project report - derivatives

7/28/2019 Project Report - Derivatives

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INTRODUCTION

The past decade has witnessed an explosive growth in the use of financial

derivatives by a wide range of corporate and financial institutions. This growth

has run in the parallel with the increasing direct reliance of the companies on

the capital markets as the major source of long term funding. In this respect,

derivatives have a vital role to play in enhancing shareholder value by

ensuring access to the cheapest source of funds. Furthermore, active use of

derivatives instruments allows the overall business risk profile to be modified,

thereby providing the potential to improve earning quality by offsetting

undesired risks.

Derivatives can be indeed be used safely and successfully provided that a

sensible controls and management strategy is established and executed.

Certainly, a degree of quantitative pricing and risk analysis may be needed,

depending on the extent and sophistication of the derivative strategies

employed.

History of Stock Market

The Bombay Stock Exchange was set up in 1875.

The markets acquired breadth and size in the late 80s and early 90s.

Initial momentum provided by MNC dilution.

Followed by a spate of public issues.

And now, PSU disinvestments.

Till recently, the Indian markets lacked the depth in terms of players and asset

classes.

As a result, the retail stakeholder was the venture capitalist, speculator and

investor all in one.

The Drivers of transition


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SEBI, RBIPOLICIES AND

REGULATIONS

ELECTRONIC TRADING,

SETTLEMENT SYSTEMS

MFS, FIIS, HEDGE FUNDS,

PVT EQUITY INVESTORS,PROF FUND

MGR, PVT BKG ARMS OF BANKS

PRIVATE EQUITY, DEBT,

EQUITIES, DERIVATIVES

ICRA, FITCH,

CARE, CRISIL

THE NATIONAL

STOCK EXCHANGE

PLAYERS

RATING AGENCIES

ASSET CLASSES


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LITERATURE REVIEW

AND

PROBLEM FORMULATION


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LITERATURE REVIEW AND PROBLEM FORMULATION

The effects of introduction of derivatives on Indian capital market have been

widely studies across the world. The empirical works have focused on the

derivatives Market to address a wide range of issues, such as volatility

implication, lead-lag relationship between spot and derivative markets, market

efficiency, etc.

Other researchers report contradictory finding in different markets. The studyon the UK markets by Watt et al. (1992) found that option listing had no effect

on beta but unsystematic risk and total risk were found to have declined.

Kabir (1999) studied the markets in Netherlands and found that no significant

changes in risk took place after the introduction of option in the Dutch

markets.

In the Indian context Arma (1999) investigated the volatility estimation models

comparing LARCH and the EWMA models in the risk management setting.

Pander (2002) explored the extreme value estimators and found that they

perform better than the traditional close to close estimators although his study

does not consider the performance of extreme s clue estimators sersus time

varying volatility models.

Kaur (2004) examined the nature and characteristics of capital market in India

from the literature review the following points emerge.

There are a number of studies on the impact of derivatives on the capital

market. The results so far are mixed. Some markets have shown increase in

volatility following derivative introductions, while in other capital markets has

decreased or remained at the same level. Studies in the Indian contest found

no significant changes in the volatility of underlying capital market after the

introduction of derivative. This study examines more closely whether the

advent of future and option trading has led to an increase in index stocks


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daily return co variation, systematic risk and volatility in the Indian capital

market.

In a recent study, Bologna and Cavallo (2002) investigated the stock market

volatility in the post derivative period for the Italian stock exchange using

Generalized Autoregressive Conditional Heteroscedasticity (GARCH) class of

models. To eliminate the effect of factors other than stock index futures (i.e.,

the macroeconomic factors) determining the changes in volatility in the post

derivative period, the GARCH model was estimated after adjusting the stock

return equation for market factors, proxied by the returns on an index (namely

Dax index) on which derivative products are not introduced. This study shows

that unlike the findings by Antoniou and Holmes (1995) for the London Stock

Exchange (LSE), the introduction of index future, per se, has actually reduced

the stock price volatility. Bologna and Covalla also found that in the post

Index-future period the importance of present news has gone up in

comparison to the old news in determining the stock price volatility.

A few studies have been undertaken to evaluate the effect of introduction of

derivative products on capital markets. While Thenmozhi (2002) showed that

the inception of futures trading has reduced the volatility of spot index returns

due to increased information flow. According to Shenbagaraman (2003), the

introduction of derivative products did not have any significant impact on

market volatility in India.

In a study made by Snehal Bendivedkar and Saurabh gosh,( following

Bologna and Cavallo (2002)) GARCH model has been used to empiricallyevaluate the effects on volatility of the Indian spot market and to see that what

extent the change (if any) could be attributed to the of introduction of index

futures. The empirical analysis points towards a decline in spot market

volatility after the introduction of index futures due to increased impact of

recent news and reduced effect of uncertainty originating from the old news.

However, further investigation also reveals that the market wide volatility has

fallen during the period under consideration.


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It is studied to analyze the role played by the Derivatives in the stock market

with emphasis on Indian capital market and how the risk can be hedged

through derivatives.

Indian securities markets have indeed waited for too long for derivatives

trading to emerge. Mutual Funds, FIIs and other investors who were deprived

of hedging opportunities now have a derivatives market to bank on. First to

emerge are the globally popular variety - index futures.

While derivatives markets flourished in the developed world Indian markets

remain deprived of financial derivatives to the beginning of this millennium.While the rest of the world progressed by leaps and bounds on the derivatives

front, Indian market lagged behind. Having emerged in the markets of the

developed nations in the 1970s, derivatives markets grew from strength to

strength. The trading volumes nearly doubled in every three years making it a

trillion-dollar business. They became so ubiquitous that, now, one cannot

think of the existence of financial markets without derivatives.

Two broad approaches of SEBI is to integrate the securities market at thenational level, and also to diversify the trading products, so that more number

of traders including banks, financial institutions, insurance companies, mutual

funds, primary dealers etc. choose to transact through the Exchanges. In this

context the introduction of derivatives trading through Indian Stock Exchanges

permitted by SEBI in 2000 AD is a real landmark.


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PROBLEM STATEMENT

Investors were too scared in investing in the stock market as they thought itas pure gamble. Moreover their interests were not safe due to lack of proper

rules and regulation. But if we look towards the development, which has taken

place in the capital market, it has gradually started adding the capital wealth

to the investors.

As this environment is dynamic and keeps on changing, so accordingly the

investor has to mould and turn out the strategies in order to over come the

risk and uncertainties of the market.

This project will help the investor to measure the market risk (systematic

risk).The market risk can be evaluated with the help of Beta. In this way the

investor will be able to allocate his funds in various derivative instruments so

that the risk is hedged.


