Deriv basics

BASICS OF
DERIVATIVES

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BASICS OF DERIVATIVES

CONTENTS

FOREWORD ...................................................................................................................... 3

1.INTRODUCTION.......................................................................................................... 5

2. FUTURES .................................................................................................................... 11

3. OPTIONS..................................................................................................................... 26

4. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 40

5. RISK MANAGEMENT IN DERIVATIVES............................................................ 50

6. SETTLEMENT OF DERIVATIVES ........................................................................ 52

7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 57

8. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58

ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63

ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72

ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74

ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75

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Foreword

New ideas and innovations have always been the hallmark of progress made by

mankind. At every stage of development, there have been two core factors that

drives man to ideas and innovation. These are increasing returns and reducing

risk, in all facets of life.

The financial markets are no different. The endeavor has always been to

maximize returns and minimize risk. A lot of innovation goes into developing

financial products centered on these two factors. It has spawned a whole new

area called financial engineering.

Derivatives are among the forefront of the innovations in the financial markets

and aim to increase returns and reduce risk. They provide an outlet for investors

to protect themselves from the vagaries of the financial markets. These

instruments have been very popular with investors all over the world.

Indian financial markets have been on the ascension and catching up with global

standards in financial markets. The advent of screen based trading,

dematerialization, rolling settlement have put our markets on par with

international markets.

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As a logical step to the above progress, derivative trading was introduced in the

country in June 2000. Starting with index futures, we have made rapid strides

and have four types of derivative products- Index future, index option, stock

future and stock options. Today, there are 30 stocks on which one can have

futures and options, apart from the index futures and options.

This market presents a tremendous opportunity for individual investors .The

markets have performed smoothly over the last two years and has stabilized. The

time is ripe for investors to make full use of the advantage offered by this market.

We have tried to present in a lucid and simple manner, the derivatives market, so

that the individual investor is educated and equipped to become a dominant

player in the market.

Editorial Team

July 11, 2002

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1.Introduction

What are derivatives?

A derivative is a financial instrument that derives its value from an underlying

asset. This underlying asset can be stocks, bonds, currency, commodities,

metals and even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor,

collars etc. The most popular derivative instruments are futures and options.

There are newer derivatives that are becoming popular like weather derivatives

and natural calamity derivatives. These are used as a hedge against any

untoward happenings because of natural causes.

What exactly is meant by “ derives its value from an asset”?

What the phrase means is that the derivative on its own does not have any value.

It is considered important because of the importance of the underlying. When we

say an Infosys future or an Infosys option, these carry a value only because of

the value of Infosys.

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What are financial derivatives?

Financial derivatives are instruments that derive their value from financial assets.

These assets can be stocks, bonds, currency etc. These derivatives can be

forward rate agreements, futures, options swaps etc. As stated earlier, the most

traded instruments are futures and options.

What kind of people will use derivatives?

Derivatives will find use for the following set of people:

• Speculators: People who buy or sell in the market to make profits. For

example, if you will the stock price of Reliance is expected to go upto Rs.400

in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make

profits

• Hedgers: People who buy or sell to minimize their losses. For example, an

importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50

/$ from Rs 48/$, then the importer can minimize his losses by buying a

currency future at Rs 49/$

• Arbitrageurs: People who buy or sell to make money on price differentials in

different markets. For example, a futures price is simply the current price plus

the interest cost. If there is any change in the interest, it presents an arbitrage

opportunity. We will examine this in detail when we look at futures in a

separate chapter.

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Basically, every investor assumes one or more of the above roles and derivatives

are a very good option for him.

How has this market developed over time?

Derivatives have been a recent development in the Indian financial markets. But

there have been derivatives in the commodities market. There is Cotton and

Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,

Coffee futures in Bangalore etc. But the players in these markets are restricted to

big farmers and industries, who need these as an input to protect themselves

from the vagaries of agriculture sector.

Globally too, the first derivatives started with the commodities, way back in 1894.

Financial derivatives are a relatively late development, coming into existence

only in the 1970’s. The first exchange where derivatives were traded is the

Chicago Board of Trade (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE)

in June 2000. The first derivatives were index futures. The index used was Nifty.

Option trading was started in June 2001, for index as well as stocks. In

November 2001, futures on stocks were allowed. Currently, there are 30 stocks

on which derivative trading is allowed.

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The 30 stocks on which trading is allowed currently are:

Name of the Scrip Lot Size

ACC 1500

Bajaj Auto 800

BHEL 1200

BPCL 1100

BSES 1100

Cipla 200

Digital Global Soft 400

Dr Reddy Laboratories 400

Grasim 700

Gujarat Ambuja 1100

Hindalco 300

Hindustan Lever 1000

HPCL 1300

HDFC 300

Infosys 100

ITC 300

L&T 1000

MTNL 1600

M&M 2500

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Ranbaxy 500

Reliance Industries 600

Reliance Petroleum 4300

Satyam Computers 1200

SBI 1000

Sterlite Opticals 600

TELCO 3300

TISCO 1800

Tata Power 1600

Tata Tea 1100

VSNL 700

NIFTY 200

SENSEX 50

The trading is done on the exchange in the F&O (Futures and Option) segment.

Index F&O is also traded in the market. The indices traded are the Nifty and the

Sensex.

Since we have talked of hedging, can we compare derivatives to

insurance?

You buy a life insurance policy and pay a premium to the insurance agent for a

fixed term as agreed in the policy. In case you survive, you are happy and the

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insurance company is happy. In case you don’t survive, your relatives are happy

as the insurance company pays them the amount for which you are insured.

Insurance is nothing but transfer of risk. An insurance company sells you risk

cover and buys your risk and you sell your risk and buy a risk cover. The risk

involved in life insurance is the death of the policyholder. The insurance

companies bet on your surviving and hence agree to sell a risk cover for some

premium.

There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,

a derivative instrument can be compared to insurance, as there is a transfer of

risk at a financial cost.

Derivatives also work well on the concept of mutual insurance. In mutual

insurance, two people having opposite risks can enter into a contract and reduce

their risk. The most classic example is that of an importer and exporter. An

importer buys goods from country A and has to pay in dollars in 3 months. An

exporter sells goods to country A and has to receive payment in dollars in 3

months. In case of an importer, the risk is of exchange rate moving up. In case of

an exporter, the risk is of exchange rate moving down. They can cover each

others risk by entering into a forward rate after 3 months.

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2. Futures

Future, as the name indicates, is a trade whose settlement is going to take place

in the future. However, before we take a look at futures, it will be beneficial for us

to take a look at forward rate agreements

What is a forward rate agreement

A forward rate agreement is one in which a buyer and a seller enter into a

contract at a specified quantity of an asset at a specified price on a specified

date.

An example for this is the exporters getting into forward rate agreements on

currencies with banks.

But there is always a risk of one of the parties defaulting. The buyer may not pay

up or the seller may not be able to deliver. There may not be any redressal for

the aggrieved party as this is a negotiated contract between two parties.

What is a future?

A future is similar to a forward rate agreement, except that it is not a negotiated

contracted but a standard instrument.

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

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

change many hands before final settlement is made.

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

exchange involved in between, and the exchange guarantees each trade, the

buyer or seller does not get affected with the opposite party defaulting.

