INTRODUCTION

Derivatives are instruments derived from the securities or physical markets. They include futures, options, warrants and convertible bonds. While shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares as they are assets). Due to their great flexibility, derivatives allow the investor the full range of investment strategy: speculation, hedging and arbitrage. Derivatives also offer the sophisticated management of risk. Derivatives allow for gearing (or leverage). Gearing is the ability of derivatives to soar 100 per cent in a few days, when the underlying security has only risen by a far smaller amount (say 10 per cent). This is possible because derivatives are contracts and not the assets themselves. One money-making strategy using derivatives revolves around looking for reasonably profitable price differentials in the cash and futures prices of stocks. Once the investor finds such a situation they can buy a company's shares and simultaneously sell its futures and pocket the spread.

OBJECTIVES OF THE STUDY To understand the regulatory frame work of financial derivatives To know the implications of options and futures To suggest the investors about risk and returns in derivatives trading

In order to find the ways and means to improve the investments in options and futures

Research Methodology
The type of research adopted is descriptive in nature and the data collected for this study is the secondary data.

Secondary method :
The secondary data collection method includes: The data collected from companys financial records. The data collected from the magazines of the NSE, economic times, etc. Various books relating to the investments, capital market and other related topics.

SCOPE OF THE STUDY

The study is confined to Indian financial system in general and 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.

LIMITATIONS OF THE STUDY

The study was conducted in Hyderabad only.

As the time was limited, study was confined to conceptual understanding of Derivatives market in India.

History of stock exchanges

The origin of the Stock Exchanges in India can be traced back to the later half of 19th Century. After the American Civil War (1860-61) due to the share mania of the public, the number of brokers dealing in shares increased. The brokers organized as informal association in Mumbai named The Native Stock and Share Brokers Association in 1875. Increased activity in trade and commerce during the First World War and Second World War resulted in an increase in the stock trading. The growth of Stock Exchanges suffered a set back after the end of World War. World Wide depression affected them. Most of the Stock Exchange in the early stages had a speculative nature of working without technical strength. After independence, Government took keen interest to regulate the speculative nature of stock exchange working. In that direction, Securities and Contract Regulation Act,1956. Was passed. This gave powers to Central Government to regulate the Stock Exchanges. Further to develop secondary market in the country, Stock exchanges were established in different centers like Chennai, Delhi, Nagpur, Kanpur, Hyderabad and Bangalore. The SCR Act recognized the stock exchanges in Mumbai, Chennai, Delhi, Hyderabad, Ahmedabad and Indore. The Ban- galore stock exchange was recognized in 1963.At present there are 23

stock exchanges.

Till recent past, floor trading took place in all the stock exchanges, in the floor trading systems; the trade takes place through open system during the official trading hours. Trading posts are assigned for different securities where buying and selling activities of securities took place. The deals were also not transparent and the system favored the brokers rather than the investors. The setting up of National Stock Exchange (NSE) and OTCEI (Over The Counter Exchange of India) with screen based trading facility resulted in more and more Stock exchanges turning towards the computers based trading. Bombay Stock Exchange (BSE) introduced the screen based trading system in 1995, which is known as BOLT (Bombay On-line Trading System) Madras Stock exchange introduced Automated Network Trading System (MANTRA) On October 7th 1996. Apart from Bombay Stock Exchange (BSE), Vodadara, Delhi, Pune, Ban galore, Kolkata and Ahmedabad Stock Exchanges have introduced screen based trading. Other exchanges are also planning to shift to the screen based trading. DEFINATION OF STOCK EXCHANGE: Stock exchange means any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. It is an association of member brokers for the purpose of self-regulation and protecting the interests of its members. It can operate only, if it is recognized by the Government under the

securities contracts (regulation) Act,1956. The recognition is granted under section 3 of the act by the central government, Ministry of Finance.

NEED FOR STOCK EXCHANGE: As the business and industry expanded and economy became more complex in nature, a need for permanent finance arose. Entrepreneurs require money for long-term needs, where as investors demand liquidity. The solution to this problem gave way for the origin of Stock Exchange, which is a ready market for investment and liquidity. FUNCTIONS OF STOCK EXCHANGE: Maintains Active Trading: Shares are traded on the Stock exchanges, enabling the investors to buy and sell securities. The prices may vary from transaction to transaction. A continuous trading increases the liquidity or marketability of the shares traded on the stock exchanges. Fixations of Prices: Prices are determined by the transactions that flow from investors demand and the supplies preferences. Usually the traded prices are named known to the public. This helps the investors to make better decisions. Ensures safe and fair dealings: The rules, regulations and byelaws of the stock exchanges provide a measure of safety to the investors to get a fair deal.

Aids in financing the industry: A continuous market for shares provided a favorable climate for raising capital. The negotiability and transferability of the securities help the companies to raise long-term funds. As it is easy to trade the securities, investors are willing to subscribe the Initial Public Offerings (IPO). This stimulates the capital formation. Dissemination of Information: Stock Exchange provide information through their various publications. They publish the share prices traded on their basis along with the volume traded. Directory of Corporate information is useful for the investors assessment regarding the corporate. Handouts, Handbooks and Pamphlets provide information regarding the functioning of the stock exchanges. Performance inducers: The prices of stocks reflect the performance of the traded companies. This makes the corporate more concerned with its public image and tries to maintain good performance. Self-regulating organizations: The Stock exchanges monitor the integrity of the members, brokers, listed companies and clients. Continuous internal audit safeguards the investors against unfair trade practices. It settles the disputes between member broker, investors and brokers. Instruments traded in the Stock Exchange: The securities in which individual investors are allowed to trade in the exchange are as follows: 2. Equity Shares: Equity shares represents ownership capital and its owners share the risk and reward associated with ownership of corporate enterprises. The prices of these shares vary widely,

depending on the Net earning and dividend policies the company. 3. Preference shares: These are also ownership capital. But, with a fixed dividend. Now-a-days preference share are not popular and have no public interest, only finance interests hold them. 4. Convertible & Partly Convertible Debentures: The Debentures are popular only if they are convertible into equity shares after a period. Non-convertible debentures carry a fixed rate of interest. But as there is no ceiling on such interest rates, they have also become attractive to the investors. They have to choose only good companies with a good credit rating so that there would be no problem in getting their interest warrants and principal back. Convertible debentures are now popular both with companies and investors as they have advantages of both debentures and equity. 5. Government Securities: The securities issued by the Central and State Government, Semi-Government bodies are also listed and quoted on the stock exchanges as per the rules. The broker members are eligible to deal in them also. In fact some members are specialized in Government securities market, but public are not in general interested in these securities, as they are less attractive. Only banks, financial institutions, insurance companies etc., deal in Government securities market. But for individual investors, corporate securities are relevant as they have higher rate of interests and higher returns due to capital appreciation and dividends.

REGULATORY FRAME WORK: The securities Contract Regulation Act,1956 and securities and

Exchange Board of India (SEBI) Act, 1992. Provided a comprehensive

legal frame work. A 3-tier regulatory structure comprising the Ministry of Finance, SEBI and the Governing Boards of the exchanges regulates the functioning of the stock exchanges. Ministry of Finance: The stock exchange division of the ministry of finance has powers related to the application of the provision of the SCR act and licensing of dealers in the other area. SAILording to SEBI Act, the Ministry of Finance has the appellate and the supervisory powers over the SEBI. It has powered to grant recognition to the stock exchanges and the regulation of their operations. Ministry of Finance has power to appointments of executive chiefs and the nominations of the public representatives in the Governing Boards of the Stock Exchanges. It has the responsibility of preventing undesirable speculation. The Securities Exchange Board of India Act, 1992[SEBI]: The Securities and Exchange Board of India even though established in the year 1988, received statutory powers only on 30th January 1992. Under the SEBI Act, a wide variety of powers are vested in the hands of SEBI. SEBI has the powers to regulate the business of stock exchanges, other security market and mutual fund organizations. Registration and regulation of market intermediaries are also carried out by SEBI. It has the responsibility to prohibit the fraudulent unfair trade practices and insider dealings. Takeovers are also monitored by the SEBI. Stock Exchanges have to submit periodic and annual returns to SEBI. SEBI has the multi-pronged duty to promote the healthy growth of the capital market and protect the investors. The Companies Act, 1956: It deals with issues, allotment and transfer of securities and various aspects relating to company management. It provides for standards of disclosure in public issues capital, particularly in the fields of company management and projects information about

other listed companies under the same management and management perception of risk factors. It also regulates underwriting the use of premium and discounts on issues, rights and bonus issues payments of interest and dividends, supply of annual report and other information. The depositories Act, 1956: The Depositories Act 1996 provides for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, SAILuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerializing the securities in the depository mode: and (c) providing for maintenance of ownership records in a book entry form. In order to stream line the settlement process the Act envisages transfer of ownership of securities electronically by book entry without making the securities of all public limited companies freely transferable, restricting the companies right to use discretion in effecting the transfer of securities, and the transfer deed and other procedural requirements under the Companies Act have dispensed with. The Governed Board: The Governing Board of the stock exchange consists of elected member directors, Government nominees and public representatives. Rules, Byelaws and regulations of the stock exchanges provide substantial powers to the executive director for maintaining efficient and smooth day-to-day functioning of stock exchange. The Government Board has the responsibility to maintain an orderly and well-regulated market. The Governing Board of the Stock Exchange consists of 13 members f which 6. Six members are elected by, the members of the Stock Exchange. 7. Central Government nominates not more than three members.

