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INTRODUCTION

A derivative security is a security whose value depends on the value of together more basic underlying variable these are also known as contingent claims. Securities have been very successful in innovation in capital markets.

The emergence of the market for derivatives product most notably forward, future and option can be traced back to willingness of risk averse economic agents to guard themselves against uncertain arising out of fluctuation in asset prices. By their very nature, financial markets are market by a very high degree of volatility. Though the use of derivatives 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 fluctuation in underlying asset prices.

However, by locking-in asset prices, derivatives products minimize the impact of fluctuation in assets prices on the profitability and cash- flow situation of risk-averse investor.

Derivatives are risk management instruments which derives their value from an underlying asset. Underlying assets can be bullion, index, share, currency, bonds, interest, etc.

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Objectives of the Study

To understand the concept of the Financial Derivatives such as Futures and

Options.

To examine the advantage and the disadvantages of different strategies along with

situations.

To study the different ways of buying and selling of Options.

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SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to

future and option in the Indian context and the India info line has been

taken as representative sample for the study.

The study cannot be said as totally perfect, any alternation may

come. The study has only made humble attempt at evaluating Derivatives

markets only in Indian context. The study is not based on the international

perspective of the Derivatives Markets.

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Research Methodology

The type of research adopted is descriptive in nature and the data collected

for this study is the secondary data i.e. from Newspapers, Magazines and

Internet.

Limitations:

The study was conducted in Hyderabad only.

As the time was limited, study was confined to conceptual

understanding of Derivatives market in India.

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6

THE INDIA INFOLINE LIMITED

Origin:

India info line was founded in 1995 by a group of professional with impeccable

educational qualifications and professional credentials. Its institutional investors

include Intel Capital (world's) leading technology company, CDC (promoted by UK

government), ICICI, TDA and Reeshanar.

India info line group offers the entire gamut of investment products including

stock broking, Commodities broking, Mutual Funds, Fixed Deposits, GOI Relief bonds,

Post office savings and life Insurance. India Infoline is the leading corporate agent of

ICICI Prudential Life Insurance Company, which is India' No.1 Private sector life

insurance Company.

www.indiainfoline. Com has been the only India Website to have been listed by

none other than Forbes in it's 'Best of the Web' survey of global website, not just once

but three times in a row and counting... a must read for investors in south Asia is how

they choose to describe India info line. It has been rated as No.l the category of

Business News in Asia by Alexia rating.

Stock and Commodities broking is offered under the trade name 5paisa. India

Infoline Commodities pvt Ltd., a wholly owned subsidiary of India Infoline Ltd., holds

membership of MCX and NCDEX

Main Objects of the Company

Main objects as contained in its Memorandum or Association are:

1. To engage or undertake software and internet based services, data processing IT

enabled services, software development services, selling advertisement space on

the site, web consulting and related services including web designing and web

maintenance, software product development and marketing, software supply

services, computer consultancy services, E-Commerce of all types including

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electronic financial intermediation business and E-broking, market research,

business and management consultancy.

2. To undertake, conduct, study, carry on, help, promote any kind of research,

probe, investigation, survey, developmental work on economy, industries,

corporate business houses, agricultural and mineral, financial institutions,

foreign financial institutions, capital market on matters related to investment

decisions primary equity market, secondary equity market, debentures, bond,

ventures, capital funding proposals, competitive analysis, preparations of

corporate / industry profile etc. and trade / invest in researched securities.

VISION STATEMENT OF THE COMPANY:

“our vision is to be the most respected company in the financial services space in

India”.

Products: the India Infoline pvt ltd offers the following products

A. E-broking.

B. Distribution

C. Insurance

D. PMS

E. Mortgages.

A. E-Broking:

It refers to Electronic Broking of Equities, Derivatives and Commodities under the

brand name of 5paisa

1. Equities

2. Derivatives

3. Commodities

B. Distribution:1. Mutual funds

2. Govt of India bonds.

3. Fixed deposits

C. Insurance:

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1. Life insurance policies

2. General insurance

3. Health insurance

THE CORPORATE STRUCTURE

The India Info line group comprises the holding company, India Info line Ltd,

which has 5 wholly-owned subsidiaries, engaged in engaged in distinct yet

complementary businesses which together offer a whole bouquet of products and

services to make your money grow.

The corporate structure has evolved to comply with oddities of the regulatory

framework but still beautifully help attain synergy and allow flexibility to adapt to

dynamics of different businesses.

The parent company, India Info line Ltd owns and managers the web properties

www.Indiainfoline.Com and www.5paisa.com. it also undertakes research. Customized

and off-the-shelf.

Indian Info line Securities Pvt. Ltd. is a member of BSE, NSE and DP with

NSDL. Its business encompasses securities broking Portfolio Management services.

India Infoline.com Distribution Company. Mobilizes Mutual Funds and other

personal investment products such as bonds, fixed deposits, etc.

India Info line Insurance Services Ltd. Is the corporate agent of ICICI Prudential Life

Insurance, engaged in selling Life Insurance products?

India Info line Commodities Pvt. Ltd. is a registered commodities broker MCX and

offers futures trading in commodities.

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India info line services Pvt Ltd., is proving margin funding and NBFC services to

the customers of India info line Ltd.,

Pictorial Representation of India infoline Ltd

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Management of India info line Ltd.,

India infoline is a professionally managed company /s day to day affairs as

executive Directors have impeccable academic professional track record .

Nirmal jain , chairman and managing director ,is a Chartered Account ,(All Indian

Rank 2 );Cost Account , (All India rank 1)and has a post-graduate management degree

from IIM Ahmedabad .He had successful career with Hindustan Lever , where he inter

alia handle commodities trading and export business . Later he was CEO of an equity

research organization.

R.Venkataraman Director, is armed with a post-graduate management degree from

IIM Bangalore,

And an Electronic engineering degree from IIT, kharagpur. He spent eight fruitful years

in equity research sales and private equity with the cream of financial houses such as

ICICI group, Barclays de Zoette and G.E capital.

The non-executive directors on the board bring a wealth of experienced and

expertise.

Satpal khattar –Reeshanar investment, Singapore the key management team comprises

seasoned and qualified professionals.

Mukesh sing - Director, India infoline securities Pvt Ltd.

Seshadri Bharathan - Director, India infoline.com distribution co Ltd

S sriram - Vice president, Technology

Sandeepa Vig Arora - Vice president, portfolio Management Services

Darmesh Pandya - Vice president , Alternative channel

Toral Munshi - Vice president, Research

Anil mascarenhas - Chief Editor

Pinkesh soni - Financial controller

Harshad Apte - Chief Marketing officer

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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 of

derivatives of 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, derivatives products

minimize the impact of fluctuations in asset prices on the profitability and cash flow

situation of risk–averse investors.

