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INTRODUCTION

A Derivative is a financial instrument that derives its value from an underlying asset. Derivative is a financial contract whose price/value is dependent upon price of one or more basic underlying assets, these contracts are legally binding agreements made on trading screens of stock exchanges to buy or sell an asset in the future. The most commonly used derivatives contracts are forwards, futures and options, which we shall discuss in detail later.

The main objective of the study is to analyze the derivatives market in India and to analyze the operations of futures and options. Analysis is to evaluate the profit/loss position of futures and options contracts. Derivative market is an innovation to cash market. Approximately its daily turnover reaches around four times the cash market segment. In cash market the profit/loss of the investor depends upon the market price of the security bought or sold. Derivatives are mostly used for hedging purpose. But the presence of speculators is equally important for the liquidity of the market. In bullish market the call option writer incurs heavy losses so the investor is suggested to go for a call option to hold, where as the put option holder suffers in a bullish market, so he is suggested to write a put option. In bearish market the call option holder will incur more losses so the investor is suggested to go for a call option to write, where as the put option writer will get more losses, so he is suggested to hold a put option.

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OBJECTIVES
 Study of derivative products using their payoff diagrams.  To understand how these products are evaluated using mathematical

models.
 Study of Options Strategies to mitigate risk when markets are highly

uncertain and volatile.  Study of important parameters which play an important role in Portfolio Design.  To determine option premium for Reliance Industry using Black Sholes model and observe the changes in the implied volatility of the stock as the time to expiration approaches.

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IMPORTANCE OF THE STUDY In today’s time understanding of derivative products is very much important because they give deep insight about F& O markets. It would be essential for the perfect way of trading in F&O segment. An investor can choose the right underlying or portfolio for investment which is risk free or bearing very little risk. The study would explain the various ways to minimize the losses and maximize the profits. The study would assist in understanding the F&O segments in a sense that how futures and options valuations are carried out. The study would assist in knowing the different factors that cause for the fluctuations in the F&O market.

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DERIVATIVE 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. Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. 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. Rationale behind the Development of Derivatives Holding portfolio of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser than what he expected to get. There are various factors, which affect the returns: 1. Price or dividend (interest). 2. Some are internal to the firm like –  Industrial policy  Management capabilities

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 Consumer’s preference  Labor strike, etc. To a large extent, these parameters are controllable and are termed as non Systematic risks. An investor can easily manage such nonsystematic risks by having a well – diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in another. There are yet other types of influences which are external to the firm and which cannot be controlled and thus affect large number of securities. They are termed as systematic risk. They are:
1. Macro Economic Factors 2. Political Instability

3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all individual stocks to move together in the same manner. We therefore quite often find stock prices falling from time to time in spite of company’s earnings rising and vice versa. Rationale behind the development of derivatives market is to manage this systematic risk, liquidity and liquidity in the sense of being able to buy and sell relatively large amounts quickly without substantial price concessions.

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Economic Functions of Derivative Market The following are the various functions that are performed by the derivative markets:
 Prices in an organized derivative market reflect the perception of

market participants about the future and lead the prices of underlying to the perceived future level.
 Derivative market helps to transfer risk from those who are

exposed to it but may like to mitigate it to those who have an appetite for risk.
 Derivative market helps increase savings and investment in the

long run.

Commencement of Derivative Trading in India The derivatives segment on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000.
1. Index Futures 2. Index Options

The F&O segment of NSE

provides trading facilities for the following derivative segment:

3. Stock Futures 4. Stock Options 5. Forex Futures (started most recently)

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Participants of Derivative Market The following are the three broad categories of participants who trade in derivative market segment. Hedgers Hedgers face risk associated with the price of an asset. They use futures & options markets to reduce or eliminate this risk. Speculators 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 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 at the same time to lock in a guaranteed profit.

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TYPES OF DERIVATIVES The following are the various types of derivative products. However at present in India only few of them are exchange traded and popular.

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. Some of its characteristics are: o These are private contracts between two parties
o Not Standardized

o Usually one specified delivery date o Settled only on maturity o Delivery or final cash settlement takes place o Lot of credit risk is involved in the absence of MTM mechanism

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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. 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 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.

LEAPS The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to 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.

