A Project Report On:

Hedging Using Options Strategies

(With special reference to KARVY)

SUMMER REPORT SUBMITTED BY:

RUSHAB MEHTA

Roll no. - 8167

INTERNATIONAL SCHOOL OF BUSINESS MEDIA,INTERNATIONAL SCHOOL OF BUSINESS MEDIA,

PUNEPUNE

CONTENTS:

serial no Topic Page no.

1 Certificate by organization 4

2 Acknowledgement 5

3 Executive summary 6

4 Company overview 7-18

5 Introduction 19

6 Research Methodology 20-22

7 Derivatives 23-26

8 Derivative – Forward 27

9 Derivative – Futures 28-30

10 Derivative – Options 31-33

11 Option Strategies 34-35

12 Hedging 36-38

13 Analysis & Interpretation 39-54

14 Findings on Cases 55-57

15 Suggestions 58-60

16 Conclusion 61

17 Bibliography 62

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DECLARATION

I, Mr Rushab Mehta do hereby declare that the project report titled “Hedging Using Options Strategies” is a genuine research work undertaken by me and it has not been published anywhere earlier.

Date:

Place:

Rushab Mehta

ISB&M, Pune

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Mr. Ravi Gaekwade

Head ,

Pune Region, KARVY

Certificate by the organization:

This is to certify that Mr Rushab Mehta, pursuing PGDBM at

International School of Business Media, Pune has worked under my

supervision and guidance on his Summer Project entitled “Hedging

Using Options Strategies” at Karvy Stock Broking Limited, Pune

from April 14th 2008 to June 14th 2008. ” To the best of my

knowledge this is an original piece of work.

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Acknowledgement

Sometimes words fall short to show gratitude, the same happened with me during this project. The immense help and support received from Karvy stock broking limited overwhelmed me during the project.

My sincere gratitude to Mr.Ravi Gaekwade (Head, Pune region, Karvy) for providing me

with an opportunity to work with Karvy stock broking limited.

I am highly indebted to Mr. Makrand., product head, Karvy Wanowarie Branch, and

company project guide, who has provided me with the necessary information and his

valuable suggestion and comments on bringing out this report in the best possible way.

I am grateful to all of the members of Wanowarie branch, who have helped me in the

successful completion of this project.

Last but not the least, my heartfelt love for my parents, whose constant support and blessings

helped me throughout this project.

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Executive summary:

This project has been a great learning experience for me; at the same time it gave me enough

scope to implement my analytical ability. This project as a whole can be divided into two

parts:

The first part gives an insight about Derivatives and its various aspects. It is purely

based on whatever I learned at Karvy. One can have a brief knowledge about

derivatives and all its basics through the project. Other than that the real servings

come when one moves ahead. Some of the most interesting questions regarding

derivatives have been covered.

All the topics have been covered in a very systematic way. The language has been

kept simple so that even a layman could understand. All the data have been well

analyzed with the help of charts and graphs.

The second part consists of data and their analysis, collected through a survey done

on people. The data collected has been well organized and presented. Hope the

research findings and conclusions will be of use.

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Organization overview

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Introduction:

“Success is a journey, not a destination.” If we look for examples to prove this quote

then we can find many but there is none like that of Karvy. Back in the year 1981, five people created

history by establishing Karvy and company which is today known as Karvy, the largest financial

service provider of India.

Success sutras of Karvy:

The success story of Karvy is driven by 8 success sutras adopted by it namely trust, integrity,

dedication, commitment, enterprise, hard work and team play, learning

and innovation, empathy and humility. These are the values that bind success with

Karvy.

Vision of Karvy:

To achieve & sustain market leadership, Karvy shall aim for complete customer satisfaction, by

combining its human and technological resources, to provide world class quality services. In the

process Karvy shall strive to meet and exceed customer's satisfaction and set industry standards.

Mission statement:

“Our mission is to be a leading and preferred service provider to our

customers, and we aim to achieve this leadership position by building an

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innovative, enterprising , and technology driven organization which will

set the highest standards of service and business ethics.”

The success ladder:

Company overview:

Karvy was established as Karvy and company by five chartered accountants during the year

1979-80, and then its work was confined to audit and taxation only. Later on it diversified

into financial and accounting services during the year 1981-82 with a capital of rs.150000. it

achieved its first milestone after its first investment in technology. Karvy became a known

name during the year 1985-86 when it forayed into capital market as registrar.

Evolution of KARVY:

It is well said that success is a journey not a destination and we can see it being proved by

Karvy. Under this section we will see that how this “Karvy and company” of 1980 became

“Karvy” of 2008. Karvy blossomed with the setting up of its first branch at Mumbai during

the year 1987-88. The turning point came in the year 1989 when it decided to enter into one

of the not only emerging rather potential field too i.e; stock broking. It added the feather of

stock broking into its cap. At the same time it became the member of Hyderabad Stock

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Exchange through associate firm Karvy securities ltd and then Karvy never looked

back……..it went on adding services one after another, it entered into retail stock broking in

the year 1990. Karvy investor service centers were set up in the year 1992. Karvy which

already enjoyed a wide network through its investor service centers, entered into financial

product distribution services in the year 1993. One year more and Karvy was now dealing

into mutual fund services too in the year 1994 but it didn’t stopped there, it stepped into

corporate finance and investment banking in the year 1995.

Karvy’s strategy has always been being the first entrant in the market. Karvy again hit the

limelight by becoming the first registrar in the country to be awarded ISO 9002 in the year

1997. Then it stepped into the other most happening sector i.e; IT enabled services by

establishing its own BPO units and at a gap of just 1 year it took the path of e-Business

through its website www.Karvy.com . Then it entered into insurance services in the year

2001 with the launch of its retail arm “Karvy- the finapolis: your personal finance advisor”.

