About The Derivative Market

Published Date: 02 Nov 2017

TOPIC

PAGE NO.

Executive Summary

Research Methodology

5

About The Stock Market

6-13

About The Derivative Market

14-23

Derivative Tools

24-34

Application Of Futures

35-37

Application Of Options

38-43

Hedging using Futures

44-47

Hedging using Options

48-58

Findings

59

Limitations

60

Conclusions

61

Bibliography

62

TABLE OF CONTENTS

Chapter 1- Introduction

Executive Summary

Objective Of The Study

EXECUTIVE SUMMARY

Derivatives are financial instruments whose value is derived on the basis of underlying instrument or assets. Most common derivative instruments are forwards, futures, options and swaps. Most important factors which contributed to the growth of derivatives are – price volatility, globalization of markets, technological advances and advances in financial theories. There are two types of derivative instruments i.e., exchange traded derivatives and over the counter (OTC) derivatives.

A forward contract obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future. Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlying, including the traditional agricultural or physical commodities, as well as currencies and interest rates.

A futures contract is an agreement between buyer and a seller which requires a seller to deliver to the buyer a specified quantity of security or asset at a fixed time in future at a predetermined price. These contracts can be bought or sold in only organised futures market. These were developed from forward market which existed earlier. Main difference between forward and futures contracts are that futures contracts are standardised in terms of quantity, delivery date and mode of delivery whereas forwards are tailor made. Futures contract do not have counter party risk which is present in forward contracts.

Futures are through futures exchange market whereas forwards are O.T.C traded.

An option is a contract between two parties in which one party has a right but not the obligation to buy or sell some underlying asset. Options are different than futures in a way, that futures contract gives equal opportunities to both long and short but option gives right to buyer and obligation to option seller. Options involve some upfront premium which is not there in futures.

Options can be both exchange traded as well as OTC type. There are two types of options i.e., Call Option and Put Option. Call option gives buyer right to buy the underlying asset at specified price during a specified period whereas put option gives option buyer a right to sell the underlying asset at a set price. Options have great utility in money market and capital market apart from foreign exchange market.

Transactions which obligate the two parties to the contract to exchange a series of cash flows at specified intervals, known as payment or settlement dates, are called as Swaps. They are portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a Swap. There are three types of swaps viz., interest rate swap, currency swap and financial swap.

Research Methodology

The main objectives behind the study of derivatives are:

To understand the finer points of derivatives.

To understand the concept of derivatives in a more appropriate

way.

To understand how the derivatives tools are used.

To understand the various tool of derivatives available in India.

To understand pay off for various tools of derivative market

Data Collection

Secondary Data- Internet, Books , Newspapers,

Research Problem

There are very few ways for hedging price risk or price volatility in equity markets. My study is see how derivatives are used for hedging price risk in equity market

Chapter 2- About the stock market

Indian stock market overview

History of Indian stock market

Definition of stock exchange

SEBI

BSE

NSE

Depository Participant

Main player in DP

Indian stock market overview

History of Indian stock market

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago. The earliest records of security dealings in India are meagre and obscure. The East India Company was the dominant institution in those days and business in its loan securities used to be transacted towards the close of the eighteenth century.

By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in Bombay. Though the trading list was broader in 1839, there were only half a dozen brokers recognized by banks and merchants during 1840 and 1850

.

The 1850's witnessed a rapid development of commercial enterprise and brokerage business attracted many men into the field and by 1860 the number of brokers increased into 60. In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to about 200 to 250. However, at the end of the American Civil War, in 1865, a disastrous slump began. At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a place in a street (now called as Dalal Street) where they would conveniently assemble and transact business. In 1887, they formally established in Bombay, the "Native Share and Stock Brokers' Association" (which is alternatively known as " The Stock Exchange "). In 1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.

Thus, the Stock Exchange at Bombay was consolidated.

No need for this section:

DEFINITION OF STOCK EXCHANGE

"Stock exchange means anybody or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities."