Futures Forwards

Futures are traded on a stock Forwards are non tradable, negotiated

exchange instruments

Futures are contracts having standard Forwards are contracts customized by

terms and conditions the buyer and seller

No default risk as the exchange High risk of default by either party

provides a counter guarantee

Exit route is provided because of high No exit route for these contracts

liquidity on the stock exchange

Highly regulated with strong margining No such systems are present in a

and surveillance systems forward market.

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There are two kinds of futures traded in the market- index futures and stock

futures.

There are three types of futures, based on the tenure. They are 1, 2 or 3 month

future. They are also known as near and far futures depending on the tenure.

What are Index futures

Index futures are futures contract on the index itself. One can buy a 1, 2 or 3-

month index future. If someone wants to take a call on the index, then index

futures are the ideal instruments for him.

Let us try and understand what an index is. An index is a set of numbers that

represent a change over a period of time.

A stock index is similarly a number that gives a relative measure of the stocks

that constitute the index. Each stock will have a different weight in the index

The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.

For example, Nifty was formed in 1995 and given a base value of 1000. The

value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000

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was invested in the stocks that form in the index, in the same proportion in which

they are weighted in the index, then Rs 1000 would have become Rs 1172 today.

There are two popular methods of computing the index. They are price weighted

method like Dow Jones Industrial Average (DJIA) or the market capitalization

method like Nifty or Sensex.

What the terminologies used in a Futures contract?

The terminologies used in a futures contract are:

• Spot Price: The current market price of the scrip/index

• Future Price: The price at which the futures contract trades in the futures

market

• Tenure: The period for which the future is traded

• Expiry date: The date on which the futures contract will be settlec

• Basis : The difference between the spot price and the future price

Why are index futures more popular than stock futures?

Globally, it has been observed that index futures are more popular as compared

to stock futures. This is because the index future is a relatively low risk product

compared to a stock future. It is easier to manipulate prices for individual stocks

but very difficult to manipulate the whole index. Besides, the index is less volatile

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as compared to individual stocks and can be better predicted than individual

stock.

How is the future price arrived at?

Future price is nothing but the current market price plus the interest cost for the

tenure of the future.

This interest cost of the future is called as cost of carry.

If F is the future price, S is the spot price and C is the cost of carry or opportunity

cost, then

F=S+C

F = S + Interest cost, since cost of carry for a finance is the interest cost

Thus,

F=S (1+r)T

Where r is the rate of interest and T is the tenure of the futures contract.

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The rate of interest is usually the risk free market rate.

Example 2.1:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will

be the price of one-month future?

Solution

The price of a future is F= S (1+r)T

The one-month Reliance future would be the spot price plus the cost of carry.

Since the bank rate is 10 %, we can take that as the market rate. This rate is an

annualized rate and hence we recalculate it on a monthly basis.

F=300(1+0.10)(1/12)

F= Rs 302.39

Example 2.2:

The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys

is Rs 3100. The returns expected from the Gsec funds for the same period is 10

%. Is the future of Infosys overpriced or underpriced?

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Solution

The 1 month Future of Infosys will be

F= 3000(1+.0.10) (1/12)

F= Rs 3023.90

But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs

76.

What happens if dividend is going to be declared?

Dividend is an income to the seller of the future. It reduces his cost of carry to

that extent. If dividend is going to be declared, the same has to be deducted from

the cost of carry

Thus the price of the future in this case becomes,

F= S (1+r-d) T

Where d is the dividend.

Example 2.3:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will

be the price of one-month future? Reliance will be paying a dividend of 50 paise

per share

Solution:

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Since Reliance is paying 50 paise per share and the face value of reliance is Rs

10, the dividend rate is 5%.

So while calculating futures,

F=300(1+0.10-0.05) (1/12)

F= Rs. 301.22

What happens if dividend is declared after buying a future?

If the dividend is declared after buying a one month future, the cost of carry will

be reduced by a pro rata amount. For example, if there is a one month future

ending June 30th and dividend is declared on June 15th, then dividend benefit will

be reduced from the cost of carry for 15 days.

Since the seller is holding the shares and will transfer the shares to the buyer

only after a month, the dividend benefit goes to the seller. The seller will enjoy

the benefit to the extent of interest on dividend.

Thus net cost of carry = cost of carry – dividend benefits

Example 2.4:

The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance

declares a dividend of 5%. What will be the price of one-month future?

Solution:

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The benefit accrued due to the dividend will be reduced from the cost of the

future.

One month future will be priced at

F= 300(1+0.10) (1/12)

F = 302.39

Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39

The interest benefit of the dividend is available for 15 days, ie 0.5 months.

Dividend for 15 days = 300(1+0.05) (0.5/12)

Dividend Benefit = Rs300.61- Rs 300= Rs0.61

Therefore, net cost of the carry is,

Rs2.39-Rs0.61 = Rs 1.78

Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78

In practice, the market discounts the dividend and the prices are automatically

adjusted. The exchange steps into the picture if the dividend declared is more

than 10 % of the market price. In such cases, there is an official change in the

price. In other cases, the market does the adjustment on its own.

What happens in case a bonus/ stock split is declared on the stock in

which I have a futures position?

If a bonus is declared, the settlement price is adjusted to reflect the bonus. For

example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the

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position becomes 400 Reliance at Rs 150 so that the contract value is

unaffected.

But is the Future really traded in this way in the market?

What has been discussed above is the theoretical way of arriving at the future

price. This can be used as a base for calculation future price

But the actual market price that we see on the trading screen depends on

liquidity too. So the prices that we observe in real world are also a function of

demand-supply position in that stock.

How do future prices behave compared to spot prices?

Future vs Spot

30
20 Future Price
Price

10 Spot Price
0
1 2 3 4 5 6 7
Tim e

Future prices lead the spot prices. The spot prices move towards the future

prices and the gap between the two is always closing with as the time to

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settlement decreases. On the last day of the future settlement, the spot price

equals the future price.

Is the futures price always higher than the spot price?

The futures price can be lower than the spot price too. This depends on the

fundamentals of the stock. If the stock is not expected to perform well and the

market takes a bearish view on them, then the futures price can be lower than

the spot price.

Future prices can fall also due to declaration of dividend.

What happens in case of index futures?

In case of index futures, the treatment of the futures calculation is the same. The

future value is calculated as the spot index value plus the cost of carry.

What happens if I buy an index future and there is a dividend declared on a

stock that comprises the index?

Practically speaking, the index is corrected for these things in case there is a

dividend declared for such a stock.

Theoretically, dividend is adjusted in the following manner:

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1.The contribution of the stock to the index is calculated. The index, as discussed

earlier, is a market capitalization index.

2. Then the number of shares in the index is calculated. This is obtained by

dividing the contribution to the index by the market price.

3. The dividend on the index is the dividend on the number of shares of the stock

in the index.

4. The interest earned on the dividend is calculated and reduced from the cost of

carry to obtain the net cost of carry.

Example 2.5:

The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL

contributes to 15 % of the index. The market price of HLL is Rs 150. What will be

the cost of the 1 month future if the bank rate is 10%?

Solution:

The future will be priced at

F= 1000(1+0.10)(1/12)

F= 1008

The weight of HLL in the index is 15% ie 0.15*1000=150.

The market price of HLL is Rs 150

Therefore, the number of shares of HLL in the index=1

The dividend earned on this is Rs 5

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Dividend benefit on Rs 5 is 5(1+0.10) (1/12)

Dividend benefit = Rs 0.04

Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95

But in practice, the market discounts the dividends and price adjustment is made

accordingly.