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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:
1)

Interest Rate Swaps
These entail swapping only the interest related cash flows between

the Parties in the same currency.
2)

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. SWAPTION Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a Swaptions is an option on a forward swap. For example, An option to enter into an interest rate swap where a specified fixed rate is exchanged for floating Among all Derivative Products, Futures and Options are highly popular among investors and generate large turnover. PURPOSE OF TRADING IN FUTURES MARKET
1) Investment - take a view on the market and buy or sell

accordingly.
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2) Price Risk Transfer- Hedging - Hedging is buying and selling

futures contracts to offset the risks of changing underlying market prices. Thus it helps in reducing the risk associated with exposures in underlying market by taking a counter - positions in the futures market. For example, the hedgers who either have security or plan to have a security is concerned about the movement in the price of the underlying before they buy or sell the security. Typically he would take a short position in the Futures markets, as the cash and futures price tend to move in the same direction as they both react to the same supply/demand factors.
3) Arbitrage - Since the cash and futures price tend to move in the

same direction as they both react to the same supply/demand factors, the difference between the underlying price and futures price called as basis. Basis is more stable and predictable than the movement of the prices of the underlying or the Futures price. Thus arbitrageur would predict the basis and accordingly take positions in the cash and future markets.
4) Leverage - Since the investor is required to pay a small fraction of

the value of the total contract as margins, trading in Futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin. Thus the Leverage enables the traders to make a larger profit or loss with a comparatively small amount of capital. PURPOSE OF TRADING IN OPTIONS MARKET Options trading will be of interest to those who wish to: 1) Participate in the market without trading or holding a large quantity of stock.
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2) Protect their portfolio by paying small premium amount.

FUTURES
DEFINITION 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. To facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. The standardized items on a futures contract are: ♦ Quantity of the underlying ♦ Quality of the underlying ♦ The date and the month of delivery ♦ The units of price quotations and minimum price change ♦ Locations of settlement Types of futures On the basis of the underlying asset they derive, the futures are divided into two types: Index futures Index futures are the futures, which have the underlying asset as an Index. The Index futures are also cash settled. The settlement price of the Index futures shall be the closing value of the underlying index on the expiry date of the contract. Stock futures The stock futures are the futures that have the underlying asset as the individual securities. The settlement of the stock futures is of cash settlement and the settlement price of the future is the closing price of the underlying security.

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Parties to Futures Contract There are two parties in a future contract, the Buyer and the Seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is one who is SHORT on the futures contract. The pay off for the buyer and the seller of the futures contract are as follows. Payoff for a Buyer of Future Contract

CASE 1: The buyer bought the future contract at 40; if the futures price goes above 40 then the buyer gets the profit of (ST1 - 40) CASE 2:

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The buyer incurs loss when the future price goes below 40; if the futures price goes below 40 the loss would be equal to (40 – ST2) Payoff for a Seller of Future Contract

CASE 1: The Seller sold the future contract at 40; if the futures price goes below 40 then the Seller would make a profit of (40 – ST1) CASE 2: The Seller made a short position at 40. He would incur loss when the future price goes above 40; The loss would be equal to (ST2 – 40)

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MARGINS Margins are the deposits, which reduce counter party risk that arise in a futures contract. These margins are collected in advance at the time of entering into the contract in order to eliminate the counter party risk. It is this concept of margins which differentiates a Futures contract from a Forward contract. There are three types of margins in a Futures contract: Initial Margin Whenever a futures contract is signed, both buyer and seller are required to deposit initial margin. Both buyer and seller are required to make security deposits that are intended to guarantee that they will in fact be able to fulfill their obligation. These deposits are Initial margins and they are often referred as performance margins. The amount of margin is varies from 5% to 15% of total contract value of futures contract. Maintenance Margin The investor is allowed to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative a maintenance margin, which is somewhat lower than the initial margin, is set. After depositing the initial margin, if the mark to marking loss occurs, it is made sure that the money in the initial margin account never falls below the maintenance margin. Variation Margin