It is an association of member brokers for the purpose of self-regulation and protecting the interests of its members. It can operate only if it is recognized by the Government under the securities contracts (regulation) Act, 1956. The recognition is granted under section 3 of the Act by the central government, Ministry of Finance.

Stock Exchange (also called Stock Market or Share Market) is one important constituent of capital market. Stock Exchange is an organized market for the purchase and sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations.

It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country.

Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange, and bonds and debentures issued by government, public corporations and municipal and port trust bodies.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

SEBI was set up as an autonomous regulatory authority by the Government of India in 1988 " to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto." It is empowered by two acts namely the SEBI Act, 1992 and the securities contract (regulation)Act, 1956 to perform the function of protecting investor's rights and regulating the capital markets.

Objectives

Protect the interest of investor in securities

Promote the development of capital market by ensuring flow of saving in

it.

Promote the development of securities market with the reasonable

Regulation thereof.

Facilitates companies to raise their finances at minimum cost long with

fair practices.

BOMBAY STOCK EXCHANGE

This stock exchange, Mumbai, popularly known as "BSE" was established in 1875 as "The Native share and stock brokers association", as a voluntary non-profit making association. It has an evolved over the years into its present status as the premiere stock exchange in the country. It may be noted that the stock exchanges the oldest one in Asia, even older than the Tokyo Stock exchange which was founded in 1878. The exchange, while providing an efficient and transparent market fo trading in securities, upholds the interests of the investors and ensures redressed of their grievances, whether against the companies or its own member brokers.

It also strives to educate and enlighten the investors by making available necessary informative inputs and conducting investor education programmes.

BSE INDICES

In order to enable the market participants, analysts etc., to track the various ups and downs in the Indian stock market, the Exchange has introduced in 1986 an equity stock index called BSE-SENSEX that subsequently became the barometer of the moments of the share prices in the Indian stock market. Itis a "Market capitalization-weighted" index of 30 component stocks representing a sample of large, well-established and leading companies. Thebase year of Sensex is 1978-79. The Sensex is widely reported in both domestic and international markets through print as well as electronic media.

Index= (Free float market capital of companies) *Index value in 1978-79

----------------------------------------------------------------------------------------

(Free float market capital of companies in 1978-79)

NATIONAL STOCK EXCHANGE

The NSE was incorporated in Nov 1992 with an equity capital of Rs. 25 crs. The International securities consultancy (ISC) of Hong Kong has helped in setting up NSE. ISC has prepared the detailed business plans and installation of hardware and software systems. The promotions for NSE were financial institutions, insurances companies, banks and SEBI capital market ltd, Infrastructure leasing and financial services ltd and stock holding corporation ltd.

NSE is not an exchange in the traditional sense where brokers own and manage the exchange. A two tier administrative set up involving a company board and a governing aboard of the exchange is envisaged.

NSE is a national market for shares PSU bonds, debentures and government securities since infrastructure and trading facilities are provided.

NSE - NIFTY

The NSE on April 22, 1996 launched a new equity Index. "Nifty " means National Index for Fifty Stocks.

The NSE-50 comprises 50 companies that represent 20 broad Industry groups. All companies included in the No index entries found. Index have a market capitalization in excess of Rs 500 crs each and should have traded for 85% of trading days.

The base period for the index is the close of prices on Nov 3, 1995, which makes one year of completion of operation of NSE’s capital market segment.

The base value of the Index has been set at 1000.

DEPOSITORY

A depository established under the depositories Act can provide any service connected with recording of allotment of securities or transfer of ownership of securities in the record of a depository.

The depositories are important intermediaries in the securities market that is scrip- less or moving towards such a state. In India , the depositories act defines a depository to mean "a company formed and registered under the Companies Act , 1956.

The principal function of depository is to Dematerialize securities Enable their transaction in book-entry form.

Dematerialization of securities occurs when securities , issued in physical form, are destroyed and an equivalent number of securities, are credited into thebeneficiary owner’s account.

BENEFITS OF DEPOSITORY SERVICES

A safe and convenient way to hold securities

Immediate transfer of securities

No stamp duty on transfer of securities

No odd lot problem , ever one share can be purchase or sold

Elimination of risk associated with physical certificates such as bad

delivery, fake securities, delays, theft etc.

