About India Infoline Group

The IIFL (India Infoline) group, comprising the holding company, India Infoline Ltd and its subsidiaries, is one of the leading players in the Indian financial services space. IIFL offers advice and execution platform for the entire range of financial services covering products ranging from E uities and derivatives, !ommodities, "ealth management, #sset management, Insurance, Fixed deposits, Loans, Investment $an%ing, &oI bonds and other small savings instruments IIFL o'ns and manages the 'ebsite, '''.indiainfoline.com, 'hich is one of India(s leading online destinations for personal finance, stoc% mar%ets, economy and business. # net'or% of over ),*++ business locations spread over more than *++ cities and to'ns across India facilitates the smooth ac uisition and servicing of a large customer base. #ll the offices are connected 'ith the corporate office in ,umbai 'ith cutting edge net'or%ing technology. The group caters to a customer base of about a million customers, over a variety of mediums vi-. online, over the phone and at the branches. 1.4.1 HISTORY AND MILESTONES 1995 !ommenced operations as an E uity .esearch firm 1997 Launched research products of leading Indian companies, %ey sectors and the economy !lient included leading FIIs, ban%s and companies 1999 Launched '''.indiainfoline.com 2000 Launched online trading through '''.*paisa.com /tarted distribution of life insurance and mutual fund 2003 Launched proprietary trading platform Trader Terminal for retail customers 2004 #c uired commodities bro%ing license Launched 0ortfolio ,anagement /ervice 2005 ,aiden I01 and listed on 2/E, $/E 3

2006 #c uired membership of 4&!5 !ommenced the lending business 2007 !ommenced institutional e uities business under IIFL Formed /ingapore subsidiary, IIFL (#sia) 0te Ltd 2008 Launched IIFL "ealth Transitioned to insurance bro%ing model 2009 #c uired registration for 6ousing Finance /E$I in7principle approval for ,utual Fund 1btained 8enture !apital license 2010 .eceived in7principle approval for membership of the /ingapore /toc% Exchange .eceived membership of the !olombo /toc% Exchange 2011- Launched IIFL ,utual Fund 20127 0F.4# appoints India Infoline Finance Ltd (IIFL) as 0oints of 0resence (0o0) under 2e' 0ension /ystem (20/). 74r. /. 2arayan as an #dditional 4irector of the !ompany. 6e 'ill be an Independent 4irector on the $oard of the !ompany.

Business Performance and Revenue of IIFL

IIFL has a well diversified revenue stream. Major income is earned from broking activities which contribute about 60% of revenue, followed b fund!based business at "#%, distribution income at $0%, and other ca%ital market!related income at #%. &his mitigates income susce%tibilit to volatilit in the e'uit markets. IIFL also %rovides loans against shares and the margin!financing facilit to its clients. )

&he com%an also %rovides wealth management services including third!%art distribution such as insurance and mutual funds, and %ortfolio management services. ()%osure to inherent uncertainties in ca%ital market *lobal events like the (uro +one crisis can have an im%act on Indian ca%ital markets INDUSTR Bro#in$ &he broking business is de%endent on the ca%ital market turnover, which is de%endent on the level of the e'uit markets and economic conditions. ,ver the last few ears, India-s *./ has shown an im%ressive growth of around 0 %er cent on account of rising investments b com%anies, leading to health cor%orate %erformance, which in turn lured retail and cor%orate investors to the stock market. 1lso, the number of com%anies, listed on the bourses has increased graduall over the %ast few ears. 2ith an increase in the number of listed com%anies and increasing investor activit , the average dail turnover has witnessed a significant s%urt over the %eriod.3rokerages though have found the going increasingl tough. 3rokerage income, in recent ears, has been im%acted b intense com%etition, leading to a decline in brokerage rates, and increasing %reference for o%tion trades, which ield relativel low brokerage income com%ared to cash market trades. Investment ban#in$ Investment banking includes activities such as ca%ital raising, mergers and ac'uisitions, %rivate e'uit advisor , %rivate wealth management, etc. &he fortunes of the investment banking business are ine)tricabl tied to overall economic growth and activit in ca%ital market transactions. &he Indian econom has grown at a strong %ace over the %ast few ears. &he economic slowdown in F405 following the global financial crisis resulted in huge ca%ital outflow, withdrawal b retail %artici%ants and reduced activities in %rimar and secondar ca%ital markets, which im%acted ca%ital market %la ers. 2ith the revival in economic growth, %artici%ation in the ca%ital markets b foreign institutional investors 6FIIs7 and domestic investors has increased. Strate$% 9 PR!FIL"

