INTRODUCTION

1

INTRODUCTION:

The only stock exchange operating in the 19th century were those of Bombay set

up in 1875 and Ahmadabad set up in 1894. These were organized as voluntary non-profit-

making association of brokers to regulate and protect their interests. Before the control

on securities trading became a central subject under the constitution in 1950, it was a

state subject and the Bombay securities contracts (control) Act of 1925 used to regulate

trading in securities. Under this Act, The Bombay stock exchange was recognized in 1927

and Ahmadabad in 1937.

During the war boom, a number of stock exchanges were organized even in

Bombay, Ahmadabad and other centers, but they were not recognized. Soon after it

became a central subject, central legislation was proposed and a committee headed by

A.D.Gorwala went into the bill for securities regulation. On the basis of the committee's

recommendations and public discussion, the securities contracts (regulation) Act became

law in 1956.

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OBJECTIVES OF STUDY:

1. To study various trends in derivative market.

2. Comparison of the profits/losses in cash market and derivative market.

3. To find out profit/losses position of the option writer and option holder.

4. To study in detail the role of the future and options.

5. To study the role of derivatives in Indian financial market.

6. To study various trends in derivative market.

7. Comparison of the profits/losses in cash market and derivative market.

8. To find out profit/losses position of the option writer and option holder.

9. To study in detail the role of the future and options.

10. To study the role of derivatives in Indian financial market.

3

NEED OF THE STUDY

Different investment avenues are available investors. Stock market also offers good

investment opportunities to the investor alike all investments, they also carry certain

risks. The investor should compare the risk and expected yields after adjustment off

tax on various instruments while talking investment decision the investor may seek

advice from exparty and consultancy include stock brokers and analysts while

making investment decisions. The objective here is to make the investor aware of the

functioning of the derivatives.

Derivatives act as a risk hedging tool for the investors. The objective if to help the

investor in selecting the appropriate derivates instrument to the attain maximum risk

and to construct the portfolio in such a manner to meet the investor should decide

how best to reach the goals from the securities available.

To identity investor objective constraints and performance, which help formulate the

investment policy?

The develop and improvement strategies in the with investment policy formulated.

They will help the selection of asset classes and securities in each class depending up

on their risk return attributes.

4

5

SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to futures and options

in the Indian context; the study is not based on the international perspective of derivative

markets.

The study is limited to the analysis made for types of instruments of derivates each

strategy is analyzed according to its risk and return characteristics and derivatives

performance against the profit and policies of the company.

The present study on futures and options is very much appreciable on the grounds

that it gives deep insights about the F&O market. It would be essential for the perfect way

of trading in F&O. An investor can choose the fight underlying or portfolio for investment

3which is risk free. The study would explain the various ways to minimize the losses and

maximize the profits. The study would help the investors how their profit/loss is

reckoned. The study would assist in understanding the F&O segments. The study assists in

knowing the different factors that cause for the fluctuations in the F&O market. The study

provides information related to the byelaws of F&O trading. The studies elucidate the role

of F&O in India Financial Markets.

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Derivative Markets today

The prohibition on options in SCRA was removed in 1995. Foreign currency

options in currency pairs other than Rupee were the first options permitted by RBI.

The Reserve Bank of India has permitted options, interest rate swaps, currency

swaps and other risk reductions OTC derivative products.

Besides the Forward market in currencies has been a vibrant market in India for

several decades.

In addition the Forward Markets Commission has allowed the setting up of

commodities futures exchanges. Today we have 18 commodities exchanges most of

which trade futures.

e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee

Owners Futures Exchange of India (COFEI).

In 2000 an amendment to the SCRA expanded the definition of securities to

included Derivatives thereby enabling stock exchanges to trade derivative

products.

The year 2000 will herald the introduction of exchange traded equity derivatives in

India for the first time.

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METHODOLOGY

To achieve the object of studying the stock market data ha been collected.

Research methodology carried for this study can be two types

Primary

Secondary

PRIMARY

The data, which is being collected for the time and it is the original data is this project the primary data has been taken from IIFL staff and guide of the project.

SECONDARY

The secondary information is mostly from websites, books, journals, etc.

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INDUSTRY

PROFILE

9

NDUSTRY PROFILE :

STOCK MARKET :

Indian stock market has shown dramatic changes last 4 to 5 years. As of 2004

march-end, Indian stock exchanges had over 9400 companies listed. Of course, the

number of companies whose shares are actively traded is smaller, around 800 at the NSE

and 2600 at the BSE. Each company may have multiple securities listed on an exchange.

