equity derivatives basics in bombay stock exchange

1. Equity Derivatives BOMBAY
STOCK EXCHANGE

2. Structure of equity derivatives
 Derivative is a product whose value is derived from the value of one or more basic variables, called
bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can
be equity, forex, commodity or any other asset.
 The price of this derivative is driven by the spot price of wheat which is the "underlying".
 Why derivative needed:
1. Price discovery: Derivatives play a crucial role in discovering the present and future price of any
commodity or financial asset. This is an essential part of an efficient economic system. Prices of stocks and
commodities tend to move in the same direction as the expectations of market participants. Hence, the
price in the futures market reveals the demand – supply expectation in the future and thus undertakes the
process of price discovery in the spot market.
2. Risk management: Derivatives are instruments meant to cover risks. Corporates, traders and individuals
use derivatives as a tool of risk management to cover the vagaries of price fluctuations
3. Speculative activity: Speculators, due to their volume of activity, drives prices in one direction and then,
in the other causing upward and downward movements in prices. What drives them is not fundamentals
but mass sentiments. Irrational speculators may get lost in the process of speculation. But, rational
speculators would jump in on any mispricings in the market and this results in the price being brought back
to equilibrium

3. TYPES OF EQUITY DERIVATIVES
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps.
We take a brief look at various derivatives contracts that have come to be used.
 Forwards: A forward contract is a customized contract between two entities, where settlement takes place on
a specific date in the future at today's pre-agreed price.
 Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. Futures contracts are special types of forward contracts in the sense that the former
are standardized exchange-traded contracts.
 Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer
the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a
given date.
forward future option warrants leaps baskets
swaps
• Insert rate swaps
• Currency swaps
swapation

4.  Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.
 LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years.
 Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average of a basket of assets. Equity index options are a form of basket
options
 Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite direction.
 Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls
and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay
fixed and receive floating.

5.  ARBITRAGE :Arbitrage means the buying and selling of shares,
commodities, futures, options or any combination of such products in
different markets at the same time to take advantage of any mis-pricing
opportunities in such market
 HEDGERS: Hedgers are people who are attempting to minimize their risk.
Hedging is meant for minimizing losses, not maximizing profits. Hedging
helps to create a more certain outcome, not a better outcome.

6. Derivative of Equities traded
Derivative
Future: Minimum
lot size of Rs5 lac
and margin of
~10% ie Rs50,000
Stock future e.g.
Infosys future
Index future eg.
Nifty future
Option: Only
margin amount
needed
Index Option e.g.
Nifty option index
Stock Option e.g
Dish TV option

7. SEBI set up a 24- member committee under the Chairmanship of Dr. L. C. Gupta to
develop the appropriate regulatory framework for derivatives trading in India. On May 11,
1998 SEBI accepted the recommendations of the committee and approved the phased
introduction of derivatives trading in India beginning with stock index futures. The
provisions in the SC(R)A and the regulatory framework developed there under govern
trading in securities. The amendment of the SC(R)A to include derivatives within the ambit
of ‘securities’ in the SC(R)A made trading in derivatives possible within the framework of
that Act.
1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta
committee report can apply to SEBI for grant of recognition under Section 4 of the
SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should
have a separate governing council and representation of trading/clearing members
shall be limited to maximum of 40% of the total members of the governing council.
The exchange would have to regulate the sales practices of its members and would
have to obtain prior approval of SEBI before start of trading in any derivative
contract.
2. The Exchange should have minimum 50 members.
3. The members of an existing segment of the exchange would not automatically
become the members of derivative segment.
Terms condition while trading or doing transactions

8. 4. The clearing and settlement of derivatives trades would be through a SEBI
approved clearing corporation/house.
5. The minimum networth for clearing members of the derivatives clearing
corporation/house shall be Rs.300 Lakh.
6. The networth of the member shall be
computed as follows:
Capital + Free reserves Less non-allowable assets viz.,
(a) Fixed assets(b) Pledged securities(c) Member’s card(d) Non-allowable securities(unlisted
securities)(e) Bad deliveries(f) Doubtful debts and advances(g) Prepaid expenses(h) Intangible
assets(i) 30% marketable securities
7. The minimum contract value shall not be less than Rs.2 Lakh
8. The L. C. Gupta committee report requires strict enforcement of “Know your
customer” rule and requires that every client shall be registered with the derivatives
Broker