88 9Focus on core com%etence in financial services 889 (nsure de:risked business through multi%le %roducts and diverse revenue streams 889 1sset:heav or long gestation businesses through se%arate ;vs< grou% com%anies 889 .rive stickiness through high 'ualit research = service 889 Maintain cutting:edge %ro%rietar technolog 889 2ide, multi:modal network serving as one sto% sho% to customers 3usiness >trateg ?ustomer >trateg

!pportunities for IIFL

889/romoted b first generation %rofessional entre%reneurs 889Management team unmatched in terms of %rofessional credentials, e)%erience as well as academic background 889@et worth a%%ro)imatel As $6 bn with negligible debt 889/resent at over ",B00 business locations, with over #00 own branches 889(ffectivel cover over C#0 cities across India .istribution reach 889&he to% management is driven b %ride and reward of ownershi% 889&o think and work like an owner is %art of organi+ation-s .@1 ,wner:mindset 889Dni'uel %laced with %ro%rietar front, mid and back office software 889(ffectivel harnessed technolog to facilitate %rocesses and %rovide su%erior customer e)%erience 889.e:risked and diversified business model across multi%le revenue streams 889Multi%le %roducts across all segments of financial services

About Financial &ar#ets

1 financial market is a broad term describing an market%lace where bu ers and sellers %artici%ate in the trade of assets such as e'uities, bonds, currencies and derivatives. Financial markets are t %icall defined b having trans%arent %ricing, basic regulations on trading, costs and fees, and market forces determining the %rices of securities that trade. &he job of balancing the su%%l of and demand for loanable funds is taken b the mone market. 2hen the 'uantit su%%lied e'uals the 'uantit demanded, the market is in e'uilibrium at the e'uilibrium %rice. ,ne in which individuals and institutions trade financial securities

,rgani+ations and institutions in the %ublic and %rivate sectors also often sell securities on the ca%ital markets in order to raise funds It includes 17 37 /rimar markets >econdar markets

'(at are Primar% mar#ets) &he %rimar market is where securities are created. ItEs in this market that firms sell 6float7 new stocks and bonds to the %ublic for the first time. For our %ur%oses, ou can think of the %rimar market as being s non mous with an initial %ublic offering 6I/,7. >im%l %ut, an I/, occurs when a %rivate com%an sells stocks to the %ublic for the first time.

'(at are Secondar% mar#ets) In the secondar market, investors trade %reviousl :issued securities without the involvement of the issuing com%anies. For e)am%le, if ou go to bu Microsoft stock, ou are dealing onl with another investor who owns shares in Microsoft. Microsoft 6the com%an 7 is in no wa involved with the transaction.

AB!UT D"RI*ATI*"S
#ccording to dictionary, derivative means ;something 'hich is derived from another source(. Therefore, derivative is not primary, and hence not independent. In financial terms, derivative is a product 'hose value is derived from the value of one or more basic variables. These basic variables are called bases, 'hich may be value of underlying asset, a reference rate etc. the underlying asset can be e uity, foreign exchange, commodity or any asset. For example<7 the value of any asset, let(s say share of a company, at a future date depends upon the share(s current price. Thus here, the share is the underlying asset, the current price of the share is the bases and the future value of the share is the derivative. /imilarly, the future rate of the foreign exchange depends upon its spot rate of exchange. Even in this case, the future exchange rate is the *

derivative and the spot exchange rate is the base. In layman terms, 4erivatives are contracts for future delivery of assets at price agreed at the time of the contract. The uantity and uality of the asset is specified in the contract. The buyer of the asset pays for it at the time of delivery.

1.2 Need of Der !"# !e$ M"r%e# 4erivatives 'ere introduced to cover ris% that people used to face due to change in economic conditions and the fluctuations in prices of the underlying assets. !onsider a situation, 'here an Indian exporter is expecting to reali-e = 3+++ in six months time from no'. 6e had priced his product 'ith a profit of .s. )+++ based on the current mar%et price of dollar at .s :*. The actual money that 'ill be reali-ed by him in Indian rupees 'ill depend upon the exchange rate prevailing six months later. $ut this rate is not %no'n today. The exporter expects .s. :*+++ but may end up getting .s. ::+++ if the exchange rate is .s :: six months later, or if fortunate he may reali-e .s :>+++ if exchange rate goes to .s :>?=. If it happens to be .s :: then his profit 'ill stand reduced to half by .s 3+++. In such a situation, 4erivatives comes into picture. The exporter may negotiate and fix the price of dollar at .s :* 'ith the exchange, i.e., he 'ill sell the 4ollar to the exchange after > months at the rate fixed no' irrespective of 'hatever maybe the exchange rate in the future. /uch a contract is called a &or'"rd (o)#r"*#. /ince the price of the contract is determined, or in other 'ords, derived from the spot price, such a contract is classified as 4erivatives

1.3 Ho' "re Der !"# !e$ +$ef,-. Leveraged 0ositions Lo'er margins than the margin funding >

Index trading @ mar%et directional trading 6edging 1f 0ortfolio #llo's to ta%e position in any mar%et conditions, /,-- $01 /e"r $01 !o-"# -e or )e,#r"-

4erivatives Includes<7 3. # security derived from a debt instrument, share, loan 'hether secured or unsecured, ris% instrument or contract for differences or any other form of security. ). # contract 'hich derives its value from the prices, or index of prices, of underlying securities.

4erivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity7lin%ed derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post73AB+ period due to gro'ing instability in the financial mar%ets. 6o'ever, since their emergence, these products have become very popular and by 3AA+s, they accounted for about t'o7thirds of total transactions in derivative products. In recent years, the mar%et for financial derivatives has gro'n tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of e uity derivatives the 'orld over, futures and options on stoc% indices have gained more popularity than on individual stoc%s, especially among institutional investors, 'ho are maCor users of index7lin%ed derivatives. Even small investors find these useful due to high correlation of the popular indexes 'ith various portfolios and ease of use.

Der !"# !e$ I)$#r,2e)#$ The main types of derivatives include for'"rd$1 f,#,re$1 o3# o)$ ")d $'"3$. They can be combined 'ith one another, such as s'aptions or options on futures, and they can be combined 'ith B

securities to form ;hybrid( instruments or structured securities. Futures and options are traded on exchanges 'here a centrali-ed trading floor or platform allo's for everyone in the mar%et to trade on a multilateral basis. It is considered multilateral because everyone can see everyone else(s uotes and execution prices. 4erivatives exchanges are usually regulated and have a clearing house. In contrast to exchange trading, for'ards, s'aps and options are traded over7the7counter (1T!) in bilateral derivatives mar%ets 'here one or more dealers serve as mar%et ma%ers. These mar%ets do not have a central trading floor or platform, and they are often unregulated. 2.1 &or'"rd (o)#r"*#$ For'ard !ontracts are all pervasive. Dno'ingly or un%no'ingly 'e all enter into for'ard contracts. In most cases 'e all ac uire assets and pay the consideration for the same simultaneously. #ll transactions of cash are made on the spot. 6o'ever, in some cases 'e boo% a purchase in advance and execute the delivery and its consideration at a later point of time. $oo%ing a movie tic%et on phone is one such example. It is a for'ard contract because 'e buy the tic%et no' and pay its price only after reaching the hall. /imilarly, 'e boo% automobiles in advance and pay the price only on physical delivery. This too is li%e a for'ard contract. # typical for'ard contract that is normally 'ritten and extends for a considerable time is rent agreement for a house?flat 'here a fixed amount of rent is determined for a specific period of time, usually a year. /o no' even if the real estate price increases or decreases, the rent 'ill be fixed. The essence of the for'ard contract lies in the fixing of the price in advance, 'hile the asset and its consideration in uestion are settled at a later date. $esides unconscious agreements that seem li%e for'ard contracts , there are fe' examples of for'ard contracts that are consciously entered by firms and individuals in business situations. For example,

 #n exporter expecting to receive = 3++++ after six months may agree to sell the same at an exchange rate of .s :* per dollar decided today but delivers foreign exchange only after > months. In 2ovember, a farmer may agree to sell )+ tons of 'heat at .s )+ per %g to a mill to be delivered in next #pril. #n investor in stoc% mar%et may 'ant to sell 3++++ shares of Infosys today to be delivered t'o 'ee%s later at a price of .s )>++ per share that is negotiated today. 6ence the for'ard price of these assets, i.e. .s :* per dollar, .s )+ per %g of 'heat, and .s )>++ per share of Infosys, is fixed and derived on the basis of the price prevailing for these assets in the spot mar%ets of 4ollar, "heat or Infosys in the foreign exchange mar%et, commodity mar%et and stoc% mar%et respectively. Thus a for'"rd contract is an agreement to buy or sell at a future time a certain amount of an underlying asset at a specified price. 2.2 &e"#,re$ of &or'"rd (o)#r"*# T'o 4"r# e$ 5 Li%e any contract, a for'ard contract too involves minimum of t'o parties , a buyer and a seller of asset. The buyer of the contract is referred to have ta%en a Long position, 'hile the seller of the contract is referred to as having ta%en a short position. O!er #0e *o,)#er 4rod,*# 5 It is an over the counter product 'here all relevant aspects of contract, such as the asset, its uantity and uality, the price and delivery date are fixed on one @to7one basis. The buyer and seller are in direct touch 'ith each other. T0e 3r *e $ f 6ed #od"7 5 The price at 'hich the exchange of asset 'ill be done is decided in advance, and is called as the for'"rd 3r *e or de- !er7 3r *e. M,#,"- O/- 8"# o) #o 3erfor2 5 1n due date of the contract the seller ma%es the delivery of the asset and the buyer ma%es the full payment. There is a mutual obligation to complete the contract by both the buyer and the seller. (o,)#er3"r#7 r $% 5 The buyer and the seller of the contract assume ris%, referred as counterparty ris% on each other. The seller may fail to deliver the asset or the buyer may fail to ma%e the full payment on agreed date. There is a ris% of default by the other party. The party in the loosing situation is li%ely to ma%e a default. A