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If the balance in the margin account falls below or touches the maintenance margin level, the investor receives a margin call from his broker and he is told to top up the margin account up to the initial margin level the next day. The top up money deposited is known as Variation Margin. If the investor does not provide the variation margin, the broker has the right to close out the open position by selling/buying the contract without even informing the investor. Marking to Market & Role of Margins The process of adjusting the amount in an investor’s margin account in order to reflect the change in the settlement price of futures contract on a daily basis is known as Marking to Market. The role of margins in the futures contract is explained in the following example. Today is August 1, 2008.Suppose Person X is bullish on August Nifty Futures and buys one contract of Nifty August Futures @ 4500. Another person Y is bearish on Nifty so he becomes the counter party by taking a short position one contract of Nifty August futures. The contract size of Nifty is 50. The total contract value is 4500 * 50 = 225000. The initial margin amount is say Rs.30000 and the maintenance margin is say 70% of Initial margin i.e. 21000
Margin Account Price of Nifty Augu st Futur es 4500 4600 Effect on Buyer 's Accou nt Depos its 30000 CR 5000 Buyer 's Balan ce Amt 3000 0 3500 0 Effect on Seller' s Accou nt Depos its 30000 DR 5000 Seller 's Balan ce Amt 3000 0 2500 0

Day

1-Aug 2-Aug

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DR 2000 5000 0 CR 2250 4-Aug 4650 2500 0 DR 7500 & CR 4500 3000 5-Aug 4800 Seller 7500 0 0 Depos its 15000 DR 3500 CR 4000 6-Aug 4600 10000 0 10000 0 On August 6, 2008 the positions are closed out Total Amt Receivable 3500 4000 from Margin Account 0 0 Total Amount Paid in 3000 4500 Margin Account 0 0 (5000 Net Profit / (Loss) 5000 ) 3-Aug 4700

CR 5000 DR 2500

4000 0 3750 0

Futures terminologies Spot Price It is the price at which an asset trades in the cash market segment. Futures Price It is the price at which a futures contract trades in the futures market. It is a future price of the underlying asset as on today. It is usually equal to spot price plus cost of carrying. Contract Cycle It is a period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month 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

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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 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.

Contract Size It is the number of securities that has to be bought or sold in a single contract. For instance, the contract size on NSE’s Nifty Index futures is 50.The total contract value is the product of total number of securities in a single contract and price of a single security. Basis In the context of financial futures, basis can be defined 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 finance the asset less the income earned on the asset.

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Open Interest It is the total outstanding long or short positions in the market at any specific time. As total long positions for market would be equal to short positions, for calculation of open interest, only one side of the contract is counted.

Pricing the Futures The fair value of the futures contract is derived from a model known as the Cost of Carry model. This model gives the fair value of the futures contract. Cost of Carry Model Future Price of an underlying when dividend yield is known in percentage terms: F = S*e(r - q) t Future Price of an underlying when dividend to be received during the course of contract is known in absolute terms: F = [ S – Q*e-rt ] * ert
Where F – Futures Price S – Spot price of the Underlying r – Cost of Financing in percentage q – Expected Dividend Yield in percentage

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Q – Expected Dividend in absolute value t – Holding Period in years

Relationship between Futures Prices and Spot Prices as the delivery period approaches:

As we can in the diagram, futures price and spot price converge as the delivery date approaches. This happens to avoid any arbitrage activity. Or we can say that both these prices converge because of the presence of arbitrageurs in the market.

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OPTIONS
DEFINITION Option is a type contract between two persons where one grants the other the right to buy a specific asset at a specific price within a specified time period. Alternatively the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. In order to have this right, the option buyer has to pay the seller of the option premium. The assets on which options can be derived are stocks, commodities, indexes etc. If the underlying asset is the financial asset, then the options are financial options like stock options, currency options, index options etc, and if the underlying asset is the non-financial asset the options are non-financial options like commodity options.

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Types of Options Call Option A call option gives the holder of the option the right but not the obligation to buy an asset by a certain date for a certain price. A call option is bought by an investor when he feels that the stock price will move upwards. To buy such an option, he has to pay some amount to acquire this option. This amount is known as call premium.

Put Option A put option gives the holder of the option the right but not the obligation to sell an asset by a certain date for a certain price. A put option is bought by an investor when he believes that the stock price will move downwards. To buy such an option, he has to pay some amount to acquire this option. This amount is known as call premium. American & European Options Depending upon the time of exercise, options can further be classified as American Option and European Option. In case the option is an American Option, the holder of the call or put option can exercise his option any time during the options contract. Usually all Stock Options are of American style.

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In case the option is a European Option, the holder of the call or put option can exercise his option only on the maturity of the option contract. Usually all Index Options are of European style.

