Financial Derivatives in India

1. INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of

traded securities and stock, prices of gold or copper. Derivatives have

become increasingly important in the field of finance, Options and Futures

are traded actively on many exchanges, Forward contracts, Swap and

different types of options are regularly traded outside exchanges by financial

institutions, banks and their corporate clients in what are termed as over-the-

counter markets – in other words, there is no single market place organized

exchanges.

1.1 NEED OF THE STUDY

Different investment avenues are available to investors. Stock market

also offers good investment opportunities to the investor alike all

investments, they also carry certain risks. The investor should compare the

risk and expected yields after adjustment of tax on various instruments while

taking investment decision the investor may seek advice from expert and

consultancy include stock brokers and analysts while making investment

decisions. The objective here is to make the investor aware of the functioning

of the derivatives.

Derivatives act as a risk hedging tool for the investors. The objective if is to

help the investor in selecting the appropriate derivates instrument to attain

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maximum risk and to construct the portfolio in such a manner to meet the

investor should decide how best to reach the goals from the securities

available.

To identity investor objective constraints and performance, which help

formulate the investment policy?

The developed and the improved strategies in the investment policy

formulated. They will help the selection of asset classes and securities in each

class depending up on their risk return attributes.

1.2 SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to futures

and options in the Indian context; the study is not based on the international

perspective of derivative markets.

The study is limited to the analysis made for types of instruments of

derivates each strategy is analyzed according to its risk and return

characteristics and derivatives performance against the profit and policies of the

company.

1.3 LIMITATION OF THE STUDY

The subject of derivates if vast it requires extensive study and research to

understand the depth of the various instrument operating in the market only a

recent phenomenon

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There are various other factors also which define the risk and return

preferences of an investor. However the study was only contained towards the

risk maximization and profit maximization objective of the investor.

The derivative market is a dynamic one premiums, contract rates strike

price fluctuate on demand and supply basis. Therefore data related to last few

trading months was only considered and interpreted.

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2. COMPANY PROFILE

2.1 SHAREKHAN

Share khan is one of India's largest and leading

financial services companies. It is an online stock trading

company of SSKI Group (S.S. Kantilal Ishwarlal

Securities Limited) which has been a provider of India-

based investment banking and corporate financial service

for over 80 years.

SSKI caters to most of the prominent financial

institutions, foreign and domestic, investing in Indian equities. It has been

valued for its strong research-led investment ideas, superior client servicing

track record and exceptional execution skills.

The key features of Sharekhan are as follows:

You get freedom from paperwork.

There are instant credit and money transfer facilities.

You can trade from any net enabled PC.

After hour orders facilities.

You can go for online orders over the phone.

Timely advice and research reports

Real-time Portfolio tracking.

Information and Price alerts.

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Sharekhan provides assistance and the advice like no one else could. It

has created special information tools to help answer any queries. Sharekhan’s

first step program, built specifically for new investors, is testament to of its

commitment to being your guide throughout your investing life cycle.

2.2 SHAREKHAN SERVICES:

The tag line of Sharekhan says that “it is your guide to the financial

jungle.” As per the tag line there are many amazing services that Sharekhan

offers like technical research, fundamental research, share shops, portfolio

management, dial-n-trade, commodities trade, online services, depository

services, equity and derivatives trading (including currency trading). With

Sharekhan’s online trading account, you can buy and sell shares at anytime and

from anywhere you like.

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With a physical presence in over 400 cities of India through more than

1200 "Share Shops" with more than 3000 employees, and an online presence

through Sharekhan.com, India's premier, it reaches out to more than 8, 00,000

trading customers.

A Sharekhan outlet online destination offers the following services:

Online BSE and NSE executions (through BOLT & NEAT terminals)

Free access to investment advice from Sharekhan's Research team

Sharekhan Value Line (a monthly publication with reviews of

recommendations, stocks to watch out for etc)

Daily research reports and market review (High Noon & Eagle Eye)

Pre-market Report (Morning Cuppa)

Daily trading calls based on Technical Analysis

Cool trading products (Daring Derivatives and Market Strategy)

Personalized Advice

Live Market Information

Depository Services: Demat Transactions

Derivatives Trading (Futures and Options)

Commodities Trading

IPOs & Mutual Funds Distribution

Internet-based Online Trading: Speed Trade

Sharekhan has one of the best state-of-art web portals providing

fundamental and statistical information across equity, mutual funds and IPOs.

Surfing can be done across 5,500 companies for in-depth information, details

about more than 1,500 mutual fund schemes and IPO data. Other market related

details such as board meetings, result announcements, FII transactions,

buying/selling by mutual funds and much more can also be accessed.

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It provides a complete life-cycle of investment solution in Equities,

Derivatives, Commodities, IPO, Mutual Funds, Depository Services, Portfolio

Management Services and Insurance. It also offers personalized wealth

management services for High Net worth individuals.

Knowledge

In a business where the right information at the right time can translate into

direct profits, investors get access to a wide range of information on the content-

rich portal, www.sharekhan.com. Investors will also get a useful set of

knowledge-based tools that will empower them to take informed decisions

Investment Advice

Sharekhan has dedicated research teams of more than 30 people for

fundamental and technical research. Their analysts constantly track the pulse of

the market and provide timely investment advice to customer in the form of

daily research emails, online chat, printed reports etc

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2.3 ONLINE SERVICES

The online trading account can be chosen as per trading habits and

preferences, that is the classic account for most investors and speed trade for

active day traders. Share khan also provides a free software called “Trade tiger”

to all its account holders.

The Classic Account enables you to trade online for investing in Equities

and Derivatives on the NSE via sharekhan.com; it gives access to all the

research content and also comes with a free Dial-n-Trade service enabling to

buy shares using the telephone.

Its features are:

Streaming quotes (using the applet based system)

Multiple watch lists

Integrated Banking, Demat and digital contracts

Instant credit and transfer

Real-time portfolio tracking with price alerts and, of course, the assurance

of secure transactions

The Trade Tiger is a next-generation online trading product that brings

the power of the broker's terminal to your PC. It's the perfect trading platform

for active day traders.

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Its features are:

A single platform for multiple exchange BSE & NSE (Cash & F&O),

MCX, NCDEX, Mutual Funds, IPO’s

Multiple Market Watch available on Single Screen

Multiple Charts with Tick by Tick Intraday and End of Day Charting

powered with various Studies

Graph Studies include Average, Band- Bollinger, Know Sure Thing,

MACD, RSI, etc

Apply studies such as Vertical, Horizontal, Trend, Retracement &

Free lines

User can save his own defined screen as well as graph template, that

is, saving the layout for future use

User-defined alert settings on an input Stock Price trigger

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Tools available to gauge market such as Tick Query, Ticker, Market

Summary, Action Watch, Option Premium Calculator, Span

Calculator

Shortcut key for FAST access to order placements & reports

Online fund transfer activated with 12 Banks

Sharekhan provides you the facility to trade in Commodities through

Sharekhan Commodities Pvt. Ltd. a wholly owned subsidiary of its

parent SSKI. It trades on two major commodity exchanges of the

country:

Multi Commodity Exchange of India Ltd, Mumbai (MCX) and

National Commodity and Derivative Exchange, Mumbai (NCDEX).

For trading in any commodity, initial margin of around 10% on any

commodity is to be maintained. Sharekhan has launched its own commodity

derivatives micro-site. The site is available through the Sharekhan home

page www.sharekhan.com. Along with the site Sharekhan has launched several

commodity derivatives products (both research and trading) too. The products

have been listed below:

Commodities Buzz: a daily view on precious metals and agro

commodities.

Commodities Beat: a summary of the day’s trading activity.

Traders Corner: Under commodity trading calls, there are two types of

trading calls:

Rapid Fire: (short-term calls for 1 day to 5 days updated

daily)

Medium-term Plays: (medium-term calls for 1 month to 3

months updated weekly or in between if needed)

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Sharekhan Exclusive: the commodity research reports and analyses

(periodical).

Market Scan: the daily commodity market data and statistics (end of day).

All these products are both e-mailed as newsletters and published on the

commodity derivatives site

EXPOSURE

In Sharekhan one can get 4 times exposure on cash and on assets one can

gets 2 times.

Sharekhan gives money only for A group and B group companies.

Only Blue-chip companies get exposure and not for x group companies.

NOTES

In Sharekhan account opening is free.

First year’s maintenance charge is zero.

Second year’s maintenance is Rs 400/-

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3. INTRODUCTION TO DERIVATIVESDERIVATIVES

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was

sown to the time it was ready for harvest, farmers would face price uncertainty.

