A Study on Financial Derivative and Risk Management

TABLE OF CONTENTSCHAPTER NO.TITLEPAGE NO.

1INTRODUCTION7-10

1.1General introduction7

1.2Objective of the study9

1.3Scope of the study9

1.4Limitations10

2COMPANY PROFILE12-28

3DERIVATIVES29-99

4FINDINGS,SUGGESTIONS & CONCLUSION100-103

5BIBLIOGRAPHY105

General introduction

The liberalization of the Indian economy has ushered in an era of opportunities for the Indian corporate sector. however, these opportunities are accomplished by challenges. The corporate are now required to operate at global capacities to be able to reap the benefits of economies of scale and be competitive. To operate at global capacities, huge investments are called for and the main source of fund in the public at large. Therefore, the corporate now started tapping the capital market in a big way. The response is also encouraging.

As the Indian nation integrates with world economy era, small tremors in the world market starts affecting the Indian economy. As an example, interest rates have been south bound in the world and the same has happened in the Indian market too. fixed income rates have fallen drastically due to fall in the real income of people. To overcome this fall , investors have been continuously seek to increase the yield of their of their investments. But, it is a time-tested fact that, the yields on investment in equity shares are maximum, the accompanying risks are also maximum. Therefore, it is absolutely essential that efforts should be made to reduce this factor.

The reduction of risk can be achieved through the process of hedging using derivatives financial instrument. A hedge is any act that reduced the price risk of an existing or anticipated position in the cash market. Basically, there are two type of hedging with futures :long hedge and short hedge. Financial derivatives are a kind of risk management instrument. A derivative's value depends on the price changes in some more fundamental underlying assets. Many forms of financial derivatives instruments exist in the financial markets. Among them, the three most fundamental financial derivatives instruments are: forward contracts, futures, and options. If the underlying assets are stocks, bonds, foreign exchange rates and commodities etc., then the corresponding risk management instruments are: stock futures (options), bond futures (options), currency futures (options) and commodity futures (options) etc. In risk management of the underlying assets using financial derivatives, the basic strategy is hedging, i.e., the trader holds two positions of equal amounts but opposite directions, one in the underlying markets, and the other in the derivatives markets, simultaneously. This risk management

strategy is based on the following reasoning: it is believed that under normal circumstances, prices of underlying assets and their derivatives change roughly in the same direction with basically the same magnitude; hence losses in the underlying assets (derivatives) markets can be offset by gains

in the derivatives (underlying assets) markets; therefore losses can be prevented or reduced by combining the risks due to the price changes. The subject of this book is pricing of financial derivatives and risk management by hedging.

SCOPE OF THE STUDY

Introduction of derivatives in the Indian capital market is the beginning of a new era , which is truly exciting. Derivatives, worldwide are recognized risk management products. These products have a long history in India, in the unorganized sector , especially in currency and commodity markets. The availability of these products on organized exchanges ha provided the market participants with broad based risk management tools.

This study mainly covers the area of hedging and speculation. The main aim of the study is to prove how risks in investing in equity shares can be reduced and how to make maximum return to the other investment.

IMPORTANCE OF THE STUDY

It helps the researcher to construct a diversified portfolio.

Provide an insight on return and risk analysis.

It helps to make a general study on derivatives.

It helps to identify and reduce by using hedging strategies and speculation.

OBJECTIVE OF THE STUDY To find out extant to which loss can be reduced by applying hedging strategies.

To determine whether the hedger enjoys better returns from the use of hedgers.

To identify how much reduction in risk is possible.

To find out the extend of loss due to misjudgment on index movements .

LIMITATION OF THE STUDY

A) While applying the strategies , transaction cost and impact cost are not taken into consideration.so,it will reflect in the profit calculation on each month of the study.

B) data were collected only on the basis of NSE trading

C) Hedging strategy is applied on historical data. so the direction of each trend in the stock market is known before hand for the period selected. As a result, some bias could have been done for the application of hedging strategy.

PROFILE OF THE COMPANY

INTRODUCTION

Mr. C.J. George and Mr. Ranajit Kanjilal founded Geojit as a partnership firm. In 1993, Mr.Ranajit Kanjilal retired from the firm and Geojit became the proprietary concern of Mr. C .J. George. In 1994, it became a Public Limited Company named Geojit Securities Ltd. The Kerala State Industrial Development Corporation Ltd. (KSIDC), in 1995, became a co-promoter of Geojit by acquiring a 24 percent stake in the company, the only instance in India of a government entity participating in the equity of a stock broking company. The year 1995 also saw Geojit being listed on the leading regional stock exchanges. Geojit listed at The Stock Exchange, Mumbai (BSE) in the year 2000. Companys wholly owned subsidiary, Geojit Commodities Limited, launched Online Futures Trading in agri-commodities, precious metals and energy futures on multiple commodity exchanges in 2003. This was also the year when the company was renamed as Geojit Financial Services Ltd. (GFSL). The Board consists of professional directors; including a Kerala Government nominee. With effect from July 2005, the company is also listed at The National Stock Exchange (NSE). Company is a charter member of the Financial Planning Standards Board of India and is one of the largest Depository Participant(DP)..brokers..in..the..country.