PARTIES IN AN OPTION CONTRACT

The following are the parties in an option contract.
1. Buyer of the Call Option:

The buyer of a call option is the one who by paying the option premium buys the right but not the obligation to buy the underlying asset at pre decided price.
2. Writer/Seller of the Call Option:

The writer of a call option is the one who receives the option premium and is there by obligated to sell the asset if the buyer exercises the option on him. 3. Buyer of the Put Option:

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The buyer of a put option is the one who by paying the option premium buys the right but not the obligation to sell the underlying asset at a pre decided price. 4. Writer/Seller of the Put Option: The writer of a put option is the one who receives the option premium and is there by obligated to buy the asset if the buyer exercises the option on him.

Underlying Asset in Options Contract The underlying asset of the options contract could be any of the followings: Index Options The Index options have the underlying asset as the index. Stock Options A stock option gives the buyer of the option the right to buy/sell stock at a specified price. Stock options are options on the individual stocks, there are currently more than 50 stocks are trading in this segment. Foreign Currency Options
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This can be used to mitigate the risk arising out of fluctuation in the exchange rate of currencies. Currency options trading takes place in over the counter market. NSE and BSE do not have options on foreign currency.

1) Pay-off Profile for Buyer of a Call Option:

The pay-off of buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of buyer of a call option:

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Call Option Buyer
Spot Strike Premium Break Even Maximum Maximum Price Price Paid Price Loss Profit 50 50 10 60 -10 Unlimited A Call Option Holder will Exercise his Option only if Spot goes beyond Strike Price

2) Pay-off Profile for Seller of a Call Option:

The pay-off of seller of the call option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a call option:

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Call Option Writer
Spot Strike Premium Break Even Maximum Maximum Price Price Received Price Loss Profit 50 50 10 60 Unlimited 10 A Call Option Writer waits for the option to expire OTM to make profit.

3) Pay-off Profile for Buyer of a Put Option:

The pay-off of buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of buyer of a call option:

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Put Option Buyer
Spot Strike Premium Break Even Maximum Maximum Price Price Paid Price Loss Profit 50 50 10 40 -10 40 A Put Option Buyer would Exercise his Option only if Spot falls below the Strike Price

4) Pay-off Profile for Seller of a Put Option:

The pay-off of seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option:
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Put Option Seller
Spot Price 50 Strike Premium Break Even Maximum Maximum Price Received Price Loss Profit 50 10 60 40 10 A Put Option Seller wishes that the option expires OTM

Options Terminology • In-The-money Option In case of a call option, an option is in the money if the spot price > strike price. In case of a put option, an option in the money if strike price > spot price. • At-The-Money Option

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Spot price and Strike price are same. In this case the intrinsic value of an option is zero. • Out-Of-The-Money Option In case of a call option, an option is out of money if spot price < strike price. In case of a put option, an option is out of money if spot price > strike price. Intrinsic Value of an Option For Call Option, Intrinsic Value = max ((Spot – Strike) or Zero) For Put Option, Intrinsic Value = max ((Strike – Spot) or Zero) Factors affecting the price of an option In general Value of an Option = Intrinsic Value + Time Value + Volatility in returns The following are the factors which affect the price of an option: 1) Spot price 2) Strike price 3) Time to expiration 4) Risk-free interest rate 5) Expected Dividend during the course of a contract 6) Volatility While valuing any option contract, the most difficult parameter to take into account is the volatility in the returns of the underlying asset price. It is measured by statistical variable known as standard deviation and it quantifies the tendency of the underlying asset’s return to move away from the average or expected returns. Higher the standard deviation,

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riskier is the underlying asset and thus higher the value of option premium. Effect of Increase in the Relevant Parameter on Option Prices
EUROPEAN OPTIONS AMERICAN OPTIONS Buying Buying

PARAMETERS
Spot Price (S) Strike Price (Xt) Time to Expiration (T) Volatility () Risk Free Interest Rates (r) Dividends (D)

CALL

PUT

CALL

PUT

?

?

Favourable Unfavourable

Black Scholes Pricing model The principle that options can completely eliminate market risk from a stock portfolio is the basis of Black Scholes pricing model in 1973. Interestingly, before Black and Scholes came up with their option pricing model, there was a wide spread belief that the expected growth of the underlying ought to effect the option price. Black and Scholes demonstrate that this is not true. The beauty of 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. The following are the assumptions; 1. There are no transaction costs and taxes. 2. The risk from interest rate is constant.

