Derivatives With Reference to Future and Options

1

Executive SummaryIntroduction

India being one of the fast moving economies in the world is registering 9-9.5 percent growth in its annual GDP. So its obvious that India is a cynosure of all the FIIs in the world. Investments in to India is mainly trough FDI and through FIIs. In the fiscal year 2006-2007 India has attracted $19 bn. which is 300 percent of previous years FDI.

Mainly the investment of these FIIs is through secondary market. The stock market comes in the secondary market. It performs activities such as trading in share, securities, guilt edge securities, bonds, mutual funds and commodities.Motilal Oswal securities is the well-diversified financial services firm offering a range of financial products and services such as retail wealth management (including securities and commodities broking), portfolio management services, institutional broking, venture capital management and investment banking services. As a leading Indian domestic brokerage house, we have a diversified client base that includes retail customers (including highnet worth individuals), mutual funds, foreign institutional investors, financial institutions and corporate clients. There are various sources which provide information to investor about return and benefit of each investment. Before investing in diversified portfolio investor undergoes various analysis some times he takes advice from experts. There are various factors which affects investors portfolio such as annual income, government policy, natural calamities, economical changes etc Topic:

Derivatives with reference to Future and OptionsName of the Organization:- Motilal Oswal Securities Ltd,Hubli. Need for the study:-

Financial Derivatives are quite new to the Indian Financial Market, but the derivatives market has shown an immense potential which is visible by the growth it has achieved in the recent past, In the present changing financial environment and an increased exposure towards financial risks, It is of immense importance to have a good working knowledge of Derivatives.

The Derivatives market in Hubli is still in a budding stage, It is necessary to study the derivatives and derivative products and understand the derivative trading in India and try to gather information regarding the Derivative products with special focused study on Future and Options. Objectives of the Study:-

To study the Derivative products with special reference to Future and Options, and a detailed study of Options strategies used in Derivatives trading in India.

Sub Objectives:

To study the trading procedures for Derivative products

To study the basic knowledge about derivative market and options To study the clearing and settlement procedure of Derivatives products To study the option as a profit making strategy.

To know the use of different strategies available in different market condition.

Methodology:-

Methodology explains the methods used in collecting information to carry out the project.

Sources of data:

Secondary data

The data was collected through secondary sources. As this project was a descriptive study conducted, there was no questionnaire used to collect primary data or any other additional data. The secondary data source is through internet, from website of National Stock Exchange Secondary data will be collected from the various books on

Derivatives, Journals, Magazines and Internet.

Sample Design:

Sample unit: Motilal Oswal securities Ltd,Hubli

Sample Size: 2 sectors and 4 companies

The sectors covered under the study are:1. Automobile sector

a. Maruti Udyog Ltd.

b. Tata Motors.

2. Cement sector

a. ACC

b. Gujarat Ambuja

INDUSSTRY PROFILE

2. CAPITAL MARKET

Capital is required to bring a business into existence, to keep it alive and see it growing. Achieving the goal of business requires the performance of such business functions as production, distribution, marketing, research and development all of which involve investment of capital. Further, companies require capital not only for meeting their long term requirements of funds for new projects, modernization, expansion and diversification programmers also for covering operational expenses.

2.1 Categories of Capital:

1. Long-term capital/fixed capital:

It represents the amount of capital invested in fixed assets. It is a long-term investment.

2. Short-term capital/working capital:

It represents the amount of capital invested in current assets. Current assets are those assets, which can be converted into cash with in a year/an accounting period. Working capital is required for meeting the operating cost of the concern.

3. Export capital:

The amount of capital required for making payment in international trade is called export capital. The methods of payment in international trade are

Cash with order

Open account

Bills of exchange and

Bankers documentary credits.

4. Venture capital:

Venture capital is the capital invested in highly risky ventures.

Meaning and Definition of Capital Market:

Generally speaking, capital market is the place wherein funds are raised for companies for meeting their long-term requirements. Capital market is a market for long-term capital.

Capital market may be defined as the mechanism which co-ordinate the demand and supply forces of long-term capital. The participants on the demand and supply side of this market are financial institutions, mutual funds, agents, brokers, dealers, borrowers and lenders.

Components of Capital Market :

Broadly speaking, capital market is composed of two segments.

1. The new issues market or Primary market

2. The secondary market

1.The new issues market or Primary market:

The primary market the existing companies or the new companies offer shares/debentures to the public for subscription. The primary market also includes the offer of securities to the existing share holders of the companies on right and bonus basis. In the primary market the companies acquire long term funds for meeting their requirements like project financing, expansion, modernizations etc. Primary market creates financial claims. In this market the public can only buy the shares. Parties involved in the primary market are the lenders and the borrowers. Merchant bankers, registrars, issue companies, under-writers, bankers to the issue, public financial institutions, mutual funds etc. are the major players in the new issue market.

