15596367 Final Project Report on Financial Derivativies

8/12/2019 15596367 Final Project Report on Financial Derivativies

1/41

CONTENTS

Derivativesan overviewFutures contract

Hedging in futures

Speculating in futures

Arbitrage in futures

Options

Options strategies

Derivatives products

Open interest

Futures price = spot price + cost of carry


2/41

DERIVATIVES

The word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a

future image or copy of a underlying asset which may be shares, stocks, commodities, stockindices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and

borrowing (bank) does not have its value borrow the value from underlying asset/ basic

variables.

Derivatives is derived from the following products:

A. SharesB. Debuntures

C. Mutual funds

D. Gold

E.

SteelF. Interest rate

G. Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and

other is bearish in the market having opposite views regarding the market. There cannot be aderivatives having same views about the market. In short it is like a INSURANCE market where

investors cover their risk for a particular position.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived

from the value of an underlying primary financial instrument, commodity or index, such as:

interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes

in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.Hedging is the most important aspect of derivatives and also its basic economic purpose. There

has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives

as means of reducing risk but its a business for them. Rathe r he accepts risks from the hedgersin pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are

essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotionand acceptance of market economy, that has really contributed towards the growing awareness of

risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introducedderivatives in the local currency Interest Rate markets, which have not really developed, but with


3/41

the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product

in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index

futures

BACKGROUND

Consider a hypothetical situation in which ABC trading company has to import a raw material

for manufacturing goods. But this raw material is required only after 3 months. However in 3months the prices of raw material may go up or go down due to foreign exchange fluctuations

and at this point of time it can not be predicted whether the prices would go up or come down.

Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then

he will incur heavy interest and storage charges. However, the availability of derivatives solvesthe problem of importer. He can buy currency derivatives. Now any loss due to rise in raw

material prices would be offset by profits on the futures contract and vice versa. Hence the

company can hedge its risk through the use of derivatives

DEFINATIONS

According to JOHN C. HUL A derivatives can be defined as a financial instrument whosevalue depends on (or derives from) the values of other, more basic underlying variables.

According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even

more simply an agreement between two people) which has a value determined by the price ofsomething else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the

definition of Securities. The term Derivative has been defined in Securities Contracts

(Regulations) Act, as:-

A Derivative includes: -

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. contract which derives its value from the prices, or index of prices, of underlying

securities.


4/41

Derivatives were developed primarily to manage, offset or hedge against risk but some were

developed primarily to provide the potential for high returns.

I NTRODUCTION TO FUTURE MARKET

Futures markets were designed to solve the problems that exit in forward markets. A futurescon tract is an agreement between two parties to buy or sell an asset at a certain time in the future

at a certain price. There is a multilateral contract between the buyer and seller for a underlying

asset which may be financial instrument or physical commodities. But unlike forward contracts

the future contracts are standardized and exchange traded.

PURPOSE

The primary purpose of futures market is to provide an efficient and effective mechanism formanagement of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are affected

mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has

to pay the margin to trade in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the

settlement day only, even though the payoffs are on a daily marking to market basis to avoid

default risk. Hence, the gains or losses are netted off on a daily basis and each morning startswith a fresh opening value. Here both the parties face an equal amount of risk and are also

required to pay upfront margins to the exchange irrespective of whether they are buyers orsellers. Index based financial futures are settled in cash unlike futures on individual stocks whichare very rare and yet to be launched even in the US. Most of the financial futures worldwide are

index based and hence the buyer never comes to know who the seller is, both due to the presence

of the clearing corporation of the stock exchange in between and also due to secrecy reasons

EXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is

bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh haspurchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of

infosys is 300 shares.

Suppose the stock rises to 2200.


5/41

Profit

202200

10

01400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit forthe buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400

Profit

20

10

0

1400 1500 1600 1700 1800 1900-10

-20


6/41

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is

250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some

date in the future. Futures are often used by mutual funds and large institutions to hedge theirpositions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or

the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in

proportion to the total value of contract

MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract.

Normally the margin requirement has been designed on the concept of VAR at 99% levels.

