550 CANBK 1600 CIPLA 200 CNXIT 10 DIGITALEQUIP 400 DRREDDY 200 GAIL 1500 GRASIM 350 GUJAMBCEMENT 110 HCL TECH 1300 HDFC 600 HDFC BANK HEROHONDA HINDALCO HINDLEVER HINDPETROL I-FLEX ICICIBANK INFOSYSTECH IOC IPCL ITC L&T M&M MARUTI 800 400 300 2000 650 300 1400 50 600 1100 300 500 625 400

CODE

COMPANY NAME ASSOCIATES CEMENT COS LTD ANDHRA BANK ARVIND MILLS LTD BAJAJ AUTOMOBILES LTD BANK OF BARODA BANK OF INDIA BHARAT ELECTRICALS LTD BHARAT HEAVY ELECTRICALS LTD BHARAT PETROL CORPORATION LTD CANARA BANK CIPLA LTD IT INDEX DIGITAL GLOBAL LTD DR. REDDYS LABORATORIES LTD GAS AUTHOURITY OF INDIA GRASIM INDUSTRIES LTD GUJARAT AMBUJA CEMENT LTD HINDUSTAN CORPORATION LTD HOUSING DEDVELOPMENT FINANCE CORPORATION HDFC BANK HERO HONDA MOTORS LTD HINDUSTAN ALUMINIUM COMPANY HINDUSTAN LEVER LTD HINDUSTAN PETROLEUM CORPORATION I-FLEX ICICI BANKING CORPORATION LTD INFOSYS TECHNOLOGIES LTD INDIAN OIL CORPORATION INDIAN PETROLEUM CHEMICALS LTD INDIAN TOBACCO COMPANY LARSEN AND TURBO MAHENDRA AND MAHENDRA LTD MARUTI UDYOG LTD 64

MASTEK MTNL NATIONALALAM NIFTY NIIT ONGC ORIENT BANK PNB POLARIS RANBAXY RELIANCE REL SATYAMCOMPU SBI SCI SYNDIBANK TATAMOTORS TATAPOWER TATA TEA TISCO UNION BANK WIPRO

1600 1600 1150 200 1500 300 1200 1200 1400 400 550 600 1200 500 1600 7600 825 50 900 4200 200 800

MASTEK MAHANAGAR TELECOM NIGAM LTD NATIONAL ALUMINIUM COMPANY NATIONAL INDEX FOR FIFTY STOCKS NATIONAL INSTITUTE OF INFORMATION TECHNOLOGY OIL AND NATURAL GAS CORPORATION ORIENTAL BANK PUNJAB NATIONAL BANK POLARIS SOFTWARE COMPANY LTD. RANBAXY LABORATORIES LTD RELIANCE INDUSTRIES LTD RELIANCE COMPUTERS SERVICES LTD SATYAM COMPUTERS LTD STATE BANK OF INDIA SHIPPPING CORPORATION OF INDIA SYNDICATE BANK TATA MOTORS TATA POWER COMPANY LTD TATA TEA LTD TATA IRON&STEEL COMPANY LTD UNION BANK OF INDIA WESTERN INDIA-VEG PRODUCTS LTD

65

DESCRIPTION OF THE METHOD:

66

DESCRIPTION OF THE METHOD: The following are the steps involved in the study.

1. Selection of the scrip: The scrip selection is done on a random basis and the scrip selected is ONGC. The lot size of the scrip is 500. Profitability position of the option holder and option writer is studied.

2. Data collection: The data of the ONGC has been collected from the The Economic Times and the Internet. The data consists of the August contract and the period of data collection is from 3rd August 2005 to 3rd September 2005.

3. Analysis: The analysis consists of the tabulation of the data assessing the profitability positions of the option holder and the option writer, representing the data with graphs and making the interpretations using the data.