 No &ro)# e)d 4"72e)# 5 2o exchange of money is done at the time of entering the for'ard contract though either party can insist on initial deposits that 'ill be adCusted against delivery price to reduce counterparty ris%. 2.4 De#er2 )"# o)$ of for'"rd 3r *e$ Follo'ing assumptions are considered before calculation of for'ard prices. A$$,23# o)$9 3. There is no transactional cost. ). /ame tax rate for all the trading profits. 9. $orro'ing and lending of money at the ris% free interest rate. :. Traders are ready to ta%e advantages of arbitrage opportunities as and 'hen arise. 3.1 Me") )8 Futures are relatively ne'er instruments as compared to for'ards, and classified as derivatives. Future contract is a modified version of a for'ard contract but is fundamentally same as a for'ard contract, i.e. promising settlement on expiry having fixed the price today. 6o'ever, operationally there are substantial differences in the for'ard and futures contracts. 3.2 (o,)#er3"r#7 R $% Future contracts came into existence to overcome some of the problems that exist in the for'ard contract. In a for'ard contract there is a very strong inclination for at least one of the parties to default in fulfilling of its commitments to'ards the other party. For example, an exporter boo%s a six months for'ard contract to sell = 3++++ at .s :* per dollar. #s per the contract the exporter stands committed six months later, to deliver = 3++++ and receive a pre determined che ue of .s :,*+,+++. If at maturity, the dollar at spot gets appreciated to .s :B, then there is a strong probability of exporter bac%ing out. 1n the other hand, if dollar fell to .s :9 at maturity, then the buying party may hesitate to execute the contract at .s :* per dollar. 1ne 'ay of eliminating ris% is to involve a third party. The for'ard contract is executed on a one to one basis and the t'o parties assume the counterparty ris%. The issue of counterparty ris% can be resolved if the transaction is done on an exchange that serves as counterparty to both the buyer and the seller. .ather than conducting business on one to one basis they do the business on the exchange. $oth the buyer and seller becomes liable to the exchange 'hich in 3+

turn meets commitments to both. "ith the exchange serving as guarantor to both the buyer and the seller, the contracts are assured of performance. Thus this also eliminated the need for parties to %no' each other. 3.3 S#")d"rd :ed (o)#r"*#;4rod,*# 6o'ever, if the trades have to ta%e place on an exchange, the product cannot be tailor made to the specific needs of the t'o parties, and instead 'ould have to be standardi-ed. Exchange cannot commit itself to the uantity, uality and timing of the asset as per the specific re uirements of the individual buyers and sellers. If the exchange has to serve as counterparty it has to deal in standardi-ed products in terms of uality, uantity and timing of the assets it is dealing in. For example, an exporter selling =3+,)*: for'ard for delivery on )> 2ovember and another buying = 3+,E++ for'ard for delivery on )A 2ovember 'ill be difficult to comply 'ith by the exchange. Instead, it 'ill be easier for the exchange to deal in standard contract of say, = 3+,+++ for one particular date of delivery in the month of 2ovember. Therefore, individual buyers and sellers 'ould have to adCust 'ith their o'n re uirements and decide the best possible deal from the menu of standard products available in the exchange. 3.4 O3e) I)#ere$# ")d <o-,2e #n important parameter in the futures mar%et is the open interest. The number of contracts outstanding at any point of time is called open interest. #s a ne' contract is introduced, the investors start ta%ing a vie' on the mar%et of the underlying asset and ta%e an exposure on the futures contract. Fnder normal circumstances, initially open interest rises 'ith times as more and more investors start evincing interest in the ne' contract and either buy or sell a contract. $ut as the maturity approaches, the investors tend to reduce their exposure and un'ind the initial position. 6ence, open interest starts declining as maturity approaches. It signifies reduced investor interest in the contracts that have little to expire. The positions that are left exposed by the investors by the investors are compulsorily settled by the exchange assuming that no delivery is sought by the buyer. The positions are settled by exchanging the differences of closing price and the price of the initial contract. 1pen interest and volumes are often thought to be same. 6o'ever they are different. 8olume refers to the number of contracts traded in a day. !umulatively it 'ould al'ays increase. 1pen interest 'ould increase by the number of ne' contracts opened in the day. The contracts that are offsetting the initial position do not add up to the open interest but they do add up to the volume. 33

