Derivative

DERIVATIVES (Instrument for risk reduction)
INTRODUCTION
The past decade witness the multiple growths in the volume of
international trade business due to the wave of globalization and liberalization
all over the world. As a result, the demand for the international money and
financial instruments increased significantly at the global level. In this respect,
changes in the interest rate, exchange rate, and stock market price at the
different financial market have increased the financial risk to the corporate
world. It is therefore to manage such risks; the new financial instrument has
been developed in this financial market, which is also known as financial
Derivatives.
The basic purpose of this instrument is to provide commitment to price
for future date for giving protection against adverse movement in future price
in order to reduce the extent of financial risks. Not only this, they also provide
opportunity to earn profit for those who are ready to go for high risks.
This instrument facilitates to transfer the risks from those who wish to
avoid it to those who are willing to accept the risks.
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WHAT IS A DERIVATIVE?
Derivatives is a product/ contract, which does not have any value on its
own i.e. it, derives its value from some underlying. Derivatives or derivatives
securities are contracts which are written between two parties (counter
parties) and whose values is derived from underlying widely held and easily
marketable assets such as agricultural and other physical (tangible)
commodities or currencies or short term and long term financial instruments
tangible things like commodities price index (inflation rate), equity price index
or bond price index. The counter parties to such contract are those other than
the original issuer (holder ) of the underlying assets . The exchange-traded
derivatives are quit liquid and have low transaction cost. It is possible to
combine them to match specific requirements.
The value 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 claims, which can be traded in respect of underlying
assets. Derivatives are ‘off balance’ instruments, a fact is said to be obscure
the leverage and financial might give to the party. They are mostly secondary
market instruments and have little usefulness in mobilizing fresh capital by the
companies. Although the standardized, general exchange traded derivatives
are being increasingly evolved, still there are many privately negotiated,
customized, OTC- traded financial contracts which are in vogue and which
expose the uses to operational risk. There is also and uncertainty about the
regulatory status of such derivatives.
Derivatives are used to facilitate hedging of price risk of inventory
holding or a financial / commercial transaction over a certain period. In
practice, every derivatives “contract” has a fixed expiration date , mostly in the
range of 1 to 12 months from the date of commencement of the contract.
(Presently 1,2,3, month’s contracts are available in India)
Example: A very simple example of derivatives is curd, which is
derivative of milk. The price of curd depends upon the price of milk which in
turn depends upon the demand & supply of milk.
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CLASSIFICATION OF DERIVATIVES
Derivatives markets can basically be classified into commodity and Financial
Derivatives market. Commodity markets are further classified into tangible
commodities & intangible commodities. Financial derivatives broadly has four
branches viz. Real Estate, Forex, Equity derivatives and Debt Derivatives.
Equity derivatives are further divided into index Products and derivatives on
securities and Debt derivatives are further divided into Interest rate Products
and GOI Securities , bonds, T-bills.
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HISTORY OF DERIVATIVES
The first centralized commodities market in Britain was founded in
the 1560s in the Royal Exchange (later to become the first home of the
London International Financial Futures Exchange). Unfortunately the Great
Fire of London destroyed the Royal Exchange in 1666, although trading
continued in the various coffee houses that were springing up in the City of
London at the time. Eventually each coffee house started to specialize in
one particular product: the London Commodity Exchange in the Virginian
and Baltic coffee house the London Metal Exchange in Jerusalem and the
London Stock Exchange in Jonathans. At the same time there was an
options market in Holland at the Amsterdam Trade Center based on tulips.
Unfortunately the speculative use of these options brought about the
collapse of the Dutch economy
Organized futures markets, as we know them today really developed in
the last century, primarily in the US, when the Chicago Board of Trade
(CBOT) was established in 1848. At that time Chicago was not only at the
center of the railroads; it was also an important port on the Great Lakes and
close to the Midwest farmlands. With Chicago being such an important center
for agricultural markets the CBOT was established to provide farmers with a
central market place to guarantee the prices for their livestock and grain.
THE NEED FOR A DERIVATIVES MARKET
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk averse 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
averse people in greater numbers
5. They increase savings and investment in the long run
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FACTORS DRIVING THE GROWTH OF FINANCIAL
DERIVATIVES:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks
and returns over a large number of financial assets leading to higher returns,
reduced risk as well as transactions costs as compared to individual financial
assets.
WHAT KINDS OF RISKS DO PARTICIPANTS IN THE
DERIVATIVES MARKETS FACE?
Some examples of risks are provided below:
Counterparty (or default) risk – very low or almost zero because
the exchange takes on the responsibility
Operational risk – risk that operational systems might fail
Legal risk – risk that legal objections might be raised, regulatory
framework might disallow some activities
Market risk – risk that market prices may move ups or down
Liquidity risk – risk that unwinding of transactions might be
difficult if the market is illiquid.
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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
Profit contracts are special types of forward contracts which 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 given 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 life of upto one year, the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options 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 upto three years.
LEAPS are not currently available in India.
Baskets: Basket options are options on portfolios of underlying assets.
The underlying asset is usually a moving average or a basket of assets.
Equity index options are a form of basket options.
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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
1. Interest rate swaps
2. Currency swaps
Interest rate swaps: These entail swapping only the interest related
cash flows between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest
between the parties with the cashflows in one direction being in a different
currency than those in the opposite direction.
Swaption: Swaption 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 Swaption market has
receiver Swaption and payer Swaption. A receiver Swaption is an option
to receive fixed and pay floating interest. A payer Swaption is an option to
pay fixed and receives floating interest.
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DERIVATIVES MEMBERSHIP
The Derivatives Segment membership is open to the existing members
of the Cash Segment as well as non-members provided they fulfill the
membership required as laid down from time to time. The following are the
different types of membership presently available for the Derivatives Segment:
1) Professional Clearing Member (PCM): PCM means a Clearing
Member, who is permitted to clear and settle trades on his own account, on
account of his clients and / or on account of trading members and their clients.
2) Custodian Clearing Member (CCM): CCM means Custodian
registered as Clearing Member, who may clear and settle trades on his own
account, on account of his clients and / or on account of trading members and
their clients.
3) Trading Cum Clearing Member (TCM): A TCM means a Trading
Member who is also a Clearing Member and can clear and settle trades on his
own account, on account of his clients and on account of associated Trading
Members and their clients.
4) Self Clearing Member (SCL): A SCM means a Trading Member who
is also a Clearing Member and can clear and settle trades on his own account
and on account of his clients.
5) Trading Member (TM): ATM is a member of the Exchange who has
only trading rights and whose trades are cleared and settled by the Clearing
Member with whom he is associated.
6) Limited Trading Member (LTM): A LTM is a member, who is not the
members of the Cash Segment of the Exchange, and would like to be a Trading
Member in the Derivatives Segment at BSE. An LTM has only the trading rights
and his trades are cleared and settled by the clearing member with whom he
is associated.
As on January 1, 2003, there are 1 Professional Clearing Member, 3
Custodian Clearing Members, 75 Trading cum Clearing Members, 93Trading
Members and 17 Limited Trading Members in the Derivative Segment of the
Exchange.
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.
Financial requirement for derivatives membership
The most basic means of controlling counter-party credit and liquidity
risks is to deal only with creditworthy counter-parties. The Exchange seek to
ensure that their members are creditworthy by laying down a set of financial
requirements for membership. The members are required to meet, both
initially and on an ongoing basis, minimum networth requirement. Unlike Cash
Segment membership where all the trading members are also the clearing
members,in the derivatives Segment the trading and clearing rights are
segregated. In other words, a member may opt to have both clearing and
trading rights or he may opt for trading rights only in which case his trades are
cleared and settled by his associated Clearing Member. Accordingly, the
networth requirement is based on the type of membership and is as under:
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CAPITAL ADEQUACY REQUIREMENT
Every Clearing Member of the Derivatives Segment is required to
maintain a minimum capital deposit of Rs. 50 lakhs with the Exchange, of
which, the 25% is to be deposited in cash, 25% by way of cash / fixed deposit
receipts of bank(s) and the balance by way of bank guarantee(s) or eligible
securities. In addition to above, a Clearing Member is required to deposit Rs.
7.5 lakhs with the Exchange in the specified form for every TM / LTM
associated with him. Amount deposited by a Clearing Member in addition to
Rs. 50 lakhs is treated as his additional capital deposit or initial margin
deposit. 50% of the additional capital deposit should be in the form of cash or
cash equivalents, viz., Cash, FDRs, bank guarantees. At all points of time, a
Clearing Member’s liquid networth, i.e., total capital deposited less capital
used towards margin should be greater than or equal to Rs. 50 lakhs.
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TYPES OF MEMBERSHIPS
NET WORTH
REQUIREMENTS
(RS. LAKHS)
Professional Clearing Member, Custodian Clearing
Member and Trading cum Clearing Member
300
Self Clearing Member 100
Trading Member 25
Limited Trading Member 25
Limited Trading Member (for members of other
stock exchange whose Clearing Member is a
subsidiary company of a Regional Stock Exchange)
10

