FDRM Project

Submitted To:
Dr. Nidhi Singh

Submitted By:
Deep Arora
Aishwarya Srivastava
Ashutosh Dhyani
Subhalaxmi Bora
Rohini Sachan
Vinay Sharma
Anshika Gupta

Derivatives
The emergence and growth of the market for derivative instruments can be traced back to the
willingness of risk averse economic agents to guard themselves against uncertainties arising out
of fluctuations in asset prices. Derivatives are meant to facilitate the hedging of price risks of
inventory holdings or a financial/commercial transaction over a certain period. 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, and thereby, serve as instruments of
risk management. By providing investors and issuers with a wider array of tools for managing
risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the
global economy, lowering the cost of capital formation and stimulating economic growth. Now
that world markets for trade and finance have become more integrated, derivatives have
strengthened these important linkages between global markets, increasing market liquidity and
efficiency, and have facilitated the flow of trade and finance.
Following the growing instability in the financial markets, the financial derivatives gained
prominence after 1970. In recent years, the market for financial derivatives has grown in terms of
the variety of instruments available, as well as their complexity and turnover. Financial
derivatives have changed the world of finance through the creation of innovative ways to
comprehend, measure, and manage risks.
Indias tryst with derivatives began in 2000 when both the NSE and the BSE commenced trading
in equity derivatives. In June 2000, index futures became the first type of derivate instruments to
be launched in the Indian markets, followed by index options in June 2001, options in individual
stocks in July 2001, and futures in single stock derivatives in November 2001. Since then, equity
derivatives have come a long way. New products, an expanding list of eligible investors, rising
volumes, and the best risk management framework for exchange-traded derivatives have been
the hallmark of the journey of equity derivatives in India so far.
Indias experience with the equity derivatives market has been extremely positive. The
derivatives turnover on the NSE has surpassed the equity market turnover. The turnover of
derivatives on the NSE increased from ` 23,654 million in 20002001 to ` 292,482,211 million in
20102011, and reached ` 157,585,925 million in the first half of 20112012. The average daily
turnover in these market segments on the NSE was ` 1,151,505 million in 20102011 compared
to ` 723,921 in 20092010.
India is one of the most successful developing countries in terms of a vibrant market for
exchange-traded derivatives. This reiterates the strengths of the modern development in Indias
securities markets, which are based on nationwide market access, anonymous electronic trading,
and a predominant retail market. There is an increasing sense that the equity derivatives market
plays a major role in shaping price discovery.

Factors Influencing Option Pricing

There are six primary factors that influence option prices, as shown in Figure 1
and discussed below.

Figure 1: Six factors that affect option prices are

shown on the top row. As indicated, the
underlying price and strike price determine the
intrinsic value; the time until expiration and
volatility determine the probability of a profitable
move; the interest rates determine the cost of
money; and dividends can cause an adjustment
to share price.
Underlying Price
The most influential factor on an option premium is the current market price of
the underlying asset. In general, as the price of the underlying increases, call
prices increase and put prices decrease. Conversely, as the price of the
underlying decreases, call prices decrease and put prices increase.
If underlying prices ... Call prices will ... Put prices will ...
Increase

Increase

Decrease

Decrease

Decrease

Increase

Expected Volatility
Volatility is the degree to which price moves, regardless of direction. It is a
measure of the speed and magnitude of the underlying's price changes.
Historical volatility refers to the actual price changes that have been observed
over a specified time period. Option traders can evaluate historical volatility to
determine possible volatility in the future. Implied volatility, on the other hand, is a
forecast of future volatility and acts as an indicator of the current market

sentiment. While implied volatility is often difficult to quantify, option premiums

will generally be higher if the underlying exhibits higher volatility, because it will
have higher expected price fluctuations.
The greater the expected volatility, the higher
the option value
Strike Price
The strike price determines if the option has any intrinsic value. Remember,
intrinsic value is the difference between the strike price of the option and the
current price of the underlying. The premium typically increases as the option
becomes further in-the-money (where the strike price becomes more favorable in
relation to the current underlying price). The premium generally decreases as the
option becomes more out-of-the-money (when the strike price is less favorable in
relation to the underlying).
Premiums increase as options become further
in-the-money