The primary market :

is made up of two components:

Where firms 80 public for the first time (through initial public offerings IPOs) and

Where firms which already traded raise additional capital (through seasoned equity offering, or SEOs).

2) The Secondary market:

In the secondary market or stock market old issue are bought and sold. In this market the public can buy and sell securities. This market does not create financial claims. In this market fund does not flow between borrowers and lenders but funds flows between lenders and others/buyers of security. The brokers, the investors, mutual funds and the financial institution are the important constituents of the secondary market.

2.3. Players in the capital market:

The players in the capital market are divided into three categories:

Companies issuing securities: -

As per the SEBI Guidelines, companies intending to issue securities are divided three categories, viz.

a) New companies

b) Existing unlisted companies

c) Existing listed companies

A company is a new company if it satisfies all the following three conditions.

1. It has not completed 12 months of commercial operations.

2. Its audited operative results are not available.

3. It is set up by entrepreneurs with or without track record.

A company is said to be an existing listed company if its shares are listed in the any one of the recognized stock exchanges.

Existing closely held or private companies are called existing unlisted companies.

1. Intermediaries:

Intermediaries are institutional or individual agencies who assist in the process of transforming savings into investment. The major intermediaries I the capital market are:

a) Merchant bankers

b) Under-writers

c) Registrars

d) Brokers

e) Depositories

f) Collecting agents

g) Adverting agencies

h) Agents

i) Stock brokers and Sub-brokers

j) Mutual Funds

2. Investors:

The investors comprising the financial and investment companies and a general public. Companies are employing funds in the hope of receiving future benefits. All rational investors prefer return, but most investors are risk averse, attempt to maximize capital gain. Their preference for dividends is a capital gain depends on their economic status and the effect of tax differential on dividends and capital gains. The institutions and companies raising capital from investors frame the schemes in such a way that these are suitable to all types of investors. The main objectives of investments are as follows.A. Safety: Safety of money is the first objective of an investor.

B. Profitability: The investor makes investment for earning money. He would like to invest in those securities where rate of return is higher.

C. Liquidity: The liquidity refers to the receipt back of investment when the investor wants it.

D. Capital appreciation and,

E. Minimum risk.

2.4. Structure of Capital Market in India:

The structure of Indian capital market has undergone a remarkable transformation over the last four and a half decades and now comprises an impressive network of financial institutions and new financial instruments. The secondary market has become more sophisticated in response to the varied needs of the investors. Provision of long term credit is entrusted with specialized financial institutions. Of these IDBI, IFCI, UTI, LIC, GIC etc. Constitute the largest segment. The various constitutes of capital market are:

i. Equity market

ii. Debt market

iii. Government securities market

iv. Mutual fund schemes.

2.5. Factors influencing the growth of Capital market:

The growth of the capital market is influenced by several factors, which are listed below:

The level of savings and investment of the household sector.

Economic development

Rapid industrialization

Speed in acquiring processing and acting upon information

Technological advances

Corporate performance

Political stability

Globalization of finance

Increased price volatility

Financial innovation

Advances in financial theory

Regulatory change

Foreign Institutional Investors (FIIs) participation in the capital market

NRIs investment

Sophistication among investment managers

Emergence of financial intermediaries like Mutual funds

Development of financial service sectors like merchant banking leasing venture capital financing

International agreement

Liquidity factors

Agency costs

Tax asymmetries

COMPANY OVERVIEWMOTILAL OSWAL SECURITIES LTD.Motilal Oswal securities is the well-diversified financial services firm offering a range of financial products and services such as retail wealth management (including securities and commodities broking), portfolio management services, institutional broking, venture capital management and investment banking services. As a leading Indian domestic brokerage house, we have a diversified client base that includes retail customers (including highnet worth individuals), mutual funds, foreign institutional investors, financial institutions and corporate clients. We are headquartered in Mumbai and as of December 31, 2006, had a network spread across 363 cities and towns comprising 1,160 Business Locations operated by our Business Associates and us.

Motilal Oswal Financial Services Limited is holding company and also provides financing for retail broking customers. We operate through the following four subsidiaries:

Motilal Oswal Securities Limited (MOSL)

Motilal Oswal Commodities Brokers Private Limited (MOCB)

Motilal Oswal Venture Capital Advisors Private Limited (MOVC)

Motilal Oswal Investment Advisors Private Limited (MOIA).

