Derivatives kotak 2010

Derivatives (Futures & Options)

CHAPTER-I
INTRODUCTION

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INTRODUCTION OF DERIVATIVES
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 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.
DEFINITION OF DERIVATIVES
“Derivative 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”.
 Securities Contracts (Regulation) Act, 1956 (SCR Act) defines “debt
instrument, share, 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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HISTORY OF DERIVATIVES MARKETS

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 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, Eurex etc.
THE GROWTH OF DERIVATIVES
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.

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 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.
TYPES OF DERIVATIVES
The following are the various types of derivatives.
FORWARDS:
A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today‟s pre-agreed price.
FUTURES:
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange traded
contracts.
OPTIONS:
Options are of two types-calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before
a give future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
Warrants:
Options generally have lives of up to one year; the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options

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are called warrants and are generally traded over-the counter.
LEAPS:
The acronym LEAPS means long-term Equity Anticipation securities. These are
options having a maturity of up to three years.
BASKETS:
Basket options are options on portfolios of underlying assets. The underlying asset is
usually a moving average of a basket of assets. Equity index options are a form of
basket options.
SWAPS:
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used Swaps are:
Interest rate Swaps:
These entail swapping only the related cash flows between the parties in the same
currency.
Currency Swaps:
These entail swapping both principal and interest between the parties, with the cash
flows in on direction being in a different currency than those in the opposite direction.
SWAPTION:
Swaptions are options to buy or sell a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a forward swap. Rather than have calls
and puts, the swaptions market has received swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is
an option to pay fixed and received floating.

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PARTICIPANTS IN THE DERIVATIVE MARKETS
The following three broad categories of participants:
HEDGERS:
Hedgers face risk associated with the price of an asset. They use futures or options
markets to reduce or eliminate this risk.
SPECULATORS:
Speculators wish to bet on future movements in the price of an asset. Futures and
options contracts can give them an extra leverage; that is, they can increase both the
potential gains and potential losses in a speculative venture.
ARBITRAGERS:
Arbitrageurs are in business to take of a discrepancy between prices in two different
markets, if, for, example, they see the futures price of an asset getting out of line with
the cash price, they will take offsetting position in the two markets to lock in a profit.

FUNCTION OF THE DERIVATIVE MARKETS

In spite of the fear and criticism with which the derivative markets are commonly
looked at, these markets perform a number of economic functions.
 Prices in an organized derivatives market reflect the perception of market
participants about the future and lead the price of underlying to the perceived
future level. The prices of derivatives converge with the prices of the underlying
at the expiration of the derivate contract. Thus derivatives help in discovery of
future as well as current prices.
 Derivatives market helps to transfer risks from those who have them but may
not like them to those who have an appetite for them.
 Derivative due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market witness

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higher trading volumes because of participation by more players who would not
otherwise participate for lack of an arrangement to transfer risk.
 Speculative trades shift to a more controlled environment of derivatives market.
In the absence of an organized derivatives market, speculators trade in the
underlying cash markets. Margining, Monitoring and surveillance of the
activities of various participants become extremely difficult in these kinds of
mixed markets.
 An important incidental benefit that flows from derivatives trading is that it acts
as a catalyst for new entrepreneurial activity. The derivatives have a history of
attracting many bright, creative, Well-educated people with an entrepreneurial
attitude. They often energize others to create new businesses, new products and
new employment opportunities, the benefit of which are immense.
 Derivatives trading acts as a catalyst for new entrepreneurial activity.
 Derivatives markets help increase saving and investment in long run.

SCOPE OF THE STUDY

The Study is limited to “Derivatives” with special reference to Futures and Option is
the Indian context and the Inter-Connected Stock Exchange have been Taken as a
representative sample for the study. The study can‟t be said as totally perfect. Any
alteration may come. The study has only made a humble Attempt at evaluation
derivatives market only in India context. The study is not based on the international
perspective of derivatives markets, which exists in NASDAQ, CBOT etc.

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OBJECTIVES OF THE STUDY

 To analyze the derivatives market in India
 To analyze the operations of futures and options
 To find the profit/loss position of futures buyer and also the option writer and
option holder.
 To study about risk management with the help of derivatives.

LIMITATIONS OF THE STUDY

The following are the limitation of this study.
 The scrip chose for analysis is M/s. RELIANCE POWER and the contract
taken is January 2009. Ending one-month contract.

 The data collected is completely restricted to the M/s. RELIANCE
POWER of January 2009; hence this analysis cannot be taken universal.

]

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CHAPTER-II
INDUSTRY PROFILE
&
COMPANY PROFILE

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Banking in India

Banking in India originated in the last decades of the 18th century. The oldest bank in existence in
India is the State Bank of India, a government-owned bank that traces its origins back to June 1806
and that is the largest commercial bank in the country. Central banking is the responsibility of the
Reserve Bank of India, which in 1935 formally took over these responsibilities from the then
Imperial Bank of India, relegating it to commercial banking functions. After India's independence in
1947, the Reserve Bank was nationalized and given broader powers. In 1969 the government
nationalized the 14 largest commercial banks; the government nationalized the six next largest in
1980.

Currently, India has 96 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the
Government of India holding a stake), 31 private banks (these do not have government stake; they
may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined
network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a
rating agency, the public sector banks hold over 75 percent of total assets of the banking industry,
with the private and foreign banks holding 18.2% and 6.5% respectively

Early history

Banking in India originated in the last decades of the 18th century. The first banks were The General
Bank of India which started in 1786, and the Bank of Hindustan, both of which are now defunct. The
oldest bank in existence in India is the State Bank of India, which originated in the Bank of Calcutta
in June 1806, which almost immediately became the Bank of Bengal. This was one of the three
presidency banks, the other two being the Bank of Bombay and the Bank of Madras, all three of
which were established under charters from the British East India Company. For many years the
Presidency banks acted as quasi-central banks, as did their successors. The three banks merged in
1921 to form the Imperial Bank of India, which, upon India's independence, became the State Bank
of India.

Indian merchants in Calcutta established the Union Bank in 1839, but it failed in 1848 as a
consequence of the economic crisis of 1848-49. The Allahabad Bank, established in 1865 and still

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functioning today, is the oldest Joint Stock bank in India. It was not the first though. That honor
belongs to the Bank of Upper India, which was established in 1863, and which survived until 1913,
when it failed, with some of its assets and liabilities being transferred to the Alliance Bank of Simla.

When the American Civil War stopped the supply of cotton to Lancashire from the Confederate
States, promoters opened banks to finance trading in Indian cotton. With large exposure to
speculative ventures, most of the banks opened in India during that period failed. The depositors lost
money and lost interest in keeping deposits with banks. Subsequently, banking in India remained the
exclusive domain of Europeans for next several decades until the beginning of the 20th century.

Foreign banks too started to arrive, particularly in Calcutta, in the 1860s. The Comptoire d'Escompte
de Paris opened a branch in Calcutta in 1860, and another in Bombay in 1862; branches in Madras
and Pondichery, then a French colony, followed. HSBC established itself in Bengal in 1869. Calcutta
was the most active trading port in India, mainly due to the trade of the British Empire, and so
became a banking center.

The Bank of Bengal, which later became the State Bank of India.

The first entirely Indian joint stock bank was the Oudh Commercial Bank, established in 1881 in
Faizabad. It failed in 1958. The next was the Punjab National Bank, established in Lahore in 1895,
which has survived to the present and is now one of the largest banks in India.

Around the turn of the 20th Century, the Indian economy was passing through a relative period of
stability. Around five decades had elapsed since the Indian Mutiny, and the social, industrial and
other infrastructure had improved. Indians had established small banks, most of which served
particular ethnic and religious communities.

