3/1/2022

Meaning of Derivatives Examples for derivatives

Devatves are hnancial contracts whose value or price Is deternined based on
The curd is the derivative of milk. The price of the curd is derived
the once ov toe unoerying from the price of the milk. Whenever the price of the milk increases,

Dervates derive their price trom the pnce of the underiying the price of the curd also increases and vice versa.
That means the prce of the derivative will change whenever the price ot the
Rellance futures price is derived from the price of Reliance in the cash
unoeryinE changes
the cash market increases,
the stock price of Reliance in
The underiying can be 3
market. It
Rellance lutures price will also increase and vice versa.

Call and put option price (premium) of HDFC Bank would change
when the price of the stock of HDFC Bank changes in the cash market.
nterest rate
A agrees to sell B 1000 KGs of pepper after 6 months at Rs.50 per
a y othet thing/ asnet KG. This is a torward contract and an example for derivative
* *onwads Futues optons and swaps are the important types of dervatives

OTC derivatives and Exchange Traded

Derivative like products Derivatives
and
When you keep fixed deposit in bank, you have a right but not obligation to When the derivative contracts like
forward contract, options or
hen you keep fixed
deposi to between two parties
either directly
d deposit at any time betore the Swaps are entered
in
sell (premature withdrawal the derivative
maturity. Depositors position milar of the buyer American put
through intermediary, it is known as OTC
Forwards and Swaps are most popular OTC derivatives
option
give token advance tor the purchase of a property, you have a
exchange
the derivative contracts are entered through
When you

Eht but not obligation to buy the property. TOur position

is S i m i d r to h a t
When
platform, it is known as exchange traded derivative.
the buyer of the call option.
When you book a vehicle by depositing a small amount, you are entering are most popular exchange traded derivatives.
Futures and options
to
dealer. Delivery and payment is going
into a
torward contract
with the
happen after some time in the future.

forward contract, the settlement of

which
like a
Marti3ge engagement is
des place on the day of marriage.

4
3

Uses of Derivatives
Long and Short Position
I f a person smiles when the price of the asset is rising, he will be Hedging8
having long position in the asset. Speculation
i f a person weeps when the price is rising, he is said to have a short
Arbitrage
position in that 3Sser.
Or in other words, long gains when the price of the asset is rising and
loses when the price of the asset is falling.

short gains when the price of the asset is falling and loses
Similarly,
when the price or the asset isS rising
Just like a buyer and a seller, the position of long and short is just

Opposite.

1
 Forward Contract

Aparties
forward
to buy
contract
or se llis an
a non-standardized bilateral contract between two

upon at the time of

Forward contract in day-to-
enterinE 'n to
contrdc
I n a forward contract delivery of the asset and payment for the asset is
EOing to ta ke place on the agreed date in the future.
day life?
One paty agrees to take delivery of the asset and make the payment in
Tuture and the other party agrees to deliver the asset and receive the
payment in future.
All the terms and conditions lke price, quality, quantity, delivery date,
packing, delivery place etc. are negotiated between the parties to the
contract at the time of making agreement.

Pas ..
.oens themcocy qht cw

Long and Short Position

If a person smiles when the price of the asset is rising, he will be
having long position in the asset.
f a person weeps when the price is risinE, he is said to have a short
position in that asset Futures Market
Or in
other words, long gains when the price of the asset is rising and
loses when the price of the asset is falling.
of the asset is falling and loses
Similarly, short gains when the price
when the price of the asset is riSiNg
Just like a buyer and a seller, the position of long and short is just
opposite.
t nots tomul ad fi onm n
do nat shei.-heut an
tomsopteht e

10

Futures Contract Features of futures contract

Meaning of
parties to Traded on the exchange
A futures contract is a standardised contract
bet ween two and at a
quantity
buy and sella particular asset o1 specific
in future
Standardized contract
predetermined price, at
a specified date No counter party tisk
The contract is entered in to through a futures exchange.
made on the future dale
High liquidity
The payment and delivery of the
asset is

termed as delivery date

12
11
 3/1/2022

Futures Market Terminologies Basis

The Difference between the Current Market Price and
Spot price Futures price is called Basis:
Futures price
Spread Spot price Future price Status

Contract cycle 5900 50 Trading at Premium

Lot size 5900 00 Trading at Par

Expiry date 5900 S850 Trading at Discount

Margin money
Marking to market Premium/Discount depends on supply and demand of
the stock

13 14

llustration - Ol
Futures Market Terminologies (contd.)
Open interest (O1): It is the number of contracts that are open.
For each contract there will be a buyer and a seller
So, while calculating open interest we need to take in to account either buyers or
sellers.
It is the total number of futures contract that are
open at the end of the trading
Volume means total number of futures contract that are traded during the
day.
day.
When a new contract starts, there will be no open interest.
o i e h e e seshematurity date comes close, most people close their

Generally less than 3% will result in actual delivery or go for cash (final) settlement at
expiry of the contract

eciurg notes " compled o m a i u t sourtes Ciedt g s to

thout

roval rom copvighi owne

15 16

Exercise-1/5 Exercise-2/5
MONDAY TUESDAY:
Subham buys 6 futures contracts and Saransh buys54 Swati wants to get rid of 8 contracts out of the 10 contracts
futures contracts, while Swati sells all of those 10 contracts. she sold, which she does. Hiba comes into the market and
HONTA takes on the 8 shorts contracts from her.
6L
Subham
Saransn 4L L L 6L
Subham
10S 105S aransh 4L 4L
4L
wati 10S 10S 8L 2S
Praveen HIba 8585|
10 Praveen

