-CA Priyanka Satarkar

TOPICS 1. Investment

meaning, importance, investment alternatives. Criteria for evaluation of investments. Portfolio management process. Approaches to investment decision making. Errors in investment management. Qualities for successful investing. 2. Financial markets and financial derivatives 3. Futures: Key features of a futures contract, Difference between futures and forwards. Calculate the theoretical price of various contracts. Use of a futures contract for hedgers and speculators. Assess economic functions performed by futures 4. Options: Meaning, how options work, equity options in India, options and their payoffs, types of options, option strategies. Factors determining option values. Models for option valuation. Calculation of option values. 5. Investment in Futures and options evaluation.

Investment vs Speculation
INVESTMENT Longer planning horizon Atleast a year Not willing to assume high risk y Modest rate of return is expected y More importance to fundamental factors for evaluation y More owned capital
y y y y

SPECULATION Short plan horizon Few days to few months Willing to assume high risk y Investor looks for high rate of return y More importance to technical charts and market psychology y More borrowed capital
y y y y

commercial property. precious stones etc y FINANCIAL ASSETS: These are paper or electronic claims on some issuer such as government or corporate body. . gold. agricultural farm.INVESTMENT ALTERNATIVES y REAL ASSETS: these are represented by tangible assets like residential houses.




Criteria for evaluation of Investment Avenues
yRate of Return yRisk yMarketability yTax Shelter

Portfolio Management Process
1. 2. 3. 4. 5. 6.

Specification of investment objectives and constraints Choice of the asset mix Formulation of Portfolio strategy Selection of Securities Portfolio Revision Performance evaluation

Approaches to portfolio management process
y Fundamental Approach y Psychological approach y Academic Approach y Eclectic Approach

Wrong attitude towards losses and profits . Naïve Extrapolation of the past 4. Vaguely formulated Investment policy 3. Over diversification and under Diversification 8. High cost 7. Untimely entry and exit 6. Cursory Decision making 5. Inadequate comparison of Risk and Return 2.1.

Composure 4. Patience 3. Decisiveness .1. Flexibility and Openness 5. Contrary Thinking 2.


is said to be in a long position y THE SELLING PARTY it is said to be in a short position.FUTURES MEANING y A futures contract is an PARTIES TO FUTURES y THE PURCHASING PARTY it agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is specified today. .

Futures .their origin y A poor philosopher in Militus used it in crude form It was used for the trade of Olive y First Futures exchange began in Japan as the Dojima rice Exchange for the Samurai in 1730 y Chicago board of trade listed the first ever traded forward contracts in 1864 which were called as future contracts y In 1875 Cotton Futures were being traded in Mumbai .

Difference between Forwards and Futures Forwards y This is a tailor made contract y No secondary market y It end with deliveries y No collateral is required y They are settled on maturity Futures y Standardized contract y Secondary market available y It ends with settlement y Margin is required y Future contract are marked to date y Both parties are exposed to credit risk market on the maturity date y It is free from credit risk as it comes with risk eliminating measures .

. This could be anything from a barrel of crude oil to a short term interest rate. etc. usually by specifying: The underlying asset or instrument. The amount and units of the underlying asset per contract. In the case of bonds.Advantages of Futures y y y y y y y Futures contracts ensure their liquidity by being highly standardized. Other details such as the the minimum permissible price fluctuation. the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity. this specifies not only the quality of the underlying goods but also the manner and location of delivery. This can be the notional amount of bonds. The delivery month and The last trading date.the location where delivery must be made. The currency in which the futures contract is quoted. either cash settlement or physical settlement. The type of settlement. as well as the pricing point -. For example. a fixed number of barrels of oil. The grade of the deliverable. units of foreign currency. this specifies which bonds can be delivered. the notional amount of the deposit over which the short term interest rate is traded. In the case of physical commodities.


y FINANCIAL FUTURES: Where the underlying is a financial asset such as Foreign Exchange. Interest rates. Shares. .Types of Futures y COMMODITY FUTURES: Where the underlying is a commodity or physical asset. Treasury bills etc.


