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INDTRODUCTION
Derivatives have made the international andfinancial headlines in the past for mostly with their
association with spectacular losses or institutional
collapses.
But market players have traded derivatives
successfully for centuries and the daily
international turnover in derivatives trading runs
into billions of dollars.
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Derivatives
What is a derivative?:A financial product which has beenderived from another financial product
or commodity.
Without the underlying product ormarket, the derivative would have no
independent existence.
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Are derivative instruments that can only be tradedby experienced, specialist traders? Although it is
true that complicated mathematical models are
used for pricing some derivatives, the basic
concepts and principles underpinning derivativesand their trading are quite easy to grasp and
understand.
Indeed, derivatives are used increasingly bymarket players ranging from governments,
corporate treasurers, dealers and brokers and
individual investors.
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Derivatives have risen from the need tomanage the risk arising frommovements in markets beyond ourcontrol, which may severely impact therevenues and costs of the firm.
Derivatives are used to shift risk and act
as a form of insurance
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Financial derivatives can serve as a risk reduction tool.
Firms are exposed to several risks in the ordinarycourse of operations and borrowing funds
For some risks, management can obtainprotection from an insurance company (fire,loss of profit , loss of stock, marineinsurance)
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Similarly, there are capital market products availableto protect against certain risks. Such risks include :
- Risks associated with a rise in the price ofcommodity purchased as an input
- A decline in a commodity price of a product thefirm sells
- A rise in the cost of borrowing funds
- An adverse exchange rate movement.- The instruments that can be used to provide such
protection are called derivative instruments
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WHAT IS A DERIVATIVE ?
A Derivatives is any security whoseprice is determined by the value ofanother asset.
--- This asset is called the underlying security , orsimply , the Underlying
UNDERLIYINGPRICE
CHANGE
DERIVATIVEPRICE
CHANGE
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WHY DO DERIVATIVES EXIST ?
TWO PURPOSES
HEDGING SPECULATION
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Types of derivatvies
FORWARDS
FUTURES
OPTIONS
SWAPS
A contract to make or take delivery of product in future ,
at a price set in present. Not standardised or regulated
Similar to Forwards . Stanardised , regulated and traded
on exchanges
A contract giving the right ,but not the obligation,tobuy or sell a security for e.g Movie ticket
A contract to exchange stream of cash flows based on certain events
Interest rates ,Currencies , Commodities prices, CREDIT DEFAULT SWAPS
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Futures Contracts
Futures contract is an agreement tobuy or sell specified quantity of theunderlying assets at a price agreed
upon by the buyer and seller, on orbefore a specified time.
By contrast in a spot contract there is
an agreement to buy or sell the assetimmediately (or within a very shortperiod of time)
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When you trade futures
Long is the equivalent of initiating a futures positionby buying a future contract and squaring up byselling it.
Short is the equivalent of initiating the position by
first selling a future contract and then squaring up bybuying it back.
You pay only margin which is a fractional portion ofthe total transaction value, generally about 15% in
case of index futures, and up to 50% in the case ofindividual stock futures
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All the future contracts are dated . For example ,Indian futures and option settlement takes place on
last Thursday of every month. So the current month
futures expire on the months last Thursday. If the
trader has to carry his position to the next month ,he has to shift his position to the next month future.
Futures are generally traded using technical analysis
because product facilitates speculation.You can go long or short on futures depending upon
the short term view of the market and or a stock
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Exchanges Trading Futures
National Stock Exchange ofIndia (NSE)
Bombay Stock Exchange (BSE)
Multi Commodity Exchange (MCX)
MCX Stock Exchange (MCX-SX)
National Commodity andDerivatives Exchange (NCDEX)
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Futures Price
The futures prices for a particularcontract is the price at which you agree
to buy or sell
It is determined by supply and demandin the same way as a spot price
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Cost of carry is the interest cost of a similar
position in cash market and carried to maturity of
the futures contract less any dividend expected
till the expiry of the contract.
Example:
Spot Price of Stock "A" = 3000, Interest Rate =
12% p.a.
Futures Price of 1 month contract = 3000 +3000*0.12*30/365
= 3000 + 30
= 3030
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Electronic Trading
Traditionally futures contracts havebeen traded using the open outcrysystem where traders physically meeton the floor of the exchange
Increasingly this is being replaced byelectronic trading where a computer
matches buyers and sellers
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Terminology
The party that has agreed to buy has
a long positionThe party that has agreed to sell has
a short position
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Example
January: an investor enters into along futures contract to buy 100 oz of
gold @ $1050 in April
April: the price of gold $1065 per oz
What is the investors profit?
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Over-the Counter Markets
The over-the counter market is animportant alternative to exchanges
It is a telephone and computer-linkednetwork of dealers who do notphysically meet
Trades are usually between financialinstitutions, corporate treasurers, andfund managers
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A forward contract is the simplest modeof a derivative transaction.
It is an agreement to buy or sell an
asset (of a specified quantity) at acertain future time for a certain price.
No cash is exchanged when the
contract is entered into.
Forward contract
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Forward Contracts
Forward contracts are similar to futuresexcept that they trade in the over-the-counter market
Forward contracts are popular oncurrencies and interest rates
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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON
NOV17, 2011
Bid/buy Offer/sell
Spot 50.96 50.87
1-month forward 51.28 51.21
3-month forward 51.71 51.64
6-month forward 52.19 52.12
Forward rate = Spot rate + Forward margin
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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON NOV
30, 2011
Bid/buy Offer/sell
Spot 52.41 52.32
1-month forward 52.72 52.66
3-month forward 53.08 53.01
6-month forward 53.49 53.43
Forward rate = Spot rate + Forward margin
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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON DEC
16, 2011
Bid/buy Offer/sell
Spot 52.82 52.72
1-month forward 53.17 53.11
3-month forward 53.73 53.68
6-month forward 54.45 54.40
Forward rate = Spot rate + Forward margin
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Shyam wants to buy a TV, which costsRs 10,000 but he has no cash to buy itoutright.
He can only buy it 3 months hence. He,
however, fears that prices of televisionswill rise 3 months from now.
So in order to protect himself from therise in prices Shyam enters into acontract with the TV dealer that 3months from now he will buy the TV forRs 10,000.
Illustration 1:
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What Shyam is doing is that he islocking the current price of a TV for aforward contract. The forward contractis settled at maturity.
The dealer will deliver the asset toShyam at the end of three months andShyam in turn will pay cash equivalentto the TV price on delivery.
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Ram is an importer who has to make apayment for his consignment in sixmonths time.
In order to meet his payment obligationhe has to buy dollars six months fromtoday.
However, he is not sure what the Re/$rate will be then.
Illustration 2:
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In order to be sure of his expenditure hewill enter into a contract with a bank tobuy dollars six months from now at adecided rate.
As he is entering into a contract on afuture date it is a forward contract and
the underlying security is the foreigncurrency.
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Example
If you agree in April with your Aunt that you will buy
five kgs of tomatoes from her garden for Rs 75, to
be delivered to you in July, you just entered into afutures contract!
