a project on derivatives _(finance)

7/31/2019 A Project on Derivatives _(Finance)

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A Project on Derivatives Market

Submitted by:

Vikas SharmaXMBA -14


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Table of contents

1. INTRODUCTION TO CAPITAL MARKET2. Introduction to Derivative market3. Types of derivatives4. Exchange-traded vs. OTC derivatives markets5. IMORTANCE OF DERIVATIVES6. EMERGENCE OF DERIVATIVE MARKET IN INDIA7. Myths and realities about derivatives8. SWAPS

9.

Currency swaps

10.INTRODUCTION TO FUTURE MARKET11.Introduction to options12.Option Terminology13.TOP 9 TRADING STRATEGIES IN DERIVATIVES14.Some strategy for Using index futures15.Some strategies to Use index options16.CONCLUSION17.Bibliography


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INTRODUCTION TO CAPITAL MARKET

Meaning:

Capital markets are markets where people, companies, and governments with more funds

than they need (because they save some of their income) transfer those funds to people,

companies, or Governments who have a shortage of funds (because they spend more than

their income). Stock and bond markets are two major capital markets. Capital markets

promote economic efficiency by channelling money from those who do not have an

immediate productive use for it to those who do.

Capital markets carry out the desirable economic function of directing capital to productive

uses. The savers (governments, businesses, and people who save some portion of their

income) invest their money in capital markets like stocks and bonds. The borrowers

(governments, businesses, and people who spend more than their income) borrow the

savers' investments that have been entrusted to the capital markets.

Introduction to Derivative market

Derivatives can be found throughout the history of mankind. In the Middle Ages, engaging

in contracts at predetermined prices for future delivery of farming products, for example,

was quite frequent. Hundreds of years ago, Japan had a semblance of an actual futures

exchange. But it was not until 1848 that the first modern, organized futures market in

North America was createdthe Chicago Board of Trade.

The emergence of the market for derivative products, most notably forwards, futures and

options, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. 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. As instruments of risk management, these generally do not influence the fluctuationsin the underlying asset prices. However, by locking-in asset prices, derivative products


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minimize the impact of fluctuations in asset prices on the profitability and cash flow

situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodity

prices and commodity-linked derivatives remained the sole form of such products for almost

three hundred years. The financial derivatives came into spotlight in post-1970 period due

to growing instability in the financial markets. However, since their emergence, these

products have become very popular and by 1990s, they accounted for about two-thirds of

total transactions in derivative products. In recent years, the market for financial derivatives

has grown tremendously both in terms of variety of instruments available, their complexity

and also turnover. In the class of equity derivatives, futures and options on stock indices

have gained more popularity than on individual stocks, especially among institutional

investors, who are major users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with

various portfolios and ease of use. The lower costs associated with index derivatives vis-vis

derivative products based on individual securities is another reason for their growing use.

The following factors have been driving the growth of financial derivatives:

1. Increased volatility in asset prices in financial markets,2. Increased integration of national financial markets with the international markets,3. Marked improvement in communication facilities and sharp decline in their costs,4. Development of more sophisticated risk management tools, providing economicagents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks andreturns over a large number of financial assets, leading to higher returns, reduced risk as

well as trans-actions costs as compared to individual financial assets.


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Derivatives defined

Derivative is a product whose value is derived from the value of one or more basic variables,

called bases (underlying asset, index, or reference rate), in a contractual manner. Theunderlying asset can be equity, forex, commodity or any other asset. For example, wheat

farmers may wish to sell their harvest at a future date to eliminate the risk of a change in

prices by that date. Such a transaction is an example of a derivative. The price of this

derivative is driven by the spot price of wheat which is the underlying. In the Indian

context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines equity derivative

to include

1. A security derived from a debt instrument, share, loan whether secured orunsecured, 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 underlyingsecurities.

The derivatives are securities under the SC(R) A and hence the trading of derivatives is

governed by the regulatory framework under the SC(R)

According to the Bank for International Settlements' October 1992 report, Recent

Developments in International Interbank Relations, ``swaps'' are the largest type of

derivatives, as measured by the notional principal amountoutstanding

A generation or so ago, the matter of what derivatives are might have been adequately

summarized by contrasting the difference between investment, on the one hand, and

gambling or speculation, on the other.

The instruments which `underlie'' derivatives--stocks, bonds, commodities, money--

represent a claim, usually through ownership, on wealth produced in the economy. Such

claims can be purchased. Thus, shares in a company can be bought, as can bonds issued by

governments or corporations, or hard commodities produced by agriculture, forest industries,

or minerals extractors and refiners.


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The instrument so purchased provides a means by which the wealth produced may be

turned into money. In the case of stock, this may take the form of the company's dividend

payment, the part of after-tax profits distributed to shareholders, or it might take the form

of capital gains realized through the appreciation of the stock's value. Formerly, suchmonetization, or potential for monetization, would have been more or less directly related

to the economic performance of the company, in contributing to an increasing overall rate

of wealth generation through productivity-enhancing increases in the powers of labor. So

too are bonds directly related to economic activity, though where stocks represent equity

ownership, bonds represent indebtedness. The interest paid corresponds, more or less, to

the dividend yield of a stock. And like stocks, bonds can provide capital appreciation.

A generation ago, such financial instruments were the means for transforming economic

surplus into monetized net profit. ``Hard'' commodities are different, because they are part

of the materials-flow needed to sustain production and consumption, which ought to be

bought and sold so that production might proceed--outputs of production on the one side,

are also the inputs for the next level of productive transformation on the other: Wheat

becomes flour, flour becomes bread; iron ore becomes steel, steel becomes machinery,

buildings, automobiles, and household appliances. Such activities used to contribute to

generation of surplus, but their monetization is not part of after-tax profits.

Purchases of stocks and bonds would once have been seen as investment for the long haul.

Trade in commodities would have been seen not as investment, but as purchases and sales.