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OBJECTIVES

AND

RESEARCH

METHODOLOGY


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OBJECTIVES OF THE PROPOSED STUDY

1 To study the emergence of derivative concept in the Indian capital market-

This project will highlight the summary of the evolution of the derivatives

and the contribution of different committees.

2 To know the various types of derivatives in the stock market- The project

will provide an insight into the various kinds of derivatives available in the

capital market like:

1. Forward Contract

2. Futures Contract

3. Call Option

4. Put Option

3. To know the various techniques of minimizing risks- In this project we will

come across various combinations of derivatives instruments that should beused in a particular market condition (bullish, bearish and stable) in order to

avoid risk.

4. To know the regulatory framework for the derivative trading in India- The

project will provide information on SEBIs regulatory role which includes

approving the rules, byelaws and regulations of derivatives and approval of

proposed derivative contracts before commencement of trading.

5. To know various challenges in trading with derivatives in Indian stock

market- As the stock market is very dynamic, the small investors are reluctant

to invest their hard earned money. Hence public awareness & education

regarding the benefits of trading sensibly is very important.


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RESEARCH METHODOLOGY

Research methodology is a way to systematically sole the research problems.It may be understood as a science of study how research is done

scientifically. In it we study the various steps that are generally adopted by a

researcher in studying his research problem along witht the logic behind them.

It is necessary for the researcher to know not only research

methods/techniques but also the methodology. Researchers not only need to

know how to develop certain indices or tests, how to calculate the mean, the

mode, the median or the standard deviation or chi-square, how to apply

particular research techniques, but they also need to know which of these

methods or techniques, are relevant and which are not, and what would they

mean and indicate and why.

Research methodology deals with the various methods of research. The

purpose of the research methodology is to explain the research procedures

used in the research methodology. It helps in carrying out the project report by

analyzing the various research findings collected through the data collectionmethod

A large number of Illustrations will be included with the aim of providing skills

to compute pricing of various derivatives instruments. Terminology of

derivatives will be explained in simple language for an easy understanding of

the underlying concept.

Now for study of derivatives we have two types of data which are in use these

are as follows:

1. Primary data

2. Secondary data


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Now, primary data are data gathered and assembled for specifically for the

project at hand. In this project I am using different type of primary data

collection like Questionnaire Method & some other methodsThis primary data

can be slow and high in cost.

Secondary, or historical, data like market figures and charts will be used to

ascertain better understanding of various concepts and ideas. The derivatives

will be more cleared by the use of different scaling techniques. Now thiese

scaling techniques are then classified as comaprative and non-comparative.

Comparative scale involve the direct measurment of stimulus objects and data

hve only ordinal or rank-order properties. Now here by the use of a type of

comparative scaling technique called Paired Comparisons where we can

make a choice between two objects is has become easy to understand the

use of derivatives. Some pricing models were used get the conclusion.

Now in this project I have studied the SEBI and RBI reports. I have also

worked on the stock exchange reports. I am also covering the growth of

derivtives market in the past few years to know more about the derivatives For

this I am using some graphs to give more idea about these derivatives. I have

also studied how the derivative products are introduced in the global market

and how is helps in reducing the risk while investing in shares.


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DATA ANALYSIS


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INTRODUCTION OF DERIVATIVES

Keeping in view the experience of even strong and developed economies the

world over, it is no denying the fact that financial market is extremely volatile

by nature. Indian financial market is not an exception to this phenomenon.

The attendant risk arising out of the volatility and complexity of the financial

market is an important concern for financial analysts. As a result, the logical

need is for those financial instruments, which allow fund managers to better,

manage or reduce these risks.

For enabling the banks and the financial institutions, among others, to

manage their risk effectively, the concept of derivatives comes into picture.

Development of Indian Derivatives Market

1995: Promulgation of the Securities Laws (Amendment) Ordinance 1995

withdrawing prohibition on options in securities.

November 1996: SEBI set up a 24 member committee under the

chairmanship of Dr. L. C. Gupta with a view to develop regulatory framework

for derivatives trading in India.

March 1998: L C Gupta Committee submitted its report recommending, inter-

alia, that derivatives be declared as securities so that regulatory framework

applicable for trading of securities could also be applicable for derivatives.

December 1999: Securities Contract Regulation Act was amended to include

derivatives within the purview of securities. Regulatory framework was

developed for governing the trading of derivatives.

June 2000: Derivative trading started in India.

2001: SEBI permitted the derivative segment of National Stock Exchange

(NSE) and Bombay Stock Exchange (BSE) and their clearing

house/corporation to commence trading and settlement in approved

derivatives contract.


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Approval and commencement of trading in index futures contract based on

S&P CNX Nifty and BSE-30 (Sensex) index as well as for trading in futures on

individual securities.

Approval and commencement of trading in index options based on S&P CNX

Nifty and BSE-30 (Sensex) index as well as for trading in options on individual

securities.

June 2003:In the first phase, only interest rate futures have been introduced

and banks were allowed to hedge interest rate risk inherent in the government

securities, portfolio. Accordingly, trading in interest rate futures contracts innotional 10-year GOI Bonds, notional 91-day Treasury Bills and 10-year zero

coupon bonds commenced at NSE.

Stock exchanges were advised to separate the cash and market segment of

the stock exchanges in terms of legal framework governing trading, clearing,

and settlement of the derivatives segment, establishment of separate

trade/settlement guarantee funds, separate membership and Governing

Council/Executive Committees.

July 2003: Authorized Dealers in Foreign Exchange were permitted to offer

foreign currency-rupee options w.e.f. July 07, 2003 to residents and non-

residents for hedging currency exposures.


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Growth of Derivatives Market in India

Index futures

Yearno. of contracts(in

lakhs) turnover(Rs in crore)

2000-2001 0.91 2365

2001-2002 10.26 21483

2002-2003 21.27 43952

2003-2004 171.92 554446

2004-2005 216.35 772147

2005-2006 585.38 15137552006-2007 814.87 2539574

2007-2008 1565.99 3820667.27

2008-2009 120.63 280100.25

index futures

0

200

400

600

800

1000

1200

1400

1600

1800

2000-

2001

2001-

2002

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

2007-

2008

2008-

2009

time period

n

o.ofcontracts(in

lakhs)

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

turnover(Rs.

in

crores)

no. of contracts(in lakhs) turnover(rs in crore)


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Index options

yearno. of contracts(in

lakhs) National turnover (Rs. Cr.)