Then in the year 2002 it launched its PCG(Private Client Group) which looks after its High

Net worth Individuals .and maintain their portfolio and provides them with other financial

services. In the year 2003, it commenced secondary debt and WDM trading.

It was a decade which saw many Indian companies going global…..so why the largest

financial service provider of India should lag behind? Hence, Karvy launched “Karvy global

services limited” after entering into a joint venture with Computershare, Australia in the year

2004.the year 2004 also saw Karvy entering into commodities marketing through Karvy

comtrade.

Year 2005 saw Karvy establishing a separate branch for its insurance services under the head

“ Karvy insurance broking ltd” and in the same year, after being impressed with the rapid

growth of Karvy stock broking limited, PCG group of Hong Kong acquired 25% stake at

KSBL. In the year 2006, Karvy entered into one of the hottest sector of present time i.e real

estate through Karvy realty & services (India) ltd. Hence, we can see now Karvy being

established as the largest financial service provider of the country.

Now Karvy group consists of 8 highly renowned entities which are as follow:

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1. : The first securities registry to receive ISO 9002 certification in India.

Registered with SEBI as Category I Registrar, is Number 1 Registrar in the Country. The

award of being ‘Most Admired’ Registrar is one among many of the acknowledgements we

received for our customer friendly and competent services.

2. : Karvy stock broking ltd. Consists of five units namely stock broking

servics, depository participant, advisory services, distribution of financial products, advisory

services and private client goups.

3. : it is registered with SEBI as a category 1 merchant banker. Its clientele

includesinclude leading corporates, State Governments, foreign institutional investors, public

and private sector companies and banks, in Indian and global markets.

4. : Karvy insurance broking ltd is also a part of Karvy stock broking ltd.

At Karvy Insurance Broking Limited both life and non-life insurance products are provided

to retail individuals, high net-worth clients and corporates.

5. : The company provides investment, advisory and brokerage services in

Indian Commodities Markets. And most importantly, it offer a wide reach through our

branch network of over 225 branches located across 180 cities.

6. : Karvy Global is a leading business and knowledge process

outsourcing Services Company offering creative business solutions to clients globally. It

operates in banking and financial services, inurance, healthcare and pharmaceuticals,

media , telecom and technology. It has its sales and business development office in New

York, USA and the offshore global delivery center in Hyderabad, India

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7. : Karvy Realty (India) Limited is engaged in the business of real estate and property services offering:

Buying/ selling/ renting of properties

Identifying valuable investments opportunities in the real estate sector

Facilitating financial support for real estate and investments in properties

Real estate portfolio advisory services

8. : it is a joint venture between Computershare, Australia and Karvy

Consultants Limited, India in the registry management services industry.

Organization structure of Karvy:

talking about the organization structure of Karvy, we have the board of directors as the supreme

governing body , the chairman being Mr. C Parthasarthy, Mr. M Yugandhar as the managing director,

Mr. M S Ramakrishna and Mr. Prasad V. Potluri as directors.

The board of diretors head the Karvy group, Karvy computershares limited, Karvy investors

services ltd., Karvy comtrade, Karvy stock broking ltd., and Karvy global services ltd.

Karvy group being the flagship company looks after the functional departments such as corporate

affairs, group human resources, finance & accounting, training & development, technology services

and corporate quality.

Karvy computershare private limited facilitates mutual fund services, share registry and issue

registry whereas merchant banking is looked after by Karvy investor services ltd. Karvy stock

broking ltd heads its another branch too ie. Karvy insurance broking ltd. The services offered by

KSBL are: stock broking, depository, research, distribution, personal client group and institutional

desk. And finally the BPO services are managed by Karvy global services ltd. Summarizing it in a

diagram, it can be presented as:

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Spectrum of services offered by Karvy:

Karvy being the top registrar and transfer agent, functions as registrar in most of the issues in the

country. Talking about the mutual fund services offered by Karvy, we can get the products of 33

AMCs over here. it deals in both closed ended funds as well as open ended too. Now one must be

thinking why to get the mutual funds from Karvy instead of getting it directly from AMCs???we have

great reasons for it: the first one being ; if we avail the services of Karvy then we can get the

information about all the AMCs and their products at a single place along with expert

recommendations whereas at an AMC we can get information about the products of that specific

AMC only. And the second being wide network of Karvy….nowadays we can find Karvy offices at

remote areas too.

Along with these, Karvy is very well handling the role of depository participant. Being registered

with both the depositories i.e.; NSDL (national securities depository ltd) and CDSL (central

depository services ltd), Karvy can have access to both. Its wide network also facilitates it in

distribution of retail financial products.

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Karvy believes in being updated always. So it is always ready to use latest technologies so that its

clients always be in touch with the latest happenings along with Karvy. It offers e-business through

internet through its website: www.Karvy.com . Other than it, it also provides its various services

through SMSes.

Karvy’s services are not limited to its investors only rather its offerings are for its corporate clients

and distributors too. it is very well aware of the fact that in this era of neck to neck competition, we

cant ignore any of the aspects of our business….so there’s a offering for everybody…everyone’s

welcome at Karvy.

Why should investors choose for Karvy?

Excellence is next to nothing….and here at Karvy everybody tries their best to offer excellent

services to its clientele through its offerings maintaining the Karvy culture which includes:

1. Controlled and low cost service culture: Karvy is there to serve its client at the minimum possible

cost. it controls cost by its various cost- cutting techniques and minimization of avoidable costs.

