Derivatives kotak 2010


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Derivatives kotak 2010

  1. 1. Derivatives (Futures & Options) CHAPTER-IINTRODUCTION 1
  2. 2. Derivatives (Futures & Options) INTRODUCTION OF DERIVATIVESThe emergence of the market for derivatives products, most notably forwards, futuresand options, can be traced back to the willingness of risk-averse economic agents toguard themselves against uncertainties arising out of fluctuations in asset prices. Bytheir 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 pricerisks by locking-in asset prices. As instruments of risk management, these generally donot influence the fluctuations in the underlying asset prices. However, by locking-inasset prices, derivative products minimize the impact of fluctuations in asset prices onthe profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from anunderlying asset. The underlying asset can be bullion, index, share, bonds, currency,interest, etc. Banks, Securities firms, companies and investors to hedge risks, to gainaccess to cheaper money and to make profit, use derivatives. Derivatives are likely togrow even at a faster rate in future. DEFINITION OF DERIVATIVES“Derivative is a product whose value is derived from the value of an underlying assetin a contractual manner. The underlying asset can be equity, forex, commodity or anyother asset”.  Securities Contracts (Regulation) Act, 1956 (SCR Act) defines “debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.  A contract which derives its value from the prices, or index of prices, of underlying securities. 2
  3. 3. Derivatives (Futures & Options) HISTORY OF DERIVATIVES MARKETS Early forward contracts in the US addressed merchants concerns about ensuringthat there were buyers and sellers for commodities. However “credit risk” remained aserious problem. To deal with this problem, a group of Chicago; businessmen formedthe Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOTwas to provide a centralized location known in advance for buyers and sellers tonegotiate forward contracts. In 1865, the CBOT went one step further and listed thefirst “exchange traded” derivatives contract in the US; these contracts were called“futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off CBOT wasreorganized to allow futures trading. Its name was changed to Chicago MercantileExchange (CME). The CBOT and the CME remain the two largest organized futuresexchanges, indeed the two largest “financial” exchanges of any kind in the worldtoday.The first stock index futures contract was traded at Kansas City Board of Trade.Currently the most popular stock index futures contract in the world is based on S&P500 indexes, traded on Chicago Mercantile Exchange. During the Mid eighties,financial futures became the most active derivative instruments generating volumesmany times more than the commodity futures. Index futures, futures on T-bills andEuro-Dollar futures are the three most popular futures contracts traded today. Otherpopular international exchanges that trade derivates are LIFFE in England, DTB inGermany, SGX in Singapore, TIFFE in Japan MATIF in France, Eurex etc. THE GROWTH OF DERIVATIVESOver the last three decades, the derivatives markets have seen a phenomenal growth.A large variety of derivative contracts have been launched at exchanges across theworld. Some of the factors driving the growth of financial derivatives are:  Increased volatility in asset prices in financial markets. 3
  4. 4. Derivatives (Futures & Options)  Increased integration of national financial markets with the international markets.  Marked improvement in communication facilities and sharp decline in their costs.  Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and  Innovations in the derivates markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. TYPES OF DERIVATIVESThe following are the various types of derivatives.FORWARDS:A forward contract is a customized contract between two entities, where settlementtakes place on a specific date in the future at today‟s pre-agreed price.FUTURES:A futures contract is an agreement between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are special types offorward contracts in the sense that the former are standardized exchange tradedcontracts.OPTIONS:Options are of two types-calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the underlying asset, at a given price on or beforea give future date. Puts give the buyer the right, but not the obligation to sell a givenquantity of the underlying asset at a given price on or before a given date.Warrants:Options generally have lives of up to one year; the majority of options traded onoptions exchanges having a maximum maturity of nine months. Longer-dated options 4
  5. 5. Derivatives (Futures & Options)are called warrants and are generally traded over-the counter.LEAPS:The acronym LEAPS means long-term Equity Anticipation securities. These areoptions having a maturity of up to three years.BASKETS:Basket options are options on portfolios of underlying assets. The underlying asset isusually a moving average of a basket of assets. Equity index options are a form ofbasket options.SWAPS:Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can be regarded as portfolios offorward contracts. The two commonly used Swaps are:Interest rate Swaps:These entail swapping only the related cash flows between the parties in the samecurrency.Currency Swaps:These entail swapping both principal and interest between the parties, with the cashflows in on direction being in a different currency than those in the opposite direction.SWAPTION:Swaptions are options to buy or sell a swap that will become operative at the expiry ofthe options. Thus a swaption is an option on a forward swap. Rather than have callsand puts, the swaptions market has received swaptions and payer swaptions. Areceiver swaption is an option to receive fixed and pay floating. A payer swaption isan option to pay fixed and received floating. 5
  6. 6. Derivatives (Futures & Options) PARTICIPANTS IN THE DERIVATIVE MARKETSThe following three broad categories of participants:HEDGERS:Hedgers face risk associated with the price of an asset. They use futures or optionsmarkets to reduce or eliminate this risk.SPECULATORS:Speculators wish to bet on future movements in the price of an asset. Futures andoptions contracts can give them an extra leverage; that is, they can increase both thepotential gains and potential losses in a speculative venture.ARBITRAGERS:Arbitrageurs are in business to take of a discrepancy between prices in two differentmarkets, if, for, example, they see the futures price of an asset getting out of line withthe cash price, they will take offsetting position in the two markets to lock in a profit. FUNCTION OF THE DERIVATIVE MARKETSIn spite of the fear and criticism with which the derivative markets are commonlylooked at, these markets perform a number of economic functions.  Prices in an organized derivatives market reflect the perception of market participants about the future and lead the price of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivate contract. Thus derivatives help in discovery of future as well as current prices.  Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.  Derivative due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witness 6
  7. 7. Derivatives (Futures & Options) higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.  Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, Monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.  An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, Well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.  Derivatives trading acts as a catalyst for new entrepreneurial activity.  Derivatives markets help increase saving and investment in long run. SCOPE OF THE STUDYThe Study is limited to “Derivatives” with special reference to Futures and Option isthe Indian context and the Inter-Connected Stock Exchange have been Taken as arepresentative sample for the study. The study can‟t be said as totally perfect. Anyalteration may come. The study has only made a humble Attempt at evaluationderivatives market only in India context. The study is not based on the internationalperspective of derivatives markets, which exists in NASDAQ, CBOT etc. 7
  8. 8. Derivatives (Futures & Options) OBJECTIVES OF THE STUDY  To analyze the derivatives market in India  To analyze the operations of futures and options  To find the profit/loss position of futures buyer and also the option writer and option holder.  To study about risk management with the help of derivatives. LIMITATIONS OF THE STUDYThe following are the limitation of this study.  The scrip chose for analysis is M/s. RELIANCE POWER and the contract taken is January 2009. Ending one-month contract.  The data collected is completely restricted to the M/s. RELIANCE POWER of January 2009; hence this analysis cannot be taken universal. ] 8
  9. 9. Derivatives (Futures & Options) CHAPTER-IIINDUSTRY PROFILE &COMPANY PROFILE 9
