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Deriv basics

  1. 1. BASICS OF DERIVATIVES© Copyright 2002 India Infoline Ltd. All rights reserved. Regd. Off: 24, Nirlon Complex, Off W E Highway, Goregaon(E) Mumbai-400 063. Tel.: +(91 22) 685 0101/0505 Fax: 685 0585
  2. 2. BASICS OF DERIVATIVESCONTENTSFOREWORD ...................................................................................................................... 31.INTRODUCTION.......................................................................................................... 52. FUTURES .................................................................................................................... 113. OPTIONS..................................................................................................................... 264. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 405. RISK MANAGEMENT IN DERIVATIVES............................................................ 506. SETTLEMENT OF DERIVATIVES ........................................................................ 527. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 578. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75 2
  3. 3. BASICS OF DERIVATIVES ForewordNew ideas and innovations have always been the hallmark of progress made bymankind. At every stage of development, there have been two core factors thatdrives man to ideas and innovation. These are increasing returns and reducingrisk, in all facets of life.The financial markets are no different. The endeavor has always been tomaximize returns and minimize risk. A lot of innovation goes into developingfinancial products centered on these two factors. It has spawned a whole newarea called financial engineering.Derivatives are among the forefront of the innovations in the financial marketsand aim to increase returns and reduce risk. They provide an outlet for investorsto protect themselves from the vagaries of the financial markets. Theseinstruments have been very popular with investors all over the world.Indian financial markets have been on the ascension and catching up with globalstandards in financial markets. The advent of screen based trading,dematerialization, rolling settlement have put our markets on par withinternational markets. 3
  4. 4. BASICS OF DERIVATIVESAs a logical step to the above progress, derivative trading was introduced in thecountry in June 2000. Starting with index futures, we have made rapid stridesand have four types of derivative products- Index future, index option, stockfuture and stock options. Today, there are 30 stocks on which one can havefutures and options, apart from the index futures and options.This market presents a tremendous opportunity for individual investors .Themarkets have performed smoothly over the last two years and has stabilized. Thetime is ripe for investors to make full use of the advantage offered by this market.We have tried to present in a lucid and simple manner, the derivatives market, sothat the individual investor is educated and equipped to become a dominantplayer in the market.Editorial TeamJuly 11, 2002 4
  5. 5. BASICS OF DERIVATIVES 1.IntroductionWhat are derivatives?A derivative is a financial instrument that derives its value from an underlyingasset. This underlying asset can be stocks, bonds, currency, commodities,metals and even intangible, pseudo assets like stock indices.Derivatives can be of different types like futures, options, swaps, caps, floor,collars etc. The most popular derivative instruments are futures and options.There are newer derivatives that are becoming popular like weather derivativesand natural calamity derivatives. These are used as a hedge against anyuntoward happenings because of natural causes.What exactly is meant by “ derives its value from an asset”?What the phrase means is that the derivative on its own does not have any value.It is considered important because of the importance of the underlying. When wesay an Infosys future or an Infosys option, these carry a value only because ofthe value of Infosys. 5
  6. 6. BASICS OF DERIVATIVESWhat are financial derivatives?Financial derivatives are instruments that derive their value from financial assets.These assets can be stocks, bonds, currency etc. These derivatives can beforward rate agreements, futures, options swaps etc. As stated earlier, the mosttraded instruments are futures and options.What kind of people will use derivatives?Derivatives will find use for the following set of people:• Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits• Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$• Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will examine this in detail when we look at futures in a separate chapter. 6
  7. 7. BASICS OF DERIVATIVESBasically, every investor assumes one or more of the above roles and derivativesare a very good option for him.How has this market developed over time?Derivatives have been a recent development in the Indian financial markets. Butthere have been derivatives in the commodities market. There is Cotton andOilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,Coffee futures in Bangalore etc. But the players in these markets are restricted tobig farmers and industries, who need these as an input to protect themselvesfrom the vagaries of agriculture sector.Globally too, the first derivatives started with the commodities, way back in 1894.Financial derivatives are a relatively late development, coming into existenceonly in the 1970’s. The first exchange where derivatives were traded is theChicago Board of Trade (CBOT).In India, the first derivatives were introduced by National Stock Exchange (NSE)in June 2000. The first derivatives were index futures. The index used was Nifty.Option trading was started in June 2001, for index as well as stocks. InNovember 2001, futures on stocks were allowed. Currently, there are 30 stockson which derivative trading is allowed. 7
  8. 8. BASICS OF DERIVATIVESThe 30 stocks on which trading is allowed currently are:Name of the Scrip Lot SizeACC 1500Bajaj Auto 800BHEL 1200BPCL 1100BSES 1100Cipla 200Digital Global Soft 400Dr Reddy Laboratories 400Grasim 700Gujarat Ambuja 1100Hindalco 300Hindustan Lever 1000HPCL 1300HDFC 300Infosys 100ITC 300L&T 1000MTNL 1600M&M 2500 8
  9. 9. BASICS OF DERIVATIVESRanbaxy 500Reliance Industries 600Reliance Petroleum 4300Satyam Computers 1200SBI 1000Sterlite Opticals 600TELCO 3300TISCO 1800Tata Power 1600Tata Tea 1100VSNL 700NIFTY 200SENSEX 50The trading is done on the exchange in the F&O (Futures and Option) segment.Index F&O is also traded in the market. The indices traded are the Nifty and theSensex.Since we have talked of hedging, can we compare derivatives toinsurance?You buy a life insurance policy and pay a premium to the insurance agent for afixed term as agreed in the policy. In case you survive, you are happy and the 9
  10. 10. BASICS OF DERIVATIVESinsurance company is happy. In case you don’t survive, your relatives are happyas the insurance company pays them the amount for which you are insured.Insurance is nothing but transfer of risk. An insurance company sells you riskcover and buys your risk and you sell your risk and buy a risk cover. The riskinvolved in life insurance is the death of the policyholder. The insurancecompanies bet on your surviving and hence agree to sell a risk cover for somepremium.There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,a derivative instrument can be compared to insurance, as there is a transfer ofrisk at a financial cost.Derivatives also work well on the concept of mutual insurance. In mutualinsurance, two people having opposite risks can enter into a contract and reducetheir risk. The most classic example is that of an importer and exporter. Animporter buys goods from country A and has to pay in dollars in 3 months. Anexporter sells goods to country A and has to receive payment in dollars in 3months. In case of an importer, the risk is of exchange rate moving up. In case ofan exporter, the risk is of exchange rate moving down. They can cover eachothers risk by entering into a forward rate after 3 months. 10
  11. 11. BASICS OF DERIVATIVES 2. FuturesFuture, as the name indicates, is a trade whose settlement is going to take placein the future. However, before we take a look at futures, it will be beneficial for usto take a look at forward rate agreementsWhat is a forward rate agreementA forward rate agreement is one in which a buyer and a seller enter into acontract at a specified quantity of an asset at a specified price on a specifieddate.An example for this is the exporters getting into forward rate agreements oncurrencies with banks.But there is always a risk of one of the parties defaulting. The buyer may not payup or the seller may not be able to deliver. There may not be any redressal forthe aggrieved party as this is a negotiated contract between two parties.What is a future?A future is similar to a forward rate agreement, except that it is not a negotiatedcontracted but a standard instrument. 11
