Comperative Study on Derivative Markets


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Comperative Study on Derivative Markets

  1. 1. A <br />Project Report <br />On<br />Comparative Study on Derivative Markets<br />With Reference To<br />Share Khan Limited<br />Submitted in partial fulfillment of<br />Post graduate Diploma in Management<br /> Batch<br /> 2010-12<br />Submitted By<br />Pramod Kumar Maurya<br />Prof. Bhagya Rao Dr. Sabyasachi Rath<br />Faculty GuideDirector Academics<br />Declaration<br />I Mr. Pramod Kumar Maurya hereby declare that the project titled “ Study on Derivative Market “is an original work carried out under the guidance of Prof. Bhagya Rao .The report submitted is a bonafide work of my own efforts and has not been submitted to any institute or published before.<br />Pramod Kumar Maurya<br />Date: <br />Place: Hyderabad<br />Faculty Guide Certificate<br />I Prof. Bhagya Rao certify Mr. Pramod Kumar Maurya that the work done and the training undertaken by him is genuine to the best of my knowledge and acceptable.<br />Signature<br />(Prof. Bhagya Rao)<br />Date: July, 2011<br /> ACKNOWLEDGEMENT<br />Apart from the effort of mine, the success of any project depends largely on the encouragement and guidelines of many others. I take this opportunity to express my gratitude to the people who have been instrumental in the successful completion of this project.<br /> I immensely pleased to express my profound gratitude to Prof. S. Bhagya Rao, Vishwa Vishwani Institute of System and Management, Hyderabad, without whose patient and involved guidance this project would not have seen the light of the day.<br /> I would like thanks to Director Academics Dr. Sabysachi Rath and Director Operation Prof. Mir Irfan Ul Haq and faculty members of Vishwa Vishwani Institute of System and Management, Hyderabad for providing me the opportunity to work in a professional environment.<br /> I also extent my gratitude to “Share Khan Limited” for giving this project an identity and to me an opportunity to represent the premier institute of professional world. For this I would like to thank my project guider (Mr. K. P. Singh, Branch Manager).<br /> Without support of all other employees, my project would not have been completed, so I am also equally thankful to all employees of Share khan limited.<br />Pramod Kumar Maurya<br />INDEX<br />Chapter. No.Content.Page NoExecutive Summary1Chapter 1Introduction4Chapter 2Company Profile11Industry Profile14Literature Review24Chapter3Research Methodology65Chapter 4Data CollectionAnalysis & Interpretation 68Chapter 5Findings84Recommendations85Conclusions86BibliographyBooks/Article Referred87Websites Referred 88Questionnaire 89<br /> <br /> Executive Summary<br />Derivatives or derivative securities are contracts which are written between two parties (counterparties) and whose value is derived from the value of underlying widely-held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short term and long-term and long term financial instruments or intangible things like commodities price index (inflation rate), equity price index or bond piece index. The counterparties to such contracts are those other than the original issuer (holder) of the underlying asset..<br />The values of derivatives and those of their underlying assets are closely related. Usually, in trading derivatives, the taking or making of delivery of underlying assets is not involved; the transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims which can be traded in respect of underlying assets. Derivatives are “off balance sheet” instruments, a fact that is said to obscure the leverage and financial might they give to the party. They are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the companies (warrants, convertibles being the exceptions). Although the standardized, general, exchange-traded derivatives are being contracts which are in vogue and which expose the users to operational risk, counterparty risk, liquidity risk, and legal risk. There is also an uncertainty about the regulatory status of such derivatives.<br />The primary purposes of a derivative contract is to transfer “risk” from one party to another i.e. risk in a financial sense is transfer from a party that is willing to take it on. Here, the risk that is being dealt with is that of price risk. The transfer of such a risk can therefore be speculative in nature or act as a hedge against price movement in a current or anticipated physical position.<br />There are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously: plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC-traded, standardized or organized-exchange traded. Although we are not going to discuss all of them, the names of certain derivatives may be noted here: futures, options, range forward and ratio range forward options, swaps, warrants, convertible bonds, credit derivatives, captions, swap options, futures options, the ratio swaps, periodic floors, spread lock one and two, treasury-linked swaps, wedding bands three and six, inverse floaters, index amortizing swaps, and so on; because of their complexity, derivatives have become a continuing pain for the accounting person and a true mind-bender for anyone trying to value them.<br />The turnover of the stock exchanges has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Mutual funds, FIIs and other investors who are deprived of hedging (i.e. risk reducing) opportunities will now have a derivatives market to bank on. <br /> <br /> Chapter -1<br /> Introduction:<br />DEFINITION:<br /> Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. <br />Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to include:-<br />1. A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.<br />2. A contract, which derives its value from the prices, or index of prices, of underlying securities. <br />The above definition conveys:<br />1-That derivative is financial products and derives its value from the underlying assets.<br />2- Derivative is derived from another financial instrument/contract called the underlying. In this case of nifty index is the underlying. <br /> <br />PARTICIPANTS/USES OF DERIVATIVES: <br />Hedgers use for protecting (risk-covering) against adverse movement. Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.<br />Speculators to make quick fortune by anticipating/forecasting future market movements. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Speculators on the other hand arte those classes of investors who willingly take price risks to profit from price changes in the underlying. <br />Arbitrageurs to earn risk-free profits by exploiting market imperfections. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in the two different markets. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets.<br />FUNCTIONS OF DERIVATIVES MARKET:<br />The following are the various functions that are performed by the derivatives markets. They are:<br />Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. <br />Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.<br />Derivative trading acts as a catalyst for new entrepreneurial activity.<br />Derivatives markets help increase savings and investment in the long run.<br />TYPES OF DERIVATIVES:<br /> Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products, in recent years, the market for financial derives has grown tremendously in terms of variety of instruments depending on their complexity and also turnover. In this class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for their growing use.<br />The most commonly used derivatives contracts are forwards, futures and options. Here we take a brief look at various derivatives contracts that have come to be used. <br />CLASSIFICATION OF DERIVATIVES:<br />ETF (Exchange Traded Fund)<br />OTF ( Out Side Traded Fund)<br />ETF (Exchange Traded Fund):<br />An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day.<br />Futures <br />Options<br />OTF (Out Side Traded Fund):<br /> Forwards<br /> Swaps <br /> Warrants <br /> Leaps<br /> Baskets <br />OTF (FORWARDS, SWAPS, WARRANTS, LESAPS, BASKETS)<br />Forwards: <br /> 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.<br />Futures: <br /> 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 exchanged-traded contracts.<br />Options:<br />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.<br />Warrants:<br />Options generally have lives of up to 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.<br />Swaps:<br />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. <br />The two commonly used swaps are:<br />Interest rate swaps: <br />These entail swapping only the interest related cash flows between the<br />Parties in the same currency.<br />Currency swaps:<br />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.<br />Swaptions: <br />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.<br /> Chapter -2<br />Company profile:<br />ABOUT SHAREKHAN LIMITED<br />Share khan Limited is one of the fastest growing financial services providers with a focus on equities, derivatives and commodities brokerage execution on the National Stock Exchange of India Ltd. (NSE), Bombay Stock Exchange Ltd. (BSE), National Commodity and Derivatives Exchange India (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX). Share khan provides trade execution services through multiple channels - an Internet platform, telephone and retail outlets and is present in 280 cities through a network of 704 locations. The company was awarded the 2005 Most Preferred Stock Broking Brand by Awwaz Consumer Vote.<br />ORIGIN<br /><ul><li>Sharekhan traces its lineage to SSKI, an organization with more than decades of trust and credibility in the stock market.
