Tulasi Krishna

8/2/2019 Tulasi Krishna

1/84

INTRODUCTION

Derivatives is a product whose value is derived from the value of an underlying

asset in a contractual manner.The underlying asset can be equity,forex,commodity or any

other asset.

With the approval of the derivatives bill in union cabinet, the investors are now in the

position to trade through futures and options, which provides the investors a greater

hedging facility. Derivatives product initially emerged as hedging devices against

fluctuations in commodity prices and different types of securities. Derivatives offer

organization the opportunity to break financial risks into smaller components and then to

buy and sell those components to best meet specific risk management objectives.

Financial derivatives came into spotlight in the year 1970 period due to growing

instability in the financial markets. However since their emergence, these accounted for

about two-third of totals transactions in derivatives products. In recent years, the market for

financial derivatives has grown tremendously in terms of variety of instruments available,

there complexity & also turn over.

The emergence of the market for derivatives products, most notably forwards, futures

and options, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. By their very

nature, the financial markets are marked by a very high degree of volatility. Through the

use of derivative products, it is possible to partially or fully transfer price risks by locking-

in asset prices. As instruments of risk management, these generally do not influence the


2/84

fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative

products minimize the impact of fluctuations in asset prices on the profitability and cash

flow situation of risk-averse investors.

Derivatives are risk management instruments, which derive their value from an

underlying asset. The underlying asset can be bullion, index, share, bonds, currency,

interest, etc. Banks, Securities firms, companies and investors to hedge risks, to gain access

to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even

at a faster rate in future.Early forward contracts in the US addressed merchants concerns

about ensuring that there were buyers and sellers for commodities. However credit risk

remained a serious problem. To deal with this problem, a group of Chicago; businessmen

formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT

was to provide a centralized location known in advance for buyers and sellers to negotiate

forward contracts. In 1865, the CBOT went one step further and listed the first exchange

traded derivatives contract in the US; these contracts were called futures contracts. In 1919,

Chicago Butter and Egg Board, a spin-off CBOT was reorganized to allow futures trading.

Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME

remain the two largest organized futures exchanges, indeed the two largest financial

exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade.

Currently the most popular stock index futures contract in the world is based on S&P 500

indexes, traded on Chicago Mercantile Exchange. During the Mid eighties, financial


3/84

futures became the most active derivative instruments generating volumes many times

more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures

are the three most popular futures contracts traded today. Other popular international

exchanges that trade derivates are LIFFE in England,DTB in Germany, SGX in Singapore,

TIFFE in Japan MATIF in France etc.

Over the last three decades, the derivatives markets have seen a phenomenal growth. A

large variety of derivative contracts have been launched at exchanges across the world.

Some of the factors driving the growth of financial derivatives are:Increased volatility in

asset prices in financial markets,increased integration of national financial markets with the

international markets,marked improvement in communication facilities and sharp decline

in their costs,Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and innovations in the

derivates markets, which optimally combine the risks and returns over a large number of

financial assets leading to higher returns, reduced risk as well as transaction costs as

compared to individual financial assets.


4/84

OBJECTIVES

With the following objectives I have undergone my project

To study the role of derivatives in Indian financial markets (F & O)

To find out profit of option holder/writer.

To find out loss of option holder/writer.

To study the cause for fluctuations in the futures and options market.

To study about risk management with the help of derivatives.

To analyze the operations of futures and options.


5/84

METHODOLOGY

The methodology adopted for the study is discussions with the personnel ( who

completed their NCFM, DERIVATIVES module ) in Sharekhan ltd.

The data that was collected for analysis purpose has been divided into primary data

and secondary data. The primary data that has been collected through personnel interview

with various heads and individual traders in Sharekhan ltd.

The secondary data has been collected from the Sharekhan ltd, books and the

internet(bseindia.com, nseindia.com).

SCOPE

The scope of the study is limited to DERIVATIVES with the special

reference to Indian context and the National stock exchange has been taken as

a representative sample for the study. The study includes futures and options.

The study cant be perfect. Any alterations may come as the market changes

due to day to day operations.

There are many organizations trading in the Sharekhan Ltd, but my study is

only for selected organizations such as INFOSYS TECHNOLOGIES &

DR.REDDYs LABORATORIES for one month period.

The study is not based on the international perspective of derivatives markets,

which exits in NASDAQ, CBOE etc.


6/84

I had chosen these companies as I wish to analysis on these companies. Moreover,

these are traded on NSE (F & O).

LIMITATIONS OF THE STUDY

The study is confined to only one month trading contract.

The study does not look any Nifty Index Futures and Options and international

markets into the consideration.

This is a study conducted within a period of 60 days.

The study contains some assumption based on the demands of the analysis.

NATURE OF THE PROBLEM

The turnover of the stock exchange has been tremendously increasing from last 10 years.

The number of trades and the number of investors, who are participating, have increased.

The investors are willing to reduce their risk, so they are seeking for the risk management

tools.

Prior to SEBI abolishing the BADLA system, the investors had this system

as a source of reducing the risk, as it has many problems like no strong margining system,

unclear expiration date and generating counter party risk. In view of this problem SEBI

abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for a

hedging system, which could reduce their portfolio risk. SEBI thought the introduction of


7/84

the derivatives trading, as a first step it has set up a 24 member committee under the

chairmanship of Dr. L.C. Gupta to develop the appropriate framework for derivatives

trading in India, SEBI accepted the recommendation of the committee on May 11, 1998

and approved the phase introduction of the derivatives trading beginning with stock index

futures.


8/84

CHAPTER-II

ORGANIZATION PROFILE


9/84

Company Profile

KARVY, is a premier integrated financial services provider, and ranked among

the top five in the country in all its business segments, services over 16 million individual

investors in various capacities, and provides investor services to over 300 corporate,

comprising the who is who of Corporate India. KARVY covers the entire spectrum of

financial services such as Stock broking, Depository Participants, Distribution of financial

products - mutual funds, bonds, fixed deposit, equities, Insurance Broking, Commodities

Broking, Personal Finance Advisory Services, Merchant Banking & Corporate Finance,

placement of equity, Initial Public Offer, among others.

KARVY covers the entire spectrum of financial services such as Stock broking,

Depository Participants, Distribution of financial products - mutual funds, bonds, fixed

deposit, equities, Insurance Broking, Commodities Broking, Personal Finance Advisory

Services, Merchant Banking & Corporate Finance, placement of equity, Initial Public

Offer, among others. KARVY has a professional management team and ranks among the

best in technology, operations and research of various industrial segments.

With the advent of depositories in the Indian capital market and the relationships

that we have created in the registry business, we believe that we were best positioned to

venture into this activity as a Depository Participant.

KARVY was one of the early entrants registered as Depository Participant with

NSDL (National Securities Depository Limited), the first Depository in the country and

then with CDSL (Central Depository Services Limited). Today, their service over 6 lakhs


10/84

customer accounts in this business spread across over 250 cities/towns in India and are

ranked amongst the largest Depository Participants in the country. With a growing

secondary market presence, company had transferred this business to KARVY Stock

Broking Limited (KSBL), KARVY associate and a member of NSE, BSE and HSE.

The term KARVY is derived from the initial letters of its founders

K - Mr. Kuttumba Rao

A - Mr. Ajay Kumar

R - Mr. Ramakrishna

V - Mr. Vaidyanathan

Y - Mr. Yugandhar These five energetic and dynamic Chartered Accountants started KARVY in 1975 as

KARVY and Company.

Role of Finance Department

In all the companies, finance and accounts are the integral part of its functioning

and effective management. It gives complete picture about each and every department

expense and income earned during particular period. It maintains books of accounts &

prepares financial statements for specific period, which is known as the accounting period,

which is of 6 months or 12 months.

