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INTRODUCTION
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INTRODUCTION
Derivatives are risk management instruments, which drive their value form
underlying asset. Underlying asset can be bullion, index, share, bonds, currency,
interest etc.
MAIN TOPICS OF STUDY
1. INTRODUCTION TO DERIVATIVE
The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was
sown to the time it was ready for harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
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partially or fully transfer price risks by locking-in asset prices. These were simple
contracts developed to meet the needs of farmers and were basically a means of
reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he
would receive for his harvest in September. In years of scarcity, he would
probably obtain attractive prices. However, during times of oversupply, he would
have to dispose off his harvest at a very low price. Clearly this meant that the
farmer and his family were exposed to a high risk of price uncertainty.
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2. DERIVATIVE DEFINED
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can
be equity, forex, commodity or any other asset. In our earlier discussion, we saw
that wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of change in price 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 this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the
forward/futures contracts in commodities all over India. As per this the Forward
Markets Commission (FMC) continues to have jurisdiction over commodity
futures contracts. However when derivatives trading in securities was introduced
in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956
(SCRA), was amended to include derivative contracts in securities.
Consequently, regulation of derivatives came under the purview of Securities
Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of
derivatives is governed by the regulatory framework under the SCRA. The
Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-
A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of
underlying securities.
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3. TYPES OF DERIVATIVES MARKET
4. TYPES OF DERIVATIVES
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A forward contract is an agreement to buy or sell an asset on a specified
date for a specified price. One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a certain specified future
date for a certain specified price. The other party assumes a short position
and agrees to sell the asset on the same date for the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally
by the parties to the contract. The forward contracts are n o r m a l l y traded
outside the exchanges.
BASIC FEATURES OF FORWARD CONTRACT
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(ii) FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date in the
future, at a pre-set price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price. The
settlement price, normally, converges towards the futures price on the delivery
date.
A futures contract gives the holder the right and the obligation to buy or sell,
which differs from an options contract, which gives the buyer the right, but not the
obligation, and the option writer (seller) the obligation, but not the right. To exit
the commitment, the holder of a futures position has to sell his long position or
buy back his short position, effectively closing out the futures position and its
contract obligations. Futures contracts are exchange traded derivatives. The
exchange acts as counterparty on all contracts, sets margin requirements, etc.
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1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
• The underlying. This can be anything from a barrel of sweet crude oil to a
short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only
the quality of the underlying goods but also the manner and location of
delivery. The delivery month.
• The last trading date.
• Other details such as the tick, the minimum permissible price fluctuation.
2. Margin:
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in value,
and creates a credit risk to the exchange, who always acts as counterparty. To
minimize this risk, the exchange demands that contract owners post a form of
collateral, commonly known as Margin requirements are waived or reduced in
some cases for hedgers who have physical ownership of the covered commodity
or spread traders who have offsetting contracts balancing the position.
Initial Margin: is paid by both buyer and seller. It represents the loss on that
contract, as determined by historical price changes, which is not likely to be
exceeded on a usual day's trading. It may be 5% or 10% of total contract price.
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Mark to market Margin: Because a series of adverse price changes may
exhaust the initial margin, a further margin, usually called variation or
maintenance margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing on a price at the end of each day, called the
"settlement" or mark-to-market price of the contract.
To understand the original practice, consider that a futures trader, when taking a
position, deposits money with the exchange, called a "margin". This is intended
to protect the exchange against loss. At the end of every trading day, the contract
is marked to its present market value. If the trader is on the winning side of a
deal, his contract has increased in value that day, and the exchange pays this
profit into his account. On the other hand, if he is on the losing side, the
exchange will debit his account. If he cannot pay, then the margin is used as the
collateral from which the loss is paid.
3. Settlement
Settlement is the act of consummating the contract, and can be done in one of
two ways, as specified per type of futures contract:
• Physical delivery - the amount specified of the underlying asset of the
contract is delivered by the seller of the contract to the exchange, and by the
exchange to the buyers of the contract. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale (covering a
short), or selling a contract to liquidate an earlier purchase (covering a long).
• Cash settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such as Euribor, or
the closing value of a stock market index. A futures contract might also opt to
settle against an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For many
equity index and interest rate futures contracts, this happens on the Last
Thursday of certain trading month. On this day the t+2 futures contract becomes
the t forward contract.
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PRICING OF FUTURE CONTRACT
In a futures contract, for no arbitrage to be possible, the price paid on delivery
(the forward price) must be the same as the cost (including interest) of buying
and storing the asset. In other words, the rational forward price represents the
expected future value of the underlying discounted at the risk free rate. Thus, for
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FUNCTIONS OF DERIVATIVES MARKETS:
The following are various functions that are performed by the derivatives
markets. They are
2) Derivatives market helps to transfer risks from those who have them but may
not like them to those who have appetite for them.
3) Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market witnesses
higher trading volumes because of participation by more players who would
not otherwise participate for lack of an arrangement to transfer risk.
6) They often energize others to create new businesses, new products and new
employment opportunities.
7) Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
Derivatives thus promote economic development.
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METHODOLOGY
Selection of scrip: Selection of scrip is done on a random basis and the scrip
selected is NIFTY ’50. The lot is of 50 size, profitability position of futures, buyers
and sellers & also the option holders and option writers is studied.
Data Collection: The data of the NIFTY ’50 has been collected from the news
paper & internet.