y The future date is called the delivery date or final settlement date.Key aspects of Futures y The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange. the underlying asset to a futures contract may not be traditional "commodities" at all that is. the underlying asset or item can be currencies Securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates . . y In many cases. for financial futures.

y Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. trades executed on regulated futures exchanges are guaranteed by a clearing house. This enables traders to transact without performing due diligence on their counterparty. typically 5%-15% of the contract's value. so that in the event of a counterparty default the clearer assumes the risk of loss. traders must post a margin or a performance bond. The clearing house becomes the buyer to each seller. and the seller to each buyer.MARGIN REQUIREMENT OF FUTURES y To minimize credit risk to the exchange. . y To minimize counterparty risk to traders.

MARGIN REQUIREMENT OF FUTURES y Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Also referred to as performance bond margin. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. The maximum exposure is not limited to the amount of the initial margin. . Margins are determined on the basis of market risk and contract value. y Customer margin Within the futures industry. Futures Commission Merchants are responsible for overseeing customer margin accounts. financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Initial margin is set by the exchange. y Initial margin is the equity required to initiate a futures position. This is a type of performance bond.

but rather it is a security deposit. However.MARGIN REQUIREMENT OF FUTURES y Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. y Margin-equity ratio is a term used by speculators. y Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. . of course. but may not set it lower. Margin in commodities is not a payment of equity or down payment on the commodity itself. The broker may set the requirement higher. The low margin requirements of futures results in substantial leverage of the investment. the exchanges require a minimum amount that varies depending on the contract and the trader. representing the amount of their trading capital that is being held as margin at any particular time. can set it above that. A trader. if he doesn't want to be subject to margin calls.

y Quotation / Base value It is the Quantity in Lot or Weights for which the prices are quoted for online trading. of lots that can be bought or sold in one Single order. he has to buy minimum 100kg of cardamom given trading unit of 100kg. The maximum order size of each commodity is given in its contract specifications. that price is for 10 grams of the Gold. If a member is buying 1 lot of cardamom.CONTRACT SPECIFICATIONS y Trading unit . e.g. . If the quotation or base value for Gold contract is given as 10 grams and the price available for trading is 8000. e.The Trading unit is the minimum quantity for a contract that can be bought or sold. g. y Maximum order size Maximum order size is the maximum no.

. Such circuit filter is different for different commodities.e.Due date rate is final settlement price for particular future contract and calculation process called computation of DDR. which are in violation of such circuit filter. are rejected by the system. Circuit filter provides the maximum range within which a contract can be traded during day. DPR Daily Price Limit i.CONTRACT SPECIFICATIONS y Tick Size Tick size is the minimum price difference between the bids and asks for a particular contract. circuit filter limit is the percentage of variation allowed in the price of a commodity in a day with respect to the previous day s close price for the day DDR . The orders. The tick size is given in the contract specifications. y y y Circuit Filter: The Exchange notifies a daily circuit filter limit for futures Contract in terms of percentage of intra day variation allowed in a day with respect to the close price of previous day.

ORDER TYPES STOP LOSS ORDER ORDERS ON BASIS OF PERIOD REGULAR ORDER Regular orders can be placed in the system with market price or limit price LIMIT ORDER: Specifying the price at which the trade should be executed MARKET ORDER: It should be executed at whatever prevailing market price .

ORDER TYPES(ON BASIS OF PERIOD End of the session (EOS): are available for execution during the current trading session until executed or cancelled. Such orders will not remain in the order book. All EOS orders will get cancelled at the end of the day during which such orders were submitted. or till it is cancelled by the Member /user. Day Order: are available for execution during the current trading until executed or cancelled. whichever is earlier. Good till date: which are available for execution till end of the date indicated in the order or till the last trading day of that contract month. Immediate or Cancel (IOC): orders will get cancelled if not executed on submission of such an order. whichever is earlier? Good till cancel: which is available for execution till maturity of the contract. All DAY orders will get cancelled at the end of the day during which such orders were submitted .

COMMODITY MARKET Meaning y These are the markets where raw or primary goods are traded y These commodities are traded on regulated commodities exchange y Here they are bought and sold on basis of standardized contracts .