17 18

3
 Fxercise 4/5
Exercise-3/5 THURSDAY Hiba
and sells 25
contracts.
market
WEDNESDAY: Praveen comes to the hence buys 10
10 contracts, and
To the existing 8 short contracts, Hiba wants to add 7 more decides to liquidate more contracts

trom Praveen. Subham adds 10 to buy the

short positions, while at the same time both Subham and contracts
Saransh decides
Praveen and finally
Saransh decide to increase their long position. Hence Hiba from
from Hariharan
Contracts
sold 3 contracts to Subham and 2 contracts t0 Saransh. remaining

Swati decides to close out her open positions. ur OL 19L

10NISA
st 3L 9L | 11L
G 6L 6L
Subham 6 L 3L
Subham 4L 4L4 2 5L

Saransh
4L 2L L
Saransh 25 2
0

Swati 0S105 252 Swati 10s105

10S 10S8 8S 8S 7S 155 10L
Hiba SS S 155
HIba 255255
Praveen 30
raveen
15 OI 10 10 15
LO
iey e Ple do not shewht
walomeo
en tepqht Cne

19
20

about Ol
Exercise- 5/5 Following four points may be noted
FRIDAY
Praveen decides to square off 20 of the 25 contracts he takes place, open interest may increase,
decrease or
1. When a trade
remain at the same level.
had sold previously. So he buys 10 contracts each from
contract with
Subham and Saransh. 2. If a trade involves two new parties entering into a

each other, Ol will rise.

3. If a trade involves one party closing out by trading with a new party,
3L 9L10L 19 105 9L
ubham5 61 then Ol will remain unchanged.
10S
4L 4L 4L 2 bl SL
Saransh 4. If a trade involves two opposite positions that offset each other,
5wati 858
c 5S then Ol will tall
d O L 5 5 | 20L 5S

Tavet
10 10
30 10 ecture notes is complied trem arout ewres Ciedt o

et iese do not shaie h o t provlfem tepvright ener

rofrom
cog hmn

22
21

From the previous ExerCIse BUILD UP

Long Build Up
Investors are expecting that - prices go up and creating long positions
1 9L 101 19L
puDnd 4L 2 G 11L 105 1 Price and Ol goes up
Safansh
10510S 8L 252
8SBS 7S 15510
255 255 201 Short Build Up
30 10
Investors are expecting that- prices go down and creating short
10
25 20
Volume positions
orn tomorrow's
Today's volume has no implication Price goes down and l goes up
is not true for Ol.
volume However, it

24
23

42
 3/1/2022

LIQUIDATION INTERPRETATION

Long Liquidation
CAAANG 4HANG OR NAPKTAION
Investors who have long positions will have to square off the LONG LIQUIDATiON

pOSitions(sell) LONG BUILDUP

The Ol will decrease, if the long positions are sold off S*1ORT BUILDU

The prices will decrease and Ol will also decrease SHORT COVERIIG
0

Long unwinding causes the prices to go down

GO UP INVESTORS
Short Covering
-

PRICE WILL
SHORT COVERING
LONG BUILDUP AND
CAN BUY CALL OPTION
Investors who have short pos1itions will have to square off the
position (buy) ONG IQUiDATION AND SHORT BUILD
UP -

PRICE VWILL GO DOWN-

The Ol will decrease, if the short positions are covered INVESTORS CAN BUY PUT OPTION

The prices will increase and Ol will decrease sUBJECT To OTHER FACTORS

Short covering causes.the priIces.to go. up

25 26

Benefits of monitoring open interest Open Interest versus Volume

By monitoring the changes in the open interest When VOLUME is HIGH; individual traders in large
figures at the end
of each trading day,
somne
conclusions about the day's activity can be drawn.
numbers are participating.
When vOLUME is LOW; traders are not participating
to a large degree.
new money is
IncreasingOpen interest means_that
result will be that
When OPEN INTEREST is RISING; traders are opening
the marketplace. The positions and assuming the risk that price will create a
Tiowing into
the present trend up, down or sideways) wil gain for them.
continue.
When OPEN INTEREST is FALLING; traders are closing
positions (liquidating) and they are EITHER acceptin8

Declining open interest means_that the market

is their loss or taking their profit.
that the prevailing price trend
liquidating and implies
etturenetes eempl.as t * u **

Coming TO an en0

28
27

Price, Volume and Open Interest Change

Open Interest Long or short-it
doesn't make any difference Interpretation
Open long side or short side? Open
interest on the
interest that's reported daily on
the newspapers and
on the long side. Pike Volune Open lutelest luteipielatlou
websiles IS the net open positions
in
Equivalently, its also
the market. So it
the number of short positions
doesn't make any difference Rismg Rsng Rismg
Risung Fallug Fallung AMaukel Weakeuug

that open interest of tallng Ristig Ring Matkct is Weak

For example- if the media reports
it neans that 1uture contiacts
Wipro futures is 2 lakhs, There are 2 ullung Falluug tallug Market is Sucugthenwg
equivalent to 2 lakh shares
vwere
unsellled.
the long side and Equal number ol
lakh shafes on
shares on the short side

