INTRODUCTION A derivative is a security whose value depends on the value of to gather more basic underlying variable. These are also known as contingent claims. Derivative securities have been very successful innovation in capital market. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, financial markets are marked by a very high degree of volatility. Through the use of derivative products, is possible to partially or fully transfer price risks by a locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuation in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in 1
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
INTRODUCTION
A derivative is a security whose value depends on the value of to
gather more basic underlying variable. These are also known as contingent
claims. Derivative securities have been very successful innovation in capital
market.
The emergence of the market for derivative products, most notably
forwards, futures and options, can be traced back to the willingness of risk
averse economic agents to guard themselves against uncertainties arising out
of fluctuations in asset prices. By their very nature, financial markets are
marked by a very high degree of volatility. Through the use of derivative
products, is possible to partially or fully transfer price risks by a locking-in
asset prices. As instruments of risk management, these generally do not
influence the fluctuation in the underlying asset prices.
However, by locking-in asset prices, derivative products minimize the
impact of fluctuations in asset prices on the profitability and cash flow
situation of risk-averse investor.
Derivatives are risk management instruments, which drive their value
form underlying asset. Underlying asset can be bullion, index; share, currency,
bonds, interest etc.
1
NEED OF THE STUDY:
Different investment avenues are available investors. Stock market also offers
good investment opportunities to the investor alike all investments, they also
carry certain risks. The investor should compare the risk and expected yields
after adjustment off tax on various instruments while talking investment
decision the investor may seek advice from expertly and consultancy include
stock brokers and analysts while making investment decisions. The objective
here is to make the investor aware of the functioning of the derivatives.
Derivatives act as a risk hedging tool for the investors. The objective if to help
the investor in selecting the appropriate derivates instrument to the attain
maximum risk and to construct the portfolio in such a manner to meet the
investor should decide how best to reach the goals from the securities
available.
To identity investor objective constraints and performance, which help
formulate the investment policy?
The develop and improvement strategies in the with investment policy
formulated. They will help the selection of asset classes and securities in each
class depending up on their risk return attributes.
2
OBJECTIVES
To study the various trends in derivatives in derivative market.
To study the role of derivatives in Indian financial market.
To study in detail the role of futures and options.
To find out profit/loss of the option holder and option writer.
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; the study is not based on the international
perspective of derivative markets.
The study is limited to the analysis made for types of instruments of
derivates each strategy is analyzed according to its risk and return
characteristics and derivatives performance against the profit and policies of
the company.
3
METHODOLOGY
To achieve the objective of studying the stock market data has been
collected.
Research methodology carried for this study can be two types
1. Primary data
2. Secondary data
PRIMARY DATA
The data, which is being collected for the first time and it is the original
detain this project the primary data has been taken from NSE staff and guide
of the project.
SECONDARY DATA
The secondary information is mostly taken from websites, books, &
journals etc.
4
LIMITATION OF THE STUDY
The subject of derivative if vast it requires extension study and research to
understand the debt of the various instrument operating in the market only
a recent plenomore.
But various international examples have also been added to make the study
more comfortable.
There are various other factors also which define the risk and return
preference of an investor however the study was only contained towards
the risk minimization and profit maximization objective of the investor.
The derivative market is a dynamic one premiums, contract rates strike
price fluctuate on demand and supply basis.
Data related to last few trading months was only consider and interpreted.
5
INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably
forwards, futures and options, can be traced back to the willingness of risk-
averse economic agents to guard themselves against uncertainties arising out
of fluctuations in asset price. By their very nature, the financial markets are
marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully
transfer price risks by locking-in asset prices. As instruments of risk
management, these generally do not influence the fluctuations in the
underlying asset prices. However, by locking-in asset prices, derivative
products minimize the impact of fluctuations in asset prices on the profitability
and cash flow situation of risk-averse investors.
Derivatives defined:
Derivative is a product whose value is derived from the value of one or
more basic variables, called bases (underlying asset, index, or reference rate),
in a contractual manner. The underlying asset can be equity, forex, commodity
or any other asset.
