Raghavendra Page 1 7/20/2012 CHAPTER-1 INRODUCTION HISTORY OF STOCK EXCHANGE The only stock exchange operating in the 19 th century were those of Bombay set up in 1875 and Ahmadabad set up in 1894 these were organized as voluntary non-profit making organization of brokers to regulate and protect interest. Before the control insecurities trading became a central subject under the constitution in 1950, it was a state subject and the Bombay securities contract (CONTROL) Act of 1952 used to regulate trade in securities. Under this act, the Bombay stock exchange in 1927 and Ahmadabad in 1937. During the war boom, a number of stock exchanges were organized in Bombay, Ahmadabad and other centers, but they were not recognized. Soon after it became a central subject, central legislation was proposed and a committee headed by A.D. Goral went in to the bill for securities regulation. On the basis of committee’s recommendations and public discussions the securities contracts (regulations) Act became law in 1956. Definition of Stock Exchange “Stock exchange means any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.” It is an association of member brokers for the purpose of self – regulation and protecting the interests of its members. It can operate only of it is recognized by the govt. Under the securities contract (regulation) Act, 1956. The recognition is granted under section 3 of the Act by the central government, ministry if finance. 1
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Raghavendra Page 1 7/20/2012
CHAPTER-1
INRODUCTION
HISTORY OF STOCK EXCHANGE
The only stock exchange operating in the 19th century were those of Bombay set
up in 1875 and Ahmadabad set up in 1894 these were organized as voluntary non-profit
making organization of brokers to regulate and protect interest. Before the control
insecurities trading became a central subject under the constitution in 1950, it was a state
subject and the Bombay securities contract (CONTROL) Act of 1952 used to regulate
trade in securities. Under this act, the Bombay stock exchange in 1927 and Ahmadabad
in 1937.
During the war boom, a number of stock exchanges were organized in Bombay,
Ahmadabad and other centers, but they were not recognized. Soon after it became a
central subject, central legislation was proposed and a committee headed by A.D. Goral
went in to the bill for securities regulation. On the basis of committee’s
recommendations and public discussions the securities contracts (regulations) Act
became law in 1956.
Definition of Stock Exchange
“Stock exchange means any body or individuals whether incorporated or not,
constituted for the purpose of assisting, regulating or controlling the business of buying,
selling or dealing in securities.” It is an association of member brokers for the purpose of
self – regulation and protecting the interests of its members. It can operate only of it is
recognized by the govt. Under the securities contract (regulation) Act, 1956. The
recognition is granted under section 3 of the Act by the central government, ministry if
finance.
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BYELAWS
Besides the above act, the securities contract (regulations) rules were also
made in 1975 to regulate certain matters of trading on the stock Exchange. These are also
byelaws of the exchanges, which are concerned with the following subjects. Opening /
closing of the stock exchange, timing of trading, regulation of bank transfer, regulation of
Badla or carryover business, control of settlement, and other activities of stock exchange,
fixations of margin, fixations of market price or marking price, regulation of tarlatan
business (jobbing), regulation of brokers trading, brokerage charges, trading rules on the
exchange, arbitration and settlement of disputes, settlement and clearing of the trading
etc.
Regulations of Stock Exchange
The securities contract (regulations) is the basis for operations of the stock
exchange in India. No exchange can operate legally without the government permission
or recognition. Stock exchanges are give monopoly in certain areas under section 19 of
the above Act to ensure that the control and regulation are facilitated. Recognition can be
granted to a stock exchange provided certain are satisfied and the necessary Information
is supplied to the government. Recognition can also be withdrawn, if necessary. Where
there are no stock exchanges, the government can license some to the brokers to perform
the functions of a stock exchange in its absence.
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
SEBI was set up as an autonomous regulatory authority by the Government of India
in 1988 “to perform the interests of investors in securities and to promote the
development and to regulate the securities market and for matters connected there with
or incidental thereto.” It is empowered by two acts namely the SEBI act, 1992 and the
securities contract (regulation) Act 1956 to perform the function of protecting investor’s
rights and regulating the capital market.
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BASIC OF DERIVATIVES
The term “Derivatives” independent value, i.e. its value is entirely “derived”
from the underlying asset. The underlying asset can be securities, commodities bullion,
currency, live stock or anything else. In other words, derivative means a forward, future,
option or any other hybrid contract of per determined fixed duration, linked for the
purpose of contract fulfillment to the value of a specified real or financial asset or to an
index of securities.
The Securities Contracts (Regulation) Act 1956 Define Derivatives as Under
“Derivative” Includes
• a securities derivatives from a debt instrument, share, lone writher secured or
• unsecured, risk instrument or contract for different or any other security
• a contract which derives its value from the prices, or index of price of underlying
• Securities
The above definition conveys: Those derivatives are financial products and derive its
value from the underlying assets.
Derivatives is derived from another financial instrument/contract called the
Underlying. In the case of Nifty futures, Nifty index is the underlying.
Significance of DerivativesDerivatives are Used
1. By Hedgers for protecting (risk-covering) against adverse movement. Hedging is
a mechanism to reduce price risk inherent in open positions. Derivatives are
widely used for hedging. A Hedge can help lock in existing profits. Its purpose is
to reduce the volatility of a portfolio by reducing the risk.
2. Speculators to make quick fortune by anticipating/forecasting future market
movement. Hedgers with to eliminate or reduce the price risk to which they are
already exposed. Speculators, on the other hand are those classes of investors
who willingly take price risks to profit from price change in the underlying.