3.5 D ffere)*e /e#'ee) &or'"rd ")d &,#,re (o)#r"*#$ $esides the standardi-ation and as exchange traded products, the futures have t'o substantial differences from for'ard contracts from the vie'point of cash flo' as follo's< 3) Initial and variation margin )) ,ar%ing to ,ar%et 3= 6 I) # "- ")d <"r "# o) M"r8 ) Re>, re2e)#$ :) The exchange serves as counterparty to both buyers and sellers of futures contract. The exchange 'or%s to eliminate the counterparty ris%, and therefore it has to assure itself of the financial standing of the participating member. It further needs to curb the tendency of overtrading by the members. *) To assure itself of financial credibility of the participants and also to chec% the speculative tendencies, the exchange prescribes the margin to be deposited 'ith it. The margin is some percentage of the contract value depending upon the !o-"# - #7 in price of the underlying asset. #n initial margin is re uired to be deposited to open a position in the futures and is normally set e ual to the 2"6 2,2 -o$$ that the position can suffer in a day. This is also called as the <"-,e A# R $% or <AR. 6= 3.7 M"r% )8 #o M"r%e# B) Initial margin is intended to cover the potential loss in an open position. 6o'ever, the loss that is already incurred during the day has to be made good at the end of the day. It is the practice of exchanges to settle the difference of price on a daily basis. This daily settlement is referred to as mar%ing to mar%et. E) E6"23-e< If an investor o'ns 3+ shares of a stoc% purchased for .s :+ per share, and that stoc% no' trades at .s >+, the Gmar%7to7mar%etG value of the shares is e ual to (3+ shares H .s >+), or .s >++, 'hereas the boo% value might only be e ual to .s :++. A) /imilarly, if the stoc% falls to .s 9+, the mar%7to7mar%et value is .s 9++ and the investor has lost .s 3++ of the original investment. If the stoc% 'as purchased on margin, this might trigger a margin call and the investor 'ould have to come up 'ith an amount sufficient to meet the margin re uirements for his account. 3+) This is done by exchanges in order to safeguard itself against ris% of customer incurring loss more than its initial deposit 'hich they may default in paying. 3)

5.1 HED?IN? STRATE?IES +SIN? &+T+RES IN STO(@ MAR@ET ,any of the participants in the mar%et are hedgers. Their aim is to use futures mar%ets to reduce a particular ris% that they face. This ris% might relate to fluctuations in the price of oil, a foreign exchange rate, level of stoc%s or some other variable. There are various hedging strategies follo'ed by hedgers to minimi-e ris%. /aying that hedging completely removes ris% 'ill not be correct, because chances of a perfect hedge are rare. $ut there are various strategies that if follo'ed may minimi-e the ris%. Lo)8 Se*,r #71 S0or# N f#7 &,#,re$ In this case, first the hedger loo%s at the beta of the !ompany he is bullish on. The beta tells the amount of movement in that particular stoc% 'ith the movement of Index, 2ifty in our case. &or e6"23-e1 /uppose a hedger is bullish about Infosys 'hich is trading at .s )E++ in the mar%et. 2ifty in future is **++. The beta of that stoc% is 3.). It means that it 'ill move by 3) I if 2ifty moves by 3+ I. If he buys 3+++ shares of Infosys, he 'ill pay ()E++ J 3+++) K .s )E+++++. 2o' to hedge it, the hedger has to sell !ontracts of 2ifty 'orth .s )E+++++. 3 contract of 2ifty (having *+ uantities) is 'orth (**++ J *+) K .s. )B*+++ Therefore, 2o. of contracts K()E+++++?)B*+++) K 3+ contracts. $ut the beta is 3.), therefore the optimal no. of contracts 'ill be (3.) J 3+) K 3) contracts 2o', if the mar%et crashes by 3+ I, 0rice of Infosys 'ill be .s ):>:, 2ifty Futures 'ill be :A*+ 7 7 Loss in Infosys 'ill be (99> J 3+++) K .s 99>+++ #nd profit in short 2ifty 'ill be (**+ J*+ J 3)) K .s 99++++

Ne# Lo$$ of .s >+++ in a mar%et crash. 2o' if the mar%et rises by 3+ I, 0rice of Infosys 'ill be .s 939>, 2ifty Futures 'ill be >+*+ 7 0rofit in Infosys 'ill be (99> J3+++) K .s 99>+++ 39