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 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 secure 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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IMPORTANCE OF DERIVATIVES

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.

More over, 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

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.

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RATIONALE BEHIND THE DEVELOPMENT OF 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.

1. Price or dividend (interest).

2. Sum are internal to the firm bike:

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

1. Economic

2. Political

3. Sociological changes are sources of Systematic Risk.

For instance inflation interest rate etc. 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.

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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 scrips from one settlement to another by paying the required margins and

barrowing 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.

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.

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MAJOR PLAYERS IN DERIVATIVE MARKET

There are three major players in their derivatives trading.

1. Hedgers.

2. Speculators.

3. Arbitrageurs.

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.

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TYPES OF DERIVATIVES

Most commonly used derivative contracts are:

Forwards: A forward contract is a customized contract between two entities where

settlement takes place on a specific date in the futures at today’s pre-agreed price. Forward

contracts offer tremendous flexibility to the party’s to design the contract in terms of the

price, quantity, quality, delivery, time and place. Liquidity and default risk are very high.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense, that the former are standardized exchange traded contracts.

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 lives 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.

Baskets: Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average of a basket of assets. Equity index options are a form of

basket options

Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a pre-arranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are: -

Interest rare 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.

RISKS INVOLVED IN DERIVATIVES

Derivatives are used to separate risks from traditional instruments and transfer these risks

to parties willing to bear these risks. The fundamental risks involved in derivative business

includes

A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation as

per the contract. Also known as default or counterpart risk, it differs with different

instruments.

B. Market Risk: Market risk is a risk of financial loss as result of adverse movements

of prices of the underlying asset/instrument.

C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing market

prices is termed as liquidity risk. A firm faces two types of liquidity risks:

Related to liquidity of separate products.

Related to the funding of activities of the firm including derivatives.

D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal aspects

associated with the deal should be looked into carefully.

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DERIVATIVES IN INDIA

Indian capital markets hope derivatives will boost the nations economic prospects. Fifty

years ago, around the time India became independent men in mumbai gambled on the price

of cotton in New York. They bet on the last one or two digits of the closing price on the

New York cotton exchange. If they guessed the last number, they got Rs.7/- for every

Rupee layout. If they matched the last two digits they got Rs.72/- Gamblers preferred using

the New York cotton price because the cotton market at home was less liquid and could

easily be manipulated.

Now, India is about to acquire own market for risk. The country, emerging from a long

history of stock market and foreign exchange controls, is one of the last major economies in

Asia, to refashion its capital market to attract western investment. A hybrid over the

counter derivatives market is expected to develop along side. Over the last couple of years

the National Stock Exchange has pushed derivatives 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.

Derivatives Segments In NSE & BSE

On June 9, 2000 BSE and NSE became the first exchanges in India to introduce trading in

exchange traded derivative products, with the launch index Futures on sensex and nifty

futures respectively. Index Options was launched in june2001, stock options in July 2001,

and stock futures in November 2001.

NIFTY is the underlying asset of the index futures at the futures and options segment of

NSE with a market lot of 100 and BSE 30 sensex is the underlying stock index in BSE with

a market lot of 30. This difference of market lot arises due to a minimum specification of a

contract value of Rs.2Lakhs by Securities and Exchange Board of India. For example

sensex is 6750 then the contract value of a futures index having sensex as underlying asset

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will 30x6750 = 202500. Similarly, if Nifty is 2100 its futures contract value will be

100x2100=210000. Every transaction shall be in multiples pf market lot. Thus, index

futures at NSE shall be traded in multiples of 100 and a BSE in multiples of 30.

Contract Periods:

At any point of time there will be always be available nearly 3months

contract periods. For example in the month of June 2005 one can enter into their June

futures contract or July futures contract or august 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. The June 30, July 28 and august 25 shall be the last trading day or the

final settlement date for June futures contract, July futures contract and august futures

contract respectively, When futures contract gets expired, a new futures contract will get

introduced automatically. For instance on July 1, June futures contract becomes invalidated

and a September futures contract gets activated.

Settlement:

The settlement of all derivative contracts is in cash mode. There is daily as well as final

settlement. Out standing 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 closed out by

the exchanged 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 and mark to market margin, which is to be paid on next day. As per SEBI

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guidelines it is mandatory for clients to give margins, fail in which the outstanding

positions or required to be closed out.

Members of F&O segment:

There are three types of members in the futures and options segment. They

are trading members, trading cum clearing member and professional clearing members.

Trading members are the members of the derivatives segment and carrying on the

transactions on the respective exchange.

The clearing members are the members of the clearing corporation who deal with payments

of margin as well as final settlements.

The professional clearing member is a clearing member who is not a trading member.

Typically, banks and custodians become professional clearing members.

It is mandatory for every member of the derivatives segment to have approved users who

passed SEBI approved derivatives certification test, to spread awareness among investors.

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 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.

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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

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.

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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 a 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 chosen 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

moments of the price of the asset. For example, if the price of the asset prices rises sharply

after the two parties have 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 that the contract is

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entered into. Over the duration of the contract, the forward price is liable to change while

the delivery price remains the same.

Essential features of Forward Contracts:

1. A forward contract is a Bi-party contract, to be performed in the future, with the

terms decided today.

2. Forward contracts offer tremendous flexibility to the parties to design the contract

in terms of the price, quantity, quality, delivery time and place.

3. Forward contracts suffer from poor liquidity and default risk.

4. Contract price is generally not available in public domain.

5. On the expiration date the contract will settle by delivery of the asset.

6. If the party wishes to reverse the contract, it is to compulsorily go to the same

counter party, which often results high prices.

Forward Trading in Securities:

The Securities Contract (amendment) Act of 1999, has allowed the trading in derivative

products in India. Has 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.

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FUTURES

The future contract is an agreement between two parties two 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 no 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.

Features of Futures Contracts

The principal features of the contract are as fallows.

Organized Exchanges: Unlike forward contracts which are traded in an over- the- counter

market, futures are traded on organized exchanges with a designated physical location

where trading takes place. This provides a ready, liquid market which futures can be bought

and sold at any time like in a stock market.

Standardization: In the case of forward contracts the amount of commodities to be

delivered and the maturity date are negotiated between the buyer and seller and can be

tailor made to buyer’s requirement. In a futures contract both these are standardized by the

exchange on which the contract is traded.

Clearing House: The exchange acts a clearinghouse to all contracts struck on the trading

floor. For instance a contract is struck between capital A and B. upon entering into the

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records of the exchange, this is immediately replaced by two contracts, one between A and

the clearing house and the 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. The 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.