Through the use of simple derivative products, it was possible for the farmer to

partially or fully transfer price risks by locking-in asset prices. These were

simple contracts developed to meet the needs of farmers and were basically a

means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he

would receive for his harvest in September. In years of scarcity, he would

probably obtain attractive prices. However, during times of oversupply, he

would have to dispose off his harvest at a very low price. Clearly this meant that

the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains

too would face a price risk that of having to pay exorbitant prices during dearth,

although favourable prices could be obtained during periods of oversupply.

Under such circumstances, it clearly made sense for the farmer and the

merchant to come together and enter into contract whereby the price of the grain

to be delivered in September could be decided earlier. What they would then

negotiate happened to be futures-type contract, which would enable both parties

to eliminate the price risk.

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In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

farmers and merchants together. A group of traders got together and created the

‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver

the grain later. These to-arrive contracts proved useful as a device for hedging

and speculation on price charges. These were eventually standardized, and in

1925 the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts

also exist on a lot of financial underlying like stocks, interest rate, exchange

rate, etc.

3.1 DERIVATIVES DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can

be equity, forex, commodity or any other asset. In our earlier discussion, we

saw that wheat farmers may wish to sell their harvest at a future date to

eliminate the risk of change in price by that date. Such a transaction is an

example of a derivative. The price of this derivative is driven by the spot price

of wheat which is the “underlying” in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward

Markets Commission (FMC) continues to have jurisdiction over commodity

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futures contracts. However when derivatives trading in securities was

introduced in 2001, the term “security” in the Securities Contracts (Regulation)

Act, 1956 (SCRA), was amended to include derivative contracts in securities.

Consequently, regulation of derivatives came under the purview of Securities

Exchange Board of India (SEBI). We thus have separate regulatory authorities

for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of

derivatives is governed by the regulatory framework under the SCRA. The

Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-

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

unsecured, risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of

underlying securities

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Derivatives

Future Option Forward Swaps

3.2 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Exchange Bombay Stock Exchange National Commodity & Derivative

exchange

Index Future Index option Stock option Stock future Interest

Rate Futures

3.3 TYPES OF DERIVATIVES

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3.4 HISTORY OF DERIVATIVES:

The history of derivatives is quite colourful and surprisingly a lot longer than

most people think. Forward delivery contracts, stating what is to be delivered

for a fixed price at a specified place on a specified date, existed in ancient

Greece and Rome. Roman emperors entered forward contracts to provide the

masses with their supply of Egyptian grain. These contracts were also

undertaken between farmers and merchants to eliminate risk arising out of

uncertain future prices of grains. Thus, forward contracts have existed for

centuries for hedging price risk.

The first organized commodity exchange came into

existence in the early 1700’s in Japan. The first formal commodities exchange,

the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal

with the problem of ‘credit risk’ and to provide centralised location to negotiate

forward contracts. From ‘forward’ trading in commodities emerged the

commodity ‘futures’. The first type of futures contract was called ‘to arrive at’.

Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT listed the

first ‘exchange traded’ derivatives contract, known as the futures contracts.

Futures trading grew out of the need for hedging the price risk involved in many

commercial operations. The Chicago Mercantile Exchange (CME), a spin-off

of CBOT, was formed in 1919, though it did exist before in 1874 under the

names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter

Board’ (CEBB). The first financial futures to emerge were the currency in

1972 in the US. The first foreign currency futures were traded on May 16, 1972,

on International Monetary Market (IMM), a division of CME. The currency

futures traded on the IMM are the British Pound, the Canadian Dollar, the

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Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and

the Euro dollar. Currency futures were followed soon by interest rate futures.

Interest rate futures contracts were traded for the first time on the CBOT on

October 20, 1975. Stock index futures and options emerged in 1982. The first

stock index futures contracts were traded on Kansas City Board of Trade on

February 24, 1982.The first of the several networks, which offered a trading

link between two exchanges, was formed between the Singapore International

Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece

and Rome. Options are very popular with speculators in the tulip craze of

seventeenth century Holland. Tulips, the brightly coloured flowers, were a

symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch

growers and dealers traded in tulip bulb options. There was so much speculation

that people even mortgaged their homes and businesses. These speculators were

wiped out when the tulip craze collapsed in 1637 as there was no mechanism to

guarantee the performance of the option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the counter.

Agricultural commodities options were traded in the nineteenth century in

England and the US. Options on shares were available in the US on the over the

counter (OTC) market only until 1973 without much knowledge of valuation. A

group of firms known as Put and Call brokers and Dealers Association were set

up in early 1900’s to provide a mechanism for bringing buyers and sellers

together.

On April 26, 1973, the Chicago Board options Exchange

(CBOE) was set up at CBOT for the purpose of trading stock options. It was in

1973 again that black, Merton, and Scholes invented the famous Black-Scholes

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Option Formula. This model helped in assessing the fair price of an option

which led to an increased interest in trading of options. With the options

markets becoming increasingly popular, the American Stock Exchange

(AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options

in 1975.

The market for futures and options grew at a rapid pace in the eighties and

nineties. The collapse of the Bretton Woods regime of fixed parties and the

introduction of floating rates for currencies in the international financial markets

paved the way for development of a number of financial derivatives which

served as effective risk management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on

which futures contracts are traded. The CBOT now offers 48 futures and option

contracts (with the annual volume at more than 211 million in 2001).The CBOE

is the largest exchange for trading stock options. The CBOE trades options on

the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange

is the premier exchange for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones

Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the

Nikkei 225 trade almost round the clock. The N225 is also traded on the

Chicago Mercantile Exchange.

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3.5 INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where

prices fluctuate every day. The introduction of risk management instruments in

India gained momentum in the last few years due to liberalisation process and

Reserve Bank of India’s (RBI) efforts in creating currency forward market.

Derivatives are an integral part of liberalisation process to manage risk. NSE

gauging the market requirements initiated the process of setting up derivative

markets in India. In July 1999, derivatives trading commenced in India

Table Chronology of instruments

1991                        Liberalisation process initiated 

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for

index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and

interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian

index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

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2 June 2001 Individual Stock Options & Derivatives

3.6 Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Today, derivatives have

become part and parcel of the day-to-day life for ordinary people in major part

of the world.

Until the advent of NSE, the Indian capital market had no access to the latest

trading methods and was using traditional out-dated methods of trading. There

was a huge gap between the investors’ aspirations of the markets and the

available means of trading. The opening of Indian economy has precipitated the

process of integration of India’s financial markets with the international

financial markets. Introduction of risk management instruments in India has

gained momentum in last few years thanks to Reserve Bank of India’s efforts in

allowing forward contracts, cross currency options etc. which have developed

into a very large market.

3.7 Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Financial derivatives came

into the spotlight along with the rise in uncertainty of post-1970, when US

announced an end to the Bretton Woods System of fixed exchange rates leading

to introduction of currency derivatives followed by other innovations including

stock index futures. Today, derivatives have become part and parcel of the day-

to-day life for ordinary people in major parts of the world. While this is true for

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many countries, there are still apprehensions about the introduction of

derivatives. There are many myths about derivatives but the realities that are

different especially for Exchange traded derivatives, which are well regulated

with all the safety mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveraged

instruments

Derivatives are complex and exotic instruments that Indian investors will

find difficulty in understanding

Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic purpose

Numerous studies of derivatives activity have led to a broad consensus, both in

the private and public sectors that derivatives provide numerous and substantial

benefits to the users. Derivatives are a low-cost, effective method for users to

hedge and manage their exposures to interest rates, commodity prices or

exchange rates. The need for derivatives as hedging tool was felt first in the

commodities market. Agricultural futures and options helped farmers and

processors hedge against commodity price risk. After the fallout of Bretton

wood agreement, the financial markets in the world started undergoing radical

changes. This period is marked by remarkable innovations in the financial

markets such as introduction of floating rates for the currencies, increased

trading in variety of derivatives instruments, on-line trading in the capital

markets, etc. As the complexity of instruments increased many folds, the

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accompanying risk factors grew in gigantic proportions. This situation led to

development derivatives as effective risk management tools for the market

participants.

Looking at the equity market, derivatives allow corporations and

institutional investors to effectively manage their portfolios of assets and

liabilities through instruments like stock index futures and options. An equity

fund, for example, can reduce its exposure to the stock market quickly and at a

relatively low cost without selling off part of its equity assets by using stock

index futures or index options.

