Dinesh Report

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1.Introduction

TITLE

Derivatives are new concept to India market. The Indian capital market is

significant in terms of the degree of development, volume of trading and its tremendous

growth. With over 21 million shareholders, India has a third largest investor base the

world after USA and Japan. Over 9000 companies are listed on stock exchange, whish

are serviced by approximately 7500 stockbrokers.

Most of the investments are not taking place in under develop as economically

weak countries because of the risk of return attached with it. In any of the investment

there is a risk of loss. The risk may include earth quake, cyclone, storm and or monsoon

failure which are uncontrollable caused by nature.

Through our study we have attempted to know the planning program, and

system used by investor and individuals to manage the risk associated with future and

options. This is leads to study about futures and options in derivatives market.

1.1 OBJECTIVES OF THE RESEARCH

Understanding derivatives system in India.

Trading method and strategies in derivative market.

Rules and guidelines trading in futures and option.

SCOPE OF STUDY

With globalization of the financial sector, it's time to recast the architecture of the

financial market. To reduce this risk, the concept of derivatives comes into the picture.

The Project is about current scenario of derivatives market and also current

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developments of market. This project leads to complete understanding derivatives

market. In India we have different types of derivatives available like futures and

options. We are using different trading strategies used for futures and options. This

project is study complete design about the futures and options. What purpose is need

for derivatives market in India and practical concept behind that trading strategy used in

options. Derivatives are products whose values are derived from one or more basic

variables called bases. India is traditionally an agriculture country with strong

government intervention Rules and guidelines followed by SEBI

LIMITATIONS

The study is conducted in Bangalore only.

Since the study covers the overview of derivatives market, it cannot be

generalized.

The depth of study has not fulfilled

Respondents information is not reliable.

1.2 RESEARCH METHODOLOGY AND RESEARCH DESIGN:

The methodology is the plan, structure and strategy of the investigation process

that sets out to obtain answer to the study. The methodology followed for the collecting

information are using two sources of data namely

Primary Data

Secondary Data

Primary Data

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The data collected first hand by the researcher concerned with the research

problem refers to the Primary data.

Personal discussion was made with Unit manager and interaction with other

personnel in the organization for this purpose. There is no formal design of

questionnaire used in this study.

Secondary Data

The information available at various sources made for some other purpose but

facilitating the study undertaken is called as Secondary Data.

The various sources that were used for the collection of secondary data are

Various Text books were used to understand the concepts of portfolio

management.

Websites

Annual reports of different companies.

Newspapers such as Economic Times, Financial Express.

Magazines such as Business World, Business Today, Investors Guide, Capital

Market.

Sample Size

Sample size : 100 respondents

Sampling procedure : Non Probability Sampling Method

Sampling type : Convience sampling

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Sampling area : Bangalore

Sampling design : Exploratory Research Design

Research instrument : Structured Distinguished Questionnaire

Description of the research design

Achieve the objectives of the project all possible information relevant the investor

profile were collected. Taking the help of the theoretical mode, the most appropriate

methodology was decided.

SAMPLING PROCEDURE

Sample unit

Who is to be surveyed? The marketing researches must define the targeted

population that will be sampled. Once this unit is determine a sampling frame must be

developed so that every one in the targeted population has as equal of known chance

of being sampled.

Sample size

How many people should be surveyed? Sampled give more reliable results than

small samples. However it is necessary to sample the entire target population or even a

substation portion to achieve reliable results. Sample of less than 1% of population

often provide good reliability, given a credible sampling procedure.

Data collection instrument

The questionnaire is the most common instrument in collect primary data. A

questionnaire of a set of question presented to respondents for their answers. The

questionnaire very flexible in that there any number of way to ask questions.

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Questionnaire need to be carefully developed tested and debugged before they are

administrated on a large scale. Once a usually spot several errors a casually prepared

questionnaire.

In preparing a questionnaire the professional researcher carefully chooses the

questions and their form, working and sequence.

A common types of errors occurs in the questions asked , that is in including

question that cannot would not , or need to be answered and in omitting questions that

be answered each question should be checked to determine whether it contributes in

the research objectives.

The question should flow in a logical order on the respondents demographics come last

because they are more personal and less interesting to the respondents

Questionnaire design

Close ended question

Questions, which restrict the interviewees answer to pre-defined options,

are called close-ended questions. Close-ended questions give respondents a finite set

of specified responses to choose firm. Such questions are deemed appropriate when

the respondent has a specific answer to give a , when the researcher has a specified

answer in mind , when detailed narrative information is not needed or when there is a

finite numbers of ways to answer a question. These questions are common in survey

researches.

Analysis of Findings

Derivative market transaction volume is four times of the Spot market's volume

the allocation into derivatives is less than the investment into the Spot market

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Investors are not confident on the research report on various stocks mainly due

to its variance from the actual happenings in the market.

Traders mainly want to make short term gain by investing into Derivatives then

for using Derivative as an instrument to reduce the market risk.

The retail investors are reluctant to go by options mainly due to the low liquidity

in the Option's market

Meanings of derivatives

Derivatives are the financial instruments, which derive their value from some

other financial instruments, called the underlying. The foundation of all derivatives

market is the underlying market, which could be spot market for gold, or it could be a

pure number such as the level of the wholesale price index of a market price.

A derivative is a financial instrument whose value depends on the value

of other basic underlying variables

John c hull

According to the Securities Contract (Regulation) Act, 1956, derivatives include:

A security derived from a debt instrument, share, and loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security.

A contract, which derives its value from the prices or index of prices of underlying

securities.

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Therefore, derivatives are specialized contracts to facilitate temporarily for

hedging which is protection against losses resulting from unforeseen price or volatility

changes. Thus, derivatives are a very important tool of risk management.

Derivatives performs a number of economic functions like price discovery, risk transfer

and market completion. The simplest kind of derivative market is the forward market.

Here a buyer and seller write a contract for delivery at a specific future date and a

specified future price. In India, a forward market exists in the form of the dollar-rupee

market. But forward market suffers from two serious problems; counter party risk

resulting in comparatively high rate of contract non-compliance and poor liquidity.

Futures markets were invented to cope with these two difficulties of forward markets.

Futures are standardized forward contracts traded on an organized stock exchange. In

essence, a future contract is a derivative instrument whose value is derived from the

expected price of the underlying security or asset or index at a pre-determined future

date.

TYPES OF DERIVATIVES

The following are the popular and important derivatives:

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DERIVATIVES


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One form of classification of derivatives is between commodity derivatives and financial

derivatives. Thus futures of option on gold sugar, jute, pepper etc are commodity

derivatives

While futures options or swaps on currencies, gilt-edged securities, stock and share

stock market indices etc are financial derivatives.

Forwards

Futures

Options and

Swaps

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FORWARD

S

FUTURE OPTIONS

SWAPS

Derivatives


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Swap

i) Forward contract

A forward contract is a customized contract between the buyer and the seller where

settlement takes place on a specific date in future at a price agreed today. The rupee-

dollar exchange rate is a big forward contract market in India with banks, financial

institutions, corporate and exporters being the market participants.

The main features of a forward contract are:

Each contract is custom designed and hence unique in terms of contract size,

expiration date, asset type, asset quality etc.

A contract has to be settled in delivery or cash on expiration date.

In case one of the two parties wishes to reverse a contract, he has to compulsorily

go to the other party. The counter party being in a monopoly situation can command

the price he wants.

Traded in Over the Counter (OTC) markets. No down payment required.

Settlement is done on the date of maturity.

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Forwards Future O tion Swap

Commodi

Security

Commodity Securit Call Put

Interest rate

Currency


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(ii) FUTURES

A future 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.

A future is a contract to buy or sell an asset at a specified future date at a specified

price. These contracts are traded on the stock exchanges and it can change many

hands before final settlement is made.

