INTRODUCTION

INTRODUCTION:
The only stock exchange operating in the 19th century were those of
Bombay set up in 1875 and Ahmadabad set up in 1894. These were
organized as voluntary non-profit-making association of brokers to regulate
and protect their interests. Before the control on securities trading became
a central subject under the constitution in 1950, it was a state subject and
the Bombay securities contracts (control) Act of 1925 used to regulate
trading in securities. Under this Act, The Bombay stock exchange was
recognized in 1927 and Ahmadabad in 1937.
During the war boom, a number of stock exchanges were organized
even in Bombay, Ahmadabad and other centers, but they were not
recognized. Soon after it became a central subject, central legislation was
proposed and a committee headed by A.D.Gorwala went into the bill for
securities regulation. On the basis of the committee's recommendations and
public discussion, the securities contracts (regulation) Act became law in
1956.

OBJECTIVES OF STUDY:
1. To study various trends in derivative market.
2. Comparison of the profits/losses in cash market and derivative market.
3. To find out profit/losses position of the option writer and option holder.
4. To study in detail the role of the future and options.
5. To study the role of derivatives in Indian financial market.
6. To study various trends in derivative market.
7. Comparison of the profits/losses in cash market and derivative market.
8. To find out profit/losses position of the option writer and option holder.
9. To study in detail the role of the future and options.
10. To study the role of derivatives in Indian financial market.

NEED OF THE STUDY

Different investment avenues are available investors. Stock market also

offers

good

investment

opportunities

to

the

investor

alike

all

investments, they also carry certain risks. The investor should compare
the risk and expected yields after adjustment off tax on various
instruments while talking investment decision the investor may seek
advice from exparty and consultancy include stock brokers and analysts
while making investment decisions. The objective here is to make the
investor aware of the functioning of the derivatives.
Derivatives act as a risk hedging tool for the investors. The objective if
to help the

investor in selecting the appropriate

derivates instrument to the attain maximum risk and to construct the

portfolio in such a manner to meet the investor should decide how best
to reach the goals from the securities available.
To identity investor objective constraints and performance, which help
formulate the investment policy?

The develop and improvement strategies in the with investment policy

formulated. They will help the selection of asset classes and securities in
each class depending up on their risk return attributes.

SCOPE OF THE STUDY

The study is limited to Derivatives with special reference to futures
and options in the Indian context; the study is not based on the
international perspective of derivative markets.
The study is limited to the analysis made for types of instruments of
derivates each strategy is analyzed according to its risk and return
characteristics and derivatives performance against the profit and policies
of the company.
The present study on futures and options is very much appreciable
on the grounds that it gives deep insights about the F&O market. It would
be essential for the perfect way of trading in F&O. An investor can choose
the fight underlying or portfolio for investment 3which is risk free. The study
would explain the various ways to minimize the losses and maximize the
profits. The study would help the investors how their profit/loss is reckoned.
The study would assist in understanding the F&O segments. The study
assists in knowing the different factors that cause for the fluctuations in the
F&O market. The study provides information related to the byelaws of F&O
trading. The studies elucidate the role of F&O in India Financial Markets.

Derivative Markets today

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

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

The Reserve Bank of India has permitted options, interest rate swaps,
currency swaps and other risk reductions OTC derivative products.

Besides the Forward market in currencies has been a vibrant market

in India for several decades.

In addition the Forward Markets Commission has allowed the setting

up of commodities futures exchanges. Today we have 18 commodities
exchanges most of which trade futures.
e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the
Coffee Owners Futures Exchange of India (COFEI).

In 2000 an amendment to the SCRA expanded the definition of

securities to included Derivatives thereby enabling stock exchanges
to trade derivative products.

The year 2000 will herald the introduction of exchange traded equity
derivatives in India for the first time.

METHODOLOGY
To achieve the object of studying the stock market data ha been collected.
Research methodology carried for this study can be two types
Primary
Secondary
PRIMARY
The data, which is being collected for the time and it is the original
data is this
project the primary data has been taken from IIFL staff and guide of
the project.
SECONDARY
The secondary information is mostly from websites, books, journals,
etc.