2. Large volume processing capability: being the largest financial service provider in the country, it

has the unique distinction of operating its activities on a large scale which benefits all the parties

cordially.

3. Adherence to strict time schedule: Karvy knows that time is money and tries it best to finish the task within the stipulated time schedule.

4. Expertise in coordinating multi-location responses: Karvy has got a wide network and hence one

can find its branches at most of the places in India. Thus it enjoys its presence everywhere and

coordinates among itself in solving the queries and in responding to any situation.

5.Expertise in managing independent entities such as banks, post-office etc.: the work culture of

Karvy and the ethics followed inside Karvy makes its workforce compatible with everybody, so the

Karvy people establishes good coordination with independent entities too.

6. Pooling of group resources: Karvy group consists of eight subsidiaries, so it can easily pool up its

resources for accomplishment of its goals, whenever needed. The groups can help each other

whenever there are peaks and lows, and even in the case when they have huge targets just as we saw

few years back, Tata group pooling its resources to acquire Corus.

How Karvy achieved it?

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The core competency of Karvy lies in the following points due to which it enjoys a competitive edge

over its competitors. The following culture adopted by Karvy makes it all time favorite among its

clientele:

1. Professionally managed by qualified and trained manpower.

2. Uniquely structured in-house software and hardware department

3. Query handling within 48 hrs.

4. Strong secretarial, accounting and audit systems.

5. Unique work culture of working 7 days a week in 3 shifts.

6. Unmatched network spreading all over India.

How Achievements sounds synonymous to Karvy:

The landmarks achieved by Karvy very well define its success story. In the previous pages,

we learnt how a company started by five chartered accountants, named as Karvy and

company turned into today’s Karvy group, the largest financial intermediary of India. But

success didn’t came to Karvy at a flow, the hard work and dedication of its workforce made

it what it is today…gradually it achieved the following landmarks and now it has became

what we call the Karvy group, now it is:

1.Largest independent distributor for financial products.

2.Amongst the top 5 stock broker.

3.Among the top 3 depository participants.

4.Largest network of branches & business associates.

5.ISO 9002 certified operations by DNV.

6.Amongst top 10 investment bankers.

7.Judged as one of the top 50 IT users in India by MIS south Asia.

8.Full- fledged IT driven operation.

9.India’s no.1 registrar & securities transfer agent.

Clientele of Karvy:

Karvy’s culture has helped Karvy in achieving such a distinct position in the market where it can

boast of its huge client base. Be it a retail investor investing Rs. 500 in a SIP in Reliance mutual fund

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or be it the largest corporate house of the country: Reliance industries- everybody is heading towards

Karvy for their wealth maximization, lets have a look at the clientele of Karvy :

According to the datas published in year 2007, Karvy stock broking ltd. Operates through

more than 12000 terminals, more than 290000 accounts are maintained and commands over

3.14% market share of NSE. The distribution services has access to more than Rs. 40 billion

Assets Under Management. Karvy being a depository participant with both NSDL and

CDSL, manages more than 700000 accounts from more than 380 locations. Talking about

the registry services, it manages over 750 public/ right issues.at the same time, it is managing

over 16 million portfolios as registrar.

If we took a look at some of the top corporate houses availing the services of Karvy then we have:

Reliance, IOC, IDBI,LIC, Hindustan Unilever, Principal Mutual Fund, Duetsche Mutual Fund,

Yogokawa, Marico Industries, Patni Computers, Morgan Stanley, Glenmark, CRISIL, 3M, Kotak

Mahindra Bank, Bharti Televenture, Infosys Technologies, Wipro, Infotech, IPCL,TATA

consultancy services, UTI mutual fund etc. Thus in total Karvy serves over 16 million investors and

300 corporates.

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Hierarchical Structure in diagram:

The above diagram shows the hierarchy of Karvy stock broking ltd. It can be easily depicted from

the diagram that the regional head (presently Mr. Alok Chaturvedi) is the supreme in the eastern

region, under whom the various zonal heads operate and under these zonal heads, the branch heads

operate. Between each level o the hierarchy, there exists a coordinator, who acts as the facilitator

between the different heads.

Karvy at Pune:

Now if we look at Karvy’s branch offices at Pune, then there exist ten branches of Karvy at Pune, which are as follow:

1. Law College Road

2. Akurdi

3. Aundh

4. Bibvewadi

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5. Chinchwad

6. Paud Road

7. Shrinath Plaza

8. Wanowarie

Structure according to the Products offered by Karvy:

KA

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REGIONAL HEADS

REGIONAL HEADS

PRODUCT HEADS

HEA

PRODUCT HEADS

HEA

Mutual funds

Mutual funds

Insurance broking

Insurance broking

commodities

commodities

Stock broking

Stock broking

Depository participant

Depository participant

Merchant & inv.banking

Merchant & inv.banking

PMSPMS

RealtyRealty

Debt division

Debt division

Introduction

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

called bases (underlying assets index) in a contractual manner. The underlying assets can be Equity,

Forex, commodity or any other assets.

There are mainly three types of Derivatives:- Forwards, futures, and Option A forward

contract is a customized contract between two entities, whereas settlement takes place on a specified

date in the future at today’s agreed price.

A future contract is an agreement between two parties to buy or sell an asset at a certain time

in the future at a certain price. Futures contracts are special types of forward contracts in the sense

that the former are standardized exchange-traded contracts.

Options are of two types:- Calls and puts option.

A call option gives the buyer the right to buy a certain asset within a fixed period of time but

not the obligation on to buy.

A put option gives the buyer the right to sell a particular asset at a fixed period of time but

not the obligation to sell it.