All that is okay in theory, but what happens in the real world?

In the real world, derivatives are highly volatile instruments and there have been

lot of losses in the various financial markets. The classic examples have been

Long Term Capital Markets (LTCM) and Barings. We will examine what

happened exactly at various places later in the book.

As a result, the regulators have decided that a minimum of Rs 2 lacs should be

the contract size. This is done primarily to keep the small investors away from a

volatile market till enough experience and understanding of the markets is

acquired. So the initial players are institutions and high net worth individuals who

have a risk taking capacity in these markets.

Because of this minimum amount, lots are decided on the market price such that

the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in

case of Sensex, 50.

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Similarly minimum lots are decided for individual stocks too. Thus you will find

different stock futures having different market lots. The lots decided for each

stock was such that the contract value was Rs 2 lacs. This was at the point of

introduction of these instruments. However the lot size has remained the same

and has not been adjusted for the price changes. Hence the value of the contract

may be slightly lower in case of certain stocks.

Trading, i.e. Buying and Selling take place in the same manner as the stock

markets. There will be an F & O terminal with the broker and the dealer will enter

the orders for you.

Another fact of the real world is that, since the future is a standard instrument,

you can close out your position at any point of time and need not hold till

maturity.

How is the trading done on the exchange?

Buying of futures is margin based. You pay an up front margin and take a

position in the stock of your choice. Your daily losses/ gains relative to the future

price will be monitored and you will have to pay a mark to market margin. On the

final day settlement is made in cash and is the difference between the futures

price and the spot price prevailing at that time

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For example, if the future price is Rs 300 and the spot price is Rs 330, then you

will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a

cash loss of Rs 10. Thus futures market is a cash market.

In future, there is a possibility that the futures may result in delivery. In such a

scenario, the future market will be merged with the spot market on the expiration

day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

How does the mark to market mechanism work?

Mark to market is a mechanism devised by the stock exchange to minimize risk.

In case you start making losses in your position, exchange collects money to the

extent of the losses up front. For example, if you buy futures at Rs 300 and its

price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This

is over and above the margin money that you pay to take a position in the future.

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3. Options

What are options?

As seen earlier, futures are derivative instruments where one can take a position

for an asset to be delivered at a future date. But there is also an obligation as the

seller has to make delivery and buyer has to take delivery.

Options are one better than futures. In option, as the name indicates, gives one

party the option to take or make delivery. But this option is given to only one

party in the transaction while the other party has an obligation to take or make

delivery. The asset can be a stock, bond, index, currency or a commodity

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

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

premium.

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

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

Thus we have seen an option is a derivative that gives one party a right and the

other party an obligation to buy /sell at a specified price for a specified quantity.

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

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

the premium.

For example, a railway ticket is an option in daily life. Using the ticket, a

passenger has an option to travel. In case he decides not to travel, he can cancel

the ticket and get a refund. But he has to pay a cancellation fee, which is

analogous to the premium paid in an option contract. The railways, on the other

hand, have an obligation to carry the passenger if he decides to travel and refund

his money if he decides not to travel. In case the passenger decides to travel, the

railways get the ticket fare. In case he does not, they get the cancellation fee.

The passenger on the other hand, by booking a ticket, has hedged his position in

case he has to travel as anticipated. In case the travel does not materialize, he

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can get out of the position by canceling the ticket at a cost, which is the

cancellation fee.

But I hear a lot of jargons about options? What are all these jargons?

There are some basic terminologies used in options. These are universal

terminologies and mean the same everywhere.

a. Option holder : The buyer of the option who gets the right

b. Option writer : The seller of the option who carries the obligation

c. Premium: The consideration paid by the buyer for the right

d. Exercise price: The price at which the option holder has the right to buy or

sell. It is also called as the strike price.

e. Call option: The option that gives the holder a right to buy

f. Put option : The option that gives the holder a right to sell

g. Tenure: The period for which the option is issued

h. Expiration date: The date on which the option is to be settled

i. American option: These are options that can be exercised at any point till the

expiration date

j. European option: These are options that can be exercised only on the

expiration date

k. Covered option: An option that an option writer sells when he has the

underlying shares with him.

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l. Naked option: An option that an option writer sells when he does not have the

underlying shares with him

m. In the money: An option is in the money if the option holder is making a profit

if the option was exercised immediately

n. Out of money: An option is in the money if the option holder is making a loss

if the option was exercised immediately

o. At the money: An option is in the money if the option holder evens out if the

option was exercised immediately

How is money made in an option?

The money made in an option is called as the option pay off. There can be two

pay off for options, for put and call option

Call option:

A call option gives the holder a right to buy shares. The option holder will make

money if the spot price is higher than the strike price. The pay off assumes that

the option holder will buy at the strike price and sell immediately at the spot price.

But if the spot price is lower than the strike, the option holder can simply ignore

the option. It will be cheaper to buy from the market. The option holder loss is to

the extent of premium he has paid.

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But if the spot price increases dramatically then he can make wind fall profits.

Thus the profits for an option holder in a call option is unlimited while losses are

capped to the extent of the premium.

Conversely, for the writer, the maximum profit he can make is the premium

amount. But the losses he can make are unlimited.

Put option

The put option gives the right to sell. The option holder will make money if the

spot price is lower than the strike price. The pay off assumes that the option

holder will buy at spot price and sell at the strike price

But if the spot price is higher than the strike, the option holder can simply ignore

the option. It will be beneficial to sell to the market. The option holder loss is to

the extent of premium he has paid.

But if the spot prices falls dramatically then he can make wind fall profits.

Thus the profits for an option holder in a put option is unlimited while losses are

capped to the extent of the premium. This is a theoretical fallacy as the maximum

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fall a stock can have is till zero, and hence the profit of a option holder in a put

option is capped.

Conversely, the maximum profit that an option writer can make in this case is the

premium amount.

But in the above pay off, we had ignored certain costs like premium and

brokerage. These are also important, especially the premium.

So, in a call option for the option holder to make money, the spot price has to be

more than the strike price plus the premium amount.

If the spot is more than the strike price but less than the sum of strike price and

premium, the option holder can minimize losses but cannot make profits by

exercising the option.

Similarly, for a put option, the option holder makes money if spot is less than the

strike price less the premium amount.

If the spot is less than the strike price but more than the strike price less

premium, the option holder can minimize losses but cannot make profits by

exercising the option.

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Example 3.1:

The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What

will be the profit for the option holder if the spot price touches a) Rs. 350 b)337

Solution

a. The option holder can buy Reliance at a price of Rs 330.

He has also paid a premium of Rs 10 for the same. So his cost of a share of

Reliance is Rs 340.

He can sell the same in the spot market for Rs 350.

He makes a profit of Rs 10

b. The option holder can buy Reliance at a price of Rs 330.

He has also paid a premium of Rs 10 for the same. So his cost of a share of

Reliance is Rs 340.

He can sell the same in the spot market for Rs 337

He makes a loss of Rs 3.

But he has reduced his losses by exercising the option. Had he not exercised the

option, he would have made a loss of Rs 10, which is the premium that he paid

for the option.

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But should one always buy an option? The buyer seems to enjoy all

advantages, then why should one write an option?