By providing investors and issuers with a wider array of tools for

managing risks and raising capital, derivatives improve the allocation of credit

and the sharing of risk in the global economy, lowering the cost of capital

formation and stimulating economic growth. Now that world markets for trade

and finance have become more integrated, derivatives have strengthened these

important linkages between global markets increasing market liquidity and

efficiency and facilitating the flow of trade and finance.

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Is Indian Market is not ready for derivative trading?

Often the argument put forth against derivatives trading is that the Indian capital

market is not ready for derivatives trading. Here, we look into the pre-requisites,

which are needed for the introduction of derivative and how Indian market

fares:

PRE-REQUISITES INDIAN SCENARIO

Large market Capitalisation India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000

crores.

High Liquidity in the

underlying

The daily average traded volume in Indian capital market

today is around 7500 crores. Which means on an average

every month 14% of the country’s Market capitalisation gets

traded. These are clear indicators of high liquidity in the

underlying.

Trade guarantee The first clearing corporation guaranteeing trades has

become fully functional from July 1996 in the form of

National Securities Clearing Corporation (NSCCL). NSCCL

is responsible for guaranteeing all open positions on the

National Stock Exchange (NSE) for which it does the

clearing.

A Strong Depository National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised the

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security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of

India) today the Indian capital market enjoys a strong,

independent, and innovative legal guardian who is helping

the market to evolve to a healthier place for trade practices.

4. PARTICIPANTS IN THE DERIVATIVES MARKET

The following three broad categories of participants who trade in the derivatives

market:

1. Hedgers

2. Speculators and

3. Arbitrageurs

Hedgers:

Hedgers face risk associated with the price of an asset. The objective

of these kinds of traders is to reduce/eliminate the risk. They are not in the

derivatives market to make profits. They are in it to safeguard their existing

positions. Apart from equity markets, hedging is common in the foreign

exchange markets where fluctuations in the exchange rate have to be taken care

of in the foreign currency transactions or could be in the commodities market

where spiraling oil prices have to be tamed using the security in derivative

instruments.

Speculators:

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Speculators wish to bet on future movements in the price of an

asset. They are traders with a view and objective of making profits. They are

willing to take risks and they bet upon whether the markets would go up or

come down. Futures and Options contracts can give them an extra leverage; that

is, they can increase both the potential gains and potential losses in a speculative

venture.

Arbitrageurs:

Arbitrageurs are in business to take advantage of a discrepancy

between prices in two different markets. Riskless Profit Making is the prime

goal of Arbitrageurs. Buying in one market and selling in another, buying two

products in the same market are common. They could be making money even

without putting their own money in and such opportunities often come up in the

market but last for very short timeframes. This is because as soon as the

situation arises, arbitrageurs take advantage and demand-supply forces drive the

markets back to normal.

For example, they see the futures price of an asset getting out of line with the

cash price; they will take offsetting positions in the two markets to lock in a

profit.

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last

few years, which have accompanied the modernization of commercial and

investment banking and globalisation of financial activities. The recent

developments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative contracts

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offer many benefits, the former have rigid structures compared to the latter. It

has been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in

1998. These episodes of turbulence revealed the risks posed to market stability

originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to

exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2. There are no formal centralized limits on individual positions, leverage,

or margining,

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

4. There are no formal rules or mechanisms for ensuring market stability

and integrity, and for safeguarding the collective interests of market

participants, and

5. The OTC contracts are generally not regulated by a regulatory authority

and the exchange’s self-regulatory organization, although they are

affected indirectly by national legal systems, banking supervision and

market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

The following features of OTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system: (i) the dynamic

nature of gross credit exposures; (ii) information asymmetries; (iii) the effects

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of OTC derivative activities on available aggregate credit; (iv) the high

concentration of OTC derivative activities in major institutions; and (v) the

central role of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counter-party credit events and sharp

movements in asset prices that underlie derivative contracts, which occur

significantly, alter the perceptions of current and potential future credit

exposures. When asset prices change rapidly, the size and configuration of

counter-party exposures can become unsustainably large and provoke a rapid

unwinding of positions.

There has been some progress in addressing these risks and perceptions.

However, the progress has been limited in implementing reforms in risk

management, including counter-party, liquidity and operational risks, and OTC

derivatives markets continue to pose a threat to international financial stability.

The problem is more acute as heavy reliance on OTC derivatives creates the

possibility of systemic financial events, which fall outside the more formal

clearing house structures. Moreover, those who provide OTC derivative

products, hedge their risks through the use of exchange traded derivatives. In

view of the inherent risks associated with OTC derivatives, and their

dependence on exchange traded derivatives, Indian law considers them illegal.

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4.1 FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects

which have value maybe commodities, local currency or foreign currency. The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.

the price one pays for use of a unit of another person’s money is called interest

rate. And the price one pays in one’s own currency for a unit of another

currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have

‘demand’ and producers or suppliers have ‘supply’, and the collective

interaction of demand and supply in the market determines the price. These

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factors are constantly interacting in the market causing changes in the price over

a short period of time. Such changes in the price are known as ‘price volatility’.

This has three factors: the speed of price changes, the frequency of price

changes and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The breakdown of the

BRETTON WOODS agreement brought an end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of

the markets and rapid industrialisation of many underdeveloped countries

brought a new scale and dimension to the markets. Nations that were poor

suddenly became a major source of supply of goods. The Mexican crisis in the

south east-Asian currency crisis of 1990’s has also brought the price volatility

factor on the surface. The advent of telecommunication and data processing

bought information very quickly to the markets. Information which would have

taken months to impact the market earlier can now be obtained in matter of

moments. Even equity holders are exposed to price risk of corporate share

fluctuates rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against

adverse price changes in commodity, foreign exchange, equity shares and

bonds.

B.} GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic concerns; what happened

in other part of the world was mostly irrelevant. Now globalisation has

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increased the size of markets and as greatly enhanced competition .it has

benefited consumers who cannot obtain better quality goods at a lower cost. It

has also exposed the modern business to significant risks and, in many cases,

led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis-à-vis depreciated currencies. Export of

certain goods from India declined because of this crisis. Steel industry in 1998

suffered its worst set back due to cheap import of steel from south East Asian

countries. Suddenly blue chip companies had turned in to red. The fear of china

devaluing its currency created instability in Indian exports. Thus, it is evident

that globalisation of industrial and financial activities necessitates use of

derivatives to guard against future losses. This factor alone has contributed to

the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely related

to advances in computer technology are advances in telecommunications.

Improvement in communications allow for instantaneous worldwide

conferencing, Data transmission by satellite. At the same time there were

significant advances in software programmes without which computer and

telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on

market price.

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Although price sensitivity to market forces is beneficial to the economy as a

whole resources are rapidly relocated to more productive use and better rationed

overtime the greater price volatility exposes producers and consumers to greater

price risk. The effect of this risk can easily destroy a business which is

otherwise well managed. Derivatives can help a firm manage the price risk

inherent in a market economy. To the extent the technological developments

increase volatility, derivatives and risk management products become that much

more important.

D.} ADVANCES IN FINANCIAL THEORIES –

Advances in financial theories gave birth to derivatives. Initially forward

contracts in its traditional form, was the only hedging tool available. Option

pricing models developed by Black and Scholes in 1973 were used to

determine prices of call and put options. In late 1970’s, work of Lewis

Edeington, extended the early work of Johnson and started the hedging of

financial price risks with financial futures. The work of economic theorists gave

rise to new products for risk management which led to the growth of derivatives

in financial markets.

The above factors in combination of lot many factors led to growth of

derivatives instruments

4.2 BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –

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Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always be

worried that the price may fall before he can sell the asset. He can protect

himself by selling a futures contract, or by buying a Put option. If the spot price

falls, the short hedgers will gain in the futures market, as you will see later. This

will help offset their losses in the spot market. Similarly, if the spot price falls

below the exercise price, the put option can always be exercised.

2.] PRICE DISCOVERY –

Price discovery refers to the market ability to determine true equilibrium prices.

Futures prices are believed to contain information about future spot prices and

help in disseminating such information. As we have seen, futures markets

provide a low cost trading mechanism. Thus information pertaining to supply

and demand easily percolates into such markets. Accurate prices are essential

for ensuring the correct allocation of resources in a free market economy.

Options markets provide information about the volatility or risk of the

underlying asset.

3.] OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower transaction

costs. Secondly, they offer greater liquidity. Large spot transactions can often

lead to significant price changes. However, futures markets tend to be more

liquid than spot markets, because herein you can take large positions by

depositing relatively small margins. Consequently, a large position in

derivatives markets is relatively easier to take and has less of a price impact as

opposed to a transaction of the same magnitude in the spot market. Finally, it is

easier to take a short position in derivatives markets than it is to sell short in

spot markets.