While the need to provide hedging avenues by means of derivative instruments is
laudable, it call for the existence of speculative traders to play the role of
counter-party to the hedgers. It is for this reason that the role of speculators gains
prominence in a derivatives market.
3. Arbitrageurs to earn risk-free profits by exploiting market importance. 3
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Arbitrageurs profits from price differential existing in two markets by
simultaneously operating in the two different markets.
Type of Derivatives
Derivatives products initially emerged devices against fluctuations in commodity
price, and commodity-linked derivatives remained the sole form of such predicts for
almost three hundred years. Financial derivatives came into spotlight in the post-1970
period due to growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990s, they accounted for
about two –thirds of total transactions in derivative products. In recent years, the market
for financial derivatives has grown tremendously in term of variety of instruments
available their complexity and also turnover. In the class of equity derivatives the world
over, future and options on stock indices have gained more popularity than on individual
stocks, especially among institutional investors, who are major uses of index-linked
derivatives. Even small investors find these useful due to high correlation of the popular
index with various portfolios and ease of use. The lower costs associated with index
derivatives vis-à-vis derivative products based on individual securities is another reason
for their growing use. The most commonly used derivatives contracts are forward,
futures and options with we shall discuss in detail later. Here we take a brief look at
various derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special type of
forward contract in the sense that the former are standardized exchange-trade contracts.
Options: options are of two types- calls and put calls give the buyer right but not the
obligation to buy a give quantity of the underlying asset, at a given price on or before a
given future date. Puts gives the buyer the right, but not the obligation to sell a given 4
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quantity of the underlying asset at a given price on or before given date.
Warrants: Options generally have lives of up to one year, the majority of option traded
on options exchanges having a maximum maturity of one month. Longer-dated options
are called warrants and are generally traded over-counter.
Leaps: The acronym LEAPS means long-term equity anticipation securities. These are
options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options.
Swaps: swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts.
The Two Commonly Used Swaps Are
Interest Rate Swaps: these entail swapping only the interest related cash flow between
the parties in the same currency.
Currency Swaps: These entail swapping both principal and interest between the parties,
with the case flows in one direction being in a different currency than those in the
opposition direction.
Swaptions: Swaptions are options to buy or sell a swap that will became operative at the
expiry of the options. Thus a Swaptions is an option on a forward swap. Rather than have
called and puts, the swaption market has receiver swaption and payer swaptions. A
receiver swaptions in an option to receiver fixed and pay floating. A player swaption is
an option to pay fixed and receive floating.
Classification of Derivatives
The Derivatives Can be Classified as
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• Forwards (Currencies, Stocks, Swaps etc)
Forward contract is different from a spot truncation, where payment of price and
delivery of commodity concurrently take place immediately the transaction is settled. In a
forward contract the sale/purchase truncation of an asset is settled including the price
payable, not for delivery/settlement at spot, but at a specified future date. India has a
strong dollar-rupee forward market with contract being traded for one, two, and six-
month expiration. Daily trading volume on this forward Market is around $500 million a
day. Indian users of hedging services are also allowed to buy derivatives involving other
A futures contract has been defined as “a standardized, exchange-traded
Agreement specifying a quantity and price of a particular type of commodity
(Soybeans, gold, oil, etc) to be purchased or sold at a pre-determined date in the
Future. On contract date, delivery and physical possession take place unless the
Contract has been closed out futures fate also available ob various financial
Products and indexes today. A futures contract is thus a forward, contract, which
trades on national stock exchange. This provides them transparency, liquidity,
anonymity of trades, and also eliminates the counter party risks due to the
guarantee provided by national securities clearing corporation limited.
• Options (Currencies, Stocks, Indexes etc)
Options are the standardized financial that allows the buyer (holder) if the
Options, i.e. the right at the cost of options premium, not the obligation, to
but (call options) or sell (put options) a specified asset at a set price on or before
a Specified date through exchange under stringent financial security against
default.
FORDWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a
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specified price. One of the parties to the contract assumes a long position and agrees to
buy the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same date for
the same price. Other contract details like delivery date, the parties to the contracts
negotiate price and quality bilaterally. The forward contracts are normally traded outside
the exchanges.
The Silent Futures of Forward Contract are
The bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed, and hence is unique in terms of contract size,
Expiration date and the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go the same
counter Party, which often results in high prices being changed.
However forward contracts in certain markets have become very standardization, as
in the case of foreign exchange, thereby reducing transaction cost and increasing
transactions volume. This process of standardization reaches its limit in the organized
futures market .Forward contracts is very useful in hedging and speculation. The classic
hedging application word is that of an exporter who expects to receive payment in dollars
three Months later he is exposed to the risk of exchange rate fluctuations. By using the
currency forward markets to sell dollars forward, he can lock on to a rate today and
reduce his uncertainty. Similarly an importer who is required to make a payment in
dollars forward if a speculator has information or analysis, which forecasts an upturn in a
price, than he can go long on the forward market instead of the cash market. The
speculator would go long on the forward, wait for the price to rise, and then take a
reversing transaction to book profits. Speculators may well be required to deposit a
margin upfront. However, this is generally a relatively small proportion of the value of
the assets underlying the forward contract. The use of forward markets here supplies
leverage to the speculator.
