History of Derivative Markets

Learn How Derivatives Evolved and Where They Are Today

© Sibananda Panigrahi

MARCH 01, 2011

Studying the history of derivative markets helps us understand derivatives better, as well it offers unique insights into how derivative
markets are structured today.

Rudimentary 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, for example, was quite frequent. Hundreds of years ago, Japan had a semblance of an
actual futures exchange. But it was not until 1848 that the first modern, organized futures market in North America was created—the
Chicago Board of Trade.

Agricultural Futures Dominate the First 100 Years of Derivatives Trading

After the Chicago Board of Trade first opened its doors, the grain market in Chicago almost exploded. Farmers needed to secure prices
for their grain, needed to know those prices in advance of the crops, needed a place to store the grain, and needed someone to
facilitate delivery and settlement of futures contracts.

Around that time, the first customized option contracts were offered, too. To illustrate, a well known financier of the era, Russell Sage,
offered customized options that effectively imitated loans at interest rates that were much higher than rates allowed under the then-
existing usury laws.

After the Chicago Board of Trade, other organized derivatives markets were established in the U.S., including the Chicago Mercantile
Exchange, and later The New York Mercantile Exchange and the Chicago Board Options Exchange. The latter two subsequently
became the main driving forces of the derivatives industry worldwide.

During the 1970s, Financial Derivatives Enter the Scene

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. In addition, although customized options existed since the 19th century at least, the introduction of
standardized options in 1973 completely overshadowed their customized counterparts.

Another important factor impacted the derivatives markets in the 1970s—deregulation of foreign exchange rates. When foreign
exchange rates became freely floating, not only have new currency markets developed, but also the markets for trading customized
forward contracts in foreign currencies. This market was later referred to as the interbank market because most of the participants
were, and still are, domestic and international banks. Aside from facilitating trading in currency derivatives, the currency interbank
market also set the stage for the banking industry to become more involved in trading of other types of financial derivatives.

The Age of Deregulation in the 1980s

More deregulation of the 1980s further blurred the regulatory lines among financial services providers, such as banks, insurance
industries, securities dealers, etc. Banks in particular discovered they could create various types of derivatives that were to be sold to
corporations, as well as to other financial institutions. The idea was to create tailored products that were designed to alleviate risk
exposure specific to certain situations and certain players.

Of course, banks were not the only ones profiting from financial derivatives designed to transfer or lay off risks elsewhere. Investment
banking firms, also called derivatives dealers, soon joined in the burgeoning derivative markets.
The Age of Maturity in the 1990s

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 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.

Derivatives Markets in the 21st century

There is a general consensus that London and New York are the world’s primary markets for over-the-counter derivatives. Notably,
significant derivatives trading is also happening in Tokyo, Paris, Frankfurt, Chicago, Amsterdam, etc.

In terms of size, today the U.S. accounts for almost 35% of futures and options trading worldwide. However, the Korea Stock Exchange
is the largest derivative exchange in the world. The second largest by volume is the Eurex (German-Swiss), followed by the Chicago
Board of Trade, the London International Financial Futures and Options Exchange, the Paris bourse, the New York Mercantile
Exchange, the Bolsa de Mercadorias & Futuros of Brazil, and the Chicago Board Options Exchange. Note that in 2001, these
exchanges traded in aggregate 70 million derivative contracts (Source: Futures Industry, January/February 2002).

HISTORY OF DERIVATIVES
HISTORY OF DERIVATIVES

With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is
driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of
multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk,
interest rate risk, economic risk and political risk.

With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries
adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate
cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every
asset—whether commodity or metal or share or currency—is subject to depreciation in its value. It may be due to certain
inherent factors and external factors like the market condition, Government’s policy, economic and political condition
prevailing in the country and so on.

In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by
shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management
becomes a must for survival since there is a high volatility in the present financial markets.

In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of
the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks.
They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives,
thus, enable the clients to transfer their financial risks to he financial service companies. This really protects the clients from
unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To
hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.
History of Derivatives Market:
In the early days forward contracts in the United States were meant to take care of the interests of the merchants and dealers by
making sure that there were enough buyers and sellers for different commodities like grains, pulses, metals etc. However, with the
forward contracts “credit risk” remained a very serious problem. In order to counter this problem of credit risk, a group of visionary
businessmen from Chicago formed the Chicago Board of Trade (CBOT), way back in the year 1848. The most important motive of the
CBOT was to provide a centralized platform or location that is known to the traders way in advance so that the buyers and sellers could
negotiate forward contracts to fulfill their respective interests. In the year 1865, the CBOT put its best foot forward in order to list the first
“exchange traded” derivatives contract in the US. On that occasion, the world’s first standardized and exchange traded derivative
instrument was born. This inovative derivative instrument was called “Future Contract”. In the year 1919, another organization known as
the Chicago Butter and Egg Board, a sister concern of the CBOT, was allowed to trade future contracts. This was the world's second
derivatives market in the organized sector. Later its name was changed to Chicago Mercantile Exchange (CME) from Chicago Butter
and Egg Board. Even to the present day, the CBOT and the CME remain the two largest organized futures exchanges in the world. As
a matter of fact these two are the largest “financial” exchanges of any kind in the whole of the world to the present day. The very first
stock index futures contract was traded at an exchange in the United States popularly known as Kansas City Board of Trade (KBOT). In
today's date, the most popular stock index futures contract in the world is based on S&P 500 index. The S&P 500 index is traded on
Chicago Mercantile Exchange and is its benchmark index. During the mid eighties, financial future contracts became the most popular
derivative instruments generating extremely huge sales volumes that are many times higher than the commodity future contracts. Stock
exchange Index futures, futures on Treasury-bills and Euro-currency futures are the three most popular future contract types traded in
the present day. Other popular international derivatives exchanges that trade futures and options are London International Financial
Futures and Options Exchange (LIFFE) in England, Deutsche Termin Boerse (DTB) in Germany, Singapore Exchange Limited (SGX) in
Singapore, Tokyo International Financial Futures Exchange Inc. (TIFFE) in Japan, Marché à Terme International de France (MATIF) in
France, Europe's Global Financial Marketplace (EUREX) of the European Union etc.