Features of future contracts

1. Highly standardized in nature.

2. No down payment is required at the time of agreement.

3. Settlement: futures instruments are marked to the market and the exchange

records profit and loss on them on daily basis though held till maturity.

4. Hedging of price risk is most common in futures.

5. Non-linearity.

6. Non-delivery of asset: In future contracts generally parties simply exchange the

difference between the future and spot prices.

The advantage of a future is that it eliminates counterparty risk. Since there is an

exchange involved in between, and the exchange guarantees each trace, the buyer or

seller does not get affected with the opposite party defaulting.

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FUTURES V/S FORWARDS

Futures Forwards

Futures are traded on a stock

exchange.

Forwards are non-tradable, negotiated

instruments.

Futures are contracts having

standard terms and conditions.

Forwards are contracts customized by

the buyer and seller.

No default risk as the exchange

provides a counter guarantee.

High risk of default by either party.

Exit route is provided because ofhigh liquidity on the stock exchange.

No exit route for these contracts.

Highly regulated with strong

margining and surveillance systems.

No such systems are present in a

forward market.

a) Commodity futures

A commodity future is a futures contract in commodities like agriculture

products, metals and minerals etc. In organized commodity future markets, contracts

are standardized with standard quantities. Of course, this standard varies from

commodity to commodity. They also fixed delivery dates in each month or a few

months in a year. In India commodity futures in agricultural products are popular.

b) Financial futures

Financial futures refer to a futures contract in foreign exchange or financial

instruments like Treasury bill, commercial paper, and stock market index or interest

rate. It is an area where financial service companies can play a very dynamic role.

Financial futures are very popular in Western countries as hedging instruments to

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protect against exchange rate/interest rate fluctuations and for ensuring future interest

rates on loans.

The Stock Index Futures contract is a futures contract on major stock market

indices. This type of contract is very much useful for speculators, investors and

especially portfolio managers. They can hedge against future decline or increase in

prices of portfolios depending upon the situation.

Generally the asset will not be delivered on the maturity of the contract. The parties

simply exchange the difference between the future and spot prices on the date of

maturity. But, these kinds of financial futures are relatively new in India. may be larger

than the initial margin deposit.

For example, assume its now January. The July crude oil futures price is

presently quoted at $15 a barrel and over the coming month you expect the price to

increase. You decide to deposit the required initial margin of $2,000 and buy one July

crude oil futures contract. Further assume that by April the July crude oil futures price

has risen to $16 a barrel and you decide to take your profit by selling. Since each

contract is for 1,000 barrels, your $1 a barrel profit would be $1,000 less transaction

costs.

Price per barrel Value of 1,000

barrel contract

January Buy 1 July crude oil

futures contract

$15.00 $15,000

April Sell 1 July crude oil

futures contract

$16.00 $16,000

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Gain $1.00 $1,000

*

For simplicity, examples do not take into account commissions and other transaction

costs. These costs are important. You should be sure you understand them.

Suppose, instead, that rather than rising to $16 a barrel, the July crude oil price by April

has declined to $14 and that, to avoid the possibility of further loss, you elect to sell the

contract at that price. On the 1,000 barrel contract your loss would come to $1,000 plus

transaction costs.

Price per barrel Value of 1,000

barrel contract

January Buy 1 July crude oil

futures contract

$15.00 $15,000

April Sell 1 July crude oil

futures contract

$14.00 $14,000

Loss $1.00 $1,000

Note that if at any time the loss on the open position had reduced funds in your margin

account to below the maintenance margin level, you would have received a margin call

for whatever sum was needed to restore your account to the amount of the initial margin

requirement.

(iii) OPTIONS

In the volatile environment, risk of heavy fluctuations in the prices of assets is

very heavy. Option is yet another tool to manage such risks. Options are one better

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than futures. In option, as the name indicates, gives one party the option to take or

make delivery. But this option is given to only one party in the transaction while the

other party has an obligation to take or make delivery. The asset can be a stock, bond,

index, currency or a commodity.

But since the other party has an obligation and a risk associated with making

good the obligation, he receives a payment for that. This payment is called as

premium. The party that had the option or the right to buy/sell enjoys low risk. The cost

or this low risk is the premium amount that is paid to the other party.

The buyer of the right is called the option holder. The seller of the right (and

buyer of the obligation) is called the option writer. The cost of this transaction is the

premium.

In an options 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 other

hand, if it can be exercised only the time of maturity, it is termed as European option.

Types of options

Options may fall under any one of the following main categories:

Call Option

Put Option

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1) CALL OPTION

A call option is one which gives the option holder the right to buy a underlying asset

(commodities, foreign exchange, stocks, 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 the specified price, in

case the buyer exercises his option to buy. Thus, the obligation to sell arises only when

the option is exercised.

2) 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.

a. Option Premium

In an option contract, the option writer agrees to buy or sell an underlying asset

at a future date for an agreed price from/to the option buyer/seller at his option. This

contract, like any other contract must be supported by consideration. The consideration

for this contract is a sum of money called premium. The premium is nothing but the

price, which is required to be paid for the purchase of right to buy or sell.

The premium, one pays is the maximum amount to which he is exposed in the

market, since, in any case he can not lose more than that amount. Thus, his risk is

limited to that extent only. However, his gain potential is unlimited. In the case of a

double option, this premium money is also double.

b. Options Market

Options market refers to the market where option contracts are brought and sold. Once

an option contract is written, it can be bought or sold on the options market. The first

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option market namely the Chicago Board of Options Exchange was set up in 1973.

Thereafter, several options markets have been established.

Features of Option Market

1. Highly Flexible.

2. Down Payment.

3. Settlement.

4. Non-Linearity.

5. No Obligation to Buy or Sell.

For example :An investor buys one European Call option on one share of Reliance

Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the

contract matures on 30 September . The payoffs for the investor on the basis of

fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be

clear form the graph that even in the worst case scenario, the investor would only lose a

maximum of Rs.2 per share which he/she had paid for the premium. The upside to it

has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of

the call options buyer. The maximum loss that he can have is unlimited though a profit

of Rs.2 per share would be made on the premium payment by the buyer.

Payoff from Call Buying/Long (Rs.)S Xt C Payoff Net Profit

57 60 2 0 -258 60 2 0 -259 60 2 0 -260 60 2 0 -261 60 2 1 -1

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62 60 2 2 063 60 2 3 164 60 2 4 265 60 2 5 366 60 2 6 4

A European call option gives the following payoff to the investor: max (S - Xt, 0).

The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).

Notes:

S - Stock Price

Xt - Exercise Price at time 't'

C - European Call Option Premium

iv) SWAPS

Swap is yet another exciting trading instrument. Infact, it is a combination of

forward by two counterparties. 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.

Features of Swaps

1. Basically a forward.

2. Double coincidence of wants.

3. Necessity of an intermediary.

4. Settlement.

5. Long term agreement.

Kinds of Swap

A swap can be arranged for the exchange of currencies, interest rates etc. A

swap in which two currencies are exchanged are exchanged is called cross-currency

swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called

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interest rate swap. This interest rate swap can also be arranged in multi-currencies. A

swap in which on stream of floating interest rate is exchanged for another stream of

floating interest is called Basis swap. Thus, swap can be arranged according to the

requirements of the parties concerned and may innovative swap instruments can be

evolved like this.

Advantages

1. Borrowing at Lower Cost.

2. Access to New Financial Markets.

3. Hedging of Risk.

4. Tool to correct Asset-Liability Mismatch.

5. Additional Income.

Distinction between futures and options

Futures Options

Exchange traded, with novation Same as futures. Exchange defines the product Same as futures

Prize is zero, strike price moves Strike price is fixed, price moves.

Price is zero Price is always positive

Linear payoff Non linear payoff.

Both long and short at risk Only short at risk.

