PROJECT REPORT

ON

“A STUDY ON FUTURES AND POTIONS”

In partial fulfilment for the award of the degree

Of
BACHELOR OF BUSINESS ADMINISTRATION

SCHOOL OF MANAGEMENT
BAHRA UNIVERSITY (H.P)

Submitted to :- Submitted By:-

Ms.Swati Piyush
Assistant professor BU2017UGBB030

Under the guidance of BBA 5TH SEMESTER (3RD YEAR)

Ms.Prerna Chandel

Assistant Professor
SCHOOL OF MANAGEMENT

BAHRA UNIVERSITY ,SHIMLA HILLS

November-201
 ACKNOWLEDGEMENT

My deepest sense of gratitude, profound respect and sincere thanks to Ms.

Prerna Chandel (Assistant Professor at School of Business Management
Bahra university ) my project guide, for his valuable assistance, keen interest
and constant motivation at each step of the project. It would not have been
possible for me to reach this stage without his support & guidance.

She always had the answers to my queries, be it regarding any concept related
to banking. Her warmth support, practical guidance and easy explanations not
only regarding the project matters but others too add to the success of my
project. Her continuous interaction and support made it possible for the
successful completion of the project.

PIYUSH

DECLARATION

I, PIYUSH, Roll No. BU2017UGBB030

hereby declare that I have done the project report on the topic“ A STUDY ON
FUTURES AND POTIONS” which is submitted in partial fulfillment of the
requirement for the degree of BACHELOR OF BUSINESS
ADMINISTRATION OF BAHRA UNIVERSITY, the data that is included in
it is pure. The assistance and help that received during the course of this
investigation has been duly acknowledged. It is further, declare that it has an
original piece of work and it is worthy of the consideration for the degree of
BBA.

Date:

Place :

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CONTENTS
 INTRODUCTION

 METHODOLOGY
 FUTURES
 OPTIONS

 ANALYSIS OF THE STUDY

 SUMMARY AND CONCLUSIONS

 BIBLIOGRAPHY
 INTRODUCTION

NATURE OF THE PROBLEM:

The turnover of the stock exchanges has been tremendously

increasing from last 10 years. The number of trades and the number of
investors, who are participating, have increased. The investors are willing to
reduce their risk, so they are seeking for the risk management tools.

Prior to SEBI abolishing the BADLA system, the investors had

this system as a source of reducing the risk, as it has many problems like no
strong margining system, unclear expiration date and generating counter party
risk. In view of this problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are

seeking for a hedging system, which could reduce their portfolio risk. SEBI
thought the introduction of the derivatives trading, as a first step it has set up a
24 member committee under the chairmanship of Dr.L.C.Gupta to develop the
appropriate regulatory framework for derivative trading in India, SEBI accepted
the recommendations of the committee on May 11, 1998 and approved the
phased introduction of the derivatives trading beginning with stock index
futures.

There are many investors who are willing to trade in the

derivative segment, because of its advantages like limited loss and unlimited
profit by paying the small premiums.

IMPORTANCE OF THE STUDY:

To evaluate the profit/loss position of option holder and option writer.

OBJECTIVES OF THE STUDY:

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

SCOPE OF THE STUDY:

The study is limited to “Derivatives” with special reference to futures

and options in the Indian context and the Hyderabad stock exchange has been
taken as a representative sample for the study. The study can’t be said as totally
perfect. Any alteration may come. The study has only made a humble attempt
at evaluating derivatives market only in Indian context. The study is not based
on the international perspective of derivatives markets, which exists in
NASDAQ, NYSE etc.

LIMITATIONS OF THE STUDY:

The following are the limitations of this study.

 The scrip chosen for analysis is STATE BANK OF INDIA and the contract
taken is March 2005 ending one-month contract.
 The data collected is completely restricted to the STATE BANK OF INDIA
of March 2005; hence this analysis cannot be taken as universal.
 METHODOLOGY

The emergence of the market for derivative products, most

notably forwards, futures and options, can be traced back to the willingness of
risk-averse economic agents to guard themselves against uncertainties arising
out of fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the use of derivative
products, it is possible to partially or fully transfer price risks by locking–in
asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking-in
asset prices, derivative products minimize the impact of fluctuations in asset
prices on the profitability and cash flow situation of risk-averse investors.