Loss in short 2ifty 'ill be (**+ J*+ J3)) K .s 99++++

Ne# 4rof # of .s >+++ Thus even in strong crashes in the mar%et, by applying such a strategy, ris% and losses can be minimi-ed. 5.2 Lo)8 Se*,r #71 Se-- &,#,re$ The problem 'ith the above strategy is that 'e are hedging the security 'ith the index based on beta 'hich is calculated from record data. $ut it may not necessarily follo' in future also. /o another strategy is to hedge the security against the futures of the security. &or e6"23-e1 /uppose a trader buys 3+++ shares of Fnitech at .s E+, but unexpectedly it goes do'n, so the trader 'ill immediately short Fnitech Futures !ontract 'hich is trading at .s BA in the mar%et. Investment in Fnitech K E+ J 3+++ K .s E++++ /ell 3 !ontract of 3+++ uantity of Fnitech Futures 'hich 'ill be e ual to .s BA+++ 2o', if Fnitech falls to .s B+, since Futures price converges to spot on expiry it 'ill be e ual to .s B+. Therefore , 7 7 Loss in Fnitech K 3+ J 3+++ K .s 3++++ 0rofit in short Fnitech Futures K A J3+++ K .s A+++

Ne# Lo$$ of only .s 3+++

5.3 S4E(+LATION IN &+T+RES 6itherto 'e loo%ed at the controlling features of the stoc% index futures. It 'ill not be 'rong to say that derivatives mar%ets 'ere designed for the purpose of hedging against the ris%. Ironically the same derivative mar%ets can serve the opposite purpose and may be used to create or magnify ris%. The ris% is increased 'hen a participant in the mar%et does not have any position in the underlying cash or physical asset. The ris% due to absence of position in the physical mar%et is compounded by the fact 3:

that a no financial outlay is re uired in the derivatives mar%et. # position in futures re uires only deposit of initial margin 'ith the exchange. Futures provide opportunity to ta%e a vie' on the mar%et. It is a leveraging mechanism that enables increased returns. #s a simple strategy of benefitting from the expected move in the mar%et one can buy or sell futures, rather than ta%e a position in the cash mar%et involving a large cash outlay. The leveraging strategies are If mar%ets are expected to go up @ buy futures no' and sell later If mar%ets are expected to go do'n @ sell futures no' and buy later

If the margin re uirement is 3+ I the investor can ta%e position 3+ times larger than the position in the cash mar%et. #ccordingly the results, positive or negative are 3+ times larger. &or e6"23-e1 #n investor has .s 3+ la%hs, one alternative is to have a diversified portfolio and if the mar%et goes up by 3+I, then he 'ill ma%e a profit of .s 3 la%h. The second alternative is to buy 2ifty Futures contract 'orth .s 3+ la%h. /uppose 2ifty in futures is **++. 1ne contract is of *+. Initial margin is 3+ I. ,ar%et 8alue of 3 contract of 2ifty 'ill be **++ J *+ K.s )B*+++ ,argin re uired K 3+ I of ,ar%et 8alue K .s )B*++ 2o. of contracts that can be bought K 3++++++?)B*++ K 9> contracts If the mar%et goes up by 3+ I, Ne# 4rof # 'ill be, 9> J**+ J*+ K .s AA++++ If the mar%et goes do'n by * I, Ne# Lo$$ 'ill be, 9> J )B* J*+ K .s :A*+++ 6ence 'ith futures the gains as 'ell as losses both are magnified as compared to the position in cash. Futures are also used by speculators in the falling mar%et. They speculate by selling the futures contract 'hen they expect the mar%et to be bearish. Even though it is a ris%y game, speculators are not restricted because they bring li uidity to the system, provide insurance to the hedgers and facilitate the price discovery in the mar%et. 3*

5.4 Ar/ #r"8 )8 I) &,#,re$ #rbitrage is the concept of simultaneous buying of securities in one mar%et 'here the price is lo' and selling in another mar%et 'here the price is higher. #rbitrageurs thrive on mar%et imperfections. #rbitrageur is intelligent and %no'ledgeable person and ready to ta%e the ris% 6e is basically ris% averse. 6e enters into those contracts 'ere he can earn ris% less profits. "hen mar%ets are imperfect, buying in one mar%et and simultaneously selling in other mar%et gives ris% less profit. #rbitrageurs are al'ays in the loo% out for such imperfections. There are various strategies used by #rbitrageurs in Futures mar%et