As the company branches are many, top management needs to be informed about the

financial aspect of the organization. In KARVY F & A Department consists of

Accounts

Treasury

Taxation

Accounts (Tally)


11/84

Debtors Management Team

Management accounting and Information Systems

Internal Audit

In order to improve its liquidity and to avoid debts turning into irrecoverable

KARVY embraced the Debtors Management Team (DMT) in its F&A department. The

debtors management team was designed to intensely watch the movement of debtors in

turn to depict the fluctuations in the outstanding debit balance of the clients and to trace the

clients/debtors who are financially weak to pay their debt in order to encode necessary

steps.

To improve the liquidity and avoid the debts turning into irrecoverable KARVY

started the debtors management team in April 2004.The debtors management team

comprises of one general manager, one senior manager three team leaders and twenty-three

team members monitoring of debtors over 350 branches of KARVY spread across the

country.

Operations of KARVY: Consultant

s

Com

puter

share

Insura

nce

broking

Comm

odities

broking

Investo

r

Services

StockBrokin

g

Glob

al

servic

es

KAR

VY


12/84

KARVY STOCK BROKING:

KARVY Stock Broking services are widely networked across India, with the

number of KARVY trading terminals providing retail stock broking facilities. KARVY

services have increasingly offered customer oriented convenience, which the company

provides to a spectrum of investors, high net worth or otherwise, with equal dedication and

competence. Company offer trading on a vast platform; National Stock Exchange, Bombay

Stock Exchange and Hyderabad Stock Exchange. More importantly, KARVY make trading

safe to the maximum possible extent, by accounting for several risk factors and planning

accordingly. KARVY offer services that are beyond just a medium for buying and selling

stocks and shares.

KARVY INVESTOR SERVICES

KARVY is well networked with 200 full-fledged branches and 350 Investor Service

Centers with a workforce of over 3500 personnel drawn from various disciplines. KARVY

Investor Services Limited, a SEBI registered Merchant Banker is a 100% subsidiary of

KARVY Consultants Limited and is among the top 10 merchant Bankers in India today.

KARVY financial advice and assistance in restructuring, divestitures, acquisitions, de-

mergers, spin-offs, joint ventures, privatization and takeover defense mechanisms have

elevated KARVY relationship with the client to one based on unshakable trust and

confidence.

KARVY - COMPUTERSHARE:

KARVY traversed wide spaces to tie up with the worlds largest transfer agent, the

leading Australian company, Computer share Limited. The company that services more

than 75 million shareholders across 7000 corporate clients and makes its presence felt in


13/84

over 12 countries across 5 continents has entered into a 50-50 joint venture with the

KARVY.

KARVY GLOBAL SERVICES:

The specialist Business Process Outsourcing unit of the Karvy Group. It offers

several delivery models on the understanding that business needs are unique and therefore

only a customized service could possibly fit the bill. Company outsourcing models are

designed for the global customer and are backed by sound corporate and operations

philosophies, and domain expertise. Providing productivity improvements, operational cost

control, cost savings, improved accountability and a whole gamut of other advantages.

They operate in the core market segments that have emerging requirements for specialized

services. Their wide vertical market coverage includes Banking, Financial and InsuranceServices (BFIS), Retail and Merchandising, Leisure and Entertainment, Energy and Utility

and Healthcare.

KARVY COMMODITIES BROKING:

KARVY Commodities, They are focused on taking commodities trading to new

dimensions of reliability and profitability. Company enables trade in all goods and products

of agricultural and mineral origin that include lucrative commodities like gold and silver

and popular items like oil, pulses and cotton through a well-systematized trading platform.

KARVY ISURANCE BROKING:

At KARVY Insurance Broking Pvt. Ltd., they provide both life and non-life

insurance products to retail individuals, high net-worth clients and corporate. With the

opening up of the insurance sector and with a large number of private players in the

business, they are in a position to provide tailor made policies for different segments of

customers.


14/84

Principal Competitors of KARVY:

Kotak Securities

India Bulls Financial Service

Angel Broking

Net worth

ICICI Direct

Arihant

Share khan

Achievements:

Among the top 5 stockbrokers in India (4% of NSE volumes).

India's No. 1 Registrar & Securities Transfer Agents.

Among the to top 3 Depository Participants.

Largest Network of Branches & Business Associates.

ISO 9002 certified operations by DNV.

Among top 10 Investment bankers.

Largest Distributor of Financial Products.

Vision 2008:


15/84

Stock Broking:

o 10% + share in cash markets

o F & O double the cash volumes (around 6%)

o Activate BSE so as to reach 5% share

Depository services:

o To reach the No.1 position

o Look at over 12 lakhs accounts by 2008

Mutual Fund distribution:

o To achieve over 250,000 applications per month

o Achieve over Rs. 10,000 crores of equity assets under advise

o Evolve into getting trail revenues to cover branch basic cost

International branches:

o 4 more branches

o To contribute 10% of KARVY overall revenues

Margin funding:

o Over Rs.2, 000 cr. Of corpus

o Provide IPO funding both for retail and HNI category

o 25% of the revenues through this business


16/84

CHAPTER-IIIDERIVATIVES


17/84

DERIVATIVES:

Derivatives are products whose value is derived from one or more variables called

bases. These bases can be underling asset such as foreign currency, stock or commodity,

bases or reference rates such as LIBOR or US treasury rate etc. Example, an Indian

exporter in anticipation of the dollar denominated export proceeds may wish to sell dollars

at a future date to eliminate the risk of exchange rate volatility by the data. Such

transactions are called derivatives, with the spot price of dollar being the underlying asset.

Derivatives thus have no value of their own but derive it from the asset that is being

dealt with under the derivative contract. A financial manager can hedge himself from the

risk of a loss in the price of a commodity or stock by buying a derivative contract. Thus

derivative contracts acquire their value from the spot price of the asset that is covered by

the contract.

The primary purposes of a derivative contract is to transfer risk from one party to

another i.e. risk in a financial sense is transfer from a party that is willing to take it on.

Here, the risk that is being dealt with is that of price risk. The transfer of such a risk can

therefore be speculative in nature or act as a hedge against price movement in a current or

anticipated physical position.


18/84

Derivatives or derivative securities are contracts which are written between two parties

(counterparties) and whose value is derived from the value of underlying widely-held and

easily marketable assets such as agricultural and other physical (tangible) commodities or

currencies or short term and long-term and long term financial instruments or intangible

things like commodities price index (inflation rate), equity price index or bond piece index.

The counterparties of such contracts are those other than the original issuer (holder) of the

underlying asset.

Derivatives are also known as deferred delivery or deferred payment instruments. In

a sense, they are similar to securitized assets, but unlike the latter, they are not the

obligations which are backed by the original issuer of the underlying asset or security. It is

easier to take a short position in derivatives than in other possible to combine them to

match specific requirements, i.e., they are more easily amenable to financial engineering.

The values of derivatives and those of their underlying assets are closely related.

Usually, in trading derivatives, the taking or making of delivery of underlying assets is not

involved; the transactions are mostly settled by taking offsetting positions in the derivatives

themselves. There is, therefore, no effective limit on the quantity of claims which can be

traded in respect of underlying assets. Derivatives are off balance sheet instruments, a

fact that is said to obscure the leverage and financial might they give to the party. They are

mostly secondary market instruments and have little usefulness in mobilizing fresh capital

by the companies (warrants, convertibles being the exceptions). Although the standardized,

general, exchange-traded derivatives are being contracts which are in vogue and which


19/84

expose the users to operational risk, counterparty risk, liquidity risk, and legal risk. There is

also an uncertainty about the regulatory status of such derivatives.

Definition

Contracts, whose values are to be derived from the asset covered by them (such as

paddy), are commonly named as derivatives. These are basically, financial instruments

whose value depends on the value of the other, more basic underlying variable-such as

commodity, stock, currency, etc

A contract or an agreement for exchange of payments, whose values derives from the

value of an underlying asset or underlying reference rates or indices.

A derivative is a security whose price ultimately depends on that of another asset called

underlying.