  2. 2. Pioneers of online trading in India- was launched in 2000 and is now the second most visited broking site in India.
  3. 3. Has one of the largest networks of Share shops in the country. </li></ul>SHAREHOLDING PATTERN<br />SHAREHOLDERSHOLDINGSCITI Venture Capital and other Private Equity Firm81%IDFC9%Employees10%<br />MANAGRMENT TEAM CONSISTS OF-<br />NAMEPOSTTarun ShahChief Executive Officer and DirectorMr.Pathik GandotraHead Of ResearchMr. Rishi KohliVice President Of Equity Derivative <br /> Mr. Nikhil Vora Vice President of Research<br /> Tushar Kamath Secretary <br />Sharekhan Limited offers blend of tradition and technology like Share shops, dial-n-trade and online trading- where there is choice of three trading interfaces which are speed trade exe for active trader, web based classic interface for investor, web based applet- fast trade for investor. Sharekhan Limited was formerly known as SSKI Investor Services Private Limited. The company is based in Mumbai, India <br /> <br />its address is- A-206 Phoenix House, 2nd Floor<br /> Senapati Bapat Marg, Lower Parel<br /> Mumbai, 400013. India<br /> Phone: 91 22 24982000<br /> Fax: 91 22 24982626<br /><br /> Industry Profile<br />FINANCIAL MARKET:<br />Financial markets are helpful to provide liquidity in the system and for smooth functioning of the system. These markets are the centers that provide facilities for buying and selling of financial claims and services. The financial markets match the demands of investment with the supply of capital from various sources.<br /> <br />According to functional basis financial markets are classified into two types.<br />They are:<br />Money markets (short-term)<br />Capital markets (long-term)<br />According to institutional basis again classified in to two types. They are <br />Organized financial market<br />Non-organized financial market.<br />The organized market comprises of official market represented by recognized institutions, bank and government (SEBI) registered/controlled activities and intermediaries. The unorganized market is composed of indigenous bankers, moneylenders, individual professional and non-professionals.<br />MONEY MARKET:<br />Money market is a place where we can raise short-term capital.<br />Again the money market is classified in to <br />Interbank call money market <br />Bill market <br /> E.g.; treasury bills, commercial papers, CD's etc. <br /> CAPITAL MARKET:<br />Capital market is a place where we can raise long-term capital.<br />Again the capital market is classified in to two types and they are<br />Primary market and <br />Secondary market.<br /> E.g.: Shares, Debentures, and Loans etc.<br />PRIMARY MARKET:<br /> Primary market is generally referred to the market of new issues or market for mobilization of resources by the companies and government undertakings, for new projects as also for expansion, modernization, addition, diversification and up gradation. Primary market is also referred to as New Issue Market. Primary market operations include new issues of shares by new and existing companies, further and right issues to existing shareholders, public offers, and issue of debt instruments such as debentures, bonds, etc.<br />The primary market is regulated by the Securities and Exchange Board of India (SEBI a government regulated authority).<br />FUNCTION:<br />The main services of the primary market are origination, underwriting, and distribution. Origination deals with the origin of the new issue. Underwriting contract make the shares predictable and remove the element of uncertainty in the subscription. Distribution refers to the sale of securities to the investors.<br />The following are the market intermediaries associated with the market:<br />Merchant banker/book building lead manager<br />Registrar and transfer agent<br />Underwriter/broker to the issue<br />Adviser to the issue<br />Banker to the issue<br />Depository<br />Depository participant<br /> INVESTORS’ PROTECTION IN THE PRIMARY MARKET:<br />To ensure healthy growth of primary market, the investing public should be protected. The term investor protection has a wider meaning in the primary market. The principal ingredients of investors’ protection are: <br />Provision of all the relevant information <br />Provision of accurate information and<br />Transparent allotment procedures without any bias.<br />SECONDARY MARKET<br />The primary market deals with the new issues of securities. Outstanding securities are traded in the secondary market, which is commonly known as stock market or stock exchange. “The secondary market is a market where scrip’s are traded”. It is a market place which provides liquidity to the scrip’s issued in the primary market. Thus, the growth of secondary market depends on the primary market. More the number of companies entering the primary market, the greater are the volume of trade at the secondary market. Trading activities in the secondary market are done through the recognized stock exchanges which are 23 in number including Over the Counter Exchange of India (OTCE), National Stock Exchange of India and Interconnected Stock Exchange of India.<br />Secondary market operations involve buying and selling of securities on the stock exchange through its members. The companies hitting the primary market are mandatory to list their shares on one or more stock exchanges in India. Listing of scrip’s provides liquidity and offers an opportunity to the investors to buy or sell the scrip’s. <br />The following are the intermediaries in the secondary market:<br />Broker/member of stock exchange – buyers broker and sellers broker<br />Portfolio Manager<br />Investment advisor<br />Share transfer agent<br />Depository<br />Depository participants.<br /> STOCK MARKETS IN INDIA:<br />Stock exchanges are the perfect type of market for securities whether of government and semi-govt bodies or other public bodies as also for shares and debentures issued by the joint-stock companies. In the stock market, purchases and sales of shares are affected in conditions of free competition. Government securities are traded outside the trading ring in the form of over the counter sales or purchase. The bargains that are struck in the trading ring by the members of the stock exchanges are at the fairest prices determined by the basic laws of supply and demand.<br />Definition of a stock exchange:<br />“Stock exchange means any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.” The securities include:<br />Shares of public company.<br />Government securities.<br />Bonds <br />HISTORY OF STOCK EXCHANGES:<br />The only stock exchanges operating in the 19th century were those of Mumbai setup in 1875 and Ahmedabad set up in 1894. These were organized as voluntary non-profit-marking associations of brokers to regulate and protect their interests. Before the control on securities under the constitution in 1950, it was a state subject and the Bombay securities contracts (control) act of 1925 used to regulate trading in securities. Under this act, the Mumbai stock exchange was recognized in 1927 and Ahmedabad in 1937. During the war boom, a number of stock exchanges were organized. Soon after it became a central subject, central legislation was proposed and a committee headed by A.D.Gorwala went into the bill for securities regulation. On the basis of the committee’s recommendations and public discussion, the securities contract (regulation) act became law in 1956.<br /> FUNCTIONS OF STOCK EXCHANGES:<br />Stock exchanges provide liquidity to the listed companies. By giving quotations to the listed companies, they help trading and raise funds from the market. Over the hundred and twenty years during which the stock exchanges have existed in this country and through their medium, the central and state government have raised crores of rupees by floating public loans. Municipal corporations, trust and local bodies have obtained from the public their financial requirements, and industry, trade and commerce- the backbone of the country’s economy-have secured capital of crores or rupees through the issue of stocks, shares and debentures for financing their day-to-day activities, organizing new ventures and completing projects of expansion, diversification and modernization. By obtaining the listing and trading facilities, public investment is increased and companies were able to raise more funds. The quoted companies with wide public interest have enjoyed some benefits and assets valuation has become easier for tax and other purposes.