Financial Derivatives Market in India:

In today's date, both in terms of trading volumes and sales turnover, the National Stock Exchange of India (NSE) is the largest
derivatives exchange in India. The average sales turnover for a day at the NSE currently crosses Rs 50,000 crores. The derivatives
trading on the National Stock Exchange (NSE) started with S&P CNX NIFTY index futures on June 12, in the year 2000. S&P CNX
NIFTY is the benchmark index of the National Stock Excfhange. The trading in index options at the NSE started on June 4, in the year
2001 and trading in options on individual stocks started on July 2, the same year. Individual securities future contracts were launched
on November 9, that year. As to the present date, the derivative contracts at the National Stock Exchange have a maximum of 3 –
month expiration cycle. At any given point of time, three derivative contracts are available for trading with respect to the expiration
cycle. They are of 1 – month, 2 – month and 3 – month time period for expiry. A new contract is introduced on the next trading day
which is Friday. The near month contract expires on Thursday.

Traders in Derivative Markets:

The following three broad categories of participants – hedgers, speculators and arbitrageurs trade in the derivative market. There is
always some risk factor associated with the price of an asset. The hedgers use derivative instruments like futures and options to reduce
or eliminate this risk. The hedgers are generally risk averse in nature. A hedger will take a position in the futures market that is opposite
to a risk to which he/she is exposed. The speculators wish to bet on future movements in the price of an asset. They forecast the future
price and accordingly take long or short position. Futures and options contracts are the instruments by which they can increase both the
potential gains and potential losses in a speculative transaction. The arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. When arbitrageurs see a discrepancy between the futures price of an asset and its cash price,
they will take offsetting positions in the two markets to lock in a profit. The spreaders are also risk averse in nature. They want to take
less risk and are satisfied with less returns. They take offsetting future position which minimizes the risk and thereby minimizes the
return as well.

Use of Derivative Instruments: In the contemporary market situation, there are many advantages of derivative instruments which
makes them increasingly popular among the investor community all over the world. Following are the main ways in which derivatives
are used.
1- The most important use of derivatives is to control, avoid, shift and manage different types of risks through strategies like hedging,
arbitraging, spreading etc.

2- Derivatives serve as measuring tools of the future price trends by spreading different information regarding the futures markets
trading of various securities thereby assisting the investors appropriate and superior allocation of resources.

3- In case of derivatives trading, no immediate full amount of the transaction is required, as a result large number of traders,
speculators and arbitrageurs are able to operate in these markets. This increases the liquidity and decreases the transaction costs.

4- With the help of derivative products, invertors, traders and fund managers can formulate strategies for proper asset allocation and
high returns thereby achieving their investment objectives.

5- Derivative instruments help in balancing price fluctuations, reduce the price spread, integrate the price structure with respect to time
and remove shortages in the markets.

6- Derivative products promote competitive trading among different market operators like hedgers, speculators, arbitrageurs etc. This
results in increase in the trading volumes and growth of financial markets.

7- Derivative trading develops the market towards “complete” and “efficient” markets. In a complete market, no particular investor is at a
better position than the other as all of them share the same market information and have similar resources at their disposal. In an
efficient market, there is no scope for any abnormal gain in a financial transaction whatsoever.

Grounds on which derivative instruments have been criticized: Despite the advantages of derivative instruments, some industry
experts have raised doubts over their rapid growth and have criticized them on the following grounds.

1- Speculative and gambling motives: One of the strongest arguments against derivatives is that they promote speculative activities in
the market. The world over, the volume of derivative trading has increased in multiples of the value of the underlying assets while a
mere one or two percent of the transactions are settled by actual delivery. The rest of the trading is done with speculative and gambling
motives.

2- Increase in risk: Derivatives are supposed to be a risk management instrument. However, it has been argued that it is not the
complete truth. Derivative instruments that are traded off-exchange or the OTC market carry more risk factor. They expose the trading
parties to operational risk, counter-party risk and legal risk.

3- Instability of the financial system: It has been argued that derivatives have increased the risk factor not only for the trading parties but
also the entire financial system. The rapid growth in the trading volumes of derivative instruments have given rise to the fear of micro
and macro financial crisis. The speculative and gambling motives of the market participants have made the financial system unstable.

4- Price instability: It has been said that derivative instruments help in balancing price fluctuations, reduce the price spread, integrate
the price structure with respect to time and remove shortages in the markets. However, the critics have doubt about this. They argue
that derivatives have caused price fluctuations and increased the price spread thereby resulting in price instability.

5- Displacement effect: Another doubt over their rapid growth of the derivative market is that it will affect the business volumes in the
primary market or the new issue market. When majority of the investors move towards the derivatives market, raising fresh capital in
the primary market will get difficult. This will give rise to the phenomenon called displacement effect.
6- Increased regulatory burden: As already pointed out, derivatives have increased the risk factor which has made the financial system
unstable. The speculative and gambling motives of the market participants have increased the burden on the government and the
regulatory authorities to exercise control, supervision and monitoring of the market movements so that frauds, scams and situations of
crisis can be avoided.

DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange
has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for
members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and
Exchange Board of India.

In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork
for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It
was headed by Mr. O.P. Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a few
derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a
limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-
the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial
intermediary.

However, there should be proper legislations for the effective implementation of derivative contracts. The utility of
derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the
derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the
success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the
provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options
and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since
derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far
more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the
market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based
derivative products rather than security based derivative products.

There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy
derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts
being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day.
Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users.

RECENT DEVELOPMENTS

At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the
NSE. The natures of derivative contracts permitted are:

• Index Futures contracts introduced in June, 2000,

• Index options introduced in June, 2001, and

• Stock options introduced in July 2001.

The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for
the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the
underlying individual security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple
of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of
contract.

Apart from the above, there are market wide limits also. The market wide limit for index products in NIL. For stock specific
products it is of open positions. But, for option and futures the following wide limits have been fixed.

• 30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the
exchange. Or

• 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms of number of shares of a
company.

ELIGIBILITY CONDITIONS

The SEBI has laid down some eligibility conditions for Derivative exchange/Segment and it’s clearing Corporation/House.
They are as follows:

• The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and
volumes on a real time basis so as to deter market manipulation.

• The Derivatives Exchange/Segment should have arrangements for dissemination of information about trades,
quantities and quotes on a real time basis through at least two information-vending networks, which are easily
accessible to investors across the country.

• The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative
from all the four areas/regions of the country.

• The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and
preventing irregularities in trading.

• The Derivative Segment of the Exchange would have a separate Investor Protection Fund.

• The Clearing Corporation/House shall perform full innovation, i.e., the Clearing Corporation/House shall interpose
itself between both legs of every trade, becoming the legal counter party to both or alternatively should provide an
unconditional guarantee for settlement of all trades.

• The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both
derivatives market and the underlying securities market for those Members who are participating in both.

• The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept
of value-at-risk shall be used in calculating required level or initial margins. The initial margins should be large
enough to cover the one-day loss that can be encountered on the position on 99% of the days.

• The Clearing Corporation/House shall establish facilities for electronic fund transfer (EFT) for swift movement of
margin payments.

• In the event of a member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client
positions and assets to another solvent Member or close- out all open positions.
 • The Clearing Corporation/House should have capabilities to segregate initial margins deposited by clearing members
for trades on their own account and on account of his client. The Clearing Corporations/House shall hold the clients’
margin money in trust for the client purposes only and should not allow its diversion for any other purpose.

• The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivatives
exchange/ segment.

INVESTORS PROTECTION

The SEBI has taken the following measures to protect the money and interest of investors in the Derivative market. They are
as follows:

Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor
and is not available to the trading member or clearing member or even any other investor.

The Trading Member is required to provide every investor with a risk disclosure document, which will disclose the risks,
associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.

Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be
executed with the identity of the client and without client ID order will not be accepted by the system. The investor could
also demand the reconfirmation slip with his ID in support of the contract note. This will protects him from the risk of price
favour, if any, extended by the Member.

In the derivative markets, all money paid by the Investor towards margins on all open positions is kept in trust with the
Clearing House/ Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the
client towards margins are segregated and not utilized towards the default of the member. However, in the event of a default
of a member, losses suffered by the Investor, if any, on settled/ closed out position are compensated from the Investor
Protection Fund, as per the rules, byelaws and regulation of the derivative segment of the exchanges.

DERIVATIVES

MEANING OF DERIVATIVES

In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an
underlying asset. For instance, equity shares itself is a derivative, since, it derive its value from the firms underlying assets.
Similarly, one takes insurance against his house. Again, if one signs a contract with a building contractor stipulating a
condition, if the cost of materials goes up by 15% the contract price will also go up by 10%. This is also a kind of derivative
contract. Thus, derivatives cover a lot of common transactions.

In a strict sense, derivatives are based upon all those major financial instruments, which are explicitly traded like equity,
debt instruments, forex instruments and commodity based contracts. Thus, when we talk about derivatives, we usually mean
only financial derivatives, namely, forward, futures, options, swaps etc. The peculiar features of these instruments are that:

• They can be designed in such a way so as to the varied requirements of the users either by simply using any one of
the above instruments or by using a combination of two or more such instruments.
 • They can be designed and traded on the basis of expectations regarding the future price movements of underlying
assets.

• They are all off –balance sheet instruments and

• They are used as device for reducing the risks of fluctuations in asset values.

• As the word implies, a derivative instrument is derived from “something” backing it. This something may be a loan,
an asset, an interest rate, a currency flow, a stock trade, a commodity transaction, a trade flow etc. Derivatives
enable a company to hedge ‘this something’ without changing the flow associated with the business operation.

DEFINITION OF DERIVATIVES

It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this
field in recent years.

Moreover, many innovative instruments have been crated by combining two or more of these financial derivatives so as to
cater to the specific requirements of users, depending upon the circumstances. Inspite of this, some attempts have been
made to define the term ‘derivatives’.

• “Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal”

• “Derivatives are a special type of off-balance sheet instruments in which no principal is ever paid”.

• “Derivatives are instruments which make payments calculated using price of interest rate derived from a balance
sheet or cash instruments, but do not actually employ those cash instruments to fund payments”.

All these definitions point out the fact that transactions are carried out on a notional principal, transferring only the income
generated by the underlying asset.