INDUSTRY
PROFILE
9

NDUSTRY PROFILE :
STOCK MARKET :
Indian stock market has shown dramatic changes last 4 to 5 years.
As of 2004 march-end, Indian stock exchanges had over 9400 companies
listed. Of course, the number of companies whose shares are actively
traded is smaller, around 800 at the NSE and 2600 at the BSE. Each
company may have multiple securities listed on an exchange. Thus, BSE has
over 7200 listed securities, of which over 2600 are traded. The market
capitalization of all listed stocks now exceeds Rs. 13 Lakh crore. Total
turnover-or the value of all sales and purchases on the BSE and the NSE
now exceeds Rs. 50 lakh crore.
As large number of indices are also available to fund managers.
The two leading market indices are NSE 50-shares (S&P CNX Nifty) index
and BSE 30-share (SENSEX) index. There are index funds that invest in the
securities that form part of one or the other index. Besides, in the
derivatives market, the fund managers can buy or sell futures contracts or
options contracts on these indices. Both BSE and NSE also have other sect
oral indices that track the stocks of companies in specific industry groupsFMCG, IT, Finance, Petrochemical and Pharmaceutical while the SENSEX and
10

Nifty indices track large capitalization stocks, BSE and NSE also have Mid
cap indices tracking mid-size company shares. The number of industries or
sectors represented in various indices or in the listed category exceeds50.
BSE has 140 scrips in its specified group A list, which are basically largecapitalization stocks. B 1 Group includes over 1100 stocks, many of which
are mid-cap companies. The rest of the B2 Group includes over 4500
shares, largely low-capitalization.

National Stock Exchange (NSE):

The NSE was incorporated in NOVEMBER 1994 with an equity
capital of Rs.25 Crores. The International Securities Consultancy (ISC) of
Hong Kong has helped in setting up NSE. The promotions for NSE were
financial institutions, insurance companies, banks and SEBI capital market
ltd,Infrastructure

leasing

and

financial

services

ltd.,stock

holding

corporation ltd.
NSE is a national market for shares, PSU bonds, debentures and
government securities since infrastructure and trading facilities are
provided. The genesis of the NSE lies in the recommendations of the
Pherwani Committee (1991).
NSE-Nifty:
The NSE on April22, 1996 launched a new equity index. The
NSE-50 the new index which replaces the existing NSE-100, is expected to
serve as an appropriate index for the new segment of futures and options.
Nifty means National Index for Fifty Stocks.

11

The NSE-50 comprises 50 companies that represent 20 broad

industry groups with an aggregate market capitalization of around Rs.
1,70,000 crores. All the companies included in the Index have a market
capitalization in excess of Rs. 500 crores. Each and should have traded for
85% of trading days at an impact cost of less than 1.5%.
NSE-Midcap Index:
The NSE midcap index or the Junior Nifty comprises 50 stocks that
represents 21 board Industry groups and will provide proper representation
of the midcap. All stocks in the index should have market capitalization of
greater than Rs.200 crores and should have traded 85% of the trading days
an impact cost of less 2.5%.
The base period for the index is Nov 4, 1996 which signifies 2
years for completion of operations of the capital market segment of the
operations. The base value of the index has been set at 1000. Average daily
turnover of the present scenario 258212(laces) and number of average
daily trades 2160(laces).
Bombay Stock Exchange (BSE):
This stock exchange, Mumbai, popularly known as BSE was
established In 1875 as The native share and stock brokers association, as
a voluntary non-profit making association .It has evolved over the years into
its present status as the premier stock exchange in the country. It may be
noted that the stock exchange is the oldest one in Asia, even older than the
Tokyo Stock Exchange, this was founded in 1878.
The Bombay Stock Exchange Limited

is the oldest stock

exchange in Asia and has the greatest number of listed companies in the
world, with 4700 listed as of August 2007.It is located at Dalal Street,
12

Mumbai, India. On 31 December 2007, the equity market capitalization of

the companies listed on the BSE was US$ 1.79 trillion, making it the largest
stock exchange in South Asia and the 12th largest in the world.
A governing board comprising of 9 elected directors, 2 SEBI
nominees, 7 public representatives and an executive director is the apex
body, which decides the policies and regulates the affairs of the exchange.

BSE Indices:
In order to enable the market participants, analysts etc., to track the
various ups and downs in Indian stock market, the exchange had introduced
in 1986 an equity stock index called BSE-SENSEX that subsequently became
the barometer of the moments of the share prices in the Indian stock
market. It is a market capitalization weighted index of 30 component
stocks representing a sample of large, well established and leading
companies. The base year of sensex is 1978-79.
The Sensex is widely reported in both domestic and international
markets through print as well as electronic media. Sensex is calculated
using a market capitalization weighted method. As per this methodology,
the level of index reflects the total market value of all 30-component stocks
from different industries related to particular base period. The total value of
a company is determined by multiplying the price of its stock by the number
of shares outstanding.
Statisticians call an index of a set of combined variables (such as
price number of shares) Composite index. An Indexed number is used to
represent the results of this calculation in order to make the value easier to
work with and track over a time. IT is much easier to graph a chart base on
indexed values then one based on actual values world over majority of the
well known indices are constructed using Market capitalization weighted
method. The divisor is only link to original base period value of the sensex.
13

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

value/old market value)
OTC Equity Derivatives

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

market.

Options of various kinds (called Teji and Mandi and Fatak) in unorganized markets were traded as early as 1900 in Mumbai

The SCRA however banned all kind of options in 1956.