  12. 12. BASICS OF DERIVATIVESA future is a contract to buy or sell an asset at a specified future date at aspecified price. These contracts are traded on the stock exchanges and it canchange many hands before final settlement is made.The advantage of a future is that it eliminates counterparty risk. Since there is anexchange involved in between, and the exchange guarantees each trade, thebuyer or seller does not get affected with the opposite party defaulting.Futures ForwardsFutures are traded on a stock Forwards are non tradable, negotiatedexchange instrumentsFutures are contracts having standard Forwards are contracts customized byterms and conditions the buyer and sellerNo default risk as the exchange High risk of default by either partyprovides a counter guaranteeExit route is provided because of high No exit route for these contractsliquidity on the stock exchangeHighly regulated with strong margining No such systems are present in aand surveillance systems forward market. 12
  13. 13. BASICS OF DERIVATIVESThere are two kinds of futures traded in the market- index futures and stockfutures.There are three types of futures, based on the tenure. They are 1, 2 or 3 monthfuture. They are also known as near and far futures depending on the tenure.What are Index futuresIndex futures are futures contract on the index itself. One can buy a 1, 2 or 3-month index future. If someone wants to take a call on the index, then indexfutures are the ideal instruments for him.Let us try and understand what an index is. An index is a set of numbers thatrepresent a change over a period of time.A stock index is similarly a number that gives a relative measure of the stocksthat constitute the index. Each stock will have a different weight in the indexThe Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.For example, Nifty was formed in 1995 and given a base value of 1000. Thevalue of Nifty today is 1172. What it means in simple terms is that, if Rs 1000 13
  14. 14. BASICS OF DERIVATIVESwas invested in the stocks that form in the index, in the same proportion in whichthey are weighted in the index, then Rs 1000 would have become Rs 1172 today.There are two popular methods of computing the index. They are price weightedmethod like Dow Jones Industrial Average (DJIA) or the market capitalizationmethod like Nifty or Sensex.What the terminologies used in a Futures contract?The terminologies used in a futures contract are:• Spot Price: The current market price of the scrip/index• Future Price: The price at which the futures contract trades in the futures market• Tenure: The period for which the future is traded• Expiry date: The date on which the futures contract will be settlec• Basis : The difference between the spot price and the future priceWhy are index futures more popular than stock futures?Globally, it has been observed that index futures are more popular as comparedto stock futures. This is because the index future is a relatively low risk productcompared to a stock future. It is easier to manipulate prices for individual stocksbut very difficult to manipulate the whole index. Besides, the index is less volatile 14
  15. 15. BASICS OF DERIVATIVESas compared to individual stocks and can be better predicted than individualstock.How is the future price arrived at?Future price is nothing but the current market price plus the interest cost for thetenure of the future.This interest cost of the future is called as cost of carry.If F is the future price, S is the spot price and C is the cost of carry or opportunitycost, thenF=S+CF = S + Interest cost, since cost of carry for a finance is the interest costThus,F=S (1+r)TWhere r is the rate of interest and T is the tenure of the futures contract. 15
  16. 16. BASICS OF DERIVATIVESThe rate of interest is usually the risk free market rate.Example 2.1:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What willbe the price of one-month future?SolutionThe price of a future is F= S (1+r)TThe one-month Reliance future would be the spot price plus the cost of carry.Since the bank rate is 10 %, we can take that as the market rate. This rate is anannualized rate and hence we recalculate it on a monthly basis.F=300(1+0.10)(1/12)F= Rs 302.39Example 2.2:The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosysis Rs 3100. The returns expected from the Gsec funds for the same period is 10%. Is the future of Infosys overpriced or underpriced? 16
  17. 17. BASICS OF DERIVATIVESSolutionThe 1 month Future of Infosys will beF= 3000(1+.0.10) (1/12)F= Rs 3023.90But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs76.What happens if dividend is going to be declared?Dividend is an income to the seller of the future. It reduces his cost of carry tothat extent. If dividend is going to be declared, the same has to be deducted fromthe cost of carryThus the price of the future in this case becomes,F= S (1+r-d) TWhere d is the dividend.Example 2.3:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What willbe the price of one-month future? Reliance will be paying a dividend of 50 paiseper shareSolution: 17
  18. 18. BASICS OF DERIVATIVESSince Reliance is paying 50 paise per share and the face value of reliance is Rs10, the dividend rate is 5%.So while calculating futures,F=300(1+0.10-0.05) (1/12)F= Rs. 301.22What happens if dividend is declared after buying a future?If the dividend is declared after buying a one month future, the cost of carry willbe reduced by a pro rata amount. For example, if there is a one month futureending June 30th and dividend is declared on June 15th, then dividend benefit willbe reduced from the cost of carry for 15 days.Since the seller is holding the shares and will transfer the shares to the buyeronly after a month, the dividend benefit goes to the seller. The seller will enjoythe benefit to the extent of interest on dividend.Thus net cost of carry = cost of carry – dividend benefitsExample 2.4:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliancedeclares a dividend of 5%. What will be the price of one-month future?Solution: 18
  19. 19. BASICS OF DERIVATIVESThe benefit accrued due to the dividend will be reduced from the cost of thefuture.One month future will be priced atF= 300(1+0.10) (1/12)F = 302.39Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39The interest benefit of the dividend is available for 15 days, ie 0.5 months.Dividend for 15 days = 300(1+0.05) (0.5/12)Dividend Benefit = Rs300.61- Rs 300= Rs0.61Therefore, net cost of the carry is,Rs2.39-Rs0.61 = Rs 1.78Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78In practice, the market discounts the dividend and the prices are automaticallyadjusted. The exchange steps into the picture if the dividend declared is morethan 10 % of the market price. In such cases, there is an official change in theprice. In other cases, the market does the adjustment on its own.What happens in case a bonus/ stock split is declared on the stock inwhich I have a futures position?If a bonus is declared, the settlement price is adjusted to reflect the bonus. Forexample, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the 19
  20. 20. BASICS OF DERIVATIVESposition becomes 400 Reliance at Rs 150 so that the contract value isunaffected.But is the Future really traded in this way in the market?What has been discussed above is the theoretical way of arriving at the futureprice. This can be used as a base for calculation future priceBut the actual market price that we see on the trading screen depends onliquidity too. So the prices that we observe in real world are also a function ofdemand-supply position in that stock.How do future prices behave compared to spot prices? Future vs Spot 30 20 Future Price Price 10 Spot Price 0 1 2 3 4 5 6 7 Tim eFuture prices lead the spot prices. The spot prices move towards the futureprices and the gap between the two is always closing with as the time to 20
  21. 21. BASICS OF DERIVATIVESsettlement decreases. On the last day of the future settlement, the spot priceequals the future price.Is the futures price always higher than the spot price?The futures price can be lower than the spot price too. This depends on thefundamentals of the stock. If the stock is not expected to perform well and themarket takes a bearish view on them, then the futures price can be lower thanthe spot price.Future prices can fall also due to declaration of dividend.What happens in case of index futures?In case of index futures, the treatment of the futures calculation is the same. Thefuture value is calculated as the spot index value plus the cost of carry.What happens if I buy an index future and there is a dividend declared on astock that comprises the index?Practically speaking, the index is corrected for these things in case there is adividend declared for such a stock.Theoretically, dividend is adjusted in the following manner: 21
  22. 22. BASICS OF DERIVATIVES1.The contribution of the stock to the index is calculated. The index, as discussedearlier, is a market capitalization index.2. Then the number of shares in the index is calculated. This is obtained bydividing the contribution to the index by the market price.3. The dividend on the index is the dividend on the number of shares of the stockin the index.4. The interest earned on the dividend is calculated and reduced from the cost ofcarry to obtain the net cost of carry.Example 2.5:The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLLcontributes to 15 % of the index. The market price of HLL is Rs 150. What will bethe cost of the 1 month future if the bank rate is 10%?Solution:The future will be priced atF= 1000(1+0.10)(1/12)F= 1008The weight of HLL in the index is 15% ie 0.15*1000=150.The market price of HLL is Rs 150Therefore, the number of shares of HLL in the index=1The dividend earned on this is Rs 5 22
