PROJECT DERIVATIVES

Risk Management Through Derivatives in Equity Segment

ACKNOWLEDGEMENT

I express my sincere gratitude to the following dignitaries for helping me and providing necessary

information during various stages of project thereby making it successful.

I would like to thank my external guide Mr. Sandeep Das Mohapatra (Manager Equity, Religare

securities ltd. Bhubaneswar) for giving me the opportunity to work in their esteemed organization

under his guidance, and helping me to complete the project in a successful manner. I am also thankful to

all the staff members of Religare securities ltd. Bhubaneswar who extended their hands and

cooperation directly or indirectly for successful completion of the training programme.

I am obliged to my Faculty guide Prof. Ashok Ku. Rath for providing time, effort and most of all his

patience in helping me for preparing this project report. I am also thankful to all the faulty members of

our college for their kind cooperation with me to write this report.

Last but not least I am thankful to my family members and friends for providing me moral support to do

this project successfully.

Date:

Place: Soumya Ranjan Tripathy

1


DECLARATION

I, SOUMYA RANJAN TRIPATHY, pursing MBA (2009-11) from Regional College Of

Management Autonomus, Bhubaneswar, bearing Registration No.-0906247039, declare that the project

titled “RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT” is an

original work of my own and submitted to Regional College Management Autonomous for partial

fulfillment of MBA programme.

This project report has not been submitted to any other institute/university for the award of any

degree or diploma.

Date:

Place: Soumya Ranjan Tripathy

2


CORPORATE GUIDE CERTIFICATE

This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES

IN EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY student of RCMA

(second year) under my guidence and supervision for partial fulfillment of MBA curriculum of

Regional College Of Management Autonomous, Bhubaneswar.

To the best of my knowledge and belief the report:

1. Is an original work done by the candidate himself

2. Has been duly completed.

3. Is up to the standard both in respect to the content and language for being referred to the

examiner.

Mr. Sandeep Das Mohapatra

Manager, Equity

Religare Securities Ltd.

Bhubaneswar

3


FACULTY GUIDE CERTIFICATE

This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES IN

EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY, student of RCMA (second

year) under the guidance and supervision for partial fulfillment of MBA curriculum of Regional

College Of Management Autonomous, Bhubaneswar.

To the best of my knowledge and belief the report:

1. Is an original work done by the candidate himself

2. Has been duly completed.

3. Is up to the standard both in respect to the content and language for being referred to the

examiner.

Prof. Ashok Ku. Rath

H.O.D. Finance

Regional College of Management (Autonomous)

Bhubaneswar

4


ABSTRACT

The emergence of the market for derivative products, most notably forwards, futures and options, can be

traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties

arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very

high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer

price risks by locking-in asset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative

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

risk-averse investors. The past decade has witnessed a massive growth in the use of financial derivatives

by a wide range of corporate and financial institutions. This growth has run in parallel with the increasing

direct reliance of companies on the capital market as the major source of long term funding. In this

respect, derivatives have a vital role to play in enhancing shareholder value by ensuring minimum risk of

investment.

During this project I got to know different ways or different strategies by using which investor can

minimize the loss. An individual always faces the problem as to which strategy he should use in different

market condition. During this course of Internship I had gathered a good knowledge of cash and

derivative market. This knowledge was helpful in my project to achieve the objective.

I had worked out on 14 strategies by applying which in appropriate market condition an investor can

minimize his risk/loss and even earn profit by only taking positions.

5


EXECUTIVE SUMMARY

This is the report submitted by Soumya Ranjan Tripathy studying at Regional College of

Management(Autonomous), Bhubaneswar, in the partial fulfillment of the requirement of MBA

Program, carried at Religare securities Ltd, Bhubaneswar.

Religare Securities Limited is engaged in providing financial services all across the country and is one of

the most renowned broking houses in India.

The project is on RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT

and the objective of the project is to identify, understand and analyze the strategy which helps to

minimize the Risk in the Indian Equity Derivative Market. Using the findings depicted at the end of the

project will helpful for the investor by indicating whether to invest in the option and future or not.

Equity market reforms are a major constituent of the overall economic reforms in India and considering

the growing surge in the broking firm, the objective of the project is such set so that it will enable the

investors as well as the RMs to formulate strategies as per market trend and investor’s risk appetite.

To achieve the objectives of the project, training was undergone to gain practical knowledge and learn

about derivatives and its applications and also to know the behaviors of investor during trading hours.

The training enabled to learn the concepts of secondary market, the derivatives and the importance of

various tools that were used to undergo the activities to invest in equity market.

6


CONTENTS

1. Introduction

a. Objectives of the study

b. Methodology used

2. Company profile

3. Investment

4. Equity investment

5. Secondary Market

6. Derivatives

(I) Forward contract

(II) Future contract

Futures terminology

Futures payoffs

Applications of future contract

(III)Option contract

Option contracts

Option terminologies

Option strategies

7. Findings

8. Conclusion

9. Bibliography

7


INTRODUCTION

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and

commodity-linked derivatives remained the sole form of such products 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 terms of variety of instruments available,

their complexity and also turnover. In the class of equity derivatives the world over, futures and options

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

investors, who are major users of index-linked derivatives. Even small investors find these useful due to

high correlation of the popular indexes with various portfolios and ease of use.

8


OBJECTIVE OF THE PROJECT:

To learn the basics of secondary market, it includes learning various terminologies used for day-to-day

trading.

To give an insight into derivatives and their application in Indian context.

To gain an insight into derivative trading at a broking firm

To identify, understand and analyze the strategies which help to minimize the Risk in the Indian Equity

Derivative Market in different market conditions.

To implement strategies on investor’s portfolio and measures the profit or loss as a result of

implementing the strategies.

METHODOLOGY USED

The information used for this study was collected through secondary sources whch are available for public

9


COMPANY PROFILE OF RELIGARE SECURITIES LTD.

10


About Religare Enterprises Ltd:

A diversified financial services group with a pan-India presence and presence in multiple international

locations, Religare Enterprises Limited ("REL") offers a comprehensive suite of customer-focused

financial products and services targeted at retail investors, high net worth individuals and corporate and

institutional clients.

REL, along with its joint venture partners, offers a range of products and services in India, including

asset management, life insurance, wealth management, equity and commodity broking, investment

banking, lending services, private equity and venture capital. Religare has also ventured into the

alternative investments sphere through its holistic arts initiative and film fund.

With a view to expand and diversify, REL operates in the life insurance space under 'Aegon Religare

Life Insurance Company Limited' and has launched India's first wealth management joint venture under

the brand name 'Religare Macquarie Private Wealth'.

REL, through its subsidiaries, has launched India's first holistic arts initiative - with a gallery - as well as

the first SEBI approved film fund, which is an initiative towards innovation and spotting new

opportunities for creation and maximization of wealth for investors.

REL operates from seven domestic regional offices, 43 sub-regional offices, and has a presence in 498

cities and towns controlling 1,837 business locations all over India & having an employee strength of

over 10000 employees.