8. The board nominates three public representatives. 9. SEBI nominates persons not exceeding three and 10.The Stock Exchange appoints one Executive Director.

One third of the elected members retire at Annual General Meeting (AGM). The retired member can offer himself for election if he is not elected for two consecutive years. If a member serves in the governing body for two years consecutively, he should refrain offering himself for another two years. The members of the Governing body elect the President and VicePresident. It needs no approval from Central Government or the Board. The office tenure for the president and vice-president is one year. They can offer themselves for re-election, if they have not held for two consecutive years. In that case they can offer themselves for reelections after a gap of one-y

NATIONAL STOCK EXCHANGE

The National Stock Exchange (NSE) of India became operational in the capital market segment on 3rd November 1994 in Mumbai. The genesis of the NSE lies in the recommendations of the pertains committee 1991. Apart from the NSE, it had recommended for the establishment of national stock market system also. The committee pointed out some major defects in the Indian stock market. The Defects specified are

1. 2. 3. 4. 5. 6.

Lack of liquidity in most of the markets in terms of depth and Lack of ability to develop markets for debts. Lack of infrastructure facilities and outdated trading system. Lack of transparency in the operations that effect investors Outdated settlement systems that are inadequate to cater to the Lack of single market due to the inability of various stock

breadth.

confidence. growing volume, leading to delays. exchanges to function cohesively with legal structure and regulatory framework. These factors led to the establishment of the NSE.

OBJECTIVES: 1) 2) 3) 4) 5) market. PROMOTERS: To establish a nation wide trading facility for equities, debt To ensure equal SAILess to investors all over the country To provide a fair, efficient and transparent securities market To enable shorter settlement cycle and book entry

instruments and hybrids. through appropriate communication network. to investors using an electronic communication network. settlement system. To meet current international standards of securities

Industrial Development Bank of India (IDBI) Industrial Credit and Investment Corporation of India (ICICI) Industrial Financing Corporation of India (IFCI) Life Insurance Corporation of India (LIC) State Bank of India (SBI) General Insurance Corporation (GIC) Bank of Baroda Canara Bank Corporation Bank Indian Bank Oriental Bank of Commerce Union Bank of India Punjab National Bank Infrastructure Leasing and Financial Services Stock Holding Corporation of India SBI capital market

MEMBERSHIP: The membership is based on the factors as capital adequacy, corporate structure, Track record, Education, Experience etc. Admission is a twostage process with applicants required to go through a written examination followed by an interview. A committee consisting of

experienced professionals from the industry, to assess the applicants capability to operate as an exchange member. The exchange admits members separately to wholesale debt Market (WDM) segment and the Capital market segment. Only corporate members are admitted to the debt market Segment whereas individuals and firms are also eligible to the capital market segment. Eligibility criteria for trading membership on the segment of WCM are as follows: 11.The person eligible to become trading members are bodies corporate, companies, institutions including subsidiaries of banks engaged in financial services and such other persons or entities are may be permitted from time to time by RBI\SEBI. 12.The whole-time Directors should possess at least two years experience in any activity related to banking or financial services. 13.The applicant must be engaged solely in the business of the securities and must not be engaged in any fund-based activities. 14.The applicant must posses a minimum of Rs.2crores

Eligibility criteria for the capital market segment are: 1. 2. Individual, registered firms, corporate bodies, companies and The applicant may be engaged in the business of securities and

such other persons may be permitted under the SCR Act, 1957.

must not be engaged in any fund-based activities. 3. follows: v v v 4. Individuals and registered firms-Rs.75Lakhs. Corporate bodies-Rs100Lakhs In case of partnership firm each partner should The minimum net worth requirements prescribed are as

contribute at least 5% of the net worth of the firm. A corporate trading member should consist only of individuals (maximum of 4) who should directly hold at least 40% of the paid-up capital in case of listed companies and at least 51% in case of these companies. 5. years The minimum prescribed qualification of graduation and two experience of handling securities as broker, Sub-broker,

authorized assistant etc., must be fulfilled by Minimum two directors in case the applicant are a corporate Minimum two partners in case of partnership firms

In case of individual or sole proprietary concerns. The two experienced directors in a corporate applicant or trading member should hold minimum 5% of the capital of the company.

NSE-NIFTY The national Stock Exchange on April 22, 1996 launched a new Equity Index. The NSE-50. The new Index which replaces the existing NSE-100 Index is expected to serve as an appropriate Index for the new segment of futures and options. Nifty means National Index for Fifty Stock. The NSE-50 comprises 50 companies that represent 20 broad Industry groups with an aggregate market capitalization of around Rs.170000crores. All companies included in the index have a market capitalization in excess of Rs.500crores each and should have traded for 85% of trading days at an impact cost of less than 1.5%. The base period for the index is the close of prices on Nov 3,1995 which makes one year of completion of operation of NSEs capital market segment. The base value of the Index has been set at 1000.

BOMBAY STOCK EXCHANGE The Stock Exchange, Mumbai, Popularly as Bombay Stock Exchange (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 year into its present status as the premier Stock Exchange in the country. It may be noted that the Bombay Stock Exchange is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was founded in 1878. The Bombay Stock Exchange, while providing an efficient and

transparent market for the trading in securities, upholds the interests of the investors and ensures redressal of their grievances, whether against the companies or its own member-brokers. It also strives to educate and enlighten the investors by making available necessary informative inputs and conducting investor education programs. A Government Board comprising of 9 elected Directors (one third of them retire every year by rotation), Two SEBI Nominees, Seven Public representatives and an Executive Director is the Apex Body, which decides the policies and regulates the affairs of the Bombay Stock Exchange. The executive Director as the Chief Executive Officer is responsible for the day-to-day administration of the Bombay Stock exchange. SECURITIES TRADED: The securities traded in the BSE are classified in to three groups namely specified shares of A group and non-specified securities. The latter is sub-divided into B1 and B groups. A group contains the companies with large outstanding shares, good track record and large volumes of

business in the secondary market. Settlements of all the shares are carried out through the Clearing House.

Number of Market Year Listed Companies 1994-95 4702 1995-96 5602 1996-97 5832 1997-98 5853 2000-03 6000

Annual

Average Daily Turnover (Rs. In Billion) 1.8 2.2 5.2 8.5 11.5

Capitalizatio Turnover n (In Crores) (In Crores) 7355 677 5365 501 4639 1243 5630 2706 5479 2449

In order to enable the market participants, analysts etc., to track the various ups and downs in the Indian Stock Market, the Exchange has 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 components. The base year of SENSEX is 1978-79. 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 the index reflects the total market value of all 30component stocks from different industries related to particular base period. The total market 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 and number of shares) a 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 based on indexed values than one based on

actual values. In practice, the daily calculation of SENSEX is done by dividing the aggregate market of the 30 Companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original based period value of the SENSEX. The divisor keeps the index comparable over a period of time and if the reference point for the entire Index maintenance adjustments. SENSEX is widely used to describe the mood in the Indian Stock Markets.

Base year average is changed as per the formula:

New Base Year Average = Old Base Year Average * (New Market Value/Old Market Value) RECENT DEVELOPMENTS IN INDIAN STOCK MARKET Many steps have been taken in recent years to reform the Stock Market such as: Regulation of Intermediaries. Changes in the Management Structure. Insistence on Quality Securities. Prohibition of Insider Trading. Transparency of SAILounting Processes. Strict supervision of Stock Market Operations. Prevention of Price Rigging. Encouragement of Market Making. Discouragement of Price Manipulations.

Introduction of Electronic Trading. Introducing of Depository System. Derivates Trading.