A,7 S3o#1 Se-- &,#,re$ In this the investor observing that futures have been overpriced, ta%es full use of the opportunity and ta%e an arbitrage position. /ay for instance #!! K 3+++ and one month expiry #!! futures K 3+)*. This sho's that futures have been overpriced and therefore as an #rbitrageur, investor can ma%e ris% less profits entering into the follo'ing set of transactions. 1n day one, borro' funds, buy security on the spot mar%et at 3+++ /imultaneously, sell the futures on the security at3+)* This .s )* is the fixed profit for the #rbitrageur Ta%e delivery of the security purchased and hold the security for a month 1n the expiry date of the futures contract, the spot and futures price converge . 2o' un'ind the position /ay the security closes at .s.3+3*. /ell the security Futures position expires 'ith the profit of .s.3+ The result is a ris% less profit of .s.3* on the spot position and .s.3+ on the futures position The profit of .s )* is the difference in the price of spot and futures of the underlying asset .eturn the $orro' funds.

Finally, if the cost of borro'ing funds to buy the security is less than the arbitrage profit possible, only then it ma%es sense for the investor to enter into the arbitrage. This is termed as cash @ and7 carry 3>

arbitrage. A,7 &,#,re$1 Se-- S3o# This is the opportunity used by #rbitrageurs 'hen the Futures price is available at a discount as compared to /pot 0rice. /ay for instance #!! K 3+++ and 1ne month #!! futures K A>*. This sho's that futures have been under priced and therefore as an #rbitrageur, investor can ma%e ris% less profits entering into the follo'ing set of transactions. 1n day one, sell the security on the spot mar%et at 3+++ /imultaneously, buy the futures on the security at A>* 1n the futures expiration date, the spot and futures price converge . 2o' un'ind the position /ay the security closes at .s.AB*. /ell the security Futures position expires 'ith the profit f .s.3+ The result is a ris% less profit of .s.)* on the spot position and .s.3+ on the futures position The #rbitrage profit i.e. .s 9* is the difference bet'een the futures price and spot price of the underlying asset 'hich remains fixed Finally if the returns one get investing in ris% less instruments is less than the returns from the arbitrage then it ma%es sense for the investor to ta%e an arbitrage position. This is termed as reverse cash @and7 carry arbitrage. 6.1 Me") )8 It is an interesting tool for small retail investors. #n option is a contract, 'hich gives the buyer (holder) the right, but not the obligation, to buy or sell specified uantity of the underlying assets, at a specific (stri%e) price on or before a specified time (expiration date). The underlying may be physical commodities li%e 'heat? rice? cotton? gold? oil or financial instruments li%e e uity stoc%s? stoc% index? bonds etc. 6.2 DI&&EREN(E AETBEEN &ORBARD1 &+T+RE AND O4TION SrNO &EAT+RES &ORBARDS &+T+RES 3B O4TIONS

S#")d"rd :"# o) No

Ye$

Ye$

4r *e )e8o# "# o)

Ae#'ee) /,7er ")d M"r%e# $e--er de#er2 )ed

O3# o) 3re2 ,2 de#er2 )ed

L >, d #7

No

Ye$

Ye$

M"r8 )$

No

Ye$

Ye$

?,"r")#or

No

Ye$

Ye$

6.3 TY4ES O& O4TIONS A"$ed o) #0e )"#,re of e6er* $e of o3# o)$

European 1ptions< 7 It is an option that can be excercised only at the time of expiry #merican 1ptions< 7 It is an option that can be excercised anytime during its lifetime, before or after the expiry. In India 'e have #merican 1ptions traded that can be excercised anytime A"$ed o) 0o' #0e7 "re 8e)er"#ed1 #r"ded ")d $e##-ed

1T! (1ver the !ounter)<7 1ptions li%e for'ard contracts 'hich are specific and negotiated by t'o contracting parties mutually 'ith direct negotiations are 1T! options Exchange Traded <7 1ptions li%e futures contract 'hich are bought and sold on the specific exchanges 3E

'here the t'o contracting parties may not be %no'n to each other are Exchange Traded options 6.4 MONEYNESS O& O4TIONS I)-#0e-2o)e7 o3# o)9

#n in7the7money (IT,) option is an option that 'ould lead to a positive cash flo' to the holder if it 'ere exercised immediately. # call option on the index is said to be in7the7money 'hen the current index stands at a level higher than the stri%e price (i.e. spot price L stri%e price). If the index is much higher than the stri%e price, the call is said to be deep IT,. In the case of a put, the put is IT, if the index is belo' the stri%e price. A#-#0e-2o)e7 o3# o)9

#n at7the7money (#T,) option is an option that 'ould lead to -ero cash flo' if it 'ere exercised immediately. #n option on the index is at7the7money 'hen the current index e uals the stri%e price (i.e. spot price K stri%e price). O,#-of-#0e-2o)e7 o3# o)9

#n out7of7the7money (1T,) option is an option that 'ould lead to a negative cash flo' if it 'ere exercised immediately. # call option on the index is out7of7the7money 'hen the current index stands at a level 'hich is less than the stri%e price (i.e. spot price M stri%e price). If the index is much lo'er than the stri%e price, the call is said to be deep 1T,. In the case of a put, the put is 1T, if the index is above the stri%e price.

