NCFM - Derivatives, NCDEX

Contents
1 Introduction to derivatives 7
1.1 Derivatives defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Products, participants and functions . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Types of derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.4 Development of exchange-traded derivatives . . . . . . . . . . . . . . . . . . . . 10
1.5 Global derivatives markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.6 Exchange-traded vs. OTC derivatives markets . . . . . . . . . . . . . . . . . . . 11
1.7 Derivatives market in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.7.1 Approval for derivatives trading . . . . . . . . . . . . . . . . . . . . . . 13
1.7.2 Derivatives market at NSE . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.3 Trading mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.4 Membership criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.5 Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.7.6 Clearing and settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.7.7 Risk management system . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2 Market index 19
2.1 Understanding the index number . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2 Economic significance of index movements . . . . . . . . . . . . . . . . . . . . 20
2.3 Index construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.4 Types of indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.5 Desirable attributes of an index . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5.1 Capturing behavior of portfolios . . . . . . . . . . . . . . . . . . . . . . 23
2.5.2 Including liquid stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.5.3 Maintaining professionally . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.6 The S&P CNX Nifty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.6.1 Impact cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.6.2 Hedging effectiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.7 Applications of index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.1 Index derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.2 Index funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.3 Exchange Traded Funds . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2 CONTENTS
3 Introduction to futures and options 29

3.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.2 Limitations of forward markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.3 Introduction to futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.4 Distinction between futures and forwards contracts . . . . . . . . . . . . . . . . 31
3.5 Futures terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.6 Introduction to options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.7 Option terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.8 Futures and options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.9 Index derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.10 Payoff for derivatives contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.11 Payoff for futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.11.1 Payoff for buyer of futures: Long futures . . . . . . . . . . . . . . . . . 37
3.11.2 Payoff for seller of futures: Short futures . . . . . . . . . . . . . . . . . 38
3.12 Options payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.12.1 Payoff profile for buyer of call options: Long call . . . . . . . . . . . . . 39
3.12.2 Payoff profile for writer of call options: Short call . . . . . . . . . . . . . 40
3.12.3 Payoff profile for buyer of put options: Long put . . . . . . . . . . . . . 40
3.12.4 Payoff profile for writer of put options: Short put . . . . . . . . . . . . . 41
4 Pricing futures 49
4.1 The cost of carry model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.1.1 Pricing futures contracts on commodities . . . . . . . . . . . . . . . . . 50
4.2 Pricing equity index futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.2.1 Pricing index futures given expected dividend amount . . . . . . . . . . 52
4.2.2 Pricing index futures given expected dividend yield . . . . . . . . . . . . 52
4.3 Pricing stock futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.3.1 Pricing stock futures when no dividend expected . . . . . . . . . . . . . 54
4.3.2 Pricing stock futures when dividends are expected . . . . . . . . . . . . 54
5 Using index futures 59

5.1 Hedging: Long security, short Nifty futures . . . . . . . . . . . . . . . . . . . . 59
5.2 Hedging: Short security, long Nifty futures . . . . . . . . . . . . . . . . . . . . 65
5.3 Hedging: Have portfolio, short Nifty futures . . . . . . . . . . . . . . . . . . . . 69
5.4 Hedging: Have funds, buy Nifty futures . . . . . . . . . . . . . . . . . . . . . . 73
5.5 Speculation: Bullish index, long Nifty futures . . . . . . . . . . . . . . . . . . . 77
5.6 Speculation: Bearish index, short Nifty futures . . . . . . . . . . . . . . . . . . 78
5.7 Arbitrage: Have funds, lend them to the market . . . . . . . . . . . . . . . . . . 80
5.8 Arbitrage: Have securities, lend them to the market . . . . . . . . . . . . . . . . 83
5.9 F&O market watch: Spot the mispricing . . . . . . . . . . . . . . . . . . . . . . 86
5.10 F&O market watch: Spread trading . . . . . . . . . . . . . . . . . . . . . . . . . 88
CONTENTS 3
6 Using futures on individual securities 93

6.1 Difference between trading securities and trading futures on individual securities 93
6.2 Hedging: Long security, sell futures . . . . . . . . . . . . . . . . . . . . . . . . 94
6.3 Speculation: Bullish security, buy futures . . . . . . . . . . . . . . . . . . . . . 94
6.4 Speculation: Bearish security, sell futures . . . . . . . . . . . . . . . . . . . . . 95
6.5 Arbitrage: Overpriced futures: buy spot, sell futures . . . . . . . . . . . . . . . . 95
6.6 Arbitrage: Underpriced futures: buy futures, sell spot . . . . . . . . . . . . . . . 96
7 Pricing options 99
7.1 Introduction to the Black–Scholes formulae . . . . . . . . . . . . . . . . . . . . 100
7.2 The Black–Scholes option pricing formulae . . . . . . . . . . . . . . . . . . . . 100
7.2.1 Pricing index options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
7.2.2 Pricing stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
8 Using index options 109

8.1 Hedging: Have portfolio, buy puts . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts . . . . . . . . . . . 115
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts . . . . . . . . . . . 119
8.4 Speculation: Anticipate volatility, buy a call and a put . . . . . . . . . . . . . . . 123
8.5 Speculation: Bull spreads - Buy a call and sell another . . . . . . . . . . . . . . 125
8.6 Speculation: Bear spreads - sell a call and buy another . . . . . . . . . . . . . . 128
8.7 Arbitrage: Put-call parity violations . . . . . . . . . . . . . . . . . . . . . . . . 131
8.8 Arbitrage: Beyond option price bounds . . . . . . . . . . . . . . . . . . . . . . 135
9 Using stock options 137

9.1 Uses of stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.1 Hedging: Have stock, buy puts . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.2 Speculation: Bullish stock, buy calls or sell puts . . . . . . . . . . . . . 138
9.1.3 Speculation: Bearish stock, buy puts or sell calls . . . . . . . . . . . . . 138
9.2 Combination positions using stock futures and stock options . . . . . . . . . . . 139
9.3 Early exercise of American options . . . . . . . . . . . . . . . . . . . . . . . . . 140
9.3.1 Early exercise of calls on non–dividend paying stock . . . . . . . . . . . 140
9.3.2 Early exercise of puts on non–dividend paying stock . . . . . . . . . . . 141
9.3.3 Early exercise of calls on dividend paying stock . . . . . . . . . . . . . . 141
9.3.4 Early exercise of puts on dividend paying stock . . . . . . . . . . . . . . 143
9.4 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
10 Trading 151
10.1 Futures and options trading system . . . . . . . . . . . . . . . . . . . . . . . . . 151
10.1.1 Entities in the trading system . . . . . . . . . . . . . . . . . . . . . . . . 151
10.1.2 Basis of trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
10.1.3 Corporate hierarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
10.1.4 Order types and conditions . . . . . . . . . . . . . . . . . . . . . . . . . 154
4 CONTENTS
10.2 The trader workstation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

10.2.1 The market watch window . . . . . . . . . . . . . . . . . . . . . . . . . 155
10.2.2 Inquiry window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
10.2.3 Placing orders on the trading system . . . . . . . . . . . . . . . . . . . . 157
10.2.4 Market spread/combination order entry . . . . . . . . . . . . . . . . . . 158
10.2.5 Basket trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
10.3 Futures and options market instruments . . . . . . . . . . . . . . . . . . . . . . 158
10.3.1 Contract specifications for index futures . . . . . . . . . . . . . . . . . . 158
10.3.2 Contract specification for index options . . . . . . . . . . . . . . . . . . 160
10.3.3 Contract specifications for stock futures . . . . . . . . . . . . . . . . . . 162
10.3.4 Contract specifications for stock options . . . . . . . . . . . . . . . . . . 162
10.4 Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
11 Clearing and settlement 167

11.1 Clearing entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.1.1 Clearing members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.1.2 Clearing banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.2 Clearing mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
11.3 Settlement mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
11.3.1 Settlement of futures contracts . . . . . . . . . . . . . . . . . . . . . . . 170
11.3.2 Settlement of options contracts . . . . . . . . . . . . . . . . . . . . . . . 172
11.4 Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
11.4.1 NSE–SPAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
11.4.2 Margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
11.4.3 Margin/position limit violations . . . . . . . . . . . . . . . . . . . . . . 177
12 Regulatory framework 185

12.1 Securities Contracts(Regulation) Act, 1956 . . . . . . . . . . . . . . . . . . . . 185
12.2 Securities and Exchange Board of India Act, 1992 . . . . . . . . . . . . . . . . . 186
12.3 SEBI (Stock brokers and Sub–Brokers) Regulations, 1992 . . . . . . . . . . . . 186
12.3.1 Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
12.4 Regulation for derivatives trading . . . . . . . . . . . . . . . . . . . . . . . . . . 187
12.4.1 NSE’s certification in financial markets . . . . . . . . . . . . . . . . . . 188
12.5 Regulation for clearing and settlement . . . . . . . . . . . . . . . . . . . . . . . 189
12.6 Regulation for membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
12.7 Regulations for risk management . . . . . . . . . . . . . . . . . . . . . . . . . . 191
12.7.1 Liquid networth requirements . . . . . . . . . . . . . . . . . . . . . . . 191
12.7.2 Initial margin computation methodology . . . . . . . . . . . . . . . . . . 192
12.7.3 Calendar spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.4 Short option minimum margin . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.5 Net option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.6 Premium margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
12.7.7 Initial margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
CONTENTS 5
12.7.8 Exposure limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

12.7.9 Exposure limit for calendar spreads(only for futures contracts) . . . . . . 195
12.7.10 Position limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
12.7.11 Real time computation . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
12.7.12 Eligibility of stocks for futures and option trading . . . . . . . . . . . . . 196
12.7.13 Adjustments for corporate actions . . . . . . . . . . . . . . . . . . . . . 197
12.8 Accounting for futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
12.8.1 Accounting at the inception of a contract . . . . . . . . . . . . . . . . . 199
12.8.2 Accounting at the time of daily settlement . . . . . . . . . . . . . . . . . 200
12.8.3 Accounting for open positions . . . . . . . . . . . . . . . . . . . . . . . 200
12.8.4 Accounting at the time of final settlement . . . . . . . . . . . . . . . . . 200
12.8.5 Accounting in case of a default . . . . . . . . . . . . . . . . . . . . . . . 201
12.8.6 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 201
12.9 Accounting for equity index options and equity stock options . . . . . . . . . . . 202
12.9.1 Accounting at the inception of a contract . . . . . . . . . . . . . . . . . 202
12.9.2 Accounting at the time of payment/receipt of margin . . . . . . . . . . . 202
12.9.3 Accounting for open positions as on balance sheet dates . . . . . . . . . 202
12.9.4 Accounting at the time of final settlement . . . . . . . . . . . . . . . . . 203
12.9.5 Accounting at the time of squaring off an option contract . . . . . . . . . 203
12.10Taxation issues: A discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Chapter 1
Introduction to derivatives
The emergence of the market for derivative products, most notably forwards, futures and options,
can be traced back to the willingness of risk-averse economic agents to guard themselves against
uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets
are marked by a very high degree of volatility. Through the use of derivative products, it is
possible to partially or fully transfer price risks by locking–in asset prices. As instruments of
risk management, these generally do not influence the fluctuations in the underlying asset prices.
However, by locking-in asset prices, derivative products minimize the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk-averse investors.
1.1 Derivatives defined
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish
to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such
a transaction is an example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the “underlying”.
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines
“derivative” to include –
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument
or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed
by the regulatory framework under the SC(R)A.
8 Introduction to derivatives
1.2 Products, participants and functions

Derivative contracts have several variants. The most common variants are forwards, futures,
options and swaps. The following three broad categories of participants - hedgers, speculators,
and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of
an asset. They use futures or options markets to reduce or eliminate this risk. Speculators wish
to bet on future movements in the price of an asset. Futures and options contracts can give them
an extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between
prices in two different markets. If, for example, they see the futures price of an asset getting
out of line with the cash price, they will take offsetting positions in the two markets to lock in a
profit.
The derivatives market performs a number of economic functions. First, prices in an
organized derivatives market reflect the perception of market participants about the future and
lead the prices of underlying to the perceived future level. The prices of derivatives converge
with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help
in discovery of future as well as current prices. Second, the derivatives market helps to transfer
risks from those who have them but may not like them to those who have an appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With
the introduction of derivatives, the underlying market witnesses higher trading volumes because
of participation by more players who would not otherwise participate for lack of an arrangement
to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives
market. In the absence of an organized derivatives market, speculators trade in the underlying
cash markets. Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these 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. Finally, derivatives markets
help increase savings and investment in the long run. Transfer of risk enables market participants
to expand their volume of activity.
1.3 Types of derivatives

The most commonly used derivatives contracts are forwards, futures and options which we shall
discuss in detail later. Here we take a brief look at various derivatives contracts that have come
to be used.
Forwards: A forward contract is a customized contract between two entities, where settlement takes place
on a specifi c date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. Futures contracts are special types of forward contracts in the sense
that the former are standardized exchange-traded contracts.
1.3 Types of derivatives 9
Derivative products initially emerged as hedging devices against fluctuations in commodity prices,
and commodity-linked derivatives remained the sole form of such products for almost three hundred
years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in
the fi nancial markets. However, since their emergence, these products have become very popular and
by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent
years, the market for fi nancial derivatives has grown tremendously in terms of variety of instruments
available, their complexity and also turnover. In the class of equity derivatives the world over, futures
and options on stock indices have gained more popularity than on individual stocks, especially among
institutional investors, who are major users of index-linked derivatives. Even small investors fi nd these
useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower
costs associated with index derivatives vis–a–vis derivative products based on individual securities is
another reason for their growing use.
Box 1.1: Emergence of financial derivative products
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.
Warrants: Options generally have lives of upto one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called warrants
and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a
moving average of a basket of assets. Equity index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according
to a prearranged formula. They can be regarded as portfolios of forward contracts. The two
commonly used swaps are :
Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties,
with the cashflows in one direction being in a different currency than those in the opposite
direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to
receive fi xed and pay floating. A payer swaption is an option to pay fi xed and receive floating.
Early forward contracts in the US addressed merchants’ concerns about ensuring that there were buyers
and sellers for commodities. However “credit risk” remained a serious problem. To deal with this
problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The
primary intention of the CBOT was to provide a centralized location known in advance for buyers and
sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the fi rst
“exchange traded” derivatives contract in the US, these contracts were called “futures contracts”. In
1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading.
Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the
two largest organized futures exchanges, indeed the two largest “fi nancial” exchanges of any kind in
the world today.
The fi rst stock index futures contract was traded at Kansas City Board of Trade. Currently the
most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago
Mercantile Exchange. During the mid eighties, fi nancial 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, Eurex etc.
Box 1.2: History of derivatives markets
1.4 Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one another.
Forward contracting dates back at least to the 12th century, and may well have been around
before then. Merchants entered into contracts with one another for future delivery of specified
amount of commodities at specified price. A primary motivation for pre-arranging a buyer or
seller for a stock of commodities in early forward contracts was to lessen the possibility that
large swings would inhibit marketing the commodity after a harvest.
The following factors have been driving the growth of financial derivatives:
1. Increased volatility in asset prices in fi nancial markets,
2. Increased integration of national fi nancial 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 fi nancial assets leading to higher returns, reduced risk as well as transactions costs as
compared to individual fi nancial assets.
1.5 Global derivatives markets 11
Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)
1995 1996 1997 1998 1999 2000
Exchange traded instruments 9283 10018 12403 13932 13522 14302
Interest rate futures and options 8618 9257 11221 12643 11669 12626
Currency futures and options 154 171 161 81 59 96
Stock Index futures and options 511 591 1021 1208 1793 1580
Some OTC instruments 17713 25453 29035 80317 88201 95199
Interest rate swaps and options 16515 23894 27211 44259 53316 58244
Currency swaps and options 1197 1560 1824 5948 4751 5532
Other instruments - - - 30110 30134 31423
Total 26996 35471 41438 94249 101723 109501
Source: Bank for International Settlements
1.5 Global derivatives markets

The derivatives markets have grown manifold in the last two decades. Table 1.1 presents
growth of the derivatives industry. According to the Bank for International Settlements(BIS), the
approximate size of global derivatives market was US$ 109.5 trillion as at end–December 2000.
The total estimated notional amount of outstanding over–the–counter(OTC) contracts stood at
US$ 95.2 trillion as at end–December 2000, an increase of 7.9% over end–December 1999.
Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of
interest rate contracts, which reflected growing corporate bond markets and increased interest
rate uncertainty at the end of 2000. The amount outstanding in organized exchange markets
increased by 5.8% from US$ 13.5 trillion as at end–December 1999 to US$ 14.3 trillion as at
end–December 2000.
The turnover data are available only for exchange–traded derivatives contracts. The turnover
in derivative contracts traded on exchanges has increased by 9.8% during 2000 to US$ 384
trillion as compared to US$ 350 trillion in 1999(Table 1.2). While interest rate futures and
options accounted for nearly 90% of total turnover during 2000, the popularity of stock market
index futures and options grew modestly during the year. According to BIS, the turnover in
exchange–traded derivative markets rose by a record amount in the first quarter of 2001, while
there was some moderation in the OTC volumes.
1.6 Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which
has accompanied the modernization of commercial and investment banking and globalisation of
financial activities. The recent developments in information technology have contributed to a
great extent to these developments. While both exchange-traded and OTC derivative contracts
offer many benefits, the former have rigid structures compared to the latter. It has been widely
Table 1.2 Turnover in derivatives contracts traded on exchanges, (in US$ trillion)
1993 1994 1995 1996 1997 1998 1999 2000
Interest rate futures 177.3 271.9 266.4 253.6 247.8 296.6 263.8 292.3
Interest rate options 32.8 46.7 43.3 41 48.6 55.8 45.6 47.5
Currency futures 2.8 3.3 3.2 2.6 2.7 2.5 2.6 2.4
Currency options 1.4 1.4 1.3 1.3 0.9 0.5 0.3 0.2
Stock market index futures 7.1 9.4 10.6 12.9 16.4 19.6 21.7 22.7
Stock market index options 6.3 8 9.3 10.2 13.1 14.7 15.7 18.7
Total 227.7 340.7 334.1 321.6 356.5 389.7 349.7 383.8
Source: Bank for International Settlements
discussed that the highly leveraged institutions and their OTC derivative positions were the main
cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks
posed to market stability originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within individual
institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for
safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-
regulatory organization, although they are affected indirectly by national legal systems, banking
supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market stability.
The following features of OTC derivatives markets can give rise to instability in institutions,
markets, and the international financial system: (i) the dynamic nature of gross credit exposures;
(ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate
credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the
central role of OTC derivatives markets in the global financial system. Instability arises when
shocks, such as counter-party credit events and sharp movements in asset prices that underlie
derivative contracts occur, which significantly alter the perceptions of current and potential future
credit exposures. When asset prices change rapidly, the size and configuration of counter-party
exposures can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including counter-
party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to
1.7 Derivatives market in India 13
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.
1.7 Derivatives market in India
1.7.1 Approval for derivatives trading
The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in
securities. The market for derivatives, however, did not take off, as there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24–member committee under
the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its report on March 17,
1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‘securities’ so that regulatory
framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also
set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures
for risk containment in derivatives market in India. The report, which was submitted in October
1998, worked out the operational details of margining system, methodology for charging initial
margins, broker net worth, deposit requirement and real–time monitoring requirements.
The SCRA was amended in December 1999 to include derivatives within the ambit of
‘securities’ and the regulatory framework was developed for governing derivatives trading. The
act also made it clear that derivatives shall be legal and valid only if such contracts are traded on
a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded
in March 2000, the three–decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval
to this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges,
NSE and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts
based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for
trading in options based on these two indexes and options on individual securities. The trading
in index options commenced in June 2001 and the trading in options on individual securities
commenced in July 2001. Futures contracts on individual stocks were launched in November
2001. Trading and settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette.
1.7.2 Derivatives market at NSE

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on
June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options
on individual securities commenced on July 2, 2001. Single stock futures were launched on
November 9, 2001. The index futures and options contract on NSE are based on S&P CNX
Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles.
Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new
contract is introduced on the next trading day following the expiry of the near month contract.
1.7.3 Trading mechanism

The futures and options trading system of NSE, called NEAT-F&O trading system, provides a
fully automated screen–based trading for Nifty futures & options and stock futures & options
on a nationwide basis and an online monitoring and surveillance mechanism. It supports an
anonymous order driven market which provides complete transparency of trading operations
and operates on strict price–time priority. It is similar to that of trading of equities in the Cash
Market(CM) segment. The NEAT-F&O trading system is accessed by two types of users. The
Trading Members(TM) have access to functions such as order entry, order matching, order and
trade management. It provides tremendous flexibility to users in terms of kinds of orders that
can be placed on the system. Various conditions like Good-till-Day, Good-till-Cancelled, Good-
till-Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order.
The Clearing Members(CM) use the trader workstation for the purpose of monitoring the trading
member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions,
which a trading member can take.
1.7.4 Membership criteria

NSE admits members on its derivatives segment in accordance with the rules and regulations
of the exchange and the norms specified by SEBI. NSE follows 2–tier membership structure
stipulated by SEBI to enable wider participation. Those interested in taking membership on
F&O segment are required to take membership of CM and F&O segment or CM, WDM and
F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing
member(CM) does clearing for all his trading members(TMs), undertakes risk management and
performs actual settlement. There are three types of CMs:
Self Clearing Member: A SCM clears and settles trades executed by him only either on his own
account or on account of his clients.
Trading Member Clearing Member: TM–CM is a CM who is also a TM. TM–CM may clear and
settle his own proprietary trades and client’s trades as well as clear and settle for other TMs.
Professional Clearing Member PCM is a CM who is not a TM. Typically, banks or custodians could
become a PCM and clear and settle for TMs.
Table 1.3 Business growth of futures and options market: Turnover(Rs.crore)

Month Index futures Stock futures Index options Stock options Total
Jun-00 35 - - - 35
Jul-00 108 - - - 108
Aug-00 90 - - - 90
Sep-00 119 - - - 119
Oct-00 153 - - - 153
Nov-00 247 - - - 247
Dec-00 237 - - - 237
Jan-01 471 - - - 471
Feb-01 524 - - - 524
Mar-01 381 - - - 381
Apr-01 292 - - - 292
May-01 230 - - - 230
Jun-01 590 - 196 - 785
Jul-01 1309 - 326 396 2031
Aug-01 1305 - 284 1107 2696
Sep-01 2857 - 559 2012 5281
Oct-01 2485 - 559 2433 5477
Nov-01 2484 2811 455 3010 8760
Dec-01 2339 7515 405 2660 12919
Jan-02 2660 13261 338 5089 21348
Feb-02 2747 13939 430 4499 21616
Mar-02 2185 13989 360 3957 20490
2001-02 21482 51516 3766 25163 101925
Details of the eligibility criteria for membership on the F&O segment are provided in Tables
12.1 and 12.2(Chapter 12). The TM–CM and the PCM are required to bring in additional security
deposit in respect of every TM whose trades they undertake to clear and settle. Besides this,
trading members are required to have qualified users and sales persons, who have passed a
certification programme approved by SEBI.
1.7.5 Turnover
The trading volumes on NSE’s derivatives market has seen a steady increase since the launch
of the first derivatives contract, i.e. index futures in June 2000. Table 1.3 gives the value of
contracts traded on the NSE from the inception of the market to March 2002. The average daily
turnover at NSE now exceeds a 1000 crore. A total of 41,96,873 contracts with a total turnover
of Rs.1,01,926 crore was traded during 2001-2002.
1.7.6 Clearing and settlement

NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It
acts as legal counterparty to all deals on the F&O segment and guarantees settlement. We take a
brief look at the clearing and settlement mechanism.
Clearing
The first step in clearing process is working out open positions or obligations of members. A
CM’s open position is arrived at by aggregating the open position of all the TMs and all custodial
participants clearing through him, in the contracts in which they have traded. A TM’s open
position is arrived at as the summation of his proprietary open position and clients open positions,
in the contracts in which they have traded. While entering orders on the trading system, TMs
are required to identify the orders, whether proprietary (if they are their own trades) or client (if
entered on behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each
contract. Clients’ positions are arrived at by summing together net (buy-sell) positions of each
individual client for each contract. A TMs open position is the sum of proprietary open position,
client open long position and client open short position.
Settlement
All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying
for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have
to be settled in cash. Futures and options on individual securities can be delivered as in the spot
market. However, it has been currently mandated that stock options and futures would also be
cash settled. The settlement amount for a CM is netted across all their TMs/clients in respect of
MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required
to open a separate bank account with NSCCL designated clearing banks for F&O segment.
1.7.7 Risk management system

The salient features of risk containment measures on the F&O segment are:
Anybody interested in taking membership of F&O segment is required to take membership of“CM
and F&O”or “CM,WDM and F&O”. An existing member of CM segment can also take membership
of F&O segment. The details of the eligibility criteria for membership of F&O segment are given in
the chapter on regulations in this book.
NSCCL charges an upfront initial margin for all the open positions of a CM upto client level. It
follows the VaR based margining system through SPAN system. NSCCL computes the initial margin
percentage for each Nifty index futures contract on a daily basis and informs the CMs. The CM in
turn collects the initial margin from the TMs and their respective clients.
NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis.
Limits are set for each CM based on his base capital and additional capital deposited with NSCCL.
The on-line position monitoring system generates alerts whenever a CM reaches a position limit
set up by NSCCL. NSCCL monitors the CMs and TMs for mark to market value violation and for
contract-wise position limit violation.
CMs are provided with a trading terminal for the purpose of monitoring the open positions of all
the TMs clearing and settling through them. A CM may set exposure limits for a TM clearing and
settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a
CM and whenever a TM exceeds the limits, it withdraws the trading facility provided to such TM.
A separate Settlement Guarantee Fund for this segment has been created out of the capital deposited
by the members with NSCCL.
Solved Problems
Q: Futures trading commenced fi rst on
1. Chicago Board of Trade 3. Chicago Board Options Exchange
4. London International Financial Futures and

2. Chicago Mercantile Exchange Options Exchange
A: The correct answer is number 1.
Q: The underlying asset for a derivative contract can be
1. Equity 3. Interest rate
2. Commodities 4. Any of the above
A: The correct answer is number 4
Q: Derivatives fi rst emerged as products
1. Speculative 3. Volatility
2. Hedging 4. Risky
Q: Who are the participants in the derivatives market?
1. Hedgers 3. Arbitrageurs
2. Speculators 4. All of the above

Q: The fi rst market to trade fi nancial futures was the
1. CBOT 3. CBOE
2. CME 4. NYSE
Q: Which of the following exchanges offer derivatives trading
1. National Stock Exchange 3. Over The Counter Exchange of India
2. Interconnected Stock Exchange 4. ICICI Securities Limited
Q: The fi rst exchange traded fi nancial derivative in India commenced with the trading of
1. Index futures 3. Stock options
2. Index options 4. Interest rate futures
Q: OTC derivatives are considered risky because
1. There is no formal margining system. 3. They are not settled on a clearing house.
2. They do not follow any formal rules or mech-
anisms. 4. All of the above
Q: Which of the following does not trade on the NSE’s Futures and Options segment?
1. Index options 3. Currency futures
2. Stock options 4. Index futures
Q: Which of the following is not an example of a derivative on security derivative?
1. Index futures 3. Stock futures
2. Index options 4. Interest rate futures

Chapter 2
Market index
To understand the use and functioning of the index derivatives markets, it is necessary to
understand the underlying index. In the following section, we take a look at index related issues.
Traditionally, indexes have been used as information sources. By looking at an index, we know
how the market is faring. In recent years, indexes have come to the forefront owing to direct
applications in finance in the form of index funds and index derivatives. Index derivatives allow
people to cheaply alter their risk exposure to an index (hedging) and to implement forecasts about
index movements (speculation). Hedging using index derivatives has become a central part of
risk management in the modern economy.
2.1 Understanding the index number

An index is a number which measures the change in a set of values over a period of time. A
stock index represents the change in value of a set of stocks which constitute the index. More
specifically, a stock index number is the current relative value of a weighted average of the prices
of a pre-defined group of equities. It is a relative value because it is expressed relative to the
weighted average of prices at some arbitrarily chosen starting date or base period. The starting
value or base of the index is usually set to a number such as 100 or 1000. For example, the base
value of the Nifty was set to 1000 on the start date of November 3, 1995.
A good stock market index is one which captures the behavior of the overall equity market.
It should represent the market, it should be well diversified and yet highly liquid. Movements of
the index should represent the returns obtained by “typical” portfolios in the country.
A market index is very important for its use
1. as a barometer for market behavior,
2. as a benchmark portfolio performance,
3. as an underlying in derivative instruments like index futures, and
4. in passive fund management by index funds

20 Market index
2.2 Economic significance of index movements

How do we interpret index movements? What do these movements mean? They reflect the
changing expectations of the stock market about future dividends of the corporate sector. The
index goes up if the stock market thinks that the prospective dividends in the future will be better
than previously thought. When the prospects of dividends in the future becomes pessimistic, the
index drops. The ideal index gives us instant readings about how the stock market perceives the
future of corporate sector.
Every stock price moves for two possible reasons:
1. News about the company (e.g. a product launch, or the closure of a factory)
2. News about the country (e.g. nuclear bombs, or a budget announcement)
The job of an index is to purely capture the second part, the movements of the stock market
as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a
mixture of two elements - stock news and index news. When we take an average of returns on
many stocks, the individual stock news tends to cancel out and the only thing left is news that is
common to all stocks. The news that is common to all stocks is news about the economy. That
is what a good index captures. The correct method of averaging is that of taking a weighted
average, giving each stock a weight proportional to its market capitalization.
Example: Suppose an index contains two stocks, A and B. A has a market capitalization of
Rs.1000 crore and B has a market capitalization of Rs.3000 crore. Then we attach a weight of
1/4 to movements in A and 3/4 to movements in B.
2.3 Index construction

A good index is a trade-off between diversification and liquidity. A well diversified index is more
representative of the market/economy. However there are diminishing returns to diversification.
Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100
stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in
risk. Hence, there is little to gain by diversifying beyond a point. The more serious problem lies
in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed
prices yield contaminated information and actually worsen an index.
2.4 Types of indexes

Most of the commonly followed stock market indexes are of the following two types: Market
capitalization weighted index or price weighted index. In a market capitalization weighted index,
each stock in the index affects the index value in proportion to the market value of all shares
outstanding. A price weighted index is one that gives a weight to each stock that is proportional
to its stock price. Indexes can also be equally weighted. Recently, major indices in the world
like the S&P 500 and the FTSE-100 have shifted to a new method of index calculation called the
“Free float” method. We take a look at a few methods of index calculation.
2.4 Types of indexes 21
Table 2.1 Price weighted index calculation

In the example below we can see that Grasim Inds and Telco have a similar weightage irrespective of the number of
outstanding shares. In a price weighted index, a small capitalization fi rm could have a much higher weightage than
a much larger fi rm if the small capitalization fi rm had a high stock price but relatively few outstanding shares. In
the present example the base index = 1000 and the index value works out to be 1049.56.

Index

Company Share price at time 0 Share price at time 1

(Rs.) (Rs.)
Grasim Inds 351.55 340.50
Telco 329.10 350.30
SBI 274.60 280.40
Wipro 1335.25 1428.75
Bajaj 539.25 570.25
Total 2829.75 2970.20
1. Price weighted index: In a price weighted index each stock is given a weight proportional to its stock
price. Table 2.1 gives an example of how a price weighted index is calculated.
2. Equally weighted index: As the name suggests, in an equally weighted index all the components
have similar weightage irrespective of their price or their market capitalization. Table 2.2 gives an
example of how an equally weighted index is calculated.
3. Market capitalization weighted index: In this type of index, the equity price is weighted by the market
capitalization of the company (share price * number of outstanding shares). Hence each constituent
stock in the index affects the index value in proportion to the market value of all the outstanding
shares. Table 2.3 gives an example of how market capitalization weighted index is calculated.
In the market capitalization weighted method,
Current market capitalisation

Index

Base value
Base market capitalisation
where :
Current market capitalization = Sum of (current market price * outstanding shares) of all
securities in the index.
Base market capitalization= Sum of (market price * issue size) of all securities as on base
date.
22 Market index
Table 2.2 Equally weighted index calculation

In the example below we can see that Grasim Inds and Wipro have a similar weightage irrespective of their share
price and number of outstanding shares. In the present example the base index = 1000 and the index value works
out to be 1036.21

Index

! " $
Company Share price at Time 0 Share price at Time 1

(Rs.) (Rs.)
Grasim Inds 351.75 340.50
Telco 329.10 350.30
SBI 274.60 280.40
Wipro 1335.25 1428.75
Bajaj 539.25 570.25
Total 2829.75 2970.20
Table 2.3 Market capitalization weighted index calculation

In the example below we can see that each stock affects the index value in proportion to the market value of
all the outstanding shares. In the present example, the base index = 1000 and the index value works out to be 1002.60
' '

Index ' ' '

Company Current Market capitalization Base Market capitalization

(Rs.Lakh) (Rs.Lakh)
Grasim Inds 1,668,791.10 1,654,247.50
Telco 872,686.30 860,018.25
SBI 1,452,587.65 1,465,218.80
Wipro 2,675,613.30 2,669,339.55
Bajaj 660,887.85 662,559.30
Total 7,330,566.20 7,311,383.40
2.5 Desirable attributes of an index

A good market index should have three attributes:
2.6 The S&P CNX Nifty 23
1. It should capture the behavior of a large variety of different portfolios in the market.
2. The stocks included in the index should be highly liquid.
3. It should be professionally maintained.
2.5.1 Capturing behavior of portfolios

A good market index should accurately reflect the behavior of the overall market as well as
of different portfolios. This is achieved by diversification in such a manner that a portfolio
is not vulnerable to any individual stock or industry risk. A well–diversified index is more
representative of the market. However there are diminishing returns from diversification. There
is very little gain by diversifying beyond a point. The more serious problem lies in the stocks
that are included in the index when it is diversified. We end up including illiquid stocks, which
actually worsens the index. Since an illiquid stock does not reflect the current price behavior
of the market, its inclusion in index results in an index, which reflects, delayed or stale price
behavior rather than current price behavior of the market.
2.5.2 Including liquid stocks

Liquidity is much more than trading frequency. It is about ability to transact at a price, which is
very close to the current market price. For example, a stock is considered liquid if one can buy
some shares at around Rs.320.05 and sell at around Rs. 319.95, when the market price is ruling
at Rs.320. A liquid stock has very tight bid–ask spread.
2.5.3 Maintaining professionally

It is now clear that an index should contain as many stocks with as little impact cost as possible.
This necessarily means that the same set of stocks would not satisfy these criteria at all times. A
good index methodology must therefore incorporate a steady pace of change in the index set. It
is crucial that such changes are made at a steady pace. It is very healthy to make a few changes
every year, each of which is small and does not dramatically alter the character of the index. On
a regular basis, the index set should be reviewed, and brought in line with the current state of
market. To meet the application needs of users, a time series of the index should be available.
2.6 The S&P CNX Nifty

What makes a good stock market index for use in an index futures and index options market?
Several issues play a role in terms of the choice of index. We will discuss how the S&P CNX
Nifty addresses some of these issues.
Diversification As mentioned earlier, a stock market index should be well–diversifi ed, thus ensuring that
hedgers or speculators are not vulnerable to individual–company or industry risk.
24 Market index
The S&P CNX Nifty is an index based upon solid economic research. It was designed not only as a
barometer of market movement but also to be a foundation of the new world of fi nancial products based
on the index like index futures, index options and index funds. A trillion calculations were expended
to evolve the rules inside the S&P CNX Nifty index. The results of this work are remarkably simple:
(a) the correct size to use is 50, (b) stocks considered for the S&P CNX Nifty must be liquid by the
‘impact cost’ criterion, (c) the largest 50 stocks that meet the criterion go into the index.
S&P CNX Nifty is a contrast to the adhoc methods that have gone into index construction in the
preceding years, where indexes were made out of intuition and lacked a scientifi c basis. The research
that led up to S&P CNX Nifty is well-respected internationally as a pioneering effort in better
understanding how to make a stock market index.
The Nifty is uniquely equipped as an index for the index derivatives market owing to its (a) low market
impact cost and (b) high hedging effectiveness. The good diversifi cation of Nifty generates low initial
margin requirement. Finally, Nifty is calculated using NSE prices, the most liquid exchange in India,
thus making it easier to do arbitrage for index derivatives.
Box 2.3: The S&P CNX Nifty
Liquidity of the index The index should be easy to trade on the cash market. This is partly related to the
choice of stocks in the index. High liquidity of index components implies that the information in the
index is less noisy.
Operational issues The index should be professionally maintained, with a steady evolution of securities in
the index to keep pace with changes in the economy. The calculations involved in the index should
be accurate and reliable. When a stock trades at multiple venues, index computation should be done
using prices from the most liquid market.
2.6.1 Impact cost

Market impact cost is a measure of the liquidity of the market. It reflects the costs faced when
actually trading an index. For a stock to qualify for possible inclusion into the Nifty, it has to
have market impact cost of below 1.5% when doing Nifty trades of half a crore rupees. The
market impact cost on a trade of Rs.3 million of the full Nifty works out to be about 0.2%. This
means that if Nifty is at 1000, a buy order goes through at 1002, i.e.1000+(1000*0.002) and a
sell order gets 998, i.e. 1000-(1000*0.002).
2.6.2 Hedging effectiveness

Hedging effectiveness is a measure of the extent to which an index correlates with a portfolio,
whatever the portfolio may be. Nifty correlates better with all kinds of portfolios in India as
compared to other indexes. This holds good for all kinds of portfolios, not just those that contain
index stocks.
Nifty is owned, computed and maintained by India Index Services & Products Limited (IISL),
a company setup by NSE and CRISIL with technical assistance from Standard & Poor’s.
2.7 Applications of index 25
Figure 2.1 S&P CNX Nifty - The futures index
2.7 Applications of index

Besides serving as a barometer of the economy/market, the index also has other applications in
finance.
2.7.1 Index derivatives

Index derivatives are derivative contracts which have the index as the underlying. The most
popular index derivatives contracts the world over are index futures and index options. NSE’s
market index, the S&P CNX Nifty was scientifically designed to enable the launch of index–
based products like index derivatives and index funds. The first derivative contract to be traded
on NSE’s market was the index futures contract with the Nifty as the underlying. This was
followed by index options.
2.7.2 Index funds

An index fund is a fund that tries to replicate the index returns. It does so by investing in index
stocks in the proportions in which these stocks exist in the index. The goal of the index fund is
to achieve the same performance as the index it tracks.
For instance, a Nifty index fund would seek to get the same return as the Nifty index. Since
the Nifty has 50 stocks, the fund would buy all 50 stocks in the proportion in which they exist in
the Nifty. Once invested, the fund will track the index, i.e. if the Nifty goes up, the value of the
fund will go up to the same extent as the Nifty. If the Nifty falls, the value of the index fund will
26 Market index
Futures markets can be used for creating synthetic index funds. Synthetic index funds created using
futures contracts have advantages of simplicity and low costs. The simplicity stems from the fact that
index futures automatically track the index. The cost advantages stem from the fact that the costs
of establishing and re-balancing the fund are substantially reduced because commissions and bid-ask
spreads are lower in the futures markets than in the equity markets.
The methodology for creating a synthetic index fund is to combine index futures contracts with bank
deposits or treasury bills. The index fund uses part of its money as margin on the futures market and
the rest is invested at the risk-free rate of return. This methodology however does require frequent
roll-over as futures contracts expire.
Index funds can also use the futures market for the purpose of spreading index sales or purchases over
a period of time. Take the case of an index fund which has raised Rs.100 crore from the market. To
reduce the tracking error, this money must be invested in the index immediately. However large trades
face large impact costs. What the fund can do is, the moment it receives the subscriptions it can buy
index futures. Then gradually over a period of say a month, it can keep acquiring the underlying index
stocks. As it acquires the index stocks, it should unwind its position on the futures market by selling
futures to the extent of stock acquired. This should continue till the fund is fully invested in the index.
Box 2.4: Use of futures market by index funds
fall to the same extent as the Nifty. The most useful kind of market index is one where the weight
attached to a stock is proportional to its market capitalization, as in the case of Nifty. Index funds
are easy to construct for this kind of index since the index fund does not need to trade in response
to price fluctuations. Trading is only required in response to issuance of shares, mergers, etc.
A few index funds were launched in the recent past to provide a return at par with the index.
For example, UTI launched in February 2000 an open ended Nifty Index Fund, which invests
in the fifty Nifty stocks in the same weightage as they have in the Nifty with an objective to
track the index with minimum error. Other Nifty based funds include Franklin India Index Fund,
Franklin India Tax Fund, IDBI Principal Index Fund, IL&FS Index Fund, Prudential ICICI Index
fund, Pioneer ITI P/E Ratio Fund, SBI Magnum Index fund. The passive investment approach
seems to be catching the fancy of investors.
2.7.3 Exchange Traded Funds

Exchange Traded Funds(ETFs) are innovative products, which first came into existence in the
USA in 1993. They have gained prominence over the last few years with over $100 billion
invested as of end 2001 in about 200 ETFs globally. About 60% of trading volumes on the
American stock exchanges are from ETFs. Among the popular ones are SPDRs(Spiders) based
on the S&P 500 Index, QQQs(Cubes) based on the Nasdaq-100 Index, iSHARES based on MSCI
Indices and TRAHK(Tracks) based on the Hang Seng Index.
ETFs provide exposure to an index or a basket of securities that trade on the exchange like a
single stock. They have a number of advantages over traditional open–ended funds as they can
be bought and sold on the exchange at prices that are usually close to the actual intra–day NAV
of the scheme. They are an innovation to traditional mutual funds as they provide investors a
2.7 Applications of index 27
fund that closely tracks the performance of an index with the ability to buy/sell on an intra–day
basis. Unlike listed closed–ended funds, which trade at substantial premia or more frequently at
discounts to NAV, ETFs are structured in a manner which allows to create new units and redeem
outstanding units directly with the fund, thereby ensuring that ETFs trade close to their actual
NAVs.
The first ETF in India, “Nifty BeEs”(Nifty Benchmark Exchange Traded Scheme) based on
S&P CNX Nifty, was launched in December 2001 by Benchmark Mutual Fund. It is bought and
sold like any other stock on NSE and has all characteristics of an index fund. It would provide
returns that closely correspond to the total return of stocks included in Nifty.
Solved problems
Q: Nifty includes the most liquid stocks that trade on NSE.
1. 30 3. 100
2. 50 4. 500
Q: The Indian company which provides professional index management services is
1. IISL 3. S&P
2. NSCCL 4. CRISIL
Q: Impact cost measures the
1. Volatility of the stock 3. Return on a stock
2. Liquidity of the stock 4. None of above
Q: Assume that the base value of a market capitalization weighted index were 1000 and the base market
capitalization were Rs.35000 crore. If the current market capitalization is Rs.42,000 crore, the index is at
1. 1200 3. 1110
2. 1250 4. 1350
A: The current index value is (42000/35000)*1000. The correct answer is number 1.

