MODULE - VI:Futures meaning, Future v/s options, Index futures, Valuation of index future. Arbitrage, Hedging, Price index futures, Advantages of futures

index, Duration effect.

Options Meaning and salient

features, calls and put options, Types of derivatives, Options price, Writer of options, Price changes, Risks, Market structure, options v/s Badla

INTRODUCTION Derivatives, as the name suggests, are financial instruments that

derive their value from an underlying security or asset.

Any security or asset that varies in value from time to time could be used as the underlying asset.

The underlying asset could therefore be securities, bullion, commodities, bonds, etc.

With variation in value comes risk – the risk that the value of an asset that you wish to buy may rise when you hoped that it will remain steady or still better fall; or the value of an asset that you wish to sell may fall when you hoped that it will remain steady or at best rise.

Derivatives essentially enable the transfer of this risk from one individual who is risk averse to another who welcomes the risk in the hope of making returns.

How to benefit from Derivatives You are bullish on a stock say Satyam, which is currently

quoting at Rs 280 per share. You believe that in one month it will touch Rs 330. 

If you buy Satyam. It touches Rs 330 as you predicted – you made a profit of Rs

50 on an investment of Rs 280 i.e. a Return of 18% in one month.

Can it get any better ? What should you do ? Yes…… Buy Satyam Futures instead. Effect: On buying Satyam Futures, you get the same

position as Satyam in the cash market, but you pay a margin and not the entire amount. For example, if the margin is 20%, you would pay only Rs 56. If Satyam goes upto Rs 330, you will still earn Rs 50 as profit. Now that translates into a fabulous return of 89% in one month.

This is the advantage of ‘leverage’ which Stock Futures provide. By investing a small margin (ranging from 10 to 25%), you can get into the same positions as you would be able to in the cash market. The returns therefore get accordingly multiplied.

What are the risks?

The risks are that losses will be get leveraged or multiplied in the same manner as profits do. For example, if Satyam drops from Rs 280 to Rs 250, you would make a loss of Rs 30. The Rs 30 loss would translate to an 11% loss in the cash market and a 54% loss in the Futures market.

Definition With Securities Laws (Second Amendment) Act,1999,

Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-

A Derivative includes: - a security derived from a debt instrument, share, loan,

whether secured or unsecured, risk instrument or contract for differences or any other form of security;

a contract which derives its value from the prices, or index of prices, of underlying securities;

HISTORY OF DERIVATIVES Derivative products in some form or the other have existed for centuries. As far back as 580 B.C., or there about, specific instances of “option

contracts” based on the price of olives, are known to have been written. The first "futures" contract is traced to the rice market in Osaka, Japan, in

approximately 1650 AD. These were evidently standardized contracts, which made them similar to

today's futures, although it is not known if the contracts were frequently traded and whether there were any credit guarantees attached to them.

The biggest step towards a formal futures market came in 1848, with the setting up of the Chicago Board of Trade.

This organization changed its perspective and trading patterns over the years until, in 1919, it finally became the Chicago Mercantile Exchange, as we now know it. Other exchanges have come up around the US and across the world since then.

In India… Interestingly, from time to time, governments and regulators have

developed discomfort with futures/options/derivatives trading. As a result, these have been banned in part or totally numerous

times in Europe, Japan and United States ever since the 1800s, though these laws have eventually been repealed.

In India too, futures trading in various commodities was widespread until it was unceremoniously banned in the 1960s.

Then, in 2000, trading in derivative products took on a whole new face when trading in equity-based derivatives was allowed on the Indian stock exchanges.

This step proved to be a shot in the arm for the capital market and volumes soared within three years.

The success of the capital market reforms motivated the government and the Forward Market Commission in India to kick off similar reforms in the commodities market as well.

As a result, in April 2003 the ban on trading in commodity futures was finally lifted.

Present scenario.. Today, both equity and commodity derivatives are thriving

in India.

Not only do they give investors a chance to hedge against price movements in the underlying, they bring stability to the cash markets as well, due to the arbitrage opportunities (an opportunity to make a quick return using the price differentials of the underlying in two different markets) that are available between the cash and the derivatives markets.

Since the introduction of futures and options in the Indian equity markets, the turnover in this segment has increased manifold.

Structure of Derivative Markets in India Derivative trading in India takes place either on a

separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange.

Derivative Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as the oversight regulator.

The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.

Futures And Options

Indian perspective

FUTURES CONTRACTS Futures contracts are derivative contracts wherein you agree to buy or

sell a specified quantity of the underlying asset on a specified particular date in the future, at the price agreed upon at the time of entering into contract.

In Indian equity futures market, this price is the spot price (i.e. the price of the underlying asset in the cash market) prevailing on the date of the expiry of the contract.

Futures are standardized contracts in terms of quantity, quality, delivery time, delivery place and date of delivery.

Further, futures are legally binding and both parties are bound to uphold the agreement.