Derivatives means forward, futures or options contracts of predetermined fixed

duration, linked for the purpose of contract fulfillment to the value of specified real or

financial asset or to an index security.

With securities Laws (second Amendment) Act, 1999, derivatives has been included in

the definition of securities. The term derivative has been defined:

In Securities Contract (Regulation) Act; as Derivatives include:


20/84

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

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

b. A contract which derives its value from the prices, or index of prices, of underling

securities;

The international monetary fund defines derivatives as financial instruments that are

linked to a specific financial instrument or indicator or commodity and through which

specific financial risks can be traded in financial markets in their own right. The value of

financial derivatives derives from the price of an underling item, such as asset or index.

Unlike debt securities, no principle is advanced to be repaid and no investment income

accrues.

History

Derivatives have probably existed ever since people have been trading with

another. Forward contracting dates back at list to the 12th century and may well have been

around before then. However the development and growth of the derivatives products has

been one of the most extraordinary things to happen in the financial markets place. In 1972,

the Bretton Woods agreement, the post-war pact that instituted a fixed exchange rate

regime to the worlds major nations, effectively collapsed, when the US suspended the

dollar convertibility into the gold. This resulted in exchange rate volatility derivative

products have come quite handy. They have established themselves as irreplaceable tools

to hedge against risks in currency, stock and commodity markets.

The history of the derivatives can be traced to the Middle Ages when formers and

traders in gains and other agriculture products used certain specific types of futures and


21/84

forwards to hedge, their risks. Essentially the former wants to ensure that he receives a

reasonable price for the grain that he would harvest (say) three to four months later. An

oversupply will hurt him badly. For the grain merchant, the opposite is true. A fall in the

agricultural production will push up the prices. It made sense therefore for the both of them

to fix a price for the future. This was now the future market first developed in agricultural

commodities such as cotton, coffee, petroleum, Soya bean, sugar and then to financial

products such at interest rates, foreign exchange and shares. In 1995 the Chicago Board of

Trade commenced trading in derivatives.

For the derivatives market to develop, three kinds of participants are necessary. They

are the hedgers, the speculators and the arbitrageurs. All the three must co-exist. For a

hedging transaction to be completed three must be another person willing to take advantage

of price movements. That is speculator.

Contrary to the hedger who avoids uncertainties the speculator thrives on them. The

speculator may loss plenty of money if his forecast goes wrong but a stand to gain

enormously if he is proved corrects.

The third category of participant is the arbitrage, which looks at risk less profit by

simultaneously buying and selling the same or similar financial products in different

financial markets.


22/84

RISK:

As per Websters Ninth New collegiate dictionary, the meaning of Risk is possibility

of loss or injury, PERIL, a dangerous element of factor; the chance or loss or perils to the

subject matter of an insurance contract; the degree of probability of such loss.

According to Harold Skipper there is no universal definition of risk. Risk is commonly

used to refer to insured items, to causes of loss and to the chance of loss. From the

managements perspectives, risk has three connotations; risk as opportunity; risk as

uncertainty; and risk as hazard. When we look at risk as an opportunity, the inherent

relationship between risk and return becomes obvious, to put it differently, greater the risk,

the greater the potential return and by extension, the greater the potential for loss. But when

we look at risk as an uncertainty it refers to the distribution of all possible outcomes, both

positive and negative. When the same is looked upon as hazard, the negative return

becomes obvious.

All proactive companies deal with these three elements of risk by installing

management techniques to reduce the probability of negative returns without incurring too

much cost and thereby enhance the scope for realizing the hoped for returns. It is in this

context, that the derivative products have evolved as one of the effective tools to hedge the

financial losses.


23/84

With the Indian rupee being convertible, since March 1994, the risk in the foreign

exchange market has become more pronounced and the need to take risk or protect oneself

from these risks has become evident. Many countries have already made their currencies

convertible and some are in the process of doing so. In the context of such scenario of free

foreign exchange markets, uncertainty of currency rates and their volatility has made it

imperative for the dealers in the foreign exchange to expose themselves to the risk. Risk is

inherent in the foreign dealings due to the following reasons.

1. Trade across countries involves dealings with parties exporter or importer who

are unknown and whose creditworthiness is uncertain.

2. Foreign dealings also involve countries whose credibility and creditworthiness is

not certain.

Full convertible of rupee

As referred to earlier the convertibility on trade account was launched on March 1993

and exporters have become convertible at free market rates up to 100% of them.


24/84

RISK IN FOREIGN EXCHANGE MARKET

There are different types of exchange risks in the foreign exchange market which are

set out briefly below:

1. Credit risk of customer: Credit rating by international banks and international

credit rating agencies will help reducing this risk. In India, ECGC and banks do

take this risk for the exporter.

2. Country risk: This is slightly different from the currency risk and arises out of the

policies of economic and political nature and there external payments position and

their export earnings to service the foreign creditors, convertibility or otherwise of

their currencies, etc.

3. Currency risk: This risk arises out of the volatility or otherwise of the currency

and its strength or weakness in terms of other currencies and interest rates and

relative degrees of inflation in the respective countries which influence the

exchange rates. It also depends on the hot money flows and speculative short terms

flows as between countries which will destabilize the exchange rates. The currency

risk is generally covered by banks on the guarantee of the ECGC in some cases or

by the EXIM bank.

4. Market risk: Risks of commodities their quality and the change of government

policies of taxation etc., are borne by the exporter or the ECGC in some cases. It

will thus be seen that some risk cannot be avoided or passed on by the exporter and


25/84

infect many more risks are to be borne by the importer than by the exporters, as the

government policy in India wants to encourage the exporter from the country.

Factors generally attributed as the major driving force behind growth of financial

derivatives are:

a. Increased volatility in asset prices in financial markets.

b. Increased integration of national financial markets with the international markets.

c. Market improvement in communication facilities and sharp decline in their costs.

d. Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies, and

e. Innovation in derivative markets, which optimally combine the risk and returns

over the large number of financial assets, leading to higher returns, reduced risk as

well as transaction costs as compared to individual financial assets.

The need for a Derivatives Market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk adverse people to risk oriented people.

2. They help in the discovery of future as well as current prices.

3. They catalyze entrepreneurial activity.

4. They increase the volume traded in markets because of participation of risk adverse

people in greater numbers.


26/84

5. They increase savings and investment in the long run.

FUNCTIONS OF DERIVATIVES

Risk transfer:

Derivative products allow splitting of economic risks into smaller units and transfer

risk, derivatives thus facilitate the allocation of risk. Derivatives redistribute the risk

between market players and are useful in risk management. Derivative instrument do not

involve any risk on them.

Essentially derivative market delivers three basic functions: Hedging, Speculation

and Arbitrage. Hedgers transfer risk to another market participant Speculators takes

un-hedged risk positions so as to exploit information inefficiencies or take

advantage of risk capacity. Arbitrageurs take position mispriced instruments in

order to earn risk less return.

The economic functions of these activities are quite different.

1. Hedging and speculation generates information about the pricing of risks.

2. While arbitrages creates a consistent price systems.

Uses of derivatives

There can be a variety of uses of derivatives.

Example: A manufacture has received order for supply of his products after six months.

Price of the product has been fixed. Production of goods will have to start after four


27/84

months. He fears that, in case the price of raw material goes up in the meanwhile, he will

suffer a loss on the order. To protect himself against the possible risk, he buys the raw

material in the futures market for delivery and payment after four months at an agreed

price, say,Rs.100 per unit.

Example: Another person who produces the raw material. He does not have advanced

orders. He knows that his products will be ready after four months. He roughly knows the

estimated cost of his products. He does not know what will be the price of his products

after four months. If the price goes down, he will suffer a loss. To protect himself against

the possible loss, he makes the future sale of his products, at an agreed price, say, Rs.100

per unit. At the end of four months, he delivers the products and receives the payment at

the rate of Rs.100 per unit of contracted quantity. The actual price may be more or less than

the contracted price at the end of the contracted period. A businessman may not be

interested in such speculative gains or losses. His main concern is to make profits from his

main business and not through rise and fall of prices.