The Nifty index fund industry will find it very useful to make a bundle of a Nifty indexfund and a nifty put option to create a new kind of a Nifty index fund, which gives the

investor protection against extreme drop in Nifty. Selling put options is selling insurance,

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so any one who feels like earning revenues by selling insurance can set himself up to

do so on the index options market.

More generally, options offer "nonlinear payoffs" whereas futures only have

"linear payoffs". By combining futures and options, a wide variety of innovative and

useful pay off structures can be created

DERIVATIVES MARKET IN INDIA

Liberalization period:

In India financial markets, there were only a few financial products and the

stringent regulatory products and the stringent regulation environment also eluded any

possibility of development of a derivatives market in country. All Indian corporate were

mainly relying on term lending institution for meeting their project financing or any other

financing requirements and on commercial banks for meeting working capital finance

requirement. Commercial banks are on their assets and liabilities. The only derivative

product they were aware of is the foreign exchange forward contract. But this scenario

changed in the post liberalization period. Conservative Indian business practitioners

began to take a different view of various aspects of their operations to remain

competitive. Financial risks were given adequate attention and treasury function has

assumed a significance role in all major corporate since then.

Initially, banks were allowed to pass on gains arising out of cancellation of

forwards contracts to the customers and customers were permitted to cancel and re-

book the forward contracts. This remarkable change was followed by the introduction of

cross currency forward contacts. But the major milestone in developing forex derivatives

market in India was the introduction of cross currency options. The RBIs objective of

introducing cross currency options was to provide a complicated hedging strategy for

the corporate in their risk management activities.

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First traded in Mumbai in 1875:

The concept of derivatives is of course not new to the Indian market. Though

derivatives in the financial markets have nothing to talk about home, in the commodity

markets they have a long history of over hundred years. In 1875, the first commodity

futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders

Association. A clearinghouse for clearing and settlement of these traders was set up in

1918. Over a period of twenty years during 1900-1920, other futures markets were set

up in various places. Futures market in raw jute in Kolkata (1912), wheat futures market

in Hapur (1913), and bullion futures market in Mumbai (1920).

When it comes to financial markets, derivatives in equities claim a long

existence. The official history of Bombay Stock Exchange (then known as Native Share

and Stock Brokers Association) reveals that the concept of options existed since 1898

as is reflected from a quote given by one of the MPs-India being the original home of

options, a native broker would give a few points to the brokers of the other nations in

the manipulation of puts and calls

Approved by government of India

However, such an early expertise gained by Indian traders in derivatives trading has

come to an end with the Government of Indias ban on forward contract during the

1960s on the ground of their intrinsic undesirability. But ironically, the same were re-

introduced by the government in the 1980s as essential instruments for eliminating

wide fluctuations in prices and more so because of the World Bank UNCTAD report,

which strongly urged the Indian government to start futures trading in major cash crops,

especially in view of Indias entry to WTO.

With the world embracing the derivative trading on large scale, the Indian

market obviously cannot remain aloof, especially after liberalization has been set in

motion. Now we are in the threshold of introducing trading in derivatives, beginning with

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the stock index futures to be well set for the introduction of derivative trading. With L.C.

Gupta committee having recently submitted its report on the subject, SEBI is engaged

in the process of assessing the feasibility and desirability of introducing such trading.

The NSE and BSE are two exchanges on which financial derivatives are traded.

The combined notional value of the daily volumes on both the bourses stand at around

RS. 400 cr. In developed markets trading in the derivatives segment are thrice as large

as in the cash markets. In India, the figure is hardly 20% of cash markets. Quite clearly

our derivative markets have a long way to go.

Traded at NSE & BSE

According to the Executive Director of Association of NSE Member of India

(Amni), Vinod Jain, Volumes in derivatives segment are stagnating due to lack of

growth in the number of markets participants. Besides these products are still to catch

up with the masses who are keeping away from this segment due to lack of

understanding of the products and high contract price

Like our stock markets, the Indian derivatives markets are also becoming

heavily dependent on few instruments. For instance, futures in three blue chip

companies such as Satyam Computers, Reliance Industries and Infosys Technologies,have accounted for as 42% of the total turnover in the derivatives segment of

the National Stock Exchange in June 2002. Stock futures of Satyam Computers, Infosys

Technologies and HPCL accounted for 37% of the total turnover in May 2002, 35% in

April 2002 and 34% in March 2002 . These highly speculative stock futures instruments

accounted for about 69% of the total turnover. This may lead to price manipulations.

Meanwhile, options contracts are witnessing a decline in trading interest. The turnover

in individual stock options plunged to Rs. 4,642cr. In June compared with Rs. 5,133cr.

In May similarly, the turnover index options also declined from Rs. 463cr. in May to Rs.

389cr. in June.

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Division of Derivatives markets

a) COMMODITIES DERIVATIVES MARKETSIn order to give more thrust on agricultural sector, the National Agricultural Policy,

2000 has envisaged and domestic market reforms and dismantling of all controls and

regulations in agricultural commodity markets. It has also proposed to extend the

coverage of futures markets to minimize the wide fluctuations in commodity market

prices and for hedging the risk from price fluctuations.

As a result of these recommendations, there are presently, 15 exchanges

carrying out futures trading in as many as 30 commodity items. Out to these, twoexchanges viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have

been upgraded to international exchanged to deal international contracts in peeper and

castor oil respectively. Moreover, permission has been given to two more exchange viz.

the First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and

oilcake), and Keshave Commodity Exchange Ltd., Delhi (for potato), where futures

trading started very recently.

The government has also permitted four exchange viz., EICA, Mumbai. The

Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton

Association Coimbatore; and the Ahmedabad Cotton Merchants Association,

Ahmedabad, for conducting forward (non-transferable specific delivery) contracts in

cotton. Lately as part of further liberalization of trade in agriculture and dismantling of

ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., E-

Commodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar India.com,

Mumbai have been given approval for conducting sugar futures (Ministry of Food and

Consumer Affairs, 1999).

In the recent past, the GOI has set up a committee to explore and appraise

matters important to the establishment and financing of the proposed national

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commodity exchange for the nationwide trading of commodity futures contracts. The

usage of warehouse receipts as a means for delivery of commodities under the

contracts is also being explored. The warehouse receipts system has been

operationalised in COFEI (coffee futures exchange of India) with effect from 1998. The

Government of India is on the move to establish a system of warehouse receipts in

other commodity stock exchanges at various places of the country.

Besides these domestic developments, during 1998, Reserve Bank of India

permitted the Indian Corporate Sector to access the exchanges subject to certain

conditions with a view to enable domestic metal manufacturers to compete with global

players. The de-regulation of oil-imports being on the cards, government should create

the right atmosphere for oil sector to participate in the international oil-derivatives

Markets.

Despite these developments, there are still many impediments that hold back the

farming community from entering the futures market and reap full benefits.

b) Currency Derivatives

Foreign exchange derivatives market is one of the oldest derivatives markets in

India. Presently, India has got a well-established dollar-rupee forward market with

contrast traded for one month, two months and three months expiration. Currency

derivatives markets have begun to evolve with the allowing of banks to pass on the

gains upon cancellation of a forward to the customer and permitting customer to cancel

and rebook forward contracts.

Introduction of cross currency options can be considered as another major step

towards developing forex derivatives markets in India. Today, Indian corporate are

permitted to purchase cross currency options to hedge exposures arising out of trade.

Authorized dealers who offer these products have to necessarily cover their exposure in

international markets i.e., they shall not carry the risk in their own books. Cross currency

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options are essentially meant for buying or selling any foreign currency in terms of US

dollar. They are therefore, useful only to those traders who invoice their exports and

imports in currencies other than US dollar or for corporate who borrow in currencies

other than US dollar. As against this, majority of Indian trade is invoiced in the US

dollars. Thus, they have almost no relevance in the Indian context.