The data consist of one month contract & period of data collection is from 27th
Feb. 2009 to 28th may 2009.
Analysis: The analysis consist of the tabulation of the data assessing the
profitability position of the fure buyers & sellers and also the option holder & the
option writer representing the data with graphs and making interpretation using
data.
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SCOPE OF THE STUDY
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OBJECTIVES OF STUDY
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LIMITATIONS
• The Scrip chosen for analysis is Nifty’50 and the contract taken in
February 2009 is a one month contract ending in March.
• The data collected is completely restricted to the NIFTY ’50 hence this
analysis cannot be taken universally.
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CHAPTER -2
LITERATURE REVIEW
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DEFINITION
EVALUTION OF DERIVATIVES:
Derivatives can be found throughout the history of mankind. In the Middle
Ages, engaging in contracts at predetermined prices for future delivery of farming
products. The new era for the derivative markets was ushered with the
introduction of financial derivatives, and it continues to last to this day. Although
commodity derivatives are still quite active, particularly oil and precious metals,
financial derivatives dominate trading in the current derivative markets.
Although the derivatives markets slowed down considerably by the end of
the 20th century, that did not mean that there were not a steady offering of
existing, as well as new derivative products. Derivatives exchanges also went
through a period of change; some consolidated, some merged, some became
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for-profit institutions. Regardless, they all had something in common—the need
for less regulation.
Aside from structural changes, some derivative exchanges also changed the way
they conducted trading. Old systems of face-to-face trading on trading floors
have been replaced with electronic trading, and telephone and computer
networks. With the advent of Internet, electronic trading evolved into e-trading.
And although trading floors still dominate derivative markets in the U.S., it is
obvious that to stay competitive, the U.S. will have to eventually embrace
electronic trading.
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PARTICIPANTS:
The following three categories of participants in the derivatives market:
1) HEDGERS
2) SPECULATORS
3) ARBITRAGEURS
HEDGERS: Hedgers face risk associated with the price of an asset. They use
futures or options market to reduce or eliminate this risk.
Hedgers are those who protect themselves from the risk associated with the
price of an asset by using derivatives. He keeps a close watch upon the prices
discovered in trading and when the comfortable price is reflected according to his
wants, he sells futures contracts. Hedgers use futures for protection against
adverse future price movements in the underlying cash commodity. Hedgers are
often businesses, or individuals, who at one point or another deal in the
underlying cash commodity.
SPECULATORS: Speculators are somewhat like a middle man. They are never
interested in actual owing the commodity. They will just buy from one end and
sell it to the other in anticipation of future price movements. They actually bet on
the future movement in the price of an asset. They are the second major group of
futures players. These participants include independent floor traders and
investors. They handle trades for their personal clients or brokerage firms.
Buying a futures contract in anticipation of price increases is known as ‘going
long’. Selling a futures contract in anticipation of a price decrease is known as
‘going short’.
ARBITRAGEIRS: Arbitrators are the person who takes the advantage of a
discrepancy between prices in two different markets. If he finds future prices of a
commodity edging out with the cash price, he will take offsetting positions in both
the markets to lock in a profit. Risk less Profit Making is the prime goal of
Arbitrageurs. Buying in one market and selling in another, buying two products in
the same market are common. They could be making money even without
putting there own money in and such opportunities often come up in the market
but last for very short timeframes. This is because as soon as the situation arises
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arbitrageurs take advantage and demand-supply forces drive the markets back to
normal.
TYPES OF DERIVATIVES:
The most commonly used derivatives contracts are forwards, futures and
options. Here are various derivatives contacts that have come to be used given
briefly:
• FORWARDS
• FUTURES
• OPTIONS
• WARRANTS
• LEAPS
• SWAPS
• SWAPTIONS
Calls option gives 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.
Put option 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.
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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.
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: 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 swaption is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver
swaptions and payer swaptions. A receiver swaption is an option to receive
fixed and pay floating. A payer swaption is an option to pay fixed and receive
floating.
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FUTURES
DEFINITION:
A future is a contract between two parties whereby the one party (the buyer)
agrees to buy an underlying asset from the other party to the contract on a
specific future date, and at a price determined at the close of the contract. A
future is a derivative that is used to transfer the price risk of the underlying
instrument from one party to another.
The underlying asset can be a financial asset such as a bond, a currency
such as US dollars, a commodity, etc.
A future is normally classified according to the underlying instrument.
Where, for instance, two parties agree to buy and sell a specific quantity of rice
(of a certain quality) at a certain price on a future date, the contract will be a
commodity futures contract. Where two parties agree to buy and sell bonds,
this will be known as a financial futures contract, and where two parties agree
to buy and sell a certain amount of foreign currency, this is a currency futures
contract.
FEATURES OF FUTURES:
• Futures are highly standardized.
• The contracting parties need not pay any down payments.
• Hedging of price risks.
• They have secondary markets to.
A futures contract is thus
• an agreement between two parties
• to buy and sell
• a standardized type and quantity
• of a specified underlying asset
• with a certain quality
• at a price determined at the closing of the contract
• on a specified date
• Through a central exchange.
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TYPES OF FUTURES:
On the basis of the underlying asset they derive, the futures are divided in to
two types:
1) 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.
2) 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.