Based on the value at risk of the stock/index margins are calculated. In general margin rangesbetween 10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on

their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin

approximately equals the maximum daily price fluctuation permitted for the contract being

traded. Upon proper completion of all obligations associated with a traders futures position, theinitial margin is returned to the trader.

OBJECTIVE

The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer andseller have to deposit margins. The initial margin is deposited before the opening of the position

in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than

initial margin. This is set to ensure that the balance in the margin account never becomes


7/41

negative. If the balance in the margin account falls below the maintenance margin, the investor

receives a margin call to top up the margin account to the initial level before trading

commencing on the next level.

ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX niftyfutures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%.

The lot size of nifty futures =200.suppose on MAY 16th

The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in themarket. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17

th

nifty futures settled at 1400.Profit of buyer will be 10,000[(1450-1350)*200]

Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to thesettlement price on a daily basis. Deficiencies in margin requirements are called for the broker,

through margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the

exchange. This is generally imposed when the exchange fears that the markets have become toovolatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by

exchange to prevent breakdown.


8/41

CROSS MARGINING:This is a method of calculating margin after taking into account combined positions in Futures,

options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is

done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin.Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market

margin also called as variation margin for trading in the future contract


9/41


10/41

HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change to which trhey are alreadyexposed.It is a mechanism by which the participants in the physical/ cash markets can cover their

price risk. Hedgers are those persons who dont want to take the risk therefore they hedge their

risk while taking position in the contract. In short it is a way of reducing risks when the investorhas the underlying security.

PURPOSE:

TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK

Figure 1.1

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is only

during adverse reward dependant 2)For Long, buy ATM Put premium.

market conditions on market prices Option. If market goes up,

as circuit filters long position benefit elselimit to curtail losses. exercise the option.

3)Sell deep OTM call option

with underlying shares, earn

premium + profit with increase prcie

Advantages Availability of Leverage


11/41

STRATEGY:The basic hedging strategy is to take an equal and opposite position in the futures market to thespot market. If the investor buys the scrip in the spot market but suddenly the market drops then

the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification.

Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging isimplemented by adding a negatively and perfectly correlated asset to an existing asset. Hedgingeliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes

risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk).

Diversification is affected by choosing a group of assets instead of a single asset (technically, byadding positively and imperfectly correlated assets).

ILLUSTRATION

Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of

manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale iscompleted.

COST SELLING PRICE PROFIT

400 1000 600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the

contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if

Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.

Shyam defaults Shyam honors

400 (Initial Investment) 600 (Initial profit)

400 (penalty from Shyam (-100) discount given to Shyam

- (No gain/loss) 500 (Net gain)


12/41

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial

investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of

Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default andprotected his initial investment.

Now lets see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that themarket would go down due to some news. Then, to minimize your downside risk you could

hedge your position by buying a Put Option. This will hedge your downside risk in the market

and your loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging is theremoval of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits

than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to

make excess profits for sure; all that can come out of hedging is reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are

not subject to margins as in hedging through futures. Options buyers are however required to pay

premium which are sometimes so high that makes options unattractive.

ILLUSTRATION:

With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the investor

excepts that price will fall by 100.So he decided to buy the put Option b y paying the premiumof Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls

by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered

Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:


13/41

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount ofNifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position.

Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the

security, without any extra risk from fluctuations of the market index. Finally the investor hasHEDGED AWAY his index exposure.

EXAMPLE:

LONG SECURITY, SELL FUTURES

Here stock futures can be used as an effective risk management tool. In this case the

investor buys the shares of the company but suddenly the rally goes down. Thus to maximize therisk the Hedger enters into a future contract and takes a short position. However the losses

suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390

Market action = 350

Loss = 40Strategy = BUY SECURITY, SELL FUTURES

Two month Futures= 390Premium = 12Short position = 390

Future profit = 40(390-350)

As the fall in the price of the security will result in a fall in the price of Futures. Now the Futureswill trade at a price lower then the price at which the hedger entered into a short position.


14/41

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made

on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares ofHLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price.Therefore the solution is buy put options on HLL.

The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here theinvestor has two possible scenarios three months later.

1) IF PRICE RISES

Market action: 215

Loss : 17(232-15)

Strike price : 240Premium : 08

Profit : 17(240-215-8)

Thus loss he suffers on the stock will be offset by the profit the investor earns on the putoption bought.