On 31st December 2007, the company closed its commodities business and surrendered its membership in the various commodity exchanges held by Geojit Commodities Ltd. Global banking major BNP Paribas took a stake in the year 2007 to become the single largest shareholder. Consequently, Geojit Financial Services Limited was renamed as Geojit BNP Paribas Financial Services Ltd.

ABOUT BNP PARIBAS

BNP Paribas is the Eurozones leading bank in terms of deposits, and one of the 10 most important banks in the world in terms of net banking income, equity capital and market value. Furthermore, it is one of the 6 strongest banks in the world according to Standard & Poor's. With a presence in 85 countries and more than 205,000 employees, 165,200 of which in Europe, BNP Paribas is a global-scale European leader in financial services. It holds key positions in its three activities: Retail banking, Investment Solutions and Corporate & Investment Banking. The Group benefits from its four domestic markets: Belgium, France, Italy and Luxembourg. BNP Paribas also has a significant presence in the United States and strong positions in Asia and the emerging markets.

BNP Paribas has been operating in India since 1860 in a number of businesses such as Investment Banking (CIB), Private banking (BNP Paribas Wealth Management), Life Insurance (SBI Life) and Asset Management (Sundaram BNP Paribas), Infrastructure Funding (Srei BNP Paribas), Retail Financing (Sundaram BNP Paribas Home Finance), Car Contract Hiring (Arval), Institutional Broking (BNP Paribas Securities India) and Securities Services (Sundaram BNP Paribas Securities Services and BNP Paribas Sundaram Global Securities Operations).

Retail..Financial..Services..Player

Geojit BNP Paribas today is a leading retail financial services company in India with a growing presence in the Middle East. The company rides on its rich experience in the capital market to offer its clients a wide portfolio of savings and investment solutions. The gamut of value-added products and services offered ranges from equities and derivatives to Mutual Funds, Life & General Insurance and third party Fixed Deposits. The needs of over 460 000 clients are met via multichannel services - a countrywide network of 500 offices, phone service, dedicated Customer..Care..centre..and..the..Internet.

Geojit BNP Paribas has membership in, and is listed on, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). In 2007, global banking major BNP Paribas joined the companys other major shareholders - Mr. C.J.George, KSIDC (Kerala State Industrial Development Corporation) and Mr.Rakesh Jhunjhunwala when it took a stake to become the single..largest..shareholder.

Strategic joint ventures and business partnerships in the Middle East has provided the company access to the large Non-Resident Indian(NRI) population in the region. Now, as a part of the BNP Paribas global network, Geojit BNP Paribas is well positioned to further expand its reach to NRIs in 85 countries. Barjeel Geojit Securities is the joint venture with the Al Saud group in the United Arab Emirates that is headquartered in Dubai with branches in Abu Dhabi, Ras Al Khaimah, Sharjah and Muscat. Aloula Geojit Brokerage Company headquartered in Riyadh is the other joint venture with the Al Johar group in Saudi Arabia. The company also has a business partnership with the Bank of Bahrain and Kuwait, one of the largest retail banks in Bahrain..and..Kuwait.

At the forefront of the many fruitful associations between Geojit BNP Paribas and BNP Paribas is their joint venture, namely, BNP Paribas Securities India Private Limited. This JV was created exclusively for domestic and foreign institutional clients. An industry first was achieved when Geojit BNP Paribas became the first broker in India to offer full Direct Market Access(DMA) on NSE to the JVs institutional clients.

A strong brand identity and extensive industry knowledge coupled with BNP Paribas international expertise gives Geojit BNP Paribas a competitive advantage.

Expanding..range..of..online..products..and..services

Geojit BNP Paribas has proven expertise in providing online services. In the year 2000, the company was the first stock broker in the country to offer Internet Trading. This was followed by integrating the first Bank Payment Gateway in the country for Internet Trading, and many other industry firsts. Riding on this experience, and harnessing BNP Paribas Personal Investors expertise as the leading online broker in Europe, is helping the company to rapidly expanding its business in this segment. Presently, clients can trade online in equities, derivatives, currency futures, mutual funds and IPOs, and select from multiple bank payment gateways for online transfer of funds. Strategic B2B agreements with Axis Bank and Federal Bank enables the respective banks clients to open integrated 3-in-1 accounts to seamlessly trade via a sophisticated..Online..Trading..platform.

Further, deployment of BNP Paribas state-of-the-art globally accepted systems and processes is already scaling up the sales of Mutual Funds and Insurance.

Wide..range..of..products..and..services

Certified financial advisors help clients to arrive at the right financial solution to meet their individual needs. The wide range of products and services on offer includes -Equities | Derivatives | Currency Futures | Custody Accounts | Mutual Funds | Life Insurance & General Insurance | IPOs | Portfolio Management Services | Property Services | Margin Funding |Loans..against..Shares

A..growing..footprint

With a presence in almost all the major states of India, the network of 500 offices across 300 cities and towns presently covers Andhra Pradesh, Bihar, Chattisgarh, Goa, Gujarat, Haryana, Jammu & Kashmir, Karnataka, Kerala, Madhya Pradesh, Maharashtra, New Delhi, Orissa, Punjab, Rajasthan,Tamil Nadu & Pondicherry, Uttar Pradesh, Uttarakhand and West Bengal.