There are two parties in a future contract, the buyer and seller. The buyer of
the futures contract is one who LONG on the futures contract and the seller of
the futures contract is who is SHORT on the futures contract.
In a futures contract, both parties have an obligation,
• one to buy the underlying instrument
• The other to sell the underlying instrument.
Both the buyer and the seller can make a profit or suffer a loss, due to the fact
that the contract price (at which the underlying instrument is bought and sold) is
determined at closing of the contract. If the market price at the delivery date is
lower than the futures contract price, the buyer suffers a loss because he could
have bought the instrument in the market at a lower price. He is now obliged,
according to the contract, to buy the underlying instrument at the higher price
specified in the contract. The opposite applies when the market value of the
underlying instrument is above the futures contract price. The buyer can now
buy the underlying instrument at the lower contract price, and sell the instrument
immediately at the higher market price, thus making an immediate profit.
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The pay off for the buyer and the seller of the futures of the contracts are as
follows:
PROFIT
P
E2
E1
L F
LOSS
F- FUTURES PRICE
E1, E2 – SETTLEMENT PRICE
CASE 1:- The buyer bought the futures 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 then (F), if
the future price goes to E2 then the buyer gets the loss of (FL)
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PAY- OFF FOR A SELLER OF FUTURES
PROFIT
P
E2
E1
L
LOSS
F- FUTURES PRICE
E1, E2 – SETTLEMENT PRICE
CASE 1:- The seller sold the future contract at (f); if the future 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
future price goes to E2 then the seller gets the loss of (FL).
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FUTURES TERMINOLOGY
Spot price:
It is the price at which an asset is traded in the current market.
Futures price:
It is the price at which the futures contract trades in the futures market.
Contract cycle:
It is the period over which the contract trades. The index futures contracts
on the NSE have one-month; two-month and three month expiry cycle which
expire on the last Thursday of the month. Thus a January expiration contract
expires on the last Thursday of January and February expiration contract ceases
trading on the last Thursday of February. On the Friday following the last
Thursday, a new contract having a three- month expiry is introduced for trading.
Expiry date:
It is the date specifies in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract size:
The amount of asset that has to be delivered under one contract. For
instance, the contract size on NSE’s futures market is 50 nifties.
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
contract. In a normal market, basis will be positive. This reflects that futures
prices normally exceed spot prices.
Cost 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 income earned
on the asset.
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Open Interest:
Total outstanding long or short position in the market at any specific time.
As total long positions in the market would be equal to short position, for
calculation of open interest, only one side of the contract is counter.
OPTIONS
DEFINITION:
Option is a type of contract between two persons where one grants the
other the right to buy a specific asset at a specific price within a specific time
period. Alternatively the contract may grant the other person the right to sell a
specific asset at a specific price within a specific time period. In order to have this
right, the option buyer has to pay the seller or the option premium.
The assets on which option can be derived are stocks, commodities,
indexes etc. If the underlying asset is the financial asset, then the option are
financial option like stock options, currency options, index options etc, and if
options like commodity option.
Options contracts are instruments that give the holder of the instrument the
right to buy or sell the underlying asset at a predetermined price.
PROPERTIES OF OPTIONS:
Options have several unique properties that set them apart from other securities.
The following are the properties of options:
• Limited Loss
• High Leverage Potential
• Limited Life
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PARTIES IN AN OPTION CONTRACT:
1. Buyer of the Option:
The buyer of an option is one who by paying option premium buys the right but
not the obligation to exercise his option on seller/writer.
2. Writer/Seller of the Option:
The writer of a call/put options is the one who receives the option premium and is
there by obligated to sell/buy the asset if the buyer exercises the option on him.
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TYPES OF OPTIONS:
The options are classified into various types on the basis of various variables.
The following are the various types of options:
• INDEX OPTIONS: The Index options have the underlying asset as the
index.
• STOCK OPTIONS: A stock option gives the buyer of the option the right
to buy/sell stock at a specified price. Stock options are options on the
individual stocks, there are currently more than 50 stocks are trading in
this segment.
• CALL OPTION:
A call options is bought by an investor when he seems that the stock price moves
upwards. A call option gives the holder of the option the right but not the
obligation to buy an asset by a certain date for a certain price.
• PUT OPTION:
A put option is bought by an investor when he seems that the stock price
moves downwards. A put option gives the holder of the option right but not the
obligation to sell an asset by a certain date for a certain price.
III). On the basis of exercise of option:
On the basis of the exercising of the option, the options are classified into two
categories.
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•AMERICAN OPTION:
American options are options that can be exercised at any time up to
the expiration date; most exchange-traded options are American.
• EUROPEAN OPTION:
European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American
option.
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CALL OPTION
Illustration 1:
An investor buys one European Call option on one share of Reliance Petroleum
at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. The payoffs for the investor on the basis of
fluctuating spot prices at any time are shown by the payoff table (Table 1). It may
be clear form the graph that even in the worst case scenario, the investor would
only lose a maximum of Rs.2 per share which he/she had paid for the premium.
The upside to it has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart
completely reverse of the call options buyer. The maximum loss that he can have
is unlimited though a profit of Rs.2 per share would be made on the premium
payment by the buyer.
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A European call option gives the following payoff to the investor:
Max (S - Xt, 0).
The seller gets a payoff of:-max (S - Xt, 0) or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at time 't1
C - European Call Option Premium
Payoff - Max (S - Xt, O)
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Net Profit - Payoff minus 'c'
Exercising the Call Option and what are its implications for the Buyer and
the Seller?