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Futures in India
Futures exists in various forms
Commodities (MCX, NCDEX)
Interest rate futures (NSE)
Stock and Index Futures (NSE)NSE Stock/Index Futures
1 month, 2 month and 3 month contracts
Near, Mid and Far month
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FUTURES
Futures
Individual stock
future
Index futures
Underlying asset is
the individual stockUnderlying asset is the stock
Index
Bombay Sensex futureNifty Future
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Let us take an example of a simple derivativecontract:
Ram buys a futures contract.
He will make a profit of Rs 1000 if the price ofInfosys rises by Rs 1000.
If the price is unchanged Ram will receivenothing.
If the stock price of Infosys falls by Rs 800 hewill lose Rs 800.
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As we can see, the above contract depends upon
the price of the Infosys scrip, which is the
underlying security.
Similarly, futures trading has already started in
Sensex futures and Nifty futures. The underlyingsecurity in this case is the BSE Sensex and NSENifty
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The Sensex and Nifty
In India the most popular indices have been the
BSE Sensex and S&P CNX Nifty.
The BSE Sensex has 30 stocks comprising the
index which are selected based on market
capitalization, industry representation, tradingfrequency etc.
It represents 30 large well-established and
financially sound companies.
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The Sensex represents a broad spectrum of
companies in a variety of industries. It represents
14 major industry groups.
Then there is a BSE national index and BSE
200. However, trading in index futures has onlycommenced on the BSE Sensex.
While the BSE Sensex was the first stock market
index in the country, Nifty was launched by theNational Stock Exchange in April 1996 taking the
base of November 3, 1995.
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The Nifty index consists of shares of 50
companies with each having a market
capitalization of more than Rs 500 crore.
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Choosing and understanding the right index is
important as the movement of stock index futures
is quite similar to that of the underlying stock
index. Volatility of the futures indexes is generally
greater than spot stock indexes.Everytime an investor takes a long or short
position on a stock, he also has an hidden
exposure to the Nifty or Sensex. As most often
stock values fall in tune with the entire market
sentiment and rise when the market as a whole is
rising.
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Retail investors will find the index derivatives
useful due to the high correlation of the index with
their portfolio/stock and low cost associated with
using index futures for hedging
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U d t di i d f t
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Understanding index 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.
Index futures are all futures contracts where the
underlying is the stock index (Nifty or Sensex)and helps a trader to take a view on the market
as a whole
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Index futures permits speculation and if a trader
anticipates a major rally in the market he can
simply buy a futures contract and hope for a price
rise on the futures contract when the rally occurs.
In India we have index futures contracts based onS&P CNX Nifty and the BSE Sensex and near 3
months duration contracts are available at all
times.
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Each contract expires on the last Thursday of the
expiry month and simultaneously a new contract
is introduced for trading after expiry of a contract
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E l
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Example:
Contract month Expiry/settlement
July 2011 July 28
August 2011 August 25
September 2011 September 29
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Futures contracts in Nifty in July 2011
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Contract month Expiry/settlement
August 2011 August 25
September 2011 September 29
October 2011 October 27
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On July 28
The permitted lot size is 50 or multiples thereof for the Nifty.
That is you buy one Nifty contract the total deal valuewill be 50*5500 (Nifty value)= Rs 2,75,000.
In the case of BSE Sensex the market lot is 15. That is you buy one
Sensex futures the total value will be 15*18000 (Sensex value)= Rs
2,70,000
H d i
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Hedging
Stocks carry two types of riskcompany specific and market risk.
While company risk can be minimized
by diversifying your portfolio .Marketrisk cannot be diversified but has to behedged.
So how does one measure the marketrisk? Market risk can be known fromBeta
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Beta measures the relationshipbetween movement of the index tothe movement of the stock.
The beta measures the percentageimpact on the stock prices for 1%change in the index. Therefore, for aportfolio whose value goes down by11% when the index goes down by10%, the beta would be 1.1.
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When the index increases by 10%,the value of the portfolio increases11%.
The idea is to make beta of yourportfolio zero to nullify your losses.
Hedging involves protecting anexisting asset position from futureadverse price movements
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In order to hedge a position, a market playerneeds to take an equal and opposite positionin the futures market to the one held in the
cash market.
Every portfolio has a hidden exposure to theindex, which is denoted by the beta.
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Assuming you have a portfolio of Rs 1 million,which has a beta of 1.2, you can factor acomplete hedge by selling Rs 1.2 mn of S&PCNX Nifty futures.
Steps:
Determine the beta of the portfolio. If the beta of
any stock is not known, it is safe to assume that it
is 1.
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Short sell the index in such a quantum that the
gain on a unit decrease in the index would offset
the losses on the rest of his portfolio.
This is achieved by multiplying the relative
volatility of the portfolio by the market value of hisholdings
Therefore in the above scenario we have to
shortsell 1.2 * 1 million = 1.2 million worth of Nifty.
Now let us study the impact on the overall
gain/loss that accrues:
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Index up 10% Index down 10%
Gain/(Loss) inPortfolio Rs 120,000 (Rs 120,000)
Gain/(Loss) inFutures
(Rs 120,000) Rs 120,000
Net Effect Nil Nil
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Now let us study the impact on the overall gain/loss that accrues
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As we see, that portfolio is completely insulated
from any losses arising out of a fall in market
sentiment.
But as a cost, one has to forego any gains that
arise out of improvement in the overall sentiment.
Then why does one invest in equities if all the
gains will be offset by losses in futures market.
The idea is that everyone expects his portfolio to
outperform the market. Irrespective of whether
the market goes up or not, his portfolio value
would increase. 53
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The same methodology can be applied to a
single stock by deriving the beta of the scrip and
taking a reverse position in the futures market.
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Speculation
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Speculation
Speculators are those who do not have any
position on which they enter in futures and
options market.
They only have a particular view on the market,
stock, commodity etc.
In short, speculators put their money at risk in
the hope of profiting from an anticipated price
change. They consider various factors such asdemand supply, market positions, open interests,
economic fundamentals and other data to take
their positions.
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Illustration
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Illustration
Ram is a trader but has no time to track and
analyze stocks. However, he fancies his chances
in predicting the market trend. So instead of
buying different stocks he buys Sensex Futures.
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On May 1, 2001, he buys 100 Sensex futures @
3600 on expectations that the index will rise in
future. On June 1, 2001, the Sensex rises to 4000
and at that time he sells an equal number of
contracts to close out his position.Selling Price : 4000*100 = Rs 4,00,000
Less: Purchase Cost: 3600*100 = Rs 3,60,000
Net gain Rs 40,000
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Ram has made a profit of Rs 40,000 by taking a
call on the future value of the Sensex. However, if
the Sensex had fallen he would have made a
loss. Similarly, if would have been bearish he
could have sold Sensex futures and made a profitfrom a falling profit. In index futures players can
have a long-term view of the market up to atleast
3 months.
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Arbitrage
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Arbitrage
An arbitrageur is basically risk averse.He enters into those contracts were hecan earn riskless profits.
When markets are imperfect, buying inone market and simultaneously sellingin other market gives riskless profit.
