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The following factors have been driving the growth of financial derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced
risk as well as trans-actions costs as compared to individual financial assets.
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 upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Derivatives – Indian Scenario -4-
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.2
2
Source: Options Futures & Other Derivatives John C Hull
Derivatives – Indian Scenario -5-
extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit
that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are
immense. 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.
The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular 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 derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE
in Japan, MATIF in France, etc.3
Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)
3
Source: Derivatives in India FAQ Ajay Shah & Susan Thomas
Derivatives – Indian Scenario -7-
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
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
Derivatives – Indian Scenario -8-
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 derivatives markets continue to
pose a threat to international financial stability. The problem is more acute as heavy
reliance on OTC derivatives creates the possibility of systemic financial events, which
fall outside the more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through 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.
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 liberalisation process and Reserve Bank of India’s
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation 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
Table 2.1 Chronology of instruments
1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and
interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
2.2.1 Derivatives increase speculation and do not serve any economic purpose
While the fact is...
Numerous studies of derivatives activity have led to a broad consensus, both in the
private and public sectors that derivatives provide numerous and substantial benefits to
the users. Derivatives are a low-cost, effective method for users to hedge and manage
their exposures to interest rates, commodity prices, or exchange rates.
The need for derivatives as hedging tool was felt first in the commodities market.
Agricultural futures and options helped farmers and processors hedge against commodity
price risk. After the fallout of Bretton wood agreement, the financial markets in the world
started undergoing radical changes. This period is marked by remarkable innovations in
the financial markets such as introduction of floating rates for the currencies, increased
trading in variety of derivatives instruments, on-line trading in the capital markets, etc.
Derivatives – Indian Scenario - 11 -
As the complexity of instruments increased many folds, the accompanying risk factors
grew in gigantic proportions. This situation led to development derivatives as effective
risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock
index futures and options. An equity fund, for example, can reduce its exposure to the
stock market quickly and at a relatively low cost without 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.4
Table 2.2
PRE-REQUISITES INDIAN SCENARIO
Large market Capitalisation India is one of the largest market-capitalised countries in
Asia with a market capitalisation of more than Rs.765000
crores.
4
Source: www.nse-india .com
Derivatives – Indian Scenario - 12 -
High Liquidity in the The daily average traded volume in Indian capital market
underlying today is around 7500 crores. Which means on an average
every month 14% of the country’s Market capitalisation
gets traded. These are clear indicators of high liquidity in
the underlying.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board
of India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping
the market to evolve to a healthier place for trade practices.
2.2.3 Disasters prove that derivatives are very risky and highly leveraged
instruments
While the fact is...
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... Here I have tried to explain some of the important issues involved in disasters
related to derivatives. Careful observation will tell us that these disasters have occurred
due to lack of internal controls and/or outright fraud either by the employees or
promoters.
Barings Collapse
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index
futures of Nikkei 225
Derivatives – Indian Scenario - 13 -
5. Market falls by more than 15% in the first two months of ’95 and Barings suffers
huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings
The reasons for the collapse:
• Leeson was supposed to be arbitraging between Osaka Securities Exchange and
SIMEX -- a risk less strategy, while in truth it was an unhedged position.
• Leeson was heading both settlement and trading desk -- at most other banks the
functions are segregated, this helped Leeson to cover his losses -- Leeson was
unsupervised.
• Lack of independent risk management unit, again a deviation from prudential norms.
There were no proper internal control mechanisms leading to the discrepancies going
unnoticed – Internal audit report which warned of "excessive concentration of power
in Leeson’s hands" was ignored by the top management.
The conclusion as summarised by Wall Street Journal article
" Bank of England officials said they did not regard the problem in this case as one
peculiar to derivatives. In a case where a trader is taking unauthorised positions, they
said, the real question is the strength of an investment houses’ internal controls and the
external monitoring done by Exchanges and Regulators. "
Metallgesellschaft
1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered
through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of oil products
to its clients -- commitments were quite large, equivalent to 85 days of Kuwait’s
oil output
3. MGRM created a hedge position for these long term contracts with short term
futures market through rolling hedge --, As there was no viable long term
contracts available
4. Company was exposed to basis risk -- risk of short term oil prices temporarily
deviating from long term prices.
Derivatives – Indian Scenario - 14 -
5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in
cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining contracts, leading to a
loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased over time.
Auditors’ report claims that the losses were caused by the size of the trading
exposure.
Reasons for the losses:
• The transactions carried out by the company were mainly OTC in nature and hence
lacked transparency and risk management system employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the company to use rolling
short term hedge -- problem arising from the hedging strategy
• Basis risk leading to short term loss
2.2.4 Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding
While the fact is...
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.
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.
World over, the spot markets in equities are operated on a principle of rolling settlement.
In this kind of trading, if you trade on a particular day (T), you have to settle these trades
on the third working day from the date of trading (T+3).
Futures market allow you to trade for a period of say 1 month or 3 months and allow you
to net the transaction taken place during the period for the settlement at the end of the
period. In India, most of the stock exchanges allow the participants to trade during one-
week period for settlement in the following week. The trades are netted for the settlement
for the entire one-week period. In that sense, the Indian markets are already operating the
futures style settlement rather than cash markets prevalent internationally.
In this system, additionally, many exchanges also allow the forward trading called badla
in Gujarati and Contango in English, which was prevalent in UK. This system is
prevalent currently in France in their monthly settlement markets. It allowed one to even
further increase the time to settle for almost 3 months under the earlier regulations. This
way, a curious mix of futures style settlement with facility to carry the settlement
obligations forward creates discrepancies.
The more efficient way from the regulatory perspective will be to separate out the
derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at
the same time allow futures and options to 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.18 crores. 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.84,000
crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although,
Derivatives – Indian Scenario - 17 -
the exposure was so high and even the loss was also very big compared to the total
exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins
that they did not stop trading for a single minute.
5
Source: Mr. Rajesh Gajra Senior writer- Intelligent Investor (rgajra@iinvestor.com)
6
Source: Invest Monitor (Magazine) July 2001
Derivatives – Indian Scenario - 18 -
Advantages
• Greater Leverage as to pay only the premium.
• Greater variety of strike price options at a given time.
Figure 2.2
Arbitrageurs
Figure 2.3
Hedgers
Advantages
• Availability of Leverage
Figure 2.4
Small Investors
Advantages
• Losses Protected.
3.0 SWAPS
A contract between two parties, referred to as counter parties, to exchange two streams of
payments for agreed period of time. The payments, commonly called legs or sides, are
calculated based on the underlying notional using applicable rates. Swaps contracts also
include other provisional specified by the counter parties. Swaps are not debt instrument
Derivatives – Indian Scenario - 20 -
to raise capital, but a tool used for financial management. Swaps are arranged in many
different currencies and different periods of time. US$ swaps are most common followed
by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has
ranged from 2 to 25 years.
matching multiple parties and by using other tools such as futures to cover an exposed
position until the book is complete.
Swap brokers, unlike a dealer do not take on a swap position themselves but simply
locate counter parties with matching needs. Therefore, brokers are free of any risks
involved with the transactions. After the counter parties are located, the brokers negotiate
on behalf of the counter parties to keep the anonymity of the parties involved. By doing
so, if the swap transaction falls through, counter parties are free of any risks associated
with releasing their financial information. Brokers receive commissions for their services.
• Benchmark price
• Liquidity (availability of counter parties to offset the swap).