The Call option gives the buyer a right to buy the requisite shares on a specific
date at a specific price. This puts the seller under the obligation to sell the shares
on that specific date and specific price. The Call Buyer exercises his option only
when he/ she feel it is profitable. This Process is called "Exercising the Option".
This leads us to the fact that if the spot price is lower than the strike price then it
might be profitable for the investor to buy the share in the open market and forgo
the premium paid. The implications for a buyer are that it is his/her decision
whether to exercise the option or not. In case the investor expects prices to rise
far above the strike price in the future then he/she would surely be interested in
buying call options. On the other hand, if the seller feels that his shares are not
giving the desired returns and they are not going to perform any better in the
future, a premium can be charged and returns from selling the call option can be
used to make up for the desired returns. At the end of the options contract there
is an exchange of the underlying asset. In the real world, most of the deals are
closed with another counter or reverse deal. There is no requirement to
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exchange the underlying assets then as the investor gets out of the contract just
before its expiry.
Put Options:
The European Put Option is the reverse of the call option deal. Here, there is a
contract to sell a particular number of underlying assets on a particular date at a
specific price. An example would help understand the situation a little better:
Illustration 2:
An investor buys one European Put Option on one share of Reliance Petroleum
at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. The payoff table shows the fluctuations of
net profit with a change in the spot price.
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These are the two basic options that form the whole gamut of transactions in the
options trading. These in combination with other derivatives create a whole world
of instruments to choose form depending on the kind of requirement and the kind
of market expectations.
Exotic Options are often mistaken to be another kind of option. They are nothing
but non-standard derivatives and are not a third type of option.
Options Classifications: Options are often classified as
In the money - These result in a positive cash flow towards the investor
At the money - These result in a zero-cash flow to the investor
Out of money - These result in a negative cash flow for the investor
Example:
Calls
Reliance 350 Stock Series
Naked Options: These are options which are not combined with an offsetting
contract to cover the existing positions.
Covered Options: These are option contracts in which the shares are already
owned by an investor (in case of covered call options) and in case the option is
exercised then the offsetting of the deal can be done by selling these shares
held.
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OPTIONS PRICING
Prices of options are commonly depending upon six factors. Option's
prices are far more complex. These are the two basic options that form the whole
gamut of transactions in the options trading. These in combination with other
derivatives create a whole world of instruments to choose form depending on the
kind of requirement and the kind of market expectations. Exotic Options are often
mistaken to be another kind of option. They are nothing but non-standard
derivatives and are not a third type of option.
Options undertakings:
Stocks
Foreign Currencies
Stock Indices
Commodities
Others - Futures Options, are options on the futures contracts or Underlying
assets are futures contracts. The futures contract generally matures shortly after
the options expiration.
OPTIONS PRICING
Prices of options are commonly depending upon six factors. Option's prices are
far more complex. The table below helps understand the affect of each of these
factors and gives a broad picture of option pricing keeping all other factors
constant. The table presents the case of European as well as American Options.
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EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION
PRICES
SPOT PRICES: In case of a call option the payoff for the buyer is max(S -Xt, 0)
therefore, more the Spot Price more is the payoff and it is favorable for the buyer.
It is the other ways round for the seller, more the Spot Price higher are the
chances of his going into a loss.
In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore, more
the Spot Price more are the chances of going into a loss. It is the reverse for Put
Writing.
STRIKE PRICE: In case of a call option the payoff for the buyer is shown above.
As per this relationship a higher strike price would reduce the profits for the
holder of the call option.
TIME TO EXPIRATION: More the time to Expiration more favorable is the option.
This can only exist in case of American option as in case of European Options
the Options Contract matures only on the Date of Maturity.
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VOLATILITY: More the volatility, higher is the probability of the option generating
higher returns to the buyer. The downside in both the cases of Call and put is
fixed but the gains can be unlimited. If the price falls heavily in case of a call
buyer then the maximum that he loses is the premium paid and nothing more
than that. More so he/ she can buy the same shares form the spot market at a
lower price.
Similar is the case of the put option buyer. The table shows all effects on the
buyer side of the contract.
RISK FREE RATE OF INTEREST: In reality the r and the stock market is
inversely related. But theoretically speaking, when all other variables are fixed
and interest rate increases this leads to a double effect: Increase in expected
growth rate of stock prices discounting factor increases making the price fall.
In case of the put option both these factors increase and lead to a decline in the
put value. A higher expected growth leads to a higher price taking the buyer to
the position of loss in the payoff chart. The discounting factor increases and the
future value become lesser.
In case of a call option these effects work in the opposite direction/The first effect
is positive as at a higher value in the future the call option would be exercised
and would give a profit. The second affect is negative as is that of discounting.
The first effect is far more dominant than the second one, and he overall effect is
favorable on the call option.
DIVIDENDS: When dividends are announced then the stock prices on ex-
dividend are reduced. This is favorable for the put option and unfavorable for the
call option.
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CALL OPTION:
C = SN (dl)-Xe"rtN(d2)
PUT OPTION:
p = xe^NC-oa-SNC-oa)
Where
C - VALUE OF CALL OPTION
S - SPOT PRICE OF STOCK
X - STRIKE PRICE
r - ANNUAL RISK FREE RETURN
t - CONTRACT CYCLE
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CHAPTER-3
COMPANY PROFILE
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Incorporated in 1993, Net worth Stock Broking Limited (NSBL) has been a listed
company at Bombay Stock Exchange (BSE), Mumbai since 1995.