In the above examples, at the end of the one year, ruling price may be more than Rs.100

or less than Rs.100. If the price is higher (sayRs.125), the buyers is gainer for the pays

Rs.100 and gets shares worth Rs.125, and the seller is the loser for he gets Rs.100 for

shares worth Rs.125 at the time of delivery. On the other hand, in case the price is lower

(say Rs.75), the purchaser is loser, and the seller is the gainer. There is the method to cut a

part of such loss by buying a futures contract with an option, on payments of fee.


28/84

From the above example it is clear that ones gain is anothers loss. That is why

derivatives are a Zero Sum Game. The mechanism helps in distribution of risks among

the market players.

The Important Recommendations of L.C.Gupta Committee

Need for coordinated development

To quote from the report of the committee- the committees main concerns is with

equity based derivatives but it has tried to examine the need for financial derivatives in a

broader perspective. Financial transactions and asset-liability positions are exposed to three

broad types of price risks, viz; Equities, market risk, also called systematic risk (which

cannot be diversified away because the stock market as a hole may up or down from time

to time).

Interest rate risk (as in the case of fixed income securities, like treasury bond holding,

whose market price could fall heavily it interest rates shot up),and Exchange rate risk

(where the position involves a foreign currency, as in the case of imports, exports, foreign

loans or investments).

The above classification of price risk explains the emergence of (a) equity

futures, (b) interest rate futures, and (c) currency futures respectively. Equity futures have

been the last to emerge.

The recent report of the RBI appointed committee on capital account convertibility

(Tarapore Committee) has expressed the view that time is ripe for introduction of futures in


29/84

currencies and interest rates to facilitate various users to have access to a wide spectrum of

cost-efficient hedge mechanism. In the some context, the Tarapore Committee has also

opinioned that a system of trading in futures.is more transparent and cost efficient than

the existing system (of forward contracts). Having a common trading infrastructure will

have important advantages. The committee, therefore, feels that the attempt should be to

develop an integrate market structure.

SEBI-RBI co-ordination mechanism

As all the three types of financial derivatives are set to emerge in India in the near

future, it is desirable that such development be coordinated. The committee recommends

that a formal mechanism be established for such coordination between SEBI and RBI in

respect of all financial derivatives markets. This will help to avoid the problem of

overlapping jurisdictions.

Derivatives exchange

The committee strongly favored the introduction financial derivatives to facilitate

hedging in most cost-efficient way against market risk. There is a need for equity

derivatives, interest rate derivative and currency derivatives; there should be phased

introduction of derivatives products. To start with, index future to be introduced, which

should be followed by options on index and later options on stocks.


30/84

The derivative trading should take place on separate segment of the existing stock

exchanges with an independent governing council where the number of trading members

should be limited to 40 percent of the total number. Trading to be based on online screen

trading with disaster recovery site. Per half hour capacity should 4-5 times the anticipated

peck load. Percentage of broker-member in the council to be prescribed by the SEBI.

The settlement of derivatives to be through an independent clearing corporate/clearing

house, which should become counter party for all trades or alternatively guarantee the

settlement of all the trades. The clearing corporation to have adequate risk containment

measures and to collect margins through EFT. The derivative exchange to have both online

trading and surveillance system. It should disseminate trade and price information on real

time basis through two information vending networks. The committee recommended

separate membership for derivatives segment.

Regulatory framework

Regulatory control should envisage systems for full proof regulation. Regulatory

framework for derivatives trading envisaged two-level regulation i.e. exchange-level and

SEBI-level, with considerable emphasis on self-regulatory competence of derivative

exchanges under the overall supervision and guidance of SEBI.

Regulatory role of SEBI

SEBI will approve rules, buy-laws and regulations. New derivative contracts to be

approved by SEBI. Derivative exchanges to provide full details of proposed contract, like


31/84

economic purposes of the contract; likely contribution to the markets development;

safeguards incorporated for investor protection and fair trading.

Specification regarding trading

Stock exchanges to stipulate in advance trading days and hours. Each contract to have

pre determined expiration date and time. Contract expiration period may not exceed 12

months. The last trading day of the trading cycle to be stipulate in advance.

Membership eligibility criteria

The trading and clearing member will have stringent eligibility conditions. The

committee recommended for separate clearing and non-clearing members. There should be

separate registration with SEBI in addition to registration with stock exchange.

Clearing corporation

The clearing system to be totally re-structured. There should be no trading interests on

board of CC. The maximum exposure limit to be liked to be deposit limit. To make the

clearing system effective the committee stressed stipulation of initial and mark to market

margins. Extent of margin prescribed to co-relate to the level of volatility of particular

scrips traded. Since margin to be adjusted frequently based on market volatility margin

payments to be remitted through EFT (Electronic Fund Transfer).


32/84

Market to Market settlement

There should the system of daily settlement of futures contracts. Similarly the closing

price of futures to be settled on daily basis. The final settlement price to be as per the

closing price of underlying security.

Sales practices

Risk disclosure document with each client mandatory.

Sales person to pass certification exam.

Specific authorization from clients board of directors/trustees.

Trading parameters

Each order- buy/sell and open/close

Unique order identification number

Regular market lot size, tick size

Gross exposure limits to be specified

Price bands for, each derivative contract

Maximum permissible open position


33/84

Brokerage

Prices on the system shall be exclusive of brokerage

Maximum brokerage rates shall be prescribed by the exchange

Brokerage to be separately indicated in the contracts note

Margins from Clients

Margins to be collected from all clients/trading members

Daily margins to be further collected

Losses if any to be charged clients/TMs and adjusted against margins

Other recommendations

Removal of regulatory prohibition on the use of derivative by mutual funds while

making the trustees responsible to restrict the use of derivatives by mutual funds

only to hedging and portfolio balancing and not for speculation.

Creation of derivative cell, a derivative advisory committee, and economic research

wing by SEBI.

Derivatives Market

There are two types of derivative market:

1. Exchanged based market.

2. Over the counter (OTC) markets.

Exchanged based market and clearing houses


34/84

These markets are developed, highly organized and regulated by their own owners who

are usually traders. It is the exchange with decides on the

1. Standard units currency, size maturity to be traded and the times when trading

begin and cease each day.

2. Rules of the clearing house through which all deals are routed.

3. Margin requirements that all members have to deposit with the clearing house to

ensure that the default is unlikely.

Mechanics of the markets

Example: In S&P 500 stock index futures contracts are tied to the standard and Poors

composite stock index. The futures have standard maturity and the exchange prescribes

rules for settlement of any outstanding contracts in cash on the expiration dates. In contrast,

OTC derivatives are customized to meet the specific needs of the counterparty. A financial

swap is a good example of OTC derivative.

An important difference between exchange traded and OTC derivative is the credit risk.

In the OTC markets, one party is exposed to the risk that his counterparty may default on

the contract. In case of default there will be need to replace the counterparty that is also

knows as replacement risk. The risk becomes insignificant in case of exchange-traded

derivatives.


35/84

Market participants in DERIVATIVES

Derivatives markets are essential frequented by three kinds of hedgers, speculators and

arbitrageurs. Traders who are exposed to market risk by virtue of their long/short position

under foreign currency; stocks, commodities, etc. visit derivatives market primarily as

hedgers. They are basically interested in reducing a risk that they already face.

The other category of visitors to derivatives markets in speculators. They bet that the

price of the stock or a currency will go up or will go down. Speculators can use all the three

products namely forward contracts, futures and options to take a position in the market. A

speculator who thinks that the price of Reliance share will rise can speculate by taking a

long position on Reliance option say @Rs.300, expiry three months. If on the date of

expiry, the price of Reliance is proved to be Rs.350, the speculator with a long position can

take delivery of reliance at Rs.300 and sell it at the market price of Rs.350. thus he will

realize a gain of Rs.50 per share. If reverse happens, his are marginal for all that he would

be losing is only the option premium paid up front.