This is not always the case. The writer of the option too can make money.

Basically, the option writers and option holders are people who are taking a

divergent view on the market. So if the option writer feels the markets will be

bearish, he can write call options and pocket the premium. In case the market

falls, the option holder will not exercise the option and the entire premium amount

can be a profit

But if the option writer is bullish on the market, then he can write put options. In

case the market goes up, the option holder will not exercise the option and the

premium amount is a profit for the option writer.

The other area that an option writer makes money is the spot price lying in the

range between the strike price and the strike plus premium

For example, if you write a call option on Reliance for a strike price of Rs 300 at a

premium of Rs 30. If the spot price is Rs 320, then the option holder will exercise

the option to reduce losses and buy it at Rs 300. But you have already got the

premium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs

10 above the spot price! This profit increases even more if you calculate the

opportunity cost of Rs 30 as this amount is received up front.

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Let us look at a typical pay off table for a call option, for the buyer as well as

writer. Let us assume a call option with a strike price of Rs 200 and a premium of

Rs 10

Table 3.1: Pay off Table for buyer and writer of an option

Spot Price Whether Buyer’s Writer Net

Exercised gain/loss gain/loss

180 No -10 +10 0

190 No -10 +10 0

195 No -10 +10 0

200(=Strike Yes/No -10 +10 0

Price)

205 Yes -5 +5 0

210 Yes 0 0 0

220 Yes +10 -10 0

In the above pay off table, if we take 200 as the median value, we see that the

writer has made money 5 out of 7 occasions. He has made money even when

the option is exercised, as long as the spot price is below the strike price plus the

premium.

Thus writers also make money on options, as the buyer is not at an advantage all

the time.

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What are the options that are currently traded in the market?

The options that are currently traded in the market are index options and stock

options on the 30 stocks. The index options are European options. They are

settled on the last day. The stock options are American options.

There are 3 options-1, 2,3 month options. There can be a series of option within

the above time span at different strike prices.

Another lingo in option is Near and Far options. A near option means the option

is closer to expiration date. A Far option means the option is farther from

expiration date. A 1 month option is a near option while a 3 month option is a far

option.

In option trading, what gets quoted in the exchange is the premium and all that

people buy and sell is the premium.

We said we could have different option series at various strike prices. How

is this strike price arrived at?

The strike price bands are specified by the exchange. This band is dependent on

the market price.

Market Price Rs. Strike Price Intervals Rs.

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<50 2.5

50-150 5

150-250 10

250-500 20

500-1000 30

>1000 50

Thus if a stock is trading at Rs. 100 then there can be options with strike price of

Rs 105,110,115, 95, 90 etc.

How is the premium of an option calculated?

In practice, it is the market that decides the premium at which an option is traded.

There are mathematical models, which are used to calculate the premium of an

option.

The simplest tool is the expected value concept. For example, for a stock that is

quoting at Rs 95. There is a 20 % probability that it will become Rs 110. There is

a 30 % probability that it will become Rs 105. There is 30% probability that the

stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.

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If the strike price of a call option is to be Rs 100, then the option will have value

when the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs

90.

If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively.

The expected returns for the above distribution is

0.20*15+0.30*10=Rs 6.

Thus this the price that one can pay as a premium for a strike price of Rs 100 for

a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the

option holder this opportunity.

This is a very simple thumb calculation. Even then, one would require a lot of

background data like variances and expected price movements.

There are more advanced probabilistic models like the Black Scholes model and

the Binomial Pricing model that calculates the options. One need not go deep

into those and it would suffice to say that option calculators are readily available.

Please visit www.indiainfoline.com/stok/ to use an option calculator based on

Black Scholes Model. The Black Scholes Model is presented in greater detail in

Annexure-3.

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I keep reading about option Greeks? What are they? They actually sound

like Greek and Latin to me.

There are something called as option Greeks but they are nothing to be scared

of. The option Greeks help in tracking the volatility of option prices.

The option Greeks are

a. Delta: Delta measures the change in option price (the premium) to the change

in underlying. A delta of 0.5 means if the underlying changes by 100 % the

option price changes by 50 %.

b. Theta: It measures the change in option price to change in time

c. Rho: It is the change in option price to change in interest rate

d. Vega: It is the change in option price to change in variance of the underlying

stock

e. Gamma: It is the change in delta to the change in the underlying. It is a

double derivative (the mathematical one) of the option price with respect to

underlying. It gives the rate of change of delta.

These are just technical tools used by the market players to analyze options and

the movement of the option prices.

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We saw that the stock options are American options and hence can be

exercised any time. What happens when one decided to exercise the

option?

When the option holder decides to exercise the option, the option will be

assigned to the option writer on a random basis, as decided by the software of

the exchange.

The European options are also the similarly decided by the software of the

exchange. The index options are European options.

In future, there is a possibility that the options may result in delivery. In such a

scenario, the option market will be merged with the spot market on the expiration

day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

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4. Trading Strategies using Futures and Options

So far, we have seen a lot of theoretical stuff on derivatives. But how is it

going to help me in practice?

There are a lot of practical uses of derivatives. As we have seen, derivatives can

be used for profits and hedging. We can use derivatives as a leverage tool too.

How do I use derivatives as a leverage?

You can use the derivatives market to raise funds using your stocks. Conversely,

you can also lend funds against stocks.

Does that mean derivatives are badla revisited?

The derivative product that comes closest to Badla is futures. Futures is not

badla, though a lot of people confuse it with badla. The fundamental difference is

badla consisted of contango and backwardation (undha badla and vyaj badla) in

the same market. Futures is a different market segment altogether. Hence

derivatives is not the same as badla, though it is similar.

How do I raise funds from the derivatives market?

This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You

have shares lying with you and are in urgent need of liquidity. Instead of pledging

your shares and borrowing from banks at a margin, you can sell the stock at Rs

40


3000. Suppose you need this liquidity only for a month and also do not want to

part with Infosys. You can buy a 1 month future at Rs 3050. After a month you

get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the

financing cost for the liquidity.

The other beauty about this is you have already locked in your purchase cost at

Rs 3050. This fixes your liquidity cost also and you are protected against further

price losses.

How do I lend into the market?

The lending into the market is exactly the reverse of borrowing. You have money

to lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000

and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs

3000 to the market for a month and earned Rs 100 on it.

Suppose I don’t want to lend/borrow money. I want to speculate and make

profits?

When you speculate, you normally take a view on the market, either bullish or

bearish. When you take a bullish view on the market, you can always sell futures

and buy in the spot market. If you take a bearish view on the market, you can buy

futures and sell in the spot market.

41


Similarly, in the options market, if you are bullish, you should buy call options. If

you are bearish, you should buy put options

Conversely, if you are bullish, you should write put options. This is so because, in

a bull market, there are lower chances of the put option being exercised and you

can profit from the premium

If you are bearish, you should write call options. This is so because, in a bear

market, there are lower chances of the call option being exercised and you can

profit from the premium

How can I arbitrage and make money in derivatives?

Arbitrage is making money on price differentials in different markets. For

example, future is nothing but the future value of the spot price. This future value

is obtained by factoring the interest rate.

But if there are differences in the money market and the interest rates change

then the future price should correct itself to factor the change in interest. But if

there is no factoring of this change then it presents an opportunity to make

money- an arbitrage opportunity.

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Let us take an example.

