Sri Sharada Institute Of Indian Management -ResearchApproved by AICTE

Plot No. 7, Phase-II, Institutional Area, Behind the Grand Hotel, Vasant Kunj,

New Delhi – 110070 Website: www.srisiim.org

“DERIVATIVES”

Project Report

On

“Security Analysis and Portfolio Management”

Submitted to:- Submitted By:-

PROF.R.Venkatraman Saurabh Tiwari (2013144)

Rohit Kumar (20130138)

Declaration

We hereby declare that the following project report of “Security

Analysis and Portfolio Management” titled “DERIVATIVES” is an

authentic work done by us. This is to declare that all work indulged in the

completion of this work such as research, analysis of activities of an

organization is a profound and honest work of ours.

PLACE:NEW DELHI

Saurabh Tiwari

Rohit Kumar

(PGDM 2013-2015)

ACKNOWLEDGEMENT

We would like to express my hearty gratitude to my faculty guide, PROF.

R.Venkatraman for giving us the opportunity to prepare a project report

on “Security Analysis and Portfolio Management” and for his valuable

guidance which helped us in completing this project.

SAURABH TIWARI

ROHIT KUMAR

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CHAPTER-1

INRODUCTION

HISTORY OF STOCK EXCHANGE

The only stock exchange operating in the 19 th century were those of

Bombay set up in 1875 and Ahmadabad set up in 1894 these were organized

as voluntary non-profit making organization of brokers to regulate and protect

interest. Before the control insecurities trading became a central subject under

the constitution in 1950, it was a state subject and the Bombay securities

contract (CONTROL) Act of 1952 used to regulate trade in securities. Under

this act, the Bombay stock exchange in 1927 and Ahmadabad in 1937.

During the war boom, a number of stock exchanges were organized in

Bombay, Ahmadabad and other centers, but they were not recognized. Soon

after it became a central subject, central legislation was proposed and a

committee headed by A.D. Goral went in to the bill for securities regulation. On

the basis of committee’s recommendations and public discussions the

securities contracts (regulations) Act became law in 1956.

Definition of Stock Exchange

“Stock exchange means any body 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 of it is recognized by the govt. Under the

securities contract (regulation) Act, 1956. The recognition is granted under

section 3 of the Act by the central government, ministry if finance.

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BYELAWS

Besides the above act, the securities contract (regulations) rules

were also made in 1975 to regulate certain matters of trading on the stock

Exchange. These are also byelaws of the exchanges, which are concerned with

the following subjects. Opening / closing of the stock exchange, timing of trading,

regulation of bank transfer, regulation of Badla or carryover business, control of

settlement, and other activities of stock exchange, fixations of margin, fixations of

market price or marking price, regulation of tarlatan business (jobbing), regulation

of brokers trading, brokerage charges, trading rules on the exchange, arbitration

and settlement of disputes, settlement and clearing of the trading etc.

Regulations of Stock Exchange

The securities contract (regulations) is the basis for operations of the stock

exchange in India. No exchange can operate legally without the government permission or

recognition. Stock exchanges are give monopoly in certain areas under section 19 of the

above Act to ensure that the control and regulation are facilitated. Recognition can be

granted to a stock exchange provided certain are satisfied and the necessary Information

is supplied to the government. Recognition can also be withdrawn, if necessary. Where

there are no stock exchanges, the government can license some to the brokers to perform

the functions of a stock exchange in its absence.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

SEBI was set up as an autonomous regulatory authority by the Government

of India in 1988 “to perform the interests of investors in securities and to promote

the development and to regulate the securities market and for matters connected

there with 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 market.

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BASIC OF DERIVATIVESThe term “Derivatives” independent value, i.e. its value is entirely

“derived” from the underlying asset. The underlying asset can be securities,

commodities bullion, currency, live stock or anything else. In other words,

derivative means a forward, future, option or any other hybrid contract of per

determined fixed duration, linked for the purpose of contract fulfillment to the

value of a specified real or financial asset or to an index of securities.

The Securities Contracts (Regulation) Act 1956 Define Derivatives

as Under “Derivative” Includes· a securities derivatives from a debt instrument, share, lone writher secured or

· unsecured, risk instrument or contract for different or any other security

· a contract which derives its value from the prices, or index of price of underlying

· Securities

The above definition conveys: Those derivatives are financial products and

derive its value from the underlying assets.

Derivatives is derived from another financial instrument/contract called

the Underlying. In the case of Nifty futures, Nifty index is the underlying.

Significance of DerivativesDerivatives are Used

1. By Hedgers for protecting (risk-covering) against adverse movement. Hedging

is a mechanism to reduce price risk inherent in open positions. Derivatives are

widely used for hedging. A Hedge can help lock in existing profits. Its purpose

is to reduce the volatility of a portfolio by reducing the risk.