International Listing. STOCK EXCHANGES IN INDIA S.NO 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 NAME OF THE STOCK EXCHANGE Bombay Stock Exchange. Hyderabad Stock Exchange. Ahmedabad Share & Stock Brokers Association. Calcutta Stock Exchange Association Limited Delhi Stock Exchange Association Limited Madras Stock Exchange Association Limited Indoor Stock Brokers Association. Ban galore Stock Exchange. Cochin Stock Exchange. Pune Stock Exchange Limited U.P Stock Exchange Association Limited Ludhiana Stock Exchange Association Limited Jaipur Stock Exchange Limited Gauhati Stock Exchange Limited Mangalore Stock Exchange Limited. Maghad Stock Exchange Limited, Patna. Bhuvaneshwar Stock Exchange Limited Over the Counter Exchange of India, Bombay Saurasthra Kutch Stock Exchange Limited Vadodara Stock Exchange Limited Coimbatore Stock Exchange Limited Meerut Stock Exchange Limited National Stock Exchange Limited Integrated Stock Exchange YEAR 1875 1943 1957 1957 1957 1957 1958 1963 1978 1982 1982 1983 1984 1984 1985 1986 1989 1989 1990 1991 1991 1991 1992 1999

STOCK EXCHANGES IN WORLD S.NO 1. 2. 3. 4. 5. 6. COUNTRY Russia Argentina Thailand Pakistan Indonesia US INDEX Moscow Times Mer Val SET Karachi 100 Jak Comp NASDAQ

7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

Czech Republic Mexico Brazil Japan Malaysia China Singapore South Korea Spain US India US Germany Hong Kong Canada India UK Australia France

PX50 IPC Bovespa Nikkei 225 KISE Comp Shanghai Comp Straits Times Seoul Comp Madrid General S & P 500 SENSEX Dow Jones Dax Hang Seng S & P TSX Composite NIFTY FTSE 100 All Ordinaries CAC 40

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A. and

E-Broking: It refers to Electronic Broking of Equities, Derivatives Commodities under the brand name of 5paisa

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India Infoline Ltd. Research and Online Media Property India Infoline Securities Pvt. Ltd. Secondary market securities trading and

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SAILountant, (All India Rank 2); Cost SAILount, (All India Rank l) and has a post-graduate management degree from IIM Ahmedabad. He had a successful career with Hindustan Lever, where he inter alia handled Commodities trading and export business. Later he was CEO of an equity research organization. R. Venkataraman, Director, is armed with a post- graduate management degree from IIM Bangalore, and an Electronics Engineering degree from IIT, Kharagpur. He spent eight fruitful years in equity research sales and private equity with the cream of financial houses such as ICICI group,

Barclays de Zoette and G.E. Capital The non-executive directors on the board bring a wealth of experience and expertise. Satpal khattar -Reeshanar investments, SingaporeThe key management team comprises seasoned and qualified professionals.

Mukesh SingLtd. Seshadri BharathanDistribution Co Ltd S SriramSandeepa Vig Arora- Vice Services Dharmesh PandyaChannel Toral MunshiAnil MascarenhasPinkesh Soni Harshad Apte

Director, India Infoline Securities Pvt Director, India Infoline. Com

Vice President, Technology President, Vice Portfolio President, Management Alternate

Vice President, Research Chief Editor Financial controller Chief Marketing Officer

DERIVATIVES
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 of derivatives of 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 underlying prices. However, by locking in asset prices, derivatives products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of riskaverse investors. DEFINITION Understanding the word itself, Derivatives is a key to mastery of the topic. The word originates in mathematics and refers to a variable, which has been derived from another variable. For example, a measure of weight in pound could be derived from a measure of weight in kilograms by multiplying by two. In financial sense, these are contracts that derive their value from some underlying asset. Without the underlying product and market it would have no independent existence. Underlying asset can a Stock, Bond, Currency, Index or a Commodity. Some one may take an interest in the derivative products. Without having an interest in the underlying product market, but the two are always related and may therefore interact with each other. The term Derivative has been defined in Securities Contracts

(Regulation) Act 1956, as: A. A security derived from a debt instrument, share, loan

whether secure or unsecured, risk instrument or contract for differences or any other form of security. B. A contract, which derives its value from the prices, or

index of prices, of underlying securities.

IMPORTANCE OF DERIVATIVES Derivatives are becoming increasingly important in world markets as a tool for risk management. Derivatives instruments can be used to minimize risk. Derivatives are used to separate risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. More over, derivatives would not create any risk. They simply manipulate the risks and transfer to those who are willing to bear these risks. For example, Mr. A owns a bike. If does not take insurance, he runs a big risk. Suppose he buys insurance [a derivative instrument on the bike] he reduces his risk. Thus, having an insurance policy reduces the risk of owing a bike. Similarly, hedging through derivatives reduces the risk of owing a specified asset, which may be a share, currency, etc.

RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVES Holding portfolio of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser

than what he expected to get. There are various influences, which affect the returns. 1. 2. Price or dividend (interest). Sum are internal to the firm bike: Industry policy Management capabilities Consumers preference Labour strike, etc.

v v v v

These forces are to a large extent controllable and are termed as Nonsystematic Risks. An investor can easily manage such non- systematic risks by having a well-diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other. There are other types of influences, which are external to the firm, cannot be controlled, and they are termed as systematic risks. Those are 24.Econonmic 25.Political 26.Sociological changes are sources of Systematic Risk. For instance inflation interest rate etc. Their effect is to cause the prices of nearly all individual stocks to move together in the same manner. We therefore quite often find stock prices falling from time to time in spite of companys earnings rising and vice versa. Rational behind the development of derivatives market is to manage

this systematic risk, liquidity. Liquidity means, being able to buy & sell relatively large amounts quickly without substantial price concessions. In debt market, a much larger portion of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small size relative to many common stocks. These factors favor for the purpose of both portfolio hedging and speculation. India has vibrant securities market with strong retail participation that has evolved over the years. It was until recently a cash market with facility to carry forward positions in actively traded A group scrips from one settlement to another by paying the required margins and barrowing money and securities in a separate carry forward sessions held for this purpose. However, a need was felt to introduce financial products like other financial markets in the world. CHARACTERISTICS OF DERIVATIVES 27.Their value is derived from an underlying instrument such as stock index, currency, etc. 28.They are vehicles for transferring risk. 29.They are leveraged instruments.

MAJOR PLAYERS IN DERIVATIVE MARKET There are three major players in their derivatives trading. 30.Hedgers. 31.Speculators.

32.Arbitrageurs. Hedgers: The party, which manages the risk, is known as Hedger. Hedgers seek to protect themselves against price changes in a commodity in which they have an interest. Speculators: They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be making money even with out putting their own money in, and such opportunities often come up in the market but last for very short time frames. They are specialized in making purchases and sales in different markets at the same time and profits by the difference in prices between the two centers.

TYPES OF DERIVATIVES Most commonly used derivative contracts are: Forwards: A forward contract is a customized contract between two entities where settlement takes place on a specific date in the futures at todays pre-agreed price. Forward contracts offer tremendous flexibility to the partys to design the contract in terms of the price, quantity, quality, delivery, time and place. Liquidity and default risk are very high. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense, that the former are standardized exchange traded contracts.

Options: Options are 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: Longer dated options are called warrants and are generally traded over the counter. Options generally have lives up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. 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 pre-arranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rare swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both the principal and interest between the parties, with the cash flows in one direction being in a different currency than those in opposite direction.

RISKS INVOLVED IN DERIVATIVES Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in derivative business includes A. Credit Risk: This is the risk of failure of a counterpart to perform

its obligation as per the contract. Also known as default or counterpart risk, it differs with different instruments. B. C. Market Risk: Market risk is a risk of financial loss as result of Liquidity Risk: The inability of a firm to arrange a transaction at

adverse movements of prices of the underlying asset/instrument. prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks: v v derivatives. D. Legal Risk: Derivatives cut across judicial boundaries, therefore Related to liquidity of separate products. Related to the funding of activities of the firm including

the legal aspects associated with the deal should be looked into carefully.

DERIVATIVES IN INDIA Indian capital markets hope derivatives will boost the nations economic prospects. Fifty years ago, around the time India became independent men in mumbai gambled on the price of cotton in New York. They bet on the last one or two digits of the closing price on the New York cotton exchange. If they guessed the last number, they got Rs.7/- for every Rupee layout. If they matched the last two digits they got Rs.72/Gamblers preferred using the New York cotton price because the cotton market at home was less liquid and could easily be manipulated. Now, India is about to acquire own market for risk. The country, emerging from a long history of stock market and foreign exchange controls, is one of the last major economies in Asia, to refashion its capital market to attract western investment. A hybrid over the counter derivatives market is expected to develop along side. Over the last couple of years the National Stock Exchange has pushed derivatives trading, by using fully automated screen based exchange, which was established by India's leading institutional investors in 1994 in the wake of numerous financial & stock market scandals. Derivatives Segments In NSE & BSE On June 9, 2000 BSE and NSE became the first exchanges in India to introduce trading in exchange traded derivative products, with the launch index Futures on sensex and nifty futures respectively. Index

Options was launched in june2001, stock options in July 2001, and stock futures in November 2001. NIFTY is the underlying asset of the index futures at the futures and options segment of NSE with a market lot of 50 and BSE 30 sensex is the underlying stock index in BSE with a market lot of 30. Contract Periods: At any point of time there will be always be available nearly 3months contract periods. For example in the month of Jan 2011 one can enter into their June futures contract or July futures contract or august futures contract. The last Thursday of the month specified in the contract shall be the final settlement date for the contract at both NSE as well as BSE. The Jan 27, Feb 24 and Mar 31 shall be the last trading day or the final settlement date for Jan futures contract, Feb futures contract and March futures contract respectively, When futures contract gets expired, a new futures contract will get introduced automatically. For instance on Jan 29, Jan futures contract becomes invalidated and a April futures contract gets activated. Settlement: The settlement of all derivative contracts is in cash mode. There is daily as well as final settlement. Out standing positions of a contract can remain open till the last Thursday of that month. As long as the position is open, the same will be marked to market at the daily settlement price, the difference will be credited or debited accordingly and the position shall be brought forward to the next day at the daily settlement price. Any position which remains open at the end of the final settlement day (i.e. last Thursday) shall closed out by the exchanged at the final settlement price which will be the closing spot value of the underlying asset.