30
29
 SI. Trnding Shares o g utures

Differences between a Forward contract and a Futures contract

itl tlr toR

uOnle "

Standardired contract

Traded threugh thange

dioent Traded betwren indi vidusls
et Fligible for eoonte Teielits Not ge o ]Hnt
Generalty by delivery of the atuei Generally, by cash stticmen

No margnMonny Margin money is requited

low liguid ty Hgh liqundity

n c r y egulated market
latin No regulation

agrerd by parties Standarie

7 N yinniiny * Tlrir isrxplry iwl

31 32

Four Positions in Futures Market llustration

1. Buy to open or increase the long position (First Leg)
2. Sell to cliose or decrease the long position (Second Leg)
3. Sell to open or increase the short position (First Leg)
4. Buy to close or decrease the sort position (Second Leg)
Assume that today a trader who is bullish, buys 4 contracts (first leg)
of 3 months Index futures contract at a price of Rs.17,300. After one
month, he sells 4 contracts (second leg) at a price of Rs.18,000. His
position is completely closed.

i*lue note i ntoenglej am a 0 saurt Ced1" goes t

teal om cou

33 34

Order matching and trade execution Order book

Order matching is matching a buy order with the sell order or vice Order book consists of all
versa for execution of a trade in the exchange platform. best to worst.
unexecuted orders arranged according to

Orders are matched using computer algorithms on the basis of price

time priority. Generally only best 5 buy orders and best 5 sell orders are shown in
the system and the
The first priority would be the price priority and the second priority remaining are hidden.
Best buy order is from the
would be the time priority seller's point of view and best sell order is
If one investor wants, to buy a quantity of stock or derivative and from buyer's point of view.
ell the same quantity at the same price, theli So best buy passive order is the order with the
orders match and a tränsaction is made.
passive sell order is the order highest pice and best
to sell at the lowest price
Active vs passive orders

35 36

6
 3/1/2022

Order book (contd.)

Sell price Sell quantity
matched Buy quantity Buy price
your order gets
When you place a market active buy order,
securities at the lowest price 100.00 50 101 00
with the best sell
order and you get the 100
prevailin8 at that point in tinme.
99.90 450 101.20
order gets matched 250
place a market active sell order, your
When you
order and you sell the
securities at the highest price
99.80 600 101 50
with the best buy 100
prevailing at that point in time.
102.00
buy or sell the security at a specified
400 99.5 2500
l f you place a limit order to
the
not worse price than
or better price but
price, yoU get that price 100 102.8
one mentioned by you in our active order. 1200 99.0
Order matching is done at the passive order price.

38
37

Types of orders

I f you place an active order to sell 50 shares at market price, you Day/1OC order
would get Rs.100.00 per share. Limit order
a limit order to sell 50 shares at Rs.95, you still
get
Even if youasplace but order existing at
Market order
our order matches with the best
RS.100.00
that point in time.
Stop loss order
share, our
But it
orderplace
active you becomes
an order to sell our shares at Rs.103 per
passiIve and sits in the order book.

shares either at the rate specified by you or

That means you get the
better but not worse.

Same thing is true for buy orders as well.

- provalrom togg oe

40
39

Margin Money Types of margins

Both the buyer and seller have the risk of adverse price movement.
Initial margin (Equity Futures and Nifty span_margin_calculato
S o margin deposited to the clearing house of the
money must be
Zerodha Margin Calculator)
seller broker on behalf of Mark to market margin
exchange by both the buyer broker and
their clients before they open the poSition in the futures contract. Maintenance margin
Percentage of margin money
differs from security to security based Variation margin
on the volatility of the asset.
Additional volatility margin

42
41
 Example for mark to market profit or loss
calculation
P/L to the Long PILto the Short
Day Dally Settlement Price (Rs.)
* Mr. X buys a futures contract while Mr. Y sells the same tutures
,600

contract through the exchange.

100 -100
The agreement price tor the contract was 17,500/index and the 17,700
market lot for the above index is 50. 7,900
200 200
B8sed on the daily settlement price (Closing price of the futures 17,700
contract) of the futures contract, mark to market profit/loss to the 17,800
buyer and the seller for the 7 trading days are given below.
17.900
1O0
7,S00
300 00
Total

43 44

Margin Account Day Dally Settleement Daily Cumulatlve Margin A/C Margin

Gain/Loss Galn/Loss Balance Call

A trader takes a long position in one two months futures contract in 1000 -1000 O0
Mini Gold (1006) at the rate of Rs.30000/106 executed through Multi 29/700 2000 -3000 12000 **
Commodity Exchange of India Limited on 1st January, 2019. 29500 -2000 -5000 10000 5000
Initial margin for the above contract is Rs.15,000 and
maintenance 00 5000 - 20000
margin is fixed at Rs. 10,000. 0S00 5000 5000 25000 w5000

His margin account for the next 10 trading days

are given below 30400 -1000 000 19000
of Mini Gold futures contract. 2000 17000
based on the daily settlement price 30200 2000
30000 2000
30000 15000
+2000
30200 +2000 17000
15 30500 8000 e 5COC 20000
WtdrawAL