Derivatives are risk management instruments, which derive their

value from an underlying asset. The underlying asset can be bullion, index,
share, bonds, currency, interest etc. Banks, securities firms, companies and
investors to hedge risks, to gain access to cheaper money and to make profit,
use derivatives. Derivatives are likely to grow even at a faster rate in future.

DEFINITION:

Derivative is a product whose value is derived from the value of

an underlying asset in a contractual manner. The underlying asset can be equity,
forex, commodity or any other asset.
Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to
include –
1. A security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for differences or any other
form of security.
2. A contract which derives its value from the prices, or index of prices,
of underlying securities.

PARTICIPANTS:

The following three broad categories of participants in the derivatives market.

HEDGERS:
Hedgers face risk associated with the price of an asset. They use futures
or options markets to reduce or eliminate this risk.

SPECULATORS:
Speculators wish to bet on future movements in the price of an asset.
Futures and options contracts can give them an extra leverage; that is, they can
increase both the potential gains and potential losses in a speculative venture.

ARBITRAGEURS:
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.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by the derivatives
markets. They are:

 Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the perceived
future level.
 Derivatives market helps to transfer risks from those who have them but may
not like them to those who have an appetite for them.
 Derivative trading acts as a catalyst for new entrepreneurial activity.
 Derivatives markets help increase savings and investment in the long run.

TYPES OF DERIVATIVES:
The following are the various types of derivatives. They are:

FORWARDS:

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed
price.

FUTURES:

A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price.

OPTIONS:

Options are of two types - calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

WARRANTS:

Options generally have lives of upto one year; the majority of options
traded on options exchanges having a maximum maturity of nine months.
Longer-dated options are called warrants and are generally traded over-the-
counter.
LEAPS:

The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of upto three years.

BASKETS:
 Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity index
options are a form of basket options.

SWAPS:

Swaps are private agreements between two parties to exchange cash

flows in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:
Interest rate swaps:
These entail swapping only the 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.

SWAPTIONS:

Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus a swaption is an option on a forward swap.

RATIONALE BEHIND THE DEVELOPMENT OF

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

1. Price or dividend (interest).

2. Some are internal to the firm like –
  Industrial policy
 Management capabilities
 Consumer’s preference
 Labor strike, etc.
These forces are to a large extent controllable and are termed as non
Systematic risks. An investor can easily manage such non-systematic by having
a well – diversified portfolio spread across the companies, industries and groups
so that a loss in one may easily be compensated with a gain in other.

There are yet other types of influences which are external to the firm,
cannot be controlled and affect large number of securities. They are termed as
systematic risk. They are:
1. Economic
2. Political
3. Sociological changes are sources of systematic risk.
For instance, inflation, interest rate, etc. their effect is to cause prices of
nearly all individual stocks to move together in the same manner. We therefore
quite often find stock prices falling from time to time in spite of company’s
earnings rising and vice versa.

Rationale behind the development of derivatives market is to manage

this systematic risk, liquidity and liquidity in the sense of being able to buy and
sell relatively large amounts quickly without substantial price concessions.

In debt market, a large position of the total risk of securities is

systematic. Debt instruments are also finite life securities with limited
marketability due to their small size relative to many common stocks. Those
factors favour for the purpose of both portfolio hedging and speculation, the
introduction of a derivative security that is on some broader market rather than
an individual security.
 India has vibrant securities market with strong retail participation that
has rolled over the years. It was until recently basically cash market with a
facility to carry forward positions in actively traded ‘A’ group scrips from one
settlement to another by paying the required margins and borrowing some
money and securities in a separate carry forward session held for this purpose.
However, a need was felt to introduce financial products like in other financial
markets world over which are characterized with high degree of derivative
products in India.

Derivative products allow the user to transfer this price risk by looking
in the asset price there by minimizing the impact of fluctuations in the asset
price on his balance sheet and have assured cash flows.