Importance of Derivatives

Thus, derivatives are becoming increasingly important in world markets as a tool for risk management. Derivative
instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to
bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what
could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the
underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the
derivative market.

Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to
bear these risks. To cite a common example, let us assume that Mr. X owns a car. If he does not take insurance, he runs a
big risk. Suppose he buys insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance
policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk of owning a specified asset,
which may be a share, currency etc.

Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative deal is likely to be offset by an
equivalent loss or gain in the values of underlying assets. 'Offsetting of risks' in an important property of hedging
transactions. But, in speculation one deliberately takes up a risk openly. When companies know well that they have to face
risk in possessing assets, it is better to transfer these risks to those who are ready to bear them. So, they have to
necessarily go for derivative instruments.

All derivative instruments are very simple to operate. Treasury managers and portfolio managers can hedge all risks without
going through the tedious process of hedging each day and amount/share separately.

Till recently, it may not have been possible for companies to hedge their long term risk, say 10-15 year risk. But with the
rapid development of the derivative markets, now, it is possible to cover such risks through derivative instruments like swap.
Thus, the availability of advanced derivatives market enables companies to concentrate on those management decisions
other than funding decisions.

Further, all derivative products are low cost products. Companies can hedge a substantial portion of their balance sheet
exposure, with a low margin requirement.

Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also possible for companies to get out of
positions in case that market reacts otherwise. This also does not involve much cost.

Thus, derivatives are not only desirable but also necessary to hedge the complex exposures and volatilities that the
companies generally face in the financial markets today.

INHIBITING FACTORS

Though derivatives are very useful for managing various risks, there are certain inhibiting factors, which stand in their way.
They are as follows:

• Misconception Of Derivatives

There is a wrong feeling that derivatives would bring in financial collapse. There is an enormous negative publicity in the
wake of incidents of financial misadventure. For instance, Baring had its entire net worth wiped out as a result of its trading
and options writing on the Nikkei index futures. There are some other similar incidents like this. To quote a few: Procter and
Gamble, Indah Kiat, Showa Shell etc. However, it must be understood that derivatives are not the root cause for all these
troubles. Derivatives themselves cannot cause such mishaps. But the improper handling of these instruments is the main
cause for this and one cannot simply blame derivatives for all these misshapennings.

• Leveraging:

One of the important characteristic features of derivatives is that they lend themselves to leveraging. That is, they are 'high
risk - high reward vehicles’. There is a prospect of either high return or huge loss in all-derivative instruments. So, there is a
feeling that only a few can play this game. There is no doubt that derivatives create leverage and leverage creates increased
risk or return. At the same time, one should keep in mind that the very same derivatives, if properly handled, could be used
as an efficient tool to minimize risks.

• Off balance sheet items:

Invariably, derivatives are off balance sheet items. For instance, swap agreements for substituting fixed interest rate bonds
by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. Hence,
accountants, regulators and other look down upon derivatives.

• Absence of proper accounting system:

To achieve the desired results, derivative must be strongly supported by proper accounting systems, efficient internal control
and strict supervision. Unfortunately, they are all at infancy level as far as derivatives are concerned.

• Inbuilt speculative machanism:

In fact all derivative contracts are structured basically on the basis of the future price movements over which the speculators
have on upper hand. Indirectly, derivatives make one accept the fact that speculation is beneficial. It may not be so always.
Thus, derivatives possess an inbuilt speculative mechanism.

• Absence of proper infrastructure:

An important requirement for using derivative instrument like, options, futures etc. is the existence of proper infrastructure.
Hence, the institutional infrastructure has to be developed. There has to be effective surveillance, price dissemination and
regulation of derivative transactions. The term of the derivative contracts has to be uniform and standardized.

KINDES OF FINANCIAL DERIVATIVES

As already discussed, the important financial derivatives are the following:

• Forwards

• Futures

• Options, and

• Swaps

FORWARDS.

Forwards are the oldest of all the derivatives. A forward contract refers to an agreement between two parties to exchange an
agreed quantity of an asset for cash at certain date in future at a predetermined price specified in that agreement. The
promised asset may be currency, commodity, instrument etc.

Example: on June 1, x enters into an agreement to buy 50 bales of cotton on December 1at Rs. 1,000/- per bale from y, a
cotton dealer. It is a case of a forward contract where x has to pay Rs. 50,000 on December 1 to y and y has to supply 50
bales of cotton.

In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is
said to be in the ‘long position’. On the other hand, the user who promises to sell at an agreed price at a future date is said
to be in ‘short position’. Thus, ‘long position & ‘short position’ take the form of ‘buy & sell’ in a forward contract.

FUTURES:

A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized
one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable
and it is always traded on an organized exchange.

Clark has defined future trading “as a special type of futures contract bought and sold under the rules of organized
exchanges.” The term ‘future trading’ includes both speculative transactions where futures are bought and sold with the
objective of making profits from the price changes and also the hedging or protective transactions where futures are bought
and sold with view to avoiding unforeseen losses resulting from price fluctuations.

A future contract is one where there is an agreement between two parties to exchange any assets or currency or commodity
for cash at a certain future date, at an agreed price. Both the parties to the contract must have mutual trust in each other. It
takes place only in organized futures market and according to well-established standards.

As in a forward contract, the trader who promises to buy is said to be in ‘long position’ and the one who promises to sell is
said to be in ‘short position’ in futures also.
SWAPS:

Swap is yet another exciting trading instrument. Infact, it is a combination of forwards by two counter parties. It is arranged
to reap the benefits arising from the fluctuations in the market-either currency market or interest rate market or any other
market for that matter.

