A Project Study on Derivatives in India A PROJECT STUDY ON “DERIVATIVES IN INDIA” Submitted By: Shah Bhavesh (13) Patel Darshan (17) Mehta Vaibhav (69) In Partial Fulfillment of Masters of Business Administration Programme, Gujarat University Project Guide: Prof. S. K. Mantrala S. K. Patel Institute of Management & Computer Studies 1
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In Partial Fulfillment of Masters of Business Administration Programme,
Gujarat University
Project Guide:Prof. S. K. Mantrala
S. K. Patel Institute of Management & Computer Studies 1
A Project Study on Derivatives in IndiaS.K.PATEL INSTITUTE OF MANAGEMENT AND COMPUTER STUDIES,
GANDHINAGAR.
Acknowledgement
Motivation and co-operation are the main two pillars on which the success of any project relies. So first of all we would like to thank core guides of our project Mr. Pradeep Hotchandani (Derivatives head) and Mr. Devarsh Vakil who made us aware about the project and motivated us to work on the guideline of this unique, new and knowledge based project. Both had guided us at each and every stage of the project. They had been enthusiastically involved in every aspects of the project. Overall we are highly indebted to them for all the knowledge, guidance and motivation that he has provided us throughout our project.
It is very interesting phenomenon that everybody is obliged to someone or the other. This obligation creates a sense of belongings and bondage, a beautiful world of people and friends. We must say that we have a feeling that we belong to such a world.
Every person wants to prove himself in this fast, dynamic and cut-throat competitive world. When he/she gets an opportunity to do so then he or she will find that success is very near to him/her. So we would like to acknowledge our beloved Director Prof. S. Chinnam Reddy who gave us the opportunity undertakes the project in derivatives.
We are thankful to Prof. Surya Krishna Mantral and Prof. Sonu Gupta for providing all the necessary support from their side. Without their continuous guidance and support, it would have been difficult for us to complete the project on time and in such a successful manner.
We would also like to thank our friends and those who have helped us during this project directly or indirectly.
Thank You All.
Bhavesh Shah (13)
Darshan Patel (17)
S. K. Patel Institute of Management & Computer Studies 2
A Project Study on Derivatives in India
Vaibhav Mehta (69)
Executive Summary
One of the interesting developments in financial market over the last 15 to 20 years has been the growing popularity of derivatives. In many situations, both hedgers and speculators find it more attractive to trade a derivative on an asset than to trade asset itself. Some derivatives are traded on exchanges. Others are made available to corporate clients by financial institutions or added to new issues of securities by underwrites.
In this report we have included history of derivatives. Than we have included derivatives market in India. And after that we have discussed stock market derivatives.
In this report we have taken a first look at forward, futures and options contract. A forward or futures contract involves an obligation to buy or sell an asset at certain time in the future for a certain price. There are two types options: calls and puts/ a call option gives the holder the right to buy an asset by a certain date for a certain price. In India the derivatives market has grown very rapidly. There are mainly three types of traders: hedgers, speculators and arbitrageurs.
In the next section we discuss about the put/call ratio (P/C Ratio) is a market sentiment indicator that shows the relationship between the numbers of put to calls traded. One can use put/call ratio as market indicator. If put/call ratio is below 0.35 then it is taken as extremely bullish and if it is above 0.75 then the market is considered as extremely bearish. However one must consider the other market indicator in conjunction with the put/call ratio. Open interest is the number of open contract of a given future or option contract. An open contract can be a long or short contract that has not been exercised, closed out, or allowed to expire. Open interest is really more of a data filed than an indicator. Open interest can be better indicator of demand than trading volume in the underlying.
S. K. Patel Institute of Management & Computer Studies 3
A Project Study on Derivatives in IndiaIn the next we have tried to find the relationship of different types
derivatives indicators on the cash price of few selected stocks like NIFTY, ACC, Reliance, Satyam and TISCO by considering various ratios and parameters like:
1. Put Call Ratio (open interest)2. Put Call Ratio (volume)3. Volume Traded4. Open Interest etc.
On the basis of different charts prepared, we have at the end provided whether there exists any relationship between the two variable being studied or not or what is the effect of one on the other variable.
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A Project Study on Derivatives in India
Acknowledgement 02 Executive Summary 03
Table of Contents:1. Derivatives-An Introduction
06 2. Company Profile
093. Theoretical Aspects of Study
163.1. A Brief History of Derivatives
173.2. Introduction to Derivatives
213.3. Forwards & Futures
293.4. Options
40 3.5. Types of Traders
573.6. Types of Orders
613.7. Types of Margins
633.8. Selection Criteria
653.9. Number of Underlying Shares
693.10. Lot Size of Underlying Shares
723.11. Strike Price Intervals
753.12. Clearings & Settlement
763.13. Regulations Related to Derivatives
854. Research Methodology
904.1. Objective of the Study
914.2. Scope of the Study
91
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A Project Study on Derivatives in India4.3. Data Collection
924.4. Selection of Securities
924.5. Analysis of Data
924.6. Data Sheets & Charts
944.7. Limitations
1365. Recent Trends in Derivatives Markets
1375.1. Derivatives in Emerging Markets
1385.2. A Boost to Derivative Market
1425.3. Security Transaction Tax
1425.4. FIIs can submit collateral for Derivatives
1435.5. Business Growth in Derivatives Segment-Futures
145 5.6. Business Growth in Derivatives Segment-Options
1465.7. Business Growth in Derivatives Segment-Total Turnover
1476. Findings
1487. Conclusion
1518. Recommendations
1529. Bibliography 15310. Glossary
154
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1. Derivatives-An Introduction
Risk is a characteristic feature of all commodity and capital markets. Prices of all commodities – be they agricultural like wheat, cotton, rice, coffee or tea, or non- agricultural kike silver, gold etc. – are subject to fluctuation over time in keeping with prevailing demand and supply conditions. Producers or possessors of these commodities obviously cannot be sure of the prices that their produce or possession may fetch when they have to sell them, in the same way as the buyers and the processors ate not sure what they would have to pay for their buy. Similarly, prices of shares and debentures or bonds and other securities are also subject to continuous changes. Those who are charged with the responsibility of managing money, their own or of others are therefore constantly exposed to the threat of risk. In the same way, the foreign exchange rates are also subject to continuous change. Thus an importer of certain piece of machinery is not sure of the amount he would have to pay in rupee terms when the payment becomes due.
While example where risk is seen to exist can be easily multiplied, it may be observed that parties involved in all such cases may see the benefits of, and are likely to desire, having some contractual form whereby forward prices may be fixed and the price risk facing them is eliminated. Derivatives came into being primarily for the reason of the need to eliminate price risk.
WHAT ARE DERIVATIVES?
A derivatives instrument broadly is a financial contract whose payoff structure is determined by the value of an underlying commodity, security, interest rate, share price index, exchange rate, oil price and the kike. Thus a derivative instrument derives its value from some underlying variable. A derivative instrument by itself does not constitute ownership. It is, instead, a promise to convey ownership.
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A Project Study on Derivatives in IndiaDerivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.
A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly.
All derivatives are based on some ‘cash’ products. The underlying basis of derivative instrument may be any product including
Commodities including grain, coffee beans, orange juice etc. Precious metals like gold and silver Foreign exchange rate Bonds of different types, including medium to long- term
negotiable debt securities issued by government, companies, etc.
Short-term debt securities such as T-bills; and Over-the-counter (OTC) money market products such as loans
or deposits.
Derivatives are specialized contracts which are employed for a variety of purposes including reduction of funding costs by borrowers, enhancing the yield on assets, modifying the payment structure of assets to correspond to the investors market view, etc. however the most important use of derivatives is in transferring market risk, called hedging, which is a protection against losses resulting form unforeseen price or volatility changes. Thus derivatives are very important tool of risk management. As awareness about the usefulness of derivatives as a risk management tool has increased, the markets for derivatives too have grown. Of late, derivatives have assumed a very significant place in the field of finance and they seem to be driving global financial markets.
Derivatives have made the international and financial headlines in the past for mostly with their association with spectacular losses or
S. K. Patel Institute of Management & Computer Studies 8
A Project Study on Derivatives in Indiainstitutional collapses. But market players have traded derivatives successfully for centuries and the daily international turnover in derivatives trading runs into billions of dollars.
There are many kinds of derivatives including futures, options, interest rate swap, and mortgage derivatives. Are derivative instruments that can only be traded by experienced, specialist traders? Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors.
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2. Company Profile
Anagram is part of the rupees 2500 cores Lalbhai group, associates of “Arvind mills”, previously anagram finance and one of India’s top broking houses, with membership of the NSE, BSE and ASE and in commodity exchange member of MCX, a decade of hard-won experience behind it.
Since 1993, it came in this filed and grown staidly. Anagram securities have always focused on the need of the retail client. From its initial stronghold in Gujarat (8 major cities) it expanded to 24 cities and 38 offices covering the entire major business centers spread across the country. Its client base besides over 11000 individual also includes a substantial amount of institutional business. Aside from conventional broking services, it offers online trading named money pore express, and depository participant facilities with NSDL (National Securities depository Ltd.). In 2000 its billings crossed Rs. 17000 crores with around 5000 people making their trades through anagram.
Anagram does no proprietarily trading and manages no mutual funds, not is it interested in corporate finance. They believe in offering advice with clients pressed to buy stocks simply because the firm has taken a position or lent money to a company.
Anagram focuses primarily on recommending purchases in financially sound companies at reasonable market prices.
It maintained a record of prompt payout to its client, winning a reputation for reliability and transparency that it not too common a currency in this business. Despite the alarming and sudden slumps that stock market and the economy have gone through over the last decade.
Value of any brokerage house is dependent on the research department it has and the qualification of its research team. At anagram we have a good research team considered to be one of the best in the industry. Research team consists of the following members:Research Teams includes,
Mr. Darshan Mehta (CEO, Anagram Stock Broking Ltd.), Mr. Keyur Shah, Mr. Ketan Thakkar, Mr. Vinod Sharma (Regularly appear on CNBC)
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A Project Study on Derivatives in IndiaMr. Devanshu Bhatt, Mr. Keyur Shah (Equity Head)
The Complete Investment Destination
It provides comprehensive range of investment services. That’s advantage of having all the services investor need under one roof.
Stock broking:It offers complete range of pre-trade and post-trade services on the BSE and the NSE. Whether an investor come into its conveniently environment, or issue instruction over the phone, its highly trained team and sophisticated equipment ensure smooth transactions and prompt services.
E-Broking and Web-Based Services:It is one of the offer online trading. At its sites, www.moneypore.com, high bandwidth leased lines, secure services and a customs-built user interface give you an international standards trading experience. It also gives regular trading hours, and access to information, analysis of information, and a range of monitoring tools.
Trading Terminals-Money pore ExpressIt offer its sub-broker and approved/authorized user fully equipped trading terminals-Money pore Express, at the location of investors choice. It is fully functional terminal, with a variety of helpful features like market watch, order entry, order confirmation, charts, and trading calls, all available in resizable windows. And it can be operated through the keyboard using F1 for buy, F2 for sell.
Depository Participant ServicesAn in house DP means hassle-free, speedy settlements. It is depository participants with NSDL.
Premium Research ServicesIts research team offers a package of fee-based services, including daily technical analysis, research reports, and advice on clients existing investments. It is research beyond desk and company-provider reports. Research team goes out and meets heads, visits
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A Project Study on Derivatives in Indiaplans and factories. If you have an equity portfolio, you know that the pace of life in the world of stocks and shares is frantic. Managing your portfolio means you have to take firm, informed decisions, and quickly!
And what do you base those decisions on? Rumors fly around with greater frequency than Indian Airlines flights. But relevant, reliable information isn't easy to get. Expert guidance costs large amounts of money. After all, it isn't everyone who can afford the services of a dedicated research cell.
That's why we are introducing a set of Premium Services from our Research team, tailored specifically to the needs of the retail investor.
These services are available via e-mail, fax, or post. They are:
Service Description Frequency
Chinta’s call
Daily market views, Outlook for the week,Technical based position trading calls and stock picks from our online investment sage, Chinta-Money. SMS stock picks on your mobile.
Daily
Anagram Mutual Fund Digest
It will provide comprehensive comparative study of all mutual fund schemes and news related to mutual funds.
Weekly
Ask ChintaChinta-Money and team answers specific stock- and market-related questions within 24 hours.
On request
Evening Review
Report and Analysis on the course of events in the market.
Daily
Weekend Wrap
Report and analysis covering domestic and international markets
Weekly
Investment calls
Research report and recommendations on 5 companies.
Weekly
Moneypore times
Bourse news and trading/investment callsFortnightly
Sector reports
We monitor the Cement, Pharma and IT sectors.
As and when
New Products
Dividend Yield, Diwali Special, Millennium Calls, Top 10
As and when
Event Reports
Budget, govt. policy, merger and acq. of comp.
As and when
Latest Quick Snapshots of financial results as As and
S. K. Patel Institute of Management & Computer Studies 12
A Project Study on Derivatives in IndiaResults they happen. when
Other Investment ProductsTo help investor balance their portfolio, it offers a completer range of other investment products, like Mutual Funds. IPO’s, Insurance of ICICI Prudential and Management related solutions with the help of Tata Consultancy Services (TCS) as sub syndicate.
Commodity ExchangeRecently it has become the member of MCX, a commodity exchange and has started providing services in the field of commodity trades to its clients. It deals in gold and silver.
Presence of Anagram in Different States
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A Project Study on Derivatives in India
Investment philosophy of Anagram
The investment philosophy of Anagram focuses primarily on recommending purchases in financially sound companies at reasonable market prices. We would also recommend sales of companies which are above the sales price targets or whose business prospects are poor.
Anagram recognizes that every individual is unique in terms of his investment time horizon, investment objectives, personal financial situations, level of interest and inclination in the investment decision taking process and last but not the least, his risk taking ability. Whilst it is hard to beat the level of absolute customization and hand holding that a qualified personal financial planner would provide, we have attempted to individualize, as much as possible, model portfolios that we believe reflect the individual’s unique investment profile.
A team of highly skilled analysts and experienced Investment professionals will be constantly monitoring a population of potential investment in companies so as to buy and sell on the basis of analytically derived risk/return ratios. The populations of companies have been selected based on many quantitative and qualitative benchmarks.
