Professional Documents
Culture Documents
BANGALORE UNIVERSITY
Submitted By:
VIJAY KUMAR B
Register No: 06XQCM6119
STUDENT DECLARATION
Place: BANGALORE
Date:
VIJAY KUMAR B
(06XQCM6119)
GUIDE CERTIFICATE
PLACE: BANGALORE
DATE:
Prof. Sathyanarayana
MPBIM
PRINCIPAL’S CERTIFICATE
PLACE: BANGALORE
DATE:
Dr.Nagesh.S.Malavalli
(Principal, MPBIM)
ACKNOWLEDGEMENT
The completion of the research would have been impossible without the
valuable contributions of people from the academics, family and friends. I
hereby wish to express my sincere gratitude to all those who supported me
throughout the study.
I also thank my family members and friends whose support and encourage
has meant a lot to me personally and also for the completion of the report.
VIJAY KUMAR B
(06XQCM6119)
TABLE OF CONTENTS
SL CHAPTERS Page
No. No.
1 RESEARCH EXRACT 1
2 INTRODUCTION TO DERIVATIVES : 3
• Background of the study
• Statement of Problem
• Need and importance of study
• Objectives of the Study
3 REVIEW OF LITERATURE 15
4 RESEARCH METHODOLOGY : 21
5 DERIVATIVES A DISCUSSION : 23
• Forward Contracts
• Future Contracts
• Option Contracts
6 ANALYSIS AND INTERPRETATION 37
7 SUMMARY AND CONCLUSION 66
8 BIBILIOGRAPHY 69
CHAPTER 1
RESEARCH EXTRACT
RESEARCH EXTRACT
The emergence of the market for derivative products, most probably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by locking-in asset prices.
This project tries to explain the in depth concepts, about the history, growth and pros
and cons in investing and dealing with the derivative instruments. And the analysis part
deals with choosing the best available option in terms of returns.
The main objective of the study is to give the knowledge of derivatives to the investors
who are uncomfortable about the equity market would enter if they were given the
alternative of buying derivatives, which controls their downside risk. This would
enhance the action of the savings of the country, which are routed through the equity
market.
The study also gives an overview of the derivative products and features and the
advantages in dealing with these financial derivatives more importantly derivatives as
one of the important hedging tools. The research also reveals the difference in trading
derivatives from those of the underlying spot.
CHAPTER 2
INTRODUCTION TO DERIVATIVES
INTRODUCTION
popularity than on individual stocks, especially among institutional investors, who are
major users of index-linked derivatives. Even small investors find these useful due to
high correlation of the popular indexes with various portfolios and ease of use.
Early forward contracts in the US addressed merchants’ concerns about ensuring that
there were buyers and sellers for commodities. However “credit risk’ remained a
serious problem. To deal with this problem, a group of Chicago businessmen formed
the “Chicago Board of Trade” (CBOT) in 1848.
The primary intention of the CBOT was to provide a centralized location known
in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT
went one step further and listed the first exchange traded derivative contract in the US,
these contracts were called future contracts. In 1919, Chicago Butter and Egg Board, a
spin-off of CBOT, was recognized to allow futures trading. Its name was changed to
Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest
organized futures exchanges, indeed the two largest financial exchanges of any kind in
the world today. The first stock index futures contract was traded at Kansas City Board
of Trade. Currently the most popular stock index futures contract in the world is based
on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties,
financial futures became the most active derivative instruments generating volumes
many times more than the commodity futures. Index futures, futures on T-bills and
Euro-Dollar futures are the three most popular futures contracts traded today. Other
popular international exchanges that trade derivative are LIFFE in England, DTB in
Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments in India
gained momentum in the last few years due to liberalization process and Reserve Bank
of India's (RBI) efforts in creating currency forward market. Derivatives are an integral
part of liberalization process to manage risk. NSE gauging the market requirements
initiated the process of setting up derivative markets in India. In July 1999, derivatives
trading commenced in India the following table shows Chronology of instruments
RBI gave permission for OTC forward rate agreements (FRAs) and
07-Jul-99
interest rate swaps.
24-May-00 SIMEX chose Nifty for trading futures and options on an Indian index.
25-May-00 SEBI gave permission to NSE and BSE to do index futures trading.