LIMITATIONS
Forward Markets World-Wide are Afflicted by Several Problems
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Lack of centralization of trading, Liquidity, and Counter party risk in the first two
of these, the basic problem is that of too much flexibility and generality. The forward
market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal, which are very
convenient in that specific situation, but makes the contracts non-tradable. Counter party
risk arises from the possibility of default by any one party to the transaction. When one
of the two sides to the transaction declares bankruptcy, the other suffers. Even when
forward markets trade standardized contracts, and hence avoid the problem of liquidity,
still the counter party risk remains a very serious issue.
FUTURES
Futures markets were designed to solve the problems that exist in forward
markets. Futures Contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the futures
contracts are standardized and exchange traded. To facilitate liquidity in the future
contracts, the exchange specifies certain standard quantity and quality of the underlying
instrument that can be delivered, (or which can be used for reference purposes in
settlement) and a standard timing of such settlement. A futures contract may be offset
prior to maturity by entering into an equal and opposite transaction. More than 99% of
futures transactions are offset this way.
The Standardized Items in a Futures Contract are
Quantity of the underlying
Quality of the underlying
The date and month of delivery
The units of price quotations and minimum price changes
Location of settlement.
DISTINCTION BETWEEN FUTURES AND FROWARDS
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Forward contracts are often confused with futures contracts. The confusion is
primarily Became both serve essentially the same economics of allocations risk in the
presence of Future price uncertainly. However futures are a significant improvement over
the forward Contracts as they eliminate counter party risk and offer more liquidity.
FUTURES TERMINOLOGY
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts on
the NSE have one-month, two-month and three-month expiry cycle, which expire on the
last Thursday of the month. Thus January expiration contract expires on the last
Thursday of February. On the Friday following the last Thursday, a new contract having
a three-month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on which
the contract will be traded, at the end of which it will case to exist.
Contract size: The amount of the asset that has to be delivered less than one contract. For
instance, the contract size on NSE’s futures market is 200 Niftiest.
Basis: In the context of financial futures, basis can be defined as the futures price minus
the spot price. There will be a different basis for each delivery month for each contract.
In a normal market, basis will be positive. This reflects that futures prices normally
exceed spot prices.
Cost of carry: the relationship between futures prices and spot prices can be
summarized.
In terms of what is known as the cost of carry. This measures the storage Cost
plus the interest that is paid to finance the asset less the income earned on the
asset.
Initial margin: the amount that must be deposited in the margin account at the
time a future contract is first entered into is known as initial margin.
Marking-to-market: in the futures market, at the end of each trading day, the
margin.
account is adjusted to reflect the investor’s gain or loss depending upon the
futures Closing price. This is called marking-to-market.
Maintenance margin: this is somewhat lower than the initial margin. This is set to 9
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ensure. That the balance in the margin account never becomes negative.
If the balance in the margin account falls below the maintenance margin, the
investor receives a Margin call and is expected to top up the margin account to
the initial margin level before trading commences on the next day.
OPTIONS
We look at the next derivative product to be traded on the NSE, namely option.
Options are fundamentally different from forward and futures contracts. An option gives
the holder of the option the right to do something. The holder does not have to exercise
this right .in contrast, in a forward or futures contract, the two parties have committed
themselves to doing something. whereas it costs nothing (except margin requirements)to
enter into a futures contract, the purchase of an option requires an up-front payments.
OPTIONS TERMINAOLOGY
Index option: There option has the index as the underlying. Some options are
European while others are American. Like index, futures, contract, index options
Contracts are also cash settled.
Stock options: stock options are options on individual stocks. option currently
trade On over 500 stocks in the United States. A contract gives the holder the
right to buy or sell shares at the specified prices.
Buyer of options: the buyer of an options is the one who by paying the options
Premium buys the right but not the obligation to exercise his option on the
Seller / writer.
Writer of an option: the writer of a call/put options is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises
on him.
There are Two Basic Types of Options, Call Options and Put Options
Call option: a call option gives the holder the right but not the obligation to buy
an Asset by a certain date for a certain price.
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Put option: a put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
Option price: option prices are the price, which the option buyer pays to option
seller. It is also referred to as option premium.
Expiration date: the date specified in the options contract is known as the
expiration Date, the exercise date, the strike date or the maturity.
Strike price: the price specified in the options contract is known as the strike
price or the exercise price.
American options: American options are options that can be exercised at any
time up to the expiration date. Most exchange-traded options are American.
European options: European options are options that can be exercised only on
the Expiration date itself. European options are easier to analyze than American
options, and Properties of American options are frequently deduced from those
of its European Counterpart.
In-the-money option: an in-the money (ITM) option that would lead to a
Positive cash flow to the holder if it were exercised immediately. A call option
on the Index is said to be in money when the current index is stands at a level
higher than the strike price, (i.e. spot price strike price). If the index is much
higher than the strike price, The call is said to be deep ITM. In the case of a put
is ITM if the index is below the strike price.
At-the-money option: an at-the money (ATM) option is an option that would
lead to Zero cash flow if it were exercised immediately. An option on the index
is at-the –money when the current index equals the strike price (i.e. spot price =
strike price.
Out-of the money option: an out-of –money (OTM) option is an option that
would lead to a negative cash flow it was exercised immediately. A call option
on the index is out-of-the-money when the current index stands at a level, which
is less than the strike Price (i.e. spot price strike price). If the index is much
lower than the strike price, the call is said to be deep OTM .in the case of a put,
the put is OTM if the index is above the Strike price.