The effort is directed to prevent permanent loss of capital and to make absolute returns over time with a minimal amount of business risk. Anagram is confident that through this process, over a three year period, the investment results will be superior to any market index. The portfolio, however, may fluctuate in the short run as the investment decisions will be guided by business prospects and not by short term market movements. We feel that this process will be well suited to the needs of investors.
We see our role as that of an unbiased information provider and advisor attempting to empower individuals to take investment decisions and styles that suit them. Our selection of companies reflects this many of the companies that we have recommended for investment are providers of goods and services that touch the every day life of most of us. Our belief is that the comfort level of investing in such companies, therefore, would be very high.
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A Project Study on Derivatives in India
Partners of Anagram Ltd.CREDIT RESOURCES INDIA LIMITED provides advisory services and financial solutions in the areas of corporate finance, investment banking, business and Net strategy for businesses across a spectrum of industries.
Credit Resources traces its genesis to a renowned Chartered Accountancy firm which specialized in corporate taxation and auditing. The firm established a financial services division in 1985, leveraging on its wide client base by providing the full spectrum of financial services. With the passage of time, this division built specialized skills in the areas of corporate advisory, corporate finance and investment banking. The division was spun off in 1990, firstly in the form of a partnership firm subsequently corporatized in 1992.
The financial solutions offerings of Credit Resources comprise Corporate Finance and Investment Banking.
Corporate Finance
In Credit Resources is placement of domestic and foreign currency debt instruments with bulk investors - All India and State level term lending institutions, financial institutions, insurance companies, banks, Non Banking Finance companies and corporate investment companies. These include:
Term Loans and Equipment finance loans Private placement of project and working capital debentures Short term and medium term loans and deposits Lease and Hire Purchase Private placement of preference shares External Commercial Borrowings
Investment Banking
In Credit Resources is placement of equities with bulk investors - domestic and foreign financial institutions, mutual funds, private equity
S. K. Patel Institute of Management & Computer Studies 16
A Project Study on Derivatives in Indiaand foreign direct investment funds and corporate investment companies. Placements include:
Private placement of fresh equity of listed companies Placement of firm allotment category of public issues Placement of equity of unlisted companies Secondary market placements
The consultancy and advisory offerings comprise Corporate Advisory and Net Strategy via Net Resources.
Corporate Advisory
In Credit Resources is consultancy assignments in the following areas: Business Strategy and Structuring Capital Structuring and Restructuring Business and Share valuations Preparation of Research Reports and Information
Memorandums
Net Resources
Is the recently formed division of Credit Resources and provides advisory and execution services in the following areas:
Business Strategy for the Net - advisory and execution in the form of Build, Operate and Transfer (BOLT)
Mergers/Acquisitions & Alliances Business Plan preparation and evaluation
Founder
Milan Sangani, 40, a Chartered Accountant by training, is the Founder and Managing Director of Credit Resources India Limited.Milan commenced his career in 1984 as a partner in charge of audits in a reputed chartered accountancy firm.
In 1985, he set-up a financial services division, which was spun-off into Credit Resources in 1991. Leveraging his skills in the financial services market and finding a need in the personal finance space, he has been instrumental in conceptualizing and creating finsights.com, a transactional oriented personal finance site addressing the Indian and
Overseas Indians that is now integrated with moneypore.com. He is actively involved with the Multiple Sclerosis Society of India and is personally responsible for creating barrier free accessibility for the disabled at various commercial buildings and public places. He is the
S. K. Patel Institute of Management & Computer Studies 17
A Project Study on Derivatives in IndiaChairman of the Business Economics Study Circle and the Internet Study Group of the Bombay Chartered Accountants' Society. He plays the jazz clarinet and is the founder of Jazz Junkeys an amateur jazz band.
3. Theoretical
Aspects
OfS. K. Patel Institute of Management & Computer Studies 18
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Study
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3.1. A Brief History Of Derivatives
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. To start we need to go back to the Bible. In Genesis Chapter 29, believed to be about the year 1700 B.C., Jacob purchased an option costing him seven years of labor that granted him the right to marry Laban's daughter Rachel. His prospective father-in-law, however, reneged, perhaps making this not only the first derivative but the first default on a derivative. Laban required Jacob to marry his older daughter Leah. Jacob married Leah, but because he preferred Rachel, he purchased another option, requiring seven more years of labor, and finally married Rachel, bigamy being allowed in those days. Jacob ended up with two wives, twelve sons, who became the patriarchs of the twelve tribes of Israel, and a lot of domestic friction, which is not surprising. Some argue that Jacob really had forward contracts, which obligated him to the marriages but that does not matter. Jacob did derivatives, one way or the other. Around 580 B.C., Thales the Milesian purchased options on olive presses and made a fortune off of a bumper crop in olives. So derivatives were around before the time of Christ. The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting. The first "futures" contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees.
Probably the next major event, and the most significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of Trade in 1848. Due to its prime location on Lake Michigan, Chicago was developing as a major center for the storage, sale, and distribution of Midwestern grain. Due to the seasonality of grain, however, Chicago's storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. Similarly, its facilities were underutilized in the spring. Chicago spot prices rose and fell drastically. A group of grain traders created the "to-arrive" contract, which permitted farmers to lock in the price and deliver the grain later. This allowed the farmer to store the grain either on the farm or at a storage facility nearby and deliver it to Chicago months
S. K. Patel Institute of Management & Computer Studies 20
A Project Study on Derivatives in Indialater. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. Farmers and traders soon realized that the sale and delivery of the grain itself was not nearly as important as the ability to transfer the price risk associated with the grain. The grain could always be sold and delivered anywhere else at any time. These contracts were eventually standardized around 1865, and in 1925 the first futures clearinghouse was formed. From that point on, futures contracts were pretty much of the form we know them today. In the mid 1800s, famed New York financier Russell Sage began creating synthetic loans using the principle of put-call parity. Sage would buy the stock and a put from his customer and sell the customer a call. By fixing the put, call, and strike prices, Sage was creating a synthetic loan with an interest rate significantly higher than usury laws allowed. One of the first examples of financial engineering was by none other than the beleaguered government of the Confederate States of America, which is sued a dual currency optionable bond. This permitted the Confederate States to borrow money in sterling with an option to pay back in French francs. The holder of the bond had the option to convert the claim into cotton, the south's primary cash crop. Interestingly, futures/options/derivatives trading was banned numerous times in Europe and Japan and even in the United States in the state of Illinois in 1867 though the law was quickly repealed. In 1874 the Chicago Mercantile Exchange's predecessor, the Chicago Produce Exchange, was formed. It became the modern day Merc in 1919. Other exchanges had been popping up around the country and continued to do so. The early twentieth century was a dark period for derivatives trading as bucket shops were rampant. Bucket shops are small operators in options and securities that typically lure customers into transactions and then flee with the money, setting up shop elsewhere. In 1922 the federal government made its first effort to regulate the futures market with the Grain Futures Act. In 1936 options on futures were banned in the United States. All the while options, futures and various derivatives continued to be banned from time to time in other countries. The 1950s marked the era of two significant events in the futures markets. In 1955 the Supreme Court ruled in the case of Corn Products Refining Company that profits from hedging are treated as ordinary
S. K. Patel Institute of Management & Computer Studies 21
A Project Study on Derivatives in Indiaincome. This ruling stood until it was challenged by the 1988 ruling in the Arkansas Best case. The Best decision denied the deductibility of capital losses against ordinary income and effectively gave hedging a tax disadvantage. Fortunately, this interpretation was overturned in 1993. Another significant event of the 1950s was the ban on onion futures. Onion futures do not seem particularly important, though that is probably because they were banned, and we do not hear much about them. But the significance is that a group of Michigan onion farmers, reportedly enlisting the aid of their congressman, a young Gerald Ford, succeeded in banning a specific commodity from futures trading. To this day, the law in effect says, "you can create futures contracts on anything but onions.” In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgages. While the contract met with initial success, it eventually died. The CBOT resuscitated it several times, changing its structure, but it never became viable. In 1975 the Merc responded with the Treasury bill futures contract. This contract was the first successful pure interest rate futures. It was held up as an example, either good or bad depending on your perspective, of the enormous leverage in futures. For only about $1,000, and now less than that, you controlled $1 million of T -bills. In 1977, the CBOT created the T -bond futures contract, which went on to be the highest volume contract. In 1982 the CME created the Eurodollar contract, which has now surpassed the T -bond contract to become the most actively traded of all futures contracts. In 1982, the Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line Index. The Chicago Mercantile Exchange quickly followed with their highly successful contract on the S&P 500 index. 1973 marked the creation of both the Chicago Board Options Exchange and the publication of perhaps the most famous formula in finance, the option pricing model of Fischer Black and Myron Scholes. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of derivatives. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor's and became known as the S&P 100, which remains the most actively traded exchange-listed option.
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A Project Study on Derivatives in India The 1980s marked the beginning of the era of swaps and other over-the-counter derivatives. Although over-the-counter options and forwards had previously existed, the generation of corporate financial managers of that decade was the first to come out of business schools with exposure to derivatives. Soon virtually every large corporation, and even some that were not so large, were using derivatives to hedge, and in some cases, speculate on interest rate, exchange rate and commodity risk. New products were rapidly created to hedge the now-recognized wide varieties of risks. As the problems became more complex, Wall Street turned increasingly to the talents of mathematicians and physicists, offering them new and quite different career paths and unheard-of money. The instruments became more complex and were sometimes even referred to as "exotic." In 1994 the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known and highly experienced firms, such as Procter and Gamble and Metallgesellschaft. One of America's wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England's venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office. These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. While some minor changes occurred in the way in which derivatives were sold, most firms simply instituted tighter controls and continued to use derivatives. These stories hit the high points in the history of derivatives. Even my aforementioned "Chronology" cannot do full justice to its long and colorful history. The future promises to bring new and exciting developments.
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3.2. Introduction To Derivatives
The term “Derivative” indicates that it has no independent value, i.e. its value is entirely “derived” from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pro determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real of financial asset of to an index of securities. Derivatives in mathematics, means a variable derived from another variable. Similarly in the financial sense, a derivative is a financial product, which has been derived from a market for another product. Without the underlying product, derivatives do not have any independent existence in the market. Derivatives have come into existence because of the existence of risks in business. Thus derivatives are means of managing risks. The parties managing risks in the market are known as HEDGERS. Some people/organizations are in the business of taking risks to earn profits. Such entities represent the SPECULATORS. The third player in the market, known as the ARBITRAGERS take advantage of the market mistakes.
The need for a derivatives market
The derivatives market performs a number of economic functions: They help in transferring risk from risk averse people to risk
oriented people. They help in the discovery of future as well as current prices. They catalyze entrepreneurial activity. They increase the volume traded in markets because of
participation of risk-averse people in greater numbers. They increase savings and investment in the long run.
Factors driving the growth of financial derivatives
Increased volatility in asset process in financial markets, Increased integration of national financial markets with the
international markets, Marked improvement in communication facilities and sharp
decline in their costs,
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A Project Study on Derivatives in India Development of more sophisticated risk management tools,
providing economic agents a wider choice of risk management strategies, and
Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.
A derivative is a financial instrument whose value depends on the value of other, more basic underlying variables.
The main instruments under the derivative are: Forward contract Future contract Options Swaps
1. Forward contract:A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions of between a financial institution and one of its corporate clients. It is not normally traded on an exchange.
One of the parties to forward contract assumes a long position and agrees to buy he underlying asset on a specified future date for a certain specified price. The other party assumes a 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 delivery price. The forward contract is settled at maturity. The holder of the short position delivers the asset to the holder price. A forward contract is worth zero when it is first entered into. Later it can have position or negative value, depending on movements in the price of the asset.
2. Future contract:A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contract are normally traded on an exchange. 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 a mechanism, which gives the two parties a guarantee that the contract will be honored.
S. K. Patel Institute of Management & Computer Studies 25
A Project Study on Derivatives in IndiaOne way in which future contract is different from a forward contract is that an exact delivery date is not specified. The contract is referred to by its delivery month, and the exchange specifies the period during the month when delivery must be made.
3. Options:An option is a contract, which gives the buyer the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be commodities like wheat/rice/cotton/gold/oil/ or financial instruments like equity stocks/ stock index/bonds etc.
There are basic two types of options. A call options gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.
4. Swaps:Swaps are private agreements between two companies to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.
5. Warrants:Options generally have lives of up to one year, the majority of options traded on options exchange having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the –counter.
6. Leaps:The scronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.
7. Baskets:Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
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A Project Study on Derivatives in India
Development Of Derivatives Market In India
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995 which withdrew the prohibition on options in securities. The market for derivatives, however did not take off as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the chairmanship of Dr. L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17.1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements.
The securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three-decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in may 2001. SEBI permitted the derivative segments of two stock exchanges, NSC and BSC, and heir clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSC-30(Sensex)
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A Project Study on Derivatives in Indiaindex. This was followed by approval for trading in options based on these two indexes and on individual securities.
The trading in BSC sensex options commenced on June 4, 2001 and the trading in options n individual securities commenced in July 2001. Futures contracts on individual socks were launched in November 2001. The derivatives trading on NSC commenced with S&P CNX Nifty index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. The index future and options contract on NSC are based on S&P CNX.
Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in he official gazette. Foreign Institutional Investors (FIIS) are permitted to trade in all Exchange traded derivative products.
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A Project Study on Derivatives in India
Measures specified by SEBI to protect the rights of investor in the Derivative Market
Investor’s money has to be kept separate at all levels and is permitted to be used only against the liability of he investor and is not available to he trading member or clearing member or even any other investor.
The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
Investor would get he contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favors, if any, extended by the Member.
In the derivative markets all money paid by the investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of he Trading or clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of he member. However, in the event of default of a member, losses suffered by the investor, if any, on settled/ closed out position are compensated from the investor Protection fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
STOCK MARKET DERIVATIVES
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A Project Study on Derivatives in IndiaFutures & Options
In India, the National Stock Exchange of India Limited (NSC) commenced trading in derivatives with ht e launch of index future on June 12, 2000. The future contracts are based on the popular benchmark S&P CNX Nifty Index.
The Exchange introduced trading in Index Options (also based on Nifty) on june4, 2001. NSC also became the first Exchange to launch trading in options on individual Securities form July 2, 2001.