Reduction in paper work involved in transfer of securities

Reduction in transaction cost

Automatic credit into Demit account of shares, arising out of

Bonus /split/ consolidation/merger etc.

THE MAIN DEPOSITORY PLAYERS IN INDIA

National Securities Depository Limited

NSDL was established in August 1996, the first depository in India. Using innovative and flexible technology system. NSDL works to support the investors and brokers in the capital market of the country. NSDL aims at ensuring the safety and soundness of Indian marketplaces by developing products and services that will continue to nurture the growing needs of the financial services industry.

NSDL is promoted by Industrial Development Bank of India Limited (IDBI) – the largest development bank of Indian, Unit Trust of India (UTI)- the largest mutual funds in India and National Stock Exchange of India Limited (NSE)- the largest stock exchange India. Some of the prominent banks in the country have a stake in NSDL.

Central depository services limited

CDSL was setup with the objective of providing convenient, dependable and secure depository services at affordable cost to all market participants .CDSL received the certificate of commencement of business from SEBI in February 1999.

PROMOTERS

CDSL Was promoted by BSE in association with Bank Of India , BOB ,and state bank of India and HDFC bank .BSE has been involved with this venture right from the inception and has contributed overwhelmingly to the fruition of the project the initial capital of the company is Rs.104.50 cores.

Chapter 3- About the Derivative market

History of derivative market in world

History of derivative market in India

Definition of derivative

Derivative Instrument in India

Participant in derivative market

Intermediary participant

Market maker and jobber

Institutional framework

Exchange

Clearing house

History of Financial Derivatives Markets

Financial derivatives have emerged as one of the biggest markets of the world during the past two decades. A rapid change in technology has increased the processing power of computers and has made them a key vehicle for information processing in financial markets. Globalization of financial markets has forced several countries to change laws and introduce innovative financial contracts which have made it easier for the participants to undertake derivatives transactions.

Credit risk, however remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location (which would be known in advance) for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first ‘exchange traded" derivatives contract in the US. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges. The first exchange-traded financial derivatives emerged in 1970’s due to the collapse of fixed exchange rate system and adoption of floating exchange rate systems. In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options on selected stocks. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial

futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro- Dollar futures are the three most popular futures contracts traded today.

History of Derivative Trading at NSE

The derivatives trading on the NSE commenced on June 12, 2000 with futures trading on S&P CNX Nifty Index. Subsequent trading in index options and options on individual securities commenced on June 4, 2001 and July 2, 2001. Single stock futures were launched on November 9, 2001.

Ever since the product base has increased to include trading in futures and options on CNX IT Index, Bank Nifty Index, Nifty Midcap 50 Indices etc. Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India.

The derivatives contracts have a maximum of 3-month expiration cycles except for a long dated Nifty Options contract which has a maturity of 5 years. Three contracts are available for trading, with 1 month, 2 months and 3 months to expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices.

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

Derivatives are used by banks, securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profits. trading in derivatives has increased even in the over the counter markets.

DEFINITION OF DERIVATIVES

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, Forex, commodity or any other asset.

In the Indian context the Securities Contracts (Regulation) Act, 1956 defines "derivative" to include

1. A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

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

Types of Derivative Contracts

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps. Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts. Let us briefly define some of the contracts

Forward Contracts: These are promises to deliver an asset at a pre- determined date in future at a predetermined price. Forwards are highly popular on currencies and interest rates. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties. Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counterparty risk i.e. the risk that one of the parties to the contract may not fulfill his or her obligation.

Futures Contracts: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded, standardized contracts. The exchange stands guarantee to all transactions and counterparty risk is largely eliminated.

The buyers of futures contracts are considered having a long position whereas the sellers are

considered to be having a short position. It should be noted that this is similar to any asset

market where anybody who buys is long and the one who sells in short. Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets. They are highly popular on stock indices, interest rates and foreign exchange.

Options Contracts: Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a

given quantity of the underlying asset at a given price on or before a given date. One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position.

