INDEX

Sr Page Topic Remarks Sign

no no
1.0 1 8 Introduction to
derivative market
1.1 4 4 Derivative chart
1.2 5 8 Forward/future contracts
2.0 9 30 Introduction to options
2.1 10 18 Call option.
2.1. 17 18 Graphs.
1 18 18 Exercising the call option
2.1. and what are the
2 implications on the buyer
and seller.

2.2 19 21 Put option

2.2. 21 21 graph
1
2.3 22 23 Market player
2.4 24 24 Option undertaking
2.5 24 25 Option classification
2.6 26 30 Option pricing
2.6. Effect of increase in the
1 27 28 relevant parameter of option
price.
2.6. 29 29
2 Time to expiration
29 29
2.6. volatility
29 29
3
risk free rate of interest
30 30
2.6.
dividends
4
2.6.
5

3.0 31 32 History of derivatives

3.1 31 32 Important aspects in the
history of derivative market
4.0 33 39 International derivatives
4.1 33 34 Major equity derivative
exchanges in the world
4.2 35 35 Other financial derivative
exchange in the world
4.3 36 39 Popular stock index future in
the world
5.0 40 46 Benefits of derivatives

6.0 47 58 Introduction of futures in

india
6.1 47 47 What are index futures
6.2 48 49 Frequently used terms in
the index futures
6.3 49 49 Concept of basis in the
futures market
6.4 50 51 Pricing futures
6.5 51 55 Index future cost and
futures model.
6.6 55 56 Risk management through
futures
6.6. 55 55
1 Some specific use of index
56 56
futures
6.6.
2 Speculation in the futures
market
6.7 56 58 Margining in the futures
market
7.0 59 62 Derivative markets today
7.1 60 60 Operators in the derivative
market
7.2 60 62 Equity derivative exchange
in the world
8.0 63 71 Introduction to indexes
8.1 63 63 What’s an index
8.2 63 63 What’s an stock index
8.3 64 64 Why do we do need an
index
8.4 64 64 What does the number
mean
8.5 65 65 How are the stocks in the
portfolio weighted?
8.6 65 65 What is better weighing
option
8.7 66 66 Who owns the index? Who
computes it ?
8.8 66 66 Who decides what stocks to
include? How?
8.9 67 67 Selection criteria
8.1 68 68 What is benchmark index
0
8.1 68 68 What are the popular
1 indexes in india?
8.1 69 69 What are sectoral indexes
2
8.1 69 71 What are the uses of index
3 in india?
9.0 7 76 Financial risk
2 management
9.1 76 72 Four steps in risk
management
 DERIVATIVE MARKET IN INDIA
Warren Buffett - (Chairman & CEO of Hathaway,
Investor)

- It takes 20 years to build a reputation and five minutes to

ruin it. If you think about that, you'll do things differently.
- Rule No.1: Never lose money. Rule No.2: Never forget rule
No.1.
- Derivatives are financial weapons of mass destruction.

[1] INTRODUCTION TO DERIVATIVE

MARKET
A Derivative is a financial instrument whose value
depends on other, more basic, underlying
variables. The variables underlying could be prices
of traded securities and stock, prices of gold or
copper. Derivatives have become increasingly
important in the field of finance,

Broadly Derivatives markets can be classified into

two categories, those that are traded on the
exchange and those traded one to one or ‘over the
counter’. They are hence known as;
1

Exchange Traded Derivatives

Exchange-traded derivative contracts are
standardized derivative contracts (e.g. futures
contracts and options) that are transacted on an
organized futures exchange. Their traded on an
organized stock exchange.

OTC Derivatives (Over The Counter)

Derivatives not traded on a futures exchange are
traded on over-the-counter markets, also known as
the OTC market. These consist of investment
banks who have traders who make markets in
these derivatives, and clients such as hedge
funds, commercial banks, government sponsored
enterprises, etc.

Derivative is a product/contract which does not

have any value on its own i.e. it derives its value
from some underlying. The underlying asset can be
equity, forex,Commodity or any other asset.
2
For example, wheat farmers may wish to sell their
harvest at a future date to eliminate the risk of a
change in prices by that date.
The price of this derivative is driven by the spot
price of wheat which is the “underlying”.
Derivative products initially emerged as hedging
devices against fluctuations in commodity prices ,
and commodity linked derivatives remained the
sole form of such products for almost three
hundred years. Derivatives are securities under the
SC®A and hence the trading of derivatives is
governed by the regulatory framework under the
SC(R)A.
In the Indian context the securities contracts
(regulation) Act, 1956 (SC(R)A) defines “derivative”
to include:
1. A security derived from a debt instrument,
share, loan whether secured or unsecured,
risk instrument or contract for differences or
any other form of security.

2. A contract which derives its value from

the prices, or index of prices, of underlying
securities.
3

[1.1] Derivative chart

 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The

Counter Derivatives

National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange

Index Future Index option Stock option Stock future

TYPES OF DERIVATIVES

Derivative
s

Future Option Forward Swaps

[1.2 ] Forward / Future Contracts

Features Forward Future Contract
Contract

Operational Not traded on Traded on

Mechanism exchange exchange
Contract Differs from Contracts are
Specification trade to trade. standardized
s contracts.

Counterpart Exists Exists, but

y Risk assumed by
Clearing
Corporation/ house.
Liquidation Poor Liquidity as Very high Liquidity
Profile contracts are as contracts are
tailor maid standardized
contracts. contracts.

Price Poor; as Better; as

Discovery markets are fragmented
fragmented. markets are
brought to the
common platform.
 5

Forward contracts

A forward contract is an agreement to buy

or sell an asset on a specified date for a
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,
price and quantity are negotiated bilaterally by
the parties to the contract. The forward
contracts are no rmal ly traded outside the
exchanges.