9. Performance of Future and option over a period
Futures are financial contracts where the underlying asset is an individual stock. Stock Future
contract is an agreement to buy or sell a specified quantity of underlying equity share for a future
date at a price agreed upon between the buyer and seller. The contracts have standardized
specifications like market lot, expiry day, unit of price quotation, tick size and method of settlement.
An option is a financial derivative that represents a contract sold by one party (the option writer) to
another party (the option holder). The contract offers the buyer the right, but not the obligation, to
buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price)
during a certain period of time or on a specific date (exercise date). 2 types of option as follows:
CALL OPTIONS)
PUT OPTIONS
Option buyer or option
holder
Buys the right to buy
the underlying asset at
the specified price
Buys the right to sell
underlying asset at the
specified price
Option seller or option
writer
Has the obligation to
sell the underlying
asset (to the option
holder) at the specified
price.
Has the obligation to
buy the underlying
asset (from the option
holder) at the specified
price

10. Risk management
Risks faced by investors are categorized into two types. They are
1) Systematic Risk : systematic risks arise from developments which affect the
entire system (for example the entire stock market might be affected by a major
earthquake or a war).
2) Non-systematic (unique risk):Unique risks are specific to each share. Thus the
market might go up, while a particular share might move down.
Managing risk
Risk Management is a process whereby the company (could be a broker, institution,
stock exchange) lays down a clear process of how its risks should be managed.
The process will include:
• Identifying risk
• Deciding how much credit should be given to each client
• Deciding the frequency of collection of margins
• Deciding how much risk is acceptable
• Controlling risk on continuous basis • Monitoring risk taken on continuous basis

11. Complaints handle
 Investors' Grievances against Listed Companies
 Investors' complaints against listed companies are forwarded by BSE to the concerned
companies, with a copy sent to the complainant. The investors are advised to inform BSE if
the complaints are not resolved within 30 days.
 Investors are expected to submit their complaints in the prescribed Complaint format to the
nearest Regional Investor Service Centre of BSE on the basis of an investor's address.
 (b) Investors' Grievances against BSE's Trading Members
Investors are expected to submit their complaints in the prescribed Complaint Form.

12.  Derivatives that trade on an exchange are called exchange traded
derivatives, whereas privately negotiated derivative contracts are called
OTC contracts.
 There has been some progress in addressing these risks and perceptions.
 The progress has been limited in implementing reforms in risk
management, including counterparty, liquidity and operational risks, and
OTC derivatives markets continue to pose a threat to international financial
stability. The problem is more acute as heavy reliance on OTC derivatives
creates the possibility of systemic financial events, which fall outside the
more formal clearing house structures.
Over the contract derivatives

13. Exchange compares with other exchange of similar nature
Equity derivatives exchange traded OTC (Over The Counter) derivatives
They are traded on exchange Trade in OTC market
Are standardized Are customized
Identify of counter parties is irrelevant Identity is relevant
It is regulated It is not regulated
Marked to market No marking to market
Easy to terminate Difficult to terminate
Less costly More costly (one to one contract)

14. Settlement of transactions
 All transactions in all groups of securities in the Equity segment and Fixed Income securities listed on BSE are required to be
settled on T+2 basis (w.e.f. from April 1, 2003). The settlement calendar, which indicates the dates of the various settlement
related activities, is drawn by BSE in advance and is circulated among the market participants.
 The pay-in and payout of funds and securities takes places on the second business day (i.e.,
excluding Saturday, Sundays and bank and BSE trading holidays) of the day of the execution of the
trade.
DAY ACTIVITY
T
•Trading on BOLT and daily downloading of statements showing details of transactions and margins at the
end of each trading day.
•Downloading of provisional securities and funds obligation statements by member-brokers.
•6A/7A* entry by the member-brokers/ confirmation by the custodians.
T+1
•Confirmation of 6A/7A data by the Custodians upto 1:00 p.m. Downloading of final securities and funds
obligation statements by members
T+2
•Pay-in of funds and securities by 11:00 a.m. and pay-out of funds and securities by 1:30 p.m. The
member-brokers are required to submit the pay-in instructions for funds and securities to banks and
depositories respectively by 10:40 a.m.
T+2 •Auction on BOLT at 2.00 p.m.
T+3 •Auction pay-in and pay-out of funds and securities by 09:30 a.m. and 10:15 a.m. respectively.

15. Conclusion and recommendation
 As per data there is no comparison between future and option. Future is
choose for a long term bases where as option is choose for short term
period.
 But for further classification we will recommend for future as over the
option, because the future are customized contracts between two parties
where each party is under an obligation to fulfil the contract at a
predetermined priced at a predetermined date.
 option contracts are those where option seller has option to buy or sell
share at a predetermined price at a predetermined date.