With what are now called derivatives, we move from investment, and purchases and sales

of hard commodities, to speculating on the future price or yield performance of what were

once investments, and relatively simple, economically necessary transactions.

All derivatives are actually variations on futures trading, and, much as some insist to the

contrary, all futures trading is inherently speculation or gambling. Thus until late in 1989, all

futures trading, of any sort, was outlawed in Germany, under the country's gambling laws.

Such activities were not treated as a legitimate part of business activity. And, who will

contend against the observation, that Germany did quite well without them?


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There are two types of futures trading; each can be applied to each of the instruments, like

stocks and bonds, which, bought directly for cash, monetize what used to be after-tax

profits. The first type is, as it were, a second step removed from economic activity as such.

This is futures trading per se: contracting to buy or sell at a future date, at a previouslynegotiated price. Here the presumption used to hold, that commodities, for example, would

actually change hands for money, as the agreed-on contracts fell due.

The other kind of futures contract, called an option, moves another step further away from

economic activity as such. Now what is bought or sold is the right, but not the obligation, to

buy or sell a commodity, stock, bond, or money, at a future price on an agreed-on date.

Where the futures contract speculates on what the price that would have to be paid against

delivery will be, the option simply speculates on the price.

At yet another remove from economic activity per se is an index. An index is not the right to

buy a commodity or stock in the future which is traded, but the future movement of an

index based on a basket of stocks, commodities, bonds, or whatever.

Types of derivatives

The most commonly used derivatives contracts are forwards, futures and options which we

shall discuss in detail later. Here we take a brief look at various derivatives contracts that

have come to be used.

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at todays pre-agreed price.

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. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts

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.


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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:

Interest rate swaps: These entail swapping only the interest related cash flowsbetween the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between theparties, with the cash flows in one direction being in a different currency than those in the

opposite direction.

Warrants: Options generally have lives of upto 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 upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset

is usually a moving average or a basket of assets. Equity index options are a form of basket

options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than have

calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay

fixed and receive floating.1

Participants and Functions

Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in the

derivatives market. Hedgers face riskassociated with the price of an asset. They use futures

1Source: Options Futures & Other Derivatives John C Hull


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or options markets to reduce or eliminate this risk. 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 are in business to take advantage of a discrepancybetween 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 to lock in a profit.

The derivative market performs a number of economic functions. First, prices in an

organized derivatives market reflect the perception of market participants about the future

and lead the prices of underlying to the perceived future level. The prices of derivatives

converge with the prices of the underlying at the expiration of derivative contract. Thus

derivatives help in discovery of future as well as current prices. Second, the derivatives

market helps to transfer risks from those who have them but may not like them to those

who have appetite for them. Third, derivatives, due to their inherent nature, are linked to

the underlying cash markets. With the introduction of derivatives, the underlying market

witnesses higher trading volumes because of participation by more players who would not

otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades

shift to a more controlled environment of derivatives market. In the absence of an

organized derivatives market, speculators trade in the underlying cash markets. Margining,

monitoring and surveillance of the activities of various participants become extremely

difficult in these kind of mixed markets. Fifth, an important incidental benefit that flows

from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The

derivatives have a history of attracting many bright, creative, well-educated people with an

entrepreneurial attitude. They often energize others to create new businesses, new

products and new employment opportunities, the benefit of which are immense. Sixth,

derivatives markets help increase savings and investment in the long run. Transfer of risk

enables market participants to expand their volume of activity. Derivatives thus promote

economic development to the extent the later depends on the rate of savings and

investment.


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Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one

another. Forward contracting dates back at least to the 12th century, and may well havebeen around before then. Merchants entered into contracts with one another for future

delivery of specified amount of commodities at specified price. A primary motivation for

prearranging a buyer or seller for a stock of commodities in early forward contracts was to

lessen the possibility that large swings would inhibit marketing the commodity after a

harvest.

Although early forward contracts in the US addressed merchants concerns about ensuring

that there were buyers and sellers for commodities, credit risk remained a serious

problem. To deal with this problem, a group of Chicago businessmen formed the

Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a

centralized location known in advance for buyers and sellers to negotiate forward contracts.

In 1865, the CBOT went one step further and listed the first exchange traded derivatives

contract in the US; these contracts were called futures contracts. In 1919, Chicago Butter

and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was

changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two

largest organized futures exchanges, indeed the two largest financial exchanges of any

kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade. Currently

the most popular index futures contract in the world is based on S&P 500 index, traded on

Chicago Mercantile Exchange. During the mid eighties, financial futures became the most

active derivative instruments generating volumes many times more than the commodity

futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular

futures contracts traded today. Other popular international exchanges that trade derivatives


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are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France,

etc.2

OTC Market size SIZE DOES MATTER !!

The total notional amount outstanding for OTC Derivative contracts for the year 2010 was

US$600tn which was almost 10 times our world GDP which is estimated to be around

US$60tn.

Table 1.2 Chronology of instruments

2Source: Derivatives in India FAQ Ajay Shah & Susan Thomas


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1874 Commodity futures

1972 Foreign currency futures

1973 Equity options

1975 Treasury bond futures

1981 Currency swaps

1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures,Options on T bond futures, Exchange listed currency options

1983 Options on equity index, Options on T-note futures, Options on currency

futures, Options on equity index futures, interest rate caps and floors

1985 Eurodollar options, Swap options

1987 OTC compound options, OTC average options

1989 Futures on interest rate swaps, Quanto options

1990 Equity index swaps

1991 Differential swaps

1993 Captions, exchange listed FLEX options

1994 Credit default options


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Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years,

which has accompanied the modernization of commercial and investment banking andglobalisation of financial activities. The recent developments in information technology have

contributed to a great extent to these developments. While both exchange-traded and OTC

derivative contracts offer many benefits, the former have rigid structures compared to the

latter. It has been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in 1998. These

episodes of turbulence revealed the risks posed to market stability originating in features of

OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded

derivatives:

1. The management of counter-party (credit) risk is decentralized and located withinindividual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring market stability and integrity,and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and theexchanges self-regulatory organization, although they are affected indirectly by national

legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market stability.