To make a mark in the global arena, REL acquired UK-based Hichens, Harrison & Co. in 2008 which

was subsequently re-named as Religare Hichens Harrison PLC ("RHH"). Hichens, Harrison & Co. was

incorporated in London in the year 1803 and is believed to be one of the oldest firms of stockbrokers in

the City of London.

Pursuant to expansion of REL's business, the company has grown from largely an equity trading

company into a diversified financial services company. With the addition of RHH the REL group now

operates out of multiple global locations, other than India, (the UK, the USA, Brazil, South Africa, South

East Asia, Dubai and Singapore).

11


Vision & Mission:

Vision: To build Religare as a globally trusted brand in the financial services domain and

present it as the ‘Investment Gateway of India'.

Mission: Providing complete financial care driven by the core values of diligence and transparency.

Brand Essence: Core brand essence is Diligence and Religare is driven by ethical and dynamic

processes for wealth creation.

Name: Religare is a Latin word that translates as 'to bind together'. This name has been chosen to

reflect the integrated nature of the financial services the company offers.

Symbol: The Religare name is paired with the symbol of a four-leaf clover. Traditionally, it is

considered good fortune to find a four-leaf clover as there is only one four-leaf clover for every

10,000 three-leaf clovers found. For us, each leaf of the clover has a special meaning. It is a symbol

of Hope, Trust, Care, & Good Fortune. For the world, it is the symbol of Religare.

The first leaf of the clover represents Hope. The aspirations to succeed. The

dream of becoming. Of new possibilities. It is the beginning of every step and the

foundation on which a person reaches for the stars.

The second leaf of the clover represents Trust. The ability to place one’s own faith

in another. To have a relationship as partners in a team. To accomplish a given

goal with the balance that brings satisfaction to all, not in the binding, but in the

bond that is built.

The third leaf of the clover represents Care. The secret ingredient that is the

cement in every relationship. The truth of feeling that underlines sincerity and the

triumph of diligence in every aspect. From it springs true warmth of service and

the ability to adapt to evolving environments with consideration to all.

The fourth and final leaf of the clover represents Good Fortune. Signifying that

rare ability to meld opportunity and planning with circumstance to generate those

often looked for remunerative moments of success.

12


Hope. Trust. Care. Good Fortune. All elements perfectly combine in the

emblematic and rare, four-leaf clover to visually symbolize the values that bind

together and form the core of the Religare vision.

13


Religare Enterprises Limited: Other group companies

Religare Securities Limited

Equity Broking

Online Investment Portal

Portfolio Management Services

Depository Services

Religare Commodities Limited

Commodity Broking

Religare Capital Markets Limited

Investment Banking

Proposed Institutional Broking

Religare Realty Limited

In house Real Estate Management

Company

Religare Hichens Harrison**

Corporate Broking

Institutional Broking

Derivatives Sales

Corporate Finance

Religare Finvest Limited

Lending and Distribution business

Proposed Custodial business

Religare Insurance Broking Limited

Life Insurance

General Insurance

Reinsurance

Religare Arts Initiative Limited

Business of Art

Gallery launched - arts-i

Religare Venture Capital Limited

Private Equity and Investment

Manager

Religare Asset Management*

*Religare Asset Management Company (P) Limited is a wholly owned subsidiary of Religare

Securities Limited (RSL), which in turn is a 100% subsidiary of Religare Enterprises Limited.

** Religare Hichens, Harrison plc. (RHH) is a part of Religare Enterprises Limited (REL).

Hichens, Harrison & Co. plc. (HH), established in 1803, is London’s oldest brokerage and

investment firm with a global footprint. Post its acquisition through REL’s indirect subsidiary -

Religare Capital Markets International (UK) Limited, HH has been rechristened as Religare

Hichens Harrison plc

14


INVESTMENT

Investment in a general way is defined as any use of resources intended to increase future production

output or income.

In finance investment refers to the purchase or acquisition of an asset or item with a hope to get return

from it in the future. The return may be in terms of regular income or value appreciation.

In an economy, people indulge in economic activity to support their consumption requirements. Savings

arise from deferred consumption, to be invested, in anticipation of future returns. Investments could be

15

http://www.fortishealthcare.com/

http://www.religarewellness.com:8080/home.html

http://www.srl.in/

http://www.religaretechnova.com/index.html


made into financial assets, like stocks, bonds, and similar instruments or into real assets, like houses,

land, or commodities.

The main idea behind investment is to utilize the saved idle money to earn a return on it. The money you

earn is partly spent and the rest is saved for meeting future expenses. Instead of keeping the savings idle

it is a general psychology of people to earn some return by utilizing the savings which form the

investment.

Common investment objectives are:-

To earn return on your idle resources

To generate specified sum of money for a specific goal in life

Make a provision for an uncertain future

One of the important reasons why one needs to invest wisely is to meet the cost of Inflation. Inflation is

the rate at which the cost of living increases. The cost of living is simply what it costs to buy the goods

and services you need to live. Inflation causes money to lose value. For example, if there will be a 6%

inflation rate for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why

it is important to consider inflation as a factor in any long-term investment strategy.

SECURITIES MARKET

A securities market is a market for securities (debt or equity), where business enterprises (companies)

and governments can raise funds. The definition of ‘Securities’ as per the Securities Contracts egulation

Act (SCRA), 1956, includes instruments such as shares, bonds, scrips, stocks or other marketable

securities of similar nature in or of any incorporate company or body corporate, government securities,

derivatives of securities, units of collective investment scheme, interest and rights in securities, security

receipt or any other instruments so declared by the Central Government. Securities market can be Money

market or Capital market. Capital market is defined as a market in which money is provided for periods

longer than a year[1], as the raising of short-term funds takes place on the money markets. The capital

16


market includes the stock market (equity securities) and the bond market (debt). A capital market is

simply any market where a government or a company can raise money(capital) to fund their operations

and long term investments.

In financial terms capital market is a market where financil instruments are issued and traded.

Capital market denotes the securities market where the stocks, bonds and several other derivatives are

traded. This market provides necessary fund to different companies and governments also. Both long and

short term debts are are raised from this market. At the same time, the capital market provides the

investors with the opportunity to make regular income from the market.

The capital market channelizes funds from surplus sources to the needy areas and here a balance is

sought to be achieved among diverse market participants. It impels enterprises to focus on performance.

EQUITY INVESTMENT

When you buy a share of a company you become a shareholder in that company. Shares are also known

as Equities. Shares are issued for the first time through Initial Public Offer(IPO) or Follow on Public

Offer (FPO) and subsequently traded in the secondary markets that are the stock exchanges. Equities

have the potential to increase in value over time. It also provides your portfolio with the growth

necessary to reach your long term investment goals. Research studies have proved that the equities have

outperformed most other forms of investments in the long term. This may be illustrated with the help of

following examples:

Fctors influencing price of a stock

Broadly there are two factors which influence the value of a stock

(1) stock specific and

(2) market specific.