OPTIONS. There are many different option contracts as the number of items to buy or sell. Eg: Stock options.Meaning An option gives the owner the right to buy or sell an underlying asset on or before a given date at a fixed price Eg: Option to buy a certain flat on or any time before 31st Jan 2011 at Rs 50 lacs. foreign exchange options etc . commodity options.

FEATURES OF AN OPTION y The option is exercisable only by the buyer of the option y The owner has limited liability y Owner of options have no right affordable to shareholders such as voting rights and dividend right y Option have high degree of risk as to the option writers y Options are popular because they allow the buyer profits from favourable movements in exchange rate y Options involve buying counter positions by the option sellers y Flexibility in investor needs y No certificates are issued by the company .

Difference between futures and options FUTURES y Both the parties are obligated to OPTIONS y Only the Seller (Writer) is perform y No premium is paid by either parties y The holder of the contract is exposed to the entire spectrum of downside risk and has the potential for all the up side return y The parties to the contract must perform at the settlement date. They are not obliged to perform before the date obligated to perform y The buyer pays the Seller (writer) a premium y The buyer s loss is restricted to the premium amount but retains upward indefinite potentials y The buyer can exercise the option at any time prior to the expiry date .

y y y y y .OPTION TERMINOLOGY CALL OPTION: the option to buy PUT OPTION: The option to sell OPTION HOLDER: Buyer of the option OPTION WRITER: Seller of the option EXERCISE PRICE OR STRIKING PRICE: The fixed price at which the option holder can buy and/or sell the underlying asset y MATURITY DATE: The date when the option expires y EUROPEAN OPTION: Can be exercised only at the time of maturity y AMERICAN OPTION: It can be exercised on or before the expiration date.

Writer short Has the right but not the obligation to buy 100 shares of the underlying stock at the strike price Is obligated on demand to sell 100 shares of the underlying stock at the strike price that the holder exercises .Holder Long SELLER.CALL OPTION: A Call option is the right but not the obligation to buy some commodity or security at a specific price which is the exercise price CALL OPTION BUYER.

EXPECTATION: Wants the market price of the underlying stock to stay flat on rise 2.Writer short 1. EXPECTATION: Wants the market price of the underlying stock to rise 2.CALL OPTION BUYER. RISK: Losses only restricted to the premium paid for the call when the market price of the underlying stock declines 1. . REWARD: Premium amount 3.Holder Long SELLER. RISK: Potentially unlimited loss when the market price of the underlying stock rises. REWARD: Potential unlimited gain when the price of the underlying stock appreciates 3.

Writer short Has the right but not the obligation to sell 100 shares of the underlying stock at the strike price Is obligated on demand to buy 100 shares of the underlying stock at the strike price that the holder exercises .Holder Long SELLER.PUT OPTION: A Put option is the right but not the obligation to sell some commodity or security at a specific price which is the exercise price PUT OPTION BUYER.

EXPECTATION: Wants the market price of the underlying stock to stay flat or rise 2. EXPECTATION: Wants the market price of the underlying stock to decline 2. RISK: Potentially unlimited loss when the market price of the underlying stock falls.PUT OPTION BUYER. REWARD: Premium amount 3. RISK: Losses only restricted to the premium paid for the call when the market price of the underlying stock rises 1. .Holder Long SELLER. REWARD: Potential unlimited gain when the price of the underlying stock appreciates 3.Writer short 1.

OPTION TYPE TYPE y ATM (At the money) y ITM (In the y CALL OPTION Exercise price=Market price money) y OTM(Out of Exercise price<Market price the money) Exercise price> Market price .

OPTION TYPE TYPE y ATM (At the money) y ITM (In the y PUT OPTION Exercise price=Market price money) y OTM(Out of Exercise price >Market price the money) Exercise price < Market price .

It is a European style contract 3. The maximum period is 3 months 4. Currently the most popular index option is the option on the S & P CNX Nifty which is traded on the NSE. The contract size is 200 times or multiples thereof the underlying index viz the S & P CNX Nifty 2. The expiry date is the last Thursday of the expiry month or the previous trading day is the last Thursday is a holiday 5.EQUITY OPTIONS IN INDIA INDEX OPTIONS : Index Options are options on stock market indices. It is cash settled . The salient features of this contract are: 1.

