investingortrading?

8/12/2019 INVESTINGorTRADING?

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+. ome savings for short term goals

. (deuate insurance

/. 0ontrol over credit use

5. !etirement plan

For Investment selection the criteria must be

". !isk

+. !eturn

. 1iuidity and marketability

/. 0ost

5. 2iversification

#. Taxes

%. 3fforts and expertise

Types of Investment4

". Investment in !eal 3state old6 7ewellery, 0ommodities etc are known as )hysical

assets investment.

+. Investment in Fixed deposits with bank, )ost office, Insurance6).).F6 )ension fund or

securities market like shares, bonds, debentures etc, is known as financial assets

investments.

*elow here we have list of different types of investment plans.

". )ublic )rovident Fund 8))F9

+. :ational savings 0ertificate8:09

. Fixed deposits with banks8F.2.9

/. !ecurring 2eposit with banks

5. Infrastructure *onds

#. Fixed deposit with companies 8:*F0;s9

%. !*I !elief *onds


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". )ost office monthly Income scheme8>I9

"". :ational savings scheme 8:9

"+. 'isan ?ikas patra

". >utual fund units

"/. hares

"5. 2ebentures

"#. overnment securities

"%. 0ompany fixed deposits.

"


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/. Anits of mutual funds etc. are some of the securities investors in the securities market

can invest in.

#$uit%&Shares&Stocks:

Total euity capital of a company is divided into eual units of small denominations, each called

a share. The holders of such shares are members of the company and have voting rights.

Thus share represents the form of fractional ownership in a company.

( stock is represented by a stock certificate. In today;s computer age , you won;t actually get to

see this document because your brokerage keeps these records electronically , and is known as

2ematerialiBed share commonly known as 23>(T hares.

Chether you say shares, euity or stock, it all means the same thing.

'ebt Instrument-

2ebt Instruments !epresents a contract whereby one party lends money to another on pre-

determined terms with regards to rate and periodicity of interest, repayment of principal

amount by the borrower to lender.

In Indian securities market , the term @*D:2; is used for debt instruments issued by the central

and state government and public sector organiBations and the term @2ebenture; is used for

instruments issued by private corporate sector.

'ebt v&s #$uit%4

The key differences between euity and debt are as follows4

".2ebt investors are entitles to a contractual set of cash flows 8interest and principal9 whereas

euity investors have a claim on the residual cash flows of the firm after it has satisfied all other

claim and liabilities.

+. Interest paid to debt investor represents a tax- deductible expense whereas dividend paid to

euity investor has to come out of profit after tax.

. 2ebt has a fixed maturity whereas euity ordinarily has an infinite life.

/. 3uity investors enEoy the right to control the affairs of the firm whereas debt investors plays

a passive role of courseG they often impose certain restrictions on the way the firm is run to

protect the interests.

ecurities market4


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ecurities markets is a place where buyers and sellers of securities can enter into transactions

to purchase and sell shares, bond , debentures etc. further, it performs an important role of

enabling corporate.

3ntrepreneurs to raise resources for their companies and business ventures through public

issues. Transfer of resources from those having idle resources 8investors9 to others who have a

need for them 8corporate9 is most efficiently achieved through the securities market. tated

formally, securities market provides channels for reallocation of savings to investment and

entrepreneurship. avings are linked to investments by a variety of intermediaries, through a

range of financial products called @securities;.

(egu)ators of the securities *arket:

The absence of conditions of perfect competition in the securities market makes the role of the

regulator extremely important. The regulator ensures that the market participants behave in a

desired manner so that securities market continues to be a maEor source of finance for

corporate and government and the interest of investors are protected.

The responsibility for regulating the securities market is shared by 2epartment of 3conomic

(ffairs 823(9, !eserve *ank of India 8!*I9, 20( 82epartment of company affairs9 and

ecurities and exchange board of India 83*I9.

(egu)ator% bod%- S#BI:

The ecurities and exchange board of India 83*I9 is the regulatory authority in India

established under section of 3*I act, "==+.

3*I act, "==+ provides for establishment of securities and exchange board of India 83*I9 with

statutory power for

a. )rotecting the interest of investors in securities.

b. )romoting the development of the securities market.

c. !egulating the securities market

Its regulatory Eurisdiction extends over corporate in the issuance of capital and transfer of

securities, in addition to all intermediaries and person associated with securities market.

The ecurities exchange board of India 83*I9 has been entrusted with the responsibilities of

dealing with various matters relating to the capital market.

S#BI+s ,rinci,a) task+s are to-

H!egulate the business in the stock exchange and any other securities market

H!egister and regulate the capital market intermediaries 8brokers, merchant bankers, portfolio

managers and so on9


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H!egister and regulate the working of mutual funds.

H)romote and regulate self regulatory organiBations.

H)revent fraudulent and unfair trade in securities market.

Hpromote investors education and training of intermediaries of securities markets.

H)rohibit insider trading in securities.

H !egulate substantial acuisition of shares and takeover of companies.

Hperform such other functions as may be prescribed.

Securities *arket ,artici,ants:

The securities market essentially has three categories of participants, namely, the issue of

securities, investor in securities and the intermediaries, such as merchant bankers, brokers etc.

while the corporate and government raise resources from the securities market to meet their

obligations , it is households that invest their savings in the securities market.