28 Market index
Q: The impact cost on a trade of Rs.3 million of the full Nifty works out to be about 0.2%. This means
that if Nifty is at 1000, a buy order will go through at roughly
1. 1002 3. 1200
2. 1020 4. None of the above
A: 0.2% of 1000 works out to be 2. Hence a buy order will go through at 1002. The correct answer is
number 1.
Q: The market impact cost on a trade of Rs.3 million of the full Nifty works out to be about 0.3%. This
means that if Nifty is at 1000, a sell order will go through at roughly
1. 997 3. 979
A: 0.3% of 1000 works out to be 3. Hence a sell order will go through at 997. The correct answer is
number 1.
Q: The S&P CNX Nifty, which is the index underlying futures and options contracts that trade on the
NSE, is maintained by
1. NSE 3. CRICIL
2. S&P 500 4. IISL
Q: Index funds are managed
1. Actively 3. Family
2. Passively 4. None of the above
Q: Which of the following is not an index based product?
1. Index funds 3. Index futures
2. Exchange traded funds 4. Stock futures

Chapter 3
Introduction to futures and options
In recent years, derivatives have become increasingly important in the field of finance. While
futures and options are now actively traded on many exchanges, forward contracts are popular
on the OTC market. In this chapter we shall study in detail these three derivative contracts.
3.1 Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price.
One of the parties to the contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price. Other contract details
like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
They are bilateral contracts and hence exposed to counter–party risk.
Each contract is custom designed, and hence is unique in terms of contract size, expiration date and
the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which
often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the case
of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This
process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging application
would be that of an exporter who expects to receive payment in dollars three months later. He is
exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell
30 Introduction to futures and options
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.
If a speculator has information or analysis, which forecasts an upturn in a price, then he
can go long on the forward market instead of the cash market. The speculator would go long
on the forward, wait for the price to rise, and then take a reversing transaction to book profits.
Speculators may well be required to deposit a margin upfront. However, this is generally a
relatively small proportion of the value of the assets underlying the forward contract. The use of
forward markets here supplies leverage to the speculator.
3.2 Limitations of forward markets

Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
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.
Counterparty risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when
forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the
counterparty risk remains a very serious issue.
3.3 Introduction to futures

Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies
certain standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,(or
which can be used for reference purposes in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying

3.4 Distinction between futures and forwards contracts 31
Merton Miller, the 1990 Nobel laureate had said that “fi nancial futures represent the most signifi cant
fi nancial innovation of the last twenty years.” The fi rst exchange that traded fi nancial derivatives was
launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called
the International Monetary Market(IMM) and traded currency futures. The brain behind this was a man
called Leo Melamed, acknowledged as the “father of fi nancial futures” who was then the Chairman of
the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange
sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts
traded at the Chicago Mercantile Exchange totaled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar
products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board
Options Exchange. By the 1990s, these exchanges were trading futures and options on everything
from Asian and American stock indexes to interest–rate swaps, and their success transformed Chicago
almost overnight into the risk–transfer capital of the world.
Box 3.5: The first financial futures market
Table 3.1 Distinction between futures and forwards

Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
hence more liquid hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
The date and the month of delivery
The units of price quotation and minimum price change
Location of settlement
3.4 Distinction between futures and forwards contracts

Forward contracts are often confused with futures contracts. The confusion is primarily because
both serve essentially the same economic functions of allocating risk in the presence of future
price uncertainty. However futures are a significant improvement over the forward contracts as
they eliminate counterparty risk and offer more liquidity. Table 3.1 lists the distinction between
the two.
3.5 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 specifi ed in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under one contract. For instance, the
contract size on NSE’s futures market is 200 Nifties.
Basis: In the context of fi nancial futures, basis can be defi ned 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
fi nance 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 fi rst entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted 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.
3.6 Introduction to options

In this section, we look at the next derivative product to be traded on the NSE, namely options.
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right.
In contrast, in a forward or futures contract, the two parties have committed themselves to doing
something. Whereas it costs nothing(except margin requirements) to enter into a futures contract,
the purchase of an option requires an up–front payment.
3.7 Option terminology

Index options: These options have the index as the underlying. Some options are European while
others are American. Like index futures contracts, index options contracts are also cash settled.
3.7 Option terminology 33
Although options have existed for a long time, they were traded OTC, without much knowledge of
valuation. The fi rst trading in options began in Europe and the US as early as the seventeenth century. It
was only in the early 1900s that a group of fi rms set up what was known as the put and call Brokers and
Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If
someone wanted to buy an option, he or she would contact one of the member fi rms. The fi rm would
then attempt to fi nd a seller or writer of the option either from its own clients or those of other member
fi rms. If no seller could be found, the fi rm would undertake to write the option itself in return for a
price.
This market however suffered from two defi ciencies. First, there was no secondary market and second,
there was no mechanism to guarantee that the writer of the option would honor the contract.
In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE
was set up specifi cally 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.
Box 3.6: History of options
Stock options: Stock options are options on individual stocks. Options currently trade on over 500
stocks in the United States. A contract gives the holder the right to buy or sell shares at the specifi ed
price.
Buyer of an option: The buyer of an option is the one who by paying the option premium buys the
right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option premium and
is thereby obliged to sell/buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain
date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
Option price: Option price is the price which the option buyer pays to the option seller. It is also
referred to as the option premium.
Expiration date: The date specifi ed in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
Strike price: The price specifi ed 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 is

which means the intrinsic value of a call is the greater of 0 or

. Similarly,

the intrinsic value of a put is ,i.e. the greater of 0 or . K is the strike price

and is the spot price.
Time value of an option: The time value of an option is the difference between its premium and its
intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time
value. Usually, the maximum time value exists when the option is ATM. The longer the time to
expiration, the greater is an option’s time value, all else equal. At expiration, an option should have
no time value.
3.8 Futures and options

An interesting question to ask at this stage is - when would one use options instead of futures?
Options are different from futures in several interesting senses. 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 option.
This is attractive to many people, and to mutual funds creating “guaranteed return products”.
3.9 Index derivatives 35
Options made their fi rst major mark in fi nancial history during the tulip-bulb mania in seventeenth-
century Holland. It was one of the most spectacular get rich quick binges in history. The fi rst tulip
was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the
most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip
bulb prices began rising. That was when options came into the picture. They were initially used for
hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract
could be assured of obtaining a fi xed number of bulbs for a set price. Similarly, tulip-bulb growers
could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however,
options were increasingly used by speculators who found that call options were an effective vehicle
for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a
call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs
themselves. The writers of the put options also prospered as bulb prices spiralled since writers were
able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in
1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable
to meet their commitments to purchase Tulip bulbs.
Box 3.7: Use of options in the seventeenth-century
Table 3.2 Distinction between futures and options

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.
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. Selling put options is selling insurance, so anyone who feels like
earning revenues by selling insurance can set himself up to do so on the index options market.
More generally, options offer “nonlinear payoffs” whereas futures only have “linear payoffs”.
By combining futures and options, a wide variety of innovative and useful payoff structures can
be created.
3.9 Index derivatives

Index derivatives are derivative contracts which derive their value from an underlying index. The
two most popular index derivatives are index futures and index options. Index derivatives have
become very popular worldwide. In his report, Dr.L.C.Gupta attributes the popularity of index
derivatives to the advantages they offer.
Institutional and large equity-holders need portfolio-hedging facility. Index–derivatives are more
suited to them and more cost–effective than derivatives based on individual stocks. Pension funds in
the US are known to use stock index futures for risk hedging purposes.
Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
Stock index is diffi cult to manipulate as compared to individual stock prices, more so in India, and
the possibility of cornering is reduced. This is partly because an individual stock has a limited supply,
which can be cornered.
Stock index, being an average, is much less volatile than individual stock prices. This implies much
lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement delays and problems
related to bad delivery, forged/fake certifi cates.
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
3. Options on individual stocks
Requirements for an index derivatives market are:
1. Index: The choice of an index is an important factor in determining the extent to which the index
derivative can be used for hedging, speculation and arbitrage. A well diversifi ed, liquid index ensures
that hedgers and speculators will not be vulnerable to individual or industry risk.
2. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk
on futures markets. The clearing corporation interposes itself into every transaction, buying from the
seller and selling to the buyer. This insulates a participant from credit risk of another.
3. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in
the economy. Hence the need to have strong surveillance on the market both at the exchange level as
well as at the regulator level.
4. Education and certification: The need for education and certifi cation in the derivatives market can
never be overemphasized. A critical element of fi nancial sector reforms is the development of a
pool of human resources with strong skills and expertise to provide quality intermediation to market
participants.
With all the above infrastructure in place, trading of index futures and index options
commenced at NSE in June 2000 and June 2001 respectively.
3.10 Payoff for derivatives contracts 37
Figure 3.1 Payoff for a buyer of Nifty futures

The fi gure shows the profi ts/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 profi t. If the index falls, his futures position starts
showing losses.
Profit
1220
Nifty
0
Loss
3.10 Payoff for derivatives contracts

A payoff is the likely profit/loss that would accrue to a market participant with change in the
price of the underlying asset. This is generally depicted in the form of payoff diagrams which
show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis. In this
section we shall take a look at the payoffs for buyers and sellers of futures and options.
3.11 Payoff for futures

Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs
are fascinating as they can be combined with options and the underlying to generate various
complex payoffs.
3.11.1 Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who buys 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 up,
Figure 3.2 Payoff for a seller of Nifty futures

The fi gure shows the profi ts/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 profi t. If the index rises, his futures position starts showing
losses.
Profit
1220
Nifty
0
Loss
the long futures position starts making profits, and when the index moves down it starts making
losses. Figure 3.1 shows the payoff diagram for the buyer of a futures contract.
3.11.2 Payoff for seller of futures: Short futures

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 3.2 shows the payoff diagram for the seller of a futures contract.
3.12 Options payoffs

The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited, however the profits are
potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to
the option premium, however his losses are potentially unlimited. 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.
3.12 Options payoffs 39
Figure 3.3 Payoff for investor who went Long Nifty at 1220
The fi gure shows the profi ts/losses from a long position on the index. The investor bought the index at 1220. If the
index goes up, he profi ts. If the index falls he looses.
Profit
+60
0 1160 1220 1280

Nifty
−60
Loss
Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and
sells it at a future date at an unknown price, . Once it is purchased, the investor is said to be

“long” the asset. Figure 3.3 shows the payoff for a long position on the Nifty.
Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and
buys it back at a future date at an unknown price, . Once it is sold, the investor is said to be

“short” the asset. Figure 3.4 shows the payoff for a short position on the Nifty.
3.12.1 Payoff profi le for buyer of call options: Long call

A call option gives the buyer the right to buy 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 exceeds the strike price, he makes a profit. Higher
the spot price, more is the profit he makes. If the spot price of the underlying is less 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 3.5 gives the payoff for the buyer of a three month call option
(often referred to as long call) with a strike of 1250 bought at a premium of 86.60.
Figure 3.4 Payoff for investor who went Short Nifty at 1220
The fi gure shows the profi ts/losses from a short position on the index. The investor sold the index at 1220. If the
index falls, he profi ts. If the index rises, he looses.
Profit
+60
0 1160 1220 1280

Nifty
−60
Loss
3.12.2 Payoff profi le for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss
that the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer. Hence as the spot price increases the writer of the
option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his option expire un-
exercised and the writer gets to keep the premium. Figure 3.6 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.
3.12.3 Payoff profi le for buyer of put options: Long put

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 3.7 gives the payoff for the buyer of a three month put option (often
Figure 3.5 Payoff for buyer of call option

The fi gure shows the profi ts/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 profi t to the extent of the difference between the Nifty-close and the strike price. The
profi ts 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
referred to as long put) with a strike of 1250 bought at a premium of 61.70.
3.12.4 Payoff profi le for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss
that the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to be below the strike
price, the buyer will exercise the option on the writer. If upon expiration the spot price of the
underlying is more than the strike price, the buyer lets his option expire un-exercised and the
writer gets to keep the premium. Figure 3.8 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.
Figure 3.6 Payoff for writer of call option

The fi gure shows the profi ts/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 profi t 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
Solved Problems
Q: Which of the following cannot be an underlying asset for a fi nancial derivative contract?
1. Equity index 3. Interest rate
2. Commodities 4. Foreign exchange
A: The correct answer is 2
Q: Which of the following exchanges was the fi rst to start trading fi nancial futures?
1. Chicago Board of Trade 3. Chicago Board Options Exchange
4. London International Financial Futures and

2. Chicago Mercantile Exchange Options Exchange
A: The correct answer is 2.

Figure 3.7 Payoff for buyer of put option

The fi gure shows the profi ts/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 profi t to the extent of the difference between the strike price and Nifty-close. The profi ts
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
Q: In an options contract, the option lies with the
1. Buyer 3. Both
2. Seller 4. Exchange
A: The option to exercise lies with the buyer. The correct answer is number 1.
Q: The potential returns on a futures position are:
1. Limited 3. a function of the volatility of the index
2. Unlimited 4. None of the above

Figure 3.8 Payoff for writer of put option

The fi gure shows the profi ts/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls,
the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below 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 strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum
extent of the strike price( Since the worst that can happen is that the asset price can fall to zero) whereas the
maximum profi t is limited to the extent of the up-front option premium of Rs.61.70 charged by him.
Profit
61.70
0 1250
Nifty
Loss
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/gm. This is an example
of a
1. Futures contract 3. Spot contract
2. Forward contract 4. None of the above

Q: On 15th January Mr.Arvind Sethi bought a January Nifty futures contract which cost him Rs.269,000.
For this he had to pay an initial margin of Rs.21,520 to his broker. Each Nifty futures contract is for
delivery of 200 Nifties. On 25th January, the index closed at 1360. How much profi t/loss did he make?
1. + 3000 3. - 3000
2. - 2500 4. + 2500
A: Mr.Sethi bought one futures contract costing him Rs.269,000. At a market lot of 200, this means he
paid Rs.1345 per Nifty future. On the futures expiration day, the futures price converges to the spot price.
If the index closed at 1360, this must be the futures close price as well. Hence he will have made of profi t
of (1360 - 1345)*200. The correct answer is number 1.
Q: Kantaben sold a January Nifty futures contract for Rs.269,000 on 15th January. For this she had to pay
an initial margin of Rs.21,520 to her broker. Each Nifty futures contract is for delivery of 200 Nifties. On
25th January, the index closed at 1260. How much profi t/loss did she make?
1. - 17,000 3. - 15,000
2. - 15,000 4. + 17,000
A: Kantaben sold one futures contract costing her Rs.269,000. At a market lot of 200, this works out to
be Rs.1345 per Nifty future. On the futures expiration day, the futures price converges to the spot price. If
the index closed at 1260, this must be the futures close price as well. Hence she will have made of profi t
of (1345 - 1260)*200. The correct answer is number 4.
Q: On 15th January, Nilish Kajaria bought one January Nifty futures contract which cost him Rs.269,000.
For this he had to pay an initial margin of Rs.21,520 to his broker. Each Nifty futures contract is for
delivery of 200 Nifties. On 25th January, the index closed at 1280. How much profi t/loss did he make?
1. + 13,000 3. - 13,000
2. - 12,500 4. + 12,500
A: Nilesh Kajaria bought one futures contract for Rs.269,000. At a market lot of 200, this means he paid
Rs.1345 per Nifty future. On the futures expiration day, the futures price converges to the spot price. If
the index closed at 1280, this must be the futures close price as well. Hence he made of loss of (1345 -
1280)*200. The correct answer is number 3.
Q: Krishna Seth sold one January Nifty futures contract for Rs.269,000 on 15th January. For this he
had to pay an initial margin of Rs.21,520 to his broker. Each Nifty futures contract is for delivery of 200
Nifties. On 25th January, the index closed at 1390. How much profi t/loss did he make?
1. - 8,000 3. - 9,500
2. - 9,000 4. + 9,000
A: Krishna Seth sold one futures contract for Rs.269,000. At a market lot of 200, this works out to be
Rs.1,345 per Nifty future. On the futures expiration day, the futures price converges to the spot price. If
the index closed at 1,390, this must be the futures close price as well. Hence he made of loss of (1,390 -
1,345)*200. The correct answer is number 2.
Q: A call option at a strike of Rs.176 is selling at a premium of Rs.18. At what price will it break even
for the buyer of the option?
1. Rs.196 3. Rs.187
2. Rs.204 4. Rs.194
A: To recover the option premium of Rs.18, the spot will have to rise to 176 + 18. The correct answer is
number 4.
Q: Typically option premium is
1. Less than the sum of intrinsic value and time 3. Equal to the sum of intrinsic value and time
value value
2. Greater than the sum of intrinsic value and
time value 4. Independent of intrinsic value and time value
Q: Spot value of S&P CNX Nifty is 1200. An investor bought a one-month S&P CNX Nifty 1220 call
option for a premium of Rs.10. The options is
1. In-the-money 3. Out-of-money
2. At-the-money 4. None of the above

Q: A stock currently sells at 120. The put option to sell the stock sells at Rs.134 costs Rs.18.
The time value of the option is .
1. Rs.18 3. Rs.14
2. Rs.4 4. Rs.12
Q: An in-the-money option contract would generate upon exercise for the buyers.
1. positive cash flow 3. no cash flow
2. pre-determined amount of cash flow 4. negative cash flow
Q: A put option gives the the right but not the obligation to the underlying
asset at a specified price.
1. seller, buy 3. owner, buy
2. seller, sell 4. owner, sell
Q: By buying index futures one can make .
1. unlimited profits or loss since 3. limited profits or losses

market may go up or down
2. limited profit but unlimited losses 4. unlimited profit but limited loss
Q: An index put option at a strike of Rs. 1176 is selling at a premium of Rs. 36. At what
index level will it break even for the buyer of the option ?
1. Rs. 1,870 3. Rs. 1,212
2. Rs. 1,140 4. Rs. 1,940

Chapter 4
Pricing futures
Stock index futures began trading on NSE on the 12th June 2000. Stock futures were launched on
9th November 2001. The volumes and open interest on this market has been steadily growing.
Looking at the futures prices on NSE’s market, have you ever felt the need to know whether
the quoted prices are a true reflection of the price of the underlying index/stock? Have you
wondered whether you could make risk-less profits by arbitraging between the underlying and
futures markets? If so, you need to know the cost-of-carry to understand the dynamics of pricing
that constitute the estimation of fair value of futures.
4.1 The cost of carry model

We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures
contract. This is the basis for the cost-of-carry model where the price of the contract is defined as:
F S
where:
F Futures price
S Spot price
C Holding costs or carry costs
This can also be expressed as:
F S

where:
r Cost of fi nancing
50 Pricing futures
T Time till expiration
If

or
, 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 futures 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 S

where:
r Cost of fi nancing(using continuously compounded interest rate)
e 2.71828
4.1.1 Pricing futures contracts on commodities

Let us take an example of a futures contract on a commodity and work out the price of the
contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15% annually, what
should be the futures price of 100 gms of silver one month down the line ? Let us assume that
we’re on 1st January 2002. How would we compute the price of a silver futures contract expiring
on 30th January? From the discussion above we know that the futures price is nothing but the
spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry
model.
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?
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

" " $

"
4.2 Pricing equity index futures 51

Under normal market conditions, F, the futures price is very close to . However, on October
19,1987, the US market saw a breakdown in this classic relationship between spot and futures prices.
It was the day the markets fell by over 20% and the volume of shares traded on the New York Stock
Exchange far exceeded all previous records. For most of the day, futures traded at signifi cant discount
to the underlying index. This was largely because delays in processing orders to sell equity made index
arbitrage too risky. On the next day, October 20,1987, the New York Stock Exchange placed temporary
restrictions on the way in which program trading could be done. The result was that the breakdown of
the traditional linkages between stock indexes and stock futures continued. At one point, the futures
price for the December contract was 18% less than the S&P 500 index which was the underlying index
for these futures contracts! However, the highlight of the whole episode was the fact that inspite of
huge losses, there were no defaults by futures traders. It was the ultimate test of the effi ciency of the
margining system in the futures market.
Box 4.8: The market crash of October 19, 1987
If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing
would increase the futures price. Therefore, the futures price would be

"

. 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 futures contract
would be Rs.708 plus the cost of storage.
4.2 Pricing equity index futures

A futures contract on the stock market index gives its owner the right and obligation to buy or
sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there
is no delivery of the underlying stocks.
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 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:
There are no costs of storage involved in holding equity.
Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive
cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with
equity futures as opposed to commodity futures is an accurate forecasting of dividends. The
better the forecast of dividend offered by a security, the better is the estimate of the futures price.
52 Pricing futures
4.2.1 Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where the carrying cost is
the cost of financing the purchase of the portfolio underlying the index, minus the present value
of dividends obtained from the stocks in the index portfolio.
Example
Nifty futures trade on NSE as one,two and three-month contracts. Money can be borrowed at a
rate of 15% per annum. What will be the price of a new two-month futures contract on Nifty?
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 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 fi gure by 200.

7. Thus, futures price F Rs.

4.2.2 Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are few historical cases
of clustering of dividends in any particular month, it is useful to calculate the annual dividend
yield.

where:
F futures price
S spot index value
r cost of fi nancing
q expected dividend yield
T holding period
4.2 Pricing equity index futures 53
Figure 4.1 Variation of basis over time

The fi gure shows how basis changes over time. As the time to expiration of a contract reduces, the basis reduces.
Towards the close of trading on the day of settlement, the futures price and the spot price converge. The closing
price for the June 28 futures contract is the closing value of Nifty on that day.
Price
Futures price
Spot price
Time
t1 t2 T
Example
A two-month futures contract trades on the NSE. The cost of financing is 15% and the dividend
yield on Nifty is 2% annualized. The spot value of Nifty 1200. What is the fair value of the
futures contract? Fair value Rs.

$ " " $ $ $ "

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 spot price and the futures 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 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.
54 Pricing futures
4.3 Pricing stock futures

A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks.
Like index futures, stock futures are also cash settled; there is no delivery of the underlying
stocks. Just as in the case of index futures, the main differences between commodity and stock
futures are that:
There are no costs of storage involved in holding stock.
Stocks come with a dividend stream, which is a negative cost if you are long the stock and a positive
cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with
stock futures as opposed to commodity futures is an accurate forecasting of dividends. The better
the forecast of dividend offered by a security, the better is the estimate of the futures price.
4.3.1 Pricing stock futures when no dividend expected

The pricing of stock futures is also based on the cost-of-carry model, where the carrying cost is
the cost of financing the purchase of the stock, minus the present value of dividends obtained
from the stock. If no dividends are expected during the life of the contract, pricing futures on
that stock is very simple. It simply involves multiplying the spot price by the cost of carry.
Example
SBI futures trade on NSE as one,two and three-month contracts. Money can be borrowed at 15%
per annum. What will be the price of a unit of new two-month futures contract on SBI if no
dividends are expected during the two-month period?
1. Assume that the spot price of SBI is Rs.228.

2. Thus, futures price F
Rs.
4.3.2 Pricing stock futures when dividends are expected

When dividends are expected during the life of the futures contract, pricing involves reducing
the cost of carry to the extent of the dividends. The net carrying cost is the cost of financing the
purchase of the stock, minus the present value of dividends obtained from the stock.
Example
M & M futures trade on NSE as one,two and three–month contracts. What will be the price
of a unit of new two–month futures contract on M & M if dividends are expected during the
two–month period?
4.3 Pricing stock futures 55
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. Assume that the market price of M & M is Rs.140.
3. 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.10. The dividend is received 15 days later and hence
compounded only for the remainder of 45 days.

4. Thus, futures price F
Rs.
Solved problems
Q: The model is used for pricing futures contracts.
1. Black & Scholes 3. Miller
2. Cost–of–carry 4. Time–value
Q: Suppose the Nifty spot is at 1000 and two-month futures trade at 1040. Suppose the transaction costs
involved in placing an index trade are 0.25% and the Nifty index dividends over two months are 0.10%.
What is the net rate of return?
1. 1.5% per month 3. 1.75% per month
A: The return on the futures is 1040/1000, i.e. 4%. After adding 0.1% dividends and deducting 0.25%
transactions cost, the total return over 2 months works out to be 3.85%. Therefore the net return per month
works out to be 1.92%. The correct answer is number 4.
Q: What is the riskless profi t that can be earned over two months if the Nifty spot is at 1000 and the two
month futures are at 1010. Suppose cash can be risklessly invested at 12% p.a. and there are no transaction
costs.
1. 1.09% 3. 0.9%
2. 0.01% 4. 0.4%
A: At a riskfree rate of 12%, futures are underpriced. One can make an arbitrage profi t by buying Nifty
futures at 1010, selling Nifty spot and investing the 1000 risklessly for two months. At the end of two
months this money would grow to be about 1019. i.e. a return of (1019-1010)/1000. The correct answer
is number 3.
56 Pricing futures
Q: What is the fair value of one month future if the spot value of Nifty is 1150? The money can be
invested at 11% p.a. and Nifty gives a dividend yield of 1% per annum.
1. 1162 3. 1180
2. 1159 4. 1170

A: The fair value is

. The correct answer is number 2.
Q: What is the fair value of one month future if the spot value of Nifty is 1150? The money can be
invested at 14% p.a. and Nifty gives a dividend yield of 4% per annum.
1. 1162 3. 1180
2. 1159 4. 1170

A: The fair value is

. The correct answer is number 2.
Q: The Nifty spot stands at 1260 and the cost of fi nancing is 12% per year. What is the fair value of
one-month Nifty futures contracts?
1. 1262 3. 1268
2. 1272 4. 1275

A: Using the cost-of-carry model, the price of the futures contract is computed as

which is approximately 1272. The correct answer is number 2.
Q: The Nifty spot stands at 1260 and the cost of fi nancing is 12% per year. The annual dividend yield on
the Nifty works out to be 2%. What is the fair value of one-month Nifty futures contracts?
1. 1268 3. 1268
2. 1272 4. 1270


which is approximately 1270. The correct answer is number 4.

4.3 Pricing stock futures 57
Q: Nifty futures trade on NSE as one, two and three-month contracts. Spot Nifty stands at 1200. BASF
which currently trades at Rs.120 has a weight of 5% in Nifty. It is expected to declare a dividend of Rs.20
per share after 15 days of purchasing the contract. The cost of borrowing is 15% per annum. What will
be the price of a new two-month futures contract on Nifty?
1. 1225.50 3. 1230.85
2. 1227.80 4. 1217.70
A: Since Nifty stands at 1200, value of the contract is 200*1200 = Rs.240000. If BASF has a weight of
5% in Nifty, its value in Nifty is Rs.12000. If the market price of BASF is Rs.120, then a traded unit of

Nifty involves 100 shares. Thus, the futures price F Rs.

The correct answer is number 4.
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 12% per year. What is the
fair value of one-month futures on Tata Tea?
1. 178.65 3. 180.15
2. 179.05 4. 177.65


which is 178.65. This could also be computed as which gives approximately the same
answer.The correct answer is number 1.
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 12% per year. It is expected
to pay a dividend of Rs.10, 45 days later. What is the fair value of three-month futures on Tata Tea?
1. 173.65 3. 182.05
2. 171.88 4. 177.65


which is 171.88. The correct answer is number 2.
Q: The ITC trades on the spot market at Rs.720. The cost of fi nancing is 15% per year. What is the fair
value of two-month futures on ITC?
1. 736.73 3. 731.45
2. 728.65 4. 732.55


which
is 736.73. The correct answer is number 1.
58 Pricing futures
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 15% per year. It is expected
to pay a dividend of Rs.10, 45 days later. What is the fair value of three-month futures on Tata Tea?
1. 173.05 3. 181.05
2. 171.20 4. 177.65


which is 173.05. The correct answer is number 1.

Chapter 5
Using index futures
There are eight basic modes of trading on the index futures market:
Hedging
1. Long security, short Nifty futures

2. Short security, long Nifty futures
3. Have portfolio, short Nifty futures
4. Have funds, long Nifty futures
Speculation
1. Bullish index, long Nifty futures

2. Bearish index, short Nifty futures
Arbitrage
1. Have funds, lend them to the market

2. Have securities, lend them to the market
5.1 Hedging: Long security, short Nifty futures

Investors studying the market often come across a security which they believe is intrinsically
undervalued. It may be the case that the profits and the quality of the company make it seem
worth a lot more than what the market thinks. A stockpicker carefully purchases securities based
on a sense that they are worth more than the market price. When doing so, 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.
60 Using index futures
The second outcome happens all the time. A person may buy Reliance at Rs.190 thinking
that it would announce good results and the security price would rise. A few days later, Nifty
drops, so he makes losses, even if his understanding of Reliance was correct.
There is a peculiar problem here. Every buy position on a security is simultaneously a buy
position on Nifty. This is because a LONG RELIANCE position generally gains if Nifty rises
and generally loses if Nifty drops. In this sense, a LONG RELIANCE position is not a focused
play on the valuation of Reliance. It carries a LONG NIFTY position along with it, as incidental
baggage. The stockpicker may be thinking he wants to be LONG RELIANCE, but a long position
on Reliance effectively forces him to be LONG RELIANCE + LONG NIFTY.
Even if you think WIPRO is undervalued, the position LONG WIPRO is not purely about
WIPRO; it is also partly about Nifty. Every trader who has a LONG WIPRO position is forced to
be an index speculator, even though he may have no interest in the index. It is useful to ask: does
the person feel bullish about WIPRO or about the index?
Those who are bullish about the index should just buy Nifty futures; they need not trade individual securities.
Those who are bullish about WIPRO 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 security, you should
sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every
long–security position. Once this is done, you will have a position which is purely about the
performance of the security. The position LONG WIPRO + SHORT NIFTY is a pure play on the
value of WIPRO, without any extra risk from fluctuations of the market index. When this is done,
the stockpicker has “hedged away” his index exposure. The basic point of this hedging strategy
is that the stockpicker proceeds with his core skill, i.e. picking securities, at the cost of lower
risk.
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.
How do we actually do this?

1. We need to know the “beta” of the security, i.e. the average impact of a 1% move in Nifty upon the security. If
betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, whose beta is
1.2, and suppose we have a LONG LUPINLAB 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 sell Rs.240,000 of Nifty we need to sell one market lot.
4. We sell one market lot of Nifty (200 nifties) to get the position:
LONG LUPINLAB Rs.200,000
SHORT NIFTY Rs.240,000
5.1 Hedging: Long security, short Nifty futures 61
This position will be essentially immune to fluctuations of Nifty. The profi ts/losses position will fully reflect
price changes intrinsic to LUPINLAB, hence only successful forecasts about LUPINLAB will benefi t from this
position. Returns on the position will be roughly neutral to movements of Nifty.
Example
1. Shyam adopts a position of Rs.1 million LONG MTNL on date 5th June 2001. He plans to hold the position till
the 25th.
2. Suppose the beta of MTNL happens to be 1.2.
3. Hence he needs a short position of Rs.1.2 million on the index futures market to totally remove his Nifty
exposure.
4. On date 5th June 2001, Nifty is 980 and the nearest futures contract (with expiration 28th June 2001) is trading
at about 1000. Hence, each market lot of the futures (200 nifties) is worth Rs.200,000. To sell Rs.1.2 million
of Nifty, we need to sell 6 lots (by rounding off to the nearest market lot).
5. He sells 6 market lots of Nifty (1200 nifties) to get the position:

LONG MTNL Rs.1,000,000
SHORT NIFTY Rs.1,200,000
6. 10 days later, Nifty crashed because of instability in the government.
7. On Thursday, Shyam unwound both positions. His position on MTNL lost Rs.120,000 since MTNL had
dropped to 880,000. His short position on Nifty June futures earned Rs.141,600. Overall, he earned Rs.21,600.
Nuances
1. How do I fi nd out the beta of a security? The betas of major securities are available in the NSE Newsletter
or over the Internet on http://www.nse-india.com. Note that the security prices and betas used in
this workbook are only illustrative in nature.
2. What if I am still stuck without a beta estimate? If a beta is not known, it is generally useful to guess that
the beta of an unknown security is near 1. In other words, a speculative long position of Rs.500,000 on any
security should be accompanied by selling Rs.500,000 of Nifty in order to obtain a complete hedge. This
(slightly wrong) hedged position is always much better than a totally un-hedged position (i.e. not selling any
Nifty). Of course, knowing the true beta gives the most accurate hedge.
3. Does this only work for index–securities? No, this works for any securities in the country. Some index
securities have a weak link to the index, and some non–index securities have a very tight link with the index.
4. How much risk reduction do I gain? It varies from security to security. The naked LONG SILVERLINE position
is around twice the risk of the hedged position LONG SILVERLINE + SHORT NIFTY. The risk reductions
obtained range of 25% to 60%.
Suppose the daily returns of a security has a variance of . Then the variance of the fully hedged position

is
where
is the standard deviation of daily returns on Nifty. Typically,

is around 1.6

percent/day. For example, if SILVERLINE has a variance of 9 and a beta of 1.2, then the fully hedged position
has a variance of 5.31. Through this formula, we can precisely quantify the magnitude of the risk reduction
that complete hedging delivers.
5. Will hedging always help if my forecast about the security is wrong? It depends. If the forecast about the
security itself is wrong, then hedging is no help. If the forecast goes wrong because Nifty crashes, then a
complete hedge will reimburse these losses.
6. Nifty futures with several different expirations are available at the same time. Which one should I use?
There are three criteria: liquidity, expiration date, and potential mispricings:
Liquidity Using the most liquid of them (i.e. the one with the tightest bid–ask spread) saves money on impact
cost.
Expiration date If the speculative position is a two–week view, then it’s convenient if the index futures that
is used also has at least two weeks to go.
Potential mispricings Finally, it never hurts to be clever and sell a futures contract which is somewhat
overpriced. This will not only do the job of hedging, but it could also yield some profi ts out of the
mispriced futures. Hence it helps to check the market price of all available futures contracts against
their fair values, and try to use the most overpriced contract as part of the hedging.
Solved problems
Q: The beta of ORIENTBANK is 0.8. A person has a long position of Rs.200,000 of ORIENTBANK.
Which of the following gives a complete hedge?
1. SELL 200,000 of Nifty 3. BUY 160,000 of Nifty
2. BUY 200,000 of Nifty 4. SELL 160,000 of Nifty
A: A long position in ORIENTBANK of Rs.200,000 is as vulnerable to the index as a long position of

Rs.160,000 of Nifty. To neutralize this, the hedger would need to sell Rs.160,000 of Nifty. The correct
answer is number 4.
Q: The beta of SBI is 0.8. A person has a LONG SBI position of Rs.200,000 coupled with a SHORT NIFTY
position of Rs.100,000. Which of the following is true?
1. He has a partial hedge against fluctuations of 4. He is bullish on Nifty and bearish on SBI
Nifty
2. He has a complete hedge against fluctuations 5. This is not a hedge; it is just speculation
of Nifty
3. He is bearish on Nifty as well as on SBI 6. He is overhedged
A: A long position in SBI of Rs.200,000 is as vulnerable to the index as a long position of Rs.160,000 of
Nifty. To completely neutralize this, the hedger would need to sell Rs.160,000 of Nifty. He has actually
sold Nifty to the extent of only Rs.100,000. Hence he is partially hedged. The correct answer is number
1.
5.1 Hedging: Long security, short Nifty futures 63
Q: The beta of STERLITE is 1.3 and the total risk of STERLITE is 9. The daily of Nifty is 1.6. Once
complete hedging is done, how much risk are we left with?
1. 4.1 4. 5.6
2. 4.6
3. 5.1 5. 6.1

A: A fully hedged position has total risk (variance) of

, which evaluates to 4.6. Hence the risk

suffered by the person with a view that STERLITE is undervalued drops from 9 to 4.6.
This illustrates the sharp reduction in risk that a stockpicker obtains using the futures. A naked LONG
STERLITE position has a variance of 9. The position LONG STERLITE + SHORT NIFTY fully captures
the extent to which STERLITE is undervalued, but suffers a total risk of only 4.6. The correct answer is
number 2.
Q: Hari buys 1000 shares of HPCL at Rs.190 and obtains a complete hedge by shorting 300 nifties at
Rs.972 each. He closes out his position at the closing price of the next day; at this point HPCL has dropped
5% and the Nifty futures have dropped 4%. What is the overall profi t/loss of this set of transactions?
1. Profi t of Rs.2,164 3. Profi t of Rs.9,500
A: The HPCL position loses Rs.9,500 and the short position on Nifty earns Rs.11,664. The net profi t on
the position is Rs.2,164. The correct answer is number 1.
Q: A speculator hopes that ROLTA is going to rise sharply. He has a long position on the cash market of
Rs.1 crore on ROLTA. The beta of ROLTA is 1.2. Which of the following positions on the index futures
gives him a complete hedge:
1. Long Nifty Rs.1 crore 4. Short Nifty Rs.1.2 crore

2. Short Nifty Rs.1 crore
3. Long Nifty Rs.1.2 crore 5. Do nothing.

Q: A speculator expects that the rupee will depreciate, and hence profi ts of INFOSYSTCH will rise.
Hence he does LONG INFOSYSTCH to the tune of Rs.2 lakh. The beta of INFOSYSTCH is 1.03. How can
this speculator completely remove his Nifty exposure?
1. Short Nifty Rs.2.06 lakh 4. Long Nifty Rs.2 lakh

2. Short Nifty Rs.2 lakh
3. Long Nifty Rs.2.06 lakh 5. Do nothing.
Q: A speculator expects that the rupee will depreciate, and hence profi ts of PENTSFWARE will rise.
Hence he does LONG PENTSFWARE to the tune of Rs.2 lakh. The beta of PENTSFWARE is 1.03. In order
to remove his Nifty exposure, he does SHORT NIFTY to the tune of Rs.2.5 lakh. Which is true:
1. He is overhedged 3. He is completely hedged
2. He is underhedged 4. None of the above
Q: The beta of VIKASWSP is 1.2 and the total risk of VIKASWSP is 9. The daily of Nifty is 1.3. One
1. 6.5 4. 5.4
2. 6.0
3. 6.2 5. 5.8
Q: Hari buys 1000 shares of HLL at Rs.210 and obtains a complete hedge by shorting 200 Nifties at
Rs.1,078 each. He closes out his position at the closing price of the next day; at this point HLL has
dropped 2% and the Nifty futures have risen 1%. What is the overall profi t/loss of this set of transactions?
2. Loss of Rs.6,356 4. Profi t of Rs.2,156

5.2 Hedging: Short security, long Nifty futures 65
5.2 Hedging: Short security, long Nifty futures

Investors studying the market often come across a security which they believe is intrinsically
over-valued. It may be the case that the profits and the quality of the company make it worth a
lot less than what the market thinks. A stockpicker carefully sells securities based on a sense that
they are worth less than the market price. In doing so he faces two kinds of risks:
1. His understanding can be wrong, and the company is really 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 sell Reliance at Rs.190 thinking
that Reliance would announce poor results and the security price would fall. A few days later,
Nifty rises, so he makes losses, even if his intrinsic understanding of Reliance was correct.
There is a peculiar problem here. Every sell position on a security is simultaneously a sell
position on Nifty. This is because a SHORT RELIANCE position generally gains if Nifty falls
and generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused
play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental
baggage. The stockpicker may be thinking he wants to be SHORT RELIANCE, but a short position
on Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.
Even if you think WIPRO is over-valued, the position SHORT WIPRO is not purely about
WIPRO; it is also partly about Nifty. Every trader who has a SHORT WIPRO position is forced
to be an index speculator, even though he may have no interest in the index. It is useful to ask:
does the person feel bearish about WIPRO or about the index?
Those who are bearish about the index should just sell nifty futures; they need not trade individual securities.
Those who are bearish about WIPRO 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 security, you should
buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every
short–security position. Once this is done, you will have a position which is purely about the
performance of the security. The position SHORT WIPRO + LONG NIFTY is a pure play on the
value of WIPRO, without any extra risk from fluctuations of the market index. When this is done,
the stockpicker has “hedged away” his index exposure. The basic point of this hedging strategy
is that the stockpicker proceeds with his core skill, i.e. picking securities, at the cost of lower
risk.
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 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.