Actual delivery is rare: In most of the forward contracts, the commodity is actually

delivered by the seller and is accepted by the buyer. Forward contracts are entered into for

acquiring or disposing of a commodity in the future for a gain at a price known today. In

contrast to this, in most futures markets, actual delivery takes place in less than one percent

of the contracts traded. Futures are used as a device to hedge against price risk and as a way

of betting against price movements rather than a means of physical acquisition of the

underlying asset. To achieve, this most of the contracts entered into are nullified by the

matching contract in the opposite direction before maturity of the first.

Margins: In order to avoid unhealthy competition among clearing members in reducing

margins to attract customers, a mandatory minimum margins are obtained by the members

from the customers. Such a stop insures the market against serious liquidity crises arising

out of possible defaults by the clearing members. The members collect margins from their

clients has may be stipulated by the stock exchanges from time to time and pass the

margins to the clearing house on the net basis i.e. at a stipulated percentage of the net

purchase and sale position.

The stock exchange imposes margins as fallows:

1. Initial margins on both the buyer as well as the seller.

2. The accounts of buyer and seller are marked to the market daily.

The concept of margin here is same as that of any other trade, i.e. to introduce a financial

stake of the client, to ensure performance of the contract and to cover day to day adverse

fluctuations in the prices of the securities.

The margin for future contracts has two components:

• Initial margin

• Marking to market

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Initial margin: In futures contract both the buyer and seller are required to perform the

contract. Accordingly, both the buyers and the sellers are required to put in the initial

margins. The initial margin is also known as the “performance margin” and usually 5% to

15% of the purchase price of the contract. The margin is set by the stock exchange keeping

in view the volume of business and size of transactions as well as operative risks of the

market in general.

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”.

Marking to Market: Marking to market means, debiting or crediting the client’s equity

accounts with the losses/profits of the day, based on which margins are sought.

It is important to note that through marking to market process, die clearinghouse substitutes

each existing futures contract with a new contract that has the settle price or the base price.

Base price shall be the previous day’s closing Nifty value. Settle price is the purchase price

in the new contract for the next trading day.

Futures Terminology:

Spot price: The price at which an asset trades in spot market.

Futures price: The price at which the futures contract trades in the futures market.

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

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 ill 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.

31

Multiplier: it is a pre-determined value, used to arrive at the contract size. It is the price

per index point.

Tick Size: It is the minimum price difference between two quotes of similar nature.

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.

Long position: Outstanding/Unsettled purchase position at any point of time.

Short position: Out standing/unsettled sales position at any time point of time.

Stock 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 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 incase 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

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the volume are 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 BSE sensex is at 6800 and each point in the index equals to Rs.30, a contract

struck at this level could work Rs.204000 (6800x30). If at the expiration of the contract, the

BSE sensex is at 6850, a cash settlement of Rs.1500 is required (6850-6800) x30).

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.

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 ACC share is Rs.170 per share. We believe that in one

month it will touch Rs.200 and we buy ACC shares. If the price really increases to Rs.200,

we made a profit of Rs.30 i.e. a return of 18%.

If we buy ACC 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.34 initially to enter into the futures contract. If ACC share goes up

to Rs.200 as expected, we still earn Rs.30 as profit.

Payoff for Futures contracts

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.

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Payoff for buyer of futures: Long futures

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 1220. 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.

Payoff for a buyer of Nifty futures

profit

1220

0 Nifty

LOSS

Payoff for seller of futures: Short futures

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.

Payoff for a seller of Nifty futures

Profit

1220

0 Nifty

LOSS

34

Take the case of a speculator who sells a two-month Nifty index futures contract when the

Nifty stands at 1220. 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.

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 fallows.

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

Pricing index futures given expected dividend amount:

The pricing of index futures is also based on the cost of carry model where the carrying

cost is the cost of financing the purchase of the portfolio underlying the index, minus the

present value of the dividends obtained from the stocks in the index portfolio.

Example

Nifty futures trade on NSE as one, two and three month contracts. Money can be barrowed

at a rate of 15% per annum. What will be the price of a new two-month futures contract on

Nifty?

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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 1200 and Nifty trade with a multiplier of 200.

3. Since Nifty is traded in multiples of 200 value of the contract is 200x1200=240000.

4. If ACC as weight of 7% in Nifty, its value in Nifty is Rs.16800 i.e. (240000x0.07).

5. If the market price of ACC is Rs.140, then a traded unit of Nifty involves 120

shares of ACC i.e. (16800/140).

6. To calculate the futures price we need to reduce the cost of carry to the extent of

dividend received is Rs.1200 i.e. (120x10). 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 dividend the compounded figure by 200.

7. Thus futures price

F = 1200(1.15) 60/365 – (120x10(1.15) 45/365)/200 = Rs.1221.80.

Pricing index futures given expected dividend yield

If the dividend flow through out the year is generally uniform, i.e. if there are few historical

cases of clustering of dividends in any particular month, it is useful to calculate the annual

dividend yield.

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 1200. What is

the fair value of the futures contract?

Fair value = 1200(1+0.15-0.02) 60/365 = Rs.1224.35

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Pricing stock futures

A futures contract on a stock gives its owner the right and the obligation to buy or sell the

stocks. Like, index futures, stock futures are also cash settled: There is no delivery of the

underlying stock.

Pricing stock futures when no dividend is expected

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

barrowed 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.228.

2. Thus, futures price F = 228(1.15) 60/365 = Rs.223.30.

Pricing stock futures when dividends are expected

When dividends are expected during the life of futures contract, pricing involves reducing

the cost of carrying to the extent of the dividends. The net carrying cost is the cost of

financing the purchase of the stock, minus the present value of the dividends obtained from

the stock.

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 pf purchasing contract.

2. Assume that the market price of ACC is Rs.140/-

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 dividend is

received 15 days later and hence, compounded only for the remaining 45 days.

4. Thus, the futures price

F = 140 (1.15) 60/365 – 10(1.15) 45/365 = Rs.133.08.

37

38

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 has 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.

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.

Options clearing corporation

The Options Clearing Corporation (OCC) is guarantor of all exchange-traded options once

an option transaction has been completed. Once a seller has written an option and a buyer

has purchased that option, the OCC takes over it. It is the responsibility of the OCC who

over sees the obligations to fulfill the exercises. If I want to exercise an ACC November

100-call option, I notify my broker. My broker notifies the OCC, the OCC then randomly

selects a brokerage firm, which is short one ACC stock. That brokerage firm then notifies

one of its customers who have written one ACC November 100 call option and exercises it.

The brokerage firm customer can be chosen in two ways. He can be chosen at random or

FIFO basis. Because, OCC has a certain risk that the seller of the option can’t full the

contract, strict margin requirement are imposed on sellers. This margins requirement act as

a performance Bond. It assures that OCC will get its money.

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Options Terminology.

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.

American option: American options are the options that the can be exercised at the 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 that 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 flow if 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 he 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.

