6. Risk Management of Portfolio – modify the risk
characteristics of a portfolio
Return Management of portfolio – enhance the
return of a portfolio
Cost Management of portfolio – reduce the costs
associated with portfolio management
Regulatory Management – achieve efficiency in
the presence of legal, tax, or regulatory obstacles
Role of Equity Derivatives
7. Over the last three decades, the derivatives market has seen
a phenomenal growth. A large
variety of derivative contracts have been launched at
exchanges across the world. Some of
the factors driving the growth of financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with
the international markets,
FACTORS DRIVING THE
GROWTH OF DERIVATIVES
8. 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
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.
9. Listed Market
• Traded on Exchanges
• Provide Exchange guarantee
• Options, Futures, Warrants
OTC (Over-the-counter) Market
• Traded directly between counterparties
• There is a credit/counterparty risk involved
• Product Types
• OTC Options, Forwards, Swaps
Equity Derivative Markets
11. Derivative contracts have several
variants. The most common variants
are forwards, futures, options and
swaps. We take a brief look at
various derivatives contracts that
have come to be used.
12. 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.
13. 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 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.
14. Contract between two parties (without any exchange between them)
Price decided today
Quantity decided today (can be based on convenience of the
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
Forwards have been used in the commodities market since
centuries. Forwards are also
widely used in the foreign exchange market.
The essential features of a forward
15. A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in
the future at a certain price. Futures contracts
are special types of forward contracts in the
sense that the former are standardized exchange-
16. Futures are similar to forwards in the sense that the
price is decided today and the delivery will take place
in future. But Futures are quoted on a stock
exchange. Prices are available to all those who want
to buy or sell because the trading takes place on a
transparent computer system.
17. Contract between two parties through an exchange
• Exchange is the legal counterparty 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
• 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
• 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
The essential features of a Futures contract
18. 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
19. An Option is a contract in which the seller of the
contract grants the buyer, the right to purchase from the
seller a designated instrument or an asset at a specific
price which is agreed upon at the time of entering into
the contract. It is important to note that the option buyer
has the right but not an obligation to buy or sell. if the
buyer decides to exercise his right the seller of the
option has an obligation to deliver or take delivery of the
underlying asset at the price agreed upon. Seller of the
option is also called the writer of the option.
20. Call Option
An option contract is called a ‘call option’, if the writer
gives the buyer of the option the right to purchase from
him the underlying asset.
Generic terms used in options
21. Put Option
An option contract is said to be a
‘put option,’ if the writer gives
the buyer of the option the right
to sell the underlying asset.
23. Strike Price
At the time of entering into the contract, the
parties agree upon a price at which the
underlying asset may be brought or sold. This
price is referred to as the exercise price or the
striking price. At this price, the buyer of a call
option can buy the asset from the seller and the
buyer of a put option can sell the asset to the
writer of the option. This is regardless of the
market price of the asset at the time of
24. Swaps: Swaps are private agreements between two parties to
exchange cash flows in the future according to a prearranged
formula. They can be regarded as portfolios of forward contracts.
The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the 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 cash flows in one direction being in a
different currency than those in the opposite direction.
25. The following three broad categories of participants –
hedgers, speculators, and arbitrageurs trade in the derivatives market.
Hedgers face risk associated with the price of an asset. They use futures
or options markets to reduce or eliminate this risk.
Speculators wish to bet on future movements in the price of an asset.
Futures and options contracts can give them an extra leverage; that is,
they can increase both the potential gains and potential losses in a
Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the
futures price of an asset getting out of line with the cash price, they will
take offsetting positions in the two markets to lock in a profit.
PARTICIPANTS IN THE
27. CONVERTIBLE BONDS
A bond that can be converted into a predetermined amount of the company's
equity at certain times during its life, usually at the discretion of the bondholder.
From the investor's perspective, a convertible bond has a value-added
component built into it; it is essentially a bond with a stock option hidden inside.
Thus, it tends to offer a lower rate of return in exchange for the value of the
option to trade the bond into stock.
28. A convertible bond issue, like that of other bonds, will state
the maturity and the coupon on the bond.
A convertible bond also has information about the conversion option,
or how many shares will be received for the bond if it is converted.
For example, take a convertible bond that sells for $1,000. It has an
annual coupon of 7% and can be converted into 100 shares at any
time. Each year, the bondholder will receive $70 ($1,000 x 7%) as
long as the bond has not been converted into shares.
If the bondholder were to convert the bond into shares, he or she
would no longer receive the coupon payment (interest), and the value
of the investment would move with the price of the stock.
29. Conversion price
Maturity / redemption date
Final conversion date
30. Call features: The ability of the issuer (on some bonds) to call a bond
early for redemption. This should not be mistaken for a call option. A Soft
call would refer to a call feature where the issuer can only call under
certain circumstances, typically based on the underlying stock price
performance (e.g. current stock price is above 130% of the conversion
price for 20 days out of 30 days). A Hard call feature would not need any
specific conditions beyond a date: that case the issuer would be able to
recall a portion or the totally of the issuance at the Call price (typically par)
after a specific date.
Put features: The ability of the holder of the bond (the lender) to force
the issuer (the borrower) to repay the loan at a date earlier than the
maturity. These often occur as windows of opportunity, every three or five
years and allow the holders to exercise their right to an early repayment.