The salient features of forward contracts

are:
 They are 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 to the same counter-
party, which often results in high prices being
charged.
Future contracts

In finance, a futures contract is a

standardized contract, traded on a futures
exchange, to buy or sell a certain underlying
instrument at a certain date in the future, at
a pre-set price. A futures contract gives the
holder the right and the obligation to buy or
sell, which differs from an options contract, which
gives the buyer the right, but not the obligation,
and the option writer (seller) the obligation, but not
the right. .

Futures contracts are exchange traded derivatives.

The exchange acts as counterparty on all
contracts, sets margin requirements, etc.
  Future contracts are organized/ standardized
contracts, which are traded on the exchanges.

 These contracts, being standardized and

traded on the exchanges are very liquid in
nature.

 In futures market, clearing corporation/ house

provides the settlement guarantee.

8
Donald trump - (Chairman and CEO of the Organization, a US-based real-estate
developer.)
- Every time you walk down the street people are screaming,
'You're fired!'
- I try to learn from the past, but I plan for the future by focusing
exclusively on the present. That's were the fun is.
- As long as your going to be thinking anyway, think big.

[2.0] Introduction to Options

Options are instruments whereby the right is

given by the option seller to the option buyer
to buy or sell a specific asset at a specific
price on or before a specific date. Options: Is it
just Another Derivative.

Options on stocks were first traded on an organized

stock exchange in 1973. Since then there has been
extensive work on
 9
these instruments and manifold growth in the field
has taken
the world markets by storm. This financial
innovation is present in cases of stocks, stock
indices, foreign currencies, debt instruments,
commodities, and futures contracts.

There are two types of options i.e., CALL OPTION

AND PUT OPTION.

[2.1] CALL OPTION:

A contract that gives its owner the right but

not the obligation to buy an underlying
asset-stock or any financial asset, at a
specified price on or before a specified date
is known as a ‘Call option’. The owner makes a
profit provided he sells at a higher current price
and buys at a lower future price.

10

The following example would clarify the basics on

Call Options.

Illustration :

An investor buys one European Call option on one

share of Reliance Petroleum at a premium of Rs. 2
per share on 31 July . The strike price is Rs.60 and
the contract matures on 30 September . The
payoffs for the investor on the basis of fluctuating
spot prices at any time are shown by the payoff
table (Table 1). It may be clear form the graph that
even in the worst case scenario, the investor would
only lose a maximum of Rs.2 per share which
he/she had paid for the premium. The upside to it
has an unlimited profits opportunity.
On the other hand the seller of the call option has a
payoff chart completely reverse of the call options
 buyer. The maximum loss that he can have is
unlimited though a profit of Rs.2 per share would
be made on the premium payment by the buyer.

11

Payoff from Call Buying/Long (Rs.)

Net
S Xt c Payoff
Profit
57 60 2 0 -2
58 60 2 0 -2
59 60 2 0 -2
60 60 2 0 -2
61 60 2 1 -1
62 60 2 2 0
63 60 2 3 1
64 60 2 4 2
65 60 2 5 3
66 60 2 6 4

A European call option gives the following

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

Notes:
S - Stock Price
Xt - Exercise Price at time 't'
C - European Call Option Premium
Payoff - Max (S - Xt, O )

15
[ 2.1.1 ] Graphs
[2.1.2] Exercising the Call Option
and what are its implications for the
Buyer and the Seller?

The Call option gives the buyer a right to buy

the requisite shares on a specific date at a
specific price. This puts the seller under the
obligation to sell the shares on that specific
date and specific price. The Call Buyer
exercises his option only when he/ she feels it
is profitable. This Process is called "Exercising
the Option".

17
This leads us to the fact that if the spot price
is lower than the strike price then it might be
profitable for the investor to buy the share in
the open market and forgo the premium
paid.
The implications for a buyer are that it is
his/her decision whether to exercise the
option or not. In case the investor expects
prices to rise far above the strike price in the
future then he/she would surely be interested
in
buying call options.

On the other hand, if the seller feels that his

shares
are not giving the desired returns and they
are not going to perform any better in the
future, a premium can be charged and
returns from selling the call option can be
used to make up for the desired returns. At
the end of the options contract there is an
exchange of the underlying asset. In the real
world, most of the deals are closed with
another counter or reverse deal. There is no
requirement to exchange the underlying
assets then as the investor gets out of the
contract just before its expiry.

18

[2.2] PUT OPTION:

A contract that gives its owner the right but not the
obligation to sell an underlying asset-stock or any
financial asset, at a specified price on or before a
specified date is known as a ‘Put option’. The
owner makes a profit provided he buys at a lower
current price and sells at a higher future price.

Hence, no option will be exercised if the future

price does not increase. Put and calls are almost
always written on equities, although occasionally
preference shares, bonds and warrants become the
subject of options.
The following example would clarify the basics on
put option.

Illustration 2:
An investor buys one European Put Option on one
share of Reliance Petroleum at a premium of Rs. 2
per share on 31 July. The strike price is Rs.60 and
the contract matures on 30 September. The payoff
table shows the fluctuations of net profit with a
change in the spot price.

19
The payoff for the put buyer is :max (Xt - S,
0)
The payoff for a put writer is : -max(Xt - S, 0)
or min(S - Xt, 0)

Payoff from Put Buying/Long (Rs.)

S Xt p Payoff Net Profit
55 60 2 5 3
56 60 2 4 2
57 60 2 3 1
58 60 2 2 0
59 60 2 1 -1
60 60 2 0 -2
61 60 2 0 -2
62 60 2 0 -2
63 60 2 0 -2
64 60 2 0 -2

20

[2.2.1] Graph
These are the two basic options that form
the whole gamut of transactions in the
options trading. These in combination with
other derivatives creat a whole world of
instruments to choose form depending on
the kind of requirement and the kind of
market expectations.

21
[2.3] Market players
;

Hedgers
:

The objective of these kind of traders is to

reduce the risk. They are not in the
derivatives market to make profits. They are
in it to safeguard their existing positions.
Apart from equity markets, hedging is
common in the foreign exchange markets
where fluctuations in the exchange rate
have to be taken care of in the foreign
currency transactions or could be in the
commodities market where spiraling oil
prices have to be tamed using the security
in derivative instruments.