2000-2001 0 0

2001-2002 1.76 3765

2002-2003 4.42 9246

2003-2004 17.32 52816

2004-2005 32.94 121943

2005-2006 129.35 338469

2006-2007 251.57 791906

2007-2008 553.66 1362110.88

2008-2009 53.65 133564.86

index options

0

100

200

300

400

500

600

2000-

2001

2001-

2002

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

2007-

2008

2008-

2009

time period

no.ofcontracts

(in

lakhs)

0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

nationalturnover(r

s.cr.

)

no. of contracts(in lakhs) national turnover(Rs. Cr.)


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Global Derivatives Market

.

Developments Leading to Inception of Financial Derivatives

Early forward contracts in the U.S addressed merchants concerns about

ensuring that there were buyers and sellers for commodities. However 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. In1865, the CBOT went one step ahead and listed the first exchange traded

derivatives contract in the U.S; these contracts were called futures contracts.

In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized

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.


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Calendar of Introduction ofDerivative Products in the Global Market

Year Products

1874 Commodity futures

1972 Foreign currency futures

1973 Equity options

1975 T-bonds futures

1981 Currency swaps

1982

Interest rate swaps; T notes futures; Eurodollar futures; Equity

index futures; options on T-bond futures; Exchange- listed

currency options

1983

Options on equity index; Options on T- notes futures; Euro-dollar

futures; options on equity index futures; interest rates caps and

floors

1985 Euro-dollar options; swaptions

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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DERIVATIVES AND ITS TYPE

A derivative security can be defined as a security whose value depends onthe values of other underlying variables. Very often, the variables underlying

the derivative securities are the prices of traded securities. Thus the

underlying asset can be equity, forex, commodity or any other asset.

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.

Derivative contracts have several variants:

Forwards

Futures

Options

Swaps

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: It is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price through exchange traded contracts.

Options: It is an agreement which gives the buyer the right but not the

obligation to buy or sell a given quantity of the underlying assets at a given

price on or before a given date.

Swaps: These are private agreements between two parties to exchange cash

flows in the future according to pre-arranged formula. They can be regarded

as portfolios of forward contracts.

TERMINOLOGY


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FUTURES TERMINOLOGY

Spot price: The price at which an asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures

market.

Contract cycle: The period over which a contract trades. The index futures

contracts on the NSE have one-month, two-months and three-month expiry

cycles which expire on the last Thursday of the month. Thus a January

expiration contract expires on the last Thursday of January and a February

expiration contract ceases trading on the last Thursday of February. On the

Friday following the last Thursday, a new contract having a three-month expiry

is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day

on which the contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one

contract. For instance, the contract size on NSEs futures market is 200 N ifties.

Basis: In the context of financial futures, basis can be defined as the futures

price minus the spot price. There will be a different basis for each delivery

month for each contract. In a normal market, basis will be positive. This reflects

that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be

summarized in terms of what is known as the cost of carry. This measures the

storage cost plus the interest that is paid to finance the asset less the incomeearned on the asset.

Initial margin: The amount that must be deposited in the margin account at the

time a futures contract is first entered into is known as initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the

margin account is adjusted to reflect the investors gain or loss depending upon

the futures closing price. This is called markingtomarket.


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Maintenance margin: This is somewhat lower than the 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 and is expected to top up the margin account to

the initial margin level before trading commences on the next day.

OPTION TERMINOLOGY

Buyer of an option: The buyer of an option is the one who by paying the

option premium 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

option premium 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 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. It is also referred to as the option premium.

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 or the exercise price.

American options: American options are options that can be exercised at any

time up to the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only

on the expiration date itself. European options are easier to analyze than


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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 a positive cash flow 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 wouldlead to zero cash flow 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

would lead to negative cash flow it was 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 muchlower than the strike price, the 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 two

components 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.

Time value of an option: The time value of an option is the difference

between its premium and its intrinsic value. Both calls and puts have time

value. An option 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 an options time value, all else equal. At expiration, an

option should have no time value.


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Derivatives Market at NSE

The derivatives trading on the exchange commenced with S&P CNX NiftyIndex futures on June 12, 2000. The trading in index options commenced on

June 4, 2001 and trading in options on individual securities commenced on

July 2, 2001. Single stock futures were launched on November 9, 2001. The

index futures and options contract on NSE are based on S&P CNX Nifty

Index. Currently, the futures contracts have a maximum of 3-month expiration

cycles. Three contracts are available for trading, with 1 month, 2 months and

3 months expiry. A new contract is introduced on the next trading day

following the expiry of the near month contract.

Trading mechanism

The futures and options trading system of NSE, called NEAT-F&O trading

system, provides a fully automated screenbased trading for Nifty futures &

options and stock futures & options on a nationwide basis and an online

monitoring and surveillance mechanism. It supports an anonymous order

driven market which provides complete transparency of trading operations

and operates on strict pricetime priority. It is similar to that of trading of

equities in the Cash Market (CM) segment. The NEAT-F&O trading system is

accessed by two types of users. The Trading Members(TM) have access to

functions such as order entry, order matching, and order and trade

management. It provides tremendous flexibility to users in terms of kinds of

orders that can be placed on the system. Various conditions like Good-till-

Day, Good-till-Cancelled, Good till- Date, Immediate or Cancel, Limit/Marketprice, Stop loss, etc. can be built into an order. The Clearing Members (CM)

uses the trader workstation for the purpose of monitoring the trading

member(s) for whom they clear the trades. Additionally, they can enter and

set limits to positions, which a trading member can take.

Membership criteria


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NSE admits members on its derivatives segment in accordance with the rules

and regulations of the exchange and the norms specified by SEBI. NSE

follows 2tier membership structure stipulated by SEBI to enable wider

participation. Those interested in taking membership on F&O segment are

required to take membership of CM and F&O segment or CM, WDM and F&O

segment. Trading and clearing members are admitted separately. Essentially,

a clearing member (CM) does clearing for all his trading members (TMs),

undertakes risk management and performs actual settlement. There are three

types of CMs:

Self Clearing Member: A SCM clears and settles trades executed by

him only either on his own account or on account of his clients.

Trading Member Clearing Member: TMCM is a CM who is also a TM.

TMCM may clear and settle his own proprietary trades and clients

trades as well as clear and settle for other TMs.

Professional Clearing Member PCM is a CM who is not a TM.

Typically, banks or custodians could become a PCM and clear and

settle for TMs.

Clearing and settlement

National Securities Clearing Corporation Limited (NSCCL) undertakes

clearing and settlement of all deals executed on the NSEs F&O segment. It

acts as legal counterparty to all deals on the F&O segment and guarantees

settlement. We take a brief look at the clearing and settlement mechanism.