For example: wheat farmers may wish to sell there heaviest at a future date to
eliminate the risk of a change in prices by that date. Such a transaction is an
example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the “underlying”. In the Indian context the Securities
Contracts (Regulation) Act, 1956(SC®A) defines “derivatives” to include…
6
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.
Derivatives are securities under the SC® A and hence the regulatory
framework under the SC® A governs the trading of derivatives.
Definitions
“A Derivative can be defined as a financial instrument whose value
depends on (or derives from) the value of other, more basic underlying
variables.”
- John C. Hull
“A Derivative is simply a financial instrument (or even more simply an
agreement between two people) which has a value determined by the price
of something else.”
- Robert L. McDonald
Derivatives are financial instruments whose value is derived from its
underlying it may be stock, commodity, gold, Index, etc.
Derivatives give an opportunity to buy or sell the underlying at a future date
but at a pre-specified price decided at the date of entry of the contract.
Functions
The following are the various functions that are performed by the derivatives
markets. They are…
7
1. Prices in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of the underlying asset to
the perceived future level.
2. Derivatives markets help to transfer risks from those who have them but
may not like them to those who want them.
3. Derivatives market helps increase savings and investments in the long run.
4. Derivatives trading act as catalyst for new entrepreneurial activity.
Advantages
1. Transactional efficiency-greater liquidity and lower cost.
2. Price discovery-dissemination of price information
3. Risk management-transfer of risks.
Characteristics of derivatives
1. Their value is derived from an underlying instrument such as stock index,
currency, etc.
2. They are vehicles for transferring risk.
3. They are leveraged instruments
Participants
There are three broad categories of participants participating in the
derivative segment
They are
Hedgers: Hedgers are investors who would like to reduce risk. Hedges
seek to protect themselves against price changes in a commodity in which
they have an interest.
8
Speculators: Speculators bet on the future price movements of an asset.
Derivatives give them an extra leverage that they can increase both the
potential gains and losses. Speculators are major players in the markets,
without whom the market probably would ever exist.
Arbitrageurs: These are specialized in making purchase and sales in
different markets at the same time and there by make profits by the
differences in the prices between two countries i.e. they take the advantage
of the discrepancy between prices in two different markets.
Functions
The following are the various functions that are performed by the
derivatives markets. They are:
Prices in an organized market reflect the perception of market participants
about the future and lead the prices of the underlying asset to the perceived
future level.
Derivatives market help to transfer risks from those who have them but
may not like them to those who want them.
Derivatives markets help increase savings and investments in the long run.
Derivatives trading act as a catalyst for new entrepreneurial activity.
ADVANTAGES
Risk management:
Risk management is not about the elimination of risk rather it is about
the management of risk. Financial derivatives provide a powerful tool for
limiting risk that individual an organizations face in ordinary conduct of
their business. Successful risk management with derivatives requires are
thorough understandings of principles that govern the pricing of financial
9
derivatives. Used correctly, derivatives can save costs and increased
returns.
Trading Efficiency:
Derivatives allow for the free trading of individual risk components,
there by improving market efficiency. Traders can use a position in one or
more financial derivatives as a substitute for a position in the underlying
instruments. In many instances traders find financial to more attractive
instrument than the underlying security is reason being the greater amounts
of liquidity in the market afford by the financial derivatives and lowered
transaction costs associated with a trading a financial derivative as
compared to the cost of trading the underlying instrument.
Speculation:
Serving as a speculative tool is not the only use, and probably not the
most important use, of financial derivatives. Financial derivatives are
considered to be risky. However, these instrument acts as a powerful
instrument for knowledgeable traders to expose themselves to properly
calculated and well understood risks in pursuit of a reward i.e. profit.
Types of Derivatives
Following are the various types of derivatives:
Forwards
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date on the future at today’s pre-agreed
price.
10
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 contract are
special types of forward contracts in the sense that the former or
standardized exchange-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 up to one year, the majority of the options
traded on options exchanges having a maximum maturity of 9 months.