  23. 23. BASICS OF DERIVATIVESDividend benefit on Rs 5 is 5(1+0.10) (1/12)Dividend benefit = Rs 0.04Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95But in practice, the market discounts the dividends and price adjustment is madeaccordingly.All that is okay in theory, but what happens in the real world?In the real world, derivatives are highly volatile instruments and there have beenlot of losses in the various financial markets. The classic examples have beenLong Term Capital Markets (LTCM) and Barings. We will examine whathappened exactly at various places later in the book.As a result, the regulators have decided that a minimum of Rs 2 lacs should bethe contract size. This is done primarily to keep the small investors away from avolatile market till enough experience and understanding of the markets isacquired. So the initial players are institutions and high net worth individuals whohave a risk taking capacity in these markets.Because of this minimum amount, lots are decided on the market price such thatthe value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or incase of Sensex, 50. 23
  24. 24. BASICS OF DERIVATIVESSimilarly minimum lots are decided for individual stocks too. Thus you will finddifferent stock futures having different market lots. The lots decided for eachstock was such that the contract value was Rs 2 lacs. This was at the point ofintroduction of these instruments. However the lot size has remained the sameand has not been adjusted for the price changes. Hence the value of the contractmay be slightly lower in case of certain stocks.Trading, i.e. Buying and Selling take place in the same manner as the stockmarkets. There will be an F & O terminal with the broker and the dealer will enterthe orders for you.Another fact of the real world is that, since the future is a standard instrument,you can close out your position at any point of time and need not hold tillmaturity.How is the trading done on the exchange?Buying of futures is margin based. You pay an up front margin and take aposition in the stock of your choice. Your daily losses/ gains relative to the futureprice will be monitored and you will have to pay a mark to market margin. On thefinal day settlement is made in cash and is the difference between the futuresprice and the spot price prevailing at that time 24
  25. 25. BASICS OF DERIVATIVESFor example, if the future price is Rs 300 and the spot price is Rs 330, then youwill make a cash profit of Rs 30. In case the spot price is Rs 290, you make acash loss of Rs 10. Thus futures market is a cash market.In future, there is a possibility that the futures may result in delivery. In such ascenario, the future market will be merged with the spot market on the expirationday and it will follow the T+ 3 rolling settlement prevalent in the stock marketsHow does the mark to market mechanism work?Mark to market is a mechanism devised by the stock exchange to minimize risk.In case you start making losses in your position, exchange collects money to theextent of the losses up front. For example, if you buy futures at Rs 300 and itsprice falls to Rs 295 then you have to pay a mark to market margin of Rs 5. Thisis over and above the margin money that you pay to take a position in the future. 25
  26. 26. BASICS OF DERIVATIVES 3. OptionsWhat are options?As seen earlier, futures are derivative instruments where one can take a positionfor an asset to be delivered at a future date. But there is also an obligation as theseller has to make delivery and buyer has to take delivery.Options are one better than futures. In option, as the name indicates, gives oneparty the option to take or make delivery. But this option is given to only oneparty in the transaction while the other party has an obligation to take or makedelivery. The asset can be a stock, bond, index, currency or a commodityBut since the other party has an obligation and a risk associated with makinggood the obligation, he receives a payment for that. This payment is called aspremium. 26
  27. 27. BASICS OF DERIVATIVESThe party that had the option or the right to buy/sell enjoys low risk. The cost ofthis low risk is the premium amount that is paid to the other party.Thus we have seen an option is a derivative that gives one party a right and theother party an obligation to buy /sell at a specified price for a specified quantity.The buyer of the right is called the option holder. The seller of the right (andbuyer of the obligation) is called the option writer. The cost of this transaction isthe premium.For example, a railway ticket is an option in daily life. Using the ticket, apassenger has an option to travel. In case he decides not to travel, he can cancelthe ticket and get a refund. But he has to pay a cancellation fee, which isanalogous to the premium paid in an option contract. The railways, on the otherhand, have an obligation to carry the passenger if he decides to travel and refundhis money if he decides not to travel. In case the passenger decides to travel, therailways get the ticket fare. In case he does not, they get the cancellation fee.The passenger on the other hand, by booking a ticket, has hedged his position incase he has to travel as anticipated. In case the travel does not materialize, he 27
  28. 28. BASICS OF DERIVATIVEScan get out of the position by canceling the ticket at a cost, which is thecancellation fee.But I hear a lot of jargons about options? What are all these jargons?There are some basic terminologies used in options. These are universalterminologies and mean the same everywhere.a. Option holder : The buyer of the option who gets the rightb. Option writer : The seller of the option who carries the obligationc. Premium: The consideration paid by the buyer for the rightd. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.e. Call option: The option that gives the holder a right to buyf. Put option : The option that gives the holder a right to sellg. Tenure: The period for which the option is issuedh. Expiration date: The date on which the option is to be settledi. American option: These are options that can be exercised at any point till the expiration datej. European option: These are options that can be exercised only on the expiration datek. Covered option: An option that an option writer sells when he has the underlying shares with him. 28
  29. 29. BASICS OF DERIVATIVESl. Naked option: An option that an option writer sells when he does not have the underlying shares with himm. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediatelyn. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediatelyo. At the money: An option is in the money if the option holder evens out if the option was exercised immediatelyHow is money made in an option?The money made in an option is called as the option pay off. There can be twopay off for options, for put and call option Call option:A call option gives the holder a right to buy shares. The option holder will makemoney if the spot price is higher than the strike price. The pay off assumes thatthe option holder will buy at the strike price and sell immediately at the spot price.But if the spot price is lower than the strike, the option holder can simply ignorethe option. It will be cheaper to buy from the market. The option holder loss is tothe extent of premium he has paid. 29
  30. 30. BASICS OF DERIVATIVESBut if the spot price increases dramatically then he can make wind fall profits.Thus the profits for an option holder in a call option is unlimited while losses arecapped to the extent of the premium.Conversely, for the writer, the maximum profit he can make is the premiumamount. But the losses he can make are unlimited.Put optionThe put option gives the right to sell. The option holder will make money if thespot price is lower than the strike price. The pay off assumes that the optionholder will buy at spot price and sell at the strike priceBut if the spot price is higher than the strike, the option holder can simply ignorethe option. It will be beneficial to sell to the market. The option holder loss is tothe extent of premium he has paid.But if the spot prices falls dramatically then he can make wind fall profits.Thus the profits for an option holder in a put option is unlimited while losses arecapped to the extent of the premium. This is a theoretical fallacy as the maximum 30
  31. 31. BASICS OF DERIVATIVESfall a stock can have is till zero, and hence the profit of a option holder in a putoption is capped.Conversely, the maximum profit that an option writer can make in this case is thepremium amount.But in the above pay off, we had ignored certain costs like premium andbrokerage. These are also important, especially the premium.So, in a call option for the option holder to make money, the spot price has to bemore than the strike price plus the premium amount.If the spot is more than the strike price but less than the sum of strike price andpremium, the option holder can minimize losses but cannot make profits byexercising the option.Similarly, for a put option, the option holder makes money if spot is less than thestrike price less the premium amount.If the spot is less than the strike price but more than the strike price lesspremium, the option holder can minimize losses but cannot make profits byexercising the option. 31