<br /> Major stock exchanges are:<br /> <br />NSE (National Stock Exchage)<br />BSE (Bombay Stock Exchange)<br /> NSE (National Stock Exchage):<br />The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FI’s) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country. On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000<br />NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of:<br />Establishing a nation-wide trading facility for equities and debt instruments. <br />Ensuring equal access to investors all over the country through an appropriate communication network. <br />Providing a fair, efficient and transparent securities market to investors using electronic trading systems.<br />Enabling shorter settlement cycles and book entry settlements systems, and <br />Meeting the current international standards of securities markets.<br />The standards set by NSE in terms of market practices and technology, have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It's that force which is guiding the industry towards new horizons and greater opportunities.<br />BSE (Bombay Stock Exchange):<br />The Stock Exchange, Mumbai, popularly known as "BSE" was established in 1875 as "The Native Share and Stock Brokers Association". It is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was established in 1878. It is a voluntary non-profit making Association of Persons (AOP) and is currently engaged in the process of converting itself into demutualised and corporate entity. It has evolved over the years into its present status as the premier Stock Exchange in the country. It is the first Stock Exchange in the Country to have obtained permanent recognition in 1956 from the Govt. of India under the Securities Contracts (Regulation) Act 1956.The Exchange, while providing an efficient and transparent market for trading in securities, debt and derivatives upholds the interests of the investors and ensures redresses of their grievances whether against the companies or its own member-brokers. It also strives to educate and enlighten the investors by conducting investor education programmers and making available to them necessary informative inputs.<br />A Governing Board having 20 directors is the apex body, which decides the policies and regulates the affairs of the Exchange. The Governing Board consists of 9 elected directors, who are from the broking community (one third of them retire ever year by rotation), three SEBI nominees, six public representatives and an Executive Director & Chief Executive Officer and a Chief Operating Officer.The Executive Director as the Chief Executive Officer is responsible for the day-to-day administration of the Exchange and the Chief Operating Officer and other Heads of Department assist him.<br />The Exchange has inserted new Rule No.126 A in its Rules, Byelaws pertaining to constitution of the Executive Committee of the Exchange. Accordingly, an Executive Committee, consisting of three elected directors, three SEBI nominees or public representatives, Executive Director & CEO and Chief Operating Officer has been constituted. <br /> Literature Review<br />There are three Market in Derivatives:<br />: Forward<br />: Future<br />: Option<br /> Forward Contract<br /> A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes along position agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same rice. Other contract details like delivery date, the parties to the contract negotiate price and quantity bilaterally. The forward contracts are normally traded outside the exchanges.<br />The salient features of forward contracts are:<br />They are bilateral contracts and hence exposed to counter-party risk.<br />Each contract is custom-designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.<br />The contract price is generally not available in public domain.<br />On the expiration date, the contract has to be settled by delivery of the asset.<br />If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.<br /> However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction cost and increasing transaction volume. This process of standardization reaches its limit in the organized futures market.<br /> <br /> Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long the forward, wait for the price to raise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward market here supplies leverage to the speculator.<br />LIMITATIONS: <br />Forward markets worldwide are afflicted by several problems:<br /> Lack of centralization of trading, liquidity and counter-party risk in the first two of these, and the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable. Counter-party risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declare bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the liquidity, still the counter-party risk remains a very serious issue. <br /> Future Contract<br /> Futures markets were designed to solve the problems that exist in forward markets. Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 90 of futures transactions are offset this way.<br />The standardized items in a futures contract are:<br />Quantity of the underlying<br />Quality of the underlying<br />The date and month of delivery<br />The units of price quotations and minimum price changes <br />Location of settlement<br />FUTURES MARKET:<br /> The Chicago Board of Trade was the earliest one found, in 1848 and currently is the largest futures exchange in the world. The method of trading futures in the organized exchanges is similar in some ways to and different in other ways from the way stocks are traded. As with the stocks and in other ways from the way stocks are traded. As with the stocks and options, customers can pace market, limit and stop orders. Further more once an order is transmitted to an exchange floor, it must be taken to a destined spot for execution by a member of exchange, just as it is done for stocks and options. This spot is known as pit because of its shape, which is circular with a set of interior descending steps on which members stand.<br /> In futures market, there are floor brokers. They execute customer’s orders. In doing so they, (or their phone clerks) each keep a file of any stop or limit orders that cannot be executed, alternatively, members can be floor traders (those with very short holding periods, of less than a day, are known as locals or scalpers), they execute orders for their own personal accounts in an attempt to make profits by “buying low and selling high”.<br />CLEARING HOUSE:<br /> Each futures exchange has an associated clearinghouse that becomes the “seller’s buyer” and the “buyer’s seller” as the trade is concluded. The people associated with futures set up specifically the Chicago Board Options Exchange). Clearing house is in a risky position as there is a chance of not delivering to the seller or not paying by the buyer as it is like a mediator between the both. The procedure that protect the clearinghouse from such potential losses involving brokers<br />Impose initial margin requirements on both buyers and sellers<br />Mark to market the accounts of buyers and sellers everyday<br />Impose daily maintenance margin requirements of both buyers and sellers<br />Use no contracts are outstanding. Subsequently as people began to make transactions, the open interest grows. At any time open interest equals the amount that those with the short position (the seller) are currently obligated to deliver. It also equals the amount that with the long positions (the buyer) are obligated to receive.<br />Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. That is, both buyer and seller are required to make security deposit that they are intended to guarantee that they will be in fact be able to fulfill their obligations, accordingly initial margin is referred to as performance margin. The amount of this margin is roughly 5% to 15% of the total purchase price of the futures contract.<br />Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to affect the investor’s gain or loss depending upon the futures closing price. This is called marking to market.<br />Maintenance margin: This is somewhat lower than the initial margin. According to the maintenance margin requirement, the investor must keep the account’s equity equal or greater than certain percentage of the amount deposited as initial margin. Because this percentage is roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the requirement is not met the investor will receive a call. This call is a request to for an additional deposit of cash known as variation margin. <br />OPEN INTEREST:<br /> The number of contracts, which are outstanding for execution, is called open interest. When trading is first allowed in a contract, there is no open interest because no contract because no contracts are outstanding. Subsequently as people began to make transactions, the open interest grows. At any time open interest equals the amount that those with the short position (the seller) are currently obligated to deliver. It also equals the amount that with the long positions (the buyer) are obligated to receive.