Trading Strategies using Futures and Option
There are a lot of practical uses of derivatives. As we have seen, derivatives can be
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used for profits and hedging. We can use derivatives as a leverage tool too.
Use of Derivatives as leverage
You can use the derivatives market to raise fund using your stocks. Conversely,
you can also lend funds against stocks.
Different Between Badla and Derivatives
The derivatives product that comes closest to Badla is futures. Futures is not
badla, through a lot of people confuse it with badla. The fundamental difference is badla
consisted of contango and backwardation (undha badla and vyaj badla) in the same
market. Futures is a different market segment altogether. Hence derivatives is not the
same as badla, through it is similar.
Raising Funds from the Derivatives Market
This is fairly simple. Say, you have Infosys, which is trading at R s 3000. You
have shares lying with you and are in urgent need of liquidity. Instead of pledging your
shares and borrowing from banks at a margin, you can sell the stock at R s 3000. Suppose
you need this liquidity only for a month and also do not want to party with Infosys. You
can buy a 1 month future at R s 3050
After a month you get back you Infosys at the cost of additional rs 50. This R s 50
is the financing cost for the liquidity. The other beauty about this is you have already
locked in your purchase cost at R s 3050. This fixes your liquidity cost also and protected
against further price losses.
Lending Funds to The Market
The lending into the market is exactly the reverse of borrowing. You have money
to lend.
You can a stock and sell its future. Say, you buy Infosys at R s 3000 and sell a 1
month future at R s 3100. In effect what you have done is lent R s 3000 to the market for
a month and earned R s 100 on it.
Using Speculation to Make Profits
When you speculate, you normally take a view on the market, either bullish or
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bearish. When you take a bullish view on the market, you can always sell futures and buy
in the spot market. If you take a bearish view on the market, you can buy futures and sell
in the sport market. Similarly, in the option market, if you are bullish, you should buy
call options. If you are bearish, you should buy put option conversely, if you are bullish,
you should write put options. This is so because, in a bull market, there are lower
changes of the put option being exercised and you can profit from the premium if you are
bearish, you should write call option. This is so because, in a bear market, there are lower
chances of the call option being exercised and you can profit from the premium.
Using Arbitrage to Make Money in Derivatives Market
Arbitrage is making money on price differential in different markets. For
example, future is nothing but the future value of the spot price. This futures value is
obtained by factoring the interest rate. But if there are differences in the money market
and the interest rates change than the future price should correct itself to factor the
change in interest. But if there is no factoring of this change than it present an
opportunity to make money-an arbitrage opportunity.
Let us take an example.
Example
A stock is quoting for Rs. 1000. The 1-month future of this stock is at rs 1005. the risk
free Interest rate is 12%. What should be the trading strategy?
Solution
The strategy for trading should be: Sell Spot and Buy Futures
Sell the stock for Rs 1000. Buy the future at Rs 1005.
Invest the Rs 1000 at 12%. The interest earned on this stock will be
1000(1+.02) (1/12) = 1009
So net gain the above strategy is Rs 1009-rs 1005= Rs 4
Thus one can make a risk less profit of Rs 4 because of arbitrage. But an important point
is that this opportunity was available due to miss-pricing and the market not correcting
itself. Normally, the time taken for the market to adjust to corrections is very less. So the
time available for arbitrage is also less. As every one to cash in on the arbitrage, the
market corrects itself.
USING FUTURE TO HEDGE POSITION
One can hedge ones by taking an opposite position in the futures market. For
example, if you are sport price, the risk you carry is that of price in the future. You can
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lock this by selling in the futures price. Even if the stock continues falling, your position
is hedge as you have firmed the price at witch you are selling. Similarly, you want to buy
a stock at a later date but face the risk of prices rising. You can hedge against this rise by
buying futures. You can use a combination of futures too to hedge yourself. There is
always a correlation between the index and individual stocks, this correlation may be
negative or positive, but there is a correlation. This is given by the beta of the stock. In
simple terms, terms, what beta indicates is the change in the price of a stock to the
change in index.
For examples
If beta of a stock is 0.8, it means that if the index goes up by the stock goes up by
8. t will also fall a similar level when the index falls.
A negative beta means that the price of the stock falls when the index rises. So, if you
have a position in a stock, you can hedge the same by buying the index at times the
value of the stock.
Example: The beta of HPCL is 0.8. The Nifty is at 1000. If I have Rs 10000 worth of
HPCL, I can hedge my position by selling 800 of Nifty. That is I well sell 8 Nifities.
Scenario 1: If index rises by 10%, the value of the index becomes 8800 I e a loss of R s
800. The value of my stock however goes up by 8% I e it becomes R s 10800 I e a gain
of R s 800.Thus my net position is zero and I am perfectly hedged.
Scenario 2:If index falls by 10%, the value of the index becomes Rs 7200 a gain of Rs
800. But the value of the stock also falls by 8%. The value of this stock becomes Rs 9200
a loss of Rs 800Thus my net position is zero and I am perfectly hedged. But against, beta
is a predicated value based on regression models. Regression is nothing but also analysis
of past data. So there is a chance that the above position may not be fully hedged if the
beta does not behave as per the predicated value.
Using Options in Trading Strategy: Options are a great tool to use for trading. If you
feel the market will go up. You should are a call option at a level lower than what you
expect the market to go up. If you think that the market will fall, you should buy a put
option at a level higher than the level to which you expect the market fall. When we say
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market, we mean the index. The same strategy can be used for individual stocks also. A
combination of futures and options can be used too, to make profits.