It should be noted that, in the first two types of derivative contracts (forwards and futures) both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset to the seller and the seller needs to deliver the asset to the buyer on the settlement date. In case of options only the seller (also called option writer) is under an obligation and not the buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put options) the asset from / to the seller of the option but he may or may not exercise this right.

Incase the buyer of the option does exercise his right, the seller of the option must fulfil whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of

the option and for a put option the seller has to receive the asset from the buyer of the option).

An option can be exercised at the expiry of the contract period (which is known as European option contract) or anytime up to the expiry of the contract period (termed as American option contract).

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

the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows between

the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the parties,

with the cash flows in one direction being in a different currency than those in the

opposite direction.

PARTICIPANTS IN THE DERIVATIVES MARKET

The following three broad categories of participants who trade in the

derivatives market:

1. Hedgers

2. Speculators and

3. Arbitrageurs

1.] HEDGERS

The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximising of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk.

2.] SPECULATORS

Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency.

They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets – commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity.

3.] ARBITRAGEURS

Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.

INTERMEDIARY PARTICIPANTS

BROKERS

For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange activity of a agent is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults.

MARKET MAKERS AND JOBBERS

They are the members of the exchange who takes the purchase or sale by other members in their books and then square off on the same day or the next day. They quote their bid-ask rate regularly. The difference between bid and ask is known as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk increases. Even by incurring loss, they square off their position as early as possible. Since they decide the market price considering the demand and supply of the commodity or asset, they are also known as market makers. Their role is more important in the exchange where outcry system of trading is present. A buyer or seller of a particular futures or option contract can approach that particular jobbing counter and quotes for executing deals.

INSTITUTIONAL FRAMEWORK

EXCHANGE

Exchange provides buyers and sellers of futures and option contractcnecessary infrastructure to trade. In outcry system, exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. In online trading system, exchange provide access to members and make available real time information online and also allow them to execute their orders. For derivative market to be successful exchange plays a very important role, there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets.

CLEARING HOUSE

A clearing house performs clearing of transactions executed in futures and option exchanges. Clearing house may be a separate company or it can be a division of exchange. It guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. Transactions are between members and clearing house. Clearing house ensures solvency of the members by putting various limits on him. Further, clearing house devises a good managing system to ensure performance of contract even in volatile market. This provides confidence of people in futures and option exchange. Therefore, it is an important institution for futures and option market.

Chapter 4- Derivative tools and their work mechanism

Function of derivative market

Types of derivative

Forward

Future

Option

Swaps

Payoff for trade

FUNCTIONS OF THE DERIVATIVES MARKET:

The derivatives market performs a number of economic functions.

They are:

1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.

2. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

3. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets.

4. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

5. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

TYPES OF DERIVATIVES

There are mainly four types of derivatives i.e. Forwards, Futures, Options

and swaps.

Derivatives

Forwards Futures Options Swaps

1. FORWARDS

A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future is known as a forward contract.

Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlying, including the traditional agricultural or physical commodities, as well as currencies and interest rates.

The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset.. Forward contracts are customised with the terms and conditions tailored to fit the particular business

2. FUTURES

A future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange-traded contracts.

Equities, bonds, hybrid securities and currencies are the commodities of the investment business. They are traded on organised exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions, so that the identity of the buyer or the seller is a matter of indifference to the opposite party. Futures contract protect those who use these commodities in their business.

DISTINCTION

Futures Forwards

Trade on an organized exchange OTC in nature

Standardized contract terms Customised contract terms

More liquid Less liquid

Requires margin payments No margin payment

Follows daily settlement Settlement happens at end of period

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index move down it starts making losses.

The above figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

The above figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index

moves up, it starts making losses.

The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

3. OPTIONS

A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION AND PUT OPTION. Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

CALL OPTION

A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.

The above figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. The losses are limited to the extent of the premium paid for buying the option.

The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited Whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.

PUT OPTION

A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen, as the spot Nifty falls, the put option is in-themoney. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, the option expires worthless. The losses are limited to the extent of the premium paid for buying the option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.