Margins: There are two types of margins collected on the open position, viz., initial margin which is collected upfront and mark to market margin, which is to be paid on next day. As per SEBI guidelines it is mandatory for clients to give margins, fail in which the outstanding positions or required to be closed out. Members of F&O segment: There are three types of members in the futures and options segment. They are trading members, trading cum clearing member and professional clearing members. Trading members are the members of the derivatives segment and carrying on the transactions on the respective exchange. The clearing members are the members of the clearing corporation who deal with payments of margin as well as final settlements. The professional clearing member is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members. It is mandatory for every member of the derivatives segment to have approved users who passed SEBI approved derivatives certification test, to spread awareness among investors. Exposure limit: The national value of gross open positions at any point in time for index futures and short index option contract shall not exceed 33.33 times the

liquid net worth of a clearing member. In case of futures and options contract on stocks the notional value of futures contracts and short option position any time shall not exceed 20 times the liquid net worth of the member. Therefore, 3 percent notional value of gross open position in index futures and short index options contracts, and 5 percent of notional value of futures and short option position in stocks is additionally adjusted from the liquid net worth of a clearing member on a real time basis. Position limit: It refers to the maximum no of derivatives contracts on the same underlying security that one can hold or control. Position limits are imposed with a view to detect concentration of position and market manipulation. The position limits are applicable on the cumulative combined position in all the derivatives contracts on the same underlying at an exchange. Position limits are imposed at the customer level, clearing member level and market levels are different. Regulatory Framework: Considering the constraints in infrastructure facilities the existing stock exchanges are permitted to trade derivatives subject to the following conditions. Trading should take place through an online screen based trading system. An independent clearing corporation should do the clearing of the derivative market. The exchange must have an online surveillance capability, which monitors positions, price and volumes in real time so as to detect market manipulations. Position limits be used for improving market

quality. Information about traded quantities and quotes should be

disseminated by the exchange in the real time over at least two information-vending networks, which are SAILessible to the investors in the country. The exchange should have at least 50 members to start derivatives trading. The derivatives trading should be done in a separate segment with a separate membership. The members of an existing segment of the exchange will not automatically become the members of derivatives segment. The derivatives market should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of total members of the governing council.

The

chairman

of

the

governing

council

of

the

derivative

division/exchange should be a member of the governing council. If the chairman is broker/dealer, then he should not carry on any broking and dealing on any exchange during his tenure.

Forwards
Forwards are the simplest and basic form of derivative contracts. These are instruments are basically used by traders/investors in order to hedge their future risks. It is an agreement to buy/sell an asset at a certain in future for a certain price. They are private agreements mainly between the financial institutions or between the financial institutions and corporate clients. One of the parties in a forward contract assumes a long position i.e. agrees to buy the underlying asset on a specified future date at a specified future price. The other party assumes short position i.e. agrees to sell the asset on the same date at the same price. This specified price referred to as the delivery price. This delivery price is chosen so that the value of the forward contract is equal to zero for both the parties. In other words, it costs nothing to the either party to hold the long/short position. A forward contract is settled at maturity. The holder of the short position delivers the asset to the holder of the long position in return for cash at

the agreed upon rate. Therefore, a key determinate of the value of the contract is the market price of the underlying asset. A forward contract can therefore, assume a positive/negative value depending on the moments of the price of the asset. For example, if the price of the asset prices rises sharply after the two parties have entered into the contract, the party holding the long position stands to benefit, that is the value of the contract is positive for him. Conversely the value of the contract becomes negative for the party holding the short position. The concept of forward price is also important. The forward price for a certain contract is defined as that delivery price which would make the value of the contract zero. To explain further, the forward price and the delivery price are equal on the day that the contract is entered into. Over the duration of the contract, the forward price is liable to change while the delivery price remains the same. Essential features of Forward Contracts: 33.A forward contract is a Bi-party contract, to be performed in the future, with the terms decided today. 34.Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality, delivery time and place. 35.Forward contracts suffer from poor liquidity and default risk. 36.Contract price is generally not available in public domain. 37.On the expiration date the contract will settle by delivery of the asset. 38.If the party wishes to reverse the contract, it is to compulsorily go to the same counter party, which often results high prices. Forward Trading in Securities:

The Securities Contract (amendment) Act of 1999, has allowed the trading in derivative products in India. Has a further step to widen and deepen the securities market the government has notified that with effect from March 1st 2000 the ban on forward trading in shares and securities is lifted to facilitate trading in forwards and futures. It may be recalled that the ban on forward trading in securities was imposed in 1986 to curb certain unhealthy trade practices and trends in the securities market. During the past few years, thanks to the economic and financial reforms, there have been many healthy developments in the securities markets. The lifting of ban on forward deals in securities will help to develop index futures and other types of derivatives and futures on stocks. This is a step in the right direction to promote the sophisticated market segments as in the western countries.

FUTURES
The future contract is an agreement between two parties two buy or sell an asset at a certain specified time in future for certain specified price. In this, it is similar to a forward contract. A futures contract is a more organized form of a forward contract; these are traded on organized exchanges. However, there are a no of differences between forwards and futures. These relate to the contractual futures, the way the markets are organized, profiles of gains and losses, kind of participants in the markets and the ways they use the two instruments. Futures contracts in physical commodities such as wheat, cotton, gold, silver, cattle, etc. have existed for a long time. Futures in financial assets, currencies, and interest bearing instruments like treasury bills and bonds and other innovations like futures contracts in stock indexes are relatively new developments. The futures market described as continuous auction markets and exchanges providing the latest information about supply and demand with respect to individual commodities, financial instruments and currencies, etc. Futures exchanges are where buyers and sellers of an expanding list of commodities; financial instruments and currencies come together to trade. Trading has also been initiated in options on futures contracts. Thus, option buyers participate in futures markets with different risk. The option buyer knows the exact risk, which is unknown to the futures trader.

Features of Futures Contracts

The principal features of the contract are as fallows. Organized Exchanges: Unlike forward contracts which are traded in an over- the- counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market which futures can be bought and sold at any time like in a stock market. Standardization: In the case of forward contracts the amount of commodities to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor made to buyers requirement. In a futures contract both these are standardized by the exchange on which the contract is traded. Clearing House: The exchange acts a clearinghouse to all contracts struck on the trading floor. For instance a contract is struck between capital A and B. upon entering into the records of the exchange, this is immediately replaced by two contracts, one between A and the clearing house and the another between B and the clearing house. In other words the exchange interposes itself in every contract and deal, where it is a buyer to seller, and seller to buyer. The advantage of this is that A and B do not have to under take any exercise to investigate each others credit worthiness. It also guarantees financial integrity of the market. The enforces the delivery for the delivery of contracts held for until maturity and protects itself from default risk by imposing margin requirements on traders and enforcing this through a system called marking to

market. Actual delivery is rare: In most of the forward contracts, the commodity is actually delivered by the seller and is SAILepted by the buyer. Forward contracts are entered into for acquiring or disposing of a commodity in the future for a gain at a price known today. In contrast to this, in most futures markets, actual delivery takes place in less than one percent of the contracts traded. Futures are used as a device to hedge against price risk and as a way of betting against price movements rather than a means of physical acquisition of the underlying asset. To achieve, this most of the contracts entered into are nullified by the matching contract in the opposite direction before maturity of the first. Margins: In order to avoid unhealthy competition among clearing members in reducing margins to attract customers, a mandatory minimum margins are obtained by the members from the customers. Such a stop insures the market against serious liquidity crises arising out of possible defaults by the clearing members. The members collect margins from their clients has may be stipulated by the stock exchanges from time to time and pass the margins to the clearing house on the net basis i.e. at a stipulated percentage of the net purchase and sale position. The stock exchange imposes margins as fallows: 39.Initial margins on both the buyer as well as the seller. 40.The accounts of buyer and seller are marked to the market daily.