• Transaction cost
• Credit risk 7
Swap rates are based on a series of benchmark instruments. They may be quoted as a
spread over the yield on these benchmark instruments or on an absolute interest rate
basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day
T-bills, CP rates and PLR rates.
Liquidity, which is function of supply and demand, plays an important role in swaps
pricing. This is also affected by the swap duration. It may be difficult to have counter
parties for long duration swaps, specially so in India Transaction costs include the cost of
hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill.
Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank
must obtain funds. The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
7
Source: www.appliederivatives.com
Derivatives – Indian Scenario - 22 -
Credit risk must also be built into the swap pricing. Based upon the credit rating of the
counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an
AAA rating.
These guidelines are intended to form the basis for development of Rupee derivative
products such as FRAs/IRS in the country. They have been formulated in consultation
with market participants. The guidelines are subject to review, on the basis of
development of FRAs/IRS market.
Accordingly, it has been decided to allow scheduled commercial banks (excluding
Regional Rural Banks), primary dealers and all -India financial institutions to undertake
FRAs/IRS as a product for their own balance sheet management and for market making
purposes.
Prerequisites
Participants are to ensure that appropriate infrastructure and risk management systems are
put in place. Further, participants should also set up sound internal control system
8
Source: RBI Guidelines
Derivatives – Indian Scenario - 23 -
whereby a clear functional separation of trading, settlement, monitoring and control and
accounting activities is provided.
An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a notional principal amount of multiple
occasions on specified periods. Accordingly, on each payment date that occurs during the
swap period-Cash payments based on fixed/floating and floating rates are made by the
parties to one another.
Currency swaps can be defined as a legal agreement between two or more parties to
exchange interest obligation or interest receipts between two different currencies. It
involves three steps:
• Initial exchange of principal between the counter parties at an agreed upon rate of
exchange which is usually based on spot exchange rate. This exchange is optional and
its sole objective is to establish the quantum of the respective principal amounts for
the purpose for calculating the ongoing payments of interest and to establish the
principal amount to be re-exchanged at the maturity of the swap.
• Ongoing exchange of interest at the rates agreed upon at the outset of the transaction.
• Re-exchange of principal amount on maturity at the initial rate of exchange.
This straight forward, three step process results in the effective transformation of the debt
raised in one currency into a fully hedged liability in other currency.
Participants
Schedule commercial banks.
Derivatives – Indian Scenario - 24 -
Primary dealers
All India financial institutions
RBI in its process of making the Indian corporates globally competitive has simplified
their access to this instrument by making changes in its credit policy. But despite an
easing regulation, swaps have not hit the market in a big way.
India has a strong dollar-rupee forward market with contracts being traded for one, two,
six-month expiration. Daily trading volume on this forward market is around $500
million a day. Indian users of hedging services are also allowed to buy derivatives
involving other currencies on foreign markets. Outside India, there is a small market for
cash –settled forward contracts on the dollar –rupee exchange rate.
While studying swaps in the Indian context, the counter parties involved are Indian
corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the
banks allowed by RBI to carry out the swaps. These banks form the counterparty to the
corporates on both sides of the swap and keep a spread between the interest rates to be
received and offered. One of the currencies involved is the Indian rupee and the other
could be any foreign currency. The interest rate on the rupee is most likely to be fixed,
and on foreign currency it could be either fixed or floating.
arise out of the mismatch between the currency of inflow and outflow. The outflow being
considered here is the interest and the principal payment on the borrowings of the
corporates. Corporates having such currency mismatches would be of the following types
3.6 The needs of the players and how currency swaps help meet
these needs
3.6.1 To manage the exchange rate risk
Since the international trade implies returns and payments in a variety of currencies
whose relative values may fluctuate it involves taking foreign exchange risk. The players
mentioned above are facing this risk. A key question facing the players then is whether
these exchange risks are so large as to affect their business. A related question is what, if
any, special strategies should be followed to reduce the impact of foreign exchange risk.
One-way to minimize the long-term risk of one currency being worth more or less in the
future is to offset the particular cash flow stream with an opposite flow in the same
currency. The currency swap helps to achieve this without raising new funds; instead it
changes existing cash flows.
Company A has an absolute advantage over B in both the markets/ rates. The advantage
in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a
comparative advantage in terms of dollar rates.
Now as A is an exporter he would be more interested in a dollar denominated loan to
offset his future receivables.
Therefore it would be advantageous if A would borrow at rupee rates and B borrows at
LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a
swap will be 50 bps, which may be shared between the parties.
The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a
13% fixed rupee rate. The swap will take place on a notional principal basis.
The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for
A is 12.75%. This results into a net saving of 25 bps for both the parties.
Figure 3.1
Company A Company B
12.75% in INR
Eg.
Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate
of 18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come
down. The 3-month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month
MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for the
next one year.
The firm can thus benefit by entering into an interest rate fixed for floating swap,
whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps
over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %.
Figure 3.2
Fixed 10.75
Mehta Ltd Counter Party
3 Months MIBOR
18.75%s MIBOR
- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank.
This risk involves losses to the extent of the interest rate differential between fixed and
floating rate payments.
- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond
10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm
hold a strong view that MIBOR shall remain below 10.75%. This will require continuous
monitoring on the path of the firm.
In India fixed rates are aplenty with banks and institutions borrowing and lending at fixed
rates. They also adopt floating rates (Prime Lending Rate or PLR) while lending. But the
PLR has two crucial deficiencies compared to rates like LIBOR: PLR is not a market
related rate, but determined, somewhat arbitrarily, on the basis of the bank rate. Besides
Derivatives – Indian Scenario - 31 -
there are no two-way quotes in PLR, in the absence of which swap deals virtually become
infructuous. Rates like LIBOR, Fed Funds Rate/ T.Bill Rate are those at which banks are
prepared to lend and borrow in any currency.
In India too, such a market does exist for the rupee- the call money market. Banks
borrow/lend at market determined rates. But where the Indian money market differs from
other major financial centers is that, in the latter money is available for periods ranging
from 1 or 7 days to 3, 6 and 12 months, whereas in India, rupee is available for a day or
two, up to a maximum period of 13 days, as a general rule. The reason being the
fortnightly reserve requirements.
Another deficiency is the lack of integration with the foreign exchange (FX) markets. In
order to protect and control the exchange rate of the rupee, strong silos have been created.
Forward premium between the rupee and another foreign currency does not reflect the
interest rate differential. If anything, it reflects the estimated risk of depreciation of the
local unit against the dollar. This gives rise to significant arbitrage opportunities between
the two markets, which are protected through the RBI diktat. At present, the tenors
available in the IRS market are short and the benchmark limited to only one, the Mumbai
Inter-bank Offer Rate (MIBOR).
9
Source: www.economictimes.com
Derivatives – Indian Scenario - 32 -
11 MAY 2001
Vysya Bank, L&T in Rs 10-cr overnight index swap deal
VYSYA Bank and Larsen & Toubro have entered into an overnight index swap (OIS)
transaction for Rs 10 crore. The one-year swap has Vysya Bank paying 8.75 per cent
against the compounded NSE Mibor to L&T. The deal, brokered by eMecklai, was done
over the internet. The verification of the swap differences will be carried out quarterly
with settlement at maturity.
17 FEBRUARY
Jet swaps $340-m floating loan with Credit Lyonnais
George Cherian
CREDIT Lyonnais and Jet Airways have concluded the largest interest rate swap in the
country. A total of $340m of the air tax operator’s outstanding foreign currency floating
rate loans has been swapped to fixed/ floating via a structured interest rate swap spread
over four years.