OPTIONS:

In the volatile environment, risk of heavy fluctuations in the price of assets is very heavy. Option is yet another tool to
manage such risks.

As the very name implies, as an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond,
currency, commodity etc.) at a predetermined price on or before a specified date in future. The price so predetermined is
called the ‘strike price’ or ‘exercise price’.

OPTIONS

A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a
price, called the stack price, during, a period or on a specific date in exchange for payment of a premium is known as
‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying asset is traded is called the
‘strike price’. It is one of the building blocks of the option contract.

TYPES OF OPTIONS

Options may fall under any one of following main categories:

• CALL OPTION

• PUT OPTION

• DOUBLE OPTION

CALL OPTION

A call option is one, which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stock
shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a
case, the writer of a call option is under an obligation to sell the asset at a specified price, in case the buyer exercises his
option to buy. Thus, the obligation to sell arises only when the option exercised.

PUT OPTION:

A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before
a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price
provided the option holder exercises his option to sell.

DOUBLE OPTION:

A double option is one, which gives the option holder both the right either to buy or to sell an underlying asset at a
predetermined price on or before a specified date in future.
FEATURES OF OPTION CONTRACT

High flexible:On one hand, option contracts are highly standardized and so they can be traded only in organized exchanges.
Such option instrument cannot be made flexible according to the requirement of the writer as well as the user. On the other
hand, there are also privately arranged options, which can be, traded ‘Over the Counter’. These instruments can be made
according to the requirements of the writer and user. Thus, it combines the feature of ‘futures’ as well as forward contracts.
Down Payment: The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the
option. This is considered to be the consideration for the contract. If the option holder does not exercise will be deduction
from the total payoff in calculating the net payoff due to the option holder.

Settlement: No money or commodity or shares is exchanged when the contract is written. Generally this option contract
terminates either at the time of exercising the option holder or maturity whichever is earlier. So, settlement is made only
when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement
automatically lapses and no settlement is required.

Non-Linearity: Unlike futures and forward, on option contract does not posses the property of linearity. It means that the
option holder’s profit, when the value of the underlying assets moves in one direction is not equal to his loss when its value
moves in the opposite direction by the same amount. In short, profit and losses are not symmetrical under an option
contract. This can be illustrated by means of an illustration:

Mr.X purchase a two month call option on rupee at Rs100=3.35$. Suppose, the rupee appreciates within two months by 0.05
$ per one hundred rupees, then the market price would be Rs.100= 3.40$. If the option holder Mr.X exercises his option, he
can purchases at the rate mentioned in the option i.e., Rs100=3.35$. He gets a payoff at the rate of 0.05$per every one
hundred rupees. On the other hands, if the exchanges rate moves in the opposite direction by the same amount and reaches
a level of Rs100=3.30$, the option contract, the gain is not equal to the loss.

No Obligation to Buy or Sell:In all option contracts, the option holder has a right to buy or sell underlying assets. He can
exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If
he does not buy or sell, the contract will be simply lapsed.

WRITER
In an option contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the
seller who is said to be in ‘short position’ in a forward contract. However, in a put option, the writer is in a different position.
He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract
for enjoying the right to buy or sell.

AMERICAN OPTION VS EUROPEAN OPTION

In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is
called as an American option. On the other hand, if it can be exercised only at the time of maturity, it is termed as European
option.

OPTION TRADING IN SHARES & STOCKS

When an option contract is entered into with an option to buy or sell shares or stock, it is knows as share option. Share
option transactions are generally index-based. All calculation is based on the change in index value. For example, the present
value of an index is 300. A person Mr.X buys a 3month call option for an index is 350 by paying 10% of the present index
value in points at the rate of Rs.10 per point. Now, the option price is taken as Rs.300 and the strike price or exercise price is
Rs. 350.
So long as the index remains below 350, the option holder will not exercise his option since he will be incurring losses. Now,
the loss will be limited to the premium paid at the rate of Rs. 10/- per point. As the spot price increases beyond the strike
price level, exercise of the option becomes profitable. Suppose the spot rate reaches 360, option may be exercised.
The option holder gets a profit of Rs100 (10pionts *10). However, his net position will be Rs.100-300 (premium 10% on 30
*10). He incurs a net loss of Rs. 200. When the spot rate reaches 380, the break-even point is reaches. Beyond this index
value, the option holder starts making a profit.

A person with more money can trade the index at a higher price of Rs.100 or 200 per index point. However, speculators can
play this kind of game only. Genuine portfolio managers can use this instrument to hedge their risks due to heavy
fluctuations in the prices of shares and stocks.

CURRENCY OPTIONS

Suppose an option contract is entered into between parties to purchase or sell foreign exchange, it is called ‘currency option’.
This can be illustrated by an example. An option holder buys in September, dollar at the exchange rate of 1 yen = 1.900$
maturity in November. The spot rate then was also pays a premium of 7.04 cents per yen 1. As long as the price of pound in
the market remains bellows 1.900$, the option will not be exercised. Off course the option holder suffers a loss, but his loss
is limited to the premium paid at the rate of 7.04 cents per yen 1. When the spot price increases beyond the strike price, it is
profitable to exercise the option. For instance, the spot rate becomes 1.9200$ per yen 1, if the option holder exercises his
option now, he will get a profit of .200$ per yen 1. However, his net position will be .0200-.0704 (premium) = -.0504 $
(loss). If the spot rate goes up to yen 1 =1.9704$, the break-even point is reached. Beyond this level, the option holder gets
profits by exercising his option.

