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Published by: api-3754054 on Oct 16, 2008
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Contents
1 Introduction to derivatives
7
1.1 Derivativesde\ufb01ned. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 Tradingmechanism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.7.4 Membershipcriteria. . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.7.5 Turnover. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 1.7.6 Clearing and settlement. . . . . . . . . . . . . . . . . . . . . . . . . . . 16 1.7.7 Risk management system. . . . . . . . . . . . . . . . . . . . . . . . . . 16

2 Marketindex
19

2.1 Understanding the index number. . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.2 Economic signi\ufb01cance of index movements. . . . . . . . . . . . . . . . . . . . 20 2.3 Indexconstruction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 Maintainingprofessionally. . . . . . . . . . . . . . . . . . . . . . . . . 23

2.6 The S&P CNX Nifty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 2.6.1 Impactcost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 2.6.2 Hedgingeffectiveness. . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.7 Applications of index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 2.7.1 Indexderivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 2.7.2 Indexfunds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 2.7.3 Exchange Traded Funds. . . . . . . . . . . . . . . . . . . . . . . . . . 26

2
CONTENTS
3 Introduction to futures and options
29

3.1 Forwardcontracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 Futuresterminology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 3.6 Introduction to options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 3.7 Optionterminology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 3.8 Futures and options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 3.9 Indexderivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 Optionspayoffs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 3.12.1 Payoff pro\ufb01le for buyer of call options: Long call. . . . . . . . . . . . . 39 3.12.2 Payoff pro\ufb01le for writer of call options: Short call. . . . . . . . . . . . . 40 3.12.3 Payoff pro\ufb01le for buyer of put options: Long put. . . . . . . . . . . . . 40 3.12.4 Payoff pro\ufb01le for writer of put options: Short put. . . . . . . . . . . . . 41

4 Pricingfutures
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 Pricingoptions
99

7.1 Introduction to the Black\u2013Scholes formulae. . . . . . . . . . . . . . . . . . . . 100
7.2 The Black\u2013Scholes 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\u2013dividend paying stock. . . . . . . . . . . 140
9.3.2 Early exercise of puts on non\u2013dividend 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 Impliedvolatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

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