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3. The markets are always open and trading is continues. 4. The stock pays no dividend. During the option period the firm should not pay any dividend. 5. The option must be European option. 6. There are no short selling constraints and investors get full use of short sale proceeds. The options price for a call, computed as per the following Black Scholes formula: Value of Call Option VC = S * N(d1) – X * e-rt * N(d2) Value of Put Option VP = X * e-rt * N(- d2) – S * N(-d1) d1= [In (S/X) + (r + σ 2 / 2)t] / σ sqrt (t) d2= d1 - σ sqrt (t) Where VC= value of call option VP= value of put option S = Spot price of the share X = Strike price of the share R = Risk free rate T = time period remaining to expiration N(d1) = after calculation of d1 value, normal distribution area is to be identified. N(d2) = after calculation of d2 value, normal distribution area is to be identified. σ = Volatility in the stock price movement In = Natural log Limitation of Black Sholes Model

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Black Sholes model cannot be used to accurately price options with an American Style exercise as it only calculates the option price at one point in time i.e. at expiration only. It does not consider the steps along the way where there could be the possibility of early exercise of an American option. As all exchange traded stock options have American Style exercise, this model cannot be used to price the stock option premiu

OPTION STRATEGIES Option strategies can be used effectively to minimize the risk of the physical portfolio. When an investor has a portfolio of number of shares and if he is uncertain about the direction in which the market would move, these strategies can be used to hedge the risk in times of uncertainty.

Market Outlook: Bullish

Strateg y

Construc tion

Market Outlook

Profit/Loss

Hedging Implications

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Bull Spread (Call Spread)

Long Call A + Short Call B

Mildly Bullish

Profit is limited; Risk is limited

Provides protection against limited price rise; If price rises above B protection is limited Provides protection against limited price rise; If price rises above B protection is limited

Bull Spread (Put Spread)

Long Put A + Short Put B

Mildly Bullish

Profit is limited; Risk is limited

Market Outlook: Bearish

Strate gy

Construc tion

Market Outlook

Profit/Loss

Hedging Implications Provides protection against moderate price decline. If prices fall below A, protection is limited. Provides protection against moderate price decline. If prices fall below A, protection is limited.

Bear Spread (Call Spread)

Short Call A + Long Call B

Mildly Bearish

Profit is limited to the difference if the strike prices; Risk is limited if expiration price is at or above B

Bear Spread (Put Spread)

Short Put A + Long Put B

Mildly Bearish

Profit is limited to the difference if the strike prices; Risk is limited if expiration price is at or above B

Market Outlook: Stable

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Strate gy

Constructi on

Market Outlook Stable price expectation & no drastic movements in either direction

Profit/Loss Profit is limited to the net premium income, if the price at expiration is equal to strike price. Risk is potentially unlimited as price moves up or down the two strike prices. Profit is limited to the premium received if the price at expiration is between two strikes. Risk is unlimited if the price moves up or down the two strikes.

Hedging Implicati ons Long Hedge & Short Hedge Benefits

Short Straddl e

Short Call & Short Put at the same Strike

Short Strangl e

Short Call & Short Put at different Strikes

Stable price expectations & no drastic movements in either direction

Long Hedge & Short Hedge Benefits

Market Outlook: Uncertain
Hedging Implicatio ns Long Hedge & Short Hedge Benefits

Strate gy

Constructi on Long Call & Long Put at same strike price

Market Outlook Uncertain price expectation. But price will move drastically in either direction

Profit/Loss Profit is unlimited if price moves up or down. Risk is limited to the premium paid. Profit is unlimited if prices move up or down. Risk is limited to the premium paid, if the price at expiration is in between A & B

Long Straddle

Long Strangle

Long Call & Long Put on different prices A & B

Uncertain Price Expectation. Price may move drastically in any direction

Long Hedge & Short Hedge Benefits

PORTFOLIO MANAGEMENT

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Portfolio means total holding of securities belonging to one person. Portfolio management is concerned with efficient management of investment in securities to optimize returns to suit the objective of the investor. Optimization of returns stands for maximization of profits and minimization of risk. Objective of Portfolio Management A managed portfolio should offer 1) Security of Principal 2) Stability of Income 3) Capital Growth 4) Liquidity 5) Diversification

Variables that affect Portfolio Design Return The return is the compensation that an investor gets for parting with his liquidity. The return from an investment is the expected cash inflows in terms of dividends, interest, bonus, capital gain etc. Riskless Securities The securities in which the rise can be forecasted with certainty are called riskless securities.