Hedging is nothing but to control or eliminate the risk to a certain extent.

Derivatives is an important tool to hedge the risk or position by dint 0f Future & option

market.

My entire project report revolves around Derivatives as a tool of Hedging.

This project has been conducted at Karvy., Pune to the best of my effort and determination.

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RESEARCH

METHODOLOGY

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Research Methodology

Objective

Primary :

1) To understand about derivatives market,

2) To study how does a derivative hedge the risk or position.

3) To know why derivatives is considered safer than cash market.

Secondary :

i) To provide better advice to the clients of Motilal Oswal Securities Ltd. in F

& O.

ii) To understand the scope of derivatives in capital market.

Research Approach

1) Study and observance

Data collection:

1) Primary Data : - Formal and informal Discussion with Company guide and

clients of the company.

2) Secondary Data : - Internet, Books, Newspapers, TV Channels, News

Channels

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Research Problem:

There are very few ways for hedging price risk or price volatility in equity

markets and derivatives is one of them. My study is to see how derivatives are

used for hedging price risk in equity market.

Limitation:

1) As research required a detail information of portfolios of clients, which is very

confidential for the client, a huge difficulty was faced in getting the data.

2) Also the data used in the research may suffer from incorrectness.

3) As the company guide was very busy in her exhausting work schedule, very

less guidance was available.

Scope of Study

As derivatives is a very vast subject the scope of research is limited to the

financial derivatives viz. futures & options.

Forwards has been kept out of the scope of this research

Since options are widely used for hedging, only the options cases have been

taken into the consideration in my research.

Sample Size : 11

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DERIVATIVES

- FORWARD

- FUTURES

- OPTIONS

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Derivatives

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

basic variables, called bases (underlying assets, index) in a contractual manner. The

underlying assets can be Equity, Forex, commodity, Bullion or any other assets.

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

Futures and Option, can be traced back to the willingness of risk averse economic

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

prices. By their very nature, the financial markets are marked by a very high degree of

volatility. Through the use of derivatives products, it is possible to partially or fully

transfer price risks by locking in asset price.

For example, wheat farmers may wish to sell their harvest at a future date to

eliminate the risk of a change in prices by that date. Such a transaction is an example of

derivative. The price of this derivative is driven by the spot price of wheat, which is the

“underlying”.

The financial derivatives came into spotlight in post- 1970 period due to growing

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

have become very popular and by 1990s, they accounted for about two third of total

transactions in the derivatives products.

In recent years, the market for financial derivatives has grown tremendously

both in terms of variety of instruments available, their complexity and also turnover.

The factors generally attributed as the major driving force behind growth of financial

derivatives are:

a) Increased volatility in asset prices in financial markets.

b) Increased integration of national financial markets with the

international markets.

c) Marked improvement in communication facilities and sharp

decline in their costs.

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d) Development of more sophisticated risk management tools,

providing economic agents a wider choice of risk management strategies.

e) Innovations in the derivatives markets, which optimally

combine the risks and returns over a large number of financial assets, leading

to higher returns, reduced risks as well as financial costs as compared to

individual financial assets.

Participants : - The following three broad categories of participants hedgers,

speculators and arbitrageurs trade in the derivatives market.

Hedgers- face risk associated with the price of an asset. They use futures and options

market to reduce or eliminate this risk.

Speculators – wish to bet on future movements in the price of an asset. Future and

Option contracts can give them an extra leverage, that 19s they can increase both the

potential gains and potential losses in a speculative venture.

Arbitrageurs – are in business to take advantage of a discrepancy between prices in

two different markets. If, for instance they see the future price of an asset getting out of

line with the cash price, they will take offsetting positions in the two markets to lock in

a profit.

Types of Derivatives: - The most commonly used derivatives contracts are forwards,

futures and options. Here I took a brief look at various derivatives contracts that have

come to be used: -

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

settlement takes place on a specified date in the future at today’s pre-agreed price.

Futures: - A future contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. Future contracts are special types

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

contracts.

Options: - Options are of two types- Calls and Puts. Call gives the buyer the right but

not the obligation to buy a given quantity of the underlying assets, at a given price on or

before a given future date. Put gives the buyer (holder) the right but not the obligation

to sell a given quantity of the underlying asset at a given price on or before a given

date.

Warrants: - Option generally has live s of upto one year, the majority of options traded

on options exchanges having maximum maturity of nine months. Longer-dated options

are called warrants and are generally traded over the counter.

Leaps: - The acronyms LEAPS means Long term Equity Anticipation Securities. These

are options having a maturity of upto three years.

Baskets: - Baskets options are option on portfolios of underlying assets. The

underlying asset is usually a moving average or a basket of assets.

Swaps: - Swaps are private agreement between two parties to exchange cash flows in

the future according to a prearranged formula. They can be regarded as portfolios of

forward contracts. The two commonly used swaps are;-

a) Interest Rate Swaps

b) Currency Swaps

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Forwards

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 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.

The salient features of forward contracts are: -

a) They are bilateral contracts and hence exposed to counter

party risk.

b) Each contract is custom designed, and hence is unique in

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

c) The contract price is generally not available in public

domain.

d) On the expiration date, the contract has been settled by

delivery of the assets.

e) If the party wishers to reverse the contract, he has to

compulsory go to the same counterparty, which often results in high prices being

charged.

Forward Contracts are very useful in hedging and speculating.

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

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

fluctuations. By using the currency forward market to sell dollars forward, he can lock

on to a rate today and reduce his uncertainties. Similarly an importer who is required to

make a payment in dollars two months hence can reduce his exposure to exchange rate

fluctuation by buying dollar forward.27

Despite it Forward Market world-wide are afflicated by several problems: -

Lack of centralization of trading,

Illiquidity, and

Counterparty Risk.