Their business has primarily focused on retail wealth management and institutional broking. In 2006, we diversified into investment banking and venture capital management.

Company Vision

To become well-respected global financial services company by assisting investors create wealth in stock markets word wide

Companies principal business activities include:-

Retail wealth management

Institutional broking

Investment banking

Venture capital management and advisory

Motilal Oswal retail wealth management business provides broking and financing services to our retail customers as well as investment advisory, financial planning and portfolio management services. As at December 31, 2006,they had 213,624 registered retail equity broking clients (as at March 31, 2006, we had 159,091 such clients) and 3,572 registered commodity broking clients (as at March 31, 2006, we had 1,536 such clients) whom they classify into three segments, being mass retail, mid-tier millionaire and private client group (PCG). They offer their retail clients investment products across the major asset classes including equities, derivatives, commodities and the distribution of third-party products such as mutual fund schemes and primary equity offerings. It distribute these products through their Business Locations and online channel. Its institutional broking business offers equity broking services in the cash and derivative segments to institutional clients in India and overseas. As at December 31, 2006, It was empanelled with 240 institutional clients including 150 FIIs. It service these clients through dedicated sales teams across different time zones.Its current organisation structure is set forth in the following chart:-

Motilal Oswal Financial

Services Limited

(MOFSL)

Incorporated on May 18,

2005

Motilal Oswal Securities

Limited (MOSL)

Incorporated on July 5,

1994

Stock Broking (Institutional

& Retail)

Shareholding:

MOFSL 99.95%

Motilal Oswal

Commodi ties Brokers

Private Limited (MOCB)

Incorporated on March 26,

1991

Commodity Broking

Shareholding:

MOFSL 97.55%

Motilal Oswal Venture

Capital Advisors Private

Limited (MOVC)

Incorporated on April 13,

2006

Private Equity Investments

Shareholding:

MOFSL 100.00%

Motilal Oswal Investment

Advisors Private Limited

(MOIA)

Incorporated on March 20,

2006

Investment & Merchant

Banking

Shareholding:

MOFSL 75.00%

Strengths:-

Their principal strengths are as follows:

1. Large and diverse distribution network

Their financial products and services are distributed through a pan-India network. Their business has grown from a single location to a nationwide network spread across 1,160 Business Locations operated by them and Their Business Associates in 363 cities and towns. Their extensive distribution network provides them with opportunities to cross-sell products and services, particularly as they diversify into new business streams. In addition to their geographical spread, They offer an online channel to service their customers. They have recently entered into a strategic alliance with State Bank of India (SBI) to offer our online brokerage services to SBIs retail banking clients. They have received a letter of intent from another bank to offer their online brokerage services to their clients.

2. Strong research and sales teams

They believed that equity as an asset class and business fundamentals drives the quality of their research and differentiates them from their competitors. Their research teams are focused on cash equities,equity derivatives and commodities. As at December 31, 2006, they had 28 equity research analysts covered 208 companies in 25 sectors and 5 analysts covered 18 commodities. The Asiamoney brokers poll has consistently recognised and rewarded in various categories.They believe their our research enables them to identify market trends and stocks with high growth potential, which facilitates more informed and timely decision making by their clients. This helps to build and

promote their brand and to acquire and retain their institutional and retail customers. Their research is complemented by a strong sales and dealing team. Each member of their institutional sales team has significant research experience. They believed that experience enables their sales team to effectively market ideas generated by the research team to their client base and to build stronger client relationships.

In 2006, Asiamoney rated a member of our sales team as the best sales person for Indian equities.

3.Experienced top management

Both its Promoters, Mr Motilal Oswal and Mr Raamdeo Agrawal, are qualified chartered accountants with over two decades of experience each in the financial services industry. In addition, their top management team comprises qualified and experienced professionals with a successful track record. Their managements entrepreneurial spirit, strong technical expertise, leadership skills, insight into the market and customer needs provide us with a competitive strength which will help them to implement business

strategies.

4.Well-established brand

Motilal Oswal is a well-established brand among retail and institutional investors in India. Their brand is associated with high quality research and advice as well as corporate values, like integrity and excellence in execution. They has been able to leverage their brand awareness to grow their businesses, build relationships and attract and retain talented individuals which is important in the financial services industry.

Wide range of financial products and services:-

Understanding

They offer a portfolio of products to satisfy the diverse investment and strategic requirements of retail, institutional and corporate clients. They believed their wide range of products and services enables to build stronger relationships with, and increase business volumes from, their clients. In addition, diverse portfolio reduces their dependence on any particular product, service or customer and allows us to exploit synergies across their businesses.Their Core Purpose and Values

Their mission is to be a well respected and preferred global financial services organisation enabling wealth creation for all their customers.