LOT SIZES OF SELECTED COMPANIES FOR ANALYSIS

CODE

LOT SIZE

COMPANY NAME

ACC

188

Associates Cement Co. Ltd. Infosys Technologies Ltd. 67

INFOSYS HLL RANBAXY SATYAM

200 Hindustan UniLever Ltd. 1000 Ranbaxy laboratories Ltd. 800 600 Satyam Computer services Ltd.

The following tables explain about the trades that took place in futures and options between 01/05/2009 and 13/05/2009. The table has various columns, which explains various factors involves in derivatives trading. Date the day on which trading took place Closing premium premium for the day Open interest No. of Options that did not get exercised Traded quantity No. of futures and options traded on that day N.O.C No. of contacts traded on that day Closing price the price of the futures at the end of the trading day

FUTURES OF ACC CEMENTS Date Open. dd/mm/yyy Rs 20/04/2011 19/04/2011 18/04/2011 17/04/2011 16/04/2011 795.95 809.00 815.00 791.00 756.00 High Rs. 809.40 819.00 827.45 816.70 793.95 Low Rs. 791.35 783.10 815.00 785.00 756.00 Close Rs 794.5 790.15 818.00 809.95 789.15 Open Int (000) 3452 3943 3810 4600 4385 N.O.C

7502 15759 7738 17265 10335

68

FINDINGS: The price gradually rose from 789.15 on first day to 18th April, where it stood at 818.00 as high. As the players in the market with an intention to short or correct the market, the players showed a bearish attitude for the next day where the price fell to 790.15. Later the players become a bullish.

At 809.95 the open interest stood at peak position of 4600000, but later the next day players sold their futures as to gain. The total contracts traded at this price stood 17265 which is higher than the week days

By the end of the trading week most of the players closed up their contracts to make loss. As the price was high, the open interest was high and the no. of contracts trades rose to 7502.

There always exit an impact of price movements on open interest and contracts traded. The futures market also influenced by cash market, Nifty index futures, and news related to the underlying asset or sector (industry), FIIs involvement, national and international affairs etc.

FUTURES OF INFOSYS Date Open dd/mm/yyy Rs. 20/04/2011 19/04/2011 18/04/2011 17/04/2011 16/04/2011 2061.00 2046.50 2076.00 2102.65 2100.00 High Rs. 2082.00 2060.50 2090.00 2110.00 2125.00 Low Rs. 2055.50 2021.25 2062.15 2055.50 2095.00 Close Rs 2061.75 2045.95 2070.30 2073.90 2118.80 Open. int (000) 3335 3397 3625 4215 3698 N.O.C

10842 13041 11886 26534 17017

FINDINGS: After the market quite relived by the fall in the discount on the Nifty in the futures and the options segment, which was used by the players to short the market shown

69

appositive upward movement in futures and options segment and cash market during the first day of the week. The futures of INFOSYS shown a bullish way till 17th of the April whose impact shown on the open interest at 4215 with 26534 contracts traded. The players at this point did not sell or close up their contracts as a hope of increase or go up in the market for a next day. Even the cash market was down on this day for this underlying at Rs. 2076.00.

The market for INFOSYS for last day of the trading week shown a decline in the opening price Rs. 15.05 when compare with the week high price. The open interest closed at 3335000 with lowest 10842 contracts traded on the last trading day of the week.

FUTURES OF THE HLL Date Open. dd/mm/yyy Rs. 20/04/2011 19/04/2011 18/04/2011 17/04/2011 16/04/2011 205.10 203.55 208.10 211.50 205.70 High Rs. 209.80 205.50 211.80 212.85 211.45 Low Rs. 204.25 201.10 205.25 208.35 204.70 Close Rs 206.20 204.15 206.00 208.75 211.10 Open. int N.O.C (000) 8742 9112 9143 9205 9232 2568 2740 2020 2454 3765

INTERPRETATION: HLL contracts traded in the futures stood at peak for the week i.e. 3765. There was a good buying in both the futures and options and cash market for this stock.

The last trading day of the week showed a high strike price or exercising price for the HLL futures i.e. Rs. 206.20 because of the huge correction done by the FII flows.

FUTURES OF RANBAXY 70

Date Open dd/mm/yyy Rs 20/04/2011 19/04/2011 18/04/2011 17/04/2011 16/04/2011 345.00 336.00 339.50 341.80 337.00

High Rs. 345.50 344.75 344.80 342.00 342.25

Low Rs. 342.05 335.10 339.00 337.25 337.00

Close Rs 344.10 342.45 341.40 338.00 339.30

Open. int N.O.C (000) 5698 6578 6731 6770 6731 1366 305.4 3008 1679 2370

INTERPRETATION: The week showed a buy for RANBAXY stock futures. Since beginning of the trading day of the week the figures has been representing a continuous bullish market for RANBAXY. The pharmacy sector is considered to be one of the eye watches for investors for investing.