Arbitrageurs are always in the look outfor such imperfections.
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In the futures market one can takeadvantages of arbitrage opportunitiesby buying from lower priced market andselling at the higher priced market.
In index futures arbitrage is possiblebetween the spot market and the futuresmarket (NSE has provided a specialsoftware for buying all 50 Nifty stocks inthe spot market.
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Take the case of the NSE Nifty.
Assume that Nifty is at 1200 and 3months Nifty futures is at 1300.
The futures price of Nifty futures can beworked out by taking the interest cost of3 months into account.
If there is a difference then arbitrageopportunity exists.
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Let us take the example of single stock to
understand the concept better.
If Wipro is quoted at Rs 1000 per share andthe 3 months futures of Wipro is Rs 1070 then
one can purchase Wipro at Rs 1000 in spot byborrowing @ 12% annum for 3 months and sellWipro futures for 3 months at Rs 1070.
Sale = 1070Cost= 1000+30 = 1030
Arbitrage profit = 40
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These kind of imperfections continue to existin the markets but one has to be alert to theopportunities as they tend to get exhaustedvery fast.
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Pricing of Index Futures
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Pricing of Index Futures
The index futures are the most popular futures
contracts as they can be used in a variety of ways
by various participants in the market.
How many times have you felt of making risk-less
profits by arbitraging between the underlying andfutures markets. If so, you need to know the cost-
of-carry model to understand the dynamics of
pricing that constitute the estimation of fair value
of futures.
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The cost of carry model
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The cost of carry model
The cost-of-carry model where the price of the
contract is defined as:
F=S+C
where:F Futures price
S Spot price
C Holding costs or carry costs
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If F < S+C or F > S+C, arbitrage opportunities
would exist i.e. whenever the futures price moves
away from the fair value, there would be chances
for arbitrage.
If Wipro is quoted at Rs 1000 per share and the 3months futures of Wipro is Rs 1070 then one can
purchase Wipro at Rs 1000 in spot by borrowing
@ 12% annum for 3 months and sell Wipro
futures for 3 months at Rs 1070.
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Here F=1000+30=1030 and is less than
prevailing futures price and hence there are
chances of arbitrage
Sale = 1070
Cost= 1000+30 = 1030
Arbitrage profit 40
However, one has to remember that thecomponents of holding cost vary with contracts
on different assets.
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Futures pricing in case of dividend
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Futures pricing in case of dividendyieldWe have seen how we have to consider the cost
of finance to arrive at the futures index value.
However, the cost of finance has to be adjusted
for benefits of dividends and interest income. In
the case of equity futures, the holding cost is thecost of financing minus the dividend returns
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Suppose a stock portfolio has a value of Rs 100
and has an annual dividend yield of 3% which is
earned throughout the year and finance
rate=10% the fair value of the stock index
portfolio after one year will be F= Rs 100 + Rs100 * (0.10 0.03)
Futures price = Rs 107
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If the actual futures price of one-year contract is
Rs 109. An arbitrageur can buy the stock at Rs
100, borrowing the fund at the rate of 10% and
simultaneously sell futures at Rs 109. At the end
of the year, the arbitrageur would collect Rs 3 fordividends, deliver the stock portfolio at Rs 109
and repay the loan of Rs 100 and interest of Rs
10.
The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 =Rs 2.
Thus, we can arrive at the fair value in the case of
dividend yield70
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TRADING STRATEGIES
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Speculation
We have seen earlier that trading in index futures
helps in taking a view of the market, hedging,
speculation and arbitrage.
In this module we will see one can trade in index
futures and use forward contracts in each of
these instances.
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Taking a view of the market
Have you ever felt that the market would godown on a particular day and feared that yourportfolio value would erode?
There are two options available
Option 1: Sell liquid stocks such as Reliance
Option 2: Sell the entire index portfolio The problem in both the above cases is that it would be very
cumbersome and costly to sell all the stocks in the index. And in the
process one could be vulnerable to company specific risk. So what is
the option? The best thing to do is to sell index futures.
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Illustration:
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Illustration:
Scenario 1:
On July 13, 2001, X feels that the market will
rise so he buys 200 Nifties with an expiry dateof July 26 at an index price of 1442 costing Rs
2,88,400 (200*1442).
On July 21 the Nifty futures have risen to 1520so he squares off his position at 1520.
X makes a profit of Rs 15,600 (200*78
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Scenario 2:
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Scenario 2:
On July 20, 2001, X feels that the market will
fall so he sells 200 Nifties with an expiry dateof July 26 at an index price of 1523 costing Rs3,04,600 (200*1523).
On July 21 the Nifty futures falls to 1456 so hesquares off his position at 1456.
X makes a profit of Rs 13,400 (200*67).
In the above cases X has profited fromspeculation i.e. he has wagered in the hope ofprofiting from an anticipated price change.
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Hedging
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edg g
Stock index futures contracts offer investors,
portfolio managers, mutual funds etc severalways to control risk.
The total risk is measured by the variance or
standard deviation of its return distribution. Acommon measure of a stock market risk is the
stocks Beta.
While hedging the cash position one needs todetermine the number of futures contracts to be
entered to reduce the risk to the minimum.
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Have you ever felt that a stock was intrinsically
undervalued? That the profits and the quality ofthe company made it worth a lot more as
compared with what the market thinks?
Have you ever been a stockpicker and carefullypurchased a stock based on a sense that it was
worth more than the market price?
A person who feels like this takes a long positionon the cash market. When doing this, he faces
two kinds of risks:
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1. His understanding can be wrong, and the
company is really not worth more than the marketprice or
2. The entire market moves against him and
generates losses even though the underlyingidea was correct.
Everyone has to remember that every buy
position on a stock is simultaneously a buyposition on Nifty. It carries a long Nifty position
along with it, as incidental baggage i.e. a part
long position of Nifty.
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Let us see how one can hedge positions using
index futures:
X holds HLL worth Rs 9 lakh at Rs 290 per
share on July 01, 2001. Assuming that the beta of
HLL is 1.13. How much Nifty futures does Xhave to sell if the index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs
1017000 lakh on the index futures i.e. 666 Niftyfutures.
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On July 19, 2001, the Nifty futures is at 1437 and
HLL is at 275. X closes both positions earningRs 13,389, i.e. his position on HLL drops by Rs
46,551 and his short position on Nifty gains Rs
59,940 (666*90).
Therefore, the net gain is 59940-46551 = Rs
13,389.
Let us take another example when one has aportfolio of stocks:
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If you sell more than 496 contracts you are
overhedged and sell less than 496 contracts youare underhedged.
Thus, we have seen how one can hedge their
portfolio against market risk.
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Margins
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g
The margining system is based on the JR Verma
Committee recommendations. The actualmargining happens on a daily basis while online
position monitoring is done on an intra-day basis.
Daily margining is of two types:
1. Initial margins
2. Mark-to-market profit/loss
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The computation of initial margin on the futures
market is done using the concept ofValue-at-Risk (VaR).
The initial margin amount is large enough to
cover a one-day loss that can be encountered on99% of the days.