2) IF PRICE RISES:

Market share : 250

Loss : 10

Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike price investor chooses) and an

unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and selling nifty futures. In the case

of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a

position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the

LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on1

stMay, 2001.

Company Beta Amount of Holding ( in Rs)

Infosys 1.55 400,000.00

Global Tele 2.06 200,000.00


15/41

Satyam Comp 1.95 175,000.00

HFCL 1.9 125,000.00

Total Value of Portfolio 1,000,000.00

Trading Strategy to be followed

The investor feels that the market will go down in the next two months and wants to protect himfrom any adverse movement. To achieve this the investor has to go short on 2 months NIFTY

futures i.e he has to sell June Nifty. This strategy is called Short Hedge.

Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level

Beta of the above portfolio

=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1stMay 2001

= (1,000,000.00 * 1.61) / 1150

= 1400 Units

Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short Hedge

Stock Market Futures Market

1sMay Holds Rs 1,000,000.00 in

stock portfolioSell 7 NIFTY futurescontract at 1150.

25 June Stock portfolio fall by 6%

to Rs 940,000.00

NIFTY futures falls by

4.5% to 1098.25

Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00

Net Profit: + Rs 15,450.00

SPECULATORS:


16/41

If hedgers are the people who wish to avoid price risk, speculators are those who are willing to

take such risk. speculators are those who do not have any position and simply play with the

others money. They only have a particular view on the market, stock, commodity etc. In short,speculators put their money at risk in the hope of profiting from an anticipated price change.

Here if speculators view is correct he earns profit. In the event of speculator not being covered,

he will loose the position. They consider various factors such as demand supply, marketpositions, open interests, economic fundamentals and other data to take their positions.

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 conservativespeculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price

discovery in the market.

Figure 1.2

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possible

trading& carry price change. 2) Buy Call &Put to premium

forward transactions. by paying paid


17/41

2) Buy Index Futures premium

hold till expiry. Advantages Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

ILLUSTRATION:

Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500

Strategy: Buy February PATNI futures contract at 1500

Lot size = 100 shares

Contract value = 1,50,000 (1500*100)

Margin = 15000 (10% of 150000)

Market action = rise to 1550

Future Gain:Rs. 5000 [(1550-1500)*100]

Market action = fall to 1400

Future loss: Rs.-10000 [(1400-1500)*100]

Thus the Speculator has a view on the market and accept the risk in anticipating of profiting fromthe view. He study the market and play the game with the stock market

TYPES:

POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until theirtarget is met.


18/41

DAY TRADERS:

. Day traders square off the position during the curse of the trading day and book the profits.

SCALPERS:

Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he can buy put or call optiondepending upon his perception about future price. If speculator has a bullish outlook, he will buy

calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If

speculators view is correct he earns profit. In the event of speculator not being covered, he willloose the position. A Speculator will buy call or put if his price outlook in a particular direction

is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn

premium in the event of price situations.

ILLUSTRATION:

Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of

Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit

otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEETELEFILMS stock will come down then he will buy put on the stale price until he can write

either call or put.

Finally Speculators provide depth an liquidity to the futures market an in their absence; the price

protection sought the hedger would be very costly.

STRATEGIES:

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish in the market.

Speculator buys the shares of the company an makes the profit. At the same time the Speculatorenters into the future contract i.e. buys futures and makes profit.

Spot Price of RELIANCE = 1000

Value = 1000*100shares = 1,00,000Market action = 1010

Profit = 1000

Initial margin = 20,000


19/41

Market action = 1010

Profit = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes

a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the

Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

BUY STOCK

ACC spot price : 150No of shares : 200Price : 150*200 = 30,000

Market action : 160

Profit : 2,000Return : 6.6% returns over 2months

BUY CALL OPTION:

Strike price : 150Premium : 8

Lot size : 200 sharesMarket action :160

Profit : (160-150-8)*200 = 400

Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a

investment of 2months as compared to 6.6% returns over a investment in stocks

BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall in price. Here simple

arbitrage ensures that futures on an individual securities more correspondingly with the


20/41

underlying security as long as there is sufficient liquidity in the market for the security. If thesecurity price rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240

Lot size = 100sharesMargin = 24

Market action = 220

Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit

because the speculator is bearish in the market and all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can BUY OR SELL

the entire index trading on one single security. Once a person is LONG NIFTY using the futuresmarket, the investor gains if the index rises and loss if the index falls.