<br />BASIS:<br /> In the context of financial futures, basis can be defined as the difference between the current spot price on an asset (that is the price of the asset for immediate delivery) and the corresponding future price (that is the purchase price stated in the contract) is known as basis.<br /> Basis = current spot price – futures price.<br /> A person with a short position in a futures contract and a long position on a deliverable asset (means that he owns a asset) will profit if the basis is positive and widens or is negative and narrow). This is because the futures price will be falling or the spot price is rising (or both). A falling futures price benefits those who are short futures and a rising spot price benefits those who own the asset. Using the same type of reasoning it can be shown that this person will lose the basis is positive and narrow (or is negative and widens).<br />SETTLEMENT OF FUTURES<br />Mark to market settlement:<br /> There is a daily settlement for mark to market. The profits/losses are computed as the difference between the trade price (or the previous day’s settlement price, as the case may be) and the current day’s settlement price. The party who have suffered a loss are required to pay the mark to market loss amount to exchange which is in turn passed on to the party who has made a profit/. This is known as daily mark to market settlement.<br />Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below:<br /> F = S*RT<br />Where:<br />F=theoretical futures price<br />S=value of the underlying index/stock<br />R=rate of interest (MIBOR – Mumbai I Inter Offer Rate)<br />T=time to expiration<br />Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After daily settlement, all the open positions are reset to the daily settlement price. the pay-in and payout of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the broker passes to the client account.<br />Final settlement:<br /> On the expiry of the futures contracts, exchange marks all positions to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit/loss is computed as the difference between trade price (or the previous day’s settlement price, as the case may be), and the final settlement price of the relevant futures contract.<br />Final settlement loss/profit amount is debited/credited to the relevant broker’s clearing bank account on T+1 day (T = expiry day). This is then passed on the client from the broker. Open positions in futures contracts cease to exist after their expiration day.<br /> <br />DISTINCTION BETWEEN FUTURES AND FORWARDS<br /> <br /> Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of the allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more liquidity.<br />TERMS USED IN FUTURES CONTRACT:<br />Spot price: the price at which an asset trades in the spot market.<br />Futures price: the price at which the futures contract trades in the futures market.<br />Contract cycle: the period over which a contract trades. The index futures contracts on the NSE have one-month, tow-months ad three-month expiry cycle, which expires on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.<br />Expiry date: it is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.<br />Contract size: the amount of asset that has to be delivered less than one contract. For instance, the contract size on NSE’s futures market is 200 Nifties.<br />Cost of carry: the relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.<br /> <br /> Option Contract <br /> Options on stocks were first traded on an organized stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts.<br /> An option is a type of contract between two people where one grants the other party the right to buy a specific asset at specific priced within a specific time period. Alternatively, the contract may grant the other person the right to sell a specific asset at a specific price within a specific period of time.<br />The person who has received the right, and thus has a decision to make, is known as the option buyer because he or she must pay for this right.<br />The person who has sold the right, and thus must respond to the buyer’s decision is known as the option writer.<br />TYPES OF OPTION CONTRACT<br /> The two most basic types of option contracts are call option and put option. Currently such options are traded on many exchanges around the world. Furthermore, many of these contracts are created privately (“that is off exchange” or “over the counter”), typically involving institutions banking firms and their clients.<br />CALL OPTION:<br /> The most prominent type of option contract is call option for stocks. It gives the buyer the right to buy (“call away”) a specific number of shares of a specific company from the option writer at a specific purchase price at any time up to and including a specific date. <br />An investor buys a call options when he seems that the stock price moves upwards. A call option gives the holder of the option the right but not the obligation to buy an asset by a certain date for a certain price.<br />PUT OPTION:<br /> A second type of option for stocks is the put option. It gives the buyer the right to sell (“put away”) a specific number of shares of a specific company to the option writer at a specific selling price at any time up to and including a specific date. An investor buys a put option when he seems that the stock price moves downwards. A put option gives the holder of the option right but not the obligation to sell an asset by a certain date for a certain price.<br />Options clearing house:<br /> The Options Clearing House (OCC), a company that is jointly owned by several exchanges, generally facilitates trading in these options. It does so by maintaining a computer system that keeps track of all those options by recording the position of all those investors in each one. Although the mechanics are complex, the principles are simple. As soon as a buyer and a writer decide to trade a particular option contract and the buyer pass the agreed upon premium the OCC steps in becoming the effective writer as buyer is concerned the effective buyer as far as the seller is concerned. Thus at this time all directs links between original buyer and seller is served.<br />TRADING ON EXCHANGES:<br /> There are two types of exchanged-based mechanisms for trading options contracts. The focal point for trading either involves specialists or market makers.<br />SPECIALISTS:<br /> These people serve two functions, acting as both dealers and brokers. As dealers they keep an inventory of the stocks that are assigned to them and buy and sell from that inventory at bid and ask process, respectively. As brokers they keep limit order book and execute the orders in it a market moves up and down. Some option market such as American Stock Exchange, function in a similar manner. These markets have specialists who assigned specific options contract, and these specialists act as dealers and brokers in their assigned options. As with the stock exchanges, there may be floor traders, who trade solely for themselves, hoping to buy low and sell high, and floor brokers who handle orders from public.<br />MARKER MAKERS<br /> Other option markets such as Chicago Board Options Exchange, do not involve specialists, instead they involve market makers, who act solely as dealers and order both officials (previously known as board brokers), who keep the limit order book. The market makers must trade with floor brokers, who are the members of Exchange that handle orders from the public. In doing so the market makers have an inventory of options and quote bid and ask prices. Whereas there in only one specialist typically assigned to a stock, there usually is more than one market maker assigned to the option on a given stock.<br />COMMISSIONS:<br /> A commission must be paid to stockbroker whenever an option is either written, bought, sold. The size of the commission has been reduced substantially since the options began trading on organize exchanges in 1973. Furthermore this typically smaller than the commission that would be paid if the underlying stock had been purchased instead of option. This is probably because that clearing and settlement are easier with the options than stock. However, the investor should be aware that exercise an option will typically result in the buyer’s having to pay commission equivalent to the commission that would be incurred if the stock itself were being bought or sold.