The stock-specific factor is related to people’s expectations about the company, its future earnings

capacity, financial health and management, level of technology and marketing skills. The market specific

factor is influenced by the investor’s sentiment towards the stock market as a whole. This factor depends

on the environment rather than the performance of any particular company. Events favourable to an

economy, political or regulatory environment like high economic growth, friendly budget, stable

government etc. can fuel euphoria in the investors, resulting in a boom in the market. On the other hand,

unfavourable events like war, economic crisis, communal riots, minority government etc. depress the

market irrespective of certain companies performing well. However, the effect of market-specific factor

is generally short-term. Despite ups and downs, price of a stock in the long run gets stabilized based on

17


the stock specific factors. Therefore, a prudent advice to all investors is to analyze and invest and not

speculate in shares.

SECONDARY MARKET

Secondary market refers to a market where securities are traded after being initially offered to the public

in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the

secondary market. Secondary market comprises of equity markets and the debt markets.

Role of the Secondary Market

For the general investor, the secondary market provides an efficient platform for trading of his securities.

For the management of the company, Secondary equity markets serve as a monitoring and control

conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based

management contracts, and aggregating information (via price discovery) that guides management

decisions.

Difference between the Primary Market and the Secondary Market

In the primary market, securities are offered to public for subscription for the purpose of raising capital or

fund. Secondary market is an equity trading venue in which already existing/pre-issued securities are

traded among investors. Secondary market could be either auction or dealer market. While stock

exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

INTRODUCTION TO THE STOCK EXCHANGE

The stock exchanges in India, under the overall supervision of the regulatory authority, the Securities and

Exchange Board of India (SEBI), provide a trading platform, where buyers and sellers can meet to

transact in securities. The trading platforms provided by NSE & BSE are electronic based and there is no

need for buyers and sellers to meet at a physical location to trade. They can trade through the

computerized trading screens available with the NSE trading members or the internet based trading

facility provided by the trading members of NSE.

A stock exchange is the place where securities, shares, debentures and bonds of joint stock companies,

central & state govt., semi govt. organizations, local bodies and foreign govt. are bought and sold. A

18


stock exchange is the nerve center of capital market. Changes in the capital market are brought about by

a complex set of factors, all operating on the market simultaneously. Such changes are subject to secular

trends set by the economic progress of the nation, and governed by the factors like general economic

situation, financial and monetary policies, tax changes, political environment, international economic and

financial development etc. A stock exchange provides necessary mobility to capital and directs the flow

of capital into profitable and successful enterprises.

Role of stock exchange

Raising capital for businesses

Mobilizing savings for investment

Facilitate company growth

Redistribution of wealth

Gain in stock prices leading to increase in wealth of investors.

Corporate governance

Ensures corporate governance (i.e segregating the ownership & management) of listed

companies.

Creates investment opportunities for small investors

Government raises capital for development projects

Barometer of the economy

Rise/fall of stock markets act as an indicator of economic growth/slowdown.

Evolution and development of Stock Exchanges

18th Century - Beginning of the capital market in India ( East India Company).

Securities trading unorganized until end of the 19th century. (Bombay and Calcutta).

Bombay was the chief trading centre wherein bank shares were the major trading stock.

During American Civil War (1860-61) - Indian stock market witnessed the first boom, lasting half

a decade.

1875- Stockbrokers in Bombay organized an informal association “Native Shares and Stock

Brokers Association”.

1894 - Ahmedabad Stock Exchange founded.

19


1908 – Calcutta Stock Exchange founded.

In the post-independence period also, the size of the capital market remained small.

1st & 2nd 5-year plans – Govt. emphasis was to develop PSUs, but their shares were not listed on

the stock exchanges.

The Controller of Capital Issues (CCI) closely supervised and controlled the timing, composition,

interest rates, pricing, allotment, and floatation costs of new issues. These strict regulations

demotivated many companies from going public for almost four and a half decades.

In 1950s - Century Textiles, Tata Steel, Bombay Dyeing, National Rayon, and Kohinoor Mills

were the favorite scrips of speculators. As speculation became rampant, the stock market came to

be known as 'Satta Bazaar'. Despite speculation, non-payment or defaults were not very frequent.

In 1956 – Govt. enacted Securities Contracts (Regulation) Act, which was characterized by the

establishment of a network for the development of financial institutions and state financial

corporations.

In 1960s - Characterized by wars and droughts in the country which led to bearish trends. Trends

were aggravated by ban in 1969 on forward trading and 'badla‘.

In 1964 - The Unit Trust of India (UTI), first mutual fund of India came into existence. FIs such

as LIC and GIC helped to revive the sentiment by emerging as the most important group of

investors.

In 1970s - Badla trading was resumed. This revived the market.

On July 6, 1974 – Govt. enforced Dividend Restriction Ordinance, restricting the payment of

dividend by companies to 12 per cent of the face value or one-third of the profits of the

companies (that can be distributed as computed under section 369 of the Companies Act),

whichever was lower. This led to a slump in market capitalization at the BSE by about 20 per cent

overnight and the stock market did not open for nearly a fortnight.

1973- Introduction of Foreign Exchange Regulation Act (FERA).

As a result, 123 MNCs offered shares, which were lower than their intrinsic worth. For the first

time, many investors got an opportunity to invest in the stocks of such MNCs as Colgate, and

Hindustan Liver Limited.

In 1977 - Dhirubhai Ambani, tapped the capital market with Reliance Textiles, the base of today’s

entire Reliance empire.

In 1980s - Witnessed an explosive growth of the securities market in India, Major events:

- Participation by small investors, speculation, defaults, ban on badla, and

- resumption of badla continued.

- Convertible debentures emerged as a popular instrument of resource mobilization

20


in the primary market.

- The introduction of public sector bonds and the successful mega issues of Reliance

Petrochemicals and Larsen and Toubro gave a new lease of life to the primary market.

- The decade of the 1980s was characterized by an increase in the number of stock

exchanges,

listed companies, paid up-capital, and market capitalization.

In1990s - Liberalization and globalization of Indian economy opening new doors for investment.

In 1992 - The Capital Issues (Control) Act, 1947 was cancelled. Emergence of new industrial

policy & SEBI as a regulator of capital market.

The securities scam of March 1992 involving Harshad Mehta, a broker as well as bankers was on

of the biggest scams in the history of the capital market. which drove away small investors from

the market.

In 1995 - The M S Shoes case, one such scam which took place, put a break on new issue activity.

In1990’s - Securities scam revealed the inadequacies of and inefficiencies in the financial system.

It was the scam, which prompted a reform of the equity market. The Indian stock market

witnessed a sea change in terms of technology and market prices because of all such scams.

Technology brought radical changes in the trading mechanism.

National Stock Exchange, set up in 1994, and Over the Counter Exchange of India, set up in

1992.

The National Securities Clearing Corporation (NSCCL) and National Securities Depository

Limited (NSDL) were set up in April 1995 and November 1996 respectively. These institutions

improved clearing and settlement and brought about dematerialized trading.

In 1995-96 - The Securities Contracts (Regulation) Act, 1956 was amended for introduction of

- options trading.

Rolling settlement was introduced in January 1998 for the dematerialized segment of all

companies.

The Indian capital market entered the twenty-first century with the Ketan Parekh scam. As a

result of this scam, badla was discontinued from July 2001 and rolling settlement was introduced

in all scrips.