It is advisable to conduct transactions through an intermediary as he is accountable for its

activities. The list of registered intermediaries is available with exchanges, industry associations

etc.

Segments of securities market:

The securities market has two interdependent segments4 the primary 8new issues9 market and

the secondary market.

)rimary market4 primary market provides the channel for sale of new securities while the

secondary market deals in securities previously issued.

econdary >arket4 econdary market refers to a market where securities are traded after

being initially offered to the public in the primary market and6or listed on the stock exchange.

>aEority of trading is done in the secondary market.

econdary market comprises of euity markets and the debt markets.

rimar% market4

The )rimary market is where securities created 8by means of an I)D9 in other words provide the

channel for sale of new securities.

)rimary market provides opportunity to issuers of securitiesG overnment as well as corporate,

to raise resources to meet their reuirements of investment and 6or discharge some obligation.


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0orporate may issue the securities at face value, or at a discount6premium and these securities

may take a variety of forms such as euity, debt etc. they may issue the securities in domestic

market and 6 or International market.

ace /a)ue of a share&debenture4

The nominal or stated amount 8in rs.9 assigned to a security by the issuer. For shares, it is the

original cost of the stock shown on the certificateG for bonds, it is the amount paid to the holder

at maturity, also known as par value or simply par.

For an euity share, the face value is usually a very small amount 8rs 5 or rs "9 and doesn;t

have much bearing on the price of the share, which may uote higher in the market, at rs " or

rs " or any other price. For a debt security, face value is amount repaid to the investor when

the bond matures8usually, government securities and corporate bonds have a face value of rs

"9.

The price at which the security trade depends on the fluctuations in the interest rates in the

economy.

)remium and discount4

Chen a security is sold above its face value, it is said to be issued at a premium and if it is sold

less than its face value then it is said to be issued at a discount.

Chy do companies need to issue shares to the public

>ost companies are usually started privately by their promoters. Jowever, the promoters;

capital and the borrowings from banks and financial institutions may not be sufficient for setting

up or running the business over a long term. o companies invite the public to contribute

towards the euity and issue shares to individual investors. the way to invite share capital from

the public is through a @public issues;. imply stated, a public issue is an offer to the public to

subscribe to the share capital of a company. Dnce this is done, the company allots shares to the

applicants as per the prescribed rules and regulations laid down by 3*I.

'ifferent kinds of issues:

". I)D8 Initial )ublic offer9

+. )ublic issue by listed company

. !ight issue

/. )referential issue

". Initial public offering8I)D9 is when an unlisted company makes either a fresh issue of

securities or an offer for sale of its existing securities or both for the first time to the

public. This paves way for listing and trading of the issuers securities.


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The price at which a company;s shares are offered initially in the primary market is

called as the issue price. Chen they begin to be traded, the market price may be

above or below the issue price.

0ut-off ,rice:

In a book building issue , the issuer is reuired to indicate either the price band or a

floor price in the prospectus. The actual discovered issue price can be any price in

the price band or any price above the floor price. This issue price is called Kcut-off

priceL. the issuer and lead manager decides this after considering the book and the

investors; appetite for the stock.

)oor ,rice:

Incase of book building process, floor price is the minimum price at which bids can

be made.

rice Band:

The prospectus may contain either the floor price for the securities or a price band

within which the investors can bid. The spread between the floor and the cap of the

price band shall not be more than +$.

ros,ectus:

(ny company floating public issues need to provide adeuate disclosure of

information to public, as per guidelines issued by 3*I.

This disclosure includes information like the reason for raising the money, the way

money is proposed to be spent, the return expected on the money etc.

This information is in the form of KprospectusL which also includes information

regarding the siBe of the issues, the current status of the company, its euity capital,

its current and past performance, the promoters , the proEect, cost of the proEect,

means of financing, product and capacity etc.

It also contains lot of mandatory information regarding underwriting and statutory

compliances. This helps investors to evaluate short term and mong term prospectus

of the company.

ow to know about A))otment of Shares& (efund

(s per 3*I guidelines, the basis of allotment should be completed with "5 days

from the issue close date. (s soon as the basis of allotment is completed, within +

working days the details of credit to demat account 6 allotment advice and dispatch


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of refund order needs to be completed. o an investor should know in about "5days

time from the closure of issue, whether shares are allotted to him or not.

isting of securities:

1isting means admission of securities of an issuer to trading privileges8dealings9 on a

stock exchange through a formal agreement . the prime obEective of admission to

dealings on the exchange is to provide liuidity and marketability to securities, as

also to provide a mechanism for effective control and supervision of trading.

Time period for listing of shares4

It would take around weeks after the closure of the book built issue.

*arket ca,ita)iation:

The market value of a uoted company, which is calculated by multiplying its current

share price8market price9 by the number of shares in issue, is called as market

capitaliBation. For example..company omvasusecurities has "# million shares in

issue. The current market price is rs ". The market capitaliBation of company

omvasusecurities is rs "# million.

oreign ca,ita) Issuance:

Indian companies are permitted to raise foreign currency resources through two main

resources.