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The presidency banks dominated banking in India but there were also some exchange banks and a
number of Indian joint stock banks. All these banks operated in different segments of the economy.
The exchange banks, mostly owned by Europeans, concentrated on financing foreign trade. Indian
joint stock banks were generally under capitalized and lacked the experience and maturity to compete
with the presidency and exchange banks. This segmentation let Lord Curzon to observe, "In respect
of banking it seems we are behind the times. We are like some old fashioned sailing ship, divided by
solid wooden bulkheads into separate and cumbersome compartments."

The period between 1906 and 1911, saw the establishment of banks inspired by the Swadeshi
movement. The Swadeshi movement inspired local businessmen and political figures to found banks
of and for the Indian community. A number of banks established then have survived to the present
such as Bank of India, Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and Central
Bank of India.

The fervour of Swadeshi movement lead to establishing of many private banks in Dakshina Kannada
and Udupi district which were unified earlier and known by the name South Canara ( South Kanara
) district. Four nationalised banks started in this district and also a leading private sector bank. Hence
undivided Dakshina Kannada district is known as "Cradle of Indian Banking".

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13


COMPANY PROFILE

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Company Overview

The Kotak Mahindra Group was born in 1985 as Kotak Capital Management Finance Limited. Uday
Kotak, Sidney A.A.Pinto and Kotak & Company promoted this company. Industrialists Harish
Mahindra and Anand Mahindra took a stake in 1986, and that‟s when the company changes its name
to Kotak Mahindra Finance Limited.

Since then it‟s been a steady and confident journey to growth and success.

1986: - Kotak Mahindra Finance Limited starts the activity of Bill Discounting.

1987: - Kotak Mahindra Finance Limited enters the lease and hire purchase
market.

1990: - The Auto Finance Division is started.

1991: - The Investment Banking Division is started.

1992: - Enters the Funds Syndication sector.

1995: - Brokerage and Distribution Businesses incorporated in to a separate
company - Kotak Securities Investment Banking Division incorporated into a
separate company – Kotak Mahindra Capital Company.

1996: - The Auto Finance Business is hired off into a separate company – Kotak
Securities investment Banking Division Incorporated into a separate company -
Kotak Mahindra Capital Company.

1998: - Enters the Mutual Fund Marker with the launch of Kotak Mahindra asset
Management Company.

2000: - Kotak Mahindra tie up with old Mutual PIC for the life insurance
business.
Kotak Securities launches its on-line broking site ( www.kotak securities .com )

2001: - Matrix sold to Friday Corporation launches insurance Services

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2003: - Kotak Mahindra Finance Limited converts to a Commercial Bank –
The first Indian Company to do so.

2004: - Launches India growth fund, a private equity fund.

2005: - Kotak group realigns Joint Ventures in ford credit; Buys Kotak Mahindra
prime and sells ford credit Kotak Mahindra.
Launches a Real-estate Fund.

Group Management : -
Mr.Uday Kotak – Executive Vice Chairman & Managing Director.

Mr.Sivaji Dam

Mr.C.Jayaram

Mr.Dipak Gupta.

Kotak Mahindra Group

Kotak Mahindra is one of India‟s leading financial institutions offering complete financial
solutions that encompass every sphere of life. From commercial banking, to stock broking, to
mutual funds, to life insurance to investment banking, the group caters to the financial needs of
individuals and corporate.
The group has a net worth of around Rs.2000 crore and the AUM across the group is around
120 billion and employs over 6000 employees in its various businesses. With a presence in 216
cities in India and offices in New York, London, Dubai and Mauritius, it services a customer base of
over 10.00,000.
The group specializes in offering top class financial services catering to every segment of the
industry. The various group companies include.

Kotak Mahindra Capital Limited
Kotak Mahindra Securities Limited
Kotak Mahindra Inc

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Kotak Mahindra (International) Limited
Global Investments Opportunities Fund Limited
Kotak Mahindra(UK) Limited Kotak Securities Limited
Kotak Mahindra Old Mutual Life Insurance Company Limited
Kotak Mahindra Asset Management Company Limited
Kotak Mahindra Trustee Company Limited
Kotak Mahindra Investments Limited
Kotak Forex Brokerage Limited
Kotak Mahindra Private-Equity Trustee Limited

Group Structure
Kotak Mahindra
Bank

Kotak Kotak Kotak Kotak Kotak Kotak
Mahindra Mahindra Mahindra Mahindra
Securities Mahindra Asset
Capital Investments Trust
Company
Prime Management
Company
Company

Kotak Mahindra Securities Kotak Mahindra (UK)

Kotak Mahindra
( International)

Global Investment
Opportunities Fund
Kotak Mahindra Inc.

Kotak Securities Limited.

Kotak Securities Ltd. Is India‟s leading stock broking house with a marker share of around 8% Kotak

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Securities Ltd. Has been the largest in IPO distribution.

The accolades that Kotak Securities has been graced with include :
Prime Ranking Award (2003-04) Largest Distributor of IPO‟s
Finance Asia Award (2004) – India‟s best Equity House.
Finance Asia Award (2005) – Best Broker in India.
Euromoney Award (2005) – Best Equities House in Inida

The company has a full-fledged research division involved in Macro Economic studies Sectoral
research and Company specific Equity Research combined with a strong and well networked sales
force which helps deliver current and up to date market information and news.

Kotak Securities Ltd is also a depository participant with National Securities Depository Limited
(NSDL) and Central Depository services Limited (CSDL), Providing dual benefit services wherein in
investors can use the brokerage services of the company for executing the transactions and the
depository services for settling them.

Kotak Securities has 122 branches servicing more than 1,70,000 customer and a coverage of 187
cities, kotaksecurities.com, the online division of Kotak Securities Limited offers internet Broking
services and also online IPO and Mutual Fund Investments.

Kotak Securities Limited Manages assets over 2500 crores of Assets under Management (AUM).
The Portfoilo Management Services provide top class service, catering to the high end of the market.
Portfolio Management from Kotak Securities comes as an answer to those who would like to grow
exponentially on the crest of the stock market, with the backing of an expert.

At Kotak securities.com, acknowledge and accept that the personal details that you inpart to us, is to
be kept in strict confidentiality and to use the information only in the manner which would be
beneficial to our customers. We consider our relationship with you as invaluable and strive to
respect and safeguard your right to privacy.

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We shall protect the personal details received from you with the same degree of care, but no less than
a reasonable degree of care, to prevent the unauthorized use, dissemination, or publication of these
information as we protect our own confidential information of a like nature.

We shall use the personal information to improve our service to you and to keep you updated about
our new product or information that may be of interest to you. The information collected from you
would be used in the right spirit and context in which it is intended to be used. Your information
would be used by us to process your trading request and to carry out the settlements of your
obligations.

We would ensure that we collect personal information only to the extent it is necessary to administer
out services in the best possible manner and what is required under the various regulations of India
Laws.
HDFC
Vision
To be a dominant player in the Indian mutual fund space recognized for its high levels of ethical and

professional conduct and a commitment towards enhancing investor interests.

Sponsors

Housing Development Finance Corporation Limited (HDFC)

HDFC was incorporated in 1977 as the first specialized Mortgage Company in India. HDFC provides

financial assistance to individuals, corporate and developers for the purchase or construction of

residential housing. It also provides property related services (e.g. property identification, sales

services and valuation), training and consultancy. Of these activities, housing finance remains the

dominant activity. HDFC has a client base of around 9.5 lac borrowers, around 1 million depositors,

over 91,000 shareholders and 50,000 deposit agents, as at June 30, 2007. HDFC has raised funds

from international agencies such as the World Bank, IFC (Washington), USAID, DEG, ADB and

KfW, international syndicated loans, domestic term loans from banks and insurance companies,

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bonds and deposits. HDFC has received the highest rating for its bonds and deposits program for the

twelfth year in succession. HDFC Standard Life Insurance Company Limited, promoted by HDFC

was the first life insurance company in the private sector to be granted a Certificate of Registration

(on October 23, 2000) by the Insurance Regulatory and Development Authority to transact life

insurance business in India.