As a result of these additional features, futures are easily tradable on exchanges and therefore offer better liquidity than forwards Contracts.

FORWARD CONTRACTS Forwards are derivative contracts wherein you agree to sell or buy the

underlying asset at an agreed price, on a predetermined date in the future.

The quantity and quality specifications of the underlying and the place of delivery are mutually decided while entering into the agreement.

Essentially, the agreement takes place on a one-to-one level, between you and the buyer/seller (as the case may be) and hence, is more or less tailor-made to meet the specific needs of both the parties involved.

The duration of the contract, the quality and quantity of the underlying, etc. are decided upon after mutual negotiation.

In India, forward contracts are used in the foreign exchange markets to reduce currency risks and in the commodities market to reduce the price risk.

Equity Derivatives in India - An Overview Derivatives Markets

Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the those traded one to one or ‘over the counter’. They are hence known as Exchange Traded Derivatives OTC Derivatives (Over The Counter)

At present the average daily turnover of 23 commodity exchanges put together crosses Rs 8,000-9,000 crore. NCDEX MCX..

Equity Derivatives Exchanges in India

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

The exchanges are expected to start trading in Stock Index futures by mid-May 2000.

BSE's and NSE’s Both the exchanges have set-up an in-house

segment instead of setting up a separate exchange for derivatives.

BSE’s Derivatives Segment, will start with Sensex futures as it’s first product.

NSE’s Futures & Options Segment will be launched with Nifty futures as the first product.

Product Specifications BSE-30 Sensex Futures Contract Size - Rs. 50 times the Index Tick Size - 0.1 points or Rs. 5 Expiry day - last Thursday of the month Settlement basis - cash settled Contract cycle - 3 months Active contracts - 3 nearest months

Product Specifications S&P CNX Nifty Futures Contract Size - Rs. 200 times the Index Tick Size - 0.05 points or Rs. 10 Expiry day - last Thursday of the month Settlement basis - cash settled Contract cycle - 3 months Active contracts - 3 nearest months

Illustration Company GTEL India Limited, which is in the business of

importing fine Fabric, requires US $ 50,000 to pay for a consignment that is due 3 months from now. Suppose one US $ 1 is currently worth Rs 40.

The company expects the price of the US $ to strengthen against the Rupee three months hence. This means that it fears that it may even have to pay Rs 42.00 per US $ by then.

It could request its bank to make an agreement with a foreign exchange dealer wherein GETL India Limited will pay Rs 41.00 per US $ three months later. This would constitute a forward agreement.

Types of Futures The Indian markets offer trading opportunities in both

Stock Futures Index futures.

A stock future is one, where the underlying asset is shares of companies that are traded on the bourses.

An index future is one, where the underlying asset is units of the index.

Pricing of a futures contract Assuming that the underlying asset

is shares of a company, the price per share of a futures contract should be the spot price, i.e., the price of the underlying stock on the day that you purchase the futures contract, plus the ‘cost of carry’.

The ‘cost of carry’ comprises of all costs that you would have had to bear if you had purchased the underlying in the cash market and kept it until the maturity date of the futures contract, less any dividends received, if any, during this period.

The costs that you would have to bear in the case of stocks typically consist of interest/financing charges, etc.

Therefore, in reality, there is always a difference between the futures price per share and the spot price per share in the cash market. This difference is called the ‘basis’ and could be positive, negative or zero.

‘Contango’\ ‘Backwardation’ If the basis is positive (which is the more common

situation), it means that the futures price per share of the underlying asset is higher than the spot price per share in the cash market. This situation is termed as a ‘contango’ market.

Sometimes the basis could turn negative, i.e., the futures price per share is lower than the spot price per share in the cash market. This situation is termed as a ‘backwardation’.

On the day of expiry of the futures contract, the basis necessarily becomes zero since futures contracts in India are settled at the spot price of the underlying asset as it prevails on the expiry date.

CommodityALUMINIUM (ALUMINIUM)  Expiry DateJan-2008  Execute

   FUTURES PRICE OF ALUMINIUM AT NCDEX

Date Prev Close Price

Open Price

High Price

Low Price

Close Price

Volume

Open Interest

Traded Value(Rs. In Lakhs)

Delivery Centre

31-DEC-2007 93.80 0.00 0.00 0.00 93.80 0 0 0.00 Mumbai

01-JAN-2008 93.80 0.00 0.00 0.00 93.80 0 0 0.00 Mumbai

02-JAN-2008 93.30 0.00 0.00 0.00 93.30 0 0 0.00 Mumbai

03-JAN-2008 93.70 0.00 0.00 0.00 93.70 0 0 0.00 Mumbai

04-JAN-2008 93.90 0.00 0.00 0.00 93.90 0 0 0.00 Mumbai

05-JAN-2008 96.20 0.00 0.00 0.00 96.20 0 0 0.00 Mumbai

07-JAN-2008 96.80 0.00 0.00 0.00 96.80 0 0 0.00 Mumbai

08-JAN-2008 96.80 0.00 0.00 0.00 96.80 0 0 0.00 Mumbai

09-JAN-2008 95.00 0.00 0.00 0.00 95.00 0 0 0.00 Mumbai

10-JAN-2008 96.40 0.00 0.00 0.00 96.40 0 0 0.00 Mumbai

11-JAN-2008 96.70 0.00 0.00 0.00 96.70 0 0 0.00 Mumbai

12-JAN-2008 95.40 0.00 0.00 0.00 95.40 0 0 0.00 Mumbai

What is a stock index? Stock Index represents change in the value of a

set of stocks, which constitute the index, over a base year.