Indian banks are allowed to use the foreign currency interest rate swaps,

forward rate agreements/interest rate options/swaps, and forward rate agreements/

interest rate option/swap/option/caps/floors to hedge interest rate and currency

mismatch in their balance sheets. Resident and the non-resident clients are also

permitted to use the above products as hedges for liabilities on their balance sheets.

Here it is worth remembering that globally, foreign exchange traders are

becoming as common as stock traders. But in India, forex dealers still play second

fiddle to stock traders and merely meet the needs of the exporters deposits. This may

be due to their risk averting behavior and perhaps lack of proper research. Such being

the position of the forex market, it is too premature to expect that once, foreign

currency-Indian rupee options are introduced, the market will pick up momentum.

This is all the more essential in a market where exchange rates though stated to

be market determined, are often found influenced by RBIs intervention in the exchange

market. As a result, exchange rate movements hardly obey the principle of interest rate

differentials. The incongruence in the domestic money rates as derived from the

USD/INR forwards yield curve supports this assertion. For example, the one-year

domestic term money is around 6-6.25% whereas that of the one-year implied forward

rate is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm

view on the exchange rate movement.

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c) Stock market derivatives

Today trading on the spot market for equity in India has always been a futures

market with weekly/fortnightly settlements. These markets features the risks and

difficulties of futures market, But without the gains in price discovery and hedging

services that come with separation the spot market from the futures market. Indias

primary market is acquainted with two types of derivatives

Convertible bonds

Warrants

As these warrants are listed and traded, it could be said that options market of a limited

sort already exist in our market.

Besides, a wide range of interesting derivatives markets exists in the informal sector.

Contracts such as bhav-bhav teji-mandietc. are traded in these markets. These

informal markets enjoy a very limited participation and have their presence outside the

conventional institutions of Indias financial system.

The first step towards introduction of derivatives trading in India in its current

format was the promulgation of the securities laws (Amendment) Ordinance, 1995 that

withdrew the prohibition on options in securities. The real push to derivatives market inIndia was however given by the SEBI. The security market watchdog, in November

1996 by setting up a committee under the chairmanship of Dr L C Gupta to develop

appropriate regulatory framework for derivatives trading in India.

In 2000, SEBI permitted NSE and BSE to commence trading in index futures

contracts based on S&P CNX Nifty and BSE 30 (sensex) index. This was followed by

approval for trading in options based on these two indexes and options on individual

securities. Futures contracts on Individual stocks were launched on November 9,2001.

Trading and settlement is done in accordance with the rules of the respective

exchanges. But the trading volumes were initially quite modest.

This could be due to -----

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Initially, few members have been permitted by SEBI to trade on

derivatives;

FIIS, MFS have been allowed to have a very limited participation;

Mandatory requirements for brokerage firms to have SEBI approved-

certification-test-passed brokers for undertaking derivatives trading and

Lack of clarity on taxation and accounting aspects under derivatives

trading.

The current trading behavior in the derivatives segments reveals that single stock

futures continues to account for sizeable proportion. A recent press report indicates that

futures in Indian exchanges have reached global volumes. One possible reason for

such skewed behavior of the traders could be that futures closely resemble the

erstwhile badla system. Such distortions are not however in the interest of the market.

SEBI has permitted trading in options and futures on individual stocks, but not on

all the listed stocks. It was very selective, stocks that are said to be highly volatile

with a low market capitalization are not allowed for option trading. This act of SEBI is

strongly resented by a section of the market. Their argument is that equity options are

indispensable to investors who need to protect their investment from volatility. The

higher the volatility of a stock the more necessary it is to list options on that stock. They

are highly vocal in arguing that SEBI should design an effective monitoring, surveillance

and risk management system at the level of the exchanges and clearing house to avert

and manage the default risks that are likely to arise owing to high volatility in low market

capital stocks instead of simply banning trading in options on them. SEBI needs to

examine these arguments. It may have to take a stand to nip in the bud all kinds of

manipulations by handling out severe punishments to all such erring companies.

Today, mutual funds are permitted to use equity derivatives products forhedging and portfolio rebalancing. However, such usage is not favored by fund

managers as they strongly apprehend that the dividing line between hedging and

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speculation being thin, they may always get exposed to the questioning by the

regulatory authorities.

d)CREDIT DERIVATIVES AND OTHERS

A credit derivative is a financial transaction whose pay-off depends on whether

or not a credit event occurs.

A credit event can be:

Bankruptcy

Default

Upgrade Downgrade

Interest rate movement

Mortgage defaults

Unforeseen pay-offs

A credit derivative, like any other derivative, derives its value from an case is the

credit. In the event of the underlying asset failing to perform as expected, credit

derivatives, ensures that someone other than the principal lender absorbs the resulting

financial loss. Credit derivatives market in India though could be said as non-existent

holds huge potential. Some of the important factors/situation such as opening up of the

insurance sector to foreign private players, relief to investors, tax benefits to corporate,

proxy hedgers etc., could provide the momentum to the credit derivatives market in

India, boosting yields and bringing down risk for both the corporate and banks.

Secondly, Indian banking system is saddled with huge NPAs, which it is of

course, eagerly trying to get rid off. The mounting pressure on profitability is making

banks more credit-averse. In such a situation, if markets can offer credit-insurance inthe form of derivatives, everyone would jump for it.

DERIVATIVES: Development in India

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The derivatives markets has existed for centuries as a result of the need for both

users and producers of natural resources to hedge against price fluctuations in the

underlying commodities. Although trading in agricultural and other commodities has

been the driving force behind the development of derivatives exchanges, the demand

for products based on financial instrumentssuch as bond, currencies, stocks and

stock indiceshave now far outstripped that for the commodities contracts.

India has been trading derivatives contracts in silver, gold, spices, coffee, cotton

and oil etc for decades in the gray market. Trading derivatives contracts in organized

market was legal before Morarji Desais government banned forward contracts.

Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets.

Recently futures contract in various commodities were allowed to trade on exchanges.

For example, now cotton and oil futures trade in Mumbai, soybean futures trade in

Bhopal, pepper futures in Kochi, coffee futures in Bangalore etc.

I n June 2000, National Stock Exchange and Bombay Stock Exchange started

trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty

commenced in June 2001. Very soon thereafter trading began on options and futures in

31 prominent stocks in the month of July and November respectively. Currently thereare 41 stocks trading on NSE Derivative and the list keeps growing.

How many stocks are trading in Futures & Option? What is the minimum quantity

we need to trade?

The minimum quantity trade in is one market lot. The market lot is different for

different stocks/index. Time to time list will keep changing.

CNXIT 100 ICICI Bank 1400 Oriental Bank 1200

Nifty 200 Infosys 200 PNB 1200

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ACC 1500 IOC 600 Polaris 1400

Andhra Bank 4600 MTNL 1600 Ranbaxy 400

Bajaj Auto 400 ONGC 300 Wipro 600

Bank of Baroda 1400 Nalco 1150 REL 550

Bank of India 3800 Tisco 1350 Union Bank 4200

BEL 550 M&M 625 TCS 250

Bank of India 3800 Maruti 400 Tata Tea 550

Grasim Ind 350 BEL 550 ITC 300

BHEL 600 IPCL 1100 RIL 600

BPCL 550 Hero Honda 400 i-flex 300

Canada Bank 1600 HDFC Bank 800 HPCL 650

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Cipla 1000 HDFC 600 HLL 2000

Dr. Reddys 200 Gujarat Ambuja 1100 Hindalco 300

GAIL 1500 HCL Tech 1300 Tata Power 800

Evolution of derivatives

Development Prior to 1995

In the last few years there have been substantial improvements in the functioning

of the securities market. Requirements of adequate capitalization, margining and

establishment of clearing corporations have reduced market and credit risks. System

improvements have been effected through introduction of screen based trading system

and electronic transfer and maintenance of ownership records of securities. However,

there are inadequate advanced risk management tools. In order to provide such tools

and to deepen and strengthen cash market, a need was felt for trading of derivatives

like futures and options.