Thus, BSE has over 7200 listed securities, of which over 2600 are traded. The market

capitalization of all listed stocks now exceeds Rs. 13 Lakh crore. Total turnover-or the

value of all sales and purchases – on the BSE and the NSE now exceeds Rs. 50 lakh crore.

As large number of indices are also available to fund managers. The two leading

market indices are NSE 50-shares (S&P CNX Nifty) index and BSE 30-share (SENSEX)

index. There are index funds that invest in the securities that form part of one or the other

index. Besides, in the derivatives market, the fund managers can buy or sell futures

contracts or options contracts on these indices. Both BSE and NSE also have other sect

oral indices that track the stocks of companies in specific industry groups-FMCG, IT,

Finance, Petrochemical and Pharmaceutical while the SENSEX and Nifty indices track

large capitalization stocks, BSE and NSE also have Mid cap indices tracking mid-size

company shares. The number of industries or sectors represented in various indices or in

the listed category exceeds50. BSE has 140 scrips in its specified group A list, which are

basically large-capitalization stocks. B 1 Group includes over 1100 stocks, many of which

are mid-cap companies. The rest of the B2 Group includes over 4500 shares, largely low-

capitalization.

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National Stock Exchange (NSE):

The NSE was incorporated in NOVEMBER 1994 with an equity capital of Rs.25

Crores. The International Securities Consultancy (ISC) of Hong Kong has helped in setting

up NSE. The promotions for NSE were financial institutions, insurance companies, banks

and SEBI capital market ltd,Infrastructure leasing and financial services ltd.,stock holding

corporation ltd.

NSE is a national market for shares, PSU bonds, debentures and government

securities since infrastructure and trading facilities are provided. The genesis of the NSE

lies in the recommendations of the Pherwani Committee (1991).

NSE-Nifty:

The NSE on April22, 1996 launched a new equity index. The NSE-50 the new

index which replaces the existing NSE-100, is expected to serve as an appropriate index

for the new segment of futures and options.

“Nifty” means National Index for Fifty Stocks.

The NSE-50 comprises 50 companies that represent 20 broad industry groups

with an aggregate market capitalization of around Rs. 1,70,000 crores. All the companies

included in the Index have a market capitalization in excess of Rs. 500 crores. Each and

should have traded for 85% of trading days at an impact cost of less than 1.5%.

NSE-Midcap Index:

The NSE midcap index or the Junior Nifty comprises 50 stocks that represents

21 board Industry groups and will provide proper representation of the midcap. All stocks

in the index should have market capitalization of greater than Rs.200 crores and should

have traded 85% of the trading days an impact cost of less 2.5%.

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The base period for the index is Nov 4, 1996 which signifies 2 years for

completion of operations of the capital market segment of the operations. The base value

of the index has been set at 1000. Average daily turnover of the present scenario

258212(laces) and number of average daily trades 2160(laces).

Bombay Stock Exchange (BSE):

This stock exchange, Mumbai, popularly known as “BSE” was established In

1875 as “The native share and stock brokers association”, as a voluntary non-profit

making association .It has evolved over the years into its present status as the premier

stock exchange in the country. It may be noted that the stock exchange is the oldest one in

Asia, even older than the Tokyo Stock Exchange, this was founded in 1878.

The Bombay Stock Exchange Limited is the oldest stock exchange in Asia and

has the greatest number of listed companies in the world, with 4700 listed as of August

2007.It is located at Dalal Street, Mumbai, India. On 31 December 2007, the equity market

capitalization of the companies listed on the BSE was US$ 1.79 trillion, making it the

largest stock exchange in South Asia and the 12th largest in the world.

A governing board comprising of 9 elected directors, 2 SEBI nominees, 7 public

representatives and an executive director is the apex body, which decides the policies and

regulates the affairs of the exchange.

BSE Indices:

In order to enable the market participants, analysts etc., to track the various ups and

downs in Indian stock market, the exchange had introduced in 1986 an equity stock index

called BSE-SENSEX that subsequently became the barometer of the moments of the share

prices in the Indian stock market. It is a “market capitalization –weighted” index of 30

component stocks representing a sample of large, well established and leading companies.