2. Speculators to make quick fortune by anticipating/forecasting future market

movement. Hedgers with to eliminate or reduce the price risk to which they

are already exposed. Speculators, on the other hand are those classes of

investors who willingly take price risks to profit from price change in the

underlying. While the need to provide hedging avenues by means of

derivative instruments is laudable, it call for the existence of speculative

traders to play the role of counter-party to the hedgers. It is for this reason

that the role of speculators gains prominence in a derivatives market.

to earn risk-free profits by exploiting market importance. 3

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Arbitrageurs profits from price differential existing in two markets by

simultaneously operating in the two different markets.

Type of Derivatives

Derivatives products initially emerged devices against fluctuations in commodity

price, and commodity-linked derivatives remained the sole form of such predicts for almost

three hundred years. Financial derivatives came into spotlight in the post-1970 period due

to growing instability in the financial markets. However, since their emergence, these

products have become very popular and by 1990s, they accounted for about two –thirds of

total transactions in derivative products. In recent years, the market for financial derivatives

has grown tremendously in term of variety of instruments available their complexity and

also turnover. In the class of equity derivatives the world over, future and options on stock

indices have gained more popularity than on individual stocks, especially among

institutional investors, who are major uses of index-linked derivatives. Even small investors

find these useful due to high correlation of the popular index with various portfolios and

ease of use. The lower costs associated with index derivatives vis-à-vis derivative products

based on individual securities is another reason for their growing use. The most commonly

used derivatives contracts are forward, futures and options with we shall discuss in detail

later. Here we take a brief look at various derivatives contracts that have come to be used.

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

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

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

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

contract in the sense that the former are standardized exchange-trade contracts.

Options: options are of two types- calls and put calls give the buyer right but not the

obligation to buy a give quantity of the underlying asset, at a given price on or before a

given future date. Puts gives the buyer the right, but not the obligation to sell a given 4

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quantity of the underlying asset at a given price on or before given date.

Warrants: Options generally have lives of up to one year, the majority of option

traded on options exchanges having a maximum maturity of one month. Longer-

dated options are called warrants and are generally traded over-counter.

Leaps: The acronym LEAPS means long-term equity anticipation securities.

These are options having a maturity of up to three years.

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

underlying asset is usually a moving average of a basket of assets. Equity

index options are a form of basket options.

Swaps: swaps are private agreements between two parties to exchange cash

flows in the future according to a prearranged formula. They can be regarded

as portfolios of forward contracts.

The Two Commonly Used Swaps AreInterest Rate Swaps: these entail swapping only the interest related cash

flow between the parties in the same currency.

Currency Swaps: These entail swapping both principal and interest between

the parties, with the case flows in one direction being in a different currency

than those in the opposition direction.

Swaptions: Swaptions are options to buy or sell a swap that will became operative

at the expiry of the options. Thus a Swaptions is an option on a forward swap.

Rather than have called and puts, the swaption market has receiver swaption and

payer swaptions. A receiver swaptions in an option to receiver fixed and pay

floating. A player swaption is an option to pay fixed and receive floating.

Classification of Derivatives

The Derivatives Can be Classified as

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· Forwards (Currencies, Stocks, Swaps etc)

Forward contract is different from a spot truncation, where payment of price

and delivery of commodity concurrently take place immediately the transaction is

settled. In a forward contract the sale/purchase truncation of an asset is settled

including the price payable, not for delivery/settlement at spot, but at a specified

future date. India has a strong dollar-rupee forward market with contract being

traded for one, two, and six-month expiration. Daily trading volume on this forward

Market is around $500 million a day. Indian users of hedging services are also

allowed to buy derivatives involving other currencies on foreign markets.

· Futures(Currencies, Stocks, Indexes, Commodities etc)

A futures contract has been defined as “a standardized, exchange-traded

Agreement specifying a quantity and price of a particular type of commodity

(Soybeans, gold, oil, etc) to be purchased or sold at a pre-determined date in the

Future. On contract date, delivery and physical possession take place unless the

Contract has been closed out futures fate also available ob various financial

Products and indexes today. A futures contract is thus a forward, contract, which

trades on national stock exchange. This provides them transparency, liquidity,

anonymity of trades, and also eliminates the counter party risks due to the

guarantee provided by national securities clearing corporation limited.

· Options (Currencies, Stocks, Indexes etc) Options are the standardized financial that allows the buyer (holder) if the

Options, i.e. the right at the cost of options premium, not the obligation, to

but (call options) or sell (put options) a specified asset at a set price on

or before a Specified date through exchange under stringent financial

security against default.

FORDWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a 6

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specified price. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a

certain specified price. The other party assumes a short position and agrees to

sell the asset on the same date for the same price. Other contract details like

delivery date, the parties to the contracts negotiate price and quality bilaterally.