Longer- dated options are called warrants and are generally trade 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
Basket options are options on portfolio of underlying assets. The
underlying asset is usually a moving average of a basket of asset. Equity
index options are a form of basket options.
11
Swaps
Swaps are private agreements between two parties to exchange cash flows
in the future according to her pre-arranged 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.
Swap options
Swap options are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swap option is an option on
a forward swap. Rather than have calls and puts, the swap options market
has receiver swap options and payer swap options. A receiver swap option
is an option to receive fixed and pay floating. A prayer swap option is an
option to pay fixed and receive floating.
Forwards
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
12
party wishes to reverse the contract, it has to compulsorily go to the same
counter party, which often results in high prices being charged.
Forward contracts are very useful in hedging and speculation.
Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading
Liquidity, and
Counter party risk is a very serious issue.
The basic problem is that of too much flexibility and generality.
Futures
Defined futures: A future contract is on by which one party agrees to
Buy from/Sell to the other party at a specified future time, on a asset at a
price agreed at the time of the contract and payable on maturity date. The
agreed price is known as the strike price. The underlying asset can be a
commodity, currency debt or equity securities etc.
The standardized items on a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery
The units of price quotation and minimum price change
Distinctive future
Trade on an organized exchange
Standardized contract terms
13
More liquid
Requires margin payments
Follows daily settlement
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.
Multiplier: It is pre-determined value, used to arrive as the contract size.
It is price per index point.
Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one-month, two-months and three-
months expiry cycles, which expire on the last Thursday of the month.
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 under one
contract. For instance, the contract size on NSE’s futures market is 200
Nifties.
Basis: In the context of financial futures, basis is the differences of futures
price minus the spot price. There will be a different basis for each delivery
month for each contract. In a normal market, basis will be positive. This
reflects that futures prices normally exceed spot prices
Cost of carry: The relationship between futures prices and spot prices can
be summarized in terms what is known as the cost of carry. This measures
14
the storage cost plus the interest that is paid to finance the asset less the
income earned on the asset.
Open Interest: Total outstanding long or short positions in the market at
any specific time. As total long positions for market would be equal to
short positions, for which calculation of open Interest, only one side of the
contract is counted.
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.
Making-to-market: In the futures market, at the end of each trading day,
the margin account is adjusted to reflect the investor’s 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.
This is set to ensure that the balance in the margin account never becomes
negative. If the balance in the account falls below the maintenance margin,
the investor receives a margin call and is expected to top up the margin
account to the initial margin level before trading commences on the next
day.
Cash settled: Open position at the expiry of the contract is cash settled.
Physical delivery: Open position at the expiry of the contract is settled
through delivery of the underlying asset. In the futures market, the
physical delivery of the underlying is very rare.
15
Parties in futures contracts
There are two parties in the future contract, the buyer and the seller. The
buyer of the contract is one who is LONG on the futures contract and the
seller of the contract is one who is SHORT on the futures contract.
The payoff for the buyer and seller of the futures contracts:
Pay-off for a buyer of futures:
P
E2 F E1
Options
Introduction: Option is a type of a contract between two persons where one
grants the other the right to buy a specific asset at a price within a specified
period of time. Alternatively the contract may grant the other person the right
to sell a specific asset at a price with in a specific period of time. In order to
have this right, the option buyer has to pay the seller of option premium.
The assets on which options can be derived are stocks, commodities, indexes,
etc., and if the underlying asset is the non-financial asset the options are Non-
financial options like Commodity options.
16
Properties of options
Options have several unique properties that set them apart from other
securities. The following are the properties of options.
Limited loss
High leverage
Limited life
Distinctive features
Exchange traded with notation.
Exchange defines the product same as futures.
Strike price is fixed, price moves
Price is always positive
Nonlinear payoff
Only short at risk
The purchase of an option requires an up-front payment.
Elementary option strategies
Pay-off profile for buyer of a call option:
The pay-off of buyer of the option depends on the spot price of the
underlying asset. The following graph shows the pay-off of buyer of a call
option.