BSE's and NSEs plans

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

setting up a separate exchange for derivatives.

BSEs Derivatives Segment, will start with Sensex futures as its first
product.

NSEs Futures & Options Segment will be launched with Nifty futures
as the first product.

Product Specifications BSE-30 Sensex Futures

Contract Size - Rs.50 times the Index

Tick Size - 0.1 points or Rs.5

Expiry day - last Thursday of the month

Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

Product Specifications S&P CNX Nifty Futures

Contract Size - Rs.200 times the Index

14

Tick Size - 0.05 points or Rs.10

Expiry day - last Thursday of the month

Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

Membership

Membership for the new segment in both the exchanges is not

automatic and has to be separately applied for.

Membership is currently open on both the exchanges.

All members will also have to be separately registered with SEBI

before they can be accepted.

Membership Criteria
NSE
Clearing Member (CM)

Networth - 300 lakh

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakh

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

Networth - Rs. 100 lakh

Interest-Free Security Deposit - Rs. 8 lakh

Annual Subscription Fees - Rs. 1 lakh

BSE
Clearing Member (CM)

Networth - 300 lacs

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakh

Non-refundable Deposit - Rs. 5 lakh

Annual Subscription Fees - Rs. 50 thousand

15

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

Cash - Rs. 2.5 lakh

Cash Equivalents - Rs. 25 lakh

Collateral Security Deposit - Rs. 5 lakh

Trading Member (TM)

Networth - Rs. 50 lakh

Non-refundable Deposit - Rs. 3 lakh

Annual Subscription Fees - Rs. 25 thousand

The Non-refundable fees paid by the members is exclusive and will be a

total of Rs.8 lakhs if the member has both Clearing and Trading rights.
Trading Systems

NSEs Trading system for its futures and options segment is called
NEAT F&O. It is based on the NEAT system for the cash segment.

BSEs trading system for its derivatives segment is called DTSS. It is

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

Certification Programmes

The NSE certification programme is called NCFM (NSEs Certification in

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

The BSE certification programme is called BCDE (BSEs Certification

for the Derivatives Exchnage). BSE conducts its own training run by
its training institute.

Both these programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle approval on
their rule and laws by SEBI.

16

According to the SEBI chairman, the Gazette notification of the ByeLaws after the final approval is expected to be completed by May
2000.

Trading is expected to start by mid-June 2000.

REVIEW
Of

17

LITERATUR
E

18

Introduction
A Derivative is a financial instrument that derives its value
from an underlying asset. Derivative is an financial contract whose
price/value is dependent upon price of one or more basic underlying asset,
these contracts are legally binding agreements made on trading screens of
stock exchanges to buy or sell an asset in the future. The most commonly
used derivatives contracts are forwards, futures and options, which we shall
discuss in detail later.
The emergence of the market for derivative products, most
notably forwards, futures and options, can be traced back to the willingness
of risk-averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices. By their very nature, the financial
markets are marked by a very high degree of volatility. Through the use of
derivative products, it is possible to partially or fully transfer price risks by
locking-in asset prices. As instruments of risk management, these generally
do not influence the fluctuations in the underlying asset prices. However, by
locking-in asset prices, derivative products minimize the impact of
fluctuations in asset prices on the profitability and cash flow situation of
risk-averse investors.
Derivative products initially emerged, as hedging devices against
fluctuations

in

commodity

prices

and

commodity-linked

derivatives

remained the sole form of such products for almost three hundred years.
The financial derivatives came into spotlight in post-1970 period due to
growing

instability

in

the

financial

markets.

However,

since

their

emergence, these products have become very popular and by 1990s, they
accounted for about two-thirds of total transactions in derivative products.
In recent years, the market for financial derivatives has grown tremendously
both in terms of variety of instruments available, their complexity and also
turnover. In the class of equity derivatives, futures and options on stock
19

indices have gained more popularity than on individual stocks, especially

among institutional investors, who are major users of index-linked
derivatives. Even small investors find these useful due to high correlation of
the popular indices with various portfolios and ease of use. The lower costs
associated with index derivatives vie derivative products based on
individual securities is another reason for their growing use.
The main objective of the study is to analyze the derivatives
market in India and to analyze the operations of futures and options.
Analysis is to evaluate the profit/loss position futures and options. Derivates
market is an innovation to cash market. Approximately its daily turnover
reaches to the equal stage of cash market
In cash market the profit/loss of the investor depend the market price
of the underlying asset. Derivatives are mostly used for hedging purpose. In
bullish market the call option writer incurs more losses so the investor is
suggested to go for a call option to hold, where as the put option holder
suffers in a bullish market, so he is suggested to write a put option. In
bearish market the call option holder will incur more losses so the investor
is suggested to go for a call option to write, where as the put option writer
will get more losses, so he is suggested to hold a put option.
Initially derivatives was launched in America called Chicago. Then in
1999, RBI introduced derivatives in the local currency Interest Rate markets,
which have not really developed, but with the gradual acceptance of the
ALM guidelines by banks, there should be an instrumental product in
hedging their balance sheet liabilities.
The first product which was launched by BSE and NSE in the
derivatives market was index futures
The following factors have been driving the growth of financial derivatives:
1. Increased volatility in asset prices in financial markets,