" Issue of foreign currency convertible bonds, more commonly known as KeuroLissues and issue of ordinary shares through depository receipts namely (merican

2epository !eceipt8(2!9 and lobal 2epository !eceipt82!9

(n (merican 2epositary !eceipt8K(2!L9 is a physical certificate evidencing

ownership of (merican 2epositary shares8K(2sL9.

(n (2 is a A.. 2ollar denominated form of euity ownership in a non- A.M

company. It represents the foreign shares of the company held on deposit by a

custodian bank in the company;s home country and carries the corporate and

economic rights of the foreign shares, subEect to the terms specified on the (2!

certificate.

(2s provide A.. Investors with a convenient way to invest in overseas securities

and to trade non A.. securities in the A.. (2s are issued by a depository bank,

such as 7)>organ chase bank. They are traded in the same manner as shares in

A.. companies , on the :ewyork stock exchange8:&39 and the (merican stock

exchange8(>3N9 or uoted on :(2(O and the over the counter8DT09 market.


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lobal depository receipts82!s9 is similar to (2!, which can be used to raise

capital simultaneously in two or more markets through a global offering. 2!s may

be used in public or private markets inside or outside A.

he ro)e of the secondar% market:

For the general Investor, the secondary market provides an efficient platform for trading of

his securities. For the management of the company , secondary euity markets serve as a

monitoring and control conduit- by facilitating value-enhancing control activities, enabling

implementation of incentive based management contracts, and aggregating information 8via

price discovery9 that guides management decisions.

'ifference between rimar% *arket and Secondar% market:

In the primary market, securities are offered to public for subscription for the purpose of

raising capital or fund. econdary market is an euity trading venue in which already

existing 6 pre-issued securities are traded among investors. econdary market could be

either auction or dealer market. Chile stock exchange is the part of an auction market, over

the counter 8DT09 is a part of dealer market.

Stock #5changes:

>ost stocks are traded on exchanges, which are places where buyers and sellers meet and

decide on a price. 3xchanges are physical locations, where transactions are carried out on atrading floor. &ou have probably seen a picture of trading floor, on which traders are wildly

throwing their arms up , waving , yelling and signaling to each other.

This is old practice which is not obsolete. The other type of exchange is a virtual kind,

composed of a network of computers where trades are made electronically which is widely

used everywhere now.

The purpose of a stock market is to facilitate the exchange of securities between buyers and

sellers, thus reducing the risk.

The stock market consists of primary and secondary market. :ew securities are issued in

primary market. 3xisting securities are traded in secondary market and they are traded

through stock exchanges.

3xchange

tock 3xchange comprises 8*3-:3 and other local exchanges9

0ommodities 3xchanges 0omprises 8>0N, :023N and :c >03I19


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Stock e5changes in India:

The secondary market in India comprises of +/ stock exchanges, recogniBed by the

government under securities contracts 8regulation9 act. Df course the principal bourses are

the national stock exchange and *ombay stock exchange, accounting for the bulk of the

trading on the Indian stock market.

6ationa) Stock #5change 76S#8:

Inaugurated in "==/, the national stock exchange seeks to

". 3stablish a nation wide trading for euities, debt and hybrids

+. Facilitate eual access to investors across the country

. Impart fairness, efficiency and transparency to securities

/. horten settlement cycle

5. >eet international securities market standards

#. It is a ring less, national, computeriBed stock exchange

It has + segments

". 0apital market segment

+. Cholesale 2ebt market

The 0apital market egment covers euities, convertible debentures, and retail trade in

non-convertible debentures.

The wholesale debt market segment is a market for high value transactions in

government securities, )A bonds , commercial paper and other debt instruments.

The trading member in the capital market segment is connected to the central computer

in >umbai through a satellite link-up, using ?(Ts 8very small aperture terminals9. The

trading members in the wholesale debt market segment are linked, through dedicated

high speed lines, to the central computer at >umbai.

The :3 has opted for an order-driven system. Chen an order is placed by a tradingmember, an order confirmation slip is generated. It gives detail like uantity, price, and

code number of counterparty and so on.

In :3 scripts is known by symbol example Infosys tech. :3 ymbol- I:FD&T0J

and its index is nifty.


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Bomba% stock e5change7BS#8:

*ombay stock 3xchange limited is the oldest stock exchange in (sia with a rich heritage.

)opularly known as *3 it was established as Kthe native share and stock brokers

associationL in "


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(s per this methodology , the level of index at any point of time reflects the free float

market value of component stocks relative to a base period. The market

capitaliBation of a company is determined by multiplying the price of its stock by the

number of share issued by the company. This market capitaliBation is further multiplied

by the free float factor to determine the free-float market capitaliBation.

The base period of sensex is "=%


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/. *anks Facilitates safekeeping of money and depository facilitates safekeeping of shares.

'e,ositor% artici,ant:

The depository provides its services to investors through its agents called depositoryparticipants 82)s9 These agents are appointed by the depository with the approval of 3*I.

(ccording to 3*I regulations, amongst others, three categories of entities, i.e. banks, Financial

Institutions and 3*I registered trading members can become 2)s.

'e,ositories in India:

(t )resent there are two depositories in India, 021 and :21.

021 was promoted by *ombay stock exchange limited8*39 7ointly with leading banks such

as state bank of India , *ank of India, *ank of *aroda, J2F0 *ank , tandard 0hartered bank,

Anion *ank of India and centurion *ank in "===.