On the last but one, trading day the RANBAXY stock futures has rose to peak level where the price stood at 451.35 an increase of 11.73% over the first trading day price 403.95. The open interest rose 52.16% to 9512000 and the contract traded, 19314 from 7645 of weeks beginning.

At the end of the week the price of the RANBAXY has rose to Rs.458.90 this is all time record of that week at this stage open interest has also gone up to 9512000, this was great boom in pharmacy sector, because FIIs were interested to invest in this sector.

FUTURES OF SATYAM COMPUTERS Date Open dd/mm/yyy Rs 20/04/2011 19/04/2011 18/04/2011 17/04/2011 16/04/2011 463.00 450.00 462.00 474.55 487.90 High Rs. 477.00 462.00 468.80 483.00 494.50 Low Rs. 461.35 445.55 460.10 456.00 476.90 Close Rs 474.75 449.50 462.95 457.95 480.95 Open. int N.O.C (000) 6226 8991 11072 13645 13043 16486 11286 11984 15747 11543

71

FINDINGS: The above table indicates decrease in the price from the 3 rd day about 23 Rs.

Call and Put Options of ACC Cements Date/ 16/04/2011 Options C.P. O.I.* CA 700 89.80 17 CA 720 66.35 17 CA 740 45.90 44 CA 760 35.40 64 CA 780 22.95 25 CA 800 13.65 38 CA 820 7.50 2 CA 840 17/04/2011 N.C. 7 21 87 161 69 114 7 C.P. 91.35 71.80 50.50 39.00 22.85 14.10 8.50 18/04/2011 19/04/2011 20/04/2011

O.I.* N.C. C.P. 17 37 57 17 49 29 6 12 91 88 63 177 136 21

O.I.* N.C. C.P.

O.I.* N.C C.P

O.I.* N.C

59.00 47.00 27.50 15.10 7.30

58 15 42 45 15

11 16 52 151 49

34.00 20.10 10.95 6.35 4.05

56 28 79 83 23

23 60 241 204 61

19.40 10.25 4.50 3.00

28 77 85 23

35 192 81 14

Date/ 16/04/2011 Options PA 720 PA 740 PA 760 PA 780 PA 800 PA 820 C.P. 2.05 3.35 7.50 16.20 O.I.* 13 17 13 7 N.C. 10 24 45 20

17/04/2011 C.P. 1.00 2.85 7.50 13.25 O.I.* 14 17 14 24

18/04/2011 N.C. C.P. 7 15 31 2.45 95 6.85 8.40 17.45

19/04/2011

20/04/2011

O.I.* N.C. C.P.

O.I.* N.C C.P

O.I.* N.C

18 14 26 26

6 11 36 98

4.35 11.20 21.55 39.00

26 23 33 26

33 63 107 47

2.90 27 5.10 27 15.65 34

14 21 19

C.P. = Close premium O.I = Open interest N.C. = No. of contracts

The following table of net payoff explains the profit/loss of option holder/writer of ACC for the week 16/04/2011-20/04/2011. Profit/loss position of Call option buyer/writer of ACC Spot Price Strike Price Premium Whether Exercised 72 Buyer Gain/Loss Writers Gain/Loss

788 788 788 788 788 788 788

700 720 740 760 780 800 820

89.80 66.35 45.90 35.40 22.95 13.65 7.50

NO YES YES NO NO NO NO

-562.5 618.75 787.5 -2775 -8598.5 -9618.75 -14812.5

562.5 -618.75 -787.5 2775 8598.5 9618.75 14812.5

Profit/Loss position of Put option buyer/writer of ACC Spot Price 788 788 788 788 Strike Price 720 740 760 780 Premium 2.05 3.35 7.50 16.20 Whether Exercised YES YES YES NO Buyer Gain/Loss 24731.25 16743.75 7687.5 -3075 Writers Gain/Loss -24731.25 -16743.75 -7687.5 3075

Findings: The Call Options 700, 760,780,800 and 820 were out-of-the-money option and the remaining 720 and 740 were in the money option. The Put Options 720,740 and 760 were in-the-money option and the remaining i.e.780 was out-of-the-money option. Profit of the holder = (spot price strike price) premium * 375 (lot size) in case of Call Option Profit of the holder = (spot price strike price) premium * 375 (lot size) in case of Put Option If it is a profit for the holder than obviously it is loss for the holder and vice-versa.