Example 4.1:

A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005.

The risk free interest rate is 12%. What should be the trading strategy?

Solution:

The strategy for trading should be : Sell Spot and Buy Futures

Sell the stock for Rs 1000. Buy the future at Rs 1005.

Invest the Rs1000 at 12 %. The interest earned on this stock will be

1000(1+.012)(1/12)

=1009

So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4

Thus one can make a risk less profit of Rs 4 because of arbitrage

But an important point is that this opportunity was available due to mis-pricing

and the market not correcting itself. Normally, the time taken for the market to

adjust to corrections is very less. So the time available for arbitrage is also less.

As everyone rushes to cash in on the arbitrage, the market corrects itself.

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How is a future useful for me to hedge my position?

One can hedge one’s position by taking an opposite position in the futures

market. For example, If you are buying in the spot price, the risk you carry is that

of prices falling in the future. You can lock this by selling in the futures price.

Even if the stock continues falling, your position is hedged as you have firmed

the price at which you are selling.

Similarly, you want to buy a stock at a later date but face the risk of prices rising.

You can hedge against this rise by buying futures.

You can use a combination of futures too to hedge yourself. There is always a

correlation between the index and individual stocks. This correlation may be

negative or positive, but there is a correlation. This is given by the beta of the

stock.

In simple terms, what β indicates is the change in the price of a stock to the

change in index. For example, if β of a stock is 0.8, it means that if the index

goes up by 10, the price of the stock goes up by 8. It will also fall by a similar

level when the index falls.

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A negative β means that the price of the stock falls when the index rises. So, if

you have a position in a stock, you can hedge the same by buying the index at β

times the value of the stock.

Example 4.2:

The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I

can hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.

Scenario 1

If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800

The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gain

of Rs 800.

Thus my net position is zero and I am perfectly hedged.

Scenario 2

If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800

But the value of the stock also falls by 8 %. The value of this stock becomes Rs

9200 a loss of Rs 800.

Thus my net position is zero and I am perfectly hedged.

But again, β is a predicted value based on regression models. Regression is

nothing but analysis of past data. So there is a chance that the above position

may not be fully hedged if the β does not behave as per the predicted value.

45


How do I use options in my trading strategy?

Options are a great tool to use for trading. If you feel the market will go up. You

should buy a call option at a level lower than what you expect the market to go

up.

If you think that the market will fall, you should buy a put option at a level higher

than the level to which you expect the market fall.

When we say market, we mean the index. The same strategy can be used for

individual stocks also.

A combination of futures and options can be used too, to make profits.

We have seen that the risk for an option holder is the premium amount. But

what should be the strategy for an option writer to cover himself?

An option writer can use a combination strategy of futures and options to protect

his position. The risk for an option writer arises only when the option is exercised.

This will be very clear with an example.

Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium

of Rs 20. The risk arises only when the option is exercised. The option will be

46


exercised when the price exceeds Rs 300. I start making a loss only after the

price exceeds Rs 320(Strike price plus premium).

More importantly, I have to deliver the stock to the opposite party. So to enable

me to deliver the stock to the other party and also make entire profit on premium,

I buy a future of Reliance at Rs 300.

This is just one leg of the risk. The earlier risk was of the call being exercised.

The risk now is that of the call not being exercised. In case the call is not

exercised, what do I do? I will have to take delivery as I have bought a future.

So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need to

pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully

covered and my net cash flow would be

Premium earned from selling call option : Rs 20

Premium paid to buy put option : (Rs 10)

Net cash flow : Rs 10

But the above pay off will be possible only when the premium I am paying for the

put option is lower than the premium that I get for writing the call.

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Similarly, we can arrive at a covered position for writing a put option too,

Another interesting observation is that the above strategy in itself presents an

opportunity to make money. This is so because of the premium differential in the

put and the call option. So if one tracks the derivative markets on a continuous

basis, one can chance upon almost risk less money making opportunities.

What are the other strategies using derivatives?

The other strategies are also various permutations of multiple puts, calls and

futures. They are also called by exotic names , but if one were to observe them

closely, they are relatively simple instruments.

Some of these instruments are:

• Butter fly spread: It is the strategy of simultaneous buying of put and call

• Calendar Spread - An option strategy in which a short-term option is sold and

a longer-term option is bought both having the same striking price. Either puts

or calls may be used.

• Double option – An option that gives the buyer the right to buy and/or sell a

futures contract, at a premium, at the strike price

• Straddle – The simultaneous purchase and sale of option of the same

specification to different periods.

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• Tandem Options – A sequence of options of the same type, with variable

strike price and period.

• Bermuda Option – Like the location of the Bermudas, this option is located

somewhere between a European style option which can be exercised only at

maturity and an American style option which can be exercised any time the

option holder chooses. This option can be exercisable only on predetermined

dates

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5. RISK MANAGEMENT IN DERIVATIVES

Derivatives are high-risk instruments and hence the exchanges have put up a lot

of measures to control this risk.

The most critical aspect of risk management is the daily monitoring of price and

position and the margining of those positions.

NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that

has origins at the Chicago Mercantile Exchange, one of the oldest derivative

exchanges in the world.

The objective of SPAN is to monitor the positions and determine the maximum

loss that a stock can incur in a single day. This loss is covered by the exchange

by imposing mark to market margins.

SPAN evaluates risk scenarios, which are nothing but market conditions.

The specific set of market conditions evaluated, are called the risk scenarios, and

these are defined in terms of:

(a) how much the price of the underlying instrument is expected to change over

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one trading day, and

(b) how much the volatility of that underlying price is expected to change over

one trading day.

Based on the SPAN measurement, margins are imposed and risk covered. Apart

from this, the exchange will have a minimum base capital of Rs 50 lacs and

brokers need to pay additional base capital if they need margins above the

permissible limits.

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6. SETTLEMENT OF DERIVATIVES

How are futures settled on the stock exchange?

Mark to market settlement

There is a daily settlement for Mark to Market .The profits/ losses are computed

as the difference between the trade price or the previous day’s settlement price,

as the case may be, and the current day’s settlement price. The party who have

suffered a loss are required to pay the mark-to-market loss amount to exchange

which is in turn passed on to the party who has made a profit. This is known as

daily mark-to-market settlement.

Theoretical daily settlement price for unexpired futures contracts, which are not

traded during the last half an hour on a day, is currently the price computed as

per the formula detailed below:

F = S * e rt

where :

F = theoretical futures price

S = value of the underlying index/ stock

r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)

t = time to expiration

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Rate of interest may be the relevant MIBOR rate or such other rate as may be

specified.

After daily settlement, all the open positions are reset to the daily settlement

price.

The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =

Trade day). The mark to market losses or profits are directly debited or credited

to the broker account from where the broker passes to the client account

Final Settlement

On the expiry of the futures contracts, exchange marks all positions to the final

settlement price and the resulting profit / loss is settled in cash.

The final settlement of the futures contracts is similar to the daily settlement

process except for the method of computation of final settlement price. The final

settlement profit / loss is computed as the difference between trade price or the

previous day’s settlement price, as the case may be, and the final settlement

price of the relevant futures contract.

Final settlement loss/ profit amount is debited/ credited to the relevant broker’s

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clearing bank account on T+1 day (T= expiry day). This is then passed on the

client from the broker. Open positions in futures contracts cease to exist after

their expiration day

How are options settled on the stock exchange?