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VaR methodology seeks to measure the amount
of value that a portfolio may stand to lose within acertain horizon time period (one day for the
clearing corporation) due to potential changes in
the underlying asset market price. Initial margin
amount computed using VaR is collected up-
front.
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The daily settlement process called "mark-to-
market" provides for collection of losses thathave already occurred (historic losses) whereas
initial margin seeks to safeguard against potential
losses on outstanding positions. The mark-to-
market settlement is done in cash.
Let us take a hypothetical trading activity of a
client of a NSE futures division to demonstrate
the margins payments that would occur.
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Let us take a hypothetical trading activity of a
client of a NSE futures division to demonstratethe margins payments that would occur.
A client purchases 200 units of FUTIDX NIFTY
29JUN2001 at Rs 1500.
The initial margin payable as calculated by VaR
is 15%.
Total long position = Rs 3,00,000 (200*1500)
Initial margin (15%) = Rs 45,000
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Assuming that the contract will close on Day + 3
the mark-to-market position will look as follows:
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Position on Day 1
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Close Price Loss Margin released Net cash outflow
1400*200 =2,80,000 20,000 (3,00,000-
2,80,000)
3,000 (45,000-
42,000)
17,000 (20,000-
3000)
Payment to be
made
(17,000)
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New position on Day 2
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Close Price Gain Addn Margin Net cash inflow
1510*200 =3,02,000 22,000 (3,02,000-
2,80,000)
3,300 (45,300-
42,000)
18,700 (22,000-
3300)
Payment to be recd 18,700
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Value of new position = 1,400*200= 2,80,000
Margin = 42,000
Position on Day 3
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Close Price Gain Net cash inflow1600*200 =3,20,000 18,000 (3,20,000-
3,02,000)
18,000 + 45,300* = 63,300
Payment to be recd 63,300
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Value of new position = 1510*200 = Rs 3,02,000Margin = Rs 45,300
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Margin account*
Initial margin = Rs 45,000
Margin released (Day 1) = (-) Rs 3,000
Position on Day 2 Rs 42,000
Addn margin = (+) Rs 3,300
Total margin in a/c Rs 45,300*
Net gain/loss
Day 1 (loss) = (Rs 20,000)
Day 2 Gain = Rs 22,000
Day 3 Gain = Rs 18,000
Total Gain = Rs 20,000
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The client has made a profit of Rs 20,000 at the
end of Day 3 and the total cash inflow at the closeof trade is Rs 63,300.
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Settlements
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All trades in the futures market are cash settled
on a T+1 basis and all positions (buy/sell)which are not closed out will be marked-to-market.
The closing price of the index futures will bethe daily settlement price and the position willbe carried to the next day at the settlementprice.
The most common way of liquidating an openposition is to execute an offsetting futurestransaction by which the initial transaction issquared up.
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The initial buyer liquidates his long position
by selling identical futures contract.
In index futures the other way of settlement iscash settled at the final settlement. At the end
of the contract period the difference betweenthe contract value and closing index value ispaid.
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How to read the futures data sheet?
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Understanding and deciphering the prices of
futures trade is the first challenge for anyoneplanning to venture in futures trading.
Economic dailies and exchange websites
www.nseindia.com and www.bseindia.comare some of the sources where one can lookfor the daily quotes.
Your website has a daily market commentary,which carries end of day derivatives summaryalong with the quotes
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The first step is start tracking the end of day
prices. Closing prices, Trading Volumes andOpen Interest are the three primary data wecarry with Index option quotes.
The most important parameter are the actualprices, the high, low, open, close, last tradedprices and the intra-day prices and to trackthem one has to have access to real time prices.
The following table shows how futures data willbe generally displayed in the business papersdaily.
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Series FirstTrade
HighLow Close Volume (Noof contracts)
Value(R
s inlakh)
No oftrades
Openinterest(No ofcontracts)
BSXJUN
2000
4755 4820 4740 4783.1 146 348.70 104 51
BSXJUL
2000
4900 4900 4800 4830.8 12 28.98 10 2
BSXAU
G2000
4800 4870 4800 4835 2 4.84 2 1
Total 160 38252 116 54
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Source: BSE
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The first column explains the series that is being
traded. For e.g. BSXJUN2000 stands for the JuneSensex futures contract.
The column on volume indicates that (in case of
June series) 146 contracts have been traded in104 trades.
One contract is equivalent to 50 times the price of
the futures, which are traded. For e.g. In case ofthe June series above, the first trade at 4755
represents one contract valued at 4755 x 50 i.e.
Rs. 2,37,750/-.
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Open interest indicates the total gross
outstanding open positions in the market forthat particular series. For e.g. Open interest inthe June series is 51 contracts.
The most useful measure of market activity isOpen interest, which is also published byexchanges and used for technical analysis.
Open interest indicates the liquidity of amarket and is the total number of contracts,which are still outstanding in a futures marketfor a specified futures contract.
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A futures contract is formed when abuyer and a seller take oppositepositions in a transaction.
This means that the buyer goes longand the seller goes short.
Open interest is calculated by looking at
either the total number of outstandinglong or short positions not both.
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Open interest is therefore a measure of
contracts that have not been matchedand closed out.
The number of open long contractsmust equal exactly the number of openshort contracts.
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Action Resulting open interest
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New buyer (long) and new seller (short)
Trade to form a new contract.
Rise
Existing buyer sells and existing seller
buysThe old contract is closed.
Fall
New buyer buys from existing buyer.
The Existing buyer closes his position
by selling to new buyer.
No change there is no increase inlong contracts being held
Existing seller buys from new seller. The
Existing seller closes his position by
buying from new seller.
No change there is no increase inshort contracts being held
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Price Open interest Market
Strong
Warning signal
Weak
Warning signal
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Open interest is also used in conjunction with other technical analysis
chart patterns and indicators to gauge market signals.The following chart may help with these signals.
The warning sign indicates that the Open interest is notsupporting the price direction.
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Hedge Ratio: The Hedge Ratio is defined as
the number of Futures contracts required tobuy or sell so as to provide the maximumoffset of risk. This depends on the
Value of a Futures contract;
Value of the portfolio to be Hedged; and
Sensitivity of the movement of the portfolio
price to that of the Index (Called Beta). The Hedge Ratio is closely linked to the correlation between the
asset (portfolio of shares) to be hedged and underlying (index)from which Future is derived.
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Initial margin: The money a customer needs
to pay as deposit to establish a position in thefutures market. The basic aim of Initial marginis to cover the largest potential loss in oneday.
Mark-to-market: The daily revaluation of openpositions to reflect profits and losses basedon closing market prices at the end of the
trading day
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VaR: Value at Risk. A risk management
methodology, which attempts to measure themaximum loss possible on a particularposition, with a specified level of certainty orconfidence.
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Options
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What are options?
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An option is a contract, which gives the
buyer the right, but not the obligation tobuy or sell shares of the underlyingsecurity at a specific price on or before
a specific date.
Option, as the word suggests, is a
choice given to the investor to either
honour the contract; or if he choosesnot to walk away from the contract.
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There are two kinds of options: Call Optionsand Put Options
A Call Option is an option to buy a stock at aspecific price on or before a certain date.