Their key corporate values are:

Integrity

Teamwork

Meritocracy

Passion and attitude

Excellence in execution.

Strategies:- They are focused on further increasing their market share in a profitable manner and capturing the significant growth opportunities across the Indian financial services spectrum. Key elements of strategies are:-

Increase market share in retail business

They are currently offering a wide range of products to their retail clients through multiple channels, which give flexibility to customers. Their primary focus is to further increase their client base and capture a greater share of their business.

By continuing to grow our distribution network across India.

They are now focused on increasing their concentration in these cities and also expanding into smaller cities and towns that are currently under-serviced by financial services firms. They believed that network expansion, complemented by client-focused relationship management,

will allow them to add new clients, particularly those in the mid-tier millionaire segment and help them to grow market share.

By focusing on wealth management solutions and new product

offerings.

Through improved client relationship management, their wealth management solution offering and convenient and effective

channels of distribution, they expect to grow wealth management business both in overall terms and on a per Business Location basis.

By leveraging research and advisory capability.

We intend to further widen our research coverage by increasing the number of companies and business sectors that we cover. They also propose to enlarge their team of advisors and dealers to strengthen relationships with their clients.

Derivatives

INTRODUCTION:

BSE created history on June 9, 2000 by launching the first Exchange traded Index Derivative Contract i.e. futures on the capital market benchmark index - the BSE Sensex. The inauguration of trading was done by Prof. J.R. Varma, member of SEBI and chairman of the committee responsible for formulation of risk containment measures for the Derivatives market. The first historical trade of 5 contracts of June series was done on June 9, 2000 at 9:55:03 a.m. between M/s Kaji & Maulik Securities Pvt. Ltd. and M/s Emkay Share & Stock Brokers Ltd. at the rate of 4755.

In the sequence of product innovation, the exchange commenced trading in Index Options on Sensex on June 1, 2001. Stock options were introduced on 31 stocks on July 9, 2001 and single stock futures were launched on November 9, 2002.

September 13, 2004 marked another milestone in the history of Indian Capital Markets, the day on which the Bombay Stock Exchange launched Weekly Options, a unique product unparallel in derivatives markets, both domestic and international. BSE permitted trading in weekly contracts in options in the shares of four leading companies namely Reliance, Satyam, State Bank of India, and Tisco in addition to the flagship index-Sensex.

Indian scenario

INDIAN DERIVATIVES MARKETS

1. Rise of DerivativesThe global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.

Price fluctuations make it hard for businesses to estimate their future production costs and revenues.2 Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term.

2. Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures, options and swaps.

Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe Indias long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge, market frictions and regulatory impediments have led to low levels of capital employed. Price volatility may reflect changes in the underlying demand and supply conditions and thereby provide useful information about the market. Thus, economists do not view volatility as necessarily harmful.

Speculators face the risk of losing money from their derivatives trades, as they do with other securities. There have been some well-publicized cases of large losses from derivatives trading. In some instances, these losses stemmed from fraudulent behavior that went undetected partly because companies did not have adequate risk management systems in place. In other cases, users failed to understand why and how they were taking positions in the derivatives.

Derivatives in arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).3. Exchange-Traded and Over-the-Counter Derivative Instruments

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in havala or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchangetraded contracts, relative to OTC contracts.5

4. Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.

In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and A clearinghouse guarantees performance of a contract by becoming buyer to every seller and seller to every buyer.

Customers post margin (security) deposits with brokers to ensure that they can cover a specified loss on the position. A futures position is marked-to-market by realizing any trading losses in cash on the day they occur.

Badla allowed investors to trade single stocks on margin and to carry forward positions to the next settlement cycle. Earlier, it was possible to carry forward a position indefinitely but later the maximum carry forward period was 90 days. Unlike a futures or options, however, in a badla trade there is no fixed expiration date, and contract terms and margin requirements are not standardized.

Derivatives Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchangetraded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.

The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges.

Finally, a 30-year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk.5. Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Nonfinancial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003). Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.

Derivative security or derivative is a contract which specifies the right or obligation between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.

Another way of defining a derivative is that it is a security whose value is determined (derived) from one or more other securities, commodities, or events. The value is influenced by the features of the derivative contract, which may include the timing of the contract fulfillment, the value of the underlying security or commodity, and other factors such as volatility.

The payments between the parties may be determined by the future changes of:

The price of some other, independently traded asset in the future (e.g., a common stock)

The level of some index (e.g., a stock index or heating-degree-days)

The occurrence of some well-specified event (e.g., a company defaulting)

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money. Depending on the definition of the contract, the potential loss or gain may be much higher than if they had traded the underlying security or commodity directly.