Futures

Definition:

“A future contract can be defined as a standardized agreement between the

buyer and seller in terms of which the seller is obligated to deliver a specified asset to

the buyer on a specified date and the buyer is obligated to pay the seller then

prevailing future price in exchange of the delivery of the asset”.

Parties Involved:

4) Buyer of the asset.

5) Exchange.

6) Seller of the asset.

The futures markets were designed to solve the problems that exist in forward

markets. A futures contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. But unlike forward contracts, the

futures contracts are standardized and exchange traded. To facilitate liquidity in the

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futures contracts the exchange specified certain standard features of the contract. It is

a standardized contract with standard underlying instrument, a standard quantity and

quality of the underlying instrument that can be delivered 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.

Futures Terminology

b) Spot Price: - The price at which an asset trades in the spot market.

c) Futures Price: - The price at which the futures contract trades in the futures

market.

d) Contract Cycle: - The period over which a contract trades. The index future

contracts on the NSE have one month, two month and three month expire

cycles. Which expire on the last Thursday of the month.

e) Expiry Date: - It is the date specified in the futures contracts. This is the last

date on which the contract will be traded at the end or which it will cease to

exist.

f) Contract Size: - The amount of asset that has to be delivered under one

contract.

g) Basis: - In the context of financial futures, basis can be defined on the future

price minus the spot price. There is a different basis for each delivery month

for each contract. In a normal market basis is positive.

h) 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.

i) Initial Margin: - The amount that must be deposited in the margin account at

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

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j) Marking to Market: - In the futures market at the end of each trading day the

margin account in adjusted to reflect the investor’s gain or loss depending

upon the futures closing price. This is called marking to market.

k) 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.

Trading in Futures Segment

It is traded basically on NSE. Unlike cash segment, a certain margin in paid is

futures segment. It operates in T+1 basis. Margins are pre-decided as per the lot size.

This is very useful for those investors, who do not have entire amount to invest. In

future contracts they pay only a certain margin and enter into trading.

For instance, Mr.X, who trades in cash market, wishes to buy 650 shares of

Patni @ Rs.350/- share. For this he will have to invest (650 x 350) = Rs.2,27,500/-

But he does not have this much amount to invest.

Now in future market, he will buy one July lot (650 shares) of Patni by paying

a premium around only 15% of total amount. In this case the total cost of Mr.X for 1

lot of Patni will be only Rs.34,125/-.

The main drawback of this trading in that it acts in T+1 basis, means a trader

has to settle his position every day, until he closes his trading in particular scrip.

Risk also can be hedged in futures market by imposing “Stop Loss”

Stop Loss: - This facility allows to the investors to release an order into the system,

after the marker price of the security reaches or crosses a threshold price, called

trigger price.

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For Example:

Mr.X bought 1 July lot of Cipla @ Rs.320/- per share by paying 15% margin.

However he does not want to take any risk of downward movement, he imposed a

stop loss at @ Rs.310/- share.

In this case Mr.X made his loss limit by Rs.10/- per share, however he can

fetch unlimited profit as price keeps going up.

Options

Definition

“Option is a legal contract in which the writer of the option grants to the buyer, the

right to purchase from or sell to the writer a designated instrument or a scrip at a

specified price within a specified period of time”.

Parties Involved

1) Buyer of the asset

2) Exchange

3) Seller of the asset

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Options are fundamentally different from forward and futures contracts. An

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

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

have committed themselves to doing something.

There are basically two types of options

a) Call Option

b) Put Option

A call option gives the holder the right but not obligation to buy an assets by a

certain date for a certain price. For instance X purchases a call option from Y of REL

it means Y gives the right to purchase REL at a fix strike price within a certain period.

Where as a put option gives the holder the right but not the obligation to sell an

asset by a certain date for a certain price.

Options terminology

a) Index option: 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.

b) Stock option: Stock options are options on individual stocks. Options

currently trade on over 500 stocks in the United States. A contract givens the

holder the right to buy or sell shares at the specified price.

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

potion premium buys the right but note the obligation to exercise his option on

the seller/writer.

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d) 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

wishes to exercise his option.

e) 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.

f) Expiration date: The date specified in the options contract is known as the

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

g) Strike price: The price specified in the options contract is known as the strike

price or the exercise price.

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

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

i) European options: European options are options that can be exercised only on

the expiration date itself.

j) In-the-money option: A call option on the index is said to be in-the-money

when the current value of index stands at a level higher than the strike price

(i.e. spot price > strike price).

k) At-the-money option: An at-the-money (ATM) option is an option that would

lead to zero cash flow if it were exercised immediately. An option on the index

is at-the-money when the value of current index equals the strike price (i.e.

spot price = strike price).

l) Out-of-the-money option: An out-of-money (OTM) option is an option that

would lead to a negative cash flow it was exercised immediately. A call option

on the index is said to be out-of-the-money when the value of current index

stands at a level which is less than the strike price (i.e. spot price < strike

price).

Distinction between futures and options:

Futures Options

33

Exchange traded, with novation Same as futures

Exchange defines the product Same as futures

Prices is zero, strike price moves Strike price is fixed, price moves.

Price is zero Price is always positive.

Linear payoff Non-linear payoff.

Both long and short at risk Only short at risk.