Speculators
.
They are traders with a view and objective
of making profits. They are willing to take
risks and they bet upon whether the
markets would go up or come down.

22

Arbitrageurs
:

Riskless Profit Making is the prime goal of

Arbitrageurs. Buying in one market and
selling in another, buying two products in
the same market are common. They could
be making money even without putting
there own money in and such opportunities
often come up in the market but last for
very short timeframes. This is because as
soon as the situation arises arbitrageurs
take advantage and demand-supply forces
drive the markets back to normal.

23

[2.4] Options undertakings

Stocks

Foreign Currencies

Stock Indices
Commodities
Others - Futures Options, are options on the
futures contracts or underlying assets are
futures contracts. The futures contract
generally matures shortly after the options
expiration
[ 2.5 ] Options Classifications

Options are often classified as ;

In the money - These result in a positive

cash flow towards the investor.

At the money - These result in a zero-cash

flow to the investor.
Out of money - These result in a negative
cash flow for the investor.

24

Example:
Calls
Reliance 350 Stock Series

Other uncommon options include ;

Naked Options: These are options which

 are not combined with an offsetting contract
to cover the existing positions.

Covered Options: These are option

contracts in which the shares are already
owned by an investor (in case of covered
call options) and in case the option is
exercised then the offsetting of the deal can
be done by selling these shares held.

25

[2.6] OPTIONS PRICING ;

Unlike futures which derives there prices

primarily from prices of the undertaking.
Option's prices are far more complex. The table
below helps understand the affect of each of
these factors and gives a broad picture of option
pricing keeping all other factors constant. The
table presents the case of European as well
as American Options. Changes in the
underlying security price can increase or
decrease the value of an option. These price
changes have opposite effects on calls and
puts. For instance, as the value of the underlying
security rises, a call will generally increase and
the value of a put will generally decrease in
price. A decrease in the underlying security's
value will generally have the opposite effect.
 26
[2.6.1] EFFECT OF INCREASE IN THE
RELEVANT PARAMETRE ON OPTION PRICES

EUROPEAN AMERICAN
OPTIONS OPTIONS
Buying Buying
PARAMETERS CALL PUT CALL PUT
Spot Price (S)
Strike Price
(Xt)
Time to ? ?
Expiration (T)
Volatility ()
Risk Free
Interest Rates
(r)
Dividends (D)

Favourab
le
Unfavour
able

27

SPOT PRICES:
In case of a call option the payoff for the buyer
is max(S - Xt, 0) therefore, more the Spot Price
more is the payoff and it is favorable for the
buyer. It is the other way round for the seller,
more the Spot Price higher are the chances of
his going into a loss.
In case of a put Option, the payoff for the buyer
is max(Xt - S, 0) therefore, more the Spot Price
more are the chances of going into a loss. It is
the reverse for Put Writing.

STRIKEPRICE
:
In case of a call option the payoff for the buyer is
shown above. As per this relationship a higher
strike price would reduce the profits for the
holder of the call option.

28

[2.6.2] TIME TO EXPIRATION

:
More the time to Expiration more favorable is the
option. This can only exist in case of American
option as in case of European Options the
Options Contract matures only on the Date of
Maturity.

[2.6.3]VOLATILITY
:
More the volatility, higher is the probability of
the option generating higher returns to the
buyer. The downside in both the cases of call
and put is fixed but the gains can be unlimited. If
the price falls heavily in case of a call buyer then
the maximum that he loses is the premium paid
and nothing more than that. More so he/ she can
buy the same shares form the spot market at a
lower price. Similar is the case of the put option
buyer.

[2.6.4] RISK FREE RATE OF INTEREST

:
In reality the r and the stock market is inversely
related. But theoretically speaking, when all
other variables are fixed and interest rate
increases this leads to a double effect: Increase
in expected growth rate of stock prices
Discounting factor increases making the price
fall.

29
In case of the put option both these factors
increase and lead to a decline in the put value. A
higher expected growth leads to a higher price
taking the buyer to the position of loss in the
payoff chart. The discounting factor
increases and the future value becomes
lesser.

In case of a call option these effects work in the

opposite direction. The first effect is positive as
at a higher value in the future the call option
would be exercised and would give a profit. The
second affect is negative as is that of
discounting. The first effect is far more dominant
than the second one, and the overall effect is
favorable on the call option.

[2.6.5] DIVIDENDS
:
When dividends are announced then the stock
prices on ex-dividend are reduced. This is
favorable for the put option and unfavorable for
the call option.
 30

Late Mr. Benjamin Graham - (American economist and

professional investor)

- If you are shopping for common stocks, choose them the way
you would buy groceries, not the way you would buy perfume.
- Individuals who cannot master their emotions are ill-suited to
profit from the investment process.
- The investor's chief problem - and even his worst enemy - is
likely to be himself.

[3.0] HISTORY OF DERIVATIVES:

The history of derivatives is quite colorful and surprisingly

a lot longer than most people think. Forward delivery
contracts, stating what is to be delivered for a fixed price
at a specified place on a specified date, existed in ancient
Greece and Rome. Roman emperors entered forward
contracts to provide the masses with their supply of
Egyptian grain. These contracts were also undertaken
between farmers and merchants to eliminate risk arising
out of uncertain future prices of grains. Thus, forward
contracts have existed for centuries for hedging price
risk.

31
[3.1] The important aspects in the history of
derivative market

The first organized commodity exchange came into existence

in the early 1700’s in Japan.

The first formal commodities exchange, the Chicago Board of

Trade (CBOT), was formed in 1848 in the US to deal with
the problem of ‘credit risk’ and to provide centralized
location to negotiate forward contracts.

On April 26, 1973, the Chicago Board options Exchange (CBOE)

was set up at CBOT for the purpose of trading stock
options. It was in 1973 again that black, Merton, and
Scholes invented the famous Black-Scholes Option
 Formula. This model helped in assessing the fair price of
an option which led to an increased interest in trading of
options.