For further details: www.hdfc.com

Standard Life Investments Limited

The Standard Life Assurance Company was established in 1825 and has considerable experience in

global financial markets. The company was present in the Indian life insurance market from 1847 to

1938 when agencies were set up in Kolkata and Mumbai. The company re-entered the Indian market

in 1995, when an agreement was signed with HDFC to launch an insurance joint venture. On April

2006, the Board of The Standard Life Assurance Company recommended that it should demutualise

and Standard Life plc float on the London Stock Exchange. At a Special General Meeting held in

May voting members overwhelmingly voted in favor of this. The Court of Session in Scotland

approved this in June and Standard Life plc floated on the London Stock Exchange on 10th July

2006. Standard Life Investments was launched as an investment management company in 1998. It is

a wholly owned subsidiary of Standard Life Investments (Holdings) Limited, which in turn is a

wholly owned subsidiary of Standard Life plc. Standard Life Investments is a leading asset

management company, with approximately US$ 282 billion as at June 30, 2007, of assets under

management. The company operates in the UK, Canada, Hong Kong, China, Korea, Ireland and the

USA to ensure it is able to form a truly global investment view. In order to meet the different needs

and risk profiles of its clients, Standard Life Investments Limited manages a diverse portfolio

covering all of the major markets world-wide, which includes a range of private and public equities,

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government and company bonds, property investments and various derivative instruments. The

company's current holdings in UK equities account for approximately 1.8% of the market

capitalization of the London Stock Exchange.

Management:

ABN AMRAO

With assets over US $504 billion and an AA credit rating, ABN AMRO Bank ranks among the top

10 banks in the world in size and strength. Our international network comprises 3,568 branches and

offices in over 320 cities and 76 countries and territories, with over 100,000 highly qualified staff. As

a global bank, we can handle the most complicated cross-border transactions, yet we also understand

the subtleties of local markets.

ABN AMRO IN INDIA

Traditionally known as a strong diamond financing bank, ABN AMRO today offers unparalleled

suite of client services in India.

By leveraging our global reach and drawing on the expertise of our team of research, sales and

trading, equity capital market and M&A advisory professionals, we have led many of the biggest and

most innovative landmark transactions in India for our Corporate and Institutional Clients.

In addition, we also offer a broad range of transaction banking products, fixed income and foreign

exchange products and services including sales and trading, fixed income origination, derivatives,

structured lending and commodity financing.

For our Business Banking clients, we offer top quality services in trade finance, business loans,

supply chain management, credit facilities, payment and cash management- solutions that help small

to medium size businesses enhance cash flow, boost overall business efficiency and capitalize on

new opportunities.

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Through a diverse range of product offerings including personal loans, credit cards, savings

accounts, financial planning, investment and insurance services, ABN AMRO meets the everyday

financial needs of over a million Personal Banking clients in India.

In addition ABN AMRO has Van Gogh Preferred Banking which represents a new standard of

relationship banking which has been exclusively created to offer an enhanced level of service to

demanding individuals. Van Gogh Preferred Banking services offers a wide range of wealth

maximization opportunities offering new standards of freedom, access, advice and service.

At ABN AMRO Broking we offer world class research, timely advice, extreme ease of use and swift

real time transaction systems for our clients.

Private Banking Services in India offers our select and premium clients a comprehensive range of

quality Portfolio Advisory Services along with a sophisticated execution platform. We aid in

enhancing their wealth with premium services including investment advisory, non-discretionary

portfolio management, investment funds, international estate planning and trust.

Asset Management in India is among the fastest growing asset managers with just two years of

operations in the country. Backed by the favourable market conditions and a strong focus on the

business we have an ever-increasing and widening distribution and aim to emerge as a leading player

in the Indian asset management industry. Leveraging our Group's comprehensive research and

diverse range of investment products, we offer our clients investment options in fixed income,

equities, money markets and structured products. The Microfinance program of ABN AMRO, the

largest amongst its peer foreign banks in India, is aimed at delivering credit to our target community

of rural poor woman through intermediaries called microfinance institutions. We today service 26

MFIs across 16 states in India with over 390,000 customers receiving micro financing small loans of

USD 200 or less. Our aim is to reach a million customers by 2009. During the annual Sustainable

22


Banking Awards ceremony held by Financial Times of London, ABN AMRO India was named the

Sustainable Bank of the Year in the Emerging Markets category - both in the Asia region as well as

globally.

Mission

"ABN AMRO's mission is to create maximum economic value for our shareholders through a

constant relationship focus on the financial services needs of our chosen client segments and a strict

adherence to our financial targets. We are operating in three principal customer segments, whereby

the objective is to maximize the value of each of these businesses as well as the synergies between

them. Excellence of service to our clients and leadership in our chosen markets are of paramount

importance to our long-term success. The Bank's corporate values play an integral role in the

fulfilment of our mission."

History

On 29 March 1824 King Willem-I issued a royal decree creating the Nederlandsche Handel-

Maatschappij with the aim of reviving trade between the Netherlands and the Dutch East Indies. In

1964, NHM merged with De Twentsche Bank to form Algemene Bank Nederland (ABN), while

Amsterdamsche Bank and Rotterdamsche Bank joined to become Amsterdam-Rotterdam (Amro)

Bank. In 1991, these two banks merged as ABN AMRO Bank. Today, ABN AMRO Bank has a

powerful presence in world markets, building on a tradition of stimulating international trade.

BIRLA SUN LIFE

Birla Sun Life Asset Management Company Ltd. (BSLAMC), the investment managers of Birla Sun

Life Mutual Fund, is a joint venture between the Aditya Birla Group and the Sun Life Financial

Services Inc. of Canada. The joint venture brings together the Aditya Birla Group's experience in the

Indian market and Sun Life's global experience.

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Since its inception in 1994, Birla Sun Life Mutual fund has emerged as one of India's leading Mutual

Funds managing assets of a large investor base. The fund offers a range of investment options, which

include diversified and sector specific equity schemes, fund of fund schemes, hybrid and monthly

income funds, a wide range of debt and treasury products and offshore funds.

BSLAMC follows a long-term, fundamental research based approach to investment. The approach is

to identify companies, which have excellent growth prospects and strong fundamentals. The

fundamentals include the quality of the company‟s management, sustainability of its business model

and its competitive position, amongst other factors. Birla Sun Life Asset Management Company has

one of the largest team of research analysts in the industry, dedicated to tracking down the best

companies to invest in.

Birla Sun Life AMC strives to provide transparent, ethical and research-based investments and

wealth management services

.VISION To be the most trusted name in investment and wealth management, to be the preferred

employer in the industry and to be a catalyst for growth and excellence of the asset management

business in India.

MISSION

To consistently pursue investor's wealth optimization by: Achieving superior and consistent

investment results. Creating a conducive environment to hone and retain talent. Providing customer

delight. Institutionalizing system-approach in all aspects of functioning. Upholding highest

standards of ethical values at all times.

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ADITYA BIRLA GROUP

The Aditya Birla Group is India's first truly multinational corporation. Global in vision, rooted in

Indian values, the Group is driven by a performance ethic pegged on value creation for its multiple

stakeholders.The Aditya Birla Group‟s products and services offer distinctive customer solutions

worldwide. The Group has operations in 20 countries - India, Thailand, Laos, Indonesia, Philippines,

Egypt, China, Canada, Australia, USA, UK, Germany, Hungary, Brazil, Italy, France, Luxembourg,

Switzerland, Malaysia and Korea.A US $24 billion corporation with a market cap. of US $31.5

billion and in the League of Fortune 500, the Aditya Birla Group is anchored by an extraordinary

force of 100,000 employees, belonging to 25 different nationalities. Over 50 per cent of its revenues

flow from its operations across the world.It's 66 state-of-the-art manufacturing units and sectoral

services span India, Thailand, Indonesia, Malaysia, Philippines, Egypt, Canada, Australia and

China.The Aditya Birla Group is a dominant player in all of the sectors in which it operates. These

sectors include viscose staple fibre, non-ferrous metals, cement, viscose filament yarn, branded

apparel, carbon black, chemicals, fertilisers, sponge iron, insulators and financial services. In India,

the Group has been adjudged “The Best Employer in India and among the top 20 in Asia” by the

Hewitt-Economic Times and Wall Street Journal Study 2007.