:21 :ational ecurities 2epository limited 8:219 and central depository services 8029.

:21 was the first Indian depository.. It was inaugurated in :ovember "==#. :21 was set up

with an initial capital of rs "+/ crores, )romoted by Industrial development bank of India8I2*I9,

Anit trust of India8ATI9, :ational stock exchange of India limited.8:3I19 and the state bank of

India8*I9.

'#*A:

2emat is a commonly used abbreviation of 2ematerialiBation , which is a process wherebysecurities like shares , debentures are converted from the material 8paper document9 form into

electronic 2ata and stored in the computers of an electronic depository.

rocedure for the demateria)iation of securities:

In order to dematerialiBe physical securities one has to fill in a demat reuest form 82!F9 which

is available with the 2) and submit the same along with physical certificates one wishes to

dematerialiBe.

eparate 2!F has to be filled for each II: number. If at a later date you wish to have these

Kdemat; ecurities converted back into paper certificates, the depository can help to revive the

paper shares.

*enefits of 2ematerialiBed shares4

Immediate transfer of securities.


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:o stamp duty on transfer of securities

3limination of risks associated with physical certificates such as bad delivery, fake

securities etc.

!eduction in paperwork involved in a transfer of securities.

!eduction in transaction cost

3ase of nomination facility

0hange in address recorded with 2) gets registered electronically with all companies in

which investor holds securities eliminating the need to correspond with each of them

separately

Transmission of securities is done directly by the 2) eliminating correspondence with

companies

0onvenient method of consolidation of folios6accounts

Jolding Investments in euity, debt instruments and overnment securities in a single

accountG automatic credit into demat account, of shares, arising out of

split6consolidation6merger etc.

'e,ositor% artici,ants 7'8:

The 2epository provides its services to investors through its agents called depository

participants 82)s9. These agents are appointed by the depository with the approval of

3*I. (ccording to 3*I regulations, amongst others, three categories of entities, i.e.banks, financial institutions and 3*I registered trading members can become 2)s.

>inimum balance of securities in your account with your 2)

:o. the depository has not prescribed any minimum balance. &ou can have Bero

balance in your account.

hat is ISI6-

II: 8International ecurities identification number9 is a uniue identification number for

a security.

ow to enter into stock market

h% shou)d one invest in e$uities;

3uities have the potential to increase in value over time. It also provides your portfolio

with the growth necessary to reach your long term investment goals. !esearch studies


18/36

have proves that the euities have outperformed most other forms of investment in the

long term.

3uities are considered the most challenging and the rewarding, when compared to

other investment options. !esearch studies have proved that investment in some shares

with a longer tenure of investment have yielded far superior returns than any other

investment.

Jowever, this doesn;t mean all euity investments would guarantee similar high returns.

3uities are high risk investments. Dne needs to study them carefully before investing.

ince "== till date, Indian stock market has returned about "%$ to investors on an

average in terms of increase in share prices or capital appreciation annually. *esides

that, on an average stocks have paid ".5 dividend annually.

9,ening of 'emat account:

2emat refers to a dematerialiBed account. 7ust as you have to open an account with a

bank if you want to save your money, make cheue payment etc, you need to open a

demat account if you want to buy or sell stocks.

&ou have to approach the 2)s 8remember, they are like bank branches9, to open your

demat account. 7ust like a bank passbook or statement the 2) will provide you with

periodic statements of holding and transactions.

&ou reuired to submit the documents for opening of your demat account which

includes your I2 and address proof with )an card mandatory.

ow to a,,)% for I9:

0ompany distributes I)D applications forms in large uantities. Ce have to fill this form

and submit it along with the cheue622 of the application amount.

Dpening Trading account with broker4

( stock broker or brokerage house is a entity affiliated to a stock market who bridges the

gap between an investor and a stock market to buy or sell the stocks and shares.

)rocess of buying and selling shares4

Chen you open an account, the 2) will allot a uniue *D I2 8*eneficial owner

identification9 number, which you need to uote for all future transactions.

If you want to sell your shares, you need to place an order with your broker and give

delivery instructions to your 2). The 2) will debit your account with the number of

shares sold.


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&ou will receive the payment from your broker.

If you want to buy shares, inform your broker about your depository account number , so

that the shares bought are credited into your account.

'erivatives

Dne of the most significant events in the securities markets has been the development and

3xpansion of financial derivatives. The term KderivativesL is used to refer to financial

Instruments which derive their value from some underlying assets. The underlying assets could

be euities 8shares9, debt 8bonds, T-bills, and notes9, currencies, and even indices of these

?arious assets, such as the :ifty 5 Index. 2erivatives derive their names from their respective

Anderlying asset. Thus if a derivative;s underlying asset is euity, it is called euity derivative

and so on. 2erivatives can be traded either on a regulated exchange, such as the :3 or off

the

3xchanges, i.e., directly between the different parties, which is called Kover-the-counterL 8DT09

Trading. 8In India only exchange traded euity derivatives are permitted under the law.9 The

basic purpose of derivatives is to transfer the price risk 8inherent in fluctuations of the asset

prices9 from one party to anotherG they facilitate the allocation of risk to those who are willing

to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of

prices. For example, on :ovember ", += a rice farmer may wish to sell his harvest at a future

date 8say 7anuary ", +"9 for a pre-determined fixed price to eliminate the risk of change in

prices by that date. uch a transaction is an example of a derivatives contract. The price of this

derivative is driven by the spot price of rice which is the RunderlyingR.