 FORWARD CONTRACT
 FUTURE CONTRACT
 OPTION CONTRACT
 SWAP CONTRACT
FORWARD CONTRACT
A forward contract is an agreement to buy or sell an asset on a
specified date for a specified price agreed upon today . It is a deal for the
purchase or sale of a commodity, security or other asset in the spot or forward
market. The essential idea of entering into a forward contract is to peg the
price and thereby avoid the price risk. Usually no party changes hands when
forward contracts are entered. Although a forward contract is a good means of
avoiding price risk but it entails an element of risk that the party to the contract
may not honor its part of the obligation.
Once a position of buyer or seller is taken an investor cannot retreat
except through mutual consent or buy entering into an identical contract by
reversing his position. With forward contracts entered into on a one to one
basis and with no standardization the forward contracts have a very low
degree of liquidity. Therefore, the problem associated with the forward
contracts led to the emergence of future contracts.
EXAMPLE
Imagine you are a farmer. You grow 1,000 dozens of mangoes every year.
You want to sell these mangoes to a merchant but are not sure what the price
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will be when the season comes. You therefore agree with a merchant to sell
all your mangoes for a fixed price for Rs 2 lakhs.
This is a forward contract wherein you are the seller of mangoes forward and
the merchant is the buyer.
The price is agreed today in advance and the delivery will take place
sometime in the future.
WHERE ARE FORWARDS USED?
Forwards have been used in the commodities market since centuries.
Forwards are also widely used in the foreign exchange market.
ESSENTIAL FEATURES OF A FORWARD CONTRACT
• Contract between two parties (without any exchange between them)
• Price decided today
• Quantity decided today (can be based on convenience of the parties)
• Quality decided today (can be based on convenience of the parties)
• Settlement will take place sometime in future (can be based on convenience
of the parties)
• No margins are generally payable by any of the parties to the other
LIMITATIONS OF FORWARDS
Forwards involve counter party risk. In the above example, if the merchant
does not buy the mangoes for Rs 2 lakhs when the season comes, what can
you do? You can only file a case in the court, but that is a difficult process.
Further, the price of Rs 2 lakhs was negotiated between you and the
merchant.
If somebody else wants to buy these mangoes from you, there is no
mechanism of knowing what the right price is.
Thus, the two major limitations of forwards are:
• Counter party risk
• Price not being transparent
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Counter party risk is also referred to as ‘default’ risk or ‘credit’ risk.
FUTURE CONTRACT
Futures trading was started in the mid – western part of USA during
1970’s , but today it is traded through out the world. 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 at a
certain time in the future at a certain price. Futures are similar to forwards but
unlike forward contracts, the futures contracts are standardized and exchange
traded. . Prices are available to all those who want to buy or sell because the
trading takes place on a transparent computer system. To facilitate liquidity in
the futures contracts, the exchange specifies certain standard features of the
contract. It is a standardized contract with standard underlying instrument, a
standard quantity and quality of the underlying instrument that can be
delivered, (or which can be used for reference purposes 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 99% 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
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FEATURES OF FUTURES
• Contract between two parties through an exchange
• Exchange is the legal counter party to both parties
• Price decided today
• Quantity decided today (quantities have to be in standard denominations
specified by the exchange)
• Quality decided today (quality should be as per the specifications decided by
the exchange)
• Tick size (i.e. the minimum amount by which the price quoted can change) is
decided by the exchange
• Delivery will take place sometime in future (expiry date is specified by the
exchange)
• Margins are payable by both the parties to the exchange
• In some cases, the price limits (or circuit filters) can be decided by the
exchange.
LIMITATION OF FUTURE:
Futures suffer from lack of flexibility.
Suppose you want to buy 103 shares of Satyam for a future delivery date of
14th February, you cannot. The exchange will have standardized
specifications for each contract. Thus, you may find that you can buy Satyam
futures in lots of 1,200 only. You may find that expiry date will be the last
Thursday of every month.
Thus, while forwards can be structured according to the convenience of the
trading parties involved, futures specifications are standardized by the
exchange.
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FUTURE 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 a contract trades. The index
futures contracts on the NSE have one-month, two-months and three-
months expiry cycles, 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 specified 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 in-stance, the contract size on NSE’s futures market is 200
Nifties.
• Basis: In the context of financial futures, basis can be defined as the
futures price minus the spot price. There 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 of 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.
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• Marking-to-market: In the futures market, at the end of each trading day,
the margin ac-count is adjusted to reflect the investor’s gain or loss
depending upon the futures closing price. This is called marking–to–
market.
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.
Maturity of futures contract
Index futures of different maturities trade simultaneously on the exchanges.
For instance, BSE trades three contracts on BSE SENSEX with one, two and
three month’s maturity. These contracts of different maturities are called near
month (one month), middle month (two months) and far month (three months)
contracts. At any point of time there will be three futures contracts available
for trading.
Meaning of expiry of Futures
Futures contracts will expire on a certain pre-specified date. In India, futures
contracts expire on the last Thursday of every month.
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For example, a February Futures contract will expire on the last Thursday of
February. In this case, February is referred to as the Contract month.
If the last Thursday is a holiday, Futures and Options will expire on the
previous working day. On expiry, all contracts will be compulsorily settled.
Settlement can be effected in cash or through delivery.
Convergence at Expiration
Futures pricing have expectations and a time value built into them. This
is the reason as time period expires the expectation value and the time value
decays and the futures price converges into the cash market price. This
process of convergence results in price discovery of cash index at a given
point in time. Convergence also forces the respective market participants to
square off their respective exposures or rollover their exposures to the next
contract month. Convergence also reiterates the fact that derivatives
instruments have limited life.
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WHAT TYPE OF MARGINS ARE PAYABLE ON
FUTURES?
Both buyers and sellers of Futures should pay an Initial Margin to the
exchange at the point of entering into Futures contracts. This Initial Margin is
retained by the exchange till these transactions are squared up.
Further, Mark to Market Margins are payable based on closing prices at the
end of each trading day. These Margins will be paid by the party who suffered
losses and will be received by the party who made profits.
The exchange thus collects these margins from the losers and pays them to
the winners on a daily basis.
MARK – TO- MARKET
Every day all the open positions in Futures contracts are marked to the
closing price and the variation, if any, is collected / paid to the members by
debiting / crediting their settlement bank accounts with the respective clearing
banks on T + 1 morning. Also, where the positions are closed, profit / loss on
such positions is also credited / debited to the member’s bank accounts.
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Methodology for calculating closing price for daily mark to
market:
The daily closing price of the futures contract for calculating mark-to-market
margin is arrived at using following algorithm:-
Weighted average price of all the trades in last half an hour of the continuous
trading session.
If there are no trades during last half an hour, then the theoretical price would
be taken as the official closing price. The theoretical price is arrived at by
using the following algorithm:-
Theoretical price = Closing value of underlying + ( closing
value of underlying * No. of days to expiry * risk free interest
rate ( at present 7.5% ) / 365 ).
HOW CAN I SQUARE UP A FUTURES CONTRACT?