1stJuly = Index will rise

Buy nifty July contract = 960

Lot =200

14th

July nifty risen= 967.35

Nifty July contract= 980

Short position =980

Profit = 4000(200*20)

ARBITRAGEURS :

Arbitrage is the concept of simultaneous buying of securities in one market where the

price is low and selling in another market where the price is higher.


21/41

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and

knowledgeable person and ready to take the risk He is basically risk averse. He enters

into those contracts were he can earn risk less profits. When markets are imperfect,

buying in one market and simultaneously selling in other market gives risk less profit.

Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower

priced market and selling at the higher priced market.

JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where

the investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operating in them

simultaneously.

Figure 1.3

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free

one and selling in whichever way the promising as still game.another exchange. Market moves. in weekly settlement

forward transactions. 2) Cash &Carry

2) If Future Contract arbitrage continuesmore or less than Fair price


22/41

Fair Price = Cash Price + Cost of Carry.

Example:

Current market price of ONGC in BSE= 500

Current market price of ONGC in NSE= 510


Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES:

In this the investor observing that futures have been overpriced, how can the investor

cash in this opportunity to earn risk less profits. Say forinstance ACC = 1000 andOne month

ACC futures = 1025.

This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make

riskless profits entering into the following set f transactions.

On day one, borrow funds, buy security on the spot market at 1000

Simultansely, sell the futures on the security at1025

Take delivery of the security purchased and hold the security for a month

on the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.1015. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futuresposition

Return the Borrow funds.


23/41

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit

possible, it makes sense for the investor to enter into the arbitrage. This is termed as cashand-

carry arbitrage.

BUY FUTURES, SELL SPOT:

In this the investor observing that futures have been under priced, how can the

investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and

One month ACC futures = 965.

This shows that futures have been under priced and therefore as an Arbitrageur, investor can

make riskless profits entering into the following set f transactions.

On day one, sell the security on the spot market at 1000

Mae delivery of the security

Simultansely, buy the futures on the security at 965

On the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.975. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from thearbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse

cashand- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between two markets. Anarbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to

arbitraged between NIFTY in the futures market and the cash market. If the futures price is anyof the prices given below other than the equilibrium price then the strategy to be followed is


24/41

CASE-1

Spot Price of INFOSEYS = 1650

Future Price Of INFOSEYS = 1675

In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the

futures at Rs.1675 and finally earn risk free profit Of Rs.25.

CASE-2

Future Price Of ACC = 675

Spot Price of ACC = 700

In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot atRs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer

(holder) the right, but not the obligation, to buy or sell specified quantity of the underlying

assets, at a specific (strike) price on or before a specified time (expiration date). The underlying

may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments likeequity stocks/ stock index/ bonds etc.

MONTHLY OPTIONS :


25/41

The exchange trade option with one month maturity and the contract usually expires on last

Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as thepremium paid for hedging is very high. Also the trader has to pay more money to take a long orshort position which results into iiliquidity in the market.Thus to overcome the problem the BSE

introduced WEEKLY OPTIONS

WEEKLY OPTIONS:

The exchange trade option with one or weak maturity and the contract expires on last Friday of

every weak

ADVANTAGES

Weekly Options are advantageous to many to investors, hedgers and traders. The premium paid for buying options is also much lower as they have shorter time to

maturity. The trader will also have to pay lesser money to take a long or short position. the trader can take a larger position in the market with limited loss. On account of low

cost, the liquidity will improve, as more participants would come in.

