Primary markets is when we transact directly with the company vs secondary market is when there

is no transaction directly from the company and people do it among themselves

Derivative business in India in 2000

Derivatives took the place of cash in the NSE

. Participants in the derivatives market:

There are 3 types of participants in the derivative markets.

Hedgers: are those participants who trade in the derivatives market with the sole intention
of risk mgmt. for eg, An exporter who will receive $1 million USD from his client has a need
to manage risk associated with currency exchange. Since the exchange rates are volatile, he
is afraid that adverse movement might impact his profitability. He can buy peace of mind by
entering into a forward contract with a bank to sell this one million $ after 1 month at a rate
specified today, as for example rs64/$ . if after 1 month rupee rises sharply, as for example
the rate become 60 rupees per $ the exporter will still be able to carry out the transaction @
64/$ because of the forward contract. So whatever be the actual exchange rate in the
market after 1 month, the exporter is assured of the rate of 64/$ are therefore he has
managed his risk.
Speculators : are those persons or entity ,who enters the derivative market to make
speculative profits . unlike hedgers a speculator has no need of risk mgmt. or for having
peace of mind. For example , Mr X is neither an importer or an exporter so he has no
definite need to enter into derivatives trading . bur Mr X firmly believes that the rupee is
going to fall from rs 64/$ currently to rs 66/$ after a month. He wants to make money on the
basis of his assumptions .so he enters into a forward contract with a commercial bank to buy
dollar after one month at a forward rate of 64 per dollar.
Situation A his assumption is correct and in a month the dollar is trading @rs66/$.
In this case he will be able to buy dollar @rs64/$ because of the forward contract
with the bank. simultaneously he will sell in the spot market @66/$ making a profit
of rs3/$
Situation B His assumption is incorrect and dollar is trading in the market @60/$
after a month . In this case he is obliged to buy dollar from the bank @ rs64. But
since the going rate in the market is only rs60/$ he will be forced to sell it at that
price only , thereby making a loss of rs4/$

The speculator plays a very important role in the derivatives market because they bring liquidity to
the market .

Q1. A speculator thinks that price of security x will increase in near future . current price of x is rs
1000 per share . based on his hunch, he decides to buy 1000 shares of x in the futures market
@1025 to be executed after 1 month. Calculate his actual profit or gain if after 1 month the actual
market price of the share is

1. 1150
2. 900

Ans.
 Arbitrageurs : a person or entity who makes riskless profit by identifying price difference of a
commodity or a security between 2 markets. For example if security X is trading in NSE
@rs100, while trading at rs 110 at BSE. The person buys from the NSE and selling it to BSE
and hence making a profit. They are very active in identifying opportunities of mispricing
between the spot and the derivatives market.
They play a very important role in financial markets. Because of their actions any mispricing
is immediately corrected and equilibrium is restored

CLASSIFICATION OF DERIVATIVES
There are several methods of classifying derivatives but we will discuss the 2 major methods
of classifying derivatives
On the basis of underlying assets :
1. Equity derivatives : equity shares are the underlying assets, eg. Equity
futures and options. For eg. A person holding 1000 shares of X of current
market price of rs 1000 can sell futures of X if he thinks price of x will fall in
near future.
2. Derivatives based on bonds or debentures : in this product the underlying
asset is a debt instrument like bonds and debentures . these products relate
to the possibility of default or to interest rate fluctuations in the debt
instrument.
Under the first category , we have instruments like interest rate swap
forward rate agreement interest rate cap. These products become valueable
or useless depending on the actual movement of interest rate in the market.
The second category of instruments have default risk on an underlying bond
or debentures as the underlying security one perfect example of this type is
credit default swap. In the case of a CDS if there is no default then the CDS
writer will accept all the premium amount without any need to perform .
however if there is a default then the cds writer has the obligation of making
good the entire amount of default to the cds buyer
3. Commodity derivatives: these instruments have a commodity as the
underlying asset as example precious metals like gold and silver and base
metals like tin zinc copper energy products like crude oil, or natural gas, or
agro commodities like potatos. Commodities future are very popular in india
and there are 2 prominent exchanges MEX and MCDEX which facilitate
trading in commodity futures in india. Commodity options although quite
popular in many countries do not yet have a market in india .
4. Currency derivatives: these products have exchange rate between a
currency pair as the underlying instrument example USD-INR , euro-INR etc.
exchange traded currency derivatives like currency options and futures or
USD-INR is a very popular product of NSE. OTC like forwards are very
popular in our country .
5. Index derivatives: These products have a broad based index like nifty,
sensex, bank nifty as the underlying instrument. Index derivatives are the
most popular category of derivatives In the world. In india futures and
options or nifty and indices make up the bulk of trading volumes of
derivatives in india. Such products find extensive use in risk management
and speculation
 On the basis of method of trading