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Intrinsic value of an option: It is one of the components of option premium. The intrinsic

value of a call is the amount the option is in the money, if it is in the money. If the call is

out of the money, its intrinsic value is Zero. For example X, take that ABC November-call

option. If ABC is trading at 102 and the call option is priced at 2, the intrinsic value is 2. If

ABC November-100 put is trading at 97 the intrinsic value of the put option is 3. If ABC

stock was trading at 99 an ABC November call would have no intrinsic value and

conversely if ABC stock was trading at 101 an ABC November-100 put option would have

no intrinsic value. An option must be in the money to have intrinsic value.

Time value of an option: The value of an option is the difference between its premium and

its intrinsic value. Both calls and puts time value. An option that is OTM or ATM has only

time value. Usually, the maximum time value exists when the option is ATM. The longer

the time to expiration, the greater is an options time value. At expiration an option should

have no time value.

Characteristics of Options

The following are the main characteristics of options:

1. Options holders do not receive any dividend or interest.

2. Options only capital gains.

3. Options holder can enjoy a tax advantage.

4. Options holders are traded an O.T.C and in all recognized stock exchanges.

5. Options holders can controls their rights on the underlying asset.

6. Options create the possibility of gaining a windfall profit.

7. Options holders can enjoy a much wider risk-return combinations.

8. Options can reduce the total portfolio transaction costs.

9. Options enable with the investors to gain a better return with a limited amount of

investment.

Call Option

An option that grants the buyer the right to purchase a designed instrument is called a call

option. A call option is contract that gives its owner the right but not the obligation, to buy

a specified asset at specified prices on or before a specified date.

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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, here will be loss.

At all points where spot prices > exercise price, there will be 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 profit

At all points where spot prices > exercise price, there will be loss

Call Option writer’s profits are limited and losses are unlimited.

Following is the table, which explains In the-money, Out-of-the-money and At-the-money

position for a Call option.

Exercise call option Spot price>Exercise price In-The-MoneyDo not exercise Spot price<Exercise price Out-of the-MoneyExercise/Do not exercise Spot price=Exercise price At-The-Money

Example:

The current price of ACC share is Rs.260. Holder expect that price in a three month period

will go up to Rs.300 but, holder do fear that the price may fall down below Rs.260.

To reduce the chance of holder risk and at the same time, to have an opportunity of making

profit, instead of buying the share, the holder can buy a three-month call option on ACC

share at an agreed exercise price of Rs.250.

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1. If the price of the share is Rs.300. then holder will exercise the option since he

get a share worth Rs.300. by paying a exercise price of Rs.250. holder will gain

Rs.50. Holder’s call option is In-The-Money at maturity.

2. If the price of the share is Rs.220. then holder will not exercise the option.

Holder will gain nothing. It is Out-of-the-Money at maturity.

Payoff for buyer of call option: Long call

The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit.

Higher the spot price, more is the profit he makes. If the spot price of the underlying is less

than the strike price, he lets his option un-exercise. His loss in this case is the premium he

paid for buying the option.

Payoff for buyer of call option

Profit

1250

0 Nifty

86.60

Loss

The figure shows the profit the profits/losses for the buyer of the three-month Nifty

1250(underlying) call option. As can be seen, as the spot nifty rises, the call option is In-

The-money. If upon expiration Nifty closes above the strike of 1250, the buyer would

exercise his option and profit to the extent of the difference between the Nifty-close and

strike price. However, if Nifty falls below the strike of 1250, he lets the option expire and

his losses are limited to the premium he paid i.e. 86.60.

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Payoff for writer of call option: Short call

For selling the option, the writer of the option charges premium. Whatever is the buyer’s

profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the

buyer will exercise the option on the writer. Hence as the spot price increases the writer of

the option starts making losses. Higher the spot price more is the loss he makes. If upon

expiration the spot price is less than the strike price, the buyer lets his option un-exercised

and the writer gets to keep the premium.

Payoff for writer of call option

Profit

86.60

1250

0 Nifty

LOSS

The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. If

upon expiration Nifty closes above the strike of 1250, the buyer would exercise his option

on the writer would suffer a loss to the extent of the difference between the Nifty-close and

the strike price. This loss that can be incurred by the writer of the option is potentially

unlimited. The maximum profit is limited to the extent of up-front option premium

Rs.86.60.

Put option

An option that gives the seller the right to sell a designated instrument is called put option.

A put option is a contract that gives the owner the right, but not the obligation to sell a

specified number of shares at a specified price on or before a specified date.

44

An American put option can be exercised on or before the specified date. But, a European

option can be exercised on the specified date only.

The following are the strategies adopted y 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 gain.

At all points where spot price>exercise price, there will be loss.

Conversely, the put option writer’s profit/loss will be as follows:

At all points where spot price<exercise price, there will be loss.

At all points where spot price>exercise price, there will be 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-MoneyDo not Exercise Spot price>Exercise price Out-of-The-MoneyExercise/Do not Exercise Spot price=Exercise price At-The-Money

Example:

The current price of ACC share is Rs.250. Holder by a three month put option at exercise

price of Rs.260. (Holder will Exercise his option only if the market price/ spot price is less

than the exercise price).

If the market/Spot price of the ACC share is Rs.245., then the holder will exercise the

option. Means put option holder will buy the share for Rs.245. In the market and deliver it

to the option writer for Rs.260., the holder will gain Rs.15 from the contract.

Payoff for buyer of put option: Long put.

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the option depends on the

spot price of the underlying. If upon the expiration, the spot price is below the strike price,

he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the

underlying is higher than the strike price, he lets his option expire un-exercised.

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Payoff for buyer of put option

Profit

1250

0

61.70 Nifty

Loss

The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option.

As can be seen, as the spot Nifty falls, the put option is In-The-Money. If upon expiration,

Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the

extent of the difference between the strike price and Nifty-close. The profits possible on

this option can be as high as the strike price. However, if Nifty rises above the strike of

1250, he lets the option expire. His losses are limited to the extent of the premium he paid.

Payoff for writer of put option: Short put

The figure below shows the profit/losses for the seller/writer of a three-month put option.

As the spot Nifty falls, the put option is In-The-Money and the writer starts making losses.

If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his

option on writer who would suffer losses to the extent of the difference between the strike

price and Nifty-close.

Payoff for writer of put option

46

Profit

61.70

1250

0 Nifty

Loss

The loss that can be incurred by the writer of the option is to a maximum extent of strike

price. Maximum profit is limited to premium charged by him.

Pricing Options

Factors determining options value:

Exercise price and Share price: If the share price is more than the exercise price then the

holder of the call option will get more net payoff, means the value of the call option is

more. If the share price is less then the exercise price then the holder of the put option will

get more net pay-off.

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

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

47

volatility based on past prices. Implied volatility starts with the option price as a given, and

works backward to ascertains the theoretical value of volatility which is equal to the market

price minus any intrinsic value.