Since hedging is mostly done by means of option nowadays. There are certain

strategies which are considered before hedging the positions or risks by the investors:

-

Option Strategies

a) Long Call: - A long call can be an ideal tool for an investors who wishes to

participate profitably from an upward price movement in the underlying stock .

b) Long put: - A long put can be an ideal tool for an investor who wishes to

participate profitably from a downward price move in the underlying stock.

c) Married Put: - An investor purchasing a put while at the same time

purchasing an equivalent number of shares of the underlying stock is

establishing a “married put” position- a hedging strategy with a name from an

old IRS ruling.

d) Protective Put: - An investor who purchases a put option while holding shares

of the underlying stock from a previous purchase is employing a “protective

put”.

34

e) Covered call: - The covered call is a strategy in which an investor writes a call

option contract while at the same time owning an equivalent number of shares

of the underlying stock. If this stock is purchased simultaneously with writing

the call contract, the strategy is commonly referred to as a “buy-write.” If the

shares are already held from a previous purchase, it is commonly referred to an

“overwrite”.

f) Cash Secured Put: - According to the terms of a put contract, a put writer is

obligated to purchase an equivalent number of underlying shares at the put’s

strike price if assigned an exercise notice on the written contract. Many

investors write puts because they are willing to be assigned and acquire shares

of the underlying stock in exchange for the premium received from the put’s

sales. For this discussion, a put writer’s position will be considered as “cash-

secured” if he has on deposit with his brokerage firm a cash amount (or

equivalent) sufficient to cover such a purchase of all option contract.

g) Bull Call spread: - Establishing a bull call spread involves the purchase of a

call option on a particular underlying stock, while simultaneously writing a call

option on the same underlying stock with the same expiration month, at a

higher strike price. Both the buy and the sell sides of this spread are opening

transactions, and are always the same number of contracts.

h) Bear Put Spread: - Establishing a bear put spread involves the purchase of a

put option on a particular underlying stock, while simultaneously writing a put

option on the same underlying stock with the same expiration month, but with

a lower strike price. Both the buy and the sell sides of this spread are opening

transactions, and are always the same number of contracts.

i) Caller: - A collar can be established by holding shares of an underlying stock,

purchasing a protective put and writing a covered call on that stock. The option

portions of this strategy are referred to as a combination. Generally, the put

and the call are both out-of-the-money when this combination is established,

and have the same expiration month.

35

HEDGING

36

Hedging

Hedging in nothing but a mechanism to reduce or control risks involved in

capital market. Various Risk involved in capital market: -

a) Price Risk

b) Liquidity Risk

c) Operational Risk

Hedging plays an important role to combat these risks.

Hedging does not mean to maximize return. It so happens that sometime despite

imposing hedging inventers may fetch unlimited profit in that case hedging does not

bear fruit. Hedging shows its colour only case of losses by limiting it.

In a simple example, a miller may buy wheat that is to be converted into flour.

At the same time, the miller will contract to sell an equal amount of wheat, which the

miller does not presently own, to another trader. The miller agrees to deliver the second

lot of wheat at the time the flour is ready fro market and at the price current at the time

37

of the agreement. If the price of wheat declines during the period between the miller’s

purchase of the grain and the flour’s entrance onto the market, there will also be a

resulting drop in the price of flour. That loss must be sustained by the miller. However,

sine the miller has a contract to sell wheat at the older, higher price, the miller makes up

for this loss on the flour sale by the gain on the wheat sales.

Terms in Hedging

Long Hedge:

Long hedge is the transaction when we hedge our position in cash market by

going long in derivatives market.

For example, let us assume that we are going to receive funds in the near future

and we want to invest it into the capital market. Also we expect the market to go up in

the near future, which is not desirable for us as we would have to invest more money.

The risk can be hedged by making use of derivatives such as F & O.

Short Hedge:

Short hedge in the hedge accomplished by going short in the derivatives market.

For example, we have a portfolio which we want to liquidate in the near future.

Meanwhile prices of the scrip may go down, which is not favourable for us. Thus to

protect our portfolio value we can go short in the derivative market.

Cross hedge:

When derivatives of the underlying assets we have, are not available, we use

derivatives on any other related underlying, that are available. This is called as cross

hedge.

38

Fore example, derivatives on Jet fuel are not available in the market, for hedging

against prices of it we may use crude oil derivatives which are related with the Jet

prices.

ANALYSIS AND INTERPRETATION

39

Awareness of hedging strategies among clients

After collecting data from clients, it reveals that clients are almost aware about Long

call/put strategy, Protective strategy and married put option strategy. Number of

clients can be shown about awareness of different strategy in following Bar graph: -

0

2

4

6

8

10

12

Long call/put

strategy

Protectivestrategy

Marriedput optionstrategy

Bear call /put spreadstrategy

Coveredcall

strategy

Callerstrategy

Series1

40

Long Call / Put Strategy

Protective Strategy

Married Put Option

41

Bear Call / Put Option Strategy

Covered Call Strategy

42

Analysis and Interpretation

Case I

Mr. Bhandari bought 675 shares of Tisco few days before the budget @ Rs.350/- per

share, as general expectation from the budget was that it will be an infrastructure of

development focused budget. He was also bullish on Tisco.

However Mr. Bhandari wanted to hedge against any downward movement of

Tisco in the Market.

Solution

43

There are following Alternatives for Mr.Bhandari to hedge his position

i) Long put strategy

ii) Protection put strategy

iii) Bear put spread strategy

Since Mr.Bhandari has to protect his 675 shares of Tisco so in this case, to hedge

against any downward movement of Tisco, Mr.Bhandari will opt protective put

strategy. So he should buy 1 lot of put option of Rs.350/- strike price @ Rs.10/-

premium at the same time.