A Member, at the National Stock Exchange of India (NSE) and Bombay Stock
Exchange, Mumbai (BSE) on the Capital Market and Derivatives (Futures &
Options) segment, NSBL has been traditionally servicing Institutional clients and
in the recent past has forayed into retail broking, establishing branches across
the country. Presence is being marked in the Middle East, Europe and the United
States too, as part of our attempts to cater to global markets. We are a
Depository participant at Central Depository Services India (CDSL) with plans to
become one at National Securities Depository (NSDL) by the end of this quarter.
We have our customers participating in the booming commodities markets with
our membership at the Multi Commodity Exchange of India (MCX) and National
Commodity & Derivatives Exchange (NCDEX), through Networth Stock.Com Ltd.
With its strong support and business units of research, distribution & advisory,
NSBL aims to become a one-stop solution to the broking and investment needs
of its clients, globally.
Strong team of professional’s experienced and qualified pool of human
resources drawn from top financial service & broking houses form the backbone
of our sizeable infrastructure. Highly technology oriented, the company’s
scalability of operations and the highest level of service standards has ensured
rapid growth in the number of locations & the clients serviced in a very short span
of time. ‘Networthians’, as each one of our 400 plus and ever growing team
members are addressed, is a dedicated team motivated to continuously progress
by imbibing the best of global practices, Indian sing such practices, and to
constantly evolve a comprehensive suite of products & services trying to meet
every financial / investment need of the clients.
41
NSE CM and Derivatives Segment SEBI Regn. 1NB230638639 &
1NF230638639
BSE CM and Derivatives Segment SEBI Regn. 1NB010638634 &
PMS SEBI Regn. 1NP000001371 CDSL DP SEBI Regn. IN-DP-CDSL 251-2004
Commodities Trading: MCX -10585 and NCDEX - 00011 (through Networth
Stock.Com
Hyderabad (Somajiguda)
401, Dega Towers, 4th Floor, Raj Bhavan Road, Somajiguda Hyderabad - 500
082
5, Church gate House, 2nd Floor, 32/ 34 Veer Nariman Road, Fort
Mumbai - 400 001
Products and services portfolio
With greater choices comes greater value. Networth offers you more choices by
providing a wide array of products and personalized services, so you can take
charge of your financial future with confidence. So whether you are a new
investor or a seasoned one, we have the resources and advice you would need
to make smart, well-researched investments and help you grow your Networth.
1. Retail and institutional broking
2. Research for institutional and retail clients
3. Distribution of financial products
• Mutual funds
• Insurance
• NBFC Loans
4. PMS
42
5. Corporate finance
6. Net trading
7. Depository services
8. Commodities Broking
Infrastructure
1 A corporate office and 3 divisional offices in CBD of Mumbai which houses
state-of-the-art dealing room, research wing & management and back
offices.
2 All of 107 branches and franchisees are fully wired and connected to hub
at corporate office at Mumbai. Add on branches also will be wired and
connected to central hub
3 Web enabled connectivity and software in place for net trading.
4 60 operative ID’s for dealing room
43
5 In house technology back up team to ensure un-interrupted connectivity.
1993: Networth Started with 300 Sq.ft. of office space & 10 employees
2006: Spread over 42 cities (around 70,000 Sq.ft of office space) with over 107
branches & employee strength over 400
44
customers, NSBL is spread across the country though its over 300+ branches.
NSBL is listed on the BSE since 1994.
At the heart of our values lie diversity and inclusion. They are a fundamental part
of our culture, and constitute a long-term priority in our aim to become the world's
best international bank.
Values
• Responsive
• Trustworthy
• Creative
• Courageous
Approach
45
• Customers:- Passionate about our customers' success, delighting them
with the quality of our service
• Our People:- Helping our people to grow, enabling individuals to make a
difference and teams to win
• Communities:- Trusted and caring, dedicated to making a difference
• Investors:- A distinctive investment delivering outstanding performance
and superior returns
• Regulators: - Exemplary governance and ethics wherever we are.
46
MARKET PROFILE
47
a right to trade on the Exchange. Only qualified traders can be involved in the
securities trading.
The NSE is one of the few exchanges in the world trading all types of securities
on a single platform, which is divided into three segments: Wholesale Debt
Market (WDM), Capital Market (CM), and Futures & Options (F&O) Market.
Each segment has experienced a significant growth throughout a few years of
their launch. While the WDM segment has accumulated the annual growth of
over 36% since its opening in 1994, the CM segment has increased by even 61%
during the same period. The National Stock Exchange of India has stringent
requirements and criteria for the companies listed on the Exchange. Minimum
capital requirements, project appraisal, and company's track record are just a few
of the criteria. In addition, listed companies pay variable listing fees based on
their corporate capital size.
The National Stock Exchange of India Ltd. provides its clients with a single, fully
electronic trading platform that is operated through a VSAT network. Unlike most
world exchanges, the NSE uses the satellite communication system that
connects traders from 345 Indian cities. The advanced technologies enable up to
6 million trades to be operated daily on the NSE trading platform.