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major part of the world. Until the
advent of NSE, the Indian capital market had no access to the latest trading methods
and was using traditional out-dated methods of trading. There was a huge gap between
the investors' aspirations of the markets and the available means of trading. The opening
of Indian economy has precipitated the process of integration of India's financial
markets with the international financial markets. Introduction of risk management
instruments in India has gained momentum in last few years thanks to Reserve Bank of
India's efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.
are also moving towards setting up separate and well-funded clearing corporations for
providing trade guarantees.
d) Physical infrastructure:
India’s equity markets are all moving towards satellite connectivity, which allows
investors and traders anywhere in the country to buy liquidity services from anywhere
else. This telecommunications infrastructure, India’s capabilities in computer hardware
and software, will enable the establishment of computer system for creation of
derivatives markets. Setting up of automated trading system as an experience with
various prospective exchanges will also be beneficial while setting up the derivative
market.
e) Risk-taking capability and Analytical skills:
India’s investors are very strong in their risk-bearing capacity and can cope with
the risk that derivatives pose. Evidence of the volumes traded on the capital markets,
which are akin to a futures market, is indicative of this capacity. In contrast, in some
other countries, investors simply lack the risk-bearing capacity to sustain the growth of
even the equity market. It is expected that such a barrier will not appear in India.
On the subject of analytical skills, derivatives require a high degree of analytical
capability for many subtle trading strategies to pricing. India has an enormous pool of
mathematically literate finance professionals, who would excel in this field. Lastly, an
obvious advantage for the Indian market is that we have enormous experience with
futures markets through the settlement cycle oriented equity which is not truly a spot
market but a futures market (including concepts like market-to-market margin, low
delivery ratios, and last-day-of settlement abnormalities in prices). We also have active
futures markets on six commodities. With this state of development of the capital
markets it is felt that there is no major hurdle left for the creation of development of the
capital markets. Hence on July 2, 1996 the SEBI board gave an in principal approval for
the launch of derivatives markets in India.
selling off part of its equity assets by using stock index futures or index options. By
providing investors and issuers with a wider array of tools for managing risks and
raising capital, derivatives improve the allocation of credit and the sharing of risk in the
global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating the flow of trade and finance.
3. Disasters prove that derivatives are very risky and highly leveraged
instruments:
Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
headlines. Some of the reasons behind disasters related to derivatives are:
1. Lack of independent risk management
2. Improper internal control mechanisms
3. Problems in external monitoring done by Exchanges and Regulators
4. Trader taking unauthorized positions
5. Lack of transparency in the entire process
4. Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding:
Trading in standard derivatives such as forwards, futures and options is already
prevalent in India and has a long history. Reserve Bank of India allows forward trading
in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of
India also allows Cross Currency options trading. Forward Markets Commission has
allowed trading in Commodity Forwards on Commodities Exchanges, which are, called
Futures in international markets. Commodities futures in India are available in turmeric,
black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set
up commodities futures exchanges in Soya bean oil as also in Cotton. International
markets have also been allowed (dollar denominated contracts) in certain commodities.
Reserve Bank of India also allows the users to hedge their portfolios through
derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for
the purpose of getting approvals to hedge the user's exposure in international markets.
Derivatives in commodities markets have a long history. The first commodity
futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton
Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission,
India, 1963-68). A clearinghouse for clearing and settlement of these trades was set up
in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market
began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912.
Bullion futures market was set up in Mumbai in 1920.
History and existence of markets along with setting up of new markets prove
that the concept of derivatives is not alien to India. In commodity markets, there is no
resistance from the users or market participants to trade in commodity futures or foreign
exchange markets. Government of India has also been facilitating the setting up and
operations of these markets in India by providing approvals and defining appropriate
regulatory frameworks for their operations. Approval for new exchanges in last six
months by the Government of India also indicates that Government of India does not
consider this type of trading to be harmful albeit within proper regulatory framework.
This amply proves that the concept of options and futures has been well
ingrained in the Indian equities market for a long time and is not alien as it is made out
to be. Even today, complex strategies of options are being traded in many exchanges
which are called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra
and Bagari, 1998) In that sense, the derivatives are not new to India and are also
currently prevalent in various markets including equities markets.
trade. This way, the regulators will also be able to regulate both the markets easily and
it will provide more flexibility to the market participants.
In addition, the existing system although futures style, does not ask for any
margins from the clients Given the volatility of the equities market in India, this system
has become quite prone to systemic collapse. This was evident in the MS Shoes
scandal. At the time of default taking place on the BSE, the defaulting member of the
BSE Mr.Zaveri had a position close to Rs.18crores. However, due to the default, BSE
had to stop trading for a period of three days. At the same time, the Barings Bank failed
on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20
billion (more than Rs.84,000crores) with a loss of approximately US $ 900 million
(around Rs.3,800crores).
Statement of Problem:
Derivatives are the financial instruments which gives appreciable returns with
the transfer of risk and hedging. But many of the investors have lack of knowledge in
derivative instruments hence the research study reveals the significance of derivative
products, how they can hedge with these products and guides in choosing the best
derivative instrument.
risk. Therefore, the study of the concept of derivatives is very important to know about
various investment alternatives in derivatives.