If you have bought a Futures contract, you can sell it and thus square up. If
you sold a Futures contract, you can buy it back and square up.
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If you do not square up till the day of expiry, it will be automatically squared up
by the exchange.
HOW TO BENEFIT FROM STOCK FUTURES
You are bullish on a stock say Satyam, which is currently quoting at Rs 280
per share. You believe that in one month it will touch Rs 330.
Question: What do you do?
Answer: You buy Satyam.
Effect: It touches Rs 330 as you predicted – you made a profit of Rs 50 on an
investment of Rs 280 i.e. a Return of 18% in one month – Fantastic !!
Wait: Can it get any better ?
Yes !!
Question: What should you do ?
Answer: Buy Satyam Futures instead.
Effect: On buying Satyam Futures, you get the same position as Satyam in
the cash market, but you pay a margin and not the entire amount. For
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example, if the margin is 20%, you would pay only Rs 56. If Satyam goes upto
Rs 330, you will still earn Rs 50 as profit. Now that translates into a fabulous
return of 89% in one month.
Unbelievable !!But True nevertheless !!
This is the advantage of ‘leverage’ which Stock Futures provide. By investing
a small margin (ranging from 10 to 25%), you can get into the same positions
as you would be able to in the cash market. The returns therefore get
accordingly multiplied.
Question : What are the risks?
Answer : The risks are that losses will be get leveraged or multiplied in the
same manner as profits do. For example, if Satyam drops from Rs 280 to Rs
250, you would make a loss of Rs 30. The Rs 30 loss would translate to an
11% loss in the cash market and a 54% loss in the Futures market.
Question : what is the main advantage of Futures?
Answer : A great advantage of Futures (at the moment) is that they are not
linked to ‘delivery’. Which means, you can sell Futures (short sell) of Satyam
even if you do not have any shares of Satyam. Thus, you can benefit from a
downturn as well as from an upturn.
If you predict an upturn, you should buy Futures and if you predict a downturn,
you can always sell Futures – thus you can make money in a falling market as
well as in a rising one – an opportunity that till recently was available only to
brokers/operators and not easily to retail investors.
You should look for opportunities where futures prices are higher than cash
prices. For example, if Satyam is quoting at Rs 250 in the cash market and
one month Satyam futures are quoting at Rs 253 in the futures market, you
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can earn Rs 3 as difference. You will then buy Satyam in the cash market and
at the same time, sell Satyam one month futures.
On or around the expiry day (last Thursday of each month), you will square up
both the positions, i.e. you will sell Satyam in the cash market and buy
futures. The two prices will be the same (or very nearly the same) as cash
and futures prices will converge on expiry. It does not matter to you what the
price is. You will make your profit of Rs 3 anyway.
For example, if the price is Rs 270, you will make a profit of Rs 20 on selling
your Cash market Satyam and a loss of Rs 17 on buying back Satyam
futures. The net profit is Rs 3. On the other hand, if the price is Rs 225, you
make a loss of Rs 25 on selling Cash market Satyam and a profit of Rs 28 on
Satyam futures. The net profit remains Rs 3.
Your investment in this transaction will be Rs 250 on cash market Satyam
plus a margin of say 20% on Satyam futures (say Rs 50 approx). Thus an
investment of Rs 300 has generated a return of Rs 3 i.e. 1% per month or
12% per annum.
Now take a situation where only 15 days are left for expiry and you spot the
same opportunity as above. You will still generate Rs 3 which will translate
into a return of 2% per month or 24% per annum.
In this manner, you will generate returns whenever the futures prices are
above cash market prices.
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TRADERS/ PARTICIPANTS/ OPERATORS OF
FUTURE MARKETS
 HEDGER
 SPECULATOR
 ARBITRAGEURS
 SPREADERS
Future contracts are bought and sold buy large number of individuals,
business organizations, governments and others for variety of purposes.
The trader in the future market can be categorized on the basis of the
purposes for which they deal in the market.
Usually financial derivatives attract following types of traders as
under:
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 HEDGER
A Hedging is a position taken in futures or other markets for the purpose of
reducing exposure to one or more types of risk. A person who undertakes
such position is called as “Hedger”. In other words, a hedger uses future
markets to reduce risk caused by the movement in prices of securities,
commodities, exchange rate, interest rate, indices, etc. as such, a hedger
will take an opposite position to a perceived risk is called (hedging strategy
in future markets”. The essence of hedging strategy is the adoption of future
position that, on average, generates profits when the market value of the
commitment is higher than the expected value.
 SPECULATOR
A Speculator may be defined as investors who are willing to take a risk
by taking future position with the expectation to earn profits. The
speculators forecast the future economic condition and decide which
position (long and short) to be taken that will yield a profit if the forecast
is realized. In other words, Speculators are those who do not have any
position on which they enter in futures and options market. They only
have a particular view on the market, stock, commodity, etc. In short,
speculators put their money at risk in the hope of profiting from an
anticipated price change. They consider various factors such as demand,
supply, market positions, open interests, economic fundamentals and
other data to take their positions.
Illustration:
Speculators usually trade in the future markets to earn profits on
the basis of difference in spot and future prices of the underlying asset.
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Ram is a trader but has no time to track and analyze the stocks.
However, he fancies his chances in predicting the market trend. So
instead of buying different stocks, he buys SENSEX futures.
On May 1, 2001, he buys 100 SENSEX futures @ 3600 on the
expectations that the index will rise in future. On June 1, 2001, the
SENSEX rises to 4000 and at that time he sells an equal number of
contracts to close out his position.
Selling price : 4000 x 100 = Rs. 4,00,000
Less: Purchase Cost : 3600 x 100 = Rs 3,60,000
Net Gain Rs 40,000
Ram has made a profit of Rs 40,000 by taking a call on the
future value of the SENSEX. However if the SENSEX had fallen, he
would have made a loss. In Index futures, players can have a long-term
view of the market up to atleast 3 months….
 ARBITRAGEURS
Arbitrageurs are another important group of participants in the future
markets. An arbitrageur is a trader who attempts to make profits by
locking in a risk less trading by simultaneously entering into two or mare
markets. In other words arbitrageurs try to earn risk less profit from
discrepancies between future and spot prices and among future prices.
An arbitrageur is basically risk averse. He enters into those contracts
were he can earn risk less profits. When markets are imperfect, buying in
one market and simultaneously selling in other market gives risk less
profit. Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities
by buying from lower priced market and selling at the higher priced
market. In Index futures arbitrage is possible between the spot market
and the futures market (NSE has provided a special software for buying
all 50 Nifty stocks in the spot market).
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 Take the case of the NSE Nifty.
 Assume that Nifty is at 1200 and 3 month’s Nifty futures is at
1300.
 The futures price of Nifty futures can be worked out by taking
the interest cost of 3 months into account.
 If there is a difference then arbitrage opportunity exists.
Let us take the example of single stock to understand the concept better.
If Wipro is quoted at Rs 1000 per share and the 3 months futures of
Wipro is Rs 1070 then one can purchase ITC at Rs1000 in spot by
borrowing @ 12% annum for 3 months at Rs 1070.
Sale = 1070
Cost = 1000+30 = 1030
Arbitrage profit = 40
These kind of imperfections continue to exist in the markets but one has
to be altert to the opportunities as they tend to get exhausted very fast.
 SPREADERS
Spreading is a specific activity trading activity in which offsetting futures
position is involved by creating almost net position. So the spreads
believes in lower expected return but at the less risk. A successful
trading in spreading, the spreaders must forecast the relevant factors
which affect the changes in the spreads. Interest rate behaviour is an
important factor which causes changes in the spreads. In a profitable
spread position, normally, there is a large gain on one side of the spread
in comparison to the loss on the other side of the spread. In this way, a
spread reduces the risks even if the forecast is incorrect. On the other
hand, the pure speculators would make money by taking only the
profitable side of the market but at very high risk.
TYBBI 26