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4.] MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot, futures and

options markets are inextricably linked. Since it is easier and cheaper to trade in

derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

prices in alignment. Hence these markets help to ensure that prices reflect true

values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable

position is less in this case. This is important because facilitation of speculation

is critical for ensuring free and fair markets. Speculators always take calculated

risks. A speculator will accept a level of risk only if he is convinced that the

associated expected return is commensurate with the risk that he is taking.

4.3 FUNCTIONS OF THE DERIVATIVES MARKET:

The derivatives market performs a number of economic functions.

They are:

1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the

perceived future level.

2. Derivatives, due to their inherent nature, are linked to the underlying cash

markets. With the introduction of derivatives, the underlying market

witnesses higher trading volumes because of participation by more players

who would not otherwise participate for lack of an arrangement to transfer

risk.

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3. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators trade

in the underlying cash markets.

4. An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

5. Derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of

activity.

5. 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

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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, NSE and

BSE, and their 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 BSE–30 (Sense) index.

This was followed by approval for trading in options based on these two

indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading

in options on individual securities commenced in July 2001. Futures contracts

on individual stocks were launched in November 2001. The derivatives trading

on NSE 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. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE

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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 the official gazette. Foreign Institutional Investors (FIIs) are

permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in

the NSE report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the

F&O segment. It constituted 70 per cent of the total turnover during June 2002.

A primary reason attributed to this phenomenon is that traders are comfortable

with single-stock futures than equity options, as the former closely resembles

the erstwhile badla system.

• On relative terms, volumes in the index options segment continue to

remain poor. This may be due to the low volatility of the spot index. Typically,

options are considered more valuable when the volatility of the underlying (in

this case, the index) is high. A related issue is that brokers do not earn high

commissions by recommending index options to their clients, because low

volatility leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have

decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put

volumes ratio suggests that the traders are increasingly becoming pessimistic on

the market.

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• Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment as

a less risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. If calls and puts are not looked as just substitutes for spot

trading, the intra-day stock price variations should not have a one-to-one impact

on the option premiums.

The spot foreign exchange market remains the most important segment

but the derivative segment has also grown. In the derivative market

foreign exchange swaps account for the largest share of the total

turnover of derivatives in India followed by forwards and options.

Significant milestones in the development of derivatives market have

been (i) permission to banks to undertake cross currency derivative

transactions subject to certain conditions (1996) (ii) allowing corporate to

undertake long term foreign currency swaps that contributed to the

development of the term currency swap market (1997) (iii) allowing dollar

rupee options (2003) and (iv) introduction of currency futures (2008). I

would like to emphasise that currency swaps allowed companies with ECBs

to swap their foreign currency liabilities into rupees. However, since banks

could not carry open positions the risk was allowed to be transferred to any

other resident corporate. Normally such risks should be taken by corporate

who have natural hedge or have potential foreign exchange earnings. But

often corporate assume these risks due to interest rate differentials and views

on currencies.

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This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations

leading to greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any underlying

need or exposure a n d on a leveraged basis on the recognized stock

exchanges with credit risks being assumed by the central counterparty

Since the commencement of trading of currency futures in all the three

exchanges, the value of the trades has gone up steadily from Rs 17, 429

crores in October 2008 to Rs 45, 803 crores in December 2008. The average

daily turnover in all the exchanges has also increased from Rs871 crores to

Rs 2,181 crores during the same period. The turnover in the currency

futures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 – 3 per cent.

5.1 National Exchanges

In enhancing the institutional capabilities for futures trading the idea of

setting up of National Commodity Exchange(s) has been pursued since 1999.

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

(NMCE), Ahmedabad, National Commodity & Derivatives

Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX),

Mumbai have become operational.  “National Status” implies that these

exchanges would be automatically permitted to conduct futures trading in all

commodities subject to clearance of byelaws and contract specifications by the

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FMC.  While the NMCE, Ahmedabad commenced futures trading in November

2002, MCX and NCDEX, Mumbai commenced operations in October/

December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and

de-mutualised multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders

of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC

Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra,

SBI Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of

Baroda, Canara Bank, Corporation Bank.

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is

offering spectacular growth opportunities and advantages to a large cross

section of the participants including Producers / Processors, Traders, Corporate,

Regional Trading Canters, Importers, Exporters, Cooperatives, Industry

Associations, amongst others MCX being nation-wide commodity exchange,

offering multiple commodities for trading with wide reach and penetration and

robust infrastructure.

MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-of-

the-art nationwide, digital Exchange, facilitates online trading, clearing and

settlement operations for a commodities futures trading.

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NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was

promoted by Central Warehousing Corporation (CWC), National Agricultural

Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries

Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board

(GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune

Overseas Limited (NOL). While various integral aspects of commodity

economy, viz., warehousing, cooperatives, private and public sector marketing

of agricultural commodities, research and training were adequately addressed in

structuring the Exchange, finance was still a vital missing link. Punjab National

Bank (PNB) took equity of the Exchange to establish that linkage. Even today,

NMCE is the only Exchange in India to have such investment and technical

support from the commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for the

participants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the

world to have received ISO 9001:2000 certification from British Standard

Institutions (BSI). NMCE was the first commodity exchange to provide trading

facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The

contracts are marked to market on daily basis. The system of upfront margining

based on Value at Risk is followed to ensure financial security of the market. In

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the event of high volatility in the prices, special intra-day clearing and

settlement is held. NMCE was the first to initiate process of dematerialization

and electronic transfer of warehoused commodity stocks. The unique strength of

NMCE is its settlements via a Delivery Backed System, an imperative in the

commodity trading business. These deliveries are executed through a sound and

reliable Warehouse Receipt System, leading to guaranteed clearing and

settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a

technology driven commodity exchange. It is a public limited company

registered under the Companies Act, 1956 with the Registrar of Companies,

Maharashtra in Mumbai on April 23, 2003. It has an independent Board of

Directors and professionals not having any vested interest in commodity

markets. It has been launched to provide a world-class commodity exchange

platform for market participants to trade in a wide spectrum of commodity

derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the

land like the Companies Act, Stamp Act, Contracts Act, Forward Commission

(Regulation) Act and various other legislations, which impinge on its working.

It is located in Mumbai and offers facilities to its members in more than 390

centres throughout India. The reach will gradually be expanded to more

centres. 

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil,

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Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags,

Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw

Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,  Silk, Silver, Soy

Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red

Maize & Yellow soyabean meal.

5.2 DERIVATIVES SEGMENT IN BSE & NSE

On June 9, 2000 BSE & NSE became the first exchanges in India to

introduce trading in exchange traded derivative product with the launch of index

futures on sense and Nifty futures respectively.

Index futures was follows by launch of index options in June 2001, stock

options in July 2001 and stock futures in Nov 2001.Presently stock futures and

options available on 41 well-capitalized and actively traded scripts mandated by

SEBI.

Nifty is the underlying asset of the Index Futures at the Futures & Options

segment of NSE with a market lot of 200 and the BSE 30 Sensex is the

underlying stock index with the market lot of 50. This difference of market lot

arises due to a minimum specification of a contract value of Rs. 2 lakhs by

Securities Exchange Board of India. A contract value is contracting Index laid

by its market lot. For e.g. If Sensex is 4730 then the contract value of a futures

Index having Sensex as underlying asset will be 50 x 4730 = Rs. 2, 36,500.

Similarly if Nifty is 1462.7, its futures contract value will be 200 x 1462.7 =

Rs.2, 92,540/-.

Every transaction shall be in multiple of market lot. Thus, Index futures at

NSE shall be traded in multiples of 200 and at BSE in multiples of 50

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5.3 CONTRACT PERIODS:

At any point of time there will always be available near three months

contract periods. For e.g. in the month of June 2009 one can enter into either

June Futures contract or July Futures contract or August Futures Contract. The

last Thursday of the month specified in the contract shall be the final settlement

date for that contract at both NSE as well BSE. Thus June 29, July 27 and

August 31 shall be the last trading day or the final settlement date for June

Futures contract, July Futures Contract and August Futures Contract

respectively.

When one futures contract gets expired, a new futures contract will get

introduced automatically. For instance, on 30th June, June futures contract

becomes invalidated and a September Futures Contract gets activated.

5.4 SETTLEMENT:

Settlement of all Derivatives trades is in cash mode. There is Daily

as well as Final Settlement.