46
45

Basis
futures contract
Methods of settlement of a
Basis = Cash price - Futures price

Daily Settlement price Time Cash Price Futures Price Basis Type of Narket
Final settlement Price
Rs (Rs.)
sEting T-0 100 103
Cash settiement ContanE
Physica 5ettlement 112 Contn
Exchange of Futures for Physicals
120 19 Ckwatditon
T- 130 132
Contungu
T-4 125 T23 Backwardituon
"

48
47
 3/1/2022

Futures Price Spread

d is the difference in price of two futures contracts
Generally far month's futures price is more than next month's futures
price and next month s futures price is more than the near month
Futures Price = Spot Price x (1 + ) - d futures price.
Again near month's futures price is more than the cash price or tne
asset
F=So.erT This behavior is also due to cost of carry.

49 50

The following market information is available

about ABC Limited's stock on 1st arcn.
Spread Trading Spread Trading- Cash market price is Rs 1000, Mar futures
price Rs. 1002, April futures price Rs.1010,
Buying spread May futures price Rs. 1020
Buying Spread - buying a near month contract and selling a far month

contract

Selling Spread - selling a near month contract and buying a far month
Contract Theoretical lutures pice Actual Futures PriceStatus
contract
(Rs.) (Rs.)

1005 1002 Undervalued

arch

1010 Fairly valued

April 1010
May | 1015 1020 Overvalued

00ifron ceptst Gune

52
51

Buy March futures (U) and sell May Spread trading- Live market
Strategy tor spread futures (O) and reverse the positions
when the price comes back to
trading A trader was tracking prices of Nifty near month and next month
relationship.
futures contract. The analysis of the futures prices revealed the
following:
May contract aiendar pP
March contract 15,39J.75
Time 17Jan 22 18,304 10 18. 384 10
13,450 S: 40
18,1130s 15,169.95 1,2420

Buy March contract @Rs.1002 Sell May contract @Rs 19-Jan 22

12,918.80 647S
T-0 17,734.35 135
1761715 17,062
1020 24-1a 22 17,149 10 11,185.25 1,253 45 TO. 20

Sell March contract @Rs.1200 Buy May contract @1212

T-1
,

54
53

9
 Hedging- Short Hedge
Hedging-Long Hedge
Dutures market
h mATKe
Time
CAsh market uture market oug in C'asli Mnt
T-0 Sort n Caslh Market Loug m u t e e Matkrt

eptenl 1M A ins dende to n 500 1e bus one menths t u e s

sres of RIL The ruurnt markrt (Marlh rontrwt olk ing
*** II Sliaes at a pke of Rs 2110 per|

T-1 The p of RIL shures pxs up to n e i 3 motln, he sels ue s

Novrmber 3 R 2000 * r sluire
at a
atires contrnet [Marh rontnct)
110 lur

sulles loss ol Rs 100 j*i Tle

nake s proit o Ra
I
1le

linte
stare

Tor
e
noretompatrem
(opv "ealomcocyt o net
remspt

55 56

Hedge ratio

Hedger may hedge the total or partial position.

Hedge ratio is the futures position taken to the size of cash market
Position in markets Short hedger Long hedger
exposure
futures market Short Long
Position in HR= QF/QC
QF= Quantity in the futures contact
Long Short
Position in cash market aC= Quantity in the cash market that is being hedged

Protection needed
Against fall in price Against nse in price
If the farmer grows S000 KGs of pepper and decides to hedge the risk
of fall in price of only 4000 KGs hedge ratio is 0.80 or 80%.
he copg omple
emners f i e e do sre e s to

m o t G-reis

58
57

Optimum hedge ratio

Raja owns 20,400 shares of Infosys Ltd. purchased at Rs. S00 per
hedging instrument, i.e.,
a

Ratio that determines the percentage of a

share. On 1 January he expected the price of the INFY to go down by
that an investor should hedge 10% by end of February. Advice an hedging
asset or liability strategy for Mr.
hedging Raja.
0ptimal Hedge Ratio= P a

the spot and futures

p Thecorrelation
coefficient ofthe changes in
prices
of changes in the spot price's'
as Standard deviation
changes in the futures price
Standard deviation of
op

60
59

10
 3/1/2022

Basis risk Causes for basis risk

Basis risk arises because the cash price and futures price generally do 1. Hedger may be uncertain as to the exact date on which asset will be
not change by the same amount between any two periods when the bought or sold
hedger in1tiates the hedge and closes the hedge. 2. Hedger may close the futures contract before its expiration date
Basis may widen or narrow in any two periods during the life of thhe 3. The asset whose price is to be hedged
futures contract. may not exactly the same as
the asset in the futures contract
The risk that basis may narrow or widen, causing gain or loss is called
basis risk. Because ot this risk, the hedger may gain or loss even after
hedging
He may not get the effect of a perfect hedge. But basis risk is
generally less than the risk of cash price.

