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1
CONTENTS
CHAPTER 1....................................................................................................................................................5
INTRODUCTION TO DERIVATIVES..................................................................................................5
1.1
DERIVATIVES
DEFINED..........................................................................................................5
1.2
FACTORS
DRIVING
THE
GROWTH
OF
DERIVATIVES.................................................6
1.3
DERIVATIVE
PRODUCTS........................................................................................................7
1.4
PARTICIPANTS
IN
THE
DERIVATIVES
MARKETS........................................................8
1.5
ECONOMIC
FUNCTION
OF
THE
DERIVATIVE
MARKET............................................8
1.6
EXCHANGE-TRADED
VS
.
OTC
DERIVATIVES
MARKETS........................................10
1.7
NSE'
S
DERIVATIVES
MARKET............................................................................................11
1.7.1
Participants and functions.................................................................................................11
1.7.2
Trading mechanism.............................................................................................................12
1.7.3
Turnover...............................................................................................................................13
CHAPTER 2..................................................................................................................................................15
MARKET INDEX.......................................................................................................................................15
2.1
UNDERSTANDING
THE
INDEX
NUMBER.......................................................................15
2.2
ECONOMIC
SIGNIFICANCE
OF
INDEX
MOVEMENTS...............................................16
2.3
INDEX
CONSTRUCTION
ISSUES........................................................................................16
2.4
T
YPES OF INDEXES
........................................................................................................................17
2.5
DESIRABLE
ATTRIBUTES
OF
AN
INDEX........................................................................18
2.5.1
Capturing behavior of portfolios......................................................................................18
2.5.2
Including liquid stocks.......................................................................................................19
2.5.3
Maintaining professionally................................................................................................19
2.6
THE
S&P
CNX
NIFTY...............................................................................................................19
2.6.1
Impact cost...........................................................................................................................20
2.6.2
Hedging effectiveness............................................................................................................20
2.7
A
PPLICATIONS OF INDEX
..............................................................................................................21
2.7.1
Index derivatives..................................................................................................................21
2.7.2
Index funds..............................................................................................................................21
2.7.3
Exchange Traded Funds....................................................................................................21
CHAPTER 3..................................................................................................................................................25
INTRODUCTION TO FUTURES AND OPTIONS..........................................................................25
3.1
FORWARD
CONTRACTS........................................................................................................25
3.2
L
IMITATIONS OF FORWARD MARKETS
........................................................................................26
3.3
INTRODUCTION
TO
FUTURES............................................................................................26
3.4
DISTINCTION
BETWEEN
FUTURES
AND
FORWARDS
CONTRACTS...................28
3.5
F
UTURES TERMINOLOGY
..............................................................................................................28
3.6
INTRODUCTION
TO
OPTIONS.............................................................................................29
3.7
OPTION
TERMINOLOGY.......................................................................................................29
3.8
F
UTURES AND OPTIONS
................................................................................................................32
3.9
I
NDEX DERIVATIVES
.....................................................................................................................33
2
CHAPTER 4..................................................................................................................................................36
APPLICATIONS OF FUTURES AND OPTIONS............................................................................36
4.1
T
RADING UNDERLYING VERSUS TRADING SINGLE STOCK FUTURES
......................................36
4.2
F
UTURES PAYOFFS
........................................................................................................................37
4.2.1
Payoff for buyer of futures: Long futures........................................................................37
4.2.2
Payoff for seller of futures: Short futures.......................................................................38
4.3
P
RICING FUTURES
..........................................................................................................................39
4.3.1
Pricing equity index futures..............................................................................................40
4.3.2
Pricing index futures given expected dividend amount................................................40
4.3.3
Pricing index futures given expected dividend yield.....................................................41
4.4
P
RICING STOCK FUTURES
.............................................................................................................43
4.4.1
Pricing stock futures when no dividend expected..........................................................43
4.4.2
Pricing stock futures when dividends are expected.......................................................44
4.5
A
PPLICATION OF FUTURES
...........................................................................................................44
4.5.1
Hedging: Long security, sell futures................................................................................45
4.5.2
Speculation: Bullish security, buy futures.......................................................................46
4.5.3
Speculation: Bearish security, sell futures......................................................................46
4.5.4
Arbitrage: Overpriced futures: buy spot, sell futures..........................................................47
4.5.5
Arbitrage: Underpriced futures: buy futures, sell spot.................................................48
4.6
O
PTIONS PAYOFFS
.........................................................................................................................48
4.6.1
Payoff profile of buyer of asset: Long asset...................................................................49
4.6.2
Payoff profile for seller of asset: Short asset.......................................................................49
4.6.3
Payoff profile for buyer of call options: Long call...............................................................49
4.6.4
Payoff profile for writer of call options: Short call.......................................................51
4.6.5
Payoff profile for buyer of put options: Long put..........................................................52
4.6.6
Payoff profile for writer of put options: Short put.........................................................52
4.7
P
RICING OPTIONS
..........................................................................................................................53
4.8
A
PPLICATION OF OPTIONS
............................................................................................................54
4.8.1
Hedging: Have underlying buy puts................................................................................54
4.8.2 Speculation: Bullish security, buy calls or sell puts.....................................................55
4.8.3
Speculation: Bearish security, sell calls or buy puts....................................................57
4.8.4
Bull spreads - Buy a call and sell another......................................................................61
4.8.5
Bear spreads - sell a call and buy another.....................................................................63
4.9
T
HE
G
REEKS
..................................................................................................................................66
4.9.1 Delta ( ).............................................................................................................................66
4.9.2
Gamma ( )..........................................................................................................................66
4.9.3 Theta ( )...........................................................................................................................67
4.9.4
Vega .................................................................................................................................67
4.9.5
Rho( ).................................................................................................................................67
CHAPTER 5..................................................................................................................................................71
TRADING......................................................................................................................................................71
5.1
F
UTURES AND OPTIONS TRADING SYSTEM
.................................................................................71
5.1.1
Entities in the trading system............................................................................................71
5.1.2
Basis of trading....................................................................................................................72
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