When you buy a Call option, the price you payfor it, called the option premium, secures yourright to buy that certain stock at a specifiedprice called the strike price.
If you decide not to use the option to buy thestock, and you are not obligated to, your onlycost is the option premium
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Put Options are options to sell a stock at aspecific price on or before a certain date. Inthis way, Put options are like insurancepolicies
If you buy a new car, and then buy auto
insurance on the car, you pay a premium andare, hence, protected if the asset is damagedin an accident.
If this happens, you can use your policy toregain the insured value of the car. In thisway, the put option gains in value as the valueof the underlying instrument decreases.
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If all goes well and the insurance is not
needed, the insurance company keeps yourpremium in return for taking on the risk.
With a Put Option, you can "insure" a stock
by fixing a selling price. If something happenswhich causes the stock price to fall, and thus,"damages" your asset, you can exercise youroption and sell it at its "insured" price level.
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If the price of your stock goes up, and there is
no "damage," then you do not need to use theinsurance, and, once again, your only cost isthe premium. This is the primary function oflisted options, to allow investors ways tomanage risk.
Technically, an option is a contract betweentwo parties. The buyer receives a privilege for
which he pays a premium. The seller acceptsan obligation for which he receives a fee.
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OPTIONS
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An option is a contract between two parties
giving the taker (buyer) the right, but not theobligation, to buy or sell a parcel of shares ata predetermined price possibly on, or before apredetermined date. To acquire this right thetaker pays a premium to the writer (seller) ofthe contract.
Call options give the taker the right, but not
the obligation, to buy the underlying shares ata predetermined price, on or before apredetermined date
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Illustration 1
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Raj purchases 1 Tata motors Aug 150 Call --
Premium 8
This contract allows Raj to buy 100 shares ofTata Motors at Rs 150 per share at any time
between the current date and the end ofAugust.
For this privilege, Raj pays a fee of Rs 800
(Rs eight a share for 100 shares).The buyer of a call has purchased the right to
buy and for that he pays a premium.
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Now let us see how one can profit from
buying an option
Sam purchases a December call option at Rs40 for a premium of Rs 15.
That is he has purchased the right to buy thatshare for Rs 40 in December.
If the stock rises above Rs 55 (40+15) he will
break even and he will start making a profit.
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Suppose the stock does not rise and instead
falls he will choose not to exercise the optionand forego the premium of Rs 15 and thuslimiting his loss to Rs 15.
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Let us take another example of a call option on
the Nifty to understand the concept better.
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A trader is of the view that the index will go up
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A trader is of the view that the index will go upto 1400 in Jan 2002 but does not want to take
the risk of prices going down.
Therefore, he buys 10 options of Jancontracts at 1345. He pays a premium for
buying calls (the right to buy the contract) for500*10= Rs 5,000/-.
In Jan 2002 the Nifty index goes up to 1365.
He sells the options or exercises the optionand takes the difference in spot index pricewhich is (1365-1345) * 200 (market lot) = 4000per contract. Total profit = 40,000/- (4,000*10).
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Call Options-Long & Short Positions
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When you expect prices to rise,then you take a long position bybuying calls. You are bullish.
When you expect prices to fall, thenyou take a short position by sellingcalls. You are bearish.
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Put Options
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A Put Option gives the holder of the right to sell aspecific number of shares of an agreed security at a
fixed price for a period of time.
eg: Sam purchases 1 INFTEC (InfosysTechnologies) AUG 3500 Put --Premium 200
This contract allows Sam to sell 100 shares
INFTEC at Rs 3500 per share at any time between
the current date and the end of August. To have this
privilege, Sam pays a premium of Rs 20,000 (Rs200 a share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a putoption has the right to sell.
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Illustration 2
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Raj is of the view that the a stock is
overpriced and will fall in future, but he doesnot want to take the risk in the event of pricerising so purchases a put option at Rs 70 onX. By purchasing the put option Raj has the
right to sell the stock at Rs 70 but he has topay a fee of Rs 15 (premium).
So he will breakeven only after the stock falls
below Rs 55 (70-15) and will start making profit ifthe stock falls below Rs 55.
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An investor on Dec 15 is of the view that Wipro is
overpriced and will fall in future but does not wantto take the risk in the event the prices rise. So he
purchases a Put option on Wipro.
Quotes are as under:Spot Rs 1040
Jan Put at 1050 Rs 10
Jan Put at 1070 Rs 30
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He purchases 1000 Wipro Put at strike price 1070 at Put price ofRs 30/-. He pays Rs 30,000/- as Put premium.
His position in following price position is discussed below.
Jan Spot price of Wipro = 1020
Jan Spot price of Wipro = 1080
In the first situation the investor is having the right to sell 1000Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. Byexercising the option he earns Rs (1070-1020) = Rs 50 per Put,which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs20,000.
In the second price situation, the price is more in the spotmarket, so the investor will not sell at a lower price by exercisingthe Put. He will have to allow the Put option to expireunexercised. He looses the premium paid Rs 30,000.
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CALL OPTIONS PUT OPTIONS
If you expect a fall in
price(Bearish)
Short Long
If you expect a rise in price
(Bullish)
Long Short
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CALL OPTION BUYER CALL OPTION WRITER (Seller)
Pays premium
Right to exercise and buy the shares
Profits from rising prices
Limited losses, Potentially unlimited
gain
Receives premium
Obligation to sell shares if exercised
Profits from falling prices or remaining
neutral
Potentially unlimited losses, limited
gain
PUT OPTION BUYER PUT OPTION WRITER (Seller)
Pays premium
Right to exercise and sell shares
Profits from falling prices
Limited losses, Potentially unlimited
gain
Receives premium
Obligation to buy shares if exercised
Profits from rising prices or remaining
neutral
Potentially unlimited losses, limited
gain
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eg: Sam purchases 1 NIFTY AUG 1110 Call --
Premium 20. The exchange will settle thecontract on the last Thursday of August. Since
there are no shares for the underlying, the
contract is cash settled.
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American: These options give the holder the
right, but not the obligation, to buy or sell theunderlying instrument on or before the expirydate.
This means that the option can be exercisedearly. Settlement is based on a particularstrike price at expiration.
Options in stocks in the Indian market are"American Options".
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eg: Sam purchases 1 ACC SEP 145 Call --
Premium 12
Here Sam can close the contract any time from
the current date till the expiration date, which is
the last Thursday of September.American style options tend to be more
expensive than European style because they
offer greater flexibility to the buyer.
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IMPORTANT CONCEPTS
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STRIKE PRICE
IN THE MONEY
OUT OF THE MONEY
AT THE MONEYMARKET LOTS
EXPIRATION DATE
OPTION VALUE
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STRIKE PRICE
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The Strike Price denotes the price at which the
buyer of the option has a right to purchase or sellthe underlying.
The strikes in options of most Indian shares are
in multiples of Rs 5 and Rs 10 . Generallyspeaking , five to six options prices are available
on both sides of the current price of the
underlying.
for example , the ACC stock trading at Rs 200
might have options listed with strike of Rs 150 ,
160 ,170, 180, 190 , 200 ,210 220 230 240 250
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The strike price is also called Exercise
Price. This price is fixed by the exchange for theentire duration of the option depending on the
movement of the underlying stock or index in the
cash market.