1. We need to know the “beta” of the security, i.e. the average impact of a 1% move in Nifty upon the security. If
betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, where the beta
is 1.2, and suppose we have a SHORT LUPINLAB 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 LUPINLAB Rs.200,000
LONG NIFTY Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profi ts/losses position will fully reflect
price changes intrinsic to LUPINLAB, hence only successful forecasts about LUPINLAB will benefi t from this
position. Returns on the position will be roughly neutral to movements of Nifty.
Example
1. Shyam adopts a position of Rs.1 million SHORT MTNL on date 1st April 1997. He plans to hold the position
till Thursday the 24th.
2. The beta of MTNL happens to be 1.2.
3. Hence he needs a long position of Rs.1.2 million on the index futures market to totally remove his Nifty
exposure.
4. On date 1st April 97, Nifty is 980 and the nearest futures contract (with expiration 24th April) is trading at
about 1000. Hence, each market lot of the futures (200 nifties) is worth Rs.200,000. To buy Rs.1.2 million of
Nifty, we need to buy 6 lots (by rounding off to the nearest market lot).
5. He buys 6 market lots of Nifty (1200 nifties) to get the position:

SHORT MTNL Rs.1,000,000
LONG NIFTY Rs.1,200,000
6. 20 days later, Nifty rose because of stable political outlook.
7. On Thursday, Shyam unwound both positions. His position on MTNL lost Rs.120,000 since MTNL had gone
up to 1,120,000. His short position on Nifty April futures earned Rs.93,600. Overall, he lost Rs.26,400.
Solved problems
Q: The beta of ORIENTBANK is 0.8. A person has a short position of Rs.200,000 of ORIENTBANK.
Which of the following gives a complete hedge?
1. SELL 200,000 of Nifty 4. SELL 160,000 of Nifty

2. BUY 200,000 of Nifty
3. BUY 160,000 of Nifty 5. Do nothing
A: A short position in ORIENTBANK of Rs.200,000 is as vulnerable to the index as a short position of

Rs.160,000 of Nifty. To neutralize this, the hedger would need to buy Rs.160,000 of Nifty. The correct
answer is number 3.
5.2 Hedging: Short security, long Nifty futures 67
Q: The beta of SBI is 0.8. A person has a SHORT SBI position of Rs.200,000 coupled with a LONG NIFTY
position of Rs.100,000. Which of the following is true?
1. He has a partial hedge against fluctuations of 4. He is bullish on Nifty and bearish on SBI
Nifty
2. He has a complete hedge against fluctuations 5. This is not a hedge; it is just speculation
of Nifty
3. He is bearish on Nifty as well as on SBI 6. He is overhedged
A: A short position in SBI of Rs.200,000 is as vulnerable to the index as a short position of Rs.160,000 of
Nifty. To completely neutralize this, the hedger would need to buy Rs.160,000 of Nifty. He has actually
bought Nifty to the extent of only Rs.100,000. Hence he is partially hedged. The correct answer is number
1.
Q: The beta of STERLITE is 1.3 and the total risk of STERLITE is 9. The daily of Nifty is 1.6. One
1. 4.1 4. 5.6
2. 4.6
3. 5.1 5. 6.1

A: A fully hedged position has total risk (variance) of

, which evaluates to 4.6. Hence the risk

suffered by the person with a view that STERLITE is undervalued drops from 9 to 4.6.
This illustrates the sharp reduction in risk that a stockpicker obtains using the futures. A naked SHORT
STERLITE position has a variance of 9. The position SHORT STERLITE + LONG NIFTY fully captures the
extent to which STERLITE is undervalued, but suffers a total risk of only 4.6. The correct answer is
number 2.
Q: Gopal sells 1000 shares of HPCL at Rs.190 and obtains a complete hedge by buying 300 nifties at
Rs.972 each. He closes out his position at the closing price of the next day; at this point HPCL has risen
5% and the Nifty futures have risen 4%. What is the overall profi t/loss of this set of transactions?
A: The HPCL position loses Rs.9,500 and the long position on Nifty earns Rs.11,664. The net profi t on
the position is Rs.2,164. The correct answer is number 1.
Q: A speculator thinks that ROLTA is going to crash sharply. He has a short position on the cash market
of Rs.1 crore on ROLTA. The beta of ROLTA is 1.2. Which of the following positions on the index futures
gives him a complete hedge?
1. Long Nifty Rs.1 crore 4. Short Nifty Rs.1.2 crore

2. Short Nifty Rs.1 crore
3. Long Nifty Rs.1.2 crore 5. Do nothing.
Q: A speculator expects that the rupee will appreciate, and hence profi ts of INFOSYSTCH will fall.
Hence he does SHORT INFOSYSTCH to the tune of Rs.2 lakh. The beta of INFOSYSTCH is 1.03. How
can this speculator completely remove his Nifty exposure?
1. Short Nifty Rs.2.06 lakh 4. Long Nifty Rs.2 lakh

2. Short Nifty Rs.2 lakh
3. Long Nifty Rs.2.06 lakh 5. Do nothing.
Q: A speculator expects that the rupee will appreciate, and hence profi ts of PENTSFWARE will fall.
Hence he does SHORT PENTSFWARE to the tune of Rs.2 lakh. The beta of PENTSFWARE is 1.03. In
order to remove his Nifty exposure, he does LONG NIFTY to the tune of Rs.2.5 lakh. Which is true:
1. He is overhedged 3. He is completely hedged
2. He is underhedged 4. None of the above
Q: The beta of ITC is 1.3 and the total risk of ITC is 9. The daily of Nifty is 1.3. One complete hedging
is done, how much risk are we left with?
1. 6.5 4. 5.4
2. 6.0
3. 6.1 5. 5.8

5.3 Hedging: Have portfolio, short Nifty futures 69
Q: Hari sells 1000 shares of HLL at Rs.210 and obtains a complete hedge by buying 200 Nifties at Rs.1078
each. He closes out his position at the closing price of the next day; at this point HLL has risen 2% and
the Nifty futures have fallen 1%. What is the overall profi t/loss of this set of transactions?
2. Loss of Rs.6,356 4. Profi t of Rs.2,156
5.3 Hedging: Have portfolio, short Nifty futures

The only certainty about the capital market is that it fluctuates! A lot of investors who own
portfolios experience the feeling of discomfort about overall market movements. Sometimes,
they may have a view that security prices will fall in the near future. At other times, they may see
that the market is in for a few days or weeks of massive volatility, and they do not have an appetite
for this kind of volatility. The union budget is a common and reliable source of such volatility:
market volatility is always enhanced for one week before and two weeks after a budget. Many
investors simply do not want the fluctuations of these three weeks.
This is particularly a problem if you 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.
When you have such anxieties, there are two alternatives:
1 Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor.
2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to “do
something” when security prices fall.
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 securities or not. In the case
of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual
securities, where only 30–60% of the securities 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 profits 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.

1. We need to know the “beta” of the portfolio, i.e. the average impact of a 1% move in Nifty upon the portfolio.
It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a
portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4 and Rs.2 million of Hindustan Lever,
which has a beta of 0.8, then the portfolio beta is (1 1.4 + 2 0.8)/3 or 1. If the beta of any securities is not

known, it is safe to assume that it is 1.
2. The complete hedge is obtained by adopting a position on the index futures market which completely removes
the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would
need a position of Rs.3 million on the Nifty futures.
3. Suppose Nifty is 1250, and the market lot on the futures market is 200. Each market lot of Nifty costs
Rs.250,000. Hence we need to sell 12 market lots, i.e. 2400 Nifties to get the position:
LONG PORTFOLIO Rs.3,000,000
SHORT NIFTY Rs.3,000,000.
This position will be essentially immune to fluctuations of Nifty. If Nifty goes up, the portfolio gains and the
futures lose. If Nifty goes down, the futures gain and the portfolio loses. In either case, the investor has no
risk from market fluctuations when he is completely hedged.
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 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 of the portfolio is held unhedged. The exact degree of hedging chosen depends upon the
appetite for risk that the investor has.
Example
1. On 25 May 2001, Shyam has a portfolio composed of fi ve securities: ITCHOTEL (100 shares, value
Rs.112.00), ORIENTBANK (200 shares, value Rs.68.25), CIPLA (100 shares, value Rs.847.65), LUPINLAB
(200 shares, value Rs.149.85), and SIEMENS (200 shares, value Rs.237.50). The total portfolio value is
187,085 and the fi ve securities have weights (5.98%, 7.29%, 45.31%, 16.02%, 25.40%). Shyam does not want
to worry about budget-related fluctuations from 26 May 2001 till 10 June 2001.
2. The fi ve securities have the following betas: ITCHOTEL (beta 0.59), ORIENTBANK (beta 0.90), CIPLA (beta
0.75), LUPINLAB (beta 1.13), and SIEMENS (beta 1.10). Hence the portfolio beta works out to (0.0598*0.59
+ 0.0729*0.90 + 0.4531*0.75 + 0.1602*1.13 + 0.2540*1.10) or 0.90.
3. For complete hedging he will need to sell futures worth 0.90 * 187,085, i.e. Rs.168,376.50. On 25 May 2001,
Nifty is at 1,122.95. So he decides to sell 200 Nifties.
5.3 Hedging: Have portfolio, short Nifty futures 71
Table 5.1 Example of hedging a portfolio

This example deliberately uses a small portfolio of small securities (each of the securities in this example has a
market capitalization of below Rs.200 crore); in practice, the effectiveness of hedging would be greater with larger
portfolios of larger securities.
The hedging strategy is designed to dodge budget–related volatility for the budget announcement of 1 June 2001.
The hedging strategy is initiated on 25 May 2001 and ended on 10 June 2001. Over this period, the portfolio loses
Rs.32990 or 17.63%.
Security 25 May 2001 10 June 2001 Profi t/Loss

ITCHOTEL 112.00 95.30
OREINTBANK 68.25 46.10
CIPLA 847.65 720.85
LUPINLAB 149.85 113.65
SIEMENS 237.50 202.65
Portfolio 187,085.00 154095 32990 (17.63%)
Nifty 1122.95 962.90 160.05 (14.25%)
4. Hence Shyam supplements his portfolio with a short position on the Nifty futures with expiry on 25th JUNE
worth Rs.224,590.
5. On 10 June he buys back futures at a lower price and ends his hedge (see Table 5.1). His profi ts on the futures
hedging was Rs.32,010 and his losses on the portfolio were Rs.32,990. Thus the net loss is Rs. 980. If he had
not hedged, he would have lost 32,990.
In this example, the budget announcement led to a drop in Nifty, so the short position on
the futures market generated profits. If the budget announcement had led to a rise in Nifty, then
the investor would have gained money on his securities portfolio, and lost money on the futures
position. In either event, he would be hedged, i.e. he would neither gain nor lose from index
fluctuations.
Solved problems
Q: A portfolio is composed of Rs.1000 invested in a securities with beta 1.1 and Rs.1000 invested in a
securities with beta 0.8. What is the portfolio beta?
1. 0.85 3. 0.95
2. 0.90 4. 1.0

Q: On 1 Jan 2001, an investor has a portfolio worth Rs.1 million which has a beta of 1.3. He will need
money in middle March as there is a marriage in the family. So he wants to totally remove his equity
market risk. The investor wants to be over–cautious so he sells Rs.2 million of the Nifty futures. What
has he achieved?
1. He is partially hedged. 3. He is overhedged (he has effectively become

a speculator betting that Nifty will drop).
2. He is completely hedged. 4. None of the above
A: To obtain a market–neutral position requires selling 1.3 Rs.1 million or Rs.1.3 million of the Nifty
futures. Over and above this, the remaining Rs.0.7 million is a bet that Nifty will drop. Even the most
over–cautious hedger does not benefi t by a larger sell position on the index futures market than the formula
specifi es – he just becomes a speculator. (Conversely, if a short position smaller than Rs.1.3 million is
taken on the index futures market, the investor is speculating that Nifty will rise). The only way to not
speculate is to completely hedge. The correct answer is number 3.
Q: When the nuclear bombs go off, an investor with $1 billion invested in India becomes fundamentally
gloomy about India and wants to embark a hedging program for the next three years. He will sell $1
billion of Nifty futures now, and constantly initiate new futures positions as old ones expire. What is the
major problem with this strategy?
1. He suffers from “rollover risk”of getting into 3. He will suffer market impact cost selling $1
new positions on the futures positions. billion of the Nifty futures.
4. He would just be better off liquidating his

2. He will have to recalculate his beta from time portfolio, staying out for 3 years, and then
to time when adopting new futures positions. getting back into equity.
A: All the alternatives have a grain of truth in them. But the most powerful criticism is number 4. It is
cheaper to implement long–duration changes of position by trading in the equity cash market. The index
futures is best–suited for rapid, short–term changes in position. The correct answer is number 4.
Q: On 1 Jan 2001, an investor has a portfolio worth Rs.2 million which has a beta of 0.5. He needs money
in middle February as there is a marriage in the family. So he wants to totally remove his equity market
risk. What is the correct hedging strategy?
1. Short Nifty futures Rs.1 million, February ex- 3. Buy Nifty futures Rs.1 million, February ex-
piration piration
2. Short Nifty futures Rs.1.3 million, March ex- 4. Buy Nifty futures Rs.1.3 million, March ex-
piration piration

5.4 Hedging: Have funds, buy Nifty futures 73
Q: On 1 Jan 2001, an investor has a portfolio worth Rs.1 million which has a beta of 1.3. He will need
money in middle March as there is a marriage in the family. So he wants to totally remove his equity
market risk. What is the correct hedging strategy?
1. Short Nifty futures Rs.1 million, February ex- 3. Buy Nifty futures Rs.1 million, February ex-
piration piration
2. Short Nifty futures Rs.1.3 million, March ex- 4. Buy Nifty futures Rs.1.3 million, March ex-
piration piration
A: To obtain a market–neutral position requires selling 1.3 Rs.1 million or Rs.1.3 million of the Nifty
futures. Since the planned expenditures will take place in late February and early March, it would make
sense to use the late March contract for hedging. The correct answer is number 2.
Q: A portfolio is composed of Rs.1000 invested in a securities with beta 0.8 and Rs.2000 invested in a
securities with beta 1.1. What is the portfolio beta?
1. 0.8 4. 1.1
2. 0.9
3. 1.0 5. 1.2
A: Portfolio beta is (1000*0.8 + 2000*1.1)/3000 or 1. The correct answer is number 3.
5.4 Hedging: Have funds, buy Nifty futures

Have you ever been in a situation where you had funds which needed to get invested in equity?
Or of expecting to obtain funds in the future which will get invested in equity. Some common
occurrences of this include:
A closed-end fund which just fi nished its initial public offering has cash which is not yet invested.
Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes
several weeks from the date that it becomes sure that the funds will come to the date that the funds actually
are in hand.
An open-ended fund has just sold fresh units and has received funds.
Getting invested in equity ought to be easy but there are three problems:
1. A person may need time to research securities, and carefully pick securities that are expected to do well. This
process takes time. For that time, the investor is partly invested in cash and partly invested in securities. 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 favorable prices. This takes time, and
during this time, he is exposed to the risk of missing out if the Nifty goes up.
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 securities 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 fi nished 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 securities so it is possible to take extremely
large positions at a low impact cost.
Later, the investor/closed-end fund can gradually acquire securities (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 securities 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 securities market while this process
is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing
securities 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!
Warning: Hedging does not always make money. The best that can be achieved using
hedging is the removal of unwanted risk. The hedged position will make less profits 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.

1. Iqbal obtained Rs.5 million on 17 Feb 1998. He made a list of 14 securities to buy, at 17 Feb prices, totaling
Rs.5 million.
2. At that time Nifty was at 991.70. He entered into a LONG NIFTY MARCH FUTURES position for 5000 nifties,
i.e. his long position was worth 5,053,600.
3. From 18 Feb 1998 to 09 March 1998 he gradually acquired the securities (see Table 5.2). On each day, he
purchased one securities and sold off a corresponding amount of futures.
On each day, the securities 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.
5.4 Hedging: Have funds, buy Nifty futures 75
Table 5.2 Gradual acquisition of securities, hedged

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 securities; hedging using index
futures works for all portfolios regardless of what securities 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 securities prices that he suffered.
Date Futures position Security purchase Futures sold MTM profi t/loss
(in Rs.)
17 Feb +5,000,000
18 Feb 4,597,074 2700 shares of ASIANHOTL 400 -17,042
19 Feb 4,190,807 2800 shares of BATAINDIA 400 38,430
20 Feb 3,786,330 5400 shares of BOMDYEING 400 18,801
23 Feb 3,375,976 55500 shares of SAIL 400 55,828
24 Feb 2,964,000 6050 shares of ESCORTS 400 13,795
25 Feb 2,648,488 1600 shares of DABUR 300 65,300
26 Feb 2,330,165 500 shares of CIPLA 300 25,290
27 Feb 2,007,454 1150 shares of CADBURY 300 35,112
02 Mar 1,673,850 4700 shares of APOLLOTYRE 300 76,248
03 Mar 1,350,948 5100 shares of FEDERALBK 300 -64,214
04 Mar 1,019,453 2150 shares of ITCHOTEL 300 42,968
05 Mar 690,853 2100 shares of LAKME 300 -11,582
06 Mar 362,993 700 shares of PFIZER 300 -2,220
09 Mar 29,828 6300 shares of TITAN 300 10,611
Total 4,982,538 249,724
Nuances
1. Why is this called “hedging”? A person who needs to invest in securities is exactly as vulnerable to a rise in
Nifty as a person who has securities is vulnerable to a drop in Nifty. Hence the natural hedging strategy is to
buy Nifty on the futures market, and reach the desired equity exposure. Later, the composition of securities
can always be adjusted over time.
2. Don’t betas enter this picture? If the investor has not decided what securities to buy, it is safe to think that the
beta will be about 1. This is the stance we have taken in this discussion.
If the investor accurately knows what portfolio will be purchased, it is obviously better to use this information
in choosing a futures position. If shares worth Rs.5 Lakh will be purchased and the desired portfolio has a
beta of 1.5 then a long position of Rs.7.5 Lakh on Nifty futures will be required.
3. Do you imply that every “IPO” of a closed-end equity growth fund should immediately invest the entire
proceeds into the Nifty futures market? Yes. The typical closed-end fund IPO has money trickling in over
a week. The funds obtained everyday should be “invested” into a long position on the Nifty futures before the
end of trading hours on that day.
After this, time is available for (a) security selection and (b) aggressive limit orders. Gradually, as the limit
orders get executed, the futures position can be unwound.
Solved problems
Q: Mythili will get Rs.5 Lakh in the next two/three weeks which she plans to buy shares with. She
adopts a long position on the Nifty futures market. Now broad market prices rise. Which of the following
happens?
1. The shares she wants to buy get costlier and but her Nifty futures position pays her daily
Nifty gets cheaper. MTM margins to compensate for that.
2. The shares she wants to buy get cheaper even
4. The shares she wants to buy get cheaper but
though Nifty rises.
her Nifty futures position requires payment of
3. The shares she wants to buy get costlier daily MTM margins to compensate for that.
A: When broad market prices rise, the shares she wants to buy and Nifty both rise. In this case, her long
position on the futures market earns profi ts, which are paid to her as MTM margin. This fi nances her
(larger) outgo in buying shares. She is hedged. The correct answer is number 3.
Q: Mythili will get Rs.5 Lakh in the next two/three weeks which she plans to buy shares with. She adopts
a long position on the Nifty futures market. Now broad market prices crash. Which of the following
happens:
1. The shares she wants to buy get costlier and but her Nifty futures position pays her daily
Nifty gets cheaper. MTM margins to compensate for that.
2. The shares she wants to buy get cheaper even
4. The shares she wants to buy get cheaper but
though Nifty rises.
her Nifty futures position requires payment of
3. The shares she wants to buy get costlier daily MTM margins to compensate for that.
Q: Mythili has fi xed up to sell some land and expect to raise Rs.5 Lakh from this. The money will appear
in her hands within two/three weeks. She plans to invest it into shares and is worried that the security
market might rise in the next few days. She should:
1. Study the security market closely and accu- 3. Hedge herself by building a LONG NIFTY po-
rately forecast prices. sition of Rs.5 Lakh.
4. Immediately go to the market and buy securi-

2. Hedge herself by shorting Rs.5 Lakh of Nifty. ties.
A: The fi rst alternative does not help if prices do rise. The second alternative is a hedging strategy for
someone with a portfolio who is afraid that Nifty might drop. The fourth is not feasible since she won’t
have Rs.5 Lakh when the time comes to take delivery of the shares. The correct answer is number 3.
5.5 Speculation: Bullish index, long Nifty futures 77
5.5 Speculation: Bullish index, long Nifty futures

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? After a good budget, or good corporate results, or the onset of
a stable government, many people feel that the index would go up. 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 securities is based on
using these liquid securities 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.
Taking a position on the index is effortless using the index futures market. Using index
futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a
person is LONG NIFTY using the futures market, he gains if the index rises and loses if the index
falls.

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. Longer dated
futures go well with long–term forecasts about the movement of the index. Shorter dated futures
tend to be more liquid.
Example
1. On 1 July 2001, Milan feels the index will rise.
2. He buys 200 Nifties with expiration date on 31st July 2001.
3. At this time, the Nifty July contract costs Rs.960 so his position is worth Rs.192,000.
4. On 14 July 2001, Nifty has risen to 967.35.
5. The Nifty July contract has risen to Rs.980.
6. Milan sells off his position at Rs.980.
7. his profi ts from the position are Rs.4000.

Solved problems
Q: You are a speculator. You predict the market will go up in the near future and want to take advantage
of it. You would:
1. Buy Nifty futures 3. Sell securities in the cash market
2. Sell Nifty futures 4. None of the above
A: If you think the market will go up, then the futures will seem underpriced compared to what it will be
in the future. So you should buy Nifty futures now and sell them later to make a profi t. The correct answer
is number 1.
Q: A long position of 10 market lots of Nifty Sep futures is purchased at 1100 and held till expiry when
the Nifty closes at expiry in September at 1124. What would be the profi t on this position?
1. 1,148,000 3. 24,000
2. 1,124,000 4. 48,000
A: Ten market lots of Nifty futures translates to Rs. 2,200,000 (10 market lots x 200 Nifties per market lot
x Rs. 1100, the price of the September futures). At the price of unwind of Rs. 1124 per Nifty, the profi t is
Rs.48,000 (Rs.2,248,000 - Rs.1,100,000). The correct answer is number 4.
Q: Babbanseth expects a bumper agricultural harvest. He is highly optimistic about the performance of
the economy. He hopes the market will go up and buys 10 market lots of the Nifty December futures.
Nifty December futures trade at 1150. His forecasts come true and he closes his position at maturity at
1174. How much profi t does he make?
1. 2,300,000 3. 48,000
2. 2,348,000 4. 480,000
A: The answer is number 3.
5.6 Speculation: Bearish index, short Nifty futures

Do you sometimes think that the market index is going to fall? That you could make a profit by
adopting a position on the index? After a bad budget, or bad corporate results, or the onset of a
coalition government, many people feel that the index would go down. How does one implement
a trading strategy to benefit from a downward movement in the index? Today, you have two
choices:
1. Sell selected liquid securities which move with the index, and buy them at a later date: or,
5.6 Speculation: Bearish index, short Nifty futures 79
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 securities is based on
using these securities 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. Taking a position on the index is effortless using the index futures
market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one
single security. Once a person is SHORT NIFTY using the futures market, he gains if the index
falls and loses if the index rises.
When you think the index will go down, sell 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. Longer dated
futures go well with long–term forecasts about the movement of the index. Shorter dated futures
tend to be more liquid.
Example
1. On 1 June 2001, Milan feels the index will fall.
2. He sells 200 Nifties with a expiration date of 26th June 2001.
3. At this time, the Nifty June contract costs Rs.1,060 so his position is worth Rs.212,000.
4. On 10 June 2001, Nifty has fallen to 962.90.
5. The Nifty June contract has fallen to Rs.990. Milan squares off his position.
6. His profi ts from the position work out to be Rs.14,000.

Solved problems
Q: You are a speculator. You predict the market will go down in the near future and want to take advantage
of it. You would:
1. Buy Nifty futures 3. Sell securities in the cash market
2. Sell Nifty futures 4. None of the above
A: If you think the market will go down, then the futures will seem overpriced compared to what it will
be in the future. So you should sell Nifty futures now and buy them later to make a profi t. The correct
answer is number 2.
Q: A short position of 10 market lots of Nifty Sep futures is purchased at 1100 and held till expiry when
the Nifty closes at expiry in September at 1076. What would be the profi t on this position?
1. 2,200,000 3. 480
2. 2,248,000 4. 48,000
A: Ten market lots of Nifty futures translates to Rs. 2,200,000 (10 market lots x 200 Nifties per market lot
x Rs. 1100, the price of the September futures). At the price of unwind of Rs. 1076 per Nifty, the profi t is
Rs.48,000 (Rs.2,200,000 - 2,152,000). The correct answer is number 4.
Q: Ravi expects a sluggish Industrial growth . He is pessimistic about the performance of the economy.
He hopes the market will go down and sells 10 market lots of the Nifty Dec futures. Nifty December
futures trade at 1150. His forecasts comes true and he closes his position at maturity at 1126. How much
profi t does he make?
1. 1,150,000 3. 48,000
2. 1,174,000 4. 480,000
A: The answer is number 3.
5.7 Arbitrage: Have funds, lend them to the market

Most people would like to lend funds into the security market, without suffering the risk.
Traditional methods of loaning money into the security 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.
5.7 Arbitrage: Have funds, lend them to the market 81
The basic idea is simple. The lender buys all 50 securities 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.

1. Calculate a portfolio which buys all the 50 securities in Nifty in correct proportion, i.e. where the money
invested in each security is proportional to its market capitalization.
2. Round off the number of shares in each security.
3. Using the NEAT software, a single keystroke can fi re off these 50 orders in rapid succession into the NSE
trading system. This gives you the buy position.
4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do
not affect you.
5. A few days later, you will have to take delivery of the 50 securities and pay for them. This is the point at which
you are “loaning money to the market”.
6. Some days later (anytime you want), you will unwind the entire transaction.
7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 securities.
8. A moment later, reverse the futures position. Now your position is down to 0.
9. A few days later, you will have to make delivery of the 50 securities and receive money for them. This is the
point at which “your money is repaid to you”.
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.7000 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 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.
Nuances
1. What if the return is something low, like 1% for a month, and hence uncompetitive? A return of 1% per month,
i.e. 12.7% per year without bearing any risk is an excellent return in India. It is competitive.
2. Okay, what if the return works out to something uncompetitive, like 0.5% for a month? Then it is not worth
lending into the index futures market.
3. Is it possible to somehow do this in quantities smaller than Rs.3 million? Portfolios of shares smaller than
Rs.3 million do not exactly replicate Nifty hence it is simplest and completely riskless to do this in portfolios
of Rs.3 million or more.
4. This sounds great – what are the catches? Some of the 50 securities might be stuck at price limits when you
are getting in or getting out.
Of course, it could always be the case that the spot–futures basis is too low, so the interest rate in lending is
unattractive. In that case it is not worth doing anyway.
5. Does one have to hold till the futures expiration date or can one “square off ” earlier? Many times the market
presents suitable opportunities to square off early and make a tidy profi t. Suppose we entered with the Nifty
spot at 1200 and the futures at 1230. Suppose, two hours later, the Nifty spot is running at 1205 and the futures
are at 1225. Then one can square off and make a profi t of (roughly) 10/1200 or 0.8% on the same day itself.
This is called “early unwind”. Internationally, early unwind is extremely common.
5.8 Arbitrage: Have securities, lend them to the market 83
Solved problems
Q: Suppose the Nifty spot is at 1000 and the two–month futures are at 1040. Suppose the transactions
costs involved are 0.4% and dividends over the two months are 0. Then what is the rate of return in loaning
money to the market?
1. 1.8% per month. 4. 1% per month.

2. 1.25% per month.
3. 1.75% per month. 5. 2% per month.
A: 1040/1000 means a return of 4% over two months. Subtract out 0.4% to get 3.6% over two months,
i.e. 1.8% per month. The correct answer is number 1.
Q: Suppose the Nifty spot is at 1000 and the two–month futures are at 1040. Suppose the transactions
costs involved are 0.4% and dividends over the two months are 0.20%. Then what is the rate of return in
loaning money to the market?
1. 1.5% per month. 3. 1.75% per month.
2. 1.25% per month. 4. 1.9% per month.
A: 1040/1000 means a return of 4% over two months. Subtract out 0.4% and add back the 0.20% received
by way of dividend. The correct answer is 4.
5.8 Arbitrage: Have securities, lend them to the market
Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues
from stocklending. However, 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 contract 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 securities 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.

Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each
share being present in the portfolio with a weight that is proportional to its market capitalization).
1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software.
2. Buy index futures of an equal value at a future date.
3. A few days later, you will receive money and have to make delivery of the 50 shares.
4. Invest this money at the riskless interest rate.
5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50
portfolio.
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 stocklending. To do this, we assume that
transactions costs account for 0.4%. Suppose the spot–futures basis is

and suppose the rate
at which funds can be invested is . Then the total return is
%, 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 (10/1100) is 0.9%. Assume that the transactions costs are 0.4%. 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.
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.40,70,199. Translated in terms of Nifty, this is 1098*
or 1120.
5.8 Arbitrage: Have securities, lend them to the market 85
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 profi ts 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 profi t, on the
entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25,400.
Nuances
1. What if the shares that I own are not exactly the NSE-50 portfolio? This only works exactly for more than Rs.3
million of the NSE-50 portfolio. You can always reshuffle your portfolio to have at least Rs.3 million of Nifty.
Any large investor can plan in advance and have a sub–component of his portfolio which looks exactly like
Nifty; the only constraint is that this sub–component has to be larger than Rs.3 million. Once this preparation
is done, it can be used for stocklending anytime the terms look attractive.
2. How does a stocklending scheme fi t into this? Suppose you do not have the exact Nifty portfolio worth Rs.3
million or more. In that case, some or all the components which are missing can be borrowed if a stocklending
scheme is working. Of course, the rate of return in stocklending through the index futures market would have
to high enough to compensate for the cost of borrowing stock through the stocklending scheme.
3. This sounds great – what is the catch? Some of the 50 securities might be stuck at price limits when you are
getting in or getting out.
Of course, it could always be the case that the spot–futures basis is too high, so the stocklending is unattractive.
In that case it is not worth doing anyway.
4. What is the relationship between moneylending and stocklending into the index futures market? When the
spot–futures basis is “too wide”,i.e. the futures price is higher than its fair value as per the cost of carry model,
moneylending is attractive. When the spot–futures basis is “too low”,i.e. the futures price is lower than its fair
value as per the cost of carry model, stocklending is attractive.
For example, assume that the Nifty spot is at 1200 and the fair value of a one month futures contract works
out to be 1220. This means that the fair basis is 20. If futures trade at 1230, the basis has widened to 30. Now
it becomes profi table to lend money to the market. Assume instead that the futures trade at 1210. The basis
has narrowed down to 10, and it now becomes profi table to lend securities to the market.
If one is highly attractive, the other will be highly unattractive. Both cannot be attractive at the same time.
The market will bounce around; sometimes the basis will be too thin and sometimes the basis will be too wide.
Alert traders will spot these opportunities and connect them up with either stocklending or moneylending,
depending upon the situation.
Solved problems
Q: Suppose the Nifty spot is 1000 and the two month futures are at 1010. Suppose cash can be risklessly
invested at 1% per month and the transactions costs involved are 0.4%. Then the total return that can be
obtained in stocklending is
1. 0.61% over two months 3. 1.61% over two months
A: 1% invested over two months earns 2.01%. Subtract from the interest earned spot-futures basis
1010/1000, that is 1% and 0.4% transactions cost to get 0.61% over two months. The correct answer is 1.
Q: Suppose the Nifty spot is at 1100 and the two-month futures are at 1120. Suppose cash can be risklessly
invested at 1.5% per month and there are no transactions costs. Then the total return that can be obtained
in stocklending is
1. 1% over two months 3. 1.55% over two months
A: 1.5% invested over two months earns 3.02%. Subtract from the interest earned spot-futures basis
1120/1100, that is 1.82% to get 1.2%. The correct answer is 2.
5.9 F&O market watch: Spot the mispricing

In all the applications so far, we assumed that there was a single futures price. In reality when
one trades on the futures market, one encounters two prices - a bid and an ask. In the following
section, we shall discuss two trading strategies that can be implemented by an investor following
the market watch screen.
Do you sometimes think that a futures contract is mispriced? As per the cost-of-carry logic
which we learned in Chapter 4, the futures price must be equal to the spot price plus the cost of
carry. If the futures price is less than the spot price plus cost of carry or if the futures price is
greater than the spot plus cost of carry, arbitrage opportunities exist.
If for instance , arbitrageurs will borrow funds, buy the spot with these

borrowed funds, sell the futures contract and carry the asset forward to deliver against the futures
contract. This is called cash-and-carry arbitrage.
If

, arbitrageurs will sell the asset, invest the proceeds from this sale and buy

futures cheap. This is called reverse cash-and-carry. As arbitrageurs enter the market, buying the
cheaper of the two (future and spot) and selling the expensive, prices will return to an equilibrium
where they obey the cost-of-carry rule.
5.9 F&O market watch: Spot the mispricing 87
Table 5.3 Market watch showing bid and ask for various futures contracts
Month Quantity Bid Ask Quantity
November 1000 1009 1010.5 1000
December 200 1022 1025 400
January 400 1028 1032 200
Table 5.4 Fair values vis-a-vis market prices for various futures contracts
Month Quantity Bid Ask Quantity Fair value
November 1000 1009 1010.5 1000 1009.50
December 200 1022 1025 400 1019.00
January 400 1028 1032 200 1028.70
What we spoke of above were arbitrage opportunities arising out of mispricings. However,
when futures price is not equal to its fair value, speculators too enter the market, buy the cheaply
available contract and sell the expensive one, wait till prices return to their fair values and close
out their positions. Hence identifying mispricings is an essential skill that must be developed.
Let us look at a few examples that will make this clear.
Case 1
On the first day of November, Nifty stands at 1000. The market watch screen shows the three
futures contracts trading at prices given in Table 5.3. .