Futures on individual securities were introduced on November 9, 2001. Future and Options on individual securities are available on 31 securities stipulated by SEBI.
Instruments available in India
The National stock Exchange (NSC) has the following derivative products:
Products Index Futures Index Options
Future on Individual securities
Options on Individual Securities
Underlying Instrument
S&P CNX Nifty S&P CNX Nifty
30 Securities stipulated by SEBI
30 Securities stipulated by SEBI
Type European American
Trading cycle
Maximum of 3-month trading cycle. At any point in time, there will be 3 contracts available:
1)Near month,2)Mid month &3)Far month duration
Same as index futures
Same as index futures
Same as index futures
Expiry Day
Last Thursday of the expiry month
Same as index futures
Same as index futures
Same as index futures
Contract Permitted lot size Same as As stipulated As stipulated
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A Project Study on Derivatives in IndiaSize is 200 & multiples
there ofindex futures
by NSC(not less than Rs.2 Lacs)
by NSC(not less than Rs.2 Lacs)
Minimum contract size
The standing committee on finance, a parliamentary committee, at the time of recommending amendment t securities contract (Regulation) Act, 1956 had recommended that the minimum contract size of derivative contracts traded in the Indian markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing he contract in the market.
Lot size of a contract
Lot size refers to number of underlying Securities in one contract. Additionally, for stock specific derivative contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of 100 and fractions, if any, should be rounded of to the next requirement of minimum contract size forms the basis of arriving at the lot size of a contract.
For example , if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 Lacs, then the lot size for that particular scrip’s stands to be 200000/1000 = 200 Shares I.e. one contract in XYZ Ltd. Covers 200 Shares.
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A Project Study on Derivatives in India
3.3. Forwards & Futures
Forward Contracts:
A deal fir the purchase or sale of a commodity, security or other asset can be in the spot or forward markets. A spot or cash market is the most commonly used for trading. A majority of our day to day transaction are in the cash market, where we pay cash and get the delivery of the goods. In addition to a cash purchase, another way to acquire or sell assets is by entering into a forward contract. In a forward contract, the buyer agrees to pay cash at a later date when the seller delivers the goods. As an analogy of a forward contract, suppose a patient calls a doctor for an appointment and sees him after two days at the appointed hour. After his examination, the patient pays the doctor. Similarly, if a car is booked with a dealer and the delivery ‘matures’ the car is delivered after its price has been paid
Usually no money changes hands when forward contracts are entered into, but sometimes one or both the parties to a contract may like to ask for some initial, good faith deposits to insure that the contract is honored by the other party.
Typically in forward contract the price at which the underlying commodity or assets will be traded, is decided at the time of entering into the contract. The essential idea of entering into the forward contract is to peg the price and thereby avoid the price risk. Thus by entering in the forward contract, one is assured of the price at which one can buy/sell goods or other assets. Manufacturers using a certain raw material whose price is subject to variation, can avoid the risk of price moving adversely by entering into a forward contract and plans his operations better. Similarly, by entering into a forward contract, a farmer can ensure the price he can get for his crops and not worry about what price would prevail at the time of maturity of the contract. Of course, at the time maturity of contract, if the market price of the commodity is greater than the price agreed, then the buyer stand to gain while the seller gains is in long position. The opposite would holds when the market price happened to be lower than the agreed price.
Forward contracts have been in existence for quite some time. The organized commodity exchanges, on which forward contracts are traded, probably started in Japan in the early 18th century, while the
S. K. Patel Institute of Management & Computer Studies 32
A Project Study on Derivatives in Indiaestablishment of the Chicago Board of Trade (CBOT) in 1848 led to start of a formal commodity exchange in the USA.
A Forward contract is evidently a good mean of avoiding price risk, but it entails and elements of risk in that a party to the contract may not honor its part of the obligation. Thus each party is the risk of default. There is another problem. Once a position of buyer and seller takes in a forward contract, an investor cannot retreat accept through mutual consent with the party or by entering into an identical contract and taking a position that is the reverse of earlier position. Alternatives are by no means very easy. With forward contract entered on a one to one basis and with no standardization, the forward contract has virtually had no liquidity. This problem of credit risk and no liquidity associated with forward contracts led to the emergence of future contract. The future contracts are the refined forward contracts.
Future Contracts
As indicated, the futures contracts represent an improvement over the forward contracts in terms of standardization, performance guarantee and liquidity. A future contract is a standardized contract between two parties where one of the parties commits to sell, and the other to buy, a stipulated quantity of a commodity, currency, security, index or some other specified item at an agreed price on a given date in the future.
The futures contracts are standardized ones, so that1 the quantity of the commodity or the other asset which would be
transferred or would form the basis of gain/loss on maturity of a contract,
2 the quantity of the commodity-if a certain commodity is involved-and the place where delivery of the commodity would be made,
3 the date and month of delivery,4 the units of price quotation,5 The minimum amount by which the price would change and the
price limits for a day’s operations, and other relevant details are all specified in a future contract. Thus, in a way, it becomes a standard asset, like any other asset, to be traded.
Futures contracts are traded on commodity exchanges or other future exchanges. People can buy or sell futures like other commodities. When an investor buy a future contract on an organized future exchange, he/she is in fact assuming the right and obligation of taking the delivery of the specified underlying item on
S. K. Patel Institute of Management & Computer Studies 33
A Project Study on Derivatives in Indiaa specified date. Similarly, when an investor sells a contract, to take a short position, one assumes the right and obligation to make the delivery of the underlying asset. There is no risk of non-performance in the case of trading in the futures contracts. This is because a clearing house or a clearing corporation is associated with the futures exchange, which plays a pivotal role in the trading of futures. A clearing house takes the opposite in each trade, so that it becomes the buyer to the seller and vice versa. When a party takes a short position in a contract, it is obliged to sell the underlying commodity in question at the stipulated price to the clearing house on maturity of the contract. Similarly, an investor who takes a long position on the contract can seek its performance through the clearing house only.
A significant point to note is that while a clearing house guarantees the performance of the future contracts, the parties in the contracts are required to keep margins with it. The margins are taken to ensure that each party to a contract performs its part. The margins are adjusted on a daily basis to account for the gains or losses, depending upon the situation. This is known as marking to the market and involves giving a credit to the buyer of the contract, if the price of the contract rises a debiting the seller’s account by an equal amount. Similarly, the buyer’s balance is reduced is reduced when the contract price declines and the seller’s account is accordingly updated.
It is not necessary to hold on to a futures contract until maturity and one can easily close out a position. Either of the parties may reverse their position by initiating a reverse trade, so that the original buyer of a contract can sell an identical contract at a later date, canceling, in effect, the original contract. Thus, the exchange facilitates subsequent selling (buying) of a contract so that a party can offset its position and eliminates the obligation. The fact that the buyer as well as the seller of a contract is free to transfer their interest in the contract to another party makes such contracts highly liquid in nature. In fact, most of the future contracts are cancelled by the parties, by engaging into reverse trades: the buyers cancels a contract by selling another contract, while the seller does so by buying another contract. Only a very small portion of them are held for actual delivery.
Evolution/History of Futures:
Futures contracts, especially those which involve agricultural commodities, have been traded for long. In USA for instance, such
S. K. Patel Institute of Management & Computer Studies 34
A Project Study on Derivatives in Indiacontracts began on the Chicago Board of Trade (CBOT) in the 1860s. Subsequently, contracts began to trade on commodities involving precious metals like gold, silver etc. However, significant changes have taken place in the last three decades with the development of financial futures contracts. They represent a very significant financial innovation. Such contracts encompass a variety of underlying asset-security, stock indices, and interest rates and so on. The beginnings of financial future were made with the introduction of foreign currency futures contracts on the International Monetary Markets (IMM) in 1972. Subsequently, interest rates futures-where a contract is on an asset whose price is dependent solely on the level of interest rates-were introduced on made headway and introduced the Government National Mortgage Association contract (GNMA), and the year 1976 and 1977 saw the launching by IMM, respectively, of the T-Bill Future and T-Bonds Futures. T-Bonds is one of the most actively traded futures contract in the world and has, in particular, lent grate impetus to the introduction of similar future on many futures exchanges the world over. An important development took place in the world of future contracts in 1982 when stock index futures were introduced in the USA, after strong initial opposition to such contracts. A future contract on a stock index has been a revolutionary and novel idea because it represents a contract based not on a readily deliverable physical commodity or currency or other negotiable instrument. It is instead based on the concept of a mathematically measurable index that is determined by the market movement of a predetermined set of equity stocks. Such contracts are now very widely traded the world over.
How Futures Come about:
Many people see pictures of the large crowd of traders standing in a crowd yelling and signaling with their hands, holding pieces of paper, and writing frantically. To the outsider, it looks like chaos. But do you really think that there is in fact chaos going on in the worlds futures pits? Not a chance. Actually, everyone in the crowd knows exactly what’s going on. It is in the fact, another language. Learn the language and you know what is going on.
Initially, the first organized and central marketplaces were created to provide spot prices for immediate delivery. Shortly thereafter, forward contracts were also established, these ‘forwards’ were forerunners to the present day futures contract.
Introduction of futures in India
S. K. Patel Institute of Management & Computer Studies 35
A Project Study on Derivatives in IndiaThe first derivative product introduced in the Indian securities
market was “INDEX FUTURES” in June 2000. In India the “stock futures” were first introduced on November 9, 2001.
The Indian capital market has grown quite well in the last decade. In the boom period of 1992 and thereafter, even the common man living in a village was attracted to the stock market. The stock market was considered a profitable investment opportunity. Before July 2001, various stock exchanges including the BSE, NSE and Delhi stock Exchange, provided carry forward facilities through the traditional badla system. By means of this system the purchase or sale of a security was not postponed till a particular future date; instead the system only provided for the carry forward of a transaction from one settlement period(seven days) to the next settlement period for the payment of a fee known as badla charges.
In the badla system, due to limited settlement period and no future price discovery, speculator could manipulate prices, thus causing loss to small investor and ultimately eroding investor’s confidence in the capital market. The last eight years have emphasized the necessity of futures trading in the capital market. In the absence of an efficient futures market, there was no price discover, therefore, prices could be moved in any desired direction. Recent developments in the capital market culminated n a ban on badla from July 2001.
In the absence of futures trading, certain operator- either on their own or in collusion with corporate management teams at times manipulated prices in the secondary market, causing irreparable damage to the growth of the market. The small and medium investor, who are the backbone of the market, whose savings come to the market via primary or secondary route shied away, having burnt their fingers. As the small investor avoided the capital market, the downturn in the secondary market ultimately affected the primary market because people stopped investing in share for fear of loss or liquidity. Introducing futures contract in major shares along with index futures helped to revive the capital market. This did not only provide liquidity and efficiency to the market, but also helped in future price discovery.
With renewed interest in old economy stock, activity in the stock futures market seems to be widening too. While initial trading was restricted to information technology stocks like satyam, infosys or digital today punter are slowly building positions in counters such as SBI, Tata Motors, TISCO, Reliance etc.
Features:
S. K. Patel Institute of Management & Computer Studies 36
A Project Study on Derivatives in IndiaEvery future contract is a forward contract. They:
Are entered in to through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
Are of standard quantity; standard quality (in case of commodities)
Have standard delivery time and price.
Difference between forward and futures contracts
We may now differentiate between forward and future contracts. Broadly, a future contract is different from a forward contract on the following counts:1) Standardization: A forward contract is a tailor-made contract
between the buyer and the seller where the terms are settled in mutual agreement between the parties. On the other hand, a future contract is standardized in regards to the quality, quantity, place of delivery of the asset etc. Only the price is negotiated.
2) Liquidity: There is no secondary market for forward contracts while futures contracts are traded on organized exchanges. Accordingly, futures contracts are usually much more liquid than the forward contracts.
3) Conclusion of contract: A forward contract is generally concluded with a delivery of the asset in question whereas the future contracts are settled sometimes with delivery of the asset and generally with the payment of the price differences. One who is long a contract can always eliminate his/her obligation by subsequently selling a contract for the same asset and same delivery date, before the conclusion of contract one holds. In the same manner, the seller of a futures contract can buy a similar contract and offset his/her position before maturity of the first contract. Each one of these actions is called offsetting a trade.
4) Margins: A forward contract has zero value for both the parties involved so that no collateral is required for entering into such a contract. There are only two parties involved. But in a futures contract, a third party called Clearing Corporation is also involved with which margin is required to be kept by both parties.
5) Profit/Loss Settlement: The settlement of a forward contract takes place on the date of maturity so that the profit/loss is
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A Project Study on Derivatives in Indiabooked on maturity only. On the other hand, the futures contracts are marked to market daily so that the profits or losses are settled daily.
Following table summarizes the difference between the Forward and Futures:
DIFFERCENCE BETWEEN FORWARD AND FUTURES CONTRACTDIFFERCENCE FORWARDS FUTURESSize of contract
Decided by buyer and seller Standardized in each contract
Price of contract
Remains fixed till maturity Changes every day
Mark to market Not done Mark to market every day
Margin No margin requiredMargins are to be paid by both buyers and sellers
Counterparty risk Present Not presentLiquidity No liquidity Highly liquidNature of Market Over the counter Exchange tradedMode of delivery Specifically decided. Standardized
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
S. K. Patel Institute of Management & Computer Studies 38
A Project Study on Derivatives in Indiaindex 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 Nifty
In 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 indices
For 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.
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A Project Study on Derivatives in India
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 month Expiry/settlement
July 2001 July 26August 2001 August 30 September 2001 September 27
On July 27
Contract month Expiry/settlement
August 2001 August 30 September 2001 September 27October 2001 October 25
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A Project Study on Derivatives in IndiaThe 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:
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.
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.
S. K. Patel Institute of Management & Computer Studies 41
A Project Study on Derivatives in IndiaThe following table shows how futures data will be generally displayed in the business papers daily.
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.
Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.
Action Resulting open interest
New buyer (long) and new seller (short) Trade to form a new contract.
Rise
S. K. Patel Institute of Management & Computer Studies 42
A Project Study on Derivatives in IndiaExisting buyer sells and existing seller buys –The old contract is closed.
Fall
New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.
No change – there is no increase in long contracts being held
Existing seller buys from new seller. The Existing seller closes his position by buying from new seller.