Black scholes pricing models:

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

Scholes came up with their option pricing model, there was a wide spread belief that

the expected growth of the underlying ought to effect the option price. Black and

Scholes 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 continues.

4. The stock pays no dividend. During the option period the firm should not pay any

dividend.

5. The option must be European option.

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

48

PX= exercise of the share

RF= Risk free rate

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

Pricing Index Option:

Under the assumptions of Black Scholes options pricing model, index options should be

valued in the way as ordinary options on common stock. The assumption is that the

investors can purchase the underlying stocks in the exact amount necessary to replicate the

index: i.e. stocks are infinitely divisible and that the index follows a diffusion process such

that the continuously compounded returns distribution of the index is normally distributed.

To use the black scholes formula for index options, we must however, make adjustments

for the dividend payments received on the index stocks. If the dividend payment is

sufficiently smooth, this merely involves the replacing the current index value S in the

model with S/eqT where q is the annual dividend and T is the time of expiration in years.

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

49

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.

50

Difference between the Futures and Options

Futures Options1. Both the parties are obligated to

perform.

2. In futures either parties pay

premium.

3. The parties to the futures contract

must perform at the settlement date

only. They are obligated to perform

the date.

4. The holder of the contract is

exposed to the entire spectrum of

downside risk and had the potential

for all the upside return.

5. In futures margins are to be paid.

They are approximately 15 to 20%

on the current stock price.

1. Only the seller (writer) is obligated

to perform.

2. In options the buyer pays the seller

a premium.

3. The buyer of an options contract

can exercise the option at any time

prior to expiration date.

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.

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52

Swaps

Financial swaps are a funding technique, which a permit a barrower to access one market

and then exchange the liability for another type of liability. Global financial markets

present barrowers 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 device to obtain the desired form of

financing indirectly. The barrower might other wise 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

barrowing 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.

Types of swaps:

All Swaps involves exchange of a series of payments between two parties. A swap

transaction usually involves an intermediary who is a large international financial

institution. The two payment streams estimated to have identical present values at the

outset when discounted at the respective cost of funds in the relevant markets.

The most widely prevalent swaps are

1. Interest rate swaps.

2. Currency swaps.

Interest rate swaps

Interest rate swaps, as a name suggest involves an exchange of different payment streams,

which are fixed and floating in nature. Such an exchange is referred to as an exchange of

barrowings. 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.

53

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’ barrows 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.

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 swap, currency swaps are frequently ware housed by financial institutions that

carefully monitor their exposure in various currencies so that they can change hedge

currency risk

54

CURRENTLY AVAILABLE FUTURE IN NSE

Span Margin:: May 30, 2008Symbol Mlot TotMgn% TotMgnPerLt

LUPIN 700 20.16 97917.75M&M 312 16.16 30677.36MAHLIFE 350 24.49 54493.22PFC 1200 22.82 36947.89PNB 600 20.23 60265.5POLARIS 2800 25.51 73359.36POWERGRID 1925 17.33 33495.81PRAJIND 1100 32.35 66106.89PUNJLLOYD 750 19.53 45815.9PURVA 500 43.81 49941.08SASKEN 1100 34.78 55144.09BALLARPUR 7300 19.32 48117.22BAJAJ-AUTO 200 23.73 28146.5MAHSEAMLES 600 18 35467.55CNX100 50 10.1 23590.2CNXIT 50 12.2 27984.65JUNIOR 25 12.11 24695.25MINIFTY 20 10.12 9825.47NFTYMCAP50 75 10.73 21004.21NIFTY 50 10.11 24573.98WOCKPHARMA 600 15.72 28099.5WWIL 3150 27.07 31470.73YESBANK 1100 24.51 41804.4ZEEL 700 15.81 25256VOLTAS 900 20.44 26499.45WELGUJ 800 24.79 75081.12WIPRO 600 18.24 55350TATASTEEL 382 18.57 64029.61TATATEA 275 16.99 40234.31TATAMOTORS 412 21.72 50775.32TATAPOWER 200 19.42 53218.07TCS 250 19.76 49098.13TECHM 200 22.27 37586.2TITAN 206 24.28 58724.44TRIVENI 1925 28.08 59872.91TTML 5225 23.93 40392.34TULIP 250 19.62 48141.27TVSMOTOR 2950 24.53 27358.42ULTRACEMCO 400 18.33 47597UNIONBANK 2100 22.05 63438.33

55

UNIPHOS 700 16.68 39998UNITECH 900 24.64 53168.03VIJAYABANK 3450 20.51 33368.06STAR 850 40.31 57264.49STER 219 20.45 40723.22STERLINBIO 2500 17.31 87743.75STRTECH 1050 27.35 60006.35SUNPHARMA 225 18.54 58020.44SUNTV 1000 20.79 67888.7SUZLON 1000 22.89 63426.61SYNDIBANK 1900 16.98 22268TATACHEM 675 22.12 61256.25TATACOMM 525 20.25 53168.72SESAGOA 75 22.33 69628SHREECEM 200 25.36 41185SIEMENS 376 16.18 34261.4SKUMARSYNF 1900 28.19 61719.9SOBHA 350 17.85 30742.1SRF 1500 23.07 41218.02SATYAMCOMP 600 17.62 55420.5SBIN 132 18.54 35808.17SCI 800 22.18 51318.66ROLTA 900 21.29 60274.77RPL 1675 21.83 64941.34RPOWER 500 18.65 38318.16SAIL 1350 21.24 46528.01RECLTD 1950 16.82 35597.75REDINGTON 500 30.87 51687.9RELINFRA 138 24.74 42607.5RELCAPITAL 138 27.22 46460.52RELIANCE 75 15.89 29582.38RENUKA 5000 30.61 175780.05RNRL 1788 27.39 50726.46RAJESHEXPO 1650 22.32 32533.48RANBAXY 800 15.71 63820RCOM 350 19.51 39324.42NUCLEUS 550 37.88 55616.73OMAXE 650 22.5 30534.9ONGC 225 15.75 30322.94ORCHIDCHEM 1050 38.18 98318.33ORIENTBANK 1200 21.08 44017.2PANTALOONR 500 22.52 50167.15PARSVNATH 700 21.98 30988.83PATELENG 250 19.41 23438.4PATNI 650 17.41 30958.62PENINLAND 2750 26.32 58316.07PETRONET 2200 20.67 31861.8MARUTI 200 15.84 24045MATRIXLABS 1250 38.31 89014.61MCDOWELL-N 125 18.68 38039.37