Call and Put Options of INFOSYS 16/04/2011 O.I.* N.C. 8 7 30 31 17/04/2011 C.P. O.I.* N.C. 28 18/04/2011 C.P. O.I.* N.C. 7 19/04/2011 C.P. O.I.* N.C. 13 20/04/2011 C.P. O.I.* N.C. 10

e/ ions

C.P. 1950 176.50 1980 145.95

102.00 27

102.0 26

79.95 26

83.05 26

73

2010 2040 2070 2100 2130 2160 2190 2220 2250

117.95 90.55 65.10 45.40 29.25 19.35 12.30 9.00 6.20

267 100 63 327 81 85 66 73 33

351 362 189 1092 205 159 67 98 29

76.55 57.90 39.25 24.80 13.65 8.30 6.30 4.50

251 107 63 340 86 93 68 77

319 271 193 1194 193 215 83 67

71.25 50.45 33.90 22.55 12.15 5.65 3.60 3.05

249 105 65 344 86 95 69 80

101 108 109 466 88 150 19 32

55.20 37.10 22.45 14.85 8.36 5.70 3.90 3.00

242 104 69 370 87 94 66 80

334 399 208 601 66 115 25 20

56.70 36.95 20.95 11.30 4.45 3.95 2.50 1.30

242 100 73 358 87 95 66 80

117 150 193 437 54 54 47 12

Date/ Options

16/04/2011 C.P. O.I. * 80 51 141 75 94 218 69 24 44 N.C . 25 34 116 34 126 351 211 128 297

17/04/2011 C.P. 3.10 3.60 4.55 7.00 9.05 14.15 25.40 36.90 52.20 O.I. * 79 50 137 73 91 200 67 23 31 N.C. 15 10 89 46 48 336 168 117 285

18/04/2011 C.P. 2.90 2.80 4.30 5.85 7.85 12.15 20.60 34.05 52.60 O.I. * 77 47 134 72 87 193 65 24 28 N.C. 37 27 41 13 80 249 77 50 72

19/04/2011 C.P. O.I. * N.C.

20/04/2011 C.P. O.I. * 46 123 64 74 171 55 19 26

PA 1830 PA 1890 PA 1920 PA 1950 PA 1980 PA 2010 PA 2040 PA 2070 PA 2100

3.15 3.40 5.20 5.65 6.75 10.40 14.45 19.70 30.45

4.90 7.70 12.75 19.60 28.50 42.25 65.75

125 67 81 169 55 19 27

113 82 123 433 313 96 76

1.25 2.25 3.25 3.30 8.35 17.0 33.6 45.0

1 2 3 9 1 6 4 1

The following pay-off for explain the profit/loss of option holder/writer of INFOSYS for the week 16/04/2011-20/04/2011.. Profit/Loss position of Call Option Buyer/Writer of INFOSYS SPOT PRICE 2040 2040 2040 2040 2040 2040 2040 2040 2040 2040 STRIKE PRICE 1950 1980 2010 2040 2070 2100 2130 2160 2190 2220 PREMIUM 176.50 145.95 117.95 90.55 65.10 45.40 29.25 19.35 12.30 9.00 WHETHER EXERCISED NO NO NO NO NO NO NO NO NO NO 74 BUYER GAIN/LOSS -8650 -8595 -8795 -9055 -9510 -10540 -11925 -13935 -16230 -18900 WRITER GAIN/LOSS 8650 8595 8795 9055 9510 10540 11925 13935 16230 18900