Derivatives are risk management instruments, which derive their value

from an underlying asset. The underlying asset can be bullion, index, shares,
bonds, currency etc.

DERIVATIVE SEGMENT AT NATIONAL STOCK

EXCHANGE:

The derivatives segment on the exchange commenced with S&P CNX

Nifty Index futures on June 12, 20007.The F&O segment of NSE provides
trading facilities for the following derivative segment:
1. Index Based Futures
2. Index Based Options
3. Individual Stock Options
4. Individual Stock Futures
 COMPANY NAME CODE LOT SIZE

ABB Ltd. ABB 200

Associated Cement Co. Ltd. ACC 750
Allahabad Bank ALBK 2450
Andhra Bank ANDHRABANK 2300
Arvind Mills Ltd. ARVINDMILL 2150
Ashok Leyland Ltd ASHOKLEY 9550
Bajaj Auto Ltd. BAJAJAUTO 200
Bank of Baroda BANKBARODA 1400
Bank of India BANKINDIA 1900
Bharat Electronics Ltd. BEL 550
Bharat Forge Co Ltd BHARATFORG 200
Bharti Tele-Ventures Ltd BHARTI 1000
Bharat Heavy Electricals Ltd. BHEL 300
Bharat Petroleum Corporation Ltd. BPCL 550
Cadila Healthcare Limited CADILAHC 500
Canara Bank CANBK 1600
Century Textiles Ltd CENTURYTEX 850
Chennai Petroleum Corp Ltd. CHENNPETRO 950
Cipla Ltd. CIPLA 1000

COCHINREFN 1300
Kochi Refineries Ltd
Colgate Palmolive (I) Ltd. COLGATE 1050
Dabur India Ltd. DABUR 1800
GAIL (India) Ltd. GAIL 1500
Great Eastern Shipping Co. Ltd. GESHIPPING 1350
Glaxosmithkline Pharma Ltd. GLAXO 300
Grasim Industries Ltd. GRASIM 175
Gujarat Ambuja Cement Ltd. GUJAMBCEM 550
HCL Technologies Ltd. HCLTECH 650
Housing Development Finance
HDFC 300
Corporation Ltd.
HDFC Bank Ltd. HDFCBANK 400
Hero Honda Motors Ltd. HEROHONDA 400
Hindalco Industries Ltd. HINDALC0 150
Hindustan Lever Ltd. HINDLEVER 2000
Hindustan Petroleum Corporation Ltd. HINDPETRO 650
ICICI Bank Ltd. ICICIBANK 700
Industrial development bank of India
IDBI 2400
Ltd.
Indian Hotels Co. Ltd. INDHOTEL 350
Indian Rayon And Industries Ltd INDRAYON 500
Infosys Technologies Ltd. INFOSYSTCH 100
Indian Overseas Bank IOB 2950
Indian Oil Corporation Ltd. IOC 600
ITC Ltd. ITC 150
Jet Airways (India) Ltd. JETAIRWAYS 200
Jindal Steel & Power Ltd JINDALSTEL 250
Jaiprakash Hydro-Power Ltd. JPHYDRO 6250
Cummins India Ltd KIRLOSKCUM 1900
LIC Housing Finance Ltd LICHSGFIN 850
Mahindra & Mahindra Ltd. M&M 625
Matrix Laboratories Ltd. MATRIXLABS 1250
Mangalore Refinery and
MRPL 4450
Petrochemicals Ltd.
Mahanagar Telephone Nigam Ltd. MTNL 1600
National Aluminium Co. Ltd. NATIONALUM 1150
Neyveli Lignite Corporation Ltd. NEYVELILIG 2950
Nicolas Piramal India Ltd NICOLASPIR 950
National Thermal Power Corporation
NTPC 3250
Ltd.
Oil & Natural Gas Corp. Ltd. ONGC 300
Oriental Bank of Commerce ORIENTBANK 600
Patni Computer System Ltd PATNI 650
Punjab National Bank PNB 600
Ranbaxy Laboratories Ltd. RANBAXY 200
Reliance Energy Ltd. REL 550
Reliance Capital Ltd RELCAPITAL 1100
Reliance Industries Ltd. RELIANCE 600
Satyam Computer Services Ltd. SATYAMCOMP 600
State Bank of India SBIN 500
Shipping Corporation of India Ltd. SCI 1600
Siemens Ltd SIEMENS 150
Sterlite Industries (I) Ltd STER 350
Sun Pharmaceuticals India Ltd. SUNPHARMA 450
Syndicate Bank SYNDIBANK 3800
Tata Chemicals Ltd TATACHEM 1350
Tata Consultancy Services Ltd TCS 250
Tata Power Co. Ltd. TATAPOWER 800
Tata Tea Ltd. TATATEA 550
Tata Motors Ltd. TATAMOTORS 825
Tata Iron and Steel Co. Ltd. TISCO 675
Union Bank of India UNIONBANK 2100
UTI Bank Ltd. UTIBANK 900
Vijaya Bank VIJAYABANK 3450
Videsh Sanchar Nigam Ltd VSNL 1050
Wipro Ltd. WIPRO 300
Wockhardt Ltd. WOCKPHARMA 600