The forward contracts are normally traded outside the exchanges.

The Silent Futures of Forward Contract are

The bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract size, Expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go the same

counter Party, which often results in high prices being changed.

However forward contracts in certain markets have become very standardization,

as in the case of foreign exchange, thereby reducing transaction cost and increasing

transactions volume. This process of standardization reaches its limit in the organized

futures market .Forward contracts is very useful in hedging and speculation. The

classic hedging application word is that of an exporter who expects to receive payment

in dollars three Months later he is exposed to the risk of exchange rate fluctuations. By

using the currency forward markets to sell dollars forward, he can lock on to a rate

today and reduce his uncertainty. Similarly an importer who is required to make a

payment in dollars forward if a speculator has information or analysis, which forecasts

an upturn in a price, than he can go long on the forward market instead of the cash

market. The speculator would go long on the forward, wait for the price to rise, and

then take a reversing transaction to book profits. Speculators may well be required to

deposit a margin upfront. However, this is generally a relatively small proportion of the

value of the assets underlying the forward contract. The use of forward markets here

supplies leverage to the speculator.

LIMITATIONS

Forward Markets World-Wide are Afflicted by Several Problems7

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Lack of centralization of trading, Liquidity, and Counter party risk in the first two

of these, the basic problem is that of too much flexibility and generality. The forward

market is like a real estate market in that any two consenting adults can form contracts

against each other. This often makes them design terms of the deal, which are very

convenient in that specific situation, but makes the contracts non-tradable. Counter

party risk arises from the possibility of default by any one party to the transaction.

When one of the two sides to the transaction declares bankruptcy, the other suffers.

Even when forward markets trade standardized contracts, and hence avoid the

problem of liquidity, still the counter party risk remains a very serious issue.

FUTURES

Futures markets were designed to solve the problems that exist in forward

markets. 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. But unlike forward contracts,

the futures contracts are standardized and exchange traded. To facilitate liquidity in

the future contracts, the exchange specifies certain standard quantity and quality of

the underlying instrument that can be delivered, (or which can be used for

reference purposes in settlement) and a standard timing of such settlement. A

futures contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of futures transactions are offset this way.

The Standardized Items in a Futures Contract are

Quantity of the underlying

Quality of the underlying

The date and month of delivery

The units of price quotations and minimum price changes Location of settlement.

DISTINCTION BETWEEN FUTURES AND FROWARDS8

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Forward contracts are often confused with futures contracts. The confusion is

primarily Became both serve essentially the same economics of allocations risk in the

presence of Future price uncertainly. However futures are a significant improvement

over the forward Contracts as they eliminate counter party risk and offer more liquidity.

FUTURES TERMINOLOGYSpot price: The price at which an asset trades in the spot market.

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

Contract cycle: The period over which a contract trades. The index futures

contracts on the NSE have one-month, two-month and three-month expiry cycle,

which expire on the last Thursday of the month. Thus January expiration contract

expires on the last Thursday of February. On the Friday following the last

Thursday, a new contract having a three-month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day

on which the contract will be traded, at the end of which it will case to exist.

Contract size: The amount of the asset that has to be delivered less than one

contract. For instance, the contract size on NSE’s futures market is 200 Niftiest.

Basis: In the context of financial futures, basis can be defined as the futures

price minus the spot price. There will be a different basis for each delivery

month for each contract. In a normal market, basis will be positive. This reflects

that futures prices normally exceed spot prices.

Cost of carry: the relationship between futures prices and spot prices can be summarized.

In terms of what is known as the cost of carry. This measures the storage Cost plus the interest that is paid to finance the asset less the income earned on the asset.

Initial margin: the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.

Marking-to-market: in the futures market, at the end of each trading day, the margin.

account is adjusted to reflect the investor’s gain or loss depending upon the futures Closing price. This is called marking-to-market.

Maintenance margin: this is somewhat lower than the initial margin. This is set to 9

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ensure. That the balance in the margin account never becomes negative.

If the balance in the margin account falls below the maintenance margin, the

investor receives a Margin call and is expected to top up the margin account to

the initial margin level before trading commences on the next day.

OPTIONS

We look at the next derivative product to be traded on the NSE, namely option.

Options are fundamentally different from forward and futures contracts. An option gives the

holder of the option the right to do something. The holder does not have to exercise this

right .in contrast, in a forward or futures contract, the two parties have committed

themselves to doing something. whereas it costs nothing (except margin requirements)to

enter into a futures contract, the purchase of an option requires an up-front payments.

OPTIONS TERMINAOLOGY

Index option: There option has the index as the underlying. Some options are European while others are American. Like index, futures, contract, index options Contracts are also cash settled.