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CHAPTER-III
REVIEW OF LITERATURE

26


REVIEW OF LITERATURE
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 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.
There are many investors who are willing to trade in the derivatives segment, because
of its advantages like limited loss unlimited profit by paying the small premiums.

THE DEVELOPMENT OF DERIVATIVES

Holding portfolios of securities is associated with the risk of the possibility that the
investor may realize his returns, which would be much lesser than what he expected to
get. There are various factors, which affect the returns:

27


1. Price or dividend (interest)
2. Some are internal to the firm like
 Industrial policy
 Management capabilities
 Consumer‟s preference
 Labour strike, etc.
These forces are to a large extent controllable and are termed as non systematic risks. An
investor can easily manage such non-systematic by having a well-diversified portfolio spread
across the companies, industries and groups so that a loss in one may easily be compensated
with a gain in other.
There are yet other of influence which are external to the firm, cannot be controlled
and affect large number of securities. They are termed as systematic risk.
They are:
1. Economic
2. Political
3. Sociological changes are sources of systematic risk.
For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all-
individual stocks to move together in the same manner. We therefore quite often find
stock prices falling from time to time in spite of company‟s earnings rising and vice
versa.
Rational Behind the development of derivatives market is to manage this systematic
risk, liquidity in the sense of being able to buy and sell relatively large amounts
quickly without substantial price concession.
In debt market, a large position of the total risk of securities is systematic. Debt
instruments are also finite life securities with limited marketability due to their small

28


size relative to many common stocks. Those factors favor for the purpose of both
portfolio hedging and speculation, the introduction of a derivatives securities that is on
some broader market rather than an individual security.
GLOBAL DERIVATIVES MARKET
The global financial centers such as Chicago, New York, Tokyo and London dominate
the trading in derivatives. Some of the world‟s leading exchanges for the exchange-
traded derivatives are:
 Chicago Mercantile Exchange (CME) & London International financial Futures
Exchange (LIFFE) (for currency & Interest rate futures)
 Philadelphia Stock Exchange (PSE), London stock Exchange (LSE) & Chicago
Board options exchange (CBOE) (for currency options)
 New York Stock Exchange (NYSE) and London Stock Exchange (LSE).
(for equity derivatives)
 Chicago Mercantile Exchange (CME) and London Metal Exchange (LME).
(for commodities)
These exchanges account for a large portion of the trading volume in the respective
derivatives segment.

NSE’s DERIVATIVES MARKET

The derivatives trading on the NSE commenced with S&P CNX Nifty index futures
on June 12, 2000. The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on June 2, 2001, Single stock
futures were launched on November 9, 2001. Today, both in terms of volume and
turnover, NSE is the largest derivatives exchange in India. Currently, the derivatives
contracts have a maximum of 3-month expiration cycles. Three contracts are
available for trading, with 1 month, 2 month & 3 month expiry. A new contract is
introduced on the next trading day following of the near month contract.

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REGULATORY FRAMEWORK
The trading of derivatives is governed by the provisions contained in the S C (R) Act,
the SEBI Act, and the regulations framed there under the rules and byelaws of stock
exchanges.
In this chapter we look at the broad regulatory frame work for derivatives
trading and the requirement to become a member and authorized dealers of the F&O
segment and the position limits as they apply to various participants.
Regulation for Derivative Trading:
SEBI set up a 24-member committed under Chairmanship of Dr.L.C.Gupta develop
the appropriate regulatory framework for derivative trading in India. On May11, 1998
SEBI accepted the recommendations of the committee and approved the phased
introduction of derivatives trading in India beginning with stock index Futures.
The provision in the SC(R) Act governs the trading in the securities. The amendment
of the SCR Act to include “DERIVATIVES” within the ambit of securities in the SCR
Act made trading in Derivatives possible within the framework of the Act.
 Any exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta
committee report may apply to SEBI for grant of recognition under section 4 of
the SCR Act, 1956 to start Derivatives Trading. The derivative exchange-
/segment should have a separate governing council and representation of
trading/clearing member shall be limited to maximum 40% of the total
members of the governing council. The exchange shall regulate the sales
practices of its members and will obtain approval of SEBI before start of
Trading in any derivative contract.
 The exchange shall have minimum 50 members.

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 The members of an existing segment of the exchange will not automatically
become the members of the derivatives segment. The members of the
derivatives segment need to fulfill the eligibility conditions as lay down by the
L. C. Gupta committee.
 The clearing and settlement of derivatives trades shall be through a SEBI
approved clearing corporation/clearing house. Clearing Corporation/Clearing
House complying with the eligibility conditions as lay down by the committee
have to apply to SEBI for grant of approval.
 Derivatives broker/dealers and Clearing members are required to seek
registration from SEBI. This is in addition to their registration as brokers of
existing stock exchanges. The minimum net worth for clearing members of the
derivatives clearing corporation/house shall be Rs.300 lakh. The net worth of
the member shall be computed as follows:
o Capital + Free reserves
o Less non-allowable assets viz.,
Fixed Assets
Pledged securities
Member‟s card
Non-allowable securities (unlisted securities)
Bad deliveries
Doubtful debts and advance
Prepaid expenses
Intangible Assets
30% marketable securities
 The Minimum contract value shall not be less than Rs.2 Lakhs. Exchange
should also submit details of the futures contract they purpose to introduce.

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 The trading members are required to have qualified approved user and sales
persons who have passed a certification programmed approved by SEBI.
 The L.C.Gupta committee report requires strict enforcement of “know your
customer” rule and requires that every client shall be registered with the
derivates broker. The members of the derivatives segment are also required to
make their clients aware of the risks involved in derivatives trading by issuing
to the client the Risk Disclosure and obtain a copy of the same duly signed by
the clients.
ELIGIBILITY OF ANY STOCK TO ENTER IN DERIVATIVES MARKET
 Non promoter holding (free float capitalization) not less than Rs.750crores from
last 6 months.
 Daily Average Trading value not less than 5 crores in last 6 months.
 At least 90% of Trading days in last 6 months.
 Non Promoters Holding at least 30%.
 BETA not more than 4 (previous last 6 months)
DESCRIPTION OF THE METHOD
The following are the steps involved in the study.
Selection of the Scrip:
The scrip selection is done on a random and the scrip selected is M/s. Reliance Power
The Lot is 500. Profitability position of the futures buyers and seller and also the
option holder and option writers is studied.
Data Collection:
The data of the M/s. Reliance Power has been collected from the “The Economic
Times” and internet. The data consist of the January Contract and period of Data
Collection is from 29th December 2008 to 29th January 2009.
Analysis:
The analysis consist of the tabulation of the data assessing the profitability position of

32


the futures buyers and sellers and also option holder and the option Writer,
representing the data with graphs and making the interpretation using Data.