  10. 10. Derivatives (Futures & Options)Banking in IndiaBanking in India originated in the last decades of the 18th century. The oldest bank in existence inIndia is the State Bank of India, a government-owned bank that traces its origins back to June 1806and that is the largest commercial bank in the country. Central banking is the responsibility of theReserve Bank of India, which in 1935 formally took over these responsibilities from the thenImperial Bank of India, relegating it to commercial banking functions. After Indias independence in1947, the Reserve Bank was nationalized and given broader powers. In 1969 the governmentnationalized the 14 largest commercial banks; the government nationalized the six next largest in1980.Currently, India has 96 scheduled commercial banks (SCBs) - 27 public sector banks (that is with theGovernment of India holding a stake), 31 private banks (these do not have government stake; theymay be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combinednetwork of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, arating agency, the public sector banks hold over 75 percent of total assets of the banking industry,with the private and foreign banks holding 18.2% and 6.5% respectivelyEarly historyBanking in India originated in the last decades of the 18th century. The first banks were The GeneralBank of India which started in 1786, and the Bank of Hindustan, both of which are now defunct. Theoldest bank in existence in India is the State Bank of India, which originated in the Bank of Calcuttain June 1806, which almost immediately became the Bank of Bengal. This was one of the threepresidency banks, the other two being the Bank of Bombay and the Bank of Madras, all three ofwhich were established under charters from the British East India Company. For many years thePresidency banks acted as quasi-central banks, as did their successors. The three banks merged in1921 to form the Imperial Bank of India, which, upon Indias independence, became the State Bankof India.Indian merchants in Calcutta established the Union Bank in 1839, but it failed in 1848 as aconsequence of the economic crisis of 1848-49. The Allahabad Bank, established in 1865 and still 10
  11. 11. Derivatives (Futures & Options)functioning today, is the oldest Joint Stock bank in India. It was not the first though. That honorbelongs to the Bank of Upper India, which was established in 1863, and which survived until 1913,when it failed, with some of its assets and liabilities being transferred to the Alliance Bank of Simla.When the American Civil War stopped the supply of cotton to Lancashire from the ConfederateStates, promoters opened banks to finance trading in Indian cotton. With large exposure tospeculative ventures, most of the banks opened in India during that period failed. The depositors lostmoney and lost interest in keeping deposits with banks. Subsequently, banking in India remained theexclusive domain of Europeans for next several decades until the beginning of the 20th century.Foreign banks too started to arrive, particularly in Calcutta, in the 1860s. The Comptoire dEscomptede Paris opened a branch in Calcutta in 1860, and another in Bombay in 1862; branches in Madrasand Pondichery, then a French colony, followed. HSBC established itself in Bengal in 1869. Calcuttawas the most active trading port in India, mainly due to the trade of the British Empire, and sobecame a banking center.The Bank of Bengal, which later became the State Bank of India.The first entirely Indian joint stock bank was the Oudh Commercial Bank, established in 1881 inFaizabad. It failed in 1958. The next was the Punjab National Bank, established in Lahore in 1895,which has survived to the present and is now one of the largest banks in India.Around the turn of the 20th Century, the Indian economy was passing through a relative period ofstability. Around five decades had elapsed since the Indian Mutiny, and the social, industrial andother infrastructure had improved. Indians had established small banks, most of which servedparticular ethnic and religious communities. 11
  12. 12. Derivatives (Futures & Options)The presidency banks dominated banking in India but there were also some exchange banks and anumber of Indian joint stock banks. All these banks operated in different segments of the economy.The exchange banks, mostly owned by Europeans, concentrated on financing foreign trade. Indianjoint stock banks were generally under capitalized and lacked the experience and maturity to competewith the presidency and exchange banks. This segmentation let Lord Curzon to observe, "In respectof banking it seems we are behind the times. We are like some old fashioned sailing ship, divided bysolid wooden bulkheads into separate and cumbersome compartments."The period between 1906 and 1911, saw the establishment of banks inspired by the Swadeshimovement. The Swadeshi movement inspired local businessmen and political figures to found banksof and for the Indian community. A number of banks established then have survived to the presentsuch as Bank of India, Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and CentralBank of India.The fervour of Swadeshi movement lead to establishing of many private banks in Dakshina Kannadaand Udupi district which were unified earlier and known by the name South Canara ( South Kanara) district. Four nationalised banks started in this district and also a leading private sector bank. Henceundivided Dakshina Kannada district is known as "Cradle of Indian Banking". 12
  13. 13. Derivatives (Futures & Options)13
  14. 14. Derivatives (Futures & Options)COMPANY PROFILE 14
  15. 15. Derivatives (Futures & Options)Company OverviewThe Kotak Mahindra Group was born in 1985 as Kotak Capital Management Finance Limited. UdayKotak, Sidney A.A.Pinto and Kotak & Company promoted this company. Industrialists HarishMahindra and Anand Mahindra took a stake in 1986, and that‟s when the company changes its nameto Kotak Mahindra Finance Limited. Since then it‟s been a steady and confident journey to growth and success.1986: - Kotak Mahindra Finance Limited starts the activity of Bill Discounting.1987: - Kotak Mahindra Finance Limited enters the lease and hire purchase market.1990: - The Auto Finance Division is started.1991: - The Investment Banking Division is started.1992: - Enters the Funds Syndication sector.1995: - Brokerage and Distribution Businesses incorporated in to a separate company - Kotak Securities Investment Banking Division incorporated into aseparate company – Kotak Mahindra Capital Company.1996: - The Auto Finance Business is hired off into a separate company – Kotak Securities investment Banking Division Incorporated into a separate company -Kotak Mahindra Capital Company.1998: - Enters the Mutual Fund Marker with the launch of Kotak Mahindra asset Management Company.2000: - Kotak Mahindra tie up with old Mutual PIC for the life insurance business. Kotak Securities launches its on-line broking site ( www.kotak securities .com )2001: - Matrix sold to Friday Corporation launches insurance Services 15
  16. 16. Derivatives (Futures & Options)2003: - Kotak Mahindra Finance Limited converts to a Commercial Bank – The first Indian Company to do so.2004: - Launches India growth fund, a private equity fund.2005: - Kotak group realigns Joint Ventures in ford credit; Buys Kotak Mahindra prime and sells ford credit Kotak Mahindra. Launches a Real-estate Fund.Group Management : - Mr.Uday Kotak – Executive Vice Chairman & Managing Director. Mr.Sivaji Dam Mr.C.Jayaram Mr.Dipak Gupta. Kotak Mahindra Group Kotak Mahindra is one of India‟s leading financial institutions offering complete financialsolutions that encompass every sphere of life. From commercial banking, to stock broking, tomutual funds, to life insurance to investment banking, the group caters to the financial needs ofindividuals and corporate. The group has a net worth of around Rs.2000 crore and the AUM across the group is around120 billion and employs over 6000 employees in its various businesses. With a presence in 216cities in India and offices in New York, London, Dubai and Mauritius, it services a customer base ofover 10.00,000. The group specializes in offering top class financial services catering to every segment of theindustry. The various group companies include. Kotak Mahindra Capital Limited Kotak Mahindra Securities Limited Kotak Mahindra Inc 16
  17. 17. Derivatives (Futures & Options) Kotak Mahindra (International) Limited Global Investments Opportunities Fund Limited Kotak Mahindra(UK) Limited Kotak Securities Limited Kotak Mahindra Old Mutual Life Insurance Company Limited Kotak Mahindra Asset Management Company Limited Kotak Mahindra Trustee Company Limited Kotak Mahindra Investments Limited Kotak Forex Brokerage Limited Kotak Mahindra Private-Equity Trustee Limited Group Structure Kotak Mahindra BankKotak Kotak Kotak Kotak Kotak KotakMahindra Mahindra Mahindra Mahindra Securities Mahindra AssetCapital Investments TrustCompany Prime Management Company Company Kotak Mahindra Securities Kotak Mahindra (UK) Kotak Mahindra ( International) Global Investment Opportunities Fund Kotak Mahindra Inc. Kotak Securities Limited. Kotak Securities Ltd. Is India‟s leading stock broking house with a marker share of around 8% Kotak 17
  18. 18. Derivatives (Futures & Options)Securities Ltd. Has been the largest in IPO distribution.The accolades that Kotak Securities has been graced with include : Prime Ranking Award (2003-04) Largest Distributor of IPO‟s Finance Asia Award (2004) – India‟s best Equity House. Finance Asia Award (2005) – Best Broker in India. Euromoney Award (2005) – Best Equities House in InidaThe company has a full-fledged research division involved in Macro Economic studies Sectoralresearch and Company specific Equity Research combined with a strong and well networked salesforce which helps deliver current and up to date market information and news.Kotak Securities Ltd is also a depository participant with National Securities Depository Limited(NSDL) and Central Depository services Limited (CSDL), Providing dual benefit services wherein ininvestors can use the brokerage services of the company for executing the transactions and thedepository services for settling them.Kotak Securities has 122 branches servicing more than 1,70,000 customer and a coverage of 187cities,, the online division of Kotak Securities Limited offers internet Brokingservices and also online IPO and Mutual Fund Investments.Kotak Securities Limited Manages assets over 2500 crores of Assets under Management (AUM).The Portfoilo Management Services provide top class service, catering to the high end of the market.Portfolio Management from Kotak Securities comes as an answer to those who would like to growexponentially on the crest of the stock market, with the backing of an expert.At Kotak, acknowledge and accept that the personal details that you inpart to us, is tobe kept in strict confidentiality and to use the information only in the manner which would bebeneficial to our customers. We consider our relationship with you as invaluable and strive torespect and safeguard your right to privacy. 18