  32. 32. BASICS OF DERIVATIVESExample 3.1:The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. Whatwill be the profit for the option holder if the spot price touches a) Rs. 350 b)337Solutiona. The option holder can buy Reliance at a price of Rs 330.He has also paid a premium of Rs 10 for the same. So his cost of a share ofReliance is Rs 340.He can sell the same in the spot market for Rs 350.He makes a profit of Rs 10b. The option holder can buy Reliance at a price of Rs 330.He has also paid a premium of Rs 10 for the same. So his cost of a share ofReliance is Rs 340.He can sell the same in the spot market for Rs 337He makes a loss of Rs 3.But he has reduced his losses by exercising the option. Had he not exercised theoption, he would have made a loss of Rs 10, which is the premium that he paidfor the option. 32
  33. 33. BASICS OF DERIVATIVESBut should one always buy an option? The buyer seems to enjoy alladvantages, then why should one write an option?This is not always the case. The writer of the option too can make money.Basically, the option writers and option holders are people who are taking adivergent view on the market. So if the option writer feels the markets will bebearish, he can write call options and pocket the premium. In case the marketfalls, the option holder will not exercise the option and the entire premium amountcan be a profitBut if the option writer is bullish on the market, then he can write put options. Incase the market goes up, the option holder will not exercise the option and thepremium amount is a profit for the option writer.The other area that an option writer makes money is the spot price lying in therange between the strike price and the strike plus premiumFor example, if you write a call option on Reliance for a strike price of Rs 300 at apremium of Rs 30. If the spot price is Rs 320, then the option holder will exercisethe option to reduce losses and buy it at Rs 300. But you have already got thepremium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs10 above the spot price! This profit increases even more if you calculate theopportunity cost of Rs 30 as this amount is received up front. 33
  34. 34. BASICS OF DERIVATIVESLet us look at a typical pay off table for a call option, for the buyer as well aswriter. Let us assume a call option with a strike price of Rs 200 and a premium ofRs 10Table 3.1: Pay off Table for buyer and writer of an optionSpot Price Whether Buyer’s Writer Net Exercised gain/loss gain/loss180 No -10 +10 0190 No -10 +10 0195 No -10 +10 0200(=Strike Yes/No -10 +10 0Price)205 Yes -5 +5 0210 Yes 0 0 0220 Yes +10 -10 0In the above pay off table, if we take 200 as the median value, we see that thewriter has made money 5 out of 7 occasions. He has made money even whenthe option is exercised, as long as the spot price is below the strike price plus thepremium.Thus writers also make money on options, as the buyer is not at an advantage allthe time. 34
  35. 35. BASICS OF DERIVATIVESWhat are the options that are currently traded in the market?The options that are currently traded in the market are index options and stockoptions on the 30 stocks. The index options are European options. They aresettled on the last day. The stock options are American options.There are 3 options-1, 2,3 month options. There can be a series of option withinthe above time span at different strike prices.Another lingo in option is Near and Far options. A near option means the optionis closer to expiration date. A Far option means the option is farther fromexpiration date. A 1 month option is a near option while a 3 month option is a faroption.In option trading, what gets quoted in the exchange is the premium and all thatpeople buy and sell is the premium.We said we could have different option series at various strike prices. Howis this strike price arrived at?The strike price bands are specified by the exchange. This band is dependent onthe market price. Market Price Rs. Strike Price Intervals Rs. 35
  36. 36. BASICS OF DERIVATIVES <50 2.5 50-150 5 150-250 10 250-500 20 500-1000 30 >1000 50Thus if a stock is trading at Rs. 100 then there can be options with strike price ofRs 105,110,115, 95, 90 etc.How is the premium of an option calculated?In practice, it is the market that decides the premium at which an option is traded.There are mathematical models, which are used to calculate the premium of anoption.The simplest tool is the expected value concept. For example, for a stock that isquoting at Rs 95. There is a 20 % probability that it will become Rs 110. There isa 30 % probability that it will become Rs 105. There is 30% probability that thestock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90. 36
  37. 37. BASICS OF DERIVATIVESIf the strike price of a call option is to be Rs 100, then the option will have valuewhen the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs90.If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively.The expected returns for the above distribution is0.20*15+0.30*10=Rs 6.Thus this the price that one can pay as a premium for a strike price of Rs 100 fora stock trading at Rs 95. Rs 6 will also be the price for the seller for giving theoption holder this opportunity.This is a very simple thumb calculation. Even then, one would require a lot ofbackground data like variances and expected price movements.There are more advanced probabilistic models like the Black Scholes model andthe Binomial Pricing model that calculates the options. One need not go deepinto those and it would suffice to say that option calculators are readily available.Please visit to use an option calculator based onBlack Scholes Model. The Black Scholes Model is presented in greater detail inAnnexure-3. 37
  38. 38. BASICS OF DERIVATIVESI keep reading about option Greeks? What are they? They actually soundlike Greek and Latin to me.There are something called as option Greeks but they are nothing to be scaredof. The option Greeks help in tracking the volatility of option prices.The option Greeks area. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.b. Theta: It measures the change in option price to change in timec. Rho: It is the change in option price to change in interest rated. Vega: It is the change in option price to change in variance of the underlying stocke. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.These are just technical tools used by the market players to analyze options andthe movement of the option prices. 38
  39. 39. BASICS OF DERIVATIVESWe saw that the stock options are American options and hence can beexercised any time. What happens when one decided to exercise theoption?When the option holder decides to exercise the option, the option will beassigned to the option writer on a random basis, as decided by the software ofthe exchange.The European options are also the similarly decided by the software of theexchange. The index options are European options.In future, there is a possibility that the options may result in delivery. In such ascenario, the option market will be merged with the spot market on the expirationday and it will follow the T+ 3 rolling settlement prevalent in the stock markets 39
  40. 40. BASICS OF DERIVATIVES 4. Trading Strategies using Futures and OptionsSo far, we have seen a lot of theoretical stuff on derivatives. But how is itgoing to help me in practice?There are a lot of practical uses of derivatives. As we have seen, derivatives canbe used for profits and hedging. We can use derivatives as a leverage tool too.How do I use derivatives as a leverage?You can use the derivatives market to raise funds using your stocks. Conversely,you can also lend funds against stocks.Does that mean derivatives are badla revisited?The derivative product that comes closest to Badla is futures. Futures is notbadla, though a lot of people confuse it with badla. The fundamental difference isbadla consisted of contango and backwardation (undha badla and vyaj badla) inthe same market. Futures is a different market segment altogether. Hencederivatives is not the same as badla, though it is similar.How do I raise funds from the derivatives market?This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. Youhave shares lying with you and are in urgent need of liquidity. Instead of pledgingyour shares and borrowing from banks at a margin, you can sell the stock at Rs 40