$
How would an investor spot mispricings? At we can calculate the fair value of the

$
futures contracts using the relationship given below:

The fair values of the three contracts are given in Table 5.4. If the fair value of the contract
is higher than the ask, the contract is underpriced and should be bought at the ask price. If the
fair value of the contract is below the bid, the contract is overpriced and should be sold at the bid
price. In the above example we can see that the December contract is overpriced. The fair value
of the contract is 1019 whereas there is a buyer at 1022. Hence an investor can sell 200 Nifties
i.e. one contract at 1022 and close the position when the contract returns to its fair value.
Case 2
On the first day of November, Nifty stands at 1000. The market watch screen shows the three
futures contracts trading at prices given in Table 5.5. . Identify the mispricing.

$
Table 5.5 Fair values vis-a-vis market prices for various futures contracts
Month Quantity Bid Ask Quantity Fair value
November 1000 1006.5 1007 1000 1009.50
December 200 1018 1025 400 1019.00
January 400 1028 1032 200 1028.70
Table 5.6 Basis and Spreads on various futures contracts

Spot Futures contract Fair values Basis Spread
1000
1010 10

1020 20 10
1030 30 10
In this case we can see that the November contract is underpriced. The fair value of the
contract is 1009.35 whereas there is a seller at 1007. The trader has the opportunity to buy 1000
Nifties i.e. 5 contracts at 1007 and close the position when the contract returns to fair value.
5.10 F&O market watch: Spread trading

As we’ve already defined earlier, basis is the difference between the spot and the futures prices.
Basis should reflect the fair value of the futures contract. When the basis between spot and futures
or the spread between two futures contracts is incorrect, arbitrage opportunities arise. Table 5.7
gives the fair values and basis of the three futures contracts. The last column shows the spreads
between the futures contracts. As we can see, the spread between and
is 10. Similarly the

spread between
and is 10 as well. We shall first try to get an intuitive understanding of the

topic assuming for the time being that there is just one single futures price.
If the basis happens to be incorrect, there can be arbitrage opportunities. Exploiting this
mispricing involves the following trades. When the spread between the two futures contracts
narrows, buy the far month contract and sell the near month one. Why do we buy the far month
and sell the near month? Because we know that if the fair spread between two contracts is 10,
but the one observed on the market watch is 6, the far month contract is underpriced and the
near month is overpriced. There is a mispricing which will be wiped out as soon as traders start
exploiting it. The basis and the spread will correct itself and return close to its fair value. Now is
the time to close the position, i.e. sell the far month contract and buy the near month.
Refer to Table 5.7 and similarly observe the spread between and . When the spread

between two futures contracts widens, sell the far month contract and buy the near-month one.
Why do we sell the far month and buy the near month? Because we know that if the fair spread
between two contracts is 10, but the one observed on the market watch is 14, the far month
contract is overpriced and the near month is underpriced. There is a mispricing which will be
5.10 F&O market watch: Spread trading 89
Table 5.7 Mispricing of Basis and Spreads on various futures contracts

The table shows the basis and spreads on one-month,two-month and three-month futures contracts. Basis is the
difference between the spot and the futures prices. It is usually negative. The difference between two futures
contracts is referred to as spreads. The fair spread between and is 10. However the spread that we observe on

the market at the moment is 6. Since the spread has narrowed, we can profi t by selling the near-month contract,i.e.
and buying the far-month contract,i.e. . Once we do this, we would have a position of:

Sell @ 1012

Buy @ 1018
After some time, the spread corrects itself and we close our position by entering into the following trades:

Buy

@ 1010

Sell

@ 1020
We end up making a profi t of Rs.4 on the round trip.

Similarly observe the spread between and . The spread has widened from an expected value of 10 to an

observed value of 14. Hence we sell the far month contract and buy the near month one. Once we do this we would
have a position of:

Sell

@ 1032

Buy @ 1018
After some time, the spread corrects itself and we close our position by entering into the following trades:

Buy

@ 1030

Sell

@ 1020
We end up making a profi t of Rs.4 on the round trip.However a word of caution. Although transaction costs on the
futures market are less than the transactions costs on the cash market, they exist anyway and should be factored into
these trades. As far as possible, closing out of positions should be done using limit orders. The Market by Price
(MBP) screen gives a fair idea of the depth of the market, and should be used while placing the limit orders. It will
help to remember that a person who trades using limit orders earns impact costs whereas a person who trades using
market orders pays impact costs.
Spot Contract Fair price Fair basis Fair Spread Mkt price Obs. basis Obs. spread
1000
1010 10 1012 12

1020 20 10 1018 18 6
1030 30 10 1032 32 14
wiped out as soon as traders start exploiting it. The basis and the spread will correct itself and
return close to its fair value. Now is the time to close the position, i.e. buy the far month contract
and sell the near month.
Table 5.8 Bid-ask on various futures contracts at time T1 and time T2

Trading to profi t from misaligned spreads seems simple when we look at a single futures price, but in the real world
we are faced with two prices, a bid and an ask. The trick is to get used to detecting misalignment of spreads across
futures contracts, given three bids and three asks.
The table shows the bid and ask for various futures contracts as one would see them on the market watch at time T1
and T2. If we typically believe that the spread between the one-month and two-month futures contracts should be
10 points, we will buy a spread at time T1 when it is less than 10 and sell a spread at time T2 when it is greater than
10. Buying a spread basically means selling the near month and buying the far month contract. So if we think that
the spread between and is narrow, what we really need to look at is the bid on

and the ask on . If the

difference between this is narrower than we expect it to be, we sell and buy . Once we do this we would have

a position of:

Sell

@ 1012

Buy

@ 1016
We now watch the market to see if the spread corrects itself. To close our position at time T2 what we should be
watching is the difference between ask on and the bid on . Once this returns close to our expected spread,

10 in this case, we close our position by buying and selling at time T2. When we do this we would have a

position of:

Buy @ 1011

Sell @ 1019
As we can see, we sold at 1012 and bought it back at 1011 making a profi t of 1. We bought at 1016 and sold

it at 1019 making a profi t of 3. Our net profi t from this set of transactions is 4.
The point to note is that when faced with a bid and an ask price, one must watch the correct prices to calculate the
spread. Familiarizing oneself with this set of transactions will enable one to quickly detect misaligned spreads on
the futures contract and instantly enter into trades to profi t from them.
Market watch at time T1

Spot Contract Bid Ask
1000
1012 1013

1014 1016
1027 1037
1000
1010 1011

1019 1022
1028 1035
Solved problems
Q: When the spread between the one–month and two–month futures contracts narrows, you can profi t by:
1. Buying the near–month contract and selling 3. Both the above

the far–month one
2. Selling the near–month contract and buying
the far–month one 4. None of the above
A: When the spread between the one–month and two–month futures contract narrows, it implies that the
one–month contract is selling at a price higher than its fair value and the two–month contract is selling at
a price lower than its fair value. Hence one can profi t by selling the one–month contract and buying the
two–month one. The correct answer is number 2.
5.10 F&O market watch: Spread trading 91
Q: In the fi rst week of March, you observe that the spread between the March and April futures contracts
has widened. How can you profi t from this observation?
1. By buying the March contract and selling the 3. Both the above
April one
2. By selling the March contract and buying the
April one 4. None of the above
A: In this case, March contract is underpriced and the April contract is overpriced. You can profi t by
buying the March contract and selling the April one. The correct answer is number 1.
Q: When the spread between the one–month and two–month futures contracts widens, you can profi t by:
1. Buying the near–month contract and selling 3. Both the above

the far–month one
2. Selling the near–month contract and buying
the far–month one 4. None of the above
Q: The bid and ask for various futures contracts at time T1 are given below. If the typical spread between
the one–month and two–month futures contracts is 10 points, what strategy will you adopt?

1000
1012 1013

1014 1016
1. At time T1, buy
@ 1013 and sell
@ 3. At time T1, buy
@ 1012 and sell
@
1014 1014
2. At time T1, sell
@ 1012 and buy
@
1016 4. None of the above
A: The correct strategy is to buy a spread at time T1 when it is less than 10 and sell a spread at time
T2 when it is greater than 10. In this case, observe that the spread between one–month and two–month
futures contracts has narrowed. When the spread narrows, you should sell the near–month contract and
buy the far–month one. Hence you should sell @ 1012 and buy

@ 1016. The correct answer is

number 2.
Q: The typical spread between the one–month and two–month futures contract is 10 points. At time T1
the spread had narrowed, so you sold @ 1012 and bought

@ 1016. You would like to unwind your

position and book your profi ts. The bid and ask for various futures contracts at time T2 are given below.
What trades will you enter into?

1000
1010 1011

1019 1022
1. At time T2, buy
@ 1011 and sell
@ 3. At time T2, buy
@ 1010 and sell
@
1019 1022
2. At time T2, sell
@ 1012 and buy
@
1016 4. None of the above
A: You are watching the market and notice that the spread has corrected itself at time T2. It has now
returned to your expected value of 10. You would now close our position by buying
at 1011 and selling

at 1019. The correct answer is number 1.
Q: In the fi rst week of March, you observe that the spread between the March and April futures contracts
has narrowed. How can you profi t from this observation?
1. By buying the March contract and selling the 3. Both the above
April one
2. By selling the March contract and buying the
April one 4. None of the above

Chapter 6
Using futures on individual securities
Index futures began trading in India in June 2000. An year later, options on index were available
for trading. July 2001 saw the launch of options on individual securities(herein referred to as
stock options) and the onset of rolling settlement. With the launch of futures on individual
securities(herein referred to as stock futures) on the 9th of November,2001, the basic range of
equity derivative products in India seems complete. Of the above mentioned products, stock
futures are particularly appealing due to familiarity and ease in understanding. A purchase or
sale of futures on a security gives the trader essentially the same price exposure as a purchase
or sale of the security itself. In this regard, trading stock futures is no different from trading
the security itself. Besides speculation, stock futures can be effectively used for hedging and
arbitrage reasons.
6.1 Difference between trading securities and trading futures on

individual securities
To trade securities, a customer must open a security trading account with a securities broker
and a demat account with a securities depository. Buying security involves putting up all the
money upfront. With the purchase of shares of a company, the holder becomes a part owner
of the company. The shareholder typically receives the rights and privileges associated with
the security, which may include the receipt of dividends, invitation to the annual shareholders
meeting and the power to vote.
Selling securities involves buying the security before selling it. Even in cases where short
selling is permitted, it is assumed that the securities broker owns the security and then “lends” it
to the trader so that he can sell it. Besides, even if permitted, short sales on security can only be
executed on an up-tick.
To trade futures, a customer must open a futures trading account with a derivatives broker.
Buying futures simply involves putting in the margin money. They enable the futures traders to
take a position in the underlying security without having to open an account with a securities
broker. With the purchase of futures on a security, the holder essentially makes a legally binding
promise or obligation to buy the underlying security at some point in the future(the expiration
94 Using futures on individual securities
date of the contract). Security futures do not represent ownership in a corporation and the holder
is therefore not regarded as a shareholder.
A futures contract represents a promise to transact at some point in the future. In this light,
a promise to sell security is just as easy to make as a promise to buy security. Selling security
futures without previously owning them simply obligates the trader to selling a certain amount
of the underlying security at some point in the future. It can be done just as easily as buying
futures, which obligates the trader to buying a certain amount of the underlying security at some
point in the future. In the following sections we shall look at some uses of security future.
6.2 Hedging: Long security, sell futures

Stock futures can be used as an effective risk–management tool. Take the case of an investor
who holds the shares of a company and gets uncomfortable with market movements in the short
run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock
futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of
a market upheaval. With security futures he can minimize his price risk. All he need do is enter
into an offsetting stock futures position, in this case, take on a short futures position. Assume
that the spot price of the security he holds is Rs.390. Two–month futures cost him Rs.402. For
this he pays an initial margin. Now if the price of the security falls any further, he will suffer
losses on the security he holds. However, the losses he suffers on the security, will be offset by
the profits he makes on his short futures position. Take for instance that the price of his security
falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures.
Futures will now trade at a price lower than the price at which he entered into a short futures
position. Hence his short futures position will start making profits. The loss of Rs.40 incurred
on the security he holds, will be made up by the profits made on his short futures position.
6.3 Speculation: Bullish security, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to trade
based on this view. He believes that a particular security that trades at Rs.1000 is undervalued
and expect its price to go up in the next two–three months. How can he trade based on this
belief? In the absence of a deferral product, he would have to buy the security and hold on to it.
Assume he buys a 100 shares which cost him one lakh rupees. His hunch proves correct and two
months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of
Rs.1,00,000 for a period of two months. This works out to an annual return of 6 percent.
Today a speculator can take exactly the same position on the security by using futures
contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures
trades at 1006. Just for the sake of comparison, assume that the minimum contract value is
1,00,000. He buys 100 security futures for which he pays a margin of Rs.20,000. Two months
later the security closes at 1010. On the day of expiration, the futures price converges to the spot
price and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual
6.4 Speculation: Bearish security, sell futures 95
return of 12 percent. Because of the leverage they provide, security futures form an attractive
option for speculators.
6.4 Speculation: Bearish security, sell futures

Stock futures can be used by a speculator who believes that a particular security is over–valued
and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a
deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to
do is sell stock futures.
Let us understand how this works. Simple arbitrage ensures that futures on an individual
securities move correspondingly with the underlying security, as long as there is sufficient
liquidity in the market for the security. If the security price rises, so will the futures price. If
the security price falls, so will the futures price. Now take the case of the trader who expects to
see a fall in the price of SBI. He sells one two–month contract of futures on SBI at Rs.240(each
contact for 100 underlying shares). He pays a small margin on the same. Two months later,
when the futures contract expires, SBI closes at 220. On the day of expiration, the spot and the
futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that
he bought, this works out to be Rs.2000.
6.5 Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the
spot price. Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.
If you notice that futures on a security that you have been observing seem overpriced, how
can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at
Rs.1000. One–month ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you
can make riskless profit by entering into the following set of transactions.
1. On day one, borrow funds, buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profi t of Rs.10.
7. The result is a riskless profi t of Rs.15 on the spot position and Rs.10 on the futures position.
8. Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to
buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage.
This is termed as cash–and–carry arbitrage. Remember however, that exploiting an arbitrage
opportunity involves trading on the spot and futures market. In the real world, one has to build
in the transactions costs into the arbitrage strategy.
6.6 Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise.
It could be the case that you notice the futures on a security you hold seem underpriced. How can
you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000.
One–month ABB futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can
make riskless profit by entering into the following set of transactions.
1. On day one, sell the security in the cash/spot market at 1000.
2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
5. Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profi t of Rs.10.
7. The result is a riskless profi t of Rs.25 on the spot position and Rs.10 on the futures position.
If the returns you get by investing in riskless instruments is less than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash–and–carry and
reverse cash–and–carry, we will see increased volumes and lower spreads in both the cash as
well as the derivatives market.
Solved problems
Q: Exchange traded stock futures began trading on the NSE from
1. November 2001 3. November 1999
2. November 2000 4. November 1995

6.6 Arbitrage: Underpriced futures: buy futures, sell spot 97
Q: A speculator with a bullish view on a security can
1. buy stock futures 3. sell stock futures
2. buy index futures 4. sell index futures
Q: Mohan owns a thousand shares of Reliance. Around budget time, he get uncomfortable with the price
movements. Which of the following will give him the hedge he desires?
1. Buy 10 Reliance futures contracts 3. Buy 5 Reliance futures contracts
2. Sell 10 Reliance futures contracts 4. Sell 5 Reliance futures contracts
A: Since he owns a thousand shares of Reliance, he will have to sell 10 Reliance futures contracts(one
contract has 100 underlying shares) to give him a complete hedge. Correct answer is number 2.
Q: Rajeev owns a 200 shares of Reliance. Around budget time, he get uncomfortable with the price
movements. Which of the following will give him the hedge he desires?
1. Buy 1 Reliance futures contract 3. Buy 2 Reliance futures contracts
2. Sell 1 Reliance futures contract 4. Sell 2 Reliance futures contracts
A: Since he owns 200 shares of Reliance, he will have to sell 2 Reliance futures contracts(one contract
has 100 underlying shares) to give him a complete hedge. Correct answer is number 4.
Q: Santosh is bullish about Reliance and buys ten one-month Reliance futures contracts at Rs.2,96,000.
On the last Thursday of the month, Reliance closes at Rs.271. He makes a
1. profi t of Rs.15000 3. loss of Rs.15000
A: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures,i.e. 2,96,000/(10 * 100). On
expiration day the spot and futures converge. Therefore he makes a loss of (296 - 271) * 1000 = 25000.
Q: Rajiv is bearish about ACC and sells twenty one-month ACC futures contracts at Rs.3.04,000. On the
last Thursday of the month, ACC closes at Rs.134. He makes a
A: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures,i.e. 3,04,000/(20 * 100).
On expiration day the spot and futures converge. Therefore his profi t is (152 - 134) * 2000 = 36000. The
correct answer is number 2.
Q: Suppose the ABB trades at 1000 in the cash market and two month ABB futures trade at 1030. If
transactions costs involved are 0.4%. What is the arbitrage return possible?
1. 1.8% per month 3. 2% per month
A: Return over two months is 1030/1000 = 3%. Minus transactions costs of 0.4% and the net return works
out to be 2.6%. The return per month is 1.3%. The correct answer is number 2.
Chapter 7
Pricing options
An option buyer has the right but not the obligation to exercise on the seller. The worst that
can happen to a buyer is the loss of the premium paid by him. His downside is limited to this
premium, but his upside is potentially unlimited. This optionality is precious and has a value,
which is expressed in terms of the option price. Just like in other free markets, it is the supply and
demand in the secondary market that drives the price of an option. On dates prior to 31 Dec 2000,
the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price
that purely reflects supply and demand. There is a separate order book for each option which
generates its own price. The values shown in Table 7.1 are derived from a theoretical model,
namely the Black-Scholes option pricing model. If the secondary market prices deviate from
these values, it would imply the presence of arbitrage opportunities, which (we might expect)
would be swiftly exploited. But there is nothing innate in the market which forces the prices in
the table to come about.
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
Table 7.1 Option prices: some illustrative values

Option strike price
1400 1450 1500 1550 1600
Calls
1 mth 117 79 48 27 13
3 mth 154 119 90 67 48
Puts
1 mth 8 19 38 66 102
3 mth 25 39 59 84 114
Assumptions: Nifty spot is 1500, Nifty
volatility is 25% annualized, interest rate
is 10%, Nifty dividend yield is 1.5%.
100 Pricing options
calculators and spread-sheets come with a built-in Black-Scholes options pricing formula so to
price options we don’t really need to memorize the formula. 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.
7.1 Introduction to the Black–Scholes formulae

Intuition would tell us that the spot price of the underlying, exercise price, risk-free interest rate,
volatility of the underlying, time to expiration and dividends on the underlying(stock or index)
should affect the option price. Interestingly before Black and Scholes came up with their option
pricing model, there was a widespread belief that the expected growth of the underlying ought
to affect the option price. Black and Scholes demonstrate that this is not true. The beauty of
the Black and Scholes model is that like any good model, it tells us what is important and what
is not. It doesn’t promise to produce the exact prices that show up in the market, but certainly
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
return 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 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.
7.2 The Black–Scholes option pricing formulae

The Black–Scholes formulas for the prices of European calls and puts on a non-dividend paying
stock are:

7.2 The Black–Scholes option pricing formulae 101

where

and

The Black/Scholes equation is done in continuous time. This requires continuous compounding. The

“r” that fi gures in this is . Example: if the interest rate per annum is 12%, you need to use

or 0.1133, which is the continuously compounded equivalent of 12% per annum.

is the cumulative normal distribution. is called the delta of the option which is a measure
of change in option price with respect to change in the price of the underlying asset.
a measure of volatility, is the annualized standard deviation of continuously compounded returns

on the underlying. When daily are given, they need to be converted into annualized .
" " % ' * + ' -
/ Number of trading days per year. On an average there are 250

trading days in a year.
X is the exercise price, S the spot price and T the time to expiration measured in years.
7.2.1 Pricing index options

Under the assumptions of the Black–Scholes options pricing model, index options should be
valued in the same way as ordinary options on common stock. The assumption is that investors
can costlessly purchase the underlying stocks in the exact amount necessary to replicate the
index; that is, stocks are infinitely divisible and that the index follows a diffusion process such
that the continuously compounded returns distribution of the index is normally distributed. To
use the Black–Scholes formula for index options, we must however make adjustments for the
dividend payments received on the index stocks. If the dividend payment is sufficiently smooth,
this merely involves replacing the current index value S in the model with where q is the
1

annual dividend yield and T is the time to expiration in years.

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.
Example: A three-month call option on the Nifty with a strike of 1180 is available for
trading. Nifty stands at 1150, and it has a volatility of 30% per annum. The annual risk-free rate
is 12%. We can calculate the price of the 1180 option using the Black-Scholes option pricing
formula. We take T = 0.25, S=1150, X=1180, r=ln(1.12), and = 0.3. Substituting these values
in the formula, we get the call price as Rs.70.15. The put price on an option with the same strike
works out to be 67.19.
102 Pricing options
When working on the option pricing problem, Black and Scholes actually had some diffi culty in solving
the partial diffential equation. Though Black had a Ph.D in applied mathematics from Harvard, he
was not a specialist in differential equations and Scholes was only an economist. Solving differential
equations is often a matter of making educated guesses and using prior knowledge of what the fi nal
solution might possibly look like. Black and Scholes benefi tted from the fact that previous researchers
had almost found the elusive formula. Their predecessors solutions looked remarkably similar to what
we today know as the correct formula. The fi nal trick was found when their differential equation was
recognized as of a form known in Physics as the heat transfer equation. The equation had a known
solution, though it involved quite a few complicated steps before getting to it.
Their diffi culties didn’t end there. Black and Scholes had trouble getting publishers of academic
journals to care about their result. One after the other, distinguished economic journals rejected them.
Finally after a lot of pursuation, the article was accepted. The rest is history.
Box 7.9: The Black and Scholes option pricing formula story
7.2.2 Pricing stock options

Much of what was discussed about index options also applies to stock options. But before
learning how to price stock options, we shall have a quick look at the factors which affect option
prices.
Factors affecting option price

Various factors affect the price of options on stocks. We shall look at the impact of changes in
each of these factors on option prices one at a time, assuming that all other factors remain the
same. There are six factors affecting the price of a stock option:
The stock price: The payoff from a call option is the amount by which the stock price exceeds
the strike price. Call options therefore become more valuable as the stock price increases and less
valuable as the stock price decreases. The payoff from a put option is the amount by which the
strike price exceeds the stock price. Put options therefore become more valuable as the stock price
decreases and less valuable as the stock price increases.
The strike price: In the case of a call, as the strike price increases, the stock price has to make a
larger upward move for the option to go in–the–money. Therefore, for a call option, as the strike
price increases, options become less valuable and as the strike price decreases they become more
valuable. Put options behave exactly in the opposite way to call options.
Time to expiration: Both put and call American options become more valuable as the time to
expiration increases. Consider the case of two options that differ only as far as their expiration
date is concerned. The owner of the long–life option has all the exercise opportunities open to the
owner of the short–life option – and more. The long–life option must therefore always be worth at
least as much as the short life option.
Volatility: The volatility of a stock price is a measure of how uncertain we are about future stock
price movements. As volatility increases, the chance that the stock will do very well or very poorly
increases. The value of both calls and puts therefore increase as volatility increases.
Risk– free interest rate: The affect of the risk–free interest rate is less clear–cut. It is found that put
option prices decline as the risk–free rate increases whereas the prices of calls always increase as the
risk–free interest rate increases.
Dividends: Dividends have the effect of reducing the stock price on the ex–dividend date. This has
a negative affect on the value of call options and a positive affect on the value of put options.
Applying Black & Scholes option pricing formula to stock options

The Black & Scholes option pricing formula which we used to price European calls and puts,
with some adjustment can be used to price American calls and puts on stocks. Pricing American
options becomes a little difficult because unlike European options, American options can be
exercised any time prior to expiration. However, it is never optimal to exercise a call option on
a non–dividend paying stock before expiration. When no dividends are expected during the life
of the option, the option can be valued simply by substituting the values of the stock price, strike
price, stock volatility, risk–free rate and time–to–expiration in the Black & Scholes formula.
However, when dividends are expected during the life of the option, it is sometimes optimal
to exercise the option just before the underlying stock goes ex-dividend. Hence when valuing
options on dividend paying stock, we should consider exercise possibilities at two times, one -
just before the underlying stock goes ex-dividend, two - at expiration of the options contract.
Therefore, owning an option on a dividend paying stock today is like owning two options,
one is a long–maturity option with a time–to–maturity from today till the expiration day, and
the other is a short–maturity option with a time–to–maturity from today till just before the stock
goes ex–dividend.
Some adjustments need to be made before the Black & Scholes formula can be used. The
first step is to value the option on the assumption that it will be exercised at expiry. Thus the
present value of the dividends is deducted from the stock price and the adjusted value is used
*
in the Black & Scholes. The second step is to assume that the option will be exercised just before
the ex–dividend date. The un–adjusted stock price is used. In addition, the time to expiry is
shortened to be the period up to the ex–dividend date. Following these adjustments, the Black
& Scholes model can be applied. The actual value of the option will be the highest of the two
valuations.
Example: Assume that the price of a stock is Rs.50, the exercise price is Rs.45, the risk–free
rate of interest is 6% per annum and that an ex–dividend adjustment of 2.5 will occur 0.1644
years hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to
be 6%. We now have two call options, a long–maturity call option with a maturity of 0.25 years
which can be exercised on the expiration date, and a short–maturity call option with a maturity
of 0.166 years which can be exercised just before the ex–dividend date. We will now value both
these options.

*

The details of the long option are: T=0.25, r=0.06, D=2.5, S=50, X=45 and =S-
.

*
The stock price to be used in the Black & Scholes option pricing formula is , the adjusted price of

the stock after deducting the present value of the dividends. Using these values, we get the price of
the long option as Rs.3.84.
104 Pricing options
The details of the short option are: T=0.166, r=0.06, D=2.5, S=50 and X=45. Note that in this case
since the option is exercised just before the stock goes ex–dividend, the unadjusted stock price of
Rs.50 is used. Using these values, we get the price of the short option as Rs.5.56.
Thus, using the above approximation, the American option on the dividend–paying stock
would be valued at the higher of the two options, i.e. at Rs.5.58.
Solved Problems
Q: If the daily volatility of Nifty is 1.92, the

fi gure used in the Black–Scholes formula should be
1. 30% 3. 1.38%
2. 1.92% 4. 35%
A: The Black–Scholes formula uses the annualized sigma. The daily sigma must be expressed in terms of
" " % ' * + ' -
annualized sigma. Number of trading days per year. On an average there

/

are 250 trading days in a year. Therefore the fi gure to be used is , i.e. about 30%. The correct /
answer is number 1.
Q: Assume that the daily volatility of Nifty is 1.75, and trading happens on 256 a year. The

fi gure
used in the Black & Scholes formula should be
1. 30% 3. 1.38%
2. 1.92% 4. 28%
A: The Black & Scholes formula uses the annualized sigma.

" " % ' * + ' -

Number of trading days per year. If there are 256 trading days in a year, the fi gure to be used is

, i.e.28%. The correct answer is number 4.
Q: If the annual risk–free rate is 12%, then the ‘r’ used in the Black–Scholes formula should be
1. 0.1133 3. 1.12
2. 0.12 4. None of the above
A: The Black–Scholes equation is done in continuous time. This requires continuous compounding. The

“r” that fi gures in this is . Therefore if the interest rate is 12%, you need to use
or 0.1133.
Q: If the continuously compounded annual risk-free rate is 0.095%, then the ‘r’ used in the Black &
Scholes formula should be
1. 0.095 3. 1.13
“r” that fi gures in this must be the continuously compounded rate. In this case it is 0.095. The correct
answer is number 1.
Q: On 1st February, a call option on the Nifty with a strike of 1280 is available for trading. Expiration
date is 22nd February. The ‘T’ that is used in the Black–Scholes formula should be
1. 0.06 3. 22
A: The time to expiration is 22 days. The ‘T’ used in the Black–Scholes is time-to-expiration measured

in years. Hence the ‘T’ used should be
, i.e.0.06. The correct answer is number 1.
Q: On 1st January, a three–month call option on the Nifty with a strike of 1280 is available for trading.
The ‘T’ that is used in the Black–Scholes formula should be
1. 0.25 3. 90
A: The time to expiration is 3 months. The ‘T’ used in the Black–Scholes is the time-to-expiration
measured in years. Hence the ‘T’ used should be
Q: On 1st May, a two–month call option on the Nifty with a strike of 1280 is available for trading. The
‘T’ that is used in the Black–Scholes formula should be
1. 0.166 3. 90
A: The time to expiration is 2 months. The ‘T’ used in the Black–Scholes is the time-to-expiration

measured in years. Hence the ‘T’ used should be

106 Pricing options
Q: A three-month call option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. If the annual risk-free rate is 12%, the price of the call is
1. Rs.63.50 3. Rs.40.85
2. Rs.83.10 4. None of the above
A: Use the Black-Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), and =
0.3. Substituting these values in the formula, the answer is Rs.83.10. The correct answer is number 2.
Q: A three–month put option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. If the annual risk-free rate is 12%, the price of the put is:
1. Rs.47.80 3. Rs.67.35
A: Use the Black–Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), = 0.3.
Substituting these values in the formula, the answer is Rs.67.35. The correct answer is number 3.
Q: A three–month call option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. The continuous dividend yield on the Nifty is 5%. If the
annual risk-free rate is 12%, the price of the call is
1. Rs.74.35 3. Rs.80.20
A: Use the Black–Scholes option pricing formula with T = 0.25, X=1280, r=ln(1.12), and = 0.3. In this

case where the annual dividend yield is known, replace the index value 1260 with 1244 ( ).
Substituting these values in the formula, the answer works out to be Rs.74.35. The correct answer is
number 1.
Q: A three–month put option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. The continuous dividend yield on the Nifty is 5%. If the
annual risk-free rate is 12%, the price of the put is
1. Rs.67.30 3. Rs.55.20
A: Use the Black–Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), =
0.3. In this case where the annual dividend yield is known, replace the index value 1260 with 1244

( ). Substituting these values in the formula, the answer works out to be Rs.74.60. The


Q: If the annual risk–free rate is 15%, then the ‘r’ used in the Black–Scholes formula should be
1. 0.15 3. 1.15

“r” that fi gures in this is

. Therefore if the interest rate is 15%, you need to use or 0.1398.
Q: A three–month call option on a stock with a strike of Rs.45 is available for trading. The spot price is
Rs.50. The risk–free rate of interest is 6% per annum and an ex–dividend adjustment of 2.5 will occur two
months hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to be 6%.
The short–maturity option has a maturity of
1. 0.166 years 3. 0.5 years
2. 0.25 years 4. 0.0833 years
A: The short–maturity option has a maturity of 0.166 years since the ex–dividend date is two months later.
The long–maturity option has a maturity of
1. 0.166 years 3. 0.5 years
2. 0.25 years 4. 0.0833 years
A: The long–maturity option has a maturity of 0.25 years since it a three–month call option. The correct
answer is number 2.
The stock price to be used for valuing the long–maturity option is
1. 50 3. 47.52
2. 47.50 4. 52.50

A: The stock price to be used for valuing the long–maturity option is

*

=

. The
108 Pricing options
Rs.50. The risk–free rate of interest is 8% per annum and an ex–dividend adjustment of 5 will occur one
month hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to be 8%.
The stock price to be used for valuing the long–maturity option is
1. 50 3. 47.52
2. 45.03 4. 55

A: The stock price to be used for valuing the long–maturity option is

*

=

. The
Chapter 8
Using index options
There are potentially innumerable ways of trading on the index options market. However we
shall look at eight basic modes of trading on the index options market:
Hedging
1. Have portfolio, buy puts
Speculation
1. Bullish index, buy Nifty calls or sell Nifty puts

2. Bearish index, sell Nifty calls or buy Nifty puts
3. Anticipate volatility, buy a call and a put at same strike
4. Bull spreads, Buy a call and sell another
5. Bear spreads, Sell a call and buy another
Arbitrage
1. Put-call parity with spot-options arbitrage

2. Arbitrage beyond option price bounds
8.1 Hedging: Have portfolio, buy puts

Owners of equity portfolios often experience discomfort about the overall stock market
movement. As an owner of a portfolio, sometimes you may have a view that stock prices will
fall in the near future. At other times you may see that the market is in for a few days or weeks
of massive volatility, and you do not have an appetite for this kind of volatility. The union budget
is a common and reliable source of such volatility: market volatility is always enhanced for one
week before and two weeks after a budget. Many investors simply do not want the fluctuations
of these three weeks. One way to protect your portfolio from potential downside due to a market
drop is to buy portfolio insurance.
110 Using index options
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.

We need to know the “beta” of the portfolio, i.e. the average impact of a 1% move in Nifty upon
the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of stock betas.
Suppose we have a portfolio composed of Rs.1 million of Zee Telefilms, which has a beta of 1.4
and Rs.2 million of Hero Honda, which has a beta of 0.8, then the portfolio beta is (1 1.4 +
2 0.8)/3 or 1. If the beta of any stock is not known, it is safe to assume that it is 1. In general,
the beta of a well diversified portfolio is close to 1. 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.
Portfolio insurance when portfolio beta is 1.0

1. Assume we have a well diversifi ed portfolio with a beta of 1.0 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 1250 and you decide to buy puts with a strike of 1125. This will insure
your portfolio against an index fall lower than 1125.
3. When the portfolio beta is one, the number of puts to buy is simply equal to the portfolio value divided by
the spot index . Assume your portfolio is worth Rs.1 million . Hence the number of puts you need to buy to
protect your portfolio from a fall in index is (10,00,000/1250) which works out to be 800. At a market lot of
200, it means that you will have to buy 4 market lots of two month puts with a strike of 1125.
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.
The above combination of portfolio plus long puts ensures that any fall in the portfolio value
will be accompanied by an equal gain on the options position, effectively ensuring that the
portfolio is insured against loses below some level. It is only the downside which is limited.
The upside is potentially unlimited. For instance if the Nifty rose to 1280, the investor would
8.1 Hedging: Have portfolio, buy puts 111
Protective puts with the required expiration and strikes are often not available in the market. Investment
managers sometimes turn to a dynamically–adjusted version of the protective put, which came to be
known as “portfolio insurance” in the mid-80s. This involved combining stocks with futures or treasury
bills. During the famous crash of 1987, the portfolio insurers were selling quickly because market
moves were faster than their models had assumed. This is called the gamma effect. Portfolio insurance
got a bad name and practically disappeared. The fact however was that portfolio insurers didn’t cause
the crash. The large amount of selling by insurers may have exacerbated the fall but not caused it. The
biggest problem with portfolio insurance was that it was based on the idea that market moves would
be very small, so that deltas could be reset reasonably fast. The insurers had missed the gamma effect.
The situation got worse when the market stopped trading and the futures price came detached from the
cash price. When this happened, portfolio insurance did not replicate a protective put as it had been
planned. However history testifi es that those who had portfolio insurance were certainly better off than
those that didn’t.
Box 8.10: Portfolio insurance and the crash of ’87
simply let the puts expire. He would of course, lose the put premium paid up–front, but that’s his
cost of buying insurance.
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 (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.
The above combination of portfolio plus long puts ensures that any fall in the portfolio
value will be accompanied by an equal gain on the options position effectively ensuring that
the portfolio is insured against losses below some level. Note that it is only the downside which
is limited. The upside is potentially unlimited. For instance if the Nifty rose to 1280, the investor
would simply let the puts expire. He would of course lose the put premium paid up-front, but
that’s his cost of buying insurance.
Solved problems
Q: You are the fund manager with a 1 million portfolio of beta 1.0. You would like to insure your portfolio
against a fall in the index of magnitude higher than 10%. Spot Nifty stands at 1250. Put options on the
Nifty are available at three strike prices. Which strike will give him the insurance he seeks?
1. 1240 3. 1125
A: For a portfolio with beta of 1.0, a 10% fall in the index translates into a 10% fall in the portfolio value.
Hence to protect his portfolio from a fall worse than 10%, he should buy Nifty puts with a strike of 1125.
Q: You own a 1 million portfolio with a beta of 1.0. Current Nifty level is 1250. Three-month puts at a
strike of 1080 are available. How many put contracts should you buy for insuring your portfolio against
an index fall below 1080?
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.0 , the right number of
puts to buy is (10,00,000/1250), i.e. 800 puts. At a market lot of 200 per contracts, you have to buy four
contracts to insure your portfolio against an index fall below 1080. The correct answer is number 1.
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.0, the right number of
puts to buy is (10,00,000/1250), i.e. 800 puts. At a market lot of 200 per contracts, you have to buy four
contracts to insure your portfolio against an index fall below 1000. The correct answer is number 1.
8.1 Hedging: Have portfolio, buy puts 113
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.25 , the right number
of puts to buy is (10,00,000*1.25)/1250, i.e. 1000 puts. At a market lot of 200 per contracts, you have to
buy fi ve contracts to insure your portfolio against an index fall below 1100. The correct answer is number
2.
Q: You are a fund manager managing a 5 million portfolio having a beta of 1. The spot Nifty stands
at 1250. You would like to insure your portfolio against a 10% fall in the index and hence you buy 25
contracts of January 1125 Nifty puts. Now your portfolio is
1. Partially insured against a 10% drop in the in- 3. Under-insured against a 10% drop in the in-
dex dex
4. Adequately insured against a 10% drop in the