Clearing

The first step in clearing process is working out open positions or obligations

of members. A CMs open position is arrived at by aggregating the open

position of all the TMs and all custodial participants clearing through him, in

the contracts in which they have traded. A TMs open position is arrived at as

the summation of his proprietary open position and clients open positions, in


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the contracts in which they have traded. While entering into orders on the

trading system, TMs are required to identify the orders, whether proprietary (if

they are their own trades) or client (if entered on behalf of clients). Proprietary

positions are calculated on net basis (buy-sell) for each contract. Clients

positions are arrived at by summing together net (buy-sell) positions of each

individual client for each contract. A TMs open position is the sum of

proprietary open position, client open long position and client open short

position.

Settlement

All futures and options contracts are cash settled, i.e. through exchange of

cash. The underlying for index futures/options of the Nifty index cannot be

delivered. These contracts, therefore, have to be settled in cash. Futures and

options on individual securities can be delivered as in the spot market.

However, it has been currently mandated that stock options and futures would

also be cash settled. The settlement amount for a CM is netted across all their

TMs/clients in respect of MTM, premium and final exercise settlement. For the

purpose of settlement, all CMs are required to open a separate bank account

with NSCCL designated clearing banks for F&O segment.

Forward Market

Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified date

for a specified price. One of the parties to the contract assumes a long

position and agrees to buy the underlying asset on a certain specified future

date for a certain specified price. The other party assumes a short position

and agrees to sell the asset on the same date for the same price. Other

contract details like delivery date, price and quantity are negotiated bilaterally

by the parties to the contract. The forward contracts are normally traded

outside the exchanges.

No cash is exchanged when the contract is entered into.


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Illustration:

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it

outright. He can only buy it 3 months hence. He, however, fears that prices of

televisions will rise 3 months from now. So in order to protect himself from the

rise in prices Shyam enters into a contract with the TV dealer that 3 months

from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is

locking the current price of a TV for a forward contract. The forward contract is

settled at maturity. The dealer will deliver the asset to Shyam at the end of

three months and Shyam in turn will pay cash equivalent to the TV price on

delivery.

The salient features of forward contracts are:

They are bilateral contracts and hence exposed to counterparty risk.

Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to

the same counterparty, which often results in high prices being

charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market.

Forward contracts are very useful in hedging and speculation. The classic

hedging application would be that of an exporter who expects to receive

payment in dollars three months later. He is exposed to the risk of exchange

rate fluctuations. By using the currency forward market to sell.


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Limitations of forward markets

Forward markets world-wide are afflicted by several problems:

Lack of centralization of trading,

Illiquidity, and

Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and

generality. The forward market is like a real estate market in that any two

consenting adults can form contracts against each other. This often makesthem design terms of the deal which are very convenient in that specific

situation, but makes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the

transaction. When one of the two sides to the transaction declares

bankruptcy, the other suffers. Even when forward markets trade standardized

contracts, and hence avoid the problem of illiquidity, still the counterparty risk

remains a very serious issue.

Future Market

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. But unlike forward contracts,

the futures contracts are standardized and exchange traded. It is a

standardized contract with standard underlying instrument, a standard

quantity and quality of the underlying instrument that can be delivered, (or

which can be used for reference purposes in settlement) and a standard

timing of such settlement.

A futures contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of futures transactions are offset this

way. The standardized items in a futures contract are:

Quantity of the underlying


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Quality of the underlying


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Understanding index 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. Index futures are all futures

contract where the underlying is the stock index (Nifty or Sensex) and helps a

trader to take a view on the market as a whole.

In India we have index futures contracts based on S&P CNX Nifty and the

BSE Sensex and near 3 months duration contracts are available at all times.

Each contract expires on the last Thursday of the expiry month and

simultaneously a new contract is introduced for trading after expiry of acontract.

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy

one Nifty contract the total deal value will be 200*1100 (Nifty value) = Rs

2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex

futures the total value will be 50*4000 (Sensex value) = Rs 2, 00,000.

Option Market

Introduction to options

Index options: These options have the index as the underlying. Some

options are European while others are American. Like index futures contracts,

index options contracts are also cash settled.

In 1973, Black, Merton and Scholes invented the famed Black-Scholes

formula. In April 1973, CBOE was set up specifically for the purpose of trading

options. The market for options developed so rapidly that by early 80s, the

number of shares underlying the option contract sold each day exceeded the

daily volume of shares traded on the NYSE. Since then, there has been no

looking back. A contract gives the holder the right to buy or sell shares at the

specified price.

Buying put options is buying insurance


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To buy a put option on Nifty is to buy insurance, which reimburses the full

extent to which Nifty drops below the strike price of the put option. This is

attractive to many people, and to mutual funds creating guaranteed return

products.

OPTION

An option is a contract, which gives the buyer the right, but not the obligation

to buy or sell shares of the underlying security at a specific price on or before

a specific date.

Option, as the word suggests, is a choice given to the investor to either

honour the contract; or if he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a

certain date. In this way, Call options are like security deposits. If, for

example, you wanted to rent a certain property, and left a security deposit for

it, the money would be used to insure that you could, in fact, rent that property

at the price agreed upon when you returned. If you never returned, you would

give up your security deposit, but you would have no other liability.

When you buy a Call option, the price you pay for it, called the option

premium, secures your right to buy that certain stock at a specified price

called the strike price. If you decide not to use the option to buy the stock, and

you are not obligated to, your only cost is the option premium.

A Put Option is an option to sell a stock at a specific price on or before acertain date. In this way, Put options are like insurance policies, If you buy a

new car, and then buy auto insurance on the car, you pay a premium and are,

hence, protected if the asset is damaged in an accident. If this happens, you

can use your policy to regain the insured value of the car. In this way, the put

option gains in value as the value of the underlying instrument decreases. If


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all goes well and the insurance is not needed, the insurance company keeps

your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If

something happens which causes the stock price to fall, and thus, "damages"

your asset, you can exercise your option and sell it at its "insured" price level.

If the price of your stock goes up, and there is no "damage," then you do not

need to use the insurance, and, once again, your only cost is the premium.

This is the primary function of listed options, to allow investors ways to

manage risk.

Technically, an option is a contract between two parties. The buyer receives a

privilege for which he pays a premium. The seller accepts an obligation for

which he receives a fee.

Call options

Call options give the taker the right, but not the obligation, to buy the

underlying shares at a predetermined price, on or before a predetermined

date.

Illustration:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8.

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share

at any time between the current date and the end of next August. For this

privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).