  41. 41. BASICS OF DERIVATIVES3000. Suppose you need this liquidity only for a month and also do not want topart with Infosys. You can buy a 1 month future at Rs 3050. After a month youget back your Infosys at the cost of an additional Rs 50. This Rs 50 is thefinancing cost for the liquidity.The other beauty about this is you have already locked in your purchase cost atRs 3050. This fixes your liquidity cost also and you are protected against furtherprice losses.How do I lend into the market?The lending into the market is exactly the reverse of borrowing. You have moneyto lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs3000 to the market for a month and earned Rs 100 on it.Suppose I don’t want to lend/borrow money. I want to speculate and makeprofits?When you speculate, you normally take a view on the market, either bullish orbearish. When you take a bullish view on the market, you can always sell futuresand buy in the spot market. If you take a bearish view on the market, you can buyfutures and sell in the spot market. 41
  42. 42. BASICS OF DERIVATIVESSimilarly, in the options market, if you are bullish, you should buy call options. Ifyou are bearish, you should buy put optionsConversely, if you are bullish, you should write put options. This is so because, ina bull market, there are lower chances of the put option being exercised and youcan profit from the premiumIf you are bearish, you should write call options. This is so because, in a bearmarket, there are lower chances of the call option being exercised and you canprofit from the premiumHow can I arbitrage and make money in derivatives?Arbitrage is making money on price differentials in different markets. Forexample, future is nothing but the future value of the spot price. This future valueis obtained by factoring the interest rate.But if there are differences in the money market and the interest rates changethen the future price should correct itself to factor the change in interest. But ifthere is no factoring of this change then it presents an opportunity to makemoney- an arbitrage opportunity. 42
  43. 43. BASICS OF DERIVATIVESLet us take an example.Example 4.1:A 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?Solution:The strategy for trading should be : Sell Spot and Buy FuturesSell the stock for Rs 1000. Buy the future at Rs 1005.Invest the Rs1000 at 12 %. The interest earned on this stock will be1000(1+.012)(1/12)=1009So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4Thus one can make a risk less profit of Rs 4 because of arbitrageBut an important point is that this opportunity was available due to mis-pricingand the market not correcting itself. Normally, the time taken for the market toadjust to corrections is very less. So the time available for arbitrage is also less.As everyone rushes to cash in on the arbitrage, the market corrects itself. 43
  44. 44. BASICS OF DERIVATIVESHow is a future useful for me to hedge my position?One can hedge one’s position by taking an opposite position in the futuresmarket. For example, If you are buying in the spot price, the risk you carry is thatof prices falling in the future. You can lock this by selling in the futures price.Even if the stock continues falling, your position is hedged as you have firmedthe price at which 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 acorrelation between the index and individual stocks. This correlation may benegative or positive, but there is a correlation. This is given by the beta of thestock.In simple terms, what β indicates is the change in the price of a stock to thechange in index. For example, if β of a stock is 0.8, it means that if the indexgoes up by 10, the price of the stock goes up by 8. It will also fall by a similarlevel when the index falls. 44
  45. 45. BASICS OF DERIVATIVESA negative β means that the price of the stock falls when the index rises. So, ifyou have a position in a stock, you can hedge the same by buying the index at βtimes the value of the stock.Example 4.2:The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, Ican hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.Scenario 1If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gainof Rs 800.Thus my net position is zero and I am perfectly hedged.Scenario 2If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800But the value of the stock also falls by 8 %. The value of this stock becomes Rs9200 a loss of Rs 800.Thus my net position is zero and I am perfectly hedged.But again, β is a predicted value based on regression models. Regression isnothing but analysis of past data. So there is a chance that the above positionmay not be fully hedged if the β does not behave as per the predicted value. 45
  46. 46. BASICS OF DERIVATIVESHow do I use options in my trading strategy?Options are a great tool to use for trading. If you feel the market will go up. Youshould buy a call option at a level lower than what you expect the market to goup.If you think that the market will fall, you should buy a put option at a level higherthan the level to which you expect the market fall.When we say market, we mean the index. The same strategy can be used forindividual stocks also.A combination of futures and options can be used too, to make profits.We have seen that the risk for an option holder is the premium amount. Butwhat should be the strategy for an option writer to cover himself?An option writer can use a combination strategy of futures and options to protecthis position. The risk for an option writer arises only when the option is exercised.This will be very clear with an example.Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premiumof Rs 20. The risk arises only when the option is exercised. The option will be 46
  47. 47. BASICS OF DERIVATIVESexercised when the price exceeds Rs 300. I start making a loss only after theprice exceeds Rs 320(Strike price plus premium).More importantly, I have to deliver the stock to the opposite party. So to enableme to deliver the stock to the other party and also make entire profit on premium,I buy a future of Reliance at Rs 300.This is just one leg of the risk. The earlier risk was of the call being exercised.The risk now is that of the call not being exercised. In case the call is notexercised, what do I do? I will have to take delivery as I have bought a future.So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need topay a premium for buying the option. I pay a premium of Rs 10.Now I am fullycovered and my net cash flow would bePremium earned from selling call option : Rs 20Premium paid to buy put option : (Rs 10)Net cash flow : Rs 10But the above pay off will be possible only when the premium I am paying for theput option is lower than the premium that I get for writing the call. 47
  48. 48. BASICS OF DERIVATIVESSimilarly, we can arrive at a covered position for writing a put option too,Another interesting observation is that the above strategy in itself presents anopportunity to make money. This is so because of the premium differential in theput and the call option. So if one tracks the derivative markets on a continuousbasis, one can chance upon almost risk less money making opportunities.What are the other strategies using derivatives?The other strategies are also various permutations of multiple puts, calls andfutures. They are also called by exotic names , but if one were to observe themclosely, they are relatively simple instruments.Some of these instruments are:• Butter fly 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 buyer 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 specification to different periods. 48
  49. 49. BASICS OF DERIVATIVES• 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 which 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 exercisable only on predetermined dates 49
  50. 50. BASICS OF DERIVATIVES 5. RISK MANAGEMENT IN DERIVATIVESDerivatives are high-risk instruments and hence the exchanges have put up a lotof measures to control this risk.The most critical aspect of risk management is the daily monitoring of price andposition and the margining of those positions.NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system thathas origins at the Chicago Mercantile Exchange, one of the oldest derivativeexchanges in the world.The objective of SPAN is to monitor the positions and determine the maximumloss that a stock can incur in a single day. This loss is covered by the exchangeby imposing mark to market margins.SPAN evaluates risk scenarios, which are nothing but market conditions.The specific set of market conditions evaluated, are called the risk scenarios, andthese are defined in terms of:(a) how much the price of the underlying instrument is expected to change over 50
  51. 51. BASICS OF DERIVATIVESone trading day, and(b) how much the volatility of that underlying price is expected to change overone trading day.Based on the SPAN measurement, margins are imposed and risk covered. Apartfrom this, the exchange will have a minimum base capital of Rs 50 lacs andbrokers need to pay additional base capital if they need margins above thepermissible limits. 51
  52. 52. BASICS OF DERIVATIVES 6. SETTLEMENT OF DERIVATIVESHow are futures settled on the stock exchange?Mark to market settlementThere is a daily settlement for Mark to Market .The profits/ losses are computedas the difference between the trade price or the previous day’s settlement price,as the case may be, and the current day’s settlement price. The party who havesuffered a loss are required to pay the mark-to-market loss amount to exchangewhich is in turn passed on to the party who has made a profit. This is known asdaily mark-to-market settlement.Theoretical daily settlement price for unexpired futures contracts, which are nottraded during the last half an hour on a day, is currently the price computed asper the formula detailed below:F = S * e rtwhere :F = theoretical futures priceS = value of the underlying index/ stockr = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)t = time to expiration 52