CHAPTER 3
REVIEW OF LITERATURE
Review of Literature
Derivatives Defined:
Derivative is a product whose value is derived from the value of one or more basic
variables called bases (underlying assets) in a contractual manner. The underlying asset
can be equity, forex, precious metals, commodity, or any other asset. For example,
wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a
change in prices by that date. Such a transaction is an example of derivatives. A
derivative instrument by itself does not constitute ownership. It is, instead, a promise to
convey ownership.
¾ A contract, which derives its value from the prices or index of prices of
underlying securities.
Derivative contracts has several variants namely forwards, futures,
options, swaps, warrants, LEAPS, Baskets, Swaptions. The participants in derivative
markets are Hedgers, Speculators, and Arbitragers.
Types of Derivatives:
The most commonly used derivatives contracts are forwards, futures and options, which
we shall discuss in detail later. Here we take a brief look at various derivatives contracts
that have come to be used.
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.
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.
Warrants: 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.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form
of basket options.
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.
immense. Sixth, derivatives markets help increase savings and investment in the long
run. Transfer of risk enables market participants to expand their volume of activity.
Derivatives thus promote economic development to the extent the later depends on the
rate of savings and investment.
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants
5. The OTC contracts are generally not regulated by a regulatory authority and
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability. The following features of OTC derivatives markets can give rise to instability
in institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
activities on available aggregate credit; (iv) the high concentration of OTC derivative
activities in major institutions; and (v) the central role of OTC derivatives markets in
the global financial system. Instability arises when shocks, such as counter-party credit
events and sharp movements in asset prices that underlie derivative contracts occur,
which significantly alter the perceptions of current and potential future credit exposures.
When asset prices change rapidly, the size and configuration of counter-party exposures
can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However,
the progress has been limited in implementing reforms in risk management, including
counter-party, liquidity and operational risks, and OTC derivative 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 the use of exchange traded derivatives. In
view of the inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.
CHAPTER 4
RESEARCH METHODOLOGY
Research Methodology:
The type of research conducted in the study is a Descriptive research with a
little bit analysis in choosing the alternate financial instruments of derivative products.
And the data collected for conducting the research study is only secondary data and no
primary data is collected from any of the companies or corporate. Hence the study is a
micro study to guide the investors about the products offered in derivative markets.
Secondary Data:
The data related to the study is collected only through secondary sources such as
internet, bulletins, magazines and tutorials.
¾ Market price: The price at which traders are willing to buy or sell the contracts
¾ Risk free profits made by trading in these derivative contracts
¾ Cost-of-carry model: Used for pricing futures
¾ Black-Scholes model: A mathematical model that allows investors to determine
option prices.
Formulas used:
The tools used in the analysis part of the study are:
1. Formula used for calculating returns is:
Returns = Spot Price – Futures price * 100
Futures price
F = Se r T
Where S = spot price of underlying
e = 2.718
r = cost of financing (using continuously compounded interest rate)
T = time till expiration in years
CHAPTER 5
DERIVATIVES A DISCUSSION
Derivatives a Discussion
1. Forward Contracts:
A forward contract is a n agreement to buy or sell an asset on a specified date
for a specified price. One of the parties to the contract assumes a long position and
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 price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward contracts
are normally traded outside the exchanges.
However forward contracts in certain markets have become very standardized, as in the
case of foreign exchange, thereby reducing transaction costs and increasing transactions
volume. This process of standardization reaches its limit in the organized futures
market.
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 a 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.
Liquidity
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generally.
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.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the other
suffers. Even when forward markets trade standardized contracts, and hence avoid the
problem of illiquidity, still the counterparty remains a very serious issue.
2. Futures Contract:
A futures contract is a type of derivative instrument, or financial contract, in
which two parties agree to transact a set of financial instruments or physical
commodities for future delivery at a particular price. If you buy a futures contract, you
are basically agreeing to buy something that a seller has not yet produced for a set price.
But participating in the futures market does not necessarily mean that you will be
responsible for receiving or delivering large inventories of physical commodities -
remember, buyers and sellers in the futures market primarily enter into futures contracts
to hedge risk or speculate rather than to exchange physical goods (which is the primary
activity of the cash/spot market). That is why futures are used as financial instruments
by not only producers and consumers but also speculators.
The consensus in the investment world is that the futures market is a major
financial hub, providing an outlet for intense competition among buyers and sellers and,
more importantly, providing a center to manage price risks. The futures market is
extremely liquid, risky and complex by nature, but it can be understood if we break
down how it functions. While futures are not for the risk-averse, they are useful for a
wide range of people.