INTRODUCTION OF FUTURES
Futures markets were designed to solve the problems that exist in forward markets. A
futures contract is an agreement between two parties to buy or sell an asset as a certain
time in the future at a certain price. But unlike forward contract, the futures contracts
are standardized and exchange traded. To facilitate liquidity in the futures contract, the
exchange specifies certain standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purpose in settlement) and a standard timing of such settlement. A futures
contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 90% of futures transactions are offset this way.
The standardized items in a futures contract are:
 Quantity of the underlying
 Quality of the underlying
 The date and the month of delivery
 The units of price quotation and minimum price change
 Location of settlement
DEFINITION
A future contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
HISTORY OF FUTURES

Merton Miller, the 1990 Nobel Laureate had said that “financial futures represent the

33


most significant financial innovation of the last twenty years”. The first exchange that
traded financial derivatives was launched in Chicago in the year 1972. A division of
the Chicago Mercantile Exchange, it was called the international monetary market
(IMM) and traded currency futures. The brain behind this was a man called Leo
Melamed, acknowledged as the “father of financial futures” who was then the
Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the
Chicago Mercantile Exchange sold Contracts whose value was counted in millions. By
1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange
totaled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array
of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade
and the Chicago Board Options Exchange. By the 1990s, these exchanges were trading
futures and options on everything from Asian & American Stock indexes to interest-
rate swaps, and their success transformed Chicago almost overnight into the risk-
transfer capital of the world.
DISTINCTION BETWEEN FUTURES & FORWARDS CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of allocating
risk in the presence of futures price uncertainty. However futures are a significant
improvement over the forward contracts as they eliminate counterparty risk and offer
more liquidity. Comparison between two as follows:
FUTURES FORWARDS
1. Trade on an Organized Exchange 1. OTC in nature
2. Standardized 2. Customized
3. More Liquidity 3. Less Liquidity
4. Require Margin payment 4. No Margin Payment
5. Follows daily settlement 5. Settlement happens at end of period

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Table 2.1

FEATURES OF FUTURES:
 Futures are highly standardized.
 The contracting parties need not pay any down payments.
 Hedging of price risks.
 They have secondary markets to.
TYPES OF FUTURES:
On the basis of the underlying asset they derive, the futures are divided into two types:
 Stock futures
 Index futures
PARTIES IN THE FUTURES CONTRACT:
There are two parties in a future contract, the buyer and the seller. The buyer of
the futures contract is one who is LONG on the futures contract and the seller
of the futures contract is who is SHORT on the futures contract.
The pay off for the buyer and the seller of the futures of the contracts are as
follows:

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PAY-OFF FOR A BUYER OF FUTURES

Figure 2.1
CASE 1:- The buyer bought the futures contract at (F); if the future price goes to E1
then the buyer gets the profit of (FP).

CASE 2:- The buyer gets loss when the future price goes less then (F), if the future
price goes to E2 then the buyer gets the loss of (FL).

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PAY-OFF FOR A SELLER OF FUTURES:

Figure 2.2
F – FUTURES PRICE
E1, E2 – SETTLEMENT PRICE

CASE 1:- The seller sold the future contract at (f); if the future goes to E1 then the

seller gets the profit of (FP).
CASE 2:- The seller gets loss when the future price goes greater than (F), if the future
price goes to E2 then the seller gets the loss of (FL).

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MARGINS
Margins are the deposits which reduce counter party risk, arise in a futures contract.
These margins are collect in order to eliminate the counter party risk. There are three
types of margins:
Initial Margins:
Whenever a futures contract is signed, both buyer and seller are required to post initial
margins. Both buyer and seller are required to make security deposits that are
intended to guarantee that they will infact be able to fulfill their obligation. These
deposits are initial margins and they are often referred as purchase price of futures
contract.
Marking to market margins:
The process of adjusting the equity in an investor‟s account in order to reflect the
change in the settlement price of futures contract is known as MTM margin.
Maintenance margin:
The investor must keep the futures account equity equal to or greater than certain
percentage of the amount deposited as initial margin. If the equity goes less than that
percentage of initial margin, then the investor receives a call for an additional deposit
of cash known as maintenance margin to bring the equity up to the initial margin.
ROLE OF MARGINS
The role of margins in the futures contract is explained in the following example. ‟A‟
sold a M/s. Reliance Power January futures contract to „B‟ at Rs.104.80; the
following table shows the effect of margins on the contract. The contract size of

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Reliance Power is 500. The initial margin amount is say Rs.14000/-, the maintenance
margin is 65% of initial margin.

PRICING FUTURES
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate
the fair value of the futures contract. Every time the observed price deviates from the
fair value, arbitragers would enter into trades to captures the arbitrage profit. This is
turn would push the futures price back to its fair value. The cost-of-carry model used
for pricing futures is given below.
F = Sert
Where:
F = Futures Price
S = Spot price of the underlying
R = cost of financing (using continuously compounded Interest rate)
T = Time till expiration in years
e = 2.71828
(OR)
F=S (1+r-q) t
Where:
F = Futures price q = Expected Dividend yield
S = Spot price of the underlying t = Holding Period
r = Cost of financing (or) interest rate
.
FUTURES TERMINOLOGY
Spot price:
The price at which an asset trades in the spot market.
Futures price:
The price at which the futures contract trades in the futures market.
Contract cycle:
The period over which contract trades. The index futures contracts on the NSE have

39


one-month, two–month and three-month expiry cycle which expire on the last
Thursday of the month. Thus a January expiration contract expires on the last
Thursday of January and a February expiration contract ceases trading on the last
Thursday of February. On the Friday following the last Thursday, a new contract
having a three-month expiry is introduced for trading.
Expiry date:
It is the date specifies in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
Contract size:
The amount of asset that has to be delivered under one contract. For instance, the
contract size on NSE‟s futures market is 50 Nifties.
Basis:
In the context of financial futures, basis can be defined as the futures price minus the
spot price. These will be a different basis for each delivery month for each contract. In
a normal market, basis will be positive. This reflects that futures prices normally
exceed spot prices.
Cost carry:
The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest that
is paid to finance the asset less the income earned on the asset.
Initial margin:
The amount that must be deposited in the margin account at the time a futures contract
is first entered into is known as initial margin.
Marking-to-market:
In the futures market, at the end of each trading day, the margin account is adjusted to
reflect the investor‟s gain or loss depending upon the futures closing price. This is
called marking-to-market.

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Maintenance margin:
This is somewhat lower than the initial margin. This is set to ensure that the balance in
the margin account never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to
top up the margin account to the initial margin level before trading commences on the
next day.

INTRODUCTION
In this section, we look at the next derivative product to be traded on the NSE, namely
options. Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does not
have to exercise this right. In contrast, in a forward or futures contract, the two parties
have committed themselves to doing something. Whereas it costs nothing (except
margin requirement) to enter into a futures contracts, the purchase of an option
requires as up-front payment.
DEFINITION
Option is a type of contract between two persons where one grants the other the right
to buy a specific asset at a specific price within a specific time period. Alternatively
the contract may grant the other person the right to sell a specific asset at a specific
price within a specific time period. In order to have this right. The option buyer has to
pay the seller of the option premium. The assets on which option can be derived are
stocks, commodities, indexes etc. If the underlying asset is the financial asset, then the
option are financial option like stock options, currency options, index options etc, and
if options like commodity option.
HISTORY OF OPTIONS
Although options have existed for a long time, they we traded OTC, without much
knowledge of valuation. The first trading in options began in Europe and the US as
early as the 17th century. It was only in the early 1900‟s that a group of firms set up

41


what was known as the put and call Brokers and Dealers Association with the aim of
providing a mechanism for bringing buyers and sellers together. If someone wanted to
buy an option, he or she would contact one of the member firms. The firms would then
attempt to find a seller or writer of the option either from its own client of those of
other member firms. If no seller could be found, the firm would undertake to write the
option itself in return for a price.
This market however suffered from two deficiencies. First, there was no secondary
market and second, there was no mechanism to guarantee that the writer of the option
would honor the contract. In 1973, Black, Merton and scholes invented the famed
Black-Scholes formula. In April, 1973 CBOE was set up specifically for the purpose
of trading options. The market for option contract sold each day exceeded the daily
volume of shares traded on the NYSE. Since then, there has been no looking back.
Option made their first major mark in financial history during the tulip-bulb mania in
seventeenth-century Holland. It was one of the most spectacular get rich quick
binges in history. The first tulip was brought into Holland by a botany professor from
Vienna. Over a decade, the tulip became the most popular and expensive item in
Dutch gardens. The more popular they became, the more Tulip bulb prices began
rising. That was when options came into the picture. They were initially used for
hedging. By purchasing a call option and tulip bulbs, a dealer who was committed to a
sales contract could be assured of obtaining a fixed number of bulbs for a set price.
Similarly, tulip bulb growers could assure themselves of selling their bulbs at a set
price by purchasing put options. Later, however, options were increasingly used by
speculators who found that call options were an effective vehicle for obtaining
maximum possible gains on investment. As long as tulip prices continued to
skyrocket, a call buyer would realize returns far in excess of those that could be
obtained by purchasing tulip bulbs themselves. The writers of the put options also
prospered as bulb prices spiraled since writers were able to keep the premiums and the

42


options were never exercised. The tulip bulb market collapsed in 1636 and a lot of
speculators lost huge sums of money. Hardest hit were put writers who were unable to
meet their commitments to purchase tulip bulbs.