  53. 53. BASICS OF DERIVATIVESRate of interest may be the relevant MIBOR rate or such other rate as may bespecified.After daily settlement, all the open positions are reset to the daily settlementprice.The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =Trade day). The mark to market losses or profits are directly debited or creditedto the broker account from where the broker passes to the client accountFinal SettlementOn the expiry of the futures contracts, exchange marks all positions to the finalsettlement price and the resulting profit / loss is settled in cash.The final settlement of the futures contracts is similar to the daily settlementprocess except for the method of computation of final settlement price. The finalsettlement profit / loss is computed as the difference between trade price or theprevious day’s settlement price, as the case may be, and the final settlementprice of the relevant futures contract.Final settlement loss/ profit amount is debited/ credited to the relevant broker’s 53
  54. 54. BASICS OF DERIVATIVESclearing bank account on T+1 day (T= expiry day). This is then passed on theclient from the broker. Open positions in futures contracts cease to exist aftertheir expiration dayHow are options settled on the stock exchange?Daily Premium SettlementPremium settlement is cash settled and settlement style is premium style. Thepremium payable position and premium receivable positions are netted across alloption contracts for each broker at the client level to determine the net premiumpayable or receivable amount, at the end of each day.The brokers who have a premium payable position are required to pay thepremium amount to exchange which is in turn passed on to the members whohave a premium receivable position. This is known as daily premium settlement.The brokers in turn would take this from their clients.The pay-in and pay-out of the premium settlement is on T+1 days ( T = Tradeday). The premium payable amount and premium receivable amount are directlydebited or credited to the broker, from where it is passed on to the client. 54
  55. 55. BASICS OF DERIVATIVESInterim Exercise Settlement for Options on Individual SecuritiesInterim exercise settlement for Option contracts on Individual Securities iseffected for valid exercised option positions at in-the-money strike prices, at theclose of the trading hours, on the day of exercise. Valid exercised optioncontracts are assigned to short positions in option contracts with the same series,on a random basis. The interim exercise settlement value is the differencebetween the strike price and the settlement price of the relevant option contract.Exercise settlement value is debited/ credited to the relevant broker account onT+3 day (T= exercise date). From there it is passed on to the clients.Final Exercise SettlementFinal Exercise settlement is effected for option positions at in-the-money strikeprices existing at the close of trading hours, on the expiration day of an optioncontract. Long positions at in-the money strike prices are automatically assignedto short positions in option contracts with the same series, on a random basis.For index options contracts, exercise style is European style, while for optionscontracts on individual securities, exercise style is American style. Final Exerciseis Automatic on expiry of the option contracts.Exercise settlement is cash settled by debiting/ crediting of the clearing accounts 55
  56. 56. BASICS OF DERIVATIVESof the relevant broker with the respective Clearing Bank, from where it is passedto the client.Final settlement loss/ profit amount for option contracts on Index is debited/credited to the relevant broker clearing bank account on T+1 day (T = expiryday), from where it is passedFinal settlement loss/ profit amount for option contracts on Individual Securities isdebited/ credited to the relevant broker clearing bank account on T+3 day (T =expiry day), from where it is passedOpen positions, in option contracts, cease to exist after their expiration day. 56
  57. 57. BASICS OF DERIVATIVES 7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVESSince derivatives are a highly risky market, as experience world over has shown,there are tight regulatory controls in this market.The same is true of India. In India, a committee was set up under Dr L C Guptato study the introduction of the derivatives market in India. The report of the LCGupta Committee is attached as Annexure-4.This committee formulated the guidelines and framework for the derivativesmarket and paved the way for the derivatives market in India.There other committee that has far reaching implications in the derivativesmarket is the J R Verma Committee. This committee has recommended normsfor trading in the exchange. A lot of emphasis has been laid on margining andsurveillance so as to provide a strong backbone in systems and processes andensure stringent controls in a risky market.As for the taxation aspect, the CBDT is treating gains from derivativetransactions as profit from speculation. Similarly losses in derivative transactionscan be treated as speculation losses for tax purpose. 57
  58. 58. BASICS OF DERIVATIVES 8. CASE STUDY- When things go wrong!In the earlier part, we saw how useful derivatives are as hedging and riskmanagement tools. However, derivatives do not come without their share ofproblems and dangers. Derivatives are highly sophisticated instruments andusers with inadequate information and understanding expose themselves to allthe risks inherent in using derivatives. Spectacular losses have been made andsome companies have even come to the point of collapse after using derivativeinstruments. Some examples of the unfortunate use of derivatives are:• In 1994, American consumer products giant Procter and Gamble (P&G), lost an estimated US$ 200 million on a complex interest rate Swap. The Swap was intended to lower funding costs for P&G if interest rates moved in a certain manner. However, the Swap turned out to be a sophisticated bet on future interest rate changes. It was the result of speculation and lax controls. The company ought not to have betted on interest rate changes. This case can be viewed as a classic case of how not to use derivatives.• Sumitomo lost 1.17 billion pounds on copper and copper derivative instruments from 1995- 1996.• NatWest Markets, in 1997,announced it had lost 77m pounds as a result of mispriced interest rate Options and Swaps. 58
  59. 59. BASICS OF DERIVATIVES• The German metals and services group, Metallgesellschaft, came to the verge of destruction in 1994 after losses exceeding DM 2.3 billion on energy derivatives.• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei Index contracts on the Singapore and Osaka Derivatives Exchanges, ultimately leading to the bank’s near collapse in 1995. The main person involved was Nick Leeson, the bank’s derivatives trader.• In 1994, Orange County, USA’s richest local authority went bankrupt after trading in high-risk derivatives. On the advice of Merrill Lynch, county treasurer, Robert Citron invested the county’s assets in interest sensitive derivatives. The market moved against him and the county faced losses of around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange County over US$ 400m rather than face trial, in a friendly agreement.The above examples are enough to make any potential user of derivativesapprehensive. However, the stories not told about derivatives represent themajority of cases where derivatives effectively reduce risk. Today, almost alllarge, non-financial organizations use financial derivatives and the number ofusers is fast increasing. Derivatives are no different than the majority of moderninventions: if used in a proper way they are powerful and, indeed valuable tools. 59
  60. 60. BASICS OF DERIVATIVESIn wrong hands, they can cause tremendous destruction as the above examplestestify. The function of a corporate financial officer is to reduce risk by usingderivatives and not to speculate. Yet, in any derivative disaster, an element ofspeculation seems to be present. Another cause of losses is decisions taken bypeople with inadequate knowledge and who do not fully understand the complexstructure of derivatives. Derivatives are highly complex instruments and are oftenresearch-derived and computer generated. The case of the Orange Countyderivatives amply demonstrates this. It is clear that the derivative products usedby the county treasurer were not fully comprehended by him.Barings—What went wrong?A careful study of the Barings case brings to light several issues. Extensive dataobtained by Singapore inspectors show that Nick Leeson lost 4.8m poundssterling between July and October 1992. Leeson covered all the losses by July’93. But it appeared that Leeson recovered his losses by selling options in a waythat stored up trouble. He used a strategy called “Straddling”. Simply put, Leesontraded in a way that he was severely exposed to the market movement and aslight movement against him would lead to huge losses. After the Kobeearthquake, the volatility of the Nikkei increased sharply and Leeson andBarings’ were left facing huge losses. 60