On the other hand, the writer of the option gets profits as long as the option is not exercised. His profit is limited to the
premium received i.e., 7.04 cents per yen 1. When the spot rate goes beyond the strike price, the option holder will exercise
his option. At the rate 1 yen =1.9704 $ the writer of the option is also at the break-even point. If spot rate goes beyond this
level, the option writer will suffer a net loss.

OPTION CONTRACT

• Contract Size

• Exercise Style

• Expiry Date

• Option Class

• Option Series

• Premium

• Settlement Style

• Strike Price

• Type

• Underlying Asset

The option buyer pays premium to the seller and acquires the right i.e. to decide whether to buy or sell the underlying asset
at the agreed price before the option contract expires.
On the other hand, the option seller receives the premium and grants the right to the buyer i.e. he is in a passive position -
he will have to perform the agreement to buy or sell the underlying asset if so requested by the buyer before the option
contract expires.

The person who bought an option contract and keeps the position open without closing out in the market owns a long
position, and is referred to as an option holder. A long option position may be offset or closed out by selling the same
contract in the market.

The person who sold an option contract and keeps the position open without closing out in the market owns a short position,
and is referred to as an option writer. A short position may be offset or closed out by buying back the same contract in the
market.

GENERAL TERMS OF OPTIONS TRADING

• CONTRACT SIZE:

Refers to the amount of the underlying asset that one option contract represents. For example, for stock option contracts
traded on the Exchange, one option contract represents one board lot of the underlying shares (except where there has been
a capitalization change).

• EXERCISE STYLE:

Refers to when the option contract can be exercised. European style options can only be exercised on the expiry date, while
American style options can be exercised at any time on or before expiry. The exercise style for the stock option contracts and
index option contracts traded on the Exchange is American style and European style respectively.

• EXPIRY DATE:

Refers to the date on which that the option contract, and hence the right to exercise, will expire.

• OPTION CLASS:

Refers to all option contracts with the same underlying asset. For instance, all option contracts of Hong Kong Bank (HKB)
represent an option class.

• OPTION SERIES:

Refers to all option contracts with the same underlying asset, expiry date, strike price and type (call/put). Therefore, each
series is equivalent to one tradable security or unit. For instance, all HKB Call option contracts with April expiry and $180
strike represent an option series.

• PREMIUM:

Refers to the price or cost at which the option trades. For Exchange-traded stock options, it is usually quoted on a per share
basis. For index options traded on the Exchange, it is quoted on index point’s basis.

• SETTLEMENT STYLE:

Refers to the way the underlying assets change hands on exercise by the option holder. Physical settlement involves physical
delivery of the underlying assets between the holder and the writer while cash settlement involves a cash transfer of the
price difference between the strike price and underlying asset.

• STRIKE PRICE:

Refers to the pre-determined price at which the underlying asset can be bought or sold. It is also known as the EXERCISE
PRICE.
 • TYPE:

Refers to the two basic types of options: CALLS and PUTS. Call options give the buyer the right to buy the underlying asset.
Put options give the buyer the right to sell the underlying asset.

• UNDERLYING ASSET:

Refers to the asset to be exchanged if the option is exercised. There are five major categories: Equity, Index, Commodity,
Debt and Forex. For instance, a call option on the shares of ABC Company gives the holder the right to buy the shares of ABC
Company. A put option on the Hang Seng Index gives the holder the right to sell the index at HK$50 per.

• TIME VALUE:

The portion of an options premium that is attributed to the option may gain value in the remaining time before it expires.
Time value is the value that is attributed to the possibility that the option will increase in value during the time before expiry.

• Time to Expiry:

All else being equal an option with more time to expiry will have more time value than an option that has less time to expiry.
The more time there is the more opportunity the underlying asset has to move.

• Volatility of Underlying Security

The greater the volatility of the underlying the more people are willing to pay for an option's time value. Time value is higher
on volatile securities because there is a possibility of larger profits.

• Opportunity Cost:

If you have a sum of money that you could earn interest on and you decided to spend that money on buying a stock, the
interest that you could have earned is an opportunity cost. There are two factors that affect the opportunity cost: the risk-
free rate of interest and the yield on the underlying (i.e. the underlying stock's dividend yield). Higher interest rates will
mean higher call premiums and lower put premiums. Higher dividend yields will mean lower call premiums and higher put
premiums. These two factors affecting opportunity cost have a minimal effect on the options price in comparison to other
factors.

• Time Decay:

As illustrated in figure 1 the closer you get to the expiry date the faster an option's time value will deteriorate; this concept is
called time decay. You will pay more money per day of time value for an option that is nearing expiry in comparison to an
option that has a long time until expiry. All other factors being equal a nine month option would lose about 10% of its time
value in the first 3 months, in the next 3 months it would lose about 30% of the original time value, and in the last 3 months
the option would lose about 60% of its original time value.

Figure 1.

Time Decay Curve Chart

• Time Value & Risk:

In-the-Money options are options that have intrinsic value. A call option with a strike price that is below the stock price is in
the money, and a put option with a strike price that is above the stock price is in the money.

The call option in figure 2 gives the holder the right to buy the stock for $10. The stock is currently trading at $15, this
means that the call option has $5.00 of intrinsic value or the call option is $5.00 in the money.
The put option in figure 2 gives the holder the right to sell the stock for $20. The stock is currently trading at $15, this
means that the put option also has $5.00 of intrinsic value or the put option is $5.00 in the money.

Figure 2.

The further in the money an option is in the less time value it will command. Deep in-the-money options are more expensive
due to the large amount of intrinsic value. When an option is more expensive the buyer is risking more money, therefore the
buyer won't be willing to spend as much money on time value.