The third category of market participants is arbitrageurs. They usually lock into a risk-

less profit by entering simultaneously into transactions in two or more markets. Consider

Infosys is treated in both New York and Mumbai exchanges and suppose the stock price is

Rs.2000 in Mumbai stock exchange and US $42 in New York stock exchange and the

dollar exchange rate is Rs.50. an arbitrageur would then jump to buy 100 shares in Mumbai

stock exchange and sell them in New York stock exchange @42 dollars per share to make

a risk free profit of Rs.10000 provided such transactions are permitted.


36/84

A wide range of participants uses derivatives instruments, such as individual investors,

institutional investors, treasury departments, banks and other financial intermediaries,

securities traders etc.

Indian derivatives market

Indian derivatives market, through has a history of more than a century, is still in its

nascent stage vis--vis global derivatives market.

The first step towards development of derivatives markets in India is the appointment

of L.C.Gupta committee by SEBI to go into the question of derivatives trading and to

suggest various policy and regulatory measures that need to be undertaken before such

trading is formally allowed. We have today active derivative markets in the segment of

stock and foreign currency while trading in commodities is in the process of stabilization.

Stock market derivative have indeed picked up momentum and the volumes under futures

on individual stock have reached global proportions. We have also well established OTC

currency derivatives market. In a net shall we may say that derivatives market in India an

evolving phase.

Derivatives products

Derivatives are in fact as old as trading but their Dramatic rise in popularly took place

in the last thirty years. The breakdown of Bretton woods system of fixed exchange rates

and the resulting volatility in forex markets put the derivative on a pedestal. The key reason

for their popularly has been that derivatives such as futures and options have indeed filed a


37/84

gap in the financial system. Prior to their emergence, there was no mechanism for that

could protect to trades, banks, etc, from price risk. Secondly, they are highly flexible and

thus have a universal applicability. For instance, stock market index futures provide

insurance against stock price risk due to market fluctuations, while currency futures

provide insurance against price risk due to exchange rate fluctuations.

All derivatives can be classified based on the following features:

1) Nature of contracts

2) Underlying assets

3) Market mechanism

Nature of contract: based on the nature of contract, derivatives can be classified into threecategories:

Forward rate contract and futures

Options

Swaps

Underlying assets: Most derivatives are based on one of the following four types of

assets:

Foreign exchange

Interest being financial assets

Commodities (grain, coffee, cotton, wool, etc.)

Equities

Precious metals (gold, silver, copper, etc.)

Bonds of all types

Market mechanism:

OTC products

Exchange traded products


38/84

Role of clearing house

A clearing house is a key institution in the derivatives market. It performs two criticalfunctions. Offering customers deals and assuring the financial integrity of the transactionsthat take place in the exchange. The clearing house could be a part of the exchange of a

separate body coordinating with the exchange.

Trading in derivatives

Indian securities markets have indeed waited for too long for derivatives trading to

emerge. Mutual funds, FIIs, and other investors who are deprived of hedging opportunities

will now have a derivatives market to bank on. First to change are the globally popular

variety index futures.

While derivatives markets flourished in the developed world Indian markets remain

deprived of financial derivatives to the beginning of this millennium. While the rest of the

world progressed by the leaps and the bonds on the derivatives front, Indian market lagged

behind. Having emerged in the market of the developed nations in the 1970s, derivatives

market grew from strength to strength. The trading volumes nearly doubled in every three

years making it a trillion-dollar business. They become so ubiquitous that, now one cannot

think of the existence of financial markets without derivatives.

Two board approaches of SEBI is to integrate the securities market at the national level,

and also to diversify the trading banks, financial institutions, insurance companies, mutual

funds, primary dealers etc, choose to transact through the exchanges. In this context the

introduction of derivatives trading through Indian stock exchanges permitted by SEBI in

2000 AD is real landmark.


39/84

SEBI first appointed the L.C.Gupta committee in 1998, to recommend the regulatory

frame work for derivatives recommended suggestive buy-laws for regulation and control of

trading and settlements of derivatives contracts. The board of SEBI in its meeting held on

May 11, 1998 accepted the recommendations of the Dr.L.C.Gupta, committee and

approved the phased introduction of derivatives trading in India beginning with stock index

futures. The board also approved the suggestive Bye-laws recommended by the

committee for regulation and control of trading and settlement of derivatives contracts.

SEBI subsequently the J.R.Varma committee to recommended risk containment

measures in the Indian stock index futures market. The report was submitted in the same

year (1998) in the month of November by the said committee.

TYPES OF DERIVATIVES:

There are four most commonly traded derivative instruments: Forwards, Futures &

Options and Swaps. Futures and Options are actively traded on many exchanges. Forward

contracts and swaps and certain kind of options are mostly traded as over the counter

(OTC) products.

FORWARD CONTRACTS:

It is an agreement to buy or sell an asset at a certain future time for a certain price.

These contracts are usually entered between two financial institutions or between a

financial institution and its corporate clients. These are traded as OTC products.

Under this agreement, one of the parties undertakes a long position by agreeing to buy

the underlying asset, Example foreign currency at a certain specified price while the other


40/84

party assumes short position having agreed to sell the same asset i.e. foreign in the example

on the same date for the same price. Since, the delivery price chosen at the time contract is

entered into, the value of the forward contract remain zero for the parties and thus, it costs

nothing to either take a long or a short position in forward market.

A forward contract is settled at maturity. The holder of the short position (seller of the

contract) delivers the underlying asset to the holder of the long position (buyer of the

contract) on the maturity date against cash payment that equals the delivery price by the

buyer. A forward contract for delivery of US dollars against payment of rupee is worth zero

the forward price is liable to change while the delivery price of the contract remain same.

Example: if a corporate enters into a forward contract for purchase of US dollar @$=Rs on

1st November for delivery on 1st December. Suppose on 1st December if the dollar

appreciates and spot dollar rupee quote moves up to $=Rs 52, the value of the long position

becomes positive and as the short position becomes negative. Conversely, if the dollar

depreciates and as a result the spot price slides to $=Rs49, the value of the long position

becomes negative while the value of the short position becomes positive. Thus, forward

contracts enable a trader to lock in certainty about the future price but cannot improve

the position.

FEATURES

Silent features of forward contracts may be enumerated as:

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

maturity date and asset type and quality.

On the expiration date the contract is normally settled by the delivery of asset.


41/84

Forward contract being bilateral are exposed to counter party.

There is no secondary market. Contracts are highly liquid and the parties have

varied clear commitment.

As a clearing house does not guarantee the contract there is a risk following from

default by the counter party.

ILLUSTRATION:

On 1st April Mr. L enters into a forward contract with Mr. S and agrees to purchase

1000 shares of X Ltd for a predetermined price of Rs.10 three months forward. On the

fixed future date Mr. L will gave the 1000 shares and will pay the price that is Rs.10000

and Mr. S will deliver the share and receive the money.

The contract is settled on maturity date. The holder of the short position delivers

the asset to the holder of the long position in return for the cash amount equivalent to the

delivery price. Forward are traded over the counter and not with in an exchange. Lack of

liquidity and counter party default risks are main Drawback of forward contract.

FUTURES:


42/84

A financial future is an agreement between two parties to buy or sell a standard

quantity of a specific asset at a future date at a price agreed between the parties through an

open outcry on the floor of an organized futures exchange. The underlying asset could as

well be a commodity such as gold, crude oil, stock market index, individual stocks, interest

rates, etc. the futures contracts are standardized in terms of quantity of underlying, quality

of underlying, the date and month of delivery, the units of the price quotation and

minimum change in price and location of settlement.

In short, futures contract is an exchange traded version of usual forward contract. There

are, significant difference between the two and the same can be appreciated the

characteristics of futures. Commodity to index futures, it tends to become quasi-gambling.