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The

premium payable position and premium receivable positions are netted across all

option contracts for each broker at the client level to determine the net premium

payable or receivable amount, at the end of each day.

The brokers who have a premium payable position are required to pay the

premium amount to exchange which is in turn passed on to the members who

have a premium receivable position. This is known as daily premium settlement.

The brokers in turn would take this from their clients.

The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade

day). The premium payable amount and premium receivable amount are directly

debited or credited to the broker, from where it is passed on to the client.

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Interim Exercise Settlement for Options on Individual Securities

Interim exercise settlement for Option contracts on Individual Securities is

effected for valid exercised option positions at in-the-money strike prices, at the

close of the trading hours, on the day of exercise. Valid exercised option

contracts are assigned to short positions in option contracts with the same series,

on a random basis. The interim exercise settlement value is the difference

between the strike price and the settlement price of the relevant option contract.

Exercise settlement value is debited/ credited to the relevant broker account on

T+3 day (T= exercise date). From there it is passed on to the clients.

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike

prices existing at the close of trading hours, on the expiration day of an option

contract. Long positions at in-the money strike prices are automatically assigned

to short positions in option contracts with the same series, on a random basis.

For index options contracts, exercise style is European style, while for options

contracts on individual securities, exercise style is American style. Final Exercise

is Automatic on expiry of the option contracts.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts

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of the relevant broker with the respective Clearing Bank, from where it is passed

to the client.

Final settlement loss/ profit amount for option contracts on Index is debited/

credited to the relevant broker clearing bank account on T+1 day (T = expiry

day), from where it is passed

Final settlement loss/ profit amount for option contracts on Individual Securities is

debited/ credited to the relevant broker clearing bank account on T+3 day (T =

expiry day), from where it is passed

Open positions, in option contracts, cease to exist after their expiration day.

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7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES
Since derivatives are a highly risky market, as experience world over has shown,

there are tight regulatory controls in this market.

The same is true of India. In India, a committee was set up under Dr L C Gupta

to study the introduction of the derivatives market in India. The report of the LC

Gupta Committee is attached as Annexure-4.

This committee formulated the guidelines and framework for the derivatives

market and paved the way for the derivatives market in India.

There other committee that has far reaching implications in the derivatives

market is the J R Verma Committee. This committee has recommended norms

for trading in the exchange. A lot of emphasis has been laid on margining and

surveillance so as to provide a strong backbone in systems and processes and

ensure stringent controls in a risky market.

As for the taxation aspect, the CBDT is treating gains from derivative

transactions as profit from speculation. Similarly losses in derivative transactions

can be treated as speculation losses for tax purpose.

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8. CASE STUDY- When things go wrong!

In the earlier part, we saw how useful derivatives are as hedging and risk

management tools. However, derivatives do not come without their share of

problems and dangers. Derivatives are highly sophisticated instruments and

users with inadequate information and understanding expose themselves to all

the risks inherent in using derivatives. Spectacular losses have been made and

some companies have even come to the point of collapse after using derivative

instruments. Some examples of the unfortunate use of derivatives are:

• In 1994, American consumer products giant Procter and Gamble (P&G), lost

an estimated US$ 200 million on a complex interest rate Swap. The Swap

was intended to lower funding costs for P&G if interest rates moved in a

certain manner. However, the Swap turned out to be a sophisticated bet on

future interest rate changes. It was the result of speculation and lax controls.

The company ought not to have betted on interest rate changes. This case

can be viewed as a classic case of how not to use derivatives.

• Sumitomo lost 1.17 billion pounds on copper and copper derivative

instruments from 1995- 1996.

• NatWest Markets, in 1997,announced it had lost 77m pounds as a result of

mispriced interest rate Options and Swaps.

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• The German metals and services group, Metallgesellschaft, came to the

verge of destruction in 1994 after losses exceeding DM 2.3 billion on energy

derivatives.

• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei

Index contracts on the Singapore and Osaka Derivatives Exchanges,

ultimately leading to the bank’s near collapse in 1995. The main person

involved was Nick Leeson, the bank’s derivatives trader.

• In 1994, Orange County, USA’s richest local authority went bankrupt after

trading in high-risk derivatives. On the advice of Merrill Lynch, county

treasurer, Robert Citron invested the county’s assets in interest sensitive

derivatives. The market moved against him and the county faced losses of

around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange

County over US$ 400m rather than face trial, in a friendly agreement.

The above examples are enough to make any potential user of derivatives

apprehensive. However, the stories not told about derivatives represent the

majority of cases where derivatives effectively reduce risk. Today, almost all

large, non-financial organizations use financial derivatives and the number of

users is fast increasing. Derivatives are no different than the majority of modern

inventions: if used in a proper way they are powerful and, indeed valuable tools.

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In wrong hands, they can cause tremendous destruction as the above examples

testify. The function of a corporate financial officer is to reduce risk by using

derivatives and not to speculate. Yet, in any derivative disaster, an element of

speculation seems to be present. Another cause of losses is decisions taken by

people with inadequate knowledge and who do not fully understand the complex

structure of derivatives. Derivatives are highly complex instruments and are often

research-derived and computer generated. The case of the Orange County

derivatives amply demonstrates this. It is clear that the derivative products used

by the county treasurer were not fully comprehended by him.

Barings—What went wrong?

A careful study of the Barings case brings to light several issues. Extensive data

obtained by Singapore inspectors show that Nick Leeson lost 4.8m pounds

sterling between July and October 1992. Leeson covered all the losses by July

’93. But it appeared that Leeson recovered his losses by selling options in a way

that stored up trouble. He used a strategy called “Straddling”. Simply put, Leeson

traded in a way that he was severely exposed to the market movement and a

slight movement against him would lead to huge losses. After the Kobe

earthquake, the volatility of the Nikkei increased sharply and Leeson and

Barings’ were left facing huge losses.

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Leeson did not take the relatively small losses he would have made had he sold

the contracts when the market started to go against him, but waited in the hope

that the situation would reverse and he would make good the losses. But this

was not to be, and the rest, they say, is history.

What Leeson did was to engage in highly speculative trading. He primarily used

derivatives, not as risk mitigating instruments, but as means of earning

speculative profits. The downside risk was huge and the risk of losses was great.

Derivatives—irreplaceable tools or weapons of destruction?

Derivatives have acquired a myth of danger and mystery. One reason is the

sensational media coverage of the derivatives disasters. However, what often

escapes notice is that these disastrous transactions involve speculation

(intentional risks to make profits) or poor oversight. Derivative instruments, per

se, rarely, if ever, cause disasters. It is to be noted that most companies use

derivatives for risk reduction and only very few businesses with poor

management hurt themselves.

As explained earlier, derivative contracts can be geared to many times their

value. In other words, contracts, which may be worth millions, if the market

moves in a certain way, cost only a fraction of that value.

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Usually, the market will not move that much and the contract will be settled or

sold to somebody else for a small gain or loss. However, if it does shift

significantly, big losses can be incurred, which are magnified due to the gearing

effect.

Banks have complex computer programmes to tell them how much they could

lose if the market moves by a certain amount. Regulations require them to put

money aside to protect against possible losses.

On exchanges, traders have to pay any losses incurred on their position at the

end of each day. This "margin" payment is to prevent risks getting out of hand.