REGULATORY FRAMEWORK:
 The trading of derivatives is governed by the provisions contained in the
SC ( R ) A, the SEBI Act, the and the regulations framed there under the rules
and byelaws of stock exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of

Dr.L.C.Gupta develop the appropriate regulatory framework for derivative
trading in India. The committee submitted its report in March 1998. On May
11, 1998 SEBI accepted the recommendations of the committee and approved
the phased introduction of Derivatives trading in India beginning with Stock
Index Futures. SEBI also approved he “Suggestive bye-laws” recommended by
the committee for regulation and control of trading and settlement of
Derivatives contracts.

The provisions in the SC (R) A govern the trading in the securities. The
amendment of the SC (R) A to include “DERIVATIVES” within the ambit of
‘Securities’ in the SC (R ) A made trading in Derivatives possible within the
framework of the Act.

1. Any exchange fulfilling the eligibility criteria as prescribed in the L.C.

Gupta committee report may apply to SEBI for grant of recognition
under Section 4 of the SC (R) A, 1956 to start Derivatives Trading. The
derivatives exchange/segment should have a separate governing council
and representation of trading / clearing members shall be limited to
maximum of 40% of the total members of the governing council. The
exchange shall regulate the sales practices of its members and will
obtain approval of SEBI before start of Trading in any derivative
contract.
2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not

automatically become the members of the derivative segment. The
members of the derivative segment need to fulfill the eligibility
conditions as lay down by the L.C.Gupta Committee.

4. The clearing and settlement of derivates trades shall be through a SEBI

approved Clearing Corporation / Clearing house. Clearing Corporation /
Clearing House complying with the eligibility conditions as lay down
By the committee have to apply to SEBI for grant of approval.

5. Derivatives broker/dealers and Clearing members are required to seek

registration from SEBI.

6. The Minimum contract value shall not be less than Rs.2 Lakh.
Exchanges should also submit details of the futures contract they
purpose to introduce.

7. The trading members are required to have qualified approved user and
sales person who have passed a certification programme approved by
SEBI.

FUTURES
DEFINITION:

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. To facilitate liquidity in
the futures contract, the exchange specifies certain standard features of the
contract. The standardized items on a futures contract are:

 Quantity of the underlying

 Quality of the underlying

 The date and the month of delivery

 The units of price quotations and minimum price change

 Locations of settlement

TYPES OF FUTURES:
 On the basis of the underlying asset they derive, the futures are divided
into two types:

 Stock futures:

The stock futures are the futures that have the underlying asset as the
individual securities. The settlement of the stock futures is of cash settlement
and the settlement price of the future is the closing price of the underlying
security.

 Index futures:

Index futures are the futures, which have the underlying asset as an
Index. The Index futures are also cash settled. The settlement price of the
Index futures shall be the closing value of the underlying index on the expiry
date of the contract.