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The following features of OTC derivatives markets can give rise to instability in institutions,

markets, and the international financial system: (i) the dynamic nature of gross credit

exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on

available aggregate credit; (iv) the high concentration of OTC derivative activities in major

institutions; and (v) the central role of OTC derivatives markets in the global financial

system. Instability arises when shocks, such as counter-party credit events and sharp

movements in asset prices that underlie derivative contracts, occur which significantly alter

the perceptions of current and potential future credit exposures. When asset prices change

rapidly, the size and configuration of counter-party exposures can become unsustainably

large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the

progress has been limited in implementing reforms in risk management, including counter-

party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat

to international financial stability. The problem is more acute as heavy reliance on OTC

derivatives creates the possibility of systemic financial events, which fall outside the more

formal clearing house structures. Moreover, those who provide OTC derivative products,

hedge their risks through the use of exchange traded derivatives. In view of the inherent

risks associated with OTC derivatives, and their dependence on exchange traded derivatives,

Indian law considers them illegal.

IMORTANCE OF DERIVATIVES

Derivatives are becoming increasingly important in world markets as a tool for risk

management. Derivative instruments can be used to minimize risk. Derivatives are used

to separate the risks and transfer them to parties willing to bear these risks. The kind of

hedging that can be obtained by using derivatives is cheaper and more convenient than

what could be obtained by using cash instruments. It is so because, when we use

derivatives for hedging,actual delivery of the underlying asset is not at all essential for


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settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative

market.

Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer

them to those who are willing to bear these risks. Hedging risk through derivatives is

not similar to speculation. The gain or loss on a derivative deal is likely to be offset

by an equivalent loss or gain in the values of underlying assets. 'Offsetting of risks' is an

important property of hedging transactions. But, in speculation one deliberately takes up a

risk openly.

When companies know well that they have to face risk in possessing assets, it is

better to transfer these risks to those who are ready to bear them. So, they have to

necessarily go for derivative instruments. All derivative instruments are very simple to

operate. Treasury managers and portfolio managers can hedge all risks without going

through the tedious process of hedging each day and amount/share separately.

But with the rapid development of the derivative markets, now, it is possible to cover

such risks through derivative instruments like swap. Thus, the availability of advanced

derivatives market enables companies to concentrate on those management decisions

other than funding decisions.

Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is

also possible for companies to get out of positions in case that market reacts otherwise.

This also does not involve much cost.

Thus, derivatives are not only desirable but also necessary to hedge the complex exposures

and volatilities that the companies generally face in the financial markets today.

EMERGENCE OF DERIVATIVE MARKET IN INDIA

With globalization of the financial sector, it's time to recast the architecture of the

financial market. The liberalized policy being followed by the Government of India and

the gradual withdrawal of the procurement and distribution channel necessitated

setting in place a market mechanism to perform the economic functions of price


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discovery and risk management. Till the mid 1980's, the Indian financial system did

not see much innovation. In the last 18 years, financial innovation in India has picked

up and it is expected to grow in the years to come, as a more liberalized environment

affords greater scope for financial innovation at the same time financial markets are,by nature, extremely volatile and hence the risk factor is an important concern for

financial agents. To reduce this risk, the concept of derivatives comes into the

picture. Derivatives are products whose values are derived from one or more basic

variables called bases. India is traditionally an agriculture country with strong

government intervention. Government arbitrates to maintain buffer stocks, fix prices,

impose import-export restrictions, etc. This paper focuses on the basic understanding

about derivatives market and its development in India.

The emergence of the market for derivatives products, most notable forwards, futures,

options and swaps can be traced back to the willingness of risk-averse economic

agents to guard themselves against uncertainties arising out of fluctuations in asset

prices. By their very nature,the financial markets can be subject to 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.

As instruments of risk management, derivatives products generally do not influence the

fluctuations in the underlying asset prices. However, by locking-in asset prices,

derivatives products minimize the impact of fluctuations in asset prices on the

profitability and cash flow situation of risk-averse investors.

Starting from a controlled economy, India has moved towards a world where pricesfluctuate every day. The introduction of risk management instruments in India gained

momentum in the last few years due to liberalization process and Reserve Bank of Indias

(RBI) efforts in creating currency forward market. Derivatives are an integral part of

liberalization process to manage risk. NSE gauging the market requirements initiated the

process of setting up derivative markets in India. In July 1999, derivatives trading

commenced in India


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Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have become the

most important markets in the world. Today, derivatives have become part and parcel of

the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading

methods and was using traditional out-dated methods of trading. There was a huge gap

between the investors aspirations of the markets and the available means of trading. The

opening of Indian economy has precipitated the process of integration of Indias financial

markets with the international financial markets. Introduction of risk management

instruments in India has gained momentum in last few years thanks to Reserve Bank of

Indias efforts in allowing forward contracts, cross currency options etc. which have

developed into a very large market.

Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become the

most important markets in the world. Financial derivatives came into the spotlight along

with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods

System of fixed exchange rates leading to introduction of currency derivatives followed by

other innovations including stock index futures. Today, derivatives have become part and

parcel of the day-to-day life for ordinary people in major parts of the world. While this is

true for many countries, there are still apprehensions about the introduction of derivatives.

There are many myths about derivatives but the realities that are different especially for

Exchange traded derivatives, which are well regulated with all the safety mechanisms in

place.


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What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveragedinstruments

Derivatives are complex and exotic instruments that Indian investors willfind difficulty in understanding

Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic

purpose

While the fact is...

Numerous studies of derivatives activity have led to a broad consensus, both in the private

and public sectors that derivatives provide numerous and substantial benefits to the users.