2. Over-insured against a 10% drop in the index index.
A: To get an insurance for a portfolio worth Rs.5 million, you will have to buy (50,00,000/1250) = 4000
puts. For a contract size of 200, it means you will have to buy 20 Nifty put contracts. The strike price will
influence the level of hedge that you acquire, not the number of puts to buy. The correct answer is number
2.
Q: You are a fund manager managing a 5 million portfolio having a beta of 1.4. The spot Nifty stands
at 1250. You would like to insure your portfolio against a 10% fall in the index and hence you buy 20
contracts of January 1125 Nifty puts. Now your portfolio is
1. Partially insured against a 10% drop in the in- 3. Adequately insured against a 10% drop in the
dex index
2. Over-insured against a 10% drop in the index
A: To get an insurance for a portfolio worth Rs.5 million, you will have to buy (50,00,000*1.4)/1250 =
5600 puts. For a contract size of 200, it means you will have to buy 28 Nifty put contracts. The strike
price will influence the level of hedge that you acquire, not the number of puts to buy. The correct answer
is number 1.
Q: You are the fund manager with a 1 million portfolio of beta 1.2. You would like to insure your portfolio
against a fall in the index of magnitude higher than 10%. Spot Nifty stands at 1250. Put options on the
Nifty are available at three strike prices. Which strike will give you the insurance you seek?
1. 1240 3. 1125
A: To insure against a 10% fall in the index he should buy a put option with a strike that is 10% below
the present index level. In this case the correct answer is 3. He will have to buy (10,00,000 * 1.2)/1250
number of puts. i.e. 960 puts. Now let us assume he can buy exactly 960 puts. Suppose the index fell by
15%. For a portfolio with beta of 1.2, a 15% fall in the index translates into a 18% fall in the portfolio
value. His portfolio value will fall to Rs.8,20,000. However with the index now at 1062.5, his put options
will provide a payoff of (1125 - 1062.5)* 960 = Rs.60,000. This is the amount needed to bring his portfolio
value back to Rs.8,80,000 which is 12% of his initial portfolio value (which results out of a 10% fall in
the index). No matter how low the index falls, his portfolio value will never fall below Rs.8,80,000. Note
that since Nifty puts will be available for trading in contract sizes of 200, he will have to buy 5 contracts
and will be slightly overinsured.
Q: You are the fund manager with a 1 million portfolio of beta 1.2. You get uncomfortable when the value
of your portfolio falls more than 12% and hence would like to insure your portfolio against a fall in value
worse than 12%. Spot Nifty stands at 1250. Put options on the Nifty are available at three strike prices.
Which strike will give you the insurance you seek?
1. 1240 3. 1125
A: For a portfolio with a beta of 1.2, a 12% fall in the portfolio value would come from a 10% fall in the
index.This means he has to insure against a 10% fall in the index. To do this he should buy a put option
with a strike that is 10% below the present index level. In this case the correct answer is 3. He will have to
buy (10,00,000 * 1.2)/1250 number of puts. i.e. 960 puts. For now let us assume he can buy exactly 960
puts. Suppose the index fell by 15%. For a portfolio with beta of 1.2, a 15% fall in the index translates
into a 18% fall in the portfolio value. His portfolio value will fall to Rs.8,20,000. However with the index
now at 1062.5, his put options will provide a payoff of (1125 - 1062.5)* 960 = Rs.60,000. This is the
amount needed to bring his portfolio value back to Rs.8,80,000 which is 12% of his initial portfolio value.
No matter how low the index falls, his portfolio value will never fall below Rs.8,80,000. Note that since
Nifty puts will be available for trading in contract sizes of 200, he will have to buy 5 contracts and will be
slightly overinsured.
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts 115
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts
There are times when investors believe that the market is going to rise. For instance, after a good
budget, or good corporate results, or the onset of a stable government. 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. Suppose you have a hunch that the market index is going to rise in a months time.
Your hunch proves correct and the index does indeed rise, it is this upside that you cash in on.
However, if your hunch proves to be wrong and the market index plunges down, what you lose
is only the option premium.
Having decided to buy a call, which one should you buy? Table 8.1 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:
1. A one month call on the Nifty with a strike of 1200.
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the market index, and how much you are willing to lose
should this upward movement not come about. There are five one–month calls and five one–
month puts trading in the market. The call with a strike of 1200 is deep in–the–money and hence
trades at a higher premium. The call with a strike of 1275 is out–of–the–money and trades at a
low premium. The call with a strike of 1300 is deep–out–of–money. Its execution depends on
the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence
buying this call is basically like buying a lottery. There is a small probability that it may be
in–the–money by expiration, in which case the buyer will make profits. In the more likely event
of the call expiring out–of–the–money, the buyer simply loses the small premium amount of
Rs.27.50.
As a person who wants to speculate on the hunch that 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. If the index does rise, the buyer of the put will let the option expire and you
Table 8.1 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are fi ve one-month calls and fi ve one-month puts trading in the market. The call
with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is
out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution
depends on the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence buying
this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration in
which case the buyer will profi t. In the more likely event of the call expiring out-of-the-money, the buyer simply
loses the small premium amount of Rs. 27.50. Figure 8.1 shows the payoffs from buying calls at different strikes.
Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money
put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be exercised in the
unlikely event that Nifty falls by 50 points on the expiration date.Figure 8.2 shows the payoffs from writing 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
1250 1300 27.50 64.80
will earn the premium. If however your hunch about an upward movement in the market proves
to be wrong and the index actually falls, then your losses directly increase with the falling index
level. If for instance the index falls to 1230 and you’ve sold a put with an exercise of 1300, the
buyer of the put will exercise the option and you’ll end up losing Rs.70. Taking into account the
premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which strike
should you choose ? This largely depends on how strongly you feel about the likelihood of the
upward movement in the market index. If you write an at–the–money put, the option premium
earned by you will be higher than if you write an out–of–the–money put. However the chances of
an at–the–money put being exercised on you are higher as well. In the example in Figure 8.2, 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.
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts 117
Figure 8.1 Payoff for buyer of call options at various strikes

The fi gure shows the profi ts/losses for a buyer of Nifty calls at various strikes. The in–the–money option with a
strike of 1200 has the highest premium of Rs.80.10 whereas the out–of–the–money option with a strike of 1300 has
the lowest premium of Rs.27.50.
Profit
1200 1250 1300

| | |
Nifty
27.50
49.45
80.10
Loss
Figure 8.2 Payoff for writer of put options at various strikes

The fi gure shows the profi ts/losses for a writer of Nifty puts at various strikes. The in–the–money option with a
strike of 1300 fetches the highest premium of Rs.64.80 whereas the out–of–the–money option with a strike of 1200
has the lowest premium of Rs.18.15.
Profit
64.80
37.00
18.15 1250
1200 1300
| | |
Nifty
Loss
Solved problems
Q: Anand is bullish about the index. Spot Nifty stands at 1200. He decides to buy one three-month Nifty
call option contract with a strike of 1260 at a premium of Rs 15 per call. Three months later, the index
closes at 1295. His payoff on the position is
1. Rs.4,000 3. Rs.12,000
2. Rs.19,000 4. None of the above
A: Each call option earns him (1295 - 1260 - 15)*200 = 20*200= Rs.4,000.The correct answer is number
1.
Q: Chetan is bullish about the index. Spot Nifty stands at 1200. He decides to buy one three month Nifty
call option contract with a strike of 1260 at Rs.60 a call. Three months later the index closes at 1240. His
payoff on the position is
1. - 7,000 3. - 4,000
2. - 8,000 4. -12,000
A: The call expires out of the money, so he simply loses the call premium he paid, i.e 60 * 200 =
Rs.12,000.The correct answer is number 4.
Q: Deepak is bullish about the index. Spot Nifty stands at 1250. He decides to buy one three-month Nifty
call option contract with a strike of 1290 at Rs.20 per call. Three months later the index closes at 1330.
His payoff on the position is
1. Rs.7,000 3. Rs.4,000
A: Each call option earns him (1330 - 1290 - 20)*200 = 20*200= Rs.4,000. The correct answer is number
3.
Q: Satish is bullish about the index. Spot Nifty stands at 1225. He decides to buy one three-month Nifty
call option contract with a strike of 1260 at Rs.20 a call. Three months later the index closes at 1235. His
payoff on the position is
1. - 7,000 3. - 4,000
2. - 8,000 4. -12,000
A: The call expires out of the money, so he simply loses the call premium he paid, i.e 20 * 200 = Rs.4,000.
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts 119
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts
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? Due to poor corporate results, or the instability of the
government, many people feel that the index would go down. 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. Suppose you have a hunch that the market index is going to fall in a
months time. Your hunch proves correct and the index does indeed fall, it is this downside that
you cash in on. When the index falls, the buyer of the call lets the call expire and you get to keep
the premium. However, if your hunch proves to be wrong and the market index soars up instead,
what you lose is directly proportional to the rise in the index.
Having decided to write a call, which one should you write? Table 8.2 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 :
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. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a
higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event
that the Nifty will rise by more than 50 points on the expiration date. Hence writing this call is
a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which
case the buyer exercises and the writer suffers losses to the extent that the Nifty is above 1300. In
the more likely event of the call expiring out-of-the-money, the writer earns the premium amount
of Rs.27.50.
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
Table 8.2 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are fi ve one-month calls and fi ve one-month puts trading in the market. The call
with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is
out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution
depends on the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence writing
this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the
buyer exercises and the writer suffers losses to the extent that the Nifty is above 1300. In the more likely event of
the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. Figure 8.3 shows the payoffs
from writing calls at different strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a
higher premium than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money
and will only be exercised in the unlikely event that Nifty falls by 50 points on the expiration date. The choice of
which put to buy depends upon how much the speculator expects the market to fall. Figure 8.4 shows the payoffs
from buying puts at different strikes.

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
index does fall, you profit to the extent the index falls below the strike of the put purchased by
you. If however your hunch about a downward movement in the market proves to be wrong and
the index actually rises, all you lose is the option premium. If for instance the index rises to 1300
and you’ve bought a put with an exercise of 1250, you simply let the put expire. If however the
market index does fall to say 1225 on expiration date, you make a neat profit of Rs.25.
Having decided to buy a put, which one should you buy? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which strike
should you choose? This largely depends on how strongly you feel about the likelihood of the
downward movement in the market index. If you buy an at-the-money put, the option premium
paid by you will by higher than if you buy an out-of-the-money put. However the chances of an
at-the-money put expiring in-the-money are higher as well.
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts 121
Figure 8.3 Payoff for seller of call option at various strikes

The fi gure shows the profi ts/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 out–of–the–money option has the lowest premium of Rs.27.50.
Profit
80.10
49.45
27.50
1200 1250 1300
| | |
Nifty
Loss
Figure 8.4 Payoff for buyer of put options at various strikes

The fi gure shows the profi ts/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 out–of–the–money option has the lowest premium of Rs.18.50.
Profit
1200 1250 1300

| | |
Nifty
18.15
37.00
64.80
Loss
Solved problems
Q: Anish is bearish about the index. Spot Nifty stands at 1250. He decides to buy one three month Nifty
put option contract with a strike of 1275 at a premium of Rs.40. Three months later the index closes at
1225. His payoff on the position is :
1. Rs.2,000 3. Rs.7,500
A: The put option contract earns him (1275 - 1225 - 40)*200 = 10*200= Rs.2,000.The correct answer is
number 1.
Q: Anand is bearish about the index. Spot Nifty stands at 1250. He decides to buy one three month Nifty
put option contract with a strike of 1225 at Rs.26.50 a put. Three months later the index closes at 1260.
His payoff on the position is :
1. - 7,000 3. - 4,000
2. - 5,300 4. -12,000
A: The put expires out of the money, so he simply loses the put premium he paid, i.e 26.50 * 200 =
Rs.5,300.The correct answer is number 2.
Q: Ashish is bearish about the index. Spot Nifty stands at 1240. He decides to buy one three month Nifty
put option contract with a strike of 1225 at Rs.34.50 a put. Three months later the index closes at 1280.
His payoff on the position is :
1. - 6,900 3. - 4,000
2. - 5,300 4. -12,000
A: The put expires out of the money, so he simply loses the put premium he paid, i.e 34.50 * 200 =
Rs.6,900. The correct answer is number 1.
Q: Anand is bearish about the index. Spot Nifty stands at 1250. He decides to sell one three month Nifty
call option contract with a strike of 1275 for a premium of Rs.28.60. Three months later the index closes
at 1225. His payoff on the position is :
1. Rs.2,860 3. Rs.7,500
A: The index closes below the strike of 1275, so the option buyer does not exercise the option. Anand
earns the option premium of Rs.5,720. The correct answer is number 2.
Q: Ashish is bearish about the index. Spot Nifty stands at 1250. He decides to sell one three month Nifty
call option contract with a strike of 1275 for a premium of Rs.28.60. Three months later the index closes
at 1295. His net payoff on the position is :
1. - 1,720 3. - 7,500
2. - 4,000 4. + 1,720
A: The index closes above the strike of 1275, so the option buyer exercises the option. Ashish earns a
upfront premium of Rs.28.60 but loses Rs.20 because of the rise in the index. His net profi t is 8.6 * 200.
8.4 Speculation: Anticipate volatility, buy a call and a put 123
8.4 Speculation: Anticipate volatility, buy a call and a put
Do you sometimes think that the market index is going to go through large swings in a given
period, but have no opinion on the direction of the swing? This could typically happen around
budget time, or during times of political uncertainty when a change in the government is
anticipated. How does one implement a trading strategy to benefit from market volatility ?
Combinations of call and put options provide an excellent way to trade on volatility. Here is
what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.
This combination of options is often referred to as a Straddle and is an appropriate strategy for
an investor who expects a large move in the index but does not know in which direction the move
will be.
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
view is that there will be a large jump in the index, this will reflect in the prices of the options.
Solved problems
Q: You are a speculator. You predict that the market will be volatile in the next three months. However
you have no idea if it will move upwards or downwards. To take advantage of this volatility you would
buy
1. Three-month calls with the same strike

2. Three-month puts
4. A three-month call and sell a three-month put
3. A three-month call and a three-month put with the same strike
A: If you think the market will be volatile, but do not know whether it will move up or down, you
should create a payoff which gives you profi ts when the market makes a large move either upward or
downward.The correct answer is number 3.
Figure 8.5 Payoff for buyer of three-month call and put options at strikes of 1250
The fi gure shows the profi ts/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 profi ts are potentially unlimited. If for instance the index jumps to 1420, he makes a neat profi t 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 profi table.
Profit
1098 1193 1250 1345 1402

| | | | |
Nifty
57.00
95.00
152.00
Loss
Q: To profi t from market volatility you buy one market lot of three-month Nifty calls at Rs.95/call and one
market lot of three-month Nifty puts at 57/put. If at the end of three months the markets haven’t shown
the magnitude of movement that you expected, the maximum you will lose on this combination position
is Rs.
1. 19,000 3. 7,600
2. 11,400 4. 30,400
A: The maximum loss would be the total premium paid for buying the calls and the puts. At a market lot
of 200, the total cost of taking on the combination position works out to be ( 95 + 57) * 200. The correct
answer is number 4.
8.5 Speculation: Bull spreads - Buy a call and sell another 125
Table 8.3 Three-month calls and puts trading at different strikes

Given below are the three-month call and put option premia on the S&P CNX Nifty. An investor who decides to
play on the volatility of the market must decide at what strike to generate the straddle. In this case he has three
three-month option contracts to choose from.

1248 1250 48.00 38.30
1248 1245 50.65 35.95
1248 1230 59.05 29.50
Q: With elections around the corner Babbanseth expects the markets to go through a period of high
volatility in the coming three months and would like to take a bet on this volatility . He is however unsure
of the direction that the market will take and decides to enter into a straddle. Three months call and put
premiums are given in Table 8.3 . He decides to buy one market lot of calls and one market lot of puts at a
strike of 1250. If three months later, the Nifty closes at 1380, his profi t net of costs from the combination
will be Rs.
1. 8,740 3. 13,000
2. 26,000 4. 16,400
A: If Nifty closes at 1380, he makes a profi t on the position of Rs.26,000, that is (1380-1250)* 200.
However he has paid an up-front price of Rs.17,260 (i.e.48.00*200 + 38.30*200). So his net profi t on the
combination works out to be Rs.8,740. The answer is number 1.
8.5 Speculation: Bull spreads - Buy a call and sell another

There are times when you think the market is going to rise over the next two months, however
in the event that the market does not rise, you would like to limit your downside. One way you
could do this is by entering into a spread. A spread trading strategy involves taking a position in
two or more options of the same type, that is, two or more calls or two or more puts. A spread
that is designed to profit if the price goes up is called a bull spread.
How does one go about doing this? This is basically done utilizing two call options having
the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with
an exercise price below the current index level and sells a call option with an exercise price above
the current index level. The spread is a bull spread because the trader hopes to profit from a rise
in the index. The trade is a spread because it involves buying one option and selling a related
option. What is the advantage of entering into a bull spread? Compared to buying the underlying
asset itself, the bull spread with call options limits the trader’s risk, but the bull spread also limits
Figure 8.6 Payoff for a bull spread created using call options
The fi gure shows the profi ts/losses for a bull spread. As can be seen, the payoff obtained is the sum of the payoffs
of the two calls, one sold at Rs.37.85 and the other bought at Rs.76.50. The cost of setting up the spread is Rs.38.65
which is the difference between the call premium paid and the call premium received. The downside on the position
is limited to this amount. As the index moves above 1260, the position starts making profi ts (cutting losses) until
the spot reaches 1350. Beyond 1350, the profi ts made on the long call position get offset by the losses made on the
short call position and hence the maximum profi t 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
1260 1298.65 1336.50 1350 1387.85

| | | | |
0
Nifty
38.65
76.50
Loss
the profit potential. In short, it limits both the upside potential as well as the downside risk. 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 8.4 gives the profit/loss incurred on a spread position as the index changes. Figure
8.6 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.
8.5 Speculation: Bull spreads - Buy a call and sell another 127
Table 8.4 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profi t 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 profi t on the spread is limited to Rs.51.35. Beyond an index
level of 1350, any profi ts made on the long call position will be cancelled by losses made on the short call position,
effectively limiting the profi t on the combination.
Nifty Buy Jan 1260 Call Sell Jan 1350 Call Cash Flow Profi t&Loss (Rs.)
1245 0 0 0 -38.65
1255 0 0 0 -38.65
1265 +5 0 5 -33.65
1275 +15 0 15 -23.65
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
Solved problems
Q: An investor buys one market lot of Feb 1300 Nifty calls at Rs.76 a call and sells one market lot of Feb
1400 Nifty calls for Rs.40 a call. If Nifty closes at 1360 on the expiration date, the payoff in Rs., net of
costs from this spread position is
1. 4,800 3. -4,800
2. -7,200 4. 12,000
A: A bull spread has a limited upside and a limited downside. If Nifty closes between 1300 and 1400,the
payoff is the amount by which the index exceeds 1300, which in this case is 60. The cost of setting up the
spread is Rs.36 i.e. (76 - 40). The net profi t from the position is Rs.24 i.e. ( 60 - 36). Hence the payoff on
one market lot is 24*200. The correct answer is number 1.
Q: An investor buys one market lot of Jan 1260 Nifty calls at Rs.96 a call and sells one market lot of Jan
1350 Nifty calls for Rs.55 a call. If on the expiration date Nifty closes at 1375, the payoff in Rs., net of
costs from this spread position is
1. +18,000 3. +9,800
2. -23,000 4. -8,200
A: A bull spread has a limited upside and a limited downside. If Nifty closes above 1350, the payoff from
the spread position is Rs.90 i.e. ( 1350 - 1260). However the investor has spent Rs.41 (Rs.96 paid for call
purchased minus Rs.55 received for call sold) on setting the spread. Hence his net profi t from the spread
position is Rs.49 i.e. ( 90 - 41). The profi t on one market lot is 49*200. The correct answer is number 3.
Q: An investor buys one market lot of Dec 1230 Nifty calls at Rs.70 a call and sells one market lot of Dec
1300 Nifty calls for Rs.34 a call. If Nifty closes at 1210 on the expiration date, the net Rs. payoff from
this spread position is
1. 14,000 3. 20,800
2. -7,200 4. -4000
A: A bull spread has a limited upside and a limited downside. If Nifty closes below 1230, both the options
are out-of-the-money and hence the payoff from the spread is the amount spent in setting it up, namely -
36 ( Rs.70 paid for call purchased minus Rs.34 received for call sold). Hence the net loss on one market
lot is 36*200. The correct answer is number 2.
Q: A bull spread is created by
1. Buying a call and a put 3. Buying two calls
2. Buying a call and selling a call 4. Selling two calls
8.6 Speculation: Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two months, however
in the event that the market does not fall, you would like to limit your downside. One way you
could do this is by entering into a spread. A spread trading strategy involves taking a position in
two or more options of the same type, that is, two or more calls or two or more puts. A spread
that is designed to profit if the price goes down is called a bear spread.
8.6 Speculation: Bear spreads - sell a call and buy another 129
How does one go about doing this? This is basically done utilizing two call options having
the same expiration date, but different exercise prices. How is a bull spread different from a bear
spread? In a bear spread, the strike price of the option purchased is greater than the strike price
of the option sold. The buyer of a bear spread buys a call with an exercise price above the current
index level and sells a call option with an exercise price below the current index level. The
spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a
spread because it involves buying one option and selling a related option. What is the advantage
of entering into a bear spread? Compared to buying the index itself, the bear spread with call
options limits the trader’s risk, but it also limits the profit potential. In short, it limits both the
upside potential as well as the downside risk.
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 8.5 gives the profit/loss incurred on a spread
position as the index changes. Figure 8.7 shows the payoff from the bull spread.
Broadly we can have three types of bear 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 bear spreads are of type 1. They cost very little
to set up, but have a very small probability of giving a high payoff. As we move from type 1 to
type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set
up. Bear spreads can also be created by buying a put with a high strike price and selling a put
with a low strike price.
Solved problems
Q: An investor buys one market lot of Feb 1400 Nifty calls at Rs.40 a call and sells one market lot of Feb
1300 Nifty calls for Rs.76 a call. If Nifty closes at 1320 on the expiration date, the net payoff from this
spread position is:
1. +3,200 3. +4,800
2. -7,200 4. 12,000
A: An investor enters into a bear spread position in the hope that the market will fall. If the market does
fall below both strikes, he profi ts to the extent of the difference between the two call premiums. If however
the market closes midway between the two strikes, his profi ts get reduced to the extent it falls short of the
lower strike. In this case the index falls short of the lower strike by 20. Hence his payoff is (36 - 20)= 16.
The payoff on one market lot is 16*200. The correct answer is number 1.
Figure 8.7 Payoff for a bear spread created using call options
The fi gure shows the profi ts/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 difference between the call premium received and the call premium paid. The upside on the
position is limited to this amount. As the index moves above 1260, the position starts making losses(cutting profi ts)
until the spot reaches 1350. Beyond 1350, the profi ts made on the long call position get offset by the losses made on
the short call position. The maximum loss on this spread is made if the index on the expiration day closes at 1350.
At this point the loss made on the two call position together is Rs.90 i.e. ( 1260-1350). However the initial inflow on
the spread being Rs.38.65, the net loss on the spread turns out to be -51.35 . The downside on this spread position
is limited to this amount. Hence the payoff on this spread lies between +38.85 to -51.35.
Profit
76.50
38.65
1260 1298.65 1336.50 1350 1387.85

| | | | |
0
Nifty
37.85
51.35
Loss
Q: An investor buys one market lot of Jan 1350 Nifty calls at Rs.55 a call and sells one market lot of Jan
1260 Nifty calls for Rs.96 a call. If on the expiration date Nifty closes at 1375, the net payoff in Rs. from
this spread position is
1. +18,000 3. -9,800
2. -23,000 4. +8,200
A: If Nifty closes above 1350, the payoff from the spread position is minus 90 i.e. ( 1260 - 1350) since the
investor has sold a call at a strike of 1350 and bought it at 1260. However the investor has earned Rs.41
(Rs.96 received for call sold minus Rs.55 paid for call bought)on setting the spread. Hence his net loss
from the spread position is Rs.49 i.e. ( 41- 90). The loss on one market lot is 49*200. The correct answer
is number 3.
8.7 Arbitrage: Put-call parity violations 131
Table 8.5 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profi t 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. The maximum profi t obtained from setting up the
spread is the difference between the premium received for the call sold (Rs.76.50) and the premium paid for the call
bought(Rs.37.85) which is Rs.38.65.
In this case the maximum loss obtained is limited to Rs.51.35. Beyond an index level of 1350, any profi ts made on
the long call position will be canceled by losses made on the short call position, effectively limiting the profi t on the
combination.
Nifty Buy Jan 1350 Call Sell Jan 1260 Call Cash Flow Profi t&Loss (Rs.)
1245 0 0 0 +38.65
1255 0 0 0 +38.65
1265 0 -5 -5 +33.65
1275 0 -15 -15 +23.65
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
1355 +5 -95 -90 -51.35
1365 +15 -105 -90 -51.35
8.7 Arbitrage: Put-call parity violations
Have you ever wondered how the put prices relate to the call prices? If you happen to know the
call price on an asset, would that help you to get some idea of the price of a put on the same
asset? Do put prices have anything at all to do with call prices? Of course, they do. The put and
the call prices are related by a condition called the put-call parity. We shall see how.
Put-call parity
To get an intuitive understanding about the put-call parity, we could think of it in the following
way. I buy the asset on spot, paying S. I buy a put at X, paying P, so my downside below X is
taken care of (if S X, I will exercise the put). I sell a call at X, earning C, so if S X, the call

holder will exercise on me, so my upside beyond X is gone. This gives me X on T with certainty.
This means that the portfolio of S+P-C is nothing but a zero-coupon bond which pays X on date
T.
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:

Where:
S Current index level
X Exercise price of option
T Time to expiration
C Price of call option
P Price of put option
risk-free rate of interest
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
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

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).
8.7 Arbitrage: Put-call parity violations 133

1. Sell off all 50 index shares on the cash market in the proportion in which they exist in the index. This can be
done using a single keystroke using the NEAT software.
2. Sell a three month Nifty 1260 put.
3. Buy a three month Nifty 1260 call.
4. You will receive the money for the stocks and the put sold and have to make delivery of the 50 shares.
5. Invest this money at the riskless interest rate. In three months Rs.1228.50 will grow to Rs.1265.35.
6. On the exercise date at the end of trading hours, if the Nifty is above 1260, exercise the call. If the Nifty is
below 1260, the put will be exercised on you.
7. Either way, you end up buying the index at Rs.1260.
8. The riskless profi t on the transaction works out to be Rs.5.35.
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

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 ends up buying
the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3 (1260 - 1257).

1. Buy all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done
using a single keystroke using the NEAT software.
2. Buy a three month Nifty 1260 put.

3. Sell a three month Nifty 1260 call.
4. You will have to pay for the shares and the put, and will receive the call premium. The entire set of transactions
will require an initial outflow of Rs.1221.20.
5. Finance this money at the riskless interest rate. The repayment at the end of three months works out to Rs.1257.
6. On the exercise date at the end of trading hours, if the Nifty is below 1260, exercise the put. If the Nifty is
above 1260, the call will be exercised on you.
7. Either way, you end up selling the index at Rs.1260.
8. The riskless profi t on the transaction works out to be Rs.3.
Nuances
1. What if the shares that I own are not exactly the NSE-50 portfolio? Any large investor can plan in advance and
have a sub–component of his portfolio which looks exactly like Nifty. Once this preparation is done, it can be
used for generating riskless profi ts due to breach in the put-call parity.
2. This sounds great – what is the catch? Some of the 50 stocks might be stuck at price limits when you are
getting in or getting out.
Solved problems
Q: Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty
call is Rs.96.50 and the price of a three month Nifty 1260 put is 60. To exploit the arbitrage, you should
1. Sell the index plus a put and buy a call 3. Buy the index plus a put and sell a call
2. Sell the index plus a call and buy a put 4. None of the above

A: In the above case,

. i.e. 1325

1321.30. Hence you should sell the index and a

put and buy a call. The correct answer is number 1.
Q: Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty
call is Rs.96 and the price of a three month Nifty 1260 put is 52.50. To exploit the arbitrage, you should
1. Buy the index plus a call and sell a put 3. Buy the index plus a put and sell a call
2. Sell the index plus a call and buy a put 4. None of the above

A: In the above case,

. i.e. 1317.50

1320.80. Hence you should buy the index and

a put and sell a call. The correct answer is number 3.
8.8 Arbitrage: Beyond option price bounds 135
8.8 Arbitrage: Beyond option price bounds

The value of an option before expiration depends on six factors:
The level of the underlying index
The exercise price of the option
The time to expiration
The volatility of the index
The risk-free rate of interest
Dividends expected during the life of the option
These factors set general boundaries for possible option prices. If the option price is above
the upper bound or below the lower bound, there are profitable arbitrage opportunities. We shall
try to get an intuitive understanding about these bounds.
Upper bounds for calls and puts

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,
If this is not true, an arbitrageur would make profit by writing puts.
Lower bounds for calls and puts

The lower bound for the price of a call option is given by . The price of a call

must be worth at least this much else, it will be possible to make riskless profits.

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. In this case,
the lower bound for the option price is $ !
i.e 161.20. Suppose the call is

$ !

" $

available at a premium of Rs.150 which is less than the theoretical minimum of Rs.161.20. An
arbitrageur can buy the 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 profi t 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 profi t of 1273 - 1235 = Rs.38.
The lower bound for the price of a put option is given by . The price of a put

must be worth at least this much else, it will be possible to make riskless profits.

Consider an example. Suppose the exercise price for a 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 profi t 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 profi t of 1275 - 1246.3 =
Rs.28.7.
Solved problems
Q: Consider a two month Nifty call option with a strike of 1260. Nifty stands at 1350. The risk-free rate
of interest is 12% per annum. Arbitrage opportunities will arise when the call premium falls below
1. Rs.113.50 3. Rs.127
2. Rs.151 4. Rs.163
A: The lower bound for a call option is given by

. This works out to be

= Rs.113.50. The correct answer is number 1.
Chapter 9
Using stock options
From July 2001, stock options began trading on NSE’s F&O segment. Today, options on many
stocks are available for trading. The market on stock options is gradually building momentum
with a steady increase in the trading volume. In this chapter we shall study more about stock
options and how they differ from index options.
One of the main issues with respect to trading stock options is its exercise. Should the option
be exercised or not? If yes, when should it be exercised? Would the exercise decision change in
light of an upcoming dividend? These are a few of the issues we will look into.
9.1 Uses of stock options
As far as using stock options for hedging, speculation and arbitrage is concerned, it is almost
like using index options. Stock options can be used to hedge an open position in the stock. They
can be used to speculate on the underlying stock price as well as underlying stock volatility. And
finally, the arbitrage arguments that we use for index options also apply to stock options.
9.1.1 Hedging: Have stock, buy puts

This is probably one of the simplest ways to take on a hedge. Take the case of an investor Mr.
Mehta, who holds 1000 shares of HLL. He plans to sell the shares three months later as he would
need the money to get his daughter married. Today HLL trades at Rs.232 in the spot market.
Mr.Mehta worries about a fall in the price of HLL three months later, when he would actually
need the money. He could of course sell the shares today and get Rs.232 for them, however he
does not want to lose on the possibility of an increase in share price three months later. How
can he ensure that he gets to profit from a price increase but does not suffer losses from a price
decrease? The answer is simple - buy put options on HLL.
Let us see how this would work. Take for instance he buys a put option with a strike of
Rs.240. This option will cost him Rs.10. How does this option provide the hedge? Let us look
at two possible scenarios three months later:
138 Using stock options
The price of HLL falls to Rs.215. This means that he has suffered a loss of Rs.17 per share. However
the put options with a strike of Rs.240 at a premium of Rs.10 are in–the–money and now trade at
Rs.25. The loss he suffers on the shares held by him is made up for by the profi ts he earns on the put
options bought. Obviously, the hedge does not come for free and he will end up paying a premium
of Rs.10 per put. By paying this premium, he ensures that he will get at least Rs.240 for the shares
held by him.
The price of HLL rises to 250. He lets his option expire, losing the Rs.10 in the process. He sells the
shares held by him in the spot market for Rs.250 per share.
What the investor actually obtains in a limited downside(determined by the strike price he
chooses) and an unlimited upside.
9.1.2 Speculation: Bullish stock, buy calls or sell puts

This strategy is exactly like the one we described in the previous chapter using index options.
Take the case of a speculator who believes that the price of ACC will go up in the next two
months. He could do any of the following:
He could buy the stock, hold it for two months and sell it off for a profi t. Say for instance, he buys
200 shares of ACC. At the rate of Rs.150 a share, it would cost him Rs.30,000. Assume that his
hunch proved correct and at the end of two months ACC sells for Rs.160. He would have earned
Rs.2,000 on an investment of Rs.30,000, a return of 6.6 percent over two months.
He could buy call options on ACC. ATM calls on ACC with a strike of 150 trade at Rs.8. He buys
200 calls which costs him Rs.1,600. Assume that his hunch proves correct and two months later ACC
trades at Rs.160. After accounting for the call premium paid by him, he earns a net profi t of Rs.400
i.e.([(160-150)-8]*200) on an investment of Rs.1,600, a return of 25 percent over two months.
Options enable speculators to take leveraged positions on stocks. By paying a small premium
amount, speculators can take fairly large exposure on the stock.
A speculator with a bullish view can also express his view by selling puts. Take the case of
a speculator who thinks that the price of ACC is going to rise. He could sell/write puts on ACC.
Assume as in the above case that the price of ACC is Rs.150. He writes puts with a strike of 160
at a premium of Rs.12. As anticipated by him, if the price of ACC does rise, the buyer of the put
will let the puts expire, and the speculator will get to keep the premium. If however, his hunch
proves wrong and the prices of ACC fall, he will suffer losses to the extent of the difference
between the strike price and the (spot price + premium). As we know, the writer of a put has a
limited upside(the premium money) and an unlimited downside.
9.1.3 Speculation: Bearish stock, buy puts or sell calls

Once again, this strategy is exactly like the one we described in the previous chapter using index
options. Take the case of a speculator who believes that the price of ACC will go down in the
next two months. In the absence of short–selling he cannot trade in the spot market based on his
hunch. He can however trade in the options market. Assume that ACC trades at Rs.150 in the
spot market. He can do one of the following:
9.2 Combination positions using stock futures and stock options 139
Buy puts: Assume that he buys 200 ATM puts at a strike of 150 and at a premium of Rs.2. They cost
him Rs.400. Assume further that his hunch proves correct and ACC price does fall to Rs.140. The
ATM puts he bought now become ITM and trade at Rs.10. He ends up making a profi t of Rs.1,600
over a two month period.
Sell calls: He sells 200 call options on ACC with a strike of Rs.150 at a premium of Rs.14. If
his hunch proves correct and the price of ACC falls to Rs.140, the buyer of the calls will let the
option expire and the speculator gets to keep the premium of Rs.2,800. However if his hunch proves
incorrect and the price of ACC rises to 170, the buyer of the put options will exercise on him and
the speculator would suffer a loss equal to the difference between the spot price and the strike price,
reduced to the extent of premium received by him earlier on.
While options enable speculators to take leveraged positions on stocks, the losses incurred
by the buyer of the option are limited to the extent of premium paid, but the losses suffered by
the seller/writer of the option are potentially unlimited.
9.2 Combination positions using stock futures and stock options

With the availability of a range of basic derivative products for trading, it is possible to create
speculative/hedged positions using a combination of these. Given a clear understanding and
imagination, a wide range of interesting payoffs/trading strategies can be generated using futures
and options. Let us look at the payoffs of the following combinations.
Long stock futures + long ATM stock put: This position has a limited downside and an unlimited
upside. If the security price goes up, the long futures position starts making money. If the security
price falls, the long put position starts going in–the–money. However the profi ts on this put position
are offset by the losses on the long futures position. The combination is nothing but a synthetic
call. When ATM puts are underpriced, it makes sense to generate a synthetic call on the security by
combining a long put and a long futures position.
Long stock futures + long ATM Nifty put + long OTM stock put: Let us fi rst look at each component
of this position. The long stock futures position gives exposure to the security. If the security price
goes up, it generates profi ts. The at–the–money Nifty put hedges away the index exposure, hence
the combination is now a pure bet on the security. Finally, the out–of–the–money put option on
the security limits my overall loss on the combination. If the price of the security rises, the long
futures position will start making profi ts. If however the security price falls below the strike of the
OTM security put, any losses on the long futures position will be offset by the profi ts on the long
put position. The combination provides a ceiling on the losses from a position which is purely a
speculative bet on the security.
The plethora of equity derivatives products that are now available for trading form the
building blocks which can be used for generating various payoffs that match the needs and
requirements of investors. The leveraged nature of the futures markets makes stock futures very
attractive for speculators.
9.3 Early exercise of American options
Stock options being American in nature, can be exercised at any point of time before their
expiration/maturity. However, early exercise may not always be optimal. In this section we
shall look at when it may be optimal to exercise options on non–dividend paying stocks and
options on dividend paying stocks from the point of view of early exercise.
9.3.1 Early exercise of calls on non–dividend paying stock

A stock option on a non–dividend paying stock could be bought for any of the following reasons:
To acquire the underlying stock and hold it beyond the life of the option. For instance, a mutual fund
that wants to buy shares using subscription money it expects to receive in a months time, may want
to buy call options on the stocks it wants to acquire.
To acquire the stock and sell it off if/when it is overpriced. A speculator who bought a call option
when it was out–of–the–money may want to exercise the option, acquire the underlying stock at the
strike price and sell it in the market at the higher spot price.
However, in either of the above situations, it is never optimal to exercise a call option on a
non–dividend paying stock before expiration date. Let us take the example of a American call
option on a non–dividend paying stock with one month to expiration. Stock price is Rs.50. Strike
price is Rs.40. The option is deep in the money.
Case 1: You plan to hold the stock for more than one month. Should you exercise the option and buy
the stock at Rs.40? If you do exercise the option, you will get to buy the stock at Rs.40 when it trades
in the market at Rs.50. However, you are buying the stock as a part of a portfolio building activity,
and not for profi ting by selling the stock in the market at Rs.50. Whether you exercise today or a
month later, you will still get the stock at Rs.40. However, the earlier you exercise, the earlier will be
your cash outflow of Rs.40 per share. If instead, you exercise at maturity, you can earn the interest
on the cash for that period. Being an option on a non–dividend paying stock, you do not forgo any
dividend inflow. Besides, there is a chance that on the day of exercise, the stock price could be less
than Rs.40. By exercising early you will have lost the opportunity of buying the stock at a lower
price.
Case 2: You want to exercise, acquire the stock at Rs.40 and sell it in the market at Rs.50. Should
you exercise? If you do exercise, you will end up earning a profi t of Rs.10 per option which is the
intrinsic value of the option. However, recollect that the option premium consists of two components,
the intrinsic value and the time value. If you exercise the option, you will only earn the intrinsic value.
Instead if you sell the option in the market, you will earn the intrinsic value of Rs.10 plus the time
value of the one–month option.
As can be seen from the above two cases, it is never optimal to exercise an call option on a
non–dividend paying stock before expiration date.
9.3 Early exercise of American options 141
9.3.2 Early exercise of puts on non–dividend paying stock
The arguments for exercise of American put options differ significantly from that of for American
call options. The reason for this is that the put option’s payoff is bounded from above by the strike
price. That is, the maximum profit obtained from a long put position is the strike, which happens
when the spot price falls to zero. In contrast, the American call’s payoff has an unlimited upside.
It can be optimal to exercise American put options on a non–dividend paying stock early.
A put option should always be exercised early if it is sufficiently deep in–the–money. Consider
the case of the owner of an in–the–money put who is also very bearish. He believes that the
expiration day stock price will be below the strike price. Assume that the stock price is Rs.5
and the strike price is Rs.50. Assume further that the put is selling for its intrinsic value, Rs.45,
(deep–in–the money puts have very little time value). The investor has three possible courses of
action: he can hold on to the option, he can exercise the option and sell the stock at Rs.50, or he
can sell the put for Rs.45. By holding on to the put, at maximum his profit can increase by Rs.5.
Clearly, holding on to the option for another day is an inferior strategy to exercising the put. By
exercising, the investor receives Rs.50 today, and he can immediately invest it to earn interest.
By waiting one day, or waiting until the expiration day, he is foregoing interest that could be
earned on the Rs.50.
Should he sell the put? One would find it hard to find a buyer to whom one could sell a deep–
in–the money put. From the point of view of the buyer, typically, no one would ever want to buy
the put for Rs.45 and hold it, because the most that he could earn on the put, would be Rs.5 in
the event that the stock price falls to near–zero. Even in cases where the put sells for more than
its intrinsic value, if the interest earned on the Rs.50 from today to expiration exceeds the time
value of the put, the holder would be better off exercising the put. In most cases is optimal to
exercise in–the–money put options early.
9.3.3 Early exercise of calls on dividend paying stock
When the stock goes ex–dividend, the stock price falls by the amount of dividend. We know
that the value of a call option increases with increase in the underlying stock price and decreases
with a decrease in the underlying stock price. The fall in the stock price when the stock goes
ex–dividend makes the option on that stock less attractive. In the case of options on dividend
paying stocks, it may at times be optimal to exercise an American call option to capture the
dividend payment. Therefore early exercise should be considered only just before the stock goes
ex–dividend. In order to find out whether it is optimal to exercise the call option, we need to find
out the value of the option when the underlying stock trades cum–dividend versus when it goes
ex–dividend. If the value of the option when the underlying stock trades cum–dividend it higher
than the value of the option when it trades ex–dividend, then it is optimal to exercise just before
the stock goes ex–dividend. We shall discuss this in detail in the following section.
Bounds on call option prices: a recap

Recollect what we learned about the bounds on option prices in the previous chapter. The worst
that can happen to a call option is that it expires worthless. This will happen when the call is
out–of–the money. The optionality in an option is precious. It offers a limited downside and an
unlimited upside. Hence its value must always be positive, i.e. c 0.
For a non–dividend paying stock,

where:
S Spot price
c Call premium
r Continuously compounded risk–free rate of interest
X Exercise price
T Time to maturity in years
D Dividend in rupees
For a dividend paying stock,

. That is, the stock price falls to the extent of dividend declared and hence the dividend amount is
subtracted from the spot.
Let us assume that t is a moment in time prior to stock going ex–dividend and d is the
corresponding dividend. We are faced with a choice - should we exercise the option or not? We
would like to check if it would be optimal to exercise the option at time t which is before T, the
maturity of the option.