20

2. Increased integration of national financial markets with the

international markets,
3. Marked improvement in communication facilities and sharp decline
in their costs,
4. Development of more sophisticated risk management tools,
providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the
risks and
returns over a large number of financial assets, leading to higher
returns, reduced
risk as well as trans-actions costs as compared to individual financial
assets.

Derivatives defined
Derivative is a product whose value is derived from the value of one
or more basic variables, called bases (underlying asset, index, or reference
rate), in a contractual manner. The underlying asset can be equity, forex,
commodity or any other asset. For example, wheat farmers may wish to sell
their harvest at a future date to eliminate the risk of a change in prices by
that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which
is the underlying.
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)
A) defines
21

equity derivative to include

1. A security derived from a debt instrument, share, loan whether
secured or
unsecured, risk instrument or contract for differences or any other form of
security.
2. A contract, which derives its value from the prices, or index of
prices, of
underlying securities.
Derivatives is derived from the following products:
A. Shares
B. Debuntures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
DEFINATIONS
According to JOHN C. HUL A derivatives can be defined as a
financial instrument whose value depends on (or derives from) the values of
other, more basic underlying variables.
According to ROBERT L. MCDONALD A derivative is simply a
financial instrument (or even more simply an agreement between two
people) which has a value determined by the price of something else.

FUNCTIONS OF DERIVATIVES MARKET:

22

The following are the various functions that are performed by the
derivatives markets. They are:
Prices in an organized derivatives market reflect the perception of
market participants about the future and lead the prices of underlying to
the perceived future level.
Derivatives market helps to transfer risks from those who have them but
may not like them to those who have an appetite for them.
Derivative trading acts as a catalyst for new entrepreneurial activity.
Derivatives markets help increase savings and investment in the long
run.
TYPES OF DERIVATIVES:
The most commonly used derivatives contracts are
forwards, futures and options which we shall discuss in detail later. Here
we take a brief look at various derivatives contracts that have come to
be used.

Forwards:
A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future at
todays pre-agreed price

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:
23

Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset,
at a given price on or before a given future date. Puts give the buyer the
right, but not the obligation to sell a given quantity of the underlying asset
at a given price on or before a given date.

Warrants:
Options generally have lives of up to one year; the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally
traded over-the-counter.

Leaps:
The acronym LEAPS means Long-Term Equity Anticipation
Securities. These are options having a maturity of up to three years.

Baskets:
Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity
index options are a form of basket options.

Swaps:
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used swaps
are
Interest rate swaps:
These entail swapping only the interest related cash flows
between the
Parties in the same currency.
Currency swaps:

24

These entail swapping both principal and interest between

the parties, with the cash flows in one direction being in a different currency
than those in the opposite Direction.

Swaptions:
Swaptions are options to buy or sell a swap that will become operative
at the expiry of the options. Thus a Swaptions is an option on a forward
swap.
PARTICIPANTS IN THE DERIVATIVES MARKET:
The following three broad categories of participants in the derivatives
market.

HEDGERS:
Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk.
SPECULATORS:
Speculators wish to bet on future movements in the price of an asset.
Futures and options contracts can give them an extra leverage; that is, they
can increase both the potential gains and potential losses in a speculative
venture.
ARBITRAGEURS:
Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the
futures price of an asset getting out of line with the cash price, they will
take offsetting positions in the two markets to lock in a profit.

25

ANY

EXCHANGE

FULFILLING

THE

DERIVATIVE

SEGMENT

AT

NATIONAL STOCK EXCHANGE:

The derivatives segment on the exchange commenced with S&P
CNX Nifty Index futures on June 12, 2000.

The F&O segment of NSE

provides trading facilities for the following derivative segment:

1. Index Based Futures
2. Index Based Options
3. Individual Stock Options
4. Individual Stock Futures
REGULATORY FRAMEWORK:
The trading of derivatives is governed by the provisions contained
in the SC (R) A, the SEBI Act and the regulations framed there under the
rules and byelaws of stock exchanges.
Regulation for Derivative Trading:
SEBI set up a 24 member committed under Chairmanship of
Dr.L.C.Gupta develop the appropriate regulatory framework for derivative
trading in India. The committee submitted its report in March 1998. On
May 11, 1998 SEBI accepted the recommendations of the committee and
approved the phased introduction of Derivatives trading in India beginning
with Stock Index Futures.