56

MOSERBAER 825 23.96 35599.95INFOSYSTCH 200 17.1 64386.5IOB 1475 19.38 35349.75IOC 600 18.67 47263.27IRB 1100 19.85 39687.82ISPATIND 4150 28.12 37819.95ITC 1125 18.25 44286.13JINDALSAW 250 22.19 30529.43JINDALSTEL 160 28.13 103176.73JPASSOCIAT 750 27.58 46707.94JPHYDRO 3125 25.73 49386.38JSTAINLESS 1000 19.69 27284.15JSWSTEEL 275 23.22 74003.64KESORAMIND 500 16.38 27438.01KOTAKBANK 275 25.86 48546.82KPIT 1650 45.3 55846KTKBANK 1250 15.72 38541.13IVRCLINFRA 500 23.76 47520.84IVRPRIME 800 39.64 67583.13J&KBANK 300 27.19 52752.75JETAIRWAYS 400 15.7 33810IDBI 1200 20.11 21374.69IDEA 2700 16.91 49565.25IDFC 1475 20.7 45242.54IFCI 1970 31.99 39546.51INDHOTEL 1899 16.39 34263.23INDIACEM 725 20.27 23584.94INDIAINFO 250 24.7 45192.45INDIANB 1100 22.36 30114.3INDUSINDBK 1925 25.25 38048.15GDL 2500 20.6 51851.73GESHIP 600 22.07 67782.55GITANJALI 500 20.34 29849.24GLAXO 300 15.84 52943.25GMRINFRA 1250 23.66 39912.39GNFC 1475 24.63 56255.97GRASIM 88 15.7 30789.08GTL 750 15.78 28406.25GTOFFSHORE 250 19.96 35509.83GUJALKALI 1400 20.19 54124.07HAVELLS 400 16.04 30828HCC 1400 24.45 38081.05HCLTECH 650 19.22 38431.25HDFC 75 18.96 34802.17HDFCBANK 200 17.13 44798HDIL 400 31.19 91804.74HEROHONDA 400 16.01 48797HINDALCO 1595 23.46 71380.32HINDOILEXP 1600 30.08 66925.91HINDPETRO 1300 17.53 57113.47

57

HINDUJAVEN 500 36.04 56013.18HINDUNILVR 1000 15.73 37495HINDZINC 250 27.19 43678.96HOTELEELA 3750 21.65 34464.17HTMTGLOBAL 500 36.11 65074.35I-FLEX 150 25.29 52524.44BEML 125 15.83 21788.13BHARATFORG 1000 16.74 43652.5BHARTIARTL 250 17.6 38130BHEL 75 18.29 22073.12BHUSANSTL 250 22.48 47380.86BINDALAGRO 4950 31.79 60673.74BIOCON 450 15.7 32163.75BIRLAJUTE 850 20.9 38084.99BOMDYEING 300 28.48 77011.55BONGAIREFN 2250 22.47 29988.11BOSCHLTD 50 15.7 33075.75BPCL 550 19.28 38216.15GAIL 750 15.82 46790.93IBN18 1250 36.77 53535.93BANKNIFTY 25 13.91 22813.88BRFL 1150 25.58 103116.17BRIGADE 550 44.23 45425.04CAIRN 1250 25.35 91901.53CANBK 800 20.17 33422.56CENTRALBK 2000 17.58 29396.64CENTURYTEX 212 23.12 33641.53CESC 550 18.93 50649.04CHAMBLFERT 3450 44.42 129217.44CHENNPETRO 900 20.64 62881.07CIPLA 1250 15.75 42213CMC 200 26.21 40240.11COLPAL 550 16.89 40180.75CORPBANK 600 16.28 34187.66CROMPGREAV 500 20.54 23271.32CUMMINSIND 475 15.72 21613.44DABUR 2700 15.82 40689DCB 1400 30.02 31760.1DENABANK 2625 22.82 31841.33DIVISLAB 155 18.25 40475.42DLF 400 20.27 48003.92DRREDDY 400 16.95 46027EDELWEISS 250 25.63 46115.4EDUCOMP 75 22.15 67873.79EKC 1000 20.55 62822.72ESCORTS 2400 23.7 54736.56ESSAROIL 1412 32.03 104838.43FEDERALBNK 851 18.74 34458.93FINANTECH 150 16.64 43661.633IINFOTECH 2700 20.06 64169.01

58

ABAN 50 24.03 49074.3ABB 250 15.71 39333.13ABIRLANUVO 200 16.61 48489.5ACC 188 15.71 19511.7ADLABSFILM 225 28.73 41189.96AIAENG 200 23.41 69537.5AIRDECCAN 850 29.44 29407.53ALBK 2450 18.91 37859.98ALOKTEXT 3350 24.82 52847.04AMBUJACEM 2062 21.91 44482.2AMTEKAUTO 600 17.03 29946ANDHRABANK 2300 18.19 31697.22ANSALINFRA 1300 25.54 45315.5APIL 200 22.87 25610.97APTECHT 650 30.2 45840.73ARVINDMILL 4300 27.67 55988.04ASHOKLEY 4775 18.99 32973.42AUROPHARMA 700 19.31 39272.86AXISBANK 225 25.3 44746.05BAJAJHIND 950 33.54 61664.81BAJAJHLDNG 250 27.72 42329.2BALRAMCHIN 2400 28.25 61327.94BANKBARODA 700 19.93 37088.93BANKINDIA 950 22.71 62621.92BATAINDIA 1050 21.04 35664.74BEL 138 17.95 28863.12NIITTECH 1200 27.22 47146.86NTPC 1625 16.27 45537.32MPHASIS 800 28.36 53407.27MRPL 2225 26.92 50382.23ICICIBANK 175 20.05 27933.35MTNL 1600 16.72 25524.38NAGARCONST 1000 19.94 38933.55NAGARFERT 3500 36.55 62757.21NATIONALUM 575 22.83 69574.28NAUKRI 150 28.77 43576.55NDTV 550 15.94 36612.63NETWORK18 500 42.92 47318.11NEYVELILIG 1475 27.79 59477.01NICOLASPIR 750 15.88 42045.5NIITLTD 1450 18.98 28992.39LAXMIMACH 100 18.32 27616.69LICHSGFIN 850 22.69 65216.63LITL 425 32.97 69809.89LT 50 19.16 27757.25

59

60

61

BASIC OPTION STRATEGIES

Long call

Market View Bullish

Action Buy a call option

Profit Potential Unlimited

Loss Potential Limited

To make a profit from an expected increase in the price of an underlying share during

option’s life:

Situation: On 28th April, CIPLA is quoting at Rs.254. and the July Rs.260 (strike price)

Call costs Rs.14 (premium). We expect the share price to rise significantly and want to

make a profit from the increase.

Action: Buy 1CIPLA calls at Rs.14; Market lot for CIPLA is 1000. So, Net outlay is

Rs.14000 (14x1000). If CIPLA shares go up we can close the position either by selling

the option back to the market or exercising the right to buy the underlying shares at the

exercise price.