  19. 19. Derivatives (Futures & Options)We shall protect the personal details received from you with the same degree of care, but no less thana reasonable degree of care, to prevent the unauthorized use, dissemination, or publication of theseinformation as we protect our own confidential information of a like nature.We shall use the personal information to improve our service to you and to keep you updated aboutour new product or information that may be of interest to you. The information collected from youwould be used in the right spirit and context in which it is intended to be used. Your informationwould be used by us to process your trading request and to carry out the settlements of yourobligations.We would ensure that we collect personal information only to the extent it is necessary to administerout services in the best possible manner and what is required under the various regulations of IndiaLaws.HDFCVisionTo be a dominant player in the Indian mutual fund space recognized for its high levels of ethical andprofessional conduct and a commitment towards enhancing investor interests.SponsorsHousing Development Finance Corporation Limited (HDFC)HDFC was incorporated in 1977 as the first specialized Mortgage Company in India. HDFC providesfinancial assistance to individuals, corporate and developers for the purchase or construction ofresidential housing. It also provides property related services (e.g. property identification, salesservices and valuation), training and consultancy. Of these activities, housing finance remains thedominant activity. HDFC has a client base of around 9.5 lac borrowers, around 1 million depositors,over 91,000 shareholders and 50,000 deposit agents, as at June 30, 2007. HDFC has raised fundsfrom international agencies such as the World Bank, IFC (Washington), USAID, DEG, ADB andKfW, international syndicated loans, domestic term loans from banks and insurance companies, 19
  20. 20. Derivatives (Futures & Options)bonds and deposits. HDFC has received the highest rating for its bonds and deposits program for thetwelfth year in succession. HDFC Standard Life Insurance Company Limited, promoted by HDFCwas the first life insurance company in the private sector to be granted a Certificate of Registration(on October 23, 2000) by the Insurance Regulatory and Development Authority to transact lifeinsurance business in India.For further details: Life Investments LimitedThe Standard Life Assurance Company was established in 1825 and has considerable experience inglobal financial markets. The company was present in the Indian life insurance market from 1847 to1938 when agencies were set up in Kolkata and Mumbai. The company re-entered the Indian marketin 1995, when an agreement was signed with HDFC to launch an insurance joint venture. On April2006, the Board of The Standard Life Assurance Company recommended that it should demutualiseand Standard Life plc float on the London Stock Exchange. At a Special General Meeting held inMay voting members overwhelmingly voted in favor of this. The Court of Session in Scotlandapproved this in June and Standard Life plc floated on the London Stock Exchange on 10th July2006. Standard Life Investments was launched as an investment management company in 1998. It isa wholly owned subsidiary of Standard Life Investments (Holdings) Limited, which in turn is awholly owned subsidiary of Standard Life plc. Standard Life Investments is a leading assetmanagement company, with approximately US$ 282 billion as at June 30, 2007, of assets undermanagement. The company operates in the UK, Canada, Hong Kong, China, Korea, Ireland and theUSA to ensure it is able to form a truly global investment view. In order to meet the different needsand risk profiles of its clients, Standard Life Investments Limited manages a diverse portfoliocovering all of the major markets world-wide, which includes a range of private and public equities, 20
  21. 21. Derivatives (Futures & Options)government and company bonds, property investments and various derivative instruments. Thecompanys current holdings in UK equities account for approximately 1.8% of the marketcapitalization of the London Stock Exchange.Management:ABN AMRAOWith assets over US $504 billion and an AA credit rating, ABN AMRO Bank ranks among the top10 banks in the world in size and strength. Our international network comprises 3,568 branches andoffices in over 320 cities and 76 countries and territories, with over 100,000 highly qualified staff. Asa global bank, we can handle the most complicated cross-border transactions, yet we also understandthe subtleties of local markets.ABN AMRO IN INDIATraditionally known as a strong diamond financing bank, ABN AMRO today offers unparalleledsuite of client services in India.By leveraging our global reach and drawing on the expertise of our team of research, sales andtrading, equity capital market and M&A advisory professionals, we have led many of the biggest andmost innovative landmark transactions in India for our Corporate and Institutional Clients.In addition, we also offer a broad range of transaction banking products, fixed income and foreignexchange products and services including sales and trading, fixed income origination, derivatives,structured lending and commodity financing.For our Business Banking clients, we offer top quality services in trade finance, business loans,supply chain management, credit facilities, payment and cash management- solutions that help smallto medium size businesses enhance cash flow, boost overall business efficiency and capitalize onnew opportunities. 21
  22. 22. Derivatives (Futures & Options)Through a diverse range of product offerings including personal loans, credit cards, savingsaccounts, financial planning, investment and insurance services, ABN AMRO meets the everydayfinancial needs of over a million Personal Banking clients in India.In addition ABN AMRO has Van Gogh Preferred Banking which represents a new standard ofrelationship banking which has been exclusively created to offer an enhanced level of service todemanding individuals. Van Gogh Preferred Banking services offers a wide range of wealthmaximization opportunities offering new standards of freedom, access, advice and service.At ABN AMRO Broking we offer world class research, timely advice, extreme ease of use and swiftreal time transaction systems for our clients.Private Banking Services in India offers our select and premium clients a comprehensive range ofquality Portfolio Advisory Services along with a sophisticated execution platform. We aid inenhancing their wealth with premium services including investment advisory, non-discretionaryportfolio management, investment funds, international estate planning and trust.Asset Management in India is among the fastest growing asset managers with just two years ofoperations in the country. Backed by the favourable market conditions and a strong focus on thebusiness we have an ever-increasing and widening distribution and aim to emerge as a leading playerin the Indian asset management industry. Leveraging our Groups comprehensive research anddiverse range of investment products, we offer our clients investment options in fixed income,equities, money markets and structured products. The Microfinance program of ABN AMRO, thelargest amongst its peer foreign banks in India, is aimed at delivering credit to our target communityof rural poor woman through intermediaries called microfinance institutions. We today service 26MFIs across 16 states in India with over 390,000 customers receiving micro financing small loans ofUSD 200 or less. Our aim is to reach a million customers by 2009. During the annual Sustainable 22
  23. 23. Derivatives (Futures & Options)Banking Awards ceremony held by Financial Times of London, ABN AMRO India was named theSustainable Bank of the Year in the Emerging Markets category - both in the Asia region as well asglobally.Mission"ABN AMROs mission is to create maximum economic value for our shareholders through aconstant relationship focus on the financial services needs of our chosen client segments and a strictadherence to our financial targets. We are operating in three principal customer segments, wherebythe objective is to maximize the value of each of these businesses as well as the synergies betweenthem. Excellence of service to our clients and leadership in our chosen markets are of paramountimportance to our long-term success. The Banks corporate values play an integral role in thefulfilment of our mission."HistoryOn 29 March 1824 King Willem-I issued a royal decree creating the Nederlandsche Handel-Maatschappij with the aim of reviving trade between the Netherlands and the Dutch East Indies. In1964, NHM merged with De Twentsche Bank to form Algemene Bank Nederland (ABN), whileAmsterdamsche Bank and Rotterdamsche Bank joined to become Amsterdam-Rotterdam (Amro)Bank. In 1991, these two banks merged as ABN AMRO Bank. Today, ABN AMRO Bank has apowerful presence in world markets, building on a tradition of stimulating international trade.BIRLA SUN LIFEBirla Sun Life Asset Management Company Ltd. (BSLAMC), the investment managers of Birla SunLife Mutual Fund, is a joint venture between the Aditya Birla Group and the Sun Life FinancialServices Inc. of Canada. The joint venture brings together the Aditya Birla Groups experience in theIndian market and Sun Lifes global experience. 23