Strategy for an option writher to cover himself
An option writer can use a combination strategy of futures and options to protect
his position. The risk for an option writer arises only when the option is exercised this
will be very clear with an example.
Supposing I sell a call option on Satyam at a strike price of Rs 300 for a premium
of rs20. The risk arises only when the option is exercised. The option will be exercised
when the price exceeds rs 300. I start making a loss only after the price exceeds Rs 320
(Strick price plus premium).
More impotently, I have to deliver the stock to the opposite party. So to enable
me to deliver the stock to the other party and also make entire profit on premium, I buy a
future of Satyam at Rs 300. This is just one leg of the risk. The earlier risk was of the
called being exercised the risk now is that of the call not being exercised. In case the call
is not exercised, what do I do?
I will have to take delivery as I have brought a future. So minimize the risk, I buy
a put option on Satyam at Rs 300. But I also need to pay a premium for buying the
option. I pay Premium of Rs 10. Now I am fully covered and my net cash flow would be.
Premium earned from selling call option Rs 20.Premium paid to buy put option (Rs 10)
Net cash flow Rs 10.
But the above pay off will be possible only when the premium I am paying for
the put Option is lower than the premium that I get for writing the call. Similarly, we can
arrive at a covered position for waiting a put option two. Another interesting observation
is that the above strategy in itself presents an opportunity to make money. This is so
because of the premium differential in the put and the call option. So if one tracks the
derivatives make on a continuous basis, one can chance upon almost risk less money
making opportunities.
Other Strategies Using Derivatives
The other strategies are also various permutations of multiple puts, call and
futures. They are also called by exotic names, but if one were to observe them closely,
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they are relatively simple instruments. Some of these instruments are
Butterfly Spread: It is the strategy of simultaneous buying of put and call
Calendar Spread: An option strategy in which a short-term option is sold and a longer-
term option is bought both having the same striking price. Either puts or calls may be
used.
Double Option: An option that gives the buyers the right to buy and/or sell a futures
contract, at a premium, at the strike price.
Straddle: The simultaneous purchase and sale of option of the same speculation to
different periods.
Tandem Options: A sequence of options of the same type, with variable strike price and
period.
Bermuda Option: Like the location of the Bermudas, this option is located somewhere
between a European style option with can be exercised only at maturity and an American
style option which can be exercised any time the option holder chooses. This option can
be exercise only on predetermined dates.
RISK MANAGEMENT IN DERIVATIVES
Derivatives are high-risk instrument and hence the exchanges have put up a lot of
measures to control this risk. The most critical aspect of risk management is the daily
monitoring of price and position and the margining of those positions.
NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that
has origins at the Chicago Mercantile Exchange, one of the oldest derivative exchanges
in the world.
The objective of SPAN is to monitor the positions and determine the maximum
loss that a stock can incur in a single day. This loss is covered by the exchange by
imposing mark to market margins.16
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SPAN evaluates risk scenarios, which are nothing but market conditions. The
specific set of market conditions evaluated, are called the risk scenarios, and these are
defined in terms of
a) How much the price of the underlying instrument is expected to change over one
trading day, and
b) How much the volatility of that underlying price is expected to change over one
trading day?
Based on the SPAN measurement, margins are imposed and risk covered. Apart
from this, the exchange will have a minimum base capital of Rs. 50 lacks and brokers
need to pay additional base capital if they need margins above the permissible limits.
SETELLEMENT OF FUTURES
Mark to Market Settlement
There is daily settlement for Mark to Market. The profits/losses are computed as
the difference between the trade price or the precious day’s settlement price as the case
may be and the current day’s settlement price. The parties who have suffered a loss are
required to pay the mark-to-market loss amount to exchange which is in turning passed
on to the party who has made a profit. This is known as daily mark-to market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not traded
during the last half on a day, is currently the price computed as per the formula detailed
below.
F = S * e rt
WhereF = theoretical futures price
S = value of the underlying index/stock
r = rate of interest (MIBOR- Mumbai Inter Bank Offer Rate)
t = time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be
specified. After daily settlement, all the open positions are reset to the daily settlement
price. The pay-in and payout of the mark-to-market settlement is on T+1 days (T = Trade
day). The mark to market losses or profits are directly debited or credited to the broker
account from where the broker passes to client account.
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Final Settlement
On the expiry of the futures contracts, exchange market all positions to the final
settlement price and the resulting profit/loss is settlement I cash. The final settlement of
the future contract is similar to the daily settlement process except for the method of
capon of final settlement price. The final settlement profit/loss is completed as the
difference between trade price or the previous day’s settlement price, as the case may be
and the final settlement price of the relevant futures contract.
Final settlement loss/profit amount is debited/credited to the relevant broker’s
clearing bank account on T + 1 day (T = expiry day). This is then passed on the client
from the broker. Open positions in futures contracts cease to exist after their expiration
day.
SETTLEMENT OF OPTIONS
Daily Premium Settlement
Premium settlement is cash settled and settlement style is premium style. The
premium payable position and premium receivable position are netted across all option
contract for each broker at the client level to determine the net premium payable or
receivable amount, at the end of each day.
The brokers who have a premium payable position are required to pay the
premium amount to exchange which is in turn passed on to the members who have a
premium receivable position. This is known as daily premium settlement. The brokers in
turn would take from their clients.