The concept of margin here is same as that of any other trade, i.e. to introduce a financial stake of the client, to ensure performance of the

contract and to cover day to day adverse fluctuations in the prices of the securities. The margin for future contracts has two components: Initial margin Marking to market

Initial margin: In futures contract both the buyer and seller are required to perform the contract. SAILordingly, both the buyers and the sellers are required to put in the initial margins. The initial margin is also known as the performance margin and usually 5% to 15% of the purchase price of the contract. The margin is set by the stock exchange keeping in view the volume of business and size of transactions as well as operative risks of the market in general. The concept being used by NSE to compute initial margin on the futures transactions is called value- at Risk(VAR) where as the options market had SPAN based margin system. Marking to Market: Marking to market means, debiting or crediting the clients equity SAILounts with the losses/profits of the day, based on which margins are sought. It is important to note that through marking to market process, die clearinghouse substitutes each existing futures contract with a new contract that has the settle price or the base price. Base price shall be the previous days closing Nifty value. Settle price is the purchase price in the new contract for the next trading day.

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

Futures price: The price at which the futures contract trades in the futures market. Expiry Date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract Size: The amount of asset that has to be delivered under one contract. For instance contract size on NSE futures market is 50 Nifties. Basis/Spread: In the context of financial futures basis can be defined as the futures price minus the spot price. There ill be a different basis for each delivery month for each contract. In formal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of Carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Multiplier: it is a pre-determined value, used to arrive at the contract size. It is the price per index point. Tick Size: It is the minimum price difference between two quotes of similar nature. Open Interest: Total outstanding long/short positions in the market in any specific point of time. As total long positions for market would be equal to total short positions for calculation of open Interest, only one side of the contract is counted. Long position: Outstanding/Unsettled purchase position at any point of time. Short position: Out standing/unsettled sales position at any time point of time.

Stock index Futures:

Stock index futures are most popular financial futures, which have been used to hedge or manage systematic risk by the investors of the stock market. They are called hedgers, who own portfolio of securities and are exposed to 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 traded on a regulated futures exchange for a specified price at a specified time in future. Stock index futures will require lower capital adequacy and margin requirement as compared to margins on carry forward of individual scrips. The brokerage cost on index futures will be much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower incase 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 refer 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 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 contracts traded. 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 are 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. Example: If BSE sensex is at 17000 and each point in the index equals to Rs.30, a contract struck at this level could work Rs.510000 (17000x30). If at the expiration of the contract, the BSE sensex is at 17100, a cash settlement of Rs.3000 is required (17100-17000) x30). Stock Futures: With the purchase of futures on a security, the holder essentially makes a legally binding promise or obligation to buy the underlying security at same point in the future (the expiration date of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a shareholder. A futures contract represents a promise to transact at same point in the future. In this light, a promise to sell security is just as easy to make as a promise to buy security. Selling security futures without previously owing them simply obligates the trader to sell a certain amount of the underlying security at same point in the future. It can be done just as easily as buying futures, which obligates the trader to buy a certain amount of the underlying security at some point in future. Example: If the current price of the ITC share is Rs.170 per share. We believe that in one month it will touch Rs.200 and we buy ITC shares. If the price really increases to Rs.200, we made a profit of Rs.30 i.e. a return of 18%. If we buy ITC futures instead, we get the same position as ITC in the cash market, but we have to pay the margin not the entire amount. In the above example if the margin is 20%, we would pay only Rs.34 initially to enter into the futures contract. If ITC share goes up to Rs.200 as expected, we still earn Rs.30 as profit.

Payoff for Futures contracts Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when Nifty stands at 5220. The underlying asset in this case is Nifty portfolio. When the index moves up, the long futures position starts making profits, and when index moves down it starts making losses.

Payoff for a buyer of Nifty futures

profit

5220
0 Nifty

LOSS

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who

shorts an asset. He has potentially unlimited upside as well as potentially unlimited downside. Payoff for a seller of Nifty futures
Profit

5220 0 Nifty

LOSS

Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 5220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when index moves up, it starts making losses.

OPTIONS An option is a derivative instrument since its value is derived from the underlying asset. It is essentially a right, but not an obligation to buy or sell an asset. Options can be a call option (right to buy) or a put option (right to sell). An option is valuable if and only if the prices are varying. An option by definition has a fixed period of life, usually three to six months. An option is a wasting asset in the sense that the value of an option diminishes has the date of maturity approaches and on the date of maturity it is equal to zero.

An investor in options has four choices before him. Firstly, he can buy a call option meaning a right to buy an asset after a certain period of time. Secondly, he can buy a put option meaning a right to sell an asset after a certain period of time. Thirdly, he can write a call option meaning he can sell the right to buy an asset to another investor. Lastly, he can write a put option meaning he can sell a right to sell to another investor. Out of the above four cases in the first two cases the investor has to pay an option premium while in the last two cases the investors receives an option premium. Definition: An option is a derivative i.e. its value is derived from something else. In the case of the stock option its value is based on the underlying stock (equity). In the case of the index option, its value is based on the underlying index. Options clearing corporation The Options Clearing Corporation (OCC) is guarantor of all exchangetraded options once an option transaction has been completed. Once a seller has written an option and a buyer has purchased that option, the OCC takes over it. It is the responsibility of the OCC who over sees the obligations to fulfill the exercises. If I want to exercise an SAIL November 100-call option, I notify my broker. My broker notifies the OCC, the OCC then randomly selects a brokerage firm, which is short one SAIL stock. That brokerage firm then notifies one of its customers who have written one SAIL November 100 call option and exercises it. The brokerage firm customer can be chosen in two ways. He can be chosen at random or FIFO basis. Because, OCC has a certain risk that the seller of the option cant full the contract, strict margin requirement are imposed on sellers. This margins requirement act as a performance Bond. It assures that

OCC will get its money.

Options Terminology.
Call Option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but the not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the option contract is known as the expiration date, the exercise date, the straight date or the maturity date. Strike Price: The price specified in the option contract is known as the strike price or the exercise price. American option: American options are the options that the can be exercised at the time up to the expiration date. Most exchange-traded options are American. European options: European options are the options that can be exercised only on the expiration date itself. European options are easier to analyze that the American options and properties of an American option are frequently deduced from those of its European counter part. In-the-money option: An in-the-money option (ITM) is an option that

would lead to a positive cash flow to the holder if it were exercised immediately. A call option in the index is said to be in the money when the current index stands at higher level that 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 in the money. In the case of a put option, the put is in the money if the index is below the strike price. At-the-money option: An At-the-money option (ATM) is an option that would lead to zero cash flow if it exercised immediately. An option on the index is at the money when the current index equals the strike price (I.e. spot price = strike price). Out-of-the-money option: An out of the money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out of he 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. Intrinsic value of an option: It is one of the components of option premium. The intrinsic value of a call is the amount the option is in the money, if it is in the money. If the call is out of the money, its intrinsic value is Zero. For example X, take that ABC November-call option. If ABC is trading at 102 and the call option is priced at 2, the intrinsic value is 2. If ABC November-100 put is trading at 97 the intrinsic value of the put option is 3. If ABC stock was trading at 99 an ABC November call would have no intrinsic value and conversely if ABC stock was trading at 101 an ABC November-100 put option would have no intrinsic value. An option must be in the money to have intrinsic value.

Time value of an option: The value of an option is the difference between its premium and its intrinsic value. Both calls and puts time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value. At expiration an option should have no time value. Characteristics of Options The following are the main characteristics of options: 41.Options holders do not receive any dividend or interest. 42.Options only capital gains. 43.Options holder can enjoy a tax advantage. 44.Options holders are traded an O.T.C and in all recognized stock exchanges. 45.Options holders can controls their rights on the underlying asset. 46.Options create the possibility of gaining a windfall profit. 47.Options holders can enjoy a much wider risk-return combinations. 48.Options can reduce the total portfolio transaction costs. 49.Options enable with the investors to gain a better return with a limited amount of investment. Call Option An option that grants the buyer the right to purchase a designed instrument is called a call option. A call option is contract that gives its owner the right but not the obligation, to buy a specified asset at specified prices on or before a specified date. An American call option can be exercised on or before the specified date. But, a European option can be exercised on the specified date only. The writer of the call option may not own the shares for which the call is

written. If he owns the shares it is a Covered Call and if he des not owns the shares it is a Naked call Strategies: The following are the strategies adopted by the parties of a call option. Assuming that brokerage, commission, margins, premium, transaction costs and taxes are ignored. A call option buyers profit/loss can be defined as follows: At all points where spot price < exercise price, here will be loss. At all points where spot prices > exercise price, there will be profit. Call Option buyers losses are limited and profits are unlimited. Conversely, the call option writers profits/loss will be as follows: At all points where spot prices < exercise price, there will be profit At all points where spot prices > exercise price, there will be loss Call Option writers profits are limited and losses are unlimited. Following is the table, which explains In the-money, Out-of-the-money and At-the-money position for a Call option.
Exercise call option Do not exercise Exercise/Do not exercise Example: Spot price>Exercise price Spot price<Exercise price Spot price=Exercise price In-The-Money Out-of the-Money At-The-Money

The current price of OBC share is Rs.260. Holder expect that price in a three month period will go up to Rs.300 but, holder do fear that the price may fall down below Rs.260. To reduce the chance of holder risk and at the same time, to have an opportunity of making profit, instead of buying the share, the holder can buy a three-month call option on OBC share at an agreed exercise price of Rs.250. 50.If the price of the share is Rs.300. then holder will exercise the option

since he get a share worth Rs.300. by paying a exercise price of Rs.250. holder will gain Rs.50. Holders call option is In-The-Money at maturity. 51.If the price of the share is Rs.220. then holder will not exercise the option. Holder will gain nothing. It is Out-of-the-Money at maturity.