'erivatives in India

In India, derivatives markets have been functioning since the nineteenth century, with

organiBed trading in cotton through the establishment of the 0otton Trade (ssociation in "


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various derivatives contracts. The first contract to be launched on :3 was the :ifty 5 index

futures contract. In a span of one and a half years after the introduction of index futures, index

options, stock options and stock futures were also introduced in the derivatives segment for

trading. :3;s euity derivatives segment is called the Futures P Dptions egment or FPD

egment. :3 also trades in 0urrency and Interest !ate Futures contracts under a separate

segment.

( series of reforms in the financial markets paved way for the development of exchange-traded

euity derivatives markets in India. In "==, the :3 was established as an electronic, national

exchange and it started operations in "==/. It improved the efficiency and transparency of the

stock markets by offering a fully automated screen-based trading system with real-time price

dissemination. ( report on exchange traded derivatives, by the 1.0. upta 0ommittee, set up

by the ecurities and 3xchange *oard of India 83*I9, recommended a phased introduction of

derivatives instruments with bi-level regulation 8i.e., self-regulation by exchanges, with 3*I

providing the overall regulatory and supervisory role9. (nother report, by the 7.!. ?arma

0ommittee in "==


21/36

securities.

(t present, the euity derivatives market is the most active derivatives market in India. Trading

volumes in euity derivatives are, on an average, more than three and a half times the trading

volumes in the cash euity markets.

%,es of 'erivatives:

There are various types of derivatives traded on exchanges across the world. They range from

the very simple to the most complex products. The following are the three basic forms of

derivatives, which are the building blocks for many complex derivatives instruments 8the latter

are beyond the scope of this book94

S Forwards

S Futures

S Dptions

".orwards

( forward contract or simply aforward is a contract between two parties to buy or sell an

asset at a certain future date for a certain price that is pre-decided on the date of the contract.

The future date is referred to as expiry date and the pre-decided price is referred to as Forward

)rice. It may be noted that Forwards are private contracts and their terms are determined by

the parties involved.

2. utures

1ike a forward contract, a futures contract is an agreement between two parties in which the

buyer agrees to buy an underlying asset from the seller, at a future date at a price that is

agreed upon today. Jowever, unlike a forward contract, a futures contract is not a private


22/36

transaction but gets traded on a recogniBed stock exchange. In addition, a futures contract is

standardiBed by the exchange. (ll the terms, other than the price, are set by the stock

exchange 8rather than by individual parties as in the case of a forward contract9. (ls o, both

buyer and seller of the futures contracts are protected against the counter party risk by an

entity called the 0learing 0orporation. The 0learing 0orporation provides this guarantee to

ensure that the buyer or the seller of a futures contract does not suffer as a result of the

counter party defaulting on its obligation. In case one of the parties defaults, the 0learing

0orporation steps in to fulfill the obligation of this party, so that the other party does not suffer

due to non-fulfillment of the contract. To be able to guarantee the fulfillment of the obligations

under the contract, the 0learing 0orporation holds an amount as a security from both the

parties. This amount is called the >argin money and can be in the form of cash or other

financial assets. (lso, since the futures contracts are traded on the stock exchanges, the parties

have the flexibility of closing out the contract prior to the maturity by suaring off the

transactions in the market.

3.9,tions

1ike forwards and futures, options are derivative instruments that provide the opportunity to

buy or sell an underlying asset on a future date.

(n option is a derivative contract between a buyer and a seller, where one party 8say First

)arty9 gives to the other 8say econd )arty9 the right, but not the obligation, to buy from 8or

sell to9 the First )arty the underlying asset on or before a specific day at an agreed-upon price.

In return for granting the option, the party granting the option collects a payment from the

other party. This payment collected is called the KpremiumL or price of the option.

The right to buy or sell is held by the Koption buyerL 8also called the option holder9G the party


23/36

granting the right is the Koption sellerL or Koption writerL. Anlike forwards and futures contracts,

options reuire a cash payment 8called the premium9 upfront from the option buyer to the

option seller. This payment is called option premium or option price. Dptions can be traded

either on the stock exchange or in over the counter 8DT09 markets. Dptions traded on the

exchanges are backed by the 0learing 0orporation thereby minimiBing the risk arising due to

default by the counter parties involved. Dptions traded in the DT0 market however are not

backed by the 0learing 0orporation.

There are two types of optionscall options and put optionswhich are explained below.

0a)) o,tion

( call option is an option granting the right to the buyer of the option to buy the underlying

asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller

who grants this right to the buyer of the option. It may be noted that the person who has the

right to buy the underlying asset is known as the Kbuyer of the call optionL. The price at which

the buyer has the right to buy the asset is agreed upon at the time of entering the contract.