Derivatives are a low-cost, effective method for users to hedge and manage their exposures

to interest rates, commodity prices, or exchange rates.

The need for derivatives as hedging tool was felt first in the commodities market.

Agricultural futures and options helped farmers and processors hedge against commodity

price risk. After the fallout of Bretton wood agreement, the financial markets in the world

started undergoing radical changes. This period is marked by remarkable innovations in the

financial markets such as introduction of floating rates for the currencies, increased tradingin variety of derivatives instruments, on-line trading in the capital markets, etc. As the


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complexity of instruments increased many folds, the accompanying risk factors grew in

gigantic proportions. This situation led to development derivatives as effective risk

management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to

effectively manage their portfolios of assets and liabilities through instruments like stock

index futures and options. An equity fund, for example, can reduce its exposure to the stock

market quickly and at a relatively low cost without selling off part of its equity assets by

using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks and raising

capital, derivatives improve the allocation of credit and the sharing of risk in the global

economy, lowering the cost of capital formation and stimulating economic growth.

Now that world markets for trade and finance have become more integrated, derivatives

have strengthened these important linkages between global markets, increasing market

liquidity and efficiency and facilitating the flow of trade and finance.3

2.2.2 Indian Market is not ready for derivative trading


Often the argument put forth against derivatives trading is that the Indian capital market is

not ready for derivatives trading. Here, we look into the pre-requisites, which are needed

for the introduction of derivatives and how Indian market fares:

3Source: www.nse-india .com


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Table 2.2

PRE-REQUISITES INDIAN SCENARIO

Large market Capitalization India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000

crores.

High Liquidity in the underlying The daily average traded volume in Indian capital market

today is around 7500 crores. Which means on an average

every month 14% of the countrys Market capitalisation gets

traded. These are clear indicators of high liquidity in the

underlying.

Trade guarantee The first clearing corporation guaranteeing trades has

become fully functional from July 1996 in the form of

National Securities Clearing Corporation (NSCCL). NSCCL is

responsible for guaranteeing all open positions on the

National Stock Exchange (NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised the

security settlement in our country.


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A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of

India) today the Indian capital market enjoys a strong,

independent, and innovative legal guardian who is helping

the market to evolve to a healthier place for trade practices.

Disasters prove that derivatives are very risky and highly leveraged

instruments


Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters

are not necessarily due to dealing in derivatives, but derivatives make headlines... Here I

have tried to explain some of the important issues involved in disasters related to

derivatives. Careful observation will tell us that these disasters have occurred due to lack of

internal controls and/or outright fraud either by the employees or promoters.

Barings Collapse

1. 233 year old British bank goes bankrupt on 26th February 19952. Downfall attributed to a single trader, 28 year old NicholasLeeson3. Loss arose due to large exposure to the Japanese futures market4. Leeson, chief trader for Barings futures in Singapore, takes huge position in indexfutures of Nikkei 225

5. Market falls by more than 15% in the first two months of 95 and Barings suffershuge losses

6. Bank looses $1.3 billion from derivative trading

7. Loss wipes out the entire equity capital of Barings


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The reasons for the collapse:

Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX --a risk less strategy, while in truth it was an unhedged position.

Leeson was heading both settlement and trading desk -- at most other banks thefunctions are segregated, this helped Leeson to cover his losses -- Leeson was unsupervised.

Lack of independent risk management unit, again a deviation from prudential norms.There were no proper internal control mechanisms leading to the discrepancies going

unnoticed Internal audit report which warned of "excessive concentration of power in

Leesons hands" was ignored by the top management.

The conclusion as summarised by Wall Street Journal article

" Bank of England officials said they did not regard the problem in this case as one peculiar

to derivatives. In a case where a trader is taking unauthorised positions, they said, the real

question is the strength of an investment houses internal controls and the external

monitoring done by Exchanges and Regulators. "

Metallgesellschaft

1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billionGermanys 14th largest industrial group nearly goes bankrupt from losses suffered through

its American subsidiary - MGRM

2. MGRM offered long term contracts to supply 180 million barrels of oil products to itsclients -- commitments were quite large, equivalent to 85 days of Kuwaits oil output

3. MGRM created a hedge position for these long term contracts with short termfutures market through rolling hedge --, As there was no viable long term contracts available

4. Company was exposed to basis risk -- risk of short term oil prices temporarilydeviating from long term prices.


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5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in cash.The Company was faced with temporary funds crunch.

6. New management team decides to liquidate the remaining contracts, leading to aloss of 1.3 billion.

7. Liquidation has been criticised, as the losses could have decreased over time.Auditors report claims that the losses were caused by the size of the trading exposure.

Reasons for the losses:

The transactions carried out by the company were mainly OTC in nature and hencelacked transparency and risk management system employed by a derivative exchange

Large exposure Temporary funds crunch Lack of matching long-term contracts, which necessitated the company to use rollingshort term hedge -- problem arising from the hedging strategy

Basis risk leading to short term lossDerivatives are complex and exotic instruments that Indian

investors will have difficulty in understanding


Trading in standard derivatives such as forwards, futures and options is already prevalent in

India and has a long history. Reserve Bank of India allows forward trading in Rupee-Dollar

forward contracts, which has become a liquid market. Reserve Bank of India also allows

Cross Currency options trading.


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Forward Markets Commission has allowed trading in Commodity Forwards on Commodities

Exchanges, which are, called Futures in international markets. Commodities futures in India

are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc.

There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton.International markets have also been allowed (dollar denominated contracts) in certain

commodities. Reserve Bank of India also allows, the users to hedge their portfolios through

derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for the

purpose of getting approvals to hedge the users exposure in international markets.

Derivatives in commodities markets have a long history. The first commodity futures

exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders

Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-68). A

clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a

futures market was established in 1900. Wheat futures market began in Hapur in 1913.

Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up

in Mumbai in 1920.