PROPERTIES OF OPTION

Options have several unique properties that set them apart from other securities. The
following are the properties of option:
 Limited Loss
 High leverages potential
 Limited Life
PARTIES IN AN OPTION CONTRACT
Buyer/Holder/Owner of an option:
The buyer of an option is one who by paying option premium buys the right but not the
obligation to exercise his option on seller/writer.
Seller/writer of an option:
The writer of the call /put options is the one who receives the option premium and is
their by obligated to sell/buy the asset if the buyer exercises on him
TYPES OF OPTIONS
The options are classified into various types on the basis of various variables. The
following are the various types of options.
I. On the basis of the underlying asset:
On the basis of the underlying asset the option are divided into two types:
INDEX OPTIONS
These options have the index as the underlying. Some options are European while
others are American. Like index futures contract, index options contracts are also cash

43


settled.
STOCK OPTIONS
Stock options are options on the individual stocks. Options currently trade on over 500
stocks in the United States. A contract gives the holder the right to buy or sell shares at
the specified price.
II. On the basis of the market movements:
On the basis of the market movements the option are divided into two types. They are:
CALL OPTION:
A call option is bought by an investor when he seems that the stock price moves
upwards. A call option gives the holder of the option the right but not the obligation to
buy an asset by a certain date for a certain price.
PUT OPTION:
A put option is bought by an investor when he seems that the stock price moves
downwards. A put option gives the holder of the option right but not the obligation to
sell an asset by a certain date for a certain price.
III. On the basis of exercise of option:
On the basis of the exercised of the option, the options are classified into two categories.
AMERICAN OPTION:
American options are options that can be exercised at any time up to the expiration date,
most exchange-traded option are American.
EUOROPEAN OPTION:
European options are options that can be exercised only on the expiration date itself.
European options are easier to analyze than American options, and properties of an
American option are frequently deduced from those of its European counterpart.

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PAY-OFF PROFILE FOR BUYER OF A CALL OPTION
The pay-off of a buyer options depends on a spot price of a underlying asset. The
following graph shows the pay-off of buyer of a call option.

Figure 2.3

S = Strike price ITM = In the money
SP = Premium/ profit ATM = At the money
E1 = Spot price 1 OTM = Out of the money
E2 = Spot price 2
SR = Profit at spot price E1

CASE 1: (Spot price > Strike price) As the spot price (E1) of the underlying asset is
more than strike price (S). The buyer gets profit of (SR), if price increases more than
E1 then profit also increase more than (SR).

CASE 2: (Spot price < Strike price)

45


As a spot price (E2) of the underlying asset is less than strike price (s) The buyer gets
loss of (SP); if price goes down less than E2 then also his loss is limited to his
premium (SP)

PAY-OFF PROFILE FOR SELLER OF A CALL OPTION
The pay-off of seller of the call option depends on the spot price of the underlying
asset. The following graph shows the pay-off of seller of a call option:

Figure 2.4
As the spot price (E1) of the underlying is less than strike price (S). The seller
gets the profit of (SP), if the price decreases less than E1 then also profit of the
seller does not exceed (SP).

CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price (S)
the seller gets loss of (SR), if price goes more than E2 then the loss of the

46


seller also increase more than (SR).

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION
The pay-off of the buyer of the option depends on the spot price of the underlying
asset. The following graph shows the pay-off of the buyer of a call option.

Figure 2.5
As the spot price (E1) of the underlying asset is less than strike price (S). The
buyer gets the profit (SR), if price decreases less than E1 then profit also
increases more than (SR).

As the spot price (E2) of the underlying asset is more than strike price (s),
47


the buyer gets loss of (SP), if price goes more than E2 than the loss of the
buyer is limited to his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION
The pay-off of a seller of the option depends on the spot price of the underlying asset.
The following graph shows the pay-off of seller of a put option. They are:

Figure 2.6
As the spot price (E1) of the underlying asset is less than strike price (S), the
seller gets the loss of (SR), if price decreases less than E1 than the loss also
increases more than (SR).


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As the spot price (E2) of the underlying asset is more than strike price (S),
the seller gets profit of (SP), if price goes more than E2 than the profit of
seller is limited to his premium (SP).

FACTORS AFFECTING THE PRICE OF AN OPTION
The following are the various factors that affect the price of an option they are:
Stock price:
The pay–off from a call option is a amount by which the stock price exceeds the strike
price. Call options therefore become more valuable as the stock price increases and
vice versa. The pay-off from a put option is the amount; by which the strike price
exceeds the stock price. Put options therefore become more valuable as the stock price
increases and vice versa.
Strike price:
In case of a call, as a strike price increases, the stock price has to make a larger upward
move for the option to go in-the-money. Therefore, for a call, as the strike price
increases option becomes less valuable and as strike price decreases, option become
more valuable.
Time to expiration:
Both put and call American options become more valuable as a time to expiration
increases.
Volatility:
The volatility of a stock price is measured of uncertain about future stock price
movements. As volatility increases, the chance that the stock will do very well or very
poor increases. The value of both calls and puts therefore increase as volatility
increase.
Risk-free interest rate:

49


The put options prices decline as the risk-free rate increases where as the prices of call
always increase as the risk-free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the x-dividend rate. This has a
negative effect on the value of call options and a positive effect on the value of put
options.
PRICING OPTIONS
An option buyer has the right but not the obligation to exercise on the seller. The worst
that can happen to a buyer is the loss of the premium paid by him. His downside is
limited to this premium, but his upside is potentially unlimited. This optionality is
precious and has a value, which is expressed in terms of the option price. Just like in
other free markets, it is the supply and demand in the secondary market that drives the
price of an option.
There are various models, which help us get close to the true price of an option. Most
of these are variants of the celebrated Black-Scholes model for pricing European
options. Today most calculators and spreadsheets come with a built-in Black-Scholes
options pricing formula so to price options we don‟t really need to memorize the
formula. All we need to know is the variables that go into the model.
The Black-scholes formulas for the price of European calls and puts on a non-dividend
paying stock are:
CALL OPTION
C = SN (D1)-Xe-r t N (D2)
PUT OPTION
P = Xe-r t N (-D2)-SN (-D1)
Where d1 = Ln(S/X) + (r+ v2/2) t
v/t
And d2 = d1- v/t
Where:
CA = VALUE OF CALL OPTION
PA = VALUE OF PUT OPTION
S = SPOT PRICE OF STOCK

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N = NORMAL DISTRIBUTION
VARIANCE (v) = VOLATILITY
X = STRIKE PRICE
r = ANNUAL RISK FREE RETURN
t = CONTRACT CYCLE
e = 2.71828
r = in (1+r)

OPTIONS TERMINOLOGY
Option price/premium:
Option price is the price, which the option buyer pays to the option seller; it is also
referred to as the option premium.
Expiration Date:
The date specified in the options contract is known as expiration date, the exercise
date, the strike date or the maturity.
Strike price:
The price specified in the options contract is known as strike price or Exercise price.
In-the-money option:
An In-the-money (ITM) option is an option that would lead to positive cash flow to
the holder if it were exercised immediately. A call option on the index is said to be in-
the-money when the current index stands at a level higher than the strike price (i.e.
spot > strike price). If the index is much higher than the strike price, the call is said to
be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
At-the-money option:
An at-the-money (ATM) option is an option that would lead to zero cash flow if it is
exercised immediately. An option on the index is at-the-money when the current index
equals the strike price (i.e. spot price = strike price).
Out-of-the-money option:
An out-of-the-money (OTM) option is an option that would lead to negative cash flow

51


if it is exercised immediately. A call option on the index is out-of-the-money when the
current index stands at a level which is less than the strike price (i.e. spot price < strike
price). If the index is much lower than the strike price, the call is said to be deep OTM.
In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of money:
The option premium can be broken down into two components-intrinsic value and
time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If
the call is OTM, its intrinsic value is zero.
Time value of an option:
The time value of an option is the difference between its premium and its intrinsic
value. Both CALL and PUT have time value. An option that is OTM or ATM has only
time value. Usually, the maximum time value exists when the option is ATM. The
longer the time to expiration, the greater is an option‟s time value, all else equal. At
expiration, an option should have no time value.