The pay-in and pay-out of the premium settlement is on T + 1) days (T = Trade
day). The premium payable amount and premium receivable amount are directly debited
or credited to the broker, from where it is passed on to the client.
Interim Exchange Settlement for Options on Individual Securities
Interim exchange settlement for Option contract on individual securities is
affected for valid exercised option at in-money strike price, at the close of the trading
hours, on the day of exercise. Valid exercise option contracts are assigned to short
position in option contracts with the same series, on a random basis. This interim 18
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exercise settlement value is the difference between the strike price and the settlement
price of the relevant option contract. Exercise settlement value is debited/credited to the
relevant option broker account on T + 3 days (T = exercise date). From there it is passed
on to clits.
Final Exercise Settlement
Final Exercise settlement is effected for option positions at in-the-money strike
price existing at the close of trading hours, on the expiration day of an option contract.
Long position at in-the money strike price are automatically assigned to short positions in
option contracts with the same series, on a random basis. For index option individual
securities, exercise style is American style. Final Exercise is Automatic on expiry of the
option contracts.
Exercise settlement is cash settled by debiting/crediting of the clearing account
or the relevant broker with the respective Clearing Bank, from where it is passed
debited/credited to the relevant broker clearing bank account on T + 1 day (T = expiry
day), from where it is passed Final settlement loss/profit amount for option contracts on
Individual Securities is debited/credited to the relevant broker clearing bank account on T
+ 3 days (T = expiry day), from where it is passed Open positions, in option contracts,
cease to exist after their expiration day.
Options valuation using Black Scholes model
The black and Scholes Option Pricing model didn’t appear overnight, in fact,
Fisher Black started out working to create a valuation model for stock warrants. This
work involved calculating a derivative to measure how the discount rate of a warrant
varies with time and stock price. The result of this calculation held a striking resemblance
to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined
Black and the result of their work is a startlingly accurate option pricing model. Black
and Scholes can’t take all credit for their infect the model is actually an improved version
of a precious model developed by A. James Boness in his Ph.D. dissertation at the
University of Chicago. Black and scholes improvement on the Bones model come in the
from of a proof that the risk- free interest raise is the correct discount factor, and with the
absence of assumptions regarding investor’s risk preferences.
The model C = SN (d1) – Ke {-rt} N (d2)
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C= Theoretical call premiumS= current stock pricet= time until option expirationK= option striking price r= risk-free interest rateN = Cumulative standard normal distribution D1 = in(S / K) + (r + s²/2)t
In order to understand the model itself, we divide into two parts. The first part,
SN (d1), derives the expected benefit from acquiring a stock outright. This is found by
multiplying stock price [S] by the change in the call premium with respect to a change in
the underlying stock price [N (d1)]. The second part of the model, Ke(-rt)N(d2), gives the
present value of paying the exercise price on the expiration day. The fair market value of
the call option is then calculated by taking the difference between these two parts.
Assumptions of the Black and Scholes Model
1) The stock pays no dividends during the option’s life: Most companies pay
dividends to their share holders, so this might see a serious limitation to the
model considering the observation that higher dividend yields elicit lower call
premiums. A common way of adjusting the model for this situation is subtract the
discounted value of a future dividend from the stock price.
2) European exercise terms are used : European exercise terms dictate that the
option can only be exercised on the expiration date. American exercise term
allow the option to be exercised at any time during the life of the option, making
American option more valuable due to their greater flexibility. This limitation is
not a major concern because very few calls are exercise before the last few days
of their life. This is true because when you exercise a call early, you forfeit the
remaining time value on the call and collect the intrinsic value. Towards the end
of the life of a call, the remaining time value is very small, but the iatric value is
the same.
3) Markets are efficient: This assumption suggests that people cannot consistent
predict the direction of the market or an individual stock. The market operates
continuously with share price followed a continuous it process. To understand
what a continues it processes, you must first known that m Markov process is
“one where the observation in time period at depends only on the preceding
observation”. An it process is simply a Marko process you would do so without
picking the pen up from the piece of paper.
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4) No commissions are charged: Usually market participants do have to pay a
commission to buy or sell options. Even floor traders pay some kind of free, but it
is usually very small. The fees that Individual investor’s pay is more substantial
and can often distort the out put of the model.
5) Interest rates remain constant and know: The Black and Scholes model uses
the Risk-free rate to represent this constant and known rate. In reality there is no
such thing as the risk-free rate, but the discount rate on U.S. Government
Treasury Bills with 30 days left until maturity is usually used to represent it.
During periods of rapidly change interest rates, these 30 day rates are often
subject to change, thereby violating one of the assumptions of the model.
REGULARITY FRAME WORK
The trading of derivatives is governed by the provisions contained in the SC(R)A,
the SCBI act, the rules and regulation framed there under and the rules and bye-laws of
stock exchange.
Securities Contracts (Regulation) Act, 1956
SC(R) A aims at preventing undesirable transactions in securities by regulating
the Business of dealing therein and by providing for certain other matters connected
therewith. This is the principal Act, which governs the trading of securities in
India. The term “securities” has been defined in the SC(R) A. as per section 2(h), the
‘securities’ include.