Case 1: If the option is exercised at time t, the buyer of the option will receive -X .

Case 2: If the option is not exercised, the stock price drops to

. As shown above, the value of
this option is greater than .

If

it cannot be optimal to exercise at time t. What this means is that, if the value of the option after
the ex–dividend date is more than the value of the option before the ex–dividend date, it makes
sense not to exercise the option. If however,

9.3 Early exercise of American options 143
, it is always optimal to exercise the option at time t. This means that if the value of the option
before the ex–dividend date is more than the value of the option after the ex–dividend date, it is
optimal to exercise the option just before the stock goes ex–dividend.
Rearranging the above two equations, we find that

If , it cannot be optimal to exercise at time t.

If
, it is always optimal to exercise at time t.

Let us try to apply the above conditions to the following numerical example. Consider an
American call option on a dividend paying stock with a maturity of six months(At the moment
only options having a maturity of one–month, two–month and three–month maturity are available
for trading in India). Ex–dividend date is three months later. Dividend on the ex–dividend date
is expected to be Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price
volatility is 30% per annum. Risk–free rate is 9% per annum. Should this option be exercised on
the ex–dividend date?
As we know, the dividend amount is Rs.0.50 which will be received three months later. We
shall test out the above conditions to see if early exercise is optimal.
In this case we find that

" $

"

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should not be exercised on the
ex–dividend date.
Let us take the same example and assume that the ex–dividend date was five months later. If
so, we find that

" $

"

. Since the dividend amount of Rs.0.50 is more than the Rs.0.29, the option should be exercised
on the ex–dividend date if it is sufficiently deep in the money.
9.3.4 Early exercise of puts on dividend paying stock

When the stock goes ex–dividend, the stock price falls by the amount of dividend. We know that
the value of a put option increases with decrease in the underlying stock price and decreases with
an increase in the underlying stock price. The fall in the stock price when the stock goes ex–
dividend makes the put option on that stock more attractive. Hence dividends will tend to delay
the exercise of an American put option. Early exercise should be considered only just after the
stock goes ex–dividend. In order to find out whether it is optimal to exercise the put option, we
need to find out the value of the option when the underlying stock trades cum–dividend versus
when it goes ex–dividend. If the value of the option when the underlying stock trades cum–
dividend it higher than the value of the option when it trades ex–dividend, then it is optimal to
exercise just after the stock goes ex–dividend. We shall discuss this in detail in the following
section.
Bounds on put option prices: a recap

Recollect what we learned about the bounds on option prices in the previous chapter. The worst
that can happen to a put option is that it expires worthless. This will happen when the put is
out–of–the money. The optionality in an option is precious. It offers a limited downside and an
unlimited upside. Hence its value must always be positive, i.e. p 0.

For a non–dividend paying stock,

.

For a dividend paying stock,

. That is, the stock price falls to the

extent of dividend declared.
As the stock price falls, a put becomes more valuable. Since the stock price falls to the extent
of dividend declared, it always makes sense to check if it would be optimal to exercise the put
option just after the ex–dividend date. Let us assume that t is a moment in time immediately
after the stock goes ex–dividend and d is the corresponding dividend. We would like to check if
it would be optimal to exercise the option at time t which is before T, the maturity of the option.

Case 1: If the option is exercised at t, the buyer of the option will receive X - .

Case 2: If the option is not exercised, the stock price drops to

. As shown above, the value of

this option is greater than .

If

, it cannot be optimal to exercise at t. What this means is that, if the value of the option after
the ex–dividend date is more than the value of the option before the ex–dividend date, it makes
sense not to exercise the option. If however,

, it is always optimal to exercise the option at time t. This means that if the value of the option
before the ex–dividend date is more than the value of the option after the ex–dividend date, it is
optimal to exercise the option just after the stock goes ex–dividend.
Rearranging the above two equations, we find that

If
, it cannot be optimal to exercise at time t.

If

, it is always optimal to exercise at time t, i.e. just after the ex–dividend

date.

Let us try to apply the above conditions to the following numerical example. Consider an
American put option on a dividend paying stock with a maturity of six months(At the moment
only options having a maturity of one–month, two–month and three–month maturity are available
for trading in India). Ex–dividend date is three months later. Dividend on the ex–dividend date
9.4 Implied volatility 145
is expected to be Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price
volatility is 30% per annum. Risk–free rate is 9% per annum. Should this option be exercised on
the ex–dividend date?
As we know, the dividend amount is Rs.0.50 which will be received three months later. We
shall test out the above conditions to see if early exercise is optimal.
In this case we find that

" $

"

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should be exercised just after
the ex–dividend date.
Let us take the same example and assume that the ex–dividend date was five months later. If
so, we find that

" $

"

. Since the dividend amount of Rs.0.50 is more than the Rs.0.29, it is not optimal to exercise the
option.
9.4 Implied volatility
Volatility is one of the important factors, which is taken into account while pricing options. It is
a measure of the amount and speed of price changes, in either direction. Everybody would like
to know what future volatility is going to be. Since it is not possible to know future volatility,
one tries to estimate it. One way to do this is to look at historical volatility over a certain period
of time and try to predict the future movement of the underlying. Alternatively, one could work
out implied volatility by entering all parameters into an option pricing model and then solving
for volatility. For example, the Black Scholes model solves for the fair price of the option by
using the following parameters – days to expiry, strike price, spot price, volatility of underlying
,interest rate, and dividend. This model could be used in reverse to arrive at implied volatility by
putting the current price of the option prevailing in the market.
Putting it simply, implied volatility is the market’s estimate of how volatile the underlying
will be from the present until the option’s expiration, and is an important input for pricing options
– when volatility is high, options are relatively expensive; when volatility is low, options are
relatively cheap. However, implied volatility estimate can be biased, especially if they are based
upon options that are thinly traded.
Solved problems
Q: Exchange traded stock options began trading on the NSE from
1. July 2000 3. July 1999
2. July 2001 4. July 1995
Q: Stock options that trade on NSE’s F&O segment are
1. American options 3. Asian options
2. European options 4. Look–back options
Q: The basis for any adjustment for corporate action shall be such that
1. The value of the position of the market partic- as possible.

ipants on ex–date is higher than the value of
the position on cum–date. 3. The value of the position on ex–date will be
independent of the value of position on cum–
2. The value of the position of the market partic- date as far as possible.
ipants on cum and ex–date for corporate ac-
tion shall continue to remain the same as far 4. None of the above
Q: In the F&O segment, any adjustment for corporate actions shall be carried out on
1. The fi rst day on which a security is traded on 3. The last day on which a security is traded on
a cum basis in the underlying cash market. a cum basis in the underlying cash market.
2. The fi rst day on which a security is traded on
an ex–dividend basis in the underlying mar-
ket. 4. None of the above.
Q: Which of the below listed factors does not affect the price of an option on a stock?
1. Stock price 3. Volatility
4. Liquidity of stock in the underlying cash mar-

2. Dividend ket

Q: It is optimal to exercise a call option on a non–dividend paying stock.
1. Sometimes 3. always
2. Never 4. rarely
Q: Mr.Bal buys 100 calls on a stock with a strike of Rs.1200. He pays a premium of Rs.50/call. A month
later the stock trades in the market at Rs.1300. He decides to exercise. He will receive
1. Rs.100 3. Rs.50
2. Rs.10,000 4. Rs.5,000
A: He receives the cash–settlement amount of Rs.100 per call. He has bought 100 calls. The correct
answer is number 2.
Q: Ramesh is bullish about Cipla which trades in the spot market at Rs.1025. He buys two one-month
call option contracts on Cipla with a strike of 1050 at a premium of Rs.10 per call. One month later, Cipla
closes at Rs. 1080. His profi t on the position is
1. Rs.6000 3. Rs.4500
2. Rs.1500 4. Rs.4000
A: His profi t is (1080 - 1050 - 10), i.e. 20 per call. He buys two contracts. Therefore the profi t on the
position is 20 * 200. The correct answer is number 4.
Q: An American call option on a non–dividend paying stock with one month to expiration trades in the
market. Stock price is Rs.50. Strike price is Rs.40. You plan to hold the stock for more than one month.
What would be the most optimal thing to do?
1. Exercise the option immediately and buy the 3. Let the option expire and buy the stock from
stock at Rs.40. the market.
2. Exercise the option on the day of expiration
and buy the stock at Rs.40. 4. None of the above

market. Stock price is Rs.50. Strike price is Rs.40. At what price will this option trade in the market?
1. At a price higher than Rs.10. 3. At Rs.10.
2. At a price lower than Rs.10. 4. None of the above.
A: The correct answer is number 1. The option will trade in the market at a price which is the sum of the
intrinsic value plus the time value.
market. Stock price is Rs.50. Strike price is Rs.40. You think the stock is overpriced. What should you
do?
1. Exercise the option, acquire the stock at Rs.40 3. Buy the stock and sell the option.
and sell it off at Rs.50.
2. Sell the option in the market. 4. None of the above.
Q: An American call option on a dividend paying stock with a maturity of six months is available for
trading. Ex–dividend date is three months later. Dividend on the ex–dividend date is expected to be
Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price volatility is 30% per annum.
Risk–free rate is 9% per annum. You should
1. Exercise the option just before the stock goes 3. Not exercise the option before the stock goes
ex–dividend. ex–dividend date.
2. Exercise the option just after the stock goes
ex–dividend. 4. None of the above.
A: In this case we fi nd that

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should not be exercised before the stock
goes ex–dividend. The correct answer is number 3.
Q: An American put option on a dividend paying stock with a maturity of six months is
available for trading. Ex-dividend date is three months later. Dividend on the ex-dividend
date is expected to be Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock
price volatility is 30% per annum. Risk-fre e rate is 9% per annum. You should
1. Exercise the option just before the stock 3. Not exercise the option before the
goes ex-dividend. stock goes ex-dividend date.
2. Exercise the option just after the stock
goes ex-dividend. 4. None of the above.
A: In this case we find that

1 1
X[1-{ } = 40[1- ]=0.85
(1+r)(T-t) (1+0.09)0.25
Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should be exercised before
the stock goes ex-dividend. The correct answer is number 2.
Q: An American call option on a dividend paying stock with a maturity of three months is
available for trading. Ex-dividend date is one months later. Dividend on the ex-dividend date
. Exercise price is Rs.80. Stock price
is expected to be Rs. 5. Current share price is Rs.100
volatility is 30% per annum. Risk-free rate is 9% per annum. You should .
1. Exercise the option just before the stock 3. Not exercise the option before the
goes ex-dividend. stock goes ex-dividend date.
2. Exercise the option just after the stock
goes ex-dividend. 4. None of the above.
Q: Rahim is bullish about HLL which trades in the spot market at Rs. 1,025. He buys twenty
one-month call option contracts on HLL with a strike of 1050 at a premium of Rs. 10 per
call. A month later, HLL closes at Rs. 1,080. His profit on the position is .
1. Rs. 40,000 3. Rs. 60,0000
2. Rs. 45,000
4. Rs. 15,000
Q: A put option should always be exercised if it is sufficiently deep in-the-

money.
1. early 3. at the beginning of the trading period
2. as late as possible
4. at the close of the trading period

Chapter 10
Trading
In this chapter we shall take a brief look at the trading system for NSE’s futures and options
market. However, the best way to get a feel of the trading system is to actually watch the screen
and observe how it operates.
10.1 Futures and options trading system

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a
fully automated screen-based trading for Nifty futures & options and stock futures & options on
a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an
order driven market and provides complete transparency of trading operations. It is similar to
that of trading of equities in the cash market segment.
The software for the F&O market has been developed to facilitate efficient and transparent
trading in futures and options instruments. Keeping in view the familiarity of trading members
with the current capital market trading system, modifications have been performed in the existing
capital market trading system so as to make it suitable for trading futures and options.
10.1.1 Entities in the trading system

There are four entities in the trading system. Trading members, clearing members, professional
clearing members and participants.
1. Trading members: Trading members are members of NSE. They can trade either on their own
account or on behalf of their clients including participants. The exchange assigns a Trading member
ID to each trading member. Each trading member can have more than one user. The number of
users allowed for each trading member is notifi ed by the exchange from time to time. Each user
of a trading member must be registered with the exchange and is assigned an unique user ID. The
unique trading member ID functions as a reference for all orders/trades of different users. This ID is
common for all users of a particular trading member. It is the responsibility of the trading member
to maintain adequate control over persons having access to the fi rm’s User IDs.
2. Clearing members: Clearing members are members of NSCCL. They carry out risk management
activities and confi rmation/inquiry of trades through the trading system.
152 Trading
Figure 10.1 Market by price in NEAT F&O
3. Professional clearing members: A professional clearing members is a clearing member who is not
a trading member. Typically, banks and custodians become professional clearing members and clear
and settle for their trading members.
4. Participants: A participant is a client of trading members like fi nancial institutions. These clients
may trade through multiple trading members but settle through a single clearing member.
10.1.2 Basis of trading

The NEAT F&O system supports an order driven market, wherein orders match automatically.
Order matching is essentially on the basis of security, its price, time and quantity. All quantity
fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The
exchange notifies the regular lot size and tick size for each of the contracts traded on this segment
from time to time. When any order enters the trading system, it is an active order. It tries to find
a match on the other side of the book. If it finds a match, a trade is generated. If it does not find
a match, the order becomes passive and goes and sits in the respective outstanding order book in
the system.
10.1 Futures and options trading system 153
10.1.3 Corporate hierarchy

In the F&O trading software, a trading member has the facility of defining a hierarchy amongst
users of the system. This hierarchy comprises corporate manager, branch manager and dealer.
1. Corporate manager: The term ‘Corporate manager’ is assigned to a user placed at the highest
level in a trading fi rm. Such a user can perform all the functions such as order and trade h related
activities, receiving reports for all branches of the trading member fi rm and also all dealers of the
fi rm. Additionally, a corporate manager can defi ne exposure limits for the branches of the fi rm. This
facility is available only to the corporate manager.
2. Branch manager: The branch manager is a term assigned to a user who is placed under the corporate
manager. Such a user can perform and view order and trade related activities for all dealers under
that branch.
3. Dealer: Dealers are users at the lower most level of the hierarchy. A Dealer can perform view order
and trade related activities only for oneself and does not have access to information on other dealers
under either the same branch or other branches.
Below given cases explain activities possible for specific user categories:
1. Clearing member corporate manager: He can view outstanding orders, previous trades and net
position of his client trading members by putting the TM ID (Trading member identifi cation) and
leaving the Branch ID and and Dealer ID blank.
2. Clearing member and trading member corporate manager: He can view
(a) Outstanding orders, previous trades and net position of his client trading members by putting
the TM ID and leaving the Branch ID and the Dealer ID blank.
(b) Outstanding orders, previous trades and net positions entered for himself by entering his own
TM ID, Branch ID and User ID. This is his default screen.
(c) Outstanding orders, previous trades and net position entered for his branch by entering his TM
ID and Branch ID fi elds
(d) Outstanding orders,previous trades, and net positions entered for any of his users/dealers by
entering his TM ID, Branch ID and user ID fi elds.
3. Clearing member and trading member dealer: He can only view requests entered by him.
4. Trading member corporate manager: He can view
(a) Outstanding requests and activity log for requests entered by him by entering his own Branch
and User IDs. This is his default screen.
(b) Outstanding requests entered by his dealers and/or branch managers by either entering the
Branch and/or User IDs or leaving them blank.
5. Trading member branch manager: He can view
(a) Outstanding requests and activity log for requests entered by him by entering his own Branch
and User IDs. This is his default screen.
154 Trading
Figure 10.2 Security/contract/portfolio entry screen in NEAT F&O
(b) Outstanding requests entered by his users either by fi lling the User ID fi eld with a specifi c user
or leaving the User ID fi eld blank.
6. Trading member dealer: He can only view requests entered by him.
10.1.4 Order types and conditions

The system allows the trading members to enter orders with various conditions attached to them
as per their requirements. These conditions are broadly divided into the following categories:
Time conditions
Price conditions
Other conditions
Several combinations of the above are allowed thereby providing enormous flexibility to the
users. The order types and conditions are summarized below.
Time conditions
10.2 The trader workstation 155
– Day order: A day order, as the name suggests is an order which is valid for the day on
which it is entered. If the order is not executed during the day, the system cancels the order
automatically at the end of the day.
– Good till canceled(GTC): A GTC order remains in the system until the user cancels it.
Consequently, it spans trading days, if not traded on the day the order is entered. The maximum
number of days an order can remain in the system is notifi ed by the exchange from time to time
after which the order is automatically cancelled by the system. Each day counted is a calendar
day inclusive of holidays. The days counted are inclusive of the day on which the order is
placed and the order is cancelled from the system at the end of the day of the expiry period.
– Good till days/date(GTD): A GTD order allows the user to specify the number of days/date till
which the order should stay in the system if not executed. The maximum days allowed by the
system are the same as in GTC order. At the end of this day/date, the order is cancelled from
the system. Each day/date counted are inclusive of the day/date on which the order is placed
and the order is cancelled from the system at the end of the day/date of the expiry period.
– Immediate or Cancel(IOC): An IOC order allows the user to buy or sell a contract as soon
as the order is released into the system, failing which the order is cancelled from the system.
Partial match is possible for the order, and the unmatched portion of the order is cancelled
immediately.
Price condition
– Stop– loss: This facility allows the user to release an order into the system, after the market
price of the security reaches or crosses a threshold price e.g. if for stop–loss buy order, the
trigger is 1027.00, the limit price is 1030.00 and the market(last traded) price is 1023.00, then
this order is released into the system once the market price reaches or exceeds 1027.00. This
order is added to the regular lot book with time of triggering as the time stamp, as a limit order
of 1030.00. For the stop–loss sell order, the trigger price has to be greater than the limit price.
Other conditions
– Market price: Market orders are orders for which no price is specifi ed at the time the order is
entered (i.e. price is market price). For such orders, the system determines the price.
– Trigger price: Price at which an order gets triggered from the stop–loss book.
– Limit price: Price of the orders after triggering from stop–loss book.
– Pro: Pro means that the orders are entered on the trading member’s own account.
– Cli: Cli means that the trading member enters the orders on behalf of a client.
10.2 The trader workstation
10.2.1 The market watch window

The following windows are displayed on the trader workstation screen.
Title bar
Ticker window of futures and options market

156 Trading
Ticker window of underlying(capital) market

Tool bar
Market watch window
Inquiry window
Snap quote
Order/trade window
System message window
As mentioned earlier, the best way to familiarize oneself with the screen and its various
segments is to actually spend some time studying a live screen. In this section we shall restrict
ourselves to understanding just two segments of the workstation screen, the market watch
window and the inquiry window.
The market watch window is the third window from the top of the screen which is always
visible to the user. The purpose of market watch is to allow continuous monitoring of contracts
or securities that are of specific interest to the user. It displays trading information for contracts
selected by the user. The user also gets a broadcast of all the cash market securities on the screen.
This function also will be available if the user selects the relevant securities for display on the
market watch screen. Display of trading information related to cash market securities will be on
“Read only ” format,i.e. the dealer can only view the information on cash market but, cannot
trade in them through the system. This is the main window from the dealer’s perspective.
10.2.2 Inquiry window

The inquiry window enables the user to view information such as Market by Order(MBO),
Market by Price(MBP), Previous Trades(PT), Outstanding Orders(OO), Activity log(AL), Snap
Quote(SQ), Order Status(OS), Market Movement(MM), Market Inquiry(MI), Net Position, On
line backup, Multiple index inquiry, Most active security and so on. Relevant information for the
selected contract/security can be viewed. We shall look in detail at the Market by Price(MBP)
and the Market Inquiry(MI) screens.
1. Market by order(MBO): The purpose of the MBO is to enable the user to view passive orders in
the trading books in the order of price/time priority for a selected security. The F5 key invokes the
selection window for MBO. If a particular contract or security is selected, the details of the selected
contract or security defaults in the selection screen or else the current position in market watch
defaults. Details of contract or security in the selection screen can also be defaulted from the last
action. One can select the security from the contract list or from the last operation. The fi elds that
are available on the selection screen are instrument, symbol, expiry and book type. The instrument
type, symbol, expiry and book type fi elds are compulsory.
2. Market by price(MBP): The purpose of the MBP is to enable the user to view passive orders in the
market aggregated at each price and are displayed in oder of best prices. The window can be invoked
by pressing the [F6] key. If a particular contract or security is selected, the details of the selected
contract or security can be seen on this screen.
10.2 The trader workstation 157
Figure 10.3 Market spread/combination order entry
3. Market inquiry(MI): The market inquiry screen can be invoked by using the [F11] key. If a particular
contract or security is selected, the details of the selected contract or selected security defaults in
the selection screen or else the current position in the market watch defaults. The fi rst line of the
screen gives the Instrument type, symbol, expiry, contract status, total traded quantity, life time high
and life time low. The second line displays the closing price, open price, high price, low price, last
traded price and indicator for net change from closing price. The third line displays the last traded
quantity, last traded time and the last traded date. The fourth line displays the closing open interest,
the opening open interest, day high open interest, day low open interest, current open interest, life
time high open interest, life time low open interest and net change from closing open interest. The
fi fth line display very important information, namely the carrying cost in percentage terms.
10.2.3 Placing orders on the trading system

For both the futures and the options market,while entering orders on the trading system, members
are required to identify orders as being proprietary or client orders. Proprietary orders should be
identified as ‘Pro’ and those of clients should be identified as ‘Cli’. Apart from this, in the case
of ‘Cli’ trades, the client account number should also be provided.
158 Trading
The futures market is a zero sum game i.e. the total number of long in any contract
always equals the total number of short in any contract. The total number of outstanding
contracts(long/short) at any point in time is called the “Open interest”. This Open interest figure
is a good indicator of the liquidity in every contract. Based on studies carried out in international
exchanges, it is found that open interest is maximum in near month expiry contracts.
10.2.4 Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination trades. Figure 10.3
shows the spread/combination screen. This enables the user to input two or three orders
simultaneously into the market. These orders will have the condition attached to it that unless
and until the whole batch of orders finds a countermatch, they shall not be traded. This facilitates
spread and combination trading strategies with minimum price risk.
10.2.5 Basket trading

In order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced
basket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generation
of portfolio offline order files in the derivatives trading system and its execution in the cash
segment. A trading member can buy or sell a portfolio through a single order, once he determines
its size. The system automatically works out the quantity of each security to be bought or sold in
proportion to their weights in the portfolio.
10.3 Futures and options market instruments

The F&O segment of NSE provides trading facilities for the following derivative instruments:
1. Index based futures
2. Index based options
3. Individual stock options
4. Individual stock futures
10.3.1 Contract specifi cations for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-month expiry cycles.
All contracts expire on the last Thursday of every month. Thus a January expiration contract
would expire on the last Thursday of January and a February expiry contract would cease trading
on the last Thursday of February. On the Friday following the last Thursday, a new contract
having a three-month expiry would be introduced for trading. Thus, as shown in Figure 10.5 at
any point in time, three contracts would be available for trading with the first contract expiring
on the last Thursday of that month. Depending on the time period for which you want to take an
10.3 Futures and options market instruments 159
Figure 10.4 Portfolio offline order entry for basket trades
exposure in index futures contracts, you can place buy and sell orders in the respective contracts.
All index futures contracts on NSE’s futures trading system are coded as shown in Table 10.1.
The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY denotes
a “Futures contract on Nifty index” and the Expiry date represents the last date on which the
contract will be available for trading. Each futures contract has a separate limit order book. All
passive orders are stacked in the system in terms of price-time priority and trades take place at
the passive order price(similar to the existing capital market trading system). The best buy order
for a given futures contract will be the order to buy the index at the highest index level whereas
the best sell order will be the order to sell the index at the lowest index level.
Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, then
the appropriate value of a single index futures contract would be Rs.200,000. The minimum tick
size for an index future contract is 0.05 units. Thus a single move in the index value would imply
a resultant gain or loss of Rs.10.00(i.e. 0.05*200 units) on an open position of 200 units.
Table 10.1 gives the contract specifications for Nifty futures.

160 Trading
Figure 10.5 Contract cycle

The fi gure shows the contract cycle for futures contracts on NSE’s derivatives market. As can be seen, at any given
point of time, three contracts are available for trading – a near-month, a middle-month and a far-month. As the
January contract expires on the last Thursday of the month, a new three-month contract starts trading from the
following day, once more making available three index futures contracts for trading.
Jan Feb Mar Apr
Time
Jan 30 contract
Feb 27 contract
Mar 27 contract
Apr 24 contract
May 29 contract
Jun 26 contract
Table 10.1 Contract specification: S&P CNX Nifty Futures

Underlying index S&P CNX Nifty
Exchange of trading National Stock Exchange of India Limited
Security descriptor N FUTIDX NIFTY
Contract size Permitted lot size shall be 200 and multiples thereof
(minimum value Rs.2 lakh)
Price steps Re. 0.05
Price bands Not applicable
Trading cycle The futures contracts will have a maximum of three
month trading cycle - the near month(one), the next
month(two) and the far month(three). New contract will be
introduced on the next trading day following the expiry of
near month contract.
Expiry day The last Thursday of the expiry month or the
previous trading day if the last Thursday is a trading holiday.
Settlement basis Mark to market and fi nal settlement will be
cash settled on T+1 basis.
Settlement price Daily settlement price will be the closing
price of the futures contracts for the trading day and the
fi nal settlement price shall be the closing value of the
underlying index on the last trading day.
10.3.2 Contract specifi cation for index options

On NSE’s index options market, contracts at different strikes, having one-month, two-month and
three-month expiry cycles are available for trading. There are typically one-month, two-month
Table 10.2 Contract specification: S&P CNX Nifty Options

Underlying index S&P CNX Nifty
Security descriptor N OPTIDX NIFTY
Contract size Permitted lot size shall be 200 and multiples thereof
(minimum value Rs.2 lakh)
Trading cycle The options contracts will have a maximum of three
Settlement basis Cash settlement on T+1 basis.
Style of option European.
Strike price interval Rs.20
Daily settlement price Premium value(net)
Final settlement price Closing value of the index on the last
trading day.
and three-month options, each with five different strikes available for trading. Hence at a given
point in time there are minimum or 30 options products. Option contracts are specified

$
as follows: DATE-EXPIRYMONTH-YEAR-CALL/PUT-AMERICAN/EUROPEAN-STRIKE.
For example the European style call option contract on the Nifty index with a strike price of
1040 expiring on the 28th June 2001 is specified as ‘28 JUN 2001 1040 CE’.
Just as in the case of futures contracts, each option product(for instance, the 28 JUN 2001
1040 CE) has it’s own order book and it’s own prices. All index options contracts are cash settled
and expire on the last Thursday of the month. The clearing corporation does the novation. Just
as in the case of futures, trading is in minimum market lot size of 200 units. The minimum tick
for an index options contract is 0.05 paise. Table 10.2 gives the contract specifications for Nifty
options.
Generation of strikes
Let us look at an example of how the various option strikes are generated by the exchange.
Suppose we start with Nifty at 1500 and options with strikes 1460, 1480, 1500, 1520, 1540.
The exchange commits itself to an inter–strike distance of say 20.
When the Nifty closing price crosses 1520, a new set of strikes at 1560 start trading from the next
day.
162 Trading
Table 10.3 Contract specification: Stock futures

Underlying Individual securities
Security descriptor N FUTSTK
Contract size 100 or multiples there of(minimum value of Rs.2 lakh)
Trading cycle The futures contracts will have a maximum of three
Settlement basis Mark to market and fi nal settlement will be
cash settled on T+1 basis.
Settlement price Daily settlement price will be the closing
price of the futures contracts for the trading day and the
fi nal settlement price shall be the closing price of the
underlying security on the last trading day.
When the Nifty closing price falls below 1480, a new set of strikes at 1440 start trading from the next
day.
10.3.3 Contract specifi cations for stock futures

Trading in stock futures commenced on the NSE from November 2001. These contracts are
cash settled on a T+1 basis. The expiration cycle for stock futures is the same as for index
futures,index options and stock options. A new contract is introduced on the trading day
following the expiry of the near month contract. Table 10.3 gives the contract specifications
for stock futures.
10.3.4 Contract specifi cations for stock options

Trading in stock options commenced on the NSE from July 2001. These contracts are American
style and are settled in cash. The expiration cycle for stock options is the same as for index futures
and index options. A new contract is introduced on the trading day following the expiry of the
near month contract. NSE provides a minimum of five strike prices for every option type(i.e. call
and put) during the trading month. There are at least two in–the–money contracts, two out–of–
the–money contracts and one at–the–money contract available for trading. Table 10.4 gives the
contract specifications for stock options.
Table 10.4 Contract specification: Stock options

Underlying Individual securities available
for trading in cash market
Security descriptor N OPTSTK
Style of option American.
Strike price interval Between Rs.2.5 and Rs.100 depending
on the price of the underlying
Contract size 100 or multiples thereof(minimum value of Rs.2 lakh)
Trading cycle The options contracts will have a maximum of three
Settlement basis Daily settlement on T+1 basis and fi nal
option exercise settlement on T+3 basis
Daily settlement price Premium value(net)
Final settlement price Closing price of underlying on exercise
day or expiry day
Settlement day Last trading day
Criteria for stocks eligible for options trading

The following criteria will have to be met before a stock can be considered eligible for options
trading.
The stock should be amongst the top 200 scrips, on the basis of average market capitalization during
the last six months and the average free float market capitalization should not be less than Rs.750
crore. The free float market capitalization means the non–promoter holding in the stock. The non–
promoter holding in the company should be at least 30%.
The stock should be amongst the top 200 scrips on the basis of average daily volume(in value terms),
during the last six months. Further, the average daily volume should not be less than Rs.5 crore in
the underlying cash market.
The stock should be traded on at least 90% of the trading days in the last six months.
The ratio of the daily volatility of the stock vis-a-vis the daily volatility of the index should not be
more than 4, at any time during the previous six months.
Based on these criteria, SEBI approved trading in option contracts on 31 stocks.

164 Trading
10.4 Charges
The maximum brokerage chargeable by a TM in relation to trades effected in the contracts

admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value in
case of index futures and 2.5% of notional value of the contract[(Strike price + Premium)
* Quantity] in case of index options, exclusive of statutory levies. The transaction charges
payable by a TM for the trades executed by him on the F&O segment are fixed at Rs.2 per
lakh of turnover(0.002%)(each side) or Rs.1 lakh annually, whichever is higher. The TMs
contribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per crore of
turnover(0.0001%)(each side).
Solved problems
Q: The best buy order for a given futures contract is the order to buy the index at the
1. Highest price 3. Lowest price
2. Average of the highest and lowest price 4. None of the above
A: The best buy order for a given futures contract is the order to buy the index at the highest price whereas
the best sell order is the order to sell the index at the lowest price. The correct answer is number 1.
Q: The F&O segment of NSE provides trading facilities for the following derivative instruments:
1. Index based futures 3. Individual stock options
2. Index based options 4. All the above
A: The F&O segment of NSE provides trading facilities for index based futures, index based options,
individual stock options and individual stock futures. The correct answer is number 4.
Q: At any given time, the F&O segment of NSE provides trading facilities for Nifty futures
contracts.
1. Two 3. Nine
2. Three 4. None of the above
A: At any given time NSE trades three Nifty futures contracts having one–month, two–month and three–
month expiry cycles. The correct answer is number 2.
10.4 Charges 165
Q: The maximum brokerage chargeable by a trading member in relation to trades effected in the contracts
on the F&O segment of NSE is fi xed at of the contract value, exclusive of statutory levies.
1. 1.5% 3. 2.0%
2. 1% 4. 2.5%
Q: All futures and options contracts expire on the
1. Last Friday of the month 3. Last Tuesday of the month
2. Last Thursday of the month 4. None of the above
A: All futures and options contracts expire on the last Thursday of the month. The correct answer is
number 2.
Q: The NEAT-F&O trading system supports an
1. Order driven market 3. Demand driven market
2. Price driven market 4. None of the above
A: The NEAT-F&O trading system supports an order driven market. The correct answer is number 1.
Q: On the NSE’s NEAT-F&O system, matching of trades takes place at the
1. Active order price 3. Market price
2. Passive order price 4. None of the above
A: All passive orders will be stacked in the system in terms of price-time priority and trades will take
place at the passive order price(similar to the existing capital market trading system). The correct answer
is number 2.
Q: On 26th January, the Nifty index stands at 1250. The value of a single index futures contract is
1. Rs.125,000 3. Rs.500,000
2. Rs.250,000 4. Rs.200,000
A: Futures trading is for a minimum lot size of 200 units. Thus if the index level is around 1250, then the
appropriate value of a single index futures contract would be Rs.250,000. The correct answer is number
2.
166 Trading
Q: All options contracts expire on the
1. Last Friday of the month 3. Last Tuesday of the month
2. Last Thursday of the month 4. None of the above
A: All options contracts will expire on the last Thursday of the month. The correct answer is number 2.
Q: New options contracts are introduced on the
1. First trading day of the month 3. Last Wednesday of the month
4. On the next trading day following the expiry

2. Last Thursday of the month of near month contract.
A: New options contracts are introduced on the next trading day following the expiry of near month
contract. The correct answer is number 4.
Q: The unique trading member ID is
1. Common for all users of a particular trading 2. Different for all users of a particular trading
member. member.
A: Each user of a trading member must be registered with the exchange and is assigned an unique user
ID. The unique trading member ID functions as a reference for all orders/trades of different users. This
ID is common for all users of a particular trading member. The correct answer is number 1.
Q: A Corporate manager can
1. Perform order and trade related activities 4. Can defi ne exposure limits for the branches of
the fi rm.
2. Receive reports for all branches of the trading
member fi rm
3. Receive reports for all dealers of the fi rm 5. All of the above
Q: A dealer can view
1. Outstanding orders, previous trades and net 3. Outstanding orders, previous trades and net
position of the trading member. position entered for his branch.
2. Requests entered by him. 4. None of the above

Chapter 11
Clearing and settlement
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement
of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal
counterparty to all trades on the F&O segment and guarantees their financial settlement.
11.1 Clearing entities

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help
of the following entities:
11.1.1 Clearing members

In the F&O segment, some members, called self clearing members, clear and settle their trades
executed by them only either on their own account or on account of their clients. Some
others, called trading member–cum–clearing member, clear and settle their own trades as well
as trades of other trading members(TMs). Besides, there is a special category of members,
called professional clearing members (PCM) who clear and settle trades executed by TMs. The
members clearing their own trades and trades of others, and the PCMs are required to bring in
additional security deposits in respect of every TM whose trades they undertake to clear and
settle.
11.1.2 Clearing banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearing
members are required to open a separate bank account with NSCCL designated clearing bank
for F&O segment. The Clearing and Settlement process comprises of the following three main
activities:
1. Clearing
2. Settlement
168 Clearing and settlement
Table 11.1 Proprietary position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The table
shows his proprietary position. Note: A buy position “200@1000”means 200 units bought at the rate of Rs.1000.
Trading member Madanbhai

Buy Sell
Proprietary position 200@1000 400@1010
Table 11.2 Client position of trading member Madanbhai on Day 1

shows his client position.

Buy Open Sell Close Sell Open Buy Close
Client position
Client A 400@1109 200@1000
Client B 600@1100 200@1099
3. Risk Management
11.2 Clearing mechanism

The clearing mechanism essentially involves working out open positions and obligations of
clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is
considered for exposure and daily margin purposes. The open positions of CMs are arrived at by
aggregating the open positions of all the TMs and all custodial participants clearing through him,
in contracts in which they have traded. A TM’s open position is arrived at as the summation of
his proprietary open position and clients’ open positions, in the contracts in which he has traded.
While entering orders on the trading system, TMs are required to identify the orders, whether
proprietary (if they are their own trades) or client (if entered on behalf of clients) through ‘Pro/
Cli’ indicator provided in the order entry screen. Proprietary positions are calculated on net
basis(buy - sell) for each contract. Clients’ positions are arrived at by summing together net (buy
- sell) positions of each individual client. A TM’s open position is the sum of proprietary open
position, client open long position and client open short position.
Consider the following example given from Table 11.1 to Table 11.4. The proprietary open
position on day 1 is simply = Buy - Sell = 200 - 400 = 200 short. The open position for client A
= Buy(O) - Sell(C) = 400 - 200 = 200 long, i.e. he has a long position of 200 units. The open
position for Client B = Sell(O) - Buy(C) = 600 - 200 = 400 short, i.e. he has a short position
11.3 Settlement mechanism 169
Table 11.3 Proprietary position of trading member Madanbhai on Day 2

Assume that the position on Day 1 is carried forward to the next trading day and the following trades are also
executed.

Buy Sell
Proprietary position 200@1000 400@1010
Table 11.4 Client position of trading member Madanbhai on Day 2

shows his client position on Day 2.