The collapse of the Bretton Woods regime of fixed parties and

the introduction of floating rates for currencies in the
international financial markets paved the way for
development of a number of financial derivatives which
served as effective risk management tools to cope with
market uncertainties.

The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the Nasdaq 100, and the Nikkei 225.

(The market in late seventeenth-century London)

32
Richard Branson - (British industrialist, best known for his Virgin brand of over 360
companies.)
- Business opportunities are like buses, there's always another
one coming.
- The balloons only have one life and the only way of finding out
whether they
work is to attempt to fly around the world.
- And obviously, from our own personal point of view, the
principal challenge is a
personal challenge.

[4.0] INTERNATIONAL DERIVATIVES

Many exchanges in the world now offer futures contracts.

Eurex, the German-Swiss derivatives exchange, was the
world’s biggest financial futures exchange at the end of
1999, overtaking the Chicago Board of Trade for the first
time after a huge increase in contracts traded in 1999.
Eurex traded more than 379 million contracts during
1999, 53% more than in 1998.

[4.1] Major Equity Derivative Exchanges in the

World

Chicago Mercantile Exchange (CME)

Futures and Options on currencies, interest rates, stock
indexes and agricultural commodities are traded on CME.

33
The International Monetary Market (IMM) was formed in
1972 and became a division of IMM in 1976. It began
trading 7 foreign currencies in 1972, which were the first
financial futures contracts ever to be traded.
Eurex
Eurex is owned jointly by Deutsche Borse AG and The
Swiss Exchange, each of which hold 50% stake in the
company. It was formed by merger of German Deutsche
Terminborse (DTB) and Switzerland’s SOFFEX. It has a
fully electronic trading platform.

Hongkong Futures Exchange

The Exchange operates futures and options markets on a
broad range of products including equity index, stock,
interest rate and foreign exchange products. These
products are traded either on the Exchange's trading
floor via open outcry or electronically on its Hong Kong
Futures

The London International Financial Futures and

Options Exchange (LIFFE)
LIFFE offers the most extensive range of derivative
products of any exchange in the world – providing futures
and options contracts across six different currencies and
across four product lines – bonds, short term interest
rates, equity indices & individual stocks and commodities.
The London Clearing House (LCH) acts as central
counterparty to all transactions on LIFFE, and offers the
world’s most diverse range of margin offsets.

Singapore Exchange
Singapore exchange is the first demutualised integrated
securities and derivatives exchange in Asia Pacific.
Inaugurated on 1st December 1999, It operates through
several subsidiaries
 34
[4.2] Other Financial Derivative Exchanges in the
World

American Stock Exchange AEX-Options Exchange (Netherlands)

MATIF (France) MONEP (France)

Warsaw Stock Exchange (Poland) Belgian Futures & Options Exchange

Chicago Board Options Exchange
Budapest Stock Exchange
Commodities and Futures Exchange (Brazil)
Chicago Board of Trade
Commodity and Monetary Exchange of Malaysia
Helsinki Exchange
Hong Kong Futures Exchange
Copenhagen Stock Exchange
Italian Derivatives Market (IDEM)
MICEX (Russia)
MICEX (Russia)
Montreal Exchange
Kansas City Board of Trade (USA)
New York Board of Trade
Korea Stock Exchange
New York Mercantile Exchange
New Zealand Futures & Options Exchange Ltd.
OM London Exchange
Oporto Derivatives Exchange (Portugal)

Oslo Stock Exchange (Norway) Osaka Securities Exchange (Japan)

Pacific Exchange (USA) South African Futures Exchange

Philadelphia Stock Exchange Spanish Financial Futures Market

Rio de Janeiro Stock Exchange Spanish Options Exchange

Taiwan International Mercantile Exchange Swedish Futures & Options Market

Sao Paulo Stock Exchange
Santiago Stock Exchange
Toronto Futures Exchange
Tokyo Stock Exchange
 35
[4.3]Popular Stock Index Futures in the World

NYSE Composite :
The NYSE composite was amongst the first stock index
futures contract to be listed on May 6, 1982 at the New
York Futures Exchange (NYFE) a subsidiary of NYSE. It is
broadest of the broad stock indexes available
representing every common stock traded on the NYSE. It
also has three choices in terms of its contract size
depending on the multiplier that best suits an investor.
The regular contract launched on May 6, 1982 has a
multiplier of $500 times the index. The NYSE Large
Composite Index Contract has multiplier at $ 1000 while
the NYSE small Composite Index uses a $ 250
multiplier.NYSE large contract was aimed at institutional
users who could reduce their commission costs.

S&P 500

It is a market-cap index representing 500 leading

companies in leading industries in U.S. in large cap blue
chip stocks. It is most often used as the benchmark by
fund managers for judging their performance in US
markets.S&P 500 futures contract dominates stock index
trading in the US. Fifteen years later share rise in index
value and consequently contract size led to reduction in
contract multiplies to $ 250.

Dow Jones Industrial Average

It is the oldest and most well known stock measure in the

world. Dow Jones & Company started it in May 26, 1896.
The next index in US came only 60 years later. The
longevity accounts for its continued popularity today as a
preferred measure of the market.
 36
It is a price-weighted index of 30 of the largest most
liquid blue chip US stocks, a number that has held steady
since 1928.

RUSSEL 1000

This is sub set of the broader Russel 3000 index which

tracks only U. S. companies. NYBOT ( New York Board of
Trade ) started futures and options based on Russel 1000
is march 99, offering two contract size – one with $500
multiplier and another with a $1000 multiplier.Russel
1000 is a market capitalization index, but each ones
weighting in the index is based on available market
capitalization. It is the stocks with the most tradable
outstanding shares at the highest price that will hold the
most influence on the index movement.

