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The emergence of the market for derivative products most notably forwards,
futures and options can be traced back to the willingness of risk-averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. By their very nature, financial markets are market by a very high degree of
volatility. Though the use of derivative products, it is possible to partially or fully
transfer price risks by locking – in asset prices. As instrument of risk management
these generally don’t influence the fluctuations in the underlying asset prices.
Derivatives are risk management instruments which derives their value from an
underlying asset. Underlying asset can be Bullion, Index, Share, Currency, Bonds,
Interest, etc.
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1.2 OBJECTIVES OF THE STUDY:
To find out profit/loss position of the option writer and option holder
To study various trends in derivatives market
To study the role of derivatives in India financial market
To study in detail the role of futures and options
To examine the advantages and the disadvantages of different strategies along
with situations
To study the different ways of buying and selling of Options
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1.3 SCOPE OF THE STUDY:
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1.4 RESEARCH METHODOLOGY:
The data had been collected through primary and secondary source.
Primary data:
The data had been collected through IIFL staff.
Secondary data:
The data had been collected through Journals, News papers, and Internet.
LIMITATIONS:
The study does not take any Nifty Index Futures and Options and International
Markets into the consideration.
This is a study conducted within a period of 45 days.
During this limited period of study, the study may not be a detailed, Full –
fledged and utilitarian one in all aspects.
The study contains some assumptions based on the demands of the analysis.
The study does not provide any predictions or forecast of the selected scripts.
The study was conducted in Hyderabad only.
As the time was limited, study was confined to conceptual understanding of
Derivatives market in India.
CHAPTER 2
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PROFILE OF IIFL INVESTMENT SOLUTIONS
India Infoline has been founded with the aim of providing world class investing
experience to hitherto underserved investor community. India Infoline is currently
providing broking services on the NSE, BSE, derivative market and commodity
exchange. India Infoline allows individual investors too conveniently, comfortably
and cost-efficiently place trades online and offline. While offering the service they
also give the added assurance of 92 branch offices. The company, created to provide
premium service with reasonable commissions, currently maintains more than 25000
individual accounts.
Mission:
To create long term value by empowering individual investors through superior
financial services supported by culture based on highest level of teamwork, efficiency
and integrity.
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April 23, 2003 under the companies act, 1956. It obtained its certificate for
commencement of business on May 9, 2003. It commenced its operations on
December 15, 2003. NCDEX is regulated by forward markets commission. It is
subjected to various laws of the land like the forward contracts (regulation) act,
companies act, stamp act, contract act and various other legislations. NCDEX is
located in Mumbai and offers facilities to its members about 550 centers throughout
India. NCDEX currently facilitates trading of 57 commodities.
Agriculture:
Barley, Cashew, Castor Seed, Chana, Chilli, Coffee - Arabica, Coffee - Robusta,
Crude Palm Oil, Cotton Seed Oilcake, Expeller Mustard Oil, Groundnut (In Shell),
Groundnut Expeller Oil, Guar Gum, Guar Seeds, Gur, Jeera, Jute Sacking Bags,
Indian Parboiled Rice, Indian Pusa Basmati Rice, Indian Traditional Basmati Rice,
Indian Raw Rice, Indian 28.5 Mm Cotton, Indian 31 Mm Cotton, Masoor Grain Bold,
Medium Staple Cotton, Mentha Oil, Mulberry Green Cocoons, Mulberry Raw Silk,
Mustard Seed, Pepper, Potato, Raw Jute, Rapeseed-Mustard Seed Oilcake, Rbd
Palmolein, Refined Soy Oil, Rubber, Sesame Seeds, Soybean, Sugar, Yellow Soybean
Meal, Tur, Turmeric, Uri, V-797 Kapas, Wheat, Yellow Peas And Yellow Red Maize.
Metals:
Aluminium Ingot, Electrolytic Copper Cathode, Gold, Mild Steel Ingots, Nickel
Cathode, Silver, Sponge Iron and Zinc Ingot.
Energy:
Brent Crude Oil and Furnace Oil.
Board of Directors:
The governance of NCDEX vests with the 12 board of directors.
Mr. Karan Bhagatis the Managing Director and Chief Executive Officer
Shareholders of NCDEX:
Source: www.ncdex.com
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Equity shareholding pattern as on 18th April, 2012
The technical analyst mainly predicts the short-term price movement rather
than long term movement. The rallies and historical charts give buying and
selling signals. They are not committed to buy and hold strategy.
It helps in identifying the best time of an investment i.e., the best time to buy
or sell a security.
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2.3 SCOPE OF THE STUDY:
This study has got the limited scope of single underlying assets silver and a
limited time period of one year. Nevertheless the scope is extended to through
scrutiny and understanding of regulatory framework of derivatives, technicalities and
influence of forward trading on spot prices. This study is purely executed with
secondary data sources, although impact of forward trading can be measured through
primary sources as well.