The base year of sensex is 1978-79.

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The Sensex is widely reported in both domestic and international markets

through print as well as electronic media. Sensex is calculated using a market

capitalization weighted method. As per this methodology, the level of index reflects the

total market value of all 30-component stocks from different industries related to

particular base period. The total value of a company is determined by multiplying the

price of its stock by the number of shares outstanding.

Statisticians call an index of a set of combined variables (such as price number

of shares) Composite index. An Indexed number is used to represent the results of this

calculation in order to make the value easier to work with and track over a time. IT is

much easier to graph a chart base on indexed values then one based on actual values

world over majority of the well known indices are constructed using “Market

capitalization weighted method”. The divisor is only link to original base period value of

the sensex.

New base year average = old base year average*(new market value/old market

value)

OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the OTC market.

Options of various kinds (called Teji and Mandi and Fatak) in un-organized

markets were traded as early as 1900 in Mumbai

The SCRA however banned all kind of options in 1956.

BSE's and NSE’s plans

Both the exchanges have set-up an in-house segment instead of setting up a

separate exchange for derivatives.

BSE’s Derivatives Segment, will start with Sensex futures as it’s first product.

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NSE’s Futures & Options Segment will be launched with Nifty futures as the first

product.

Product Specifications BSE-30 Sensex Futures

Contract Size - Rs.50 times the Index

Tick Size - 0.1 points or Rs.5

Expiry day - last Thursday of the month

Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

Product Specifications S&P CNX Nifty Futures

Contract Size - Rs.200 times the Index

Tick Size - 0.05 points or Rs.10

Expiry day - last Thursday of the month

Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

Membership

Membership for the new segment in both the exchanges is not automatic and has

to be separately applied for.

Membership is currently open on both the exchanges.

All members will also have to be separately registered with SEBI before they can

be accepted.

Membership Criteria

NSE

Clearing Member (CM)

Networth - 300 lakh

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakh

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In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh.

Trading Member (TM)

Networth - Rs. 100 lakh

Interest-Free Security Deposit - Rs. 8 lakh

Annual Subscription Fees - Rs. 1 lakh

BSE

Clearing Member (CM)

Networth - 300 lacs

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakh

Non-refundable Deposit - Rs. 5 lakh

Annual Subscription Fees - Rs. 50 thousand

In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh with the

following break-up.

Cash - Rs. 2.5 lakh

Cash Equivalents - Rs. 25 lakh

Collateral Security Deposit - Rs. 5 lakh

Trading Member (TM)

Networth - Rs. 50 lakh

Non-refundable Deposit - Rs. 3 lakh

Annual Subscription Fees - Rs. 25 thousand

The Non-refundable fees paid by the members is exclusive and will be a total of Rs.8 lakhs

if the member has both Clearing and Trading rights.

Trading Systems

NSE’s Trading system for it’s futures and options segment is called NEAT F&O. It is

based on the NEAT system for the cash segment.

BSE’s trading system for its derivatives segment is called DTSS. It is built on a

platform different from the BOLT system though most of the features are common.

Certification Programmes

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The NSE certification programme is called NCFM (NSE’s Certification in Financial

Markets). NSE has outsourced training for this to various institutes around the

country.

The BSE certification programme is called BCDE (BSE’s Certification for the

Derivatives Exchnage). BSE conducts it’s own training run by it’s training institute.

Both these programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle approval on their rule and

laws by SEBI.

According to the SEBI chairman, the Gazette notification of the Bye-Laws after the

final approval is expected to be completed by May 2000.

Trading is expected to start by mid-June 2000.

REVIEW

Of16

LITERATURE

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Introduction

A Derivative is a financial instrument that derives its value from an underlying

asset. Derivative is an financial contract whose price/value is dependent upon price of

one or more basic underlying asset, these contracts are legally binding agreements made

on trading screens of stock exchanges to buy or sell an asset in the future. The most

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

discuss in detail later.