Risky Securities
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The risky securities are those where the return cannot be forecasted with certainty as there is always risk involved that the cash flows may not result as expected. Risk Risk refers to the variability of return from those that are expected. The most common and reliable measure of risk is the tendency of returns to move away from the expected return. This is known as Standard Deviation. Standard Deviation & Beta Risk can be diversifiable risk and non diversifiable risk. Standard deviation is a measure of total risk whereas another variable called as Beta measures only non diversifiable risk. Beta is a measure of systematic risk of an asset relative to that of market portfolio. Beta of market portfolio is always one whereas Beta for government securities is zero (risk free). Standard Deviation should be used only when different investments have same expected rate of return. It may give misleading results in comparing the risk if the alternative investments have different expected rate of return. In such case, another variable known as Coefficient of Variation is used to compare risk of different investments. Coefficient of Variation Coefficient of Variation is a measure of relative dispersion. It is a measure of total risk per unit of expected return. The larger the CV, larger is the relative risk of the investment. CV is used to compare risk of those investment options which have different expected rate of return.
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Correlation Coefficient It measures the degree of association of two variables. It measures not only magnitude of co relation but also the direction. It ranges from -1 to +1. It is shown by ‘r’ If r = 0 It indicates there is no correlation If r = 1 It indicates perfect positive relation If r = -1 It indicates perfect negative correlation Existence of correlation between two securities does not necessarily mean that movement in one security is because of the movement in another security. Covariance It is an absolute measure of variability of one variable in relation to another variable. Suppose there are two securities x and y, then Covariance depends upon Standard deviation of x; Standard Deviation of y & correlation coefficient between x, y. Systematic & Unsystematic Risk Types of Systematic Risk 1) Market Risk 2) Interest Rate Risk 3) Social or Regulatory Risk 4) Purchasing Power Risk Types of Unsystematic Risk 1) Business Risk
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2) Financial Risk 3) Default Risk Efficient Portfolio Efficient portfolio is one which provides the maximum return for a particular degree of risk, or lowest risk for any given rate of return. In the following figure number of portfolios is shown on the basis of their tradeoff between expected return and degree of risk. The red line is known as efficient frontier as every portfolio lying on it offers maximum return at that level of risk. Portfolios A, B and C are efficient portfolios.

The Security Market Line It is a graph plotted between required rate of return along Y axis and non diversifiable risk (beta) of a security along X axis. Required rate of return is calculated using CAPM model and the beta of the security. It represents a linear relationship between them. If we know the beta of number of securities and calculate the required rate of return using CAPM model, all the securities are expected to be plotted along one single line which is SML. This SML can be used to

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classify securities as aggressive securities and defensive securities. If the securities with beta greater than one lies above SML, they are aggressive securities. Securities beta less than one lying below SML are defensive securities. The Slope of SML = Required Return using CAPM – Risk Free Return Beta

The Capital Market Line Capital market line is a trade off between risk and return. Every point on capital market line represents an efficient portfolio. Therefore, its

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correlation with the market portfolio is one as all the possible diversification is done. The slope of CML = Required Return – Risk Free Return Standard Deviation

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Company Profile

BIRLA SUN LIFE INSURANCE LIMITED

About Birla Sun Life Insurance Company Limited:

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Birla Sun Life Insurance pioneered the unique Unit Linked Life Insurance Solutions in India. Within 4 years of its launch, BSLI has cemented its position as a leading player in the Private Life Insurance Industry. There has been focus on Investment Linked Insurance Products, supported with protection products to maintain leadership in product innovation. Multi Distribution Channels- Direct Sales Force, Alternate Channels and Group offering convenient channels of purchase to customers. Web-enabled IT systems for superior customer services. First to have issued policies over the Internet. Corporate governance and a high degree of transparency in all business practices and procedures. First to have an operational Business Continuity Plan. Strong fundamentals based on the Aditya Birla group's local insight and Sun Life financials's global expertise.