CHAPTER 3
THEORITICAL CONCEPTS ON DERIVATIVES
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3.1 DERIVATIVES:
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. By their very nature, the financial markets are marked by a very high degree of
volatility. Through the use of derivative products, it is possible to partially or fully
transfer price risks by locking –in asset prices. As instruments of risk management,
these generally do not influence the fluctuations underlying prices. However, by
locking –in asset prices, derivative products minimizes the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk–averse investors.
3.1.1 DEFINITION:
Understanding the word itself, Derivatives is a key to mastery of the topic. The
word originates in mathematics and refers to a variable, which has been derived from
another variable. For example, a measure of weight in pound could be derived from a
measure of weight in kilograms by multiplying by two. In financial sense, these are
contracts that derive their value from some underlying asset. Without the underlying
product and market it would have no independent existence. Underlying asset can be a
Stock, Bond, Currency, Index or a Commodity. Some one may take an interest in the
derivative products without having an interest in the underlying product market, but
the two are always related and may therefore interact with each other.
The term Derivative has been defined in Securities Contracts (Regulation) Act 1956,
as:
A. 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.
B. A contract, which derives its value from the prices, or index of prices,
of underlying securities.
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Derivatives are becoming increasingly important in world markets as a tool for
risk management. Derivatives instruments can be used to minimize risk. Derivatives
are used to separate risks and transfer them to parties willing to bear these risks. The
kind of hedging that can be obtained by using derivatives is cheaper and more
convenient than what could be obtained by using cash instruments. It is so because,
when we use derivatives for hedging, actual delivery of the underlying asset is not at
all essential for settlement purposes.
Moreover, derivatives would not create any risk. They simply manipulate the
risks and transfer to those who are willing to bear these risks.
For example,
Mr. A owns a bike If he does not take insurance, he runs a big risk. Suppose he
buys insurance [a derivative instrument on the bike] he reduces his risk. Thus, having
an insurance policy reduces the risk of owing a bike. Similarly, hedging through
derivatives reduces the risk of owing a specified asset, which may be a share,
currency, etc.
DERIVATIVES:
Holding portfolio of securities is associated with the risk of the possibility that the
investor may realize his returns, which would be much lesser than what he expected
to get. There are various influences, which affect the returns.
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2. Sum are internal to the firm like:
Industry policy
Management capabilities
Consumer’s preference
Labour strike, etc.
These forces are to a large extent controllable and are termed as “Non-systematic
Risks”. An investor can easily manage such non- systematic risks by having a well
diversified portfolio spread across the companies, industries and groups so that a loss
in one may easily be compensated with a gain in other.
There are other types of influences, which are external to the firm, cannot be
controlled, and they are termed as “systematic risks”. Those are
Economic
Political
Sociological changes are sources of Systematic Risk
Their effect is to cause the prices of nearly all individual stocks to move together
in the same manner. We therefore quite often find stock prices falling from time to
time in spite of company’s earnings rising and vice –versa.
Rational behind the development of derivatives market is to manage this systematic
risk, liquidity. Liquidity means, being able to buy & sell relatively large amounts
quickly without substantial price concessions.
In debt market, a much larger portion of the total risk of securities is systematic.
Debt instruments are also finite life securities with limited marketability due to their
small size relative to many common stocks. These factors favor for the purpose of
both portfolio hedging and speculation.
India has vibrant securities market with strong retail participation that has
evolved over the years. It was until recently a cash market with facility to carry
forward positions in actively traded “A” group scripts from one settlement to another
by paying the required margins and borrowing money and securities in a separate
carry forward sessions held for this purpose. However, a need was felt to introduce
financial products like other financial markets in the world.
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3.1.4 CHARACTERISTICS OF DERIVATIVES:
1. Their value is derived from an underlying instrument such as stock index,
currency, etc.
2. They are vehicles for transferring risk.
3. They are leveraged instruments.
Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek
to protect themselves against price changes in a commodity in which they have an
interest.
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.
Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could
be making money even with out putting their own money in, and such opportunities
often come up in the market but last for very short time frames. They are specialized
in making purchases and sales in different markets at the same time and profits by the
difference in prices between the two centers.
Options: Options are two types - Calls and Puts. Calls give the buyer the right but
not the obligation to buy a given quantity of the underlying asset at a given price on or
before a given future date. Puts give the buyer the right but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.
Warrants: Longer – dated options are called warrants and are generally traded over
the – counter. Options generally have life up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months.
LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a pre-arranged 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 flows
between the parties in the same currency
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Currency swaps: These entail swapping both the principal and interest between
the parties, with the cash flows in one direction being in a different currency than
those in opposite direction.
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trading, by using fully automated screen based exchange, which was established by
India's leading institutional investors in 1994 in the wake of numerous financial &
stock market scandals.
Contract Periods:
At any point of time there will be always be available nearly 3months contract
periods in Indian Markets.
These were
1) Near Month
2) Next Month
3) Far Month
For example in the month of September 2018 one can enter into September
futures contract or October futures contract or November futures contract. The last
Thursday of the month specified in the contract shall be the final settlement date for
the contract at both NSE as well as BSE; it is also known as Expiry Date.