They will be of American style 8. The salient features of this contract are: 1. Value shall not be less than Rs 2.OPTIONS ON INDIVIDUAL SECURITIES Options on individual securities have been introduced in the NSE and BSE. Cash Settled . Price steps shall be Rs 0.00. The contracts shall expire on last Thursday of the expiry month 4. Permitted lot size will be 100 units or multiples 5.000. Minimum of 5 strike prices for every option type 3. Base price shall be arrived at using the Black Scholes model 7. Maximum 3-month trading cycle 2.05 6.

Strategies with individual Stock options y PROTECTIVE PUT: Protect against downfall. y SPREAD: Combining two or more call options or two or more put options . y COVERED CALL: It involves writing a call option on an asset along with buying the asset. Buy the stock and invest in put option.

Formula for calculating Future price Fo =So(1+rf-d)^T Where: F0= futures price S0=Stock index Rf = Risk free interest rate d= Dividend yeild T=Time in months .

If an option is traded it will be a call option at a premium of 10% of the option value. If you do not purchase any option but decide to buy the shares in secondary market at the cost of 2% per trade and either the part a) or b) above works out . If market price declines to Rs 90 and no option is traded c. In May beginning you decide that shares of X Ltd will rise over the next months. If the option is traded in July as the market price is Rs 150 per share b.Problems on Futures & Options 1. Calculate your position for 100 shares a. The current price is Rs 100 and you hope that it will rise to Rs 150 by the end of July.

1127. 1126 and 1128.Problem 2 Assume that an investor buys a stock index futures contract on 1st March at Rs 1125. The position is closed out on March 5th at that day s settlement price. . Calculate the cash flow to the investor on daily basis. Ignore margin requirements. The stock index prices on four days after purchase were 1128.

Problem 3 Stock index is currently Rs 1200.25% per month. The risk free interest rate is 1% per month and the dividend yield on the stock is 0. What will be the futures price if the risk free rate is 8% and the maturity of the futures contract is 2 months . Find net cost of carry and also the stock future price if the future matures after 3 months PROBLEM 4 A non dividend paying stock has a current price of Rs 40.

Currently they are selling at Rs 1000.Problem 5 A Person Mr Q is expecting that the shares of a petroleum company would be traded ahead after 2 months for Rs 2500. Share price after 2 months is Rs 1000 . Share price after 2 months is Rs 850 c. He purchases a call option for 100 shares from Mr Z at the current market price. Share price after 2 months is Rs 2100 b. He pays a premium of 10% of the current market price. Estimate the profit or loss that Mr Q and Mr Z will incur in case: a.

Computation of Price of spread This is used to determine the relationship between future prices of contracts having different maturity dates. F(T2) = F(T1) (1+rf d) ^(T2-T1) Where T1 and T2 are the two time periods .

.Problem 1 If the risk free interest rate is 6% and the dividend yield is 2% and the contract prices and maturity is given as follows: June 25th Future price is Rs 1060 July 25th Future price is Rs 1063 Calculate the correct price of July future and check whether there is any arbitrage opportunity.

. The risk free interest rate is 0. Develop an arbitrage strategy and show how your profit will be three months hence. A three month futures contract is selling for Rs 152.Problem 2 The share of Omega Company which is not expected to pay dividend in the near future is currently selling for Rs 150.8% per month.

Investors desired holdings of financial assets derive from an optimization problem. Arbitrage opportunities tend to be eliminated by trading in financial markets since prices adjust in investors attempt to exploit them y The second concept is financial markets equilibrium.Asset Pricing models y The first is the non-arbitrage principle which states that the market forces tend to align the prices of financial assets so as to eliminate arbitrage opportunities Arbitrage opportunity arises when assets can be combined in a portfolio by buying and selling such that the portfolio has zero cost. . no chance of a loss and a positive probability of gain. In financial market equilibrium the first order conditions of an optimization problem must be satisfied.

y All securities are infinitely divisible (i. . it is possible to buy any fraction of a share). y There is no arbitrage opportunity..e. taxes or bid-ask spread. y The stock price follows a geometric Brownian motion with constant drift and volatility. y There are no transaction costs. y The underlying security does not pay a dividend. y There are no restrictions on short selling.Black-Scoles Model y The Black Scholes model of the market for a particular equity makes the following explicit assumptions: y It is possible to borrow and lend cash at a known constant risk-free interest rate.