R S ITM
E2 E1
O T M ATM
P
17
S = strike price ITM = In-the-MoneySP = Premium/profit ATM = At-the-MoneyE1 = Spot price 1 OTM = Out-of the MoneyE2 = Spot price 2 SR = Profit at Spot price E2
Case1: (Strike price > Strike price)
As the spot price [E1] of the underlying asset is more than strike price [S].
The buyer gets the profit increases more than [E1] then the profit also
increase more than SR.
Case 2: (Strike price < Strike price)
As the spot price [E2] of the price underlying asset is less than strike price
[S]. The buyer gets loss of [SP], if price goes down less than [E2] then also
his loss is limited to his premium [SP].
Pay-off profile for seller of a call option:
The pay-off of seller of the call option depends on the spot price of the
underlying asset.
The following graph shows the pay-off of seller of a call option.
P ATM
ITM E1 E2
S O T M
R
S = Strike price ITM = In-the-MoneySP = Premium/profit ATM = At-the-MoneyE1 = Spot price 1 OTM = Out-of the MoneyE2 = Spot price 2 SR = Profit at Spot price E2
18
Case1: (Strike price < Strike price)
As the spot price [E1] of the underlying asset is more than strike price [S].
The seller gets the profit of [SP], if price decreases less than [E1] then also
profit of the seller does not exceed [SP].
Case 2: (Strike price > Strike price)
As the spot price [E2] of the price underlying asset is more than strike
price [S]. The seller gets loss of [SR], if price goes more less than [E2]
then also the loss of the seller increases more than [SR].
Pay-off profile for buyer of a put option:
The pay-off of seller of the call option depends on the spot price of the
underlying asset.
The following graph shows the pay-off of seller of a put option.
R ITM
E1 E2
S O T M
ATM P
S = Strike price ITM = In-the-MoneySP = Premium/profit ATM = At-the-MoneyE1 = Spot price 1 OTM = Out-of the MoneyE2 = Spot price 2 SR = Profit at Spot price E2
Case1: (Strike price < Strike price)
As the spot price [E1] of the underlying asset is less than strike price [S].
The buyer gets the profit of [SR], if price decreases less than [E1] then
also profit increases more than [SR].
19
Case 2: (Strike price > Strike price)
As the spot price [E2] of the underlying asset is more than strike price [S].
The buyer gets loss of [SP], if price goes more than [E2] then the loss of
the buyer is limited to his premium [SP].
Pay-off profile for seller of a put option:
The pay-off of seller of the call option depends on the spot price of the
underlying asset.
The following graph shows the pay-off of seller of a call option.
P ATM ITM
E1 E2
S
S = Strike price ITM = In-the-MoneySP = Premium/profit ATM = At-the-MoneyE1 = Spot price 1 OTM = Out-of the MoneyE2 = Spot price 2 SR = Profit at Spot price E2
Case1: (Strike price < Strike price)
As the spot price [E1] of the underlying asset is less than strike price [S].
The seller gets the loss of [SR], if price decreases less than [E1] then also
loss exceeds more than [SR].
Case 2: (Strike price > Strike price)
20
As the spot [E2] of the price underlying asset is more than strike price [S].
The seller gets profit of [SP], if price goes more than [E2] then the profit
of the seller is limited to his premium [SP].
Factors affecting the price of an option:
The following are the various factors, which 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 strike price exceeds the stock price.
Put option 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
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 a stock price is a measure of uncertain about futures stock
price movements. As volatility increases, the change of that the stock will
21
do very well or very poor increases. The value of both calls and puts
therefore increases as volatility increase.
Risk free interest rate:
The put option prices decline as the risk-free rate increase where as the
prices of calls always increase as the risk-free interest 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 terminology
Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
Option price: Option price is the price, which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity.