  61. 61. BASICS OF DERIVATIVESLeeson did not take the relatively small losses he would have made had he soldthe contracts when the market started to go against him, but waited in the hopethat the situation would reverse and he would make good the losses. But thiswas not to be, and the rest, they say, is history.What Leeson did was to engage in highly speculative trading. He primarily usedderivatives, not as risk mitigating instruments, but as means of earningspeculative profits. The downside risk was huge and the risk of losses was great.Derivatives—irreplaceable tools or weapons of destruction?Derivatives have acquired a myth of danger and mystery. One reason is thesensational media coverage of the derivatives disasters. However, what oftenescapes notice is that these disastrous transactions involve speculation(intentional risks to make profits) or poor oversight. Derivative instruments, perse, rarely, if ever, cause disasters. It is to be noted that most companies usederivatives for risk reduction and only very few businesses with poormanagement hurt themselves.As explained earlier, derivative contracts can be geared to many times theirvalue. In other words, contracts, which may be worth millions, if the marketmoves in a certain way, cost only a fraction of that value. 61
  62. 62. BASICS OF DERIVATIVESUsually, the market will not move that much and the contract will be settled orsold to somebody else for a small gain or loss. However, if it does shiftsignificantly, big losses can be incurred, which are magnified due to the gearingeffect.Banks have complex computer programmes to tell them how much they couldlose if the market moves by a certain amount. Regulations require them to putmoney aside to protect against possible losses.On exchanges, traders have to pay any losses incurred on their position at theend of each day. This "margin" payment is to prevent risks getting out of hand. 62
  63. 63. BASICS OF DERIVATIVESANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES1. Arbitrage - The simultaneous purchase and sale of a commodity or financial instrument in different markets to take advantage of a price or exchange rate discrepancy.2. Backwardation – The price differential between spot and back months when the nearby dates are at a premium. It is the opposite of ‘contango.’3. Butterfly spread – The placing of two inter-delivery spreads in opposite directions with the centre delivery month common to both. The perfect butterfly spread would require no net premium paid.4. 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.5. Call option – An option that gives the buyer right to buy a futures contract at a premium, at the strike price.6. Contango – The price differential between spot and back months when the marking dates are at a discount. It is the opposite of ‘backwardation.’ 63
  64. 64. BASICS OF DERIVATIVES7. Currency swap – A swap in which the counterparties’ exchange equal amounts of two currencies at the sot exchange rate.8. Derivative – A derivative is an instrument whose value is derived from the value of one or more underlying assets, which can be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the trading of rights or obligations based on the underlying product, but do not directly transfer property.9. Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price.10. Futures contract – A legally binding agreement for the purchase and sale of a commodity, index or financial instrument some time in the future.11. Hedge fund – A large pool of private money and assets managed aggressively and often riskily on any futures exchange, mostly for short-term gain. 64
  65. 65. BASICS OF DERIVATIVES12. In-the money option – An option with intrinsic value. A call option is in-the- money if its strike price is below the current price of the underlying futures contract and a put option is in-the-money if it is above the underlying.13. Kerb trading - Trading by telephone or by other means that takes place after the official market has closed. Originally it took place in the street on the kerb outside the market.14. Margin call – A demand from a clearing house to a clearing member or from a broker to a customer to bring deposits up to a required minimum level to guarantee performance at ruling prices.15. Mark to market – A process of valuing an open position on a futures market against the ruling price of the contract at that time, in order to determine the size of the margin call.16. Naked option – An option granted without any offsetting physical or cash instrument for protection. Such activity can lead to unlimited losses.17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock at a set price on or before a given date. Investors who purchase call options bet the stock will be worth more than the price set by the option (the strike 65
  66. 66. BASICS OF DERIVATIVES price), plus the price they paid for the option itself. Buyers of put options bet the stocks price will go down below the price set by the option.18. Out-of-the money option – An option with no intrinsic value. A call option is out-of-the money if its strike price is above the underlying and a put option is so if its below the underlying.19. Premium - The price of an option contract, determined on the exchange, which the buyer of the option pays to the option writer for the rights to the option contract.20. Spread – The difference between the bid and asked prices in any market.21. Stop-loss orders – An order placed in the market to buy or sell to close out an open position in order to limit losses when the market moves the wrong way.22. Straddle – The simultaneous purchase and sale of the same commodity to different delivery months or different strategies.23. Swap – An agreement to exchange one currency or index return for another, the exchange of fixed interest payments for a floating rate payments or the 66
  67. 67. BASICS OF DERIVATIVES exchange of an equity index return for a floating interest rate.24. Underlying – The currency, commodity, security or any other instrument that forms the basis of a futures or options contract.25. Writer – The person who originates an option contract by promising to perform a certain obligation in return for the price of the option. Also known as Option Writer.26. All-or nothing Option – An option with a fixed, predetermined payoff if the underlying instrument is at or beyond the strike price at expiration.27. Average Options - A path dependant option that calculates the average of the path traversed by the asset, arithmetic or weighted. The payoff therefore is the difference between the average price of the underlying asset, over the life of the option, and the exercise price of the option.28. Barrier Options - These are options that have an embedded price level, (barrier), which if reached will either create a vanilla option or eliminate the existence of a vanilla option. These are referred to as knock-ins/outs that are further explained below. The existence of predetermined price barriers in an option makes the probability of pay off all the more difficult. Thus the reason a 67
  68. 68. BASICS OF DERIVATIVES buyer purchases a barrier option is for the decreased cost and therefore increased leverage.29. Basket Option – A third party option or covered warrant on a basket of underlying stocks, currencies or commodities.30. Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which 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 exercisable only on predetermined dates,31. Compound Options - This is simply an option on an existing option such as a call on a call, a put on a put etc, a call on a put etc.32. Cross-Currency Option – An outperformance option struck at an exchange rate between two currencies.33. Digital Options - These are options that can be structured as a "one touch" barrier, "double no touch" barrier and "all or nothing" call/puts. The "one touch" digital provides an immediate payoff if the currency hits your selected price barrier chosen at outset. The "double no touch" provides a payoff upon 68
  69. 69. BASICS OF DERIVATIVES expiration if the currency does not touch both the upper and lower price barriers selected at the outset. The call/put "all or nothing" digital option provides a payoff upon expiration if your option finishes in the money34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii) down and in. With knock-in options, the buyer starts out without a vanilla option. If the buyer has selected an upper price barrier and the currency hits that level, it creates a vanilla option with maturity date and strike price agreed upon at the outset. This would be called an up and in. The down and in option is the same as the up and in, except the currency has to reach a lower barrier. Upon hitting the chosen lower price level, it creates a vanilla option.35. Multi-Index Options – An outperformance option with a payoff determined by the difference in performance of two or more indices.36. Outperformance Option – An option with a payoff based on the amount by which one of two underlying instruments or indices outperforms the other.37. Rainbow Options - This type of option is a combination of two or more options combined each with its own distinct strike, maturity, etc. In order to achieve a payoff, all of the options entered into must be correct. 69