BLACK AND SCHOLES OPTION PRICING MODEL y BLACK AND SCHOLES FORMULA FOR EUROPEAN CALL: Rt C=S N(d1)-K/e N(d2) Where: C= Market value of an option S = Current market price of underlying stock k= Option s Striking price r = The continuously compounded risk free rate(annual) t=The time until expiration in years .

t = standard deviation of changes in price of the underlying ie volatility ^2 =Instantaneous variation of the price of the underlying ie measure of the return volatility of the underlying ln =Natural Log .N(d1) (Read as N of d1) =Normal distribution function at value d1 =ln (S/k)+(r+0.5 ^2)t t N(d2) (Read as N of d2) =Normal distribution function at d2 =d1.

log and PV need to be found and inserted y Then insert the final values and calculate C .Steps y Values of d1 and d2 must be computed first y Values for the normal distribution.

5493) = 0.5 Interest rate per annum =0.7086 and PV of .0714=0.0726] .14 Apply the black-Scholes formula and calculate the option price [ln of 1.7768 N(0.068993.3 Years to maturity = 0.Problem 1 The following is a data for a stock Price of the stock currently is =Rs 60 Exercise price = Rs 56 Standard deviation of continuously compounded annual returns = 0.7614) = 0. N (0.007 is 1.

Understanding the put-call parity The put-call parity is said to work when the price lines up with the calculation as per the put-call parity formula which is C = S + P E/e ^ rt .

Calculating the value of Put option from the call option Value of the put option is calculated as follows P = C S + E/e^rt .

025 Particulars Call Option Put Option Ti e t ex irati ( t s) Risk free rate Exercise rice St ck Price Price 3 3 10% Rs 50 Rs 60 Rs 16 10% Rs 50 Rs 60 Rs 2 .Problem Check from the following data if the put-call parity is working when PV of 0.025 is 1.

y the assumption of instant. which is difficult to hedge. which can be hedged with out-of-the-money options. yielding gap risk. y the assumption of a stationary process. which can be hedged with Gamma hedging. in practice there are many other sources of risk. y the assumption of continuous time and continuous trading. yielding tail risk. yielding liquidity risk. cost-less trading. . yielding volatility risk.LIMITATIONS OF THE MODEL y Among the most significant limitations are: y the underestimation of extreme moves. which can be hedged with volatility hedging. while in the Black Scholes model one can perfectly hedge options by simply Delta hedging. y In short.

Market risk: Risk of adverse price. 7. interest rate. . management failure or fraud Valuation risk: Models of valuation may not reflect the real picture Regulatory Risk: These markets are relatively new hence there is a possibility of this risk Contagion Risk: A large amount of inter dealer position and high replacement cost to total assets ratio expose major OTC to derivative risk.Risks associated with derivatives 1. 6. 2. 5. Credit Risk: It is the risk of the derivative contract counterparty would default Liquidity risk: Relating to getting or giving at the time of fulfillment of the contract Legal Risk: This arises with the possibility that the entity may not be able to collect on a winning position or enforce a hedge Operational risk: By human error. 3. 4. 8. index level and other fluctuations.

Advantages of Derivatives y RISK SHARING y Implementation of asset allocation decision y Information gathering y Price discovery and liquidity .

Total return Swap 4. Credit Linked notes . Credit spread option 3.Derivatives their other types y Weather Derivatives: They provide hedging against the weather changes that affect the products or services y Credit Derivatives: Types are: 1. Credit default Swap 2.

Risk minimization through derivatives y Reducing the risk by selling the source of it y Reducing the risk of diversification y Reducing the risk of buying the insurance against losses .