Settlement:
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The settlement of all derivative contracts is in cash mode. There is daily as well
as final settlement. Outstanding positions of a contract can remain open till the last
Thursday of that month. As long as the position is open, the same will be marked to
market at the daily settlement price, the difference will be credited or debited
accordingly and the position shall be brought forward to the next day at the daily
settlement price. Any position which remains open at the end of the final settlement
day. (i.e. last Thursday) shall be closed out by the exchange at the final settlement
price which will be the closing spot value of the underlying asset.
Margins:
There are two types of margins collected on the open position, viz., initial
margin which is collected upfront which is named as “SPAN MARGIN” and mark to
market margin, which is to be paid on next day. As per SEBI guidelines it is
mandatory for clients to give margins, failing in which the outstanding positions are
required to be closed out.
Exposure limit:
The national value of gross open positions at any point in time for index futures
and short index option contract shall not exceed 33.33 times the liquid net worth of a
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clearing member. In case of futures and options contract on stocks the notional value
of futures contracts and short option position any time shall not exceed 20 times the
liquid net worth of the member. Therefore, 3 percent notional value of gross open
position in index futures and short index options contracts, and 5 percent of notional
value of futures and short option position in stocks is additionally adjusted from the
liquid net worth of a clearing member on a real time basis.
Position limit:
It refers to the maximum no of derivatives contracts on the same underlying
security that one can hold or control. Position limits are imposed with a view to detect
concentration of position and market manipulation. The position limits are applicable
on the cumulative combined position in all the derivatives contracts on the same
underlying at an exchange. Position limits are imposed at the customer level, clearing
member level and market levels are different.
Regulatory Framework:
Considering the constraints in infrastructure facilities the existing stock
exchanges are permitted to trade derivatives subject to the following conditions:
Trading should take place through an online screen based trading system
An independent clearing corporation should do the clearing of the
derivative market
The exchange must have an online surveillance capability, which
monitors positions, price and volumes in real time so as to detect market
manipulations. Position limits be used for improving market quality
Information about traded quantities and quotes should be disseminated
by the exchange in the real time over at least two information-vending
networks, which are accessible to the investors in the country
The exchange should have at least 50 members to start derivatives trading
The derivatives trading should be done in a separate segment with a
separate membership. The members of an existing segment of the
exchange will not automatically become the members of derivatives
segment
The derivatives market should have a separate governing council and
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representation of trading/clearing members shall be limited to maximum
of 40% of total members of the governing council
The chairman of the governing council of the derivative
division/exchange should be a member of the governing council. If the
chairman is broker/dealer, then he should not carry on any broking and
dealing on any exchange during his tenure
3.2 Forwards
Forwards are the simplest and basic form of derivative contracts. These are
instruments are basically used by traders/investors in order to hedge their future risks.
It is an agreement to buy/sell an asset at certain in future for a certain price. They are
private agreements mainly between the financial institutions or between the financial
institutions and corporate clients.
One of the parties in a forward contract assumes a long position i.e. agrees to
buy the underlying asset on a specified future date at a specified future price. The
other party assumes short position i.e. agrees to sell the asset on the same date at the
same price. This specified price referred to as the delivery price. This delivery price is
choosen so that the value of the forward contract is equal to zero for both the parties.
In other words, it costs nothing to the either party to hold the long/short position.
A forward contract is settled at maturity. The holder of the short position
delivers the asset to the holder of the long position in return for cash at the agreed
upon rate. Therefore, a key determinate of the value of the contract is the market price
of the underlying asset. A forward contract can therefore, assume a positive/negative
value depending on the movements of the price of the asset. For example, if the price
of the asset rises sharply after the two parties entered into the contract, the party
holding the long position stands to benefit, that is the value of the contract is positive
for him.
Conversely the value of the contract becomes negative for the party holding the
short position.
The concept of forward price is also important. The forward price for a certain
contract is defined as that delivery price which would make the value of the contract
zero. To explain further, the forward price and the delivery price are equal on the day
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that the contract is entered into. Over the duration of the contract, the forward price is
liable to change while the delivery price remains the same.
The Securities Contract (amendment) Act of 1999 has allowed the trading in
derivative products in India. As a further step to widen and deepen the securities
market the government has notified that with effect from March 1st 2000 the ban on
forward trading in shares and securities is lifted to facilitate trading in forwards and
futures.
It may be recalled that the ban on forward trading in securities was imposed in
1986 to curb certain unhealthy trade practices and trends in the securities market.
During the past few years, thanks to the economic and financial reforms, there have
been many healthy developments in the securities markets.
The lifting of ban on forward deals in securities will help to develop index
futures and other types of derivatives and futures on stocks. This is a step in the right
direction to promote the sophisticated market segments as in the western countries.
3.3 FUTURES
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The future contract is an agreement between two parties to buy or sell an asset
at a certain specified time in future for certain specified price. In this, it is similar to a
forward contract. A futures contract is a more organized form of a forward contract;
these are traded on organized exchanges. However, there are a number of differences
between forwards and futures. These relate to the contractual futures, the way the
markets are organized, profiles of gains and losses, kind of participants in the markets
and the ways they use the two instruments.