It will insulate Jet Airways against rising interest rates. It will also give Jet Airways the
opportunity to take advantage of falling interest rates in later years. The swap, which has
been executed in two tranches of $200m and $140m, is the largest ever derivatives
transaction in the domestic 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.
In the first two of these, 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.
Derivatives – Indian Scenario - 34 -
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 for-ward markets trade standardized contracts, and hence avoid the
problem of illiquidity, still the counterparty risk remains a very serious issue.
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
Hence more liquid Hence less liquid 4.4
Requires margin payments No margin payment
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 and three-months 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 three-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
in-stance, 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 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.
10
Source: Derivatives in India FAQ’s by Ajay Shah & Susan Thomas
Derivatives – Indian Scenario - 36 -
• Marking-to-market: In the futures market, at the end of each trading day, the margin
ac-count 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.
from two deficiencies. First, there was no secondary market and second, there was no
mechanism to guarantee that the writer of the option would honor the contract. It was in
1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In
April 1973, CBOE was set up specifically for the purpose of trading options. The market
for options developed so rapidly that by early ’80s, the number of shares underlying the
option contract sold each day exceeded the daily volume of shares traded on the NYSE.
Since then, there has been no looking back.
• 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
upto 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 counterpart.
• In-the-money option: An in-the-money (ITM) option is an option that would lead to
a positive cashflow 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 said 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 option: An at-the-money (ATM) option is an option that would lead
to zero cashflow 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 option: An out-of-the-money (OTM) option is an option that
would lead to a negative cashflow it 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 isN½P which means the intrinsic
value of a call is Max [0, (St – K)] which means the intrinsic value of a call is the (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.
Derivatives – Indian Scenario - 39 -
• Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. A call 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 a call’s time value, all else equal. At expiration, a call
should have no time value. 11
Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
At a practical level, the option buyer faces an interesting situation. He pays for the option
in full at the time it is purchased. After this, he only has an upside. There is no possibility
of the options position generating any further losses to him (other than the funds already
paid for the option). This is different from futures, which is free to enter into, but can
generate very large losses. This characteristic makes options attractive to many
occasional market participants, who cannot put in the time to closely monitor their futures
positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance,
which reimburses the full extent to which Nifty drops below the strike price of the put
11
Source: www.derivativesindia.com
Derivatives – Indian Scenario - 40 -
option. This is attractive to many people, and to mutual funds creating “guaranteed return
products”. The Nifty index fund industry will find it very useful to make a bundle of a
Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which
gives the investor protection against extreme drops in Nifty.
The L.C.Gupta committee which was setup for developing a regulatory framework for
derivatives trading in India had suggested a phased introduction of derivative products in
the following order:
1. Index futures
2. Index options
Derivatives – Indian Scenario - 41 -
The payoff for a person who sells a futures contract is similar to the payoff for a person
who shorts an asset. He has a potentially unlimited upside as well as a potentially
unlimited downside. Take the case of a speculator who sells a two-month Nifty index
futures contract when the Nifty stands at 1220. The underlying asset in this case is the
Nifty portfolio. When the index moves down, the short futures position starts making
profits, and when the index moves up, it starts making losses. Figure 5.2 shows the
payoff diagram for the seller of a futures contract.
Figure 5.1 Payoff for a buyer of Nifty futures
The figure shows the profits/losses for a long futures position. The investor bought
futures when the index was at 1220. If the index goes up, his futures position starts
making profit. If the index falls, his futures position starts showing losses.
Profit
1220
0 Nifty
Loss
Figure 5.2 Payoff for a seller of Nifty futures
The figure shows the profits/losses for a short futures position. The investor sold futures
when the index was at 1220. If the index goes down, his futures position starts making
profit. If the index rises, his futures position starts showing losses.
Profit
1220
0 Nifty
Loss
These non-linear payoffs are fascinating as they lend themselves to be used to generate
various payoffs by using combinations of options and the underlying. We look here at the
six basic payoffs.
Figure 5.3 Payoff for investor who went Long Nifty at 1220
The figure shows the profits/losses from a long position on the index. The investor
bought the index at 1220. If the index goes up, he profits. If the index falls he looses.
Profit
+60
-60
Loss
12
Source: NSE Derivatives Core Module
Derivatives – Indian Scenario - 44 -
Figure 5.4 Payoff for investor who went Short Nifty at 1220
The figure shows the profits/losses from a short position on the index. The investor sold
the index at 1220. If the index falls, he profits. If the index rises, he looses.
Profit
+60
Loss
keep the premium. Figure 5.6 gives the payoff for the writer of a three month call option
(often referred to as short call) with a strike of 1250 sold at a premium of 86.60.
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option.
As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration,
Nifty closes above the strike of 1250, the buyer would exercise his option and profit to
the extent of the difference between the Nifty-close and the strike price. The profits
possible on this option are potentially unlimited. However if Nifty falls below the strike
of 1250, he lets the option expire. His losses are limited to the extent of the premium he
paid for buying the option.
Profit
1250
0 Nifty
86.60
Loss
The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option.
As the spot Nifty rises, the call option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise
his option on the writer who would suffer a loss to the extent of the difference between
the Nifty-close and the strike price. The loss that can be incurred by the writer of the
option is potentially unlimited, whereas the maximum profit is limited to the extent of the
up-front option premium of Rs.86.60 charged by him.
Profit
86.60
1250
0 Nifty
Loss
A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price is below the strike price, he
makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the
underlying is higher than the strike price, he lets his option expire un-exercised. His loss
in this case is the premium he paid for buying the option. Figure 5.7 gives the payoff for
the buyer of a three month put option (often referred to as long put) with a strike of 1250
bought at a premium of 61.70.
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option.
As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration,
Nifty closes below the strike of 1250, the buyer would exercise his option and profit to
the extent of the difference between the strike price and Nifty-close. The profits possible
on this option can be as high as the strike price. However if Nifty rises above the strike of
1250, he lets the option expire. His losses are limited to the extent of the premium he paid
for buying the option.
Profit
1250
0 Nifty
61.70
Loss
buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure
5.8 gives the payoff for the writer of a three-month put option (often referred to as short
put) with a strike of 1250 sold at a premium of 61.70.
Profit
61.70
1250
0 Nifty
Loss
F=S+C
Where:
F: Futures price
S: Spot price
C: Holding costs or carry costs
This can also be expressed as:
F=s (1+r) T
Where:
r: Cost of financing
T: Time till expiration
T
If F < s (1+r) or F > s (1+r) T, arbitrage opportunities would exist i.e. whenever the
futures price moves away from the fair value, there would be chances for arbitrage. We
know what the spot and future prices are, but what are the components of holding cost?
The components of holding cost vary with contracts on different assets. At times the
holding cost may even be negative. In the case of commodity futures, the holding cost is
the cost of financing plus cost of storage and insurance purchased etc. In the case of
equity futures, the holding cost is the cost of financing minus the dividends returns.
Note: In the futures pricing examples worked out in this book, we are using the concept
of discrete compounding, where interest rates are compounded at discrete intervals, for
example, annually or semiannually. Pricing of options and other complex derivative
securities requires the use of continuously compounded interest rates. Most books on
derivatives use continuous compounding for pricing futures too. However, we have used
discrete compounding as it is more intuitive and simpler to work with. Had we to use the
concept of continuous compounding, the above equation would have been expressed as:
F= Se rT
Where:
r: Cost of financing (using continuously compounded interest rate)
T: Time till expiration
e: 2.71828
Derivatives – Indian Scenario - 49 -
1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg.