1. Shares, scraps, stocks, bonds, debenture stock or other marketable securities of a like
Nature in or of any incorporated company or other body corporate. Derivative
2. Units or any other instrument issued by any collective investors in such schemes
To the investors in such schemes, risk Government securities. Such other
instruments as may be declared by the central government to be securities rights or
interests in securities. “Derivative” is defined to include: A security derived from a
debt instrument, share, loan whether secured or unsecured instrument or contract for
differences or any other from of security.
A contracts which derives its value from the prices, or index of prices, of
Underlying Securities.
Section 18 a provides that notwithstanding anything contained in any other
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law for the time being in force, contracts in derivative shall be legal and valid
if such contracts are :
Traded on a recognized stock exchange – settled on the clearing hose of the
recognized stock exchange, in accordance with the rules and bye –loss of
such stock exchanges
Securities and Exchange Board of India Act, 1992
SEBI Act, 1992 provides for establishment of Securities and Exchange Board of
India (SEBI) with statutory powers for (A) protecting the interests of investors in
securities (B) promoting the development of the securities market and (C) regulating
the securities market. Its regulatory jurisdiction extends over corporate in the
issuance of capital and transfer of securities, in addition to all intermediaries and
persons associated with securities market. SEBI has been obligated to perform the
aforesaid functions by such measures as it thinks fit.
In Particular, it has Powers For
Regulating the business in stock exchanges and any other securities markets
Registering and regulating the working of stock brokers, sub-brokers etc.
Promoting and regulating self – regulatory organizations
Prohibiting fraudulent and unfair trade practices.
Calling for information from, undertaking inspection, conducting inquires and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries and self-regulatory organization in the securities market
Performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government
SEBI (Stockbrokers and Sub-brokers) Regulations, 1992
In this section we shall have a look at the regulations that apply to brokers under the SEBI Regulation.
BROKERS
A broker is an intermediary who arranges to buy and sell securities on behalf of
clients (the buyers and the seller). According to section2 (e) of the SEBI (Stock Brokers
and sub brokers) Rules, 1992, a stock broker mean of a recognized stock exchange. No
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stock broker is allowed to buy, sell or deal in securities, unless he or she holds a
certificate of registration granted by SEBI. A stock broker applies for registration to
SEBI through a stock exchange or stock exchanges of which he or she is admitted as a
member. SEBI may grant a certificate to a stock-broker [as per SEBI (stock Brokers and
Sub-Brokers) Rules, 1992] subject to the conditions that,
1. He holds the membership of stock exchange.
2. Sell abide by the rules, regulations and buy-laws of the stock exchange or stock
exchange of which he is a member.
3. In case of any change in the status and constitution, he shall obtain prior
permission of SEBI to continue to buy, sell or deal in securities in any stock
exchange.
4. He shall pay the amount of fees for registration in the prescribed manner, and
5. He shall take adequate steps for redressed of grievances of the investors within
one month of the date of the receipt of the complaint and keep SEBI informed
about the number, nature and other particulars of the complaints as per
SEBI(Stock Brokers) Regulations, 1992,SEBI shall take into account for
considering the grant of a certificate all matters relating to buying, selling, or
dealing in securities and in particular the following namely,
Whether the Stock Broker
(a) Is eligible to be admitted as a member of a stock exchange.
(b) Has the necessary infrastructure like adequate office space, equipment and man
power to effectively discharge his activities.
(c) Has any past experience in the business of buying, selling or dealing in securities.
(d) Is subjected to disciplinary proceeding under the rules, regulations and buy-laws of a
stock exchange with respect to his business as a stock-broker involving either himself
or any of his partners, directors or employees.
REGULATION FOR DERIVATIVES TRADING
SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta
to develop the appropriate regulatory framework for derivatives trading in India. The
committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the
recommendations of the committee and approved the phased introduction of
derivatives trading in India beginning with stock index futures. SEBI also approved
the “suggestive bye-laws” recommended by the committee for regulation and control
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of trading settlement of derivatives contracts.
The provision in the SC(R)A and the regulatory framework developed there
under govern trading in securities .
The amendment of the SC(R) A to included derivatives with in the ambit of
‘securities’ in the SC(R) A made trading in derivatives possible within the frame work of
that 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 30% pf the total members and will obtain
Prior approval of SEBI before start of trading in any derivatives contract.
2. The exchange shall have maximum 50 members.
3. The members of an existing segment of the exchange will not automatically become
the members of derivatives segment. The members of the derivatives segment need
to fulfill the eligibility conditions as laid down by the L.C.Gupta committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI approved
clearing corporations/house. Clearing corporation/house complying with the
eligibility conditions as laid down by the committee have to apply to SEBI for grant of
approval.
5. Derivatives brokers/dealers and clearing members are required to seek registration
from SEBI. This is in additional top their registration as brokers of existing stock
exchanges. The minimum net worth for clearing members of the derivatives clearing
corporation/house shall be Rs. 300 lakh.
The Net Worth of the Members Shall be Computed as Follows
Capital + Free reserves
Less non-allowable assets viz,
Fixed assets
Pledged securities
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Member’s card
Non-allowable securities (unlisted securities)
Bad deliveries
Doubtful debts and advances
Prepaid expenses
Intangible asset
30% marketable securities
6. The minimum contract value shall not to be less than Rs. 2 Lakh. Exchanges should
also submit details of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and
margin demands related to the risk of loss on the position shall be prescribed by
SEBI/Exchange from time to time.