The futures market is a centralized marketplace for buyers and sellers from
around the world who meet and enter into futures contracts. Pricing can be based on an
open cry system, or bids and offers can be matched electronically. The futures contract
will state the price that will be paid and the date of delivery. But don't worry, almost all
futures contracts end without the actual physical delivery of the commodity.
Futures Terminology:
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts
on the NSE have one-month, two-months & three-month expiry cycles which expire
on the last Thursday of the month. Thus a January expiration contract expires on the
last Thursday of January and a February expiration contract ceases trading on the
last Thursday of February. On the Friday following the last Thursday, a new
contract having a tree-month expiry is introduced for trading.
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.
Contract Size: The amount of asset that has to be delivered under one contract. For
instance, the contract size on NSE’s futures market is 200 Nifties.
Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for
each contract. In a normal market, basis will be positive. This reflects that futures
prices normally exceed spot prices.
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 up to finance the asset less the income
earned on the asset.
Initial Margin: The amount that must be deposited in the margin account at the time
a futures contract is first entered into is known as initial margin.
Marking-to-Market: In the future market at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures
closing price this is called Marking-to-market
Maintenance Margin: This is somewhat lower than the initial margin. This is set to
ensure that the balance in the margin account never becomes negative. If the
balance in the margin account falls below the maintenance margin the investor
receives a margin call and is expected to top up the margin account to the initial
margin level before trading commences on the next day.
Pricing Futures:
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the
fare value of a futures contract. Every time the observed price deviates from the fair
value, arbitragers would enter into trades to capture the arbitrage profit. This in turn
would push the futures price back to its fair value. The cost-of-carry model used for
pricing futures is given below:
F = Se r T
3. Options Contract:
An option is a contract that gives the buyer the right, but not the obligation, to
buy or sell an underlying asset at a specific price on or before a certain date. An option,
just like a stock or bond, is a security. It is also a binding contract with strictly defined
terms and properties.
Say, for example, that you discover a house that you'd love to purchase.
Unfortunately, you won't have the cash to buy it for another three months. You talk to
the owner and negotiate a deal that gives you an option to buy the house in three
months for a price of Rs.200,000. The owner agrees, but for this option, you pay a price
of Rs.3,000.
Now, consider two theoretical situations that might arise:
1. It is discovered that the house is actually the true birthplace of some great person. As
a result, the market value of the house skyrockets to Rs.1 million. Because the owner
sold you the option, he is obligated to sell you the house for Rs.200,000. In the end, you
stand to make a profit of Rs.797,000 (Rs.1 million – Rs.200,000 – Rs.3,000).
2. While touring the house, you discover not only that the walls are chock-full of
asbestos, but also the ghost haunts the master bedroom; furthermore, families of super-
intelligent rats have built a fortress in the basement. Though you originally thought you
had found the house of your dreams, you now consider it worthless. On the upside,
because you bought an option, you are under no obligation to go through with the sale.
Of course, you still lose the Rs.3,000 price of the option.
This example demonstrates two very important points. First, when you buy an
option, you have a right but not an obligation to do something. You can always let the
expiration date go by, at which point the option becomes worthless. If this happens, you
lose 100% of your investment, which is the money you used to pay for the option.
Second, an option is merely a contract that deals with an underlying asset. For this
reason, options are called derivatives, which mean an option derives its value from
something else. In our example, the house is the underlying asset. Most of the time, the
underlying asset is a stock or an index.
Calls and Puts: The two types of options are calls and puts:
Call Option: A call gives the holder the right to buy an asset at a certain price within a
specific period of time. Calls are similar to having a long position on a stock. Buyers of
calls hope that the stock will increase substantially before the option expires.
Put Option: A put gives the holder the right to sell an asset at a certain price within a
specific period of time. Puts are very similar to having a short position on a stock.
Buyers of puts hope that the price of the stock will fall before the option expires.
People who buy options are called holders and those who sell options are called
writers; furthermore, buyers are said to have long positions, and sellers are said to have
short positions.
¾ Call holders and put holders (buyers) are not obligated to buy or sell. They have the
choice to exercise their rights if they choose.
¾ Call writers and put writers (sellers), however, are obligated to buy or sell. This
means that a seller may be required to make good on a promise to buy or sell.
Option Terminology:
Index Options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.
Stock Options: Stock options are options on individual 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.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/option put option is the one receives the
option premium and is thereby obligated to sell/buy the asset if he buyer exercises
on him.
Call Option: A call option gives the holder the right but not the obligation to buy an
asset by a certain date for a certain price.
Put Option: A put option gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price.
Option price/Premium: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration Date: The date specified in the option Contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike Price: The price specified in the options contract is known as the strike price
or the exercise price.