2. What is the cost of financing for a month? (1+0.15) 30/365
3. What are the holding costs? Let us assume that the storage cost = 0.
In this case the fair value of the futures price, works out to be = Rs.708.
F=s (1+r) T + C = 700(1.15) 30/365 =Rs. 708
If the contract was for 3 month period i.e. expiring 30th March the cost of financing would
90/365
increase the futures price. Therefore, the futures price would be C = 700(1.15) =
Rs.724.5. On the other hand, if the one-month contract was for 10,000 kg. Of silver
instead of 100 gms, then it would involve a non-zero storage cost, and the price of the
future contract would be Rs. 708 +the cost of storage.
In their short history of trading, index futures have had a great impact on the world’s
securities markets. Indeed, index futures trading has been accused of making the world’s
stock markets more volatile than ever before. The critics claim that individual investors
have been driven out to the equity markets because the actions of institutional traders in
both the spot and futures markets cause stock values to gyrate with no links to their
fundamental values. Whether stock index futures trading is a blessing or a curse is
Derivatives – Indian Scenario - 50 -
debatable. It is certainly true, however, that its existence has revolutionized the art and
science of institutional equity portfolio management.
The main differences between commodity and equity index futures are that: _
1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15
days of purchasing the contract.
2. Current value of Nifty is 1200 and Nifty trades with a multiplier of 200.
3. Since Nifty is traded in multiples of 200, value of the contract is 200*1200 =
Rs.240,000.
4. If M & M has a weight of 7% in Nifty, its value in Nifty is Rs.16,800 i.e.(240,000 *
0.07).
5. If the market price of M & M is Rs.140, then a traded unit of Nifty involves 120 shares
of M & M i.e.(16,800/140).
6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of
dividend received. The amount of dividend received is Rs.1200 i.e.(120 * 10). The
dividend is received 15 days later and hence compounded only for the remainder of 45
Derivatives – Indian Scenario - 51 -
days. To calculate the futures price we need to compute the amount of dividend received
per unit of Nifty. Hence we divide the compounded dividend figure by 200.
7. Thus, futures price F = 1200(1.15) 60/365 {120*10(1.15) 45/365 /200} =Rs. 1221.80
Example
A two-month futures contract trades on the NSE. The annual dividend yield on Nifty is
2% annualized. The spot value of Nifty 1200. What is the fair value of the futures
contract?
Fair value = 1200(1+.015-0.02) 60/365 =Rs. 1224.35
The cost of carry model explicitly defines the relationship between the futures price and
the related spot price. As we know, the difference between the futures price and the spot
price is called the basis.
Nuances
• As the date of expiration comes near, the basis reduces - there is a convergence of the
futures price towards the spot price. On the date of expiration, the basis is zero. If it is
not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when
the basis (difference between spot and futures price) or the spreads (difference
Derivatives – Indian Scenario - 52 -
between prices of two futures contracts) during the life of a contract are incorrect. At
a later stage we shall look at how these arbitrage opportunities can be exploited.
• There is nothing but cost-of-carry related arbitrage that drives the behavior of the
futures price.
• Transactions costs are very important in the business of arbitrage.
Note: The pricing models discussed in this chapter give an approximate idea about the
true future price. However the price observed in the market is the outcome of the price–
discovery mechanism (demand–supply principle) and may differ from the so-called true
price.
There are various models, which help us get close to the true price of an option. Most of
these are variants of the celebrated Black-Scholes model for pricing European options.
Today most calculators and spreadsheets come with a built-in Black-Scholes options
pricing formula so to price options we don’t really need to memorize the formula. What
we shall do here is discuss this model in a fairly non-technical way by focusing on the
basic principles and the underlying intuition.
Derivatives – Indian Scenario - 53 -
produce the exact prices that show up in the market, but definitely does a remarkable job
of pricing options within the framework of assumptions of the model. Virtually all option
pricing models, even the most complex ones, have much in common with the Black–
Scholes model.
Black and Scholes start by specifying a simple and well–known equation that models the
way in which stock prices fluctuate. This equation called Geometric Brownian Motion,
implies that stock returns will have a lognormal distribution, meaning that the logarithm
of the stock’s re-turn will follow the normal (bell shaped) distribution. Black and Scholes
then propose that the option’s price is determined by only two variables that are allowed
to change: time and the underlying stock price. The other factors - the volatility, the
Derivatives – Indian Scenario - 54 -
exercise price, and the risk–free rate do affect the option’s price but they are not allowed
to change. By forming a portfolio consisting of a long position in stock and a short
position in calls, the risk of the stock is eliminated. This hedged portfolio is obtained by
setting the number of shares of stock equal to the approximate change in the call price for
a change in the stock price. This mix of stock and calls must be revised continuously, a
process known as delta hedging.
Black and Scholes then turn to a little–known result in a specialized field of probability
known as stochastic calculus. This result defines how the option price changes in terms of
the change in the stock price and time to expiration. They then reason that this hedged
combination of options and stock should grow in value at the risk–free rate. The result
then is a partial differential equation. The solution is found by forcing a condition called a
boundary condition on the model that requires the option price to converge to the exercise
value at expiration. The end result is the Black and Scholes model.
• The Black Scholes equation is done in continuous time. This requires continuous
compounding. The “ r ” that in this is ln(1+r). E.g. if the interest rate per annum is
12%, you need to use ln1.12 or 0.1133, which is continuously compounded
equivalent of 12% per annum.
• N () is the cumulative normal distribution. N(d1 ) is called the delta of the option
which is a measure of change in option in option price with respect to change in the
price of the underlying asset.
Derivatives – Indian Scenario - 55 -
The Black-Scholes formula is so commonly used that it comes programmed into most
calculators and spreadsheets. Hence it is not necessary to memorize the formula. One
only needs to know how to use it.
Note: The pricing models discussed in this chapter give an approximate idea about the
true options price. However the price observed in the market is the outcome of the price–
discovery mechanism (demand–supply principle) and may differ from the so-called true
price.
Derivatives – Indian Scenario - 56 -
Hedging
H1 Long stock, short Nifty futures
H2 Short stock, long Nifty futures
H3 Have portfolio, short Nifty futures
H4 Have funds, long Nifty futures
Speculation
www.erivativesreview.com
Derivatives – Indian Scenario - 57 -
Arbitrage
A1 Have funds, lend them to the market
A2 Have securities, lend them to the market
A person who feels like this takes a long position on the cash market. When doing this,
he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the
market price; or,
2. The entire market moves against him and generates losses even though the underlying
idea was correct.
The second outcome happens all the time. A person may buy Infosys at Rs.190 thinking
that it would announce good results and the stock price would rise. A few days later,
Nifty drops, so he makes losses, even if his understanding of Infosys was correct.
There is a peculiar problem here. Every buy position on a stock is simultaneously a buy
position on Nifty. This is because a LONG INFOSYS position generally gains if Nifty
rises and generally loses if Nifty drops. The stock picker may be thinking he wants to be
LONG INFOSYS, but a long position on Reliance effectively forces him to be LONG
INFOSYS + LONG NIFTY.
It is useful to ask: does the person feel bullish about INFOSYS or about the index?
• Those who are bullish about the index should just buy Nifty futures; they need not
trade individual stocks.
Derivatives – Indian Scenario - 58 -
• Those who are bullish about INFOSYS do wrong by carrying along a long position
on Nifty as well.