  24. 24. Derivatives (Futures & Options)Since its inception in 1994, Birla Sun Life Mutual fund has emerged as one of Indias leading MutualFunds managing assets of a large investor base. The fund offers a range of investment options, whichinclude diversified and sector specific equity schemes, fund of fund schemes, hybrid and monthlyincome funds, a wide range of debt and treasury products and offshore funds.BSLAMC follows a long-term, fundamental research based approach to investment. The approach isto identify companies, which have excellent growth prospects and strong fundamentals. Thefundamentals include the quality of the company‟s management, sustainability of its business modeland its competitive position, amongst other factors. Birla Sun Life Asset Management Company hasone of the largest team of research analysts in the industry, dedicated to tracking down the bestcompanies to invest in.Birla Sun Life AMC strives to provide transparent, ethical and research-based investments andwealth management services.VISION To be the most trusted name in investment and wealth management, to be the preferredemployer in the industry and to be a catalyst for growth and excellence of the asset managementbusiness in India.MISSIONTo consistently pursue investors wealth optimization by: Achieving superior and consistentinvestment results. Creating a conducive environment to hone and retain talent. Providing customerdelight. Institutionalizing system-approach in all aspects of functioning. Upholding higheststandards of ethical values at all times. 24
  25. 25. Derivatives (Futures & Options)ADITYA BIRLA GROUPThe Aditya Birla Group is Indias first truly multinational corporation. Global in vision, rooted inIndian values, the Group is driven by a performance ethic pegged on value creation for its multiplestakeholders.The Aditya Birla Group‟s products and services offer distinctive customer solutionsworldwide. The Group has operations in 20 countries - India, Thailand, Laos, Indonesia, Philippines,Egypt, China, Canada, Australia, USA, UK, Germany, Hungary, Brazil, Italy, France, Luxembourg,Switzerland, Malaysia and Korea.A US $24 billion corporation with a market cap. of US $31.5billion and in the League of Fortune 500, the Aditya Birla Group is anchored by an extraordinaryforce of 100,000 employees, belonging to 25 different nationalities. Over 50 per cent of its revenuesflow from its operations across the world.Its 66 state-of-the-art manufacturing units and sectoralservices span India, Thailand, Indonesia, Malaysia, Philippines, Egypt, Canada, Australia andChina.The Aditya Birla Group is a dominant player in all of the sectors in which it operates. Thesesectors include viscose staple fibre, non-ferrous metals, cement, viscose filament yarn, brandedapparel, carbon black, chemicals, fertilisers, sponge iron, insulators and financial services. In India,the Group has been adjudged “The Best Employer in India and among the top 20 in Asia” by theHewitt-Economic Times and Wall Street Journal Study 2007. 25
  26. 26. Derivatives (Futures & Options) CHAPTER-IIIREVIEW OF LITERATURE 26
  27. 27. Derivatives (Futures & Options) REVIEW OF LITERATUREThe turnover of the stock exchange has been tremendously increasing from last 10years. The number of trades and the number of investors, who are participating, haveincreased. The investors are willing to reduce their risk, so they are seeking for the riskmanagement tools.Prior to SEBI abolishing the BADLA system, the investors had this system as asource of reducing the risk, as it has many problems like no strong margining system,unclear expiration date and generating counter party risk. In view of this problemSEBI abolished the BADLA system.After the abolition of the BADLA system, the investors are seeking for a hedgingsystem, which could reduce their portfolio risk. SEBI thought the introduction of thederivatives trading, as a first step it has set up a 24 member committee under thechairmanship of Dr. L.C. Gupta to develop the appropriate framework for derivativestrading in India, SEBI accepted the recommendation of the committee on May 11,1998 and approved the phase introduction of the derivatives trading beginning withstock index futures.There are many investors who are willing to trade in the derivatives segment, becauseof its advantages like limited loss unlimited profit by paying the small premiums. THE DEVELOPMENT OF DERIVATIVESHolding portfolios of securities is associated with the risk of the possibility that theinvestor may realize his returns, which would be much lesser than what he expected toget. There are various factors, which affect the returns: 27
  28. 28. Derivatives (Futures & Options) 1. Price or dividend (interest) 2. Some are internal to the firm like  Industrial policy  Management capabilities  Consumer‟s preference  Labour strike, etc.These forces are to a large extent controllable and are termed as non systematic risks. Aninvestor can easily manage such non-systematic by having a well-diversified portfolio spreadacross the companies, industries and groups so that a loss in one may easily be compensatedwith a gain in other. There are yet other of influence which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are: 1. Economic 2. Political 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all- individual stocks to move together in the same manner. We therefore quite often find stock prices falling from time to time in spite of company‟s earnings rising and vice versa. Rational Behind the development of derivatives market is to manage this systematic risk, liquidity in the sense of being able to buy and sell relatively large amounts quickly without substantial price concession. In debt market, a large position of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small 28
  29. 29. Derivatives (Futures & Options)size relative to many common stocks. Those factors favor for the purpose of bothportfolio hedging and speculation, the introduction of a derivatives securities that is onsome broader market rather than an individual security. GLOBAL DERIVATIVES MARKETThe global financial centers such as Chicago, New York, Tokyo and London dominatethe trading in derivatives. Some of the world‟s leading exchanges for the exchange-traded derivatives are:  Chicago Mercantile Exchange (CME) & London International financial Futures Exchange (LIFFE) (for currency & Interest rate futures)  Philadelphia Stock Exchange (PSE), London stock Exchange (LSE) & Chicago Board options exchange (CBOE) (for currency options)  New York Stock Exchange (NYSE) and London Stock Exchange (LSE). (for equity derivatives)  Chicago Mercantile Exchange (CME) and London Metal Exchange (LME). (for commodities)These exchanges account for a large portion of the trading volume in the respectivederivatives segment. NSE’s DERIVATIVES MARKETThe derivatives trading on the NSE commenced with S&P CNX Nifty index futureson June 12, 2000. The trading in index options commenced on June 4, 2001 andtrading in options on individual securities commenced on June 2, 2001, Single stockfutures were launched on November 9, 2001. Today, both in terms of volume andturnover, NSE is the largest derivatives exchange in India. Currently, the derivativescontracts have a maximum of 3-month expiration cycles. Three contracts areavailable for trading, with 1 month, 2 month & 3 month expiry. A new contract isintroduced on the next trading day following of the near month contract. 29
  30. 30. Derivatives (Futures & Options) REGULATORY FRAMEWORKThe trading of derivatives is governed by the provisions contained in the S C (R) Act,the SEBI Act, and the regulations framed there under the rules and byelaws of stockexchanges. In this chapter we look at the broad regulatory frame work for derivativestrading and the requirement to become a member and authorized dealers of the F&Osegment and the position limits as they apply to various participants.Regulation for Derivative Trading:SEBI set up a 24-member committed under Chairmanship of Dr.L.C.Gupta developthe appropriate regulatory framework for derivative trading in India. On May11, 1998SEBI accepted the recommendations of the committee and approved the phasedintroduction of derivatives trading in India beginning with stock index Futures.The provision in the SC(R) Act governs the trading in the securities. The amendmentof the SCR Act to include “DERIVATIVES” within the ambit of securities in the SCRAct made trading in Derivatives possible within the framework of the Act.  Any exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta committee report may apply to SEBI for grant of recognition under section 4 of the SCR Act, 1956 to start Derivatives Trading. The derivative exchange- /segment should have a separate governing council and representation of trading/clearing member shall be limited to maximum 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain approval of SEBI before start of Trading in any derivative contract.  The exchange shall have minimum 50 members. 30
  31. 31. Derivatives (Futures & Options) The members of an existing segment of the exchange will not automatically become the members of the derivatives segment. The members of the derivatives segment need to fulfill the eligibility conditions as lay down by the L. C. Gupta committee. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/clearing house. Clearing Corporation/Clearing House complying with the eligibility conditions as lay down by the committee have to apply to SEBI for grant of approval. Derivatives broker/dealers and Clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 lakh. The net worth of the member shall be computed as follows:o Capital + Free reserveso Less non-allowable assets viz., Fixed Assets Pledged securities Member‟s card Non-allowable securities (unlisted securities) Bad deliveries Doubtful debts and advance Prepaid expenses Intangible Assets 30% marketable securities The Minimum contract value shall not be less than Rs.2 Lakhs. Exchange should also submit details of the futures contract they purpose to introduce. 31