But it was not possible in view of prohibitions in the SCRA. Its preamble stated

that the Act is to prevent undesirable transactions in securities by prohibiting options

and by providing for certain others matters connected therewith. Section 20 of the Act

explicitly prohibited all options in securities. The Act empowered central Government to

prohibit by notification any type of transaction in any security. In exercise of this power,Government by its notification in 1969 prohibited all forward trading in securities. As the

need for derivatives was felt, it was thought that if these prohibitions were withdrawn,

trading in derivatives could commence. The securities laws (amendment) ordinance,

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1995, promulgated on 25th January 1995, lifted the ban by repealing section 20 of the

SCRA and amending its preamble.

From 1996 to 1997

The market for derivatives, however, did not take off, as there was no regulatory

framework to govern trading of derivatives. SEBI set up a 24 member committee under

the Chairmanship of Dr. L.C.Gupta on 18th November 1996 to develop appropriate

regulatory framework for derivatives trading in India. The Committee submitted its

report on March 17, 1998.

Market went ahead with preparation. It was soon realized that there was no law

under which the regulations could be framed for derivatives. It was felt that if

derivatives could be treated as securities under the SC(R) Act, trading in derivatives

would be possible within the framework of that Act. According to section 2(h) of the

SC(R) Act, securities includes shares, scrips, stocks bonds, debentures, debentures

stock, or other marketable securities of a like nature in or of any incorporated company

or other body corporate, government securities, such other instruments as may be

declared by the Central Government to be securities, and rights and interest in

securities.

SEBI felt that the definition of Securities under SC(R)A could be expanded by

declaring derivative contracts based on index of prices of securities and other derivative

contracts as securities. It was thought that Government could declare derivatives to be

securities under its delegated powers. Government, however did not declare

derivatives as securities, probably because its power was circumscribed by the words

such other. Only those instruments, which resemble the ones listed in the Act could be

declared.

EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA

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November 1996, SEBI set up a committee under the chairmanship of Dr. L C

Gupta, the well known economist and former SEBI Board Member.

The Committee submitted its report on the March 17 1998. It advocated the

introduction of derivatives in Indian market in a phased manner, starting with the

Index Futures.

SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a

circulation allowing exchanges to submit their proposals for introduction of Derivative

trading.

Government issued notification delineating the areas of responsibility between

RBI and Market Regulator SEBI.

On June 2000, derivative trading started in NSE and BSE.

Market players of Derivatives market:

Hedgers: The objective of these kind of traders is to reduce the risk. They are not in thederivatives market to make profits. They are in it to safeguard their existing positions.

Apart from equity markets, hedging is common in the foreign exchange markets where

fluctuations in the exchange rate have to be taken care of in the foreign currency

transactions or could be in the commodities market where spiraling oil prices have to be

tamed using the security in derivative instruments.

Speculators: They are traders with a view and objective of making profits. They are

willing to take risks and they bet upon whether the markets would go up or come down.

Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one

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market and selling in another, buying two products in the same market are common.

They could be making money even without putting there own money in and such

opportunities often come up in the market but last for very short timeframes. This is

because as soon as the situation arises arbitrageurs take advantage and demand-

supply forces drive the markets back to normal.

Derivatives Trading in Financial Markets

Derivatives were not traded in the financial markets of the world up to the period

about three decades back, though Stock Exchanges trading in securities in the cash

market came to be in vogue more than a century ago. In India the first Stock Exchange,

BSE was established in 1875. But BSE commenced trading in derivatives only from

2001. Even in the international financial/securities market the advent of derivatives as

trading products was a concurrent-effect with the process of globalization and

integration of the national economies of the developed countries beginning from the

Seventies of the last Century. As volumes traded increased and as competition turned

intense, trade & business became more complex in the new environment. The new

opportunities were matched by fresh challenges and unpredictable volatility of the

trading environment. Corporate for the first time sensed the formidable risks inherent inbusiness transactions and the unpredictability of the markets to which they are

exposed. Facing multiple risks the business organizations, were induced to search for

new remedies, i.e. risk containment devices/instruments. Derivatives came to be the

natural remedy in this context. To quote an international professional authority:

"As capital markets become increasingly integrated, shocks transmit easily from

one market to another. The proliferation of new instruments with complex features has

led to enhanced investment opportunities. One such instrument which has become

darling of corporate, banks, institutions alike is 'Derivatives'. To have a touch of the tree

top's view, Derivatives transaction is defined as a bilateral contract whose value is

derived, from the value of an underlying asset, or reference rate, or index. Derivative

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transactions have evolved in the past twenty years to cover a broad range of products

which include instruments like 'forwards', 'futures', 'options', 'swaps' covering a broad

spectrum of underlying assets including exchange rates, interest rates, commodities,

and equities."

Though recent in origin derivatives instruments issued over the years have

grown by leaps and bounds and the total amount issued globally is estimated to

approach $80 trillion by the advent of the new millennium.

Derivative positions have grown at a compounding rate of 20% since 1990. In

India though derivatives were introduced very recently in 2001, the trading turnover hasalready surpassed that of the equity segment. In NSE alone as per a report on its

website the total turnover of the derivatives segment for the month of May 2003 stood at

Rs. 53424 crores. During the month of May 2003, the percentage of derivatives

segment as a percentage of the cash segment was 97.68%. However in the earlier two

months the turnover of Derivatives was higher than that of the cash segment.

Trading process of derivatives

Detailed knowledge about derivatives market

Open a Demat Account with minimum balance

Starting process of Trading with help of demat account.

Create market watch and watching that particulars of derivatives market.

Buy commodities like oil and currency.

Select particulars buying & selling contract for derivatives market.

Minimum amount entering in to derivatives Rs.40000.

Incur Initial expense of transaction.

Buyers usually enter into lot size.

Decides whether states price at spot or futures prices

Waiting for increase price for contract

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Laterally square off transaction both futures & options.

Different types of derivatives products

Commodity

Oil

Currency

Agricultural commodities

Ornaments like gold.

Cattle

TRADING METHOD

Listed securities are traded on the floor of the recognized stock exchange where its

members trade. An investor is not permitted to enter the floor of the exchange and he

has to trust the broker to:

1. Negotiate the best price for the trade.

2. Settle the account, i.e. payment for securities sold due date.

3. Take delivery of securities purchased.

Trading in a stock exchange is conducted in two ways:

1. Ready delivery contracts.

2. Forward delivery contracts.

Ready delivery contracts or cash trading on cash transaction. These fulfill the following

criterion:

All listed securities can be traded.

Settlement within seven days.

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Carryover facilities not permitted.

Depository account:

A depository account is similar to the bank accounts. It gives a summary of an

investors holding of securities in the companies traded in the Indian Stock Exchanges

and records transaction details of securities bought and sold during the period. This

information of securities holding is maintained in the electric form. The securities in the

depository account do not have any numbers to distinguish them and are identified by

the total number of securities held for each company by the depository on the investors

account.

INTRODUCTION TO ONLINE TRADING

There is a world of difference in the way people trade these days. Gone are the

days when traders and brokers jostled, screaming their lungs out in a crowded bullring

to make various deals. With the advent of Internet trading there has come about a

drastic change in trading. It is now rather quite on the stock market front.

After online banking, online trading is probably the biggest revolution unleashed

by technological innovation. For the first time in a century and a half, trading power has

shifted from stockbrokers to individual investors. This revolution has advanced

significantly in the US and is being felt in Europe, Japan, Australia, China and South

Korea.