Stock options: stock options are options on individual stocks. option currently

trade On over 500 stocks in the United States. A contract gives the

holder the right to buy or sell shares at the specified prices.

Buyer of options: the buyer of an options is the one who by paying

the options Premium buys the right but not the obligation to exercise his option on the Seller / writer.

Writer of an option: the writer of a call/put options is the one who receives the

option premium and is thereby obliged to sell/buy the asset if the buyer

exercises on him.

There are Two Basic Types of Options, Call Options and Put Options

Call option: a call option gives the holder the right but not the obligation to buy an Asset by a certain date for a certain price.

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Put option: a put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price: option prices are the price, which the option buyer pays to option seller. It is also referred to as option premium.

Expiration date: the date specified in the options contract is known as

the expiration Date, the exercise date, the strike date or the maturity.

Strike price: the price specified in the options contract is known as the strike price or the exercise price.

American options: American options are options that can be exercised at any

time up to the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised

only on the Expiration date itself. European options are easier to analyze

than American options, and Properties of American options are frequently

deduced from those of its European Counterpart.

In-the-money option: an in-the money (ITM) option that would lead to a

Positive cash flow to the holder if it were exercised immediately. A call

option on the Index is said to be in money when the current index is stands

at a level higher than the strike price, (i.e. spot price strike price). If the

index is much higher than the strike price, The call is said to be deep ITM.

In the case of a put is ITM if the index is below the strike price.

At-the-money option: an at-the money (ATM) option is an option that

would lead to Zero cash flow if it were exercised immediately. An

option on the index is at-the –money when the current index equals

the strike price (i.e. spot price = strike price.

Out-of the money option: an out-of –money (OTM) option is an option that

would lead to a negative cash flow it was exercised immediately. A call option

on the index is out-of-the-money when the current index stands at a level,

which is less than the strike Price (i.e. spot price strike price). If the index is

much lower than the strike price, the call is said to be deep OTM .in the case

of a put, the put is OTM if the index is above the Strike price.

Trading Strategies using Futures and Option

There are a lot of practical uses of derivatives. As we have seen, derivatives can be

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used for profits and hedging. We can use derivatives as a leverage tool too.

Use of Derivatives as leverageYou can use the derivatives market to raise fund using your stocks.

Conversely, you can also lend funds against stocks.

Different Between Badla and DerivativesThe derivatives product that comes closest to Badla is futures. Futures is

not badla, through a lot of people confuse it with badla. The fundamental

difference is badla consisted of contango and backwardation (undha badla and

vyaj badla) in the same market. Futures is a different market segment

altogether. Hence derivatives is not the same as badla, through it is similar.

Raising Funds from the Derivatives MarketThis is fairly simple. Say, you have Infosys, which is trading at R s 3000.

You have shares lying with you and are in urgent need of liquidity. Instead of

pledging your shares and borrowing from banks at a margin, you can sell the

stock at R s 3000. Suppose you need this liquidity only for a month and also do

not want to party with Infosys. You can buy a 1 month future at R s 3050

After a month you get back you Infosys at the cost of additional rs 50.

This R s 50 is the financing cost for the liquidity. The other beauty about this is

you have already locked in your purchase cost at R s 3050. This fixes your

liquidity cost also and protected against further price losses.

Lending Funds to The MarketThe lending into the market is exactly the reverse of borrowing. You have money

to lend.

You can a stock and sell its future. Say, you buy Infosys at R s 3000 and

sell a 1 month future at R s 3100. In effect what you have done is lent R s 3000

to the market for a month and earned R s 100 on it.

Using Speculation to Make ProfitsWhen you speculate, you normally take a view on the market, either bullish or

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bearish. When you take a bullish view on the market, you can always sell futures and buy

in the spot market. If you take a bearish view on the market, you can buy futures and sell

in the sport market. Similarly, in the option market, if you are bullish, you should buy call

options. If you are bearish, you should buy put option conversely, if you are bullish, you

should write put options. This is so because, in a bull market, there are lower changes of

the put option being exercised and you can profit from the premium if you are bearish, you

should write call option. This is so because, in a bear market, there are lower chances of

the call option being exercised and you can profit from the premium.

Using Arbitrage to Make Money in Derivatives MarketArbitrage is making money on price differential in different markets. For

example, future is nothing but the future value of the spot price. This futures

value is obtained by factoring the interest rate. But if there are differences in the

money market and the interest rates change than the future price should

correct itself to factor the change in interest. But if there is no factoring of this

change than it present an opportunity to make money-an arbitrage opportunity.

Let us take an example.

ExampleA stock is quoting for Rs. 1000. The 1-month future of this stock is at rs 1005.

the risk free Interest rate is 12%. What should be the trading strategy?

SolutionThe strategy for trading should be: Sell Spot and Buy Futures

Sell the stock for Rs 1000. Buy the future at Rs 1005.