VISION To create long term value along with market leadership. MISSION To help people mitigate risks of life, accident, health and money at all stages and under all circumstances. Enhance the financial future of our customers, including enterprises. VALUES Integrity Commitment

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Passion Seamlessness Speed Board of Directors Mr. Kumar M. Birla Mr. Donald A. Stewart Mr. Bishwanath N. Puranmalka Mr. Ajay Srinivasan Mr. Suresh N. Talwar Mr. Gian P. Gupta Mr. Stephan Rajotte Dr. Bharat K. Singh Mr. Venkatesh S. Mysore

At Birla Sun Life Distribution, we put knowledge, expertise and experience to good use to preserve, nurture and nourish your wealth. For your today and your tomorrow. We are a part of the Joint Venture between The Aditya Birla Group and Sun Life Financial of Canada. The synergy of these two accomplished conglomerates brings you global financial know-how and local market insight. It is said that: "To acquire wealth is difficult, to preserve it more difficult, but to nourish it wisely, the most difficult of all." Our commitment to excellence along with roots up approach to research and analysis, coupled with technology driven processes has enabled us to emerge as one of the leading wealth management & investment Advisory Services Company in the country.

Achievements:
Leading Distribution House in the country Over 2,50,000 customers countrywide 6000 plus business associates
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Business across all important segments : Institutional, Private Client Group, Direct Sales and Channel National presence 40 Branches across the country. Leading corporate agent of Birla Sun Life Insurance. "Knowledge is a treasure but practice is the key to it" We believe that the desire for knowledge increases with the acquisition of it. At Birla Sun Life Distribution Co Ltd., we make the best use of intellect and expertise putting knowledge to good practice. As and when and where you need it. For us the concept of perfect service is constantly expanding. This along with transparent business ethics, inspired and innovative solutions is what our investors have come to expect from us. A fact, which has been reaffirmed by recognition and awards, conferred on us by the leading names of the India Financial Services Industry.

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Data analysis and Observations

Application of Black Sholes Model for Reliance Industry Why Reliance Industry has been picked for Analysis ?

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This particular analysis was carried out during the month of July 2008. During that period all the index heavyweights except Reliance Industry were trading far below than their 52 weeks high/low because of poor global financial scenario. People have lost the trust in most of the heavyweights which form the benchmark index Sensex or Nifty. But the faith in the stock of Reliance Industry was intact and it was getting traded at higher volume as well. This is the reason Reliance Industry has been chosen and option pricing is calculated using Black Sholes model as no dividend was expected within a period of 15 days. The data for closing price of call option premium as well as put option premium at the available strike prices is obtained. Data was input in the excel sheet and option premiums were calculated 1) neglecting volatility factor and then 2) by using Black Sholes model assuming the stock as non dividend paying stock. The analysis and the graphs are shown below:

Today’s Date 16-Jul-08

Expiration Date 31-Jul-08

Risk Free Return 8.24%

Spot 1976. 8

Lot Size 75

Volatil ity 42.00%

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Strike Price 1890 1920 1950 1980 2010 2040 2070 2100 2130 2160 2190 2220 2250 2310 2340 2370 2400 2500

Type ITM ITM ITM ATM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM

Neglecti ng σ 93.19 63.29 33.39 3.49 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Black Scholes Pricing 122.40 102.46 84.58 68.83 55.19 43.60 33.92 26.00 19.63 14.59 10.69 7.71 5.49 2.66 1.81 1.22 0.81 0.19

Actual Premium NA NA 90.05 74.35 59.35 48.10 36.50 27.75 25.00 15.75 10.75 9.65 7.30 4.45 3.30 3.70 3.45 3.00

Implied Volatility

43.34% 45.40% 44.55% 44.75% 43.63% 43.16% 46.46% 43.24% 42.20% 44.74% 45.22% 46.81% 47.15% 51.00% 53.28% 60.52%

Today’s Date 16-Jul-08

Expiration Date 31-Jul-08

Risk Free Return 8.24%

Spot 1976. 8

Lot Size 75

Volatil ity 42.00%

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Strike Price 1890 1920 1950 1980 2010 2040 2070 2100 2130 2160 2190 2220 2250 2310 2340 2370 2400 2500

Type OTM OTM OTM ATM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM

Neglecti ng σ 0.00 0.00 0.00 0.00 26.41 56.30 86.20 116.10 146.00 175.90 205.80 235.70 265.59 325.39 355.29 385.19 415.09 514.75