4. SWAPS

Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:

A. INTEREST RATE SWAPS :

B. CURRENCY SWAPS :

C. FINANCIAL SWAP :

Application of Futures Contracts

Long security, sell futures

Futures can be used as a risk-management tool. For example, an investor who holds the shares of a company sees the value of his security falling from Rs. 450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he needs to do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security which he holds is Rs.390. Two-month futures cost him Rs.402. For this he pays an initial margin.

Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. Take 29 for instance that the price of his security falls to Rs.350.

The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position.

Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position.

Speculation: Bullish security, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He believes that a particular security that trades at Rs.1000 is undervalued and expect its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume that he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs. 100,000 for a period of two months. This works out to an annual return of 6 percent.

Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 100,000. He buys 100 security futures for which he pays a margin of Rs. 20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs. 400 on an investment of Rs. 20,000. This works out to an annual return of 12 percent. Because of the leverage they provide, security futures form an attractive option for speculators.

Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities

arise. It could be the case that you notice the futures on a security you hold seem underpriced.

How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd.

trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced. As an

arbitrageur, you can make riskless profit by entering into the following set of transactions.

1. On day one, sell the security in the cash/spot market at 1000.

2. Make delivery of the security.

3. Simultaneously, buy the futures on the security at 965.

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

position. Say the security closes at Rs.975. Buy back the security.

6. The futures position expires with a profit of Rs.10.

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

If the returns you get by investing in riskless instruments is more than the return from the

arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash and-carry and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

Application of Options

We look here at some applications of options contracts. We refer to single stock options here. However since the index is nothing but a security whose price or level is a weighted average of securities constituting the index, all strategies that can be implemented using stock futures can also be implemented using index options.

Hedging: Have underlying buy puts

Owners of stocks or equity portfolios often experience discomfort about the overall stock

market movement. As an owner of stocks or an equity portfolio, sometimes one may have a

view that stock prices will fall in the near future. At other times one may witness massive volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options.

Index and stock options are a cheap and can be easily implemented to seek insurance from

the market ups and downs. The idea is simple. To protect the value of your portfolio from

falling below a particular level, buy the right number of put options with the right strike price.

If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen

by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level.

This level depends on the strike price of the index options chosen by you. Portfolio insurance using put options is of particular interest to mutual funds who already own

well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall.

Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise. How does one

implement a trading strategy to benefit from an upward movement in the underlying security?

Using options there are two ways one can do this:

1. Buy call options; or

2. Sell put options

We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a months time. Your hunch proves correct and the price does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be wrong and the security price plunges down, what you lose is only the option premium.

Having decided to buy a call, which one should you buy? Illustration 5.1 gives the premia for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose?

Let us take a look at call options with different strike prices. Assume that the price level is 1250, risk-free rate is 12% per year and volatility of the underlying

security is 30%. The following options are available:

1. A one month call with a strike of 1200.

2. A one month call with a strike of 1225.

3. A one month call with a strike of 1250.

4. A one month call with a strike of 1275.

5. A one month call with a strike of 1300.

Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the price, and how much you are willing to lose should this upward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration, in which case the buyer will make profits. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs.27.50.

As a person who wants to speculate on the hunch that prices may rise, you can also do so by

selling or writing puts. As the writer of puts, you face a limited upside and an unlimited

downside. If prices do rise, the buyer of the put will let the option expire and you will earn the premium. If however your hunch about an upward movement proves to be wrong and prices actually fall, then your losses directly increase with the falling price level. If for instance the price of the underlying falls to 1230 and you’ve sold a put with an exercise of 1300, the buyer of the put will exercise the option and you’ll end up losing Rs.70. Taking into account the premium earned by you when you sold the put, the net loss on the trade is Rs.5.20. Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose?

This largely depends on how strongly you feel about the likelihood of the upward movement in the prices of the underlying. If you write an at-the-money put, the option premium earned by you will be higher than if you write an out-of-the-money put. However the chances of an at-the-money put being exercised on you are higher as well.

Illustration: One month calls and puts trading at different strikes

The spot price is 1250. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher

premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.