Payoff for buyer of call option: Long call The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option un-exercise. His loss in this case is the premium he paid for buying the option.

Payoff for buyer of call option

Profit

5250

0
86.60

Nifty

Loss

The figure shows the profit the profits/losses for the buyer of the threemonth Nifty 5250(underlying) call option. As can be seen, as the spot nifty rises, the call option is In-The-money. If upon expiration Nifty closes

above the strike of 5250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and strike price. However, if Nifty falls below the strike of 5250, he lets the option expire and his losses are limited to the premium he paid i.e. 86.60.

Payoff for writer of call option: Short call For selling the option, the writer of the option charges premium. Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price is less than the strike price, the buyer lets his option un-exercised and the writer gets to keep the premium.

Payoff for writer of call option

Profit

86.60 5250 0 Nifty

LOSS

The figure shows the profits/losses for the seller of a three-month Nifty 5250 call option. If upon expiration Nifty closes above the strike of 5250,

the buyer would exercise his option on the writer would suffer a loss to the extent of the difference between the Nifty-close and the strike price. This loss that can be incurred by the writer of the option is potentially unlimited. The maximum profit is limited to the extent of up-front option premium Rs.86.60. Put option An option that gives the seller the right to sell a designated instrument is called put option. A put option is a contract that gives the owner the right, but not the obligation to sell a specified number of shares at a specified price on or before a specified date. An American put option can be exercised on or before the specified date. But, a European option can be exercised on the specified date only. The following are the strategies adopted y the parties of a put option. A put option buyers profit/loss can be defined as follows: At all points where spot price<exercise price, there will be gain. At all points where spot price>exercise price, there will be loss.
Conversely, the put option writers profit/loss will be as follows: At all points where spot price<exercise price, there will be loss. At all points where spot price>exercise price, there will be profit. Following is the table, which explains In-the-money, Out-of-the Money and At-the-money positions for a Put option. Exercise put option Do not Exercise Exercise/Do not Exercise Spot price<Exercise price Spot price>Exercise price Spot price=Exercise price In-The-Money Out-of-The-Money At-The-Money

Example:

The current price of OBC share is Rs.250. Holder by a three month put option at exercise price of Rs.260. (Holder will Exercise his option only if the market price/ spot price is less than the exercise price). If the market/Spot price of the OBC share is Rs.245., then the holder will exercise the option. Means put option holder will buy the share for Rs.245. In the market and deliver it to the option writer for Rs.260., the holder will gain Rs.15 from the contract. Payoff for buyer of put option: Long put. A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon the expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire unexercised.
Payoff for buyer of put option
Profit

5250 0 61.70 Nifty

Loss

The figure shows the profits/losses for the buyer of a three-month Nifty 5250 put option. As can be seen, as the spot Nifty falls, the put option is In-The-Money. If upon expiration, Nifty closes below the strike of 5250,

the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However, if Nifty rises above the strike of 5250, he lets the option expire. His losses are limited to the extent of the premium he paid. Payoff for writer of put option: Short put The figure below shows the profit/losses for the seller/writer of a threemonth put option. As the spot Nifty falls, the put option is In-The-Money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 5250, the buyer would exercise his option on writer who would suffer losses to the extent of strike price and Nifty-close. the difference between the

Payoff for writer of put option

Profit

61.70 5250

Nifty

Loss

The loss that can be incurred by the writer of the option is to a maximum extent of strike price. Maximum profit is limited to premium charged by him.

Pricing Options Factors determining options value: Exercise price and Share price: If the share price is more than the exercise price then the holder of the call option will get more net payoff, means the value of the call option is more. If the share price is less then the exercise price then the holder of the put option will get more net pay-off. Interest Rate: The present value of the exercise price will depend on the interest rate. The value of the call option will increase with the rise in interest rates. Since, the present value of the exercise price will fall. The effect is reversed in the case of a put option. The buyer of a put option receives exercise price and therefore as the interest increases, the value of the put option will decrease. Time to Expiration: The present value of the exercise price also

depends on the time to expiration of the option. The present value of the exercise price will be less if the time to expiration is longer and consequently value of the option will be higher. Longer the time to expiration higher is the possibility of the option to be more in the money.

Volatility: The volatility part of the pricing model is used to measure fluctuations expected in the value of the underlying security or period of time. The more volatile the underlying security, the greater is the price of the option. There are two different kinds of volatility. They are Historical Volatility and Implied Volatility. Historical volatility estimates volatility based on past prices. Implied volatility starts with the option price as a given, and works backward to ascertains the theoretical value

of volatility which is equal to the market price minus any intrinsic value. Black scholes pricing models: The principle that options can completely eliminate market risk from a stock portfolio is the basis of Black Scholes pricing model in 1973. Interestingly, before Black and Scholes came up with their option pricing model, there was a wide spread belief that the expected growth of the underlying ought to effect the option price. Black and Scholes demonstrate that this is not true. The beauty of black and scholes model is that like any good model, it tells us what is important and what is not. It doesnt promise to produce the exact prices that show up in the market, but certainly does a remarkable job of pricing options within the framework of assumptions of the model. The following are the assumptions; 52.There are no transaction costs and taxes. 53.The risk from interest rate is constant. 54.The markets are always open and trading is continues. 55.The stock pays no dividend. During the option period the firm should not pay any dividend. 56.The option must be European option. 57.There are no short selling constraints and investors get full use of short sale proceeds. The options price for a call, computed as per the following Black Scholes formula: VC =PS N (d1)- PX/(e (RF)(T)) N (d2) The value of Put option as per Black scholes formula: VP=PX/(e Where d1= (In [PS/PX]+T[RF+(S.D)2 / 2]) / S.D (sq rt (T)) d2= d1-S.D (sq rt (T))
(RF)(T)

) N (-d2 )-PS N (-d1)

VC= value of call option VP= value of put option PS= current price of the share PX= exercise of the share RF= Risk free rate T= time period remaining to expiration N (d1)= after calculation of d1, value normal distribution area is to be identified. N (d2)= after calculation of d2, value normal distribution area is to be identified. S.D= risk rate of the share In = Natural log value of ratio of PS and PX Pricing Index Option: Under the assumptions of Black Scholes options pricing model, index options should be valued in the way as ordinary options on common stock. The assumption is that the investors can purchase the underlying stocks in the exact amount necessary to replicate the index: i.e. stocks are infinitely divisible and that the index follows a diffusion process such that the continuously compounded returns distribution of the index is normally distributed. To use the black scholes formula for index options, we must however, make adjustments for the dividend payments received on the index stocks. If the dividend payment is sufficiently smooth, this merely involves the replacing the current index value S in the model with S/eqT where q is the annual dividend and T is the time of expiration in years. Pricing Stock Options: The Black Scholes options pricing formula that we used to price European calls and puts, with some adjustments can be used to price

American calls and puts & stocks. Pricing American options becomes a little difficult because, unlike European options, American options can be exercised any time prior to expiration. When no dividends are expected during the life of options the options can be valued simply by substituting the values of the stock price, strike price, stock volatility, risk free rate and time to expiration in the black scholes formula. However, when dividends are expected during the life of the options, it is some times optimal to exercise the option just before the underlying stock goes ex-dividend. Hence, when valuing options on dividend paying stocks we should consider exercised possibilities in two situations. Onejust before the underlying stock goes Ex-dividend, Two at expiration of the options contract. Therefore, owing an option on a dividend paying stock today is like owing to options one in long maturity option with a time to maturity from today till the expiration date, and other is a short maturity with a time to maturity from today till just before the stock goes Ex-dividend.