Futures or futures contracts are transferable specific delivery forward contracts. They

are agreements between two counterparties that fix the terms of an exchange, or that lock in

the price today of an exchange, which will take place between them at some fixed future

date. They are highly standardized contracts between the sellers or writers or shorts

and the buyers or longs which obligate the former to deliver, and the latter to receive, the

given assets in specified quantities, of specified grades, at fixed times in future at

contracted prices. The period of contract (deferment) may be several months; it normally

varies between three to 21 months abroad. Depending on the underlying assets, one can

talk of (a) commodity futures and (b) financial futures; stock index futures, interest rates

futures and currency futures are the examples of the latter. While the stock index futures

are traded on the basis of different share price indices rather than on any individual share,

interest rates futures are written on the basis of interest rates or price indices of fixed


43/84

interest securities such as treasury bills and bonds, industrial bonds (debentures),

commercial paper, certificates of deposits and mortgage loans.

Example: a former who is growing corn, say the month running is April and corn is likely

the harvest in the month of July. There is uncertainty about price you will receive for the

corn. In the year of low supply or scarcity of corn, he might obtain a relatively high price

especially if you are not in a hurry. In the year of oversupply of corn, you may have to

dispose at lower prices. In the later case, you are exposed to a great deal of risk.

On the other hand, consider a merchant who has an ongoing requirement for corn. In

the year of oversupply, he could fetch the corn at a competitive rate. But, in the ear of

scarcity, he is exposed to price risk, as the prices may be highly exorbitant.

Among financial futures, the first to emerge ware currency futures 1972 in USA

followed soon by interest rate futures. Stock index futures and options first emerged in the

year 1982.

The prime objective of using futures market is to manage price risk.

The largest futures exchanges in the world are the Chicago Mercantile Exchange

(CME) and Chicago Board of Trade (CBOT).

Definition of Futures


44/84

A futures contract can be defined as an agreement to buy and sell a standard quality of

a specific instrument at a predetermined future date and at a price agreed between the

parties through open outcry on the floor of an organized futures exchange.

Futures are considered to be a better when compared to forward because of the

following reasons:

1. Standard volume

2. Liquidity

3. Counterparty guarantee by exchange

4. Intermediate cash flows

Organized exchanges:

Futures are traded on organized exchanges with a designated physical location

where trading takes place. This provides a ready liquid market.

Standardization

Amount of the commodity to be delivered and the maturity date are standardized

by the exchange on which the contract is traded.


45/84

Clearing House:

On the trading floor of the future exchange, a future contract is agreed upon

between two parties A and B is replaced by the two contract one between A and the

clearing house and the other between the B and the clearing house.

The exchange interposes itself in every deal as a buyer to every seller and as a

seller to every buyer. This guarantees all the transactions routed through the exchange. The

clearing house protects itself from the counterparty default from imposing margin

requirements on traders.

The clearing house may subsidiary of the exchange itself or an independent

corporation.

Margins:

Only members of exchange can trade in futures on the exchange. A sub-set of

exchange members are clearing members i.e. members of the clearing house when the

clearing house is a subsidiary of the exchange. Every transaction is thus between an

exchange member and the exchange clearing house.

Since the clearing house assumes the credit risk in futures transactions, it demands

a performance bond in the form of margin to be deposited with the clearing house by each

member, who enters into the futures commitment. The amount of margin is fixed by the

exchange and it has to be complied with. The compliance could be in the form of cash or

securities such as treasury bills etc.


46/84

Market to market:

At the end of the trading session, all outstanding contracts are reprised by the

clearing corporation the settlement price of that session. Margin accounts of those, who

made losses, are debited and those who gained are credited.

Example:

A trader Shyam bought on 2nd December, 2002 single stock futures contract of

NSE on ACC at Rs.162, expiry date being 26th December, 2002. Suppose next day, the

price on the futures contract on ACC increases and at the end of the trading session on 3rd

December the settlement price is Rs.163. It means, Shyam the trader who bought futures on

ACC made a profit of Rs.1 (as 163-162=1 and obviously, someone with the corresponding

short position lost a matching amount). This gain is credited to the margin amount of

Shyam and contract is reprised at Rs.163. Shyam can immediately withdraw this gain.

Suppose the reverse happens, the loss is debited to margin account and a demand is made

on Shyam to make good the loss is debited to the margin account by a fresh credit.

Trading process:

Futures contracts are traded by a system of open-outcry on the trading floor of a

centralized and regulated exchange. The exchange member can alone take part in the

trading. Members, who trade for their own account, are called as Floor traders and who

trade on behalf of others, are called as Floor brokers while those, who trade for both are

known as Dual traders.


47/84

A buyer of traders in terms of negotiated price and the member of contracts

acquire a long position while the seller requires short positions.

Owing to losses, if the margin account falls below a certain level viz.,

maintenance margin, the trader is served with a margin sell and the trader has to

deposit the required money to bring the margin back to maintenance level within the

specific time.

If the trader fails to do so, his position to be liquidated immediately, so as to

limit the losses, the exchange or the broker may have to incur, to almost a days price

change.

In future market, actual derivatives are very uncommon as most of the contract

is extinguished by entering into a matching contract in the opposite direction.

However those, who have not liquidated their contracts by the end of the

declared last trading day, are obliged to make or accept delivery.

Clearing house:

A clearing house is an institution which clears all the transactions under taken by a

futures exchange.

Members who execute trade on the exchange floor are:

1. Floor brokers

2. Floor traders


48/84

Floor brokers

This broker will execute the orders on others account. They are normally self-

employed individual members of the exchange.

Floor traders

These traders execute the trading on their own account. Some floor traders may also

execute the orders of the account of others. This mechanism is known as dual trading.

Spreads:

The difference between two futures price is referred to as spread. For the same

underlying good, if there are two different prices on two different expiration dates, the

underlying spread is referred to as intra commodity spread (also known as a time spread)

if the trade between two futures prices for two different, but related commodities, such as

corn oil futures and cottonseed oil futures. It is referred to as inter commodity spread'. If

the price difference is between two markets for the same commodity, it is known as inter

market spread

US Exchanges:

1. 3 month Eurodollar (CME)

2. 90 days T-bill (CME)

3. 1 month LIBOR (CME)

Foreign Exchanges:


49/84

1. 3 month Euro yen TIFFE, Japan

2. 3 month Sterling LIFFE, UK

3. 90 day Bank Bill Sydney Futures Exchange, Australia

4. 3 month Eurodollar LIFFE, UK

5. 3 month Euro mark MATIF, France

6. 3 month HIBOR Hong Kong Futures Exchange

7. 3 month Euro Yen SIMEX, Singapore

Strip and stack hedging strategies:

There are two popular hedging strategies on the futures contract, which are used by

investors who like to insure the surety of their earnings for a longer period of time. One of

the strategies is called the stack hedging and other is the strip hedging.

1. Strip hedging: Strip hedging implies buying various futures contracts with

different delivery times, which are matching the investors risk exposure dates. The

basic risk is less in this strategy.

2. Stack hedging: stack hedging implies buying various futures contracts which are

concentrated in the nearby delivery months. While the basic risk is more in this

strategy, the liquidity position is far superior to the strip hedging.

OPTIONS

An option gives its owner the right to buy or sell an underlying asset at a future date.

This can be done at the price specified in the option contract. But one can use it only if the

option contract price is favorable to him. If the price trend is unfavorable, he need not

exercise the option. Instead he can go and buy or sell the asset in the market at a price


50/84

better than the option contract price. This means an option holder has a right but not the

obligation to exercise the contract.

Options are first traded in 1973 on an organized exchange and are now traded on

exchanges, by banks and financial institutions. The underlying asset in options includes

stocks, stock indices, foreign currencies, debt instruments, commodities and future

contracts.

Options are available on many traditional products such as equities, stock indices

commodities and foreign exchange interest rates, etc. foreign exchange markets are

particularly suited to the use of options as they have traditionally been very volatile. The

holder of an option has the right, but not obligation, to buy or sell the underlying asset at

the fixed rate (strike price) on a date in the future. The quantity of underlying asset, rate

and date are all predetermined.