SEBI also approved he Suggestive bye-laws

recommended by the committee for regulation and control of trading and

settlement of Derivatives contracts.
The provisions in the SC (R) A govern the trading in the
securities. The amendment of the SC (R) A to include DERIVATIVES within
the ambit of Securities in the SC (R ) A made trading in Derivatives
possible within the framework of the Act.

26

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

may apply to SEBI for grant of recognition under Section 4 of the SC
( R ) A, 1956 to start Derivatives Trading.

The derivatives

exchange/segment should have a separate governing council and

representation of trading / clearing members shall be limited to
maximum of 40% of the total members of the governing council. The
exchange shall regulate the sales practices of its members and will
obtain approval of SEBI before start of Trading in any derivative
contract.
2. The exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not
automatically become the members of the derivative segment. The
members of the derivative segment need to fulfill the eligibility
conditions as lay down by the L.C.Gupta Committee.
4.

The clearing and settlement of derivates trades shall be through a

SEBI
approved Clearing Corporation / Clearing house.

Clearing

Corporation /
Clearing House complying with the eligibility conditions as lay down
By the committee have to apply to SEBI for grant of approval.
5. Derivatives broker/dealers and Clearing members are required to seek
registration from SEBI.
6. The Minimum contract value shall not be less than Rs.2 Lakh.
Exchanges should also submit details of the futures contract they
purpose to introduce.

27

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

and sales person who have passed a certification programmed
approved by SE
INTRODUCTION TO FUTURE MARKET:
Futures markets were designed to solve the problems that exit in
forward markets. A futures contract is an agreement between two parties to
buy or sell an asset at a certain time in the future at a certain price. There is
a multilateral contract between the buyer and seller for a underlying asset
which may be financial instrument or physical commodities. But unlike
forward contracts the future contracts are standardized and exchange
traded.
PURPOSE:
The primary purpose of futures market is to provide an efficient and
effective mechanism for management of inherent risks, without counterparty risk. The future contracts are affected mainly by the prices of the
underlying asset. As it is a future contract the buyer and seller has to pay
the margin to trade in the futures market.
It is essential that both the parties compulsorily discharge their
respective obligations on the settlement day only, even though the payoffs
are on a daily marking to market basis to avoid
default risk. Hence, the gains or losses are netted off on a daily basis and
each morning starts
with a fresh opening value. Here both the parties face an equal amount of
risk and are also
required to pay upfront margins to the exchange irrespective of whether
they are buyers or

28

sellers. Index based financial futures are settled in cash unlike futures on
individual stocks which
are very rare and yet to be launched even in the US. Most of the financial
futures worldwide are
index based and hence the buyer never comes to know who the seller is,
both due to the presence
of the clearing corporation of the stock exchange in between and also due
to secrecy reasons
EXAMPLE:
The current market price of INFOSYS COMPANY is Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish
and kishore is
bearish in the market. The initial margin is 10%. paid by the both parties.
Here the Hitesh has
purchased the one month contract of INFOSYS futures with the price of
Rs.1650.The lot size of
Infosys is 300 shares.
Suppose the stock rises to 2200.
Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and
notional profit for
the buyer is 500.
Unlimited loss for the buyer because the buyer is bearish in the market
Suppose the stock falls to Rs.1400
Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional
profit for the seller is
250.
29

Unlimited loss for the seller because the seller is bullish in the market.
Finally, Futures contracts try to "bet" what the value of an index
or commodity will be at some date in the future. Futures are often used by
mutual funds and large institutions to hedge their positions when the
markets are rocky. Also, Futures contracts offer a high degree of leverage, or
the ability to control a sizable amount of an asset for a cash outlay, which is
distantly small in proportion to the total value of contract.

DEFINITION
A Futures contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price.

To facilitate

liquidity in the futures contract, the exchange specifies certain standard

features of the contract. The standardized items on a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery
The units of price quotations and minimum price change
Locations of settlement
Types of futures:
On the basis of the underlying asset they derive, the futures are
divided into two types:
Stock futures:
The stock futures are the futures that have the underlying asset as
the individual securities.