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

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

to guard themselves against uncertainties arising out of fluctuations in asset prices. By

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

Through the use of derivative products, it is possible to partially or fully transfer price

risks by locking-in asset prices. As instruments of risk management, these generally do

not influence the fluctuations in the underlying asset prices. However, by locking-in asset

prices, derivative products minimize the impact of fluctuations in asset prices on the

profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in

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

products for almost three hundred years. The financial derivatives came into spotlight in

post-1970 period due to growing instability in the financial markets. However, since their

emergence, these products have become very popular and by 1990s, they accounted for

about two-thirds of total transactions in derivative products. In recent years, the market

for financial derivatives has grown tremendously both in terms of variety of instruments

available, their complexity and also turnover. In the class of equity derivatives, futures

and options on stock indices have gained more popularity than on individual stocks,

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

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

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

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

18

The main objective of the study is to analyze the derivatives market in India and

to analyze the operations of futures and options. Analysis is to evaluate the profit/loss

position futures and options. Derivates market is an innovation to cash market.

Approximately its daily turnover reaches to the equal stage of cash market

In cash market the profit/loss of the investor depend the market price of the

underlying asset. Derivatives are mostly used for hedging purpose. In bullish market the

call option writer incurs more losses so the investor is suggested to go for a call option to

hold, where as the put option holder suffers in a bullish market, so he is suggested to write

a put option. In bearish market the call option holder will incur more losses so the

investor is suggested to go for a call option to write, where as the put option writer will

get more losses, so he is suggested to hold a put option.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI

introduced derivatives in the local currency Interest Rate markets, which have not really

developed, but with the gradual acceptance of the ALM guidelines by banks, there should

be an instrumental product in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was

index futures

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

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets, leading to higher returns, reduced

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

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Derivatives defined

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

variables, called bases (underlying asset, index, or reference rate), in a contractual

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

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

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

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

“underlying”.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines

“equity derivative” to include –

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

unsecured, risk instrument or contract for differences or any other form of security.

2. A contract, which derives its value from the prices, or index of prices, of

underlying securities.

Derivatives is derived from the following products:

A. Shares

B. Debuntures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

DEFINATIONS

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According to JOHN C. HUL “ A derivatives can be defined as a financial instrument

whose value depends on (or derives from) the values of other, more basic underlying

variables.”

According to ROBERT L. MCDONALD “A derivative is simply a financial instrument

(or even more simply an agreement between two people) which has a value determined

by the price of something else.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by the derivatives

markets. They are:

Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level.

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

them to those who have an appetite for them.

Derivative trading acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

TYPES OF DERIVATIVES:

The most commonly used derivatives contracts are forwards, futures and

options which we shall discuss in detail later. Here we take a brief look at various

derivatives contracts that have come to be used.

Forwards:

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

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

Futures :

21

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

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

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

contracts

Options :

Options are of two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given

quantity of the underlying asset at a given price on or before a given date.

Warrants :

Options generally have lives of up to one year; the majority of options traded on

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

are called warrants and are generally traded over-the-counter.

Leaps :

The acronym LEAPS means Long-Term Equity Anticipation Securities. These are

options having a maturity of up to three years.

Baskets :

Basket options are options on portfolios of underlying assets. The underlying

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

basket options.

Swaps :

Swaps are private agreements between two parties to exchange cash flows in the

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

contracts. The two commonly used swaps are

Interest rate swaps:

These entail swapping only the interest related cash flows between the

Parties in the same currency.

Currency swaps:

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These entail swapping both principal and interest between the parties, with

the cash flows in one direction being in a different currency than those in the opposite

Direction.

Swaptions:

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

expiry of the options. Thus a Swaptions is an option on a forward swap.

PARTICIPANTS IN THE DERIVATIVES MARKET:

The following three broad categories of participants in the derivatives market.

HEDGERS:

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

markets to reduce or eliminate this risk.

SPECULATORS:

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

options contracts can give them an extra leverage; that is, they can increase both the

potential gains and potential losses in a speculative venture.

ARBITRAGEURS:

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

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

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

profit.

ANY EXCHANGE FULFILLING THE DERIVATIVE SEGMENT AT NATIONAL STOCK

EXCHANGE:

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The derivatives segment on the exchange commenced with S&P CNX Nifty Index

futures on June 12, 2000. The F&O segment of NSE provides trading facilities for the

following derivative segment:

1. Index Based Futures

2. Index Based Options

3. Individual Stock Options

4. Individual Stock Futures

REGULATORY FRAMEWORK:

The trading of derivatives is governed by the provisions contained in the SC (R) A,

the SEBI Act and the regulations framed there under the rules and byelaws of stock

exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of Dr.L.C.Gupta develop

the appropriate regulatory framework for derivative 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 Stock Index Futures. SEBI also approved he “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 govern the trading in the 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 the Act.