Online trading has become quite popular in the last couple of years because of

the convenience and ease of use. Online trading has basically replaced a phone call

with the Internet. Instead of interacting with the brokers over the phone, consumers are

now clicking the mouse. Online trading has given customers access to account

information, stock quotes, elaborate market research and interacting.

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Online trading is the perfect combination of the medium of the net catering to a

real life concept. Given that trading is all about having access to multiple information

sources, from the companys performance to the industrial and economic scenarios as

well as possessing the analytical tools to process this information, the net is the perfect

solution to investor needs. Online trading is all about bringing together under one site all

the relevant factors to enable an informed investment at cheaper rates.

Through online trading, the securities industry has, for the first time paved the

way for implementation of direct order placement, directly onto the broking firms trading

system via the Internet. Due to this price setting power for trading execution has shifted

from the brokers and traditional stock exchanges to the Electronic Communication

Networks (ECN).

ADVANTAGES

Internet trading has a variety of advantages, and below, a few of them are listed.

They are:

1. Easy access to information and research: Internet brokerage houses offer easily

accessible company information, investment advice, counseling on how to profitablyinvest and better manage an investors portfolio and verity the various portfolio and

verify the various tips got from various sources.

2. Markets on the desktop: Investors do not have to go take the trouble of going to

the stock exchange or to his brokers office, the investor has got all he requires on his

desktop.

3. Portfolio management: Investors can track their portfolio performance, that is, it is

faring in the market. If the portfolio is not performing well investors can get advice on

restructuring it.

4. Best prices: Online trading has resulted in a phenomenal reduction in the

transaction cost for the investor as online trading ensures a matching of buying and

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selling orders within an ENC without the intervention of market markets or traditional

stock exchanges.

5. Liquidity: The liquidity option available for investors has been considerably

stretched as the online trading offers 24 hours trading facilities.

6. Audit trial: Online trading has imparted greater transparency which is subject to

scrutiny, by providing an audit trial for an investor right at his desk, which earlier, used

to stop at his brokers trading terminal. The integrated electronic chain, starting with the

order-placement-clearing and settlement function and ending with the credit and

settlement function and ending with the credit to the depositary an account of the

investor is largely a transparent process.

7. Benefit of saving: Individual investors can save a lot more through online trading

as the cost per trade while trading online is less.

8. Variety: Individual invests in a variety of products, unlike earlier when investors

bought bonds, mutual funds and stocks for long-term basis and sat on term. Now

individuals can invest in stocks, stick options, mutual funds, individual, government,

corporate, municipal bonds, various types of IRA account mortgages and even

insurance.

DISADVANTAGES

A few of the possible disadvantages of online trading can be noted as follows:

1. Speedy net connection: One the most important requirements for any investor

while trading online is the need for fast internet connection as time is of essence while

trading. This has not yet been well established in India.

2. Guidance: Individuals are restricted to first hand guidance; the individual is the

one to make the own decision, online trading doesnt help investors while decision

making as a broker can.

3. Crashes: If the network crashes, there will be problems and delays due to large

influx of traffic and rapid online trading criteria.

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4. Communication links: There is need more effective communication links over the

internet and the ability of the server to deal with the volume of visitors.

Profit is ascertained

Payoff For Derivatives Contracts

A payoff is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. This is generally depicted in the form of

payoff diagrams which show the price of the underlying asset on the Xaxis and the

profits/losses on the Yaxis.

Payoff For A Buyer Of Nifty Futures

The figure shows the profits/losses for a long futures position. The investor

bought futures when the index was at 1220. If the index goes up, his futures position

starts making profit. If the index falls, his futures position starts showing losses.

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Payoff For A Buyer Of Nifty Futures


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Futures contracts have linear payoffs. In simple words, it means that the losses

as well as profits for the buyer and the seller of a futures contract are unlimited. These

linear payoffs are fascinating as they can be combined with options and the underlying

to generate various complex payoffs.

Payoff For A Seller Of Nifty Futures

The figure shows the profits/losses for a short futures position. The investor sold

futures when the index was at 1220. If the index goes down, his futures position starts

making profit. If the index rises, his futures position starts showing losses.

The payoff for a person who sells a futures contract is similar to the payoff for a

person who shorts an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside.

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Payoff For A Seller Of NiftyFuture


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Payoff Profile For Buyer Of Call Options Long Call

A call

option gives the buyer the right to buy the underlying asset at the strike price specified

in the option. The profit/loss that the buyer makes on the option depends on the spot

price of the underlying. If upon expiration, the spot price exceeds the strike price, he

makes a profit.

Higher the spot price, more is the profit he makes. If the spot price of the underlying is

less than the strike price, he lets his option expire un-exercised. His loss in this case is

the premium he paid for buying the option. The figure shows the profits/losses for the

buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises,

the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250,

the buyer would exercise his option and profit to the extent of the difference between

the Nifty-close and the strike price. The profits possible on this option are potentially

unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His

losses are limited to the extent of the premium he paid for buying the option i.e. Rs.86.6

/-

Payoff Profile For Writer Of Call Options - Short Call

For selling the option, the writer of the option charges a premium. The profit/loss

that the buyer makes on the option depends on the spot price of the underlying.

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Payoff For Buyer Of Call Option


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Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price

exceeds the strike price, the buyer will exercise the option on the writer. Hence as the

spot price increases the writer of the option starts making losses. Higher the spot price,

more is the loss he makes. If upon expiration the spot price of the underlying is less

than the strike price, the buyer lets his option expire unexercised and the writer gets to

keep the premium.

The figure shows the profits/losses for the seller of a three-month Nifty 1250 call

option. As the spot Nifty rises, the call option is in-the-money and the writer starts

making losses . If upon expiration, Nifty closes above the strike of 1250, the buyer

would exercise his option on the writer who would suffer a loss to the extent of the

difference between the Nifty-close and the strike price. The loss that can be incurred by

the writer of the option is potentially unlimited, whereas the maximum profit is limited to

the extent of the up-front option premium of Rs.86.60 charged by him.

Payoff Profile For Buyer Of Put Options: Long Put

A put option gives the buyer the right to sell the underlying asset at the strike

price specified in the option. The profit/loss that the buyer makes on the option depends

on the spot price of the underlying. If upon expiration, the spot price is below the strike

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Payoff For Writer Of Call Option


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price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot

price of the underlying is higher than the strike price, he lets his option expire un-

exercised. His loss in this case is the premium he paid for buying the option.

The below figure shows the profits/losses for the buyer of a three-month Nifty

1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money.

If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his

option and profit to the extent of the difference between the strike price and Nifty-close.

The profits possible on this option can be as high as the strike price. However if Nifty

rises above the strike of 1250, he lets the option expire. His losses are limited to the

extent of the premium he paid for buying the option i.e. Rs.61.70/-

Payoff Profile For Writer Of Put Options - Short Put

A put option gives the buyer the right to sell the underlying asset at the strike

price specified in the option. For selling the option, the writer of the option charges a

premium. The profit/loss that the buyer makes on the option depends on the spot price

of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration,

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the spot price happens to be below the strike price, the buyer will exercise the option on

the writer. If upon expiration the spot price of the underlying is more than the strike

price, the buyer lets his option expire un-exercised and the writer gets to keep the

premium.

The below figure shows the profits/losses for the seller of a three-month Nifty 1250 put

option. As the spot Nifty falls, the put option is in-the-money and the writer starts making

losses. If upon expiration, Nifty closes below the strike of 1250, the buyer would

exercise his option on the writer who would suffer a loss to the extent of the difference

between the strike price and Nifty-close.

The loss that can be incurred by the writer of the option is a maximum extent of

the strike price( Since the worst that can happen is that the asset price can fall to zero)

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whereas the maximum profit is limited to the extent of the up-front option premium of

Rs.61.70 charged by him.

TRADING STRATEGIES

Single Option and Stock

These strategies involve using an option along with a position in a stock.