<br />MARGINS:<br /> Margins are the deposits, which reduce counter party risk, arise in a futures contract. These margins are collected in order to eliminate the counter party risk. There are three types of margins:<br />Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. That is, both buyer and seller are required to make security deposit that they are intended to guarantee that they will be in fact be able to fulfill their obligations, accordingly initial margin is referred to as performance margin. The amount of this margin is roughly 5% to 15% of the total purchase price of the futures contract.<br />Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to affect the investor’s gain or loss depending upon the futures closing price. This is called marking to market.<br />Maintenance margin: This is somewhat lower than the initial margin. According to the maintenance margin requirement, the investor must keep the account’s equity equal or greater than certain percentage of the amount deposited as initial margin. Because this percentage is roughly 5%, the investor must have equal 65% or greater than 65% of initial margin. If the requirement is not met the investor will receive a call. This call is a request to for an additional deposit of cash known as variation margin. <br /> In the case of a call, shares are to be delivered by the writer in return for the exercise price. In case of a put, cash has to be delivered in return for shares. In either case the net cost to the option writer will be the absolute difference the exercise price and the stocks market value at the time of exercise. As the OCCs at risk if the writer is unable to bear this cost, it is not surprising that the OCC would have a system in place protecting itself from the actions of the write. This system is known margin.<br />PARTIES IN AN OPTION CONTRACT:<br />Buyer of the Option:<br /> The buyer of an option is one who by paying option premium buys the right but not the obligation to exercise his option on seller/writer.<br /> <br />Writer/Seller of the Option:<br /> The writer of a call/put options is the one who receives the option premium and is there by obligated to sell/buy the asset if the buyer exercises the option on him.<br />SETTLEMENT OF OPTIONS<br />Daily premium settlement<br /> Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each broker at the client level to determine the net premium payable or receivable amount, at the end of each day. The brokers who have a premium payable position are required to pay the premium receivable position. This is known as daily premium settlement. The brokers in turn would take this from their clients. The pay-in and payout of the premium settlement is on T+1 days (T=Trade Day). The premium payable amounts are directly debited or credited to the broker, from where it is passed on to the client.<br />Interim Exercise Settlement for Options on Individual Securities:<br /> Interim exercise settlement for Option contracts on Individual Securities is affected for valid exercised option positions at in the money strike prices, at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in option contracts with the same series, on a random basis. The interim exercise settlement value is the difference between the strike price and the settlement price of the relevant option contract. Exercise settlement value is debited/credited to the relevant broker account in T+3 days (T=exercise date). From there it is passed on to the clients.<br />Final Exercise Settlement:<br /> Final Exercise Settlement is affected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the-money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts, exercise style is European style, while for options contracts on individual securities, exercise style is American style. Final Exercise is automatic on expiry of the option contracts.<br /> Exercise Settlement is cash settled by debiting/crediting of the clearing accounts of the relevant broker with the respective clearing bank, from where it is passed to the client. Final settlement profit/loss amount for option contracts on Index is debited/credited to the relevant broker clearing bank account on T+1 day (T=expiry day), from where it is passed Final Settlement profit/loss amount for option contracts on individual Securities is debited/credited to the relevant broker clearing bank account on T=3 day (T=expiry day), from where it is passed open positions, in option contracts, cease to exist after their expiration day.<br />Payoffs for an option buyer:<br /> The following example would clarify the basics on Call Options:<br />Illustration 1: An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear from the graph that even in the worst-case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though the buyer would make a profit of Rs.2 per share on the premium payment.<br />Payoff from Call Buying/Long (Rs.) SXtcPayoffNet Profit576020-2586020-2596020-2606020-2616021-162602206360231646024265602536660264<br />A European call option gives the following payoff to the investor: max (S - Xt, 0).The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).Notes:S - Stock PriceXt - Exercise Price at time 't'C - European Call Option PremiumPayoff - Max (S - Xt, O )<br />Payoffs from a put buying:<br />Put OptionsThe European Put Option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better:<br />Illustration 2:An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price<br />Payoff from Put Buying/Long (Rs.) SXtpPayoffNet Profit5560253566024257602315860220596021-1606020-2616020-2626020-2636020-2646020-2<br />The payoff for the put buyer is: max (Xt - S, 0)The payoff for a put writer is: -max(Xt - S, 0) or min(S - Xt, 0)<br />These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives create a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations.Factors affecting the price of an option:<br />The following are the various factors that affect the price of an option. They are:<br />Stock price:<br />The pay-off from a call option is the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa.<br />Strike price:<br />In the case of a call, as the strike price increases, the stock price has to make a larger upward move for the option to go in-the –money. Therefore, for a call, as the strike price increases, options become less valuable and as strike price decreases, options become more valuable.<br />Time to expiration:<br />Both Put and Call American options become more valuable as the time to expiration increases.<br />Volatility:<br />The volatility of n a stock price is a measure of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both Calls and Puts therefore increase as volatility increase.<br />Risk-free interest rate:<br />The put option prices decline as the risk – free rate increases where as the prices of calls always increase as the risk – free interest rate increases.<br />Dividends:<br />Dividends have the effect of reducing the stock price on the ex dividend date. This has a negative effect on the value of call options and a positive affect on the value of put options.<br />OPTION VALUATION USING BLACK AND SCHOLES:<br /> The Black and Scholes Option Pricing Model didn’t appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well known the transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startling accurate option-pricing model. Black and Scholes can’t take all credit for their work; in fact their model is actually an improved version of a previous model developed by A. James Boness in Ph.D dissertation at the University of Chicago. Black and Scholes’ improvement son the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor and with the absence of assumptions regarding investor’s risk preferences.<br />THE MODEL:<br />C=SN (d1)-Ke (-r t) N (d2)<br />C=theoretical call premium<br />S=current stock price<br />T=time until option expiration<br />K=option striking price<br />R=risk free interest rate<br />N=cumulative standard normal distribution<br />E=exponentil terms (2.1783)<br />d1=in(s/k) + (r + s2/2) T<br />D2=d1 – St<br /> In order to understand the model itself, we divide it into two parts. The first part SN (d1) derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price(s) by the change in the call premium with respect to a change in the underlined stock price [N (d1)]. The second part of the model, ke (-r t) N (d2), gives the resent value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.<br />Assumptions of the Black and Scholes model:<br />The stock pays no dividend to option’s life: most companies pay dividends to their shareholders, so this might seem a serious limitations to the model considering the observation that higher dividend is elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend form the stock price.