  70. 70. BASICS OF DERIVATIVES38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate currency risk by effectively hedging it. It involves combining an equity option and incorporating a predetermined fx rate. Example, if the holder has an in- the-money Nikkei index call option upon expiration, the quanto option terms would trigger by converting the yen proceeds into dollars which was specified at the outset in the quanto option contract. The rate is agreed upon at the beginning without the quantity of course, since this is an unknown at the time.39. Secondary Currency Option – An option with a payoff in a different currency than the underlying’s trading currency.40. Swaption – An option to enter into a swap contract.41. Tandem Options – A sequence of options of the same type, usually covering non-overlapping time periods and often with variable strikes.42. Up-and-Out Option – The call pays off early if an early exercise price trigger is hit. The put expires worthless if the market price of the underlying risks is above a pre-determined expiration price. 70
  71. 71. BASICS OF DERIVATIVES43. Zero Strike Price Option – An option with an exercise price of zero, or close to zero, traded on exchanges where there is transfer tax, owner restriction or other obstacle to the transfer of the underlying. 71
  72. 72. BASICS OF DERIVATIVESANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIAThe derivatives market in India has rapidly grown and is fast becoming verypopular. It is offering an alternate source for people to deploy investible surplusand make money out of itThe table below indicates the growth witnessed in the derivatives market.Month/ Index Futures Stock Futures Index Options Stock OptionsYear No. of Turnover No. of Turnover Call Put Call Put contracts (Rs. cr.) contracts (Rs. cr.) No. of Notional No. of Notional No. of Notional No. of Notional contracts Turnover contracts Turnover contracts Turnover contracts Turnover (Rs. cr.) (Rs. cr.) (Rs. cr.) (Rs. cr.)Jun.00 1,191 35 - - - - - - - - - -Jul.00 3,783 108 - - - - - - - - - -Aug.00 3,301 90 - - - - - - - - - -Sep.00. 4,376 119 - - - - - - - - - -Oct.00 6,388 153 - - - - - - - - - -Nov.00 9,892 247 - - - - - - - - - -Dec.003 9,208 237 - - - - - - - - - -Jan.01 17,860 471 - - - - - - - - - -Feb.01 19,141 524 - - - - - - - - - -Mar.01 15,440 381 - - - - - - - - - -00-01 90,580 2,365 - - - - - - - - - -Apr.01 13,274 292 - - - - - - - - - -May.01 10,048 230 - - - - - - - - - -Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,09401-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643 Source: Note: 1.Stock futures were started only in November 2001 2.Index options and stock options were started only in June and July 2001 respectively 72
  73. 73. BASICS OF DERIVATIVES Growth of Derivatives in India 3000Value Rs Crores 2500 2000 1500 1000 500 0 Jun.00 Jun.01 Aug.00 Aug.01 Feb.01 Feb.02 Dec.003 Apr.01 Apr.02 Oct.00 Oct.01 From June 2000 to May 2002 Dec.01 73
  74. 74. BASICS OF DERIVATIVESANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULAThe options price for a Call, computed as per the following Black Scholesformula:C = S * N (d1) - X * e- rt * N (d2)and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)where :d1 OQ6;
  75. 75. U12
  76. 76. W@1VTUWW
  77. 77. d2 OQ6;
  78. 78. U12
  79. 79. W@1VTUWW
  80. 80. = d11VTUWW
  81. 81. C = price of a call optionP = price of a put optionS = price of the underlying assetX = Strike price of the optionr = rate of interestt = time to expiration1 YRODWLOLWRIWKHXQGHUOLQJN represents a standard normal distribution with mean = 0 and standarddeviation = 1ln represents the natural logarithm of a number. Natural logarithms are based onthe constant e (2.718). 74
  82. 82. BASICS OF DERIVATIVESANNEXURE 4- L C GUPTA COMMITTEE REPORT EXECUTIVE SUMMARY 1. The Committee strongly favours the introduction of financial derivatives in order to provide the facility for hedging in the most cost-efficient way against market risk. This is an important economic purpose. At the same time, it recognises that in order to make hedging possible, the market should also have speculators who are prepared to be counter-parties to hedgers. A derivatives market wholly or mostly consisting of speculators is unlikely to be a sound economic institution. A soundly based derivatives market requires the presence of both hedgers and speculators. 2. The Committee is of the opinion that there is need for equity derivatives, interest rate derivatives and currency derivatives. In the case of equity derivatives, while the Committee believes that the type of derivatives contracts to be introduced will be determined by market forces under the general oversight of SEBI and that both futures and options will be needed, the Committee suggests that a beginning may be made with stock index futures. 3. The Committee favours the introduction of equity derivatives in a phased manner so that the complex types are introduced after the market participants have acquired some degree of comfort and familiarity with the simpler types. This would be desirable from the regulatory angle too. 4. The Committees recommendations on regulatory framework for derivatives trading envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main emphasis is on exchange-level regulation by ensuring that the derivative exchanges operate as effective self-regulatory organisations under the overall supervision of SEBI. 5. Since the Committee has placed considerable emphasis on the self-regulatory competence of derivatives exchanges under the over-all supervision and guidance of 75
  83. 83. BASICS OF DERIVATIVES SEBI, it is necessary that SEBI should review the working of the governance system of stock exchanges and strengthen it further. A much stricter governance system is needed for the derivative exchanges in order to ensure that a derivative exchange will be a totally disciplined market place.6. The Committee is of the opinion that the entry requirements for brokers/dealers for derivatives market have to be more stringent than for the cash market. These include not only capital adequacy requirements but also knowledge requirements in the form of mandatory passing of a certification program by the brokers/dealers and the sales persons. An important regulatory aspect of derivatives trading is the strict regulation of sales practices.7. Many of the SEBIs important regulations relating to exchanges, brokers-dealers, prevention of fraud, investor protection, etc., are of general and over-riding nature and hence, these should be reviewed in detail in order to be applicable to derivatives exchanges and their members.8. The Committee has recommended that the regulatory prohibition on the use of derivatives by mutual funds should go. At the same time, the Committee is of the opinion that the use of derivatives by mutual funds should be only for hedging and portfolio balancing and not for speculation. The responsibility for proper control in this regard should be cast on the trustees of mutual funds. The Committee does not favour framing of detailed SEBI regulations for this purpose in order to allow flexibility and development of ideas.9. SEBI, as the overseeing authority, will have to ensure that the new futures market operates fairly, efficiently and on sound principles. The operation of the underlying cash markets, on which the derivatives market is based, needs improvement in many respects. The equity derivatives market and the equity cash market are parts of the equity market mechanism as a whole. 76
  84. 84. BASICS OF DERIVATIVES10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic Research Wing. It would need to develop a competence among its personnel in order to be able to guide this new development along sound lines.Chapter 1THE EVOLUTION AND ECONOMIC PURPOSEOF DERIVATIVES Appointment of the Committee1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by a Board resolution dated November 18, 1996 in order to develop appropriate regulatory framework for derivatives trading in India. List of the Committee members is shown in the end2. The Committee’s concern is with financial derivatives in general and equity derivatives in particular. The evolution of derivatives3. The development of futures trading is an advancement over forward trading which has existed for centuries and grew out of the need for hedging the price-risk involved in many commercial operations. Futures trading represents a more efficient way of hedging risk. Futures vs. Forward contracts4. As both forward contracts and futures contracts are used for hedging, it is important to understand the distinction between the two and their relative merits. Forward contracts are private bilateral contracts and have well-established commercial usage. They are exposed to default risk by counterparty. Each forward contract is unique in terms of contract size, expiration date and the asset type/quality. The contract price is not 77