Strategy 1:

A Covered Call: A long position in stock and short position in a call option.

Illustration : An investor enters into writing a call option on one share of Rel. Petrol. At a

strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months

form now and along with this option he/she buys a share of Rel.Petrol. in the spot

market at Rs. 58 per share.

By this the investor covers the position that he got in on the call option contract and if

the investor has to fulfill his/her obligation on the call option then can fulfill it using the

Rel.Petrol. share on which he/she entered into a long contract. The payoff table below

shows the Net Profit the investor would make on such a deal.

Writing a Covered Call Option

S Xt C Profit from

writing call

Net Profit from

Call Writing

Share

bought

Profit

from

stock

Total

Profit

50 60 6 0 6 58 -8 -2

52 60 6 0 6 58 -6 0

54 60 6 0 6 58 -4 2

56 60 6 0 6 58 -2 4

58 60 6 0 6 58 0 6

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60 60 6 0 6 58 2 8

62 60 6 -2 4 58 4 8

64 60 6 -4 2 58 6 8

66 60 6 -6 0 58 8 8

68 60 6 -8 -2 58 10 8

70 60 6 -10 -4 58 12 8

Strategy 2:

Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is

applied by taking a long position or buying a call option and selling the stocks.

Illustration :

An investor enters into buying a call option on one share of Rel. Petrol. At a strike price

of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now

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and along with this option he/she sells a share of Rel.Petrol. in the spot market at Rs.

58 per share.

The payoff chart describes the payoff of buying the call option at the various spot rates

and the profit from selling the share at Rs.58 per share at various spot prices. The net

profit is shown by the thick line.

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Strategy 3:

Protective Put Strategy:

This strategy involves a long position in a stock and long position in a put. It is a

protective strategy reducing the downside heavily and much lower than the premium

paid to buy the put option. The upside is unlimited and arises after the price rises high

above the strike price.

Illustration 5:

An investor enters into buying a put option on one share of Rel. Petrol. At a strike price


and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58

per share.

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Protective Put Strategy

S Xt p Profit from

buying put

option

Net Profit

from Buying

put option

Spot Price

of Buying

the stock

Profit from

stock

Total

Profit

50 60 -6 10 4 58 -8 -4

52 60 -6 8 2 58 -6 -4

54 60 -6 6 0 58 -4 -4

56 60 -6 4 -2 58 -2 -4

58 60 -6 2 -4 58 0 -4

60 60 -6 0 -6 58 2 -4

62 60 -6 0 -6 58 4 -2

64 60 -6 0 -6 58 6 0

66 60 -6 0 -6 58 8 2

68 60 -6 0 -6 58 10 4

70 60 -6 0 -6 58 12 6

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Strategy 4:

Reverse of Protective Put

This strategy is just the reverse of the above and looks at the case of taking short

positions on the tock as well as on the put option.

Illustration 6:

An investor enters into selling a put option on one share of Rel. Petrol. At a strike price


and alongwith this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58

per share.

Reverse of Protective Put Strategy

S Xt p Profit from

writing a put

option

Net Profit

from Put

Writing

Spot Price of

Selling the

stock

Profit

from

stock

Total Profit

50 60 6 -10 -4 58 8 4

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52 60 6 -8 -2 58 6 4

54 60 6 -6 0 58 4 4

56 60 6 -4 2 58 2 4

58 60 6 -2 4 58 0 4

60 60 6 0 6 58 -2 4

62 60 6 0 6 58 -4 2

64 60 6 0 6 58 -6 0

66 60 6 0 6 58 -8 -2

68 60 6 0 6 58 -10 -4

70 60 6 0 6 58 -12 -6

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All the four cases describe a single option with a position in a stock. Some of these

cases look similar to each other and these can be explained by Put-Call Parity.

Put Call Parity

P + S = c + Xe-r(T-t) + D ---------------------- (1)

Or

S - c = Xe-r(T-t) + D - p ---------------------- (2)

The second equation shows that a long position in a stock and a short position in a call

is equivalent to the short put position and cash equivalent to Xe -r(T-t) + D.

The first equation shows a long position in a stock combined with long put position is

equivalent to a long call position plus cash equivalent to Xe -r(T-t) + D.

SPREADS

The above involved positions in a single option and squaring them off in the spot

market. The spreads are a little different. They involve using two or more options of the

same type in the transaction.

Strategy 1:

Bull Spread:

The investor expects prices to increase in the future. This makes him purchase a

call option at X1 and sell a call option on the same stock at X2, where X1


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describes the net profit that one earns on the buy call option, sell call option and both

contracts together.

Payoff From a Bull Spread

S X1 X2 c1 c2 Profit from

X1

Net profit

from X1

Profit form

X2

Net

Profit

from X2

Total

Profit

4200 4300 4500 -450 400 0 -450 0 400 -50

4250 4300 4500 -450 400 0 -450 0 400 -50

4300 4300 4500 -450 400 0 -450 0 400 -50

4350 4300 4500 -450 400 50 -400 0 400 0

4400 4300 4500 -450 400 100 -350 0 400 50

4450 4300 4500 -450 400 150 -300 0 400 100

4500 4300 4500 -450 400 200 -250 0 400 150

4550 4300 4500 -450 400 250 -200 -50 350 150

4600 4300 4500 -450 400 300 -150 -100 300 150

4650 4300 4500 -450 400 350 -100 -150 250 150

4700 4300 4500 -450 400 400 -50 -200 200 150

4750 4300 4500 -450 400 450 0 -250 150 150

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The premium on call with X1 would be more than the premium on call with X2. This is

because as the strike price rises the call option becomes unfavourable for the buyer.

The payoffs could be generalised as follows.

Spot Rate Profit on

long call

Profit on

short call

Total

Payoff

Net Profit Which

option(s)

Exercised

S >= X2 S - X1 X2 - S X2 - X1 X2 - X1 - c1 +

c2

Both

X1 < S = X1 0 0 0 c2 - c1 None

The features of the Bull Spread:

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This requires an initial investment.

This reduces both the upside as well as the downside potential.

The spread could be in the money, on the money and out of money.

Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell

the same stock put at a higher strike price.

This contract would involve an initial cash inflows unlike the Bull Spread based on the

Call Options. The premium on the low strike put option would be lower than the

premium on the higher strike put option as more the strike price more is favourability to

buy the put option on the part of the buyer.

Illustration

An investor purchases a put option on the BSE Sensex at premium of Rs.50 for a strike

price at 4300. The investor squares this off with a sell put option at Rs. 100 for a strike

price at 4500. The contracts mature on the same date. The payoff chart below

describes the net profit that one earns on the buy put option, sell put option and both

contracts together.

Payoff From a Bull Spread (Put Options)

S X1 X2 p1 p2 profit from

X1

Net profit

from X1

Profit

from X2

Net

Profit

from X2

Total

Profit

4200 4300 4500 -50 100 100 50 -300 -200 -150

4250 4300 4500 -50 100 50 0 -250 -150 -150

4300 4300 4500 -50 100 0 -50 -200 -100 -150

4350 4300 4500 -50 100 0 -50 -150 -50 -100

4400 4300 4500 -50 100 0 -50 -100 0 -50

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4450 4300 4500 -50 100 0 -50 -50 50 0

4500 4300 4500 -50 100 0 -50 0 100 50

4550 4300 4500 -50 100 0 -50 0 100 50

4600 4300 4500 -50 100 0 -50 0 100 50

4650 4300 4500 -50 100 0 -50 0 100 50

4700 4300 4500 -50 100 0 -50 0 100 50

4750 4300 4500 -50 100 0 -50 0 100 50

Spot Rate Profit on

long put

Profit on

short put

Total Payoff Net Profit Which option(s)

Exercised

S >= X2 0 0 0 p2 - p1 None

X1 < S


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1.3 Empirical analysis

TABLE NO.1

TABLE SHOWING DIFFERENT TYPE OF INVESTORS

investments

Frequency

Long term investor 47

Short term investor 24

Daily trader 29

Graph No.1

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GRAPH SHOWING DIFFERENT TYPE OF INVESTORS

Type of Investors

Analysis :

The above table shows the different type of investors long term short term

and day trade. As per the graph are 47%long term, 24% are short term and 29%

are day trader.