NSE Nifty:
The S&P CNX Nifty (nicknamed Nifty 50 or simply Nifty), is the leading index for
large companies on the National Stock Exchange of India. S&P CNX Nifty is a
well diversified 50 stock index accounting for 22 sectors of the economy. It is
used for a variety of purposes such as benchmarking fund portfolios, index based
derivatives and index funds.
Nifty was developed by the economists Ajay Shah and Susan Thomas, then at
IGIDR. Later on, it came to be owned and managed by India Index Services and
Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is
India's first specialized company focused upon the index as a core product. IISL
have a consulting and licensing agreement with Standard & Poor's (S&P), who
are world leaders in index services.
48
CNX stands for CRISIL NSE Indices. CNX ensures common branding of indices,
to reflect the identities of both the promoters, i.e. NSE and CRISIL. Thus, 'C'
stands for CRISIL, 'N' stands for NSE and X stands for Exchange or Index. The
S&P prefix belongs to the US-based Standard & Poor's Financial Information
Services.
NSE other indices:
S&P CNX Nifty
CNX Nifty Junior
CNX 100
S&P CNX 500
CNX Midcap
S&P CNX Defty
CNX Midcap 200
49
BOMBAY STOCK EXCHANGE:
The Bombay Stock Exchange Limited (formerly, The Stock Exchange, Mumbai;
popularly called The Bombay Stock Exchange, or BSE) is the oldest stock
exchange in Asia. It is located at Dalal Street, Mumbai, India.
Bombay Stock Exchange was established in 1875. There are around 5,600
Indian companies listed with the stock exchange, and has a significant trading
volume. As of October2006, the market capitalization of the BSE was about Rs.
33.4 trillion (US $ 730 billion). The BSE SENSEX (Sensitive index), also called
the BSE 30, is a widely used market index in India and Asia. As of 2005, it is
among the 5 biggest stock exchanges in the world in terms of transactions
volume.
History:
An informal group of 22 stockbrokers began trading under a banyan tree
opposite the Town Hall of Bombay from the mid-1850s, 1875, was formally
organized as the Bombay Stock Exchange (BSE).In January 1899, the stock
exchange moved into the Brokers’ Hall after it was inaugurated by James M
MacLean. After the First World War, the BSE was shifted to an old building near
the Town Hall. In 1956, the Government of India recognized the Bombay Stock
Exchange as the first stock exchange in the country under the Securities
Contracts (Regulation) Act.1995, when it was replaced by an electronic
(e.trading) system named BOLT, or the BSE Online Trading system. In 2005, the
status of the exchange changed from an Association of Persons (AoP) to a fully
fledged corporation under the BSE (Corporatization and Demutualization)
Scheme, 2005 (and its name was changed to The Bombay Stock Exchange
Limited).
50
BSE Sensex:
The BSE SENSEX (also known as the BSE 30) is a value-weighted index
composed of 30 scrip’s, with the base April 1979 = 100. The set of companies
which make up the index has been changed only a few times in the last 20 years.
These companies account for around one-fifth of the market capitalization of the
BSE.
SENSEX, first compiled in 1986 was calculated on a "Market Capitalization-
Weighted" methodology of 30 component stocks representing a sample of large,
well-established and financially sound companies. The base year of SENSEX is
1978-79. The index is widely reported in both domestic and international markets
through print as well as electronic media. SENSEX is not only scientifically
designed but also based on globally accepted construction and review
methodology. From September 2003, the SENSEX is calculated on a free-float
market capitalization methodology. The "free-float Market Capitalization-
Weighted" methodology is a widely followed index construction methodology on
which majority of global equity benchmarks are based.
The growth of equity markets in India has been phenomenal in the decade gone
by. Right from early nineties the stock market witnessed heightened activity in
terms of various bull and bear runs. More recently, the bourses in India
witnessed a similar frenzy in the 'TMT' sectors. The SENSEX captured all these
happenings in the most judicial manner. One can identify the booms and bust of
the Indian equity market through SENSEX.
The values of all BSE indices are updated every 15 seconds during the market
hours and displayed through the BOLT system, BSE website and news wi wire
agencies.
51
set of combined variables (such as price and number of shares) is commonly
referred as a 'Composite Index' by statisticians. A single indexed number is used
to represent the results of this calculation in order to make the value easier to
work with and track over time. It is much easier to graph a chart based on
indexed values than one based on actual values.
The base period of SENSEX is 1978-79. The actual total market value
of the stocks in the Index during the base period has been set equal to an
indexed value of 100. This is often indicated by the notation 1978-79=100. The
formula used to calculate the Index is fairly straightforward. However, the
calculation of the adjustments to the Index (commonly called Index maintenance)
is more complex.