8. The L .C. Gupta committee report requires strict enforcement of “know your
customer” Rules and requires that every client shall be registered with the derivative
broker. The Members of the derivatives segment are also required to make their clients
aware of the Risks involved in derivatives trading by issuing to the client the risk
disclosure Document and obtain a copy of the same duly signed by the client. A trading
members are required to have qualified approved user and sales person who have passed
a certification programmed approved by SEBI.
NSE’S CERTIFICATION IN FINANCIAL MARKETS
A critical element of financial sector reforms is the development of a pool of
human resources having right skills and expertise to provide quality intermediation
services in Each segment of the market. In order to dispense quality intermediation,
personnel providing services need to possess requisite skills and knowledge. This is
generally achieved through a system of testing and certification. Such testing and
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certification has assumed added significance in India as there is no formal
education/training on financial Markers, especially in the area of operations. Taking into
account international experience and needs of the Indian financial Market, NSE offers
NCFM (NSE’ s Certification in Financial Markets) to test practical knowledge and
skills that are required to operate in financial markets in a very secure and unbiased
manner and to certify personnel with a view to improve quality of intermediation. NCFM
offers a comprehensive range of Modules covering many different areas in finance
including a module in derivatives. The Module on derivatives has been recognized by
SEBI. SEBI requires that derivative Brokers/dealers and sales persons must mandatory
pass this module of the NCFM
. Regulation For Clearing And Settlement
The L. C Gupta committee has recommended that the clearing corporation
must perform full notation i.e. the clearing corporation should interpose
itself between both legs of every trade, becoming the legal counter party to
both or alternatively should provide an unconditional guarantee for
settlement of all trades.
The clearing corporation should ensure that none of the Board member has
trading interests.
The definition of net-worth as prescribed by SEBI need to be incorporated in
the c application/regulations of the clearing corporation.
The regulations relating to arbitration need to be incorporated in the clearing
corporation.
Specific provision/chapter relating to declaration of default must be
incorporated by the clearing corporation in its regulations.
The regulations relating to investor protection fund for the derivatives market
must be included in the clearing corporation application/regulations.
The clearing corporation should have the capabilities to segregate
upfront/initial margins deposited by clearing members for trades on their
own account and on account of his clients. The clearing corporation shall
hold the clients’ margin money in trust for the clients’ purposes only and
should not allow its diversion for ant other purposes. This condition must be
incorporated in the clearing corporation regulations.
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The clearing member shall collect margins from his constituents
(clients/trading members). He shall clear and settle deals in derivative
contracts on behalf of the constituents only on the receipt of such minimum
margin.
Exposure limits based on the value at risk concept will be used and the
exposure limits. Will be continuously monitored. These shall be within the
limits prescribed by SEBI from time to time.
The clearing corporation must lay down a procedure of periodic review of
the net worth of its members.
The clearing corporation must lay down a procedure for periodic review of
the net worth of its members.
The clearing corporation must inform SEBI how it proposes to monitor the
exposure of its members in the underlying market.
Any changes in the bye-laws, rules or regulations which are covered under
the “suggestive bye-laws for regulations and control of trading and
settlement of derivatives contracts” would require prior approval of SEBI.
Product Specifications BSE-30 Sensex Futures
• Contract size – R s .50 times the Index
• Tick size – 0.1 points or R s. 5
• Expiry day – last Thursday of the month
• Settlement basis – cash settled
• Contract cycle – 3 months
• Active contracts – 3 nearest months
Product Specifications S&P CNX Nifty Futures
• Contract size – R s . 200 times the Index
• Tick size – 0.05 points or R s. 10
• Expiry day – last Thursday of the month
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• Settlement basis – cash settled
• Contract cycle -3 months
• Active contracts -3 nearest months
Membership
• Membership for the new segment in both the exchanges is not automatic and has
To be separately applied fir.
• Membership is currently open on both the exchanges.
• All members will also have to be separately registered with SEBI before they can be accepted.
Membership Criteria – National Stock Exchange (NSE)
Clearing Member (CM)
• Net worth – 300 lakh
• Interest – free security Deposit – Rs.25 lakh
• Collateral Security Deposit – Rs.25 lakh
In addition for every TM be wishes to clear for the CM has to deposit Rs.10 lakh.
Trading Member (TM)
• Net worth – R s .100 lakh
• Interest – fee security Deposits – R s. 8 lakh
• Annul subscription fee – R s .1 lakh
Membership Criteria – Mumbai Stock Exchange (BSE)
Clearing Member (CM)
• Net worth – 300 lake
• Interest – free Security Deposits – R s. 25 lakh
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• Collateral Security Deposits – R s. 25 lakh
• Non-refundable Deposit – R s. 5 lakh
• Annual Subscription Fee – R s.50 thousand
In addition for every TM he wishes to clear for the CM has to deposit R s. 10 lake with
The following break-up.
I.Cash – R s. 2.5 lakh
II.Cash Equivalents – R s. 25 lakh
III.Collateral Security Deposit – R s. 5 lakh
Trading Member (TM)
• Net worth – R s. 50 lakh
• Non-refundable Deposit – R s.3 lakh
• Annual subscription Fees – R s.25 thousand
The non-refundable fees paid by the members are exclusive and will be a total of R s. 8
Lakh if the member has both clearing and trading rights.
Trading Systems
• NSE’s trading system for it’s futures and options segment is called NEAT F&O.
• It is based on the NEAT system for the cash segment.
• BSE’s trading system for its derivatives segment is called DTSS. It is built on a Platform different from the BOLT system though most of the features are common