S & P Midcap 400

It is a capitalization weighted index of 400 U.S. stocks

representing companies whose capitalization is in the
middle range of all firms. None of the stocks in S&P 500
can be in S&P Midcap 400 and vice versa. Futures &
Options on this index are traded at CME with a Contract
multiplier of $500.

NASDAQ 100
It comprises of top 100 non-financial stocks, domestic as
well as foreign, listed on NASDAQ. It trades on CME with
two different contract multipliers - $100 and $20. It is a
market cap index with modified capitalization to reduce
the overwhelming influence of its top stocks like
microsoft.

37
Hang Seng Index

This index is market capitalization weighted index of 33

stocks, representing about 70% of the stock market’s
total capitalization. Futures on Hang Seng Index are
traded on Hong Kong futures Exchange with a contract
multiplier of H. K. $50.

Nikkei 225 Average

It is Japan’s longest running stock index. It is a price

weighted stock index. Future contracts on NIKKEI 225
trade or three exchange CME, OSE (Osaka) and Simex
with contract multiples of $5, Yen 1000 & Yen 500
respectively.

DAX

It is Germany’s blue chip index of 30 leading stocks. It is

calculated on total returns basis and not just on price
basis.Income from dividends and rights issues are
reinvested in the index portfolio and are reflected in the
index value. It is traded on Eurex with a contract
multiplier of Euro 25.

MIB-30

The MIB-30 is a capitalization weighted index of 30 blue

chip stocks listed on the Italian exchange. Futures &
Options are traded in Italian derivatives market with a
contract multiples of Euro 5. The index typically accounts
for more than 70% of the markets’ total capitalization.

38
OMX

The Swedish Equity Index(OMX) is a capital weighted

index of the 30 stocks with the market trading volumes at
the Stockholm Stock exchange. They account for about
66% of the total market capitalization. Futures on the
index are traded on OM Stockholm and OM London.

FTSE 100

The FTSE 100 represents the value of the 100 largest

companies listed on the LSE. These blue chip stocks
typically equal 2/3rd of the market’s total capitalization.
FISE 100 is maintained by FTSE International Ltd, a
company formed in 1995 and jointly owned by LSE and
the Financial times. It is a market capitalization index.
Futures & options on the index are traded on LIFFE with a
contract multiplier of Pound 10.

(Chicago board of trade building) ( NASDAQ building )

39
Robert Kiyosaki - ( Investor, entrepreneur, author, motivational )

- Your future is created by what you do today, not tomorrow

- The size of your success is measured by the strength of your
desire; the size of your dream; and how you handle
disappointment along the way
- The only difference between a rich person and poor person is
how they use their time

[5.0] BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

RISK MANAGEMENT
Futures and options contract can be used for altering the
risk of investing in spot market. For instance, consider
an investor who owns an asset. He will always be
worried that the price may fall before he can sell the
asset. He can protect himself by selling a futures
contract, or by buying a Put option. This will help offset
their losses in the spot market. Similarly, if the spot
price falls below the exercise price, the put option can
always be exercised.

40
PRICE DISCOVERY
Price discovery refers to the markets ability to determine
true equilibrium prices. Futures prices are believed to
contain information about future spot prices and help in
disseminating such information. As we have seen,
futures markets provide a low cost trading mechanism.
 Thus information pertaining to supply and demand
easily percolates into such markets. Options markets
provide information about the volatility or risk of the
underlying asset.

OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve

lower transaction costs. Secondly, they offer greater
liquidity. Large spot transactions can often lead to
significant price changes. However, futures markets
tend to be more liquid than spot markets, because
herein you can take large positions by depositing
relatively small margins

MARKET EFFICIENCY
The availability of derivatives makes markets more
efficient; spot, futures and options markets are
inextricably linked. Since it is easier and cheaper to
trade in derivatives, it is possible to exploit arbitrage
opportunities quickly and to keep prices in alignment.
Hence these markets help to ensure that prices reflect
true values.

45
EASE OF SPECULATION
Derivative markets provide speculators with a cheaper
alternative to engaging in spot transactions. Also, the
amount of capital required to take a comparable
position is less in this case. This is important because
facilitation of speculation is critical for ensuring free
and fair markets. Speculators always take calculated
risks. A speculator will accept a level of risk only if he is
convinced that the associated expected return is
commensurate with the risk that he is taking.
 46

Steve Jobs – (Chairman and CEO, Apple Inc. Board of Directors, Walt Disney Company)

- You can't just ask customers what they want and then try to
give that to them. By the time you get it built, they'll want
something new.
- Why join the navy if you can be a pirate?
- Be a yardstick of quality. Some people aren't used to an
environment where excellence is expected.

[6.0] Introduction of futures in India

The first derivative product to be introduced in the Indian

securities market is going to be "INDEX FUTURES".
In the world, first index futures were traded in U.S. on
Kansas City Board of Trade (KCBT) on Value Line
Arithmetic Index (VLAI) in 1982.
[6.1] What are Index Futures ?
Index futures are the future contracts for which
underlying is the cash market index.
For example: BSE may launch a future contract on "BSE
Sensitive Index" and NSE may launch a future contract on
"S&P CNX NIFTY".

47
[6.2] Frequently used terms in Index Futures
market

Contract Size - The value of the contract at a specific

level of Index. It is Index level Multiplier.

Multiplier - It is a pre-determined value, used to arrive

at the contract size. It is the price per index point.

Tick Size - It is the minimum price difference between

two quotes of similar nature.

Contract Month - The month in which the contract will

expire.

Expiry Day - The last day on which the contract is

available for trading.

Open interest - Total outstanding long or short positions

in the market at any specific point in time. As total long
positions for market would be equal to total short
positions, for calculation of open Interest, only one side of
the contracts is counted.
Volume - No. of contracts traded during a specific period
of time. During a day, during a week or during a month.

Long position- Outstanding/unsettled purchase position

at any point of time.

Short position - Outstanding/ unsettled sales position at

any point of time.