No change – there is no increase in short contracts being held
Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.
Market
Price
Open interest
Strong
Warning signal
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A Project Study on Derivatives in India
3.4. OptionsWhat are options?
Like forward and futures, options represent another derivative instrument and provide a mechanism by which one can acquire a certain commodity or other asset, or take positions in, in order to make profit or cover risk for a price. The options are similar to the futures contracts in the sense that they are also standardized but are different from them in many ways. Options, in fact, represent the rights.
An option is the right, but not the obligation, to buy or sell a specified amount (and quality) of a commodity, currency, index, or financial instrument, or to buy or sell a specified number of underlying futures contracts, at a specific price on or before a given date in future. Like other contracts, there are two parties to an options contract: the buyer who takes a long position and the seller or writer, who takes a short position. The options contract gives the owner a right to buy/sell a particular commodity or other asset at a specific predestined price by a specified date. The price involved is called exercise or strike price and the date involved is known as expiration. It is important to understand that such a contract fives its holder the right, and not the obligation to buy/sell. The option writer, on the other hand, undertakes upon himself the obligation to sell/buy the underlying asset if that suits the option holder. The notion of options can be exemplified as follows.
Options are of two types: call option and put option. A call option gives an owner the right to buy while a put option gives its owner the right to sell. There is a wide variety of underlying assets including agricultural commodities, metals, shares, indices and so on, on which options are written. Further, like futures contracts, options are also tradeable on exchanges. The exchange-traded options are standardized contracts and their trading is regulated by the exchanges that ensure the honoring of such contracts. Thus, in case of options as well, a clearing corporation takes the other side in every contract so that the party with the long position has a claim against the clearing corporation and the one with short position is obliged to it. However, while buying or selling of futures contracts does not require any price to be paid, called premium. The writer of an option receives the premium as a compensation of the risk that he takes upon himself. The premium belongs to the writer and is not adjusted in the price if the holder of the option decides to exercise it. This price is determined on the exchange, like the price of a share, by the forces of demand and
S. K. Patel Institute of Management & Computer Studies 44
A Project Study on Derivatives in Indiasupply. Further, like the share prices, the option prices also keep on changing with passage of time as trading in the, takes place.
One difference between future and option trading may be noted. Whereas both parties to a futures contract are required to deposit margins to the exchange, only the party with the short position is called upon to pay margin in case of options trading. The party with the long position does not pay anything beyond the premium.
Options: A Historical Perspective
The options have a long history. The idea of an option existed in ancient Greece and Rome. The Romans wrote options on the cargoes that were transported by their ships. In the 17th century, there was an active options market in Holland. In fact, options were used in a large measure in the ‘tulip bulb mania’ of that century. However, in the absence of a mechanism to guarantee the performance of the contract, the refusal of many put option writers to take delivery of the tulip bulbs and pay the high prices of the bulbs they had originally agreed to, led to bursting of the bulb bubble during the winter 1637. A number of speculators were wiped out in the process.
Options were traded in the USA and UK during the 19th century and confined mainly to the agricultural commodities. Earlier, they were declared illegal in UK in1733 and remained so until 1860 when the Act declaring them illegal was repealed. They were again banned in the third decade of this century, albeit temporarily. In the USA, options on equity stocks of the companies were available on the over-the-counter (OTC) market only, until April, 1973. They were not standardized and involved the intra-party risk. In India, options on stocks of companies, through illegal, have been traded for many years on a limited scale in the form of teji and mandi, and related transactions. As such, this trading has been a very risky proposition to undertake.
In spite of the long time that has elapsed since the inception of options, they were, until not very long ago, looked down upon as mere speculative tools and associated with corrupt practices. Things changed dramatically in the 1970s when options were transformed from relative obscurity to a systematically traded asset which is an integral part of financial portfolios. In fact, the year 1973 witnessed some major developments. Black and Scholes published a seminal paper explaining the basic principal of options pricing and hedging. In the same year, the Chicago Board Options Exchange (CBOT) was created. It was the first registered securities exchange dedicated to
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A Project Study on Derivatives in Indiaoptions trading. While trading in options existed for long, it experienced a gigantic growth with the creation of this exchange. The listing of options meant orderly and thicker markets for this kind of securities. Options trading are now undertaken widely in many countries besides the USA and UK. In fact, options have become an integral part of the large and development financial markets.
Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more often than not the scenario is the reverse. Investing in stocks has two sides to it
a) Unlimited profit potential from any upside or
b) A downside which could make you a pauper.
Derivative products are structured precisely for this reason -- to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable you to hedge your portfolio or open positions in the market. Option contracts allow you to run your profits while restricting your downside risk.
Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios. We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we will try and understand some basic concepts of options. Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance. An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. ‘Option’, as the word suggests, is a choice given to the investor to either honor the contract; or if he chooses not to walk away from the contract.
To begin, there are two kinds of options: Call Options and Put Options.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability.
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A Project Study on Derivatives in IndiaCall options usually increase in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.
This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.
There are two types of options:
Call Options Put Options
Call options
Call 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.
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A Project Study on Derivatives in IndiaThis 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 contract Strike price Call premium
Dec Nifty 1325 Rs 6,0001345 Rs 2,000
Jan Nifty 1325 Rs 4,5001345 Rs 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).
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A Project Study on Derivatives in IndiaIf 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.
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A Project Study on Derivatives in IndiaQuotes 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.
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CALL OPTIONS PUT OPTIONS
If you expect a fall in price(Bearish)
Short Long
If you expect a rise in price (Bullish)
Long Short
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SUMMARY:
CALL OPTION BUYER CALL 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 BUYER PUT 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.
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A Project Study on Derivatives in Indiaeg: 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.
Calls Puts
.JUL AUG SEP JUL AUG SEP
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A Project Study on Derivatives in IndiaWipro Wipro
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
Concepts
Strike price:
The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.
In-the-money:
A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.
eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10
In the above example, the option is "in-the-money", till the market price of SATCOM is ruling above the strike price of Rs 190, which is the price at which Raj would like to buy 100 shares anytime before the end of August.
Similary, if Raj had purchased a Put at the same strike price, the option would have been "in-the- money", if the market price of SATCOM was lower than Rs 190 per share.
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A Project Study on Derivatives in IndiaOut-of-the-Money:
A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.
eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150
In the above example, the option is "out-of- the- money", if the market price of INFTEC is ruling below the strike price of Rs 3500, which is the price at which SAM would like to buy 100 shares anytime before the end of August.
Similary, if Sam had purchased a Put at the same strike price, the option would have been "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.
At-the-Money:
The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money.
eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10
In the above case, if the market price of ACC is ruling at Rs 150, which is equal to the strike price, then the option is said to be "at-the-money".
If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that the underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390, which are lower than the underlying of 1,410.
At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in.
Covered Call Option
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A Project Study on Derivatives in IndiaCovered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected).
eg: Raj believes that HLL has hit rock bottom at the level of Rs.182 and it will move in a narrow range. He can take a long position in HLL shares and at the same time write a call option with a strike price of 185 and collect a premium of Rs.5 per share. This will bring down the effective cost of HLL shares to 177 (182-5). If the price stays below 185 till expiry, the call option will not be exercised and the writer will keep the Rs.5 he collected as premium. If the price goes above 185 and the Option is exercised, the writer can deliver the shares acquired in the cash market.
Covered Put Option
Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.
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:
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A Project Study on Derivatives in India 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 underlying
The 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 following chart summarises the above for Calls and Puts.
Opt
Option Underlying price Premium cost
Call
Put
Time Value of an Option
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A Project Study on Derivatives in IndiaGenerally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s 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 option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.
Option Time to expiry Premium cost
Call
Put
Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s 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 option’s 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 premium
Lower volatility = Lower premium
Option Volatility Premium cost
Call
Put
Interest rates
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A Project Study on Derivatives in IndiaIn 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.
Option Interest rates Premium cost
Call
Put
Reading Stock Option Tables
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A Project Study on Derivatives in IndiaIn India, option tables published in business newspapers and are fairly similarto the regular stock tables.
The following is the format of the options table published in Indian business news papers:
NIFTY OPTIONS
Contracts
Exp.Date
Str.Price
Opt.Type
Open
High
Low
Trd.Qty
No.of.Cont.
Trd.Value
RELIANCE 7/26/01 360 CA 3 3 2 4200 7 1512000
RELIANCE 7/26/01 360 PA 29 39 29 1200 2 432000
RELIANCE 7/26/01 380 CA 1 1 1 1200 2 456000
RELIANCE 7/26/01 380 PA 35 40 35 1200 2 456000
RELIANCE 7/26/01 340 CA 8 9 6 11400 19 3876000
RELIANCE 7/26/01 340 PA 10 14 10 13800 23 4692000
RELIANCE 7/26/01 320 CA 22 24 16 11400 19 3648000
RELIANCE 7/26/01 320 PA 4 7 2 29400 49 9408000
RELIANCE 8/30/01 360 PA 31 35 31 1200 2 432000
RELIANCE 8/30/01 340 CA 15 15 15 600 1 204000
RELIANCE 8/30/01 320 PA 10 10 10 600 1 192000
RELIANCE 7/26/01 300 CA 38 38 38 600 1 180000
RELIANCE 7/26/01 300 PA 2 2 2 1200 2 360000
RELIANCE 7/26/01 280 CA 59 60 53 1800 3 504000
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The first column shows the contract that is being traded i.e Reliance.
The second coloumn displays the date on which the contract will expire i.e. the expiry date is the last Thursday of the month.
Call options-American are depicted as 'CA' and Put options-American as 'PA'.
The Open, High, Low, Close columns display the traded premium rates.
Advantages of option trading
Risk management: Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.
Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.
Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.
Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.
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A Project Study on Derivatives in IndiaIncome generation: Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price.
Strategies: By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.
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3.5. Traders in Derivatives Market
Hedgers:
Hedgers are the traders who wish to eliminate the risk (of price change) to which they are already exposed. They may take a long position on, or short sell, a commodity and would, therefore, stand to lose should the prices move in the adverse direction. The trader can sell futures (or forward) contracts with a matching price, to hedge. Thus, if the wheat prices do fall, the trader would lose money on the inventory of wheat but will profit from the futures contract, which would balance the loss.
It may be noted that hedging only makes an outcome more certain, it does not necessarily lead to an improved outcome.
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 price Profit
1000 4000 3000
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 defaults Shyam honours
1000 (Initial Investment) 3000 (Initial profit)1000 (penalty from Shyam) (-1000) discount given to Shyam- (No gain/loss) 2000 (Net gain)
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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 above 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 study the impact on the overall gain/loss that accrues:
Index up 10%
Index down 10%
Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)Gain/(Loss) in Futures (Rs 120,000) Rs 120,000Net Effect Nil Nil
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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 have seen how one can use hedging in the futures market to offset losses in the cash market.
Speculators:
If hedgers are the people who wish to avoid the price risk, speculators are those who are willing to take such risk. These are the people who take position in the market and assume risks to profit from fluctuations in prices. In fact, the speculators consume information, make forecasts about the prices and put their money in these forecasts. Depending on their perceptions, they may take long or short positions on futures and/or options, or may hold spread positions (simultaneous long and short positions on the same derivatives).
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.
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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.
Arbitrageurs:
Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given commodity, or other item, that sells for different prices in different markets.
Simultaneous purchase of securities in one market where the price thereof is low and sale thereof in another market, where the price thereof is comparatively higher. There are done when the same securities are being quoted at different prices in the two markets, with a view to make a profit and carried on whth the conceived intention to derive advantage from difference in prices of securities prevailing in the two markets.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 month’s 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
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Sale = 1070Cost= 1000+30 = 1030Arbitrage profit = 40
These 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.
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3.6. Types of Orders
In the stock market, when prices of the well traded securities are quoted, full prices are seldom indicated. The various kinds of order given by various traders are as explained as below.
1) Market Order: Market Order is the most common type of order and simply involves an instruction to buy or sell at the prevailing price in the market. It represents the best price one can get at a point of time. Small orders can be conveniently executed at the market rate but if the size of the order is larger than the volume which is currently available in the dealing pit, then executions might not all be at the same price because the dealer would have to bid up or offer down until desired volumes are secured. Thus, large orders ‘at market’ have a tendency to move against those who give them. No wonder, then, that large orders may be placed by market participants who wish to move the market in a particular direction.
2) Limit Order: A limit order is an order to buy or sell at a specified price, or a price better than that. Thus, a limit order is exemplified when a clent may give a broker a price limit above which he should not buy or below which he should not sell. Also, there is a time limit for which it may be given. This kind of an order puts more responsibility on the dealer since he has to be aware of his limits orders once the limit is reached. A limit order kind of an order is feasible whin it is considered that there is sufficient market force in the opposite direction at current prices. This has the advantage that it is far less likely to push prices in an adverse direction.
3) Stop-Loss Order: A stop-loss order is aimed at closing out positions whin a particular price level is traded. It is this kind of an order when, for instance, a cleent orders his broker to sell a share or some other security, if its market price falls to a certain level below the current price. Thus, once the specified price is reached or penetrated, the order becomes the market order. Stop-loss orders are a good means of protecting oncs’ profits, or limiting ones’ loss, while waiting for the market to recover.
4) Stop-Limit Order: A stop-limit order is said to be placed when, for example, a client can place a stop order at a particular level with a limit beyond which the market would cease to be chased. For the order, say, sell on stop 3188 limit 82, the broker/dealer to look to sell the position once the market declines and trades at 3188, but he would not sell below 3182.
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A Project Study on Derivatives in India5) Fill or Kill Order: This is an order to a broker to buy or sell a
security or derivative immediately. If the order is not executed at once, it is treated as withdrawn. This type of an order is often used by a party wishing to take out a large bid/offer but, in case of a failure, it does not wish to be viewed as a possible large counter party in the market.
6) Market if Touched (MIT): It is a limit order which automatically becomes a market order once a predetermined price is reached.
7) Good Till Cancelled (GTC): This is a client’s order to buy or sell, usually at a specified price, which remains valid until its execution or cancellation.
8) Day Order or Good for the Day: As the name implies, this means the limits or stop order would lapes at the end of the day (of dealing) if it has not been executed during the day.
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3.7. Various Kinds of Margins
Variation or mark-to-market margin
All daily losses must be met by depositing of further collateral – known as variation margin, which is required by he close of business, the following day. Any profits on the contract are credited to the clients variation margin account.