Parties in the Futures Contract:

There are two parties in a future contract, the Buyer and the Seller. The
buyer of the futures contract is one who is LONG on the futures contract and
the seller of the futures contract is one who is SHORT on the futures contract.

The pay off for the buyer and the seller of the futures contract are as follows.
PAYOFF FOR A BUYER OF FUTURES:

CASE 1:

The buyer bought the future contract at (F); if the futures price goes to
E1 then the buyer gets the profit of (FP).

CASE 2:

The buyer gets loss when the future price goes less than (F), if the
futures price goes to E2 then the buyer gets the loss of (FL).

PAYOFF FOR A SELLER OF FUTURES:

F – FUTURES PRICE
E1, E2 – SETTLEMENT PRICE.

CASE 1:

The Seller sold the future contract at (f); if the futures price goes to E1
then the Seller gets the profit of (FP).

CASE 2:

The Seller gets loss when the future price goes greater than (F), if the
futures price goes to E2 then the Seller gets the loss of (FL).

MARGINS:
 Margins are the deposits, which reduce counter party risk, arise in a
futures contract. These margins are collected in order to eliminate the counter
party risk. There are three types of margins:

Initial Margin:
Whenever a futures contract is signed, both buyer and seller are required
to post initial margin. Both buyer and seller are required to make security
deposits that are intended to guarantee that they will infact be able to fulfill their
obligation. These deposits are Initial margins and they are often referred as
performance margins. The amount of margin is roughly 5% to 15% of total
purchase price of futures contract.

Marking to Market Margin:

The process of adjusting the equity in an investor’s account in order to
reflect the change in the settlement price of futures contract is known as MTM
Margin.

Maintenance margin:
The investor must keep the futures account equity equal to or greater
than certain percentage of the amount deposited as Initial Margin. If the equity
goes less than that percentage of Initial margin, then the investor receives a call
for an additional deposit of cash known as Maintenance Margin to bring the
equity up to the Initial margin.

Role of Margins:
The role of margins in the futures contract is explained in the following
example.
S sold a Satyam February futures contract to B at Rs.300; the following
table shows the effect of margins on the contract. The contract size of Satyam
is 1200. The initial margin amount is say Rs.20000, the maintenance margin is
65% of Initial margin.

DAY PRICE OF SATYAM EFFECT ON EFFECT ON REMARKS

BUYER (B) SELLER (S)
MTM MTM
P/L P/L
Bal.in Margin Bal.in Margin

Contract is
1 300.00
entered and
initial margin
is deposited.

2 311(price increased)
+13,200 -13,200 B got profit
+13,200 and S got
loss, S
deposited
maintenance
margin.

3 -28,800 +28,800 B got loss and

287
+15,400 deposited
maintenance
margin.

4 +21,600 -21,600 B got profit, S

305
got loss.
Contract
settled at 305,
totally B got
profit and S
got loss.

Pricing the Futures:

 The fair value of the futures contract is derived from a model known as
the Cost of Carry model. This model gives the fair value of the futures contract.

Cost of Carry Model:

F=S (1+r-q) t
Where

F – Futures Price

S – Spot price of the Underlying

r – Cost of Financing

q – Expected Dividend Yield

T – Holding Period.

FUTURES TERMINOLOGY:

Spot price:

The price at which an asset trades in the spot market.

Futures price:

The price at which the futures contract trades in the futures market.

Contract cycle:
The period over which a contract trades. The index futures contracts on
the NSE have one-month, two-months and three-month expiry cycles which
expire on the last Thursday of the month. Thus a January expiration contract
expires on the last Thursday of January and a February expiration contract
ceases trading on the last Thursday of February. On the Friday following the last
Thursday, a new contract having a three-month expiry is introduced for trading.
Expiry date:
It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.

Contract size:
The amount of asset that has to be delivered under one contract. For
instance, the contract size on NSE’s futures market is 200 Nifties.

Basis:
In the context of financial futures, basis can be defined as the futures
price minus the spot price. There will be a different basis for each delivery
month for each contract. In a normal market, basis will be positive. This
reflects that futures prices normally exceed spot prices.