Outstanding positions of a contract can remain open till the last

Thursday of that month. As long as the position is open, the same will be

marked to Market at the Daily Settlement Price, the difference will be credited

or debited accordingly and the position shall be brought forward to the next day

at the daily settlement price. Any position which remains open at the end of the

final settlement day (i.e., last Thursday) shall be closed out by the Exchange at

the Final Settlement Price which will be the closing spot value of the underlying

(Nifty or Sensex, or respective stocks as the case may be).

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5.5 Regulation for Derivatives Trading

SEBI set up a 24-member committee under 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 there under 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 the Act.

1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta

committee report may apply to SEBI for grant of recognition under Section 4

of the SC(R) a, 1956 to start trading derivatives. The derivatives

exchange/segment should 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 of its members and will obtain approval of SEBI

before start of trading in any derivative contract

2. The exchange shall have minimum 50 members.

3. 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 fulfil the eligibility conditions as laid down by the L C

Gupta committee.

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4. The clearing and settlement of derivatives trades shall be through a SEBI

approved clearing corporation / house. Clearing corporation / 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.

6. The minimum contract value shall not be less than Rs. 2 Lakhs. Exchanges

should also submit details of the futures contract they propose to introduce.

7. The trading members are required to have qualified approved user and sales

person who have passed a certification programme approved by SEBI.

While from the purely regulatory angle, a separate exchange for

trading would be a better arrangement. Considering the constraints in

infrastructure facilities, the existing stock (cash) exchanges may also be

permitted to trade derivatives subject to the following conditions.

I. Trading should take place through an on-line screen based trading system.

II. An independent clearing corporation should do the clearing of the

derivative market.

III. The exchange must have an online surveillance capability, which monitors

positions, price and volumes in real time so as to deter market manipulation

price and position limits should be used for improving market quality.

IV. Information about trades quantities, and quotes should be disseminated by

the exchange in the real time over at least two information-vending

networks, which are accessible to investors in the country.

V. The exchange should have at least 50 members to start derivatives trading.

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VI. The derivatives trading should be done in a separate segment with separate

membership; That is, all members of the cash market would not

automatically become members of the derivatives market.

VII. The derivatives market should have a separate governing council which

should not have representation of trading by clearing members beyond

whatever percentage SEBI may prescribe after reviewing the working of

the present governance system of exchanges.

VIII. The chairman of the governing council of the derivative division /

exchange should be a member of the governing council. If the chairman is

broker / dealer, then he should not carry on any broking or dealing on any

exchange during his tenure.

IX. No trading/clearing member should be allowed simultaneously to be on the

governing council both derivatives market and cash market.

6. TYPES OF DERIVATIVES

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The most commonly used derivatives contracts are forwards,

futures and options. Here various derivatives contracts that have come to be

used are given briefly:

1. Forwards

2. Futures

3. Options

4. Warrants

5. LEAPS

6. Baskets

7. Swaps

8. Swaptions

6.1Forward contracts

A forward contract is a customised contract between the buyer and the

seller where settlement takes place on a specific date in future at a price

agreed today. The rupee-dollar exchange rate is a big forward contract

market in India with banks, financial institutions, corporate and exporters

being the market participants.

Features of a forward contract

The main features of a forward contract are:

It is a negotiated contract between two parties and hence exposed to

counter party risk. eg: Trade takes place between A&B@ 100 to buy & sell x

commodity. After 1 month it is trading at Rs.120. If A was he buyer he would

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gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter

party Risk i.e. you will now entitled to your gains. In case of Future, the

exchange gives a counter guarantee even if the counter party defaults you

will receive Rs.20/- as a gain.

Each contract is custom designed and hence unique in terms of contract

size, expiration date, asset type, asset quality etc.

A contract has to be settled in delivery or cash on expiration date as

agreed upon at the time of entering into the contract. In case one of the

two parties wishes to reverse a contract, he has to compulsorily go to the

other party. The counter party being in a monopoly situation can

command the price he wants.

6.2 FUTURES

Futures contract is a firm legal commitment between a buyer & seller in

which they agree to exchange something at a specified price at the end of a

designated period of time. The buyer agrees to take delivery of something and

the seller agrees to make delivery.

6.2.1 STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures,

which have been used to hedge or manage the systematic risk by the investors

of Stock Market. They are called hedgers who own portfolio of securities and

are exposed to the systematic risk. Stock Index is the apt hedging asset since the

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rise or fall due to systematic risk is accurately shown in the Stock Index. Stock

index futures contract is an agreement to buy or sell a specified amount of an

underlying stock index traded on a regulated futures exchange for a specified

price for settlement at a specified time future.

Stock index futures will require lower capital adequacy and

margin requirements as compared to margins on carry forward of individual

scrip. The brokerage costs on index futures will be much lower.

Savings in cost is possible through reduced bid-ask spreads where

stocks are traded in packaged forms. The impact cost will be much lower in

case of stock index futures as opposed to dealing in individual scrips. The

market is conditioned to think in terms of the index and therefore would prefer

to trade in stock index futures. Further, the chances of manipulation are much

lesser.

The Stock index futures are expected to be extremely liquid given

the speculative nature of our markets and the overwhelming retail participation

expected to be fairly high. In the near future, stock index futures will definitely

see incredible volumes in India. It will be a blockbuster product and is pitched

to become the most liquid contract in the world in terms of number of contracts

traded if not in terms of notional value. The advantage to the equity or cash

market is in the fact that they would become less volatile as most of the

speculative activity would shift to stock index futures. The stock index futures

market should ideally have more depth, volumes and act as a stabilizing factor

for the cash market. However, it is too early to base any conclusions on the

volume or to form any firm trend.

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The difference between stock index futures and most other

financial futures contracts is that settlement is made at the value of the index at

maturity of the contract.

6.2.2 FUTURES TERMINOLOGY

Contract Size

The value of the contract at a specific level of Index. It is Index

level * Multiplier.

Multiplier

It is a pre-determined value, used to arrive at the contract size. It

is the price per index point.

Tick Size

It is the minimum price difference between two quotes of similar

nature.

Contract Month

The month in which the contract will expire.

Expiry Day

The last day on which the contract is available for trading.

Open interest

Total outstanding long or short positions in the market at any

specific point in time. As total long positions for market would be equal

to total short positions, for calculation of open Interest, only one side of

the contracts is counted.

Volume

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No. Of contracts traded during a specific period of time i.e.

during a day, during a week or during a month.

Long position

Outstanding/unsettled purchase position at any point of time.

Short position

Outstanding/ unsettled sales position at any point of time.

Open position

Outstanding/unsettled long or short position at any point of time.

Physical delivery

Open position at the expiry of the contract is settled through

delivery of the underlying. In futures market, delivery is low.

Cash settlement

Open position at the expiry of the contract is settled in cash.

These contracts Alternative Delivery Procedure (ADP) - Open position at the

expiry of the contract is settled by two parties - one buyer and one seller, at

the terms other than defined by the exchange. Worldwide a significant

portion of the energy and energy related contracts (crude oil, heating and

gasoline oil) are settled through Alternative Delivery Procedure.

Theoretical way of pricing futures

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The theoretical price of a futures contract is spot price of the underlying plus the

cost of carry (futures are not about predicting future prices of the underlying

assets).

In general, Futures Price = Spot Price + Cost of Carry

The Cost of Carry is the sum of all costs incurred if a similar position is taken in

cash market and carried to expiry of the futures contract less any revenue that

may arise out of holding the asset. The cost typically includes interest cost in

case of financial futures (insurance and storage costs are also considered in case

of commodity futures). Revenue may be in the form of dividend. Though one

can calculate the theoretical price, the actual price may vary depending upon the

demand and supply of the underlying asset.

Example on how futures are priced

Suppose Reliance shares are quoting at Rs1500 in the cash market. The interest

rate is about 12% per annum. The cost of carry for one month would be about

Rs15.

As such a Reliance future contract with one-month maturity should quote at

nearly Rs1515. Similarly Nifty level in the cash market is about 4000. One

month Nifty future should quote at about 4040. However it has been observed

on several occasions that futures quote at a discount or premium to their

theoretical price, meaning below or above the theoretical price. This is due to

demand-supply pressures.

Every time a Stock Future trades over and above its cost of carry i.e. above Rs.

the arbitragers would step in and reduce the extra premium commanded by the

future due to demand. e.g.: would buy in the cash market and sell the equal

amount in the future, hence creating a risk free arbitrage, vice-versa for the

discount. It is also observed that index futures generally don't command a huge

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premium as stocks, due to many reasons such as dividends in index stocks,

hedging and speculation etc which keeps the index premium under check.