TYPES OF FUTURES
Futures contract are broadly divided into two types:
 COMMODITY FUTURES
 FINANCIAL FUTURES
COMMODITY FUTURES
TYBBI 27

A commodity futures is a contract in commodity like agricultural products,
metals & minerals etc. in organized commodity futures markets,
contractscontracts are standardized with standard quantities. Of course this
standard varies from commodity to commodity .they also have fixed delivery
dates in each month or a few months on a year.
In India commodity futures in agricultural products are popular.
Some of the well established commodity futures are as
follows:
1. London metal stock exchange (LME) to deal in gold
2. Chicago board of trade (CBT) to deal in soyabean oil
3. New York cotton exchange (CTN) to deal in cotton
4. Commodity exchange, NEW York (COMEX) to deal in agricultural
products
5. International petroleum exchange of London (IPE) to deal in crude oil
FINANCIAL FUTURES
The standardized features or specification make Futures tradable like a
contract. And since Futures are derivatives, the Futures contracts are based
on an underlying. It is the movement of the underlying that decides how the
Futures price will move.
There are only two possible trades with a futures contract – Buy or Sell. If
investor’s expectations for the underlying asset are bullish they should buy
futures. If the expectations prove to be correct, the futures contract will rise in
value allowing them to close out the position at a profit. If, on the other hand,
investors view the underlying asset as bearish, then they should sell the
futures contract. If the view is correct, they will be able to buy back the futures
at a lower price than they were sold for, the difference being the profit they
have made. Index Futures contracts can be used to take a view on the
directions of the overall market with the added advantage of gearing.
TYBBI 28

For example, lets take the underlying asset on SENSEX. If you believe the
SENSEX will rise you can buy the futures contract (by going long on the
SENSEX futures) or if you believe the SENSEX will fall, you can sell the
SENSEX futures (by going short on the SENSEX futures).
Financial Derivatives like futures do not generally terminate in delivery. Most
positions are closed out before expiry. So if investor, “A” had bought two
SENSEX futures contracts giving them a long position, then he is required to
sell two SENSEX futures, which will result in the investor having a short
position. This will mean that as far as the Clearing House is concerned the
investor is both long and short of two contracts.
 Sell it back into the market (If he is long)
 Buy it back from the market (If he is short)
These two positions are then filed away together netting one off with the
other. Not only this will result in the investors having no outstanding position
in the futures, but will also enable investors either to realize their profits or
reduce their losses.
TYPES OF FINANCIAL FUTURE
1) INTEREST RATE FUTURE CONTRACT:
It is one of the important financial future instruments in the world. Future
trading on interest bearing securities started only in 1975, but growth in the
market has been tremendous. Important interest bearing securities are like
treasury bills, notes, bonds, debenture, euro dollar time deposits and
municipal bonds. In this market almost entire ranges of maturities bearing
securities are traded.
TYBBI 29

For eg: Three month maturity instruments like treasury bills & , including
foreign debt instruments at CME, British govt. bond at London International .
financial future exchange (LIFFE), Japanese govt. bond at CBOT etc. are
traded.
2) FOREIGN CURRENCY FUTURE CONTRACT:
This financial future , as the name indicates, trade in Foreign currencies , thus
known as exchange rate futures . active future trading in certain currencies
started in the early 1970s. Important Foreign currencies in which this future
contract are made are US $ ,Pound sterling, Yen French Francs etc. these
contracs have directly corresponding to spot market, known as inter bank
foreign currency market , and also have a parallel inter bank foreign market.
Normally this contracts are used for hedging purpose by the exporters,
importers, bankers, financial institutions and large companies.
3) STOCK INDEX FUTURE:
A futures contract is a standardized contract to buy or sell a specific
security at a future date at an agreed price.
An index future is, as the name suggests, a future on the index i.e. the
underlying is the index itself. There is no underlying security or a stock,
which is to be delivered to fulfill the obligations as index futures are cash
settled. As other derivatives, the contract derives its value from the
underlying index. The underlying indices in this case will be the various
eligible indices and as permitted by the Regulator from time to.
CONTRACT SPECIFICATIONS OF SENSEX FUTURES
Features SENSEX Futures
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Underlying index BSE sensitive index (SENSEX)
Contract Multiplier 50
Tick size or minimum price
difference
0.1 index point or Rs. 5
Last trading day/expiration day Last Thursday of the expiration month. If it
happens to be a holiday, the contract will expire
on the previous day.
Contract months 3 contracts of 30, 60 and 90 days maturity. Thus,
at any point of time, there will be 3 contracts
available for trading
Daily settlement price Closing price of the futures contract.
Final settlement price Closing price of the cash index on the expiry date
of the futures contract.
4) STOCK FUTURE CONTRACT
A stock futures contract is a standardized contract to buy or sell a specific
stock at a future date at an agreed price. A stock future is, as the name
suggests, a future on a stock i.e. the underlying is a stock. The contract
derives its value from the underlying stock. Single stock futures are cash
settled.
CONTRACT SPECIFICATIONS OF STOCK FUTURES
TYBBI 31