1. Eligibility criteria as prescribed in the L.C. Gupta committee report may apply to

SEBI for grant of recognition under Section 4 of the SC ( R ) A, 1956 to start

Derivatives Trading. 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

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exchange shall regulate the sales practices of its members and will obtain 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 the derivative segment. The members of the derivative

segment need to fulfill the eligibility conditions as lay down by the L.C.Gupta

Committee.

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

approved Clearing Corporation / Clearing house. Clearing Corporation /

Clearing House complying with the eligibility conditions as lay down

By the committee have to apply to SEBI for grant of approval.

5. Derivatives broker/dealers and Clearing members are required to seek

registration from SEBI.

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

also submit details of the futures contract they purpose to introduce.

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

person who have passed a certification programmed approved by SE

INTRODUCTION TO FUTURE MARKET:

Futures markets were designed to solve the problems that exit in forward

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

a certain time in the future at a certain price. There is a multilateral contract between the

buyer and seller for a underlying asset which may be financial instrument or physical

25

commodities. But unlike forward contracts the future contracts are standardized and

exchange traded.

PURPOSE:

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

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

contracts are affected mainly by the prices of the underlying asset. As it is a future

contract the buyer and seller has to pay the margin to trade in the futures market.

It is essential that both the parties compulsorily discharge their respective

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

market basis to avoid

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

starts

with a fresh opening value. Here both the parties face an equal amount of risk and are also

required to pay upfront margins to the exchange irrespective of whether they are buyers

or

sellers. Index based financial futures are settled in cash unlike futures on individual stocks

which

are very rare and yet to be launched even in the US. Most of the financial futures

worldwide are

index based and hence the buyer never comes to know who the seller is, both due to the

presence

of the clearing corporation of the stock exchange in between and also due to secrecy

reasons

EXAMPLE:

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

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

is

26

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

has

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

size of

Infosys is 300 shares.

Suppose the stock rises to 2200.

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

profit for

the buyer is 500.

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

Suppose the stock falls to Rs.1400

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

seller is

250.

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

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

will be at some date in the future. Futures are often used by mutual funds and large

institutions to hedge their positions when the markets are rocky. Also, Futures contracts

offer a high degree of leverage, or the ability to control a sizable amount of an asset for a

cash outlay, which is distantly small in proportion to the total value of contract.

DEFINITION

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. To facilitate liquidity in the futures contract,

the exchange specifies certain standard features of the contract. The standardized items

on a futures contract are:

Quantity of the underlying

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Quality of the underlying

The date and the month of delivery

The units of price quotations and minimum price change

Locations of settlement

Types of futures:

On the basis of the underlying asset they derive, the futures are divided into two

types:

Stock futures:

The stock futures are the futures that have the underlying asset as the individual

securities. The settlement of the stock futures is of cash settlement and the settlement

price of the future is the closing price of the underlying security.

Index futures:

Index futures are the futures, which have the underlying asset as an Index. The

Index futures are also cash settled. The settlement price of the Index futures shall be the

closing value of the underlying index on the expiry date of the contract.

STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures, which have

been used to hedge or manage the systematic risk by the investors of Stock Market. They

are called hedgers who own portfolio of securities and are exposed to the systematic risk.

Stock Index is the apt hedging asset since the rise or fall due to systematic risk is

accurately shown in the Stock Index. Stock index futures contract is an agreement to buy

or sell a specified amount of an underlying stock index traded on a regulated futures

exchange for a specified price for settlement at a specified time future.

Stock index futures will require lower capital adequacy and margin

requirements as compared to margins on carry forward of individual scrips. The

brokerage costs on index futures will be much lower.

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Savings in cost is possible through reduced bid-ask spreads where stocks are

traded in packaged forms. The impact cost will be much lower in case of stock index

futures as opposed to dealing in individual scrips. The market is conditioned to think in

terms of the index and therefore would prefer to trade in stock index futures. Further, the

chances of manipulation are much lesser.

The Stock index futures are expected to be extremely liquid given the

speculative nature of our markets and the overwhelming retail participation expected to

be fairly high. In the near future, stock index futures will definitely see incredible volumes

in India. It will be a blockbuster product and is pitched to become the most liquid contract

in the world in terms of number of contracts traded if not in terms of notional value. The

advantage to the equity or cash market is in the fact that they would become less volatile

as most of the speculative activity would shift to stock index futures. The stock index

futures market should ideally have more depth, volumes and act as a stabilizing factor for

the cash market. However, it is too early to base any conclusions on the volume or to form

any firm trend.