DISTINCTION BETWEEN FUTURES AND OPTIONS

FUTURES OPTIONS

1.Exchange traded, with Novation 1.Same in nature
2.Exchange defines the product 2.Same in nature
3.Price is zero, strike Price moves 3.Strike price is fixed, price moves
4.Price is zero 4.Price is always positive
5.Linear payoff 5.Nonlinear payoff
6.Both long & Short at risk 6.only short at risk

Table 2.2

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INTRODUCTION
The futures & options trading system of NSE, called NEAT-F&O trading system,
provides a fully automated screen-based trading for Nifty futures & options and stock
futures & options on a nationwide basis as well as online monitoring and surveillance
mechanism. It supports an order driven market and provides complete transparency of
trading operations. It is similar to that of trading of equities in the cash market
segment.
The software for the F&O market has been developed to facilitate efficient and
transparent trading in futures and options instruments. Keeping in view the familiarity
of trading members with the current capital market trading system, modifications have
been performed in the existing capital market trading system so as to make it suitable
for trading futures and options.
On starting NEAT (National Exchange for Automatic Trading) application, the log on
(pass word) screen appears with the following details.
1. User ID
2. Trading Member ID
3. Password – NEAT CM (default pass word)
4. New Pass Word
Note: -
1. User ID is a Unique
2. Trading Member ID is Unique & Function; it is common for all user of the
Trading Member.

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3. New password–Minimum 6 Characteristic, Maximum 8 characteristics only 3
attempts are accepted by the user to enter the password to open the screen.
4. If password is forgotten the user required to inform the exchange in writing to
reset the password.

TRADING SYSTEM
Nationwide online fully Automated Screen Based Trading System (SBTS)
 Price priority
 Time priority
Note: -
1. NEAT system provides open electronic consolidated limit orders book (OECLOB)
2. Limit order means: stated quantity and stated price
Before Opening the market
User allowed to set up:
1. market watch screen
2. inquiry screens only
Open phase (open Period):
User allowed to
1. Enquiry
2. Order Entry
3. Order Modification
4. Order Cancellation
5. Order Matching
Market Closing Period
User allowed only for inquires
Surcon period

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(Surveillance & Control period)
The system process the Date, for making the system, for the next trading day.

Log of the Screen (Before Surcon Period)
The screen shows: -
1. Permanent sign off
2. Temporary sign off
3. Exit
Permanent sign off: Market not updates.
Temporary sign off: Market up date (temporary sign off, after 5 minutes
Automatically Activate)
Exit: The user comes out sign off screen.
Local Database
Local Database is used for all inquiries made by the user for own order/trades
information. It is used for corporate manager/ Branch Manager Makes inquiries for
orders/trades of any branch manager/dealer of the trading firm, and then the inquiry is
serviced by the host. The local database also includes message of security information.
Ticker Window
The ticker window displays information of all trades in the system. The user has the
option of selecting the security, which should be appearing in the ticker window.
Securities in ticker can be selected for each market types
The ticker window displays both derivative and capital market segment
Market Watch Window
Title Bar: Title Bar Shows: NEAT, Date & Time.
Market watch window felicitate to set only 500 scrip‟s, but the user set up a Maximum
of 30 securities in one page.

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Previous Trade Screen
Previous trade screen shows & allows security wise information to user for his own
trade in chronological order.
1. Request for trade modification allowed with the following conditions
 During the day only
 Must be lower than the traded quantity
 Both parties acceptance (Buyer & Seller)
 Final Decision is taken by NSE (to accept or reject)
2. Request for trade cancellation allowed with same as above conditions (A).
Outstanding order Screen
Outstanding order screen show, Status outstanding order enters by user for a particular
security (R.L. Order & SL Order) it allows: - order Modification & Orders
Cancellation.
Activity Log Screen
Activity logon screen show, all activities performed on any order by the user, in
Reversal Chronological Order
B = Buying
S = Selling orders
OC = Cancellation of order
OM = Modifying order
TC = Buy order & Sell order, involving in trade and cancelled
TM = Buy order & sell orders, involving trade is modified
It is very useful to a corporate manager to view all the activities that have been
performed on any order (or) all ordered under his branches & dealers
Order status screen
Order status screen shows, current status of “dealers” own specified orders.
SNAP Quote Shows

56


Instantaneous information about a particular security can be shown on Market watch
window (which is not set up in market watch window)
Market Movement Option
Over all movement of the security, in current day, on time basis.
Market Inquiry
Market inquiry screen shows market statistics for particular market, for a particular
security.

It shows information about:-
RL Market (Regular lot Market)
RD Market (Retail Debt Market)
OL Market (Odd lot Market)
It shows following statistics:- open price, High price, Low price, Last Traded Price,
Traded Quantity, 52 weeks high/low price.
MBP (Market by Price)
MBP (F6) screen shows total outstanding orders of a particular security, in the market,
Aggregate at each price in order of Best 5 prices.
It shows: -
RL Market (Regular lot Market)
SL Market (Stop Loss order)
ST order (Special Term orders)
Buy Back Order with „*‟ symbol
P = indicate pre open position
S = indicate Security Suspend
Security/Portfolio list
It Facilitate the user to set up market watch screen
And facilitate to set up his own portfolios
ON-LINE Batch Up
It facilitates the user to take back up of all orders & trade related information, for

57


current day only.
ON-LINE/TABULAR SLIPS
It selects the format for conformation slips
About Window
This window displays software related version numbers details and copy right
information.
Most Activity Securities Screen
It shows most active securities, based on the total traded value during the day

Report Selection Window
It facilitates to print each copy of report at any time. These reports are
1. Open order report: For details of outstanding orders
2. Order log report: For details of orders placed, modified & cancelled
3. Trade Done-today report: For details of orders traded
4. Market Statistics report: For details of all securities traded information in a day
Internet Broking
NSE introduced Internet trading system from February 2000.
Client place the order through brokers on order routing system.
WAP (Wireless application protocol)
NSE.IT Launches the from November 2000
1st Step-getting the permission from exchange for WAP

2nd step-approved by the SEBI (SEBI Approved only for SEBI registered members)
X.25 Address Check
X.25 Address Check is performed in the NEAT System, when the user log on into the
NEAT, system & during report down load request.
FTP (File Transfer Protocol)
1. NSE Provide for each member a separate directory (file) to know their trading
DATA, clear DATA, bill trade Report.
2. NSE Provide in addition a “common” directory also, to know circulars, NCFM &
Bhava Copy information
3. FTP is connected to each member through VSAT, leased line and Internet.
4. VSAT (FROM 4.15PM to 9.30AM), Internet (24Hours).
Bhava Copy Database

58


Bhava copy data provides summary information about each security, for each day
(only last 7 days bhava copy file are stored in report directory.)
Note: - Details in bhava copy-open price, high and low prices, closing prices traded
value, traded volume and No. of transactions.

