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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 committees 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 investors rights and regulating the capital market.

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 Derivatives
Derivatives 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.

arket importance. 3

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.

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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--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 todays 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. Longerdated 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 currencies on foreign markets.

Futures(Currencies, Stocks, Indexes, Commodities etc)

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 6

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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 NSEs 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 investors 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
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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.
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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 days settlement price as the
case may be and the current days 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
Where
F = 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 days 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

brokers 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-themoney 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 didnt 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 wellknown 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
cant 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 investors risk preferences.

The model
C = SN (d1) Ke {-rt} N (d2)
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C= Theoretical call premium

S= current stock price
t= time until option expiration
K= option striking price

r= risk-free interest rate

N = Cumulative standard normal
distribution D1 = in(S / K) + (r + s/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 options 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 investors
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, subbrokers 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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Members 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.

NSES 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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