Buy Open Sell Close Sell Open Buy Close
Client position
Client A 400@1109 200@1000
Client B 600@1100 400@1099
of 400 units. Now the total open position of the trading member Madanbhai at end of day 1
is 200(his proprietary open position on net basis) plus 600(the Client open positions on gross
basis), i.e. 800.
The proprietary open position at end of day 1 is 200 short. The end of day open position for
proprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position at
the end of day 2 is 400 short. Similarly, Client A’s open position at the end of day 1 is 200 long.
The end of day open position for trades done by Client A on day 2 is 200 long. Hence the net
open position for Client A at the end of day 2 is 400 long. Client B’s open position at the end
of day 1 is 400 short. The end of day open position for trades done by Client B on day 2 is 200
short. Hence the net open position for Client B at the end of day 2 is 600 short. The net open
position for the trading member at the end of day 2 is sum of the proprietary open position and
client open positions. It works out to be 400 + 400 + 600, i.e. 1400.
The following table illustrates determination of open position of a CM, who clears for two
TMs having two clients.
11.3 Settlement mechanism

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying
for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have
to be settled in cash. Futures and options on individual securities can be delivered as in the spot
Table 11.5 Determination of open position of a clearing member

TMs clearing Proprietary trades Trades: Client 1 Trades: Client 2 Open position
through CM
Buy Sell Net Buy Sell Net Buy Sell Net Long Short
ABC 4000 2000 2000 3000 1000 2000 4000 2000 2000 6000 -
PQR 2000 3000 (1000) 2000 1000 1000 1000 2000 (1000) 1000 2000
Total 6000 5000 +2000 5000 2000 +3000 5000 4000 +2000 7000 2000
-1000 -1000
market. However, it has been currently mandated that stock options and futures would also be
cash settled. The settlement amount for a CM is netted across all their TMs/clients, with respect
to their obligations on MTM, premium and exercise settlement.
11.3.1 Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last trading
day of the futures contract.
MTM settlement:
All futures contracts for each member are marked-to-market(MTM) to the daily settlement price
of the relevant futures contract at the end of each day. The profits/losses are computed as the
difference between:
1. The trade price and the day’s settlement price for contracts executed during the day but not squared
up.
2. The previous day’s settlement price and the current day’s settlement price for brought forward
contracts.
3. The buy price and the sell price for contracts executed during the day and squared up.
Table 11.6 explains the MTM calculation for a member. The settlement price for the contract
for today is assumed to be 105.
The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount in
cash which is in turn passed on to the CMs who have made a MTM profit. This is known
as daily mark-to-market settlement. CMs are responsible to collect and settle the daily MTM
profits/losses incurred by the TMs and their clients clearing and settling through them. Similarly,
TMs are responsible to collect/pay losses/ profits from/to their clients by the next day. The pay-in
and pay-out of the mark-to-market settlement are effected on the day following the trade day. In
case a futures contract is not traded on a day, or not traded during the last half hour, a ‘theoretical
settlement price’ is computed as per the following formula:
Table 11.6 Computation of MTM at the end of the day

The table gives the MTM charged on various positions. The margin charged on the brought forward contract is the
difference between the previous day’s settlement price of Rs.100 and today’s settlement price of Rs.105. Hence on
account of the position brought forward, the MTM shows a profi t of Rs.500. For contracts executed during the day,
the difference between the buy price and the sell price determines the MTM. In this example, 200 units are bought
@ Rs.100 and 100 units sold @ Rs.102 during the day. Hence the MTM for the position closed during the day shows
a profi t of Rs.200. Finally, the open position of contracts traded during the day, is margined at the day’s settlement
price and the profi t of Rs.500 credited to the MTM account. So the MTM account shows a profi t of Rs.1200.
Trade details Quantity bought/sold Settlement price MTM

Brought forward
from previous day 100@100 105 500
Traded during day

Bought 200@100
Sold 100@102 102 200
Open position 100@100 105 500

(not squared up)
Total 1200
F S

where:
F Theoretical futures price
S Value of the underlying index
r Cost of fi nancing(using continuously compounded interest rate) or rate of interest(MIBOR)
e 2.71828
After completion of daily settlement computation, all the open positions are reset to the daily
settlement price. Such positions become the open positions for the next day.
Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all
positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final
settlement loss/profit amount is debited/ credited to the relevant CM’s clearing bank account on
the day following expiry day of the contract.
Settlement prices for futures
Daily settlement price on a trading day is the closing price of the respective futures contracts
on such day. The closing price for a futures contract is currently calculated as the last half an
hour weighted average price of the contract in the F&O Segment of NSE. Final settlement price
is the closing price of the relevant underlying index/security in the capital market segment of
NSE, on the last trading day of the contract. The closing price of the underlying Index/security
is currently its last half an hour weighted average value in the capital market segment of NSE.
11.3.2 Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise settlement,
interim exercise settlement in the case of option contracts on securities and final settlement.
Daily premium settlement
Buyer of an option is obligated to pay the premium towards the options purchased by him.
Similarly, the seller of an option is entitled to receive the premium for the option sold by him.
The premium payable amount and the premium receivable amount are netted to compute the net
premium payable or receivable amount for each client for each option contract.
Exercise settlement
Although most option buyers and sellers close out their options positions by an offsetting closing
transaction, an understanding of exercise can help an option buyer determine whether exercise
might be more advantageous than an offsetting sale of the option. There is always a possibility
of the option seller being assigned an exercise. Once an exercise of an option has been assigned
to an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash
settlement amount in the case of a cash-settled option) even though he may not yet have been
notified of the assignment.
Interim exercise settlement
Interim exercise settlement takes place only for option contracts on securities. An investor can
exercise his in-the-money options at any time during trading hours, through his trading member.
Interim exercise settlement is effected for such options at the close of the trading hours, on the
day of exercise. Valid exercised option contracts are assigned to short positions in the option
contract with the same series (i.e. having the same underlying, same expiry date and same strike
price), on a random basis, at the client level. The CM who has exercised the option receives the
exercise settlement value per unit of the option from the CM who has been assigned the option
contract.
Final exercise settlement
Final exercise settlement is effected for all open long in–the–money strike price options existing
at the close of trading hours, on the expiration day of an option contract. All such long positions
are exercised and automatically assigned to short positions in option contracts with the same
series, on a random basis. The investor who has long in–the–money options on the expiry date
will receive the exercise settlement value per unit of the option from the investor who has been
assigned the option contract.
Exercise process
The period during which an option is exercisable depends on the style of the option. On NSE,
index options are European style, i.e. options are only subject to automatic exercise on the
expiration day, if they are in–the–money. As compared to this, options on securities are American
style. In such cases, the exercise is automatic on the expiration day, and voluntary prior to
the expiration day of the option contract, provided they are in–the–money. Automatic exercise
means that all in–the–money options would be exercised by NSCCL on the expiration day of the
contract. The buyer of such options need not give an exercise notice in such cases. Voluntary
exercise means that the buyer of an in–the–money option can direct his TM/CM to give exercise
instructions to NSCCL. In order to ensure that an option is exercised on a particular day, the
buyer must direct his TM to exercise before the cut-off time for accepting exercise instructions
for that day. Usually, the exercise orders will be accepted by the system till the close of trading
hours. Different TMs may have different cut–off times for accepting exercise instructions from
customers, which may vary for different options. An option, which expires unexercised becomes
worthless. Some TMs may accept standing instructions to exercise, or have procedures for the
exercise of every option, which is in–the–money at expiration. Once an exercise instruction is
given by a CM to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer
at anytime on a day are processed by NSCCL after the close of trading hours on that day. All
exercise notices received by NSCCL from the NEAT F&O system are processed to determine
their validity. Some basic validation checks are carried out to check the open buy position of the
exercising client/TM and if option contract is in–the–money. Once exercised contracts are found
valid, they are assigned.
Assignment process
The exercise notices are assigned in standardized market lots to short positions in the option
contract with the same series (i.e. same underlying, expiry date and strike price) at the client
level. Assignment to the short positions is done on a random basis. NSCCL determines short
positions, which are eligible to be assigned and then allocates the exercised positions to any one
or more short positions. Assignments are made at the end of the trading day on which exercise
instruction is received by NSCCL and notified to the members on the same day. It is possible
that an option seller may not receive notification from its TM that an exercise has been assigned
to him until the next day following the date of the assignment to the CM by NSCCL.
Exercise settlement computation

In case of index option contracts, all open long positions at in–the–money strike prices are
automatically exercised on the expiration day and assigned to short positions in option contracts
with the same series on a random basis. For options on securities, where exercise settlement
may be interim or final, interim exercise for an open long in–the–money option position can
be effected on any day till the expiry of the contract. Final exercise is automatically effected
by NSCCL for all open long in–the–money positions in the expiring month option contract, on
the expiry day of the option contract. The exercise settlement price is the closing price of the
underlying(index or security) on the exercise day(for interim exercise) or the expiry day of the
relevant option contract(final exercise). The exercise settlement value is the difference between
the strike price and the final settlement price of the relevant option contract. For call options,
the exercise settlement value receivable by a buyer is the difference between the final settlement
price and the strike price for each unit of the underlying conveyed by the option contract, while
for put options it is difference between the strike price and the final settlement price for each
unit of the underlying conveyed by the option contract. Settlement of exercises of options on
securities is currently by payment in cash and not by delivery of securities. It takes place for
in-the-money option contracts.
The exercise settlement value for each unit of the exercised contract is computed as follows:
Call options Closing price of the security on the day of exercise
Strike price
Put options Strike price
Closing price of the security on the day of exercise
For final exercise the closing price of the underlying security is taken on the expiration day
The exercise settlement by NSCCL would ordinarily take place on 3rd day following the day of
exercise. Members may ask for clients who have been assigned to pay the exercise settlement
value earlier.
Special facility for settlement of institutional deals

NSCCL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/Mutual
Funds etc. to execute trades through any TM, which may be cleared and settled by their own CM.
Such entities are called custodial participants (CPs). To avail of this facility, a CP is required to
register with NSCCL through his CM. A unique CP code is allotted to the CP by NSCCL. All
trades executed by a CP through any TM are required to have the CP code in the relevant field
on the trading system at the time of order entry. Such trades executed on behalf of a CP are
confirmed by their own CM (and not the CM of the TM through whom the order is entered),
within the time specified by NSE on the trade day though the on-line confirmation facility. Till
such time the trade is confirmed by CM of concerned CP, the same is considered as a trade
of the TM and the responsibility of settlement of such trade vests with CM of the TM. Once
confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of deals
of such custodial clients. FIIs have been permitted to trade in all the exchange traded derivative
11.4 Risk management 175
contracts subject to compliance of the position limits prescribed for them and their sub-accounts,
and compliance with the prescribed procedure for settlement and reporting. A FII/a sub-account
of the FII, as the case may be, intending to trade in the F&O segment of the exchange, is required
to obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FIIs/sub–accounts
of FIIs which have been allotted a unique CP code by NSCCL are only permitted to trade on
the F&O segment. The FII/sub–account of FII ensures that all orders placed by them on the
Exchange carry the relevant CP code allotted by NSCCL.
11.4 Risk management

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The
salient features of risk containment mechanism on the F&O segment are:
1. The fi nancial soundness of the members is the key to risk management. Therefore, the requirements
for membership in terms of capital adequacy (net worth, security deposits) are quite stringent.
2. NSCCL charges an upfront initial margin for all the open positions of a CM. It specifi es the initial
margin requirements for each futures/options contract on a daily basis. It also follows value-at-
risk(VaR) based margining through SPAN. The CM in turn collects the initial margin from the TMs
and their respective clients.
3. The open positions of the members are marked to market based on contract settlement price for each
contract. The difference is settled in cash on a T+1 basis.
4. NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis.
Limits are set for each CM based on his capital deposits. The on-line position monitoring system
generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the
CMs for MTM value violation, while TMs are monitored for contract-wise position limit violation.
5. CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs
clearing and settling through him. A CM may set exposure limits for a TM clearing and settling
through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and
whenever a TM exceed the limits, it stops that particular TM from further trading.
6. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.
Position violations result in withdrawal of trading facility for all TMs of a CM in case of a violation
by the CM.
7. A separate settlement guarantee fund for this segment has been created out of the capital of members.
The fund had a balance of Rs. 648 crore at the end of March 2002.
The most critical component of risk containment mechanism for F&O segment is the
margining system and on-line position monitoring. The actual position monitoring and
margining is carried out on–line through Parallel Risk Management System (PRISM). PRISM
uses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of computation of
on-line margins, based on the parameters defined by SEBI.
11.4.1 NSE–SPAN
The objective of NSE–SPAN is to identify overall risk in a portfolio of all futures and options
contracts for each member. The system treats futures and options contracts uniformly, while
at the same time recognizing the unique exposures associated with options portfolios, like
extremely deep out–of–the–money short positions and inter–month risk. Its over–riding objective
is to determine the largest loss that a portfolio might reasonably be expected to suffer from one
day to the next day based on 99% VaR methodology. SPAN considers uniqueness of option
portfolios. The following factors affect the value of an option:
1. Underlying market price
2. Strike price
3. Volatility(variability) of underlying instrument
4. Time to expiration
5. Interest rate
As these factors change, the value of options maintained within a portfolio also changes.
Thus, SPAN constructs scenarios of probable changes in underlying prices and volatilities in
order to identify the largest loss a portfolio might suffer from one day to the next. It then sets
the margin requirement to cover this one–day loss. The complex calculations(e.g. the pricing of
options) in SPAN are executed by NSCCL. The results of these calculations are called risk arrays.
Risk arrays, and other necessary data inputs for margin calculation are provided to members
daily in a file called the SPAN risk parameter file. Members can apply the data contained in
the risk parameter files, to their specific portfolios of futures and options contracts, to determine
their SPAN margin requirements. Hence, members need not execute complex option pricing
calculations, which is performed by NSCCL. SPAN has the ability to estimate risk for combined
futures and options portfolios, and also re–value the same under various scenarios of changing
market conditions.
11.4.2 Margins
The margining system for F&O segment is explained below:
Initial margin: Margin in the F&O segment is computed by NSCCL upto client level for open
positions of CMs/TMs. These are required to be paid up-front on gross basis at individual client
level for client positions and on net basis for proprietary positions. NSCCL collects initial margin
for all the open positions of a CM based on the margins computed by NSE-SPAN. A CM is required
to ensure collection of adequate initial margin from his TMs up-front. The TM is required to collect
adequate initial margins up-front from his clients.
Premium margin: In addition to initial margin, premium margin is charged at client level. This
margin is required to be paid by a buyer of an option till the premium settlement is complete.
Assignment margin for options on securities: Assignment margin is levied in addition to initial
margin and premium margin. It is required to be paid on assigned positions of CMs towards
interim and fi nal exercise settlement obligations for option contracts on individual securities, till
such obligations are fulfi lled. The margin is charged on the net exercise settlement value payable by
a CM towards interim and fi nal exercise settlement.
Client margins: NSCCL intimates all members of the margin liability of each of their client.
Additionally members are also required to report details of margins collected from clients to NSCCL,
which holds in trust client margin monies to the extent reported by the member as having been
collected form their respective clients.
11.4.3 Margin/position limit violations

PRISM generates various alerts whenever a CM exceeds any limits set up by NSCCL. These are
detailed below:
Initial margin violation: Initial margin limits are set by NSCCL for each CM based on the collateral
deposited by the CM in accordance with SEBI recommendations. CMs are provided a F&O clearing
member terminal for the purpose of monitoring the open positions of all the TMs and/or CPs clearing
and settling through him. A CM may also set initial margin limits for a TM clearing and settling
through him. NSCCL assists a CM to monitor the intra-day initial margin limits. Whenever a TM
exceeds the limits, his trading facility is withdrawn. Initial margin on positions taken by a CM is
computed on a real time basis, i.e. for each trade. The initial margin amount is reduced from the
effective deposits of a CM with NSCCL. As the effective deposit is used up to 70%, 80%, and 90%,
the member receives a warning message on his terminal. Once it is used 100%, the clearing facility
provided to a CM is automatically withdrawn. The liquid net worth of a CM at any point of time
should not be less than Rs.50 lakh. Withdrawal of clearing facility of a CM in case of a violation leads
to automatic withdrawal of trading facility for all TMs and/or CPs clearing and settling through such
CM. Similarly, the initial margin on positions taken by a TM is also computed on a real time basis
and compared with the TM initial margin limits set by his CM. The initial margin amount is reduced
from the TM initial margin limit set by a CM. As the TM limit is used up to 70%, 80%, and 90%,
the member receives a warning message on his terminal. Once it is used 100%, the trading facility
provided to the TM is automatically withdrawn. A member is provided with adequate warnings on
the violation before his trading/clearing facility is withdrawn. A CM may appropriately reduce his
exposure to contain the violation or alternately bring in additional capital.
Member-wise position limit violation: The member-wise position limit check is carried out by
PRISM on open position of a TM. The open position in all index futures and index option contracts
of any TM, cannot exceed 15% of the total open interest of the market or Rs. 100 crore, whichever
is higher at any time, including during trading hours. The open positions in all the futures and option
contracts on the same underlying security of any TM, cannot exceed 7.5% of the total open interest
of the market or Rs. 50 crore, whichever is higher, at any time, including during trading hours. For
futures contracts, open interest is equivalent to the open positions in the futures contract multiplied
by last available traded price or closing price, as the case may be. For option contracts, open interest
is equivalent to the notional value which is computed by multiplying the open position in that option
contract multiplied with the last available closing price of the underlying.
Exposure Limit Violation: PRISM monitors exposure of members. The exposure for a CM to all
futures and option contracts cannot exceed 33.33 times the liquid net worth for index options and
index futures contracts, and 20 times the liquid net worth for futures/options contracts on individual
securities. This means that 3% of exposure in case of index futures/options and 5% of exposure in
case of stock futures/options shall not exceed liquid networth, after adjusting for initial margin.
Market-wide position limit violation for futures and options on securities: PRISM monitors market
wide position limits for futures and option contracts on individual securities. The open position
across all members, across all futures and option contracts on an underlying security, conveyed by
the number of units of underlying security, cannot exceed lower of the following limits: 30 times the
average number of shares traded daily, during the previous calendar month, in the relevant underlying
security in the underlying segment of the relevant exchange, or 10% of the number of shares held by
non-promoters in the relevant underlying security, i.e. 10% of the free float in terms of the number of
shares of a company. When the total open interest in an option contract, across all members, reaches
80% of the market wide position limit for a contract, the price scan range and volatility scan range
(for SPAN margin) are doubled. NSCCL specifi es the market-wide position limits once every month,
at the beginning of the month, which is applicable for the subsequent month.
Client– wise position limit violation: This occurs when the open position of any client exceeds 1%
of the free float market capitalization (in terms of no. of shares) or 5% of the open interest (in
terms of number of shares) whichever is higher, in all the futures and option contracts on the same
underlying security. The TM/CM through whom the client trades/clears his deals shall be liable for
such violation and penalty may be levied on such TM/CM which he may in turn recover from the
client. In the event of such a violation, TM/CM shall immediately ensure, that the client does not
take fresh positions and reduces the positions of such clients to be within permissible limits. For
futures contracts, open interest is equivalent to the open positions in the futures contract multiplied
by last available traded price or closing price, as the case may be. For option contracts, open interest
is equivalent to the notional value which is computed by multiplying the open position in that option
contract multiplied with the last available closing price of the underlying.
Position limits for FIIs: The position limits specifi ed for FIIs and their sub-account/s is as under:
– At the level of the FII

In the case of index related derivative products, the position limit is 15% of open interest
in all futures and options contracts on a particular underlying index, or Rs.100 crore,
whichever is higher.
In the case of an underlying security, the position limit is 7.5% of open interest, in
all futures and options contracts on a particular underlying security, or Rs.50 crore,
– At the level of the sub-account
The CM/TM is required to disclose to the NSCCL details of any person or persons acting
in concert who together own 15% or more of the open interest of all futures and options
contracts on a particular underlying index on the exchange.
In the case of futures and option contracts on securities, the gross open position across all
futures and options contracts on a particular underlying security of a sub-account of an
FII, should not exceed the higher of 1% of the free float market capitalization (in terms
of number of shares) or 5% of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
These position limits are applicable on the combined position in all futures and options contracts on
an underlying security on the Exchange.
Misutilisation of TM/constituent’s collateral and/or deposit: A CM cannot utilize the collateral of

one TM and/or constituent towards the exposure and/or obligations of another TM and/or constituent.
Where such an act is detected, it is treated as a violation.
Violation of exercised positions: NSCCL verifi es whether open long positions for such CM/TM
and/or constituent exist in relation to option contracts, which are exercised by a CM/TM, before
initiating exercise processing. Where contracts are exercised though there are no open positions,
such cases are treated as violations.
Solved Problems
Q: In futures trading, profi ts are received or losses are paid
1. In the delivery month 3. On the day of expiry of the contract
2. On daily settlement 4. On a weekly settlement basis
Q: Which of the following prices is used to compute MTM of a futures contract in case it is not traded on
a given day?
1. Closing price of the underlying 3. Theoretical price
2. Closing price of the futures contract 4. MTM is not levied in such cases
Q: Exercise settlement for option contracts takes place at
1. Settlement price of the futures contract 3. Closing price of the far month contract
2. Closing price of the underlying 4. Closing price of the options contract
Q: On the last day of trading, settlement for futures contracts takes place at
1. Average of high and low for the underlying 3. Closing price of the far month contract
on that day
2. Closing price of the underlying 4. Closing price of the options contract

Q: In the case of options, fi nal exercise settlement is
1. Sequential 3. Automatic
2. Random 4. Voluntary
Q: Which of the following option contracts are compulsorily settled on exercise date?
1. In the money options contracts 3. Out of the money options contracts
2. At the money options contracts 4. Deep out of the money options contracts
Q: The market-wide position limit for stock futures/options is
1. higher of 10% of non–promoter holding or 30 3. higher of 1% of non–promoter holding or 5%

times the average traded quantity of open interest in the market
2. lower of 10% of non–promoter holding or 30 4. lower of 1% of non–promoter holding or 5%

times the average traded quantity of open interest in the market
Q: Assignment margin is charged at
1. Client level 3. Clearing member level
2. Trading member level 4. Institution level
Q: A Trading member Manojbhai took proprietary positions in a November 2000 expiry contract. He
bought 3000 trading units at 1210 and sold 2400 at 1220. The end-of-day settlement price for November
2000 expiry contract is 1220. If the initial margin per unit for the November 2000 contract is Rs 100 per
unit, then the total initial margin payable by Manojbhai would be
1. Rs.60,000 3. Rs.3,00,000
2. Rs.30,000 4. Rs.5,40,000

Q: Initial margin is collected to
1. Make good losses on the outstanding position 3. Safeguard against potential losses on out-
standing positions
2. Make good daily losses 4. None of the above
A: Initial margin seeks to safeguard against potential losses on outstanding positions. The correct answer
is number 3.
Q: The initial margin amount is large enough to cover a one-day loss that can be encountered on
1. 99% of the days. 3. 95% of the days.
2. 90% of the days. 4. None of the above
Q: On expiry of a derivatives contract, the settlement price is the
1. Spot price of underlying asset 3. Spot price plus cost-of-carry
2. Futures close price 4. None of the above.
A: On expiry, the settlement price is the spot price of the underlying asset(index closing value in case
of index futures/options and closing price of stock on spot market in case of stock futures/options). The
Q: The following are the details of trading member Ratanlal’s proprietary and client position:
Proprietary : he buys 600 units @ 1020 and sells 1800 units @ 1025.
Client A: he buys 2000 units @ 1015
Client B: he buys 1600 units @ 1016 and sells 800 units @ 1022.
The settlement price of the day is 1023. What is MTM profi t/loss for Ratanlal?
1. Rs.31,800 3. Rs.26,600
2. Rs.28,400 4. Rs.31,200
A: The index closes at 1023. He makes a profi t of 1800 on the proprietary buy position (i.e. (1023-
1020)*600) and a profi t of 3600 on the proprietary sell position (i.e. (1025-1023)*1800). On client A’s
account he makes a profi t of Rs.16,000 (i.e. (1023 -1015)*2000). On client B’s account he makes a profi t
of Rs.11,200(i.e. (1023-1016)*1600) and a loss of Rs.800(i.e. (1023-1022)*800). Hence his MTM profi t
is (1800+3600+16,000+11,200-800). The correct answer is number 1.
Q: What is the outstanding position on which initial margin will be calculated if Mr.Madanlal buys 800
which @ 1060 and sells 400 units @1055?
1. 1250 units 3. 450 units
2. 800 units 4. 400 units
Q: What will be MTM profi t/loss of Mr. Ramesh if he buys 800 @ 1040 and sells 600 @ 1045? The
settlement price of the day was 1035.
1. - 4000 3. + 6000
2. - 6000 4. + 2000
Q: Mr. Amar buys 600 units @ 1040 and sells 400 units @ 1030. The settlement price is 1030. What is
his MTM profi t/loss?
1. +Rs.7,200 3. -Rs.6,000
2. +Rs.8,000 4. +Rs.6,000
A: Mr. Amar makes a loss of Rs.6000 on his buy position and breaks even on his sell position. The correct
answer is number 3.
Q: Trading member Shantilal took proprietary purchase in a March 2000 contract. He bought 1600 units
@1200 and sold 1200 @1220. The end of day settlement price was 1221. What is the outstanding position
on which initial margin will be calculated?
1. 2700 units 3. 1500 units
2. 1200 units 4. 400 units

Q: What is the outstanding position on which initial margin will be charged if no proprietary trading is
done and the details of client trading are: one client buys 800 units @1260. The second client buys 1000
units @ 1255 and sells 1200 units @ 1260.
1. 900 units 3. 800 units
2. 1000 units 4. 2700 units
A: One client buys 800, he is long 800. The second buys 1000 and sells 1200, hence he is short 200. The
outstanding position on which margin is charged is 1000 (i.e. 800 + 200). The correct answer is number
2.
Q: The May futures contract on INFOSYSTCH closed at Rs.3940 yesterday. It closes today at
Rs.3898.60. The spot closes at Rs.3800. Raju has a short position of 3000 in the May futures contract.
He sells 2000 units of May expiring put options on INFOSYSTCH with a strike price of Rs.3900 for a
premium of Rs.110 per unit. What is his net obligation to/from the clearing corporation today?
1. Payin of Rs.344200 3. Payout of Rs.344200
2. Payout of Rs.640000 4. Payin of Rs.95800
A: On the short position of 3000 May futures contract, he makes a profi t of Rs.124200(i.e. 3000 * (3940
- 3898.60)). He receives Rs.220000 on the put options sold by him. Therefore his net obligation from the
clearing corporation is Rs.344200. The correct answer in number 3.
Q: On April 1,2002, Ms.Shetty has sold 400 calls on Reliance at a strike price of Rs.200 for a premium
of Rs.20/call. On the cash market, Reliance closes at Rs.240 on that day. If the call option is assigned to
her on that day, what is her net obligation on April 1,2002?
A: On the 400 calls sold by her, she receives a premium of Rs.8000. However on the calls assigned to her,
she loses Rs.16,000(400 * (240-200)). Her payin obligation is Rs.8000. The correct answer is number 2.
Q: Rahul has the following carried forward net positions in the F&O segment on 27th June 2002:
1. Long 500 SBIN June Futures
2. Long 200 SBIN July Futures
3. Short position of 300 SBIN June calls at a strike price of Rs.260
Given below is the data pertaining to SBIN on 2 consecutive days. What is the net funds obligations
to/from the clearing corporation?
Contract Date Futures/options Underlying(spot)

descriptor closing price market closing price
June Futures 26-Jun-2002 277 270
June 260 calls 26-Jun-2002 9 270
June Futures 27-June-2002 275 275
June 260 calls 27-Jun-2002 12 275
July Futures 26-Jun-2002 278 270
July Futures 27-Jun-2002 280 275
A: On the long position of 500 June futures, he makes a loss of Rs.1000(i.e.500 * (277-275)). On the long
position of 200 July futures, he makes a profi t of Rs.400(i.e.200 * (280-278)). On the short position of
300 June calls, he makes a loss of Rs.4500(i.e. 300 * (275-260)). Therefore the net loss is Rs.5100. The
Q: The following are the details of trading member Ratanlal’s proprietary and client position:
Proprietary : he buys 500 units @ 1020 and sells 1700 units @ 1025.
Client A: he buys 2000 units @ 1015
Client B: he buys 1500 units @ 1016.
The settlement price of the day is 1023. What is MTM profi t/loss for Ratanlal?
1. Rs.30,700 3. Rs.26,600
2. Rs.28,400 4. Rs.31,400
A: The index closes at 1023. He makes a profi t of 1500 on the proprietary buy position(i.e. (1023-
1020)*500) and a profi t of 3400 on the proprietary sell position(i.e. (1025-1023)*1700). On client A’s
account he makes a profi t of Rs.16000(i.e. (1023 -1015)*2000). On client B’s account he makes a profi t
of Rs.10500(i.e. (1023-1016)*1500). Hence his MTM profi t is (1500+3400+16000+10500). The correct
answer is number 4.
Chapter 12
Regulatory framework
The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act,
the rules and regulations framed thereunder and the rules and bye–laws of stock exchanges.
12.1 Securities Contracts(Regulation) Act, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the business of
dealing therein and by providing for certain other matters connected therewith. This is the
principal Act, which governs the trading of securities in India. The term “securities” has been
defined in the SC(R)A. As per Section 2(h), the ‘Securities’ include:
1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like
nature in or of any incorporated company or other body corporate
2. Derivative
3. Units or any other instrument issued by any collective investment scheme to the investors in such
schemes
4. Government securities
5. Such other instruments as may be declared by the Central Government to be securities
6. Rights or interests in securities.
“Derivative” is defined to include:
A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument
or contract for differences or any other form of security
A contract which derives its value from the prices, or index of prices, of underlying securities.
Section 18A provides that notwithstanding anything contained in any other law for the time
being in force, contracts in derivative shall be legal and valid if such contracts are:
Traded on a recognized stock exchange
Settled on the clearing house of the recognized stock exchange, in accordance with the rules and
bye–laws of such stock exchanges.
186 Regulatory framework
12.2 Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI)
with statutory powers for (a) protecting the interests of investors in securities (b) promoting the
development of the securities market and (c) regulating the securities market. Its regulatory
jurisdiction extends over corporates in the issuance of capital and transfer of securities, in
addition to all intermediaries and persons associated with securities market.
SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit.
In particular, it has powers for:
regulating the business in stock exchanges and any other securities markets
registering and regulating the working of stock brokers, sub–brokers etc.
promoting and regulating self-regulatory organizations
prohibiting fraudulent and unfair trade practices
calling for information from, undertaking inspection, conducting inquiries and audits of the stock
exchanges, mutual funds and other persons associated with the securities market and intermediaries
and self–regulatory organizations in the securities market
performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956,
as may be delegated to it by the Central Government
12.3 SEBI (Stock brokers and Sub–Brokers) Regulations, 1992

In this section we shall have a look at the regulations that apply to brokers under the SEBI
Regulations.
12.3.1 Brokers
A broker is an intermediary who arranges to buy and sell securities on behalf of clients (the
buyer and the seller). According to Section 2(e) of the SEBI (Stock Brokers and Sub-Brokers)
Rules, 1992, a stockbroker means a member of a recognized stock exchange. No stockbroker
is allowed to buy, sell or deal in securities, unless he or she holds a certificate of registration
granted by SEBI. A stockbroker applies for registration to SEBI through a stock exchange or
stock exchanges of which he or she is admitted as a member. SEBI may grant a certificate
to a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers) Rules, 1992] subject to the
conditions that:
1. He holds the membership of any stock exchange;
2. He shall abide by the rules, regulations and bye-laws of the stock exchange or stock exchanges of
which he is a member;
12.4 Regulation for derivatives trading 187
3. In case of any change in the status and constitution, he shall obtain prior permission of SEBI to
continue to buy, sell or deal in securities in any stock exchange;
4. He shall pay the amount of fees for registration in the prescribed manner; and
5. He shall take adequate steps for redressal of grievances of the investors within one month of the
date of the receipt of the complaint and keep SEBI informed about the number, nature and other
particulars of the complaints.
As per SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, SEBI shall take into
account for considering the grant of a certificate all matters relating to buying, selling, or
dealing in securities and in particular the following, namely, whether the stock broker - (a) is
eligible to be admitted as a member of a stock exchange; (b) has the necessary infrastructure like
adequate office space, equipment and man power to effectively discharge his activities; (c) has
any past experience in the business of buying, selling or dealing in securities; (d) is subjected
to disciplinary proceedings under the rules, regulations and bye-laws of a stock exchange with
respect to his business as a stock-broker involving either himself or any of his partners, directors
or employees.
12.4 Regulation for derivatives trading

SEBI set up a 24-member committee under the Chairmanship of Dr.L.C. Gupta to develop the
appropriate regulatory framework for derivatives trading in India. The committee submitted its
report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee
and approved the phased introduction of derivatives trading in India beginning with stock index
futures. SEBI also approved the “suggestive bye-laws” recommended by the committee for
regulation and control of trading and settlement of derivatives contracts.
The provisions in the SC(R)A and the regulatory framework developed thereunder govern
trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of
‘securities’ in the SC(R)A made trading in derivatives possible within the framework of that Act.
1. Any Exchange fulfi lling the eligibility criteria as prescribed in the LC Gupta committee report
may apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading
derivatives. The derivatives exchange/segment should have a separate governing council and
representation of trading/clearing members shall be limited to maximum of 40% of the total members
of the governing council. The exchange shall regulate the sales practices of its members and will
obtain prior approval of SEBI before start of trading in any derivative contract.
2. The Exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not automatically become the members of
derivative segment. The members of the derivative segment need to fulfi ll the eligibility conditions
as laid down by the LC Gupta committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing
corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid
down by the committee have to apply to SEBI for grant of approval.
5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This
is in addition to their registration as brokers of existing stock exchanges. The minimum networth for
clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The networth
of the member shall be computed as follows:
Capital + Free reserves

Less non-allowable assets viz.,
(a) Fixed assets
(b) Pledged securities
(c) Member’s card
(d) Non-allowable securities(unlisted securities)
(e) Bad deliveries
(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities
6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also submit details
of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands
related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.
8. The L.C.Gupta committee report requires strict enforcement of “Know your customer” rule and
requires that every client shall be registered with the derivatives broker. The members of the
derivatives segment are also required to make their clients aware of the risks involved in derivatives
trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly
signed by the client.
9. The trading members are required to have qualifi ed approved user and sales person who have passed
a certifi cation programme approved by SEBI.
12.4.1 NSE’s certifi cation in fi nancial markets

A critical element of financial sector reforms is the development of a pool of human resources
having right skills and expertise to provide quality intermediation services in each segment of
the market. In order to dispense quality intermediation, personnel providing services need to
possess requisite skills and knowledge. This is generally achieved through a system of testing
and certification. Such testing and certification has assumed added significance in India as there
is no formal education/training on financial markets, especially in the area of operations. Taking
into account international experience and needs of the Indian financial market, NSE offers NCFM
(NSE’s Certification in Financial Markets) to test practical knowledge and skills that are required
to operate in financial markets in a very secure and unbiased manner and to certify personnel with
a view to improve quality of intermediation. NCFM offers a comprehensive range of modules
covering many different areas in finance including a module on derivatives. The module on
12.5 Regulation for clearing and settlement 189
derivatives has been recognized by SEBI. SEBI requires that derivative brokers/dealers and sales
persons must mandatorily pass this module of the NCFM.
12.5 Regulation for clearing and settlement

1. The LC Gupta committee has recommended that the clearing corporation must perform full novation,
i.e. the clearing corporation should interpose itself between both legs of every trade, becoming the
legal counterparty to both or alternatively should provide an unconditional guarantee for settlement
of all trades.
2. The clearing corporation should ensure that none of the Board members has trading interests.
3. The defi nition of net-worth as prescribed by SEBI needs to be incorporated in the

application/regulations of the clearing corporation.
4. The regulations relating to arbitration need to be incorporated in the clearing corporations

regulations.
5. Specifi c provision/chapter relating to declaration of default must be incorporated by the clearing

corporation in its regulations.
6. The regulations relating to investor protection fund for the derivatives market must be included in
the clearing corporation application/regulations.
7. The clearing corporation should have the capabilities to segregate upfront/initial margins deposited
by clearing members for trades on their own account and on account of his clients. The clearing
corporation shall hold the clients’ margin money in trust for the clients’ purposes only and should
not allow its diversion for any other purpose. This condition must be incorporated in the clearing
corporation regulations.
8. The clearing member shall collect margins from his constituents (clients/trading members). He shall
clear and settle deals in derivative contracts on behalf of the constituents only on the receipt of such
minimum margin.
9. Exposure limits based on the value at risk concept will be used and the exposure limits will be
continuously monitored. These shall be within the limits prescribed by SEBI from time to time.
10. The clearing corporation must lay down a procedure for periodic review of the networth of its
members.
11. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members
in the underlying market.
12. Any changes in the the bye-laws, rules or regulations which are covered under the “Suggestive bye-
laws for regulations and control of trading and settlement of derivatives contracts” would require
prior approval of SEBI.
The importance of adequate risk–management and control, both at the exchange level and at the level
of members of the exchange, can never be overstated. The failure of Barings is a case in point of lack
of trader controls and what it can result into.
In the 1980s, Barings had installed a credit risk–management system in London and was in the process
of installing market risk–management system. The system had the capacity to price derivatives and
to support VAR reports. Baring’s technology, however, was far more advanced in London than in its
foreign branches. As big systems were expensive to install and support for small operations, the bank
relied heavily on local management for its smaller foreign branches.
The most risky aspect of the Barings affair was Leeson’s joint responsibility for front and back–offi ce
functions, which allowed him to hide trading losses. In July 1992, he created a special “error” account,
numbered 88888, which was hidden form the trade fi le, price fi le, and the London gross fi le. Losing
trades and unmatched trades were parked in this account. Daily reports to Baring’s Asset and Liability
showed Leeson’s trading positions on the Nikkei 255 as fully matched. Reports to London therefore
showed no risk. Had Barings used internal audits to provide independent checks on input, the company
might have survived.
Box 12.11: A lesson in risk management: Barings
Table 12.1 Eligibility criteria for membership on F&O segment

Particulars CM and F&O segment CM, WDM and F&O segment
(all values in Rs.Lakh)
Net worth 1 100 200
Interest free security
deposit(IFSD)2 125 275
Collateral security
deposit(CSD)3 25 25
Annual subscription 1 2
1: No additional networth is required for self clearing members. However, a networth of Rs. 300
Lakh is required for TM–CM and PCM.
2 & 3: Additional Rs. 25 Lakh is required for clearing membership(SCM,TM–CM). In addition,
the clearing member is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 lakh per trading
member he undertakes to clear and settle.
12.6 Regulation for membership
The eligibility criteria for membership on the F&O segment is as given in Table 12.1. Table 12.2
gives the requirements for professional clearing membership. As mentioned earlier, anybody
interested in taking membership of F&O segment is required to take membership of “CM and
F&O segment” or “CM,WDM and F&O segment”. An existing member of CM segment can
also take membership of F&O segment. A trading member can also be a clearing member by
meeting additional requirements. There can also be only clearing members.
12.7 Regulations for risk management 191
Table 12.2 Requirements for professional clearing membership

Particulars F&O segment CM & F&O segment
(all values in Rs.Lakh)
Eligibility Trading members of Trading members of
NSE/SEBI registered NSE/SEBI registered
custodians/recognized custodians/recognized
banks banks
Networth 300 300
Interest free security deposit(IFSD) 25 34
Collateral security deposit 25 50
Annual subscription Nil 2.5
Note: The PCM is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 Lakh per trading
member whose trades he undertakes to clear and settle in the F&O segment.
12.7 Regulations for risk management
12.7.1 Liquid networth requirements

Liquid net worth for a clearing member means: a)total liquid assets deposited by a clearing member
with the clearing corporation towards initial margin and capital adequacy, less b) initial margin
applicable to the total gross open positions at any given point of time of all trades cleared through
the clearing member. A clearing member’s minimum liquid net worth must be at least Rs.50 Lakh at
any point of time.
Liquid assets include cash, fi xed deposits, bank guarantees, treasury bills, government securities or
dematerialized securities (with suitable haircuts) pledged in favor of clearing corporation.
At least 50% of the total liquid assets shall be in the form of cash equivalents viz. cash, bank
guarantee, fi xed deposits, T-bills and dated government securities.
Bank guarantees: Not more than 5% of the settlement guarantee fund or 1% of the total liquid assets
deposited with the clearing corporation, whichever is lower, may be exposed to bank guarantees of a
single bank which is not rated P1 (or P1+) or equivalent by a RBI recognized credit rating agency.
Further, not more than 50% of the settlement guarantee fund or 10% of the total liquid assets
deposited with the clearing corporation, whichever is lower, may be exposed to bank guarantees
issued by all such lower rated banks put together.
Securities: Equity securities may be deposited only in dematerialized form.