History and existence of markets along with setting up of new markets prove that the

concept of derivatives is not alien to India. In commodity markets, there is no resistance

from the users or market participants to trade in commodity futures or foreign exchange

markets. Government of India has also been facilitating the setting up and operations of

these markets in India by providing approvals and defining appropriate regulatoryframeworks for their operations.

Approval for new exchanges in last six months by the Government of India also indicates

that Government of India does not consider this type of trading to be harmful albeit within

proper regulatory framework.


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This amply proves that the concept of options and futures has been well ingrained in the

Indian equities market for a long time and is not alien as it is made out to be. Even today,

complex strategies of options are being traded in many exchanges which are called teji-

mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998)In that sense, the derivatives are not new to India and are also currently prevalent in various

markets including equities markets.

Is the existing capital market more safer than Derivatives?


World over, the spot markets in equities are operated on a principle of rolling settlement. In

this kind of trading, if you trade on a particular day (T), you have to settle these trades on

the third working day from the date of trading (T+3).

Futures market allow you to trade for a period of say 1 month or 3 months and allow you to

net the transaction taken place during the period for the settlement at the end of the

period. In India, most of the stock exchanges allow the participants to trade during one-

week period for settlement in the following week. The trades are netted for the settlement

for the entire one-week period. In that sense, the Indian markets are already operating the

futures style settlement rather than cash markets prevalent internationally.

In this system, additionally, many exchanges also allow the forward trading called badla in

Gujarati and Contango in English, which was prevalent in UK. This system is prevalent

currently in France in their monthly settlement markets. It allowed one to even further

increase the time to settle for almost 3 months under the earlier regulations. This way, a

curious mix of futures style settlement with facility to carry the settlement obligations

forward creates discrepancies.


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The more efficient way from the regulatory perspective will be to separate out the

derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the

same time allow futures and options to trade. This way, the regulators will also be able to

regulate both the markets easily and it will provide more flexibility to the marketparticipants.

In addition, the existing system although futures style, does not ask for any margins from

the clients. Given the volatility of the equities market in India, this system has become quite

prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default

taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to

Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three

days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX)

for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of

approximately US $ 900 million ( around Rs.3,800 crore). Although, the exposure was so

high and even the loss was also very big compared to the total exposure on MS Shoes for

BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for

a single minute.

SWAPS

A contract between two parties, referred to as counter parties, to exchange two streams of

payments for agreed period of time. The payments, commonly called legs or sides, are

calculated based on the underlying notional using applicable rates. Swaps contracts also

include other provisional specified by the counter parties. Swaps are not debt instrument to

raise capital, but a tool used for financial management. Swaps are arranged in many

different currencies and different periods of time. US$ swaps are most common followed by

Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged

from 2 to 25 years.

Why did swaps emerge?

Facilitators


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The problem of locating potential counter parties was solved through dealers and brokers. A

swap In the late 1970's, the first currency swap was engineered to circumvent the currency

control imposed in the UK. A tax was levied on overseas investments to discourage capital

outflows. Therefore, a British company could not transfer funds overseas in order to expandits foreign operations without paying sizeable penalty. Moreover, this British company had

to take an additional currency risks arising from servicing a sterling debt with foreign

currency cash flows. To overcome such a predicament, back-to-back loans were used to

exchange debts in different currencies. For example, a British company wanting to raise

capital in the France would raise the capital in the UK and exchange its obligations with a

French company, which was in a reciprocal position. Though this type of arrangement was

providing relief from existing protections, one could imagine, the task of locating companies

with matching needs was quite difficult in as much as the cost of such transactions was high.

Dealer takes on one side of the transaction as counterparty. Dealers work for investment,

commercial or merchant banks. "By positioning the swap", dealers earn bid-ask spread for

the service. In other words, the swap dealer earns the difference between the amount

received from a party and the amount paid to the other party. In an ideal situation, the

dealer would offset his risks by matching one step with another to streamline his payments.

If the dealer is a counterparty paying fixed rate payments and receiving floating rate

payments, he would prefer to be a counterparty receiving fixed payments and paying

floating rate payments in another swap. A perfectly netted position as just described is not

necessary. Dealers have the flexibility to cover their exposure by matching multiple parties

and by using other tools such as futures to cover an exposed position until the book is

complete.

Swap brokers, unlike a dealer do not take on a swap position themselves but simply locate

counter parties with matching needs. Therefore, brokers are free of any risks involved with

the transactions. After the counter parties are located, the brokers negotiate on behalf of

the counter parties to keep the anonymity of the parties involved. By doing so, if the swap

transaction falls through, counter parties are free of any risks associated with releasing their

financial information. Brokers receive commissions for their services.

3.2 Swaps Pricing:


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There are four major components of a swap price.

Benchmark price Liquidity (availability of counter parties to offset the swap). Transaction cost Credit risk 4

Swap rates are based on a series of benchmark instruments. They may be quoted as a

spread over the yield on these benchmark instruments or on an absolute interest rate basis.

In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP

rates and PLR rates.

Liquidity, which is function of supply and demand, plays an important role in swaps pricing.

This is also affected by the swap duration. It may be difficult to have counter parties for long

duration swaps, specially so in India Transaction costs include the cost of

hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now

in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must

obtain funds. The transaction cost would thus involve such a difference.

Yield on 91 day T. Bill - 9.5%

Cost of fund (e.g.- Repo rate) 10%

The transaction cost in this case would involve 0.5%

Credit risk must also be built into the swap pricing. Based upon the credit rating of the

counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an

AAA rating.

4Source: www.appliederivatives.com


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Currency swaps

Currency Swaps can be defined as a legal agreement between two or more parties to

exchange interest obligation or interest receipts between two different currencies. Itinvolves three steps:

Initial exchange of principal between the counter parties at an agreed upon rate ofexchange which is usually based on spot exchange rate. This exchange is optional and its

sole objective is to establish the quantum of the respective principal amounts for the

purpose for calculating the ongoing payments of interest and to establish the principal

amount to be re-exchanged at the maturity of the swap.

Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. Re-exchange of principal amount on maturity at the initial rate of exchange.This straight forward, three step process results in the effective transformation of the debt

raised in one currency into a fully hedged liability in other currency.

Participants

- Schedule commercial banks.- Primary dealers- All India financial institutions

Currency Swaps in India

RBI in its slack season credit policy '97 allowed the authorized dealers to arrange currency

swap without its prior approval. This was to enable those requiring long-term forward cover

to hedge themselves without altering the external liability of the country. Prior to this policy


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RBI had been approving rupee foreign currency swaps between corporates on a case basis,

but no such swaps were taking place.

RBI in its process of making the Indian corporates globally competitive has simplified their

access to this instrument by making changes in its credit policy. But despite an easing

regulation, swaps have not hit the market in a big way.

India has a strong dollar-rupee forward market with contracts being traded for one, two, six-

month expiration. Daily trading volume on this forward market is around $500 million a day.

Indian users of hedging services are also allowed to buy derivatives involving other

currencies on foreign markets. Outside India, there is a small market for cashsettled

forward contracts on the dollarrupee exchange rate.

While studying swaps in the Indian context, the counter parties involved are Indian

corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the

banks allowed by RBI to carry out the swaps. These banks form the counterparty to the

corporates on both sides of the swap and keep a spread between the interest rates to be

received and offered. One of the currencies involved is the Indian rupee and the other could

be any foreign currency. The interest rate on the rupee is most likely to be fixed, and on

foreign currency it could be either fixed or floating.

Uses of Swaps an Example : Swaps for reducing the cost of

borrowing

With the introduction of rupee derivatives the Indian corporates can attempt to reduce

their cost of borrowing and thereby add value. A typical Indian case would be a corporate

with a high fixed rate obligation.


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Eg.

Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of

18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come down. The

3-month MIBOR is quoting at 10%.

Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month

MIBOR.

The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next

one year.

The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it

makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day

treasury yield i.e. 10.25 + 0.50 = 10.75 %.

Figure 3.2

Fixed 10.75

Mehta Ltd Counter Party

3 Months MIBOR

18.75%s MIBOR

The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75


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= 7.75 + MIBOR

At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%

The gain for the firm is (18.5 - 17.75) = 0.75 %

The risks involved for the firm are

- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank.

This risk involves losses to the extent of the interest rate differential between fixed and

floating rate payments.

- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond

10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm

hold a strong view that MIBOR shall remain below 10.75%. This will require continuous

monitoring on the path of the firm.

How does the bank benefit out of this transaction?

The bank either goes for another swap to offset this obligation and in the process earn a

spread. The bank may also use this swap as an opportunity to hedge its own floating

liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall

rise beyond 10.75%.

Taking advantage of future views/ speculation

If a bank holds a view that interest rate is likely to increase and in such a case the return on

fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may

also swap floating rate liabilities with a fixed rate.

Factors to be looked at while doing a swap


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Though swaps can be used in the above conditions effectively, corporates need to look at a

few factors before deciding to swap.

The estimated net exposure

They need to estimate the net exposure that they are likely to have in the future. Projecting

the growth in exports/ imports, taking into account the changes in management and

government policies can do this.

Expected range of exchange rates

This can be determined by a fundamental and technical analysis. For fundamental analysis

one needs to keep track of the balance of payment condition, GDP growth rate, etc. of the

country. The technical factors look at past trends and expected demand-supply position.

Other factors like political stability also needs to be considered.

Expected interest rates

Since currency swaps include exchange of interest payments, the interest rates also need to

be traced. By keeping an eye on the yield curve of long term bonds and the macro economic

variables of different countries, the interest rates can be estimated.

Amount of cover to be taken

Having estimated the amount of exposure, the expected exchange rates and the interest

rates, the parties can determine the risks involved and can decide upon the amount of cover

to be taken. This shall depend on the management policy whether they believe in

minimizing the risk for a given level of return or maximizing the gain for a given level of risk.

The risk taking capability of a corporate will depend upon the financial backup to absorb the

losses, if any, the availability of time and resources to monitor the forex market.

INTRODUCTION TO FUTURE MARKET


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Futures markets were designed to solve the problems that exist in forward markets. 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. There is a multilateral contract between the buyer and

seller for a underlying asset which may be financial instrument or physical commodities. Butunlike forward contracts the future contracts are standardized and exchange traded.

PURPOSE

The primary purpose of futures market is to provide an efficient and effective mechanism

for management of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are

affected mainly by the prices of the underlying asset. As it is a future contract the buyer

and seller has to pay the margin to trade in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the

settlement day only, even though the payoffs are on a daily marking to market basis to

avoid default risk. Hence, the gains or losses are netted off on a daily basis and each

morning starts with a fresh opening value. Here both the parties face an equal amount ofrisk and are also required to pay upfront margins to the exchange irrespective of whether

they are buyers or sellers. Index based financial futures are settled in cash unlike futures on

individual stocks which are very rare and yet to be launched even in the US. Most of the

financial futures worldwide are index based and hence the buyer never comes to know who

the seller is, both due to the presence of the clearing corporation of the stock exchange in

between and also due to secrecy reasons

EXAMPLE

If The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is

bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh

has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot

size of infosys is 300 shares.


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Suppose the stock rises to 2200.

Profit

20

2200

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit

for the buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400

Profit

20

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss


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Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the

seller is 250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at

some date in the future. Futures are often used by mutual funds and large institutions to

hedge their positions when the markets are rocky. Also, Futures contracts offer a high

degree of leverage, or the ability to control a sizable amount of an asset for a cash outlay,

which is distantly small in proportion to the total value of contract

MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the

contract. Normally the margin requirement has been designed on the concept of VAR at

99% levels. Based on the value at risk of the stock/index margins are calculated. In general

margin ranges between 10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform

on their contract obligations.