Maintenance Margin
It is typically three-forth of initial margin. Some exchanges work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the maintenance margin limit. For e.g.. if initial margin is fixed at 100 and maintenance margin is at 80, then the broker is permitted to trade till such time that the balance in this initial margin account is 80 or more. If it drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the levels of initial margin. This concept is not expected to be used in India.
Margin Call
In the process of marking to the market, if the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is required to deposit additional funds to bring the balance to the level of initial margin in a very short period of time. The extra funds deposited are called variation margin.
Additional Margin
In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. this is preemptive move by exchange to prevent breakdown.
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Cross Margining
This is a method of calculating margin after taking into account combined positions in Future, options, cash market etc. Hence the total margin requirement reduces due to cross-hedges. This is unlikely to be introduced in India immediately.
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3.8. Selection CriteriaEligibility Criteria for selection of Securities and Indices:
SEBI vide its Circular No. : SEBI/DNPD/Cir-26/2004/07/16 dated July 16, 2004 has revised the eligibility criteria for introducing Futures & Options contracts on Stocks and Indices.
Based on the above circular, the following criteria will be adopted by the Exchange w.e.f September 1, 2004, for selecting stocks and indices on which Futures & Options contracts would be introduced.
1. Eligibility criteria of stocks
The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis.
The stock’s median quarter-sigma order size over the last six months shall be not less than Rs. 0.10 million (Rs. 1 lac). For this purpose, a stock’s quarter-sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.
The market wide position limit in the stock shall not be less than Rs. 500 million (Rs. 50 crores). The market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be lower of :
30 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment,
or 20% of the number of shares held by non-
promoters in the relevant underlying security i.e. free-float holding.
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three months consecutively, then no fresh month contract shall be issued on that security.
Further, the members may also refer to circular no. NSCC/F&O/C&S/365 dated August 26, 2004, issued by NSCCL regarding Market Wide Position Limit, wherein it is clarified that a stock which has remained subject to a ban on new position for a significant part of the month consistently for three months, shall be phased out from trading in the F&O segment.
However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months.
2. Eligibility criteria of Indices
Futures & Options contracts on an index can be introduced only if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index on which futures and options contracts are permitted shall be required to comply with the eligibility criteria on a continuous basis.
SEBI has subsequently modified the above criteria, vide its clarification issued to the Exchange “The Exchange may consider introducing derivative contracts on an index if the stocks contributing to 80% weightage of the index are individually eligible for derivative trading. However, no single ineligible stocks in the index shall have a weightage of more than 5% in the index.”
The above criteria is applied every month, if the index fails to meet the eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that index, However, the existing unexpired contacts shall be permitted to trade till expiry and new strikes may also be introduced in the existing contracts.
The following procedure is adopted for calculating the Quarter Sigma Order Size :
1. The applicable VAR (Value at Risk) is calculated for each security based on the J.R. Varma Committee guidelines. (The formula suggested by J. R. Varma for computation of VAR for margin calculation is statistically known as ‘Exponentially weighted moving average (EWMA)’ method. In comparison to the traditional method, EWMA has the advantage of giving more
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A Project Study on Derivatives in Indiaweight to the recent price movements and less weight to the historical price movements.)
2. Such computed VAR is a value (like 0.03), which is also called standard deviation or Sigma. (The meaning of this figure is that the security has the probability to move 3% to the lower side or 3% to the upper side on the next trading day from the current closing price of the security).
3. Such arrived at standard deviation (one sigma), is multiplied by 0.25 to arrive at the quarter sigma.(For example, if one sigma is 0.09, then quarter sigma is 0.09 * 0.25 = 0.0225)
4. From the order snapshots (taken four times a day from NSE’s Capital Market Segment order book) the average of best buy price and best sell price is computed which is called the average price.
5. The quarter sigma is then multiplied with the average price to arrive at quarter sigma price. The following example explains the same :
6. Based on the order snapshot, the value of the order (order size in Rs.), which will move the price of the security by quarter sigma price in buy and sell side is computed. The value of such order size is called Quarter Sigma order size. (Based on the above example, it will be required to compute the value of the order (Rs.) to move the stock price to Rs. 306.00 in the buy side and Rs. 307.40 on the sell side. That is Buy side = average price – quarter sigma price and Sell side = average price + quarter sigma price). Such an exercise is carried out for four order snapshots per day for all stocks for the previous six months period
7. From the above determined quarter sigma order size (Rs.) for each order book snap shot for each security, the median of the order sizes (Rs.) for buy side and sell side separately, are
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8. The average of the median order sizes for buy and sell side are taken as the median quarter sigma order size for the security.
9. The securities whose median quarter sigma order size is equal to or greater than Rs. 0.1 million (Rs. 1 Lac) qualify for inclusion in the F&O segment.Futures & Options contracts may be introduced on new securities which meet the above mentioned eligibility criteria, subject to approval by SEBI.
New securities being introduced in the F&O segment are based on the eligibility criteria which take into consideration average daily market capitalization, average daily traded value, the market wide position limit in the security, the quarter sigma values and as approved by SEBI. The average daily market capitalisation and the average daily traded value would be computed on the 15th of each month, on a rolling basis, to arrive at the list of top 500 securities. Similarly, the quarter sigma order size in a stock would also be calculated on the 15th of each month, on a rolling basis, considering the order book snapshots of securities in the previous six months and the market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month.The number of eligible securities may vary from month to month depending upon the changes in quarter sigma order sizes, average daily market capitalisation & average daily traded value calculated every month on a rolling basis for the past six months and the market wide position limit in that security. Consequently, the procedure for introducing and dropping securities on which option and future contracts are traded will be as stipulated by SEBI in its circular no. SEBI/DNPD/Cir-26/2004/07/16 dated July 16, 2004.
Selection criteria for unlisted companies:
For unlisted companies coming out with initial public offering, if the net public offer is Rs. 500 crs. or more, then the Exchange may consider introducing stock options and stock futures on such stocks at the time of its’ listing in the cash market.
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3.9. List of Underlying :
The following companies are eligible for derivatives segment in India. Moreover every script has its own unique symbol which is mentioned as below. This list of securities are changing according to selection criteria, new script can be added if it fulfils the selection criteria and existing script can be removed if it not satisfies the criteria.
No.
Underlying Symbol
1 S&P CNX Nifty NIFTY
2 CNX IT CNXIT
Derivatives on Individual Securities
1 Associated Cement Co. Ltd. ACC
2 Andhra Bank ANDHRABANK
3 Arvind Mills Ltd. ARVINDMILL
4 Bajaj Auto Ltd. BAJAJAUTO
5 Bank of Baroda BANKBARODA
6 Bank of India BANKINDIA
7 Bharat Electronics Ltd. BEL
8 Bharat Heavy Electricals Ltd. BHEL
9 Bharat Petroleum Corporation Ltd. BPCL
10 Canara Bank CANBK
11 Cipla Ltd. CIPLA
12 Dr. Reddy's Laboratories Ltd. DRREDDY
13 GAIL (India) Ltd. GAIL
14 Grasim Industries Ltd. GRASIM
15 Gujarat Ambuja Cement Ltd. GUJAMBCEM
16 HCL Technologies Ltd. HCLTECH
17Housing Development Finance Corporation Ltd.
HDFC
18 HDFC Bank Ltd. HDFCBANK
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The market lot for individual stock and its symbol are mentioned in the table given below. The order should be of that lot size. Odd lots are not allowed in derivatives segment. This lot size is fixed in accordance with minimum contract value. If anybody wants to take position, then he/she has to follow the below market lot (size or number of shares).
No.
Underlying SymbolMarket Lot
1 S&P CNX Nifty NIFTY 200
2 CNX IT CNXIT 100
Derivatives on Individual Securities
1 Associated Cement Co. Ltd. ACC 1500
2 Andhra Bank ANDHRABANK 4600
3 Arvind Mills Ltd. ARVINDMILL 4300
4 Bajaj Auto Ltd. BAJAJAUTO 400
5 Bank of Baroda BANKBARODA 1400
6 Bank of India BANKINDIA 3800
7 Bharat Electronics Ltd. BEL 550
8 Bharat Heavy Electricals Ltd. BHEL 600
9Bharat Petroleum Corporation Ltd.
BPCL 550
10 Canara Bank CANBK 1600
11 Cipla Ltd. CIPLA 1000
12 Dr. Reddy's Laboratories Ltd. DRREDDY 200
13 GAIL (India) Ltd. GAIL 1500
14 Grasim Industries Ltd. GRASIM 350
15 Gujarat Ambuja Cement Ltd. GUJAMBCEM 1100
16 HCL Technologies Ltd. HCLTECH 1300
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The Exchange provides a minimum of seven strike prices for every option type (i.e Call & Put) during the trading month. At any time, there are three contracts in-the-money (ITM), three contracts out-of-the-money (OTM) and one contract at-the-money (ATM).
The strike price interval would be:
Price of UnderlyingStrike Price interval (Rs.)
Less than or equal to Rs. 50 2.50
> Rs.50 to less than or equal to Rs. 250 5
> Rs.250 to less than or equal to Rs. 500 10
> Rs.500 to less than or equal to Rs. 1000 20
> Rs.1000 to less than or equal to Rs. 2500
30
> Rs.2500 50
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous day's underlying close values, as and when required. In order to decide upon the at-the-money strike price, the underlying closing value is rounded off to the nearest strike price interval.The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price interval
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3.12. Settlement Mechanism
Clearing and settlement
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal counterparty to all trades on the F&O segment and guarantees their financial settlement.Clearing entitiesClearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of the following entities:Clearing membersIn the F&O segment, some members, called self clearing members, clear and settle their trades executed by them only either on their own account or on account of their clients. Some others, called trading member–cum–clearing member, clear and settle their own trades as well as trades of other trading members(TMs). Besides, there is a special category of members, called professional clearing members (PCM) who clear and settle trades executed by TMs. The members clearing their own trades and trades of others, and the PCMs are required to bring in additional security deposits in respect of every TM whose trades they undertake to clear and settle.Clearing banksFunds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with NSCCL designated clearing bank for F&O segment. The Clearing and Settlement process comprises of the following three mainactivities:1. Clearing2. Settlement
Proprietary position of trading member Madanbhai on Day 1
Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The table shows his proprietary position. Note: A buy position “200@1000”means 200 units bought at the rate of Rs.1000.Trading member Madanbhai
Buy SellProprietary position 200@1000 400@1010
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Client position of trading member Madanbhai on Day 1
Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The table shows his client position.Trading member Madanbhai
Buy Open Sell Close Sell Open Buy CloseClient positionClient A 400@1109 200@1000Client B 600@1100 200@1099
3. Risk Management
Clearing mechanismThe clearing mechanism essentially involves working out open positions and obligations of clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is considered for exposure and daily margin purposes. The open positions of CMs are arrived at by aggregating the open positions of all the TMs and all custodial participants clearing through him, in contracts in which they have traded. A TM’s open position is arrived at as the summation of his proprietary open position and clients’ open positions, in the contracts in which he has traded. While entering orders on the trading system, TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients) through ‘Pro/ Cli’ indicator provided in the order entry screen. Proprietary positions are calculated on net basis(buy - sell) for each contract. Clients’ positions are arrived at by summing together net (buy - sell) positions of each individual client. A TM’s open position is the sum of proprietary openposition, client open long position and client open short position.Consider the following example given The proprietary open position on day 1 is simply = Buy - Sell = 200 - 400 = 200 short. The open position for client A= Buy(O) - Sell(C) = 400 - 200 = 200 long, i.e. he has a long position of 200 units. The open position for Client B = Sell(O) - Buy(C) = 600 - 200 = 400 short, i.e. he has a short position
Proprietary position of trading member Madanbhai on Day 2
Assume that the position on Day 1 is carried forward to the next trading day and the following trades are also executed.Trading member Madanbhai
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Proprietary position 200@1000 400@1010
Client position of trading member Madanbhai on Day 2Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The tableshows his client position on Day 2.Trading member Madanbhai
Buy Open Sell Close Sell Open Buy CloseClient positionClient A 400@1109 200@1000Client B 600@1100 400@1099
of 400 units. Now the total open position of the trading member Madanbhai at end of day 1 is 200(his proprietary open position on net basis) plus 600(the Client open positions on gross basis), i.e. 800. The proprietary open position at end of day 1 is 200 short. The end of day open position for proprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position at the end of day 2 is 400 short. Similarly, Client A’s open position at the end of day 1 is 200 long. The end of day open position for trades done by Client A on day 2 is 200 long. Hence the net open position for Client A at the end of day 2 is 400 long. Client B’s open position at the end of day 1 is 400 short. The end of day open position for trades done by Client B on day 2 is 200 short. Hence the net open position for Client B at the end of day 2 is 600 short. The net open position for the trading member at the end of day 2 is sum of the proprietary open position and client open positions. It works out to be 400 + 400 + 600, i.e. 1400. The following table illustrates determination of open position of a CM, who clears for two TMs having two clients.Settlement mechanismAll futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot
Determination of open position of a clearing memberTMs clearing through CM
Proprietary trades Trades: Client 1 Trades: Client 2 Open position
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ABC 4000
2000
2000 3000
1000
2000 4000
2000
2000 6000
-
PQR 2000
3000
(1000)
2000
1000
1000 1000
2000
(1000)
1000
2000
Total 6000
5000
+2000
5000
2000
+3000
5000
4000
+2000
7000
2000
-1000 -1000
market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients, with respect to their obligations on MTM, premium and exercise settlement.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:1. The trade price and the day’s settlement price for contracts executed during the day but not squared up.2. The previous day’s settlement price and the current day’s settlement price for brought forwardcontracts.3. The buy price and the sell price for contracts executed during the day and squared up.Table 11.6 explains the MTM calculation for a member. The settlement price for the contract for today is assumed to be 105. 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 as per the following formula:
Table 11.6
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A Project Study on Derivatives in IndiaComputation of MTM at the end of the dayThe table gives the MTM charged on various positions. The margin charged on the brought forward contract is the difference between the previous day’s settlement price of Rs.100 and today’s settlement price of Rs.105. Hence on account of the position brought forward, the MTM shows a profit of Rs.500. For contracts executed during the day, the difference between the buy price and the sell price determines the MTM. In this example, 200 units are bought @Rs.100 and 100 units [email protected] during the day. Hence the MTM for the position closed during the day shows a profit of Rs.200. Finally, the open position of contracts traded during the day, is margined at the day’s settlement price and the profit of Rs.500 credited to the MTM account. So the MTM account shows a profit of Rs.1200.