Futures contracts in physical commodities such as wheat, cotton, gold, silver,
cattle, etc. have existed for a long time. Futures in financial assets, currencies, and
interest bearing instruments like treasury bills and bonds and other innovations like
futures contracts in stock indexes are relatively new developments.
The futures market described as continuous auction markets and exchanges
providing the latest information about supply and demand with respect to individual
commodities, financial instruments and currencies, etc. Futures exchanges are where
buyers and sellers of an expanding list of commodities; financial instruments and
currencies come together to trade. Trading has also been initiated in options on futures
contracts. Thus, option buyers participate in futures markets with different risk. The
option buyer knows the exact risk, which is unknown to the futures trader.
Clearing House: The exchange acts a clearing house to all contracts struck on the
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trading floor. For instance a contract is struck between capital A and B. Upon entering
into the records of the exchange, this is immediately replaced by two contracts, one
between A and the clearing house and another between B and the clearing house. In
other words the exchange interposes itself in every contract and deal, where it is a
buyer to seller, and seller to buyer. The advantage of this is that A and B do not have
to under take any exercise to investigate each other’s credit worthiness. It also
guarantees financial integrity of the market. This enforces the delivery for the delivery
of contracts held for until maturity and protects itself from default risk by imposing
margin requirements on traders and enforcing this through a system called marking –
to – market.
The concept being used by NSE to compute initial margin on the futures
transactions is called “value- at –Risk” (VAR) where as the options market had SPAN
based margin system”.
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 cease to exist.
Contract Size: The amount of asset that has to be delivered under one contract. For
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instance contract size on NSE futures market is 100 Nifties.
Basis/Spread: 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 formal 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.
Tick Size: It is the minimum price difference between two quotes of similar nature.
Open Interest: Total outstanding long/short positions in the market in any specific
point of time. As total long positions for market would be equal to total short
positions for calculation of open Interest, only one side of the contract is counted.
Index Futures: Stock Index futures are most popular financial futures, which have
been used to hedge or manage systematic risk by the investors of the stock market.
They are called hedgers, who own portfolio of securities and are exposed to
systematic risk. Stock index is the apt hedging asset since, the rise or fall due to
systematic risk is accurately shown in the stock index. Stock index futures contract is
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an agreement to buy or sell a specified amount of an underlying stock traded on a
regulated futures exchange for a specified price at a specified time in future.
Stock index futures will require lower capital adequacy and margin requirement
as compared to margins on carry forward of individual scrip’s. The brokerage cost on
index futures will be much lower. Savings in cost is possible through reduced bid-ask
spreads where stocks are traded in packaged forms. The impact cost will be much
lower in case of stock index futures as opposed to dealing in individual scrips. The
market is conditioned to think in terms of the index and therefore, would refer trade in
stock index futures. Further, the chances of manipulation are much lesser.
The stock index futures are expected to be extremely liquid, given the
Speculative nature of our markets and overwhelming retail participation expected to
be fairly high. In the near future stock index futures will definitely see incredible
volumes in India. It will be a blockbuster product and is pitched to become the most
liquid contract in the world in terms of contracts traded. The advantage to the equity
or cash market is in the fact that they would become less volatile as most of the
speculative activity would shift to stock index futures. The stock index futures market
should ideally have more depth, volumes and act as a stabilizing factor for the cash
market.
However, it is too early to base any conclusions on the volume or to form any
firm trend. The difference between stock index futures and most other financial
futures contracts is that settlement is made at the value of the index at maturity of the
contract.
Example:
If NSE NIFTY is at 12000 and each point in the index equals to Rs.50, a contract
struck at this level could work Rs6,00,000 (12000x50). If at the expiration of the
contract, the NSE NIFTY is at 12100, a cash settlement of Rs.5000 is required
(12100-12000) x50).
Stock Futures:
With the purchase of futures on a security, the holder essentially makes a legally
binding promise or obligation to buy the underlying security at same point in the
future (the expiration date of the contract). Security futures do not represent
ownership in a corporation and the holder is therefore not regarded as a shareholder.
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A futures contract represents a promise to transact at same point in the future. In
this light, a promise to sell security is just as easy to make as a promise to buy
security.
Selling security futures without previously owing them simply obligates the trader to
sell a certain amount of the underlying security at same point in the future. It can be
done just as easily as buying futures, which obligates the trader to buy a certain
amount of the underlying security at some point in future.
Example:
If the current price of the TITAN share is Rs.1000 per share. We believe
that in one month it will touch Rs.1100 and we buy TITAN shares. If the price
really increases to Rs.1100, we made a profit of Rs.100 i.e. a return of 10%.
If we buy TITAN futures instead, we get the same position as ACC in the cash
market, but we have to pay the margin not the entire amount. In the above example if
the margin is 20%, we would pay only Rs.200 per share initially to enter into the
futures contract. If TITAN share goes up to Rs.200 as expected, we still earn Rs.100
as profit.
Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of a futures contract are unlimited. These
linear payoffs are fascinating as they can be combined with options and the
underlying to generate various complex payoffs.