Classification of derivatives:

Derivatives are basically classified based upon the mechanism that is used to trade on them.

They are:

Over the Counter derivatives

Exchange traded derivatives

The OTC derivatives are between two private parties and are designed to suit the requirements of the parties concerned.

The Exchange traded ones are standardized ones where the exchange sets the standards for trading by providing the contract specifications and the clearing corporation provides the trade guarantee and the settlement activities

The OTC derivatives markets have the fallowing features compared to exchange traded derivatives:

1. The management of the counter-party (credit) risk is decentralized and located within the individual institutions,

2. There are no formal centralize limits on individual positions, leverages, or margining.

3. There are no formal rules for risk and burden sharing.

4. there are no formal rules or mechanism for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally are not regulated by regulatory authority and the exchanges self regulatory originations, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Common examples of derivatives are:

Forward contracts

Futures contracts

Options such as stock options

Swaps

Some less common, but economically intriguing, examples are:

Economic derivatives which pay off according to the state of the economy as measured by national statistical agencies

Weather derivatives.

Three types of investors trade in derivatives markets.

1) Hedgers: Hedgers enter the derivatives market to lock-in their prices to avoid exposure to adverse movements in the price of an asset. While such locking may not be extremely profitable the extent of loss is known and can be minimized.

2) Speculators: Speculators take positions in the market. They actually bet on the direction of price movements. While profits could be extremely high, potential for losses are also large.

3) Arbitrageurs: Arbitrageurs enter simultaneously into contracts in two or more markets to lock in risk less profit. In India such gains are minimal as price differences on NSE and the BSE are extremely small.

FORWARD CONTRACTS

A forward contract is a particularly simple derivative. It is an agreement to buy or to sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions and one of its corporate clients. It is not normally traded on exchange.

One of the parties to a forward contract assumes a long position and 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 price. The specified price in a forward contract will be referred to as the delivery price. At the time the contract is entered into the price is chosen so that the value of the forward contract to both parties is zero. This means that it costs nothing to take either a long or short position.

A forward contract is settled at maturity. The holder of short position delivers the asset to the holder of long position in return for a cash amount equal to delivery price. A key variable determining the value of a forward contract at any given time is the market price of the asset. As already mentioned, a forward contract is worth zero when it is first entered into. Later it can have a positive or negative value, depending on movements in the price of the asset. For example, if the price of the asset rises sharply soon after the initiation of contract, the value of a long position in the forward contract becomes positive and value of a short position of a forward contract becomes negative.

The main 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.

The contract has to be settled by delivery of the asset on expiration date.

In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

FUTURES CONTRACTA futures contract is a form of forward contract, a contract to buy or sell an asset of any kind at a pre-agreed future point in time that has been standardized for a wide range of uses. It is traded on a futures exchange. Futures may also differ from forwards in terms of margin and delivery requirements. To make trading possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other, the exchange also provides the mechanism which gives the two parties guarantee that the contract will be honored.

For example, Coffee grower may enter into a contract with a wholesale buyer to sell Coffee at a particular price on a future date. The coffee buyer could have a mutually agreed contract with the seller (Forward Contract) or he / she could buy a contract through a regulated market like the Coffee Futures Exchange India Limited (COFEI). The National Stock Exchange and the Bombay Stock Exchange offer such facilities for trading Futures and Options contracts an underlying financial instrument like stocks/shares.

The types of futures that are traded fall into four fundamentally different categories. The underlying asset traded may be a physical commodity, foreign currency, an interest-earning asset or an index, usually a stock index.

A commodity futures contract is an agreement between two parties to buy or sell a specified quantity and quality of commodity at a certain time in future at a certain price agreed at the time of entering into the contract on the commodity futures exchange.

A currency future is a transferable futures contract that fixes the price at which a foreign currency can be bought or sold at a specified future date. Investors use these financial future contracts to hedge against foreign exchange risk. These financial derivatives can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. Investors can close out the contract at any time prior to the contract's delivery date. The futures can be on the interbank cash rate or on the forward exchange rate of the currency. Currency futures are quoted in US-dollars per unit of foreign currency.

An interest rate future is a futures contract with an interest bearing instrument as the underlying asset. Examples include Treasury-bill futures, Treasury-bond futures, LIBOR futures, Eurodollar futures.

