Professional Documents
Culture Documents
PROJECT ON
EQUITY DERIVATIVES IN INDIA
SUBMITTED BY
LACHHANI NISHA M.
PROJECT GUIDE
Bhavdas sir
SEMESTER V
(2009-2010)
V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE,
SINDHI COLONY, CHEMBUR 400071
1
UNIVERSITY OF MUMBAI
PROJECT ON
Submitted
In Partial Fulfillment of the requirements
For the Award of the Degree of
Bachelor of Management
By
LACHHANI NISHA M.
PROJECT GUIDE
MR. BHAVDAS SIR
Declaration
I
Students Signature
Name of Student
LACHHANI NISHA M.
C E R T I F I C A T E
completed
DERIVATIVES
IN
the
INDIA
project
under
the
on
EQUITY
guidance
MR.BHAVDAS SIR.
Principal
Project Guide
Course Co-ordinator
Mrs. A. MARTINA
of
External Examiner
ACKNOWLEDGEMENT
This project took nearly 2months to complete the task. And this took a lot of
hard work from not just me but a lot of people who gave me not only their time
and attention but a true response as well.
I would like to thank the following people for their dedication and contribution
without which this project could have not been created.
Firstly, My Family members- my parents and sister for giving me space,
time and emotional support I needed to follow and complete what seemed like an
endless task.
Then to my project guide MR. BHAVDAS who helped me develop a proper
project plan, and being my professor showed me the right track to follow. He also
encouraged me a lot to take up this topic which seemed easier as I had his support.
Financial market:Financial market is a mechanism that allows people to easily buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural
goods), Financial markets have evolved significantly over several hundred years and are
undergoing constant innovation to improve liquidity.
A system that facilitates the exchange of money for financial assets. A security market such as
the National Stock Exchange is an example of a financial market.
Financial
market
Equity
market
Derivative
market
Equity market:A equity market is a public market for the trading of company stock at an
agreed price; these are securities listed on a stock exchange as well as those only traded
privately.
Derivative market: -
The derivatives markets are the financial markets for derivatives. The market can
be divided into two, that for exchange traded derivatives (ETD) and that for over-the-counter
derivatives(OTC).
Introduction of derivatives:The word DERIVATIVES is derived from the word itself derived of an underlying
asset. It is a future image or copy of an underlying asset which may be shares, stocks,
commodities, stock index, etc.
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".
Derivatives have become very important in the field finance. They are very important
financial instruments for risk management as they allow risks to be separated and traded.
Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each
party involved in the contract should be able to identify all the risks involved before the contract
is agreed.
It is also important to remember that derivatives are derived from an underlying asset.
This means that risks in trading derivatives may change depending on what happens to the
underlying asset. The underlying asset can be equity, forex, commodity or any other asset.
For example, if the settlement price of a derivative is based on the stock price of a stock for e.g.
Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on
a daily basis. This means that derivative risks and positions must be monitored constantly.
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 financial 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 find these useful due to
high correlation of the popular indexes with various portfolios and ease of use.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized around
1865. From then on, futures contracts have remained more or less in the same form, as we know
them today.
Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on these
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exchanges. The derivatives market in India has grown exponentially, especially at NSE. Stock
Futures are the most highly traded contracts on NSE accounting for around 55% of the total
turnover of derivatives at NSE, as on April 13, 2005.
Badla is nothing but a carry forward system which means getting something in
return. The badla system was acceptable to be an important need for the investors in the stock
market. Here in this system the investor feels that the price of a particular share is expected to go
up or down, without giving or taking the delivery he can participate in the possible fluctuation of
the share.
In the badla system, a position is carried forward, be it a short sale or a long purchase. In the
event of a long purchase, the market player may want to carry forward the transaction to the next
settlement cycle and for doing this he has to compensate the other party in the contract. While in
case of a short sale, the market player wants tom carry forward the transaction to the next
settlement cycle, he has to borrow the stocks to compensate the other party in the contract
The investor has purchased the 100shares of INFOSYS COMPANY for Rs.7000
which is trading at Rs. 7300. After this the investor expects to rise further. Therefore he wishes
to carry the contract forward to the next trading session by paying what are called badla charges.