Trade details Quantity bought/sold
Settlement price
MTM
Brought forward from previous day
100@100 105 500
Traded during dayBought 200@100Sold 100@102 102 200Open position (not squared up)
100@100 105 500
Total 1200F _ S_ _ _where:F Theoretical futures priceS Value of the underlying indexr Cost of fi nancing(using continuously compounded interest rate) or rate of interest(MIBOR)T Time till expiratione 2.71828After completion of daily settlement computation, all the open positions are reset to the daily settlement price. Such positions become the open positions for the next day. Final settlement for futures on the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CMto the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant CM’s clearing bank account on the day following expiry day of the contract.
Settlement prices for futures Daily settlement price on a trading day is the closing price of the respective futures contracts on such day. The
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Settlement of options contractsOptions contracts have three types of settlements, daily premium settlement, exercise settlement, interim exercise settlement in the case of option contracts on securities and final settlement. Daily premium settlement Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the option sold by him. The premium payable amount and the premium receivable amount are netted to compute the net premium payable or receivable amount for each client for each option contract.
Exercise settlementAlthough most option buyers and sellers close out their options positions by an offsetting closing transaction, an understanding of exercise can help an option buyer determine whether exercise might be more advantageous than an offsetting sale of the option. There is always a possibility of the option seller being assigned an exercise. Once an exercise of an option has been assigned to an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash settlement amount in the case of a cash-settled option) even though he may not yet have been notified of the assignment.
Interim exercise settlementInterim exercise settlement takes place only for option contracts on securities. An investor can exercise his in-the-money options at any time during trading hours, through his trading member. Interim exercise settlement is effected for such options at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the option contract with the same series (i.e. having the same underlying, same expiry date and same strike price), on a random basis, at the client level. The CM who has exercised the option receives the exercise settlement value per unit of the option from the CM who has been assigned the option contract.
Final exercise settlementFinal exercise settlement is effected for all open long in–the–money strike price options existing at the close of trading hours, on the
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A Project Study on Derivatives in Indiaexpiration day of an option contract. All such long positions are exercised and automatically assigned to short positions in option contracts with the same series, on a random basis. The investor who has long in–the–money options on the expiry date will receive the exercise settlement value per unit of the option from the investor who has been assigned the option contract.
Exercise processThe period during which an option is exercisable depends on the style of the option. On NSE, index options are European style, i.e. options are only subject to automatic exercise on the expiration day, if they are in–the–money. As compared to this, options on securities are American style. In such cases, the exercise is automatic on the expiration day, and voluntary prior to the expiration day of the option contract, provided they are in–the–money. Automatic exercise means that all in–the–money options would be exercised by NSCCL on the expiration day of the contract. The buyer of such options need not give an exercise notice in such cases. Voluntary exercise means that the buyer of an in–the–money option can direct his TM/CM to give exercise instructions to NSCCL. In order to ensure that an option is exercised on a particular day, the buyer must direct his TM to exercise before the cut-off time for accepting exercise instructions for that day. Usually, the exercise orders will be accepted by the system till the close of trading hours. Different TMs may have different cut–off times for accepting exercise instructions from customers, which may vary for different options. An option, which expires unexercised becomes worthless. Some TMs may accept standing instructions to exercise, or have procedures for the exercise of every option, which is in–the–money at expiration. Once an exercise instruction is given by a CM to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer at anytime on a day are processed by NSCCL after the close of trading hours on that day. All exercise notices received by NSCCL from the NEAT F&O system are processed to determine their validity. Some basic validation checks are carried out to check the open buy position of the exercising client/TM and if option contract is in–the–money. Once exercised contracts are found valid, they are assigned.
Assignment processThe exercise notices are assigned in standardized market lots to short positions in the option contract with the same series (i.e. same underlying, expiry date and strike price) at the client level. Assignment to the short positions is done on a random basis. NSCCL determines short positions, which are eligible to be assigned and then allocates the exercised positions to any one or more short positions. Assignments are made at the end of the trading day on which exercise
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A Project Study on Derivatives in Indiainstruction is received by NSCCL and notified to the members on the same day. It is possible that an option seller may not receive notification from its TM that an exercise has been assigned to him until the next day following the date of the assignment to the CM by NSCCL.
Exercise settlement computationIn case of index option contracts, all open long positions at in–the–money strike prices are automatically exercised on the expiration day and assigned to short positions in option contracts with the same series on a random basis. For options on securities, where exercise settlement may be interim or final, interim exercise for an open long in–the–money option position can be effected on any day till the expiry of the contract. Final exercise is automatically effected by NSCCL for all open long in–the–money positions in the expiring month option contract, on the expiry day of the option contract. The exercise settlement price is the closing price of the underlying(index or security) on the exercise day(for interim exercise) or the expiry day of the relevant option contract(final exercise). The exercise settlement value is the difference between the strike price and the final settlement price of the relevant option contract. For call options, the exercise settlement value receivable by a buyer is the difference between the final settlement price and the strike price for each unit of the underlying conveyed by the option contract, while for put options it is difference between the strike price and the final settlement price for each unit of the underlying conveyed by the option contract. Settlement of exercises of options on securities is currently by payment in cash and not by delivery of securities. It takes place for in-the-money option contracts. The exercise settlement value for each unit of the exercised contract is computed as follows:
Call options Closing price of the security on the day of exercise _ Strike pricePut options Strike price _ Closing price of the security on the day of exerciseFor final exercise the closing price of the underlying security is taken on the expiration day The exercise settlement by NSCCL would ordinarily take place on 3rd day following the day of exercise. Members may ask for clients who have been assigned to pay the exercise settlement value earlier.
Special facility for settlement of institutional dealsNSCCL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared and settled by their own CM. Such entities are called custodial participants (CPs). To avail of this facility, a CP is
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A Project Study on Derivatives in Indiarequired to register with NSCCL through his CM. A unique CP code is allotted to the CP by NSCCL. All trades executed by a CP through any TM are required to have the CP code in the relevant field on the trading system at the time of order entry. Such trades executed on behalf of a CP are confirmed by their own CM (and not the CM of the TM through whom the order is entered), within the time specified by NSE on the trade day though the on-line confirmation facility. Till such time the trade is confirmed by CM of concerned CP, the same is considered as a trade of the TM and the responsibility of settlement of such trade vests with CM of the TM. Once confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of deals of such custodial clients. FIIs have been permitted to trade in all the exchange traded derivative contracts subject to compliance of the position limits prescribed for them and their sub-accounts, and compliance with the prescribed procedure for settlement and reporting. A FII/a sub-account of the FII, as the case may be, intending to trade in the F&O segment of the exchange, is required to obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FIIs/sub–accounts of FIIs which have been allotted a unique CP code by NSCCL are only permitted to trade on the F&O segment. The FII/sub–account of FII ensures that all orders placed by them on the Exchange carry the relevant CP code allotted by NSCCL.
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3.13. Regulations Related to Derivatives:
Securities Contracts(Regulation) Act, 1956
SC(R)A aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term “securities” has beendefined in the SC(R)A. As per Section 2(h), the ‘Securities’ include:1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate2. Derivative3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes4. Government securities5. Such other instruments as may be declared by the Central Government to be securities6. Rights or interests in securities.
“Derivative” is defined to include:A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security A contract which derives its value from the prices, or index of prices, of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are:
Traded on a recognized stock exchange Settled on the clearing house of the recognized stock exchange,
in accordance with the rules and bye–laws of such stock exchanges.
Securities and Exchange Board of India Act, 1992SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) promoting the development of
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A Project Study on Derivatives in Indiathe securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for:
regulating the business in stock exchanges and any other securities markets
registering and regulating the working of stock brokers, sub–brokers etc.
promoting and regulating self-regulatory organizations prohibiting fraudulent and unfair trade practices calling for information from, undertaking inspection, conducting
inquiries and audits of the stock exchanges, mutual funds and other persons associated with the
securities market and intermediaries and self–regulatory organizations in the securities market performing such functions and exercising according to Securities
Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government
Regulation for derivatives tradingSEBI set up a 24-member committee under the Chairmanship of Dr.L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the committee for regulation and control of trading and settlement of derivatives contracts. The provisions in the SC(R)A and the regulatory framework developed thereunder govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of ‘securities’ in the SC(R)A made trading in derivatives possible within the framework of that Act. 1. Any Exchange fulfi lling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices o its members and will obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange shall have minimum 50 members.
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A Project Study on Derivatives in India3. The members of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfi ll the eligibility conditions as laid down by the LC Gupta committee.4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum networth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The networth of the member shall be computed as follows:Capital + Free reservesLess non-allowable assets viz.,(a) Fixed assets(b) Pledged securities(c) Member’s card(d) Non-allowable securities(unlisted securities)(e) Bad deliveries(f) Doubtful debts and advances(g) Prepaid expenses(h) Intangible assets(i) 30% marketable securities6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also submit details of the futures contract they propose to introduce.7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.8. The L.C.Gupta committee report requires strict enforcement of “Know our customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivativestrading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client.9. The trading members are required to have qualifi ed approved user and sales person who have passed a certifi cation programme approved by SEBI.
Regulation for clearing and settlement1. The LC Gupta committee has recommended that the clearing corporationmust perform full novation, i.e. the clearing corporation
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A Project Study on Derivatives in Indiashould interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.2. The clearing corporation should ensure that none of the Board members has trading interests.3. The defi nition of net-worth as prescribed by SEBI needs to be incorporated in the application/regulations of the clearing corporation.4. The regulations relating to arbitration need to be incorporated in the clearing corporations regulations.5. Specifi c provision/chapter relating to declaration of default must be incorporated by the clearing corporation in its regulations.6. The regulations relating to investor protection fund for the derivatives market must be included in the clearing corporation application/regulations.7. The clearing corporation should have the capabilities to segregate upfront/initial margins deposited by clearing members for trades on their own account and on account of his clients. The clearing corporation shall hold the clients’ margin money in trust for the clients’ purposes nly and should not allow its diversion for any other purpose. This condition must be incorporated in the clearing corporation regulations.8. The clearing member shall collect margins from his constituents (clients/trading members). He shall clear and settle deals in derivative contracts on behalf of the constituents only on the receipt of such minimum margin.9. Exposure limits based on the value at risk concept will be used and the exposure limits will be continuously monitored. These shall be within the limits prescribed by SEBI from time to time. 10. The clearing corporation must lay down a procedure for periodic review of the networth of its members.11. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members in the underlying market.12. Any changes in the the bye-laws, rules or regulations which are covered under the “Suggestive byelaws for regulations and control of trading and settlement of derivatives contracts” would require prior approval of SEBI.
Table 12.1 Eligibility criteria for membership on F&O segmentParticulars (all values in Rs.Lakh) CM and F&O segment CM, WDM and F&O
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A Project Study on Derivatives in IndiaCollateral securityDeposit (CSD) (3) 25 25Annual subscription 1 21: No additional networth is required for self clearing members. However, a networth of Rs. 300Lakh is required for TM–CM and PCM.2 & 3: Additional Rs. 25 Lakh is required for clearing membership(SCM,TM–CM). In addition,the clearing member is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 lakh per tradingmember he undertakes to clear and settle.
Regulation for membershipThe eligibility criteria for membership on the F&O segment are as given in Table 12.1. Table 12.2 gives the requirements for professional clearing membership. As mentioned earlier, anybody interested in taking membership of F&O segment is required to take membership of “CM andF&O segment” or “CM,WDM and F&O segment”. An existing member of CM segment can also take membership of F&O segment. A trading member can also be a clearing member by meeting additional requirements. There can also be only clearing members.
Table 12.2 Requirements for professional clearing membershipParticulars (all values in Rs.Lakh) F&O segment CM & F&O segmentEligibility Trading members of
NSE/SEBI registered custodians/recognized banks
Trading members of NSE/SEBI registered custodians/recognized banks
Note: The PCM is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 Lakh per trading
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4. Research
Methodology
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Research Methodology
4.1. Objectives of the study:
To study the derivatives market in India
To study how derivatives market has evolved in India in the last few years.
To understand how derivatives market work, how contract is executed, how settlement of a contract takes place, what are the different factor which had contributed to the success of derivatives in India.
To Study the relationship of different derivatives parameters on Cash market on overall basis
To Study the relationship of different derivatives parameters on Cash price of a particular share.
4.2. Scope of the Study:
Derivatives since its introduction have gained a lot of importance from the all segment of the society. Since the very beginning of it, players started finding out relationship between the Cash Market and the Derivatives Market. So in this project we had tried to understand the derivatives market in India along with that what’s happening around the world over in the same market.
We had tried to study the relationship between the Cash Market and different derivatives market parameters like “Put call Ratio (open interest), Put call Ratio (volume), Volume Traded in derivatives Market, Open Interest” The study will be helpful to those investor who tried to get some insight of the derivatives market and want to invest in cash market on the basis of it.
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4.3. Data Collection:
The study examines one index option and four individual securities on National stock Exchange over the period from March 2003 to June 2004. One index option and four individual securities we have studied are:
NIFTY (Index) ACC Reliance Satyam, and TISCO
The data of the stock prices as well as other derivatives market parameters taken are the closing data for each particular day of the study. The secondary data for the price and derivatives market was collected and filtered from the CD provided by the company and some missing data which were not available from the company were collected from the website of www.nseindia.com and www.bseindia.com The data for share price was also collected from Capitaline 2000.
4.4. Selection of Securities:
To study the relationship of derivatives and cash market we have selected one index i.e. “NIFTY” and four individual securities on which derivatives trading is allowed. Selection of the security for the study is purely based on the following grounds:
Liquidity Contract traded in a particular day Continuation of security in F & O Segment Turnover over of a particular security in derivatives as a % of
total derivatives turnover.