The settlement of the stock futures is of cash

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

30

 Index futures:
Index futures are the futures, which have the underlying asset as an
Index. The Index futures are also cash settled. The settlement price of the
Index futures shall be the closing value of the underlying index on the
expiry date of the contract.
STOCK INDEX FUTURES
Stock Index futures are the most popular financial
futures, which have been used to hedge or manage the systematic risk by
the investors of Stock Market. They are called hedgers who own portfolio of
securities and are exposed to the systematic risk. Stock Index is the apt
hedging asset since the rise or fall due to systematic risk is accurately
shown in the Stock Index. Stock index futures contract is an agreement to
buy or sell a specified amount of an underlying stock index traded on a
regulated futures exchange for a specified price for settlement at a
specified time future.
Stock index futures will require lower capital adequacy and
margin requirements as compared to margins on carry forward of individual
scrips. The brokerage costs on index futures will be much lower.
Savings in cost is possible through reduced bid-ask spreads
where stocks are traded in packaged forms. The impact cost will be much
lower in case of stock index futures as opposed to dealing in individual
scrips. The market is conditioned to think in terms of the index and
therefore would prefer to trade in stock index futures. Further, the chances
of manipulation are much lesser.
The Stock index futures are expected to be extremely liquid
given the speculative nature of our markets and the overwhelming retail
participation expected to be fairly high. In the near future, stock index
futures will definitely see incredible volumes in India. It will be a blockbuster
product and is pitched to become the most liquid contract in the world in
terms of number of contracts traded if not in terms of notional value. The
31

advantage to the equity or cash market is in the fact that they would
become less volatile as most of the speculative activity would shift to stock
index futures. The stock index futures market should ideally have more
depth, volumes and act as a stabilizing factor for the cash market. However,
it is too early to base any conclusions on the volume or to form any firm
trend.
The difference between stock index futures and most
other financial futures contracts is that settlement is made at the value of
the index at maturity of the contract.

Futures terminology :a) Spot price : The price at which an asset trades in the spot market
b) Futures price : The price at which the futures contract trades in the
futures market.
c) Contract cycle : The period over which a contract trades. The index
futures contracts on the NSE have one-month, two-month and threemonths expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract trading on the last
Thursday of February. On the Friday following the last Thursday, a
new contract having a three-month expiry is introduced for trading.
d) Expiry date : It is the date specified in the futures contract. This is
the last day on which the contract will be traded, at the end of which
it will cease to exist.

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

one contract. For instance, the contract size on NSEs futures market
is 200 Nifties.
f) Basis :In the context of financial futures, basis can be defined as the
futures price minus the spot price. There will be a different basis for
each delivery month for each contract. In a normal market, basis will
be positive. This reflects that futures prices normally exceed spot
prices.
g) Cost of carry : The relationship between futures prices and spot
prices can be summarized in terms of what is known as the cost of
carry. This measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
h) Margin: Margin is money deposited by the buyer and the seller to
ensure the integrity of the contract. Normally the margin requirement
has been designed on the concept of VAR at 99% levels. Based on
the value at risk of the stock/index margins are calculated. In general
margin ranges between 10-50% of the contract value.
i) Initial margin : The amount that must be deposited in the margin
account at the time a futures contract is first entered into is known
as initial margin. Both buyer and seller are required to make security
deposits that are intended to guarantee that they will infact be able
to fulfill their obligation. These deposits are Initial margins and they
are often referred as performance margins. The amount of margin is
roughly 5% to 15% of total purchase price of futures contract
j) Marking-to-market : In the futures market, at the end of each
trading day, the margin account is adjusted to reflect the investors
gain or loss depending upon the futures closing price. This is called
marking-to-market.
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k) Maintenance margin : This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin account
never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call
and is expected to top up the margin account to the initial margin
level before trading commences on the next day.

PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller.
The buyer of the futures contract is one who is LONG on the futures
contract and the seller of the futures contract is one who is SHORT on the
futures contract.
The pay off for the buyer and the seller of the futures contract are as
follows.
Pay off for futures:
A Pay off is the likely profit/loss that would accrue to a market
participant with change in the price of the underlying asset. Futures
contracts have linear payoffs. In simple words, it means that the losses as
well as profits, for the buyer and the seller of futures contracts, are
unlimited.
PAYOFF FOR A BUYER OF FUTURES:
The pay offs for a person who buys a futures contract is similar to
the pay off for a person who holds an asset. He has potentially unlimited
upside as well as downside.
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Take the case of a speculator who buys a two-month Nifty index

futures contract when the Nifty stands at 1220. The underlying asset in
this case is the Nifty portfolio. When the index moves up, the long
futures position starts making profits and when the index moves down it
starts making losses

PROFIT

LOSS

CASE 1:
The buyer bought the future contract at (F);

if

the

futures

price

goes to E1 then the buyer gets the profit of (FP).

CASE 2:
The buyer gets loss when the future price goes less than (F), if the
futures price goes to E2 then the buyer gets the loss of (FL).
PAYOFF FOR A SELLER OF FUTURES:
The pay offs for a person who sells a futures contract is
similar to the pay off for a person who shorts an asset. He has potentially
unlimited upside as well as downside.
Take the case of a speculator who sells a two-month Nifty index
futures contract when the Nifty stands at 1220. The underlying asset in
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this case is the Nifty portfolio. When the index moves down, the short
futures position starts making profits and when the index moves up it
starts making losses.