  32. 32. Derivatives (Futures & Options)  The trading members are required to have qualified approved user and sales persons who have passed a certification programmed approved by SEBI.  The L.C.Gupta committee report requires strict enforcement of “know your customer” rule and requires that every client shall be registered with the derivates broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure and obtain a copy of the same duly signed by the clients. ELIGIBILITY OF ANY STOCK TO ENTER IN DERIVATIVES MARKET  Non promoter holding (free float capitalization) not less than Rs.750crores from last 6 months.  Daily Average Trading value not less than 5 crores in last 6 months.  At least 90% of Trading days in last 6 months.  Non Promoters Holding at least 30%.  BETA not more than 4 (previous last 6 months) DESCRIPTION OF THE METHODThe following are the steps involved in the study.Selection of the Scrip:The scrip selection is done on a random and the scrip selected is M/s. Reliance PowerThe Lot is 500. Profitability position of the futures buyers and seller and also theoption holder and option writers is studied.Data Collection:The data of the M/s. Reliance Power has been collected from the “The EconomicTimes” and internet. The data consist of the January Contract and period of DataCollection is from 29th December 2008 to 29th January 2009.Analysis:The analysis consist of the tabulation of the data assessing the profitability position of 32
  33. 33. Derivatives (Futures & Options)the futures buyers and sellers and also option holder and the option Writer,representing the data with graphs and making the interpretation using Data. INTRODUCTION OF FUTURESFutures markets were designed to solve the problems that exist in forward markets. Afutures contract is an agreement between two parties to buy or sell an asset as a certaintime in the future at a certain price. But unlike forward contract, the futures contractsare standardized and exchange traded. To facilitate liquidity in the futures contract, theexchange specifies certain standard underlying instrument, a standard quantity andquality of the underlying instrument that can be delivered, (or which can be used forreference purpose in settlement) and a standard timing of such settlement. A futurescontract may be offset prior to maturity by entering into an equal and oppositetransaction. More than 90% of futures transactions are offset this way.The standardized items in a futures contract are:  Quantity of the underlying  Quality of the underlying  The date and the month of delivery  The units of price quotation and minimum price change  Location of settlement DEFINITIONA future contract is an agreement between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are special types offorward contracts in the sense that the former are standardized exchange-tradedcontracts. HISTORY OF FUTURESMerton Miller, the 1990 Nobel Laureate had said that “financial futures represent the 33
  34. 34. Derivatives (Futures & Options)most significant financial innovation of the last twenty years”. The first exchange thattraded financial derivatives was launched in Chicago in the year 1972. A division ofthe Chicago Mercantile Exchange, it was called the international monetary market(IMM) and traded currency futures. The brain behind this was a man called LeoMelamed, acknowledged as the “father of financial futures” who was then theChairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, theChicago Mercantile Exchange sold Contracts whose value was counted in millions. By1990, the underlying value of all contracts traded at the Chicago Mercantile Exchangetotaled 50 trillion dollars.These currency futures paved the way for the successful marketing of a dizzying arrayof similar products at the Chicago Mercantile Exchange, the Chicago Board of Tradeand the Chicago Board Options Exchange. By the 1990s, these exchanges were tradingfutures and options on everything from Asian & American Stock indexes to interest-rate swaps, and their success transformed Chicago almost overnight into the risk-transfer capital of the world. DISTINCTION BETWEEN FUTURES & FORWARDS CONTRACTSForward contracts are often confused with futures contracts. The confusion isprimarily because both serve essentially the same economic functions of allocatingrisk in the presence of futures price uncertainty. However futures are a significantimprovement over the forward contracts as they eliminate counterparty risk and offermore liquidity. Comparison between two as follows: FUTURES FORWARDS 1. Trade on an Organized Exchange 1. OTC in nature 2. Standardized 2. Customized 3. More Liquidity 3. Less Liquidity 4. Require Margin payment 4. No Margin Payment 5. Follows daily settlement 5. Settlement happens at end of period 34
  35. 35. Derivatives (Futures & Options) Table 2.1FEATURES OF FUTURES:  Futures are highly standardized.  The contracting parties need not pay any down payments.  Hedging of price risks.  They have secondary markets to.TYPES OF FUTURES:On the basis of the underlying asset they derive, the futures are divided into two types:  Stock futures  Index futures PARTIES IN THE FUTURES CONTRACT: There are two parties in a future contract, the buyer and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is who is SHORT on the futures contract. The pay off for the buyer and the seller of the futures of the contracts are as follows: 35
  36. 36. Derivatives (Futures & Options) PAY-OFF FOR A BUYER OF FUTURES Figure 2.1CASE 1:- The buyer bought the futures contract at (F); if the future price goes to E1then the buyer gets the profit of (FP).CASE 2:- The buyer gets loss when the future price goes less then (F), if the futureprice goes to E2 then the buyer gets the loss of (FL). 36
  37. 37. Derivatives (Futures & Options) PAY-OFF FOR A SELLER OF FUTURES: Figure 2.2F – FUTURES PRICEE1, E2 – SETTLEMENT PRICECASE 1:- The seller sold the future contract at (f); if the future goes to E1 then the seller gets the profit of (FP).CASE 2:- The seller gets loss when the future price goes greater than (F), if the future price goes to E2 then the seller gets the loss of (FL). 37
  38. 38. Derivatives (Futures & Options) MARGINSMargins are the deposits which reduce counter party risk, arise in a futures contract.These margins are collect in order to eliminate the counter party risk. There are threetypes of margins:Initial Margins:Whenever a futures contract is signed, both buyer and seller are required to post initialmargins. Both buyer and seller are required to make security deposits that areintended to guarantee that they will infact be able to fulfill their obligation. Thesedeposits are initial margins and they are often referred as purchase price of futurescontract.Marking to market margins:The process of adjusting the equity in an investor‟s account in order to reflect thechange in the settlement price of futures contract is known as MTM margin.Maintenance margin:The investor must keep the futures account equity equal to or greater than certainpercentage of the amount deposited as initial margin. If the equity goes less than thatpercentage of initial margin, then the investor receives a call for an additional depositof cash known as maintenance margin to bring the equity up to the initial margin. ROLE OF MARGINSThe role of margins in the futures contract is explained in the following example. ‟A‟sold a M/s. Reliance Power January futures contract to „B‟ at Rs.104.80; thefollowing table shows the effect of margins on the contract. The contract size of 38
  39. 39. Derivatives (Futures & Options)Reliance Power is 500. The initial margin amount is say Rs.14000/-, the maintenancemargin is 65% of initial margin. PRICING FUTURESPricing of futures contract is very simple. Using the cost-of-carry logic, we calculatethe fair value of the futures contract. Every time the observed price deviates from thefair value, arbitragers would enter into trades to captures the arbitrage profit. This isturn would push the futures price back to its fair value. The cost-of-carry model usedfor pricing futures is given below. F = SertWhere: F = Futures Price S = Spot price of the underlying R = cost of financing (using continuously compounded Interest rate) T = Time till expiration in years e = 2.71828 (OR) F=S (1+r-q) tWhere: F = Futures price q = Expected Dividend yield S = Spot price of the underlying t = Holding Period r = Cost of financing (or) interest rate . FUTURES TERMINOLOGYSpot price:The price at which an asset trades in the spot market.Futures price:The price at which the futures contract trades in the futures market.Contract cycle:The period over which contract trades. The index futures contracts on the NSE have 39
  40. 40. Derivatives (Futures & Options)one-month, two–month and three-month expiry cycle which expire on the lastThursday of the month. Thus a January expiration contract expires on the lastThursday of January and a February expiration contract ceases trading on the lastThursday of February. On the Friday following the last Thursday, a new contracthaving a three-month expiry is introduced for trading.Expiry date:It is the date specifies in the futures contract. This is the last day on which the contractwill be traded, at the end of which it will cease to exist.Contract size:The amount of asset that has to be delivered under one contract. For instance, thecontract size on NSE‟s futures market is 50 Nifties.Basis:In the context of financial futures, basis can be defined as the futures price minus thespot price. These will be a different basis for each delivery month for each contract. Ina normal market, basis will be positive. This reflects that futures prices normallyexceed spot prices.Cost carry:The relationship between futures prices and spot prices can be summarized in terms ofwhat is known as the cost of carry. This measures the storage cost plus the interest thatis paid to finance the asset less the income earned on the asset.Initial margin:The amount that must be deposited in the margin account at the time a futures contractis first entered into is known as initial margin.Marking-to-market:In the futures market, at the end of each trading day, the margin account is adjusted toreflect the investor‟s gain or loss depending upon the futures closing price. This iscalled marking-to-market. 40