The buyer of a call has purchased the right to buy and for that he pays apremium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That

is he has purchased the right to buy that share for Rs 40 in December. If the

stock rises above Rs 55 (40+15) he will break even and he will start making a

profit. Suppose the stock does not rise and instead falls he will choose not to


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exercise the option and forego the premium of Rs 15 and thus limiting his loss

to Rs 15.

Let us take another example of a call option on the Nifty to understand the

concept better.

A trader is of the view that the index will go up to 1400 in Jan 2002 but doesnot want to take the risk of prices going down. Therefore, he buys 10 options

of Jan contracts at 1345. He pays a premium for buying calls (the right to buy

the contract) for 500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises

the option and takes the difference in spot index price which is (1365-1345) *

200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

He had paid Rs 5,000/- premium for buying the call option. So he earns by

buying call option is Rs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to

forego his premium of Rs 5,000. So, in the event the index falls further his

loss is limited to the premium he paid upfront, but the profit potential is

unlimited.

Call Options-Long & Short Positions


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When you expect prices to rise, then you take a long position by buying calls.

You are bullish.

When you expect prices to fall, then you take a short position by selling calls.

You are bearish.

Put Options

A Put Option gives the holder of the right to sell a specific number of shares of

an agreed security at a fixed price for a period of time.

Illustration: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put

--Premium 200.

This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at

any time between the current date and the end of August. To have this

privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell.

Illustration : Raj is of the view that the a stock is overpriced and will fall in

future, but he does not want to take the risk in the event of price rising so

purchases a put option at Rs 70 on X. By purchasing the put option Raj has

the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will

start making profit if the stock falls below Rs 55.


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Illustration:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in

future but does not want to take the risk in the event the prices rise. So he

purchases a Put option on Wipro.

Quotes are as under:

Spot Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He

pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

Jan Spot price of Wipro = 1020

Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares

at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he

earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net

income is Rs (50000-30000) = Rs 20,000.


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In the second price situation, the price is more in the spot market, so the

investor will not sell at a lower price by exercising the Put. He will have to

allow the Put option to expire unexercised. He looses the premium paid Rs

30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts.

You are bearish.

When you expect prices to rise, then you take a short position by selling Puts.

You are bullish.

CALL

OPTIONSPUT OPTIONS

If you expect a fall in price(Bearish) Short Long

If you expect a rise in price (Bullish) Long Short


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USES OF DERIVATIVES

Hedging

We have seen how one can take a view on the market with the help of index

futures. The other benefit of trading in index futures is to hedge your portfolio

against the risk of trading. In order to understand how one can protect his

portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to

Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs

1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs) Selling

price

Profit

1000 4000 3000

However, Ram fears that Shyam may not honour his contract six months from

now. So he inserts a new clause in the contract that if Shyam fails to honour

the contract he will have to pay a penalty of Rs 1000. And if Shyam honour

the contract Ram will offer a discount of Rs 1000 as incentive.

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he

will recover his initial investment. If Shyam honour the contract, Ram will still

make a profit of Rs 2000. Thus, Ram has hedged his risk against default and

protected his initial investment.


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The above example explains the concept of hedging. Let us try understanding

how one can use hedging in a real life scenario.

Stocks carry two types of risk company specific and market risk. While

company risk can be minimized by diversifying your portfolio market risk

cannot be diversified but has to be hedged. So how does one measure the

market risk? Market risk can be known from Beta.

Beta measures the relationship between movements of the index to the

movement of the stock. The beta measures the percentage impact on the

stock prices for 1% change in the index. Therefore, for a portfolio whose valuegoes down by 11% when the index goes down by 10%, the beta would be 1.1.

When the index increases by 10%, the value of the portfolio increases 11%.

The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse

price movements. In order to hedge a position, a market player needs to take

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

cash market. Every portfolio has a hidden exposure to the index, which isdenoted by the beta. Assuming you have a portfolio of Rs 1 million, which has

a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P

CNX Nifty futures.

Speculation

Speculators are those who do not have any position on which they enter in

futures and options market. They only have a particular view on the market,

stock, commodity etc. In short, speculators put their money at risk in the hope

of profiting from an anticipated price change. They consider various factors

such as demand, supply, market positions, open interests, economic

fundamentals and other data to take their positions.

Illustration:


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Ram is a trader but has no time to track and analyze stocks. However, he

fancies his chances in predicting the market trend. So instead of buying

different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that

the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at

that time he sells an equal number of contracts to close out his position.

Selling Price: 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the

Sensex. However, if the Sensex had fallen he would have made a loss.

Similarly, if would have been bearish he could have sold Sensex futures and

made a profit from a falling profit. In index futures players can have a long-

term view of the market up to at least 3 months.

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he

can earn risk less profits. When markets are imperfect, buying in one market

and simultaneously selling in other market gives risk less profit. Arbitrageurs

are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by

buying from lower priced market and selling at the higher priced market. In

index futures arbitrage is possible between the spot market and the futures

market (NSE has provided special software for buying all 50 Nifty stocks in

the spot market).

Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300.


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The futures price of Nifty futures can be worked out by taking the interest cost

of 3 months into account.

If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If

Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs

1070 then one can purchase ITC at Rs 1000 in spot by borrowing @ 12%

annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40

These kinds of imperfections continue to exist in the markets but one has to

be alert to the opportunities as they tend to get exhausted very fast.


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TRADING STRATEGIES WITH DERIVATIVES

Bull Market Strategies

Calls in bullish strategies

Puts in bullish strategies

Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect

the market price of the underlying asset to rise, then you would rather have

the right to purchase at a specified price and sell later at a higher price than

have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's

profit is the market price less the exercise price less the premium. The greater


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the increase in price of the underlying asset, the greater will be the investor's

profit.

The investor's potential loss is limited. Even if the market takes a drastic

decline in price levels, the holder of a call is under no obligation to exercise

the option. He may let the option expire worthless.

The investor breaks even when the market price equals the exercise price

plus the premium.

An increase in volatility will increase the value of your call and increase your

return. Because of the increased likelihood that the option will become in- the-

money, an increase in the underlying volatility (before expiration), will increase

the value of a long options position. As an option holder, your return will also

increase.

A simple example will illustrate the above:

Suppose there is a call option with a strike price of Rs 2000 and the option

premium is Rs 100. The option will be exercised only if the value of the

underlying is greater than Rs 2000 (the strike price). If the buyer exercises the

call at Rs 2200 then his gain will be Rs 200. However, this would not be his

actual gain for that he will have to deduct the Rs 100 (premium) he has paid.

The profit can be derived as follows:

Profit = Market price - Exercise price Premiumor

Profit = Market price Strike price Premium.