2040

2250

6.20

NO

-21620

21620

Profit/Loss position of Put Option Buyer/writer of INFOSYS SPOT PRICE 2040 2040 2040 2040 2040 2040 2040 2040 2040 STRIKE PRICE 1830 1890 1920 1950 1980 2010 2040 2070 2100 PREMIUM 3.15 3.40 5.20 5.65 6.75 10.40 14.45 19.70 30.45 WHETHER EXERCISED YES YES YES YES YES YES NO NO NO BUYER GAIN/LOSS 20685 14660 11480 8435 5325 1960 -1445 -4970 -9045 WRITER GAIN/LOSS -20685 -14660 -11480 -8435 -5325 -1960 1445 4970 9045

Findings: The Call options all were in out-of-money option. The Put option1830, 1890,1920,1950,1980 and 2010 were in-the-money options and the remaining 2040, 2070 and 2100 were out of option. Profit of the holder = (spot price strike price) premium*100 (lot size) in case call option Profit of the holder = (spot price-spot price)-premium*100 (lot Size) in case of put option. If it is profit for the holder than obviously it will be loss for the holder and viceversa.

Call and Put Option of HLL Date/ Options CA 200 CA 205 CA 210 CA 215 CA 220 CA 225 16/04/2011 C.P. 13.80 9.20 4.80 2.65 1.60 0.75 O.I.* 238 108 396 78 255 32 N.C. 120 65 263 62 97 25 17/04/2011 C.P. 11.55 6.25 3.70 2.15 1.25 0.80 O.I.* 231 105 385 108 284 37 N.C. 45 34 213 68 66 7 18/04/2011 C.P. 8.50 4.65 2.65 1.40 0.75 .50 O.I.* 148 98 417 126 287 40 N.C. 67 18 152 44 31 8 19/04/2011 C.P. 6.95 3.90 1.75 1.00 0.60 2.10 O.I.* 173 116 475 129 286 86 N.C. 107 44 109 13 11 30 20/04/2011 C.P. 7.45 3.80 1.80 0.55 0.40 1.05 O.I.* 108 112 470 122 278 88 N.C. 57 33 113 19 13 17

75

Date/ Options PA 200 PA 205 PA 210

16/04/2011 C.P. 1.35 2.70

17/04/2011 O.I.* 90 16 9 N.C. 16 9 12

18/04/2011 C.P. 1.80 3.20 5.05 O.I.* 90 18 17 N.C. 18 10 26

19/04/2011 C.P. 2.10 4.00 8.55 O.I.* 86 17 14 N.C. 30 14 5

20/04/2011 C.P. 1.05 2.70 5.90 O.I.* 88 32 26 N.C. 17 29 13

O.I.* N.C. C.P. 85 34 1.35 11 11 2.20 4.50

The following table of net payoff explains the profit/loss of option holder/writer of HLL for the week 16/04/2011-20/04/2011... Profit/Loss position of Call Option Buyer/Writer of HLL SPOT PRICE 207 207 207 207 207 207 STRIKE PRICE 200 205 210 215 220 225 PREMIUM 13.80 9.20 4.80 2.65 1.60 0.75 WHETHER EXERCISED NO NO NO NO NO NO BUYER GAIN/LOSS -6800 -7200 -7800 -10650 -14600 -18750 WRITER GAIN/LOSS 6800 7200 7800 10650 14600 18750

Profit/Loss position of Put Option Buyer/Writer of HLL SPOT PRICE 207 207 Findings: STRIKE PRICE 200 205 PREMIUM 1.35 2.70 WHETHER EXERCISED YES NO BUYER GAIN/LOSS 5650 -700 WRITER GAIN/LOSS -5650 700

The Call Options all were out-of-the-money options

The Put Options200 was in-the-money option and 205was out-of-the-money option.

76

Profit of the holder = (spot price-strike piece)-premium*1000(lot size) in case of Call option.

Profit of the holder = (strike price-spot price) - premium*1000(lot size) in case of Put option.

If it is profit for the holder then obviously it will be loss for the holder and viceversa.