This price is known as the strike price of the contract 8call option strike price in this case9. ince

the buyer of the call option has the right 8but no obligation9 to buy the underlying asset, he will

exercise his right to buy the underlying asset if and only if the price of the underlying

asset in the market is more than the strike price on or before the expiry date of the

contract. The buyer of the call option does not have an obligation to buy if he does not want

to.

ut o,tion

( put option is a contract granting the right to the buyer of the option to sell the underlying

asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is


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the seller who grants this right to the buyer of the option. The person who has the right to sell

the underlying asset is known as the Kbuyer of the put optionL. The price at which the buyer

has the right to sell the asset is agreed upon at the time of entering the contract. This price is

known as the strike price of the contract 8put option strike price in this case9. ince the buyer

of the put option has the right 8but not the obligation9 to sell the underlying asset, he will

exercise his right to sell the underlying asset if and only if the price of the underlying

asset in the market is less than the strike price on or before the expiry date of the

contract. The buyer of the put option does not have the obligation to sell if he does not want

to.

'ifference between forwards and futures

".Forwards contracts are )rivately negotiated contracts Traded on an exchange

Chereas futures contracts are tandardiBed contracts

+.Ander Forward contracts ettlement dates can be set by the parties

Chereas under future contracts there are Fixed settlement dates as declared by the

3xchange.

.Jigh counter party risk under forward contracts and (lmost no counter party risk under future

contracts.

9,tions

1ike forwards and futures, options are derivative instruments that provide the opportunity to

buy or sell an underlying asset on a future date.

(n option is a derivative contract between a buyer and a seller, where one party 8say First

)arty9 gives to the other 8say econd )arty9 the right, but not the obligation, to buy from 8or

sell to9 the First )arty the underlying asset on or before a specific day at an agreed-upon price.

In return for granting the option, the party granting the option collects a payment from the


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other party. This payment collected is called the KpremiumL or price of the option.

The right to buy or sell is held by the Koption buyerL 8also called the option holder9G the party

granting the right is the Koption sellerL or Koption writerL. Anlike forwards and futures contracts,

options reuire a cash payment 8called the premium9 upfront from the option buyer to the

option seller. This payment is called option premium or option price. Dptions can be traded

either on the stock exchange or in over the counter 8DT09 markets. Dptions traded on the

exchanges are backed by the 0learing 0orporation thereby minimiBing the risk arising due to

default by the counter parties involved. Dptions traded in the DT0 market however are not

backed by the 0learing 0orporation.

There are two types of optionscall options and put optionswhich are explained below.

0a)) o,tion

( call option is an option granting the right to the buyer of the option to buy the underlying

asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller

who grants this right to the buyer of the option. It may be noted that the person who has the

right to buy the underlying asset is known as the Kbuyer of the call optionL. The price at which

the buyer has the right to buy the asset is agreed upon at the time of entering the contract.

This price is known as the strike price of the contract 8call option strike price in this case9. ince

the buyer of the call option has the right 8but no obligation9 to buy the underlying asset, he will

exercise his right to buy the underlying asset if and only if the price of the underlying

asset in the market is more than the strike price on or before the expiry date of the

contract. The buyer of the call option does not have an obligation to buy if he does not want

to.


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ut o,tion

( put option is a contract granting the right to the buyer of the option to sell the underlying

asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is

the seller who grants this right to the buyer of the option. The person who has the right to sell

the underlying asset is known as the Kbuyer of the put optionL. The price at which the buyer

has the right to sell the asset is agreed upon at the time of entering the contract. This price is

known as the strike price of the contract 8put option strike price in this case9. ince the buyer

of the put option has the right 8but not the obligation9 to sell the underlying asset, he will

exercise his right to sell the underlying asset if and only if the price of the underlying

asset in the market is less than the strike price on or before the expiry date of the

contract. The buyer of the put option does not have the obligation to sell if he does not want

Uto.

I))ustration

uppose ( has Kbought a call optionL of + shares of Jindustan Anilever 1imited 8J119 at a

strike price of !s +# per share at a premium of !s ". This option gives (, the buyer of the

option, the right to buy + shares of J11 from the seller of the option, on or before (ugust

+%, += 8expiry date of the option9. The seller of the option has the obligation to sell +

shares of J11 at !s +# per share on or before (ugust +%, += 8i.e. whenever asked by the

buyer of the option9.

uppose instead of buying a call, ( has Ksold a put optionL on " !eliance Industries 8!I19

shares at a strike price of !s + at a premium of !s


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'ifferences between futures and o,tions

". Ander Futures

*oth the buyer and the seller are

under an obligation to fulfill the

contract.

Chereas in Dptions

The buyer of the option has the right and not an

obligation whereas the seller is under obligation

to fulfill the contract if and when the buyer

exercises his right.

+. Ander future The buyer and the seller are

subEect to unlimited risk of loss wereas in options

The seller is subEected to unlimited risk of losing

whereas the buyer has limited potential to lose

8which is the option premium9.

.Ander future The buyer and the seller have

potential to make unlimited gain or

loss whereas in option

The buyer has potential to make unlimited gain

while the seller has a potential to make limited

gain. Dn the other hand the buyer has a limited

loss potential and the seller has an unlimited loss

potential.


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ermino)og% of 'erivatives

In this section we explain the general terms and concepts related to derivatives.

S,ot ,rice 7S8

pot price of an underlying asset is the price that is uoted for immediate delivery of the asset.