6.2.3 Advantages and risks of trading in futures over cash

The biggest advantage of futures is that you can short sell without having stock

and you can carry your position for a long time, which is not possible in the

cash segment because of rolling settlement. Conversely you can buy futures and

carry the position for a long time without taking delivery, unlike in the cash

segment where you have to take delivery because of rolling settlement.

Further futures positions are leveraged positions, meaning you can take Rs100

position by paying Rs25 margin and daily mark-to-market loss, if any. This can

enhance the return on capital deployed.

For example, you expect Rs100 stock to go up by Rs10. One way is to buy the

stock in the cash segment by paying Rs100. You make Rs10 on investment of

Rs100, giving about 10% returns. Alternatively you take futures position in the

stock by paying about Rs30 toward initial and mark-to-market margin. You

make Rs10 on investment of Rs30, i.e. about 33% returns. Please note that

taking leveraged position is very risky, you can even lose your full capital in

case the price moves against your position.

Advantages of index futures

After listening to the news and other happenings in the economy, we take a

view that the market would go up. We substantiate our view after talking to our

near and dear ones. When the market opens, we express our view by buying

ABC stock. The whole market goes up as we expected but the price of ABC

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stock falls due to some bad news related to the company. This means that while

our view was correct, its expression was wrong.

Using Nifty/Sensex futures we can express our view on the market as a whole.

In this case, we take only market risk without exposing our self to any company

specific risk. Though trading on Nifty or Sensex might not give us a very high

return as trading in stock can, yet at the same time our risk is also limited as

index movements are smooth, less volatile without unwarranted swings.

Use of volume and open interest figures to predict the market movement

The total outstanding position in the market is called open interest. In case

volumes are rising and the open interest is also increasing, it suggests that more

and more market participants are keeping their positions outstanding. This

implies that the market participants are expecting a big move in the price of the

underlying. However to find in which direction this move would be, one needs

to take help of charts. In case the volumes are sluggish and the open interest is

almost constant, it suggests that a lot of day trading is taking place. This implies

sideways price movement in the underlying.

Hedging stock position using futures

Suppose we are holding a stock that has futures on it and for two to three weeks

the stock does not look good to you. We do not want to lose the stock but at the

same time we want to hedge against the expected adverse price movement of

the stock for two to three weeks. One option is to sell the stock and buy it back

after two to three weeks. This involves a heavy transaction cost and issue of

capital gain taxes. Alternatively, we can sell futures on the stock to hedge our

position in the stock. In case the stock price falls, we make profit out of our

short position in the futures. Using stock futures we would virtually sell our

stock and buy it back without losing it. This transaction is much more

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economical as it does not involve cost of transferring the stock to and from

depository account. We might say that if the stock had moved up, we would

have made profit without hedging. However it is also true that in case of a fall,

you might have lost the value too without hedging. Please remember that a

hedge is not a device to maximise profits. It is a device to minimise losses. As

they say, a hedge does not result in a better outcome but in a predictable

outcome.

Basis

The difference between the futures price and cash price is called basis.

Generally futures prices are higher than cash prices (positive basis) as we are

positive interest rate economy. However there are times when futures prices are

lower than cash prices (negative basis). Basis is also popularly termed spread by

the trading community.

6.2.4 Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market

participant with change in the price of the underlying asset. Futures contracts

have linear payoffs. In simple words, it means that the losses as well as profits,

for the buyer and the seller of futures contracts, are unlimited.

Pay off for Buyer of futures: (Long futures)

The pay offs for a person who buys a futures contract is similar to

the pay off for a person who holds an asset. He has potentially unlimited

upside as well as downside. Take the case of a speculator who buys a two-

month Nifty index futures contract when the Nifty stands at 1220. The

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underlying asset in this case is the Nifty portfolio. When the index moves up,

the long futures position starts making profits and when the index moves

down it starts making losses

.

Pay off for seller of futures: (short futures)

The pay offs for a person who sells a futures contract is similar to

the pay off for a person who shorts an asset. He has potentially unlimited

upside as well as downside. Take the case of a speculator who sells a two-

month Nifty index futures contract when the Nifty stands at 1220. The

underlying asset in this case is the Nifty portfolio. When the index moves

down, the short futures position starts making profits and when the index

moves up it starts making losses.

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6.2.5 DISTINCTION BETWEEN FUTURES AND FORWARDS

CONTRACTS

FEATURES FORWARD

CONTRACT

FUTURE CONTRACT

Operational

Mechanism

Traded directly between two

parties (not traded on the

exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are tailor

made contracts catering to the

needs of the needs of the

parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets are

scattered.

Efficient, as markets are centralized and

all buyers and sellers come to a common

platform to discover the price.

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Examples Currency market in India. Commodities, futures, Index Futures and

Individual stock Futures in India.

6.3 OPTIONS

An option agreement is a contract in which the writer of the option

grants the buyer of the option the right to purchase from or sell to the writer a

designated instrument at a specific price within a specified period of time.

Certain options are of short term in nature and are issued by investors

another group of options are long-term in nature and are issued by companies.

6.3.1 OPTIONS TERMINOLOGY:

Call option:

A call is an option contract giving the buyer the right to purchase

the stock.

Put option:

A put is an option contract giving the buyer the right to sell the

stock.

Expiration date:

It is the date on which the option contract expires.

Strike price:

It is the price at which the buyer of an option contract can

purchase or sell the stock during the life of the option

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Premium:

Is the price the buyer pays the writer for an option contract.

Writer:

The term writer is synonymous to the seller of the option contract.

Holder:

The term holder is synonymous to the buyer of the option

contract.

Straddle:

A straddle is combination of put and calls giving the buyer the

right to either buy or sell stock at the exercise price.

Strip:

A strip is two puts and one call at the same period.

Strap:

A strap is two calls and one put at the same strike price for the

same period.

Spread:

A spread consists of a put and a call option on the same security

for the same time period at different exercise prices.

The option holder will exercise his option when doing so provides him a benefit

over buying or selling the underlying asset from the market at the prevailing

price. These are three possibilities.

1. In the money: An option is said to be in the money when it is

advantageous to exercise it.

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2. Out of the money: The option is out of money if it not advantageous to

exercise it.

3. At the money: If the option holder does not lose or gain whether he

exercises his option or buys or sells the asset from the market, the option is

said to be at the money. The exchanges initially created three expiration cycles

for all listed options and each issue was assigned to one of these three cycles.

January, April, July, October.

February, March, August, November.

March, June, September, and December.

In India, all the F and O contracts whether on indices or individual stocks

are available for one or two or three months series and they expire on the

Thursday of the concerned month.

American style options

Option contracts which can be exercised on or before the expiry are called

American options. All stock option contracts are American style.

European style options

The options on Nifty and Sensex or any other index options are European style

options-meaning that buyer of these options can exercise his options only on the

expiry day. He cannot exercise them before expiry of the contract as is the case

with options on stocks. As such the buyer of index options needs to square up

his position to get out of the market.

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6.3.2 CALL OPTION:

An option that grants the buyer the right to purchase a designated

instrument is called a call option. A call option is a contract that gives its owner

the right, but not the obligation, to buy a specified price on or before a specified

date.

Example

An investor buys one European Call option on one share of Reliance Petroleum

at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the

contract matures on 30 September. The payoffs for the investor on the basis of

fluctuating spot prices at any time are shown by the payoff table (Table 1). It

may be clear from the graph that even in the worst case scenario; the investor

would only lose a maximum of Rs.2 per share which he/she had paid for the

premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely

reverse of the call options buyer. The maximum loss that he can have is

unlimited though a profit of Rs.2 per share would be made on the premium

payment by the buyer.

Payoff from Call Buying/Long (Rs.)

S Xt c Payoff Net Profit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -2

60 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

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65 60 2 5 3

66 60 2 6 4

A European call option gives the following payoff to the investor: max (S - Xt,

0).

The seller gets a payoff of: -max (S - Xt, 0) or min (Xt - S, 0).

Notes:

S - Stock Price

Xt - Exercise Price at time’t’

C - European Call Option Premium

Payoff - Max (S - Xt, O)

Graph

Net Profit - Payoff minus 'c'

6.3.3 PUT OPTION:

It is an option contract giving the owner the right, but not the

obligation, to sell a specified amount of an underlying security at a specified

price within a specified time. This is the opposite of a call option, which gives

the holder the right to buy shares.

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Illustration:

An investor buys one European Put Option on one share of Reliance Petroleum

at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the

contract matures on 30 September. The payoff table shows the fluctuations of

net profit with a change in the spot price.

Payoff from Put Buying/Long (Rs.)