<br />European exercise terms are used: European exercise terms dictate thbat the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option,, making American options more valuable due to the greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.<br />Markets are efficient: this assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous it process.<br />No commissions are charged: usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that individual investors pay is more substantial and can often distort the output of the model. <br />Interest rates remain constant and known: The Black and Scholes model uses the risk free rate to represent this constant and known rate. In reality there is no such thing as the risk free rate, but the discount rate on US government treasury bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 days rates are often subject to change. There by violating one of the assumptions of the model.<br />SOME TERMS USED IN OPTIONS CONTRACT<br />Index options:<br />These options have the index as the underlined. Some options are European while others are American. Like index, futures contracts, index options. Contracts are also cash settled.<br />Stock options:<br />Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. <br />American options:<br />American options are options that can be exercised any time up to the expiration date. Most exchange traded options are American.<br />European options:<br />European options are options that can be exercised only on the expiration date itself. European options are easier to analyze that American option are frequently deduced from those of its European counterpart.<br />In-the-money options:<br />An in-the-money option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in the money when the current index stands at a level higher than the strike price. If the index is much higher than the strike price the call is said to be deep in the money.<br />At-the-money option:<br />An at-the-money option is an option that would lead to zero cash flow if it were exercised immediately. An option in the index is at the money when the current index equal that strike price (i.e. spot price=strike price)<br /> <br />Out-of-the-money option:<br />An out-of-the-money option is an option that would lead to a negative cash flow. A call option on the index is out of the money when the current index stands at a level, which is less than the strike price (i.e. spot price-strike price).<br />Effect of increase in the relevant parameter on Option Prices:<br /> European Options BuyingAmerican Options BuyingParametersCallPutCallPutSpot price (S)↑↓?↓Strike price (Xt)↓?↓?Time to expiration (T)??↑↑Volatility↑↑↑↑Risk free interest rates ®↑↓↑↓Dividends (D)↓↑↓↑<br />↑-Favorable↓-Unfavorable<br /> Trading Strategies Using Future and Option<br /> There are a lot of practical uses of derivatives. As we have seen derivatives can be used for profits and hedging. We can use derivatives as a leverage tool too.<br />Using speculation to make profits:<br /> When you speculate you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market, you can always sell futures and buy in the spot market. Similarly, in the options market if you are a bullish you <br />Should buy call options? If you are bearish, you should buy put options of conversely, if you are bullish, you should write put options. This is so because, in a bull market, there are lower chances of the put option being exercised and you can profit from the premium of you are bearish, you should write call options. This is so because, in a bear market, there are lower chances of the call options being exercised and you can profit from the premium. <br />Using arbitrage to make money in derivatives market:<br /> Arbitrage is making money on price differentials in different markets. For <br />Example, future is nothing but the future value of the spot price. This future value is obtained by factoring the interest rate. But if there are differences in the money <br />Market and the interest rate changes then the future price should correct itself to factor the change in making money an arbitrage opportunity.<br />Let us take an example:<br />Example:<br />A stock us quoting for Rs.1000. The one-month future of this stock is at Rs.1005. The risk free rate is 12%. The trading strategy is:<br />Solution:<br />The strategy for trading should be – Sell Spot and Buy Futures sell the stock for Rs.1000. Buy the future at Rs.1005. Invest the Rs.1000 at12%. The interest earned on this stock will be 1000(1+0.12)(1/2)=1009.<br />So net gain the above strategy is Rs.1009-Rs.1005=Rs.4.<br />Thus one can make risk less profit of Rs.4 because of arbitrage. But an important point is that this opportunity was available due to mispricing and the market not correcting itself. Normally, the time taken for the market to adjust to corrections is very less. S, the time available for arbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.<br />Using future to hedge position:<br /> One can hedge one’s position by taking an opposite position in the futures market. For example, if you are buying in the spot price, the risk you carry is that of prices falling in the future. You can lock this by selling in the futures price.<br /> Even if the stock continues falling, you position is hedged as you have formed the price at which you are selling. Similarly, you want to buy a stock at a later date but face the risk of prices rising. You can hedge against this rise by buying futures.<br /> You can use a combination of futures too to hedge yourself. There is always a correlation between the index and individual stocks. This correlation may be negative or positive, but there is a correlation. This is given by the beta of the stock. In simple terms, beta indicates the change in the price of a stock to every change in index.<br />For example, if beta of a stock is 0.18, it means that if the index goes up by when the index falls, a negative beta means that the price of the stock falls when the index rises. So, if you have a position in a stock, you can hedge the same by buying the index at times the value of the stock.<br />Example:<br />The beta of HPCL is 0.8 the Nifty is at 1000. If there is a stock of Rs.10, 000 worth of HPCL, hedging of position can be done by selling 8000 of Nifty. That is there is a sale.<br />Scenario 1<br />If index rises by 10% the value of the index becomes 8800 i.e. a loss of Rs.800. The value of the stock however goes up by 8 i.e. it becomes Rs.10, 800 i.e. a gain of Rs.800.<br />Thus the net position is zero and there is a perfect hedging.<br />Scenario 2<br />If index falls by 10%, the value of the index becomes Rs.7, 200 a gain of Rs.800. But the value of the stock also falls by 8%. The value of this stock becomes Rs.9, 200 a loss of Rs.800. thus the net position is zero and it is hedged.<br />But again, beta is predicted value based on regression models. Regression is nothing but analysis of past data. So there is a chance that the above position may not be fully hedged if the beta does not behave as per the predicted value.<br />Using options in trading strategy:<br /> Options are a great tool to use for trading. If traders feel the market will go up. He should buy a call option at a level lower than what he expects the market tot go up. If he thinks that the market will fall, you should buy a put option at a level higher than the level to which he expect the market fall. When we say market, we mean the index. The same strategy can be used for individual stocks also.<br />A combination of futures and options can be used too, to make profits.<br />Strategy for an option writer to cover himself:<br /> An option writer can use a combination strategy of futures and options to protect his position. The risk for an option writer arises only when the options exercised. This will be very clear with an example.<br /> Supposing I sell a call option on satyam at a strike price of Rs.300/- for a premium of Rs.20/-, the risk arises only when the option is exercised. The option will be exercised when the price exceeds rs.300/-. I start making a loss only after the price exceeds Rs.32/- (strike price plus premium).<br /> More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the stock to the other party and also makes entire profit on premium, I buy a future of Satyam at Rs.300/-.<br /> This is just one leg of the risk. The earlier risk was of the call being exercised. The risk now is that of the call not being exercised. In case the call is not exercised, I will have to take delivery as I have bought a future.