61 62

Gains and losses A person who is long

in hedging in the cash market
Tlane Cash narket Autu and short in the Time Cash Futures Basis
e utures
A person who is long futures market gains market market

in the cash market

if the basis is positive T=O Long Short 10
and short in the January 1) Rs 1000 Rs010
futures market Bins T n 5) Siort Rs oug R 10 and widens OR is
1250 1210
if the basis is positive negative and
T-1 Short Rs Long Rs5
T i t -Rs 250| o s -Rs 215
and widens OR (January 15)| 1250
narrows. T25
negative dna

rows. Profit Loss

Rs 250 Rs 245

63 64

Summary BETA
Beta measures the relationship between movement
of the index to the movement of the stock.
Basis Positive basis Negative basis The Beta measures the percentage impact on the
stock prices for 1% change in the index.
Basis widens Gain Loss
Therefore, for a portfolio whose value goes down by
11% when the index goes down by 10%, the beta
Basis narrows Loss Gain
would be 1.1.

, A

66
65

11
 BETA How BETA is helpful to Hedge?
when the index increases by 10%, the value of the
Every portfolio has a hidden exposure to the index, which is denoted
portfolio increases 11%.
by Beta.
The idea is to make beta of vour_portfolio zero to Assuming that you have a port folio of Rs. 1 million, which has a beta
nullify yoUr losses. of 1.2, you can factor a complete hedge by selling Rs.1.2 millions of
Hedging involves protecting an existing asset position
from future adverse price nmovements. NIFTY futures.

I n order to hedge a position, a market player needs to

take an equal and opposite position in the futures
market to the one held in the cash market.

67 68

How BETA is helpíful to Hedge? Contd. Stock index futures for Hedging
1. If the beta of any stock is not known, it is safe to Stock Index futures contracts offer investors, portfolio
assume that it is 1 managers, mutual funds e several ways to control
2. Short sell the index in a such a quantum that the gain risk.
on a unit decrease in the index would offset the The total risk is measured by the variance or standard
losses on the rest the portfolio. This is achieved by deviation of its return distribution.
multiplying the relative volatility of the portfolio by A
the market value of his holdings. common measure of a stock market risk is the
stock's
Beta.(discussed in previous slides)
Therefore in the above scenario we have to short sell The beta of the stocks
1.2 1million = 1.2 million worth of NIFTY
are available in NSE and BSE
web sites.

. mpo

69 70

Hedging Strategies Case let 1 (Hedging)

You had invested 10,000 shares of Zomato in their 1PO.Based on her
analys1s she feels that the Zomato is due for a correction in the range of
20% by end of October. Design a hedging strategy 139 50

71 72

12
 3/1/2022

Investment value
1,335,000.00
1.60
Stock beta 14%
Zomato-(20%), Nifty -(12%) Zomato 20%, Nifty
2,136,000.00 267.000.0o
Hedge value -267,000.00
Cash Market
NIFTY futures price
17,975.00
-251650 00
118.83 Futures Market 215700.00
Number of futures required 15,350.00
-51,300.00
S0.00 Net OSs
NIFTY market lot
2.38 or 2 contracts h e epeaht omres Fiene do rot th oithont ar

Number of contracts

74
73

let 2 contd..
Trading Strategies Case
let 2( Hedging) (Hedging)
Trading Strategies Case if the index is 50 (market lot)= 8,95,000.
at 17,900
of the portfolio The number of contracts to be sold is
of Rs.10 crore. The beta
Suppose you have a portfolio futures contracts.
is 1.19. The portfolio
is to be hedged by using Nifty
futures market to neutralize each of value 8,95,000
contracts in
To find out the number of 1.19*10 crore/8,95,O00
=
approx. 112 contracts
risk. NIFTY Is at 17,900

are over hedged and sell less

more than 112 contracts you
If you sell
han 112 contracts you are under hedged.

sompied fiom nout 1ourcer Crait n t o

Ihe t o y h t oanar *"*******

. . do not share =thot an

76
75

Hedging: Long Security,

Short Nifty
Modes of Trading Futures
Basic modes of trading on the index futures market.
market often come across a security which
Investors studying the
undervalued.
they believe is intrinsically
Hedging
Long security, Short Nifty Futures I t may be the case that the profits and the quality or
the company
what the market thinks.
make it seem worth lot more than
Short Security, Long Nifty Futures
based on a sense that
Have Portfolio, Short Nifty Futures A stockplcker carefully purchases securities
are worth more the market price.
than
Have Funds, Long Nifty Futures they
faces two kinds of risksS:
When
doing so, he
Speculation
Bullish Index, Long Nifty Futures
Bearish Index, Short Nifty Futures .

78
77

13
 Hedging: Long Security, Short Nifty Futures Hedging: Long Security, Short Nifty Futures
His/Her understanding can be wrong, and the company is really not The second outcome happens most of the time.
Worth more than the market price, or
A person may buy Reliance at Rs. 2479 thinking that it would
The entire market nmoves against him/her and generates losses even announce good results and the security price would rise.
though the underly1ng idea was correct.
A few days later, Nifty drops, so he/she makes losses, even if his
understanding of Reliance was correct.

r e l a e do not aaie hod

79 80

Hedging: Long Security, Short Nifty Futures

here is a peculiar problem here.
Hedging: Long Security, Short Nifty Futures
Every buy position on a security Is Simultaneously a buY Even
pOsition on Nifty.
if you think
Reliance is undervalued, the position LONG Reliance
iS not purely about Reliance, it is also partly about Nifty.
This is because a LoNG RELIANCE
it
position generally gains
Nifty rises and generally loses it Nitty drops.
In this sense, a LONG RELIANCE position is not a focused Every trader who has a LONG Reliance is forced to be an
play on the valuation of Reliance. speculator, even though he/she may have no interest in the index.index
It carries a LONG NIFTY Position along with it, as
incidenta baggage.
The stockpicker may be thinking he/she wants to be LONG
RELIANCE, but a long position on Reliance effectively
torces him to be.lONG.RELIANCE+.LONS. NIFTY