  41. 41. Derivatives (Futures & Options)Maintenance margin:This is somewhat lower than the initial margin. This is set to ensure that the balance inthe margin account never becomes negative. If the balance in the margin account fallsbelow the maintenance margin, the investor receives a margin call and is expected totop up the margin account to the initial margin level before trading commences on thenext day. INTRODUCTIONIn this section, we look at the next derivative product to be traded on the NSE, namelyoptions. Options are fundamentally different from forward and futures contracts. Anoption gives the holder of the option the right to do something. The holder does nothave to exercise this right. In contrast, in a forward or futures contract, the two partieshave committed themselves to doing something. Whereas it costs nothing (exceptmargin requirement) to enter into a futures contracts, the purchase of an optionrequires as up-front payment. DEFINITIONOption is a type of contract between two persons where one grants the other the rightto buy a specific asset at a specific price within a specific time period. Alternativelythe contract may grant the other person the right to sell a specific asset at a specificprice within a specific time period. In order to have this right. The option buyer has topay the seller of the option premium. The assets on which option can be derived arestocks, commodities, indexes etc. If the underlying asset is the financial asset, then theoption are financial option like stock options, currency options, index options etc, andif options like commodity option. HISTORY OF OPTIONSAlthough options have existed for a long time, they we traded OTC, without muchknowledge of valuation. The first trading in options began in Europe and the US asearly as the 17th century. It was only in the early 1900‟s that a group of firms set up 41
  42. 42. Derivatives (Futures & Options)what was known as the put and call Brokers and Dealers Association with the aim ofproviding a mechanism for bringing buyers and sellers together. If someone wanted tobuy an option, he or she would contact one of the member firms. The firms would thenattempt to find a seller or writer of the option either from its own client of those ofother member firms. If no seller could be found, the firm would undertake to write theoption itself in return for a price.This market however suffered from two deficiencies. First, there was no secondarymarket and second, there was no mechanism to guarantee that the writer of the optionwould honor the contract. In 1973, Black, Merton and scholes invented the famedBlack-Scholes formula. In April, 1973 CBOE was set up specifically for the purposeof trading options. The market for option contract sold each day exceeded the dailyvolume of shares traded on the NYSE. Since then, there has been no looking back.Option made their first major mark in financial history during the tulip-bulb mania inseventeenth-century Holland. It was one of the most spectacular get rich quickbinges in history. The first tulip was brought into Holland by a botany professor fromVienna. Over a decade, the tulip became the most popular and expensive item inDutch gardens. The more popular they became, the more Tulip bulb prices beganrising. That was when options came into the picture. They were initially used forhedging. By purchasing a call option and tulip bulbs, a dealer who was committed to asales contract could be assured of obtaining a fixed number of bulbs for a set price.Similarly, tulip bulb growers could assure themselves of selling their bulbs at a setprice by purchasing put options. Later, however, options were increasingly used byspeculators who found that call options were an effective vehicle for obtainingmaximum possible gains on investment. As long as tulip prices continued toskyrocket, a call buyer would realize returns far in excess of those that could beobtained by purchasing tulip bulbs themselves. The writers of the put options alsoprospered as bulb prices spiraled since writers were able to keep the premiums and the 42
  43. 43. Derivatives (Futures & Options)options were never exercised. The tulip bulb market collapsed in 1636 and a lot ofspeculators lost huge sums of money. Hardest hit were put writers who were unable tomeet their commitments to purchase tulip bulbs. PROPERTIES OF OPTIONOptions have several unique properties that set them apart from other securities. Thefollowing are the properties of option:  Limited Loss  High leverages potential  Limited Life PARTIES IN AN OPTION CONTRACTBuyer/Holder/Owner of an option:The buyer of an option is one who by paying option premium buys the right but not theobligation to exercise his option on seller/writer.Seller/writer of an option:The writer of the call /put options is the one who receives the option premium and istheir by obligated to sell/buy the asset if the buyer exercises on him TYPES OF OPTIONSThe options are classified into various types on the basis of various variables. Thefollowing are the various types of options.I. On the basis of the underlying asset:On the basis of the underlying asset the option are divided into two types:INDEX OPTIONSThese options have the index as the underlying. Some options are European whileothers are American. Like index futures contract, index options contracts are also cash 43
  44. 44. Derivatives (Futures & Options)settled.STOCK OPTIONSStock options are options on the individual stocks. Options currently trade on over 500stocks in the United States. A contract gives the holder the right to buy or sell shares atthe specified price.II. On the basis of the market movements:On the basis of the market movements the option are divided into two types. They are:CALL OPTION:A call option is bought by an investor when he seems that the stock price movesupwards. A call option gives the holder of the option the right but not the obligation tobuy an asset by a certain date for a certain price.PUT OPTION:A put option is bought by an investor when he seems that the stock price movesdownwards. A put option gives the holder of the option right but not the obligation tosell an asset by a certain date for a certain price.III. On the basis of exercise of option:On the basis of the exercised of the option, the options are classified into two categories.AMERICAN OPTION:American options are options that can be exercised at any time up to the expiration date,most exchange-traded option are American.EUOROPEAN OPTION: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 anAmerican option are frequently deduced from those of its European counterpart. 44
  45. 45. Derivatives (Futures & Options) PAY-OFF PROFILE FOR BUYER OF A CALL OPTIONThe pay-off of a buyer options depends on a spot price of a underlying asset. Thefollowing graph shows the pay-off of buyer of a call option. Figure 2.3S = Strike price ITM = In the moneySP = Premium/ profit ATM = At the moneyE1 = Spot price 1 OTM = Out of the moneyE2 = Spot price 2SR = Profit at spot price E1CASE 1: (Spot price > Strike price) As the spot price (E1) of the underlying asset ismore than strike price (S). The buyer gets profit of (SR), if price increases more thanE1 then profit also increase more than (SR).CASE 2: (Spot price < Strike price) 45
  46. 46. Derivatives (Futures & Options)As a spot price (E2) of the underlying asset is less than strike price (s) The buyer getsloss of (SP); if price goes down less than E2 then also his loss is limited to hispremium (SP) PAY-OFF PROFILE FOR SELLER OF A CALL OPTIONThe pay-off of seller of the call option depends on the spot price of the underlyingasset. The following graph shows the pay-off of seller of a call option: Figure 2.4CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying is less than strike price (S). The seller gets the profit of (SP), if the price decreases less than E1 then also profit of the seller does not exceed (SP).CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S) the seller gets loss of (SR), if price goes more than E2 then the loss of the 46
  47. 47. Derivatives (Futures & Options) seller also increase more than (SR). PAY-OFF PROFILE FOR BUYER OF A PUT OPTIONThe pay-off of the buyer of the option depends on the spot price of the underlyingasset. The following graph shows the pay-off of the buyer of a call option. Figure 2.5CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the profit (SR), if price decreases less than E1 then profit also increases more than (SR).CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (s), 47
  48. 48. Derivatives (Futures & Options) the buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium (SP). PAY-OFF PROFILE FOR SELLER OF A PUT OPTIONThe pay-off of a seller of the option depends on the spot price of the underlying asset.The following graph shows the pay-off of seller of a put option. They are: Figure 2.6CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of (SR), if price decreases less than E1 than the loss also increases more than (SR).CASE 2: (Spot price > Strike price) 48