31. Hedged/Arbitrage/Swap investors: Proprietary trading desk or
hedged-funds using as core strategy Convertible Arbitrage which
consists in, for its most basic iteration, as being long the convertible
bonds while being short the underlying stock.
Buying the convertible while selling the stock is often referred to as
being "on swap". Hedged investors would modulate their different risks
(e.g. Equity, Credit, Interest-Rate, Volatility, Currency) by putting in
place one or more hedge (e.g. Short Stock, CDS, Asset Swap, Option,
Long-only/Outright Investors: Convertible investors who will own the
bond for their asymmetric payoff profiles. They would typically be
exposed to the various risk. Please note that Global convertible funds
would typically hedged their currency risk as well as interest rate risk in
some occasions, however Volatility, Equity & Credit hedging would
typically be excluded from the scope of their strategy.
Convertible bond investors get split into two broad categories: Hedged and
32. Trading Clearing and Settlement
BOI Shareholding Ltd. a joint company between BSE and
Bank of India handles the
operations of funds and securities for the Exchange.
33. Funds settlement takes place through clearing banks.
For the purpose of settlement all clearing members are
required to open a separate bank account with BOISL
designated clearing bank for F&O segment.
The Clearing and Settlement process comprises of the
following three main activities:
34. The Derivatives Trading at BSE takes place through a
fully automated screen-based trading platform called
It generates trades by matching opposite orders, the
DTSS also generates various reports for the member
In case the order is not exhausted further matching
orders are searched for and trades generated till the order
gets exhausted or no more match-able orders are found
35. All orders have following attributes
• Order Type (Limit / Market PF/Market PC/ Stop Loss)
• Asset Code, Product Type, Maturity, Call/Put and Strike
• Buy/Sell Indicator
• Order Quantity
• Client Type (Proprietary / Institutional / Normal)
36. The clearing mechanism essentially involves working out
open positions and obligations of clearing members.
While entering orders on the trading system, TMs are
required to identify the orders, whether proprietary or client
Proprietary positions are calculated on net basis for each
Clients' positions are arrived at by summing together net
positions of each individual client.
A TM's open position is the sum of proprietary open position,
client open long position and client open short position.
37. All futures and options contracts are cash settled, i.e.
through exchange of cash
Futures and options on individual securities can be
delivered as in the spot market
39. A derivative security that gives the holder the
right to purchase securities (usually equity)
from the issuer at a specific price within a
certain time frame. Warrants are often
included in a new debt issue as a "sweetener"
to entice investors.
40. Call warrant
A call warrant represents a specific number of shares that
can be purchased from the issuer at a specific price, on
or before a certain date.
A put warrant represents a certain amount of equity that
can be sold back to the issuer at a specified price, on or
before a stated date.
Types of warrant….
41. 1. Warrant certificates have stated particulars regarding the
investment tool they represent. All warrants have a specified
expiry date, the last day the rights of a warrant can be
executed. Warrants are classified by their exercise style:
2. American warrant, for instance, can be exercised anytime
before or on the stated expiry date, and a
3. European warrant, on the other hand, can be carried out only
on the day of expiration.
Characteristics of a Warrant
42. The underlying instrument the warrant
represents is also stated on warrant
certificates. A warrant typically corresponds
to a specific number of shares, but it can
also represent a commodity, index or
43. Let's look at an example that illustrates one of the potential
benefits of warrants. Say that XYZ shares are currently priced
on the market for $1.50 per share. In order to purchase 1,000
shares, an investor would need $1,500. However, if the
investor opted to buy a warrant (representing one share) that
was going for $0.50 per warrant, he or she would be in
possession of 3,000 shares using the same $1,500.
Because the prices of warrants are low the leverage they
offer is high. This means that there is a potential for larger
capital gains and losses. While it is common for both a
share price and a warrant price to move in parallel
44. Like any other type of investment, warrants also have
their drawbacks and risks. As mentioned above, the
leverage and gearing warrants offer can be high. But
these can also work to the disadvantage of the investor.
A holder of a warrant does not have any voting,
shareholding or dividend rights. The investor can
therefore have no say in the functioning of the company,
even though he or she is affected by any decisions made.
45. LEAP – Long-term Equity
Offer options with longer maturities
Maturities range up to 39 months
Available on Stock and some Stock Indexes
46. Underlying – Stock or Index
Contract Size –
Equity – 100 Shares or ADRs
Index – Full or partial value of stock index
Equity – same as equity option
Index – based on the contract size
Equity – Shares
Index – Cash
Exercise Style – American or European
January expiration only – up to 39 months from the date of initial listing
Features of LEAP
47. Price of Option = Intrinsic value + Time Value
Intrinsic Value: Economic value if it is exercised immediately. If there
is no positive value then intrinsic is zero.
Intrinsic value of Call option = Current Stock Price – Strike Price
Eg: 105 – 100 = 5
Option is in-the-money (ITM) – if the intrinsic value is positive
Options is out-of-the-money (OTM) – if there is no intrinsic value
Options is at-the-money (ATM) – if the intrinsic value is zero
Time Value – is the amount by which the option price exceeds its
intrinsic value prior to expiration. This is the premium buyer is willing
Option Price (Value of Option)