Invest the Rs 1000 at 12%. The interest earned on this

stock will be 1000(1+.02) (1/12) = 1009

So net gain the above strategy is Rs 1009-rs 1005= Rs 4

Thus one can make a risk less profit of Rs 4 because of arbitrage. But an

important point is that this opportunity was available due to miss-pricing and the

market not correcting itself. Normally, the time taken for the market to adjust to

corrections is very less. So the time available for arbitrage is also less. As every

one to cash in on the arbitrage, the market corrects itself.

USING FUTURE TO HEDGE POSITIONOne can hedge ones by taking an opposite position in the futures market. For

example, if you are sport price, the risk you carry is that of price in the future. You can

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lock this by selling in the futures price. Even if the stock continues falling, your

position is hedge as you have firmed the price at witch you are selling. Similarly,

you want to buy a stock at a later date but face the risk of prices rising. You can

hedge against this rise by buying futures. You can use a combination of futures too

to hedge yourself. There is always a correlation between the index and individual

stocks, this correlation may be negative or positive, but there is a correlation. This

is given by the beta of the stock. In simple terms, terms, what beta indicates is the

change in the price of a stock to the change in index.

For examplesIf beta of a stock is 0.8, it means that if the index goes up by the stock

goes up by 8. t will also fall a similar level when the index falls.

A negative beta means that the price of the stock falls when the index rises.

So, if you have a position in a stock, you can hedge the same by buying the

index at times the value of the stock.

Example: The beta of HPCL is 0.8. The Nifty is at 1000. If I have Rs 10000 worth of

HPCL, I can hedge my position by selling 800 of Nifty. That is I well sell 8 Nifities.

Scenario 1: If index rises by 10%, the value of the index becomes 8800 I e a loss of R

s 800. The value of my stock however goes up by 8% I e it becomes R s 10800 I e a

gain of R s 800.Thus my net position is zero and I am perfectly hedged.

Scenario 2:If index falls by 10%, the value of the index becomes Rs 7200 a gain of Rs

800. But the value of the stock also falls by 8%. The value of this stock becomes Rs

9200 a loss of Rs 800Thus my net position is zero and I am perfectly hedged. But

against, beta is a predicated value based on regression models. Regression is nothing

but also analysis of past data. So there is a chance that the above position may not be

fully hedged if the beta does not behave as per the predicated value.

Using Options in Trading Strategy: Options are a great tool to use for trading. If you feel

the market will go up. You should are a call option at a level lower than what you expect

the market to go up. If you think that the market will fall, you should buy a put option at a

level higher than the level to which you expect the market fall. When we say

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market, we mean the index. The same strategy can be used for individual stocks

also. A combination of futures and options can be used too, to make profits.

Strategy for an option writher to cover himself

An option writer can use a combination strategy of futures and options

to protect his position. The risk for an option writer arises only when the option

is exercised this will be very clear with an example.

Supposing I sell a call option on Satyam at a strike price of Rs 300 for a

premium of rs20. The risk arises only when the option is exercised. The option

will be exercised when the price exceeds rs 300. I start making a loss only after

the price exceeds Rs 320 (Strick price plus premium).

More impotently, I have to deliver the stock to the opposite party. So to

enable me to deliver the stock to the other party and also make entire profit on

premium, I buy a future of Satyam at Rs 300. This is just one leg of the risk.

The earlier risk was of the called being exercised the risk now is that of the call

not being exercised. In case the call is not exercised, what do I do?

I will have to take delivery as I have brought a future. So minimize the

risk, I buy a put option on Satyam at Rs 300. But I also need to pay a premium

for buying the option. I pay Premium of Rs 10. Now I am fully covered and my

net cash flow would be. Premium earned from selling call option Rs

20.Premium paid to buy put option (Rs 10) Net cash flow Rs 10.

But the above pay off will be possible only when the premium I am paying

for the put Option is lower than the premium that I get for writing the call. Similarly,

we can arrive at a covered position for waiting a put option two. Another interesting

observation is that the above strategy in itself presents an opportunity to make

money. This is so because of the premium differential in the put and the call option.

So if one tracks the derivatives make on a continuous basis, one can chance upon

almost risk less money making opportunities.

Other Strategies Using Derivatives

The other strategies are also various permutations of multiple puts, call and

futures. They are also called by exotic names, but if one were to observe them closely,

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they are relatively simple instruments. Some of these instruments are

Butterfly Spread: It is the strategy of simultaneous buying of put and call

Calendar Spread: An option strategy in which a short-term option is sold and a

longer-term option is bought both having the same striking price. Either puts or

calls may be used.

Double Option: An option that gives the buyers the right to buy and/or sell a

futures contract, at a premium, at the strike price.