Cost of carry:
The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income
earned on the asset.

Open Interest:
Total outstanding long or short positions in the market at any specific
time. As total long positions for market would be equal to short positions, for
calculation of open interest, only one side of the contract is counted.

OPTIONS
DEFINITION:

Option is a type of contract between two persons where one grants the
other the right to buy a specific asset at a specific price within a specified time
period. Alternatively the contract may grant the other person the right to sell a
specific asset at a specific price within a specific time period. In order to have
this right, the option buyer has to pay the seller of the option premium.

The assets on which options can be derived are stocks, commodities,

indexes etc. If the underlying asset is the financial asset, then the options are
financial options like stock options, currency options, index options etc, and if
the underlying asset is the non-financial asset the options are non-financial
options like commodity options.

PROPERTIES OF OPTIONS:

Options have several unique properties that set them apart from other
securities. The following are the properties of options:

 Limited Loss

 High Leverage Potential

 Limited Life

PARTIES IN AN OPTION CONTRACT:

1. Buyer of the Option:

 The buyer of an option is one who by paying option premium
buys the right but not the obligation to exercise his option on
seller/writer.

2. Writer/Seller of the Option:

The writer of a call/put options is the one who receives the

option premium and is there by obligated to sell/buy the asset if the
buyer exercises the option on him.
.
TYPES OF OPTIONS:

The options are classified into various types on the basis of various
variables. The following are the various types of options:

I) On the basis of the Underlying asset:

On the basis of the underlying asset the options are divided into two types:

 INDEX OPTIONS:

The Index options have the underlying asset as the index.

 STOCK OPTIONS:

A stock option gives the buyer of the option the right to buy/sell stock at
a specified price. Stock options are options on the individual stocks, there
are currently more than 50 stocks are trading in this segment.

II. On the basis of the market movement:

 On the basis of the market movement the options are divided into two
types. They are:

 CALL OPTION:
A call options is bought by an investor when he seems that the stock
price moves upwards. A call option gives the holder of the option the right
but not the obligation to buy an asset by a certain date for a certain price.

 PUT OPTION:
A put option is bought by an investor when he seems that the stock price
moves downwards. A put option gives the holder of the option right but not
the obligation to sell an asset by a certain date for a certain price.

III. On the basis of exercise of Option:

On the basis of the exercising of the option, the options are classified
into two categories.

 AMERICAN OPTION:

American options are options that can be exercised at any time up to the
expiration date, most exchange-traded options are American.

 EUROPEAN OPTION:

European options are options that can be exercised only on the

expiration date itself. European options are easier to analyze than American
options.

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION:

 The pay-off of a buyer options depends on the spot price of the
underlying asset. The following graph shows the pay-off of buyer of a call
option:

S
-

Strike
price

OTM -
Out of the
Money

SP
- Premium/Loss ATM - At the Money

E1 - Spot price 1 ITM - In The Money

E2 - Spot price 2

SR - profit at spot price E1

CASE 1: (Spot price > Strike Price)

As the spot price (E1) of the underlying asset is more than strike price
(S). The buyer gets the profit of (SR), if price increases more than E1 than
profit also increase more than SR.
CASE 2: (Sport price < Strike Price)
As the spot price (E2) of the underlying asset is less than strike price (s).
The buyer gets loss of (SP), if price goes down less than E2 than also his loss is
limited to his premium (SP).
PAY – OFF PROFILE FOR SELLER OF A CALL OPTION:

The pay-off of seller of the call option depends on the spot price of the
underlying asset. The following graph shows the pay-off of seller of a call
option:
S - Strike price ITM - In the Money

SP - Premium/profit ATM - At the Money

E1 - Spot price 1 OTM - Out of The Money

E2 - Spot price 2

SR - profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S).
The seller gets the profit of (SP), if the price decreases less than E1 than also
profit of the seller does not exceed (SP).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price
(S). The seller gets loss of (SR), if price goes more less than E2 than the loss of
the seller also increase more than (SR).