81
82

Hedging: Long Security, Short Nifty Futures Hedging: Long Security, Short Nifty Futures
There iS a Simple way out. The position LONG Reliance +
SHORT NIFTY is a
play on the value of Reliance, without any extra pure
risk
Every time you adopt a long position on a security, you should sell
Some amount of Nifty futures.
from fiuctuations of the market index
When this is done, the
This offsets the hidden Nifty
exposure that is inside every stockpicker has hedged away
security position.
long his Index exposure.
The basic point of this
Once this is done, you will have a position which is purely about the hedging strategY Is that the
periormance of the security stockpicker proceeds with his core skil, ie, picking
securities, at the cost of lower risk

83
84

14
 3/1/2022

hedging: Long Security, Short Nitty Futures
Hedging does not removethe losses
The best that can be achieved using hedging is the
removal of unwanted exposure. i.e. unnecessary risk.
The hedged position will make less profits than the
un-hedged position, hait the time
One should not enter into a hedging strategy hoping
to make excess profits for sure; all that can come out
Hedging: Long Security, Short Nitty Futures
How do we actually do this?
We need to know the 'beta of the security, 1.e. the average impact of
a 1% move in Nifty upon the security.
If betas are not known, it is generally safe to assume the beta is 1
Suppose wve take Reliance, whose beta is 1.68 and suppose we have a
LONG Reliance position of Rs. 5,25,000.

ofhedging is reduced risk.

86

Hedging: Long Security, Short Nifty Futures
The size of the position that we need on the Index
futures market to completely remove the hidden Nifty
exposure, is 1.68°5,25,000 = RS. 8,S2,000.
Suppose Nifty is at 17,300 and the market lot on the
futures market is 50. Hence each market lot of Nifty is
17,800"50 = Rs. 8,90,000.
We sell one market lots of Nifty (50) to get the
position.
Hedging: Long Security, Short Nifty Futures
LONG RELIANCE Rs.5,25,000
SHORTNIFTY RS. 8,90,00
This position will be essentially immune to fluctuations
of Nifty.
The price changes intrinsic to Reliance, hence only
successful forecasts about Reliance will be benefit from
this position.
Returns on the position will be roughly neutral to
movements of Nifty

87 88

Hedging: Long Security, Short Nifty Futures

DATA SLIDE

Case ler 1 . *** N

.The beta of SBi (SEIN) 1s 1 44. A person has a long position of RS.
200,000 of SBIN How to hedge his risk?
Case et

.The beta of SBl (SBIN) is 144 A person has a long position of Rs

200,000 of SBiN COupled with a SHORTNIFTY position of 120,000.
Does t represent ight Hedge?

89 90

15
 Hedging: Long Security, Short Nifty Futures Hedging: Long Security, Short Nifty Futures
ase let 3:
Hari buys 4000 shares of HPCL Case let 4:
complete hedge by Nifty 50.(HINDPETRO)
obtains a and
oSition at the
He closes out the A speculator hopes that Rolta India Limited (ROLTA) is going to rise
closing price on the day of the session. sharply. He has a long position on the cash market of Rs. 1 crore on
At this
point HPCL has ROLTA. The beta of ROLTA is 1.32. which position on the
futures have dropped dropped to 5% and the
to 5%. What is
Nifty gives him a complete hedge:
Index futures
profit/loss of this set of transactions. the overall

Data available in the DATA

slide Short Nifty Rs. 1.32 crores

91 erespf, gmae t onre

-

92

Hedging: Long Security, Short Nifty Futures

Case let 5S:
Hedging: Long Security, Short Nifty Futures
A Case let 6:
Speculator expects that the rupee will
(INFY) will rise. Hence hedepreciate,
of Infosys Limited and hence
does
profits Hari buys 4000 shares of HPCL (HINDPETRO) and
of Rs. 2 lakhs. The beta of LONGINFY to the tune obtains
INEY is O.54. a
complete hedge by Nifty 50. He closes out the
his Nifty exposure. suggest a strategy to minimize
position at the closing price on the day of the session.
At this pointHPCL has
futures have risen to 4%. dropped
He should to 5% and the
gofor SHORTNIFTY to the tune
of 2lckhs "0 54 =
108,000 What is the overall Nifty
of this set of
transactions. profit/loss
(Data available in the Data Slide)

nI"i4he do nut ihare1het

93 re

94

Hedging: Have portfolio, Short Nifty Futures

Hedging: Have portfolio, Short Nifty Futures
The only certainty about the capital market is that it fluctuates. We need to know
A lot
of investors who
own portfolios
the "beta of
the porttolio Suppose have
experience the feeling of
discomfort about overall market movements. portfolio composed
and Rs.2 million
of Rs.1 million of
Hindalco, which as a we a
beta ot 1 4
of Hindustan Unilevei, which has a beta ot O.8
Sometimes, they may have a view that security prices will fall in the the portfolio beta is then
(1*1.4+2 0.8)/ 3 =
1
near future.
The complete
hedge is obtained by adopting a position on the
At other times, they may see that the market Is in for a few days or
futures
mar ket which is completely removes the hidden exp0surelndex
weeks of massive volatility, and they do not have appetite for this In the above case, the
kind of volatility. we would need a
portfolio
is Rs.3 a beta otmilion with
1. hence
position of Rs. 3 million on the Nitty tutures.