• Time Value & Probability of Profitability:

Out-of-the-Money is the opposite of in-the-money options. A call option with a strike price that is above the stock price is
out-of-the-money, and a put option with strike prices that is below the stock price is out-of-the-money.

The call option in figure 3 gives the holder the right to buy the stock for $20 while the stock is currently trading at $15.
Exercising the call option would mean buying the stock for $5.00 more than the current price, this is another way of saying
the call option is $5.00 out-of-the-money.

The put option in figure 3 gives the holder the right to sell the stock for $10 while the stock is currently trading at $15.
Exercising the put option would be selling the stock for $5.00 less than the current price; this means the put option is $5.00
out-of-the-money.

Figure 3.

The further out-of-the-money an option is in the less time value it will have. When you buy deep out-of-the-money options
the stock has to move a lot in order for it to have any value on expiry. The probability of the option transaction being
profitable is lower on deep out-of-the-money options anything on expiry, therefore the buyer won't be willing to spend as
much money on time value.

• INTRINSIC VALUE

Factors Affecting Intrinsic Value:

Intrinsic value is the value that could be realized by exercising an option then immediately liquidating the position in the
underlying. (I.e. exercise a call option to buy XYZ at a strike price of $20, then sell XYZ at the current price of $25; in this
example there would be an intrinsic value of $5).

There are two factors affecting intrinsic value: the strike price and the underlying security price.

Call Options: Intrinsic Value = Underlying Security Price - Strike Price

Put Options: Intrinsic Value = Strike Price - Underlying Security Price

(Note: Intrinsic Value cannot be negative, if the above equations produce a negative number the intrinsic value is zero.)

In-the-money options have an intrinsic value, which is the same amount, as the option is in the money.
At-the-money options have a market price, which is currently at or very close to the strike price. At-the-money options don't
have intrinsic value either, however they are on the verge of gaining intrinsic value if the underlying stock moves in a
favorable direction.

Out-of-the-Money options have no intrinsic value.

• Holder: The holder is the person who bought an option contract. Someone who buys an option they previously wrote
is not a holder, they are just closing an existing position. An option holder is said to be "long" the option they
bought.
• Long Call: Buying a call gives you the right to buy the underlying stock at the strike price any time until expiry.

• Long Call (Buy a Call): You would buy a call if you think the price of the underlying stock is going to rise (when you
are bullish on the underlying stock).

• Long Call Chart:If the price of the stock rose to $40 by the expiry date the call option would be worth $15 ($40 the
stock price - $25 the strike price). In this example the holder of the call option would have a profit of $10 ($15 the
value of the option at expiry - $5 the premium paid for the option).

• Short Call: Writing a call obligates you to sell the underlying stock at the strike price any time until expiry if you are
assigned.
You short a call when you write (sell) a call that you don't currently own. There are two basic types of short calls
covered and uncovered (naked).

• Naked Call (Uncovered Call): You could write a call if you think the price of the underlying stock is going to stay the
same or fall (when you are neutral or bearish on the underlying stock).

• Naked Call Chart: If the price of the stock rose to $40 by the expiry date the naked call position would be in a loss of
$10 ($5 premium you originally received for writing the naked call + $25 the strike price which you are obligated to
sell the stock for - $40 the price you would have to buy the stock for).

• Covered Call: A covered call is when you own the underlying stock and you write a call. The call is covered because if
you get assigned and have to sell the underlying stock it is OK because you already own it. If you think that a stock
price will stay the same or move up slightly you could write a covered call.

• Covered Call Chart: If the price of the underlying stock rose to $25 or higher by the expiry date the overall position
would have a profit of $6 (this remains the same because any profits on the stock are offset by losses on the short
call). If the price of the underlying stock fell to $10 your combined loss would be $9 ($10 the current price of the
stock - $22 the price paid for the stock + $3 the premium received for writing the call). A covered call position has
the same risk reward profile as writing a naked put.

• Long Put: Buying a put gives you the right to sell the underlying stock at the strike price any time until expiry.
When you buy a put to open a position you are said to be “long a put”. You can buy a put either to speculate or to
protect a position.

• Speculative Put: A speculative put is when you buy a put in hopes that the stock will fall, as opposed to buying a put
to protect a position in the underlying stock.

• Speculative put chart: If the price of the stock fell to $10 by the expiry date, the put option would have a value of
$15 ($25 strike price that you could sell the stock for - $10 current stock price that you could buy the stock for). In
this example the put holder would have a $10 profit ($15 the value of the option at expiry - $5 the premium paid for
the option).

• Protective Put: A protective put is when you have a position in the underlying stock and you buy a put to protect
against a drop in the stock's price. A protective put is like buying an insurance policy on your stock to protect against
the drop in price. You may want to buy a protective put if you think the underlying stock is going to rise buy you
have some short term concerns, and you want to protect yourself in case there is a sharp drop in the stock price.
Figure 8 shows the risk and return involved with holding a stock and buying a protective put on it. When you buy a
protective put you still have unlimited profit potential while you are able to limit your risk.
• Protective Put Chart: If the price of the underlying stock fell to $25 or lower by the expiry date the combined
position would have a loss of $10 (this remains the same because the profits on the put option will offset any losses
on the stock below the $25 strike price). If the price of the underlying stock went up to $45 there would be a profit
of $10 ($15 the gain on the stock - $5 the premium paid to buy the protective put).
A protective put has the same risk reward profile as buying a call option.