In-the-money option: An in-the-money (ITM) 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 (i.e. spot
price - strike price). If the index is much higher than the strike price, the
call is said to be deep ITM. In the case of a put, the put is ITM if the index
is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that
would lead to zero cash flow, if it were exercised immediately. An option
22
on the index is at-the-money when the current index equals the strike price
(i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an
option that would lead to a negative cash flow, if it were exercised
immediately. A call option on the index is out-of-the-money when the
current index stands at a level, which is less than the strike price (i.e. spot
price _strike price). If the index is much lower than the strike price, the
call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.
Intrinsic value of an option: The option premium can be broken down
into two components – intrinsic value and time value. The intrinsic value
of a call is the amount the option is ITM, if it is ITM. If the call is OTM,
its intrinsic value is zero.
Time value of an option: The time value of an option is the difference
between its premium and its intrinsic value. Both calls and puts have time
value. An option that is OTM or ATM has only time value. Usually, the to
expiration, the greater is an option’s time value, all else equal. At
expiration, an option should have no time value.
Futures and Options
Futures…
Futures price: Agreed-upon price at maturity.
Long position: Agree to purchase.
Short position: Agree to sell.
Profit or loss is unlimited to both buyer and seller of the Futures.
23
Stock Futures: The underlying to these contracts are the individual stocks
like Satyam, Infosys, HCL, HPCL, Wipro, etc..
Index Futures: The underlying to these contracts are indices like S&P
(Standard and Poor’s), CNX, Nifty, Sensex…
Implied cost of carry:
(Future Price – spot price) / spot price
It indicates the notional cost the investor would have incurred in carrying
the stock.
Options…
Option class: All listed options of a particular type (call or put) on a
particular underlying instrument. E.g.: Infosys calls or Infosys puts.
Option series: All options of a given class with the same expiration date
and strike price.
Open interest: The total number of options contract outstanding in the
market at any given point of time.
Covered option: If an investor takes a position in options and also on its
underlying then his position is covered.
E.g.: If investor buys a put on Reliance and also possesses Reliance shares
then his position is covered. This is protective in nature.
Naked option: If the investor takes a position only in option with out
possessing its underlying then its naked option.
E.g.: If investor buys either a put or call option on Reliance with out
possessing the underlying then it is a naked option. This is speculative in
nature.
24
Buy call Option Buy Put Option Sell Call Option
Sell Put Option
A right to buy A right to sell A duty to buy
A duty to
At set strike At set strike At set strike At set strikeFor an expiry For an expiry For an
expiryFor an
Paying a price Paying a price Receive a price
Receive a
Sans a duty Sans a duty Sans a right Sans a rightSettle in cash Settle in cash Settle in
cashSettle in
Particulars Futures OptionsContract Size Standardized StandardizedProfits Unlimited Unlimited to buyer
Losses Unlimited Limited to BuyerType of Trade Exchange traded Exchange tradedCounter party Risk Does not exist Does not existPrice Margin is paid, No cost Premium is paid,
This is the price of the Right.
Derivatives are the contracts for a limited time period say one month, two
months, and three months. The last Thursday of the month is expiry day for
those contracts. The proceeding day to last Thursday of the month only
trading will starts and new contracts will exist.
One month trading contract is called “Near month contract”,
Two month trading contract is called “Middle month contract”, and
Three months trading contract is called “Far month contract”.
At any point of time there would be three contracts of varying maturities. The
maximum maturity of the month contract will be one (1) month and the
maximum of a far month contract will be three (3) months.
An example on PUT option:
25
X buys one April month put option on NIFTY at the strike price of
Rs.1470/- of Infosys at a premium of Rs.35/-.
1). If on the date of expiry the market price is less than 1470, the put
option will be economically viable and hence exercised.
2). The investor will earn profits once the share price falls below Rs.
1435/- (strike price – premium [i.e. 1470-35).
3). Suppose price of NIFTY is at 1430 on expiry date, the investor who
will get a profit of Rs.5/-, will exercise the put option.
[(Strike price – spot price) - premium][(1470 = 1430) - 35].Long on PUT (buyer’s perspective)
Pay-off on NIFTY long put for different spot pricesStrike Price – 1470/- Premium – 35/-Spot Price