Open position - Outstanding/unsettled long or short

position at any point of time.
48
Physical delivery - Open position at the expiry of the
contract is settled through delivery of the underlying. In
futures market, delivery is low.

Cash settlement - Open position at the expiry of the

contract is settled in cash. These contracts are
designated as cash settled contracts. Index Futures fall in
this category.

[6.3] Concept of basis in futures market

 Basis is defined as the difference between cash and

futures prices:
 Basis can be either positive or negative (in Index
futures, basis generally is negative).
 Basis may change its sign several times during the
life of the contract.
 Basis turns to zero at maturity of the futures contract
i.e. both cash and future prices converge at maturity

49
[6.4] Pricing Futures

Cost and carry model of Futures pricing

Fair price = Spot price + Cost of carry – Inflows

FPtT = CPt + CPt (RtT - DtT) (T-t)/365

FPtT - Fair price of the asset at time t for time T.

CPt - Cash price of the asset.
RtT - Interest rate at time t for the period up to T.
DtT - Inflows in terms of dividend or interest between t
and T.

Cost of carry = Financing cost, Storage cost and

insurance cost.

If Futures price > Fair price; Buy in the cash

market and simultaneously sell in the futures
market.
If Futures price < Fair price; Sell in the cash
market and simultaneously buy in the futures
market.

This arbitrage between Cash and Future markets will

remain till prices in the Cash and Future markets get
aligned.

50
Set of assumptions
- No seasonal demand and supply in the underlying
asset.
- Storability of the underlying asset is not a problem.
- The underlying asset can be sold short.
- No transaction cost; No taxes.
- No margin requirements, and so the analysis relates to
a forward contract, rather than a futures contract.

[6.5] Index Futures and cost and carry model

In the normal market, relationship between cash and
future indices is described by the cost and carry model of
futures pricing.

Expectancy Model of Futures pricing

S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.
 51
Expectancy model says that many a times it is not the
relationship between the fair price and future price but
the expected spot and future price which leads the
market. This happens mainly when underlying is not
storable or may not be sold short. For instance in
commodities market.

E(S) can be above or below the current spot prices. (This

reflects market’s expectations)

[6.6] Risk management through Futures

Which risk are we going to manage through Futures ?

Basic objective of introduction of futures is to manage the

price risk.
Index futures are used to manage the systemic risk,
vested in the investment in securities.

Hedge terminology
Long hedge- When you hedge by going long in futures
market.
Short hedge - When you hedge by going short in futures
market.
Cross hedge - When a futures contract is not available
on an asset, you hedge your position in cash market on
this asset by going long or short on the futures for
another asset whose prices are closely associated with
that of your underlying.

[6.6.1] Some specific uses of Index Futures

Portfolio Restructuring - An act of increasing or

decreasing the equity exposure of a portfolio, quickly,
with the help of Index Futures.

55
Index Funds - These are the funds which
imitate/replicate index with an objective to generate the
return equivalent to the Index. This is called Passive
Investment Strategy.

[6.6.2] Speculation in the Futures market

Speculation is all about taking position in the futures

market without having the underlying. Speculators
operate in the market with motive to make money. They
take:

Naked positions - Position in any future contract.

Spread positions - Opposite positions in two future
contracts. This is a conservative speculative strategy.
Speculators bring liquidity to the system, provide
insurance to the hedgers and facilitate the price
discovery in the market.
[6.7] Margining in Futures market

Whole system dwells on margins:

Daily Margins
Initial Margins
Maintenance margin

Daily Margins
Daily margins are collected to cover the losses which
have already taken place on open positions.
Price for daily settlement - Closing price of futures index.

56
Price for final settlement - Closing price of cash index.
For daily margins, two legs of spread positions would be
treated independently.
Daily margins should be received by CC/CH and/or
exchange from its members before the market opens for
the trading on the very next day.
Daily margins would be paid only in cash.

Initial Margins
Margins to cover the potential losses for one day.
To be collected on the basis of value at risk at 99% of the
days.
Maintenance margin
This is somewhat lower than the initial margin. This is set
to ensure that the 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.

57
Striking an intelligent balance between safety and
liquidity while determining margins, is a million
dollar point.

58

Jehangir Ratanji Dadabhoy Tata – (pioneer aviator, Industrialist and was awarded
India's highest civilian award, the Bharat Ratna in 1992)
 - Money is like manure. It stinks when you pile it; it grows
when you spread it.
- When you work, work as if everything depends on you. When
you pray, pray as if everything depends on God.
- Making steel may be compared to making a chappati
(tortilla). To make a good chappati, even a golden pin will
not work unless the dough is good.

[7.0] Derivative Markets today

The Reserve Bank of India has permitted options, interest

rate swaps, currency swaps and other risk reductions OTC
derivative products.

Forward Markets Commission has allowed the setting up

of commodities futures exchanges. Today we have 18
commodities exchanges most of which trade futures.
e.g. The Indian Pepper and Spice Traders Association
(IPSTA) and the Coffee Owners Futures Exchange of India
(COFEI).

59
In 2000 an amendment to the SCRA expanded the
definition of securities to included Derivatives thereby
enabling stock exchanges to trade derivative products.

[7.1] Operators in the derivatives market

Hedgers - Operators, who want to transfer a risk

component of their portfolio.

Speculators - Operators, who intentionally take the risk

from hedgers in pursuit of profit.

Arbitrageurs - Operators who operate in the different

markets simultaneously, in pursuit of profit and eliminate
mis-pricing.

[7.2] Equity Derivatives Exchanges in India

In the equity markets both the National Stock Exchange
of India Ltd. (NSE) and The Stock Exchange, Mumbai
(BSE) have applied to SEBI for setting up their derivatives
segments.

BSE's and NSE’s plans

Both the exchanges have set-up an in-house segment

instead of setting up a separate exchange for derivatives.
BSE’s Derivatives Segment, will start with Sensex futures
as it’s first product.
NSE’s Futures & Options Segment will be launched with
Nifty futures as the first product.