Call and Put Options of RANBAXY Date/ Options CA 330 CA 340 CA 350 CA 360 CA 370 CA 400 16/04/2011 C.P. 8.90 5.65 3.35 0.60 17/04/2011 O.I.* N.C. . 122 54 123 22 105 5 44 9 18/04/2011 C.P. 15.00 8.75 4.70 2.45 1.70 O.I.* 28 124 130 106 42 N.C. 8 61 42 16 9 19/04/2011 C.P. 16.65 8.35 4.10 2.20 O.I.* 26 124 133 102 N.C. 8 32 23 9 20/04/2011 C.P. 8.40 3.60 1.75 O.I.* N.C. 118 129 103 29 15 8

O.I.* N.C. C.P. 102 115 103 22 63 51 11 6 8.45 4.80 3.00 1.25

Date/ Options PA 330

16/04/2011 C.P. 4.60

17/04/2011

18/04/2011

19/04/2011

20/04/2011 O.I.* N.C.

O.I.* N.C. C.P. 22 6

O.I.* N.C. C.P. 2.60

O.I.* N.C. C.P. 24 9

O.I.* N.C. C.P.

The following tables of net payoff explain the following Profit/Loss of option holder/writer of RANBAXY for the week 16/04/2011-20/04/2011... Profit/Loss position of Call Buyer/Writer of RANBAXY SPOT PRICE 340 340 340 STRIKE PRICE 340 350 360 PREMIUM 8.90 5.65 3.35 WHETHER EXERCISED NO NO NO 77 BUYER GAIN/LOSS -7120 -12520 -18680 WRITER GAIN/LOSS 7120 12520 18680

340

400

0.60

NO

-48480

48480

Profit/Loss position of Put option Buyer/Writer of RANBAXY SPOT PRICE 340 Findings: The Call options all were in the out-of-the-money options. STRIKE PRICE 330 PREMIUM 4.60 WHETHER BUYER WRITER EXERCISED GAIN/LOSS GAIN/LOSS NO -4320 4320

The Put option also was in the out-of-the-money options.. Profit of the holder = (spot price- strike price) premium* 800 (lot size) in case of call option.

Profit for the holder = (strike price-spot price) premium* 800(lot size) in case of Put option.

If it is a profit of the holder then obviously it will be loss for the holder and viceversa.

Call and Put Option of the SATYAM COMPUTERS Date/ Options 16/04/2011 C.P. CA 440 CA 450 CA 460 CA 470 CA 480 CA 490 CA 500 CA 510 CA 520 O.I. * 44 88 115 161 55 194 31 26 N.C. 17/04/2011 C.P. O.I. * 51 120 185 292 96 326 34 39 18/04/2011 N.C C.P. . 63 258 306 435 112 310 12 29 21.65 15.20 10.45 7.15 4.25 2.95 1.90 1.30 O.I .* 61 133 205 329 130 358 37 41 N.C . 36 113 123 171 66 120 17 6 19/04/2011 C.P. 18.35 12.85 7.55 4.25 2.80 2.05 1.40 1.00 9.60 O.I. * 50 152 302 325 446 143 430 33 4 N.C. 21 282 569 334 353 61 186 13 8 20/04/2011 C.P. 32.25 26.50 18.25 12.10 6.35 2.90 1.65 0.80 0.25 O.I. * 44 91 185 266 418 175 442 36 40

35.00 28.05 22.20 15.75 11.40 7.85 5.00 3.00

26 35 72 310 101 300 58 44

18.10 13.40 8.85 6.35 4.00 2.95 2.05 1.50

N.C . 18 263 701 971 855 136 328 22 11

78

Date/ 16/04/2011 Options C.P. O.I.* PA 420 PA 430 PA 440 3.75 38 PA 450 5.15 60 PA 460 6.85 104 PA 470 10.50 36 PA 480 14.85 35 PA 490 17.05 11 PA 500 24.90 9