Features Stock Futures
Underlying Stock Respective Stock (Annexure)
Contract Multiplier Varies from Stock to Stock (Annexure)
Tick size or minimum price difference -
Last trading day/expiration day
Last Thursday of the expiration month.
If it happens to be a holiday, the
contract will expire on the previous
day.
Contract months
3 contracts of 30, 60 and 90 days
maturity. Thus, at any point of time,
there will be 3 contracts available for
trading
Daily settlement price Closing price of the futures contract.
Final settlement price
Closing price of the underlying scrip on
the expiry date of the futures contract.
PAYOFF
A payoff is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. This is generally depicted in the
form of payoff diagrams which show the price of the underlying asset on the
X–axis and the profits/losses on the Y–axis.
TYBBI 32

PAYOFF FOR FUTURES
Futures contracts have linear payoffs. In simple words, it means that the
losses as well as profits for the buyer and the seller of a futures contract are
unlimited.
These linear payoffs are fascinating as they can be combined with options
and the underlying to generate various complex payoffs.
PAYOFF FOR BUYER OF FUTURES: LONG FUTURES
The payoff for a person who buys a futures contract is similar to the payoff for
a person who holds an asset. He has a potentially unlimited upside as well as
a potentially unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures
contract when the Nifty stands at 1220. The underlying asset in this case is
the Nifty portfolio. When the index moves up, the long futures position starts
making profits, and when the index moves down it starts making losses.
Figure 1 shows the payoff diagram for the buyer of a futures contract.
PAYOFF FOR A BUYER OF NIFTY FUTURES
The figure shows the profits/losses for a long futures position. The investor
bought futures when the index was at 1220. If the index goes up, his futures
position starts making profit. If the index falls, his futures position starts
showing losses.
Profit
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1220
0 Nifty
Loss
( FIGURE 1)
PAYOFF FOR SELLER OF FUTURES: SHORT
FUTURES
The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has a potentially unlimited upside as well as
a potentially unlimited downside. Take the case of a speculator who sells a
two-month Nifty index futures contract when the Nifty stands at 1220. The
underlying asset in this case is the Nifty portfolio. When the index moves
down, the short futures position starts making profits, and when the index
TYBBI 34

moves up, it starts making losses. Figure 2 shows the payoff diagram for the
seller of a futures contract.
PAYOFF FOR A SELLER OF NIFTY FUTURES
The figure shows the profits/losses for a short futures position. The investor
sold futures when the index was at 1220. If the index goes down, his futures
position starts making profit. If the index rises, his futures position starts
showing losses.
Profit
1220
0 Nifty
Loss
(FIGURE 2)
FORWARD V/S FUTURE
TYBBI 35

OPTIONS
Option is a security that represents the right, but not the obligation, to buy
or sell a specified amount of an underlying security (stock, bond, futures
contract, etc.) at a specified price within a specified time. Option Holder is
the buyer of either a call or put option. Option Writer is the seller of either
a call or put option.
TYBBI 36
Features Forward
Contract
Future Contract
Operational
Mechanism
Not traded on
exchange
Traded directly
between 2 parties.
Traded on exchange
Contract
Specifications
Differs from trade to
trade.
Contracts are standardized
contracts.
Counter party
Risk
Exists Exists, but assumed by Clearing
Corporation/ house.
Liquidation
Profile
Poor Liquidity as
contracts are tailor
maid contracts.
Very high Liquidity as contracts are
standardized contracts.
Price Discovery Poor; as markets are
fragmented.
Better; as fragmented markets are
brought to the common platform.
Examples Currency market in
India
Index, Stock& commodity futures

Options are different from futures in many ways. Not only both the
instrument have separate payoff profiles but also Options have host of
parameters that affect their pricing compared to just expectations and time
in the case of Futures pricing. The risk return profile of options is different
from futures.
Options unlike futures are also concerned with speed of the trend and not
just the underlying trend. This makes them a little more complex than
Futures, but then it's this inbuilt complexity in them that also makes them
more versatile instruments. With Options traders can play non - directional
strategies i.e. strategies which will make money for you no matter whether
markets move up, down or remain sideways. Even Directional strategies
can be implemented using Options. Just like Futures there can be an
underlying view even in Options, a view to buy or a view to sell. But the
buyer pays up an upfront premium to protect himself if his view is
incorrect. The seller on the other hand though is playing on a view wants
to be the one to book an upfront premium, as a trade off against a
possible loss. The seller gets paid only because he is providing the hedge
to the long positions at his own risk.
Options can be categorized as call and put options. The option, which
gives the buyer a right to buy the underlying asset, is called Call option
and the option, which gives the buyer a right to sell the underlying asset,
is called Put option. Options are instruments that give the buyer a right
and the seller an obligation. However, a buyer can buy a right to buy or
right to sell an underlying security. The writer on the other hand charges a
premium to fulfil both these obligations. We will discuss this at length later.
Long option (a call or a put) position has no downside risk as his loss is
protected to the premium he pays whereas a seller (of a call or put) aka
writer can suffer an unlimited loss if the market moves against him.
There are four basic payoffs that an option has a long call, a short call, a
long put and a short put. The four payoffs or as we call them strategies
TYBBI 37

are discussed later. These are the basic four payoffs are at the heart of
the Option theory.
HISTORY OF OPTIONS
Although options have existed for a long time, they were traded OTC, without
much knowledge of valuation. Today exchange-traded options are actively
traded on stocks, stock indexes, foreign currencies and futures contracts. The
first trading in options began in Europe and the US as early as the eighteenth
century. It was only in the early 1900s that a group of firms set up 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 firm would then attempt to find a seller or writer of the option either from
its own clients or 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. It was in 1973, that 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 options
developed so rapidly that by early ’80s, the number of shares underlying the
option contract sold each day exceeded the daily volume of shares traded on
the NYSE. Since then, there has been no looking back.
OPTION TERMINOLOGY
• Index options: These options have the index as the underlying. Some
options are European while others are American. Like index futures
contracts, index options contracts are also cash settled.
TYBBI 38

• Stock options: Stock options are options on 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.
• Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his option
on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives
the option premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him. There are two basic types of options, call options and
put options. Call option: A call option gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price. Put option:
A put option gives the holder the right but not the obligation to sell an asset
by a certain date for a certain price.
• Option price: Option price is the price which the option buyer pays to the
option seller.
• Expiration date: The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
• American options: American options are options that can be exercised at
any time upto the expiration date. Most exchange-traded options are
American.
• European options: 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.
• In-the-money option: An in-the-money (ITM) option is an option that
would lead to a positive cashflow 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
price > strike price). If the index is much higher than the strike price, the
TYBBI 39