S Xt P Payoff Net Profit

55 60 2 5 3

56 60 2 4 2

57 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -2

63 60 2 0 -2

64 60 2 0 -2

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

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

Graph

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These are the two basic options that form the whole gamut of transactions in the

options trading. These in combination with other derivatives create a whole

world of instruments to choose form depending on the kind of requirement and

the kind of market expectations.

Exotic Options are often mistaken to be another kind of option. They are

nothing but non-standard derivatives and are not a third type of option.

6.3.4 FACTORS DETERMINIG OPTION VALUE:

Stock price

Strike price

Time to expiration

Volatility

Risk free interest rate

Dividend

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SPOT PRICES:

In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more

the Spot Price more is the payoff and it is favourable for the buyer. It is the

other way round for the seller, more the Spot Price higher is the chances of his

going into a loss.

In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore,

more the Spot Price more are the chances of going into a loss. It is the reverse

for Put Writing.

STRIKE PRICE:

In case of a call option the payoff for the buyer is shown above. As per this

relationship a higher strike price would reduce the profits for the holder of the

call option.

TIME TO EXPIRATION:

More the time to Expiration more favourable is the option. This can only exist

in case of American option as in case of European Options the Options Contract

matures only on the Date of Maturity.

VOLATILITY:

More the volatility, higher is the probability of the option generating higher

returns to the buyer. The downside in both the cases of call and put is fixed but

the gains can be unlimited. If the price falls heavily in case of a call buyer then

the maximum that he loses is the premium paid and nothing more than that.

More so he/ she can buy the same shares form the spot market at a lower price.

Similar is the case of the put option buyer. The table show all effects on the

buyer side of the contract.

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RISK FREE RATE OF INTEREST:

In reality the r and the stock market is inversely related. But theoretically

speaking, when all other variables are fixed and interest rate increases this leads

to a double effect: Increase in expected growth rate of stock prices discounting

factor increases making the price fall

In case of the put option both these factors increase and lead to a decline in the

put value. A higher expected growth leads to a higher price taking the buyer to

the position of loss in the payoff chart. The discounting factor increases and the

future value become lesser.

In case of a call option these effects work in the opposite direction. The first

effect is positive as at a higher value in the future the call option would be

exercised and would give a profit. The second affect is negative as is that of

discounting. The first effect is far more dominant than the second one, and the

overall effect is favourable on the call option.

DIVIDENDS:

When dividends are announced then the stock prices on ex-dividend are

reduced. This is favourable for the put option and unfavourable for the call

option.

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6.3.5 DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES OPTIONS

1) Both the parties are obligated to

perform.

1) Only the seller (writer) is

obligated to perform.

2) With futures premium is paid by

either party.

2) With options, the buyer pays the

seller a premium.

3) The parties to futures contracts

must perform at the settlement

date only. They are not

obligated to perform before that

date.

3) The buyer of an options contract

can exercise any time prior to

expiration date.

4) The holder of the contract is

exposed to the entire spectrum

of downside risk and had the

potential for all upside return.

5) In futures margins to be paid.

They are approximate 15-20%

on the current stock price.

4) The buyer limits the downside

risk to the option premium but retain

the upside potential.

5) In options premiums to be paid.

But they are very less as

compared to the margins.

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6.3.6 Advantages of option trading:

Risk management: put option 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 exercised the option and buys the shares. Likewise the

taker of a put option has time to decide whether

or not to sell the shares.

Speculations: The ease of trading in and out of option position makes it

possible to trade options with no intention of ever exercising them. If

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 share.

Trading in options can allow investors to benefit from a change in the

price of the share without having to pay of the share.

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6.3.7 TRADING STRATEGIES :

Single Option and Stock

These strategies involve using an option along with a position in a stock.

Strategy 1:

A Covered Call: A long position in stock and short position in a call option.

Illustration: An investor enters into writing a call option on one share of Rel.

Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity

date is two months from now and along with this option he/she buys a share of

Rel.Petrol in the spot market at Rs. 58 per share.

By this the investor covers the position that he got in on the call option contract

and if the investor has to fulfil his/her obligation on the call option then can

fulfil it using the Rel.Petrol share on which he/she entered into a long contract.

The payoff table below shows the Net Profit the investor would make on such a

deal.

Writing a Covered Call Option

S Xt C Profit from

writing call

Net Profit

from Call

Writing

Share

bought

Profit

from

stock

Total

Profit

50 60 6 0 6 58 -8 -2

52 60 6 0 6 58 -6 0

54 60 6 0 6 58 -4 2

56 60 6 0 6 58 -2 4

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58 60 6 0 6 58 0 6

60 60 6 0 6 58 2 8

62 60 6 -2 4 58 4 8

64 60 6 -4 2 58 6 8

66 60 6 -6 0 58 8 8

68 60 6 -8 -2 58 10 8

70 60 6 -10 -4 58 12 8

Strategy 2:

Reverse of Covered Call: This strategy is the reverse of writing a covered call.

It is applied by taking a long position or buying a call option and selling the

stocks.

Illustration:

An investor enters into buying a call option on one share of Rel. Petrol. At a

strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two

months from now and along with this option he/she sells a share of Rel.Petrol in

the spot market at Rs. 58 per share.

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The payoff chart describes the payoff of buying the call option at the various

spot rates and the profit from selling the share at Rs.58 per share at various spot

prices. The net profit is shown by the thick line.

Buying a Covered Call Option

S Xt c Profit from

buying call

option

Net Profit from

Call Buying

Spot Price of

Selling the

stock

Profit from

stock

Total Profit

50 60 -6 0 -6 58 8 2

52 60 -6 0 -6 58 6 0

54 60 -6 0 -6 58 4 -2

56 60 -6 0 -6 58 2 -4

58 60 -6 0 -6 58 0 -6

60 60 -6 0 -6 58 -2 -8

62 60 -6 2 -4 58 -4 -8

64 60 -6 4 -2 58 -6 -8

66 60 -6 6 0 58 -8 -8

68 60 -6 8 2 58 -10 -8

70 60 -6 10 4 58 -12 -8

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Strategy 3:

Protective Put Strategy:

This strategy involves a long position in a stock and long position in a put. It is

a protective strategy reducing the downside heavily and much lower than the

premium paid to buy the put option. The upside is unlimited and arises after the

price rise high above the strike price.

Illustration 5:

An investor enters into buying a put option on one share of Rel. Petrol. At a

strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two

months from now and along with this option he/she buys a share of Rel.Petrol in

the spot market at Rs. 58 per share.

Protective Put Strategy

S Xt p Profit from

buying put

option

Net Profit

from Buying

put option

Spot Price of

Buying the

stock

Profit from

stock

Total

Profit

50 60 -6 10 4 58 -8 -4

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52 60 -6 8 2 58 -6 -4

54 60 -6 6 0 58 -4 -4

56 60 -6 4 -2 58 -2 -4

58 60 -6 2 -4 58 0 -4

60 60 -6 0 -6 58 2 -4

62 60 -6 0 -6 58 4 -2

64 60 -6 0 -6 58 6 0

66 60 -6 0 -6 58 8 2

68 60 -6 0 -6 58 10 4

70 60 -6 0 -6 58 12 6

Strategy 4:

Reverse of Protective Put

This strategy is just the reverse of the above and looks at the case of taking short

positions on the stock as well as on the put option.

Illustration 6:

An investor enters into selling a put option on one share of Rel. Petrol. At a

strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two

months from now and along with this option he/she sells a share of Rel.Petrol in

the spot market at Rs. 58 per share.

Reverse of Protective Put Strategy

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S Xt p Profit from

writing a put

option

Net Profit from

Put Writing

Spot Price of

Selling the

stock

Profit

from stock

Total Profit

50 60 6 -10 -4 58 8 4

52 60 6 -8 -2 58 6 4

54 60 6 -6 0 58 4 4

56 60 6 -4 2 58 2 4

58 60 6 -2 4 58 0 4

60 60 6 0 6 58 -2 4

62 60 6 0 6 58 -4 2

64 60 6 0 6 58 -6 0

66 60 6 0 6 58 -8 -2

68 60 6 0 6 58 -10 -4

70 60 6 0 6 58 -12 -6

All the four cases describe a single option with a position in a stock. Some of

these cases look similar to each other and these can be explained by Put-Call

Parity.

Put Call Parity

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P + S = c + Xe-r(T-t) + D ---------------------- (1)

Or

S - c = Xe-r(T-t) + D - p ---------------------- (2)

The second equation shows that a long position in a stock and a short position in

a call is equivalent to the short put position and cash equivalent to Xe-r(T-t) + D.