For example, at the :3, the spot price of !eliance 1td. at any given time is the price at which

!eliance 1td. shares are being traded at that time in the 0ash >arket egment of the :3.

pot

price is also referred to as cash price sometimes.

orward ,rice or futures ,rice 78

Forward price or futures price is the price that is agreed upon at the date of the contract for the

delivery of an asset at a specific future date. These prices are dependent on the spot price, the

prevailing interest rate and the expiry date of the contract.

Strike ,rice 8'9

The price at which t he buyer of an option can buy the stock 8in the case of a call option9 or sell

the stock 8in the case of a put option9 on or before the expiry date of option contracts is called

strike price. It is the price at which the stock will be bought or sold when the option is

exercised. trike price is used in the case of options onlyG it is not used for futures or forwards.

#5,iration date 8T9

In the case of Futures, Forwards, Index and tock Dptions, 3xpiration 2ate is the date on which

settlement takes place. It is also called the final settlement date.

%,es of o,tions

Dptions can be divided into two different categories depending upon the primary exercise styles

associated with options. These categories are4


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#uro,ean 9,tions4 3uropean options are options that can be exercised only on the expiration

date.

American o,tions4 (merican options are options that can be exercised on any day on or

before the expiry date. They can be exercised by the buyer on any day on or before the final

settlement date or the expiry date.

0ontract sie

(s futures and options are standardiBed contracts traded on an exchange, they have a fixed

contract siBe. Dne contract of a derivatives instrument represents a certain number of shares of

the underlying asset. For example, if one contract of *J31 consists of shares of *J31,

then

if one buys one futures contract of *J31, then for every !e " increase in *J31;s futures price,

the buyer will make a profit of N " Q !s and for every !e " fall in *J31;s futures price,

he will lose !s .

0ontract /a)ue

0ontract value is notional value of the transaction in case one contract is bought or sold. It is

the contract siBe multiplied but the price of the futures. 0ontract value is used to calculate

margins etc. for contracts. In the example above if *J31 futures are trading at !s. + the

contract value would be !s. + x Q !s. # lacs.

*argins

In the spot market, the buyer of a stock has to pay the entire transaction amount 8for

purchasing the stoc k9 to the seller. For example, if Infosys is trading at !s. + a share and

an investor wants to buy " Infosys shares, then he has to pay !s. + N " Q !s.

+,, to the seller. The settlement will take place on TV+ basisG that is, two days after t he

transaction date.

In a derivatives contract, a person enters into a trade today 8buy or sell9 but the settlement

happens on a future date. *ecause of this, there is a high possibility of default by any of the


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parties. Futures and option contracts are t raded through exchanges and the counter party risk

is taken care of by the clearing corporation. In order to prevent any of the parties from

defaulting on his trade commitment, the clearing corporation levies a margin on the buyer as

well as seller of the futures and option contracts. This margin is a percentage 8approximately

+$9 of the total contract value. Thus, for the aforementioned example, if a person wants to

buy " Infosys futures, then he will have to pay +$ of the contract value of !s +,, Q

!s /, as a margin to the clearing corporation. This margin is applicable to both, the buyer

and the seller of a futures contract.

*one%ness of an 9,tion

K>oneynessL of an option indicates whether an option is worth exercising or not i.e. if the

option is exercised by the buyer of the option whether he will receive money or not.

K>oneynessL of an option at any given time depends on where the spot price of the underlying

is at that point of time relative to the strike price. The premium paid is not taken into

consideration while calculating moneyness of an Dption, since the premium once paid is a sunk

cost and the profitability from exercising the option does not depend on the siBe of the

premium. Therefore, the decision 8of the buyer of the option9 whether to exercise the option or

not is not affected by the siBe of the premium. The following three terms are used to define the

moneyness of an option.

In-the-mone% o,tion

(n option is said to be in-the-money if on exercising the option, it would produce a cash inflow

for the buyer. Thus, 0all Dptions are in-the-money when the value of spot price of the

underlying exceeds the strike price. Dn the other hand, )ut Dptions are in-the-money when the

spot price of the underlying is lower than the strike price. >oneyness of an option should not be

confused with the profit and loss arising from holding an option contract. It should be noted

that while moneyness of an option does not depend on the premium paid, profit6loss do. Thus a


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holder of an in-the-money option need not always make profit as the profitability also depends

on the premium paid.

"#

9ut-of-the-mone% o,tion

(n out-of-the-money option is an opposite of an in-the-money option. (n option-holder will not

exercise the option when it is out-of-the-money. ( 0all option is out-of-the-money when its

strike price is greater than the spot price of the underlying and a )ut option is out-of-themoney

when the spot price of the underlying is greater than the option;s strike price.

At-the-mone% o,tion

(n at-the-money-option is one in which the spot price of the underlying is eual to the strike

price. It is at the stage where with any movement in the spot price of the underlying, the

option will either become in-the-money or out-of-the-money.

artici,ants in the 'erivatives *arket

(s euity markets developed, different categories of investors started participating in the

market. In India, euity market participants currently include retail investors, corporate

investors, mutual funds, banks, foreign institutional investors etc. 3ach of these investor

categories uses the derivatives market to as a part of risk management, investment strategy or

speculation.