The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the price of underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be inthe-money by expiration in which case the buyer will profit. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs. 27.50.

Speculation: Bearish security, sell calls or buy puts

Do you sometimes think that the market is going to drop? Could you make a profit by adopting a position on the market? Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. How does one implement a trading strategy to benefit from a downward movement in the market? Today, using options, you have

two choices:

1. Sell call options; or

2. Buy put options

We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to fall in a months time. Your hunch proves correct and it does indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security.

Bull spreads - Buy a call and sell another

There are times when you think the market is going to rise over the next two months, however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread.

How does one go about doing this?

This is basically done utilizing two call options having the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level.

The spread is a bull spread because the trader hopes to profit from a rise in the index. The trade is a spread because it involves buying one option and selling a related option. Compared to buying the underlying asset itself, the bull spread with call options limits the trader’s risk, but the bull spread also limits the profit potential.

Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two months. However in the event that the market does not fall, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts.

A spread that is designed to profit if the price goes down is called a bear spread. This is basically done utilizing two call options having the same expiration date, but different exercise prices. In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price

above the current index level and sells a call option with an exercise price below the current

index level. The spread is a bear spread because the trader hopes to profit from a fall in the

index. The trade is a spread because it involves buying one option and selling a related option.

Compared to buying the index itself, the bear spread with call options limits the trader’s risk, but it also limits the profit potential. In short, it limits both the upside potential as well as the downside risk.

HEDGING

Hedging Using Stock Index Futures

Broadly there are two types of risks (as shown in the figure below) and hedging is used to

minimize these risks.

Systematic

Unsystematic

Risk

Unsystematic risk is also called as Company Specific Risk or Diversifiable Risk. Suppose, an investor holds shares of steel company and has no other investments. Any change in the government policy would affect the price of steel and the companies share price. This is considered as Unsystematic Risk. This risk can be reduced through appropriate diversification.

The investor can buy more stocks of different industries to diversify his portfolio so that the price change of any one stock does not affect his portfolio. However, diversification does not reduce risk in the overall portfolio completely. Diversification reduces unsystematic risk. But there is a risk associated with the overall market returns, which is called as the Systematic Risk or Market Risk or Non-diversifiable Risk. It is that risk which cannot be reduced through diversification. Given the overall market movement (falling or rising), stock portfolio prices are affected.

Generally, a falling overall market would see most stocks falling (and vice versa). This is the market specific risk. The market is denoted by the index. A fall in the index (say Nifty 50) in a day sees most of the stock prices fall. Therefore, even if the investor has a diversified portfolio of stocks, the portfolio value is likely to fall of the market falls. This is due to the inherent Market Risk or Unsystematic Risk in the portfolio. Hedging using Stock Index Futures or Single Stock Futures is one way to reduce the Unsystematic Risk.

Hedging Using Futures

Case 1 - By Selling Index Futures

On March 12 2010, an investor buys 3100 shares of Hindustan Lever Limited (HLL) @ Rs. 290 per share (approximate portfolio value of Rs. 9,00,000). However, the investor fears that the market will fall and thus needs to hedge. He uses Nifty March Futures to hedge.

• HLL trades as Rs. 290

• Nifty index is at 4100

• March Nifty futures is trading at Rs. 4110.

• The beta of HLL is 1.13.

To hedge, the investor needs to sell [Rs. 9,00,000 *1.13] = Rs. 10,17,000 worth of Nifty

futures (10,17,000/4100 = 250 Nifty Futures)

On March 19 2010, the market falls.

• HLL trades at Rs. 275

• March Nifty futures is trading at Rs. 3915

Thus, the investor’s loss in HLL is Rs. 46,500 (Rs. 15 × 3100). The investors portfolio value now drops to Rs. 8,53,500 from Rs. 9,00,000. However, March Nifty futures position gains by Rs. 48,750 (Rs. 195 × 250). Thus increasing the portfolio value to Rs. 9,02,250 (Rs. 8,53,500 + Rs. 48,750).