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IN THE MONEY (ITM)
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A Call Option is said to be "In-the-Money" if the
strike price is less than the market price of theunderlying stock.
A Put Option is In-The-Money when the strike
price is greater than the market price.For Example , if the ACC stock is trading at Rs
200 , the ACC call option with strike 190, 180,170 and below are all in-the money.
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AT- THE MONEY (ATM)
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This is an option that has a strike price equal to
the current price of the underlying stock
The ACC option with strike of Rs 200 as at- the
money when the stock is trading at or near the
strike price .
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OPTION (PREMIUM) VALUE
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The option value is composed of two parts :
Intrinsic value
Time value
Intrinsic value is the amount by which theoption is in the money.
For example , lets suppose the ACC stock istrading at Rs 220 and 200 ACC call option istrading at a premium of Rs 32. of thepremium of Rs 32 , the intrinsic value is Rs 20
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Time value is the part of an option premium
that exceeds its intrinsic value . In the aboveexample , therefore , the time value is Rs 12.
Just to clarify in terms of which options to
buy ; if I am bullish on ACC and the share istrading at Rs 200 , I would take quotes of 200,210 220 ACC call options and compare theintrinsic values with the time values and buy
the one with the maximum intrinsic value.
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Out of the money (OTM) options costs less
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Out of the money (OTM) options costs lessthan in the money (ITM) options because thechances of appreciation are higher in ITMoptions . Personally , I buy in the moneyoptions with the least amount of time value in
them.Thus in the above ACC example , if the 200
call is selling for Rs 30 and 210 call is sellingfor Rs 25., I would buy the 200 call even if thismeans paying Rs 5 more. This is because theless time value there is in the option, thelower is the value that is lost because of time
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Currently , in India only the near month
(current month) options are actually liquidenough to trade. Accordingly , unless thereare strong trending moves , the options time
value can evaporate in a hurry.
Options with more time till expiration costmore than those with less time.
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EXPIRATION DATE
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The date when the term of an options contract
terminates is called its expiration date.
The expiry of Indian options mandated by the stockexchanges is the last Thursday of every month.
Technically speaking , options contract are availablefor the near month ( current ), mid month (next) andfar month ( the month after next) . Currently , however,only the near month options usually have tradableliquidity and only towards the last week of the near
month do the options of the mid month gatherenough liquidity to be traded comfortably
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MARKET LOTS
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The stock exchanges in their wisdom decided
to limit the Indian derivatives market to therelatively larger players and thus introducedmarket lots with a minimum contract size ofRs 2 lakh.
As the derivative market was firstimplemented at a Nifty level of about 1000 ( orSensex 3,300 )the average contract sizes in
some cases rose close to over Rs 10 lakh.When the market rallied.
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FACTORS THAT DETERMINE THE PRICE OF AN OPTION
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The minor factors are :
Prevalent risk free interest rate
Dividend rate of the underlying stock
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The Intrinsic Value of an Option
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The intrinsic value of an option is defined as the
amount by which an option is in-the-money, orthe immediate exercise value of the option when
the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price -Strike Price
For a put option: Intrinsic Value = Strike Price- Spot Price
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The intrinsic value of an option must be positive
or zero. It cannot be negative.
For a call option, the strike price must be less
than the price of the underlying asset for the call
to have an intrinsic value greater than 0. For a put option, the strike price must be greater
than the underlying asset price for it to have
intrinsic value.
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Price of underlying
The premium is affected by the price
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The premium is affected by the pricemovements in the underlying instrument.
For Call options the right to buy theunderlying at a fixed strike price as theunderlying price rises so does its premium.
As the underlying price falls so does the cost ofthe option premium.
For Put options the right to sell the underlyingat a fixed strike price as the underlying pricerises, the premium falls; as the underlying pricefalls the premium cost rises.
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Option Underlying price Premium cost
Call
Put
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The following chart summarises the above for Calls and Puts.
The Time Value of an Option
G ll th l th ti i i til
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Generally, the longer the time remaining until an
options expiration, the higher its premium will be.
This is because the longer an options lifetime,
greater is the possibility that the underlying share
price might move so as to make the option in-the-money.
All other factors affecting an options price
remaining the same, the time value portion of an
options premium will decrease (or decay) with
the passage of time.
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N t Thi ti d i idl i th l t
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Note: This time decay increases rapidly in the last
several weeks of an options life. When an optionexpires in-the-money, it is generally worth only its
intrinsic value.
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Option Time to expiry Premium cost
Call
Put
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The following chart summarises the above for Calls and Puts.
Volatility
V l tilit i th t d f th d l i
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Volatility is the tendency of the underlying
securitys market price to fluctuate either upor down.
It reflects a price changes magnitude; it does
not imply a bias toward price movement inone direction or the other.
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Th s it is a major factor in determining an
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Thus, it is a major factor in determining an
options premium. The higher the volatility of the underlying
stock, the higher the premium because there
is a greater possibility that the option willmove in-the-money.
Generally, as the volatility of an under-lyingstock increases, the premiums of both callsand puts overlying that stock increase, andvice versa
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Hi h l tilit Hi h
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Higher volatility=Higherpremium
Lower volatility = Lower
premium
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Option Volatility Premium cost
Call
Put
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The following chart summarises the above for Calls and Puts.
Volatility
Volatility is a measure of the fluctuation in a
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Volatility is a measure of the fluctuation in a
stock s ( or index s ) price and often playsthe most important role in option trading.
Knowing the volatility can help you :
1. Choose and implement an appropriatestrategy
2. Improve your timing in entering or exiting
positions3. Identify overpriced and underpriced options
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Understanding Volatility
Volatility is a measure of the amount by which
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Volatility is a measure of the amount by which
an asset s price fluctuation in a given time .Mathematically , volatility is the annualizedstandard deviation of an asset s daily price
changes.
There are two types of volatility:
1. Historical volatility , and
2. Implied volatility
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Historical volatility is a measure of actual
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Historical volatility is a measure of actual
changes in an assets price over a specificperiod of time. Historical volatility is availablein most trading software.
Implied volatility is a measure of how muchthe market expects an option price move.
Thus it is the volatility that the market itself isimplying , rather than that indicated by thepast movements of the stock price.
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The inputs you need to calculate implied
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volatility are very simple .
You need the current date and the date of expiry, the options strike price , the current price of theunderlying , risk free rate and historical
volatility.
Given these , you will automatically get theimplied volatility in the option.
Traders should avoid buying options which havelot of volatility premiumsor time value in it ,instead should sell a high volatility option
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Interest rates
In general interest rates have the least influence
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In general interest rates have the least influence
on options and equate approximately to the costof carry of a futures contract.
If the size of the options contract is very large,
then this factor may take on some importance. All other factors being equal as interest rates
rise, premium costs fall and vice versa.
The relationship can be thought of asan opportunity cost.