OVERSEAS JOINT VENTURES

Barjeel geojit securities, LLC Dubai, is a joint venture of geojit with al Saud group belonging to sultan bin saud AL Qassemi having diversified interests in the area of equity markets, real estates and trading. Barjeel geojit is a financial intermediary and the first licensed brokerage company in USA.

It has facilities for off-line and on-line trading in Indian capital market and also in US, European and far-eastern capital markets. it also provides depository services and deals in Indian and international funds. An associate company, global financial investments S.A.O.G provides similar services in Oman.

Aloua geojit brokerage company, is geojits recently promoted joint venture in Saudi Arabia with the al johar group. Saudi is home to the worlds single largest NRI population. The new venture is expected to start operations in the latter half of 2008. The Saudi national and the NRI would be able to invest in the Saudi capital market. The NRI would also be able to invest in the Indian stock market and in Indian mutual funds. This joint venture makes geojit the first Indian stock broking company to commence domestic retail brokerage operations in any foreign country.

OVERSEAS BUSINESS ASSOCIATION

Bank of Bahrain and Kuwait(BBK), one of the largest retail banks in Bahrain& Kuwait through its NRI-Business, and geojit entered into an exclusive agreement in September 2007. This association will provide the banks sophisticated client base, the opportunity to diversify their holdings through investments in the Indian stock market. Services offered are investment advisory,portfolio management, mutual funds, trading in Indian equity market, demat and bank account, offline share transactions and PAN CARD. MILESTONES BY GEOJIT BNP PARIBAS

1986

Membership in Cochin Stock Exchange (CSE).

1994 Becomes a Public Limited Company named Geojit Securities Ltd.

1995 Kerala State Industrial Development Corporation Ltd.(KSIDC) acquires 24 percent equity stake.

Membership in National Stock Exchange (NSE).

Public Issue

1996 Launch of Portfolio Management Services with SEBI registration.

1997 Depository Participant (DP) under National Securities Depository Limited.

1999 Membership in Bombay Stock Exchange (BSE).

2000 BSE Listing.

1st broking firm in India to offer online trading facility.

Commences Derivative Trading with NSE.

Integrates the 1st Bank Payment Gateway in the country for Internet Trading.

2001 Becomes India's first DP to launch depository transactions through Internet.

Establishes Joint Venture in the UAE to serve NRI customers.

2002 1st in India to launch an integrated internet trading system for Cash & Derivatives segments.

2003 Geojit Commodities Limited, wholly owned subsidiary, launched Online Futures Trading in agri-commodities, precious metals and in energy futures on multiple commodity exchanges.

National launch of online futures trading in Rubber, Pepper, Gold, Wheat and Rice.

Company renamed as Geojit Financial Services Ltd.

2004 National launch of online futures trading in Cardamom.

2005 NSE Listing.

Geojit Credits, a subsidiary, registers with RBI as a Non-Banking Financial Company (NBFC).

National launch of online futures trading in Coffee.

2006 Charter member of the Financial Planning Standards Board of India.

2007 BNP Paribas takes a stake in the companys equity, making it the single largest shareholder.

Establishes Joint Venture in Saudi Arabia to serve the Saudi national and the NRI.

2008 BNP Paribas Securities India (P) Ltd. a Joint Venture with BNP Paribas S.A. for Institutional Brokerage.

1st brokerage to offer full Direct Market Access execution in India for institutional clients.

2009 Launch of Property Services division.

Launch of online trading in Currency Derivatives.

Consequent to BNP Paribas becoming the largest stakeholder in Geojit Financial Services, company is renamed as Geojit BNP Paribas Financial Services Ltd.BOARD OF DIRECTORS

Mr. A. P. KurianNon - Executive & Independent Chairman

Mr. C. J. George Managing Director & Chief Promoter

Mr. Manoj Joshi Non - Executive & Independent Director

Mr. Mahesh Vyas Non - Executive & Independent Director

Mr. Rakesh Jhunjhunwala Non - Executive Director)

Mr. Ramanathan Bupathy Non - Executive & Independent Director

Mr. Punnoose George Non - Executive Director

Mr. Olivier Le GrandNon - Executive Director

Mr. Pierre RousseauNon - Executive Director

MANAGEMENT

NameDesignation

Mr. C. J. George

Managing Director

Mr. Satish Menon

Director (Operations)

Mr. A. Balakrishnan

Chief Technology Officer

Mr. K. Venkitesh

National Head - Distribution

Mr. Stefan Groening

Director (Planning and Control)

Mr. Jean-Christophe G

Director (Marketing)

Mr. Binoy .V.Samuel

Chief Financial Officer

Mrs. Jaya Jacob Alexander

Chief of Human Resources

CODE OF CONDUCT FOR THE DIRECTORS AND SENIOR OFFICERS

As per Clause 49 of the Listing Agreement with the Stock Exchanges, it shall be obligatory for the Board of Directors of all listed Companies to lay down a code of conduct for all Board members and senior management of the Company in order to ensure good Corporate Governance.