Therefore, the investor does not face any loss in the portfolio. Without an exposure to Nifty Futures, he would have faced a loss of Rs. 46,500

Case 2- By Selling Stock Futures and Buying in Spot market

An investor on March 12, 2010 buys 2000 shares of Infosys at the price of Rs. 390 per share. The portfolio value being Rs. 7,80,000 (Rs. 390x2000). The investor feels that the market will fall and thus needs to hedge by using Infosys Futures (stock futures).

• The Infosys futures (near month) trades at Rs. 402.

• To hedge, the investor will have to sell 2000 Infosys futures.

On futures expiry day:

• The Infosys spot price is Rs. 300.

Thus the investor’s loss is Rs. 90 (Rs. 390-Rs. 300) and the portfolio value would reduce to Rs 6,00,000 (Rs. 7,80,000–Rs. 1,80,000). On the other hand the investors profit in the futures market would be Rs. 102 (Rs. 402-Rs. 300). The portfolio value would now become Rs. 8,04,000 (Rs. 6,00,000+ Rs. 2,04,000).

Hedging Using Options

STRATEGY 1 : LONG CALL

For aggressive investors who are very bullish about the prospects for a stock / index, buying

calls can be an excellent way to capture the upside potential with limited downside risk.

Buying a call is the most basic of all options strategies. It constitutes the first options trade

for someone already familiar with buying / selling stocks and would now want to trade options. Buying a call is an easy strategy to understand. When you buy it means you are bullish. Buying a Call means you are very bullish and expect the underlying stock / index to rise in future.

When to Use: Investor is very bullish on the stock / index.

Risk: Limited to the Premium. (Maximum loss if market expires at or below the option strike price).

Reward: Unlimited

Breakeven: Strike Price + Premium

STRATEGY 2 : SHORT CALL

When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices.

When to use: Investor is very aggressive and he is very bearish about the stock / index. Risk: Unlimited

Reward: Limited to the amount of premium

Break-even Point: Strike Price + Premium

STRATEGY 3 : SYNTHETIC LONG CALL: BUY STOCK, BUY PUT

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the stock went down. You wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price).

In case the price of the stock rises you get the full benefit of the price rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped your loss in this manner because the Put option stops your further losses. It is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call!

STRATEGY 4: LONG PUT

Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the stock / index. When an investor is bearish, he can buy a Put option. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.

A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options.

When to use: Investor is bearish about the stock / index.

Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or above the option strike price).

Reward: Unlimited

Break-even Point: Stock Price – Premium

STRATEGY 5: COVERED CALL

You own shares in a company which you feel may rise but not much in the near term (or at

best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately

Bullish about the stock.

An investor buys a stock or owns a stock which he feel is good for medium to long term but

is neutral or bearish for the near term. At the same time, the investor does not mind exiting

the stock at a certain price (target price). The investor can sell a Call Option at the strike

price at which he would be fine exiting the stock (OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock.

When to Use: This is often employed when an investor has a short-term neutral to moderately bullish view on the stock he holds. He takes a short position on the Call option to generate income from the option premium.

Since the stock is purchased simultaneously with writing (selling) the Call, the strategy is commonly referred to as "buy-write".

Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but retains the premium, since the Call will not be exercised against him. So maximum risk = Stock Price Paid – Call Premium Upside capped at the Strike price plus the Premium received. So if the Stock rises beyond the Strike price the investor (Call seller) gives up all the gains on the stock.

Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received

STRATEGY 6 : LONG STRADDLE

A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index.

If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index shows volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction neutral.

When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term.

Risk: Limited to the initial premium paid.

Reward: Unlimited

Breakeven: · Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid · Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

STRATEGY 7 : LONG STRANGLE

A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration

date.

Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher.

However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside

potential.

When to Use: The investor thinks that the underlying stock / index will experience very high levels of volatility in the near term.

Risk: Limited to the initial premium paid

Reward: Unlimited

Breakeven: · Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid

Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

STRATEGY 8 : BULL PUT SPREAD STRATEGY: SELL PUT OPTION, BUY PUT OPTION

A bull put spread can be profitable when the stock / index is