The difference between stock index futures and most other financial

futures contracts is that settlement is made at the value of the index at maturity of the

contract.

Futures terminology :-

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

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

market.

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

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

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contract 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.

d) 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.

e) Contract size : The amount of asset that has to be delivered under one contract.

For instance, the contract size on NSE’s futures market is 200 Nifties.

f) 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.

g) 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 income

earned on the asset.

h) Margin: Margin is money deposited by the buyer and the seller to ensure the

integrity of the contract. Normally the margin requirement has been designed on

the concept of VAR at 99% levels. Based on the value at risk of the stock/index

margins are calculated. In general margin ranges between 10-50% of the contract

value.

i) 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. Both buyer

and seller are required to make security deposits that are intended to guarantee

that they will infact be able to fulfill their obligation. These deposits are Initial

margins and they are often referred as performance margins. The amount of

margin is roughly 5% to 15% of total purchase price of futures contract

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

margin account is 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. 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.

PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller. The buyer of

the futures contract is one who is LONG on the futures contract and the seller of the

futures contract is one who is SHORT on the futures contract.

The pay off for the buyer and the seller of the futures contract are as follows.

Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. Futures contracts have linear payoffs. In

simple words, it means that the losses as well as profits, for the buyer and the seller of

futures contracts, are unlimited.

PAYOFF FOR A BUYER OF FUTURES:

The pay offs for a person who buys a futures contract is similar to the pay off for a

person who holds an asset. He has potentially unlimited upside as well as downside.

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LOSS

PROFIT

F

L

P

E1E2

Take the case of a speculator who buys a two-month Nifty index futures contract

when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio.

When the index moves up, the long futures position starts making profits and when

the index moves down it starts making losses

CASE 1:

The buyer bought the future contract at (F); if the futures price goes to E1

then the buyer gets the profit of (FP).

CASE 2:

The buyer gets loss when the future price goes less than (F), if the futures price

goes to E2 then the buyer gets the loss of (FL).

PAYOFF FOR A SELLER OF FUTURES:

The pay offs for a person who sells a futures contract is similar to the pay off

for a person who shorts an asset. He has potentially unlimited upside as well as

downside.

Take the case of a speculator who sells a two-month Nifty index futures contract

when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio.

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F

LOSS

PROFIT

E1

P

E2

L

When the index moves down, the short futures position starts making profits and

when the index moves up it starts making losses.

F – FUTURES PRICE

E1, E2 – SETTLEMENT PRICE.

CASE 1:

The Seller sold the future contract at (f); if the futures price goes to E1 then the

Seller gets the profit of (FP).

CASE 2:

The Seller gets loss when the future price goes greater than (F), if the futures price

goes to E2 then the Seller gets the loss of (FL).

Pricing the Futures:

The fair value of the futures contract is derived from a model known as the Cost of

Carry model. This model gives the fair value of the futures contract.

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Cost of Carry Model:

F=S (1+r-q) t

Where

F – Futures Price S – Spot price of the Underlying r – Cost of Financing q – Expected Dividend Yield T – Holding Period.

INTRODUCTION TO OPTIONS:

It is a interesting tool for small retail investors. An option is a contract, which

gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity

of the underlying

assets, at a specific (strike) price on or before a specified time (expiration date). The

underlying

may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments

like

equity stocks/ stock index/ bonds etc.

Option Terminology:-

a) Index options: These options have the index as the underlying. Some options are

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

index options

ii. contracts are also cash settled.

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

i. trade on over 500 stocks in the United States. A contract gives the

holder the right to 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 option

i. premium buys the right but not the obligation to exercise his option

on the

ii. seller/writer.

d) Writer of an option: The writer of a call/put option is the one who receives the

i. option premium and is thereby obliged to sell/buy the asset if the

buyer exercises on

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ii. him. There are two basic types of options, call options and put

options.

e) 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.

f) 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.

g) Option price: Option price is the price which the option buyer pays to the option

seller.

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

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

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

price

or the exercise price.

j) American options: American options are options that can be exercised at any time

Up to the expiration date. Most exchange-traded options are

American.