American Options: American options are options that can be exercised at any time
up to the expiration date. Most exchange-traded options are American.
European Options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options,
and properties of an American option are frequently deduced from those of its
European counter parts.
In-the-money: An in-the money (ITM) 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 (i.e., spot price > strike price). If the index is much higher than
the strike price, the call is to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.
At-the-money: An At-the-money (ATM) option is an option that would lead to zero
cash flow if it were exercised immediately. An option on the index is At-the-money
when the current index equals the strike price (i.e., spot price = strike price).
Out-of-the-money: An out-of-the-money (OTM) option is an option that would lead
to a negative cash flow if it were exercised immediately. A call option on the index
is out-of-the-money when the current index stands at a level which is less than the
strike price (i.e., spot price < strike price). If the index is much lower than the strike
price, the call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.
Intrinsic value of an option: the option premium can be broken down into two
components – intrinsic value and time value. The intrinsic value of a call is the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Putting it another way, the intrinsic value of a call is max [0, (St – K)] which means
the intrinsic value of a call is the greater of 0 or (St – K). Similarly, the intrinsic
value of a put is max [0, K – St], i.e., the greater of 0 or (K-St). K is the strike price
and St is the spot price.
Time value of an option: the time value of an option is the difference between its
premium and intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is an option’s time
value, all else equal. At expiration, an option should have no time value.
Pricing Options:
Black–Scholes model: Robert C. Merton was the first to publish a paper expanding
our mathematical understanding of the options pricing model and coined the term
"Black-Scholes" options pricing model, by enhancing work that was published by
Fischer Black and Myron Scholes. It is somewhat unfair to Merton that the resulting
formula has ever since been known as Black-Scholes, but with another hyphen the label
would be unwieldy. The paper was first published in 1973. The foundation for their
research relied on work developed by scholars such as Louis Bachelier, A. James
Boness, Edward O. Thorp, and Paul Samuelson. The fundamental insight of Black-
Scholes is that the option is implicitly priced if the stock is traded. Merton and Scholes
received the 1997 Nobel Prize in Economics for this and related work; Black was
ineligible, having passed away in 1995.
An option buyer has the right but not the obligation to exercise on the seller. The
worst that can happen to a buyer is the loss of the premium paid by him. His downside
is limited to this premium, but his upside is potentially unlimited. This optionality is
precious and has a value, which is expressed in terms of the option price. Just like in
other free markets, it is the supply and demand in the secondary market that drives the
price of an option.
There are various models which help us to the true price of an option. Most of these
are variants of the celebrated Black-Scholes model for pricing European options. Today
mast calculators and spread-sheets come with a built-in Black-Scholes options pricing
formula so to price options we don’t really need to memorize the formula. All we need
to know is the variables that go into the model.
The Black-Scholes formulas for the prices of European calls and puts on a non-
dividend paying stock are:
and d2 = d1 – σ√T
Benefits that acquire to the Indian capital markets and the Indian economy from
derivatives are discussed here. Derivatives will make possible hedging which otherwise
is infeasible this is illustrated by the dollar-rupee forward market. Imports and exports
used to take place in the country under the presumption that importer and exporters
have to bear currency risk.
To the extent that importers and exporters are risk averse, the existence of this
risk would lead them to do international trade in smaller quantities than they have liked
to. Once the dollar-rupee forward market came about, importers and exporters could
hedge themselves against currency risk. Today the use of such hedging is extremely
common amongst companies that are exposed to currency risk. This hedging facility
has definitely helped importers and exporters do international trade in larger quantities
than before. The RBI’s permission for the dollar-rupee forward market is therefore part
of the explanation for the enormous growth in imports and exports that has taken place
in the last five years.
Similarly, on the equity market, many retail investors who are uncomfortable
about the equity market would enter if they were given the alternative of buying
insurance, which controls their downside risk. This would enhance the action of the
savings of the country, which are routed through the equity market. The same would be
the case with international investors, who would place limit orders. These
improvements in the quality of the underlying market have been observed across a
variety of research studies done on foreign markets, which have compared market
quality before introduction of derivatives as compared with after.
Comparison of the close prices of the NIFTY near month Futures contract of the
(F&O segment Oct2007 to March2008) with the underlying movement of the NIFTY
Index (Cash Segment), along with the daily traded value of the Future and option
segment.
Inference: In the Index Futures Segment in the last year the open interest (no. of
contracts) has been increased by 51.11% and the turnover has been increased by
75.20%.
Inference: In the Stock Futures Segment in the last year the open interest has been
increased by 51.45% and the turnover has been increased by 11.38%.
Inference: In the Index Options Segment in the last year the open interest has been
decreased by 6.5% and the turnover has been increased by 23.84%.