  49. 49. Derivatives (Futures & Options) As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of (SP), if price goes more than E2 than the profit of seller is limited to his premium (SP). FACTORS AFFECTING THE PRICE OF AN OPTIONThe following are the various factors that affect the price of an option they are:Stock price:The pay–off from a call option is a amount by which the stock price exceeds the strikeprice. Call options therefore become more valuable as the stock price increases andvice versa. The pay-off from a put option is the amount; by which the strike priceexceeds the stock price. Put options therefore become more valuable as the stock priceincreases and vice versa.Strike price:In case of a call, as a strike price increases, the stock price has to make a larger upwardmove for the option to go in-the-money. Therefore, for a call, as the strike priceincreases option becomes less valuable and as strike price decreases, option becomemore valuable.Time to expiration:Both put and call American options become more valuable as a time to expirationincreases.Volatility:The volatility of a stock price is measured of uncertain about future stock pricemovements. As volatility increases, the chance that the stock will do very well or verypoor increases. The value of both calls and puts therefore increase as volatilityincrease.Risk-free interest rate: 49
  50. 50. Derivatives (Futures & Options)The put options prices decline as the risk-free rate increases where as the prices of callalways increase as the risk-free interest rate increases.Dividends:Dividends have the effect of reducing the stock price on the x-dividend rate. This has anegative effect on the value of call options and a positive effect on the value of putoptions. PRICING OPTIONSAn option buyer has the right but not the obligation to exercise on the seller. The worstthat can happen to a buyer is the loss of the premium paid by him. His downside islimited to this premium, but his upside is potentially unlimited. This optionality isprecious and has a value, which is expressed in terms of the option price. Just like inother free markets, it is the supply and demand in the secondary market that drives theprice of an option.There are various models, which help us get close to the true price of an option. Mostof these are variants of the celebrated Black-Scholes model for pricing Europeanoptions. Today most calculators and spreadsheets come with a built-in Black-Scholesoptions pricing formula so to price options we don‟t really need to memorize theformula. All we need to know is the variables that go into the model.The Black-scholes formulas for the price of European calls and puts on a non-dividendpaying stock are: CALL OPTION C = SN (D1)-Xe-r t N (D2) PUT OPTION P = Xe-r t N (-D2)-SN (-D1) Where d1 = Ln(S/X) + (r+ v2/2) t v/t And d2 = d1- v/t Where: CA = VALUE OF CALL OPTION PA = VALUE OF PUT OPTION S = SPOT PRICE OF STOCK 50
  51. 51. Derivatives (Futures & Options) N = NORMAL DISTRIBUTION VARIANCE (v) = VOLATILITY X = STRIKE PRICE r = ANNUAL RISK FREE RETURN t = CONTRACT CYCLE e = 2.71828 r = in (1+r) OPTIONS TERMINOLOGYOption price/premium:Option price is the price, which the option buyer pays to the option seller; it is alsoreferred to as the option premium.Expiration Date:The date specified in the options contract is known as expiration date, the exercisedate, the strike date or the maturity.Strike price:The price specified in the options contract is known as strike price or Exercise price.In-the-money option:An In-the-money (ITM) option is an option that would lead to positive cash flow tothe 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 ( > strike price). If the index is much higher than the strike price, the call is said tobe 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 cash flow if it isexercised immediately. An option on the index is at-the-money when the current indexequals 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 negative cash flow 51
  52. 52. Derivatives (Futures & Options)if it is exercised immediately. A call option on the index is out-of-the-money when thecurrent index stands at a level which is less than the strike price (i.e. spot price < strikeprice). 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 money:The option premium can be broken down into two components-intrinsic value andtime value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. Ifthe call is OTM, its intrinsic value is zero.Time value of an option:The time value of an option is the difference between its premium and its intrinsicvalue. Both CALL and PUT have time value. An option that is OTM or ATM has onlytime value. Usually, the maximum time value exists when the option is ATM. Thelonger the time to expiration, the greater is an option‟s time value, all else equal. Atexpiration, an option should have no time value. DISTINCTION BETWEEN FUTURES AND OPTIONS FUTURES OPTIONS 1.Exchange traded, with Novation 1.Same in nature 2.Exchange defines the product 2.Same in nature 3.Price is zero, strike Price moves 3.Strike price is fixed, price moves 4.Price is zero 4.Price is always positive 5.Linear payoff 5.Nonlinear payoff 6.Both long & Short at risk 6.only short at risk Table 2.2 52
  53. 53. Derivatives (Futures & Options) INTRODUCTIONThe futures & options trading system of NSE, called NEAT-F&O trading system,provides a fully automated screen-based trading for Nifty futures & options and stockfutures & options on a nationwide basis as well as online monitoring and surveillancemechanism. It supports an order driven market and provides complete transparency oftrading operations. It is similar to that of trading of equities in the cash marketsegment.The software for the F&O market has been developed to facilitate efficient andtransparent trading in futures and options instruments. Keeping in view the familiarityof trading members with the current capital market trading system, modifications havebeen performed in the existing capital market trading system so as to make it suitablefor trading futures and options.On starting NEAT (National Exchange for Automatic Trading) application, the log on(pass word) screen appears with the following details. 1. User ID 2. Trading Member ID 3. Password – NEAT CM (default pass word) 4. New Pass WordNote: - 1. User ID is a Unique 2. Trading Member ID is Unique & Function; it is common for all user of the Trading Member. 53
  54. 54. Derivatives (Futures & Options) 3. New password–Minimum 6 Characteristic, Maximum 8 characteristics only 3 attempts are accepted by the user to enter the password to open the screen. 4. If password is forgotten the user required to inform the exchange in writing to reset the password. TRADING SYSTEMNationwide online fully Automated Screen Based Trading System (SBTS)  Price priority  Time priorityNote: - 1. NEAT system provides open electronic consolidated limit orders book (OECLOB) 2. Limit order means: stated quantity and stated price Before Opening the marketUser allowed to set up: 1. market watch screen 2. inquiry screens onlyOpen phase (open Period):User allowed to 1. Enquiry 2. Order Entry 3. Order Modification 4. Order Cancellation 5. Order MatchingMarket Closing PeriodUser allowed only for inquires Surcon period 54
  55. 55. Derivatives (Futures & Options)(Surveillance & Control period)The system process the Date, for making the system, for the next trading day. Log of the Screen (Before Surcon Period)The screen shows: - 1. Permanent sign off 2. Temporary sign off 3. ExitPermanent sign off: Market not updates.Temporary sign off: Market up date (temporary sign off, after 5 minutesAutomatically Activate)Exit: The user comes out sign off screen. Local DatabaseLocal Database is used for all inquiries made by the user for own order/tradesinformation. It is used for corporate manager/ Branch Manager Makes inquiries fororders/trades of any branch manager/dealer of the trading firm, and then the inquiry isserviced by the host. The local database also includes message of security information. Ticker WindowThe ticker window displays information of all trades in the system. The user has theoption of selecting the security, which should be appearing in the ticker window. Securities in ticker can be selected for each market typesThe ticker window displays both derivative and capital market segment Market Watch WindowTitle Bar: Title Bar Shows: NEAT, Date & Time.Market watch window felicitate to set only 500 scrip‟s, but the user set up a Maximumof 30 securities in one page. 55
  56. 56. Derivatives (Futures & Options) Previous Trade ScreenPrevious trade screen shows & allows security wise information to user for his owntrade in chronological order. 1. Request for trade modification allowed with the following conditions  During the day only  Must be lower than the traded quantity  Both parties acceptance (Buyer & Seller)  Final Decision is taken by NSE (to accept or reject) 2. Request for trade cancellation allowed with same as above conditions (A). Outstanding order ScreenOutstanding order screen show, Status outstanding order enters by user for a particularsecurity (R.L. Order & SL Order) it allows: - order Modification & OrdersCancellation. Activity Log ScreenActivity logon screen show, all activities performed on any order by the user, inReversal Chronological Order B = Buying S = Selling orders OC = Cancellation of order OM = Modifying order TC = Buy order & Sell order, involving in trade and cancelled TM = Buy order & sell orders, involving trade is modifiedIt is very useful to a corporate manager to view all the activities that have beenperformed on any order (or) all ordered under his branches & dealers Order status screenOrder status screen shows, current status of “dealers” own specified orders. SNAP Quote Shows 56
  57. 57. Derivatives (Futures & Options)Instantaneous information about a particular security can be shown on Market watchwindow (which is not set up in market watch window) Market Movement OptionOver all movement of the security, in current day, on time basis. Market InquiryMarket inquiry screen shows market statistics for particular market, for a particularsecurity.It shows information about:- RL Market (Regular lot Market) RD Market (Retail Debt Market) OL Market (Odd lot Market)It shows following statistics:- open price, High price, Low price, Last Traded Price,Traded Quantity, 52 weeks high/low price. MBP (Market by Price)MBP (F6) screen shows total outstanding orders of a particular security, in the market,Aggregate at each price in order of Best 5 prices.It shows: - RL Market (Regular lot Market) SL Market (Stop Loss order) ST order (Special Term orders) Buy Back Order with „*‟ symbol P = indicate pre open position S = indicate Security Suspend Security/Portfolio listIt Facilitate the user to set up market watch screenAnd facilitate to set up his own portfolios ON-LINE Batch UpIt facilitates the user to take back up of all orders & trade related information, for 57