Straddle: The simultaneous purchase and sale of option of the same

speculation to different periods.

Tandem Options: A sequence of options of the same type, with variable strike

price and period.

Bermuda Option: Like the location of the Bermudas, this option is located

somewhere between a European style option with can be exercised only at

maturity and an American style option which can be exercised any time the option

holder chooses. This option can be exercise only on predetermined dates.

RISK MANAGEMENT IN DERIVATIVES

Derivatives are high-risk instrument and hence the exchanges have put up

a lot of measures to control this risk. The most critical aspect of risk management

is the daily monitoring of price and position and the margining of those positions.

NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a

system that has origins at the Chicago Mercantile Exchange, one of the oldest

derivative exchanges in the world.

The objective of SPAN is to monitor the positions and determine the maximum loss that a stock can incur in a single day. This loss is covered by the exchange by imposing mark to market margins.16

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SPAN evaluates risk scenarios, which are nothing but market conditions.

The specific set of market conditions evaluated, are called the risk scenarios,

and these are defined in terms of

a) How much the price of the underlying instrument is expected to change

over one trading day, and

b) How much the volatility of that underlying price is expected to change

over one trading day?

Based on the SPAN measurement, margins are imposed and risk covered. Apart

from this, the exchange will have a minimum base capital of Rs. 50 lacks and brokers

need to pay additional base capital if they need margins above the permissible limits.

SETELLEMENT OF FUTURES

Mark to Market Settlement

There is daily settlement for Mark to Market. The profits/losses are computed

as the difference between the trade price or the precious day’s settlement price as the

case may be and the current day’s settlement price. The parties who have suffered a

loss are required to pay the mark-to-market loss amount to exchange which is in

turning passed on to the party who has 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 on a day, is currently the price computed as

per the formula detailed below.

F = S * e rt

WhereF = theoretical futures price

S = value of the underlying index/stock

r = rate of interest (MIBOR- Mumbai Inter Bank Offer

Rate) 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. The pay-in and payout 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 broker account from where the broker passes to client account.

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Final Settlement

On the expiry of the futures contracts, exchange market all positions to the final

settlement price and the resulting profit/loss is settlement I cash. The final settlement

of the future contract is similar to the daily settlement process except for the method of

capon of final settlement price. The final settlement profit/loss is completed as the

difference between trade price or the previous day’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

broker’s clearing bank account on T + 1 day (T = expiry day). This is then

passed on the client from the broker. Open positions in futures contracts cease

to exist after their expiration day.

SETTLEMENT OF OPTIONS

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium

style. The premium payable position and premium receivable position are

netted across all option contract for each broker at the client level to determine

the net premium payable or receivable amount, at the end of each day.

The brokers who have a premium payable position are required to pay

the premium amount to exchange which is in turn passed on to the members

who have a premium receivable position. This is known as daily premium

settlement. The brokers in turn would take from their clients.

The pay-in and pay-out of the premium settlement is on T + 1) days (T =

Trade day). The premium payable amount and premium receivable amount are

directly debited or credited to the broker, from where it is passed on to the client.

Interim Exchange Settlement for Options on Individual Securities

Interim exchange settlement for Option contract on individual securities is

affected for valid exercised option at in-money strike price, at the close of the trading

hours, on the day of exercise. Valid exercise option contracts are assigned to short

position in option contracts with the same series, on a random basis. This interim 18

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exercise settlement value is the difference between the strike price and the

settlement price of the relevant option contract. Exercise settlement value is

debited/credited to the relevant option broker account on T + 3 days (T =

exercise date). From there it is passed on to clits.

Final Exercise SettlementFinal Exercise settlement is effected for option positions at in-the-

money strike price existing at the close of trading hours, on the expiration day

of an option contract. Long position at in-the money strike price are

automatically assigned to short positions in option contracts with the same

series, on a random basis. For index option individual securities, exercise style

is American style. Final Exercise is Automatic on expiry of the option contracts.

Exercise settlement is cash settled by debiting/crediting of the clearing

account or the relevant broker with the respective Clearing Bank, from where it is

passed debited/credited to the relevant broker clearing bank account on T + 1 day

(T = expiry day), from where it is passed Final settlement loss/profit amount for

option contracts on Individual Securities is debited/credited to the relevant broker

clearing bank account on T + 3 days (T = expiry day), from where it is passed

Open positions, in option contracts, cease to exist after their expiration day.

Options valuation using Black Scholes modelThe black and Scholes Option Pricing model didn’t appear overnight, in fact, Fisher

Black started out working to create a valuation model for stock warrants. This work

involved calculating a derivative to measure how the discount rate of a warrant varies with

time and stock price. The result of this calculation held a striking resemblance to a well-

known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and

the result of their work is a startlingly accurate option pricing model. Black and Scholes

can’t take all credit for their infect the model is actually an improved version of a precious

model developed by A. James Boness in his Ph.D. dissertation at the University of

Chicago. Black and scholes improvement on the Bones model come in the from of a proof

that the risk- free interest raise is the correct discount factor, and with the absence of

assumptions regarding investor’s risk preferences.