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A Project Study on Derivatives in India4.5. Analysis of Data:
For the purpose of analyzing data we have first put all the data collected in Excel Sheet and on the basis of that we had prepared different charts representing closing cash price of share or index and a particular derivative parameter. Then on the basis of chart we had tried to find out how a particular derivative parameter affect the cash price of securities being studied. The following excel sheets shows the list of data collected by us for the different shares cash price and different derivatives parameters like “Put call Ratio (open interest), Put call Ratio (volume), Volume Traded in derivatives Market, Open Interest” and after that various charts representing cash market and derivatives parameters are shown, on the basis of which we had arrived at conclusions.
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4.6. Data
Sheets
&
Charts
NIFTY
Date
Closing price
Put Call Ratio OI Volumes OI Rs.
Cr.Cash F & O OI Volume Future Call Put Total200317-Mar 993.00 1003.05 0.44 0.84 3726600 2012000 885800 6624400 639.00
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A Project Study on Derivatives in IndiaNIFTY V/s PC OI
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
TIME
NIF
TY
0.25
0.35
0.45
0.55
0.65
0.75
0.85
0.95
1.05
1.15
1.25
1.35
1.45
1.55
PC
OI
NIFTY PC RATIO
NIFTY V/s PC VOL
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
TIME
NIF
TY
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
PC
VO
LNIFTY PC RATIO
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A Project Study on Derivatives in IndiaNIFTY V/s OI VOL TOTAL
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
TIME
NIF
TY
2
5
8
11
14
17
20
23
26
Mill
ion
sO
I V
OL
TO
TA
L
NICTY VOLUME
NIFTY Vs OI Rs. Cr.
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
TIME
NIF
TY
250
500
750
1000
1250
1500
1750
2000
2250
2500
2750
3000
3250
3500
3750
4000
4250
OI
RS
CR
.NIFTY OI
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NIFTY Vs OVERALL OI
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
TIME
NIF
TY
1500
3000
4500
6000
7500
9000
10500
12000
13500
15000
OI
RS
.
NIFTY OVERALL OI
ACC (CASH Vs PC OI)
100
120
140
160
180
200
220
240
260
280
300
TIME
CA
SH
0.10
0.20
0.30
0.40
0.50
0.60
0.70
PC
OI
PRICE PC OI
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A Project Study on Derivatives in IndiaACC (CASH Vs PC VOL)
120
140
160
180
200
220
240
260
280
300
TIME
CA
SH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
PC
VO
L
PRICE VOLUME
ACC (CASH Vs OI VOL TOTAL)
120
140
160
180
200
220
240
260
280
300
TIME
CA
SH
1
3
5
7
9
11
13
15
17
Mil
lio
ns
OI
VO
L T
OT
AL
PRICE VOLUME
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A Project Study on Derivatives in IndiaACC (CASH Vs OI Rs Cr.)
120
140
160
180
200
220
240
260
280
300
TIME
CA
SH
0
50
100
150
200
250
300
350
400
OI
Rs
CR
.
PRICE OI Rs Cr.
SATYAM (CASH Vs PC OI)
100
150
200
250
300
350
400
TIME
CA
SH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
PC
OI
PRICE OI
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A Project Study on Derivatives in IndiaSATYAM (CASH VS PC VOL)
125
175
225
275
325
375
425
TIME
CA
SH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
PC
VO
L
PRICE VOLUME
SATYAM (CASH Vs OI VOL TOTAL)
100
150
200
250
300
350
400
TIME
CA
SH
2
5
8
11
14
17
20
23
26
29
Mil
lio
ns
OI
VO
L T
OT
AL
PRICE TOTAL
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A Project Study on Derivatives in IndiaSATYAM (CASH Vs OI RS CR.)
100
150
200
250
300
350
400
TIME
CA
SH
0
100
200
300
400
500
600
700
OI
Rs.
Cr.
PRICE OI RS CRORES
RELIANCE (CASH V/s PC VOL)
230
260
290
320
350
380
410
440
470
500
530
560
590
620
650
TIME
CA
SH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
PC
VO
L
PRICE PC VOL
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RELIANCE (CASH V/s PC OI)
200
250
300
350
400
450
500
550
600
650
TIME
CA
SH
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
PC
OI
PRICE PC OI
REL (PRICE V/s OI VOL TOTAL)
150
200
250
300
350
400
450
500
550
600
650
TIME
CA
SH
3
5
7
9
11
13
15
17
Mil
lio
ns
OI
VO
L T
OT
AL
PRICE OI VOL TOTAL
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REL (PRICE V/s OI IN Rs. Cr.)
150
200
250
300
350
400
450
500
550
600
650
TIME
CA
SH
0
100
200
300
400
500
600
700
800
900
OI
Rs.
Cr.
PRICE OI IN RS CR.
TISCO (CASH Vs PC OI)
75
125
175
225
275
325
375
425
475
525
TIME
CA
SH
0.10
0.20
0.30
0.40
0.50
0.60
0.70
PC
OI
PRICE PC OI
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TISCO (CASH Vs PC VOL)
75
125
175
225
275
325
375
425
475
525
TIME
CA
SH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
PC
VO
L
PRICE PC VOL
TISCO (CASH Vs OI Rs. Cr.)
75
125
175
225
275
325
375
425
475
525
TIME
CA
SH
100
200
300
400
500
600
700
800
900
1000
1100
OI
Rs.
Cr.
PRICE OI RS.
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TISCO (CASH Vs OI VOL TOTAL)
75
125
175
225
275
325
375
425
475
525
DATE
CA
SH
10
12
14
16
18
20
22
24
26
28
30
Mil
lio
ns
OI
VO
L T
OT
AL
PRICE VOLUME
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4.7. Limitations of the Study:
First and the foremost limitation of the study relates to the closing price being taken for the study. The price taken is average of the trade of last 30 minutes, which may not reflect the true price prevailing in a particular day.
Some data were missing and were also not available from the other sources, so we had to fill this gap of data through approximation, which can limit the analysis.
Relationship provided solely on the basis of chart may not be exact in nature.
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5. Recent
Trends
In
Derivatives
Market
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5.1. Derivatives In Emerging Markets
As we watch these efforts going into the creation of India's exchange--traded derivatives industry, comparisons with international experiences are inevitably useful. We know that in all OECD countries, derivatives are a crucial and vibrant part of the financial system. In addition, one interesting question has been ``what has the experience of other emerging markets been like''?
Consider the 23 significant exchanges in 16 emerging markets:
Brazil (BM & F) China (SSE, SME, SHME, SCCFE) Guatemala (BDP) Hungary (BCE & BSE) Korea (KSE) Malaysia (KLOFFE, KLCE) Philippines (MIFE) Portugal (PSE) Russia (MICEX & MCE) Slovak Republic (Bratislava) Slovenia (Ljubljana) South Africa (SAFEX) Argentina (MERFOX) Spain (Meff Renta) Singapore (SIMEX) Hong Kong (HKFE, SEHK)
These countries have come to this level of development via a variety of different routes.
The most interesting and important experience is that of China, a fascinating case study of the merits and demerits of a relatively unregulated start of derivatives trading. In the early 1990s, a plethora of unregulated derivatives exchanges came up in China. Many of these exchanges lacked the key institution of the clearinghouse as counterparty, and most of them featured rampant market manipulation where insiders in the exchange management earned abnormal profits at the expense of outside market participants. In 1994, the 50 exchanges were consolidated into 15. In 1995, China's futures markets did a trading volume of around $1.2 trillion (for a
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A Project Study on Derivatives in Indiacomparison, India's equity markets do an annual trading volume of roughly $180 billion).
Many observers have cited China's experience with 50 exchanges as an example of how poorly--regulated and hasty growth of derivatives markets may be problematic. However, the other side of the picture is now clear: the experience with these 50 exchanges got the Chinese markets off the ground, and generated the necessary know-how amongst exchange staff, regulators and users. In the end, China has stolen a march ahead of us: it now has derivatives exchanges which have significant trading volumes on a world scale, while we have just started.
One of the key motivations underlying futures markets in both Russia and China is quite important in India and other emerging markets. This is the weakness of commercial law both in precept and in practice. Under a weak legal environment, individuals and firms in the economy face problems in their contractual arrangements with each other. There are strong temptations to renege on a contract given the poor legal support for contract enforcement. In this situation, the futures clearinghouse is a vital institution which enables the functioning of the economy by supplying credit guarantees and producing contract performance. Indeed, the derivatives Clearing Corporation is often referred to as a credit guarantee corporation.
NSE's experience so far is a textbook example of this nature: the introduction of the clearing corporation (NSCC) has enabled a large--scale participation in the market by many individuals and firms which would otherwise have been thought uncreditworthy; this has enabled the growth of liquidity in the market and lowered entry barriers in the securities industry. If the legal system had been strong, then many of these firms could have fully participated in the economy even without the existence of NSCC.
It should be noted that countries often venture into derivatives as part of a broader economic liberalization process; hence the gains documented here are partly owing to this contemporaneous liberalization process and not solely owing to the launch of equity derivatives. India as of 1997 has a market capitalization of $125 billion and an annual trading volume of $145 billion.
Consider the list of countries now working towards building derivatives markets:
Turkey Bulgaria
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A Project Study on Derivatives in India Chile Colombia Costa Rica Czech Republic Greece Indonesia Mexico Poland Taiwan Thailand
An important case study is Mexico, which is in the same time zone as Chicago: the derivatives exchanges of Chicago have done a thorough job of launching numerous derivative products based on Mexican underlying. This has made the creation of exchanges in Mexico much harder. Taiwan is another interesting case study. Taiwan is like India in the enormous delays which have beset the creation of a domestic derivatives exchange. In January 1997, markets in Chicago and Singapore started trading futures on a Taiwanese market index.
These episodes are reminders that the development of the derivatives area should be viewed in the global perspective and not just as an Indian question. Exchanges such as the Chicago Mercantile Exchange (CME), Chicago Board Of Trade (CBOT), Chicago Board Options Exchange (CBOE), American Stock Exchange, Sydney Futures Exchange, Hong Kong Futures Exchange and Singapore International Monetary Exchange (SIMEX) have all launched emerging market initiatives, whereby they aim to trade derivatives off underlying from emerging markets. As far as Indian underlying go, the main two objectives for these exchanges are a well-structured market index and the dollar--rupee exchange rate, based on which these exchanges would trade options and futures. Delays in the creation of exchange--traded derivatives in India are beneficial to them, and hinder the future potential of exchanges in India.
What are the problems which seem to bedevil the growth of derivatives markets across emerging markets in general? One source of difficulty is poor infrastructure, particularly in clearing and settlement. In India, two major initiatives in clearing for derivatives are National Securities Clearing Corporation (NSCC) which was created by NSE, and the First Commodities Clearing Corporation of India (FCCCI) which is being setup at the pepper futures market in Cochin.
National Securities Clearing Corporation (NSCC) was the first effort in clearing where the clearing corporation becomes the legal counterparty to both legs of every transaction, and thus eliminates
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“Jealousy or competition between securities, banking and derivatives sectors, and disputes as to who should supervise the market and under what rules” has often been a problem. The experience of India, with the highly inaccurate comparison between derivatives and badla, is probably a variant of these conflicts. As far as the regulatory apparatus goes, things are simpler with equity derivatives, where SEBI is the only regulator.
Derivatives is an area where a unified picture of the entire securities industry -- spanning equity, debt, foreign exchange, commodities and real estate -- is enormously useful. The functioning of the derivatives industry emphasizes that a futures is a futures, regardless of the underlying on which the futures is being traded. The great derivatives exchanges of the world simultaneously trade derivatives on all of equity, debt, foreign exchange, commodities and real estate. In this sense, the basic policy issues faced in the derivatives area (market manipulation, strength of the clearinghouse and competition between exchanges worldwide) are universal to all five major markets. ``Turf wars'' inevitably lead to inferior development of financial markets.
The US is an example of a clumsy regulatory approach, where an agency named the CFTC regulates futures while the traditional securities markets regulator, the SEC, regulates options on securities. This artificial distinction has no economic rationale, and has served to distort the development of the markets. Similarly, while the focus of developing exchange--traded derivatives in India has been on futures on the equity index, the question of the RBI's regulatory approach looms large over the development of the derivatives exchanges, since interest--rate and currency futures are a crucial next steps in the development of the markets.
A clarification of some these issues is a major question in the agenda for policy--making in India's financial sector. Perhaps, this task rightfully falls upon the Finance Ministry, which would steer SEBI and RBI into equilibrium conducive to the health of exchange--traded derivatives.
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5.2. A boost to derivative market
From 1995 onwards, a variety of developments have been taking place in India on the subject of derivatives markets. The 1997 Union Budget announced policy measures towards more commodity futures markets. SEBI has constituted the L. C. Gupta Committee to formulate the regulations through which exchange--traded derivatives can commence in India. The focus of the work of this committee has been on equity index derivatives. The recently released report of the Tarapore Committee on Convertibility has recommended that exchange--traded derivatives should come about on the dollar--rupee and on treasury bills. These steps in policy--making are supported by NSE's efforts in this direction. NSE's developmental work towards exchange--traded derivatives began in 1995.
The derivative market has got a shot in the arm with the Government deciding to treat income from derivatives trading as a non-speculative income.
The decision to treat income from derivative trading as a non-speculative income will contribute to an increase in trading volume in the derivative market since it provided for setting off of derivative income/loss against normal income/loss. However, market analyst expressed fear that the increase in securities transaction tax for day traders from 0.015 per cent to 0.020 per cent would affect the trading volume and would lead to reduction in spread and increase in the transaction cost.
Market analyst hoped that investments in equities, in both primary and secondary markets, would qualify for deduction in taxable income up to Rs 1 lakh. If this happened, the stock market would firm up further.
5.3. Stock-trading tax:
The securities transaction tax (STT) has stabilized, but the rates are widely perceived to be too low. Therefore, propose to make a very nominal increase in the rates for all categories of transactions.
F & O not speculative:
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A Project Study on Derivatives in IndiaThere have been significant developments in the past decade in the capital market including the introduction of trading in financial derivatives. We have also established a transparent system of trading with adequate safeguards for audit trail. Proposed amendment to the Income Tax Act to provide that trading in derivatives in specified stock exchanges will not be treated as `speculative transactions' for the purposes of the Income Tax Act.
All good things come in the budget:
Derivatives traders could not have asked for more. The FM has acceded to their long standing demand for keeping futures and options outside the purview of the taxes on speculative transactions. Trading losses can now be offset against gains while calculating the tax outgo.