Interpretation :

Out of the 100 investors surveyed 47 investors are long term investors which

makes a percent of 47%. Here investors who have an investment of three months

or more than three months are called long term investors. Investors with an

investment period in between one to three months are called short term investors.

About 29 percent of the investors are day traders who buy and sell on the samedate.

TABLE NO.2

TABLE SHOWING THE PERCENTAGE OF INVESTMENT IN

DERIVATIVES

FrequencyLess than 20 % 37

20%-40% 28

40%-60% 19

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Above 60% 16

GRAPH NO.2

GRAPH SHOWING THE PERCENTAGE OF INVESTMENT IN

DERIVATIVES

Analysis :

The above table shows the percentage of investment in derivatives. As per the table

37% investors invest in less than 20% derivatives.

Interpretation :

Around 37 percent of the investors invest less than twenty percent of theirinvestment into derivatives. And around 28 percent allocate 20% to 40% into

derivatives.

TABLE NO.3

TABLE SHOWING THE INFORMATION USED FOR TRADE

IN DERIVATIVES

Frequency

Technical information 10

Market information 25

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Individual analysis 45

All the above 20

GRAPH NO.3

GRAPH SHOWING THE INFORMATION USED FOR TRADE IN

DERIVATIVES

Analysis :

The above table shows that different information used for derivatives trading

such as technical information, market information and individual analysis. As per

the graph 45% investor go by their by their individual analysis.

Interpretation :

On the question about the information used in order to trade in derivatives it

was found that around 45% of the investors go by their individual analysis before

investing.

TABLE NO.4

TABLE SHOWING THE INSTRUMENTS TRADED IN

DERIVATIVES

Frequency

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futures 69

options 31

GRAPH NO.4

GRAPH SHOWING THE INSTRUMENTS TRADED IN

DERIVATIVES

Analysis :

The above table shows the investors trading future and option. As per graph

investors in futures are more compared to the investors in option.

Interpretation :

69% of the investors have traded in Futures segment and around 31 percent

of the traders traded in options. So investors are favoring futures than options.

TABLE NO.5

TABLE SHOWING THE MOST INSTRUMENTS

Frequency

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Stock index futures 40

Futures on individual stocks 35

Stock index options 11Options on individual stocks 14

GRAPH NO.5

GRAPH SHOWING THE MOST FAVORED DERIVATIVES IN

INSTRUMENT

Analysis :

The above table shows the instruments traded in derivatives. out of 100

respondents 69 invest in futures and 31 invest in option.

Interpretation :

When asked about the most favored derivative instruments, forty percent of

the investors favored index futures and 35% of the investor went for futures on

individual stocks. So it is obvious that options are still not favored by investors.

TABLE NO.6

TABLE SHOWING THE DIFFERENT CONTRACTS ENTERED

Frequency

index futures 24

index options 14

stock futures 43

stock options 19

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GRAPH NO.6

GRAPH SHOWING THE DIFFERENT CONTRACTS ENTERED

Analysis :

The above table shows that 24 respondents invest in index futures , 43invest instock future and 19 in stock options.

Interpretation :

Around 43 percent of the respondents have entered into stock futures contract.

TABLE NO.7

TABLE SHOWING THE BEST DERIVATIVES

Frequency

Hedging 35

Speculation 65

GRAPH NO.7

GRAPH SHOWING THE BEST DERIVATIVES

Hedging vs. Speculations

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Analysis:

The above table shows the best for derivatives out of 100 respondents 65 investors

prefer hedging and 35 investors prefer speculation.

Interpretation:

More than 65% traders feel that Derivative is best for speculation than for hedging.

Out of 100 investors 35 were favoring derivative as a speculative instrument.

Traders mainly want to make short term gain by investing into Derivatives then for

using Derivative as an instrument to reduce the market risk.

TABLE NO.8

TABLE SHOWING STRATEGY USED FOR HEDGING

FrequencyLong & Short Futures 35

Short stock & Long Futures 14

Long & Shot Call 11

Short Stock & Long Call 15

Long Stock & Long Put 7

Short Stock & Short Put 7

Long Index futures & Short stock 6

Short Index Futures & Long Stock 5

GRAPH NO.8

GRAPH SHOWING STRATEGY USED FOR HEDGING

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Analysis:

The above table shows 35 respondents prefer long and short futures hedging, 14

prefer short and long futures, 11long and short call, 15short stock and long call, 7

long stock and long put, 7 in short stock and short put, 6 in long index future and

short stock, 5 in short index future and long stock.

Interpretation:

Among the strategies used for hedging Short Stock & Long Call have used as the

most used strategy.

TABLE NO.9

TABLE SHOWING THE STRATEGIES USED FOR HEDGING IN

A

BULLISH MARKET

Frequency

long futures 34

long call 23

long index futures 18

long index call 25

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GRAPH NO.9

GRAPH SHOWIN THE STRATEGOES USED FOR HEDGING INA BULLISH MARKET

Analysis :

The above table shows 34& respondents prefer long index future, 23% prefer

long index call, 18% prefer long call, 25% prefer long future.

Interpretation :

Among the strategies used for hedging in a bullish market, Long Index

Futures is being preferred by majority of the respondent

TABLE NO.10

TABLE SHOWING STRATEGIES USED IN A BEARISH MARKET

Frequency

short futures 36

short index futures 19

short call 29

short index call 16

Graph No.10

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GRAPH SHOWING STRATEGIES USED IN A BEARISH

MARKET

Analysis :

The above table shows 36%respondents prefer short futures in bearish

market, 19% prefers short calls, 29% prefers short index future and 16% prefer

short index call.

Interpretation :

In a bearish market, the most preferred strategy is Index Future short call

and its percentage is 29%.

TABLE NO.11

TABLE SOWING EXPECTED RISH REWARD RATIO

Frequency

1:0.2 32

1:0.4 23

1:0.6 221:0.8 10

1:1 13

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Graph No.11

GRAPH SHOWING EXPECTED RISK-REWARD RATIO

ANALYSIS:

The above table shows that out of total respondent 27 respondents expect 1:0.4

risk reward ratio, 21 expect 1:0.6, 8 expect 1:0.8, and the remaining 14 respondent

expects 1:1 ratio.

Interpretation :

Around 38 percent of the investors are looking out for an annual return of 40

percent from their investments. And 20 percent of the respondents have a high

expectation of 100 percent return.

TABLE NO.12

TABLE SHOWING GROWTH RATE IN OPTIONS IN INDIA

Frequency

Grow very fast 15

Grow Moderately 19

Not Much Growth 11

Can't Say anything 25

Graph No.12

GRAPH SHOWING GROWTH RATE IN OPTIONS IN INDIA

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Analysis :

The above table shows the growth rate in options in India. Fast growth frequency is

21%, moderate growth frequency is 27% , no much growth is 16% , no idea

frequency is 36%.

Interpretation.

More than 36 percent of the investors are still don't have any idea about the future

growth of the Option market in India, And 27% respondents feel that the option

market would grow moderately. And 21 percent expect the market to grow very

fast.

TABLE NO.13

TABLE SHOWING INTERESTED CONTRACT MATURITY

PERIOD FOR INDEX FUTURES & OPTIONS

Frequency

Current 45

Next month 35

Forward month 20

Graph No.13

GRAPH SHOWING INTERESTED CONTRACT MATURITY

P

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