The modelC = SN (d1) – Ke {-rt} N (d2)

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C= Theoretical call premium S= current stock pricet= time until option expiration K= option striking pricer= risk-free interest rateN = Cumulative standard normal distribution D1 = in(S / K) + (r + s²/2)t

In order to understand the model itself, we divide into two parts. The first part, SN

(d1), derives the expected benefit from acquiring a stock outright. This is found by

multiplying stock price [S] by the change in the call premium with respect to a change in

the underlying stock price [N (d1)]. The second part of the model, Ke(-rt)N(d2), gives the

present value of paying the exercise price on the expiration day. The fair market value of

the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes Model1) The stock pays no dividends during the option’s life: Most companies

pay dividends to their share holders, so this might see a serious limitation to

the model considering the observation that higher dividend yields elicit lower

call premiums. A common way of adjusting the model for this situation is

subtract the discounted value of a future dividend from the stock price.

2) European exercise terms are used : European exercise terms dictate that

the option can only be exercised on the expiration date. American exercise

term allow the option to be exercised at any time during the life of the

option, making American option more valuable due to their greater flexibility.

This limitation is not a major concern because very few calls are exercise

before the last few days of their life. This is true because when you exercise

a call early, you forfeit the remaining time value on the call and collect the

intrinsic value. Towards the end of the life of a call, the remaining time value

is very small, but the iatric value is the same.

3) Markets are efficient: This assumption suggests that people cannot consistent

predict the direction of the market or an individual stock. The market operates

continuously with share price followed a continuous it process. To understand

what a continues it processes, you must first known that m Markov process is

“one where the observation in time period at depends only on the preceding

observation”. An it process is simply a Marko process you would do so without

picking the pen up from the piece of paper.

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4) No commissions are charged: Usually market participants do have to

pay a commission to buy or sell options. Even floor traders pay some

kind of free, but it is usually very small. The fees that Individual investor’s

pay is more substantial and can often distort the out put of the model.

5) Interest rates remain constant and know: The Black and Scholes model uses

the Risk-free rate to represent this constant and known rate. In reality there is no

such thing as the risk-free rate, but the discount rate on U.S. Government Treasury

Bills with 30 days left until maturity is usually used to represent it. During periods of

rapidly change interest rates, these 30 day rates are often subject to change,

thereby violating one of the assumptions of the model.

REGULARITY FRAME WORKThe trading of derivatives is governed by the provisions contained in the

SC(R)A, the SCBI act, the rules and regulation framed there under and the

rules and bye-laws of stock exchange.

Securities Contracts (Regulation) Act, 1956SC(R) A aims at preventing undesirable transactions in securities by

regulating the Business of dealing therein and by providing for certain other

matters connected therewith. This is the principal Act, which governs the

trading of securities in India. The term “securities” has been defined in the

SC(R) A. as per section 2(h), the ‘securities’ include.

1. Shares, scraps, stocks, bonds, debenture stock or other marketable securities of a

like Nature in or of any incorporated company or other body corporate. Derivative

2. Units or any other instrument issued by any collective investors in such schemes

To the investors in such schemes, risk Government securities. Such other

instruments as may be declared by the central government to be securities

rights or interests in securities. “Derivative” is defined to include: A security

derived from a debt instrument, share, loan whether secured or unsecured

instrument or contract for differences or any other from of security.

A contracts which derives its value from the prices, or index of prices, of Underlying Securities.

Section 18 a provides that notwithstanding anything contained in any other

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law for the time being in force, contracts in derivative shall be legal

and valid if such contracts are :

Traded on a recognized stock exchange – settled on the clearing hose of the recognized stock exchange, in accordance with the rules and bye –loss of such stock exchanges

Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange

Board of India (SEBI) with statutory powers for (A) protecting the interests of

investors in securities (B) promoting the development of the securities market

and (C) regulating the securities market. Its regulatory jurisdiction extends over

corporate in the issuance of capital and transfer of securities, in addition to all

intermediaries and persons associated with securities market. SEBI has been

obligated to perform the aforesaid functions by such measures as it thinks fit.

In Particular, it has Powers For

Regulating the business in stock exchanges and any other securities

markets Registering and regulating the working of stock brokers, sub-

brokers etc. Promoting and regulating self – regulatory organizations

Prohibiting fraudulent and unfair trade practices.

Calling for information from, undertaking inspection, conducting inquires and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries and self-regulatory organization in the securities market

Performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government

SEBI (Stockbrokers and Sub-brokers) Regulations, 1992

In this section we shall have a look at the regulations that apply to brokers under the SEBI Regulation.