These products which are traded through an exchange are called exchange traded derivatives. Ex
- options and features. These products are always traded through an exchange and those which
arent but are private agreements between 2 parties is OTC

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PAYOFF DIAGRAM :Significance :

1. It is linear
2. Seller of forward contract has Unlimited downside risk
3. A potential upside profit.
4. Forward contracts are 0 sum gain. Ie. The buyers P/L = the sellers P/L

Limitations of forward contract:

Forward contracts are easy to understand, they enable customisation and are very widely used . but
they have some serious limitations.

1. Since a fwd contract is a private contract between 2 parties , they are exposed to counter
party default risks
2. Fwd contracts are illiquid . it is difficult to find another counter party who has the exact
requirements as the party wishing to opt out of the contract

Difference between fwd contracts and future contract

Point of difference FUTURES FORWARDS

1. Type of Exchange traded OTC

contract
2. Default risk Borne by the exchange Borne by counter parties
3. What to Standardized Negotiable
trade
4. Price Agreed on initiation then marked to Agreed on an initiation, payment
market at contract termination
5. Where to Standardised through the exchange Negotiable
trade
6. When to Standardized Negotiable
trade
7. Liquidity risk Easy to exit Exit is not as easy
8. How much Standardized Negotiable
to trade
9. What type to Standardized Negotiable
trade
10. Margin Required No, margin but collateral maybe
negotiated
11. Holding Offset prior to expiry date is possible Delivery takes place on expiry
period of
contract
 Futures:

A future contract is a contract to buy or sell a predetermined quantity and quality of

an underlying instrument at a pre determined time in futures and at a pre determined price
through an exchange. Structurally a futures contract is quite to similar to a forward contract but
futures are exchange traded while forward contracts are OTC . futures contract eliminate many
of the limitations or shortcomings of forward contract.

Initial margin :

q) Shares of x ltd are trading currently @ rs 500 per share. Mr ABC is interested in buying 1000
shares of this company after 1 month. So he buys a future contract for 1000 shares expiring on
28th of September. The futures price at which he decided to contract was rs 510. Initial margin
requirement by the exchange is 10%. At the end of day 1 spot price of x was 490, at the end of
day 2 it was 480, at the end of day 3 it was 470. Maintenance margin requirement is 50% of
initial margin. Calculate the Mark To Market margins on a daily basis and also highlight if Mr.
ABC will get a margin call from his broker. If he gets it how much margin amount he has to pay?

Hypothetically the futures price on the end of day 2 is rs 485

DAY PRICE MTM NETWORTH

0 - - 51000(initial margin)
1 490 20000( loss/share * nos) 31000(>50% of initial) no call from broker
2 480 10000 21000 less than 50 % so broker will sell the shares at
the futures price after buying it at at 510

Assume that in the previous question , the buyer has paid the margin money and protected his
position. At the end of day 4 the price was 500 , end of day 5 spot price was 520 and at day 6 , it was
540. At this point the futures price was rs 550 and Mr. ABC decided to exit

DAY PRICE MTM NETWORTH

0 - - 51000(initial margin)
1 490 20000( loss/share * nos) 31000(>50% of initial) no call from broker
2 480 10000 21000 less than 50 % . and he pays the balance rs.
30000 = 51000 again
3 470 10000 41000
4 500 30000 71000
5 520 20000 91000
6 540 20000 110000
Sold the shares at 550 at futures market = additional 10000

Final networth rs 121000

Profit = 121000- ( 51000 + 30000)

Rs 40000

Profit percentage = 40000/ 81000 = almost 50%

Pricing of futures contract

Futures are contracts which derive their value from the underlying asset. If the underlying price
increases the futures value will also increase and vice versa. Is there a theoretical equation that will
help us quantify this relationship ?