I. CORPORATE GOVERNANCE Corporate governance is about commitment to values and about ethical business conduct. It is about how an organization is managed. This includes its corporate and other structures, its culture, its policies and the manner in which it deals with various stakeholders. Accordingly, timely and accurate disclosure of information regarding the financial situation, performance, ownership and governance of the company, is an important part of corporate governance. This improves public understanding of the structure, activities and policies of the organization. Consequently, the organization is able to attract investors, and to enhance the trust and confidence of the stakeholders.

We believe that sound corporate governance is critical to enhance and retain investor trust. Accordingly, we always seek to attain our performance rules with integrity. The Board extends its fiduciary responsibilities in the widest sense of the term. Our disclosures always seek to attain the best practices in international corporate governance. We are also responsible to enhance long term shareholder value and respect minority rights in all our business decisions.

II. INTRODUCTION OF CODE (Preamble)This Code of Ethics for Directors and Senior Executives (the Code) helps to maintain the standards of business conduct for Geojit BNP Paribas Financial Services Limited (the Company) and ensures compliance with legal requirements particularly of Companies Act, SEBI Regulations and the Listing Agreement with Stock Exchanges. The purpose of the Code is to deter wrongdoing and promote ethical conduct. The matters covered in this Code are of utmost importance to the Company, our shareholders and our business partners. Further, these are essential so that we can conduct our business in accordance with our stated values.

The Code is applicable to the following persons, referred to as Officers :

Directors of the Company

Our Senior Management

Members of the Board of Subsidiary Company

Ethical business conduct is critical to our business. Accordingly, Officers are expected to read and understand this Code, uphold these standards in day-to-day activities, and comply with all applicable laws, rules and regulations, the Geojit BNP Paribas Code of Conduct, Service rules and all applicable policies and procedures adopted by the Company that govern the conduct of its employees.

Because the principles described in this Code are general in nature, Officers should also review the Companys other applicable policies and procedures.

Officers should sign the acknowledgment form at the end of this Code and return the form to the HR department indicating that they have received, read and understood, and agree to comply with the Code. The signed acknowledgement form should be available with officers concerned. Each year, as part of their annual review, Officers will be asked to sign an acknowledgement indicating their continued understanding and adherence of the code.

III. HONEST AND ETHICAL CONDUCTWe expect all Officers to act in accordance with highest standards of personal and professional integrity, honesty and ethical conduct, while working on the Companys premises, at offsite locations where the Companys business is being conducted, at Company sponsored business and social events, or any other place where Officers are representing the Company.

We consider honest conduct to be conduct that is free from fraud or misrepresentation or deception. We consider ethical conduct to be conduct conforming to the accepted professional standards of conduct. Ethical conduct includes ethical handling of actual or apparent conflicts of interest between personal and professional relationships. This is discussed in more detail in Section..IV..below.

IV.CONFLICTS..OF..INTERESTAn Officers duty to the Company demands that he or she avoids and discloses actual and apparent conflicts of interest. A conflict of interest exists where the interests or benefits of one person or entity conflict with the interests or benefits of the Company. Examples include:

A. Employment/Outside employment:With regard to the employment with the Company, Officers are expected to devote their full attention to the business interests of the Company. Officers are prohibited from engaging in any activity that interferes with their employment with the Company. Our policies prohibit Officers from accepting simultaneous employment with suppliers, customers, developers or competitors of the Company, or from taking part in any activity that enhances or supports a competitors position. Additionally, Officers must disclose to the Companys Audit Committee, any interest that they have that may conflict with the business of the Company.

B. Outside directorships: It is a conflict of interest to serve as a director of any company that competes with the Company. Officers must first obtain approval from the Companys audit committee before accepting a directorship.

C. Business Interests: If an Officer is considering investing in any customer, supplier, developer or competitor of the Company, he or she must first take care to ensure that these investments do not compromise on their responsibilities to the Company. Our policy requires that Officers first obtain approval from the Companys Audit Committee before making such an investment. Many factors should be considered in determining whether a conflict exists, including the size and nature of the investments, the Officers ability to influence the Companys decisions, his or her access to confidential information of the Company or of the other company, and nature of the relationship between the Company and the other company. At the time of application for approval, full facts of the proposed investment shall be placed before the Committee.

D. Related parties: As a general rule, Officers should avoid conducting Companys business with a relative, or have business in which a relative is associated in any significant role. A relative means and includes spouse, children, parents, grandparents, grandchildren, aunts, uncles, nieces, nephews, cousins, step relationships, and in-laws. Subject to the rules and regulation, the Company discourages the employment of relatives of Officers in key positions or assignments within the same department. Further, the Company prohibits the employment of such individuals in positions that have a financial dependence or influence (e.g. an auditing or control relationship, or a supervisor/subordinate relationship). Every employee drawing a monthly salary of Rs.10,000/- or more shall disclose whether he is a relative or not of any of our directors.