The attributes in which the futures contracts differ from forwards are:

Forward ContractFutures Contract

Nature of TransactionBuyer and seller make a custom-tailored agreement to buy/sell a given amount of a commodity at a set price on a future date.Buyer and seller agree to buy or sell a standardized amount of a standardized quality of a commodity at a set price on, Standardized

Size of ContractNegotiableStandardized

Delivery DateNegotiableStandardized

Security DepositDependent on credit relationship between buyer and seller. May be zero. Both buyer and seller post a performance bond (funds) with the exchange. Daily price changes may require one party to post additional funds and allow the other party to withdraw such funds

PricingPrices are negotiated in private by buyer and seller, and are normally not made publicPrices are determined publicly in open, competitive, auction-type market at a registered exchange. Prices are continuously made public

Getting Out of DealsDifficult to do, so most forwards result in a physical delivery of goodsEasy to do by entering into an opposite transaction from that initially taken

Futures contracts are traded on an exchange. Forward contracts are mutually agreed between two parties. As expected, the only benefit of entering into a Forwards contract comes from the flexibility of having tailor-made contracts. Yet, Forwards are important as prices in Forward markets serve as indicator of Futures prices. Contracts on Futures markets are fixed in terms of contract size, product type, product quality, expiry, and mode of settlement. Futures markets, however, provide liquidity as contracts are traded on a broader client base. Counter party risk (of non-delivery / non payment) is also eliminated in the Futures market as the designated clearing house becomes counter party to each trade that is, it acts as buyer to seller and as a seller to the buyer and guarantees the trades.

What is an Index?

To understand the use and functioning of the index derivatives markets, it is necessary to understand the underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivative instruments such as index futures.

The Sensex and NiftyIn India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based on market capitalization, industry representation, trading frequency etc. It represents 30 large well-established and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore.

Futures and stock indicesFor understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index.

Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes.

Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index 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. Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. We shall learn in subsequent lessons how one can leverage ones position by taking position in the futures market.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.Example:Futures contracts in Nifty in July 2001

Contract monthExpiry/settlement

July 2007July 26

August 2007August 30

September 2007September 27

On July 27Contract monthExpiry/settlement

August 2001August 30

September 2001September 27

October 2001October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.

The index futures symbols are represented as follows:

BSENSE

BSXJUN2001 (June contract)FUTDXNIFTY28-JUN2001

BSXJUL2001 (July contract)FUTDXNIFTY28-JUL2001

BSXAUG2001 (Aug contract)FUTDXNIFTY28-AUG2001

Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example.

Illustration:Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs)Selling priceProfit

100040003000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.

Shyam defaultsShyam honours

1000 (Initial Investment)3000 (Initial profit)

1000 (penalty from Shyam)(-1000) discount given to Shyam

- (No gain/loss)2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.

The example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.

Stocks carry two types of risk company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us see the impact on the overall gain/loss that accrues:

Index up 10%Index down 10%

Gain/(Loss) in PortfolioRs 120,000(Rs 120,000)

Gain/(Loss) in Futures(Rs 120,000)Rs 120,000

Net EffectNilNil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market.

Thus, we understand how one can use hedging in the futures market to offset losses in the cash market.

Speculation

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.

Illustration:Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position.

Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market.

Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300.

The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account.

If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Sale = 1070

Cost= 1000+30 = 1030Arbitrage profit = 40These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.

Pricing of Index FuturesThe index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging between the underlying and futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

1. The cost of carry modelThe cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage.

Sale = 1070

Cost= 1000+30 = 1030Arbitrage profit 40However, one has to remember that the components of holding cost vary with contracts on different assets.

2. Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns.

Example:Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 0.03)

Futures price = Rs 107

If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10. The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2. Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies1. SpeculationWe have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. Now we will see one can trade in index futures and use forward contracts in each of these instances.

Taking a view of the marketHave you ever felt that the market would go down on a particular day and feared that your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing to do is to sell index futures.

Scenario 1:On July 13, 2001, X feels that the market will rise so he buys 200 Nifties with an expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

X makes a profit of Rs 15,600 (200*78)

Scenario 2:On July 20, 2001, X feels that the market will fall so he sells 200 Nifties with an expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

X makes a profit of Rs 13,400 (200*67).

In the above cases X has profited from speculation i.e. he has wagered in the hope of profiting from an anticipated price change.

2. HedgingStock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stocks Beta. The Beta of stocks are available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.

Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks?

Have you ever been a stockpicker and carefully purchased a stock based on a sense that it was worth more than the market price?

A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:

a. His understanding can be wrong, and the company is really not worth more than the market price or

b. The entire market moves against him and generates losses even though the underlying idea was correct.

Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:

X holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does X have to sell if the index futures is ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. X closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.

Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk . If the index is at 1200 * 200 (market lot) = Rs 2,40,000, The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000

If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.