• Short Put: Writing a put obligates you to buy the underlying stock at the strike price any time until expiry if you are
assigned.

• Short Put (Writing a Put): When you write (sell) a put that you don't already own you are said to be "short a put".
You could write a put if you think the price of the underlying stock is going to stay the same or rise (when you are
neutral or bullish on the underlying stock).

• Short Put Chart: If the price of the stock fell to $5 by the expiry date, the put option would have a value of -$20 ($5
current stock price that you could sell the stock for - $25 strike price that you would have to buy the stock for). In
this example the put writer would have a $15 loss ($5 the premium received for writing the option - $20 the value of
the option you wrote at expiry). Writing a put has the same risk reward profile as a covered call position.
Naked Put (Uncovered) vs. Short Put Covered by Cash:

• There are two basic types of short puts covered and uncovered (naked). When you write a put you are taking on an
obligation to buy the underlying stock at the strike price. You can cover this obligation by having enough cash to buy
the shares at the strike price. There are several other methods of covering a short put. If you write a put option that
is not covered you are taking on more risk, this is called a naked or an uncovered put.

• Sell the Options: You can sell an option that you previously bought on or before the expiry date. Selling an option is
often the best way to close out a position if there is still time remaining before expiry. This is because when you sell
an option you will sell it for the total price (the intrinsic value + the time value). If you sell the option you will not
need to take a position in the underlying asset.

• Exercise the Options: You can only exercise an option if you are long the option (if you own the option). You can
exercise American style option any time on or before the expiry date. When an option is exercised, only the intrinsic
value is realized, and any time value remaining is lost. When you exercise an option you are actually buying or
selling the underlying stock. Exercising an option would be appropriate in a situation where there is little or no time
value, and you want to buy the stock in the case of a call, or sell the stock in the case of a put.

• Get Assigned: You can only get assigned if you are short the option. You will get assigned if the person who buys the
option from you exercises it. Being assigned is a possibility however you have no control over this; it is the decision
of the other party in the options contract. When you are assigned you must simply fulfill your obligation under the
option contract. In the case of a call option you would have to sell the stock at the strike price to the call holder, and
in the case of a put option you would have to buy the stock at the strike price from the put holder.

• Let the Options Expire: An option will expire worthless if the option is either at-the-money or out-of-the-money on
expiry. Letting your options expire worthless is the only viable decision when they are out-of-the-money on expiry.
When you let an option expire, you lose all the money you invested in the option.

• Opening an Account: Before you start trading options you will need to open a margin account. If you have a cash
account you will need to open a new account because you cannot trade options in a cash account.

When you apply for a margin account you will need to specify that you want to trade options, and you may be
required to specify what type of options strategies you would like to do in the account. If the account application
form asks it is important to tell your brokerage firm what type of option strategies you would like to be allowed to
 do. If you don't tell them you may find that they won't let you do certain types of strategies.

You can also trade options in registered accounts, however with a registered account you may also have to apply for
options approval on the account. We would recommend for you to check with your brokerage firm to see if they have
any additional requirements for trading options. For example some firms require you to have a minimum balance
before writing any naked options.

• Registered Accounts: Options can be traded in registered accounts such as RRSP or RRIF accounts, however you will
first need to get options approval on your account. Registered accounts also have restrictions as to what type of options
strategies can be done.

ANNEXURE
HOW OPTIONS WORK:

• An option is a special contract in which the option owner enjoys the right to buy or sell something without
the obligation to do so.

• The option to buy under the contract is called Call option and the options to sell are call put option.

• The option holder is the buyer of the option and the option writer is the seller of that option.

• The price at which the option holder can buy or sell the underlying asset is called the striking price or
exercise price.

• The date on which the option expires or matures is known as expiration date. The option becomes worthless
after the expiration date.

• The act of buying and selling the underlying Asset as per the option contract is called exercising the option.
An option can exercise on or before expiration date.

• These options are traded on stock exchanges. Some of these options can be traded over the counter.
Exchange traded options are standardized in terms of quantity, expiration date, strike prices, type of
options, mode of settlement trading cycle etc.

• Options contracts on individual securities on the NSE are in the multiple of 100 and have three months
trading cycle. These options expire on the last Thursday of the month.

• These options have five strike prices stipulated by the exchange and the prices have to be settled in cash.

• The value of an option expiring immediately is called its intrinsic value.

• The excess of the market price of any options over its intrinsic value is known as time value of an option.

• For e.g.: the market price of a share is Rs 520/-, the exercise price of a call option on the share is Rs 500/-
and the market price of the call option is Rs30/-. In this case, the intrinsic value of the option is Rs 20/-
(Rs520-Rs500/-) and the time value of the option is Rs 10/- (Rs 30 - Rs 20).

OPTIONS PRICING:

• The price of a put or call option depends upon the market behaviour of the equity that underlines the option.

• Generally, stock options are looked upon, as a speculative vehicle as in any option there is a risk of loss to both
the contracting parties.

• The price at which the stock under option may be put or called is the contract price. It is also referred to as a
striking price.
 • The contract price remains fixed during the life of the contract. However as per market practice, the contract
price can reduce by the amount of any dividend paid or by the value of any right, which becomes effective
during the period of contract.

• The amount the buyers pay for the option privilege in purchasing an option is called the premium. Sometimes,
it may be called as the option money. In most of the transactions the contract price is the stock market price
prevailing at the time the option is written and the premium becomes the variable for the buyer and the seller
to bargain. There are many expiration dates and striking prices offered with option, which benefit many
investors.

__________________________________________THANK YOU_______________________________________