E. Payments or gifts from others: Under no circumstance the Officers shall accept any offer, payment, promise to pay, or authorisation to pay any money, gift, or anything of value from customers, vendors, consultants, etc., that is perceived as intended, directly or indirectly, to influence any business decision, any act or failure to act, any commitment of fraud, or opportunity for the commitment of any fraud. Inexpensive gifts, infrequent business meals, celebratory events and entertainment, provided that they are not excessive or create an appearance of impropriety, do not violate this policy. Questions regarding whether a particular payment or gift violates this policy are to be directed to Finance Department. Gifts given by the Company to suppliers or customers should be appropriate to the circumstances and should never be of a kind that could create an appearance of impropriety. The nature and cost must always be accurately recorded in the Companys books and records.

F. Corporate opportunities: Officers may not exploit for their own personal gain, opportunities that are discovered through the use of corporate property, information or position, unless the opportunity is disclosed fully in writing to the Companys Board of Directors and the Board declines to pursue such opportunity.

G. Interested Contracts: Except with the consent of the Board of Directors of the Company, any of the Director or his relative or a firm in which a director or his relative is a partner, any other partner in such a firm, or a private company of which the director is a member or director shall enter into any contract Whistle Blower Policy: Employees who came across any unethical or improper practice (not necessarily a violation of law) shall be free to approach the Audit Committee without necessarily informing their supervisors. All officers are requested to inform their subordinates about their this right through an effective manner. For any clarification in this regard please contact Finance Department / Secretarial Department / Legal Department.

H. Other Situations: It would be impractical to attempt to list all possible situations. If a proposed transaction or situation raises any questions or doubts, please contact Finance Department.

I. V. COMPLIANCE WITH GOVERNMENTAL LAWS, RULES AND REGULATIONSOfficers must comply with all applicable governmental laws, rules and regulations, Officers must acquire appropriate knowledge of the legal requirements relating to their duties sufficient to enable them to recognise potential dangers, and to know when to seek advice from the Finance Department. Violations of applicable governmental laws, rules and regulations will lead to penal action as specified in the respective statutes. In any doubt about the compliance with laws rules/regulations /guidelines contact appropriate department of the Company.

VI.VIOLATIONS..OF..THE..CODE Part of an Officers job, and of his or her ethical responsibility, is to help enforce this Code. Officers should be alert against possible violations and report this to appropriate department. Officers must co-operate in any internal or external investigations of possible violations. Reprisal, threat, retribution or retaliation against any person who has, in good faith, reported a violation or a suspected violation of law, this Code or other Company policies, or against any person who is assisting in any investigation or process with respect to such a violation, is prohibited.

The Company will take appropriate action against any Officer whose actions are found to violate the Code or any other policy of the Company. Disciplinary actions may include immediate termination of employment at the Companys sole discretion. Where the Company has suffered a loss, it may pursue its remedies against the individuals or entities responsible. Where laws have been violated, the Company will cooperate fully with the appropriate authorities.

VII. WAIVERS AND AMENDMENTS OF THE CODE We are committed to continuously reviewing and updating our policies and procedures. Therefore, this Code is subject to modification. Any amendment or waiver of any provision of this Code must be approved in writing by the Companys Board of Directors and promptly disclosed on the Companys website and in applicable regulatory filings pursuant to applicable laws and regulations, together with details about the nature of amendment or waiver. with the Company for sale, purchase or supply of goods, materials or services, or for underwriting the subscription of any shares in or debentures of the Company except for purchase or sale of goods for market price or such contracts which either party regularly trades or does business. For any clarification in this regard, the officers are requested to contact to the Finance Department / Secretarial Department / Legal Department.

J. Whistle Blower Policy: Employees who came across any unethical or improper practice (not necessarily a violation of law) shall be free to approach the Audit Committee without necessarily informing their supervisors. All officers are requested to inform their subordinates about their this right through an effective manner. For any clarification in this regard please contact Finance Department / Secretarial Department / Legal Department.

K. Other Situations: It would be impractical to attempt to list all possible situations. If a proposed transaction or situation raises any questions or doubts, please contact Finance Department.

V. COMPLIANCE WITH GOVERNMENTAL LAWS, RULES AND REGULATIONSOfficers must comply with all applicable governmental laws, rules and regulations, Officers must acquire appropriate knowledge of the legal requirements relating to their duties sufficient to enable them to recognise potential dangers, and to know when to seek advice from the Finance Department. Violations of applicable governmental laws, rules and regulations will lead to penal action as specified in the respective statutes. In any doubt about the compliance with laws rules/regulations /guidelines contact appropriate department of the Company.

VIVIOLATIONS..OF..THE..CODEPart of an Officers job, and of his or her ethical responsibility, is to help enforce this Code. Officers should be alert against possible violations and report this to appropriate department. Officers must co-operate in any internal or external investigations of possible violations. Reprisal, threat, retribution or retaliation against any person who has, in good faith, reported a violation or a suspected violation of law, this Code or other Company policies, or against any person who is assisting in any investigation or process with respect to such a violation, is prohibited.