Snap Shot Database
Snap shot database provides snap shot of the limit order book at many time points in a
day.
Index Database
Index Database provides information about stock market indexes.
Trade Database
Trade database provides a database of every single traded order, take place in
exchange.
BASKET TRADING SYSTEM
1. Taking advantage for easy arbitration between future market and cash market
difference, NSE introduce basket-trading system by offsetting position through off
line-order-entry facility.
2. Orders are created for a selected portfolio to the ratio of their market capitalization
from 1 lakh to 30 crores.
3. Offline-order-entry facility: Generate order file in as specified format outside the
system & up load the order file into the system by invoking this facility in Basket
Trading System.
Participants in Security Market
1) Stock Exchange (registered in SEBI)-23 stock Exchanges
2) Depositaries (NSDL, CDSL)-2 Depositaries
3) Listed Securities-9, 413
4) Registered Brokers-9, 519

59


5) FIIs-502

Investor Education & Protection Fund
This fund used to educate & develop the awareness of the Investors. The following
funds credited to IE & PF.
1) Unpaid Dividends.
2) Due for refund (application money received for allotment).
3) Matured deposits & debentures with company.
4) Government donations.
Issue & Allotment of the Shares
1) Issued & subscribing
A. Either Physical or dematerialized.
B. Issuing capital exceed 10 crores compulsory issued in dematerialized
2) Trading compulsory in dematerialized form.
3) Allotment made until the beginning of the 5th day after the day issue of prospectus.
4) Listing is possible issuing not less than 10% of the total equity and minimum of 20
Lakhs.
Holding of Shares (Voting Right) disclosing obligation
1. Any person or Director or Officer or the company
2. More than 5% share or Voting Right
3. Within 4th day inform to company is necessary
4. Company inform with in 5th day to stock exchange is compulsory
First Started
Future Trading: Chicago Board of Trading 1848

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Financial Future Trading: CME (Chicago Mercantile Exchange 1919)

Stock Index Futures: Kansas City Board of trade

Option First Trade: Holland – Tulip Balabmania.

BROKER (Trading Member)
(Broker means a member in recognized stock exchange)
Eligibility: 21 Years, graduation, 2 years experience in stock market relative affairs
and
o 30 Lakhs paid up capital
o 100 Lakhs net worth
o 125 Lakhs interest free security deposit
o 25 Lakhs collatery security deposit
o 1 Lakh annual business subscription.
Necessary Infrastructure: Office Space, Manpower, Equipment
Disciplinary proceedings: Not convicted involving fraud & Dishonesty
Fitness: Not Bankrupt, not default in any stock exchange, not previously refused by
NSE, fully discharged from Debts by creditors (self declaration)
First send application to stock exchange for broker ship-stock exchange send that
application to SEBI 30 days - SEBI satisfy above 1 & 2 points to grant Certificate of
Registration.
Maximum commission of the broker 2.5% (including sub broker commission 1.5%)
on cash market and feature market buy and sell values but option market 2.5% is
charged on (Strike Price + Premium value).
Contract note issued and signed by broker or authorized signatory within 24hrs.
On contract note printed both offices registered office & dealing office address is
must.

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Each trading member (broker) in F&O segment of NSEIL (NSE India Limited) can
have as many users are he wishes.
Compliance officer is appointed by the Broker.
Broker ship Transfer fee 1 Lakh.

Dominant Promoters
a) For Individual (not exceeding 4 members) his & his spouse not less than 51%-1
person Graduation is compulsory.
b) For firm: - Not less than 51% his & his spouse, children‟s & brother‟s -1 person
graduation is compulsory.
c) Corporate Company: - Not less than 40% of the director‟s share holding (at least
50% each director) – 2 Directors Graduation is compulsory.
BROKER & CLIENT RELATIONSHIP
1. Fill the client Registration Application form (for all details of clients).
2. Agreement on non-judicial form (specified by SEBI that form)
3. PAN, Passport, Driving License or Voter Identity Card (SEBI Registration Number
in case of FII‟s)-pan cards are must to future and option trading.
4. And then Allot-Unique Client Code.
5. Take copy of instruction in writing before placing order, cancellation &
modification.
6. If order values exceed 1 Lakh maintain the client record for 7 years.
7. On conformation any order issue contract note within 24hrs.
8. Collect margin of 50,000 & multiple with 10,000.
NOTE: - PAN is compulsory if the transaction cost exceed Rs.1 Lakh.
9. Issuing the “Know your client” form is must.
For Continuing Membership-Trading Member
Fulfill the following documents

62


1. Audited two important financial statement (profit & loss account, balance sheet)
2. Net worth certificate (certificate by CA)
3. Details of Directors, Share holders (certificate by CA)
4. Renewal insurance covering proof.

NSCCL CHARGED PENAL CHARGES (PENALTY POINTS)
TO MEMBERS (CAUSING FOLLOWING FAILURES)
1. Failure to funds obligations
2. Failure to security delivery obligation
3. Gross exposure turnover violations
4. Margin shortages
5. Security deposit shortage
6. Client code modification & non-confirmation of custodial trades.
NOTE: - Penalty points charged on calendar month basis.
Maintaining & Preserving Books of Accounts by Trading Member
1. Up to 5yrs must be maintaining these books, by trading member.
a. Registrar of transaction (Saudha Book).
b. Client ledger.
c. General Ledger
d. Journal
e. Cash Book
f. Bank Pass Book
g. Document Register (particular of Securities received & delivered)
2. Up to 2yrs must be maintaining these books, by trading member.
a. Member contract book.
b. Counter foils of contract notes
c. Return consent of clients (at the time order place).

63


SUB-BROKER
1. Eligibility: - 21 years, 10+2 qualification and paid up capital 5 Lakhs.
2. Not convicted involving fraud and dishonesty.
3. Not debarred by SEBI previously.
4. 51% of shares as dominant promoters his/her and his/her spouse.
5. First application to stock exchange-stock exchange send his application to SEBI-
SEBI satisfied issued certificate Registration.
6. A registered sub-broker, holding registration, granted by SEBI on the
Recommendations of a trading member, can transact through the member (broker)
who had recommend his application for registration.
7. Maximum Brokerage Commission 1.5%
8. Purchase note and sales note issued by the sub broker with 24 hours.
Investor Protection Fund
1. Investor protection fund setup under Bombay public trust Act 1950.
2. IPF maintained by NSE Exact mane of this fund is NSE Investors Protection Fund
Trust.
3. Any Member defaulter the IPF paid maximum 10 Lakhs only to each investor.
4. Client against default member, customers have right to apply within 3 months from
the date of publishing notice by a widely circulated minimum one daily Newspaper.
Demat of the Shares
1. Agreement with depository by security holder (at the time opening the demat
Account)
2. Surrender the security certificates to “issuer” (company) for cancellation.
3. Issuer (company) informs the “depository” about the transfer of the shares.
4. Participant (company) informs the “depository” about the transfer of the shares.
5. “Depository” records the “transferee” name as “beneficial owner” in “book entry
form” in his records.

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6. Each custodian/clearing member is requiring maintaining a clear pool account with
depositaries.
7. The investor has no restriction and has full right to open many (number of)
depository accounts.
8. Shares or securities are transferred from one account to another account only on the
instruction of the beneficial owner.
ISIN (International Securities Identification Number)
Any company going to for dematerialized with shares that company get this ISIN for
Demat shares.
ISIN is assigned by SEBI
ISIN is allotted by NSDL.
Main Objectives of Demat Trading
1. Freely transferability
2. Dematerialized in depository mode
3. Maintenance of ownership records in book entry form
Short term capital (according to the Income Tax Act 1961)
1. Not more than 36 months immediately preceding the date of its transfer for any
asset.
2. Not more than 12 months immediately preceding the date of its transfer for any
security UTI units and mutual fund units.
3. No Tax per long term capital gains (after 1yr) (10%).
Risk in Settlement
1. Counter party Risk:
Replacement cost risk-short/long covering risk
Principle risk-counter party default
Liquidity risk-failure of the settlement of the transaction

65

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