17/04/2011 N.C. C.P. 2.25 13 73 78 42 189 25 13 6.55 10.10 15.10 19.55 28.40

18/04/2011

19/04/2011 O.I.* 14 13 64 56 97 21 N.C. 11 12 80 77 159 9

20/04/2011 C.P. 0.50 1.40 2.25 3.60 7.15 11.25

O.I.* N.C. C.P. 10 6 44 58 92 22 28 38 82 183 45 41

O.I.* N.C. C.P. 4.10 6.30 6.00 48 17 8.30 8.05 58 30 13.30 12.65 100 57 18.45 20.15

O.I.* N.C. 12 59 149 149 52 73 6 46 282 282 137 130

The following table of net payoff explains profit/loss of option holder/writer of SATYAM COMPUTERS for the week 16/04/2011-20/04/2011... Profit/Loss position of Call Option Buyer/Writer of SATYAM COMPUTERS SPOT PRICE 448 448 448 448 448 448 448 448 STRIKE PRICE 450 460 470 480 490 500 510 520 PREMIUM 35.00 28.05 22.20 15.75 11.40 7.85 5.00 3.00 WHETHER EXERCISED NO NO NO NO NO NO NO NO BUYER GAIN/LOSS -22200 -24030 -26520 -28650 -32040 -35910 -40200 -22200 WRITER GAIN/LOSS 22200 24030 26520 28650 32040 35910 40200 22200

Profit/Loss position of Put Option Buyer/Writer of TATA CONSULTANCY SERVICES SPOT PRICE 448 448 448 448 448 448 448 STRIKE PRICE 440 450 460 470 480 490 500 PREMIUM 3.75 5.15 6.85 10.50 14.85 17.05 24.90 WHETHER EXERCISED YES NO NO NO NO NO NO BUYER GAIN/LOSS 2550 -4290 -11310 -19500 -28110 -35430 -46140 WRITER GAIN/LOSS -2550 4290 11310 19500 28110 35430 46140

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Findings: The Call Options all were out-of-the-money option All Put Option 440 was in-the-money option and remaining 450,460,470,480,490 and 500 were out-of-the-money options. Profit of the holder = (spot price-strike price)-premium*600 (lot size) in case of Call Option. Profit of the holder = (strike piece-spot price)-premium*600 (lot size) in case of Put Option. If it is a profit for the holder then obviously it will be loss for the holder and viceversa.

Conclusion and suggetions:

The above analysis Futures and Options of ACC, INFOSYS, HLL, RANBAXY and SATYAM COMPUTERS had shown a positive market in the week.

The major factors that will influence the futures and options market, FII involvement, News related to the underlying asset, National and International markets, Researchers view etc.

In a bearish market it is suggested to an investor to opt for Put Option in order to minimize losses.

In a bearish market it is suggested to an investor to opt for Call Option in order to minimize profits.

In a cash market the profit/loss is limited but where in futures and options an investor can enjoy unlimited profit/loss.

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It is recommended that SEBI should take measures in improving awareness about the futures and options market as it is launched very recently.

It is suggested to an investor to keep in mind the time and expiry duration of futures and options contracts before trading. The lengthy the time, the risk is low and profit making. The fever time may be high risk and chances of loss making.

At present futures and options are traded on NSE. It is recommended to SEBI to take actions in trading of futures and options in other regional exchanges.

At present scenario the derivatives market is increased to a great position. Its daily turnover reaches to the equal stage of cash market. The average daily turnover of NSE in derivatives market is 400000 (vol.).

The derivatives are mainly used for hedging purpose.

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Glossary
Arbitrage The simultaneous purchase and sale of a commodity or financial instrument in different markets to take advantage of a price or exchange rate discrepancy.

Calendar Spread An option strategy in which a short term option is sold and a longer term option is bought both having the same striking price. Either puts or calls may be used. Call Option An option that gives the buyer right to buy a future contract at a premium, at the strike price. Currency Swap A Swap in which the counter parties exchange equal amounts of two currencies at the spot exchange rate. Derivative A derivative is an instrument whose value derived from the value of one or more underlying assets, which can be commodities, precious

metals, currency, bonds, stocks, stock indices, etc. derivatives involves the trading of rights or obligations based on the underlying assets, but do not directly transfer the property. Double Option An option that gives the buyer the right to buy and or sell a future

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Contract, at a premium, at a strike price.

Futures Contract A legally binding agreement for the purpose and a sell of a commodity, index or financial instrument some time in the future.

Hedge Fund A large pool of private money and asset managed aggressively and often riskily on any future exchange, mostly for short term gain.

In-the-money option An option with intrinsic value, a Call option is in the money if its strike price is below the current price of the underlying futures contract and the put option is in the money if it is above the underlying.