<br /> So minimize this risk, I buy a put option on Satyam at Rs.300. but I also need to pay a premium for buying the option. I pay a premium of Rs.10/-. Now I am covered and my net cash flow would be <br /> Premium earned from selling call option: Rs.20<br /> Premium paid to buy put option: Rs.10<br /> Net cash flow: Rs.10/-<br /> But the above pay off will be possible only when the premium I am paying for the put option is lower than the premium that I get for writing the call. Similarly, we can arrive at a covered position for writing a put option too, another interesting observation is that the above strategy in itself presents an opportunity to make money. This is so because of the premium differential in the put and the call option. So if one tracks the derivative markets on a continuous basis, one can chance upon almost risk less moneymaking opportunities. <br /> Suggetions:<br />The major factors that will influence the futures and options market, FII involvement, News related to the underlying asset, National and International markets, Researchers view etc.<br />In a cash market the profit/loss is limited but where in futures and options an investor can enjoy unlimited profit/loss.<br />It is suggested to an investor to keep in mind the time and expiry duration of futures and options contracts before trading. The lengthy the time, the risk is low and profit making. The fever time may be high risk and chances of loss making.<br />At present scenario the derivatives market is increased to a great position. Its daily turnover reaches to the equal stage of cash market. <br />The derivatives are mainly used for hedging purpose. <br /> <br /> Chapter - 3<br />Research Methodology:<br />The following are the steps involved in the study.<br />Selection of the scrip:<br />The scrip selection is done on a random basis and the scrip selected is ACC, INFOSYS, HUL, RANBAXY, The lot size of the scrips ARE 250, 125, 1000, 500,. Profitability position of the option holder and option writer is studied.<br /> Objectives of the study:<br />To analyze the derivatives market in India.<br />To analyze the operations of futures and options.<br />To find out the profit/loss position of the option writer and option holder.<br />To study about risk management with the help of derivatives.<br /> Data collection:<br />The data of the scrips has been collected from the Internet. The data consists of the May contract and the period of data collection is from 1st May 2011 to 22 May 2011.<br /> Analysis technique:<br />The analysis consists of the tabulation of the data assessing the profitability positions of the option holder and the option writer, representing the data with graphs and making the interpretations using the data.<br />LOT SIZES OF SELECTED COMPANIES FOR ANALYSIS<br />CODELOT SIZECOMPANY NAMEACC250Associates Cement Co. Ltd.INFOSYS125Infosys Technologies Ltd.HUL1000Hindustan UniLever Ltd.RANBAXY500Ranbaxy laboratories Ltd.<br />The following tables explain about the trades that took place in futures and options between 16/05/2011 and 20/07/2011. The table has various columns, which explains various factors involves in derivatives trading.<br />Date – the day on which trading took place<br />Closing premium – premium for the day<br />Open interest – No. of Options that did not get exercised(000)<br />Traded quantity – No. of futures and options traded on that day<br />N.O.C – No. of contacts traded on that day<br />Closing price – the price of the futures at the end of the trading day.<br /> <br /> Chapter - 4 <br /> <br /> Data Collection Analysis $ Interpretation:<br />FUTURES OF ‘ACC CEMENTS’<br />Datedd/mm/yyyOpen.RsHighRs.LowRs.CloseRsOpen Int(‘000’)N.O.C20/05/2011795.95809.40791.35794.53452750219/05/2011809.00819.00783.10790.1539431575918/05/2011815.00827.45815.00818.003810773817/05/2011791.00816.70785.00809.9546001726516/05/2011756.00793.95756.00789.15438510335<br />FINDINGS:<br />At 809.95 the open interest stood at peak position of 4600000, but later the next day players sold their futures as to gain. The total contracts traded at this price stood 17265 which is higher than the week days <br />By the end of the trading week most of the players closed up their contracts to make loss. As the price was high, the open interest was high and the no. of contracts trades rose to 7502.<br />There always exit an impact of price movements on open interest and contracts traded. The futures market also influenced by cash market, Nifty index futures, and news related to the underlying asset or sector (industry), FII’s involvement, national and international affairs etc.<br />FUTURES OF ‘INFOSYS’<br />Datedd/mm/yyyOpenRs.HighRs.LowRs.CloseRsOpen. int(‘000’)N.O.C20/05/20112061.002082.002055.502061.7533351084219/05/20112046.502060.502021.252045.9533971304118/05/20112076.002090.002062.152070.3036251188617/05/20112102.652110.002055.502073.9042152653416/05/20112100.002125.002095.002118.80369817017<br />FINDINGS:<br />After the market quite relived by the fall in the discount on the Nifty in the futures and the options segment, which was used by the players to short the market shown appositive upward movement in futures and options segment and cash market during the first day of the week.<br />The futures of INFOSYS shown a bullish way till 17th of the May whose impact shown on the open interest at 4215 with 26534 contracts traded. The players at this point did not sell or close up their contracts as a hope of increase or go up in the market for a next day. Even the cash market was down on this day for this underlying at Rs. 2076.00.<br />The market for INFOSYS for last day of the trading week shown a decline in the opening price Rs. 15.05 when compare with the week high price. The open interest closed at 3335000 with lowest 10842 contracts traded on the last trading day of the week.<br />FUTURES OF THE ‘HUL’<br />Datedd/mm/yyyOpen.Rs.HighRs.LowRs.CloseRsOpen. int(‘000’)N.O.C20/05/2011205.10209.80204.25206.208742256819/05/2011203.55205.50201.10204.159112274018/05/2011208.10211.80205.25206.009143202017/05/2011211.50212.85208.35208.759205245416/05/2011205.70211.45204.70211.1092323765<br />INTERPRETATION:<br />HLL contracts traded in the futures stood at peak for the week i.e. 3765. There was a good buying in both the futures and options and cash market for this stock.<br />The last trading day of the week showed a high strike price or exercising price for the HLL futures i.e. Rs. 206.20 because of the huge correction done by the FII flows.<br />FUTURES OF ‘RANBAXY’<br />Datedd/mm/yyyOpenRsHighRs.LowRs.CloseRsOpen. int(‘000’)N.O.C20/05/2011345.00345.50342.05344.105698136619/05/2011336.00344.75335.10342.456578305.418/05/2011339.50344.80339.00341.406731300817/05/2011341.80342.00337.25338.006770167916/05/2011337.00342.25337.00339.3067312370<br />INTERPRETATION:<br />The week showed a buy for RANBAXY stock futures. Since beginning of the trading day of the week the figures has been representing a continuous bullish market for RANBAXY. The pharmacy sector is considered to be one of the eye watches for investors for investing.<br />On the last but one, trading day the RANBAXY stock futures has rose to peak level where the price stood at 451.35 an increase of 11.73% over the first trading day price 403.95. The open interest rose 52.16% to 9512000 and the contract traded, 19314 from 7645 of week’s beginning.<br />At the end of the week the price of the RANBAXY has rose to Rs.458.90 this is all time record of that week at this stage open interest has also gone up to 9512000, this was great boom in pharmacy sector, because FII’s were interested to invest in this sector. <br /> Call and Put Options of ‘ACC Cements’<br /> <br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.CC.PO.I.*N.C89.8017766.35172191.35171245.90448771.80379135.406416150.50578859.00581134.00562322.95256939.00176347.00151620.10286019.40283513.653811422.854917727.50425210.957924110.25771927.502714.102913615.10451516.35832044.5085818.506217.3015494.0523613.002314<br /> <br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.CC.PO.I.*N.C2.0513101.001473.3517242.8517157.5013457.5014312.451864.3526332.90271416.2072013.2524956.85141111.2023635.1027218.40263621.553310715.65341917.45269839.002647<br /> C.P. = Close premium<br /> O.I = Open interest<br /> N.C. = No. of contracts<br />The following table of net payoff explains the profit/loss of option holder/writer of ACC for the week 16/05/2011-20/05/2011.<br />Profit/loss position of Call option buyer/writer of ACC<br />Spot PriceStrike PricePremiumWhether ExercisedBuyerGain/LossWritersGain/Loss78870089.80NO-562.5 562.578872066.35YES 618.75-618.7578874045.90YES 787.5-787.578876035.40NO-2775 277578878022.95NO-8598.5 8598.578880013.65NO-9618.75 9618.757888207.50NO-14812.5 14812.5<br />Profit/Loss position of Put option buyer/writer of ACC<br />Spot PriceStrike PricePremiumWhether ExercisedBuyerGain/LossWritersGain/Loss7887202.05YES 24731.25-24731.257887403.35YES 16743.75-16743.757887607.50YES 7687.5-7687.578878016.20NO-3075 3075<br />Findings:<br />The Call Options 700, 760,780,800 and 820 were out-of-the-money option and the remaining 720 and 740 were in the money option.