In any badla transaction there are two key elements, the hawala rate and the bald
charge for the scrip. The badla charge is the interest payable by the investor for carrying forward
the position. It is fixed individually for each scrip by the exchange every Saturday and it is
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calculated on what is called the heal rate. The hawala rate is the price at which a share is squared
up in the current settlement and carried forward into the next settlement in the next trading
session. The existing position is squared up against the hawala rate fixed and carried forward
after factoring in the badla rate. The difference is paid to the broker (charges).
Thus if hawala rata Rs.7180 is lower than the initial margin the difference is paid to the broker.
The badla charges vary from broker to broker and proper relationship with the broker If broker
insists on a 25% margin, the investor get 400% leverage or four times the amount investor is
ready to deposit as margin. Thus At the end of each settlement, investor carry forward the
position at the hawala rate. This position will also be adjusted for badla. Thus investor can carry
forward the transactions for settlement
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1. They help in transferring risks from risk averse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
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1. Today's sophisticated international markets have helped foster the rapid growth in
2. Help of hedge against inflation and deflation, and generate returns that are not correlated
with more traditional investments. The two most widely recognized benefits attributed to
derivative instruments are price discovery and risk management and others.
3. Price discovery: -
The kind of information and the way people absorb it constantly changes
the price of a commodity. This process is known as price discovery. the price of all future
contracts serve as prices that can be accepted by those who trade the contracts in lieu of
facing the risk of uncertain future prices.
12
4. Risk management: -
6. By allowing transfer of unwanted risks, derivatives can promote more efficient allocation
of capital across the economy and thus, increasing productivity in the economy.
Over the last three decades, the derivatives market has seen a
phenomenal growth. A large variety of derivative contracts have been launched at
exchanges across the world. Some of the factors driving the growth of financial
derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
13
5. Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets leading to higher returns, reduced risk as well
as transactions costs as compared to individual financial assets.
Derivative market
Exchange
traded
derivatives
Over the counter derivatives are contracts that are traded (and
privately negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps and forward rate agreements are almost always traded in
this way. The OTC derivative market is the largest market for derivatives, and is largely
unregulated with respect to disclosure of information between the parties, since the OTC market
is made up of banks and other highly sophisticated parties.
Because OTC derivatives are not traded on an exchange, there is no
central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract,
since each counter party relies on the other to perform.
15
1.
individual institutions.
2.
3.
4.
There are no formal rules or mechanisms for ensuring market stability and integrity, and
for safeguarding the collective interests of market participants, and
The OTC contracts are generally not regulated by a regulatory authority and the
5.
When asset prices change rapidly, the size and configuration of counter-party exposures
6.
Exchange traded derivatives:They are standardized ones where the exchange sets the
standards for trading by providing the contract specifications and the clearing corporation
provides the trade guarantee and the settlement activities. Futures and Options are the
derivatives. Products like futures and options are traded in this way.
16
The management of counter party risk is centralized and located with high
institutions.
2.
3.
4.
There are formal rules or mechanisms for ensuring market stability and integrity,
and for safeguarding the collective interests of market participants, and
5.
Types of derivatives:-
17
Derivative contracts have several types. The most common variants are forwards, futures,
options and swaps.
1.
Forwards:
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed price.
2.
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.
3. 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.
4.
Warrants:
Options generally have lives of up to one year; the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.
5.
LEAPS:
The acronym LEAPS means Long-Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
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6.
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.
7.
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:
Currency swaps:
These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite
direction.
8. Swaptions:
Swaptions are options to buy or sell a swap that will become operative
at the expiry of the options. Thus a swaption is an option on a forward Swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.