There is a simple way out. Every time you adopt a long position on a stock, you should
sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside
every long–stock position. Once this is done, you will have a position, which is purely
about the performance of the stock. The position LONG INFOSYS + SHORT NIFTY is
a pure play on the value of INFOSYS, without any extra risk from fluctuations of the
market index. When this is done, the stockpicker has “hedged away” his index exposure.
Warning: Hedging does not remove losses. The best that can be achieved using hedging
is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will
make less profits than the un-hedged position, half the time. One should not enter into a
hedging strategy hoping to make excess profits for sure; all that can come out of hedging
is reduced risk.
• Those who are bearish about the index should just sell nifty futures; they need not
trade individual stocks.
• Those who are bearish about RELIANCE do wrong by carrying along a short position
on Nifty as well.
There is a simple way out. Every time you adopt a short position on a stock, you should
buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside
every short–stock position. Once this is done, you will have a position which is purely
about the performance of the stock. The position SHORT RELIANCE + LONG NIFTY is a pure
Derivatives – Indian Scenario - 60 -
play on the value of RELIANCE, without any extra risk from fluctuations of the market
index.
position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely
remove the hidden Nifty exposure, is 1.2 * 200,000, i.e. Rs.240,000.
¨
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each
market lot of Nifty is Rs.240,000. To long Rs.240,000 of Nifty we need to buy one
market lot.
4. We buy one market lot of Nifty (200 nifties) to get the position:
SHORT WIPRO Rs.200, 000, LONG NIFTY Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profits/losses
position will fully reflect price changes intrinsic to WIPRO, hence only successful
forecasts about WIPRO will benefit from this position. Returns on the position will be
roughly neutral to movements of Nifty.
This is particularly a problem if you expect to need to sell shares in the near future, for
example, in order to finance a purchase of a house. This planning can go wrong if by the
time you sell shares, Nifty has dropped sharply.
Derivatives – Indian Scenario - 61 -
In addition, with the index futures market, a third and remarkable alternative becomes
available:
3 Remove your exposure to index fluctuations temporarily using index futures. This
allows rapid response to market conditions, without “panic selling” of shares. It allows an
investor to be in control of his risk, instead of doing nothing and suffering the risk.
The idea here is quite simple. Every portfolio contains a hidden index exposure. This
statement is true for all portfolios, whether a portfolio is composed of index stocks or not.
In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations
(unlike individual stocks, where only 30–60% of the stock risk is accounted for by index
fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one–
tenth as risky as the LONG PORTFOLIO position!
Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete
hedge is obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved using
hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position
will make less profit than the unhedged position, half the time. One should not enter into
a hedging strategy hoping to make excess profits for sure; all that can come out of
hedging is reduced risk.
The investor should adopt this strategy for the short periods of time where (a) the market
volatility that he anticipates makes him uncomfortable, or (b) when his financial planning
involves selling shares at a future date and would be affected if Nifty drops. It does not
make sense to use this strategy for long periods of time – if a two–year hedging is
Derivatives – Indian Scenario - 62 -
desired, it is better to sell the shares, invest the proceeds, and buy back shares after two
years. This strategy makes the most sense for rapid adjustments.
Another important choice for the investor is the degree of hedging. Complete hedging
eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some
risk of loss so as to hang on to some risk of gain. In that case, partial hedging is
appropriate. The complete hedge may require selling Rs.3 million of the futures, but the
investor may choose to only sell Rs.2 million of the futures. In this case, two–thirds of his
portfolio is hedged and one–third ofthe portfolio is held unhedged. The exact degree of
hedging chosen depends upon the appetite for risk that the investor has.
Getting invested in equity ought to be easy but there are three problems:
1. A person may need time to research stocks, and carefully pick stocks that are expected
to do well. This process takes time. For that time, the investor is partly invested in cash
and partly invested in stocks. During this time, he is exposed to the risk of missing out if
the overall market index goes up.
2. A person may have made up his mind on what portfolio he seeks to buy, but going to
the market and placing market orders would generate large ‘impact costs’. The execution
would be improved substantially if he could instead place limit orders and gradually
accumulate the portfolio at favor-able prices. This takes time, and during this time, he is
exposed to the risk of missing out if the Nifty goes up.
Derivatives – Indian Scenario - 63 -
3. In some cases, such as the land sale above, the person may simply not have cash to
immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually
cheap. He is exposed to the risk of missing out if Nifty rises.
So far, in India, we have had exactly two alternative strategies which an investor can
adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying in cash. With Nifty
futures, a third alternative becomes available:
• The investor would obtain the desired equity exposure by buying index futures,
immediately. A person who expects to obtain Rs.5 million by selling land would
immediately enter into a position LONG NIFTY worth Rs.5 million. Similarly, a
closed end fund which has just finished its initial public offering and has cash which
is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants
to be invested in equity. The index futures market is likely to be more liquid than
individual stocks so it is possible to take extremely large positions at a low impact
cost.
• Later, the investor/closed-end fund can gradually acquire stocks (either based on
detailed research and/or based on aggressive limit orders). As and when shares are
obtained, one would scale down the LONG NIFTY position correspondingly. No
matter how slowly stocks are purchased, this strategy would fully capture a rise in
Nifty, so there is no risk of missing out on a broad rise in the stock market while this
process is taking place. Hence, this strategy allows the investor to take more care and
spend more time in choosing stocks and placing aggressive limit orders.
Hedging is often thought of as a technique that is used in the context of equity exposure.
It is common for people to think that the owner of shares needs index futures to hedge
against a drop in Nifty. Holding money in hand, when you want to be invested in shares,
is a risk because Nifty may rise. Hence it is equally important for the owner of money to
use index futures to hedge against a rise in Nifty!
On 17 Feb, Iqbal purchased 5000 nifties to obtain a position of Rs.5 million. From 18 Feb
onwards, on each day, Iqbal purchased one security worth Rs.357,000 (at 17 Feb prices)
and sold off a similar value of futures thus shrinking his futures position. For this
example, we deliberately use non–index small stocks; hedging using index futures works
for all portfolios regardless of what stocks go into them. Nifty rose sharply on 27
February and 28 February, so his outstanding futures position generated an infusion of
cash for him on these days. This inflow paid for the higher stock prices that he suffered.
On each day, the stocks purchased were at a changed price (as compared to the price
prevalent on 17 Feb). On each day, he obtained or paid the ‘mark–to–market margin’ on
his outstanding futures position, thus capturing the gains on the index.
4. By 09 Mar 1998 he had fully invested in all the shares that he wanted (as of 17 Feb)
and had no futures position left.
5. The same sequencing of purchases, without the umbrella of protection of the LONG
NIFTY MARCH FUTURES position, would have cost Rs.249,724 more.
Do you sometimes think that the market index is going to rise? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from an upward movement in the index? Today, you have two choices:
1. Buy selected liquid securities, which move with the index, and sell them at a later date:
or, 2. Buy the entire index portfolio and then sell it at a later date.
The first alternative is widely used – a lot of the trading volume on liquid stocks is based
on using these liquid stocks as an index proxy. However, these positions run the risk of
making losses owing to company–specific news; they are not purely focused upon the
index. The second alternative is cumbersome and expensive in terms of transactions
costs.
How do we actually do this?
When you think the index will go up, buy the Nifty futures. The minimum market lot is
200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000.
When the trade takes place, the investor is only required to pay up the initial margin,
which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the
investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000,
the investor gets a claim on Nifty worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose any of them
to implement this position. The choice is basically about the horizon of the investor.
Derivatives – Indian Scenario - 66 -
Longer dated futures go well with long–term forecasts about the movement of the index.