Difference between the Futures and Options

Futures Options 1. Both the parties are obligated 1. Only to perform. 2. 3. premium. contract settlement 4. must date perform only. at They In futures either parties pay 2. The parties to the futures 3.

the

seller

(writer)

is

obligated to perform. In options the buyer pays the The buyer of an options seller a premium. the contract can exercise the option at are any time prior to expiration date. The buyer limits the downside

obligated to perform the date. The holder of the contract is 4. exposed to the entire spectrum of risk to the option premium but downside risk and had the potential retain the upside potential. for all the upside return. 5. In futures margins are to be 5. In options premium are to be paid. They are approximately 15 to paid. But they are less as compare 20% on the current stock price. to margin in futures.

Swaps

Financial swaps are a funding technique, which a permit a barrower to SAILess one market and then exchange the liability for another type of liability. Global financial markets present barrowers and investors with a variety of financing and investment vehicles in terms of currency and type of coupon fixed or floating. It must be noted that the swaps by themselves are not a funding instrument: They are device to obtain the desired form of financing indirectly. The barrower might other wise as found this too expensive or even inaccessible. A common explanation for the popularity of swaps concerns the concept of comparative advantage. The basis principle is that some companies have a comparative advantage when barrowing in fixed markets while other companies have a comparative advantage in floating markets. Swaps are used to transform the fixed rate loan into a floating rate loan. Types of swaps: All Swaps involves exchange of a series of payments between two parties. A swap transaction usually involves an intermediary who is a large international financial institution. The two payment streams estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets. The most widely prevalent swaps are 58.Interest rate swaps. 59.Currency swaps.

Interest rate swaps Interest rate swaps, as a name suggest involves an exchange of different payment streams, which are fixed and floating in nature. Such an exchange is referred to as an exchange of barrowings. For example, B to pay the other party A cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At

the same time, party A agrees to pay B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. The life of the swap can range from two years to fifty years. Usually two non-financial companies do not get in touch with each other to directly arrange a swap. They each deal with a financial intermediary such as a bank. At any given point of time, the swaps spreads are determined by supply and demand. If no participants in the swaps market want to receive fixed rather than floating, Swap spreads tend to fall. If the reverse is true, the swaps spread tend to rise. In real life, it is difficult to envisage a situation where two companies contact a financial institution at a exactly same with a proposal to take opposite positions in the same swap.

Currency Swaps Currency swaps involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on an approximately equivalent loan in another currency. Example: Suppose that a company A and company B are offered the fixed five years rates of interest in US $ and Sterling. Also suppose that sterling rates are higher than the dollar rates. Also, company A a better credit worthiness then company B as it is offered better rates on both dollar and sterling. What is important to the trader who structures the swap deal is that the difference in the rates offered to the companies on both currencies is not same. Therefore, though company A has a better deal. In both the currency markets, company B does enjoy a comparative lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such

that the company B barrows in the market in which it has a lower disadvantage and company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned. A point to note is that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and the end of the life of the swap. They are chosen such that they are equal at the exchange rate at the beginning of the life of the swap. Like interest swap, currency swaps are frequently ware housed by financial institutions that carefully monitor their exposure in various currencies so that they can change hedge currency risk

BASIC OPTION STRATEGIES

Long call
Market View Action option Profit Potential Unlimited Loss Potential Limited To make a profit from an expected increase in the price of an underlying share during options life: Case 1: On 2nd April 2012, HUL is quoting at 405 and April 420 call costs Rs.16.45.We expect the share price to rise significantly and want to make a profit from the increase. Bullish Buy a call

(i) HUL 26 APRIL 2012 CE 400 is trading @ 16.45 (Buying Out The Money Call Option):
Buy 1 HUL call at Rs.16.45, Market lot for HUL is 1000. So, Net outlay is Rs.16450. If HUL shares go up, we can close the position either by selling the option back to the market or exercising the right to buy the underlying shares at the exercise price. On2 nd Apr 2012 Market Price of HUL is Rs.405.65/DATE Share price (Cash 2ndApr market) Rs405.65 400 16.45 Buy 1 Apr 420 Call @ Rs16.45 Cost = 16450 13th Apr Rs. 425.15 400 26 1. Sell 1 FEB contract Net gain Rs.9.55(2616.45)*1000 = Rs.9550 Strike Price Call Premium CALL OPTION VALUE

On 13 Apr profit is Rs 9550 if the share price goes up then the profit will be more. On Expiry HUL closed at 414.70 it is below strike price Rs 420,therefore the settlement price will be zero(out of money option) loss will be 16450(1000*16.45).it suggests that call buyer will have payoff will be unlimited profit anf limited loss(premium paid).

(ii) ICICI BANK 26 APRIL 2012 CE 900 is trading @ 29.95 (Buying Out The Money Call Option):
Buy 1 ICICI BANK call at Rs.29.95, Market lot for ICICI BANK is 850. So, Net outlay is Rs.7487.50 If ICIC BANK share go up, we can close the position either by selling the option back to the market or exercising the right to buy the underlying shares at the exercise price. On13TH Apr 2012 Market Price of ICICI bank is Rs.890.45/DATE Share price (Cash 2
nd

Strike Price

Call Premium

CALL OPTION VALUE

Apr

market) Rs890.45

900

29.95

Buy 1 Apr 900 Call @ Rs29.95 Cost = 7487.50

3rd Apr

Rs. 908.20 900

35.65

1. Sell 1 FEB contract Net gain rs.5.70(35.6529.95)*250= Rs.1425

On 3 Apr profit is Rs 1425 after that share price fallen up to 841 on expiry ,therefore the settlement price will be zero(out of money option) loss will be 7487.50(250*29.95).

(iii) Ranbaxy 26 APRIL 2012 CE 480 is trading @ 9.50 (Buying Out The Money Call Option):
Buy 1 Ranbaxy call at Rs.9.5., Market lot for Ranbaxy is 500. So, Net

outlay is Rs.4750 If Ranbaxy share go up, we can close the position either by selling the option back to the market or exercising the right to buy the underlying shares at the exercise price. On2nd Apr 2012 Market Price of Ranbaxy is Rs.458.9 5/DATE Share price (Cash 2
nd

Strike Price

Call Premium

CALL OPTION VALUE

Apr

market) Rs458.95

480

9.50

Buy 1 Apr 480 Call @ Rs9.5 Cost = 4500

26th Apr Rs.505.6

480

25

Net

gain

rs.15.5(25-

9.50)*500= Rs.7750

On 2nd Apr Ranbaxy 480 call is at Rs.950 and on Expiry Ranbaxy closed at Rs.505.60 with call premium Rs.25.profit on expiry is Rs7750.

Short call
To earn additional income from a static shareholding, over and above any dividend earnings, in terms of premium received on writing the option (Covered short call). Market View Action: shareholding Profit Potential Loss Potential Limited Unlimited Bearish/Neutral Sell call against an existing

(i) HUL 26 APRIL 2012 CE 420 is trading @ 6.5 (selling

Out The Money Call Option):

Sell 1 HUL call at Rs.6.50, Market lot for HUL is 1000. So, Net outlay is Rs.6500. If HUL shares goes down, we can close the position either by square up the option back to the market . On2nd Apr 2012 Market Price of HUL is Rs.405.65 DATE Share price (Cash 2ndApr market) Rs405.65 420 6.50 Sel1 Apr 420 Call @ Rs6.50 Cost = 6500 26th Apr Rs. 425.15 420 0 Net gain Rs.6.5(6.50)*1000 = Rs.6500 Strike Price Call Premium CALL OPTION VALUE

On 2nd April HUL 420 call trading at rs.6.5. On Expiry HUL closed at 414.70 it is below strike price Rs 420,therefore the settlement price will be zero(out of money option) profit will be Rs.6500(as we short).it suggests that call write will have payoff will be limited profit (premium paid) and unlimited loss.

(ii) ICICI BANK 26 APRIL 2012 CE 900 is trading @ 29.95 (Selling Out The Money Call Option):
Sell 1 ICICI BANK call at Rs.29.95, Market lot for ICICI BANK is 250. So, Net outlay is Rs.7487.50 If ICIC BANK share goes down, we can close the position by Square up the option back to the market. On 2 nd Apr 2012 Market Price of ICICI BANK is Rs.890.45/-

DATE

Share price (Cash market) Rs890.45

Strike Price

Call Premium

CALL OPTION VALUE

nd

Apr

900

29.95

sell 1 Apr 900 Call @ Rs29.95 Cost = 7487.50

26th Apr Rs. 841

900

35.65

Net gain rs.29.95(29.950))*250= Rs.7487.5

On 2 Apr we short ICICI bank 900 call at Rs.29.95on expiry share price fallen up to 841 on expiry, therefore the settlement price will be 7487.50(250*29.95) premium paid.