Trading of futures commenced from June 2000, and Internet trading was permitted in February

2000.

On July 2, 2001, the Unit Trust of India announced suspension of the sale and repurchase of its

flagship US-64 scheme due to heavy redemption leading to panic on the bourses.

21


Then, the government's decision to privatize oil PSUs in 2003 fuelled stock prices. One big

divestment of international telephony major VSNL took place in early February 2002.

Major Stock Exchanges In INDIA

Bombay Stock Exchange (BSE)

National stock Exchange (NSE)

Apart from these 2 there are 21 regional stock exchanges in India. These are:

- Ahmedabad Stock Exchange - Madhya Pradesh Stock Exchange

- Bangalore Stock Exchange - Madras Stock Exchange

- Bhubaneshwar Stock Exchange - Magadh Stock Exchange

- Calcutta Stock Exchange - Mangalore Stock Exchange

- Cochin Stock Exchange - Meerut Stock Exchange

- Coimbatore Stock Exchange - OTC Exchange Of India

- Delhi Stock Exchange - Pune Stock Exchange

- Guwahati Stock Exchange - Saurashtra Kutch Stock Exchange

- Hyderabad Stock Exchange - Uttar Pradesh Stock Exchange

- Jaipur Stock Exchange - Vadodara Stock Exchange

- Ludhiana Stock Exchange

Bombay Stock Exchange

BSE, earlier known as "The Native Share & Stock Brokers' Association" is the oldest stock

exchange in Asia with a rich heritage, now spanning three centuries in its 134 years of existence.

1st stock exchange in the country to obtain permanent recognition (in 1956) from the Government

of India under the Securities Contracts (Regulation) Act 1956.

It migrated from the open outcry system to an online screen-based order driven trading system in

1995 (BOLT).

Earlier an Association Of Persons (AOP), BSE is now a corporatised and demutualised entity

incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE

(Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange

Board of India (SEBI).

With demutualisation, BSE has two of world's best exchanges, Deutsche Börse and Singapore

Exchange, as its strategic partners.

Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the

world's 5th in transaction numbers.22


An investor can choose from more than 4,700 listed companies, which for easy reference, are

classified into A, B, S, T and Z groups.

The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature, and is

tracked worldwide. It is an index of 30 stocks representing 12 major sectors, and is sensitive to

market sentiments and market realities.

Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices.

Emergence of NSE

The NSE has genesis in the report of the High Powered Study Group on Establishment of New

Stock Exchanges. Based on the recommendations, NSE was promoted by leading Financial

Institutions at the behest of the Government of India and was incorporated in November 1992 as a

tax-paying company unlike other stock exchanges in the country.

NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The

Capital Market (Equities) segment commenced operations in November 1994 and operations in

Derivatives segment commenced in June 2000.

The following years witnessed rapid development of Indian capital market with introduction of

internet trading, Exchange traded funds (ETF), stock derivatives and the first volatility index -

IndiaVIX in April 2008.

August 2008 - introduction of Currency derivatives in India with the launch of Currency Futures

in USD-INR by NSE. Interest Rate Futures was introduced for the first time in India by NSE on

31st August 2009, exactly after one year of the launch of Currency Futures.

STOCK TRADING

Screen Based Trading

The trading on stock exchanges in India used to take place through open outcry without use of

information technology for immediate matching or recording of trades. This was time consuming and

inefficient. This imposed limits on trading volumes and efficiency. In order to provide efficiency,

liquidity and transparency, NSE introduced a nationwide, on-line, fully automated screen based trading

system (SBTS) where a member can punch into the computer the quantities of a security and the price at

which he would like to transact, and the transaction is executed as soon as a matching sale or buy order

from a counter party is found.

23


What is NEAT?

NSE is the first exchange in the world to use satellite communication technology for trading. Its trading

system, called National Exchange for Automated Trading (NEAT), is a state of-the-art client server based

application. At the server end all trading information is stored in an in memory database to achieve

minimum response time and maximum system availability for users. It has uptime record of 99.7%. For

all trades entered into NEAT system, there is uniform response time of less than one second.

24


DERIVATIVES

INTRODUCTION

Financial market have been innovating and acquiring new shapes and dimensions. There are two core

factors which directs the financial market, they are increasing returns and reducing risks in investment.

There have been continuous innovations and developments in the financial markets on these two factors.

25


One of the most significant developments in these two factors in the securities markets has been the

development and expansion of financial derivatives. The term “derivatives” is used to refer to financial

instruments which derive their value from some underlying assets. The underlying assets could be

equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets,

such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Thus if

a derivative’s underlying asset is equity, it is called equity derivative and so on.

Origin of derivatives

While trading in derivatives products has grown tremendously in recent times, the earliest evidence of

these types of instruments can be traced back to ancient Greece. Even though derivatives have been in

existence in some form or the other since ancient times, the advent of modern day derivatives contracts is

attributed to farmers’ need to protect themselves against a decline in crop prices due to various economic

and environmental factors. Thus, derivatives contracts initially developed in commodities. The first

“futures” contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers

were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell

the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers.

These were evidently standardized contracts, much like today’s futures contracts. In 1848, the Chicago

Board of Trade (CBOT) was established to facilitate trading of forward contracts on various

commodities. From then

on, futures contracts on commodities have remained more or less in the same form, as we know them

today.

Derivatives in India

In India, derivatives markets have been functioning since the nineteenth century, with

organized trading in cotton through the establishment of the Cotton Trade Association in 1875.

Derivatives, as exchange traded financial instruments were introduced in India in June 2000.

The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various

derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract. In

a span of one and a half years after the introduction of index futures, index options, stock options and

stock futures were also introduced in the derivatives segment for trading. NSE’s equity derivatives

segment is called the Futures & Options Segment or F&O Segment. NSE also trades in Currency and

Interest Rate Futures contracts under a separate segment.

26


A series of reforms in the financial markets paved way for the development of exchange-traded equity

derivatives markets in India. In 1993, the NSE was established as an electronic, national exchange and it

started operations in 1994. It improved the efficiency and transparency of the stock markets by offering a

fully automated screen-based trading system with real-time price dissemination. A report on exchange

traded derivatives, by the L.C. Gupta Committee, set up by the Securities and Exchange Board of India

(SEBI), recommended a phased introduction of derivatives instruments with bi-level regulation (i.e., self-

regulation by exchanges, with SEBI providing the overall regulatory and supervisory role). Another

report, by the J.R. Varma Committee in 1998, worked out the various operational details such as

margining and risk management systems for these instruments. In 1999, the Securities Contracts

(Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared as “securities”.

This allowed the regulatory

framework for trading securities, to be extended to derivatives. The Act considers derivatives on equities

to be legal and valid, but only if they are traded on exchanges.

The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to include:

1. A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument, or contract for differences or any other form of security.

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

securities.

At present, the equity derivatives market is the most active derivatives market in India. Trading volumes

in equity derivatives are, on an average, more than three and a half times the trading volumes in the cash

equity markets.