Shorter dated futures tend to be more liquid.
1. Sell selected liquid securities which move with the index, and buy them at a later date:
or, 2. Sell the entire index portfolio and then buy it at a later date.
The first alternative is widely used – a lot of the trading volume on liquid stocks is based
on using these stocks as an index proxy. However, these positions run the risk of making
losses owing to company–specific news; they are not purely focused upon the index.
The second alternative is hard to implement. This strategy is also cumbersome and
expensive in terms of transactions costs.
Would you like to lend funds into the stock market, without suffering the slightest risk?
Traditional methods of loaning money into the stock market suffer from (a) price risk of
shares and (b) credit risk of default of the counter-party. What is new about the index
futures market is that it supplies a technology to lend money into the market without
suffering any exposure to Nifty, and without bearing any credit risk.
The basic idea is simple. The lender buys all 50 stocks of Nifty on the cash market, and
simultaneously sells them at a future date on the futures market. It is like a repo. There is
no price risk since the position is perfectly hedged. There is no credit risk since the
counterparty on both legs is the NSCCL which supplies clearing services on NSE. It is an
ideal lending vehicle for entities which are shy of price risk and credit risk, such as
traditional banks and the most conservative corporate treasuries.
What is the interest rate that you will receive? We will use one specific case, where you
will unwind the transaction on the expiration date of the futures. In this case, the
difference between the futures price and the cash Nifty is the return to the moneylender,
with two complications: the moneylender additionally earns any dividends that the 50
shares pay while he has held them, and the moneylender suffers transactions costs
(impact cost, brokerage) in doing these trades. On 1 July 1998, if the Nifty spot is 942.25,
and the Nifty July 1998 futures are at 956.5 then the difference (1.5% for 30 days) is the
return that the moneylender obtains.
Example
On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for
1230. Ashish wants to earn this return (30/1200 for 27 days).
1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market
orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e.
he has obtained the Nifty spot for 1204.
2. He sells Rs.3 million of the futures at 1230. The futures market is extremely liquid so
the market order for Rs.3 million goes through at near–zero impact cost.
3. He takes delivery of the shares and waits.
4. While waiting, a few dividends come into his hands. The dividends work out to
Rs.7,000.
5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio,
putting 50 market orders to sell off all the shares. Nifty happens to have closed at 1210
and his sell orders (which suffer impact cost) goes through at 1207.
6. The futures position spontaneously expires on 27 August at 1210 (the value of the
futures on the last day is always equal to the Nifty spot).
7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for
a return of near 1.88%. In addition, he has gained Rs.70,000 or 0.23% owing to the
dividends for a total return of 2.11% for 27 days, risk free.
It is easier to make a rough calculation of the return. To do this, we ignore the gain from
dividends and we assume that transactions costs account for 0.4%. In the above case, the
Derivatives – Indian Scenario - 69 -
return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions
costs giving 2.1% for 27 days. This is very close to the actual number.
Most owners of shares answer in the affirmative to these questions. Yet, stocklending
schemes that are widely accessible do not exist in India.
The index futures market offers a riskless mechanism for (effectively) loaning out shares
and earning a positive return for them. It is like a repo; you would sell off your
certificates and con-tract to buy them back in the future at a fixed price. There is no price
risk (since you are perfectly hedged) and there is no credit risk (since your counterparty
on both legs of the transaction is the NSCCL).
The basic idea is quite simple. You would sell off all 50 stocks in Nifty and buy them
back at a future date using the index futures. You would soon receive money for the
shares you have sold. You can deploy this money as you like until the futures expiration.
On this date, you would buy back your shares, and pay for them.
6. A few days later, you will need to pay in the money and get back your shares.
When is this worthwhile? When the spot-futures basis (the difference between spot Nifty
and the futures Nifty) is smaller than the riskless interest rate that you can find in the
economy. If the spot–futures basis is 2.5% per month and you are loaning out the money
at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per
month and you are loaning out money at 1.2% per month, this stocklending could be
profitable.
It is easy to approximate the return obtained in stock lending. To do this, we assume that
transactions costs account for 0.4%. Suppose the spot–futures basis is x% and suppose
the rate at which funds can be invested is y% Then the total return is y-x-0.4%, over the
time that the position is held.
This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of
Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures
basis is somewhat wider.
Example
Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the
spot– futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1%
per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the
total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the two–
month period.
Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4
million of the Nifty portfolio which he would like to lend to the market.
1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly
place 50 market orders in quick succession. The seller always suffers impact cost;
suppose he obtains an actual execution at 1098.
2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures.
The order executes at 1110. At this point, he is completely hedged.
Derivatives – Indian Scenario - 71 -
3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million
(assuming an impact cost of 2/1100).
4. Suppose Akash lends this out at 1% per month for two months.
5. At the end of two months, he get back Rs.4,072,981. Translated in terms of Nifty, this
is 1098*1.012 or 1120.
6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market
orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time.
This makes shares are costlier in buying back, but the difference is exactly offset by
profits on the futures contract.
When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to
impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110)
so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a
base of Rs.4 million, this is Rs.25, 400.
Table 6.2 Market watch showing bid and ask for various futures contracts
Hedging
H5 Have portfolio, buy puts
Derivatives – Indian Scenario - 72 -
Speculation
S3 Bullish index, buy Nifty calls or sell Nifty puts
S4 Bearish index, sell Nifty calls or buy Nifty puts
S5 Anticipate volatility, buy a call and a put at same strike
S6 Bull spreads, Buy a call and sell another
S7 Bear spreads, Sell a call and buy another
Arbitrage
A3 Put-call parity with spot-options arbitrage
A4 Arbitrage beyond option price bounds14
Index options is a cheap and easily implementable way of seeking this insurance. The
idea is simple. To protect the value of your portfolio from falling below a particular level,
buy the right number of put options with the right strike price. When the index falls your
portfolio will lose value and the put options bought by you will gain, effectively ensuring
that the value of your portfolio does not fall below a particular level. This level depends
on the strike price of the options chosen by you.
Portfolio insurance using put options is of particular interest to Mutual funds who already
own well-diversified portfolios. By buying puts, the fund can limit its downside in case of
a market fall.
www.erivativesreview.com, www.rediff/money/derivatives.htm
Derivatives – Indian Scenario - 73 -
We need to know the “beta” of the portfolio. We look at two cases, case one where the
portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1.
Now let us look at the outcome. We have just bought two–month Nifty puts at a strike of
1125. This is designed to ensure that the value of our portfolio does not decline below
Rs.0.90 million. (For a portfolio with a beta of 1, a 10% fall in the index directly
translates into a 10% fall in the portfolio value). During the two–month period, suppose
the Nifty drops to 1080. This is a 13.6% fall in the index. The portfolio value too falls at
the same rate and declines to Rs.0.864 million. However the options provide a payoff of
(1125-1080)*4*200 which is equal to Rs.36,000. This is the amount needed to bring the
value of the portfolio back to Rs.0.90 million.
Portfolio insurance when portfolio beta is not 1.0
1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure
against a fall in the market.
2. Now we need to choose the strike at which we should buy puts. This is largely a
function of how safe we want to play. Assume that the spot Nifty is 1200 and we decide
to buy puts with a strike of 1140. This will insure our portfolio against an index fall lower
than 1140.
3. For a portfolio with a non-unit beta, the number of puts to buy equals (portfolio value *
portfolio beta)/Index. Assume our portfolio is worth Rs.1 million with a beta of 1.2.