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ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES

1. Arbitrage - The simultaneous purchase and sale of a commodity or financial

instrument in different markets to take advantage of a price or exchange rate

discrepancy.

2. Backwardation – The price differential between spot and back months when

the nearby dates are at a premium. It is the opposite of ‘contango.’

3. Butterfly spread – The placing of two inter-delivery spreads in opposite

directions with the centre delivery month common to both. The perfect

butterfly spread would require no net premium paid.

4. Calendar Spread - An option strategy in which a short-term option is sold and

a longer-term option is bought both having the same striking price. Either puts

or calls may be used.

5. Call option – An option that gives the buyer right to buy a futures contract at a

premium, at the strike price.

6. Contango – The price differential between spot and back months when the

marking dates are at a discount. It is the opposite of ‘backwardation.’

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7. Currency swap – A swap in which the counterparties’ exchange equal

amounts of two currencies at the sot exchange rate.

8. Derivative – A derivative is an instrument whose value is derived from the

value of one or more underlying assets, which can be commodities, precious

metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the

trading of rights or obligations based on the underlying product, but do not

directly transfer property.

9. Double option – An option that gives the buyer the right to buy and/or sell a

futures contract, at a premium, at the strike price.

10. Futures contract – A legally binding agreement for the purchase and sale of a

commodity, index or financial instrument some time in the future.

11. Hedge fund – A large pool of private money and assets managed

aggressively and often riskily on any futures exchange, mostly for short-term

gain.

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12. In-the money option – An option with intrinsic value. A call option is in-the-

money if its strike price is below the current price of the underlying futures

contract and a put option is in-the-money if it is above the underlying.

13. Kerb trading - Trading by telephone or by other means that takes place after

the official market has closed. Originally it took place in the street on the kerb

outside the market.

14. Margin call – A demand from a clearing house to a clearing member or from a

broker to a customer to bring deposits up to a required minimum level to

guarantee performance at ruling prices.

15. Mark to market – A process of valuing an open position on a futures market

against the ruling price of the contract at that time, in order to determine the

size of the margin call.

16. Naked option – An option granted without any offsetting physical or cash

instrument for protection. Such activity can lead to unlimited losses.

17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock

at a set price on or before a given date. Investors who purchase call options

bet the stock will be worth more than the price set by the option (the strike

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price), plus the price they paid for the option itself. Buyers of put options bet

the stock's price will go down below the price set by the option.

18. Out-of-the money option – An option with no intrinsic value. A call option is

out-of-the money if its strike price is above the underlying and a put option is

so if its below the underlying.

19. Premium - The price of an option contract, determined on the exchange,

which the buyer of the option pays to the option writer for the rights to the

option contract.

20. Spread – The difference between the bid and asked prices in any market.

21. Stop-loss orders – An order placed in the market to buy or sell to close out an

open position in order to limit losses when the market moves the wrong way.

22. Straddle – The simultaneous purchase and sale of the same commodity to

different delivery months or different strategies.

23. Swap – An agreement to exchange one currency or index return for another,

the exchange of fixed interest payments for a floating rate payments or the

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exchange of an equity index return for a floating interest rate.

24. Underlying – The currency, commodity, security or any other instrument that

forms the basis of a futures or options contract.

25. Writer – The person who originates an option contract by promising to

perform a certain obligation in return for the price of the option. Also known as

Option Writer.

26. All-or nothing Option – An option with a fixed, predetermined payoff if the

underlying instrument is at or beyond the strike price at expiration.

27. Average Options - A path dependant option that calculates the average of the

path traversed by the asset, arithmetic or weighted. The payoff therefore is

the difference between the average price of the underlying asset, over the life

of the option, and the exercise price of the option.

28. Barrier Options - These are options that have an embedded price level,

(barrier), which if reached will either create a vanilla option or eliminate the

existence of a vanilla option. These are referred to as knock-ins/outs that are

further explained below. The existence of predetermined price barriers in an

option makes the probability of pay off all the more difficult. Thus the reason a

67


buyer purchases a barrier option is for the decreased cost and therefore

increased leverage.

29. Basket Option – A third party option or covered warrant on a basket of

underlying stocks, currencies or commodities.

30. Bermuda Option – Like the location of the Bermudas, this option is located

somewhere between a European style option which can be exercised only at

maturity and an American style option which can be exercised any time the

option holder chooses. This option can be exercisable only on predetermined

dates,

31. Compound Options - This is simply an option on an existing option such as a

call on a call, a put on a put etc, a call on a put etc.

32. Cross-Currency Option – An outperformance option struck at an exchange

rate between two currencies.

33. Digital Options - These are options that can be structured as a "one touch"

barrier, "double no touch" barrier and "all or nothing" call/puts. The "one

touch" digital provides an immediate payoff if the currency hits your selected

price barrier chosen at outset. The "double no touch" provides a payoff upon

68


expiration if the currency does not touch both the upper and lower price

barriers selected at the outset. The call/put "all or nothing" digital option

provides a payoff upon expiration if your option finishes in the money

34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii)

down and in. With knock-in options, the buyer starts out without a vanilla

option. If the buyer has selected an upper price barrier and the currency hits

that level, it creates a vanilla option with maturity date and strike price agreed

upon at the outset. This would be called an up and in. The down and in option

is the same as the up and in, except the currency has to reach a lower

barrier. Upon hitting the chosen lower price level, it creates a vanilla option.

35. Multi-Index Options – An outperformance option with a payoff determined by

the difference in performance of two or more indices.

36. Outperformance Option – An option with a payoff based on the amount by

which one of two underlying instruments or indices outperforms the other.

37. Rainbow Options - This type of option is a combination of two or more options

combined each with its own distinct strike, maturity, etc. In order to achieve a

payoff, all of the options entered into must be correct.

69


38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate

currency risk by effectively hedging it. It involves combining an equity option

and incorporating a predetermined fx rate. Example, if the holder has an in-

the-money Nikkei index call option upon expiration, the quanto option terms

would trigger by converting the yen proceeds into dollars which was specified

at the outset in the quanto option contract. The rate is agreed upon at the

beginning without the quantity of course, since this is an unknown at the time.

39. Secondary Currency Option – An option with a payoff in a different currency

than the underlying’s trading currency.

40. Swaption – An option to enter into a swap contract.

41. Tandem Options – A sequence of options of the same type, usually covering

non-overlapping time periods and often with variable strikes.

42. Up-and-Out Option – The call pays off early if an early exercise price trigger is

hit. The put expires worthless if the market price of the underlying risks is

above a pre-determined expiration price.

70


43. Zero Strike Price Option – An option with an exercise price of zero, or close to

zero, traded on exchanges where there is transfer tax, owner restriction or

other obstacle to the transfer of the underlying.