Share price

(Cash market) Option market28 April Rs.254 Buy 1 July 260 call at

Rs.14; cost = 14000.28 July Rs.300 1. Sell 1 Jan contract

(expiry)

2. Net gain Rs.40

(300-260)*1000

units =m Rs.40000.Analysis Rises by Rs.46. Return 18% Gain: Option sale =

Rs.40000. Premium

Paid = Rs.14000. Net Profit

= Rs.26000.

Possible Outcome at Expiry

Share price Rs.300 Option worth Rs.40000. Closing the

62

position now will produce a net profit of

Rs.26000

Share price<260 Option expires worthless. The loss is

Rs.14000 (premium paid)Share price>274 Net profit = Intrinsic value of (Break even

= 260+14) option i.e. by whatever amount

the share price exceeds Rs.274.

To establish a maximum cost at which to purchase shares at a lesser date if funds are not

available immediately:

Situation: On 28th April, an investor takes the view that CIPLA’s share price is likely to

rise over the coming months. He does not have the sufficient funds to buy the shares and

decides to again exposure to the stocks and therefore participate in the rise by buying a call

option. If the share price increases, selling the call option releases income to offset the

higher share to be acquired at the exercise price that is below the share price.

Action: Buy 1 July 240-call option CIPLA at Rs.25 for total outlay of Rs.25000 and

purchase share on 28th July, the option expiry day.

Share price

(Cash market) Option market28 Apr Rs.254 Buy Jan 240 call @ Rs.25000 (25x1000)28 July Rs.300 1. Sell 1 Jan 240 call option (or)

2. Exercise 1 Jan 240 call and

purchase 1000 shares at 240000.

63

Analysis Rises by Rs.46 (300-254) 1. Sale of option = Rs.60000

Cost of purchase = Rs.25000

Net profit = Rs.35000.

2. Option purchase = Rs.25000

Exercise option =Rs.240000

Net outlay = Rs.265000

Rs.265/share.

Possible outcome at Expiry

Share price > Rs.265

Break even (240+25)

Net profit = Intrinsic value of the option

less cost of purchase i.e. the amount by

which the share price exceeds breakeven

values.Share price = Rs.265 Break-even value.

Option worth is Rs.25 (265-240).

Share price < 240 Option expires worthless.

Total loss Rs.25000 (Cost of purchase)

This simple strategy provides investor with maximum effective buying price of Rs.265

(240+25) in three-month time.

In gaining exposure to stock through call option, the investor has secured two major

advantages. Firstly, he guarantees exposure for limited outlay (i.e. Rs.25 per share) and if

the share does not rise as anticipated, the maximum loss is limited to the premium paid.

Secondly, the payment of Rs.25 rather than Rs.254 per share helps cash flow.

To hedge against a fall in share value over coming months:

64

Situation: An investor holding 10000 CIPLA share at Rs.254 each, which originally

purchased at Rs.200, believes that the share price may decrease soon. He has made a

considerable gain of his investment and he is concerned that he should not lose any of that

profit. However, if the price continues to rise instead, he does not want to miss out that

profit.

Action: Sell 10000 CIPLA shares at Rs.254 each and buy 10 (for 10000 shares, number of

market lots = 10000/1000 = 10) 260-calls at Rs.14 worth Rs.140000. the investor books

profit of Rs.40x10000 = 400000 (254-214 = 40). The released money is now available for

re-investment and a small proportion will fund the call purchase.

Share price

(Cash market) Option market28 Apr Rs.254, sell 10000 shares

for Rs.2554000.

Buy 10 July 260 call at

Rs.14 Rs.140000.28 July Rs.220 Option expires worthlessAnalysis Fall of Rs.34 Total loss = Rs.140000

(premium paid) instead of

Rs.340000 (original share

holding of 10000 if nor

sold).

Possible outcome at expiry

Share price < Rs.260 Option expires worthless creating

maximum loss, which is equal to the

amount of premium paid.Share price between 260 & 274 Sell the option for any intrinsic value to

recover some of their cost.Share price > 274 Sell the option for intrinsic value and take

more profit. (Or) Exercise option.

65

Short call

To earn additional income from a static shareholding, over and above any dividend

earnings, in terms of premium received on writing the option (Covered short call).

Market View Bullish

Action: Sell call against an existing shareholding

Profit Potential Limited

Loss Potential Limited

Situation: On 28th April CIPLA share is trading at Rs.254. an investor holds 10000 shares,

he does not expect their price to move very much in the next few months. So, he decides to

write call option against this shareholding.

Action: The July 260 calls are trading at Rs.14 and investor sells 10 contracts (one contract

= 1000 shares). He received an option premium of Rs.140000 and takes on the obligation to

deliver 10000 shares at Rs.260 each if the holder exercises the option

Share price

(Cash market) Option market28 Apr Rs.254 Sell 10 July 260 calls @

Rs.14

Income = Rs.140000

(14x10000).28 July Rs.254 Option expires worthlessAnalysis No change in shareholding Profit = Rs.140000

(Option Premium received)

66

Possible Outcome at Expiry

Share > Rs.260 The holder will exercise his option.

The investor as a writer will sell shares

originally purchased for Rs.254 at Rs.274

(260+14).Share price < 260 The option expires worthless.

To reduce the cost of stock purchase:

Situation: It is early April and Reliance share is trading at Rs.406. At investor thinks that

the shares have a long-term price rise potential, but before the end of the July he does not

expect the share to go above Rs.420

Action; Buy 1000 Reliance shares at Rs.406 per share and sell Reliance July 420 call at

Rs.9.

Share price

(Cash market)

Option market

28 Apr Rs.406. For 1000 shares

Total outlay = Rs.406000

Sell 1 Reliance call at Rs.9

(premium)

Income = Rs.9000 (1000x9)

Possible Outcome at Expiry

Share price < Rs.420 The option will not be exercised and the

investor will retain both the shares and the

option premium, thus effectively reducing

the original cost of the shares to Rs.397

(406-9).Share price > Rs.420 The option will be exercised and the shares

have to be sold at Rs.420. This effectively

produced a total sale price of Rs.429, an

increase of Rs.23 on the original purchase

price.

67

Long put

Market View Bearish

Action Buy a Put option

Profit Potential Unlimited

Loss Potential Limited

To make profit, from a fall in value of share price:

Situation: Current price of GAIL is Rs.270. An investor thinks GAIL share is overvalued

and may fall substantially. He therefore decides to buy Put option to gain exposure to its

anticipated fall.

Action: Buy 1 GAIL July Rs.260 Put at Rs.8 for a total consideration of Rs.8000.

Share price

(Cash market) Option market28 Apr Rs.270 Buy 1 GAIL July put at

Rs.8.

Total outlay = Rs.8000.28 July Rs.240 Sell 1 July contract.