The Company will take appropriate action against any Officer whose actions are found to violate the Code or any other policy of the Company. Disciplinary actions may include immediate termination of employment at the Companys sole discretion. Where the Company has suffered a loss, it may pursue its remedies against the individuals or entities responsible. Where laws have been violated, the Company will cooperate fully with the appropriate authorities.

VII. WAIVERS AND AMENDMENTS OF THE CODE We are committed to continuously reviewing and updating our policies and procedures. Therefore, this Code is subject to modification. Any amendment or waiver of any provision of this Code must be approved in writing by the Companys Board of Directors and promptly disclosed on the Companys website and in applicable regulatory filings pursuant to applicable laws and regulations, together with details about the nature of amendment or waiver.

DERIVATIVES

The word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives is derived from the following products:

A. Shares

B. Debuntures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivatives having same views about the market. In short it is like a INSURANCE market where investors cover their risk for a particular position.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities.

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

INTRODUCTION TO FUTURE MARKET

Futures markets were designed to solve the problems that exit in forward markets. A futures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. There is a multilateral contract between the buyer and seller for a underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.PURPOSE

The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be launched even in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons

EXAMPLE

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

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares.

Suppose the stock rises to 2200. Profit

20

2200

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the buyer is 500.

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

Suppose the stock falls to Rs.1400 Profit

20

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is 250.

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

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

MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a traders futures position, the initial margin is returned to the trader.

OBJECTIVE

The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call to top up the margin account to the initial level before trading commencing on the next level.

EXAMPLE:-On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%. The lot size of nifty futures =200.suppose on MAY 16thThe price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the market. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)

Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th nifty futures settled at 1400.

Profit of buyer will be 10,000[(1450-1350)*200]

Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)

Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600 While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]

Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)

Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to the settlement price on a daily basis. Deficiencies in margin requirements are called for the broker, through margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

CROSS MARGINING:

This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g. Investor has purchase the Wipro FUTURES. and pays the Initial margin. Suddenly script of Wipro falls then the investor is required to pay the mark-to-market margin also called as variation margin for trading in the future contract

HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change to which they are already exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who dont want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security.

PURPOSE:

TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK

Figure 1.1Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional

offload holding available risk latter by paying premium. cost is only

during adverse reward dependant 2)For Long, buy ATM Put premium.

market conditions on market prices Option. If market goes up,

as circuit filters long position benefit else

limit to curtail losses. exercise the option.

3)Sell deep OTM call option

with underlying shares, earn

premium + profit with increase prcie

Advantages Availability of Leverage

STRATEGY:

The basic hedging strategy is to take an equal and opposite position in the futures market to the spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging is implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets).

Example:-Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is completed.

COSTSELLING PRICEPROFIT

4001000600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.Shyam defaultsShyam honors

400 (Initial Investment)600 (Initial profit)

400 (penalty from Shyam(-100) discount given to Shyam

- (No gain/loss)500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment.

Now lets see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that the market would go down due to some news. Then, to minimize your downside risk you could hedge your position by buying a Put Option. This will hedge your downside risk in the market and your loss of value in XYZ will be set off by the purchase of the Put Option.Therefore hedging does not remove losses .The best that can be achieved using hedging is the removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits 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 reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are not subject to margins as in hedging through futures. Options buyers are however required to pay premium which are sometimes so high that makes options unattractive.

Example:-With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the investor excepts that price will fall by 100.So he decided to buy the put Option b y paying the premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position. Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the security, without any extra risk from fluctuations of the market index. Finally the investor has HEDGED AWAY his index exposure.

LONG SECURITY, SELL FUTURES

Here stock futures can be used as an effective risk management tool. In this case the investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the risk the Hedger enters into a future contract and takes a short position. However the losses suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390

Market action = 350

Loss = 40

Strategy = BUY SECURITY, SELL FUTURES

Two month Futures= 390

Premium = 12

Short position = 390

Future profit = 40(390-350)

As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price. Therefore the solution is buy put options on HLL.

The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the investor has two possible scenarios three months later.

1) IF PRICE RISES

Market action: 215

Loss : 17(232-15)

Strike price : 240

Premium : 08

Profit : 17(240-215-8)

Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option bought.

2) IF PRICE RISES:

Market share : 250

Loss : 10

Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike price investor chooses) and an unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and selling nifty futures. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on 1st May, 2001.

CompanyBetaAmount of Holding ( in Rs)

Infosys1.55400,000.00

Global Tele2.06200,000.00

Satyam Comp1.95175,000.00

HFCL1.9125,000.00

Total Value of Portfolio1,000,000.00

Trading Strategy to be followedThe investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge.Formula to calculate the number of futures for hedging purposes is Beta adjusted Value of Portfolio / Nifty Index level Beta of the above portfolio=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000=1.61075 (round to 1.61)Applying the formula to calculate the number of futures contractsAssume NIFTY futures to be 1150 on 1st May 2001= (1,000,000.00 * 1.61) / 1150= 1400 UnitsSince one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts. Short Hedge Stock MarketFutures Market

1st MayHolds Rs 1,000,000.00 in stock portfolio Sell 7 NIFTY futures contract at 1150.