Inference: In the Stock Options Segment in the last year the open interest has been
decreased by 21.66% and the turnover has been decreased by 38.04%.
CHAPTER 6
ANALYSIS AND INTERPRETATION
Stock/Index Futures:
1 NIFTY 50
2 CNX 100 50
3 NIFTY MIDCAP 75
10 ISPAT 4150
11 ITC 1125
12 NTPC 1625
13 RPL 1675
14 TCS 250
The Future prices of these contracts of March month expiring contract which
expires on last Thursday of the month i.e. on 27th March, 2008 are compared with that
of the spot price of the underlying asset on expiry. And the corresponding returns have
been calculated although the brokerage is not included. The following data gives you a
view of returns in buying these following Index Futures and Stock Futures contracts
and exercising them on expiry:
The formula used to calculate the returns is:
Index Futures:
Inference: In the index futures the NIFTY index futures achieves -1.3% returns, NIFTY
MIDCAP achieves -14.61% returns and CNX100 returns -3.82%. By considering the
above index returns we can conclude that the market is bearish and the indexes and also
most of the individual stocks results in declining the spot.
Stock Futures:
Inference: As the markets are bearish many of the stock prices falls as shown in the
above table but some of the stocks have beaten the marked outperformed to be bullish
even though the markets are declining.
Inference: Arvind Mills has been declined by 23.27% in the spot market and Bharti
Airtel has been increased by 0.09%.
Inference: Dr. Reddy’s has been decreased 0.094% and GMR INFRA has been
decreased by 14.04% in their spot markets.
Inference: Hero Honda has been decreased by 9.92% in the spot market and Infosys
Technologies has been decreased by 6.87% in the spot.
Inference: ISPAT has been decreased by 29.09% in the spot market and ITC has been
decreased by 1.30% in the spot.
Inference: NTPC has been decreased by 2.37% in the spot market and RPL has been
decreased by12.20% in the spot.
Inference: TCS has been decreased by 2.83% in the spot market and Vijaya Bank has
been decreased by 23.84% in the spot.
Inference: Nifty Index has been decreased by 7.52% in the spot market and the
CNX100 has been decreased by 8.967% in the spot.
Inference: The NIFTY MIDCAP INDEX has been decreased by 17.53% in the spot
price of the market.
Interpretation of results:
By looking at the above data it is clear that the market is bearish over the
contract period and the buyers of future contracts are incurring the above shown loses.
From the above furnished data analysis the buyers of index futures namely NIFTY,
CNX 100 and Nifty Midcap have incurred negative returns of -1.30, -14.61 and -3.82
respectively. And when it comes to stock futures as the market declines many of the
individual stocks also declines. In our study i.e. Arvind Mills, GMR Infrastructures,
Hero Honda Motors, Infosys Technologies, ISPAT Industries, RPL and Vijaya Bank
show a positive correlation with that of the market movements. But some of the stocks
like Bharti Airtel, Dr.Reddy’s laboratories; ITC, NTPC and TCS have overcome the
market and shows appreciable returns in buying those futures. From the above data the
highest positive returns are obtained by buying NTPC futures and highest negative
returns are obtained by buying ISPAT Futures. Although when it comes to the
percentage of declining no Index will have such declining returns when compared to
that of the individual stocks i.e. ISPAT in our study.
The reasons for this declining movement may be many like overpricing of the
underlying, economic activities, Foreign Institutional Investors withdrawing money
from our markets like this many of the reasons will lead the market to the bearish state,
so one should also consider such factors in buying future contracts along with the past
data analysis. Hence a person who is bullish about the market here expects the
underlying asset prices to rise and buys the future contracts and the market doesn’t
move as per his expectations and he incurs loses. Instead of buying such selling of
futures are profitable as the market is bearish and results futures price is greater than the
spot price on expiry.
F = SerT
Here ‘F’ is the Futures price for the next month contract, ‘S’ is the spot price of the
underlying asset as on March 27, 2008, ‘e’ is the exponential constant i.e. 2.718, ‘r’ is
rate of interest @ 11% and ‘T’ is the period of expiry of contract i.e. one month.
Index Futures:
Stock Futures:
Application of Futures:
Here it is refereed to single stock futures, however since the index is nothing but a
security whose price or level is a weighted average of securities consisting an index, all
strategies that can be implemented using stock futures can also be implemented using
index futures.
enter into a hedging strategy hoping to make excess profits for sure; all that can come
out of hedging is reduced risk.
day of expiration, the spot and the futures price converges. He has made a clean profit
of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.