Time Until Expiration

The longer an option has until expiration, the greater the chance that it will end
up in-the-money, or profitable. As expiration approaches, the option's time value
decreases. In general, an option loses one-third of its time value during the first
half of its life and two-thirds of its value during the second half. The underlying's
volatility is a factor in time value; if the underlying is highly volatile, one could
reasonably expect a greater degree of price movement before expiration. The
opposite holds true where the underlying typically exhibits low volatility; the time
value will be lower if the underlying price is not expected to move much.
The longer the time until expiration, the higher
the option price
The shorter the time until expiration, the lower
the option price

Interest Rate and Dividends

Interest rates and dividends also have small, but measurable, effects on option
prices. In general, as interest rates rise, call premiums will increase and put
premiums will decrease. This is because of the costs associated with owning the
underlying; the purchase will incur either interest expense (if the money is
borrowed) or lost interest income (if existing funds are used to purchase the
shares). In either case, the buyer will have interest costs.
If interest rates Call prices will Put prices will
...
...
...
Rise

Increase

Decrease

Fall

Decrease

Increase

Dividends can affect option prices because the underlying stock's price typically
drops by the amount of any cash dividend on the ex-dividend date. As a result, if
the underlying's dividend increases, call prices will decrease and put prices will
increase. Conversely, if the underlying's dividend decreases, call prices will
increase and put prices will decrease.
If dividends
...

Call prices will

...

Put prices will

...

Rise

Decrease

Increase

Fall

Increase

Decrease

Empirical Study
For the purpose of the study, we have taken the values of call and put options of SBI from a
period of 26 August 2014 to 25 September 2014 for contract expiring on 25 September 2014.
These values of underlying price, call and put values, open interest and number of contracts will
be used for finding how the stock options are affected by different factors. We will be grouping
the calls and puts and checking the most traded options depending whether the options are ITM
or OTM.

Intrinsic Value

Intrinsic value is the value that any given option would have if it were exercised today. Basically,
the intrinsic value is the amount by which the strike price of an option is in the money. It is the
portion of an option's price that is not lost due to the passage of time. The following equations
can be used to calculate the intrinsic value of a call or put option:
Call Option Intrinsic Value = Underlying Stock\'s Current Price Call Strike Price

Put Option Intrinsic Value = Put Strike Price Underlying Stock\'s Current Price
The intrinsic value of an option reflects the effective financial advantage that would result from
the immediate exercise of that option. Basically, it is an option's minimum value. Options
trading at the money or out of the money have no intrinsic value.

Time Value

The time value of options is the amount by which the price of any option exceeds the intrinsic
value. It is directly related to how much time an option has until it expires as well as the
volatility of the stock. The formula for calculating the time value of an option is:

Time Value = Option Price Intrinsic Value

The more time an option has until it expires, the greater the chance it will end up in the money.
The time component of an option decays exponentially. The actual derivation of the time value
of an option is a fairly complex equation. As a general rule, an option will lose one-third of its
value during the first half of its life and two-thirds during the second half of its life. This is an
important concept for securities investors because the closer you get to expiration; the more of a
move in the underlying security is needed to impact the price of the option. Time value is often
referred to as extrinsic value.
Implied Volatility
Implied volatility isnt based on historical pricing data on the stock. Instead, its what the
marketplace is implying the volatility of the stock will be in the future, based on price
changes in an option. Like historical volatility, this figure is expressed on an annualized basis.
But implied volatility is typically of more interest to retail option traders than historical volatility
because it's forward-looking. Implied volatility is a dynamic figure that changes based on
activity in the options marketplace. Usually, when implied volatility increases, the price of
options will increase as well, assuming all other things remain constant. So when implied
volatility increases after a trade has been placed, its good for the option owner and bad for the
option seller. Conversely, if implied volatility decreases after your trade is placed, the price of
options usually decreases. Thats good if youre an option seller and bad if youre an option
owner.