Thus, we have seen how one can hedge their portfolio against market risk.

3. Margins

The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front. The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.

A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.

The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Position on Day 1Close PriceLossMargin releasedNet cash outflow

1400*200 =2,80,00020,000 (3,00,000-2,80,000)3,000 (45,000-42,000)17,000 (20,000-3000)

Payment to be made(17,000)

New position on Day 2Value of new position = 1,400*200= 2,80,000

Margin = 42,000Close PriceGainAddn MarginNet cash inflow

1510*200 =3,02,00022,000 (3,02,000-2,80,000)3,300 (45,300-42,000)18,700 (22,000-3300)

Payment to be recd18,700

Position on Day 3Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 3,300

Close PriceGainNet cash inflow

1600*200 =3,20,00018,000 (3,20,000-3,02,000)18,000 + 45,300* = 63,300

Payment to be recd63,300

Margin account*Initial margin = Rs 45,000

Margin released (Day 1) = (-) Rs 3,000Position on Day 2 Rs 42,000

Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/lossDay 1 (loss) = (Rs 17,000)

Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000Total Gain = Rs 19,700The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

Settlement of futures contracts:

Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract.

MTM settlement:

All futures contracts for each member are marked-to-market(MTM) to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference between: The trade price and the days settlement price for contracts executed during the day but not squared up.

The previous days settlement price and the current days settlement price for brought forward contracts.

The buy price and the sell price for contracts executed during the day and squared up.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount in cash which is in turn passed on to the CMs who have made a MTM profit. This is known as daily mark-to-market settlement. CMs are responsible to collect and settle the daily MTM profits/losses incurred by the TMs and their clients clearing and settling through them. Similarly, TMs are responsible to collect/pay losses/ profits from/to their clients by the next day. The pay-in and pay-out of the mark-to-market settlement are effected on the day following the trade day. In case a futures contract is not traded on a day, or not traded during the last half hour, a theoretical settlement price is computed.

Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant CMs clearing bank account on the day following expiry day of the contract.

All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price.

The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract.

In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary alongwith the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameters are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices.

The following table shows how futures data will be generally displayed in the business papers daily.SeriesFirst TradeHighLowCloseVolume (No of contracts)Value (Rs in lakh)No of tradesOpen interest (No of contracts)

BSXJUN20004755482047404783.1146348.7010451

BSXJUL20004900490048004830.81228.98102

BSXAUG2000480048704800483524.8421

Total1603825211654

Source: BSE The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract.

The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades.

One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts.

The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions not both.

OPTIONSWhat is an Option?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).

In detail an option is a contract whereby the contract buyer has a right to exercise a feature of the contract (the option) at future date (the exercise date), and the seller has the obligation to deliver the specified feature of the contract. Since the option gives the buyer a right and the seller (also known as a writer) an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

The buyer will exercise his right only if it is favorable to him. If it is not, he will not exercise his right because he has no obligation. Thus, the underlying asset moves from to another only when the option is exercised. When it moves from one counterpart to another, its price (in cash) must move in the opposite direction. The amount of price in cash is fixed at the time of contract and is called the strike price or exercise price.

An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

Listed options have been available since 1973, when the Chicago Board Options Exchange, still the busiest options exchange in the world, first opened.

The World With and Without Options

Prior to the founding of the CBOE, investors had few choices of where to invest their money; they could either be long or short individual stocks, or they could purchase treasury securities or other bonds.

Once the CBOE opened, the listed option industry began, and investors now had a world of investment choices previously unavailable. Options vs. StocksIn order to better understand the benefits of trading options, one must first understand some of the similarities and differences between options and stocks.

Similarities:

Listed Options are securities, just like

stocks.

Options trade like stocks, with buyers

making bids and sellers making offers.

Options are actively traded in a listed

market, just like stocks. They can be

bought and sold just like any other security.

Differences:

Options are derivatives, unlike stocks

(i.e, options derive their value from

something else, the underlying security).

Options have expiration dates, while stocks

do not.

There is not a fixed number of options, as

there are with stock shares available.

Stockowners have a share of the company,

with voting and dividend rights. Options

convey no such rights.

Option Feature

In other contracts, the focus is on underlying asset and each counterpart has right and obligation (r&o) to perform. For example, in futures contract, the buyer has the right and obligation to buy; and seller, the right and obligation to sell.

Option contract differs from others in two respects. The primary focus is on r&o, not on underlying asset. Second, the r&o are separated, with buyer taking the right without obligation (r w/o o) and seller taking the obligation without right. Thus, the distinguishing feature of option is the right-without-obligation for the buyer.