  58. 58. Derivatives (Futures & Options)current day only. ON-LINE/TABULAR SLIPSIt selects the format for conformation slipsAbout WindowThis window displays software related version numbers details and copy rightinformation.Most Activity Securities ScreenIt shows most active securities, based on the total traded value during the day Report Selection WindowIt facilitates to print each copy of report at any time. These reports are 1. Open order report: For details of outstanding orders 2. Order log report: For details of orders placed, modified & cancelled 3. Trade Done-today report: For details of orders traded 4. Market Statistics report: For details of all securities traded information in a day Internet BrokingNSE introduced Internet trading system from February 2000.Client place the order through brokers on order routing system. WAP (Wireless application protocol)NSE.IT Launches the from November 20001st Step-getting the permission from exchange for WAP2nd step-approved by the SEBI (SEBI Approved only for SEBI registered members) X.25 Address CheckX.25 Address Check is performed in the NEAT System, when the user log on into theNEAT, system & during report down load request. FTP (File Transfer Protocol) 1. NSE Provide for each member a separate directory (file) to know their trading DATA, clear DATA, bill trade Report. 2. NSE Provide in addition a “common” directory also, to know circulars, NCFM & Bhava Copy information 3. FTP is connected to each member through VSAT, leased line and Internet. 4. VSAT (FROM 4.15PM to 9.30AM), Internet (24Hours). Bhava Copy Database 58
  59. 59. Derivatives (Futures & Options)Bhava copy data provides summary information about each security, for each day(only last 7 days bhava copy file are stored in report directory.)Note: - Details in bhava copy-open price, high and low prices, closing prices tradedvalue, traded volume and No. of transactions. Snap Shot DatabaseSnap shot database provides snap shot of the limit order book at many time points in aday. Index DatabaseIndex Database provides information about stock market indexes. Trade DatabaseTrade database provides a database of every single traded order, take place inexchange. BASKET TRADING SYSTEM 1. Taking advantage for easy arbitration between future market and cash market difference, NSE introduce basket-trading system by offsetting position through off line-order-entry facility. 2. Orders are created for a selected portfolio to the ratio of their market capitalization from 1 lakh to 30 crores. 3. Offline-order-entry facility: Generate order file in as specified format outside the system & up load the order file into the system by invoking this facility in Basket Trading System. Participants in Security Market1) Stock Exchange (registered in SEBI)-23 stock Exchanges2) Depositaries (NSDL, CDSL)-2 Depositaries3) Listed Securities-9, 4134) Registered Brokers-9, 519 59
  60. 60. Derivatives (Futures & Options)5) FIIs-502 Investor Education & Protection FundThis fund used to educate & develop the awareness of the Investors. The followingfunds credited to IE & PF.1) Unpaid Dividends.2) Due for refund (application money received for allotment).3) Matured deposits & debentures with company.4) Government donations. Issue & Allotment of the Shares1) Issued & subscribing A. Either Physical or dematerialized. B. Issuing capital exceed 10 crores compulsory issued in dematerialized2) Trading compulsory in dematerialized form.3) Allotment made until the beginning of the 5th day after the day issue of prospectus.4) Listing is possible issuing not less than 10% of the total equity and minimum of 20Lakhs. Holding of Shares (Voting Right) disclosing obligation 1. Any person or Director or Officer or the company 2. More than 5% share or Voting Right 3. Within 4th day inform to company is necessary 4. Company inform with in 5th day to stock exchange is compulsory First StartedFuture Trading: Chicago Board of Trading 1848 60
  61. 61. Derivatives (Futures & Options)Financial Future Trading: CME (Chicago Mercantile Exchange 1919)Stock Index Futures: Kansas City Board of tradeOption First Trade: Holland – Tulip Balabmania. BROKER (Trading Member) (Broker means a member in recognized stock exchange)Eligibility: 21 Years, graduation, 2 years experience in stock market relative affairsand o 30 Lakhs paid up capital o 100 Lakhs net worth o 125 Lakhs interest free security deposit o 25 Lakhs collatery security deposit o 1 Lakh annual business subscription.Necessary Infrastructure: Office Space, Manpower, EquipmentDisciplinary proceedings: Not convicted involving fraud & DishonestyFitness: Not Bankrupt, not default in any stock exchange, not previously refused byNSE, fully discharged from Debts by creditors (self declaration) First send application to stock exchange for broker ship-stock exchange send that application to SEBI 30 days - SEBI satisfy above 1 & 2 points to grant Certificate of Registration. Maximum commission of the broker 2.5% (including sub broker commission 1.5%) on cash market and feature market buy and sell values but option market 2.5% is charged on (Strike Price + Premium value). Contract note issued and signed by broker or authorized signatory within 24hrs. On contract note printed both offices registered office & dealing office address is must. 61
  62. 62. Derivatives (Futures & Options) Each trading member (broker) in F&O segment of NSEIL (NSE India Limited) can have as many users are he wishes. Compliance officer is appointed by the Broker. Broker ship Transfer fee 1 Lakh. Dominant Promoters a) For Individual (not exceeding 4 members) his & his spouse not less than 51%-1 person Graduation is compulsory. b) For firm: - Not less than 51% his & his spouse, children‟s & brother‟s -1 person graduation is compulsory. c) Corporate Company: - Not less than 40% of the director‟s share holding (at least 50% each director) – 2 Directors Graduation is compulsory. BROKER & CLIENT RELATIONSHIP1. Fill the client Registration Application form (for all details of clients).2. Agreement on non-judicial form (specified by SEBI that form)3. PAN, Passport, Driving License or Voter Identity Card (SEBI Registration Numberin case of FII‟s)-pan cards are must to future and option trading.4. And then Allot-Unique Client Code.5. Take copy of instruction in writing before placing order, cancellation &modification.6. If order values exceed 1 Lakh maintain the client record for 7 years.7. On conformation any order issue contract note within 24hrs.8. Collect margin of 50,000 & multiple with 10,000.NOTE: - PAN is compulsory if the transaction cost exceed Rs.1 Lakh.9. Issuing the “Know your client” form is must. For Continuing Membership-Trading Member Fulfill the following documents 62
  63. 63. Derivatives (Futures & Options)1. Audited two important financial statement (profit & loss account, balance sheet)2. Net worth certificate (certificate by CA)3. Details of Directors, Share holders (certificate by CA)4. Renewal insurance covering proof. NSCCL CHARGED PENAL CHARGES (PENALTY POINTS) TO MEMBERS (CAUSING FOLLOWING FAILURES)1. Failure to funds obligations2. Failure to security delivery obligation3. Gross exposure turnover violations4. Margin shortages5. Security deposit shortage6. Client code modification & non-confirmation of custodial trades.NOTE: - Penalty points charged on calendar month basis. Maintaining & Preserving Books of Accounts by Trading Member1. Up to 5yrs must be maintaining these books, by trading member. a. Registrar of transaction (Saudha Book). b. Client ledger. c. General Ledger d. Journal e. Cash Book f. Bank Pass Book g. Document Register (particular of Securities received & delivered)2. Up to 2yrs must be maintaining these books, by trading member. a. Member contract book. b. Counter foils of contract notes c. Return consent of clients (at the time order place). 63
  64. 64. Derivatives (Futures & Options) SUB-BROKER1. Eligibility: - 21 years, 10+2 qualification and paid up capital 5 Lakhs.2. Not convicted involving fraud and dishonesty.3. Not debarred by SEBI previously.4. 51% of shares as dominant promoters his/her and his/her spouse.5. First application to stock exchange-stock exchange send his application to SEBI-SEBI satisfied issued certificate Registration.6. A registered sub-broker, holding registration, granted by SEBI on theRecommendations of a trading member, can transact through the member (broker)who had recommend his application for registration.7. Maximum Brokerage Commission 1.5%8. Purchase note and sales note issued by the sub broker with 24 hours. Investor Protection Fund1. Investor protection fund setup under Bombay public trust Act 1950.2. IPF maintained by NSE Exact mane of this fund is NSE Investors Protection FundTrust.3. Any Member defaulter the IPF paid maximum 10 Lakhs only to each investor.4. Client against default member, customers have right to apply within 3 months fromthe date of publishing notice by a widely circulated minimum one daily Newspaper. Demat of the Shares1. Agreement with depository by security holder (at the time opening the demat Account)2. Surrender the security certificates to “issuer” (company) for cancellation.3. Issuer (company) informs the “depository” about the transfer of the shares.4. Participant (company) informs the “depository” about the transfer of the shares.5. “Depository” records the “transferee” name as “beneficial owner” in “book entryform” in his records. 64