(iii) Ranbaxy 26 APRIL 2012 CE 480 is trading @ 9.50 (Selling Out The Money Call Option):
Sell 1 Ranbaxy call at Rs.9.50, Market lot for Ranbaxy is 500. So, Net outlay is Rs.4750 If Ranbaxy share goes down, we can close the position by square up the option back to the market. On2 nd Apr 2012 Market Price of Ranbaxy is Rs.458.9 5/DATE Share price (Cash 2nd Apr market) Rs458.95 480 9.50 Buy 1 Apr 480 Call @ Rs9.5 Cost = 4500 26th Apr Rs.505.6 480 25 Net Loss rs.15.5(25Strike Price Call Premium CALL OPTION VALUE

9.50)*500= Rs.7750

On 2nd Apr Ranbaxy 480 call is at Rs.950 and on Expiry Ranbaxy closed at Rs.505.60 with call premium Rs.25.loss on expiry is Rs7750 as we short call option which is in the money on expiry.

Long Put
Market View Action option Profit Potential Loss Potential Unlimited Limited Bearish Buy a Put

To make profit, from a fall in value of share price:

(i) HUL 26 APRIL 2012 PE 420 is trading @ 15.30 (BUYING In The Money PUT Option):
Buy 1 HUL put at Rs.15.30, Market lot for HUL is 1000. So, Net outlay is Rs.15300. If HUL shares goes down, we can close the position by selling the option on back to the market . On2nd Apr 2012 Market Price of HUL is Rs.405.65 DATE Share price (Cash 2
nd

Strike Price

Call Premium

PUT OPTION VALUE

Apr

market) Rs405.65

420

15.30

BUY Apr 420 put @ Rs15.30 Cost = 15300

4th Apr

Rs. 399.20 420

20.8

Sell 1 Apr put option Net gain Rs.5.50(20.8-15.30) *1000 = Rs.5500

On 2nd April HUL 420 put trading at Rs. 15.30. On 4th April HUL closed at

399.20 with put premium at Rs. 20.80 then the profit will be Rs.550 (20.8-15.30). on expiry HUL closed at 414.70 then we will get only amount of Rs.5.3*1000(420-414.70) = 5300 as it is in the money. but it is less than our cost i.e. Rs.6500.then our loss will be Rs.10000(1530005300).

(ii) ICICI BANK 26 APRIL 2012 PE 880 is trading @ 32 (BUYING OutThe Money PUT Option):
Buy 1 ICICI BANK put at Rs.32, Market lot for ICICI BANK is 250. So, Net outlay is Rs.7750 If ICICI BANK shares goes down, we can close the position by selling the option on back to the market . On 2nd Apr 2012 Market Price of ICICI BANK is Rs.890.45 DATE Share price (Cash 2nd Apr market) Rs890.45 880 32 BUY Apr 880 put @ Rs32 Cost = 7750 25th Apr Rs. 838.40 880 42.75 Sell 1 Apr put option Net gain Rs.(42.75-32)*250 = Rs.2687.50 On 2nd April ICICI BANK 880 put trading at Rs. 32. On 25th April ICICI BANK put closed at 42.75 then the profit will be Rs. 42.75-32)*250 = Rs.2687.50. on expiry ICICI BANK closed at 841.45 then we will get only amount of Rs.38.55(880-841.75)*250 = 9637.50 as it is in the money. But it our cost i.e. Rs.7750.then our profit will be Rs.1887.5 (9637.507750). Strike Price Call Premium PUT OPTION VALUE

(iii) Ranbaxy 26 APRIL 2012 PE 480 is trading @ 31.10 (Buying In The Money Put Option):

Buy 1 Ranbaxy call at Rs.31.10, Market lot for Ranbaxy is 500. So, Net outlay is Rs.4750 If Ranbaxy share goes down, we can close the position by square up the option back to the market. On 2nd Apr 2012 Market Price of Ranbaxy is Rs.458.9 5/DATE Share price (Cash 2
nd

Strike Price

Call Premium

PUT OPTION VALUE

Apr

market) Rs458.95

480

31.1

Buy 1 Apr 480 put @ Rs31.10 Cost = 15550

26th Apr Rs.505.6

480

Net Loss rs.31.10 (31.100)*500= Rs15550

On 2nd Apr Ranbaxy 480 PUT is at Rs.31.10 and on Expiry Ranbaxy closed at Rs.505.6,it is out money option .loss on expiry is Rs. 15550.

Short put
Market View Action option Profit Potential Loss Potential Limited Unlimited Bullish/neutral Sell put

To make profit, from a rise in value of share price

(i) HUL 26 APRIL 2012 PE 420 is trading @ 15.30 (Selling In The Money PUT Option):
sell 1 HUL put at Rs.15.30, Market lot for HUL is 1000. So, Net outlay is Rs.15300. If HUL shares goes down, we can close the position by Squaring the option on back to the market.

On2nd Apr 2012 Market Price of HUL is Rs.405.65 DATE Share price (Cash 2
nd

Strike Price

Call Premium

PUT OPTION VALUE

Apr

market) Rs405.65

420

15.30

Sell Apr 420 put @ Rs15.30 Cost =15300

26th Apr

Rs. 414.70 420

20.8

Net loss Rs.20.8 *1000 = Rs.20800

On 2nd April HUL 420 put trading at Rs. 15.30. On expiry HUL closed at 414.70 then we then our loss will be Rs 15300 as it is in the money option.

(ii) ICICI BANK 26 APRIL 2012 PE 880 is trading @ 32 (Selling Out The Money PUT Option):
sell 1 ICICI BANK put at Rs.32, Market lot for ICICI BANK is 250. So, Net outlay is Rs.7750 If ICICI BANK shares goes down, we can close the position by squaring the option on back to the market . On 2nd Apr 2012 Market Price of ICICI BANK is Rs.890.45 DATE Share price (Cash 2nd Apr market) Rs890.45 880 32 Sell Apr 880 put @ Rs32 Cost = 7750 26th Apr Rs. 838.40 841.45 39.55 Net loss Rs.39.55*250 = Strike Price Call Premium PUT OPTION VALUE

Rs.9887.5

On 2nd April ICICI BANK 880 put trading at Rs. 32. on expiry ICICI BANK closed at 841.45 our loss will be Rs.38.55*250 = 9887.50 as it is in the money loss will be unlimited.

(iii) Ranbaxy 26 APRIL 2012 PE 480 is trading @ 31.10 (Selling In the Money Put Option):
sell 1 Ranbaxy call at Rs.31.10, Market lot for Ranbaxy is 500. So, Net outlay is Rs.4750 If Ranbaxy share goes down, we can close the position by square up the option back to the market. On 2nd Apr 2012 Market Price of Ranbaxy is Rs.458.9 5/DATE Share price (Cash 2
nd

Strike Price

Call Premium

PUT OPTION VALUE

Apr

market) Rs458.95

480

31.1

sell 1 Apr 480 put @ Rs31.10 Cost = 15550

26th Apr Rs.505.6

480

Net gain is Rs. 15500

On 2nd Apr Ranbaxy 480 PUT is at Rs.31.10 and on Expiry Ranbaxy closed at Rs.505.6,it is out money option .profit on expiry is Rs. 15550(premium paid is profit in this case).

CONCLUSION Derivatives have existed and evolved over a long time, with roots in commodities market. In the recent years advances in financial

markets and the technology have made derivatives easy for the investors. Derivatives market in India is growing rapidly unlike equity markets. Trading in derivatives require more than average understanding of finance. Being new to markets maximum number of investors have not yet understood the full implications of the trading in derivatives. SEBI should take actions to create awareness in investors about the derivative market. Introduction of derivatives implies better risk management. These markets can give greater depth, stability and liquidity to Indian capital markets. Successful risk management with derivatives requires a through understanding of principles that govern the pricing of financial derivatives. In order to increase the derivatives market in India SEBI should revise some of their regulation like contract size, participation of FII in the derivative market. Contract size should be minimized because small investor cannot afford this much of huge premiums.

Suggestions to Investors
The investors can minimize risk by investing in derivatives. The use of derivative equips the investor to face the risk, which is uncertain. Though the use of derivatives does not completely eliminate the risk, but it certainly lessens the risk. It is advisable to the investor to invest in the derivatives market because of the greater amount of liquidity offered by the financial derivatives and the lower transactions costs associated with the trading of financial derivatives. The derivatives products give the investor an option or choice whether to exercise the contract or not. Options give the choice to the investor to either exercise his right or not. If an expiry date the investor finds that the underlying asset in the option contract is traded at a less price in the stock market then, he has the full liberty to get out of the option contract and go ahead and buy the asset from the stock market. So in case of high uncertainty the investor can go for options. However, these instruments act as a powerful instrument for knowledgeable traders to expose them to the properly calculated and well understood risks in pursuit of reward i.e. profit.

Bibliography Indian financial system Investment management Publications of National Stock Exchange Websites www.nseindia.org www.bseindia.com www.sharekhan.com www.sebi.gov.in www.moneycontrol.com www.geojit.com www.indianfoline.com www.icicidirect.com www.hseindia.org - M.Y. Khan - V.K. Bhalla