The first equation shows a long position in a stock combined with long put

position is equivalent to a long call position plus cash equivalent to Xe-r(T-t) + D.

6.3.8 SPREADS

The above strategies involved positions in a single option and squaring them off

in the spot market. The spreads are a little different. They involve using two or

more options of the same type in the transaction.

Strategy 1:

Bull Spread:

The investor expects prices to increase in the future. This makes him

purchase a call option at X1 and sell a call option on the same stock at X2,

where X1<X2.

Using an illustration it would be clear how this is put to use.

 Illustration

An investor purchases a call option on the BSE Sensex at premium of Rs.450

for a strike price at 4300. The investor squares this off with a sell call option at

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Rs. 400 for a strike price at 4500. The contracts mature on the same date. The

payoff chart below describes the net profit that one earns on the buy call option,

sell call option and both contracts together.

Payoff From a Bull Spread

S X1 X2 c1 c2 Profit from

X1

Net profit

from X1

Profit form

X2

Net

Profit

from X2

Total

Profit

4200 4300 4500 -450 400 0 -450 0 400 -50

4250 4300 4500 -450 400 0 -450 0 400 -50

4300 4300 4500 -450 400 0 -450 0 400 -50

4350 4300 4500 -450 400 50 -400 0 400 0

4400 4300 4500 -450 400 100 -350 0 400 50

4450 4300 4500 -450 400 150 -300 0 400 100

4500 4300 4500 -450 400 200 -250 0 400 150

4550 4300 4500 -450 400 250 -200 -50 350 150

4600 4300 4500 -450 400 300 -150 -100 300 150

4650 4300 4500 -450 400 350 -100 -150 250 150

4700 4300 4500 -450 400 400 -50 -200 200 150

4750 4300 4500 -450 400 450 0 -250 150 150

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The premium on call with X1 would be more than the premium on call with X2.

This is because as the strike price rise the call option becomes unfavourable for

the buyer. The payoffs could be generalised as follows.

Spot Rate Profit on

long call

Profit on

short call

Total

Payoff

Net Profit Which option(s)

Exercised

S >= X2 S - X1 X2 - S X2 - X1 X2 - X1 - c1 + c2 Both

X1 < S <= X2 S - X1 0 S - X1 S - X1 - c1 +c2 Option 1

S >= X1 0 0 0 c2 - c1 None

The features of the Bull Spread:

This requires an initial investment.

This reduces both the upside as well as the downside potential.

The spread could be in the money, on the money and out of money.

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Another side of the Bull Spread is that on the Put Side. Buy at a low strike price

and sell the same stock put at a higher strike price.

This contract would involve initial cash inflows unlike the Bull Spread based on

the Call Options. The premium on the low strike put option would be lower than

the premium on the higher strike put option as more the strike price more is

favourability to buy the put option on the part of the buyer.

Illustration

An investor purchases a put option on the BSE Sensex at premium of Rs.50 for

a strike price at 4300. The investor squares this off with a sell put option at Rs.

100 for a strike price at 4500. The contracts mature on the same date. The

payoff chart below describes the net profit that one earns on the buy put option,

sell put option and both contracts together.

Payoff From a Bull Spread (Put Options)

S X1 X2 p1 p2 profit from

X1

Net profit

from X1

Profit

from X2

Net

Profit

from X2

Total

Profit

4200 4300 4500 -50 100 100 50 -300 -200 -150

4250 4300 4500 -50 100 50 0 -250 -150 -150

4300 4300 4500 -50 100 0 -50 -200 -100 -150

4350 4300 4500 -50 100 0 -50 -150 -50 -100

4400 4300 4500 -50 100 0 -50 -100 0 -50

4450 4300 4500 -50 100 0 -50 -50 50 0

4500 4300 4500 -50 100 0 -50 0 100 50

4550 4300 4500 -50 100 0 -50 0 100 50

4600 4300 4500 -50 100 0 -50 0 100 50

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4650 4300 4500 -50 100 0 -50 0 100 50

4700 4300 4500 -50 100 0 -50 0 100 50

4750 4300 4500 -50 100 0 -50 0 100 50

Spot Rate Profit on

long put

Profit on

short put

Total Payoff Net Profit Which option(s)

Exercised

S >= X2 0 0 0 p2 - p1 None

X1 < S <= X2 0 S - X2 S - X2 S - X2 - p1 + p2 Option 2

S <= X1 X1 - S S - X2 X1 - X2 X2 - X1 - p1 + p2 Both

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6.3.9 Summary of options

Call option buyer Call option writer (seller)

Pays premium

Right to exercise and buy the

share

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

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6.4. SWAPS:

Swaps are transactions which obligates the two parties to the contract to

exchange a series of cash flows at specified intervals known as payment or

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based on

some notional principle amount is called as a ‘SWAP’. In case of swap, only

the payment flows are exchanged and not the principle amount. The two

commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his

series of fixed rate interest payments to a party in exchange for his variable rate

interest payments. The fixed rate payer takes a short position in the forward

contract whereas the floating rate payer takes a long position in the forward

contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the

interest on loan in one currency are swapped for the principle and the interest

payments on loan in another currency. The parties to the swap contract of

currency generally hail from two different countries. This arrangement allows

the counter parties to borrow easily and cheaply in their home currencies. Under

a currency swap, cash flows to be exchanged are determined at the spot rate at a

time when swap is done. Such cash flows are supposed to remain unaffected by

subsequent changes in the exchange rates.

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FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to

access one market and then exchange the liability for another type of liability. It

also allows the investors to exchange one type of asset for another type of asset

with a preferred income stream.

The other kind of derivatives, which are not, much popular are as follows:

6.5. BASKETS:

Baskets options are option on portfolio of underlying asset. Equity Index

Options are most popular form of baskets.

6.6. LEAPS:

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years.

These long-term option contracts are popularly known as Leaps or Long term

Equity Anticipation Securities.

Example:

An option to sell 5000 shares of GMR after a period of 2 ½ years from the date

of entering into contract can be termed as LEAPS. This is not different from an

option except the period of validity.

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6.7. WARRANTS:

Options generally have lives of up to one year; the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated

options are called warrants and are generally traded over-the-counter.

Example:

An option to buy 1000 shares of RIL after a period of 1 ½ years from the date of

entering into contract can be termed as a Warrant. This is no way different from

an option except the period of validity.

6.8. SWAPTIONS:

Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather

than have calls and puts, the swaptions market has receiver swaptions and payer

swaptions. A receiver swaption is an option to receive fixed and pay floating. A

payer swaption is an option to pay fixed and receive floating.

Example:

A and B enter into a SWAP contract. A is swapping his fixed interest rate

against B. That B can receive fixed interest rate and now pay floating.

When c buys an option to buy this swap from B, it becomes a receiver swaption.

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7. Experience at Sharekhan

We came to know about various products of Sharekhan along with its

features and advantages.

We also learnt about various competitors of Share khan like 5paisa.com,

Reliance Securities, Angel broking, HDFC securities, Kotak Securities,

Motilal Oswal etc.

We came to know about advantages of Sharekhan over its competitors.

Morning 9a.m.we used to sit next to Mr. Jikesh Vakharia (Dealer) and see

how trading is done.

He also used to share various research reports of Sharekhan and solve our

queries.

We had various training sessions with Mr. Ghanashyam Kale, one of the

topic was Derivative, wherein we learnt what are derivatives, how they

are traded, how research reports are important in derivative trading, etc.

We studied various research reports daily such as Pre-market report,

Investors Eye report, Eagles Eye report, Post-market report, Weekly

report etc.

We also learnt how to pitch various products of Sharekhan to the

potential clients like Trade Tiger, classic and fast trade with various

advance brokerage plans like Rs750, 1000, 2000 and 6000.

We made phone calls to various people from a few database.

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We got a few clients from our personal contacts and some other from the

appointments we got from various phone calls we made.

8. Recommendations & Suggestions

There should be a separate cabin or a desk for trainees to work.

There should be more training sessions with professional trainers.

Trainees should be divided in groups according to location and should be

reporting to offices near their vicinity as after meeting clients we had to

report to Lower Parel office.

There should be only 5 trainees under a trainer.

There should also be training given on equity research and also on how

research reports are generated.

There should be more information available to individual investors about

derivatives.

There should be special seminars conducted by SEBI about creating

awareness about derivatives to individual investors.

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9. BIBLIOGRAPHY

Books referred:

NSE’s Certification in Financial Markets: - Derivatives Core module

Reports:

Options report by Sharekhan

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.google.com

www.derivativesindia.com

www.scribd.com

www.sharekhan.com

Search Engine:

www.google.com

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