Weekly Options would lead to better price discovery and improvement in market depth,

resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of

the underlying asset at the strike price on or before expiration date. The seller (one who is shortcall) however, has the obligation to sell the underlying asset if the buyer of the call option

decides to exercise his option to buy. To acquire this right the buyer pays a premium to the

writer (seller) of the contract.ILLUSTRATION

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the

market and other is Rakesh (call seller) who is bearish in the market.The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be

excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will

earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has


26/41

crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from

the seller at Rs.600 and sell in the market at Rs.660.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

Unlimited profit for the buyer = Rs.35{(spot pricestrike price)premium}

Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock

price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20

10


27/41

0

590 600 610 620 630 640

-10

-20

-30

Loss

Profit for the Seller limited to the premium received = Rs.25

Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the

lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimitedlosses and have limited losses to the certain extent

Thus call option indicates two positions as follows: LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying

call option. SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling

call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity ofthe underlying asset at the strike price on or before a expiry date. The seller of the put option

(one who is short Put) however, has the obligation to buy the underlying asset at the strike price

if the buyer decides to exercise his option to sell.

ILLUSTRATION

Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the

market and other is Amit(put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):


28/41

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be

excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyersbreakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the

share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be

exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to theseller at Rs.800

Profit

20

10

0

600 700 800 900 1000 1100-10

-20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike pricespot price)premium}

Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of thePut option will choose not to exercise his option to sell as he can sell in the market at a higher

rate.

profit


29/41

20

10

0

600 700 800 900 1000 1100-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for

the seller because the seller is bullish in the market = 780 - 750 = 30

Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITIONIf the investor expects price to fall i.e. bearish in the market he takes a long position by buyingPut option.

SHORT POSITION

If the investor expects price to rise i.e. bullish in the market he takes a short position by sellingPut option

CALL OPTIONS PUT OPTIONS

Option buyer oroption holder

Buys the right to buy theunderlying asset at the

specified price

Buys the right to sell theunderlying asset at the

specified price


30/41

Option seller or

option writer

Has the obligation to sell

the underlying asset (to theoption holder) at the

specified price

Has the obligation to buy

the underlying asset (fromthe option holder) at the

specified price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)Changes in the underlying asset price can increase or decrease the premium of an option. Theseprice changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and thepremium of a put will decrease. A decrease in the price of the underlying assets value will

generally have the opposite effect

Premium of the Premium of the

Price of the CALL Price of CALLUnderlying Underlying

asset asset

Premium of the

Premium of the PUTPUT

THE SRIKE PRICE: (K)The strike price determines whether or not an option has any intrinsic value. An options

premium generally increases as the option gets further in the money, and decreases as the option

becomes more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value, for puts and calls, decreases.

Volatility:Volatility is simply a measure of risk (uncertainty), or variability of an options underlying.

Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying

price levels. This expectation generally results in higher option premiums for puts and calls alike,and is most noticeable with at- the- money options.


31/41

Interest rate: (R1)This effect reflects the COST OF CARRY the interest that might be paid for margin, in caseof an option seller or received from alternative investments in the case of an option buyer for the

premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:

a)Developmental institutionsb)Mutual Fundsc)Domestic & Foreign Institutional Investorsd)Brokers

e)

Retail Participants


32/41


33/41

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION :

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at aprice agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller

are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlyingasset.

RISKFutures Contracts have symmetric risk profile for both the buyer as well as the seller.

While options have asymmetric risk profile. In case of Options, for a buyer (or holder of theoption), the downside is limited to the premium (option price) he has paid while the profits may

be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits

are limited to the premium he has received from the buyer.

PRICES:

The Futures contracts prices are affected mainly by the prices of the underlying asset.

While the prices of options are however, affected by prices of the underlying asset, time

remaining for expiry of the contract & volatility of the underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options

contract, termed as Premium.

STRIKE PRICE:


34/41

In the Futures contract the strike price moves while in the option contract the strike price

remains constant .

Liquidity:

As Futures contract are more popular as compared to options. Also the premium charged is high

in the options. So there is a limited Liquidity in the options as compared to Futures. There is no

dedicated trading and investors in the options contract.

Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of

the underlying only. While trading in option is two-dimensional as the price of the option

depends upon the price and volatility of the underlying.

PAY OFF:

As options contract are less active as compared to futures which results into non linear pay off.

While futures are more active has linear pay off .


35/41

OPTION STRATAGIES:

1. BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull CallSpread consists of the purchase of a lower strike price call an sale of a higher strike price call, of

the same month. However, the total investment is usually far less than that required to purchase

the stock.

Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of

1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)


BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at

Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will

expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5which is less than premium paid result in loss of 5.While 1510 call option sold will not expire

which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of

10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium

receive generate profit .


36/41

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless.While 1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in themoney. While 1510 call sold will have no intrinsic value and expire worthless and profit is the

premium received of Rs. 10

iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10

while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result inloss to the premium paid.

The pay-off table:

PATNI COMPUTERS

AT EXPIRATION

1485

(belowlower

price)

1490

(At thelower

price)

1495

(Betweenlower strike

&BEP

1500

(At BEP)

1510

Intrinsic value of 1490long call at expiration (a)

0 0 5 10 20

Premium paid (b) 25 25 25 25 25

Intrinsic value of 1510short call at expiration

(c)

0 0 0 0 0

Premium received (d) 15 15 15 15 15

profit/loss(a-c)-(b- d) -10 -10 -5 0 10

PATNI COMPUTERS

AT EXPIRATION

1495

(below

higher

price)

1510

(At the

higher

price)

1505

(Between

higher strike

&BEP

1500

(At BEP)

1520

(Above BEP


37/41

Intrinsic value of 1510

short call at expiration(a)

0 0 0 0 10

Premium paid (b) 15 15 15 15 15


long call at expiration (c)

5 20 15 10 30


profit/loss(c-a)-( d - b) -5 10 5 0 10

Profit

20

10

01490 1500 1510 1520 1530 1540

-10

-20

Loss

2.BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists

of the purchase a higher strike price put and sale of a lower strike price put, of the same month.

It provides high leverage over a limited range of stock prices. However, the total investment is

usually far less than that required to buy the stock shares.

Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell onemonth put of 4490 (lower price) and receive 45 ticks per contract.

Premium = 10 ticks per contract(55 paid- 45 received)


38/41


BREAK- EVEN- POINT= 5510-10 = 5500.



On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at

Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium

paid while the 4490 put option sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5

which is less than premium paid result in loss of 5.While 4490 call option sold will not expire

which will reduce the loss of Rs.10 through receiving the net premium.

If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium

receive will generate profit .

iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expireworthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as

the premium received

If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While

4490 put sold will have no intrinsic value and expire worthless and profit is the premium

received between the strike price an premium paid.

iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic

value. while the 4490 put option sold result in maximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic

value. while the 5510 put option sold result in the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and

4490 option sold will be assigned (strike pricepremium paid) = profit .


39/41

The pay-off table:

INFOSYS ATEXPIRATION

5520

(Above

strike)

5510

(At the

strike)

5505

(Between

lower strike&BEP

5500

(At BEP)

4480


long put at expiration (a)

0 0 5 10 30

Premium paid (b) 55 55 55 55 55Intrinsic value of 4490

short put at expiration (c)

0 0 0 0 10


profit/loss(a-c)-(b- d) -10 -10 -5 0 10

INFOSYS ATEXPIRATION

5505

(Above

strike)

4490

(At the

strike)

4495

(Between

strike &BEP

5500

(At BEP)

4480

(below

strike price)


short put at expiration (a)

0 0 0 0 10

Premium received (b) 45 45 45 45 45


long put at expiration (c)

5 30 15 10 30

Premium paid (d) 55 55 55 55 55

profit/loss[(c-a)-( d - b)] -5 20 15 0 10


40/41

Profit

20

10

0

3000 3500 4000 4500 5000 5500 6000 6500 7000-10

-20

Loss

3.BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market

to provide high leverage over a limited range of stock prices. The investor buys a lower strike putand selling a higher strike put with the same expiration dates. The strategy has both limited profit

potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell

one month put of 1310 (higher price) and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid- 15 received)


BREAK- EVEN- POINT= 1300-10 = 1290




41/41

On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an

intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have anintrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no

intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of

5.

iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire

worthless. While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money

and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t

the premium received

FOR COMPLETE REPORT AND

DOWNLOADING

VISIT

HTTP://PAKISTANMBA.JIMDO.COM

Date post:	03-Jun-2018
Category:	Documents
Upload:	alkanm750
View:	222 times
Download:	0 times

15596367 Final Project Report on Financial Derivativies

Documents