6.5 (ALL O4TION # call option gives the holder (buyer? one 'ho is long call), the right and not obligation to buy specified uantity of the underlying asset at the stri%e price on or before expiration date. The seller (one 'ho is short call) ho'ever, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To ac uire this right the buyer pays a premium to the 'riter (seller) of the contract. ILLF/T.#TI12 3A

/uppose in this option there are t'o parties one is call buyer 'ho is bullish in the mar%et and other is call seller 'ho is bearish in the mar%et. The current mar%et price of .ELI#2!E !1,0#2N is .s.>++ and premium is .s.)* (ALL A+YER 6ere the buyer has purchase the call option 'ith a stri%e price of .s.>++.The option 'ill be exercised once the price 'ent above >++. The premium paid by the buyer is .s.)*.The buyer 'ill earn profit once the share price crosses .s.>)*(stri%e price O premium). /uppose the stoc% has crossed .s.>>+ ,the option 'ill be exercised i.e. the buyer 'ill purchase the .ELI#2!E scrip from the seller at .s.>++ and sell in the mar%et at .s.>>+. Fnlimited profit for the buyer K .s.9*P(spot price @ stri%e price) @ premiumQ Limited loss for the buyer 'hich is up to the premium paid. (ALL SELLER For selling the option, the 'riter of the option charges a premium. In this case the 'riter? seller of the call charge a premium of .s )*. If upon expiration, the spot price exceeds the stri%e price, the buyer 'ill exercise the option on the 'riter. 6ence as the spot price increases and goes to >)+, the 'riter of the option starts ma%ing losses. 6igher the spot price, more is the loss he ma%es. If upon expiration the spot price of the underlying is less than the stri%e price i.e. *E, the buyer lets his option expire un7exercised and the 'riter gets to %eep the premium of .s )*.

)+

Thus 'e can say profit for the seller?'riter is limited up to the premium 6o'ever Losses for the seller is unlimited and 'ill increase as much as the spot price increases 6.6 4+T O4TIONS # 0ut option gives the holder the right to sell specified uantity of the underlying asset at the stri%e price on or before a expiry date. The seller of the put option ho'ever, has the obligation to buy the underlying asset at the stri%e price if the buyer decides to exercise his option to sell. ILLF/T.#TI12 /uppose in this option there are t'o parties one is put buyer 'ho is bearish in the mar%et and other is put seller 'ho is bullish in the mar%et. The current mar%et price of T"#" Mo#or$ is .s.3+++ and premium is .s.)+ 4+T A+YER The profit?loss that the put buyer ma%es on the option depends on the spot price of the underlying. If upon expiration, the spot price is belo' the stri%e price, then only the put buyer 'ill exercise the option. If the spot price of the underlying is higher than the stri%e price, he lets his option expire un7 exercised. 6is loss in this case is the premium he paid for buying the option.

)3

In this case the buyer 'ill exercise the option only if the spot price of Tata ,otors goes belo' AE+ (/tri%e 0rice @ 0remium 0aid) as this is the brea%even level for him since he has paid .s )+ as premium. $ut if the spot price goes above 3+++, up to 3+9+ or 3+:+ then the buyer 'ill not exercise the option since he has the right to sell and not the obligation. Thus, the 0ut buyer has limited losses up to the premium paid. $ut he can have unlimited profit depending on the movement of the /pot 0rice 4+T SELLER9 The 'riter of the put option is called the 0ut /eller. For selling the option, the 'riter of the option charges a premium. "hatever is the buyerRs profit is the sellerRs loss. If upon expiration, the spot price happens to be belo' the stri%e price, the buyer 'ill exercise the option on the 'riter. If upon expiration the spot price of the underlying is more than the stri%e price, the buyer lets his option unexercised and the 'riter? seller gets to %eep the premium /uppose the seller has sold a put of stri%e price 3+++ for a premium of .s )+, if the spot price goes belo' it, then only the put buyer 'ill exercise the option, if the spot price goes above 3+++ then the buyer 'ill not exercise the option and the seller 'ill get to %eep the premium of .s )+ Thus, there are limited profit and unlimited losses for the seller of the put since he has the obligation to sell the asset if the buyer agrees to exercise the contract. The above graph explains the concept, if price goes belo' 3+++, unlimited losses for the seller starts increasing and if it goes above 3+++ then the seller 'ill get a limited profit of .s. )+

))

)9