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 cashflow if it were 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 a negative cashflow it it were 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 an option: 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. Putting it another way, the intrinsic value of a call
isN½P which means the intrinsic value of a call is Max [0, (St – K)] which
means the intrinsic value of a call is the (St – K). Similarly, the intrinsic
value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the
strike price and St is the spot price.
• Time value of an option: The time value of an option is the difference
between its premium and its intrinsic value. A call 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 a call’s time value,
all else equal. At expiration, a call should have no time value. 1
TYPES OF OPTIONS
 Call option
 Put option
1
TYBBI 40

CALL OPTION
Call Options give the buyer the right to buy a specified underlying at a set
price on or before a particular date.
For example, Satyam 260 Feb Call Option gives the Buyer the right to buy
Satyam at a price of Rs 60 per share on or before the last Thursday of
February. The price of 260 in the above example is called the strike price or
the exercise price.
Call Options are also called teji in the Indian markets.
PUT OPTION
Put Options give the buyer the right to sell a specified underlying at a set price
on or before a particular date.
For example, Satyam 260 Feb Put Option gives the Buyer the right to sell
Satyam at a price of Rs 260 per share on or before the last Thursday of
February.
Put Options are also called mandi in the Indian markets.
OPTIONS CLASSIFICATIONS
Options are often classified as:
 In the money - These result in a positive cash flow towards the investor
TYBBI 41

 At the money - These result in a zero-cash flow to the investor
 Out of money - These result in a negative cash flow for the investor
'IN THE MONEY','AT THE MONEY'& ‘OUT OF THE MONEY'
OPTIONS.
 OPTION:
An option is said to be 'at-the-money', when the option's strike price is
equal to the underlying asset price. This is true for both puts and calls.
 CALL OPTION:
A call option is said to be ‘in the money’ when the strike price of the
option is less than the underlying asset price.
For example: A Sensex call option with strike of 3900 is 'in-the-money',
when the spot Sensex is at 4100 as the call option has value. The call
option holder has the right to buy a Sensex at 3900, no matter by what
amount the spot price exceeded the strike price. With the spot price at 4100,
selling Sensex at this higher price can make a profit.
On the other hand, a call option is out-of-the-money when the strike price
is greater than the underlying asset price. Using the earlier example of
Sensex call option, if the Sensex falls to 3700, the call option no longer has
positive exercise value. The call holder will not exercise the option to buy
Sensex at 3900 when the current price is at 3700 and allow his ‘option’ right
to lapse.
 PUT OPTION :
A put option is in-the-money when the strike price of the option is greater
than the spot price of the underlying asset.
For example, a Sensex put at strike of 4400 is in-the-money when the
Sensex is at 4100. When this is the case, the put option has value because
TYBBI 42

the put option holder can sell the Sensex at 4400, an amount greater than
the current Sensex of 4100.
Likewise, a put option is out-of-the-money when the strike price is less than
the spot price of underlying asset. In the above example, the buyer of
Sensex put option won't exercise the option when the spot is at 4800. The
put no longer has positive exercise value and therefore in this scenario, the
put option holder Will allow his ‘option’ right to lapse.
CALL OPTION PUT OPTION
In-the-
money
Strike price < Spot price
of underlying asset
Strike price > Spot price
of underlying asset
At-the-
money
Strike price = Spot price
of underlying asset
Strike price = Spot price
Of underlying asset
Out-of-the-
money
Strike price > Spot price
of underlying asset
Strike price < Spot price
Of underlying asset
AMERICAN & EUROPEAN OPTION
There are two kind of options based on the date.
The first is the European Option, which can be exercised only on the
maturity date. The second is the American Option, which can be exercised
before or on the maturity date.
TYBBI 43

American and European Exercise Style of Options
American and European are primarily natures of exercise or settlement of
Options. American Options can be Exercised anytime prior to the the
expiration date. European options in the other hand can only be exercised
at the Expiration day. Indian stock options have the American Exercise
settlement while Index Options can only be settles at Expiration.
In India, both styles are available. Index Options are European style, while
individual stock options are American style.
EXCHANGE TRADE AND OTC – TRADE OPTIONS:-
The option can be traded like other financial assets either on an
organized exchange or on the over-the counter (OTC) market. Exchange
option contracts, like future contracts are traded on the recognized
exchanges. On the other hand, over the counter (OTC) option are customer
TYBBI 44

tailored agreement sold directly by the dealer rather than through the
organized exchange. The terms and conditions of these contracts are
negotiated by the parties to the contracts. Both the option has have different
mechanism of functioning, which are discussed here as under:
• Exchange traded option like futures contracts, are standardized and
are traded on organized (or government designated) exchanges. On
the other hand, the OTC options are written on the counters of the
large commercial and investment bankers.
• Exchange traded option have certain specified norms relating to
quantity, maturity date, underlying assets, etc. which are determined by
the exchanges how ever in the case of OTC option all such terms are
subject to negotiation and mutually determined by buyer and seller of
the option contracts.
• Being standardize in nature an option contract traded through the
recognized exchange has uniform underlying assets, limited no of
strike prices, limited expiration dates and so on.
• Exchange traded option are performed and cleared through a clearing
house corporation which interposes it self as a thirty party to the all
options contracts.
Since, these options are guaranteed by the exchanges, hence default
risks is almost eliminated.
• On buying an option contracts from a recognized exchange, the
obligation can be fulfilled in one of the three ways which are
mentioned as follows:
TYBBI 45

1. The option buyer may not exercise the current, allowing the option
to expire. The entire premium is retained by the seller and seller’s
obligation is discharged.
2. In case of the parties to the option, the buyer can exercise his right
on or before the expiration date.
3. Either of the parties to the option contract can execute an offsetting
transaction in the option market to eliminate the obligation.
THE UNDERLYING ASSET IN EXCHANGE TRADED
OPTION
Various assets , which are actively traded on recognized exchanges are
stocks, stocks indices, foreign currencies and future contract .
TYBBI 46

These are explained as follows.
1. Stocks options
2. Stocks indices,
3. Foreign currencies
4. Futures Option
5. Interest rate Option
1. STOCKS OPTIONS:
Options on Individual Stocks are options contracts where the underlyings
are individual stocks. Based on eligibility criteria and subject to the approval
from the regulator, stocks are selected on which options are introduced.
These contracts are cash settled and are American style.
Trading on standardized call option on equity shares started in 1973 on
CBOE where as on Put option began in 1977. Stock options are most
popular asset , which are traded on various exchanges all over the world. In
India, NSE and BSE have started option trading in certain stock from the
year 2001.
CONTRACT SPECIFICATIONS OF STOCK OPTIONS
Underlying: Individual scrip
TYBBI 47