BROKERS

A broker is an intermediary who arranges to buy and sell securities on behalf of

clients (the buyers and the seller). According to section2 (e) of the SEBI (Stock Brokers

and sub brokers) Rules, 1992, a stock broker mean of a recognized stock exchange. No

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stock broker is allowed to buy, sell or deal in securities, unless he or she holds a

certificate of registration granted by SEBI. A stock broker applies for registration to

SEBI through a stock exchange or stock exchanges of which he or she is admitted

as a member. SEBI may grant a certificate to a stock-broker [as per SEBI (stock

Brokers and Sub-Brokers) Rules, 1992] subject to the conditions that,

1. He holds the membership of stock exchange.

2. Sell abide by the rules, regulations and buy-laws of the stock

exchange or stock exchange of which he is a member.

3. In case of any change in the status and constitution, he shall obtain

prior permission of SEBI to continue to buy, sell or deal in

securities in any stock exchange.

4. He shall pay the amount of fees for registration in the prescribed manner, and

5. He shall take adequate steps for redressed of grievances of the investors

within one month of the date of the receipt of the complaint and keep SEBI

informed about the number, nature and other particulars of the complaints as

per SEBI(Stock Brokers) Regulations, 1992,SEBI shall take into account for

considering the grant of a certificate all matters relating to buying, selling, or

dealing in securities and in particular the following namely,

Whether the Stock Broker(a) Is eligible to be admitted as a member of a stock exchange.

(b) Has the necessary infrastructure like adequate office space, equipment and

man power to effectively discharge his activities.

(c) Has any past experience in the business of buying, selling or dealing in securities.

(d) Is subjected to disciplinary proceeding under the rules, regulations and buy-laws of a

stock exchange with respect to his business as a stock-broker involving either himself

or any of his partners, directors or employees.

REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta to

develop the appropriate regulatory framework for derivatives trading in India. The

committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the

recommendations of the committee and approved the phased introduction of

derivatives trading in India beginning with stock index futures. SEBI also approved the

“suggestive bye-laws” recommended by the committee for regulation and control

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of trading settlement of derivatives contracts.

The provision in the SC(R)A and the regulatory framework developed

there under govern trading in securities .

The amendment of the SC(R) A to included derivatives with in the ambit

of ‘securities’ in the SC(R) A made trading in derivatives possible within the

frame work of that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta

Committee report may apply to SEBI for grant of recognition under section 4 of the

SC(R) A, 1956 to start trading derivatives. The derivatives exchange/segment

Should have a separate governing council and representation of trading /clearing

Members shall be limited to maximum of 30% pf the total members and will obtain

Prior approval of SEBI before start of trading in any derivatives contract.

2. The exchange shall have maximum 50 members.

3. The members of an existing segment of the exchange will not automatically become

the members of derivatives segment. The members of the derivatives segment need

to fulfill the eligibility conditions as laid down by the L.C.Gupta committee.

4. The clearing and settlement of derivatives trades shall be through a SEBI approved

clearing corporations/house. Clearing corporation/house complying with the

eligibility conditions as laid down by the committee have to apply to SEBI for

grant of approval.

5. Derivatives brokers/dealers and clearing members are required to seek

registration from SEBI. This is in additional top their registration as brokers of

existing stock exchanges. The minimum net worth for clearing members of

the derivatives clearing corporation/house shall be Rs. 300 lakh.

The Net Worth of the Members Shall be Computed as Follows

Capital + Free reserves

Less non-allowable assets viz,

Fixed assets

Pledged securities

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Member’s card

Non-allowable securities (unlisted

securities) Bad deliveries

Doubtful debts and advances

Prepaid expenses

Intangible asset

30% marketable securities

6. The minimum contract value shall not to be less than Rs. 2 Lakh. Exchanges

should also submit details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy

and margin demands related to the risk of loss on the position shall be

prescribed by SEBI/Exchange from time to time.

8. The L .C. Gupta committee report requires strict enforcement of “know your

customer” Rules and requires that every client shall be registered with the

derivative broker. The Members of the derivatives segment are also required to

make their clients aware of the Risks involved in derivatives trading by issuing to

the client the risk disclosure Document and obtain a copy of the same duly signed

by the client. A trading members are required to have qualified approved user and

sales person who have passed a certification programmed approved by SEBI.

NSE’S CERTIFICATION IN FINANCIAL MARKETS

A critical element of financial sector reforms is the development of a pool of

human resources having right skills and expertise to provide quality intermediation

services in Each segment of the market. In order to dispense quality intermediation,

personnel providing services need to possess requisite skills and knowledge. This is

generally achieved through a system of testing and certification. Such testing and

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