Milestones in the development of Indian derivative market

November 18, 1996 - L.C. Gupta Committee set up to draft a policy framework for introducing

derivatives

May 11, 1998 - L.C. Gupta committee submits its report on the policy framework

May 25, 2000 - SEBI allows exchanges to trade in index futures

27


June 12, 2000 - Trading on Nifty futures commences on the NSE

June 4, 2001 - Trading for Nifty options commences o n the NSE

July 2, 2001 - Trading on Stock options commences on the NSE

November 9, 2001 - Trading on Stock futures commences on the NSE

August 29, 2008 - Currency derivatives trading commences on the NSE

August 31, 2009 - Interest rate derivatives trading commences on the NSE

Average Daily Turnover in derivative segment(Rs. cr.)

114101752

838810107

1922029543

52153.345310.63

72392.07

2000-01

2001-022002-03

2003-04

2004-052005-06

2006-072007-08

2008-09

2009-10

Average DailyTurnover (Rs. cr.)

The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices)

from one party to another; they facilitate the allocation of risk to those who are willing to take it. In so

doing, derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on

November 1, 2009 a rice farmer may wish to sell his harvest at a future date (say January 1, 2010) for a

pre-determined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an

example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is

the "underlying asset".

The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a

speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range

of derivatives contracts available to be traded in the market. The main types of derivatives are

1. Future Contracts

2. Forward Contracts

3. Option Contracts and

28


4. Swaps

FORWARD CONTRACT

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any

kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is

used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or

EUR) or commodity prices (e.g. forward contracts on oil).

One party agrees to sell, the other to buy, for a forward price agreed in advance. In a forward transaction,

no actual cash changes hands. The forward price of such a contract is commonly contrasted with the spot

price, which is the price at which the asset changes hands (on the spot date, usually two business days).

The difference between the spot and the forward price is the forward premium or forward discount. For

example, Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery date)

from gold mining concern Goldseller. No money changes hands between Goldbuyer and Goldseller at the

time the forward contract is created. Rather, Goldbuyer’s payoff depends on the spot price at the time of

delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then Goldbuyer gains Rs. 10

on his forward position (i.e. the difference between the spot and forward prices) by taking delivery of the

gold at Rs. 600. Risk

29


FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a

certain underlying instrument at a certain date in the future, at a specified price. The future date is called

the delivery date or final settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract,

which gives the holder the right, but not the obligation. In other words, the owner of an options contract

may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement

date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is

transferred from the futures trader who sustained a loss to the one who made a profit. To exit the

commitment prior to the settlement date, the holder of a futures position has to offset his position by

either selling a long position or buying back a short position, effectively closing out the futures position

and its contract obligations.

Future urnover with growth percentage

0

2000000

4000000

6000000

8000000

10000000

12000000

Year

-100%

0%

100%

200%

300%

400%

500%

National Turnover(Rs cr.) Growth(%)

National Turnover(Rs cr.) 72998 330485 1860385 2256203 4305452 6370541 11369230.5 7049753.52 9129635.31

Growth(%) 0% 352.73% 462.93% 21.28% 90.83% 47.96% 78.47% -37.99% 29.50%

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

FUTURES TERMINOLOGY

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

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

30


o 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 cycles which expire on the last Thursday of

the month. Thus a January expiration contract expires on the last Thursday of January and a

February expiration contract ceases trading 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.

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

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

o Contract size: The amount of asset that has to be delivered under one contract called lot size.

o 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.

o 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.

o Initial margin: The amount that must be deposited in the margin account at the time a futures

contract is first entered into is known as initial margin.

o 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.

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

31


FUTURES PAYOFFS

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the

buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can

be combined with options and the underlying to generate various complex payoffs.

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 twomonth Nifty index futures contract when the Nifty stands at 5220. 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 moves down it starts making losses. Figure 4.1 shows the

payoff diagram for the buyer of a futures contract.

Payoff for a buyer of index futures

The figure shows the profits/losses for a long futures position. The investor bought futures when the

index was at 5200. If the index goes above 5200, 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 n

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 5200. The

profit

Loss

32


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. Figure 4.2 shows the

payoff diagram for the seller of a futures contract.

Payoff for a seller of an index futures

The figure shows the profits/losses for a short futures position. The investor sold futures when the index

was at 5200. If the index goes down, his futures position starts making profit. If the index rises, his

futures position starts showing losses.

Difference between futures contract and a forwards contract

A Futures contract is similar to a Forward contract, with some exceptions. Futures contracts are traded

on exchange markets, whereas forward contracts typically trade on OTC (over-the-counter) markets.

Also, futures contracts are settled daily (marked-to-market), whereas forwards are settled only at

expiration.

33

profit

Loss


APPLICATION OF FUTURES

Hedging: Long security, sell futures

Futures can be used as an effective risk-management tool. Take the case of an investor who holds the

shares of a company and gets uncomfortable with market movements in the short run. He 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 need 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 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 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.

Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every

portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios,

whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio

risk is accounted for by index fluctuations (unlike individual securities, where only 30-60% of the

securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT

NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position!

Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is obtained

by selling Rs.1.25 million of Nifty futures.

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

34


deferral product, he would have to buy the security and hold on to it. Assume he buys a 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. 1,00,000 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 1,00,000. 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.

Speculation: Bearish security, sell futures

Stock futures can be used by a speculator who believes that a particular security is over-valued and is

likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product,

there wasn't much he could do to profit from his opinion. Today all he needs to do is sell stock futures.

Let us understand how this works. Simple arbitrage ensures that futures on an individual securities move

correspondingly with the

underlying security, as long as there is sufficient liquidity in the market for the security. If the security

price rises, so will the futures price. If the security price falls, so will the futures price.

Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two-month

contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin

on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of

expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For

the one contract that he bought, this works out to be Rs.2000.

Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price.

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you

notice that futures on a security that you have been observing seem overpriced, how can you cash in on

this opportunity to earn riskless profits?

35


Say for instance, ABC Ltd. trades at Rs.1000. One- month ABC futures trade at Rs.1025 and seem

overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of

transactions.

1. On day one, borrow funds, buy the security on the cash/spot market at 1000.

2. Simultaneously, sell the futures on the security at 1025.

3. Take delivery of the security purchased and hold the security for a month.

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

5. Say the security closes at Rs.1015. Sell the security.

6. Futures position expires with profit of Rs.10.

7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position.

8. Return the borrowed funds. When does it make sense to enter into this arbitrage? If your cost of

borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to

arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage

opportunity involves trading on the spot and futures market. In the real world, one has to build in the

transactions costs into the arbitrage strategy.

Reverse Arbitrage: Under priced 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.

5. 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

36


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.

37


OPTION CONTRACTS

Options are financial instruments that convey the right, but not the obligation, to engage in a future

transaction on some underlying security. For example, buying a call option provides the right to buy a

specified amount of a security at a set strike price at some time on or before expiration, while buying a

put option provides the right to sell. Upon the option holder's choice to exercise the option, the party that

sold, or wrote, the option must fulfill the terms of the contract.