25th JuneStock portfolio fall by 6% to Rs 940,000.00NIFTY futures falls by 4.5% to 1098.25

Profit / LossLoss: -Rs 60,000.00Profit: 72,450.00

Net Profit: + Rs 15,450.00

SPECULATORS:

If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. speculators are those who do not have any position and simply play with the others money. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. Here if speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.

SPECULATION IN THE FUTURES MARKET

Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:

Naked positions - Position in any future contract.

Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Figure 1.2

Speculators

Existing SYSTEM New


1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum

Trading, margin loss to extent of on delivery basis loss possible

trading& carry price change. 2) Buy Call &Put to premium

forward transactions. by paying paid

2) Buy Index Futures premium

hold till expiry. Advantages*Greater Leverage as to pay only the premium.*Greater variety of strike price options at a given time.

EXAMPLE:-Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500

Strategy: Buy February PATNI futures contract at 1500

Lot size = 100 shares

Contract value = 1,50,000 (1500*100)

Margin = 15000 (10% of 150000)

Market action = rise to 1550

Future Gain:Rs. 5000 [(1550-1500)*100]

Market action = fall to 1400

Future loss: Rs.-10000 [(1400-1500)*100]

Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from the view. He study the market and play the game with the stock market

TYPES:

POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until their target is met.

DAY TRADERS:. Day traders square off the position during the curse of the trading day and book the profits.

SCALPERS:

Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he can buy put or call option depending upon his perception about future price. If speculator has a bullish outlook, he will buy calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. A Speculator will buy call or put if his price outlook in a particular direction is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn premium in the event of price situations.

Example:-Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE TELEFILMS stock will come down then he will buy put on the stale price until he can write either call or put. Finally Speculators provide depth an liquidity to the futures market an in their absence; the price protection sought the hedger would be very costly.

STRATEGIES:

BULLISH SECURITY,SELL FUTURES:Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator buys the shares of the company an makes the profit. At the same time the Speculator enters into the future contract i.e. buys futures and makes profit.

Spot Price of RELIANCE = 1000

Value = 1000*100shares = 1,00,000

Market action = 1010

Profit = 1000

Initial margin = 20,000

Market action = 1010

Profit = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

BUY STOCK

ACC spot price : 150

No of shares : 200

Price : 150*200 = 30,000

Market action : 160

Profit : 2,000

Return : 6.6% returns over 2months

BUY CALL OPTION:

Strike price : 150

Premium : 8

Lot size : 200 shares

Market action :160

Profit : (160-150-8)*200 = 400

Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a investment of 2months as compared to 6.6% returns over a investment in stocks

BEARISH SECURITY,SELL FUTURES:In this case the stock futures is overvalued and is likely to see a fall in price. Here simple arbitrage ensures that futures on an individual securities more correspondingly with the underlying security as long as there is sufficient liquidity in the market for the security. If the security price rises the future price will also rise and vice-versa.Two month Futures on SBI = 240Lot size = 100shares

Margin = 24

Market action = 220

Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit because the speculator is bearish in the market and all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can BUY OR SELL the entire index trading on one single security. Once a person is LONG NIFTY using the futures market, the investor gains if the index rises and loss if the index falls.

1st July = Index will rise

Buy nifty July contract = 960

Lot =200

14th July nifty risen= 967.35

Nifty July contract= 980

Short position =980

Profit = 4000(200*20)ARBITRAGEURS:

Arbitrage is the concept of simultaneous buying of securities in one market where the price is low and selling in another market where the price is higher.

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person and ready to take the risk He is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where the investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

Figure 1.3

Arbitrageurs

Existing SYSTEM New


1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free

one and selling in whichever way the promising as still game.

another exchange. Market moves. in weekly settlement

forward transactions. 2) Cash &Carry

2) If Future Contract arbitrage continues

more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Example:

Current market price of ONGC in BSE= 500

Current market price of ONGC in NSE= 510


Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES: In this the investor observing that futures have been overpriced, how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 1025.

This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.

On day one, borrow funds, buy security on the spot market at 1000

Simultansely, sell the futures on the security at1025

Take delivery of the security purchased and hold the security for a month

on the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.1015. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position

Return the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash and- carry arbitrage.

BUY FUTURES, SELL SPOT: In this the investor observing that futures have been under priced, how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 965.

This shows that futures have been under priced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.

On day one, sell the security on the spot market at 1000

Mae delivery of the security

Simultansely, buy the futures on the security at 965

On the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.975. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from the arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash and- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is

CASE-1

Spot Price of INFOSEYS = 1650

Future Price Of INFOSEYS = 1675

In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free profit Of Rs.25.

CASE-2

Future Price Of ACC = 675

Spot Price of ACC = 700

In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.

MONTHLY OPTIONS :

The exchange trade option with one month maturity and the contract usually expires on last Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as the

premium paid for hedging is very high. Also the trader has to pay more money to take a long or short position which results into iiliquidity in the market.Thus to overcome the problem the BSE introduced WEEKLY OPTIONS

WEEKLY OPTIONS:

The exchange trade option with one or weak maturity and the contract expires on last Friday of every week

ADVANTAGES

Weekly Options are advantageous to many to investors, hedgers and traders.