When does it make sense to enter into this arbitrage? If your cost of borrowing funds to
buy the security is less than the arbitrage profit possible, it makes sense for you to
arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that
exploiting an arbitrage opportunity involves trading on the spot and futures market. In
the real world, one has to build in the transactions costs into the arbitrage strategy.
profits? Say for instance ABC Ltd trades at Rs.1000. one-month ABC futures trade at
Rs.965 and seem underpriced. As an arbitrageur you can make risk less profit by
entering into the following set of transactions.
a) On day one, sell the security in the cash/spot market at 100.
b) Make delivery of the security.
c) Simultaneously, buy the futures an the security at 1965.
d) On the futures expiration date, the spot and the futures price converge. Now unwind
the position.
e) Say the security closes at Rs.975. buy back the security.
f) The futures position expires with a profit of Rs.10.
g) The result is a risk less profit of Rs.25 on the spot position and Rs.10 on the futures
position.
If the returns you get by investing in risk less instruments are more than the return from
the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-
and-carry arbitrage. It is this arbitrage activity that ensures that the spot and futures
prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves
trading on the spot market. As more and more players in the market develop the
knowledge and skills to do cash-and-carry and reverse cash-and-carry, we will see
increased volumes and lower spreads in both the cash as well as the derivatives market.
Options Segment:
Here it is refereed to single stock futures, however since the index is nothing but
a security whose price or level is a weighted average of securities consisting an index,
all strategies that can be implemented using stock options can also be implemented
using index options.
expiration date. Hence buying this call is basically like buying a lottery. There is a
small probability that it may be in-the-money by expiration in which case the buyer will
profit. In the more likely event of the call expiring out-of-the-money, the buyer simply
loses the small premium amount of Rs.27.50. the following shows the payoffs from
buying calls at different strikes. Similarly the put with a strike of 1300 is deep in-the-
money and trades at a higher premium than the at-the-money put at a strike of 1250. the
put with a strike of 1200 is deep out-of-the-money and will only be experienced in the
unlikely event that underlying falls by 50 points on the expiration date. The table shows
the payoffs from writing puts at different strikes.
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the price, and how much you are willing to loose
should this upward movement not come about. There are five one-month calls and five
one-month puts trading in the market. The call with a strike of 120 is deep in-the-money
and hence trades at a higher premium. The call with a strike of 1275 is out-of-money
and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its
execution depends on the unlikely event that the underlying will rise by more than 50
points on the expiration date. Hence buying this call is basically like buying a lottery.
There is a small probability that it may be in-the-money by expiration, in which case the
buyer will make profits. In the more likely event of the call expiring out-of-the-money,
the buyer simply loses the small premium amount of Rs.27.50
As a person who wants to speculate on the hunch that prices may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited upside and
an unlimited downside. If prices do rise, the buyer of the put will let the option expire
and you will earn the premium. If however your hunch about an upward movement
proves to be wrong and prices actually fall, then your losses directly increase with the
falling price level. If for instance the price of the underlying falls to 1230 and you’ve
sold a put with an exercise of 1300, the buyer of the put will exercise the option and
you’ll end up losing Rs.70 taking into account the premium earned by you when you
sold the put, the net loss on trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there
are a number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly you
feel about the likelihood of the upward movement in the prices of the underlying. If you
write an at-the-money put, the option premium earned by you will be higher than if you
write an out-the-money put. However the chances of an at-the-money put being
exercised on you are higher as well. In the example at a price level of 1250, one option
is in-the-money and one is out-the-money. As expected, the in-the-money option
fetches the highest premium of Rs.64.80 whereas the out-of-the-money option has the
lowest premium of Rs.18.15.
number of one-month calls trading, each with a different strike price, the obvious
question is: assume that the current stock price is 1250; risk-free rate per year and stock
volatility is 30%. You could write the following options:
o A one month call with a strike of 1200
o A one month call with a strike of 1225
o A one month call with a strike of 1250
o A one month call with a strike of 1275
o A one month call with a strike of 1300
The spot price is 1250. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence
trades at a higher premium. The call with a strike of 1275 is out-of-the-money and
trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its
execution depends on the unlikely event that the price will raise by more than 50 points
on the expiration date.
Hence writing this call is a fairly safe bet. There is a small probability that it
may be in-the-money by expiration in which case the buyer exercises and the writer
suffers losses to the extent that the price is above 1300. in the more likely event of the
call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. the
payoffs from writing calls at different strikes similarly, the put with a strike of 1300 is
deep in-the-money and trades at a higher premium than the at-the-money put at a strike
of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be
exercised in the unlikely event that the price falls by 50 points on the expiration date.
The choice of which put to buy depends upon how much the speculator expects the
market to fall. The table shows the payoffs from buying puts at different strikes.