Now the total cost of Bhandari is: -

Bought Tisco @ Rs.350/- share = 2,36,250/-

cost of 1 lot of Tisco put option @ Rs.10/- = 6,750/-

2,43,000/-

Analysis

S. No. Stock

Price

Stock

Value

Put Value Cost of

Premium

Return

44

1 320 2,16,000 20,250 6,750 (6,750)

2 330 2,22,750 13,500 6,750 (6,750)

3 340 2,29,500 6,750 6,750 (6,750)

4 350 2,36,250 0 6,750 (6,750)

5 360 2,43,000 0 6,750 Nil

6 370 2,49,750 0 6,750 6,750

7 380 2,56,500 0 6,750 13,500

8 390 2,63,250 0 6,750 20,250

9 400 2,70,000 0 6,750 27,000

0

5000

10000

15000

20000

25000

30000

2,4

9,7

50

2,5

6,5

00

2,6

3,2

50

2,7

0,0

00

370 380 390 400

6 7 8 9

Put Value20,250 13,5006,750 0 0

Cost ofPremium 6,7506,750 6,7506,750 6,750

Return -6,750 -6,750 -6,750 -6,750 Nil

45

Interpretation

1) The stock value is arrived at as (stock value x 675 shares).

2) If the stock price is below Rs.350/- in the spot market, the put option will be

executed. Thus put value is arrived at as

(strike price – stock price) x 675

3) If the stock price goes below from Rs.360/- loss is limit to the extent of its

premium amount (Rs.10/-), or Rs.6750/-.

4) If the stock price goes up from Rs.360/- it can fetch unlimited profit as stock

price keeps going up.

Case II

Mr.Bhalgat was mildly bullish on Bank of India. He already got 1900 shares of Bank

of India @ rs.110/- Shares few days back. Though Mr.Bhalgat, bullish on Bank of

India, wanted to hedge against any downside movement of Bank of India due to

budget related volatility.

Solution

That time Bank of India was trading around Rs.120 – 130 range.

46

There are following Alternatives for Mr.Bhalgat to hedge his position

iv) Long put strategy

v) Protection put strategy

vi) Bear call spread strategy

Since Mr. Bhalgat is mildly bullish on BOI, he will opt Bull call spread

strategy as the best strategy, following things might be suggested –

a) Buy a July call option of Bank of India for 1 lot of strike price Rs.120/- shares,

at a premium of Rs.12/- share.

b) Sell a July call option for one lot of Bank of India Rs.140/- strike price at a

premium of Rs.2/- shares.

Costs

Buying 1 lot of call option of BOI

(1900 x 12) = 22,800/-

( – ) selling 1 lot of call option of BOI

(1900 x 2) = 3,800/-

19,000/-

Analysis

S. No. Stock Stock Bought Sold Cost of Return

47

Price Value Call

Value

Call

Value

Premium

1 90 1,71,000 0 0 19,000 (19,000)

2 100 1,90,000 0 0 19,000 (19,000)

3 110 2,09,000 0 0 19,000 (19,000)

4 120 2,28,000 0 0 19,000 Nil

5 130 2,47,000 19,000 0 19,000 19,000

6 140 2,66,000 38,000 0 19,000 38,000

7 150 2,85,000 57,000 19,000 19,000 38,000

8 160 3,04,000 76,000 38,000 19,000 38,000

Interpretation

1) Stock price is arrived at as (stock price x 1900)

2) At any price above Rs.120/- shares bought call value is arrived at as {(stock

price – 120 ) x 1900}.

3) At any price above Rs.140/- share, sold call value is arrived at as {(stock price

– 140 ) x 1900}.

4) Return is maximum loss Rs.19,000 and maximum profit Rs.38,000.

48

Case III

Mr. Sonagra is a regular mid to long term investor. In the beginning of the month of

the July he had not enough money in hand to invest in shares. He was supposed to get

money at the end of the month.

However he was bearish on Titan. He want to buy Titan but not after few days as it

could lead to a loss of thousands.

Solution

Since Mr. Sonagra has not sufficient amount to invest in shares, he will adopt

only Long call strategy to hedge his position.

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In such circumstance Mr.Sonagra will buy one lot (800 shares) of call option at a

premium of Rs.10/- per share the strike price of which is Rs.510/-.

Cost for 1 lot of Titan in call option will be

800 x 10 = Rs.8,000/-

Analysis

Sr. No. Stock price Stock value Cost of Premium

Value of call Option

1 480 3,84,000 8000 0

2 490 3,92,000 8000 0

3 500 4,00,000 8000 0

4 510 4,08,000 8000 0

5 520 4,16,000 8000 10

6 530 4,24,000 8000 20

7 540 4,32,000 8000 30

50

8 550 4,40,000 8000

Interpretation

i) Though Mr.Sonagra bought a call option of a strike price of Rs.150/-, he

expects that stock price will go up.

ii) No matter how much stock price goes up stock price goes up more he can

fetch profit more, became he can purchase at a fix stock price of Rs.510/-.

iii) If the stock price goes down, call option will not be executed, because

purchasing a lot in Rs.510/- in downward movement does not sound

reasonable.

iv) In downward movement his loss will be limit to the extent of premium

amount (Rs.8,000).

v) While in upward movement his profit will be unlimit as the price goes up

deducting (premium + strike price).

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Case IV

Mr.Pandit was holding 550 shares of Reliance Energy Ltd. (REL), which he had

purchased @ Rs.620. Due to market sentiments and his personal study he was bearish

on REL. In the fear of losing he wanted to hedge against downfall in the prices of

REL. (Lot size = 550)

Solution

52

There are following Alternatives for Mr.Pandit to hedge his position

vii) Long put strategy

viii) Protection put strategy

ix) Bear put spread strategy

Since Mr. Pandit has to protect its 550 shares of REL, In such circumstance Mr.Pandit

will prefer to buy 1 lot of put option at a premium of lets assume Rs.10/- per share,

strike price of which is Rs.620.