TYPES OF MARGIN

1. INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin

approximately equals the maximum daily price fluctuation permitted for the contract being

traded. Upon proper completion of all obligations associated with a traders futures position,

the initial margin is returned to the trader.

OBJECTIVE


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The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer

and seller have to deposit margins. The initial margin is deposited before the opening of the

position in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower

than initial margin. This is set to ensure that the balance in the margin account never

becomes negative. If the balance in the margin account falls below the maintenance margin,

the investor receives a margin call to top up the margin account to the initial level before

trading commencing on the next level.

ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX

nifty futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance

margin of 12%. The lot size of nifty futures =200.suppose on MAY 16th

The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in

the market. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)

Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th

nifty futures settled at 1400.

Profit of buyer will be 10,000[(1450-1350)*200]

Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)


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Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600

While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]

Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)

Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to the

settlement price on a daily basis. Deficiencies in margin requirements are called for the

broker, through margin calls. Till now the concept of maintenance margin is not used in

India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the

exchange. This is generally imposed when the exchange fears that the markets have become

too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive

move by exchange to prevent breakdown.

CROSS MARGINING:

This is a method of calculating margin after taking into account combined positions in

Futures, options, cash market etc. Hence, the total margin requirement reduces due to

cross-Hedges.

MARK-TO-MARKET MARGIN:


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It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is

done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin.

Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market

margin also called as variation margin for trading in the future contract

Introduction to options

In this section, we look at the next derivative product to be traded on the NSE, namely

options. Options are fundamentally different from forward and futures contracts. An option

gives the holder of the option the right to do something. The holder does not have to

exercise this right. In contrast, in a forward or futures contract, the two parties have

committed themselves to doing something. Whereas it costs nothing (except margin

requirements) to enter into a futures contract, the purchase of an option requires an up

front payment.

Option Terminology

Index options: These options have the index as the underlying. Some options areEuropean while others are American. Like index futures contracts, index options

contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade onover 500 stocks in the United States. A contract gives the holder the right to buy or sell

shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the optionpremium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who receives the optionpremium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options. Call option: A call


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option gives the holder the right but not the obligation to buy an asset by a certain date

for a certain price. Put option: A put option gives the holder the right but not the

obligation to sell an asset by a certain date for a certain price.

Option price: Option price is the price which the option buyer pays to the option seller. Expiration date: The date specified in the options contract is known as the expiration

date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price orthe exercise price.

American options: American options are options that can be exercised at any time uptothe expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only on theexpiration date itself. European options are easier to analyze than American options,

and properties of an American option are frequently deduced from those of its

European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to apositive cashflow to the holder if it were exercised immediately. A call option on the

index is said to be in-the-money when the current index stands at a level higher than the

strike price (i.e. spot price > strike price). If the index is much higher than the strike

price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is

below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead tozero cashflow if it were exercised immediately. An option on the index is at-the-money

when the current index equals the strike price (i.e. spot price = strike price)._

Out-of-the-money option: An out-of-the-money (OTM) option is an option that wouldlead to a negative cashflow it it were exercised immediately. A call option on the index is

out-of- the-money when the current index stands at a level which is less than the strike

price (i.e. spot price < strike price). If the index is much lower than the strike price, the


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call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the

strike price.

Intrinsic value of an option: The option premium can be broken down into twocomponents - intrinsic value and time value. The intrinsic value of a call is the amount

the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it

another way, the intrinsic value of a call isNP which means the intrinsic value of a call is

Max [0, (St K)] which means the intrinsic value of a call is the (St K). Similarly, the

intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the strike

price and St is the spot price.

Time value of an option: The time value of an option is the difference between itspremium and its intrinsic value. A call that is OTM or ATM has only time value. Usually,

the maximum time value exists when the option is ATM. The longer the time to

expiration, the greater is a calls time value, all else equal. At expiration, a call should

have no time value.

Table : Distinction between futures and options

Futures Options

Exchange traded, with novation Same as futures.

Exchange defines the product Same as futures.

Price is zero, strike price moves Strike price is fixed, price moves.Price is zero Price is always positive.

Linear payoff Nonlinear payoff.

Both long and short at risk Only short at risk.

TYPES OF OPTION:

CALL OPTION


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A call option gives the holder (buyer/ one who is long call), the right to buy specified

quantity of the underlying asset at the strike price on or before expiration date. The seller

(one who is short call) however, has the obligation to sell the underlying asset if the buyer of

the call option decides to exercise his option to buy. To acquire this right the buyer pays a

premium to the writer (seller) of the contract.

ILLUSTRATION

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the

market and other is Rakesh (call seller) who is bearish in the market.

The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be

excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer

will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the

stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE

scrip from the seller at Rs.600 and sell in the market at Rs.660.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

Unlimited profit for the buyer = Rs.35{(spot pricestrike price)premium}

Limited loss for the buyer up to the premium paid.


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1. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the

stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

Profit for the Seller limited to the premium received = Rs.25

Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has

the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the

unlimited losses and have limited losses to the certain extent

Thus call option indicates two positions as follows:

LONG POSITIONIf the investor expects price to rise i.e. bullish in the market he takes a long position by

buying call option.

SHORT POSITIONIf the investor expects price to fall i.e. bearish in the market he takes a short position by

selling call option.

PUT OPTIONA Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity

of the underlying asset at the strike price on or before a expiry date. The seller of the put

option (one who is short Put) however, has the obligation to buy the underlying asset at thestrike price if the buyer decides to exercise his option to sell.


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ILLUSTRATION

Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the

market and other is Amit(put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be

excerised once the price went below 800. The premium paid by the buyer is Rs.20.The

buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit

once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the

option will be exercised the buyer will purchase the RELIANCE scrip from the market at

Rs.700and sell to the seller at Rs.800

Profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike pricespot price)premium}

Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):


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In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of

the Put option will choose not to exercise his option to sell as he can sell in the market at a

higher rate.

profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for

the seller because the seller is bullish in the market = 780 - 750 = 30

Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITIONIf the investor expects price to fall i.e. bearish in the market he takes a long position by

buying Put option.