95 96

16
 3/1/2022
3

Hedging: Have funds, buy Nifty futures

Case let 7: Determination of Futures

weeks which she has a
Mythili will get Rs. 5 lakh in the next two/three
plan to buy shares with. she adopts long position
a on the Nifty futures Prices
broad market prices crash.
market. Now
What will happen

her Nitty futures position requires payment

The shares she
wants to buy Eet cheaper but
to compensate for that
daily MTM margins

ret.om

98

NO
Valuation of forward contracts- Providing Case let 1
INCOME on a non-dividend paying
share which is
Consider a futures contract
zero-coupon bonds are the examples of such 3 time. The rate
risk tree o
Non dividend paying stockS and available at Rs.70.00 to
mature
in months
Determine the theoretical
contracts. p.a. compounded annually.
interest is 8% contract. Indicate what do you
do? it the contract is
price of the futures
F= So.e available at market at a price of Rs. 71.000

-Forward Price

S.-Spot Price
e-2.718

T-Time to Maturity
r Risk free interest rate tu ncomi tem* eute
o a l f g m n tovvi ght w-

100
99

Futures Price
Case let - 1 contd.
Quote
Tata *****i
Cons ultaney ea L
Limitod
Servicos - TCS
imited- TCSS

F So.eT
zanrnzo1
F-Forward Price

T Time to Maturity ,3 O0
r Risk free interest rate -is
*****
oB U 25 71.41
e0
F 70.
=
=

But in the market it is available at * ***

The futures price is Rs.71.41.

Rs 71.00 Hence we should buy the futures contract.
n irt

102
101

17
 Valuation of forward contracts
KNOWN INCOME
-

Providing Case let -2

A forward contract
on an investment
asset that will provide a
predictablecash pertectly Consider a 6 months futures contract on 100 shares with a price of
income to the
holder.
known dividend and coupon-bearing bonds.Examples
are stocks
paying Rs.38.00 each. The risk free rate of interest continuously compounded
is 10% p.a. The share underlying the contract is expected to yield a
F = (So - 1) e" dividend of Rs. 1.50 per share in 4 months from now. Determine the
= Y.. e T value of the futures contract.
Y = Dividend Income

103
104

Case let-2 contd.. Valuation of forward contracts -

Providing
F,= (So - ) erT KNOWN YIELD
I = Y. eT The asset underlying a forward contract provides a
known yield rather than a known cash income.
Y = Dividend Income
This means that the income is known when expressed
F = (38-1.45) eo 10- (T) = s812
as a percentage of the assets price at the time the
income is paid.

I = 1.50. eo10T7= 1.45 Suppose that an asset is expected to provide a yield

of 5% p.a. this could mean that income is paid once a
Value of the futures contract is 38.42 year and is equal to 5% with annual compounding.
PO = So. er-Y).T

Y percentage of yield

105 106

Case let 3 Case let -3 contd.

A futures contract having underlying asset of index providing a dividend 'O = So.e-)i

yield of 4% p.a. the current value of the index is 6990. The continuously
riSk Iless rate of interest is 10%% p.a. Find out the value of
Onpounoeo Y = percentage of yield
3 months futures Contrac

Fo = 6990. e" - 0 G 70gs

107 108

18
 3/1/2022

ASSUMPTIONS
There are no transaction costs

MECHANICS OF ARBITRAGE There are no restrictions on short sales. In particular, the tul
available Immediately for investment to
proceeds ofl short sales
the short seller.
are

The risk-free interest rate of interest is the same for borrowing and

lending.

109 110

Cash and carry arbitrage Cash and carry arbitrage

Iortw moncy to buy slharCs

When a futures contract is overpriced, cash and carry arbitrage can
be executed by selling the futures now and buying the underlying
asset derive a riskless profit. Duy the slhares

Snultaneousiy sell lorward comtract

Ilold slha

Deliver slharcs as filfillment of fwd Obllgution nnd repay ilhe loan

112
111

If actual futures price is more than theoretical

Illustration 1
futures price-Futures price is overvalued
* Cast. a r k e t prce ot DrC as on 1 January i s Rs 100o

R i s k ree rate of nterest o pa 80troWRD700D t olteratlar 3months 1000

T h r r e inonths (March Contract) f u t u r e s price Rs.1030P

Theoretucal futures prce Rs 1015

sqLthomont totugscontrgtaraadoa afB,1030

YMathZ)
1030
oAvertiaharesn the turasnarkevandrsee 1015
pEYioeo hintreuennep
nauaawua*s*

15

113 114

1
19
 Reverse cash and carry
arbitrage Reverse cash and carrY

When a
futures contract is underpriced, reverse cash-and-carry Sull sha1 hort
arbitrage can be executed by buying
the futures and
in spot to derive riskless profit
now selling short
Lend proxcrds from sale