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In order to buy an option the buyer must either
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In order to buy an option, the buyer must either
borrow funds or use funds on deposit.
Either way the buyer incurs an interest rate cost.
If interest rates are rising, then the opportunity
cost of buying options increases and tocompensate the buyer premium costs fall.
Why should the buyer be compensated?
Because the option writer receiving the premium
can place the funds on deposit and receive more
interest than was previously anticipated.
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The situation is reversed when interest rates fall
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The situation is reversed when interest rates fall
premiums rise. This time it is the writer whoneeds to be compensated
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While the stock price itself usually undergoes a single
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While the stock price itself usually undergoes a single
adjustment by the amount of the dividend, optionprices anticipate dividends that will be paid in theweeks and months before they are announced.
The dividends paid should be taken into account
when calculating the theoretical price of an optionand projecting your probable gain and loss whengraphing a position. This applies to stock indices aswell. The dividends paid by all stocks in that index(adjusted for each stock's weight in the index) should
be taken into account when calculating the fairvalue of an index option.
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Option Interest rate Premium cost
Call
Put
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The following chart summarises the above for Calls and Puts.
DIVIDENDS
It's easier to pinpoint how dividends affect
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It s easier to pinpoint how dividends affect
option premium.Cash dividends affect option prices through
their effect on the underlying stock price.
Because the stock price is expected to dropby the amount of the dividend on the ex-dividend date, high cash dividends implylower call premiums and higher put
premiums.
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Greeks
The options premium is determined by the
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The options premium is determined by the
three factors mentioned earlier intrinsicvalue, time value and volatility. But there aremore sophisticated tools used to measure thepotential variations of options premiums.
They are as follows:Delta
Gamma
Vega
Rho
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Delta
Delta is the measure of an options sensitivity
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to changes in the price of the underlyingasset. Therefore, its is the degree to which anoption price will move given a change in theunderlying stock or index price, all else being
equal. Change in option premium
Delta = --------------------------------Change in underlying price
For example, an option with a delta of 0.5 willmove Rs 5 for every change of Rs 10 in theunderlying stock or index.
175
Illustration:
A trader is considering buying a Call option
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A trader is considering buying a Call option
on a futures contract, which has a price of Rs19.
The premium for the Call option with a strike
price of Rs 19 is 0.80.The delta for this option is +0.5. This means
that if the price of the underlying futurescontract rises to Rs 20 a rise of Re 1 then
the premium will increase by 0.5 x 1.00 = 0.50.The new option premium will be 0.80 + 0.50 =Rs 1.30.
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`
Far out-of-the-money calls will have a delta
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Far out of the money calls will have a delta
very close to zero, as the change inunderlying price is not likely to make themvaluable or cheap.
An at-the-money call would have a delta of0.5 and a deeply in-the-money call would havea delta close to 1.
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TABLE : TISCO CALL OPTION
Strike price : 300
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Price of the underlying
TISCO
Calculated option
premium
Delta
280 5.75 +.29
285 7.32 +.343
290 9.15 +.397
295 11.26 +.452300 13.64 +.508
305 16.30 +.562
310 19.22 +.614
315 22.39 +.664
320 25.81 +.71
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While Call deltas are positive, Put deltas are
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While Call deltas are positive, Put deltas are
negative, reflecting the fact that the put optionprice and the underlying stock price areinversely related.
This is because if you buy a put your view isbearish and expect the stock price to godown. However, if the stock price moves up itis contrary to your view therefore, the value of
the option decreases. The put delta equals thecall delta minus 1.
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It may be noted that if delta of your position is
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It may be noted that if delta of your position is
positive, you desire the underlying asset torise in price.
On the contrary, if delta is negative, you wantthe underlying assets price to fall.
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TABLE : TISCO PUT OPTION
Strike price : 300
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Price of the underlying
TISCO
Calculated option
premium
Delta
320 7.44 -.29
315 8.99 -.336
310 10.78 -.386
305 12.82 -.438300 15.13 -.492
295 17.71 -.548
290 20.57 -.603
285 23.7 -.657
280 27.1 - .71
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Uses:
The knowledge of delta is of vital importance forti t d b thi t i h il
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option traders because this parameter is heavily
used in margining and risk managementstrategies.
The delta is often called the hedge ratio. e.g. if you
have a portfolio of n shares of a stock then ndivided by the delta gives you the number of callsyou would need to be short (i.e. need to write) tocreate a riskless hedge i.e. a portfolio which
would be worth the same whether the stock pricerose by a very small amount or fell by a very smallamount.
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Gamma
This is the rate at which the delta value of an
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This is the rate at which the delta value of an
option increases or decreases as a result of amove in the price of the underlyinginstrument.
Change in an option deltaGamma =-------------------------------------
Change in underlying price
For example, if a Call option has a delta of
0.50 and a gamma of 0.05, then a rise of 1 inthe underlying means the delta will move to0.55 for a price rise and 0.45 for a price fall.
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Gamma
Gamma is rather like the rate of change in the
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Ga a s at e e t e ate o c a ge t e
speed of a car its acceleration in movingfrom a standstill, up to its cruising speed, andbraking back to a standstill.
Gamma is greatest for an ATM (at-the-money)option (cruising) and falls to zero as an optionmoves deeply ITM (in-the-money ) and OTM(out-of-the-money) (standstill).
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If you are hedging a portfolio using the
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If you are hedging a portfolio using the
delta-hedge technique described under"Delta", then you will want to keepgamma as small as possible as the
smaller it is the less often you will haveto adjust the hedge to maintain a deltaneutral position.
If gamma is too large a small change instock price could wreck your hedge.
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Adjusting gamma, however, can be tricky and
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j g g , , y
is generally done using options -- unlike delta,it can't be done by buying or selling theunderlying asset as the gamma of theunderlying asset is, by definition, always zero
so more or less of it won't affect the gamma ofthe total portfolio.
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Theta
It is a measure of an options sensitivity to time
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p y
decay. Theta is the change in option price given aone-day decrease in time to expiration. It is a
measure of time decay (or time shrunk). Theta is
generally used to gain an idea of how time decay
is affecting your portfolio.
Change in an option premium
Theta = --------------------------------------
Change in time to expiry Theta is usually negative for an option as with a decrease
in time, the option value decreases. This is due to the fact
that the uncertainty element in the price decreases.187
Assume an option has a premium of 3 and a
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p p
theta of 0.06. After one day it will decline to 2.94,the second day to 2.88 and so on. Naturally other
factors, such as changes in value of the
underlying stock will alter the premium. Theta is
only concerned with the time value.Unfortunately, we cannot predict with accuracy
the changes in stock markets value, but we can
measure exactly the time remaining until
expiration.
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Vega
This is a measure of the sensitivity of an option
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y p
price to changes in market volatility. It is thechange of an option premium for a given change
typically 1% in the underlying volatility.
Change in an option premium
Vega = -----------------------------------------
Change in volatilityIf for example,
XYZ stock has a volatility factor of 30% and the
current premium is 3, a vega of .08 wouldindicate that the premium would increase to 3.08
if the volatility factor increased by 1% to 31%.