52
BSE SENSEX 2009 is calculated based on the 30scrips. Those thirty scrips are
as
follows:
Code Name Sector
500410 ACC Ltd. Housing Related
500103 Bharat Heavy Electricals Ltd. Capital Goods
53
532540 Tata Consultancy Services Limited Information Technology
500570 Tata Motors Ltd. Transport Equipments
500400 Tata Power Company Ltd. Power
500470 Tata Steel Ltd. Metal,Metal Products & Mining
507685 Wipro Ltd. Information Technology
54
CHAPTER-4
DATA ANALYSIS
&
INTERPRETATION
55
ANALYSIS AND INTERPRETATION
56
Symbol Date Expiry Strike Price Open High Low Close
NIFTY 26-Mar- 29-Apr-10 5400 46 58.9 43 55.25
10
NIFTY 29-Mar- 29-Apr-10 5400 54 73.75 50 65.35
10
NIFTY 30-Mar- 29-Apr-10 5400 67 69 46 49.15
10
NIFTY 31-Mar- 29-Apr-10 5400 48.9 55 41.7 45.2
10
NIFTY 1-Apr-10 29-Apr-10 5400 49 51.8 44.25 48.35
NIFTY 5-Apr-10 29-Apr-10 5400 50.35 62.8 48.8 61.05
NIFTY 6-Apr-10 29-Apr-10 5400 65 68.3 55.25 59.25
NIFTY 7-Apr-10 29-Apr-10 5400 63 73 50.6 64.5
NIFTY 8-Apr-10 29-Apr-10 5400 60 60.8 40 43.1
NIFTY 9-Apr-10 29-Apr-10 5400 45 69.3 43.65 58.3
NIFTY 12-Apr-10 29-Apr-10 5400 60.5 61.95 47.25 51.65
NIFTY 13-Apr-10 29-Apr-10 5400 49 52 39.05 42.65
NIFTY 15-Apr-10 29-Apr-10 5400 67.7 67.7 26.8 28.6
NIFTY 16-Apr-10 29-Apr-10 5400 25 27.4 18.5 20.55
NIFTY 19-Apr-10 29-Apr-10 5400 10 14 5.6 9.8
NIFTY 20-Apr-10 29-Apr-10 5400 10.5 11.7 6 6.6
NIFTY 21-Apr-10 29-Apr-10 5400 7.5 9.25 5.15 5.75
NIFTY 22-Apr-10 29-Apr-10 5400 4.35 23 3.4 7.4
NIFTY 23-Apr-10 29-Apr-10 5400 6.45 11.9 5.4 8.1
NIFTY 26-Apr-10 29-Apr-10 5400 12.2 14 5.9 7.05
NIFTY 27-Apr-10 29-Apr-10 5400 4.95 9.5 2.6 3.15
NIFTY 28-Apr-10 29-Apr-10 5400 1.4 2 0.35 0.55
NIFTY 29-Apr-10 29-Apr-10 5400 0.2 0.2 0.05 0.05
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5400 PUT OPTION FOR APRIL 2010
58
Margin
Margin amount is security to the Broking firms In derivatives market trading
happens on basis of margin amount, here Margin amount is investment of
customers, sometimes margin may becomes zero, sometimes it may go negative
values.
Ex: if a Nifty contract worth is 2 lakhs, broking companies will not take total
amount, normally they used to collect 15% on actual worth it means they collect
only 30k. if nifty looses 600 points , margin amount becomes zero, if nifty looses
more than 600 points, it comes in negative
When coming to may contract, there is lot of positive fluctuations (Never happen
in stock market). Because of Old Govt. formation on 16th May 2009.
Here , in a situation, a investor expects correction on may 13th and he had
short sell nifty future on same day @ 3700 ( keep in mind elections results on
16th) and Paid margin amount of 30k. and he knows that if Nifty crosses 4250 his
margin becomes Zero.
In above situation, to give the security to his margin amount, I am
suggesting 3900 call option .on 15th may 2009 for the investment of 3500
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• Nifty option hits 680 it means is he was in gain of 600 points
600*50 = 30000
It means after deducting the margin amount he has still 15000 positive balance
with the company.
Here Rs 3500 worth call option given the 30k worth security
On 19th may if he sold the call option he gains 610 points and he hold the
position short sell of 3700.
On 22nd may he covers the nifty (3700 short) @4200, here the loss was
500 points.
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27-MAY-2010 FUTURES INDEX NIFTY-50
61
NIFTY5000 CALL OPTION TABLE FOR 27-MAY-2010
62
NIFTY 5000 PUT OPTION TABLE FOR 26-MARCH-2009
63
NIFTY 5100 PUT OPTION TABLE FOR 27-MAY-2010
OPEN = 5263.8
HIGH = 5290
LOW = 4786.45
CLOSE = 5004
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INTERPRETATION: In the above graph I calculated BEP.
Here I observed as a value share is high rate so Nifty-50 value was (5038.225 -
5290.00=251.775) so here share value is decreased so in this period of so here
investors gets more losses, when goes for more longs .if investor enter for longs
on 7th of May, with in short span of time investor get good profits. So this is good
signal of the investors. So here I again observed nifty-50 losses of the period so
here Nifty-50 share value is (5038.225-4786.45=251.775) so share value is
increased so here investor gets more profits, when attempts for more shorts. So
this is unexpected changes in market and politics and lack of experts of
investors.
2nd
So here investor in the contract Thursday was more losses. So May
contract was started 5263.8 and ending of the contract 5004 so here investor
gets more losses in longs and more profits in shorts.
When an investor goes for shorts in 3 levels, when compare to BEP
Explaining the actual position of investor
(1)Margin of Safety (M.o.S) =opening share value – BEP
. =5263.8-5038.225
=-225.575
So here margin of safety is less than to the BEP share value. So here investor
gets some profits in shorts.
(2) Margin of Safety (M.o.S) =high share value –BEP
=5290.00-5038.225
=251.775
So here margin of safety is more than to the BEP share value. So here investor
gets more profits and longs.