19
Forward contract:It is an agreement between two parties to buy or sell an asset on a specified date
for a specified price. A forward contract is a simple derivative. It is a type of market where buyer
and seller predict the future for the underlying asset which may be stocks, currency, interest rate
etc. One of the parties to the contract assumes a long position which agrees to buy underlying
asset for a certain specified price. The other Party assumes a short position and agrees to sell at
the same price. Forward contract can be 30days, 90days and 180days
The contract is usually between two financial institutions or between a financial
institution and its corporate client. A forward contract is not normally traded on an exchange. It
is traded on the OTC (over the counter) derivatives where the intermediator or exchange has no
role to play and contract is smoothly settled by the parties or normally traded outside the
exchanges.
At delivery, ownership of the good is transferred and payment is made. In other
words, whereas the forward contract is executed today, and the price is agreed upon today, the
actual transaction in which the underlying asset is traded does not take place until a later date.
Typically, no money changes hands on the origination date of a forward contract.
Forward contracts are not standardized unlike futures contracts. They are
customized and each contract is unique in terms of contract size, expiration date and the asset
type and quality. Terms of Forward contracts are negotiated between buyer and seller. As there is
no exchange involved in it there is chance of default of either party.
Forward contracts are very useful in hedging and speculation. Here the
importer and exporter can hedge their risk exposure with respect to exchange rate fluctuations
while entering into the currency forward market.
The first formal commodities exchange in the United States for spot and
forward contracting was formatted in 1848: the Chicago Board of Trade (CBOT).
20
ILLUSTRATION
On 1st march 2004 Mukesh has entered into a forward contract with Anil In this Mukesh takes a
long position(buy) on the scrip and Anil takes a short position(short) on the scrip. Here Mukesh
agrees to purchase 100 shares of RELIANCE ENERGY from the Anil for a predetermined price
of Rs.400.The contract is three months forward. Thus on future Anil will deliver the shares to
Mukesh while in return Mukesh will pay the amount of Rs.40,000(400*100).
Suppose during the maturity date Mukesh may default for the transaction he refuse to
make the payment for the shares or Anil refuse to deliver the shares. Therefore in this there is a
counter party risk one party may default due to this other party suffers because there is no
standardized exchange between the parties and the contract is OTC in nature and also prices are
decided by the buyers and sellers.
Finally forward contract is settled at maturity. The holder of the short position delivers the asset
to the holder of the long position in return for cash at the agreed upon rate. Therefore, a key
determinant of the value of the contract is the market price of the underlying asset. A forward
contract can therefore, assume a positive or negative value depending on the movements of the
price of the asset. For example, if the price of the asset rises sharply after the two parties have
entered into the contract, the party holding the long position stands to benefit, i.e. the value of the
contract is positive for her. Conversely, the value of the contract becomes negative for the party
holding the short position.
21
forward contract that can be easily traded. In future contract default risk is lower on futures than
on forwards for several reasons:a) The counterparty to all futures trades is actually the clearing house of the futures
exchange, which guarantees that all payments will be made.
b) Future contracts are marked to market daily settled which means that any change in
the value of the contract is realized as a profit or loss every day.
c) Initial margin, which serves as a performance bond, is required when trading futures.
In contrast, because they are not marked to market, forward contracts can build up
large unrealized profits for one party and equally large unrealized losses for the other
party.
There is a multilateral contract between the buyer and seller for an
underlying asset which may be financial instrument or physical commodities. But unlike forward
contracts the future contracts are standardized and exchange traded.
The primary purpose of futures market is to provide an efficient and
effective mechanism for management of inherent risks, without counter-party risk. As it is a
future contract the buyer and seller has to pay the margin to trade in the futures market.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery
The units of price quotation and minimum price change.
. Location of settlement.
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Profit
20
2200
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the buyer (Hitesh) = Rs.1, 65,000 [(2200-1650*3oo)] and notional profit for
the buyer is 550.
Unlimited loss for the buyer because the buyer is bearish in the market
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20
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is
250.
Unlimited loss for the seller because the seller is bullish in the market.
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History of future derivatives:Merton Miller, the 1990 Nobel laureate had said that 'financial futures
represent the most significant financial innovation of the last twenty years." The first exchange
that traded financial 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 financial 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 dollar.