60
Product Specifications BSE-30 Sensex Future

Contract Size - Rs. 50 times the Index Active

contracts - 3 nearest months
Tick Size - 0.1 points or Rs. 5
Settlement basis - cash settled
Expiry day - last Thursday of the month Contract
cycle - 3 months

Product Specifications S&P CNX Nifty Futures

Contract Size - Rs. 200 times the Index Active

contracts - 3 nearest months
Tick Size - 0.05 points or Rs. 10
Settlement basis - cash settled
Expiry day - last Thursday of the month Contract
cycle - 3 months

Membership
Membership for the new segment in both the exchanges
is not automatic and has to be separately applied for.
Membership is currently open on both the exchanges.
All members will also have to be separately registered
with SEBI before they can be accepted.

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.
61
Settlement and Risk Management systems
Systems for settlement and risk management are
required to satisfy the conditions specified by the L.C.
Gupta Committee and the J.R. Verma committee. These
include upfront margins, daily settlement, online
surveillance and position monitoring and risk
management using the Value-at-Risk concept.

Certification programs
The NSE certification programme is called NCFM (NSE’s
Certification in Financial Markets). NSE has outsourced
training for this to various institutes around the country.
The BSE certification programme is called BCDE (BSE’s
Certification for the Derivatives Exchange). BSE conducts
it’s own training run by it’s training institute. Both these
programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle
approval on their rule and laws by SEBI. According to the
SEBI chairman, the Gazette notification of the Bye-Laws
after the final approval is expected to be completed by
May 2000.
Expected advantages of derivatives to the cash
market

 Availability of risk management products attracts

more investors to the cash market.
 Arbitrage between cash and futures markets fetches
additional business to cash market.
 Improvement in delivery based business.
 Lesser volatility
 Improved price discovery.
 Higher liquidity.
62

Late Mr. Enzo Anselmo Ferrari – (was an Italian race car driver and
entrepreneur, Founder of Ferrari )
- I use a derivative of this one, "If you buy the engine, I'll give you
everything else for free.
- I don't sell cars; I sell engines. The cars I throw in for free since
something has to hold the engines in.
- If you can dream it you can do it.

[8.0] INTRODUCTION TO INDEXES

[8.1]What’s an Index?
An Index is a number used to represent the changes in a set of
values between a base time period and another time period.
[8.2]What’s a Stock Index?
A Stock Index is a number that helps you measure
the levels of the market. Most stock indexes
attempt to be proxies for the market they exist in.
Returns on the index thus are supposed to
represent returns on the market i.e. the returns
that you could get if you had the entire market in
your portfolio.
63
[8.3] Why do we need an Index?
Students of Modern Portfolio Theory will appreciate
that the aim of every portfolio manager is to beat
the market.
In order to benchmark the portfolio against the
market we need some efficient proxy for the
market.
Indexes arose out of this need for a proxy.

[8.4] What does the number mean?

The index value is arrived at by calculating the
weighted average of the prices of a basket of
stocks of a particular portfolio.
This portfolio is called the index portfolio and
attempts a high degree of correlation with the
market.
Indexes differ based on the method of assigning
the weightages to the stocks in the portfolio.

64
But why a portfolio? Why not the entire
market?
This is because for someone who wishes to
replicate the return on the market it is infinitely
more expensive to buy the whole market and for
small portfolio sizes it is almost impossible.The
alternative is to choose a portfolio that has a high
degree of correlation with the market.

[8.5] How are the stocks in the portfolio

weighted?

There are basically three types of weighing :

Market Capitalisation weighted

Price weighted
Equal weighted
As may be discerned, the stocks in the index could
be weighted based on their individual prices, their
market capitalisation or equally.
[8.6] What is the better weighing option?
The market capitalisation weighted model is the
most popular and widely considered to be the best
way of determining the index values.
In India both the BSE-30 Sensex and the S&P CNX
Nifty are market capitalisation weighted indexes.

65
[8.7] Who owns the index? Who computes it ?

Typically exchanges around the world compute

their own index and own it too. The Sensex and the
Nifty are case in point.
There are notable exceptions like the S&P 500
Index in the U.S. (owned by S&P which is a credit
rating company) and the Strait Times Index in
Singapore (owned by the newspaper of the same
name).

[8.8] Who decides what stocks to include?

How?
Most index providers have a index committee of
some sort that decides on the composition of the
index based on standardised selection and
elimination criteria.
The criteria for selection of course depends on the
philosophy of the index and its objective.

66
[8.9] Selection Criteria

Most indexes attempt to strike a balance between

the following criteria.

 Better Industry representation

 Maximum coverage of market
capitalisation
  Higher Liquidity or Lower Impact cost.

Industry Representation
Since the objective of any index is to be a proxy for
the market it becomes imperative that the broad
industry sectors are faithfully represented in the
Index too.Though this seems like an easy enough
task, in practice it is very difficult to achieve due to
a number of issues, not least of them being the
basic method of industry classification.

Market Capitalisation
Another objective that most index providers strive
to achieve is to ensure coverage of some minimum
level of the capitalisation of the entire market. As a
result within every industry the largest market
capitalisation stocks tend to select themselves.
However it is quite a balancing act to achieve the
same minimum level for every industry.

67
Liquidity or Impact Cost
It is important from the point of usability for all the
stocks that are part of the index to be highly liquid.
The reasons are two-fold. An illiquid stock has stale
prices and this tends to give a flawed value to the
index. Further for passive fund managers, the entry
and exit cost at a particular index level is high if
the stocks are illiquid. This cost is also called the
impact cost of the index.
[8.10] What is a Benchmark Index?
An index which acts as the benchmark in the
market has an important role to play.While it has to
be responsive to the changes in the market place
and allow for new industries or give up on dead
industries, at the same time it should also maintain
a degree of continuity in order to survive as an
benchmark index.

[8.11] What are the popular indexes in India?