Contract Multiplier: As specified
Ticker Symbol: As specified
Strike Prices: minimum of 5 strikes (2 in the money, 1 near the money, 2
Out of the money).
Premium Quotation: Rupees per share.
Last Trading Day: Last Thursday of the month. If it is a holiday than the
preceding business day.
Expiration Day: Last Thursday of contract month. If it is a holiday than the
preceding business day.
Note: Business day is a day during which the underlying stock market is
open for trading
Contract Month: 1, 2 and 3 months
Exercise Style: American.
Settlement Style: Cash
Trading Hours: 9:30 A.M. to 3:30 P.M.
Tick Size: 0.01
TYBBI 48

2. INDEX OPTION.
Many different index options are currently traded on the different exchanges in
different countries. For ex .S$P 100 index at CBOE and major index at AMEX
are traded in the US option markets. Similarly, in India, such index option has
been started on national stock exchange and Bombay stock exchange. Like
stock option, index options strike prices are the index value at which the buyer
of the option can buy or sell the underlying stock index. The strike index is
converted into dollar (rupee) value by multiplying the strike index by the
multiple for the contract.
If the buyer of the stock index option indented to exercise the option then the
stock must be delivered. It would be complicated settle a stock index option
by delivering all the stock that makes the particular index. If the option is
exercise, the stock exchange assigned option writer pays cash to the option
buyer, and there will no delivery of any share.
The money value of the stock index underlying an index option is equal to the
current cash index value multiplied by the contracts multiplied.
Rupees value of the underlying index = cash index value x contract multiplies
3. FOREIGN CURRENCIES OPTION.
Foreign currencies is another important assets, which is traded on varies
stock exchanges. Foreign exchange option has traded on the Philadelphia
stock exchange since 1984. Major currencies traded in the option markets are
TYBBI 49

us dollar, Australian dollar, British pounds, Canadian dollar, German mark,
French franc, Japanese yen, Swiss franc, etc.
Call option gives the owner the right to buy stated amount of foreign exchange
at strike rate. The strike price is itself exchange rate. Foreign currencies puts
give the owner the right to sell foreign exchange at strike prices. The
exchange traded currency option market is quit liquid.
4. FUTURE OPTION.
In the future option (or option on futures), the underlying assets is a future
contract at a designated price at a time during life of the options. If the future
option is call option, the buyer has the right to acquire a long future position.
Similarly, a put option on a future contract grants the buyer the right.
5. INTEREST RATE OPTION.
Interest rate options are another important option contract, which are popular
in the international financial markets. Interest rate option can be written on
cash instrument or future. These are various debt instruments which are used
as underlying instrument for interest rate option in different exchanges. These
contracts are referred as option on physicals. Recently, these instrument rate
option have also gained popularity on the over the – counter markets like on
treasury bounds, agency debentures, large banking firms, and mortgage -
backed – securities
OPTIONS PAY OFFS
The optionality characteristic of options results in a non-linear payoff for
options. In simple words, it means that the losses for the buyer of an option
are limited, however the profits are potentially unlimited. For a writer, the
TYBBI 50

payoff is exactly the opposite. His profits are limited to the option premium,
however his losses are potentially unlimited.
These non-linear payoffs are fascinating as they lend themselves to be used
to generate various payoffs by using combinations of options and the
underlying.
PAYOFF PROFILE FOR BUYER OF CALL OPTIONS:
LONG CALL
A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the
option depends on the spot price of the underlying. If upon expiration, the spot
price exceeds the strike price, he makes a profit. Higher the spot price, more
is the profit he makes. If the spot price of the underlying is less than the strike
price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option. Figure 3 gives off for the buyer of a
three month call option (often referred to as long call) with a strike of 1250
bought at a premium of 86.60.
PAY OFF FOR BUYER OF CALL OPTION
The figure shows the profits/losses for the buyer of a three-month Nifty 1250
call option. As can be seen, as the spot Nifty rises, the call option is in-the-
money. If upon expiration, Nifty closes above the strike of 1250, the buyer
would exercise his option and profit to the extent of the difference between the
TYBBI 51

Nifty-close and the strike price. The profits possible on this option are
potentially unlimited. However if Nifty falls below the strike of 1250, he lets the
option expire. His losses are limited to the extent of the premium he paid for
buying the option.
Profit
1250
0 Nifty
86.60
Loss
( FIGURE 3 )
PAYOFF PROFILE FOR WRITER OF CALL OPTIONS:
SHORT CALL
A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer’s profit is
the seller’s loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer. Hence as the spot price increases
the writer of the option starts making losses. Higher the spot price, more is the
loss he makes. If upon expiration the spot price of the underlying is less than
the strike price, the buyer lets his option expire un-exercised and the writer
gets to keep the premium. Figure 4 gives for the writer of a three month call
option (often referred to as short call) with a strike of 1250 sold at a premium
of 86.60.
PAYOFF FOR WRITER OF CALL OPTIONS
TYBBI 52

The figure shows the profits/losses for the seller of a three-month Nifty 1250
call option. As the spot Nifty rises, the call option is in-the-money and the
writer starts making losses. If upon expiration, Nifty closes above the strike of
1250, the buyer would exercise his option on the writer who would suffer a
loss to the extent of the difference between the Nifty-close and the strike
price. The loss that can be incurred by the writer of the option is potentially
unlimited, whereas the maximum profit is limited to the extent of the up-front
option premium of Rs.86.60 charged by him.
Profit
Profit
86.60
1250
0 Nifty
Loss
(FIGURE 4)
PAYOFF PROFILE FOR BUYER OF PUT OPTIONS:
LONG PUT
A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the
option depends on the spot price of the underlying. If upon expiration, the spot
price is below the strike price, he makes a profit. Lower the spot price, more is
the profit he makes. If the spot price of the underlying is higher than the strike
TYBBI 53

price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option. Figure 5gives the payoff for the buyer
of a three-month put option (often referred to as long put) with a strike of 1250
bought at a premium of 61.70.
PAYOFF FOR BUYER OF PUT OPTIONS
The figure shows the profits/losses for the buyer of a three-month Nifty 1250
put option. As can be seen, as the spot Nifty falls, the put option is in-the-
money. If upon expiration, Nifty closes below the strike of 1250, the buyer
would exercise his option and profit to the extent of the difference between the
strike price and Nifty-close. The profits possible on this option can be as high
as the strike price. However if Nifty rises above the strike of 1250, he lets the
option expire. His losses are limited to the extent of the premium he paid for
buying the option.
Profit
1250
0 Nifty
61.70
Loss
( FIGURE 5 )
PAYOFF PROFILE FOR WRITER OF PUT OPTIONS:
SHORT PUT
A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer’s profit is
TYBBI 54

the seller’s loss. If upon expiration, the spot price happens to be below the
strike price, the buyer will exercise the option on the writer. If upon expiration
the spot price of the underlying is more than the strike price, the buyer lets his
option expire un-exercised and the writer gets to keep the premium. Figure
6gives the payoff for the writer of a three-month put option (often referred to
as short put) with a strike of 1250 sold at a premium of 61.70.
PAYOFF FOR WRITER OF PUT OPTIONS
The figure shows the profits/losses for the seller of a three-month Nifty 1250
put option. As the spot Nifty falls, the put option is in-the-money and the writer
starts making losses . If upon expiration, Nifty closes below the strike of 1250,
the buyer would exercise his option on the writer who would suffer a loss to
the extent of the difference between the strike price and Nifty-close. The loss
that can be incurred by the writer of the option is a maximum extent of the
strike price(Since the worst that can happen is that the asset price can fall to
zero) whereas the maximum profit is limited to the extent of the up-front option
premium of Rs.61.70 charged by him.
Profit
61.70
1250
0 Nifty
Loss
( FIGURE 6 )
FUTURE V/S OPTIONS
Long
Futures
Short
Futures
Long
Call
Short Call Long Put Short Put
TYBBI 55