FUTURES TERMINOLOGY:a)
Spot price: The price at which an asset trades in the spot market.
b) Futures price: The price at which the futures contract trades in the futures market.
c) Contract cycle: The period over which a contract trades. The index futures contracts
on the NSE have one- month, two-month 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.
d) Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
25
e) Contract size: The amount of asset that has to be delivered under one contract. Also
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.
g) Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the storage
cost plus the interest that is paid to finance the asset less the income earned on the
asset.
h) Initial margin: The amount that must be deposited in the margin account at the time
account is adjusted to reflect the investor's gain or loss depending upon the futures
closing price. This is called marking-to-market.
j) 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.
26
Introduction to options:It is an interesting tool for small retail investors. An option is a contract, which
gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the
underlying assets, at a specific (strike) price on or before a specified time (expiration date). The
underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial
instruments like equity stocks/ stock index/ bonds etc.
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. The options are
also traded on stock exchange.
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of
the underlying asset at the strike price on or before expiration date. The seller (one who is short
call) however, has the obligation to sell the underlying asset if the buyer of the call option
decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer
(seller) of the contract.
ILLUSTRATION
Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the
market and other is Rakesh (call seller) who is bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25
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1. CALL BUYER
Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be
exercised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will
earn profit once the share price crossed to Rs.625 (strike price + premium). Suppose the stock
has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip
from the seller at Rs.600 and sell in the market at Rs.660.
Profit
30
20
10
0 590 600 610 620 630 640
-10
-20
-30
Loss
Unlimited profit for the buyer = Rs.35{(spot price strike price) premium}
Limited loss for the buyer up to the premium paid.
2. CALL SELLER:
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In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock
price fall to Rs.550 the buyer will choose not to exercise the option.
Profit
30
20
10
0 590 600 610 620 630 640
-10
-20
-30
Loss
PUT OPTION
A Put option gives the holder (buyer/ one who is long Put), the right
to sell specified quantity of the underlying asset at the strike price on or before an expiry date.
The seller of the put option (one who is short put) however, has the obligation to buy the
underlying asset at the strike price if the buyer decides to exercise his option to sell.
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ILLUSTRATION
Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the
market and other is Amit (put seller) who is bullish in the market.
The current market price of TISCO COMPANY is Rs.800 and premium is Rs.20.
20
10
0
600
700
10
20
Loss
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800
900
1000
1100
Unlimited profit for the buyer = Rs.80 {(Strike price spot price) premium}
Loss limited for the buyer up to the premium paid = 20.
In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. The buyer of the
Put option will choose not to exercise his option to sell as he can sell in the market at a higher
rate.
Profit
20
10
0 600 700 800 900 1000 1100
10
20
Loss
Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for
the seller because the seller is bullish in the market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20
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LONG POSITION
If the investor expects price to fall i.e. bearish in
SHORT POSITION
If the investor expects price to rise i.e. bullish in
CALL OPTIONS
PUT OPTIONS
Option
buyer
option holder
Option
seller
option writer
3)
Index options:
33
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.
4)
Stock options:
Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the right to
buy or sell shares at the specified price.
5) 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.
6)
Writer of an option:
The writer of a call/put option is the one who receive 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.
7)
Option price/premium:
Option price is the price which the option buyer pays to
the option seller. It is also referred to as the option premium.
8) Expiration date:
The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
9)
Strike price:
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10)
American options:
American options are options that can be exercised at any
13)
At-the-money option:
An at-the-money (ATM) option is an option that would lead to
zero cash flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price
(i.e. spot price = strike price).
Changes in the underlying asset price can increase or decrease the premium of an option. These
price changes have opposite effects on calls and puts.
For instance, as the price of the underlying asset rises, the premium of a call will increase and the
premium of a put will decrease. A decrease in the price of the underlying assets value will
generally have the opposite effect.
The strike price determines whether or not an option has any intrinsic value. An options
premium generally increases as the option gets further in the money, and decreases as the option
becomes more deeply out of the money.