SHORT POSITIONIf the investor expects price to rise i.e. bullish in the market he takes a short position by

selling Put option


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CALL OPTIONS PUT OPTIONS

Option buyer or

option holder

Buys the right to buy the

underlying asset at the

specified price

Buys the right to sell the

underlying asset at the

specified price

Option seller or

option writer

Has the obligation to sell

the underlying asset (to the

option holder) at the

specified price

Has the obligation to buy

the underlying asset (from

the option holder) at the

specified price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)

Changes in the underlying asset price can increase or decrease the premium of an option.

These price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and

the premium of a put will decrease. A decrease in the price of the underlying assets value

will generally have the opposite effect

Premium of the Premium of the

Price of the CALL Price of CALLUnderlying UnderlyingAssets Assets

Premium of thePremium of the PUTPUT

THE SRIKE PRICE: (K)


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The strike price determines whether or not an option has any intrinsic value. An options

premium generally increases as the option gets further in the money, and decreases as the

option becomes more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value, for puts and calls, decreases.

Volatility:

Volatility is simply a measure of risk (uncertainty), or variability of an options underlying.

Higher volatility estimates reflect greater expected fluctuations (in either direction) in

underlying price levels. This expectation generally results in higher option premiums for puts

and calls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in

case of an option seller or received from alternative investments in the case of an option

buyer for the premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

TOP 9 TRADING STRATEGIES IN DERIVATIVES1. BUY CALLWhen market is down, buy just out of money Call.

2. BUY PUT

When market is Up and correction is due, buy Put.

3. BUY FUTURE AND SELL CALL


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When you are bullish but at the same time you want to cover any downward.

4. BULL SPREAD

When market is in narrow range, buy IN THE MONEY CALL and sell OUT OF

MONEY CALL.

5. CALENDER SPREAD

When you want to take TEJI POSITION for the next month, Sell Current Month CALL

and Buy Next month Call.

6. STRANGLE

When you are not sure in which direction the market will go, Buy CALL & PUT of the

same strike price.

7. STRADDLE

When results are expected and you do not know in which direction the stock will move,

Buy OUT OF MONEY Call and OUT OF MONEY Put.

8. STOCK INSURANCE

Buy Future and Buy PUT to cover down side

9. SELL CALL & PUT

In the last days of the Contract Period, Sell naked OUT OF MONEY Call & Put.

Some strategy for Using index futures


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There are eight basic modes of trading on the index futures market:5

Hedging

H1 Long stock, short Nifty futures

H2 Short stock, long Nifty futures

H3 Have portfolio, short Nifty futures

H4 Have funds, long Nifty futures

Speculation

S1 Bullish index, long Nifty futures

S2 Bearish index, short Nifty futures

Arbitrage

A1 Have funds, lend them to the market

A2 Have securities, lend them to the market

Some strategies to Use index options

There are potentially innumerable ways of trading on the index options market. However we

shall look at eight basic modes of trading on the index futures market:

Hedging

H5 Have portfolio, buy puts

Speculation

S3 Bullish index, buy Nifty calls or sell Nifty puts

5

Source: NSE Derivatives Module & www.rediff/money/derivatives.htm &www.erivativesreview.com


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S4 Bearish index, sell Nifty calls or buy Nifty puts

S5 Anticipate volatility, buy a call and a put at same strike

S6 Bull spreads, Buy a call and sell another

S7 Bear spreads, Sell a call and buy another

Arbitrage

A3 Put-call parity with spot-options arbitrage

A4 Arbitrage beyond option price bounds6

CONCLUSION

Derivatives occupy a very significant place in the field of finance and are virtually driving the

global financial markets of the day. Several markets of the world have witnessed a

phenomenal rise in trading derivative instruments over a past three decades.

With the world embracing the derivatives trading on a large scale, the Indian marketobviously cannot remain aloof, especially after liberalization has been set in motion.

Derivatives are like a deep ocean of knowledge for the learners of finance. The reason to

choose this subject was the emergence of derivatives trading in the different sectors of the

Indian economy. Derivatives are the means to achieve the objectives like risk management by

fund managers and hedging by traders. By looking at the importance of the derivatives we

make an attempt to determine the trend of Nifty and on the basis of that framing trading

strategies to minimize the risk while maximize the profit exposure.

This project would be a powerful base for us to undergo further studies in the risk

management field and even in the field of finance as a whole.

One of the interesting developments in financial markets over the last 15 to 20 years has been

the growing popularity of derivatives or contingent claims. In many situations, both hedgers

and speculators find it more attractive to trade a derivative on an asset than to trade the asset

6


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itself. Some derivatives are traded on exchanges. Others are made available to corporate

clients by financial institutions or added to new issues of securities by underwriters.

In this report we have included history of Derivatives. Than we have included Derivatives

Market in India. Than after we have included stock market Derivatives.


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Bibliography

Books

1. Options Futures, and other Derivatives by John C Hull2. Derivatives FAQ by Ajay Shah3. NSEs Certification in Financial Markets: - Derivatives Core module4. Investment Monitor Magazine July 2001

Reports

1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta2. Risk containment in the derivatives markets by Prof.J.R.Verma

Websites

www.derivativesindia.com www.nse-india.com www.sebi.gov.in www.rediff/money/derivatives.htm www.igidr.ac.in/~ajayshah www.iinvestor.com www.appliederivatives.com www.erivativesreview.com www.economictimes.com www.cboe.com (Chicago Board of Exchange) www.adtading.com www.numa.org
http://www.numa.org/http://www.numa.org/http://www.numa.org/

a project on derivatives _(finance)

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