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(3) Margin of Safety (M.o.S) =low share value –BEP
= 4786.45 – 5038.225
= 251.775
So, in the above situation , after low recorded price 4786.45, nifty maximum
reached 5004, so the max loss in the current contract is 217.55 here margin of
safety is less than to the BEP so here investor gets more losses when investor
goes for more shorts.
Hedging
Hedging does not remove losses. The best that can be achieved using hedging
is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position
will make less profit than the un-hedged position, half the time. One should not
enter into a hedging strategy hoping to make excess profits for sure; all that can
come out of hedging is reduced risk
Example for Hedging
In stock market terminology Hedging means Risk Minimizing
1. A customer buys the 10 lots nifty May Future @5280 in first day of May. till end
of the May he has not covered the position.
In last week of May nifty has closed @5004. So the loss per lot is Approx
13800. So which instrument gives the best HEDGING for him?
According to analyst words on 30th April 2010, market performance for the
current contract will be based on these factors.
If nifty crosses 5301, next level will be 5381 and 5450. If nifty breaks 5220 next
levels will be continue in down trend, like 5150, 5080,5020,4950,4880. Where
continuous down trend also not possible, there will be some ups and downs.
Above I have mentioned call option table for 5000 and put option table for 5000
and 5100 for May 2010, if you observe on 3rd May 5100 put option recorded
Rs55.00, assume that customer entered in this level and exits at this level.
Rs310 on 25th may 2010.
Here, nifty unable to break its next resistance level 4780 on the 25 th May 2010.
So and recorded huge volume in open interest for 5100 puts.
66
According to market sentiment, when a product records high volumes in open
interest, probability is very less to increase.
Based on above information first, customer has to exit put option from the market
on 25th and has to maintain his future long position in the market.
67
NIFTY June 2010 CONTRACT
68
5100 CALL OPTION FOR JUNE 2010 CONTRACT
69
5100 PUT OPTION FOR JUNE 2010 CONTRACT
70
= 5155.525
So here margin of safety is less than to the BEP share value . so here investor
gets some losses in shorts.
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How Premiums works on Options
In derivatives market, customers can invest in only options also. But here the
maximum risk is Premium amount paid by the investor.
The reason investor’s shown more interest on options: less risk with high returns.
Ex: Ramesh buys 300 equity shares of RIL @1000 on 1st January 2010, for a
target price of Rs.1200 by 28th January2010. According to his expectation target
reaches to 1200, what are the returns generated by ramesh
In futures long / short investor no need to pay complete contract amount. Here
investor has to pay 25% as margin amount.
In the above example, 300 RIL shares contain one lot. Total contract value is
300000. But the margin amount is only 75000.
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An equity customer can invest with his investment 4 times in future, this is the
one reason people shown interest on futures investment.
Ex: in the above example, on 1000 RIL strike price investor paid Rs.25 as
premium on each unit. Contract size is 300 units. Investment value is 7500. Here
7500 giving the right on 300000 contract. Here assumption of buy price is 1025,
because Rs.25 premium is added in the contract.
End of the contract price appreciation on RIL is 200. But here we have to take
Rs.175 into consideration.
In the above example if the stock price falls to Rs.500 also, the maximum loss
would be only the premium. He no need to bare any extra loses.
This is the only one reason, I have found in the study people shown more interest
towards futures and options.
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1. NIFTY EXAMPLE FOR JUNE CONTRACT 2010:
On 16th June, nifty traded between 5215 to 5230, where investor expected
market fall for the month below 5100.and he bought 15000 nifty 5100 puts @ 20.
According to put concept, if the value of underlying asset increases, put value
decreases, so here end of the contract put became zero. The same one can
observe in June month put option table.
2. One client expected that LT share price will increases to 1800, when market
trades at 1635, on 7th June 2010. He knows 3 alternative investments in the
market one is buying in equities, or entering into futures contract or buying
nearest call option. So, he ready to do high risk and entered into 1650 call on 07 th
June 2010 at Rs.35.
In the above situation if investor takes any other investments like investing in
equities and futures, he would not able to generate above mentioned ret
74
CHAPTER – 6
FINDINGS,
SUGGESTIONS
&
CONCLUSION
75
FINDINGS:
1. Derivative have existed and evolved over a long time, with roots in
commodities market .In the recent years advances in financial markets
and technology have made derivatives easy for the investors.
6. In derivative market the profit and loss of the option writer/option holder
purely depends on the fluctuations of the underlying.
7. Where investor have higher risk, is getting high returns, it’s clearly
showing in live examples.
76
SUGGESSIONS
• The derivative products give the investor an option or choice whether the
exercise the contract or not. Option gives the choice to the investor to
either exercise his right or not.
• If on 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 option.
77
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 technologies have made derivatives easy for the investors.
• Derivatives market in Indian is growing unlike equity markets. Trading in
derivatives require more than average understanding of finance. Being
new to markets maximum number of investors has not yet understood the
full implications of the trading and 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 thorough
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 minimize because small
investor cannot afford this much of huge premiums.
78
CHAPTER-7
BIBLIOGRAPHY
79
BIBLIOGRAPHY
Text Books:
News papers:
Economic Times
Business Line
Times of India
Websites:
www.indianderivatives.com
www.nseindia.com
www.bseindia.com
www.networthdirect .com
80