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As the stock becomes more volatile the changes
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g
in premium will increase in the same proportion.Vega measures the sensitivity of the premium to
these changes in volatility.
What practical use is the vega to a trader? If a
trader maintains a delta neutral position, then it is
possible to trade options purely in terms of
volatility the trader is not exposed to changes in
underlying prices.
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Rho
The change in option price given a one
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g p p g
percentage point change in the risk-free interestrate. Rho measures the change in an options
price per unit increasetypically 1% in the cost
of funding the underlying.
Change in an option premium
Rho = ---------------------------------------------------
Change in cost of funding underlying
191
Example
Assume the value of Rho is 14.10. If the risk free
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interest rates go up by 1% the price of the optionwill move by Rs 0.14109. To put this in another
way: if the risk-free interest rate changes by a
small amount, then the option value should
change by 14.10 times that amount. For example,if the risk-free interest rate increased by 0.01
(from 10% to 11%), the option value would
change by 14.10*0.01 = 0.14. For a put option the
relationship is inverse. If the interest rate goes upthe option value decreases and therefore, Rho for
a put option is negative. In general Rho tends to
be small except for long-dated options. 192
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OPTIONS PRICING MODELS
193
There are various option pricing models which
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traders use to arrive at the right value of theoption.
Some of the most popular models have been
enumerated below
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The Binomial Pricing Model
The binomial model is an options pricing model
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which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing
models which differ according to their hypotheses
or the underlying instruments upon which they
are based (stock options, currency options,
options on interest rates).
195
The Black & Scholes Model
The Black & Scholes model was published in 1973
by Fisher Black and Myron Scholes
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by Fisher Black and Myron Scholes.
It is one of the most popular options pricing
models.
The Black-Scholes model is used to calculate atheoretical call price (ignoring dividends paid during
the life of the option) using the five key
determinants of an option's price: stock price, strike
price, volatility, time to expiration, and short-term(risk free) interest rate.
196
The original formula for calculating the theoretical
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option price (OP) is as follows:
197
The variables are:
S = stock price
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X = strike pricet = time remaining until expiration
r = current continuously compounded risk-free
interest rate
v = annual volatility of stock price (the standarddeviation of the short-term returns over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution
functione = the exponential function
198
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BACK UP SLIDES
199
Indicative on Thursday November 17, 2011
IMPORT EXPORT
S t 1 th 3 th 6 th C S t 1 th 3 th 6 th
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Spot 1month 3months6months Currency Spot 1month 3months6months
0.7426 0.7427 0.742 0.7414 Euro 0.7424 0.7427 0.7426 0.7421
0.6354 0.6356 0.636 0.6364 Pound Sterling 0.6353 0.6354 0.6356 0.636
76.9905 76.9392 76.8008 76.5811 Japanese Yen* 77.0291 76.9959 76.9368 76.8052
0.9214 0.9208 0.9196 0.9169 Swiss Franc 0.9217 0.9214 0.9208 0.9197
1.295 1.2949 1.2944 1.2915 Singapore Dollar 1.2957 1.2948 1.2949 1.2946
7.792 7.7815 7.7759 7.7779 Hong Kong Dollar 7.7902 7.7827 7.7888 7.7791
0.9945 0.9944 1.0039 1.0116 Australian Dollar 0.9943 0.9946 0.9979 1.0048
5.7909 5.8009 5.8166 5.8313 Norwegian Kroner 5.8005 5.793 5.8022 5.817
6.7947 6.8101 6.8763 6.8401 Swedish Kroner 6.8008 6.8008 6.8037 6.822
1.0243 1.0252 1.0264 1.0276 Canadian Dollar 1.025 1.0244 1.0252 1.0266
50.96 51.28 51.71 52.19 Indian Rupees 50.8700 51.21 51.64 52.12
200
Rolling Settlement
Rolling Settlement is a mechanism of settling
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trades done on a stock exchange on T i.e. tradeday plus "X" trading days, where "X" could be
1,2,3,4 or 5 days.
In other words, in T+5 environment, a trade done
on T day is settled on the 5th working day
excluding the T day.
w.e.f. April 1, 2002, the trades in all the scrips
listed and traded on the exchange are nowsettled on T+3 basis.
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Instrument wise volume and turnover
As on Dec 02, 2011 15:30:24 IST
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Product No. of contracts Traded Value(Rs crores)
Index Futures 6,03,261 14,001.34
Stock Futures 5,06,921 11,659.79
Index Options 33,57,031 84,448.92
Stock Options 1,47,517 3,426.77
F&O Total 46,14,730 1,13,536.82
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Daily Mark to Market settlement
The positions in the futures contracts for each
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member is marked-to-market to the dailysettlement price of the futures contracts at the
end of each trade day.
The profits/ losses are computed as the
difference between the trade price or the previous
day's settlement price, as the case may be, and
the current day's settlement price.
203
The CMs who have suffered a loss are required
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to pay the mark-to-market loss amount to NSCCLwhich is passed on to the members who have
made a profit. This is known as daily mark-to-
market settlement.
Theoretical daily settlement price for unexpired
futures contracts, which are not traded during the
last half an hour on a day, is currently the price
computed as per the formula detailed below:F = S * e rt
204
where :
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F = theoretical futures priceS = value of the underlying index
r = rate of interest (MIBOR)
t = time to expiration
Rate of interest may be the relevant MIBOR rate
or such other rate as may be specified.
After daily settlement, all the open positions are
reset to the daily settlement price.
205
CMs are responsible to collect and settle the daily
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mark to market profits / losses incurred by theTMs and their clients clearing and settling
through them.
The pay-in and pay-out of the mark-to-market
settlement is on T+1 days (T = Trade day). The
mark to market losses or profits are directly
debited or credited to the CMs clearing bank
account.
206
On the expiry of the futures contracts, NSCCL
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marks all positions of a CM to the final settlementprice and the resulting profit / loss is settled in
cash.
The final settlement of the futures contracts is
similar to the daily settlement process except for
the method of computation of final settlement
price.
207
The final settlement profit / loss is computed as
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the difference between trade price or the previousday's settlement price, as the case may be, and
the final settlement price of the relevant futures
contract.
Final settlement loss/ profit amount is debited/
credited to the relevant CMs clearing bank
account on T+1 day (T= expiry day).
Open positions in futures contracts cease to existafter their expiration day
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Futures Quiz
In India, futures contracts have an expiry period
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of
Choices:
One month
Two months
Three months
All of the above
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The cost of carry is represented by
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Choices:
F= S+C
F=S-C
F=S+C-B
None of the above
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In the case of index futures the contract expires
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on the last ______ of the month
Choices:
Monday
Thursday
Friday
Saturday
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4. In the case of index futures all positions are
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daily marked-to-market
Choices:
True
False
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In stock index futures trading, profits are
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received or losses are paid
Choices:
In the delivery month
On daily settlement
On the day of the expiry of the contract
On a weekly settlement basis
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The underlying asset for a derivatives instrument
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can be
Choices:
Equity
Commodities
Interest rate intruments
All of the above
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The beta of ACC is 0.8. Assuming you have a
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