For example, Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery

date) from gold mining concern Goldseller. Suppose that Goldbuyer belives that there is some chance for

the spot price to fall below Rs.600, so that he losses on his forward position. To limit his loss, Goldbuyer

could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs.

600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not

the obligation) to buy gold at the strike price on the expiration date. Then, if the spot price indeed

declines, he could choose not to exercise the option, and his loss would be limited to the purchase price

of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot price is very likely to decline, and attempt

to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike

price on the expiration date

38

OPTION

CALL OPTION

PUT OPTION

BUY SELL BUY SELL

PUT EUROPEAN

PUT AMERICAN

CALL EUROPEAN

CALL AMERICAN


Options turnover over years with growth percentage

0

1000000

2000000

3000000

4000000

5000000

6000000

7000000

8000000

9000000

0.00%

50.00%

100.00%

150.00%

200.00%

250.00%

300.00%

National turnover(Rs cr.) Growth

National turnover(Rs cr.) 28928 109377 270023 290779 518722 985701 1721247.43 3960728.65 8534029.38

Growth 0.00% 278.10% 146.87% 7.69% 78.39% 90.02% 74.62% 130.11% 115.47%

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

OPTION TERMINOLOGY

Index options: These options have the index as the underlying. Some options are

European while others are American. Like index futures contracts, index options contracts

are also cash settled.

Stock options: Stock options are options on individual stoc ks. Options 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 price.

Buyer of an option: The buyer of an option is the one who by paying the option 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 option 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.

39


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/premium: Option price is the price which the option buyer pays to the option

seller. It is also referred to as the option premium.

Expiration date: The date specified in the 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 upto

the expiration date. In India stock options are American options

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 an American option are frequently deduced from those of its European

counterpart. In Indian context Index options are European options

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

positive cashflow to the holder if it were exercised immediately. A call option on the

index is said to be in-the-money when the current index 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, the 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

cashflow 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-the-money (OTM) option is an option that would

lead to a negative cashflow if it were 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.

Intrinsic value of an option: The option premium can be broken down into two

components - intrinsic value and time value. The intrinsic value of a call is the amount the

option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another

way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a

40


call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K —

St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.

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

premium and its intrinsic value. Both calls and puts have time value. An option that is

OTM or ATM has only time value. Usually, the maximum time value exists when the

option is ATM. The longer the time to expiration, the greater is an option's time value, all

else equal. At expiration, an option should have no time value.

FACTS RELATING TO OPTION

1. Option gives its holder the right to buy an underlying asset.

2. The buyer of the option simply has the right to and not obligation to sell the underlying asset.

3. The seller of the option is obligated to deliver the underlying asset (call) or take delivery of the

underlying asset (put) at the strike price of the option regardless of the current price of the underlying

asset if the option is exercised.

4. Options are good for a specified period of time, after which they expire and the holder loses the right

to buy or sell the underlying instrument at the specified price.

5. Options when bought are done so at a debit to the buyer.

6. Options when sold are done so by giving a credit to the seller

7. Options are available in several strike prices representing the price of the underlying instrument.

8. The cost of an option is referred to as the option premium. The price reflects a variety of factors

including the current price of the underlying asset, the strike price of the option, the time remaining until

expiration, and volatility.

9. Options are not available on every stock. There are approximately 2,200 stocks with tradable options.

41


OPTION STRATEGIES

BUY CALL

Strategy View Investor thinks that the market will rise significantly in the short-term.

Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor

is, the higher the strike price should be. By this strategy, the downside risk is avoided

PAY OFF FROM BUY CALL (RELIANCE CAPITAL)

Price of Rel Cap on 1st June 2010 Rs 652.56.

The stock is expected to increase up to Rs 765 in

Short term.

So buy a call option of Rel cap with a strike price

Of Rs 720 of the maturity 24 June.

Premium paid for the option – Rs 37.50

Exercise the option on 21 June 2010 as on 21 june, the price of the scrip touched Rs 766.05

Payoff = 766.05-(720+37.50)

Rs 8.55(profit)

This strategy has an unlimited profit potential as the diagram depicts but the loss is limited upto the premium amount paid. The strategy works in a bullish market.

42

a

Profit

Loss

Stock Price

Buy call

Profit/Loss


BUY PUT Strategy View - Investor thinks that the market will fall significantly in the short-term. .

Strategy Implementation - Put option is bought with a strike price of E. The more bearish the investor

is, the lower the strike price should be.

EXAMPLE

Option premium to be paid – Rs7.50*100 = Rs750

Amount to be received for selling shares = Rs110*100 = Rs11000

If market value of the underlying share will be Rs100 then

Profit/Loss = 11000-(10000+750) = 250(profit)

43

E Stock price

Profit

Loss

Buy Put

Profit/loss


This strategy gives increaing profit with decrease in price. As the diagram depicts the loss is limited upto the premium amount paid. The strategy works in a bearish market.

SELL CALL

Strategy View Investor is certain that the market will not rise and is unsure/ unconcerned whether it will

fall.

Strategy Implementation Call option is sold with a strike price of E. If the investor is very certain of his

view then at-the-money options should be sold, if less certain, then out-of-the-money ones should be

sold.

EXAMPLE

Option premium to be received – Rs10.00*100 = Rs1000

Amount to be received for selling shares = Rs150*100 = Rs15000

If market value of the underlyned share will be Rs140, then the buyer will not exercise the contract.

Exercise Price 150

Size of the contract 100 shares

Price of the share on the date of contract 144

Price of option on the date of contract 10

44


Hence Profit/Loss will be the premium received = 100*10 = 1000(profit)

This strategy has a limited profit potential upto the amount of premium received as the diagram depicts but the loss is unlimited with the increase in stock price. The strategy works when the investor is not bullish.

SELL PUT

Strategy View Investor is certain that the market will not go down, but unsure/unconcerned about

whether it will rise.

Strategy Implementation Put options are sold with a strike price E. If an investor is very bullish, then

in-the-money puts would be sold.

EXAMPLE

Exercise price Rs110

Size of the contract 100 shares

Price of the put option on the date of the contract Rs7.5

Option premium to be received – Rs7.50*100 = Rs750.

Amount to be paid for buying shares = Rs110*100 = Rs11000

If market value of the underlyned share will be Rs100, then the buyer will exercise the contract.

Hence Profit/Loss will be the premium received = (100*100)+750-11000 = 250(loss)

45

E Stock price

Profit

Loss

Sell Call


Possible prices of the share Investor Position

80 -2250

90 -1250

100 -250

110 750

120 750

130 750

140 750

Stock pricce Payoff from short put Total pay off Net profit=

Payoff + premium

S1>110 0(Not exercised) 0 Rs7.50

S1=102.50 102.50 – 110 - 7.50 -7.50+7.50=0

S1<102.50 X<102.50-110

This strategy has a limited profit potential as the diagram depicts but the loss is unlimited upto the amount increase in stock cash market price. The strategy works when the investor is not bearish.

46

E

Stock price

Profit

Loss

Sell Put


BULL SPREAD (CALL)

Strategy View Investor thinks that the market will not fall. It is a Conservative strategy for one who

thinks that the market is more likely to rise than fall.