*ased on the applications that derivatives are put to, these investors can be broadly classified

into three groups4

S Jedgers


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S peculators, and

S (rbitrageurs

Ce shall now look at each of these categories in detail.

edgers

These investors have a position 8i.e., have bought stocks9 in the underlying market but are

worried about a potential loss arising out of a change in the asset price in the future. Jedgers

participate in the derivatives market to lock the prices at which they will be able to transact in

the future. Thus, they try to avoid price risk through holding a position in the derivatives

market. 2ifferent hedgers take different positions in the derivatives market based on their

exposure in the underlying market. ( hedger normally takes an opposite position in the

derivatives market to what he has in the underlying market.

S,ecu)ators

( peculator is one who bets on the derivatives market based on his views on the potential

movement of the underlying stock price. peculators take large, calculated risks as they trade

based on anticipated future price movements. They hope to make uick, large gainsG but may

not always be successful. They normally have shorter holding time for their positions as

compared to hedgers. If the price of the underlying moves as per their expectation they can

make large profits. Jowever, if the price moves in the opposite direction of their assessment,

the losses can also be enormous.

Arbitrageurs

(rbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous

trades that offset each other and capture a risk-free profit. (n arbitrageur may also seek to

make profit in case there is price discrepancy between the stock price in the cash and the

derivatives markets.

'erivatives rading on 6S#


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The FPD segment on :3 provides trading facilities for the following derivative instruments4

S Index futures,

S Index options,

S Individual stock futures, and

S Individual stock options.

(s an investor one can invest in any of these products. (ll these products have different

contract specifications.

0learing banks

ome commercial banks have been designated by the :001 as 0learing *anks. Financial

settlement can take place only through 0learing *anks. (ll the clearing members are reuired

to open a separate bank account with an :001 designated clearing bank for the FPD

segment.

The clearing members keep a margin amount in these bank accounts.

Sett)ement of utures

Chen two parties trade a futures contract, both have to deposit margin money which is called

the initial margin. Futures contracts have two types of settlement4 8i9 the mark-to-market

8>T>9 settlement which happens on a continuous basis at the end of each day, and 8ii9 the final

settlement which happens on the last trading day of the futures contract i.e., the last Thursday

of the expiry month.

*ark to market sett)ement

To cover for the risk of default by the counterparty for the clearing corporation, the futures

contracts are marked-to-market on a daily basis by the exchange. >ark to market settlement is

the process of adEusting the margin balance in a futures account each day for the change in the

value of the contract from the previous day, based on the daily settlement price of the futures


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contracts 8)lease refer to the Tables given below.9. This process helps the clearing corporation

in managing the counterparty risk of the future contracts by reuiring the party incurring a loss

due to adverse price movements to part with the loss amount on a daily basis. imply put, the

party in the loss position pays the clearing corporation the margin money to cover for the

shortfall in cash. In extraordinary times, the 3xchange can reuire a mark to market more

freuently 8than daily9.

To ensure a fair mark-to-market process, the clearing corporation computes and declares the

official price for determining daily gains and losses. This price is called the Ksettlement priceL

and represents the closing price of the futures contract. The closing price for any contract of

any given day is the weighted average trading price of the contract in the last half hour of

trading.

ina) sett)ement for futures

(fter the close of trading hours on the expiry day of the futures contracts, :001 marks all

positions of clearing members to the final settlement price and the resulting profit6loss is

settled in cash. Final settlement loss is debited and final settlement profit is credited to the

relevant clearing bank accounts on the day following the expiry date of the contract. uppose

the above contract closes on day # 8that is, it expires9 at a price of !s. "/, then on the day

of expiry, !s. " would be debited from the seller 8short position holder9 and would be

transferred to the buyer 8long position holder9.

Sett)ement of 9,tions

In an options trade, the buyer of the option pays the option price or the option premium. The

options seller has to deposit an initial margin with the clearing member as he is exposed to

unlimited losses.


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There are basically two types of settlement in stock option contracts4 daily premium settlement

and final exercise settlement. Dptions being 3uropean style, they cannot be exercised before

expiry.

'ai)% ,remium sett)ement

*uyer of an option is obligated to pay the premium towards the options purchased by him.

imilarly, the seller of an option is entitled to receive the premium for the options sold by him.

The same person may sell some contracts and buy some contracts as well. The premium

payable and the premium receivable are netted to compute the net premium payable or

receivable for each client for each options contract at the time of settlement.

#5ercise sett)ement

:ormally most option buyers and sellers close out their option positions by an offsetting closing

transaction but a better understanding of the exercise settlement process can help in making

better Eudgment in this regard. tock and index options can be exercised only at the end of the

contract.

ina) #5ercise Sett)ement

Dn the day of expiry, all in the money options are exercised by default. (n investor who has a

long position in an in-the-money option on the expiry date will receive the exercise settlement

value which is the difference between the settlement price and the strike price. imilarly, an

investor who has a short position in an in-the-money option will have to pay the exercise

settlement value.

The final exercise settlement value for each of the in the money options is calculated as follows4

0all Dptions Q 0losing price of the security on the day of expiry strike price 8if closing price M


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strike price, else 9

)ut Dptions Q trike price closing price of the security on the day of expiry 8if closing price W

strike price, else 9

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