The payoff for a person who buys a futures contract is similar to the payoff for
a person who holds an asset. He has a potentially unlimited upside as well as
potentially unlimited downside. Take the case of a speculator who buys a two-month
Nifty index futures contract when Nifty stands at 12000. The underlying asset in this
case is Nifty portfolio. When the index moves up, the long futures position starts
making profits, and when index moves down it starts making losses.
26
Payoff for a buyer of Nifty futures
PROFIT
12000
0 NIFTY
LOSS
The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has potentially unlimited upside as well as
potentially unlimited downside.
Profit
12000
0 NIFTY
Loss
Take the case of a speculator who sells a two-month Nifty index futures
contract when the Nifty stands at 12000. The underlying asset in this case is the Nifty
portfolio. When the index moves down, the short futures position starts making
profits, and when index moves up, it starts making losses.
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3.3.4 PRICING FUTURES
Cost of Carry Model: We use fair value calculation of futures to decide the no
arbitrage limits on the price of the futures contract. This is the basis for the cost-of-
carry model where the price of the contract is defined as follows.
F=S+C
Where
F - Futures
S - Spot price
C - Holding cost or Carry cost
This can also be expressed as
F = S (1+r) T
Where
r - Cost of financing
T - Time till expiration
Example
Nifty futures trade on NSE as one, two and three month contracts. Money can be
borrowed at a rate of 15% per annum. What will be the price of a new two-month
futures contract on Nifty?
1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days of purchasing of contract.
2. Current value of Nifty is 12000 and Nifty trade with a multiplier of 200.
3. Since Nifty is traded in multiples of 200 value of the contract is
200x12000=2400000.
4. If ACC has weight of 7% in Nifty, its value in Nifty is Rs.1680000 i.e.
(2400000x0.07).
5. If the market price of ACC is Rs.1400, then a traded unit of Nifty involves 1200
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shares of ACC i.e. (1680000/1400).
6. To calculate the futures price we need to reduce the cost of carry to the extent of
dividend received is Rs.12000 i.e. (1200x10). The dividend is received 15 days
later and hence compounded only for the remainder of 45 days. To calculate the
futures price we need to compute the amount of dividend received for unit of
Nifty. Hence, we divided the compounded figure by 2000.
7. Thus futures price
F = 12000(1.15) 60/365 – (1200x10(1.15) 45/365)/2000 = Rs.2267.64.
F = S (1+ r-q) T
Where
F- Futures price
S - Spot index value
r - Cost of financing
q - Expected dividend yield
T - Holding period
Example:
A two-month futures contract trades on the NSE. The cost of financing is 15% and the
dividend yield on Nifty is 2% annualized. The spot value of Nifty is 12000. What
would be the fair value of the futures contract?
Fair value = 12000(1+0.15-0.02) 60/365 = Rs.2229.04
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The pricing of stock futures is also based on the cost of carry model, where the
carrying cost is the cost of financing the purchase of the stock, minus the present
value of the dividends obtained from the stock. If no dividends are expected during
the life of the contract, pricing futures on that stock is very simple. It simply involves
the multiplying the spot price by the cost of carry.
Example:
SBI futures trade on NSE as one, two and three month contracts. Money can be
borrowed at 15% per annum. What will be the price of a unit of new two-month
futures
contract on SBI if no dividends are expected during the period?
1. Assume that the spot price of SBI is Rs.340.
2. Thus, futures price F = 340(1.15) 60/365 = Rs.64.27.
Example:
ACC futures trade on NSE as one, two and three month contracts.
What will be the price of a unit of new two-month futures contract on ACC if
dividends are expected during the period?
1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days of purchasing contract.
2. Assume that the market price of ACC is Rs.1400/-
3. To calculate the futures price, we need to reduce the cost of carrying to the
extent of dividend received. The amount of dividend received is Rs.10/-. The
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dividend is received 15 days later and hence, compounded only for the
remaining 45 days.
4. Thus, the futures price
F = 1400 (1.15) 60/365 – 10(1.15) 45/365 = Rs.263.23
3.4 OPTIONS
An option is a derivative instrument since its value is derived from the
underlying asset. It is essentially a right, but not an obligation to buy or sell an asset.
Options can be a call option (right to buy) or a put option (right to sell). An option is
valuable if and only if the prices are varying.
An option by definition has a fixed period of life, usually three to six months.
An option is a wasting asset in the sense that the value of an option diminishes as the
date of maturity approaches and on the date of maturity it is equal to zero.
An investor in options has four choices before him. Firstly, he can buy a call option
meaning a right to buy an asset after a certain period of time. Secondly, he can buy a
put option meaning a right to sell an asset after a certain period of time. Thirdly, he
can write a call option meaning he can sell the right to buy an asset to another
investor. Lastly, he can write a put option meaning he can sell a right to sell to another
investor.
Out of the above four cases in the first two cases the investor has to pay an option
premium while in the last two cases the investors receives an option premium.
3.4.1 DEFINITION:
An option is a derivative i.e. its value is derived from something else. In the
case of the stock option its value is based on the underlying stock (equity). In the case
of the index option, its value is based on the underlying index.
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.