71


ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA

The derivatives market in India has rapidly grown and is fast becoming very

popular. It is offering an alternate source for people to deploy investible surplus

and make money out of it

The table below indicates the growth witnessed in the derivatives market.
Month/ Index Futures Stock Futures Index Options Stock Options
Year
No. of Turnover No. of Turnover Call Put Call Put
contracts (Rs. cr.) contracts (Rs. cr.)
No. of Notional No. of Notional No. of Notional No. of Notional
contracts Turnover contracts Turnover contracts Turnover contracts Turnover
(Rs. cr.) (Rs. cr.) (Rs. cr.) (Rs. cr.)
Jun.00 1,191 35 - - - - - - - - - -
Jul.00 3,783 108 - - - - - - - - - -
Aug.00 3,301 90 - - - - - - - - - -
Sep.00. 4,376 119 - - - - - - - - - -
Oct.00 6,388 153 - - - - - - - - - -
Nov.00 9,892 247 - - - - - - - - - -
Dec.003 9,208 237 - - - - - - - - - -
Jan.01 17,860 471 - - - - - - - - - -
Feb.01 19,141 524 - - - - - - - - - -
Mar.01 15,440 381 - - - - - - - - - -
00-01 90,580 2,365 - - - - - - - - - -
Apr.01 13,274 292 - - - - - - - - - -
May.01 10,048 230 - - - - - - - - - -
Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -
Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106
Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263
Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690
Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801
Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638
Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674
Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253
Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864
Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,094
01-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383
Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170
May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643
Source: www.nseindia.com

Note: 1.Stock futures were started only in November 2001

2.Index options and stock options were started only in June and July 2001 respectively

72


Growth of Derivatives in India

3000
Value Rs Crores

2500
2000
1500
1000
500
0
Jun.00

Jun.01
Aug.00

Aug.01
Feb.01

Feb.02
Dec.003

Apr.01

Apr.02
Oct.00

Oct.01
From June 2000 to May 2002 Dec.01

73


ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA

The options price for a Call, computed as per the following Black Scholes
formula:
C = S * N (d1) - X * e- rt * N (d2)

and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)

where :
d1 OQ6;

C = price of a call option
P = price of a put option
S = price of the underlying asset
X = Strike price of the option
r = rate of interest
t = time to expiration
1 YRODWLOLWRIWKHXQGHUOLQJ
N represents a standard normal distribution with mean = 0 and standard
deviation = 1
ln represents the natural logarithm of a number. Natural logarithms are based on
the constant e (2.718).

74


ANNEXURE 4- L C GUPTA COMMITTEE REPORT

EXECUTIVE SUMMARY

1. The Committee strongly favours the introduction of financial derivatives in order to

provide the facility for hedging in the most cost-efficient way against market risk. This is

an important economic purpose. At the same time, it recognises that in order to make

hedging possible, the market should also have speculators who are prepared to be

counter-parties to hedgers. A derivatives market wholly or mostly consisting of

speculators is unlikely to be a sound economic institution. A soundly based derivatives

market requires the presence of both hedgers and speculators.

2. The Committee is of the opinion that there is need for equity derivatives, interest rate

derivatives and currency derivatives. In the case of equity derivatives, while the

Committee believes that the type of derivatives contracts to be introduced will be

determined by market forces under the general oversight of SEBI and that both futures

and options will be needed, the Committee suggests that a beginning may be made with

stock index futures.

3. The Committee favours the introduction of equity derivatives in a phased manner so that

the complex types are introduced after the market participants have acquired some

degree of comfort and familiarity with the simpler types. This would be desirable from the

regulatory angle too.

4. The Committee's recommendations on regulatory framework for derivatives trading

envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main

emphasis is on exchange-level regulation by ensuring that the derivative exchanges

operate as effective self-regulatory organisations under the overall supervision of SEBI.

5. Since the Committee has placed considerable emphasis on the self-regulatory

competence of derivatives exchanges under the over-all supervision and guidance of

75


SEBI, it is necessary that SEBI should review the working of the governance system of

stock exchanges and strengthen it further. A much stricter governance system is needed

for the derivative exchanges in order to ensure that a derivative exchange will be a totally

disciplined market place.

6. The Committee is of the opinion that the entry requirements for brokers/dealers for

derivatives market have to be more stringent than for the cash market. These include not

only capital adequacy requirements but also knowledge requirements in the form of

mandatory passing of a certification program by the brokers/dealers and the sales

persons. An important regulatory aspect of derivatives trading is the strict regulation of

sales practices.

7. Many of the SEBI's important regulations relating to exchanges, brokers-dealers,

prevention of fraud, investor protection, etc., are of general and over-riding nature and

hence, these should be reviewed in detail in order to be applicable to derivatives

exchanges and their members.

8. The Committee has recommended that the regulatory prohibition on the use of

derivatives by mutual funds should go. At the same time, the Committee is of the opinion

that the use of derivatives by mutual funds should be only for hedging and portfolio

balancing and not for speculation. The responsibility for proper control in this regard

should be cast on the trustees of mutual funds. The Committee does not favour framing

of detailed SEBI regulations for this purpose in order to allow flexibility and development

of ideas.

9. SEBI, as the overseeing authority, will have to ensure that the new futures market

operates fairly, efficiently and on sound principles. The operation of the underlying cash

markets, on which the derivatives market is based, needs improvement in many respects.

The equity derivatives market and the equity cash market are parts of the equity market

mechanism as a whole.

76


10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic

Research Wing. It would need to develop a competence among its personnel in order to

be able to guide this new development along sound lines.

Chapter 1

THE EVOLUTION AND ECONOMIC PURPOSE

OF DERIVATIVES

Appointment of the Committee

1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by

a Board resolution dated November 18, 1996 in order to develop appropriate regulatory

framework for derivatives trading in India. List of the Committee members is shown in

the end

2. The Committee’s concern is with financial derivatives in general and equity derivatives in

particular.

The evolution of derivatives

3. The development of futures trading is an advancement over forward trading which has

existed for centuries and grew out of the need for hedging the price-risk involved in many

commercial operations. Futures trading represents a more efficient way of hedging risk.

Futures vs. Forward contracts

4. As both forward contracts and futures contracts are used for hedging, it is important to

understand the distinction between the two and their relative merits. Forward contracts

are private bilateral contracts and have well-established commercial usage. They are

exposed to default risk by counterparty. Each forward contract is unique in terms of

contract size, expiration date and the asset type/quality. The contract price is not

77


transparent, as it is not publicly disclosed. Since the forward contract is not typically

tradable, it has to be settled by delivery of the asset on the expiration date.

5. In contrast, futures contracts are standardized tradable contracts. They are standardized

in terms of size, expiration date and all other features. They are traded on specially

designed exchanges in a highly sophisticated environment of stringent financial

safeguards. They are liquid and transparent. Their market prices and trading volumes are

regularly reported. The futures trading system has effective safeguards against defaults

in the form of Clearing Corporation guarantees for trades and the daily cash adjustment

(mark-to-market) to the accounts of trading members based on daily price change.

Futures are far more cost-efficient than forward contracts for hedging.

6. Forward contracts are being used in India on a fairly large scale in the foreign exchange

market for covering currency risk but there are neither currency futures nor any other

financial futures in India at present. This report deals only with exchange-traded

derivatives. Over-the-Counter derivatives are not covered here.

A world-wide long-term process

7. The evolution of markets in commodities and financial assets may be viewed as a

worldwide long-term historical process. In this process, the emergence of futures has

been recognized in economic literature as a financial development of considerable

significance. A vast economic literature has been built around this subject. From

forward trading in commodities emerged the commodity futures. The emergence of

financial futures is a more recent phenomenon and represents an extension of the idea of

organized futures markets.

8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A.,

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

1982 only. Since then, financial futures have quickly spread to an increasing number of

developed and developing countries. They are recognized as the best and most cost-

efficient way of meeting the felt need for risk-hedging in certain types of commercial and

78

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