2200 2000 100 = Rs 100


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Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option.

Basically, an investor anticipating a bull market could write Put options. If the

market price increases and puts become out-of-the-money, investors with

long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of

the underlying asset increases and the option expires worthless. The

maximum profit is limited to the premium received.

However, the potential loss is unlimited. Because a short put position holder

has an obligation to purchase if exercised. He will be exposed to potentially

large losses if the market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price:

minus the premium. At any price less than the exercise price minus the

premium, the investor loses money on the transaction. At higher prices, his

option is profitable.

An increase in volatility will increase the value of your put and decrease your

return. As an option writer, the higher price you will be forced to pay in order

to buy back the option at a later date, lower is the return.

Bear Market Strategies

Puts in bearish strategies

Calls in bearish strategies

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put

option is a bearish position. It will increase in value if the market falls. An

investor with a bearish market outlook shall buy put options. By purchasing

put options, the trader has the right to choose whether to sell the underlying


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asset at the exercise price. In a falling market, this choice is preferable to

being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price

of the underlying asset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises

instead of falling as the investor has anticipated, he may let the option expire

worthless. At the most, he may lose the premium for the option.

The trader's breakeven point is the exercise price minus the premium. To

profit, the market price must be below the exercise price. Since the trader has

paid a premium he must recover the premium he paid for the option.


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An increase in volatility will increase the value of your put and increase your

return. An increase in volatility will make it more likely that the price of the

underlying instrument will move. This increases the value of the option.

Calls in a Bearish Strategy

Another option for a bearish investor is to go short on a call with the intent to

purchase it back in the future. By selling a call, you have a net short position

and needs to be bought back before expiration and cancel out your position.

For this an investor needs to write a call option. If the market price falls, long

call holders will let their out-of-the-money options expire worthless, because

they could purchase the underlying asset at the lower market price.


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The investor's profit potential is limited because the trader's maximum profit is

limited to the premium received for writing the option.

Here the loss potential is unlimited because a short call position holder has an

obligation to sell if exercised; he will be exposed to potentially large losses if

the market rises against his position.

The investor breaks even when the market price equals the exercise price:

plus the premium. At any price greater than the exercise price plus the

premium, the trader is losing money. When the market price equals the

exercise price plus the premium, the trader breaks even.

An increase in volatility will increase the value of your call and decrease your

return.

When the option writer has to buy back the option in order to cancel out his

position, he will be forced to pay a higher price due to the increased value of

the calls.


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The investor's profit potential is limited. If the market remains stable, traders

long out-of-the-money calls or puts will let their options expire worthless.

Writers of these options will not have be called to deliver and will profit from

the sum of the premiums received.

The investor's potential loss is unlimited. Should the price of the underlying

rise or fall, the writer of a call or put would have to deliver, exposing himself to

unlimited loss if he has to deliver on the call and practically unlimited loss if on

the put.

The breakeven points occur when the market price at expiration equals the

exercise price plus the premium and minus the premium. The trader is short

two positions and thus, two breakeven points; One for the call (common

exercise price plus the premiums paid), and one for the put (common exercise

price minus the premiums paid).

Strangles in a Stable Market Outlook

A strangle is similar to a straddle, except that the call and the put have

different exercise prices. Usually, both the call and the put are out-of-the-

money.

To "buy a strangle" is to purchase a call and a put with the same expiration

date, but different exercise prices. Usually the call strike price is higher than

the put strike price.


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To "sell a strangle" is to write a call and a put with the same expiration date,

but different exercise prices.

A trader, viewing a market as stable, should: write strangles.

A "strangle sale" allows the trader to profit from a stable market.

The investor's profit potential is: unlimited.

If the market remains stable, investors having out-of-the-money long put or

long call positions will let their options expire worthless.

The investor's potential loss is: unlimited.

If the price of the underlying interest rises or falls instead of remaining stable

as the trader anticipated, he will have to deliver on the call or the put.

The breakeven points occur when market price at expiration equals...the high

exercise price plus the premium and the low exercise price minus the

premium.

The trader is short two positions and thus, two breakeven points. One for the

call (high exercise price plus the premiums paid), and one for the put (low

exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle?


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The risk is lower with a strangle. Although the seller gives up a substantial

amount of potential profit by selling a strangle rather than a straddle, he also

holds less risk. Notice that the strangle requires more of a price move in both

directions before it begins to lose money.

Long Butterfly Call Spread Strategy

The long butterfly call spread is a combination of a bull spread and a bear

spread, utilizing calls and three different exercise prices.

A long butterfly call spread involves:

Buying a call with a low exercise price,

Writing two calls with a mid-range exercise price,

Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50

strike and sell two 45 strikes.

This spread is put on by purchasing one each of the outside strikes and

selling two of the inside strike. To put on a short butterfly, you do just the

opposite.

The investor's profit potential is limited.

Maximum profit is attained when the market price of the underlying interest

equals the mid-range exercise price (if the exercise prices are symmetrical).


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The investor's potential loss is limited.

The maximum loss is limited to the net premium paid and is realized when the

market price of the underlying asset is higher than the high exercise price or

lower than the low exercise price.

The breakeven points occur when the market price at expiration equals ... the

high exercise price minus the premium and the low exercise price plus the

premium. The strategy is profitable when the market price is between the low

exercise price plus the net premium and the high exercise price minus the net

premium.

PRICING OF OPTIONS

Options are used as risk management tools and the valuation or pricing of the

instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

Price of Underlying

Time to Expiry

Exercise Price Time to Maturity

Volatility of the Underlying


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And two less important factors:

Short-Term Interest Rates

Dividends

The Intrinsic Value of an Option

The intrinsic value of an option is defined as the amount by which an option is

in-the-money or the immediate exercise value of the option when the

underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative.

For a call option, the strike price must be less than the price of the underlying

asset for the call to have an intrinsic value greater than 0. For a put option, the

strike price must be greater than the underlying asset price for it to have

intrinsic value.

Price of underlying

The premium is affected by the price movements in the underlying instrument.

For Call options the right to buy the underlying at a fixed strike price as

the underlying price rises so does its premium. As the underlying assets price

falls so does the cost of the option premium.

For Put options the right to sell the underlying at a fixed strike price as

the underlying price rises, the premium falls; as the underlying price falls the

premium cost rises.

The Time Value of an Option

Generally, the longer the time remaining until an options expiration, the

higher its premium will be. This is because the longer an options lifetime,

greater is the possibility that the underlying share price might move so as to

make the option in-the-money. All other factors affecting an options price


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remaining the same, the time value portion of an options premium will

decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an

options life. When an option expires in-the-money, it is generally worth only

its intrinsic value.