An expiration approaches, the level of an options time value, for puts and calls, decreases.
Volatility:
37
This effect reflects the COST OF CARRY the interest that might be paid for margin, in case
of an option seller or received from alternative investments in the case of an option buyer for the
premium paid.
Higher the interest rate, higher is the premium of the option as the cost of carry increases.
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RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of the
underlying assets at a price agreed upon by the buyer & seller, on or before
a specified time. Both the buyer and seller are obligated to buy/sell the
underlying asset. In case of options the buyer enjoys the right & not the
obligation, to buy or sell the underlying asset.
RISK:
Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While
options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the
downside is limited to the premium (option price) he has paid while the profits may be unlimited.
For a seller or writer of an option, however, the downside is unlimited while profits are limited to
the premium he has received from the buyer.
PRICES:
The Futures contracts prices are affected mainly by the prices of the underlying asset. While the
prices of options are however, affected by prices of the underlying asset, time remaining for
expiry of the contract & volatility of the underlying asset.
COST:
It costs nothing to enter into a futures contract whereas there is a cost of entering into an options
contract, termed as Premium.
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STRIKE PRICE:
In the Futures contract the strike price moves while in the option contract the strike price remains
constant.
Liquidity:
As Futures contract are more popular as compared to options. Also the premium charged is high
in the options. So there is a limited Liquidity in the options as compared to Futures. There is no
dedicated trading and investors in the options contract.
Price behavior:
The trading in future contract is one-dimensional as the price of future depends upon the price of
the underlying only. While trading in option is two-dimensional as the price of the option
depends upon the price and volatility of the underlying.
PAY OFF:
As options contract are less active as compared to futures which results into non linear pay off.
While futures are more active has linear pay off.
FUTURES PAYOFFS
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.
40
down, the short futures position starts making profits, and when the index moves up, it starts
making losses. Figure shows the payoff diagram for the seller of a futures contract.
OPTIONS PAYOFFS
42
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.
43
The figure shows the profits/losses from a long position on the index. The investor bought the
index at 2220. If the index goes up, he profits. If the index falls he looses.
The figure shows the profits/losses from a short position on the index. The investor sold the
index at 2220. If the index falls, he profits. If the index rises, he looses.
45
46
47
48
The figure shows the profits/losses for the buyer of a three-month Nifty 2250 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 2250, the buyer would exercise his option and profit to the extent of the
difference between the strike price and Nifty-close. The profits possible on this option can be as
high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire.
His losses are limited to the extent of the premium he paid for buying the option.
49
50
APPLICATION OF OPTIONS
Since the index is nothing but a security whose price or level is a weighted average of securities
constituting the index, all strategies that can be implemented using stock futures can also be
implemented using index options.
51
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.
53
Underlying
Strike price of
option
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
At a price 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.
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profit by adopting a position on the market? Due to poor corporate results, or the instability of
the government, many people feel that the stocks prices would go down. How does one
implement a trading strategy to benefit from a downward movement in the market? Today, using
options, you have two choices:
1. Sell call options; or
2. Buy put options
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 price of a particular security
is going to fall in a months time. Your hunch proves correct and it does indeed fall, it is this
downside that you cash in on. When the price 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 soars
up instead, what you lose is directly proportional to the rise in the price of the security.
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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 there under and the rules and byelaws of stock
exchanges.
in such schemes.
4. Government securities
5. Such other instruments as may be declared by the Central Government to be securities.
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1.
committee report can 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 would have to regulate the sales practices of
its members and would have to obtain prior approval of SEBI before start of trading in any
derivative contract.
2. The Exchange should have minimum 50 members.
3.
become the members of derivative segment. The members of the derivative segment would
need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee.
4.
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5.
registration from SEBI. This is in addition to their registration as brokers of existing stock
exchanges. The minimum net worth 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) Members 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 have to submit
The initial margin requirement, exposure limits linked to capital adequacy and
margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange
from time to time.
8.
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.
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CONCLUSION
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