In option contract, what the buyer buys is the right, not the underlying asset; and what the seller sells is the right, not the underlying asset.

Exhibit 1: Option v Other Contracts

The option contract

For the option purchaser (also called the holder or taker), the option:

Offers the right (but imposes no obligation),

To buy (call option) or sell (put option)

A specific quantity,

Of a given financial underlying.

At an agreed price (exercise or strike price), or calculable value (based on a reference rate)

Either before maturity date (American option) or at a fixed maturity date (European option)

For a premium (option price).

The counterparty (option writer / seller) has an obligation to fulfill if the option holder exercises the option. In return, the option seller receives the option price or premium.

Call optionsCall options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.

Illustration 1:Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contractStrike priceCall premium

Dec Nifty1325Rs 6,000

1345Rs 2,000

Jan Nifty1325Rs 4,500

1345Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put Options :

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on X. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro.

Quotes are as under:

Spot Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020

2. Jan Spot price of Wipro = 1080 In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

CALL OPTIONSPUT OPTIONS

If you expect a fall in price(Bearish) ShortLong

If you expect a rise in price (Bullish)LongShort

SUMMARY:CALL OPTION BUYERCALL OPTION WRITER (Seller)

Pays premium

Right to exercise and buy the shares

Profits from rising prices

Limited losses, Potentially unlimited gain Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining neutral

Potentially unlimited losses, limited gain

PUT OPTION BUYERPUT OPTION WRITER (Seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, Potentially unlimited gain Receives premium

Obligation to buy shares if exercised

Profits from rising prices or remaining neutral

Potentially unlimited losses, limited gain

Option styles

Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.

American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are "American Options". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.

Option Class & Series Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.

CallsPuts

.JULAUGSEPJUL AUGSEP

Wipro

1300 456075152028

1400 3545652528 35

150020 4248304055

eg: Wipro JUL 1300 refers to one series and trades take place at differentpremiums

All calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

Pricing of options

Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

Price of Underlying

Time to Expiry

Exercise Price Time to Maturity

Volatility of the Underlying

And two less important factors:

Short-Term Interest Rates

Dividends

Review of Options Pricing Factors

The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlyingThe premium is affected by the price movements in the underlying instrument. For Call options the right to buy the underlying at a fixed strike price as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options the right to sell the underlying at a fixed strike price as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

The Time Value of an Option Generally, the longer the time remaining until an options expiration, the higher its premium will be. This is because the longer an options lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an options price remaining the same, the time value portion of an options premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Volatility Volatility is the tendency of the underlying securitys market price to fluctuate either up or down. It reflects a price changes magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premiumLower volatility = Lower premiumInterest ratesIn general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall premiums rise. This time it is the writer who needs to be compensated.

OPTIONS PRICING MODELSThere are various option pricing models which traders use to arrive at the right value of the option. Some of the most popular models have been enumerated below.

1. The Binomial Pricing Model The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing models which differ according to their hypotheses or the underlying instruments upon which they are based (stock options, currency options, options on interest rates). 2. The Black & Scholes ModelThe Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation: unlike the binomial model, it does not rely on calculation by iteration.

The intention of this section is to introduce you to the basic premises upon which this pricing model rests. A complete coverage of this topic is material for an advanced course

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock priceX = strike pricet = time remaining until expiration, expressed as a percent of a yearr = current continuously compounded risk-free interest ratev = annual volatility of stock price (the standard deviation of the short-term returns over one year).ln = natural logarithmN(x) = standard normal cumulative distribution functione = the exponential function

Lognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed to a normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution of between zero and infinity (ie no negative prices) and has an upward bias (representing the fact that a stock price can only drop 100 per cent but can rise by more than 100 per cent). Risk-neutral valuation: The expected rate of return of the stock (ie the expected rate of growth of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-Scholes model (or any other model for option valuation). The important implication is that the price of an option is completely independent of the expected growth of the underlying asset. Thus, while any two investors may strongly disagree on the rate of return they expect on a stock they will, given agreement to the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that underlying asset.

The key concept underlying the valuation of all derivatives -- the fact that price of an option is independent of the risk preferences of investors -- is called risk-neutral valuation. It means that all derivatives can be valued by assuming that the return from their underlying assets is the risk free rate. Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely used adaptations to the original formula, which I use in my models, which enable it to handle both discrete and continuous dividends accurately.

However, despite these adaptations the Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option.

As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercised at expiration) this is a significant limitation.

The exception to this is an American call on a non-dividend paying asset. In this case the call is always worth the same as its European equivalent as there is never any advantage in exercising early. Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large number of option prices in