Put option:
A put option gives the holder the right but the not the obligation to sell an asset by
a certain date for a certain price.
Option price:
Option price is the price, which the option buyer pays to the option seller. It is
also referred to as the option premium.
Expiration date:
The date specified in the option contract is known as the expiration date, the
exercise date, the straight date or the maturity date.
Strike Price:
The price specified in the option contract is known as the strike price or the
exercise price.
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American options:
American options are the options that the can be exercised at any time up to the
expiration date. Most exchange-traded options are American.
European options:
European options are the options that can be exercised only on the expiration
date itself. European options are easier to analyze than the American options and
properties of an American option are frequently deduced from those of its European
counter part.
In-the-money option:
An in-the-money option (ITM) is an option that would lead to a positive cash
flow to the holder if it were exercised immediately. A call option in the index is said to
be in the money when the current index stands at higher level that 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 in the money. In the case of a put option, the put is in the money if the
index is below the strike price.
At-the-money option:
An At-the-money option (ATM) is an option that would lead to zero cash flowif it
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 the money (OTM) option is an option that would lead to a negative
cash flow if it were 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.
An option that grants the buyer the right to purchase a desired instrument is
called a call option. A call option is contract that gives its owner the right but not the
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obligation, to buy a specified asset at specified prices on or before a specified date.
An American call option can be exercised on or before the specified date. But, a
European option can be exercised on the specified date only.
The writer of the call option may not own the shares for which the call is
written. If he owns the shares it is a ‘Covered Call’ and if he des not owns the shares it
is a ‘Naked call’.
Strategies:
The following are the strategies adopted by the parties of a call option.
Assuming that brokerage, commission, margins, premium, transaction costs and taxes
are ignored.
A call option buyer’s profit/loss can be defined as follows:
At all points where spot price < exercise price, there will be a loss.
At all points where spot prices > exercise price, there will be a profit.
Call Option buyer’s losses are limited and profits are unlimited.
Conversely, the call option writer’s profits/loss will be as follows:
At all points where spot prices < exercise price, there will be a profit
At all points where spot prices > exercise price, there will be a loss
Call Option writer’s profits are limited and losses are unlimited.
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The following are the strategies adopted by the parties of a put
option.
A put option buyer’s profit/loss can be defined as follows:
At all points where spot price<exercise price, there will be a gain.
At all points where spot price>exercise price, there will be a loss.
Conversely, the put option writer’s profit/loss will be as follows:
At all points where spot price<exercise price, there will be a loss.
At all points where spot price>exercise price, there will be a profit.
Following is the table, which explains In-the-money, Out-of-the Money and At-the
money positions for a Put option.
Exercise put option Spot price<Exercise price In-The-Money
Do not Exercise Spot price>Exercise price Out-of-The-Money
Exercise/Do not Exercise Spot price=Exercise price At-The-Money
Interest Rate:
The present value of the exercise price will depend on the interest rate. The value
of the call option will increase with the rise in interest rates. Since, the present value
of the exercise price will fall; the effect is reversed in the case of a put option. The
buyer of a put option receives exercise price and therefore as the interest increases,
the value of the put option will decrease.
Time to Expiration:
The present value of the exercise price also depends on the time to expiration
of the option. The present value of the exercise price will be less if the time to
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expiration is longer and consequently value of the option will be higher. Longer the
time to expiration higher is the possibility of the option to be more in the money.
Volatility:
The volatility part of the pricing model is used to measure fluctuations expected
in the value of the underlying security or period of time. The more volatile the
underlying security, the greater is the price of the option. There are two different kinds
of volatility.
They are Historical Volatility and Implied Volatility. Historical volatility
estimates volatility based on past prices. Implied volatility starts with the option price
as a given, and works backward to ascertain the theoretical value of volatility which is
equal to the market price minus any intrinsic value.
The principle that options can completely eliminate market risk from a stock
portfolio is the basis of Black Scholes pricing model in 1973. Interestingly, before
Black and Sholes came up with their option pricing model, there was a wide spread
belief that the expected growth of the underlying asset ought to effect the option price.
Black and Sholes demonstrate that this is not true. The beauty of black and scholes
model is that like any good model, it tells us what is important and what is not. It
doesn’t promise to produce the exact prices that show up in the market, but certainly
does a remarkable job of pricing options within the framework of assumptions of the
model.
The following are the assumptions;
1. There are no transaction costs and taxes.
2. The risk from interest rate is constant.
3. The markets are always open and trading is continuous.
4. The stock pays no dividend. During the option period the firm should not pay
any dividend.
5. The option must be European option.
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6. There are no short selling constraints and investors get full use of short sale
proceeds.
The options price for a call computed as per the following Black Scholes formula:
VC =PS N (d1) - PX/ (e (RF) (T)) N (d2)
The value of Put option as per Black scholes formula:
VP=PX/(e (RF)(T)) N (-d2 )-PS N (-d1)
Where
d1= In [PS/PX] +T [RF+ (S.D) 2 / 2] / S.D (sqrt (T))
d2= d1-S.D (sqrt (T))
VC= value of call option
VP= value of put option
PS= current price of the share
PX= exercise price of the share
RF= Risk free rate of return
T= time period remaining to expiration
N (d1) = after calculation of d1, value normal distribution area is to be identified.