P
PROFIT

LOSS
L

F FUTURES PRICE
E1, E2 SETTLEMENT PRICE.
CASE 1:
The Seller sold the future contract at (f); if the futures price goes to E1
then the Seller gets the profit of (FP).
CASE 2:
The Seller gets loss when the future price goes greater than (F), if the
futures price goes to E2 then the Seller gets the loss of (FL).
Pricing the Futures:

36

The fair value of the futures contract is derived from a model known
as the Cost of Carry model. This model gives the fair value of the futures
contract.
Cost of Carry Model:
F=S (1+r-q) t
Where
F Futures Price

S Spot price of the Underlying r Cost of Financing q Expected Dividend Yield

T Holding

Period.

INTRODUCTION TO OPTIONS:
It is a interesting tool for small retail investors. An option is a
contract, which gives the buyer (holder) the right, but not the obligation, to
buy or sell specified quantity of the underlying
assets, at a specific (strike) price on or before a specified time (expiration
date). The underlying
may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial
instruments like
equity stocks/ stock index/ bonds etc.
Option Terminology:a) Index options: These options have the index as the underlying.
Some options are
i. European while others are American. Like index futures
contracts, index options
ii. contracts are also cash settled.
b) Stock options: Stock options are options on individual stocks.
Options currently
i. trade on over 500 stocks in the United States. A contract
gives the holder the right

to

to buy or sell shares at the specified price.

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

the option
i. premium buys the right but not the obligation to exercise
his option on the
ii. seller/writer.
d) Writer of an option: The writer of a call/put option is the one who
receives the
i. option premium and is thereby obliged to sell/buy the
asset if the buyer exercises on
ii. him. There are two basic types of options, call options and
put options.
e) Call option: A call option gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price.
f) Put option: A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.
g) Option price: Option price is the price which the option buyer pays
to the option
seller.
h) Expiration date: The date specified in the options contract is known
as the
expiration date, the exercise date, the strike date or the
maturity.
i) Strike price: The price specified in the options contract is known as
the strike price
or the exercise price.
j) American options: American options are options that can be
exercised at any time
Up to the expiration date. Most exchange-traded options
are American.

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k) European options: European options are options that can be

exercised only on the
expiration date itself. European options are easier to
analyze than American options, and properties of an
American option are frequently deduced from those of its
European counterpart.
l)

In-the-money option: An in-the-money (ITM) option is an option

that would lead

to a positive

exercised immediately. A call option

cash flow to the holder if it were

on the index is said to be in-the-

money when the current index stands at a level higher than the strike price
(i.e. spot price > strike price). If the index is much higher than the strike
price, the call is said to be deep ITM. In the case of a put, the put is ITM if
the index is below the strike price.
m)

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

option that would lead

to zero cashflow if it were exercised immediately. An option on the index is
at-themoney
when the current index equals the strike price (i.e. spot price = strike
price)._
n)

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

an option that
would lead to a negative cash flow it were exercised immediately. A call
option on
the index is out-of- the-money when the current index stands at a level
which is less
than the strike price (i.e. spot price < strike price). If the index is much
lower than the

39

strike price, the call is said to be deep OTM. In the case of a put, the put is
OTM if
the index is above the strike price.
o)

Intrinsic value of an option: The option premium can be

broken down into two

components - intrinsic value and time value. The intrinsic value of a call is
the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is
zero.
Putting it another way, the intrinsic value of a call is N.P which means the
intrinsic
value of a call is Max [0, (St K)] which means the intrinsic value of a call is
the (St
K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater
of 0 or
(K - St ). K is the strike price and St is the spot price.
p)

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

the difference between its premium and its intrinsic value. A call that is OTM
or ATM has only time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is a calls
time value, all else equal. At expiration, a call
should have no time value.
TYPES OF OPTION:
CALL OPTION
A call option gives the holder (buyer/ one who is long call), the
right to buy specified quantity of the underlying asset at the strike price on
or before expiration date. The seller (one who is short call) however, has the
obligation to sell the underlying asset if the buyer of the call option decides
40

to exercise his option to buy. To acquire this right the buyer pays a premium
to the writer (seller) of the contract.
Illustration
Suppose in this option there are two parties one is Mahesh (call
buyer) who is bullish in the market and other is Rakesh (call seller) who is
bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and
premium is Rs.25

1) Call buyer
Here the Mahesh has purchase the call option with a strike price of
Rs.600.The option will be excerised once the price went above 600. The
premium paid by the buyer is Rs.25.The buyer will earn profit once the
share price crossed to Rs.625(strike price + premium). Suppose the stock
has crossed Rs.660 the option will be exercised the buyer will purchase the
RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660.
Unlimited profit for the buyer = Rs.35{(spot price strike price)
premium}
Limited loss for the buyer up to the premium paid.