Unlike under a forward contract or futures contract where the holder is obliged to buy or

sell the underlying asset, the option gives the buyer of the contract or buyer has a right to

do something and he does not have to necessarily exercise that right. As against this the

writer or seller of the option is obligated upon to honor the commitments as per the terms

of the contract should the buyer exercise it. Obviously, a buyer has to pay a cost, usually

referred to as premium to acquire such a right.

SEBI has permitted option trading in Indian capital market securities in the year 2001;

both buy way of trading in stock options and also index options. Options are currently

traded on the Mumbai stock exchange (BSE) and National Stock Exchange (NSE). Like


51/84

trading in stocks, options trading are regulated by SEBI. These exchanges seek to provide

competitive, liquid and orderly markets for the purpose and sale of standardized options.

Options are an important element of investing in markets, serving a function of managing

risk and generating income. Unlike the most other types of investments today, options

provide a unique set of benefits. Not only does option trading provide a chip a defective

means of hedging ones portfolio against adverse and unexpected price fluctuations, but it

also offers a tremendous speculative dimension to trading.

GENERAL FEATURES OF OPTIONS

Options are traded both on exchanges and in the over-the-counter market. There are

two basic types of options. A call option gives the holder the right to buy the underlying

asset by a certain date for a certain price. A put option gives the holder the right to sell the

underlying asset by a certain date in the contract is known as the expiration date or

maturity. American options can be exercised at any time up to the expiration date.

European options can be exercised only on the expiration date itself. Most of the options

that are traded on exchanges are American. In the exchange-traded equity options market,

one contract is usually an agreement to buy or sell 100 shares. European options are

generally easier to analyze than American option are frequently deduced from those of its

European counterpart.

It should be emphasized that an option gives the holder the right to do something. The

holder does not have to exercise this right. This is what distinguishes options from

forwards and futures, where the holder is obligated to buy or sell the underlying asset. Note


52/84

that whereas it costs nothing to enter into a forward or futures contract, there is a cost to

acquiring an option.

In options markets, the exercise (strike or striking) price means the price at which

the option holder can buy and/or sell the underlying asset. If the current price of the

underlying asset exceeds the exercise price of a call option, the call is said to be in the

money. Similarly, if the current piece of the underlying asset is less than the exercise price

of a call option, it is said to be out of the money. The near the money call options are

those whose exercise price is slightly greater than current market price of the asset.

Premium is the price paid by the buyer to the seller of the option, whether put or call. A

call option when it is written against the asset owned by the option writer is called a

covered option, and the one written without owning the asset is called naked option.

Option contract illustrated:

On March 1, 2003, A sells a call option (right to buy) on INFOSYS to B for a

price of say Rs. 300. Now B has the right to approach A on march 31, 2003 and he buy

1 share of INFOSYS at Rs. 5000. Here:

B may find it worthwhile to exercise his right to buy only if INFOSYS Ltd. trades

above Rs. 5000. If B exercises his option, A has to necessary sell B one share of

INFOSYS. At Rs. 5000 on March 31, 2003. So if the price INFOSYS goes above Rs.

5000 B may exercise this option, or else the option, or else the option may lapse. Then

B loses the original option price of Rs. 300 and A as gained it.


53/84

Basic Terms used in Option Trading Explained:

Option premium or option price:

The buyer pays to the seller (sometimes called the writer) of the option, a fee for

acquiring the right to say or sell the underlying, known as premium. It represents the

maximum that can be lost by the buyer and the maximum profit available to the seller of

the option.

In the above transaction Rs. 300 is called is the option price or option premium. In the

trading of the options, the holder (buyer) of the options is enjoying the right to buy/sell

while the writer (seller) is obliged to sell/buy depending of the action of the holder.

Exercise Price or Strike Price:

Exercise:

If the option buyer decides to take delivery of the underlying asset say Example,

foreign exchange, the most notify the seller of his decision by exercising his right to

delivery. This exercise is effectively the collection of option and the resultant creation of

foreign exchange transaction, value spot. Options that are not exercised expire worthless.

Strike:

It is also known as the strike or striking price. This is determined rate of exchange at

which the underlying asset is to be exchanged the option is exercisable.


54/84

Strike is usually chosen at a level close the current spot or forward rate (if available as

in the case of forex-market) of the underlying asset or at any reasonable level as perceived

by the parties. Rs. 5000 is the exercise price or strike price in the above example.

The strike price is the price at which an option can be exercised. For instance, assume

that you hold a European option on INFOSYS Company for one share. The strike price is

fixed at Rs. 5000 and the expiration date is 31st march 2003. If the prevailing market price

is say Rs. 5500, then you can exercise your option on the 31st march and buy one share of

INFOSYS for Rs. 5000.

Expiration Date:

In illustration referred above March 31st, 2003 is the expiration date i.e. the date on

which the option expires. Option quoted in exchange includes the date and the month on

which the option can exercise. This is called the expiration date.

Contract cycle:

The period over which the contract trades. The futures and option contract at NSE have

one month, two months and three months expiry cycles. The contracts expire on the last

Tuesday of the corresponding month.

Basis:


55/84

Basis is defined as the future price minus the spot price. In most of the times basis shall

be positive, which reflect that futures price normally exceeds spot price.

Covered & Naked Calls:

A call option position that is covered by an opposite position in the underlying

instrument (Example shares, commodities etc.) is called a covered call. Writing covered

calls involves writing call options when the shares that might have to be delivered (if

position holder exercises his right to buy), are already owned. E.g. writer writes a call on

Reliance and at the same time holds share of Reliance so that if the call is exercised by the

buyer, he can deliver the stock. Covered calls are far less risky than naked calls (where is

no opposite position in the underlying), since the most can happen is that the investor is

required to sell shares already owned at below their market value. When a physical

delivery uncovered/naked call is assigned a exercise, the writer will have to purchase the

underlying asset to meet his call obligation and his loss will be the excess of the purchase

price over the exercise price of the call reduced by the premium received for writing the

call.

Intrinsic Value of Option:

The intrinsic value of an option is defined as the amount by which an option is in the

money or the immediate exercise value of the option when the underlying position is

marked-to-market.

For a call option: Intrinsic value = Spot price-Strike price

For a put option: Intrinsic value = Strike price-Spot price


56/84

The intrinsic value of an option must be a positive number or 0. if cant be negative.

Option Holder:

He is the one who buys an option, which can be a call or a put option. He enjoys the

right to buy or sell the underlying asset at a specified price on or before specified time.

Cash-Settled Options:

This gives the owner the right to receive a cash payment based on the difference

between a determined value of the underlying at the time of exercise and the fixed exercise

price of the option, Nifty options shall be cash settled.

Example: a bought Nifty November call at a strike price of 1400. On expiration of

November options, the expiration level was 1430. The cash settlement will be 30 per Nifty

and for one contract, Rs.6000 (that is, 30x200, is the minimum contract size).

Cash settled options are those where, on exercise the buyers is paid the difference

between stock price and exercise price (call) or between exercise price and stock price

(put). Delivery settles options are those where the buyer takes delivery of undertaking

(calls) or offers delivery of the undertaking (puts).

CALL OPTION & PUT OPTION

Call Option:

Acall option gives the right but not the obligation to buy the underlying asset at a

specific price. Since the initial cash flow to buy the option is comparatively small, investor

bullish on the asset (can be a stock or any other asset for that matter) can use call option to


57/84

maximize the returns by buying into the product. Further, even in the case of the asset

moving the other way, the maximum loss for the investor is only the premium he has paid.