N (d2) = after calculation of d2, value normal distribution area is to be identified.
S.D= risk rate of the share
In = Natural log value of ratio of PS and PX
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Pricing Stock Options:
The Black Scholes options pricing formula that we used to price European calls
and puts, with some adjustments can be used to price American calls and puts &
stocks. Pricing American options becomes a little difficult because, unlike European
options, American options can be exercised any time prior to expiration. When no
dividends are expected during the life of options the options can be valued simply by
substituting the values of the stock price, strike price, stock volatility, risk free rate
and time to expiration in the black scholes formula. However, when dividends are
expected during the life of the options, it is some times optimal to exercise the option
just before the underlying stock goes ex-dividend. Hence, when valuing options on
dividend paying stocks we should consider exercised possibilities in two situations.
One-just before the underlying stock goes Ex-dividend, two – at expiration of the
options contract.
Therefore, owing an option on a dividend paying stock today is like owing to
options one in long maturity option with a time to maturity from today till the
expiration date, and other is a short maturity with a time to maturity from today till
just before the stock goes Ex-dividend.
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4. The buyer limits the downside risk to the option premium but retain the upside
potential.
5. In options premium are to be paid. But they are less as compare to margin in
futures.
3.5 Swaps
Financial swaps are a funding technique, which permit a borrower to access
one market and then exchange the liability for another type of liability. Global
financial markets present borrowers and investors with a variety of financing and
investment vehicles in terms of currency and type of coupon – fixed or floating. It
must be noted that the swaps by themselves are not a funding instrument: They are
devices to obtain the desired form of financing indirectly. The borrower might
otherwise as found this too expensive or even inaccessible.
A common explanation for the popularity of swaps concerns the concept of
comparative advantage. The basis principle is that some companies have a
comparative advantage when borrowing in fixed markets while other companies have
a comparative advantage in floating markets. Swaps are used to transform the fixed
rate loan into a floating rate loan.
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payment streams, which are fixed and floating in nature. Such an exchange is referred
to as an exchange of borrowings. For example, ‘B’ to pay the other party ‘A’ cash
flows equal to interest at a pre-determined fixed rate on a notional principal for a
number of years. At the same time, party ‘A’ agrees to pay ‘B’ cash flows equal to
interest at a floating rate on the same notional principal for the same period of time.
The currencies of the two sets of interest cash flows are the same. The life of the swap
can range from two years to fifty years. Usually two non-financial companies do not
get in touch with each other to directly arrange a swap. They each deal with a
financial intermediary such as a bank.
At any given point of time, the swaps spreads are determined by supply and
demand. If no participants in the swaps market want to receive fixed rather than
floating, Swap spreads tend to fall. If the reverse is true, the swaps spread tend to rise.
In real life, it is difficult to envisage a situation where two companies contact a
financial institution at a exactly same with a proposal to take opposite positions in the
same swap.
Currency Swaps
Currency swaps involves exchanging principal and fixed interest payments on
a loan in one currency for principal and fixed interest payments on an approximately
equivalent loan in another currency.
Example:
Suppose that a company ‘A’ and company ‘B’ are offered the fixed five years
rates of interest in US $ and Sterling. Also suppose that sterling rates are higher than
the dollar rates. Also, company ‘A’ a better credit worthiness then company ‘B’ as it is
offered better rates on both dollar and sterling. What is important to the trader who
structures the swap deal is that the difference in the rates offered to the companies on
both currencies is not same. Therefore, though company ‘A’ has a better deal. In both
the currency markets, company ‘B’ does enjoy a comparative lower disadvantage in
one of the markets. This creates an ideal situation for a currency swap. The deal could
be structured such that the company ‘B’ borrows in the market in which it has a lower
disadvantage and company ‘A’ in which it has a higher advantage. They swap to
achieve the desired currency to the benefit of all concerned.
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A point to note is that the principal must be specified at the outset for each of the
currencies. The principal amounts are usually exchanged at the beginning and the end
of the life of the swap. They are chosen such that they are equal at the exchange rate
at the beginning of the life of the swap.
Like interest swaps, currency swaps are frequently warehoused by financial
institutions that carefully monitor their exposure in various currencies so that they can
hedge currency risk.
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CHAPTER-IV
4.1 FUTURES
Example:
On 7th Jan 2016 HDFC is trading at 1200 and HDFC Jan 2016 Contract is trading @
1210.
We expect the share price to rise significantly and want to make a profit from the
increase.
Lot size of HDFC is 550
Span Margin for HDFC Future is 42.93% on the contract value
If an Investor bought 1 HDFC Future @ 2120 on 7 th January 2012 and the closing
price
of HDFC Future on 16th Jan 2016 is . To make profit from this transaction the buyer of
the contract can sell the Future and book profit.