2) Call seller:
In another scenario, if at the tie of expiry stock price falls below Rs.
600 say suppose the stock price fall to Rs.550 the buyer will choose not to
exercise the option.
Profit for the Seller limited to the premium received = Rs.25
Loss unlimited for the seller if price touches above 600 say 630
then the loss of Rs.30
Finally the stock price goes to Rs.610 the buyer will not exercise the option
because he has the
41

lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.
Thus from the above example it shows that option contracts are
formed so to avoid the unlimited losses and have limited losses to the
certain extent
Thus call option indicates two positions as follows:
LONG POSITION
If the investor expects price to rise i.e. bullish in the market he
takes a long position by buying call option.
SHORT POSITION
If the investor expects price to fall i.e. bearish in the market he
takes a short position by selling call option.
PUT OPTION
A Put option gives the holder (buyer/ one who is long Put), the
right to sell specified quantity of the underlying asset at the strike price on
or before a expiry date. The seller of the put option (one who is short Put)
however, has the obligation to buy the underlying asset at the strike price if
the buyer decides to exercise his option to sell.
Illustration
Suppose in this option there are two parties one is Dinesh (put buyer)
who is bearish in the
market and other is Amit(put seller) who is bullish in the market.
The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2
0

1) Put buyer(dinesh)
Here the Dinesh has purchase the put option with a strike price of
Rs.800.The option will be excerised once the price went below 800. The
premium paid by the buyer is Rs.20.The buyers breakeven point is
42

Rs.780(Strike price Premium paid). The buyer will earn profit once the
share price crossed below to Rs.780. Suppose the stock has crossed Rs.700
the option will be
exercised the buyer will purchase the RELIANCE scrip from the market at
Rs.700and sell to the
seller at Rs.800
Unlimited profit for the buyer = Rs.80 {(Strike price spot price)
premium}
Loss limited for the buyer up to the premium paid = 20

2) put seller(Amit):
In another scenario, if at the time of expiry, market price of TISCO is
Rs. 900. the buyer of the Put option will choose not to exercise his option to
sell as he can sell in the market at a higher rate.
Unlimited loses for the seller if stock price below 780 say 750 then
unlimited losses for
the seller because the seller is bullish in the market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20
Thus Put option also indicates two positions as follows:
LONG POSITION
If the investor expects price to fall i.e. bearish in the market he takes
a long position by buying Put option.
SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he takes a
short position by selling Put option
FACTORS AFFECTING OPTION PREMIUM:

Price of the underlying asset: (s)

Changes in the underlying asset price can increase or decrease the
premium of an option. These price changes have opposite effects on calls
43

and puts. For instance, as the price of the underlying asset rises, the
premium of a call will increase and the premium of a put will decrease. A
decrease in the price of the underlying assets value will generally have the
opposite effect

Strike price: (k)

The strike price determines whether or not an option has any
intrinsic value. An options premium generally increases as the option gets
further in the money, and decreases as the option becomes more deeply
out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value, for
puts and calls, decreases.

Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of
an options underlying. Higher volatility estimates reflect greater expected
fluctuations (in either direction) in underlying price levels. This expectation
generally results in higher option premiums for puts and calls alike, and is
most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might
be paid for margin, in case of an option seller or received from alternative
investments in the case of an option buyer for the premium paid. Higher the
interest rate, higher is the premium of the option as the cost of carry
increases.
FUTURES V/S OPTIONS:

Right or obligation :
44

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

underlying assets at a
price agreed upon by the buyer & seller, on or before a specified time. Both
the buyer and seller
are obligated to buy/sell the underlying asset. In case of options the buyer
enjoys the right & not the obligation, to buy or sell the underlying asset.

Risk:
Futures Contracts have symmetric risk profile for both the buyer as well
as the seller.
While options have asymmetric risk profile. In case of Options, for a buyer
(or holder of the
option), the downside is limited to the premium (option price) he has paid
while the profits may
be unlimited. For a seller or writer of an option, however, the downside is
unlimited while profits
are limited to the premium he has received from the buyer.

Prices:
The Futures contracts prices are affected mainly by the prices of the
underlying asset.
While the prices of options are however, affected by prices of the underlying
asset, time
remaining for expiry of the contract & volatility of the underlying asset

Cost:
It costs nothing to enter into a futures contract whereas there is a cost
of entering into an options contract, termed as Premium.

Strike price:
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In the Futures contract the strike price moves while in the option
contract the strike price
remains constant .

Liquidity:
As Futures contract are more popular as compared to options. Also the
premium charged is high in the options. So there is a limited Liquidity in the
options as compared to Futures. There is no dedicated trading and investors
in the options contract.

Price behavior:
The trading in future contract is one-dimensional as the price of future
depends upon the price of the underlying only. While trading in option is
two-dimensional as the price of the option
depends upon the price and volatility of the underlying.

Pay off:
As options contract are less active as compared to futures which results
into non linear pay off.
While futures are more active has linear pay off .

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