Strategy Implementation It involves having two calls on the same stock with same expiry date but with

different exercise prices. Call option is bought with a strike price below the stock price and another call

option sold with a strike price above the stock price.

PAY OFF FROM BULL SPREAD (SIEMENS) WITH CALL

Price of Siemens on 1st June 2010 Rs 684.

The stock is expected to increase up to Rs 735 in Short term.

So buy a call option of 24 June with a strike price of Rs 680 – premium paid Rs 104.90

& sell a call option with same maturity date with a strike price of 700 – premium received Rs 29.00.

Initial outlay = 29 – 104.90 = -76.10

Exercise the option on 23 June 2010 as on 23 June, the price of the scrip touched Rs 738.

Payoff from bought call = 738 -680 = 58

Payoff from sold call = 700-738 = -38

Total payoff = 58 - (76.10+38) = Rs 56.10(loss)

This strategy minimizes the loss up to the amount of initial outlay due to difference in premium

paid amount and received amount. The profit is also limited.

47

a

Stock price

Profit

Loss

Bull Spread (Call)

b

Profit/loss


BULL SPREAD (PUT)

Strategy View Investor thinks that the market will not fall, but wants to minimize the risk. It is a

conservative strategy for one who thinks that the market is more likely to rise than fall.

Strategy Implementation It involves writing put b at a higher strike price and buying a put a with a

lower strike price.

PAY OFF FROM BULL SPREAD (AXIS BANK) WITH PUT

Price of Axis Bank stock on 1st June 2010 Rs 1180.

The stock is expected to increase up to Rs 1250 in Short term.

So buy a put option with maturity 29 July with a strike price of Rs 1100 – premium paid Rs 18.05

& sell a put option with same maturity date with a strike price of 1250 – premium received Rs 41.00.

Initial payoff = 41.00 – 18.05 = 22.95

Exercise the option on 29 July 2010 as on 23 June, the price of the scrip touched Rs 738.

Payoff from bought call = 0

Payoff from sold call = 0

Total payoff = 22.95(loss)

This strategy gives protection from downside risk as loss of sold put gets adjusted with profits from

bought put and the strategy gives usually an initial inflow of premium which is a clear profit in an

increasing market.

48

a

Stock price

Profit

Loss

Bull Spread (Put)

b

Profit/loss


BEAR SPREAD (CALL)

Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. It is a

conservative strategy for one who thinks that the market is more likely to fall than rise.

Strategy Implementation Call option is sold with a lower strike price of ‘a’ and another call option is

bought with a higher strike of ‘b’

PAY OFF FROM BEAR SPREAD (PATNI) WITH CALL

Price of Patni stock on 2nd June 2010 = Rs 577.

The stock is expected to be bearish in Short term.

1. Buy a call option with maturity 29 July with a strike price of Rs 600 – premium paid Rs 03.50

2. Sell a call option with same maturity date with a strike price of Rs 540 – premium received Rs

09.75.

Initial payoff = 09.75 – 03.50 = 06.25

Exercise the option on 24th June 2010. Stock price on 24th june = Rs 505

Payoff from bought call = 0 (as the option will not be exercised)

Payoff from sold call = 0 (as the option will not be exercised)

Total payoff = 06.25 (profit)

This strategy involves very less risk in a bearish outlook. In this strategy both profit and loss gets

limited thus provides a hedge against risk.

49

a

Stock price

Profit

Loss

Bear Spread (Call)

b

Profit/loss


BEAR SPREAD (PUT)

Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. Conservative

strategy for one who thinks that the market is more likely to fall than rise.

Strategy Implementation Put option is sold with a lower strike price of a and another put option is

bought with a strike of b

PAY OFF FROM BEAR SPREAD (BPCL) WITH PUT

Price of BPCL stock on 1st June 2010 = Rs 583.

The stock is expected to be bearish in Short term.

1. Option 1 - Sell a put option with maturity of 24th June with an exercise price of Rs 580 –

premium received Rs 79.50.

2. Option 2 - Buy a put option with same maturity date with an exercise price price of Rs 600 –

premium paid Rs 95.60.

Initial payoff = 79.50 – 95.60 = (-16.10)

Exercise the option on 24th June 2010. Stock price on 24th june = Rs 550.05

Payoff from put-1 = 550.05-580 = (-29.95)

Payoff from Put-2 = 600-550.05 = 49.95

Net payoff = 49.95- (16.10+29.95) Rs 03.90(profit)

.

BUY STRADDLE (LONG STRADDLE)

50

a

Stock price

Profit

Loss

Buy StraddleProfit/loss


Strategy view Where the Investor expects a sharp movement in the share price, but unsure of direction, it

is an appropriate strategy.

Strategy implementation long straddle involves buying a Call & a Put at the same exercise price and for

the same tenure. A buyer of the Straddle buys both call & the put.

EXAMPLE

ASSUMPTION -- STRIKE = Rs 100 CALL PREMIUM = Rs 5 Put premium = Rs 4

Initial investment = Rs 9

IF END STOCK IS CALL PAYOFF PUT PAYOFF NET PAYOFF95 0 5 -496 0 4 -597 0 3 -698 0 2 -799 0 1 -8100 0 0 -9101 1 0 -8102 2 0 -7103 3 0 -6104 4 0 -5105 5 0 -4

In this strategy maximum loss can be the amount of total premium paid for the call and put where

as the amount of profit can be unlimited as the diagram indicates.

SHORT STRADDLE

51


Strategy view: Investor thinks that the market will be not be very volatile in the short-term. It is a

strategy for relatively stable stock. A short straddle works whenever the price remains within the band.

Strategy implementation: A short straddle involves selling both the call and the put.

PAY OFF FROM SHORT STRADDLE (JP ASSOCIATE)

Price of BPCL stock on 1st June 2010 = Rs 117.6.

The stock is a relatively less volatile one.

1. Option 1 - Sell a call option with maturity of 29th July with an exercise price of Rs 130 –


2. Option 2 - Sell a put option with same maturity date and exercise price – premium paid Rs 05.55.

Initial payoff = 06.00 + 05.55 = Rs 11.55

Exercise the option on 22nd July 2010. Stock price on 22nd July Rs 131.50

Payoff from option-1 = 130.00-131.50 = (-01.50)

Payoff from option-2 = 0 option will not be exercised.

Net payoff = 11.55-01.50Rs 10.05(profit)

This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.

BUY STRANGLE

52

a

Stock price

Profit

Loss

Sell StraddleProfit/loss


Strategy view: Investor thinks that the market will be very volatile in the short-term.

Strategy implementation: This is identical to the straddle except that the call has an exercise price

above the stock price and the put has an exercise price below the stock price and the premium paid is

less.

PAY OFF FROM BUY STRANGLE (TATA STEEL)

Price of Tata Steel stock on 1st June 2010 = Rs 493.17.

The stock shows a high volatility in the short term.

1. Option 1 - Buy a call option with maturity of 24th June with an exercise price of Rs 480.00 –


2. Option 2 – Buy a put option with same maturity date and exercise price of Rs 500.00 – premium

paid Rs 01.05.