Now the total cost of Mr.Pandit will be : -

Buying of 550 shares of REL @ Rs.620/-

(550 x 620) = 3,41,000/-

( + ) buying of 1 lot of put opition @ Rs.10/- share

(10 x 550) = 5,500/-

3,46,500/-

Analysis

53

Sr. No. Stock

Price

Stock

Value

Bought

Put Value

Cost of

premium

Return

1 590 3,24,500 16,500 5,500 (5,500)

2 600 3,30,000 11,000 5,500 (5,500)

3 610 3,35,500 5,500 5,500 (5,500)

4 620 3,41,000 0 5,500 (5,500)

5 630 3,46,500 0 5,500 Nil

6 640 3,52,000 0 5,500 5,500

7 650 3,57,500 0 5,500 11,000

8 660 3,63,000 0 5,500 16,500

9 670 3,68,500 0 5,500 22,000

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

3,52,000 3,57,500 3,63,000

640 650 660

6 7 8

Bought Put Value16,500 11,0005,500 0 0

Cost of premium5,500 5,500 5,5005,500 5,500

Return -5,500 -5,500 -5,500 -5,500 Nil

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Interpretation

i) Stock value is arrived at as (stock price x 550 shares)

ii) If the stock price goes below from Rs.620/- put option is executed. The put

value is arrived at as

( strike price – stock price ) x 550

iii) If the stock price goes below from Rs.630/- (cost price) the loss is limit to

the extent of its premium means Rs.5,500/-.

iv) If the stock price goes up from Rs.630/- of can fetch unlimited profit an

stock price keeps going up and put option will not be executed.

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FINDING

Findings

Case I

i) As the stock price goes down value of put option increases.

ii) Break Even point (B.E.P.) for Mr.Bhandari in Rs.360/- share or

Rs.2,43,000/-

iii) Loss in limit to the extent of its premium.

iv) As the stock price goes up value of put option loses its significance.

56

v) If the put option is not executed till its expiration period it will

automatically repudiate.

Case II

i) As the value of stock price goes up from strike price the bought call value

and sold call value increases.

ii) Rs.120/- share or Rs.2,28,000/- is the Break Even point (B.E.P.) for

Mr.Bhalgat.

iii) Mr.Bhalgat made limit his profit and loss by buying and selling 1 lot of call

option simultaneously.

iv) As the stock price goes down from its strike price the value of call option

loses its significance.

Case III

i) Mr.Sonagra should be quite sure that the value of stock price will increase

in coming future.

ii) He will fetch profit when market will be at bullish by purchasing the shares

@ Rs.510/- share and selling it in more that Rs.520/- in spot market.

iii) Mr.Sonagra has been given right but not obligation to buy shares @

Rs.510/- in lieu of Rs.10/- per share as premium whatever market condition

may be.

57

iv) The value of call option become insignificant if stock price goes below

from Rs.510/-.

Case IV

i) As the stock price decreases the value of bought put option increases.

ii) Rs.630/- share or Rs.3,46,500/- is the Break Even point for Mr.Pandit.

iii) As the stock price goes up form its strike price put option become

insignificant.

iv) Here loss is limit to the extent of its premium amount.

v) If the put option is not executed till its expiration period it in automatically

repudiated.

58

SUGGESTION & CONCLUSION

Suggestion

Case I

59

i) Mr.Bhandari should be very conscious about premium rate and expiration

period before opting put option.

ii) If the stock price starts to decline he should not execute his put option

immediately because in any low cases he will lose Rs.6,750/- while he may

fetch profit in going up of stock price after downward movement.

Case II

ii) Mr.Bhalgat should adopt this strategy only in that case, when he is quite

sure that profit is not possible after a certain extent.

Case III

ii) Mr.Sonagra should buy September call option instead of July call option,

because during this gap stock price must go up.

iii) When stock price reaches up to its highest level he should execute his call

option.

60

Case IV

i) Mr.Pandit should be very conscious about premium rate and expiration

period of option.

ii) If the stock price starts to decline, he should not execute his put option

immediately, because in any low cases he will lose Rs.5,500/- while he

may fetch profit in going up of stock price after downward movement.

General Suggestion

It is humbly suggested to all the clients of Motilal Oswal Securities

Ahmednagar that they develop their knowledge in future & option market because it

is only the way by dint of which risk or position and they should always consider the

rolling settlement of period.

Conclusion

i) Derivative is the best tool for hedging the position or risk.

61

ii) Hedging is basically done in option market.

iii) Purchaser of a call option always hopes that the stock price will go

up.

iv) Purchaser of the put option always hopes that stock price will go

down.

v) Strike price and Expiration period plays important role in hedging.

vi) Fund managers use basically use index option to hedge their position.

vii) Individuals use generally stock option to hedge risks.

viii) Individuals use option in speculative manner.

ix) There is a wide scope of derivatives markets.

Bibliography:

62

Websites:www.the-finapolis.com

www.Karvy.com

www.mutualfundsindia.com

www.valueresearchonline.com

www.moneycontrol.com

www.morningstar.com

www.yahoofinance.com

www.theeconomictimes.com

www.rediffmoney.com

www.bseindia.com

www.nseindia.com

www.investopedia.com

journals & other references:

Karvy –the finapolis

Karvy- business associates manual

The Economic Times

Business Standard

The Telegraph

Business India

Fact sheet and statements of various fund houses.

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