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

the

expiration date itself. European options are easier to analyze than

American options, and properties of an American option are

frequently deduced from those of its European counterpart.

l) 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.

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

lead

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to zero cashflow if it were exercised immediately. An option on the index is at-themoney

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

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

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

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

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

strike price, the 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.

o) 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.

Putting it another way, the intrinsic value of a call is N.P which means the intrinsic

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

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

(K - St ). K is the strike price and St is the spot price.

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

between its premium and its intrinsic value. A call that is OTM or ATM has only time value.

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

expiration, the greater is a call’s time value, all else equal. At expiration, a call

should have no time value.

TYPES OF OPTION:

CALL OPTION

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

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

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

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

buyer pays a premium to the writer (seller) of the contract.

Illustration

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

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

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

1) Call buyer

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

option will be excerised once the price went above 600. The premium paid by the buyer is

Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price +

premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer

will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at

Rs.660.

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

Limited loss for the buyer up to the premium paid.

2) Call seller:

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

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

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

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

Rs.30

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

has the

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

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

avoid the unlimited losses and have limited losses to the certain extent

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Thus call option indicates two positions as follows:

LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long

position by buying call option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short

position by selling call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell

specified quantity of the underlying asset at the strike price on or before a expiry date.

The seller of the put option (one who is short Put) however, has the obligation to buy the

underlying asset at the strike price if the buyer decides to exercise his option to sell.

Illustration

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

bearish in the

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

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

1) Put buyer(dinesh)

Here the Dinesh has purchase the put option with a strike price of Rs.800.The

option will be excerised once the price went below 800. The premium paid by the buyer is

Rs.20.The buyer’s breakeven point is Rs.780(Strike price – Premium paid). The buyer will

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

Rs.700 the option will be

exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell

to the

seller at Rs.800

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

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

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2) put seller(Amit):

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

buyer of the Put option will choose not to exercise his option to sell as he can sell in the

market at a higher rate.

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

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

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

Thus Put option also indicates two positions as follows:

LONG POSITION

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

by buying Put option.

SHORT POSITION

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

by selling Put option

FACTORS AFFECTING OPTION PREMIUM:

Price of the underlying asset: (s)

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

option. These price changes have opposite effects on calls and puts. For instance, as the

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

a put will decrease. A decrease in the price of the underlying asset’s value will generally

have the opposite effect

Strike price: (k)

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

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

decreases as the option becomes more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an option’s time value, for puts and calls,

decreases.

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Volatility:

Volatility is simply a measure of risk (uncertainty), or variability of an option’s

underlying. Higher volatility estimates reflect greater expected fluctuations (in either

direction) in underlying price levels. This expectation generally results in higher option

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

Interest rate: (R1)

This effect reflects the “COST OF CARRY” – the interest that might be paid for

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

an option buyer for the premium paid. Higher the interest rate, higher is the premium of

the option as the cost of carry increases.

FUTURES V/S OPTIONS:

Right or obligation :

Futures are agreements/contracts to buy or sell specified quantity of the underlying

assets at a

price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and

seller

are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the right

& not the obligation, to buy or sell the underlying asset.

Risk:

Futures Contracts have symmetric risk profile for both the buyer as well as the seller.

While options have asymmetric risk profile. In case of Options, for a buyer (or holder of

the

option), the downside is limited to the premium (option price) he has paid while the

profits may

be unlimited. For a seller or writer of an option, however, the downside is unlimited while

profits

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are limited to the premium he has received from the buyer.

Prices:

The Futures contracts prices are affected mainly by the prices of the underlying asset.

While the prices of options are however, affected by prices of the underlying asset, time

remaining for expiry of the contract & volatility of the underlying asset

Cost:

It costs nothing to enter into a futures contract whereas there is a cost of entering into

an options contract, termed as Premium.

Strike price:

In the Futures contract the strike price moves while in the option contract the strike

price

remains constant .

Liquidity:

As Futures contract are more popular as compared to options. Also the premium

charged is high in the options. So there is a limited Liquidity in the options as compared to

Futures. There is no dedicated trading and investors in the options contract.

Price behavior:

The trading in future contract is one-dimensional as the price of future depends upon

the price of the underlying only. While trading in option is two-dimensional as the price of

the option

depends upon the price and volatility of the underlying.

Pay off:

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As options contract are less active as compared to futures which results into non linear

pay off.

While futures are more active has linear pay off .

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