We do have a model called the cost of carrying model. We will understand this model through 2
situations:

Situation 1: the three month future price of a stock is rs 43. The 3 month risk free interest
rate is 5 % per annum. The current spot price is rs 40. Is there any opportunity to make
riskless arbitrage profit.
Yes it is possible to make riskless arbitrage profit in this scenario.
1. Borrow Rs 40 today and buy 1 share from the spot market.
2. Simultaneously sell 1 share in the futures market at 43 rs.
3. Assuming continuous compounding, we will have to pay 40 * e(0.05*3/12) = rs 40.5
4. After 3 months we will collect rs 43 but exercising the futures contract and
paying of 40.5 to the lender
5. Therefore profit from the whole transaction is rs 2.5
Situation 2: the 3 months futures price of a stock is rs 39. The 3 month risk free interest rate
is 5% per annum and the current spot price is 40. Do you see any chance to make profit.
1. There is an arbitrage opportunity even if you hold the share in your DMAT
account or if you can borrow 1 share from your friend.
2. Sell the share in the spot market at 40 simultaneously buy a futures contract to
buy the contract at 39 after 3 months.
3. Immediately loan out the 40 received for 3 months. After 3 months collect
interest of 0.5 and recover the principal from the borrower
4. Exercise the futures contract and buy the share for 39 . return the share back
to the rightful person
5. Total profit made from this transaction is =

In scenario 1 the spot price was quite high compared to the spot price. Where as in scenario 2 it was
reverse. Can you identify 1 price at which arbitrage profit was not possible.

Ans: 40.5 ie. where F=S ert

As per the cost of carrying model , F=S ert

MARKET INDEX

Index is a basket of stocks

Q. assume that there are only 3 stocks in the economy a, b, c. the number of shares of a, b, c are
1000, 100, 500. The current market price of 3 shares are 90, 200, 30.

what is the total market capitalisation on the 3 shares today.

Solution: market capitalisation is the total wealth of shareholders from holding the shares. It is equal
to no of shares * current market price. So market cap for a is 90000,b is 20000 and c is 15000.

The total market cap is = 125000.

You want to create an index using these 3 stocks . why would we create this index?

Solution: there are several reasons behind our purpose

1. Individual stocks will move up and down but how do we judge the overall sentiment in
the market? Only when the important shares in an economy are put together in the
form of an index or a market portfolio, are we in a position to determine how well the
market is doing. An index is a parameter of the performance of the overall or broader
market.
2. How will this parameter work? Market cap of the important shares of an economy is a
very large number. In our example the total market cap is 1.25 lakhs. Human beings are
not comfortable with very large numbers, so when we are forming the index today,
instead of putting the number 1.25l we will feel much more comfortable to use 100 to
represent the market cap. Suppose tomorrow the price of a become 100, b remains at
200 and c becomes 25 . the new market cap becomes 132500. Therefore the value of
index will . use percentage change for that , the new index is 106.
It is much easier to understand the difference between 2 index values than their actual
market cap
3. On popular market indices like nifty and sensex, some beautiful derivative products like
exchange traded futures and options have been devised. This has been tremendously
used my hedgers and speculators.

What is NIFTY?

It is the most popular index designed by NSE of india. It is a basket of 50 best stocks in the
indian economy judged initially by market cap and now by free float market cap. The
composition of NIFTY is not constant. Shares which dont do well move out of nifty and make
way for new shares. The performance of the overall industry also matters .

***assignment 1 (5% weightage) (groups of 4)

Q1. What are the 50 stocks that comprise NIFTY today

Q2. What is the weightage of each company in the index on the day when you are
solving the assignment
 Q3. What are the weightages of the different industries in NIFTY as on the day of
solving

Q4. Study nifty 1 year back and highlight how it has changed and also highlight
which shares have moved out and moved in.