Any Index is an average of its constituents.

For example, the BSE Sensex is a weighted average of prices of 30 select stocks and S&P CNX Nifty of 50 select stocks, where the weight is the market capitalization of individual stocks.

SR. NO. PRODUCT CODE

1 BSE 30 SENSEX FUTURES SENFUT

2 BSE SENSEX MINI FUTURES MSXFUT

3 BSE TECK FUTURES TECKFUT

4 BSE BANKEX FUTURES BNKXFUT

5 BSE OIL & GAS FUTURES ONGXFUT

6 BSE PSU FUTURES PSUFUT

7 BSE METAL FUTURES METLFUT

8 BSE FMCG FUTURES FMCGFUT

Index Futures Products

TRADING SYSTEM The Derivatives Trading at BSE takes place through a fully

automated screen based trading platform called as DTSS (Derivatives Trading and Settlement System).

The DTSS is designed to allow trading on a real time basis.

In addition to generating trades by matching opposite orders, the DTSS also generates various reports for the member participants.

Order Matching Rules Order Matching will take place after order

acceptance wherein the system searches for an opposite matching order. If a match is found, a trade will be generated.

The order against which the trade has been generated will be removed from the system.

In case the order is not exhausted further matching orders will be searched for and trades generated till the order gets exhausted or no more match-able orders are found.

If the order is not entirely exhausted, the system will retain the order in the pending order book.

Matching of the orders will be in the priority of price and timestamp.

A unique trade-id will be generated for each trade and the entire information of the trade is sent to the members involved.

SESSION TIMINGSSESSION NAME FROM TO

Login Session 8:30 9:55Trading Session 9:55 15:30Position Transfer Session 15:30 15:50Closing Session 15:50 16:10Option Exercise Session 16:10 16:40Margin Session 16:40 16:55Query Session 16:55 17:40

Option contract An option is a contract, which gives the buyer

(holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date).

The underlying may be commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.

Definition Under Securities Contracts (Regulations)

Act,1956 options on securities has been defined as "option in securities" means a

contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;

Example: An investor buys One European call option on

Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 { (Spot price - Strike price) - Premium}.

Option Premium This is the price paid by the

buyer to the seller to acquire the right to buy or sell

Strike Price or Exercise Price The strike or exercise price of an option is

the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.

Expiration date The date on which the option expires is

known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.

Exercise Date The date on which the option is actually

exercised.

Open Interest The total number of options

contracts outstanding in the market at any given point of time.

Example `A' buys one contract of Nifty on Monday while

`B' buys two on the same day. Open interest at the end of the day will be three.

On Tuesday, while `A' sells his one contract to `C', `B' buys another Nifty contract.

The open interest at the end of the day is now four. In other words, if both parties to the trade initiate a new position, it increases the open interest by one contract.

But if the traders square off their existing positions, open interest will decrease by the same number of contracts.

However, if one of the parties to the transaction squares off his position while the other creates one, open interest will remain unchanged.

Open interest, thus, mirrors the flow of money into the derivatives market, which makes it a vital indicator of market direction. Here is how you interpret open interest:

The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium.

The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right.

The underlying asset could include securities, an index of prices of securities etc.

Types of options

An Option to buy is called Call option

An option to sell is called Put option.

What are Call Options? A call option gives the holder (buyer/ one who is

long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.

The seller however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Example: An investor buys One European call option on

Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 { (Spot price - Strike price) - Premium}.

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which shall be the profit earned by the seller of the call option.

What are Put Options? A Put option gives the holder (buyer/ one who is

long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date.

The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

Example: An investor buys one European Put option on Reliance

at the strike price of Rs. 300/-, at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'.

The investor's Break even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ - , the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.

In this case the investor loses the premium paid (i.e Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)

American\ European option if an option that is exercisable on or before

the expiry date is called American option in the case of American options the buyer

has the right to exercise the option at anytime on or before the expiry date.

and one that is exercisable only on expiry date, is called European option.

In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option)

settlement As in the case of futures contracts, option contracts

can be also be settled by delivery of the underlying asset or cash.

Option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.

How are options different from futures?The significant differences in Futures and Options are as under:Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.In case of options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile.In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited.For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset.It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.Explain In the Money, At the Money and Out of the money Options.An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value.The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price.On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100.Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.What are Covered and Naked Calls?A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call.Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value.When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.