Black Scholes Pricing 29.21 39.17 51.19 65.33 81.60 99.90 120.13 142.10 165.63 190.49 216.49 243.41 271.08 328.05 357.10 386.41 415.90 514.94

Actual Premium 46.40 56.50 63.60 80.30 91.10 108.85 128.85 148.00 173.75 200.95 224.00 239.00 NA NA NA NA NA NA

Implied Volatility

49.50% 50.98% 47.45% 47.05% 47.11% 45.32% 47.35% 50.00% 47.95% Nil

Today’s Date 29-Jul-08

Expiration Date 31-Jul-08

Risk Free Rate 8.24%

Spot 2085.2

Lot Size 75

Volatil ity 55.00%

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Strike Price 1890 1950 1980 2010 2040 2070 2100 2130 2160 2190 2220 2250 2280 2310 2340 2350 2400 2500

Type ITM ITM ITM ITM ITM ITM ATM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM OTM

Neglecti ng σ 196.05 136.08 106.09 76.11 46.12 16.13 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Black Scholes Pricing 196.26 137.74 110.00 84.27 61.48 42.41 27.50 16.68 9.42 4.95 2.41 1.09 0.46 0.18 0.06 0.04 0.01 0.00

Actual Premium NA 150.00 NA 86.20 65.00 42.45 25.20 16.65 10.90 6.90 4.20 3.25 1.95 1.65 1.00 1.00 1.00 0.15

Implied Volatility 97.98% 59.76% 61.40% 54.95% 51.15% 54.76% 58.48% 60.78% 63.01% 68.44% 70.23% 76.22% 77.70% 80.21% 91.81% 91.50%

Today’s Date 29-Jul-08

Expiration Date 31-Jul-08

Risk Free Rate 8.24%

Spot 2085.2

Lot Size 75

Volatil ity 55.00%

Strike Price

Type

Neglecti ng σ

Black Scholes Pricing

Actual Premium

Implied Volatility

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1890 1950 1980 2010 2040 2070 2100 2130 2160 2190 2220 2250 2280 2310 2340 2350 2400 2500

OTM OTM OTM OTM OTM OTM ATM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM ITM

0.00 0.00 0.00 0.00 0.00 0.00 13.85 43.84 73.82 103.81 133.80 163.78 193.77 223.76 253.74 263.74 313.72 413.67

0.20 1.66 3.91 8.17 15.36 26.28 41.35 60.51 83.25 108.76 136.21 164.87 194.23 223.93 253.81 263.78 313.72 413.67

1.85 2.40 4.05 6.75 14.15 20.00 36.85 52.60 80.05 107.30 132.95 164.30 193.00 224.40 NA NA NA NA

77.08% 59.47% 55.70% 51.33% 52.51% 44.37% 47.44% 39.28% 46.70% 48.88% Nil Nil

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Observations

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Implied at every strike price was calculated for call option premium and it has been observed that 1) As the time to expiration approaches, the perception of the market participant about the volatolity changes significantly. 2) The uncertainty about the movement in the price increases as the time to expiration reduces. 3) 15 days before the expiration the implied volatility was ranging between 42% to 62% but just two days before the expiration date, the new range for implied volatility was seen at 51% to 98%. 4) Implied volatility was seen increasing at higher strike prices 5) For a Call Option, volatility was seen increasing as the option is more out of the money. 6)This trend of implied volatility with the strike price is called as volatility smile.

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Observations

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Implied volatility at every strike price was calculated for put option premium and it has been observed that 1) As the time to expiration approaches, the perception of the market participant about the volatility changes significantly. 2) The uncertainty about the movement in the price increases as the time to expiration reduces. 3) 15 days before the expiration the implied volatility was ranging between 44% to 52% but just two days before the expiration date, the new range for implied volatility was seen at 40% to 78% 4) Implied volatility was seen higher at lower strike prices. 5) For a Put Option, volatility was seen increasing as the option is more out of the money. 6) This trend of implied volatility with the strike price is called as volatility smile.

.BIBLOGRAPHY

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Books  Derivatives Dealers Module Work Book - NCFM  Options, Futures and other derivatives – John C Hull News Papers

 ECONOMIC TIMES
WEB SITES www.birlasunlife.com www.nseindia.com www.bseindia.com

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