Volatility

Volatility is the tendency of the underlying securitys market price to fluctuate

either up or down. It reflects a price changes magnitude; it does not imply a

bias toward price movement in one direction or the other. Thus, it is a major

factor in determining an options premium. The higher the volatility of the

underlying stock, the higher the premium because there is a greater possibility

that the option will move in-the-money. Generally, as the volatility of an under-

lying stock increases, the premiums of both calls and puts overlying that stock

increase, and vice versa.

Higher volatility=Higher premium

Lower volatility = Lower premium

Interest rates

In general interest rates have the least influence on options and equate

approximately to the cost of carry of a futures contract. If the size of the

options contract is very large, then this factor may take on some importance.

All other factors being equal as interest rates rise, premium costs fall and vice

versa. The relationship can be thought of as an opportunity cost. In order tobuy an option, the buyer must either borrow funds or use funds on deposit.

Either way the buyer incurs an interest rate cost. If interest rates are rising,

then the opportunity cost of buying options increases and to compensate the

buyer premium costs fall. Why should the buyer be compensated? Because

the option writer receiving the premium can place the funds on deposit and

receive more interest than was previously anticipated. The situation is


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reversed when interest rates fall premiums rise. This time it is the writer who

needs to be compensated.

The Black & Scholes Model

The Black & Scholes model was published in 1973 by Fisher Black and Myron

Scholes. It is one of the most popular options pricing models. It is noted for its

relative simplicity and its fast mode of calculation: unlike the binomial model, it

does not rely on calculation by iteration.

The Black-Scholes model is used to calculate a theoretical call price (ignoring

dividends paid during the life of the option) using the five key determinants of

an option's price: stock price, strike price, volatility, time to expiration, and

short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as

follows:

Where:

The variables are:

S = stock price

X = strike price

t = time remaining until expiration, expressed as a percent of a year

r = current continuously compounded risk-free interest rate

v = annual volatility of stock price (the standard deviation of the short-term

returns over one year).

ln = natural logarithm

N(x) = standard normal cumulative distribution function

e = the exponential function


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Lognormal distribution: The model is based on a lognormal distribution of

stock prices, as opposed to a normal, or bell-shaped, distribution. The

lognormal distribution allows for a stock price distribution of between zero and

infinity (ie no negative prices) and has an upward bias (representing the fact

that a stock price can only drop 100 per cent but can rise by more than 100

per cent).

Risk-neutral valuation: The expected rate of return of the stock (i.e. the

expected rate of growth of the underlying asset which equals the risk free rate

plus a risk premium) is not one of the variables in the Black-Scholes model (or

any other model for option valuation). The important implication is that the

price of an option is completely independent of the expected growth of the

underlying asset. Thus, while any two investors may strongly disagree on the

rate of return they expect on a stock they will, given agreement to the

assumptions of volatility and the risk free rate, always agree on the fair price

of the option on that underlying asset.

The key concept underlying the valuation of all derivatives -- the fact that price

of an option is independent of the risk preferences of investors -- is called risk-

neutral valuation. It means that all derivatives can be valued by assuming that

the return from their underlying assets is the risk free rate.

Limitation: Dividends are ignored in the basic Black-Scholes formula, but

there are a number of widely used adaptations to the original formula, which I

use in my models, which enable it to handle both discrete and continuous

dividends accurately.

However, despite these adaptations the Black-Scholes model has one major

limitation: it cannot be used to accurately price options with an American-style

exercise as it only calculates the option price at one point in time -- at

expiration. It does not consider the steps along the way where there could be

the possibility of early exercise of an American option.


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As all exchange traded equity options have American-style exercise (ie they

can be exercised at any time as opposed to European options which can only

be exercised at expiration) this is a significant limitation.

The exception to this is an American call on a non-dividend paying asset. In

this case the call is always worth the same as its European equivalent as

there is never any advantage in exercising early.

Advantage: The main advantage of the Black-Scholes model is speed -- it

lets you calculate a very large number of option prices in a very short time.

Since, high accuracy is not critical for American option pricing (eg whenanimating a chart to show the effects of time decay) using Black-Scholes is a

good option. But, the option of using the binomial model is also advisable for

the relatively few pricing and profitability numbers where accuracy may be

important and speed is irrelevant. You can experiment with the Black-Scholes

model using on-line options pricing calculator.

The Binomial Model

The binomial model is an options pricing model which was developed by

William Sharpe in 1978. Today, one finds a large variety of pricing models

which differ according to their hypotheses or the underlying instruments upon

which they are based (stock options, currency options, options on interest

rates).

The binomial model breaks down the time to expiration into potentially a very

large number of time intervals, or steps. A tree of stock prices is initially

produced working forward from the present to expiration. At each step it is

assumed that the stock price will move up or down by an amount calculated

using volatility and time to expiration. This produces a binomial distribution, or

recombining tree, of underlying stock prices. The tree represents all the

possible paths that the stock price could take during the life of the option.


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At the end of the tree -- i.e. at expiration of the option -- all the terminal option

prices for each of the final possible stock prices are known as they simply

equal their intrinsic values.

Next the option prices at each step of the tree are calculated working back

from expiration to the present. The option prices at each step are used to

derive the option prices at the next step of the tree using risk neutral valuation

based on the probabilities of the stock prices moving up or down, the risk free

rate and the time interval of each step. Any adjustments to stock prices (at an

ex-dividend date) or option prices (as a result of early exercise of American

options) are worked into the calculations at the required point in time. At the

top of the tree you are left with one option price.

Advantage:

The big advantage the binomial model has over the Black-Scholes model is

that it can be used to accurately price American options. This is because, with

the binomial model it's possible to check at every point in an option's life (ie at

every step of the binomial tree) for the possibility of early exercise (eg where,due to eg a dividend, or a put being deeply in the money the option price at

that point is less than the its intrinsic value).

Where an early exercise point is found it is assumed that the option holder

would elect to exercise and the option price can be adjusted to equal the

intrinsic value at that point. This then flows into the calculations higher up the

tree and so on.

Limitation:

As mentioned before the main disadvantage of the binomial model is its

relatively slow speed. It's great for half a dozen calculations at a time but even

with today's fastest PCs it's not a practical solution for the calculation of

thousands of prices in a few seconds which is what's required for the

production of the animated charts in my strategy evaluation model.


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REGULATORY FRAMEWORK FOR DERIVATIVESMARKET IN INDIA

The trading of derivatives is governed by the provisions contained in the

SC(R)A, the SEBI Act, the rules and regulations framed there under and the

rules and byelaws of stock exchanges.