Which of these options you write largely depends on how strongly you feel
about the likelihood of the downward movement of prices and how much you are
willing to lose should this downward movement not come about. There are five one-
month calls and five one-month puts trading in the market. The call with a strike of
1200 is deep in-the-money and hence trades at a higher premium. The call with a strike
of 1275 is out-of-money. Its execution depends on the unlikely event that the stock will
raise by more than 50 points on the expiration date. Hence writing this call is a fairly
safe bet. There is small probability that it may be in-the-money by expiration in which
case the buyer exercises and the writer suffers losses to the extent that the price is above
1300. in the more likely event of call expiring out-of-the-money, the writer earns the
premium amount of Rs.27.50
As a person who wants to speculate on the hunch that the market may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited downside.
If the price does fall, you profit to the extent the price falls below the strike of the put
purchased by you. If however your hunch about a downward movement in the market
in the market proves to be wrong and the price actually rises, all you lose is the option
premium. If for instance the security price rises to 1300 and you’ve bought a put with
an exercise of 1250, you simply let the put expire. If however the price does fall to say
1225 on expiration date, you make a neat profit of Rs.25. having decided to buy a put,
which one should you buy? Given that there are a number of one-month puts trading,
each with a different strike price, the obvious question is: which strike should you
choose? This largely depends on how strongly you feel about the likelihood of the
downward movement in the market. If you buy an at-the-money put, the option
premium paid by you will by higher than if you buy an out-of-the-money put. However
the chances of an at-the-money put expiring in-the-money are higher as well.
Put Options:
Symbol Open Interest(no. of contracts) Percentage
NIFTY 477636 95.55%
RELIANCE 7174 1.44%
RPL 1389 0.28%
RNRL 873 0.17%
DLF 849 0.17%
OTHERS 11964 2.39%
TOTAL 499885 100%
CHAPTER 7
SUMMARY AND CONCLUSIONS
2. The players in the Derivatives market are hedgers and speculators. A hedger tries to
minimize risk by buying or selling now in an effort to avoid rising or declining
prices. Conversely, the speculator will try to profit from the risks by buying or
selling now in anticipation of rising or declining prices.
3. Buying and selling in the futures market can seem risky and complicated. Futures
and Options trading are not for everyone, but it works for a wide range of people.
The futures market is a global marketplace, initially created as a place for farmers
and merchants to buy and sell commodities for either spot or future delivery. This
was done to lessen the risk of both waste and scarcity.
4. Rather than trade in physical commodities, futures markets buy and sell futures
contracts, which state the price per unit, type, value, quality and quantity of the
commodity in question, as well as the month the contract expires.
5. The futures market is also characterized as being highly leveraged due to its
margins. Prices of derivative instruments converge with the prices of the underlying
at the expiration of the derivative contracts.
6. Always there will be three contracts available for trading with 1 month, 2 months
and 3 months which of those expires on the last Thursday of the respective month.
7. In forward contracts counterparty risk arises from the possibility of default by any
one of the party to the transaction wherein future contracts exchanges acts as a
counterparty and it is standardized contract with standard underlying instrument, a
standard quantity and quality of the underlying instrument that can be delivered at a
standard timing of such settlement.
8. In forward and future contracts both the parties are obligated to exercise the contract
at expiry wherein options the buyer of an option contract is not obligated to exercise
the contract it’s his wish to exercise or not on the expiry date.
9. Future contracts have linear payoffs; it means that the losses as well as profits for
the buyer and the seller of a futures contract are unlimited.
10. Whereas option contracts have non-linear payoffs; it means that the losses for the
buyer of an option are limited; however the profits are potentially unlimited. For a
writer the payoff is exactly the opposite his profits are limited to the option
premium; however his losses are potentially unlimited.
Suggestions:
1. So to deal with the Derivatives one should have a clear knowledge about the
products and specifications and he should know the upside and downside in buying
are selling the product and should have the ability to analyze its behavior with that
of the spot price of the underlying asset.
2. It is preferred to use the derivative products as hedging tool, if the buyers are risk
averse i.e. they can use these products as insurance to their asset price fluctuations
in the spot market.
3. There are numerous derivatives strategies, but the common thread is that they all
allow you to either buy or sell an investment without actually taking possession of
it, with the ultimate goal of allowing you to profit from a move in the underlying
asset in a specified amount of time. And because derivatives trade for a fraction of
the price of the underlying asset, you have the opportunity to spend less money to
control more of the asset.
CONCLUSION
BIBILIOGRAPHY
Websites:
www.nseindia.com
www.derivativesindia.com
www.sharekhan.com
www.moneycontrol.com
www.investopedia.com
www.businessmapsofindia.com
www.finance.yahoo.com