Trader’s
rights and
obligation
s
Right and
obligation
to buy
Right and
obligation
to sell
Right but
not the
obligation
to buy
Obligation
to deliver
Right but
not the
obligation
to sell
Obligation
to buy
Premium
paid or
received
- - Paid Received Paid Received
Margin
requireme
nt
Yes Yes None Yes None Yes
Risk (loss)
Unlimited
in case of
a decline
in prices
Unlimited
in case
prices
rise.
Loss and
risk
limited to
the
premium
paid
upfront.
Unlimited
in case
prices rise
Loss and
risk limited
to the
premium
paid
upfront
Unlimited
in case of a
decline in
prices
Return
(Profit)
Unlimited,
if prices
rise
Unlimited
in case of
a decline
in prices
Unlimited
in case
prices
rise
Return
limited the
premium
received
upfront
Unlimited,
in case
prices
decline
Return
limited to
the extent
of the
premium
received
upfront
WHAT ARE SWAPS?
A contract between two parties, referred to as counterparties, to exchange
two streams of payments for agreed period of time. The payments, commonly
called legs or sides, are calculated based on the underlying notional using
TYBBI 56

applicable rates. Swaps contracts also include other provisional specified by
the counterparties. Swaps are not debt instrument to raise capital, but a tool
used for financial management. Swaps are arranged in many different
currencies and different periods of time. US$ swaps are most common
followed by Japanese yen, sterling and Deutsche marks. The length of past
swaps transacted has ranged from 2 to 25 years.
WHY DID SWAPS EMERGE?
In the late 1970's, the first currency swap was engineered to circumvent the
currency control imposed in the UK. A tax was levied on overseas
investments to discourage capital outflows. Therefore, a British company
could not transfer funds overseas in order to expand its foreign operations
without paying sizeable penalty. Moreover, this British company had to take
an additional currency risks arising from servicing a sterling debt with foreign
currency cash flows. To overcome such a predicament, back-to-back loans
were used to exchange debts in different currencies. For example, a British
company wanting to raise capital in the France would raise the capital in the
UK and exchange its obligations with a French company, which was in a
reciprocal position. Though this type of arrangement was providing relief from
existing protections, one could imagine, the task of locating companies with
matching needs was quite difficult in as much as the cost of such transactions
was high. In addition, back-to-back loans required drafting multiple loan
agreements to state respective loan obligations with clarity. However this type
of arrangement lead to development of more sophisticated swap market of
today.
TYPES OF SWAP
1) Currency swaps
TYBBI 57

Currency swaps can be defined as a legal agreement between two or more
parties to exchange interest obligation or interest receipts between two
different currencies. It involves three steps:
• Initial exchange of principal between the counter parties at an agreed upon
rate of exchange which is usually based on spot exchange rate. This
exchange is optional and its sole objective is to establish the quantum of
the respective principal amounts for the purpose for calculating the
ongoing payments of interest and to establish the principal amount to be
re-exchanged at the maturity of the swap.
• Ongoing exchange of interest at the rates agreed upon at the outset of the
transaction.
• Re-exchange of principal amount on maturity at the initial rate of
exchange.
This straight forward, three step process results in the effective transformation
of the debt raised in one currency into a fully hedged liability in other currency.
2) Interest Rate Swap
An Interest Rate Swap (IRS) is a financial contract between two parties
exchanging or swapping a stream of interest payments for a notional principal
amount of multiple occasions on specified periods. Accordingly, on each
payment date that occurs during the swap period-Cash payments based on
fixed/floating and floating rates are made by the parties to one another.
3) Debt – Equity Swap
In Debt – Equity Swap , a firm buy a counter debt on the secondary loan
market at a discount & Swap it into local eqyuity . in other words , the debt’s
are exchanged for equity by one firm with another.
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA
TYBBI 58

The first step towards introduction of derivatives trading in India was the
promulgation of options in securities. The market for derivatives, however, did
not take off, as there was no regulatory framework to govern trading of
derivatives. SEBI set up a 24–member committee under the Chairmanship of
Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its report
on March 17, 1998 prescribing necessary pre–conditions for introduction of
derivatives trading in India. The committee recommended that derivatives
should be declared as ‘securities’ so that regulatory framework applicable to
trading of ‘securities ’ could also govern trading of securities. SEBI also set up
a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives mark et in India. The
report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker
net worth, deposit requirement and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December
1999 to include derivatives within the ambit of ‘securities’ and the regulatory
framework was developed for governing derivatives trading. The act also
made it clear that derivatives shall be legal and valid only if such contracts are
traded on a recognized stock exchange, thus precluding OTC derivatives. The
government also rescinded in March 2000, the three– decade old notification,
which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2001. SEBI permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved
derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was
followed by approval for trading in options based on these two indexes and
options on individual securities.
TYBBI 59

The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001. The
derivatives trading on 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 July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures
and options contract on NSE are based on S&P CNX.
Trading and settlement in derivative contracts is done in accordance with the
rules, byelaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.
INDIAN DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments
in India gained momentum in the last few years due to liberalisation process
TYBBI 60

and Reserve Bank of India’s (RBI) efforts in creating currency forward market.
Derivatives are an integral part of liberalisation process to manage risk. NSE
gauging the market requirements initiated the process of setting up derivative
markets in India. In July 1999, derivatives trading commenced in India.
CHRONOLOGY OF INSTRUMENTS
1991 Liberalisation process initiated
14 December
1995
NSE asked SEBI for permission to trade index futures.
18 November
1996
SEBI setup L.C.Gupta Committee to draft a policy framework
for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements
(FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an
Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures
trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September
2000
Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
CONCLUSION
This project conclude that derivatives are powerful and innovative product
which transfer the risk from those who do not want to take it at a price to those
who are capable of and expert in managing risk. Hedger, Speculator and
Arbitrageurs are the people who are prepared to deal wIth the risk.
TYBBI 61

Financial institution are very sensitive to the risk exposer measures so they
look Forward to derivatives market and use various innovative products like
Forward, Future, Options and Swaps.
Indian derivatives market is strongly routed through the stock exchanges and
commodities market derivatives. Future traders deal through the stock
exchanges in a standardize manner. NSE India is the Pioneer of derivatives
product in India.
Derivatives are important tools which help in growth of Indian Capital Markets.
SEBI on time to time issue various guidelines to all the dealers of derivatives
to bring transparency in the working.
TYBBI 62

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