Simultancously buy the forward contract

Wait until espiry

Encash the deposit. pay the moncy under fwd And delvcr theve
sharesagainst the short sale

, - **

115
116

Illustration 2 If actual futures price is less than theoretical futures

price-Futures price is undervalued- Delivery option
Cash market price of HDFC as on 1st January is Rs.10000
Risk free rate of interest: 6% p.a.
Tanations
LEDIanus)
Three months (March Contract) futures price: Rs.1005 Borow lieoek and sel hthecath mrkat +1000
Theoretical futures price: Rs.1015 ruestthepoeedsat 6%ealor lircemenths 1000
Buy the oturiscntailol reatoereotR

TeMErdh 31)
RGIe delven oftieshartmtnefunmtkaEndpuy 1005

RegthecrottedsttominveEmeibwib hlGctat6Kpa 1015

s****

10

117 118

Case Let 1
uotaAon r . 2023 c1011
Chambat ertilzers a
18T
hemicals Limited CHAMBLFERT

De*istie ***
inptrument Tpei at
Iy
Arbitrage in Reality 373. P r e Clo pon w

10
Funnentain

. .
Dy P

******"

119 120

20
 3/1/2022

Case Let 2

Quot , Paintn Liemitnd . asIaNP/

*-
23-Feb-22 Cash flow
Buy in the spot Rs 365 9 -550,350.0o
Sell one Iot of Oct futures 111,960.00 PrecIe
s70.60
Total cash outfiow 662,310.00
una**ats
28-Apr-22
Spot Rs. 390 Spot Rs. 350

34,650.00 -25,350.00
Profit from cash seEment J tt u ***
-25,200.00 34,800.00 .
Loss from futures w

9,450.00 9,450.00
Net gain ****
1.3 4% 1.34%
RO 7.62% 7.62% ' * d ,
Annualised RO

122
121

Case Let3
Quote a u n reb 22. 2022 1 t 0 .
The India Comnt Limited . iNDIACEM

28 Sept. 2021 Cash flow atre **"**

"stkDea
Cur

-1,010,400.00 p t ian VE * * * * * *

300 AP stocks in the cash market ate

piry
Buy n D1AcC 31MAAO22
Sell one lot of Sept Futures (100% margin) -1,011,180.00
208. 10 Pre o>* o.O 2cu.49
-2,021,580.00 200.75
Net cash flow
30 Sept. 2021 Spot is Rs. 3,380 *****"| "

Profit from CM
3,600.00
e t vaiur ines)
-2,820.00 vwAP * 7.c 07 *S|
Loss from futures
780o.00 d y " *** na.so

Net gain 2.v

0.04 n interwt
ROI
4.69 mpiir ua***
Annualiised ROI

124
123

Arbitrage funds
xheme e AuM(Cr) Iw
IM M 6M TD 2 Y

n a ret Man

6,549 65 0 16% 0.49% 1 20% 2 24% 08S 83* a8i 9>** *

Cash flow Nippon India Ar bitrage Fund - Ditxi Pan-

23-Feb-22 046 11% ?
9 0s?x 177 10 S4IN aaOs

Sell 2900 in the spot R s . 207 55 1,750.0 GtowthA bilage tuna und Dhiect Plan
11.75660 0 16%
Ola quty Abila
Buy one ot o1 Apr. tutures 1/5,012. 10 Tata Arbiltege Fund D ECt Han GrowtlAr biliag*
s26,737.900 11,192 27 01 a11n 12% 201N 0.70% s S0J s71
Total cash outtiov und
SuI ArLitrage Opporlunities Turnd Drect Pian
22
Spot Rs. 230 Spot Rs. 180
Aditya i la Sun ile Arb.tlage Fund Miect PHan

Gain/Loss from cash segment 65,250.00 79,750.00 o w l A D i a g e Tu

& Abilage Oppurlunilies Fuhd hrect Han
-81,490 00
Gain/Loss from futures 63,510.00
1,740.00 1,740.00 DIC Arbitge und Dect Piarn uruwilAr bitrage
Net gain
Tund
interest income 4,489.52 4,489.5
149.4 1 LUL9In 00/ 44N 424% 49%SJn
Total income 2,749.52 2,749.52 vwwog

125
126

21
 Summary of Futures

https://www.tatamutualfund.com/docs/default-source/latest
porttoli0/2022/january/arbitrage- Meanin8
fund621e28bb38c944a7bfde005f10bbd0a5.pdf?sfvrsn=c90956fe 4 Features
Terminologies
Uses
Speculation
Hedging
Arbitrage
Pricing

127
128

Options Contract

Movie ticket
Masala dosa
Fundamentals of Options Marriage engagement
An options contract is an agreement between a buyer and seller that
Bives the purchaser of the option the right to buy (in case of call
option) or sell (in case of put option) a particular asset later at an
3greed upon price (strike price).

t u e not# Eomplid liont waio sur nt

129 130

Terminologies Terminologies (contd.)

In the money option (ITM)
Call option
At the money option (ATM)
Put option
Out of the money option (OTM)
American option
Near the money option
European option
Deep in the money option
Expiry date
Exercise date Deep out of the money option

Assignment
Option premium Intrinsic Value and Time value
Strike price or Exercise pricee

131 132

22