<br />The Put Options 720,740 and 760 were in-the-money option and the remaining i.e.780 was out-of-the-money option.<br />If it is a profit for the holder than obviously it is loss for the holder and vice-versa.<br />Call and Put Options of ‘INFOSYS’<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.176.5087145.953031102.002728102.026779.95261383.052610117.9526735176.5525131971.2524910155.2024233456.7024211790.5510036257.9010727150.4510510837.1010439936.9510015065.106318939.256319333.906510922.456920820.957319345.40327109224.80340119422.5534446614.8537060111.3035843729.258120513.658619312.1586888.3687664.45875419.35851598.30932155.65951505.70941153.95955412.3066676.3068833.6069193.9066252.5066479.0073984.5077673.0580323.0080201.3080126.203329<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.3.1580253.1079152.9077373.4051343.6050102.8047271.2546115.201411164.55137894.30134414.901251132.25123245.6575347.0073465.8572137.7067823.2564386.75941269.0591487.85878012.75811233.30749010.4021835114.1520033612.1519324919.601694338.3517111314.456921125.406716820.60657728.505531317.0556719.702412836.902311734.05245042.25199633.6194130.454429752.203128552.60287265.75277645.02612<br />The following pay-off for explain the profit/loss of option holder/writer of ‘INFOSYS’<br />for the week 16/05/2011-20/05/2011.<br />Profit/Loss position of Call Option Buyer/Writer of ‘INFOSYS’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS20401950176.50NO-8650865020401980145.95NO-8595859520402010117.95NO-879587952040204090.55NO-905590552040207065.10NO-951095102040210045.40NO-10540105402040213029.25NO-11925119252040216019.35NO-13935139352040219012.30NO-1623016230204022209.00NO-1890018900204022506.20NO-2162021620<br />Profit/Loss position of Put Option Buyer/writer of ‘INFOSYS’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS204018303.15YES20685-20685204018903.40YES14660-14660204019205.20YES11480-11480204019505.65YES8435-8435204019806.75YES5325-53252040201010.40YES1960-19602040204014.45NO-144514452040207019.70NO-497049702040210030.45NO-90459045<br />Findings:<br />The Call options all were in out-of-money option.<br />The Put option1830, 1890,1920,1950,1980 and 2010 were in-the-money options and the remaining 2040, 2070 and 2100 were out of option.<br />If it is profit for the holder than obviously it will be loss for the holder and vice-versa.<br />Call and Put Option of HUL<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.13.8023812011.55231458.50148676.951731077.45108579.20108656.25105344.6598183.90116443.80112334.803962633.703852132.654171521.754751091.804701132.6578622.15108681.40126441.00129130.55122191.60255971.25284660.75287310.60286110.40278130.7532250.80377.504082.1086301.058817<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.1.3585341.3590161.8090182.1086301.0588172.7011112.201693.2018104.0017142.7032294.509125.0517268.551455.902613<br />The following table of net payoff explains the profit/loss of option holder/writer of ‘HLL’ for the week 16/05/2011-20/05/2011.<br />Profit/Loss position of Call Option Buyer/Writer of ‘HUL’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS20720013.80NO-680068002072059.20NO-720072002072104.80NO-780078002072152.65NO-10650106502072201.60NO-14600146002072250.75NO-1875018750<br />Profit/Loss position of Put Option Buyer/Writer of ‘HUL’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS2072001.35YES5650-56502072052.70NO-700700<br />Findings:<br />The Call Options all were out-of-the-money options <br />The Put Options200 was in-the-money option and 205was out-of-the-money option.<br />If it is profit for the holder then obviously it will be loss for the holder and vice-versa.<br />Call and Put Options of ‘RANBAXY’<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C..15.0028816.652688.90102638.45122548.75124618.35124328.40118295.65115514.80123224.70130424.10133233.60129153.35103113.0010552.45106162.2010291.7510381.254491.704290.60226<br />16/05/201117/05/201118/05/201119/05/201120/05/2011C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.C.P.O.I.*N.C.4.602262.60249<br />The following tables of net payoff explain the following Profit/Loss of option holder/writer of ‘RANBAXY’ for the week 16/05/2011-20/05/2011.<br />Profit/Loss position of Call Buyer/Writer of ‘RANBAXY’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS3403408.90NO-712071203403505.65NO-12520125203403603.35NO-18680186803404000.60NO-4848048480<br />Profit/Loss position of Put option Buyer/Writer of ‘RANBAXY’<br />SPOT PRICESTRIKE PRICEPREMIUMWHETHER EXERCISEDBUYER GAIN/LOSSWRITER GAIN/LOSS3403304.60NO-43204320<br />Findings:<br /> The Call options all were in the out-of-the-money options.<br />The Put option also was in the out-of-the-money options..<br />If it is a profit of the holder then obviously it will be loss for the holder and vice-versa.<br /> <br /> Chapter – 5<br /><ul><li>Findings
  4. 4. Recommendations
  5. 5. Conclusion</li></ul>Findings:<br />: Future has more possibility of high return and high loss.<br />: In Option whether market is increasing r decreasing investor can make profit. <br /> : Derivatives are mostly used for hedging.<br />: Derivative market is growing very rapidly, as market is very volatile<br />: Forward market is not standardize.<br />: Option and Future are traded on exchange and standardize.<br /> <br />Recommendations:<br />: When Market is more volatile one should go for option.<br />: If investor expect that market will only increase should go for future contract.<br />: Use Derivative mostly as hedging.<br />: Invest in put option if investor expects market will go down.<br />: One should go for call option if he expects market will go up. <br />Conclusion:<br />: Market is very volatile so Derivatives is playing very important role in market.<br />: Always use Derivative for hedging. Because the primary purpose of derivative contract is to transfer “Risk” from one party to another.<br /> : Derivative trading acts as a catalyst for new entrepreneurial activity.<br /> : Derivatives have no value of their own but derive it from the asset that is being dealt with under the derivative contract.<br /> : People give first give priority to security in investments and than to the high return on the investment. <br /> : In a bearish market it is suggested to an investor to opt for Put Option in order to minimize losses.<br /> <br /> <br /> Bibliography <br /> Books Author<br />Securities Analysis and <br />Portfolio Management R. Madhumati <br />Investments Schaum’s <br /> <br />International Financial P.G.Apte <br />Management <br />Financial Institutions and L.M.Bhole <br />Markets <br />Options, Futures and John C. hull <br />Other Derivatives <br />WEB SITES Reffered:<br /><br /><br /><br /><br /><br /> <br />QUESTIONNAIRE<br />Objective:<br /><ul><li>To estimate the awareness of Commodity market viz.a.viz Share market.
  6. 6. To detect the profile of the prospective client for commodity futures market. </li></ul>Personal Information:<br />Q1. What is your profession?<br /><ul><li>Businessman
  7. 7. Service
  8. 8. Exporter/ Importer
  9. 9. Trader
  10. 10. If other, please specify……………………………..
  11. 11. Q2. Do you have a trading account? If yes, please specify ……………………………</li></ul>Q3. Your marital status? <br /><ul><li>Married b. Unmarried</li></ul>Q4. How many members are dependent on you?<br /><ul><li>Less than 3 b. 3-5 c. 5-7 d. More than 7
  12. 12. Q5. What is your annual income? (In Rs.)</li></ul>a. Less than 200000 b. 200001-4000000<br />c. 400001- 6000000 d. More than 6000001<br /><ul><li>Q6. What are your expectation regarding annual salary?
  13. 13. Less than 500000 b.500001-800000
  14. 14. 800001-1500000 d. More than 1500000
  15. 15. Q7. How much do you save annually? (In Rs.)
  16. 16. Less than 50000
  17. 17. 50001-150000
  18. 18. 150001-300000
  19. 19. More than 300000
  20. 20. Q8. For how long do you want to invest? (In years)
  21. 21. Less than 2 years
  22. 22. 2-5
  23. 23. 5-10
  24. 24. More than 10
  25. 25. Q9. How much do you like to earn on your saving?
  26. 26. Less than 10% p.a. b. 18%-25% p.a.
  27. 27. c.10%-18% p.a. d.More than 25% p.a.</li></ul>Q10. Please mark appropriate response to the following:<br />Strongly AgreeAgreeNeutralDisagreeStrongly DisagreeI prefer investing my savings in Shares.12345I am fully aware of Futures and Options in Stock Market12345I prefer trading in futures and Options12345I am fully aware of what hedging is?12345High Returns is my prime priority12345Security in investments is my prime priority12345<br /> <br /> <br /> <br />