Margin call A demand from a clearing house to a clearing member or from a broker to a customer bring deposits up to a required minimum level to guarantee performance at ruling prices.

Option it gives the buyer the right, but not the obligation, to buy or sell stock at a set. price on or before a given date. Investors who purchase call options but the stock will be worth more than the price set by the option (strike price), plus the price they paid for the option itself. Buyer of put option bet the stock price will go down below the price set by the option.

Out-of-the-money option An option with no intrinsic value, a call option is out of Money if its strike price is above the underlying and a put option is so if it is below the underlying.

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Premium The price of an option contract, determined on the exchange, which the buyer of the option pays to the option writer for the rights to the option contract. Spread The difference between the bid and asked prices in any market. Stop loss orders An order place in the market to buy or sell to close out an open position on order to limit losses when market moves the wrong way. Swap An agreement to exchange on currency on index return for another, the exchange on fixed interest payments for a floating rates payments or the exchange of an equity index return for a floating interest rate. Underlying The currency, commodity, security or any other instrument that forms the basis of a future or a option contract. Writer The person who originates the option contract by promising to perform the Certain obligation in return for the price of the option. Also known as the option writer. All or noting option An option with a fixed, predetermined payoff if the underlying instrument is at or beyond the strike price at expiration. Average option A path dependent option that calculates the average of the path traversed by the asset, arithmetic or weighted. The payoff therefore the difference between the average price of the underlying asset, over the life of option and the exercise price of the option. Basket option A third party option covered warrant on a basket of underlying stocks, Currencies or commodities.

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Bermuda option Like the location of the Bermudas, this option located somewhere between a European style options, this can be exercised only at Maturity and an American style option which can be exercised any time. Option holders choose this option can be exercisable only on predetermined dates. Compound options This is simply an option on an existing option such as a call on a Call a put on a put etc, a call on a put etc. Cross-currency options An out performance option stock at an exchange rate between.two currency. Digital options These are options that can be structured as a one touch barrier, double no touch barrier and: all nothing call/puts. The one touch digital provides an immediate payoff if the currency hits your selected price barrier chosen at outset. The double no touch provides a payoff upon expiration if the currency does not touch both the upper and lower price. Barrier selected at the outset. The call/put all or nothing digital option provides a payoff upon expiration if your option finishes in the money. Knock-in-options There are two kinds of known in options, 1) up and in, 2) down and. in. with known in options, the buyer starts out without a vanilla option. If the buyer has selected an upper price barrier and the currency hits that level; it creates the vanilla option with maturity date and strike price agreed upon at the outset. This would be called an up and in. the down and in option is the same as the up and in, expect the currency has to reach a lower barrier. Upon hitting the chosen lower price level, it creates the vanilla option. Multi-index option An out performance option with a payoff determined by the 85

deference in performance of two or more indices. Out performance option An option with a payoff based on the amount by which one of two underlying instruments or indices out performs the other. Quantity adjusting option This is an option design to eliminate the currency risk by fix effectively hedging it. It evolves combining an equity option and incorporating a predetermined rate.

Example: if the holder has in the money Nikkei index call option expiration, the quanto option terms would trigger by covering the yen proceeds into dollar which was specified at the out set in the quanto option contract. The rate is agreed upon at the beginning without the quantity of course, since this is an unknown at the time. Secondary currency option An option with a payoff in a difference currency than the underlings trading currency. Swaption An option to enter into a Swap contract. Up-and-out-option The call pays of early exercise price trigger is hit. The put expires. Worthless if the market price of the underlying risks is above a predetermined expiration price. Zero strike price option An option with an exercise price of zero, or close to zero, Traded on exchanges were there is transfer tax, owner Restriction or other obstacle to the transfer of the underlying.

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TITLE

AUTHOR

PUBLICATION

Securities Analysis and Portfolio Management R. Madhumati Pearson Education

Investments

Schaums

TATA McGraw-Hill

International Financial Management

P.G.Apte

TATA McGraw-Hill

Financial Institutions and Markets

L.M.Bhole

TATA McGraw-Hill

Options, Futures and Other Derivatives

John C. hull

Pearson Education

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