Net gain = Rs.20000

[Rs.20 (260-240) x 1000

(Lot)]Analysis Fall of share price Rs.30. Option purchase = Rs.8000

Option sale = Rs.20000.

Net profit = Rs.12000.

Possible Outcome at Expiry

Share price = Rs.240 The put will be trading at Rs.20, which

gives a profit of Rs.12 (20-8), if the

68

position is closed out.Share price between 240 & 260 Recover intrinsic value premium.

Protect a share purchase by simultaneously buying put options:

Situation: An investor wants to buy GAIL shares at the current price of Rs.270 in the

expectation that the share price will rise, but he is concerned about its short-term

performance. He feels that he could effort to see the shares as low as Rs.250.

Action: Buy 1000 shares of GAIL at Rs.270 each and buy one GAIL July 260 put at Rs.8.

Since, the investor holds the stock, he participates in any further rise in the share price

above Rs.217.

Share price

(Cash market) Option market28 Apr Rs.270 buy 1000 shares at

Rs.27000

Buy 1 July Rs.260 put @

Rs.8.

Cost = Rs.8000 (8x1000)20 July Rs.240

Total worth = Rs.240000

Exercise the Rs260 put

option.

Analysis: In cash market the share price decreased to Rs.240.

If the investor does not purchase the Rs.260 put option. Then

Loss = 30000 (27000-24000).

If the investor purchases the Rs.260 put option.

When the share price in cash market is Rs.240, he will buy 1000 shares for Rs.240 each in

cash market and will sell the same in the options market by exercising the Rs.260 put

option.

Share purchase =Rs.270000

Add. Buying option = Rs.8000 (premium Rs.8 per share)

Less. Sale of option = Rs.260000

Net Loss = Rs.18000

By buying the put option simultaneously the investor’s loss is decreased to Rs.18000

instead of Rs.30000.

69

Short put

Market View Bearish

Action Sell put option

Profit Potential Limited

Loss Potential Unlimited

To generate earnings on portfolio of shares:

Situation: An investor owns 10000 shares of NIIT and also has cash holding of around

Rs.6000000. In early April he feels that the share price of NIIT will either remain constant

or slightly rise.

Action: The investor decides to generate some additional income on his portfolio writes 10

NIIT Rs.550 puts at Rs.40. Thus he received a premium of Rs.400000 (40x10000 shares).

Possible Outcome at Expiry

Share price > (or) = Rs.550 The investor’s expectation is correct and

the put will expire unexercised.

Profit = Rs.400000 (premium received).Share price < Rs.550 The put option will be exercised and the

stock will have to be purchased for

Rs.5100000 (5500000-400000).

To buy a stock at a price which is lower than the current available price in the market.

Situation: The shares of L&T are currently trading at Rs.242.

Action: Sell 10 L&T July Rs.240 puts at Rs.10.

Share price

(Cash market) Option market

70

28 Apr Rs.242 Sell 10 July Rs.240 puts at

Rs.10.

Total outlay = Rs.10000028 July Rs.230 Option is exercised.

Possible Outcome at Expiry

Share price < Rs.240 The put writer will take delivery of the

stock at Rs.230 i.e. Rs.10 below the current

market price.Share price > Rs.240 The option will not be exercised and the

investor keeps the premium.

71

LOT SIZES OF DIFFERENT COMPANIES

Index/Scrip Market LotCNXIT

NIFTY

ABB

ASSOCIATED CEMENT COMPANIES.LTD.

ALBK

ANDHRABANK

ARVINDMILLS

ASHOKLEYLAND

BAJAJ AUTO

BANK OF BARODA

BANK OF INDIA

BHARAT ELECTRICALS

BHARATFORG

BHARTI

BHEL

BPCL

CADILAHC

CANARA BANK

CENTURY TEXTILES

CHENNAI PETRO

CIPLA

COCHIN REFINARY

COLGATE

DABUR

Dr. REDDY

GAIL

GE SHIPPING

GLAXO

GRASIM

100

100

200

750

2450

2300

2150

9550

200

1400

1900

550

200

1000

300

550

500

1600

850

950

1000

1300

1050

1800

200

1500

1350

300

175

72

GUJARATH AMBUJA CEMENT

HCL TECH

HDFC

HDFC BANK

HERO HONDA

HINDALCO

HLL

HPCL

I-FLEX

ICICI BANK

IDBI

INDHOTEL

INDRAYON

INFOSYS

INDIAN OVERSEAS BANK

INDIAN OIL CORPORATION

IPCL

ITC

JET AIRWAYS

JINDAL STEEL

JP HYDRO

KIRLOSKCUM

LIC HOUSING FINANCE

M&M

MARUTI UDYOG

MATRIX LABS

MRPL

MTNL

NALCO

NEYVELI LIGNITE

NICOLASPIR

NTPC

550

650

300

400

400

150

2000

650

300

700

2400

350

500

100

2950

600

1100

150

200

250

6250

1900

850

625

400

1250

4450

1600

1150

2950

950

3250

73

ONGC

ORIENTAL BANK OF COMMERCE

PATNI

PUNJAB NATIONAL BANK

POLARIS

RANBAXY

RELIANCE

RELIANCE CAPITAL

RELIANCE INDUSTRIES LTD.

SATYAM

STATE BANK OF INDIA

SCI

SIEMENS

STER

SUN PHARMA

SYNDICATE BANK

TATA CHEMICALS

TATA MOTORS

TATA POWER

TATA TEA

TATA CONSULTANCT SERVICES

TISCO

UNION BANK OF INDIA

UTI BANK

VIJAYA BANK

VSNL

WIPRO

WOCKPHARMA

300

600

650

600

1400

200

550

1100

600

600

500

1600

150

350

450

3800

1350

825

800

550

250

675

2100

900

3450

1050

300

600

CONCLUSION

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.

74

Derivatives market in India is growing rapidly unlike equity markets. Trading in

derivatives require more than average understanding of finance. Being new to markets

maximum number of investors have not yet understood the full implications of the trading

in derivatives. SEBI should take actions to create awareness in investors about the

derivative market.

Introduction of derivatives implies better risk management. These markets can give greater

depth, stability and liquidity to Indian capital markets. Successful risk management with

derivatives requires a through understanding of principles that govern the pricing of

financial derivatives.

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.

75

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

an 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.

However, these instruments act as a powerful instrument for knowledgeable traders to

expose them to the properly calculated and well understood risks in pursuit of reward i.e.

profit.

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Bibliography

Indian financial system - M.Y. Khan

Investment management - V.K. Bhalla

Publications of National Stock Exchange

Websites

www.nseindia.org

www.bseindia.com

www.sharekhan.com

www.sebi.gov.in

www.moneycontrol.com

www.geojit.com

www.indianfoline.com

www.icicidirect.com

www.hseindia.org

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