Example: an investor buys one European call option on Infosys at the strike price of

Rs. 5000 at a premium of Rs. 300. if the market price of Infosys on the day of expiry is

more than Rs. 5000, the option will be exercised. The investors will earn profits once the

share price crosses Rs. 5300, (strike price + premium i.e. 5000+300). Suppose stock price

is Rs. 5800, the option will be exercised and the investor will buy 1 share of Infosys from

the seller of the option at Rs. 5000 and sell it in the market at Rs. 5800 making a profit of

Rs. 500 [(spot price strike price )-premium].

In another scenario, if at the time of expiry stock price falls below Rs. 5000 say

suppose it touches Rs. 4800, the buyer of the call option will choose not to exercise to his

option. In this case the investor losses the premium (Rs. 300), paid which should be the

profit earned by the seller of the call option.

Example: Shyam, purchase a call option on ACC at a strike of R. 150 exercisable on

December 26th 2004 by paying the specified premium to the seller. On 26th December 2004

Shyam observes that the price of ACC in the cash market is Rs. 155. The option is than

obviously, worth exercising therefore, Shyam exercise the option and demands for delivery

of ACC shares. Excluding the premium, paid upfront by Shyam, the pay off from the

option is:

Spot price of ACC = Rs. 155.00

Exercise price of ACC = Rs. 150.00


58/84

Pay off = Rs. 5.00

The net gain under this call option is:

Pay off = Rs. 5.00

Less: Premium = Rs. 1.00

Net gain = Rs.4.00

On the other hand if the price of ACC on the maturity dates of the option is Rs.143, the

option has finished out of the money and thus it becomes worthless. The payoff is zero.

Therefore, Shyam will not exercise the option and he goes to the cash market and purchase

ACC shares @ Rs. 145.

Illustration 1:

An investor buys one European call option on one share of Reliance petroleum at a

premium of Rs. 2 per share on 31st July. Then strike price is Rs. 60 and the contract

matures on 30th September. The pay off for the investor by the basis of fluctuating spot

prices at any time is shown by the pay off table (table 1). It may be clear on 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.


59/84

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

the call option buyer. The maximum loss that he can have is unlimited though the buyer

would make a profit of Rs. 2 per share on the premium payment.

Payoff from Call Buying/long (Rs)

S Xt C Payoff NetProfit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -260 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

65 60 2 5 3

66 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

Payoff Max (S-Xt, 0)

Payoff from Call Buying/long

Net profit - Payoff minus C


60/84

Exercising the Call Option and its implications for the buyer and the seller:

The Call Option gives the buyer a right to buy the requisite shares on a specific price.

This puts the seller under the obligation to sell the shares on that specific price. The Call

buyer exercises his option only when he/she felt it is profitable. This process is called

exercising the option.

The implications for a buyer are that it is his/her decision whether to exercise the option

or not. In case the investor expects prices to rise for above the strike price in the future then

he/she would surely be interested in buying call options. On the other hand, if the seller

feels that his shares are not giving to perform any better in the future, a premium can be

charged and returns from the selling the call option can be used to make up for the desired

returns.

Put Option:

A Put Option is the reverse of the Call Option. It gives the holder the right to sell an

asset at the predetermined price. When a put option is exercised, the holder/buyer of the

option sells the underlined asset and the writer/seller of the option has to accept it at the

pre-specified strike price.

Example: an investor buying one European put option on Reliance at the strike price of

Rs. 300, at a premium of Rs. 25. If the market price of Reliance, on the day of expiry is less

than RS.300, the option can be exercised as it is in the money. The investors Break-even

point is Rs. 275 (strike price premium paid) i.e., investors make earn profit if the market

falls below Rs. 275. suppose stock price is Rs. 260, the buyer of the put option immediately


61/84

buys Reliance share in the market @ Rs. 260 and exercises his option selling the Reliance

share at Rs. 300 to the option writer thus making a net profit of Rs. 15 [(strike price spot

price) premium paid].

In other scenario, if at the time of expiry, market price of the Reliance is Rs. 320, the

buyer of the put option will choose not to exercise his option to sell a share can sell in the

market at a higher rate. In this case the investor losses the premium paid (i.e. Rs. 25),

which shall be the profit earned by the seller of the put option.

Example: Shyam, a stock market investor buys a put option from NSE for selling

BPCL shares at the strike price of Rs. 230, expiry date being 26th December, 2002. -If

BPCL trades at Rs. 225 on 26th December, Shyam would exercise the option. He will

deliver the BPCL shares and demand for the payment @ Rs. 230 the pay off under the put

option is:

Strike price = Rs. 230.00Current price = Rs. 225.00

In the money = Rs. 5.0

In otherwise means that excluding upfront premium, by exercising the put option, Shyam

realizes the gain of Rs. 5 per share.

On the other hand if the price of the BPCL shares at the maturity is Rs. 240, Shyam will

not exercise the option since, he can sell the same in the cash market at a price higher than

the strike price of the option. Thus the put option becomes worthless.


62/84

Illustration 2:

An investor buys one European put option on one share of Reliance petroleum at a

premium of Rs.2 per share on 31st

July. The strike price is Rs.60 and the contract matures

on 30th September. The pay off table shows the fluctuations of net profit with a change in

spot price.

Payofffrom put buying/long (Rs.)

S XT P PAYOFF NET PROFIT

55 60 2 5 3

56 60 2 4 257 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -2

63 60 2 0 -2

64 60 2 0 -2

The payoff for the put buyer is: max (Xt-S, 0)

The payoff for the put writer is: max (Xt-S, 0)

Options Classifications:

In the money These result in a positive cash flow towards the investor.

At the moneyThese result in a zero cash flow to the investor.

Out of money These result in a negative cash flow for the investor.

Naked options: These are options which are not combined with an offsetting contractto cover the existing positions.


63/84

Covered options: These are options contract in which the shares are already owned by

the investor (in case of the covered call option) and in case of the option is exercised then

the offsetting of the deal can be done by selling these shares held.

Options pricing

Prices of the options are commonly depending upon six factors. Unlike futures will

derived there prices primarily form prices from the undertaking. Options prices are far

more complex. The table below helps understanding the effect of each these factors and

gives the broad picture of option pricing keeping all other factors constant. The table

presents the case of the European as well as American options.

Effect of increase in the relevant parameter on Option Prices:

European Options Buying

American Options

Buying

Parameters Call

Put

Call

Put

Spot price (S) ?

Strike price (Xt) ? ?

Time to expiration (T) ? ? Volatility

Risk free interest rates

Dividends (D)

-Favorable

-Unfavorable

Spot price:


64/84

In case of a Call Option the payoff for the buyer is Max (Xt-S, 0) therefore, more the

spot price more the payoff and it are favorable for the buyer. It is the other way round for

the seller; more the spot price higher is the chances of his going into a loss.

In case of the Put Option, the payoff for the buyer is Max (Xt-S, 0) therefore, more the

spot price more the chances of going into the loss. It is reverse for the put writing.

LOT SIZES OF CONTRACTS:

Underlying Symbol Market Lot

S&P CNX Nifty Nifty 100CNX IT CNX IT 100

Bank Nifty BANK NIFTY 100

Derivatives on Individual Securities:

Underlying Symbol MarketLot

ABB Ltd. ABB 100

Associated cement Co. Ltd ACC 375

Allahabad Bank ALBK 2450

Alok Industries Ltd. ALOKTEXT 3350

Andhra Bank ANDHRABANK 2300

Arvind Mills Ltd. ARVINDMILL 4300

Ashok Leyland Ltd. ASHOKLEY 4775

Aurobindo Pharma Ltd. AUROPHARMA 350

Bajaj Auto Ltd. BAJAJAUTO 100

Bank Of Baroda BANKBARODA 1400

Bank of India BANKINDIA 1900

Bharat Electronics Ltd. BEL 275

Bharti Tele-Ventures Ltd. BHARTI 1000Bharat Heavy Electricals Ltd. BHEL 150

Ballarpur Industries Ltd. BILT 1900

Bongaigaon Refinery Ltd. BONGAIREFN 4500

Bharat Petroleum Corporation Ltd. BPCL 1100

Documents

Tulasi Krishna