The premium paid for buying options is also much lower as they have shorter time to maturity.

The trader will also have to pay lesser money to take a long or short position.

the trader can take a larger position in the market with limited loss. On account of low cost, the liquidity will improve, as more participants would come in.

Weekly Options would lead to better price discovery and improvement in market depth, resulting in better price discovery and improvement in market efficiencyTYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract.Example:-Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market.

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

1. CALL BUYER

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

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

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

Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

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

Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent

Thus call option indicates two positions as follows: LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

Example:-Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put seller) who is bullish in the market.

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

1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the seller at Rs.800

Profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

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

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

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.

profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 - 750 = 30

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

Thus Put option also indicates two positions as follows:

LONG POSITION

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

SHORT POSITION

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

CALL OPTIONSPUT OPTIONS

Option buyer oroption holder Buys the right to buy the underlying asset at the specified priceBuys the right to sell the underlying asset at the specified price

Option seller oroption writer Has the obligation to sell the underlying asset (to the option holder) at the specified priceHas the obligation to buy the underlying asset (from the option holder) at the specified price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)

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

For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying assets value will generally have the opposite effect THE SRIKE PRICE: (K)

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

Time until expiration: (t)

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

Volatility:

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

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:a) Developmental institutionsb) Mutual Fundsc) Domestic & Foreign Institutional Investorsd) Brokerse) Retail Participants

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION :

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.

RISK

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

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

PRICES:

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

While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset.

COST:

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

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

Liquidity:

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

Price behaviour:

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

PAY OFF:

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

OPTION STRATAGIES:

1. BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month. However, the total investment is usually far less than that required to purchase the stock.

Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of 1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)


BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10

iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid.

The pay-off table:

PATNI COMPUTERS AT EXPIRATION 1485

(below lower price)

1490

(At the lower price)1495

(Between lower strike &BEP1500

(At BEP)1510

Intrinsic value of 1490 long call at expiration (a)0051020

Premium paid (b)2525252525

Intrinsic value of 1510 short call at expiration (c)00000

Premium received (d)1515151515

profit/loss(a-c)-(b- d)-10-10-5010

PATNI COMPUTERS AT EXPIRATION 1495

(below higher price)

1510

(At the higher price)1505

(Between higher strike &BEP1500

(At BEP)1520

(Above BEP

Intrinsic value of 1510 short call at expiration (a)000010


Intrinsic value of 1490 long call at expiration (c)520151030


profit/loss(c-a)-( d - b)-5105010

Profit

20

10

0

1490 1500 1510 1520 1530 1540

-10

-20

Loss

2. BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares.

Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract.

Premium = 10 ticks per contract(55 paid- 45 received)


BREAK- EVEN- POINT= 5510-10 = 5500.



On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the loss of Rs.10 through receiving the net premium.

If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium receive will generate profit .

iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received

If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium received between the strike price an premium paid.

iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic value. while the 4490 put option sold result in maximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic value. while the 5510 put option sold result in the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490 option sold will be assigned (strike price premium paid) = profit .

The pay-off table:

INFOSYS AT EXPIRATION 5520

(Above strike)

5510

(At the strike)5505

(Between lower strike &BEP5500

(At BEP)4480

Intrinsic value of 5510 long put at expiration (a)0051030


Intrinsic value of 4490 short put at expiration (c)000010


profit/loss(a-c)-(b- d)-10-10-5010

INFOSYS AT EXPIRATION 5505

(Above strike)

4490

(At the strike)4495

(Between strike &BEP5500

(At BEP)4480

(below strike price)

Intrinsic value of 4490 short put at expiration (a)000010

Premium received (b)4545454545

Intrinsic value of 5510 long put at expiration (c)530151030

Premium paid (d)5555555555

profit/loss[(c-a)-( d - b)]-52015010

Profit

20

10

0

3000 3500 4000 4500 5000 5500 6000 6500 7000

-10

-20

Loss

3. BULL PUT SPREAD.This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market to provide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell one month put of 1310 (higher price) and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid- 15 received)


BREAK- EVEN- POINT= 1300-10 = 1290



On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of 5.

iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless. While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t the premium received

iv. ABOVE STRIKE PRICE:

If the index is above1300 say 1310, the 1300 put option buyer has lost the premium while the 1310 put option seller receive premium to the limited profit

If the index is above 1310, say 1320 the 1290 put option buyer will have maximum loss results in deep out the money while the 1310 put option will have the limited profit.

v. BELOW STRIKE PRICE: If the index is below 1300 say (1290) , the 1300 put option buyer will have an intrinsic value of 10 while the 1310 put option sold receive only premium as the profit is limited for the seller.

4.BEAR CALL SPREAD:This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. Here the investor buys a higher strike call and sells a lower strike call with the same expiration dates. However, the total investment is usually far less than that required

Documents

A Study on Financial Derivative and Risk Management