Hence the number of puts we need to buy to protect our portfolio from a downside is
Derivatives – Indian Scenario - 74 -
(10,00,000 *1.2)/1200 which works out to 1000. At a market lot of 200, it means that we
will have to buy 5 market lots of two month puts with a strike of 1140.
Now let us look at the outcome. We have just bought two month Nifty puts at a strike of
1140. This is designed to ensure the value of our portfolio does not decline below Rs.0.94
million. (For a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in
the portfolio value). During the two-month period, suppose the Nifty drops to 1080. The
portfolio value has declined to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2,
a 10% fall in the index translates into a 12% fall in the portfolio value). However the
options provide a payoff of (1140-1080)*5*200 which is equal to Rs.60,0000. This is the
amount needed to bring the value of the portfolio back to Rs.0.94 million.
7.2 S3: Bullish index, buy Nifty calls or sell Nifty puts
Do you sometimes think that the market index is going to rise? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from an upward movement in the index? Today, using options you have two
choices:
1. Buy call options on the index; or,
2. Sell put options on the index
We have already seen the payoff of a call option. The downside to the buyer of the call
option is limited to the option premium he pays for buying the option. His upside
however is potentially unlimited.
Having decided to buy a call, which one should you buy? Table 7.1 gives the premia for
one-month calls and puts with different strikes. Given that there are a number of one–
month calls trading, each with a different strike price, the obvious question is: which
strike should you choose? Let us take a look at call options with different strike prices.
Assume that the current index level is 1250, risk-free rate is 12% per year and index
volatility is 30%. The following options are available:
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
As a person who wants to speculate on the hunch that the market index 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.
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 market index. In the example in Figure 7.2,
at a Nifty level of 1250, one option is in–the–money and one is out–of–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.
Profit
49.45
80.10
Loss
Profit
64.80
37.00
18.15
Loss
7.3 S4: Bearish index: sell Nifty calls or buy Nifty puts
Derivatives – Indian Scenario - 77 -
Do you sometimes think that the market index is going to drop? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from a downward movement in the index? Today, using options, you have two
choices:
1. Sell call options on the index; or,
2. Buy put options on the index
We have already seen the payoff of a call option. The upside to the writer of the call
option is limited to the option premium he receives upright for writing the option. His
downside however is potentially unlimited. Having decided to write a call, which one
should you write? Table 7.2 gives the premiums for one month calls and puts with
different strikes. Given that there are a number of one-month calls trading, each with a
different strike price, the obvious question is: which strike should you choose ? Let us
take a look at call options with different strike prices. Assume that the current index level
is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the
following options :
1. A one month call on the Nifty with a strike of 1200.
2. A one month call on the Nifty with a strike of 1225.
3. A one month call on the Nifty with a strike of 1250.
4. A one month call on the Nifty with a strike of 1275.
5. A one month call on the Nifty with a strike of 1300.
Which of this options you write largely depends on how strongly you feel about the
likelihood of the downward movement in the market index and how much you are willing
to lose should this downward movement not come about.
Table 7.2 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are five one-month calls and five one-month puts
trading in the market. Figure 7.3 shows payoff for seller of various calls at different
strikes. Figure 7.4 shows the payoffs from buying puts at different strikes.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
Derivatives – Indian Scenario - 78 -
As a person who wants to speculate on the hunch that the market index may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited downside.
If the index does fall, you profit to the extent the index falls below the strike of the put
purchased by you. 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 index.
The figure shows the profits/losses for a seller of Nifty calls at various strike prices. The
in–the–money option has the highest premium of Rs.80.10 whereas the at–the–money
option has the lowest premium of Rs.27.50.
Profit
80.10
1327.5
49.45
27.50
Loss 1280.10
1299.45
The figure shows the profits/losses for a buyer of Nifty puts at various strike prices. The
in–the–money option has the highest premium of Rs.64.80 whereas the at–the–money
option has the lowest premium of Rs.18.50.
Profit
Derivatives – Indian Scenario - 79 -
37.00
64.80
Loss
Consider an investor who feels that the index which currently stands at 1252 could move
significantly in three months. The investor could create a straddle by buying both a put
and a call with a strike close to 1252 and an expiration date in three months. Suppose a
three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same
strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00. If
at the end of three months, the index remains at 1252, the strategy costs the investor
Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires
worth Rs.2). If at expiration the index settles around 1252, the investor incurs losses.
However, if as expected by the investors, the index jumps or falls significantly, he profits.
For a straddle to be an effective strategy, the investor’s beliefs about the market
movement must be different from those of most other market participants. If the general
Derivatives – Indian Scenario - 80 -
view is that there will be a large jump in the index, this will reflect in the prices of the
options.
Figure 7.5 Payoff for buyer of three-month call and put options at strikes of 1250
The figure shows the profits/losses for a combination of a long call and a long put at the
same strike and expiration. The investor has bought both a call and a put on the Nifty
index. If on the expiration date, the index closes between 1098 and 1402, he losses a
maximum of Rs.152. If however, his expectation of high volatility does come true, his
profits are potentially unlimited. If for instance the index jumps to 1420, he makes a neat
profit of Rs.18 i.e. (1420-1250)-152. The effectiveness of this combination depends how
different is the investors belief about market movement from that of most other
participants. The higher the cost of setting up this combination, the more the index would
have to move for it to be profitable.
Profit
57.00
95.00
152.00
Loss
generate the straddle. In this case he has three three-month option contracts to choose
from.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
The cost of the bull spread is the cost of the option that is purchased, less the cost of the
option that is sold. Table 7.4 gives the profit/loss incurred on a spread position as the
index changes.
Figure 7.6 shows the payoff from the bull spread.
Broadly, we can have three types of bull spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk
the investor is willing to take. The most aggressive bull spreads are of type 1. They cost
very little to set up, but have a very small probability of giving a high payoff.
Table 7.4 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profit for a bull spread created by buying one
market lot of calls at a strike of 1260 and selling a market lot of calls at a strike of 1350.
The cost of setting up the spread is the call premium paid (Rs.76.50) minus the call
premium received (Rs.37.85), which is Rs.38.65. This is the maximum loss that the
position will make. On the other hand, the maximum profit on the spread is limited to
Derivatives – Indian Scenario - 82 -
Rs.51.35. Beyond an index level of 1350, any profits made on the long call position will
be cancelled by losses made on the short call position, effectively limiting the profit on
the combination.
Nifty Buy Jan 1260 Sell Jan 1350 Cash Flow Profit & Loss
Call Call (Rs.)
1245 0 0 0 -38.95
1255 0 0 0 -38.65
1265 +5 0 5 -33.65
1275 +15 0 15 -23.656
1285 +25 0 25 -13.65
1295 +35 0 35 -3.65
1305 +45 0 45 +6.35
1315 +55 0 55 +16.35
1325 +65 0 65 +26.35
1335 +75 0 75 +36.35
1345 +85 0 85 +46.35
1355 +95 -5 90 +51.35
1365 +105 -15 90 +51.35
Figure 7.6 Payoff for a bull spread created using call options
The figure shows the profits/losses for a bull spread.As the index moves above 1260, the
position starts making profits (cutting losses) until the spot reaches 1350. Beyond 1350,
the profits made on the long call position get offset by the losses made on the short call
position and hence the maximum profit on this spread is made if the index on the
expiration day closes at 1350. Hence the payoff on this spread lies between 38.85 to
51.35.
Profit
51.35
37.85
| | | | |
Loss
38.65
76.50
A bear spread created using calls involves initial cash inflow since the price of the call
sold is greater than the price of the call purchased. Table 7.5 gives the profit/loss incurred
on a spread position as the index changes. Figure 7.7 shows the payoff from the bull
spread.