Span Margin Payable for buying HDFC Contract = 1210x550x42.93%=28333.8
Capital Invested on this contract is Rs.28333.8/-
On 16th Jan 2016 HDFC January Contract is trading @1500, If the investor sold the
contract then he would have gained profit of Rs.665500/-
Profit = (-1210) x 550 = Rs.665500/-
On 23rd Jan 2016 HDFC Jan Future closed @ 1000; if the investor holds the future till
date. His Mark to Market loss is as follows
Mark to Market Loss = (1000-1210) x 550 = Rs.664500/-
Investor has to pay/receive the margin with respect to the yesterday’s closing price
and to the today’s closing price.
Mark to Market margin payable/receivable = (Today’s Closing price – Yesterdays
Closing Price) x Lot Size
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CHAPTER-5
CONCLUSIONS
Derivatives have existed and evolved over a long time, with roots in
commodities market. In the recent years advances in financial markets and the
technology have made derivatives easy for the investors.
In order to increase the derivatives market in India SEBI should revise some
of their regulation like contract size, participation of FII in the derivative
market. Contract size should be minimized because small investor cannot
afford this much of huge premiums.
In cash market the profit/loss is limited but where in F& O an investor can
enjoy unlimited profits/loss.
In cash market the investor has to pay the total money, but in derivatives the
investor has to pay premiums or margins, which are some percentage of
totaloney.
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Suggestions to Investors
The investors can minimize risk by investing in derivatives. The use of derivative
equips the investor to face the risk, which is uncertain. Though the use of derivatives
does not completely eliminate the risk, but it certainly lessens the risk.
It is advisable to the investor to invest in the derivatives market because of the greater
amount of liquidity offered by the financial derivatives and the lower transactions
costs associated with the trading of financial derivatives.
The derivatives products give the investor an option or choice whether to exercise
the contract or not. Options give the choice to the investor to either exercise his right
or not. If on expiry date the investor finds that the underlying asset in the option
contract is traded at a less price in the stock market then, he has the full liberty to get
out of the option contract and go ahead and buy the asset from the stock market. So in
case of high uncertainty the investor can go for options.
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Bibliography
Books:-
Indian financial system - M.Y. Khan
Investment management - V.K. Bhalla
Publications of National Stock Exchange
News Papers:-
The Financial Express
Business World
Economic Times
Websites
www.nseindia.org
www.bseindia.com
www.Unicon.com
www.sebi.gov.in
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GLOSSARGLOSSARY
Derivatives – Derivatives are instruments that derive their value and payoff from
Another asset, called underlying asset.
Call Option – the option to buy an asset is known as a call option
Put option – the option to an asset is called a put option.
Exercise Prices – The price at which option can be exercised is called an exercise
price or a strike price.
European option – Where an option is allowed to be exercised only on the maturity
Date, it is called a European option
American option – When the option can be exercised any time before its maturity, it
is called an American Option.
In-the-money option – A put or a call option is said to in-the-option when it is
advantageous for the investor to exercise it. In the case of in-the-money call option,
the exercise price is less than the current value of the underlying asset, while in the
case of the in-the-money put options; the exercise price is higher than the current
value of stage underlying asset.
Out-of-the money option – A put or call option is out-of-the-money if it is not
Advantageous for the investor to exercise it. In the case of the out-of-the-money call
option, the exercise price is less than the current value of the underlying asset,
While in the case of the out – of-the-money put option, the exer4cise price is lower
than the current value of the underlying asset.
At-the-option – When the holder of a put or a call option does not lose of gain
whether of not he exercises his option, the option is said to be at-the-money. In the
case of the out-of-the-money option the exercise price is equal to the current value of
the underlying asset.
Straddle – The investor can also create a portfolio of a call and a put with the same
Exercise price. This is called a straddle.
Spread – If call and put with different exercise price are combined, it is called a
spread.
Strip – A strips is a combination of two puts and one call with the same exercise price
and the expiration date.
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Strap – A strap, on the other hand, entails combing two calls and one put.
Swaps – Swaps are similar to futures and forwards contracts in providing hedge
against financial risk. A swap is an agreement between two parties, called
counterparties, to trade cash flows over a period of time.
Currency Swaps – Currency swaps involves an exchange of payments in one
currency for cash payments in another currency.
Bullish spread – An investor may be expecting the price of an underlying share to
rise. But he may not like to take higher risk.
Bearish Spread – An investor, who is expecting a share of index to0 fall, may sell the
Higher-*priced option and buy the lower-price option.
Index options – Index options are call or put options on the stock markets indices. In
India, there are options on the Bombay Stock Exchange, Sensex and the national
Stock Exchange, Nifty.
Premium – The price of an option contract, determined on the exchange which the
Buyer of the option pays to the options writer for the fights to the option contract.
Futures – Futures is a financial contract which derives its value for the underlying
asset.
Forward – In a forward contract, two parties agree to buy or sell some underlying
Asset on some future date at a stated price and quantity.
Index futures – Index futures is one of the most successful financial innovation of the
Financial market. In 1982, the stock index future was introduced.
Margin – Depending upon the nature of the buyer and seller the margin requirement
to deposit with the stock exchange is fixed.
Hedging – Hedging is the term used for reducing risk by using derivatives.
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