The FM also said that Sebi may allow FIIs to use shares as collateral for margin payment while trading in derivatives. Rough estimates show that the proposal could bring down trading rates by nearly 30% for FIIs.
At present, only cash and cash-like instruments are accepted as collateral for margin payments two types of margins have to be paid- Initial Margin and Mark to Market Margin- at the rate of 22-30%. The bulk of derivatives trading by FIIs is undertaken for hedging or arbitrage strategies. These involve buying of share in cash market and selling the corresponding future contract on the derivatives platform. The proposal will allow use of the stock bought in the cash side as margin or the derivatives par of the strategies. The entire outgo on margin payments could thus, be saved. The FM’s announcement on evolving legality for over-the –counter derivatives contract will be another positive. It will enable larger investor to enter long- dated contracts.
5.4. FIIs can submit collateral for derivatives
The Finance Minister has sought to correct an anomaly in the derivatives margin payment norms for FIIs.
He said that "FIIs are to be permitted to submit appropriate collateral, in cash or otherwise" when trading in domestic derivatives. According to market players, this will bring about flexibility and encourage FIIs to take greater exposure through the derivatives contracts.
Local players already had the flexibility of submitting collaterals, such as bank guarantee or shares or deposit receipt, in place of cash or
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A Project Study on Derivatives in Indiaalong with cash, for meeting their margin obligations. According to Market analysts, the proposal will ensure equal treatment for FIIs and domestic players in derivatives trading.
SEBI will make a suitable announcement shortly to this effect, the Finance Minister suggested in his Budget speech. Market analysts felt that the positive impact would be increase in trading volumes in derivatives. Investment Intermediates felt that the move is positive for FII fund flow into derivatives.
According to, an investment strategist, the move will technically help FIIs take greater positions in the derivatives, and arbitrage margins (between spot and derivatives) would come down. "This in turn would bring down the overall cost of carrying the trades," he added.
The overall benefit for the market would be higher liquidity and greater turnover in derivatives, traders observed.
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5.5 Business Growth in Derivatives segment- Futures
Index Futures, Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001 and November 2001, respectively
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6. FindingsFindings are the main part of any project report carried out because it shows the out come of a particular study being conducted. These findings are for individual security and may not be applicable to the overall market as such. We have studied the following parameters with respect to individual share price:
Put Call Ratio (Open Interest) Put Call Ratio (Volume) Volume traded in Derivatives Open Interest (Rs. Crores)
We have tried to establish relationship between the cash and future market parameters. And we also tried to find out the effect of different Future and Options market parameters on cash price of individual share.
On the basis of the data collected, chats prepared and by consulting with the project guide, we have arrived at the following findings for each of the scrip we have studied.
NIFTY
Put Call ratios as far as Nifty is concerned, Nifty rises when ratio is below 0.7 and direct positive relationship exists between the two and the ratio is not sustainable above the level of 1.00, depicting bearish outlook for future. Put Call Ratio (Open Interest)
Put Call Volume ratio below 0.7 bullish sign and if crosses that level we can expect correction in near future. Put Call Ratio (Volume)
Direct relationship of rising volume with rising nifty and vice versa. Moreover it has been seen that on the expiration day volume considerably falls down, due to which Nifty also falls.- F & O Volume
Positive relationship between Nifty & Open Interest, increasing Open Interest shows bullish market ahead, leading to rise in the cash market. F & O Open Interest
It has been seen that on the expiration day overall Open Interest falls considerably down, which leads Nifty southwards.
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Put Call ratio below 0.3 shows inverse relationship with cash price while above that level it shows direct relationship.- Put Call Ratio (Open Interest)
Inverse relationship between the Cash Price & Put Call Volume ratio Put Call Ratio (Volume)
We can clearly establish inverse relationship between the Derivatives Volume & Cash Price of the share - F & O Volume
It is not possible to establish definite relationship between the cash price of the share and Open Interest in Rs. Crores - F & O Open Interest
SATYAM
Direct and Positive relationship between the Cash Price & Put Call Open Interest ratio through out the period - Put Call Ratio (Open Interest)
Inverse relationship between the Cash Price & Put Call Volume ratio Put Call Ratio (Volume)
No exact relationship exists but at the time of expiration of future contract there is great amount of reduction in volume generally leading to fall in Cash Price F & O Volume
Positive relationship between the Cash & Open Interest Rs. Crores. But at the time of expiration because of fall in volume, Open Interest Rs. Crores fall but it doesn't have much impact on Cash market. - F & O Open Interest
RELIANCE
To some extent only there is positive relationship between Cash price and Put Call Volume ratio, Put Call Volume ratio is very volatile for Reliance scrip as compared to other scripts. - Put Call Ratio (Volume)
Positive relationship between the two when Put Call Open Interest ratio below 0.5 and negative when it crosses that level, leading to fall in price in cash market. Put Call Ratio (Open Interest)
Prices increases throughout the period in spite of cyclical volatility found in Volume - F & O Volume
Whenever a new future contract is introduced OI starts increasing which in turn leads to a new peak level of Price in Cash Market - F & O Open Interest
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A positive relationship exist between the two variables but whenever the Put Call Open Interest ratio crosses the level of 0.45 there are chances of price correction in near future - Put Call Ratio (Open Interest)
No exact relationship can be found out and Open Interest Volume ratio rarely crosses the level of 0.4 - Put Call Ratio (Volume)
Good direct relationship exists and a new peak in cash price is created with mounting Open Interest Rs. Crore. - F & O Open Interest
There is no much effect of volume on the cash price - F & O Volume
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7. Conclusion
From the report we come to know several things about Derivatives Market. The Derivatives market is developing in India. It has great future as several measures are being taken to develop the market.
The market is dominated by few large players. Generally, individual investors are not having enough knowledge for derivatives market. There is unawareness regarding derivatives in case of individual.
India is one of the most successful developing countries in terms of a vibrant market for derivatives. This episode reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous electronic trading, and a predominantly retail market.
As with most of the financial sector innovations of the last decade, individuals have displayed intellectual capacity and a speed of exploiting new ideas which has just not been found with finance companies. Internationally, banks and mutual funds are major players on the equity derivatives market.
The new world of the equity market is working out very well: no badla, no weekly settlement, rolling settlement, futures, and options.
We have found the there exist a positive relationship between the Put-Call Open Interest Ratio and Cash Market Price. It means that rise in Put-Call Open Interest Ratio shows bearish outlook over the Cash Market Price. It is desirable to have Put-Call Open Interest Ratio below 0.7.
We cannot define the exact relationship between the Put-Call Volume Ratio and Cash Market Price. It shows positive relationship in case of Nifty & Reliance and negative relationship ACC & Satyam.
Looking towards the charts we come to the conclusion that, generally there is no exact relationship between Open Interest Volume & Cash Market Price. But, in case of Nifty direct relationship is there & in case of ACC inverse relationship is there. As the expiration approaches, we found considerable fall in volumes.
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A Project Study on Derivatives in India There is positive/direct relationship found between Open Interest Rs. (Cr.)
& Cash Market Price. Mounting open interest in Rs. Cr. shows bullish market sentiments or expectations for futures.
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8. Recommendations
From the study of the findings and conclusions we have arrived at on the basis of the data collected by us and preparation of charts, we would like to give the following recommendation which will be useful for the development of derivatives market in India and also will be useful to the future investor who would like to invest on the basis of the trends in the derivatives market. We summarize our recommendation in the following points:
Derivatives market has surpassed the cash market in terms of turnover but it much behind the turnover in developed market like USA, UK. etc. Some steps should be taken to encourage wider participations.
SEBI should strengthen its efforts to educate investor about the Derivatives Market in India along with its other programs of education investors.
The contracts value of Rs300000/- is very high for retail investor so measures are needed to reduce that limit so that wider participation from retail investor can be encouraged.
The investor who is interested in investing in cash market on the basis of derivatives parameters can consider Put Call Open Interest ratio serves as a good indicator while investing in cash market.
The other good indicator that will help retail investor in investing is the Open Interest Rs Crore of that particular share, because it directly shows the future expectations for that particular share.
Other derivatives parameter which we had studied like Put Call Volume Ratio and Volume Traded are not a good indicator and should be used very cautiously by the investor while basing his investment decision on these parameters.
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9. Bibliography
For preparation of this project report we have collected information from various sources like visiting various websites, referring to journals, publications. For gathering information we have also referred to various books on “Futures & Options” written and published by different authors and publications. Following are some of the major sources we have referred to for getting information:
10. GlossaryAmerican style optionsAn option contract that may be exercised at any time between the date of purchase and the expiration date.
ArbitrageThe purchase or sale of a security in one market and the simultaneous purchase or sale in another to take advantage of price differentials.
At-the-moneyAn option is said to be at the money if it would lead to zero cash flow if exercised immediately. When the price of the underlying security is equal to the strike price, an option is at-the-money.
BasisThe difference between the Index and the respective contract is the basis i.e. cash netted for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions.
Basis Point It is equal to one hundredth of a percentage point
Bear marketA market where the prices are falling.
Brokerage feeA fee charged by a broker for execution of a transaction. The fee may be a flat amount or a percentage.
Bull marketA market in which prices are continuously rising.
Call optionA call option gives the buyer the right but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy.
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Class of optionsOptions contracts of the same type (call or put) and style (American or European) that covers the same underlying asset.
Close outA purchase or sale transaction leaving a trader with a zero net position.
Closing buy transactionMeans a buy transaction which will have the effect of partly or fully offsetting a short position.
Closing sell transactionMeans a sell transaction which will have the effect of partly or fully offsetting a long position.
Cost of carryCosts incurred in warehousing a physical commodity including interest for purchase storage & insurance
Day orderA day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day.
Day traderSpeculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day, thereby avoiding overnight margin calls.
Delivery monthIs the month in which delivery of futures contracts need to be made.
Delivery priceThe price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.
DerivativeA financial instrument designed to replicate an underlying security for the purpose of transferring risk.
Derivative instruments
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A Project Study on Derivatives in IndiaA derivative instrument is an instrument whose value is derived from the value of one or more underlying which can be commodities, precious metals, currency, bonds, stock, stock indices etc..
European style optionsAn option contract that may be exercised only during a specified period of time just prior to its expiration
Exercise settlement amountThe difference between the exercise price of the option and the exercise settlement value of Index on the day an exercise notice is tendered, multiplied by the index multiplier.
Expiration dateThe last day on which an option may be exercised.
Exercise / AssignmentWhen you buy an option you have the right either to purchase or sell the underlying at a predetermined price. When if you choose to purchase or sell the underlying at the predetermined price you are said to be “exercising your right”.
Fair valueTheoretical value of a futures contract derived from a mathematical model of valuation.
Forward contractsA forward contract is contract between two parties where settlement takes place on a specific date in future at a price agreed today.
Futures Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for Future delivery at an agreed price.
Give up tradesThe purpose of this functionality is to provide the clearing member users to confirm or reject the trades, on orders entered by other trading members, on behalf of Participants, clearing through the clearing member.
GTCA Good Till Cancelled (GTC) order remains in the system until it is cancelled by the user.
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GTDA Good Till Days (GTD) order allows the user to specify the number of days / date till which the order should stay in the system if not executed.
HedgeA conservative strategy used to limit investment loss by effecting a transaction which offsets an existing position.
HolderPurchaser of option.
In-the-moneyAn option is said to be in the money if it would lead to a positive cash flow to the holder if it were exercised immediately. A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in the money if the strike price is greater than the market price of the underlying security.
Initial marginThe amount of money required to be paid by market participant in the F&O segment at the time they place orders to buy or sell contracts.
Intrinsic valueThe amount by which an option is in the money
Kill / Fill OrderAn Immediate or Cancel (IOC) order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system.
Long PositionLong Position in a derivatives contract means outstanding purchase obligations in respect of a permitted derivatives contract at any point of time.
Mark to marketProcess of revaluing positions daily using daily settlement prices to obtain profit or loss.
Market order
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A Project Study on Derivatives in IndiaAn order to buy or sell a contract at whatever price is available at the time of entering the order on the system.
Net positionThe difference between the buy and sell contracts held by a trader.
OfferWillingness to sell a contract at a given price.
Open InterestOpen Interest means the total number of Derivatives Contracts of an underlying security that have not yet been offset and closed by an opposite Derivatives transaction nor fulfilled by delivery of the cash or underlying security or option exercise. For calculation of Open Interest only one side of the Derivatives Contract is counted.
Opening buy transaction Means a buy transaction which will have the effect of creating or increasing a long position.
Opening sell transactionMeans a sell transaction which will have the effect of creating or increasing a short position
Out-of-moneyAn option is said to be out of money if it would lead to a negative cash flow to the holder if it were exercised immediately. A call option is out of money if the strike price is greater than the market price of the underlying security. A put option is out of money if the strike price is less than the market price of the underlying security.
OptionsWhen you sell an option you now have an obligation to sell or purchase the underlying. You have or may not have to fulfill that obligation. When you are required to fulfill the obligation to either purchase or sell the underlying you are said to be “assigned’. Typically this occurs when the option is in the money.
Option holderThe person who buys the option contract is known as the holder of an option. In purchasing the option, the buyer makes payments and receives rights to buy or sell the underlying on specific terms.
Option premium
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A Project Study on Derivatives in IndiaThe premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer or seller of the option. In return, the writer, of a call option is obligated to deliver the underlying security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.
Price priorityPrice priority means that if two orders are entered into the system, the order having the best price gets the priority.
Put Call RatioIt is the ratio of put to call in terms of either open interest or in volume terms
Put optionA put option gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell.
Regular lot/Market LotMeans the number of units that can be bought or sold in a specified derivatives contract as specified by the F&O Segment of the Exchange from time to time.
SeriesAll option contracts of the same classes that have the same expiration date and strike price.
Settlement DateMeans the date on which the settlement of outstanding obligations in a permitted Derivatives contract are required to be settled as provided in these Regulations.
Short PositionShort position in a derivatives contract means outstanding sell obligations in respect of a permitted derivatives contract at any point of time.
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A Project Study on Derivatives in IndiaStrike priceThe stated price per unit for which the underlying index may be purchased (incase of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Time priorityTime priority means if two orders having the same price are entered, the order which entered the trading system first gets the highest priority.
TypeThe classification of an option contract as either a call or put.
WriterThe seller of an option contract.
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