Figure 7.7 Payoff for a bear spread created using call options
The figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained
is the sum of the payoffs of the two calls, one sold at Rs.76.50 and the other bought at
Rs.37.85. The maximum gain from setting up the spread is Rs.38.65 which is the
Derivatives – Indian Scenario - 84 -
difference between the call premium received and the call premium paid. The upside on
the position is limited to this amount. Hence the payoff on this spread lies between
+38.85 to -51.35.
Profit
76.50
38.65
37.85
51.35
Loss
Table 7.5 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profit for a bear spread created by selling one market lot
of calls at a strike of 1260 and buying a market lot of calls at a strike of 1350.
Nifty Buy Jan 1350 Sell Jan 1260 Cash Flow Profit & Loss
Call Call (Rs.)
1245 0 0 0 +38.95
1255 0 0 0 +38.65
1265 0 -5 -5 +33.65
1275 0 -15 -15 +23.656
1285 0 -25 -25 +13.65
1295 0 -35 -35 +3.65
1305 0 -45 -45 -6.35
1315 0 -55 -55 -16.35
1325 0 -65 -65 -26.35
1335 0 -75 -75 -36.35
1345 0 -85 -85 -46.35
Derivatives – Indian Scenario - 85 -
What happens if the above equation does not hold good ? It gives rise to arbitrage
opportunities. The put-call parity basically explains the relationship between put, call,
stock and bond prices.
It is expressed as:
S + P – C = X / (1+r) T
Where:
S: Current index level
X: Exercise price of option
T: Time to expiration
C: Price of call option
P: Price of put option
R: risk-free rate of interest
Derivatives – Indian Scenario - 86 -
The above expression shows that the value of a European call with a certain exercise
price and exercise date can be deduced from the value of a European put with the same
exercise price and date and vice versa. It basically means that the payoff from holding a
call plus an amount of cash equal to X / (1+r) T is the same as that of holding a put option
plus the index.
Case 1
Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of
a three month Nifty 1260 call is Rs.96.50 and the price of a three month Nifty 1260 put is
Rs.60. In this case we can see that
S + P – C (not equal to) X / (1+r) T
1325 > 1321.30
What does this mean? If we think of index plus put as portfolio A and the call plus cash
as portfolio B, clearly portfolio A is overpriced relative to portfolio B. What would be the
arbitrage strategy in this case? Sell the securities in portfolio A and buy those in portfolio
B. This involves shorting the index and a put on the index and buying a call. How would
one short the index? One way to do it would be to actually sell off all 50 Nifty stocks in
the proportions in which they exist in the index. Another easier way to do this would be
to sell units of Index funds instead of the actual index stocks. This would achieve a
similar outcome. This entire set of transactions generates an up-front cash-flow of (1265
+ 60 - 96.50) = Rs.1228.50. When invested at the riskfree rate of 12%, this amount grows
to Rs.1265.35.
At expiration, if the index is higher than 1260, you will exercise the call. If the index is
lower than 1260, the buyer of the put will exercise on you. In either case, the investor
ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is
Rs.5.35 (i.e. 1265.35-1260).
Case 2:
Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of
a three month Nifty 1260 call is Rs.96 and the price of a three month Nifty 1260 put is
51.50. In this case, we can see that
S + P – C (not equal to) X / (1+r) T
1316.50 < 1320.80
What does this mean? If we think of index plus put as portfolio A and the call plus cash
as portfolio B, clearly portfolio B is overpriced relative to portfolio A. What would be the
arbitrage strategy in this case? Buy the securities in portfolio A and sell those in portfolio
B. This involves buying the index and a put on the index and selling a call. How would
one buy the index? One way to do it would be to actually buy all 50 Nifty stocks in the
proportions in which they exist in the index. An easier way to do this would be to buy
units of Index funds instead of the actual index stocks. This would achieve a similar
outcome. This entire set of transactions involves an initial investment of Rs.1220.50(i.e.
1265 - 51.50 + 96) When financed at the riskfree rate of 12%, the repayment required at
the end of three months is Rs.1257.
At expiration if the index is lower than 1260, you will exercise the put. If the index is
higher than 1260, the buyer of the call will exercise on you. In either case, the investor
Derivatives – Indian Scenario - 88 -
ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3
(1260 - 1257).
A call option gives the holder the right to buy the index for a certain price. No matter
what happens, the option can never be worth more than the index. Hence the index level
is an upper bound to the option price.
If this relationship is not true, an arbitrageur can easily make a riskless profit by buying
the index and selling the call option.
As we know a put option gives the holder the right to sell the index for X. No matter how
low the index becomes, the option can never be worth more than X. Hence,
Consider an example. Suppose the exercise price for a three-month Nifty call option is
1260. The spot index stands at 1386 and the risk-free rate of interest is 12% per annum.
–0.25
In this case, he lower bound for the option price is 1386-1260 (1+1.2) i.e. 161.20
Suppose the call is available at a premium of Rs.150 which is less than the theoretical
minimum of Rs. 163.20. An arbitrageur can buy a call and short the index. This provides
a cashflow of 1386-150 = 1236. If invested for three months at 12% per annum, the
Rs.1236 grows to Rs.1273. At the end of three months, the option expires. At this point,
the following could happen:
1. The index is above 1260, in which case the arbitrageur exercises his option and buys
back the index at 1260 making a profit of Rs.1273 - 1260 = Rs.13.
2. The index is below 1260 at say 1235, in which case the arbitrageur buys back the index
at the market price. He makes an even greater profit of 1273 - 1235 = Rs.38.
Derivatives – Indian Scenario - 90 -
The lower bound for the price of a put option is given by X (1+r) -T –S. The price of a put
must be worth at least this much else, it will be possible to make riskless profits.
X (1+r) -T –S. < P
Consider an Example. Suppose exercise price for three- month Nifty put option is 1260.
The spot index stands at 1165 and the risk-free rate of interest is 12% per annum. In this
case the lower bound for the option price is Rs.59.80. Suppose the put is available at a
premium of Rs.45 which is less than the theoretical minimum of Rs.59.80. An arbitrageur
can borrow Rs.1210 for three months to buy both the put and the index. At the end of the
three months, the arbitrageur will be required to pay Rs.1246.3. Three months later the
option expires. At this point, the following could happen:
1. The index is below 1260, in which case the arbitrageur exercises his option, sells the
index at Rs.1260, repays the loan amount of Rs.1246.3 and makes a profit of Rs.13.7.
2. The index is above 1260 at say 1275, in which case the arbitrageur discards the option,
sells the index at 1275, repays the loan amount of Rs.1246.3 and makes an even greater
profit of 1275 - 1246.3 = Rs.28.7.
Bibliography
Derivatives – Indian Scenario - 91 -
Books
1. Options Futures, and other Derivatives by John C Hull
2. Derivatives FAQ by Ajay Shah
3. NSE’s Certification in Financial Markets: - Derivatives Core module
4. Investment Monitor Magazine July 2001
Reports
1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta
2. Risk containment in the derivatives markets by Prof.J.R.Verma
Websites
• www.derivativesindia.com
• www.nse-india.com
• www.sebi.gov.in
• www.rediff/money/derivatives.htm
• www.igidr.ac.in/~ajayshah
• www.iinvestor.com
• www.appliederivatives.com
• www.erivativesreview.com
• www.economictimes.com
• www.cboe.com (Chicago Board of Exchange)
• www.adtading.com
• www.numa.org