The acceptable securities are determined by taking the top 100 securities by market capitalization out
of the top 200 securities by market capitalization and also by trading value. This list is updated on the
basis of the average market capitalization over the period of six months. When a security is dropped
from the list of acceptable securities, existing deposits of that security continue to be counted for
liquid assets for a period of one month. Haircuts on equities must be at least 15% with weekly mark
to market.
Table 12.3 Worst scenario loss

Risk scenario Price move in Volatility move in Fraction of loss
number multiples of price multiples of considered (%)
scan range volatility range
1 0 +1 100
2 0 -1 100
3 +1/3 +1 100
4 +1/3 -1 100
5 -1/3 +1 100
6 -1/3 -1 100
7 +2/3 +1 100
8 +2/3 -1 100
9 -2/3 +1 100
10 -2/3 -1 100
11 +1 +1 100
12 +1 -1 100
13 -1 +1 100
14 -1 -1 100
15 +2 0 35
16 -2 0 35
All securities deposited for liquid assets are required to be pledged in favor of clearing corporation.
The marking to market of securities is carried out weekly for all securities. Debt securities are
acceptable only if they are investment grade with haircuts of 10% and weekly mark to market.
The total exposure of the clearing corporation to the debt or equity securities of a company may not
exceed 75% of the trade guarantee fund or 15% of the total liquid assets of the clearing corporation,
whichever is lower.
12.7.2 Initial margin computation methodology

A portfolio based margining approach has been adopted which takes an integrated view of the
risk involved in the portfolio of each individual client comprising of his positions in all derivative
contracts i.e. futures and options. The initial margin requirements are based on worst scenario
loss of a portfolio of an individual client to cover 99% VaR over one day horizon across various
scenarios of price changes and volatility shifts. The parameters for such a model include:
Worst Scenario Loss

The worst case loss of a portfolio is calculated by valuing the portfolio under several scenarios
of changes in the underlying and changes in the volatility of the underlying. The scenarios to be
used for this purpose are:
The maximum loss under any of the scenario(considering only 35% of the loss in case of
scenarios 15 and 16) is referred to as the worst scenario loss. For the purpose of the calculation
of option values Black–Scholes model is used.
For index products the price scan range is specified at three standard deviation(3 sigma) and
the volatility scan range is specified at 4%. Additionally, for index futures contracts the initial
margin may not be less than 5% of the value of the contract. For futures and option contracts on
stocks the price scan range is specified at three and a half standard deviation(3.5 sigma) and the
volatility scan range is specified at 10%. The minimum initial margin for stock futures contract
is 7.5% of the value of the contract.
12.7.3 Calendar spreads

A calendar spread is a position in an underlying with one maturity which is hedged by an
offsetting position in the same underlying with a different maturity: for example, a short position
in a July futures contract on Reliance and a long position in the August futures contract on
Reliance is a calendar spread. Calendar spreads attract lower margins because they are not
exposed to market risk of the underlying. If the underlying rises, the July contract would make a
profit while the August contract would make a loss.
Margin on calendar spreads is levied at 0.5% per month of spread on the far month contract
of the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far month
contract of the spread.
Margin on calendar spread is calculated on the basis of delta of the portfolio consisting of
futures and option contract in each month. Thus, a portfolio consisting of near month futures
and options contracts with a delta of 100 and far month futures and option contracts with a delta
of -100 bears a spread charge equal to the spread charge for a portfolio which is long 100 near
month futures and short 100 far month futures. The calendar spread margin is charged in addition
to the worst scenario loss of the portfolio. A calendar spread is treated as a naked position in the
far month contract three trading days before the expiry of near month contract.
12.7.4 Short option minimum margin

The short option minimum margin equal to 3% of the notional value of all short index options is
charged if sum of the worst scenario loss and the calendar spread margin is lower than the short
option minimum margin. For stock options it is equal to 7.5% of the notional value based on
the previous days closing value of the underlying stock. Notional value of option positions
is calculated on the short option positions by applying the last closing price of the relevant
underlying.
12.7.5 Net option value

The net option value is calculated as the current market value of the option times the number of
option units(positive for long options and negative for short options) in the portfolio.
Net option value is added to the liquid net worth of the clearing member. This means that the
current market value of short options are deducted from the liquid net worth and the market value
of long options are added thereto. Thus mark to market gains and losses on option positions get
adjusted against the available liquid net worth. Since the options are premium style, mark to
market gains and losses are not settled in cash for option positions. Net option value is computed
based on the last closing price.
12.7.6 Premium margin

Premium amount due for a client is deducted from the available liquid net worth towards
premium margins on a real time basis till the completion of premium settlement on T+1 day.
12.7.7 Initial margin

Margins in the derivatives markets are based on a 99% Value at Risk (VAR) approach at three
sigma limits over a one day horizon. Accordingly, margins are computed based on volatility
computations.
The initial margin is netted with respect to each contract at level of individual client and is
on gross basis across all clients for a trading/clearing member. The initial margin for proprietary
position of a trading/clearing member is done on net basis. Initial margins are required to be
collected upfront. Accordingly, the initial margin plus the calendar spread charge is adjusted
against the available liquid networth of a member. The member is in turn required to collect the
initial margin from his clients upfront.
Method of computation of volatility

The exponential moving average method is used to obtain the volatility estimate every day. The
estimate at the end of day t, is estimated using the previous day’s volatility estimate (as

at the end of day t-1), and the return observed in the futures market on day t.

where is a parameter which determines how rapidly volatility estimates change. A value of
0.94 is used for .
12.7.8 Exposure limits

The notional value of gross open positions at any point in time for index futures and short index

option contracts shall not exceed (thirty three one by three) times the liquid networth of a

clearing member. In case of futures and option contracts on stocks, the notional value of futures
contracts and short option position at any time shall not exceed 20(twenty) times the liquid
networth of a member.
Therefore, 3% of the notional value of gross open position in index futures and short index
option contracts, and 5% of the notional value of futures and short option position in stocks
is additionally adjusted from the liquid networth of a clearing member on a real time basis.
Notional value of the options contract is calculated on the basis of the previous days closing
price of the underlying. These exposure limits are in addition to the initial margin and calendar
spread requirements.
12.7.9 Exposure limit for calendar spreads(only for futures contracts)

For exposure purpose, calendar spreads are regarded as an open position of one third(1/3rd) of the
mark to market value of the far month futures contract. As the near month contract approaches
expiry, the spread is treated as a naked position in the far month contract three trading days prior
to the expiry of the far month contract.
12.7.10 Position limits

Position limits have been specified by SEBI at trading member, client, market and FII levels
respectively.
Trading member position limits

There is a position limit in derivative contracts on an index of 15% of the open interest or Rs.100
Crore, whichever is higher. The position limit in derivative contracts on an individual stock is
7.5% of the open interest in that underlying on the exchange or Rs.50 Crore, whichever is higher.
Once a member, in a particular underlying reaches the position limit then he is permitted to take
only offsetting positions(which result in lowering the open position of the member) in derivative
contracts on such underlying.
Client level position limits

On index based derivative contracts, at the client level there is a self–disclosure requirement as
follows: Any person or persons acting in concert who together own 15% or more of the open
interest in all futures and option contracts on the same index are required to report this fact to
the clearing corporation and failure to do so attracts a penalty. This does not mean a ban on
large open positions but is a disclosure requirement.
On stock based derivative contracts, the gross open position across all such derivative
contracts in a particular underlying of a single customer/client shall not exceed the higher of 1%
of the free float market capitalization(in terms of number of shares) or 5% of the open interest in
a particular underlying stock(in terms of number of contracts). This position limit is applicable
on the combined position in all derivative contracts in an underlying stock at an exchange.
Market wide position limits

The market wide limit of open positions(in terms of the number of units of underlying stock) on
all futures and option contracts on a particular stocks is lower of 30 times the average number
of shares traded daily, during the previous calendar month, in the capital market segment of the
exchange, or 10% of the number of shares held by non–promoters i.e. 10% of the free float, in
terms of number of shares of a company.
This market wide limit is applicable on a particular underlying. When the total open interest
in a contract reaches 80% of the market wide limit in that contract, the price scan range and
volatility scan range in SPAN would be doubled.
Position limits for FIIs

The position limits specified for FIIs and their sub-account/s is as under:
At the level of the FII
– In the case of index related derivative products, the position limit is 15% of open interest in
all futures and options contracts on a particular underlying index on an exchange, or Rs.100
Crore, whichever is higher.
– In the case of an underlying security, the position limit is 7.5% of open interest, in all futures
and options contracts on a particular underlying security on an exchange or Rs.50 Crore,
At the level of the sub-account
– The CM/TM is required to disclose to the clearing corporation details of any person or persons
acting in concert who together own 15% or more of the open interest of all futures and options
contracts on a particular underlying index on the exchange.
– The gross open position across all futures and options contracts on a particular underlying
security, of a sub–account of an FII, should not exceed the higher of 1% of the free float
market capitalization (in terms of number of shares) or 5% of the open interest in the derivative
contracts on a particular underlying stock(in terms of number of contracts).
These position limits are applicable on the combined position in all futures and options
contracts on an underlying security on the exchange.
12.7.11 Real time computation

The computation of worst scenario loss has two components. The first is the valuation of each
contract under sixteen scenarios. The second is the application of these scenario contract values
to the actual positions in a portfolio to compute the portfolio values and the worst scenario loss.
For computational ease, the scenario contract values are updated at least 5 times in the day,
which may be carried out by taking prices at the start of trading, at 11:00 a.m, at 12:30 p.m , at
2:00 p.m., and at the end of the trading session.
12.7.12 Eligibility of stocks for futures and option trading

The stocks which are eligible for futures and option trading, should meet the following criteria:
1. The stock should be amongst the top 200 scrips, on the basis of average market capitalization during
the last six months and the average free float market capitalization should not be less than Rs.750
Crore. The free float market capitalization means the non–promoter holding in the stock.
2. The stock should be amongst the top 200 scrips on the basis of average daily volume(in value terms),
during the last six months. Further, the average daily volume should not be less than Rs.5 Crore in
the underlying cash market.
3. The stock should be traded on at least 90% of the trading days in the last six months, with the
exception of cases in which a stock is unable to trade due to corporate actions like de–mergers etc.
4. The non promoter holding in the company should be at least 30%.
5. The ratio of the daily volatility of the stock vis–a–vis the daily volatility of the index(either BSE-
30 Sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous six
months. For this purpose the volatility would be computed as per the exponentially weighted moving
average(EWMA) formula.
6. The stock on which option contracts are permitted to be traded on one derivative exchange/segment
would also be permitted to trade on other derivative exchanges/segments.
12.7.13 Adjustments for corporate actions

Adjustments for corporate actions for stock options would be as follows:
The basis for any adjustment for corporate action shall be such that the value of the position of the
market participants on cum and ex-date for corporate action shall continue to remain the same as
far as possible. This will facilitate in retaining the relative status of positions namely in-the-money,
at-the-money and out-of-money. This will also address issues related to exercise and assignments.
Adjustment for corporate actions shall be carried out on the last day on which a security is traded on
a cum basis in the underlying cash market.
Adjustments shall mean modifi cations to positions and/or contract specifi cations namely strike price,
position, market lot, multiplier. These adjustments shall be carried out on all open, exercised as well
as assigned positions.
The corporate actions may be broadly classifi ed under stock benefi ts and cash benefi ts. The various
stock benefi ts declared by the issuer of capital are bonus, rights, merger/de–merger, amalgamation,
splits, consolidations, hive–off, warrants and secured premium notes and dividends.
The methodology for adjustment of corporate actions such as bonus, stock splits and consolidations
is as follows:
– Strike price: The new strike price shall be arrived at by dividing the old strike price by the
adjustment factor as under.
– Market lot/multiplier: The new market lot/multiplier shall be arrived at by multiplying the old
market lot by the adjustment factor as under.
– Position: The new position shall be arrived at by multiplying the old position by the adjustment
factor, which will be computed using the pre-specifi ed methodology.
The adjustment factor for bonus, stock splits and consolidations is arrived at as follows:
– Bonus: Ratio - A : B ; Adjustment factor : (A+B)/B

– Stock splits and consolidations : Ratio - A : B ; Adjustment factor : B/A
– Right : Ratio - A : B
Premium : C
Face value : D
Existing strike price : X
New strike price : ((B * X) + A * (C + D))/(A+B)
– Existing market lot/multiplier/position: Y ; New issue size : Y * (A+B)/B
The above methodology may result in fractions due to the corporate action e.g. a bonus ratio of
3:7. With a view to minimizing fraction settlements, the following methodology is proposed to be
adopted:
1. Compute value of the position before adjustment.

2. Compute value of the position taking into account the exact adjustment factor.
3. Carry out rounding off for the Strike Price and Market Lot.
4. Compute value of the position based on the revised strike price and market lot.
The difference between 1 and 4 above, if any, shall be decided in the manner laid down by the group
by adjusting strike price or market lot, so that no forced closure of open position is mandated.
Dividends which are below 10% of the market value of the underlying stock, would be deemed to
be ordinary dividends and no adjustment in the strike price would be made for ordinary dividends.
For extra-ordinary dividends, above 10% of the market value of the underlying stock, the strike price
would be adjusted.
The exchange will on a case to case basis carry out adjustments for other corporate actions as decided
by the group in conformity with the above guidelines.
12.8 Accounting for futures

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting
of index futures contracts from the view point of parties who enter into such futures contracts as
buyers or sellers. For other parties involved in the trading process, like brokers, trading members,
clearing members and clearing corporations, a trade in equity index futures is similar to a trade
in, say shares, and does not pose any peculiar accounting problems. Hence in this section we
shall largely focus on the accounting treatment of equity index futures in the books of the client.
But before we do so, a quick re-look at some of the terms used.
1. Clearing corporation/house: Clearing corporation/house means the clearing corporation/house

approved by SEBI for clearing and settlement of trades on the derivatives exchange/segment. All
the clearing and settlement for trades that happen on the NSE’s market is done through NSCCL.
12.8 Accounting for futures 199
2. Clearing member: Clearing member means a member of the clearing corporation and includes
all categories of clearing members as may be admitted as such by the clearing corporation to the
derivatives segment.
3. Client: A client means a person, on whose instructions and, on whose account, the trading member
enters into any contract for the purchase or sale of any contract or does any act in relation thereto.
4. Contract month: Contract month means the month in which the exchange/clearing corporation rules
require a contract to be fi nally settled.
5. Daily settlement price: Daily settlement price is the closing price of the equity index futures contract
for the day or such other price as may be decided by the clearing house from time to time.
6. Derivative exchange/segment: Derivative exchange means an exchange approved by SEBI as a

derivative exchange. Derivative segment means segment of an existing exchange approved by SEBI
as derivatives segment.
7. Final settlement price: The fi nal settlement price is the closing price of the equity index futures
contract on the last trading day of the contract or such other price as may be specifi ed by the clearing
corporation, from time to time.
8. Long position: Long position in an equity index futures contract means outstanding purchase
obligations in respect of the equity index futures contract at any point of time.
9. Open position: Open position means the total number of equity index futures contracts that have not
yet been offset and closed by an opposite position.
10. Settlement date: Settlement date means the date on which the settlement of outstanding obligations
in an equity index futures contract are required to be settled as provided in the Bye-Laws of the
Derivatives exchange/segment.
11. Short position: Short position in an equity index futures contract means outstanding sell obligations
in respect of an equity index futures contract at any point of time.
12. Trading member: Trading member means a Member of the Derivatives exchange/segment and
registered with SEBI.
12.8.1 Accounting at the inception of a contract

Every client is required to pay to the trading member/clearing member, the initial margin
determined by the clearing corporation as per the bye-laws/regulations of the exchange for
entering into equity index futures contracts. Such initial margin paid/payable should be debited
to “Initial margin - Equity index futures account”. Additional margins, if any, should also be
accounted for in the same manner. It may be mentioned that at the time when the contract
is entered into for purchase/sale of equity index futures, no entry is passed for recording the
contract because no payment is made at that time except for the initial margin. At the balance
sheet date, the balance in the ‘Initial margin - Equity index futures account’ should be shown
separately under the head ‘current assets’. In those cases where any amount has been paid in
excess of the initial/additional margin, the excess should be disclosed separately as a deposit
under the head ‘current assets’. In cases where instead of paying initial margin in cash, the client
provides bank guarantees or lodges securities with the member, a disclosure should be made in
the notes to the financial statements of the client.
12.8.2 Accounting at the time of daily settlement

This involves the accounting of payment/receipt of mark-to-market margin money. Payments
made or received on account of daily settlement by the client would be credited/debited to the
bank account and the corresponding debit or credit for the same should be made to an account
titled as “Mark-to-market margin - Equity index futures account”.
Some times the client may deposit a lump sum amount with the broker/trading member in
respect of mark-to-market margin money instead of receiving/paying mark-to-market margin
money on daily basis. The amount so paid is in the nature of a deposit and should be debited
to an appropriate account, say, “Deposit for mark-to-market margin account”. The amount of
“mark-to-market margin” received/paid from such account should be credited/debited to “Mark-
to-market margin - Equity index futures account” with a corresponding debit/credit to “Deposit
for mark-to-market margin account”. At the year-end, any balance in the “Deposit for mark-to-
market margin account” should be shown as a deposit under the head “current assets”.
12.8.3 Accounting for open positions

Position left open on the balance sheet date must be accounted for. Debit/credit balance in the
“mark-to-market margin - Equity index futures account”, maintained on global basis, represents
the net amount paid/received on the basis of movement in the prices of index futures till the
balance sheet date. Keeping in view ‘prudence’ as a consideration for preparation of financial
statements, provision for anticipated loss, which may be equivalent to the net payment made
to the broker (represented by the debit balance in the “mark-to-market margin - Equity index
futures account”) should be created by debiting the profit and loss account. Net amount received
(represented by credit balance in the “mark-to-market margin - Equity index futures account”)
being anticipated profit should be ignored and no credit for the same should be taken in the
profit and loss account. The debit balance in the said “mark-to-market margin - Equity index
futures account”, i.e., net payment made to the broker, may be shown under the head “current
assets, loans and advances” in the balance sheet and the provision created there-against should
be shown as a deduction therefrom. On the other hand, the credit balance in the said account,
i.e., the net amount received from the broker, should be shown as a current liability under the
head “current liabilities and provisions in the balance sheet”.
12.8.4 Accounting at the time of fi nal settlement

This involves accounting at the time of final settlement or squaring-up of the contract. At the
expiry of a series of equity index futures, the profit/loss, on final settlement of the contracts
in the series, should be calculated as the difference between final settlement price and contract
prices of all the contracts in the series. The profit/loss, so computed, should be recognized in
12.8 Accounting for futures 201
the profit and loss account by corresponding debit/credit to “mark-to-market margin - Equity
index futures account”. However, where a balance exists in the provision account created for
anticipated loss, any loss arising on such settlement should be first charged to such provision
account, to the extent of the balance available in the provision account, and the balance of loss,
if any, should be charged to the profit and loss account. Same accounting treatment should
be made when a contract is squared-up by entering into a reverse contract. It appears that, at
present, it is not feasible to identify the equity index futures contracts. Accordingly, if more than
one contract in respect of the series of equity index futures contracts to which the squared-up
contract pertains is outstanding at the time of the squaring of the contract, the contract price
of the contract so squared-up should be determined using First-In, First-Out (FIFO) method for
calculating profit/loss on squaring-up.
On the settlement of an equity index futures contract, the initial margin paid in respect of the
contract is released which should be credited to “Initial margin - Equity index futures account”,
and a corresponding debit should be given to the bank account or the deposit account (where the
amount is not received).
12.8.5 Accounting in case of a default

When a client defaults in making payment in respect of a daily settlement, the contract is closed
out. The amount not paid by the Client is adjusted against the initial margin. In the books of
the Client, the amount so adjusted should be debited to “mark-to-market - Equity index futures
account” with a corresponding credit to “Initial margin - Equity index futures account”. The
amount of initial margin on the contract, in excess of the amount adjusted against the mark-to-
market margin not paid, will be released. The accounting treatment in this regard will be the
same as explained above. In case, the amount to be paid on daily settlement exceeds the initial
margin the excess is a liability and should be shown as such under the head ‘current liabilities
and provisions’, if it continues to exist on the balance sheet date. The amount of profit or loss on
the contract so closed out should be calculated and recognized in the profit and loss account in
the manner dealt with above.
12.8.6 Disclosure requirements

The amount of bank guarantee and book value as also the market value of securities lodged
should be disclosed in respect of contracts having open positions at the year end, where initial
margin money has been paid by way of bank guarantee and/or lodging of securities.
Total number of contracts entered and gross number of units of equity index futures traded
(separately for buy/sell) should be disclosed in respect of each series of equity index futures.
The number of equity index futures contracts having open position, number of units of equity
index futures pertaining to those contracts and the daily settlement price as of the balance sheet
date should be disclosed separately for long and short positions, in respect of each series of equity
index futures.
12.9 Accounting for equity index options and equity stock options
The Institute of Chartered Accountants of India issued guidance note on accounting for index
options and stock options from the view point of the parties who enter into such contracts as
buyers/holder or sellers/writers. Following are the guidelines for accounting treatment in case of
cash settled index options and stock options:
12.9.1 Accounting at the inception of a contract

The seller/writer of the option is required to pay initial margin for entering into the option
contract. Such initial margin paid would be debited to ‘Equity Index Option Margin Account’ or
to ‘Equity Stock Option Margin Account’, as the case may be. In the balance sheet, such account
should be shown separately under the head ‘Current Assets’. The buyer/holder of the option is
not required to pay any margin. He is required to pay the premium. In his books, such premium
would be debited to ‘Equity Index Option Premium Account’ or ‘Equity Stock Option Premium
Account’, as the case may be. In the books of the seller/writer, such premium received should be
credited to ‘Equity Index Option Premium Account’ or ‘Equity Stock Option Premium Account’
as the case may be.
12.9.2 Accounting at the time of payment/receipt of margin

Payments made or received by the seller/writer for the margin should be credited/debited to the
bank account and the corresponding debit/credit for the same should also be made to ‘Equity
Index Option Margin Account’ or to ‘Equity Stock Option Margin Account’, as the case may be.
Sometimes, the client deposit a lump sum amount with the trading/clearing member in respect of
the margin instead of paying/receiving margin on daily basis. In such case, the amount of margin
paid/received from/into such accounts should be debited/credited to the ‘Deposit for Margin
Account’. At the end of the year the balance in this account would be shown as deposit under
‘Current Assets’.
12.9.3 Accounting for open positions as on balance sheet dates

The ‘Equity Index Option Premium Account’ and the ‘Equity Stock Option Premium Account’
should be shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the case may be.
In the books of the buyer/holder, a provision should be made for the amount by which the
premium paid for the option exceeds the premium prevailing on the balance sheet date. The
provision so created should be credited to ‘Provision for Loss on Equity Index Option Account’
to the ‘Provision for Loss on Equity Stock Options Account’, as the case may be. The provision
made as above should be shown as deduction from ‘Equity Index Option Premium’ or ‘Equity
Stock Option Premium’ which is shown under ‘Current Assets’.
In the books of the seller/writer, the provision should be made for the amount by which
premium prevailing on the balance sheet date exceeds the premium received for that option.
This provision should be credited to ‘Provision for Loss on Equity Index Option Account’
12.9 Accounting for equity index options and equity stock options 203
or to the ‘Provision for Loss on Equity Stock Option Account’, as the case may be, with a
corresponding debit to profit and loss account. ‘Equity Index Options Premium Account’ or
‘Equity Stock Options Premium Account’ and ‘Provision for Loss on Equity Index Options
Account’ or ’Provision for Loss on Equity Stock Options Account’ should be shown under
‘Current Liabilities and Provisions’.
In case of any opening balance in the ‘Provision for Loss on Equity Stock Options Account’
or the ‘Provision for Loss on Equity Index Options Account’, the same should be adjusted against
the provision required in the current year and the profit and loss account be debited/credited with
the balance provision required to be made/excess provision written back.
12.9.4 Accounting at the time of f i nal settlement

On exercise of the option, the buyer/holder will recognize premium as an expense and debit
the profit and loss account by crediting ‘Equity Index Option Premium Account’ or ‘Equity
Stock Option Premium Account’. Apart from the above, the buyer/holder will receive favorable
difference, if any, between the final settlement price as on the exercise/expiry date and the strike
price, which will be recognized as income. On exercise of the option, the seller/writer will
recognize premium as an income and credit the profit and loss account by debiting ‘Equity Index
Option Premium Account’ or ‘Equity Stock Option Premium Account’. Apart from the above,
the seller/writer will pay the adverse difference, if any, between the final settlement price as on
the exercise/expiry date and the strike price. Such payment will be recognized as a loss.
As soon as an option gets exercised, margin paid towards such option would be released by
the exchange, which should be credited to ‘Equity Index Option Margin Account’ or to ‘Equity
Stock Option Margin Account’, as the case may be, and the bank account will be debited.
12.9.5 Accounting at the time of squaring off an option contract

The difference between the premium paid and received on the squared off transactions should be
transferred to the profit and loss account. Following are the guidelines for accounting treatment
in case of delivery settled index options and stock options: The accounting entries at the time
of inception, payment/receipt of margin and open options at the balance sheet date will be the
same as those in case of cash settled options. At the time of final settlement, if an option expires
unexercised then the accounting entries will be the same as those in case of cash settled options.
If the option is exercised then shares will be transferred in consideration for cash at the strike
price. For a call option the buyer/holder will receive equity shares for which the call option
was entered into. The buyer/holder should debit the relevant equity shares account and credit
cash/bank. For a put option, the buyer/holder will deliver equity shares for which the put option
was entered into. The buyer/holder should credit the relevant equity shares account and debit
cash/bank. Similarly, for a call option the seller/writer will deliver equity shares for which the
call option was entered into. The seller/writer should credit the relevant equity shares account
and debit cash/bank. For a put option the seller/writer will receive equity shares for which the
put option was entered into. The seller/writer should debit the relevant equity shares account and
credit cash/bank. In addition to this entry, the premium paid/received will be transferred to the
profit and loss account, the accounting entries for which should be the same as those in case of
cash settled options.
12.10 Taxation issues: A discussion

The income-tax Act does not have any specific provision regarding taxability from derivatives.
Hence we restrict ourselves to a discussion on the topic of taxability of derivatives. The reader
may keep track of the developments in this regard as and when they occur.
The only provisions which have an indirect bearing on derivative transactions are sections
73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative
business carried on by the assessee, shall not be set off except against profits and gains, if
any, of speculative business. Section 43(5) of the Act defines a speculative transaction as a
transaction in which a contract for purchase or sale of any commodity, including stocks and
shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the
commodity or scrips. It excludes the following types of transactions from the ambit of speculative
transactions:
1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against
loss in his holding of stocks and shares through price fluctuations;
2. A contract entered into by a member of a forward market or a stock exchange in the course of any
transaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinary
course of business as such member.
From the above, it appears that a transaction is speculative, if it is settled otherwise than
by actual delivery. The hedging and arbitrage transactions, even though not settled by actual
delivery are considered non-speculative. A transaction to be speculative therefore requires that:
1. The transaction is in commodities, shares, stock or scrips
2. The transaction is settled otherwise than by actual delivery
3. The participant has no underlying position
4. The transaction is not for jobbing/arbitrage
In the absence of a specific provision, it is apprehended that the derivatives contracts,

particularly the index futures which are essentially cash-settled, may be construed as speculative
transactions and therefore the losses, if any, will not be eligible for set off against other income
of the assessee and will be carried forward and set off against speculative income only up to
maximum of eight years.
The fact, however, is that derivative contracts are not for purchase/sale of any
commodity,stock,share or scrip. Derivatives are a special class of securities under the SC(R)A,
1956 and do not any way resemble any other type of securities like share,stocks or scrips.
Derivative contracts, particularly index futures are cash-settled, as these cannot be settled
otherwise. As explained earlier, derivative contracts are entered into by hedgers,speculators
12.10 Taxation issues: A discussion 205
and arbitrageurs. A derivative contract has any of these two parties and hence some of the
derivative contracts, not all, have an element of speculation. At least one of the parties to a
derivative contract is a hedger or an arbitrageur. It would, therefore, be unfair to treat derivative
transactions as speculative. Otherwise it would be a penalty on hedging which the Securities
Laws (Amendment) Act, 1999 seeks to promote. In view of these difficulties in applying the
existing provisions, it is desirable to clarify or make special provision for derivatives of securities.
Section 43 is relevant in case of contracts where actual delivery is possible, but these are
settled otherwise than by actual delivery. This provision cannot be applied to derivatives,
particularly index futures, which can be settled only by cash. There cannot be actual delivery.
Hence the actual delivery for a contract to be non-speculative cannot be applied to derivatives
contracts.
As emphasized earlier by the L C Gupta Committee, the futures market should have
speculative appeal. This means, the speculators have to be treated equitably, that is at least
at par with hedgers, if not better. All types of participants need to be provided level playing
field so that the market is competitive and efficient. As regards taxability, the law should not
treat income of the hedger,speculators and arbitrageurs differently. Income of all the participants
from derivatives needs to be treated uniformly.
Further, a transaction is considered speculative, if a participant enters into a hedging

transaction in scrips outside his holdings. It is possible that an investor does not have all the 30
or 50 stocks represented by the index. As a result an investor’s losses or profits out of derivatives
transactions, even though they are of hedging nature in real sense, it is apprehended, may be
treated as speculative. This is contrary to capital asset pricing model which states that portfolios
in any economy move in sympathy with the index although the portfolios do not necessarily
contain any security in the index. The index futures are, therefore, used even for hedging the
portfolio risk of non-index stocks. An investor who does not have the index stocks can also use
the index futures to hedge against the market risk as all the portfolios have a correlation with the
overall movement of the market (i.e. the index).
In view of the practical difficulties in administration of tax for different purposes of the same
transaction, inherent nature of derivative contract requiring its settlement otherwise than by actual
delivery, need to promote level playing field to all parties to derivatives contracts, and the need
to promote derivatives markets, it is suggested that the exchange-traded derivatives contracts are
exempted from the purview of speculative transactions. These must, however be taxed as normal
business income. This would be fiscally more prudent.
Solved problems
Q: The Securities and Exchange Board of India Act, 1992 was an act to provide for the establishment of
a Board
1. To protect the interests of investors 3. To regulate the securities market

2. To promote the development of securities
market 4. All of the above
Q: The regulatory framework for the derivatives market in India has been developed by the
1. L.C.Gupta committee 3. A.C.Gupta committee
2. J.R.Varma committee 4. None of the above
Q: A member is short 400 March futures contracts and long 200 April futures contracts. A calendar spread
in this case will be
1. Long 200 futures contracts 3. Long 400 futures contracts
2. Short 200 futures contracts 4. Short 400 futures contracts
Q: As per the requirements of SEBI, a derivatives exchange must have a minimum of members
1. 100 3. 75
2. 50 4. 25
Q: The minimum networth for clearing members of the derivatives clearing corporation/house shall be
1. Rs.300 Lakh 3. Rs.500 Lakh
2. Rs.250 Lakh 4. None of the above

Q: Which of the following persons are eligible to become trading members in the F&O segment of NSE?
1. Individuals 3. Companies
2. Registered fi rms 4. Any of the above
Q: The dealer/broker and sales persons in the F&O segment shall be required to pass which of the
following examinations?
1. MBA (Finance) 3. Certifi ed Financial Analyst
2. Chartered Accountancy 4. NCFM
Q: Which of the following Acts governs trading of derivatives in India?
1. Securities Contracts (Regulation) Act, 1956 3. Capital Issues (Control) Act, 1947
2. SEBI Act, 1992 4. Depositories Act, 1956
Q: The open position for the proprietary trades will be on a
1. Net basis 2. Gross basis
Q: The computation of open position for client trades would be carried out on a
1. Gross basis i.e.long minus short. 2. Net basis i.e. long and short separately.
Q: A clearing member of F&O segment is required to have a networth of and keep collateral
security deposit of
1. Rs.3 Crore, 50 Lakh. 3. Rs.3 Crore, 80 Lakh.
2. Rs.5 Crore, 50 Lakh. 4. Rs.5 Crore, 10 Lakh.

Q: The clearing member has to maintain a minimum liquid networth of .
Q: Initial margin paid/payable should be debited to
1. “Initial margin - Equity index futures ac- 3. “Initial margin - Equity index futures client’s
count” account”
2. “Initial margin - Equity index futures broker’s
account” 4. None of the above
Q: At the year-end, any balance in the “Deposit for mark-to-market margin account” should be shown as
a deposit under the head
1. “current assets”. 3. “pre-paid expenses”
2. “current liabilities” 4. None of the above
Q: The sum of percent of the notional value of gross open position in index futures and short index
option contracts and percent of the notional value of futures and short option position in stocks shall
not exceed liquid networth.
1. 3,5 3. 8,16
2. 5,3 4. 5,10
Q: The CM/TM is required to disclose to the clearing corporation details of any person or persons acting in
concert who together own percent or more of the open interest of all futures and options contracts
on a particular underlying index on the exchange.
1. 20 3. 15
2. 12 4. 25

Q: In which of the following cases will the futures and options contracts be adjusted for dividends?
1. aggregate dividend is more than 10% of the 3. aggregate dividend is 5% of the face value
market value
2. aggregate dividend is more than 1% of the
market value 4. aggregate dividend is 10% of the face value
Q: Margins may be deposited in the form of
1. Cash only 3. Cash + fi xed deposits only
2. Cash + bank guarantee + fi xed deposit + se- 4. 30% cash and fi xed deposits + 70% bank
curities guarantee and securities
A: The correct answer 2.

References/suggested readings
The readings suggested here are supplementary in nature and would prove to be helpful for those
interested in learning more about derivatives.
1. Derivatives FAQ by Ajay Shah and Susan Thomas
2. Escape to the futures by Leo Melamed
3. Futures and options by Hans R.Stoll and Robert E. Whaley.
4. Futures and options in risk management by Terry J. Watsham.
5. Futures, options and swaps by Robert W. Kolb.
6. Indian Securities Market Review,2001, National Stock Exchange
7. Introduction to futures and options markets by John Kolb
8. NSENEWS, National Stock Exchange
9. Options and financial future: Valuation and uses by David A. Dubofsky.
10. Regulatory framework for financial derivatives in India by Dr.L.C.Gupta Committee
11. Risk containment in the derivatives market by Prof.J.R.Varma group
12. Rubinstein on derivatives by Mark Rubinstein.
13. Rules, regulations and bye– laws, (F &O segment) of NSE & NSCCL
14. Understanding futures markets by Robert W. Kolb.
15. http://www.derivativesindia.com
16. http://www.derivatives-r-us.com
17. http://www.igidr.ac.in./ ajayshah
18. http://www.mof.nic.in
19. http://www.nseindia.com
20. http://www.rediff/money/derivatives
21. http://www.sebi.gov.in
Index
arbitrage funds, 25
transactions costs in, 86 Market capitalization weighted, 20
arbitrageurs, 8 price weighted, 20
S&P CNX Nifty, 23
basis, 32 inquiry window, 156
basket trading, 158 inter-futures trading, 90
baskets, 9
beta LEAPS, 9
portfolio, 70
security, 61 market by price, 156
market watch, 156
clearing member, 151
trading, 14 option
professional, 14 american, 33
self, 14 at-the-money, 33
contract cycle buyer, 33
futures, 159 call, 33
cost-of-carry, 49 european, 33
in-the-money, 33
derivatives index, 33
exchange traded, 12 intrinsic value, 34
OTC, 12 out-of-money, 33
premium, 33
Exchange Traded Fund, 26 put, 33
financial derivatives, 29 stock, 33
forwards, 29 time value, 34
futures, 8 writer, 33
commodity, 50 order
index, 51 day, 155
individual security, 54 GTC, 155
GTD, 155
hedgers, 8 IOC, 155
stop–loss, 155
impact cost, 24
on futures market, 86 price
index limit, 155
equally weighted, 20 trigger, 155
212 INDEX
pricing
index options, 101
options on individual security, 102
put-call parity, 131
speculators, 8
spot price, 31
spreads trading, 90
strike price, 102
swaps, 9
currency, 9
interest rate, 9
swaptions, 9
warrants, 9

NCFM - Derivatives, NCDEX

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Contents

3 Introduction to futures and options 29

5 Using index futures 59

6 Using futures on individual securities 93

8 Using index options 109

9 Using stock options 137

10.2 The trader workstation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

11 Clearing and settlement 167

12 Regulatory framework 185

12.7.8 Exposure limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

1.1 Derivatives defined

1.2 Products, participants and functions

1.3 Types of derivatives

Box 1.1: Emergence of financial derivative products

Box 1.2: History of derivatives markets

1.4 Development of exchange-traded derivatives

1. Increased volatility in asset prices in fi nancial markets,

2. Increased integration of national fi nancial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

1.5 Global derivatives markets

1.6 Exchange-traded vs. OTC derivatives markets

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

1.7 Derivatives market in India

1.7.1 Approval for derivatives trading

1.7.2 Derivatives market at NSE

1.7.3 Trading mechanism

1.7.4 Membership criteria

Table 1.3 Business growth of futures and options market: Turnover(Rs.crore)

1.7.6 Clearing and settlement

1.7.7 Risk management system

1. Chicago Board of Trade 3. Chicago Board Options Exchange

4. London International Financial Futures and

A: The correct answer is number 1.

Q: The underlying asset for a derivative contract can be

1. Equity 3. Interest rate

2. Commodities 4. Any of the above

A: The correct answer is number 4

Q: Derivatives fi rst emerged as products

A: The correct answer is number 2.

Q: Who are the participants in the derivatives market?

2. Speculators 4. All of the above

A: The correct answer is number 4.

Q: The fi rst market to trade fi nancial futures was the

A: The correct answer is number 2.

Q: Which of the following exchanges offer derivatives trading

1. National Stock Exchange 3. Over The Counter Exchange of India

2. Interconnected Stock Exchange 4. ICICI Securities Limited

A: The correct answer is number 1.

1. Index futures 3. Stock options

2. Index options 4. Interest rate futures

A: The correct answer is number 1.

Q: OTC derivatives are considered risky because

A: The correct answer is number 4.

1. Index options 3. Currency futures

2. Stock options 4. Index futures

A: The correct answer is number 3.

Q: Which of the following is not an example of a derivative on security derivative?

1. Index futures 3. Stock futures

2. Index options 4. Interest rate futures

A: The correct answer is number 4.

2.1 Understanding the index number

Index ' ' '