BSE-30 S&P CNX Nifty

Sensex S&P CNX Nifty
BSE-100 Jr.
Natex S&P CNX Defty
BSE Dollex S&P CNX
BSE-200 Midcap
BSE-500 S&P CNX 500
 68
[8.12] What are Sectoral Indexes?
These indexes provide the benchmark for sector
specific funds.Fund managers and other investors
who track particular sectors of the economy like
Technology, Pharmaceuticals, Financial Sector,
Manufacturing or Infrastructure use these indexes
to keep track of the sector performance.
[8.13] What are the uses of an Index ?

Index based funds

These funds tend to replicate the index as it is in
order to match the returns on the market. This is
also know as passive management. Their argument
is that it is not possible to beat the market over a
sustained period of time through active
management and hence it’s better to replicate the
index. Example in India are
UTI’s fund on the Sensex , IDBI MF’s fund on
the Nifty

69
Exchange traded funds (ETFs)
These are similar to index funds that are traded on
an exchange.
These are pretty popular world wide with non-
resident investors who like to take an exposure to
the entire market.
S&P’s SPDRs and MSCI’s WEBS products are
amongst the most popular products.

Index futures
Index futures are possibly the single most popular
exchange traded derivatives products today.The
S&P 500 futures products is the largest traded
index futures product in the world.In India both the
BSE and NSE are due to launch their own index
futures product on their benchmark indexes
the Sensex and the Nifty.

What is the trend abroad?

Although we have a whole host of popular
exchange owned indexes abroad including the DAX
30, the CAC 40 and the Hang Seng we see an
increasing trend where global index providers are
seen to have more influence among the foreign
funds and investing community.

What do Global Index providers bring ?

In the age of cross border capital flows and global
funds, global index provider provide the uniformity
and standardization in their index philosophy and
methodologies that allows a global

70
fund to compare performance across regions or
sectors.
By following a common industry classification
standard in all the countries that they operate in,
index providers hope to wean away liquidity from
the more popular and home grown indexes.Also
global providers are currently, the only ones in a
position to provide pan-continental or pan-global
indexes.

What does the future look like?

The future in India looks pretty exciting with Index
futures being launched and Index options expected
to follow. Hopefully with the growing popularity of
ETF’s we might see SEBI allowing them in India
too.Globally while the debate between active and
passive fund management still rages, we see
standardised indexes growing in popularity.
 71
Sir Winston Leonard Spencer-Churchill –( Prime Minister of the United
Kingdom { 26 October 1951 – 7 April 1955 } )

- The price of greatness is responsibility

- I am always ready to learn although I do not always like being
taught.
- We shall fight on the beaches. We shall fight on the landing
grounds. We shall fight in the fields, and in the streets, we shall
fight in the hills. We shall never surrender.

[9.0] Financial Risk Management

[9.1] Four Steps in Risk Management

1. Understand the nature of various risks.

2. Define a risk management policy for the
organization and quantifying maximum risk that
organization is willing to take if quantifiable.

3. Measure the risks if quantifiable and enumerate

otherwise.
4. Build internal control mechanism to control and
monitor all the risks.
72
Step 1 – Understand the nature of various
risks

Risks can be classified into four categories.

 Price or Market Risk

 Counterparty or Credit Risk
 Dealing Risk
 Settlement Risk
 Operating Risks

Price or market Risks

This is the risk of loss due to change in market
prices. Price risk can increase further due to
Market Liquidity Risk, which arises when large
positions in individual instruments or exposures
reach more than a certain percentage of the
market, instrument or issue. Such a large position
could be potentially illiquid and not be capable of
being replaced or hedged out at the current
market value and as a result may be assumed to
carry extra risk.
Counterparty or credit risk Risks
This is the risk of loss due to a default of the
Counterparty in honoring its commitment in a
transaction (Credit Risk). If the Counterparty is
situated in another country, this also involves
Country Risk, which is the risk of the
Counterparty not honoring its commitment
because of the restrictions imposed by the
government though counterparty itself is capable
to do so.

74
Dealing Risk
Dealing Risk is the sum total of all unsettled
transactions due for all dates in future. If the
Counterparty goes bankrupt on any day, all
unsettled transactions would have to be redone in
the market at the current rates. The loss would be
the difference between the original contract rate
and the current rates. Dealing risk is therefore
limited to only the movement in the prices and is
measured as a percentage of the total exposure.

Settlement Risk
Settlement risk is the risk of Counterparty
defaulting on the day of the settlement. The risk in
this case would be 100% of the exposure if the
corporate gives value before receiving value from
the Counterparty. In addition the transaction would
have to be redone at the current market rates.

Operating Risks
Operational risk is the risk that the organization
may be exposed to financial loss either through
human error, misjudgment, negligence and
malfeasance, or through uncertainty,
misunderstanding and confusion as to
responsibility and authority.

Step 2 - Define Risk Policy

Decide the basic risk policy that the organisation
wants to have. This may vary from taking no
risk (cover all) to taking high risks (open all). Most
organisations would fall somewhere in between the
two extremes. Risk and reward go hand in hand.
Cost Center Vs. Profit Center
75
A cost centre approach looks at exposure
management as insurance against adverse
movements. One is not looking for optimisation of
cost or realisation but meeting certain budgeted or
targeted rates. In a profit centre approach, the
business is taking deliberate risks to make money
out of price movements.
Step 3- Risk Measurement
There are a number of different measures of price
or market risk which are mainly based on historical
and current market values Examples are Value at
Risk (VAR), Revaluation, Modelling, Simulation,
Stress Testing, Back Testing, etc.

Step 4- Risk Control

Control of Price Risk

Position limits are established to control the level
of price or market risk taken by the organization.
Diversification is used to reduce systematic risk in
a given portfolio.

Control of Credit Risk

Credit limits are established for each counterparty
for both Dealing Risk and Settlement Risk
separately depending upon the risk perception of
the counterparty.

Control of Operating Risk

Establishment of an effective and efficient internal
control structure over the trading and settlement
activities, as well as implementing a timely and
accurate management information system (M.I.S.).

76