Securities Contracts(Regulation) Act, 1956 SC(R)A aims at preventing

undesirable transactions in securities by regulating the business of dealing

therein and by providing for certain other matters connected therewith. This is

the principal Act, which governs the trading of securities in India. The term

securities has been defined in the SC(R)A. As per Section 2(h), the

Securities include:

1. Shares, scrip, stocks, bonds, debentures, debenture stock or other

marketable securities of a like nature in or of any incorporated company or

other body corporate

2. Derivative

3. Units or any other instrument issued by any collective investment scheme

to the investors in such schemes

4. Government securities

5. Such other instruments as may be declared by the Central Government to

be securities

6. Rights or interests in securities.

Regulation for Derivatives Trading

SEBI set up a 24-member committee under the Chairmanship of

Dr.L.C.Gupta to develop the appropriate regulatory framework for derivatives

trading in India. The committee submitted its report in March 1998. On May

11, 1998 SEBI accepted the recommendations of the committee and

approved the phased introduction of derivatives trading in India beginning with


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stock index futures. SEBI also approved the suggestive bye -laws

recommended by the committee for regulation and control of trading and

settlement of derivatives contracts. The provisions in the SC(R)A and the

regulatory framework developed there under govern trading in securities. The

amendment of the SC(R)A to include derivatives within the ambit of

securities in the SC(R)A made trading in derivatives possible within the

framework of that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta

committee report may apply to SEBI for grant of recognition under Section 4

of the SC(R)A, 1956 to start trading derivatives. The derivatives

exchange/segment should have a separate governing council and

representation of trading/clearing members shall be limited to maximum of

40% of the total members of the governing council. The exchange shall

regulate the sales practices of its members and will obtain prior approval of

SEBI before start of trading in any derivative contract.

2. The Exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically

become the members of derivative segment. The members of the derivative

segment need to fulfill the eligibility conditions as laid down by the LC Gupta

committee.

4. The clearing and settlement of derivatives trades shall be through a SEBI

approved clearing corporation/house. Clearing corporations/houses complying

with the eligibility conditions as laid down by the committee have to apply to

SEBI for grant of approval.

5. Derivative brokers/dealers and clearing members are required to seek

registration from SEBI. This is in addition to their registration as brokers of

existing stock exchanges. The minimum networth for clearing members of the

derivatives clearing corporation/house shall be Rs.300 Lakh. The networth of

the member shall be computed as follows:


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Capital + Free reserves

Less non-allowable assets viz.

(a) Fixed assets

(b) Pledged securities

(c) Members card

(d) Non-allowable securities (unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges

should also submit details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy

and margin demands related to the risk of loss on the position shall be

prescribed by SEBI/Exchange from time to time.

8. The L.C.Gupta committee report requires strict enforcement of Know your

customer rule and requires that every client shall be registered with the

derivatives broker. The members of the derivatives segment are also required

to make their clients aware of the risks involved in derivatives trading byissuing to the client the Risk Disclosure Document and obtain a copy of the

same duly signed by the client.

9. The trading members are required to have qualified approved user and

sales person who have passed a certification programme approved by SEBI.

NSEs Certification in Financial Markets


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A critical element of financial sector reforms is the development of a pool of

human resources having right skills and expertise to provide quality

intermediation services in each segment of the market. In order to dispense

quality intermediation, personnel providing services need to possess requisite

skills and knowledge. This is generally achieved through a system of testing

and certification. Such testing and certification has assumed added

significance in India as there is no formal education/training on financial

markets, especially in the area of operations. Taking into account international

experience and needs of the Indian financial market, NSE offers NCFM

(NSEs Certification in Financial Markets) to test practical knowledge and

skills that are required to operate in financial markets in a very secure and

unbiased manner and to certify personnel with a view to improve quality of

intermediation. NCFM offers a comprehensive range of modules covering

many different areas in finance including a module on derivatives. The module

on derivatives has been recognized by SEBI. SEBI requires that derivative

brokers/dealers and sales persons must mandatory pass this module of the

NCFM.

Regulation for Clearing and Settlement

1. The LC Gupta committee has recommended that the clearing corporation

must interpose itself between both legs of every trade, becoming the legal

counterparty to both or alternatively should provide an unconditional

guarantee for settlement of all trades.

2. The clearing corporation should ensure that none of the Board membershas trading interests.

3. The definition of net-worth as prescribed by SEBI needs to be incorporated

in the application/regulations of the clearing corporation.

4. The regulations relating to arbitration need to be incorporated in the

clearing corporations regulations.


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5. Specific provision/chapter relating to declaration of default must be

incorporated by the clearing corporation in its regulations.

6. The regulations relating to investor protection fund for the derivatives

market must be included in the clearing corporation application/regulations.

7. The clearing corporation should have the capabilities to segregate

upfront/initial margins deposited by clearing members for trades on their own

account and on account of his clients. The clearing corporation shall hold the

clients margin money in trust for the clients purposes only and should not

allow its diversion for any other purpose. This condition must be incorporatedin the clearing corporation regulations.

8. The clearing member shall collect margins from his constituents

(clients/trading members). He shall clear and settle deals in derivative

contracts on behalf of the constituents only on the receipt of such minimum

margin.

9. Exposure limits based on the value at risk concept will be used and the

exposure limits will be continuously monitored. These shall be within the limits

prescribed by SEBI from time to time.

10. The clearing corporation must lay down a procedure for periodic review of

the net worth of its members.

11. The clearing corporation must inform SEBI how it proposes to monitor the

exposure of its members in the underlying market.

12. Any changes in the bye-laws, rules or regulations which are coveredunder the Suggestive byelaws for regu lations and control of trading and

settlement of derivatives contracts would require prior approval of SEBI.

Position limits

Position limits have been specified by SEBI at trading member, client, market

and FII levels respectively.


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Trading member position limits

There is a position limit in derivative contracts on an index of 15% of the open

interest or Rs.100 Crore, whichever is higher. The position limit in derivative

contracts on an individual stock is 7.5% of the open interest in that underlying

on the exchange or Rs.50 Crore, whichever is higher.

Once a member, in a particular underlying reaches the position limit then he is

permitted to take only offsetting positions (which result in lowering the open

position of the member) in derivative contracts on such underlying.

Client level position limits

On index based derivative contracts, at the client level there is a self

disclosure requirement as follows: Any person or persons acting in concert

who together own 15% or more of the open interest in all futures and option

contracts on the same index are required to report this fact to the clearing

corporation and failure

project report - derivatives

Documents