Initial outlay = -(14.25 + 01.05) = -15.30

Exercise the option on 24th June 2010. Stock price on 24th June Rs 501.12

Payoff from option-1 = 501.12-480.00 = 21.12

Payoff from option-2 = 0 option will not be exercised.

Net payoff = 21.12-15.30Rs 05.82(profit)

In this strategy maximum loss can be the amount of total premium paid for the call and put where

as the amount of profit can be unlimited as the diagram indicates.

SELL STRANGLE53

a

Stock price

Profit

Loss

Buy Strangle

Profit/lossFrom put option

b

Profit/lossFrom call option


Strategy view: The investor thinks that the market will not be volatile within a broadish band.

Strategy implementation: This is identical to the straddle except that the call has an exercise price

above the stock price and the put has an exercise price below the stock price and the premium paid is

less.

PAY OFF FROM SELL STRANGLE (SUZLON)

Price of Suzlon stock in June 2010 = Rs 55.6.

The stock shows a relative stability in the short term.

1. Option 1 - Sell a call option with maturity of 24 th June with an exercise price of Rs 60.00 –


2. Option 2- Sell a put option with same maturity date and exercise price of Rs 50.00 – premium

received Rs 00.05.

Initial payoff = 00.60+00.05 = 00.65

Exercise the option on 24th June 2010. Stock price on 24th June Rs 57.65

Payoff from option-1 = 0 (option will not be exercised).

Payoff from option-2 = 0 (option will not be exercised).

Net payoff = 00.65(Profit)

This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.

54

a

Profit

Loss

Sell Strangle

Profit/lossFrom put option

b

Profit/lossFrom call option


BUTTERFLY SPREAD

Strategy view: This strategy hopes that the price will remain within a steady range , but does not want

exposure to an unexpected rise or fall.

Strategy implementation: This involves the following;-

1. Buying a call at low exercise price

2. Buying a call at higher exercise price

3. Selling two calls at an intermediate price.

PAYOFF OF BUTTERFLY SPREAD (UNITECH)

Price of Suzlon stock in June 2010 = Rs 69.00.

1. Option 1 - Buy a call option with maturity of 24th June with an exercise price of Rs 65.00 –


2. Option 2- Buy another call option with same maturity date and exercise price of Rs 75.00 –


3. Option 3&4- Sell two calls with the same maturity of intermediate strike price of

Rs 70.00 – premium received 2*4.35 = Rs 08.70

Initial payoff = 08.70-(10.00+00.05) = -01.35

Exercise the option on 23rd June 2010. Stock price = Rs 76.45

Payoff from option-1 = 76.45- 65.00 = Rs 11.45

Payoff from option-2 = 76.45- 75.00 = Rs 01.45

Payoff from option-3&4 = 2*(70.00- 76.45) = -12.90

Net payoff = 01.35(Loss)

In this strategy there is very minimum risk and limited profit. This strategy should be used when

proper strike prices are available to make this strategy.

FINDINGS

55


BULLISH STRATEGIES

A. Buy Call: This strategy is very easy to implement and give good amount of return if price

increase. Here maximum loss is only the premium paid.

B. Buy Futures: Futures has given large amount of profits as compared to options

strategies but at the same time risk associated with it also very high.

C. Bull Spread (Call): It provides limited profits and limited loss. If Index/ Scrip goes up

then one can have profits and vice-versa. This strategy should be use when expected

volatility in the market is less.

D. Bull Spread (Put): It provides limited profit and limited loss. The maximum gain can be

net premium received in this strategy.

E. Sell Put: In this strategy maximum profit is premium received and loss is unlimited. If

a person expects bullish view then he may go with this strategy but this strategy is quite

risky.

NEUTRAL STRATEGIES

F. Buy Straddle: This strategy should only be used when expected volatility is very high and

market outlook is not known. If scrip remains at the same price then loss will be maximum.

G. Buy Strangle: This strategy should be used in very volatile market.

H. Sell Strangle: This strategy should be used when volatility is very less.

I. Long Butterfly: In this strategy there is very minimum risk and limited profit. This strategy

should be used when proper strike prices are available to make this strategy.

J. Short Butterfly: This strategy led to profit when volatility is very high in the option

market.

K. Sell Straddle: When investor want more returns at higher risk then he may go with this

strategy. IF suddenly the volatility increases at a very high rate then huge losses may occur.

BEARISH STRATEGIES

56


L. Buy Put: This strategy should be used when investors perceive that the option price will

go down.

M. Sell Future: This strategy can be use to hedge or it can be use as a speculative

strategy when option market is expected to fall.

N. Bear Spread (Put) & Bear Spread (Call): This strategy involves very less risk & bearish

outlook. So for those investors who expect the option prices will go down but they are not

sure about it then they may use this strategy.

O. Sell Call: In this strategy maximum profit earned and maximum loss is unlimited. So

less risk takers should select very lower strike price while selecting this strategy.

CONCLUSION AND RECOMMENDATIONS

57


Although derivative market is growing in a faster rate still it is not so popular in Indian financial market.

Due to lack of awareness or risk averseness, Indian investors don’t show interest to use derivatives to

hedge in equity market. Notwithstanding the endorsement of derivatives by financial economists and

business persons, there is a widespread belief among regulators, bureaucrats and politicians that

derivatives are employed mainly for speculation purposes, and they accentuate the volatility of the

underlying cash markets.

Many in the profession, however, disagree vehemently with the view that derivatives accentuate

volatility in the cash markets. On the contrary volatility in the underlying cash market declines with the

introduction of derivatives. Since hedging opportunities prove valuable only if the underlying cash

markets are volatile, derivatives are introduced only when the underlying asset prices become more

volatile.

After studying about financial derivatives and different derivative strategies following

recommendations are suggested:

Many strategies like straddle, strangle and butterfly depend upon volatility of scrip or

index and give returns accordingly. So volatility should be forecasted before forming any

strategy.

Fundamental and Technical analysis of the scrip or index should be done before

formulating any strategy.

Specific strategy should be used according to the purpose of investor instead of investing

haphazardly in futures and options.

Derivative market is highly ill- famed among the investor. Thus it is required to provide

in depth knowledge of the market to investors.

Strategies should be evaluated daily for better returns and less risk.

Theoretical price of an option should be found out using option pricing models and

those options whose price is less than theoretical price should be used for formulation

of strategy.

By using a hedging strategy an investor can recover some of his losses and can also make

profit.

58


When the movement and volatility of market or scrip is not known at that time

investor should use hedging strategies.

Investor should make strategy according to position in the cash market and accordingly

make strategy.

BIBLIOGRAPHY

Books

59


(a) Options, futures and Other Derivatives by JOHN C. HULL

(b) NCFM Derivative Market (dealers) Module

(c) Future and Option‖ second edition Tata McGraw- Hill by N D VOHRA, B R Bagri

Websites (a) www.nseindia.com

(c) www.bseindia.com

(d) www.investopedia.com

(f ) http://www.cboe.com/Strategies/EquityOptions/BuyingCalls/Part1.aspx

(g) www.religare.in

60

Documents

PROJECT DERIVATIVES