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION:

The payoff of buyer of the option depends on the spot price of the
underlying asset. The following graph shows the pay off of the buyer of a call
option:
S - Strike price ITM - In The Money

SP - Premium/profit OTM - Out of The Money

E1 - Spot price 1 ATM - At The Money

E2 - Spot price 2

SR - profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S).
The buyer gets the profit of (SR), if price decreases less than E1 than the profit
also increases more than (SR).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price
(s), the buyer gets loss of (SP), if price goes more than E2 than the loss of the
buyer is limited to his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION:

The pay off of seller of the option depends on the spot price of the
underlying asset. The following graph shows the pay-off of seller of a put
option:
S - Strike price ITM - In The Money

SP - Premium/profit ATM - At The Money

E1 - Spot price 1 OTM - Out of The Money

E2 - Spot price 2

SR - profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S),
the seller gets the loss of (SR), if price decreases less than E1 than the loss also
increases more than (SR).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price
(S), the seller gets profit of (SP), if price goes more than E2 than the profit of
the seller is limited to his premium (SP).

FACTORS AFFECTING THE PRICE OF AN OPTION:

The following are the various factors that affect the price of an option.
They are:
Stock price:
 The pay-off from a call option is the amount by which the stock price
exceeds the strike price. Call options therefore become more valuable as the
stock price increases and vice versa. The pay-off from a put option is the
amount; by which the strike price exceeds the stock price. Put options therefore
become more valuable as the stock price increases and vice versa.
Strike price:
In the case of a call, as the strike price increases, the stock price has to
make a larger upward move for the option to go in-the –money. Therefore, for a
call, as the strike price increases, options become less valuable and as strike
price decreases, options become more valuable.
Time to expiration:
Both Put and Call American options become more valuable as the time
to expiration increases.
Volatility:
The volatility of n a stock price is a measure of uncertain about future
stock price movements. As volatility increases, the chance that the stock will do
very well or very poor increases. The value of both Calls and Puts therefore
increase as volatility increase.
Risk-free interest rate:
The put option prices decline as the risk – free rate increases where as
the prices of calls always increase as the risk – free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the ex dividend
date. This has a negative effect on the value of call options and a positive affect
on the value of put options.

PRICING OPTIONS

The Black Scholes formulas for the prices of European Calls and puts on a non-
dividend paying stock are:
CALL OPTION:

C = SN (D1)-Xe-rtN(D2)

PUT OPTION:

P = Xe-rtN(-D2)-SN (-D2)

C – VALUE OF CALL OPTION

S – SPOT PRICE OF STOCK
X – STRIKE PRICE
r - ANNUAL RISK FREE RETURN
t – CONTRACT CYCLE
D1 – (ln(s/x) +(r+ )/2) t)/
D2 – D1-

Options Terminology:

Strike Price:

The price specified in the options contract is known as the Strike price
or Exercise price.
Option Premium:

Option premium is the price paid by the option buyer to the option
seller.

Expiration Date:

The date specified in the options contract is known as the expiration

date.
In-The-Money Option:
 An in the money option is an option that would lead to a positive cash
inflow to the holder if it is exercised immediately.
At-The-Money Option:

An at the money option is an option that would lead to zero cash flow if
it is exercised immediately.
Out-Of-The-Money Option:

An out of the money option is an option that would lead to a negative

cash flow if it is exercised immediately.
Intrinsic Value of an Option:

The intrinsic value of an option is ITM, if option is ITM. If the option is

OTM, its intrinsic value is ZERO.
Time Value of an Option:

The time value of an option is the difference between its premium and
its intrinsic value.

DESCRIPTION OF THE METHOD:

The following are the steps involved in the study.

1. Selection of the scrip:

 The scrip selection is done on a random basis and the scrip selected is
RELIANCE COMMUNICATIONS. The lot size of the scrip is 500.
Profitability position of the option holder and option writer is studied.

2. Data collection:

The data of the RELIANCE COMMUNICATIONS has been collected

from the “The Economic Times” and the internet. The data consists of the
March contract and the period of data collection is from 30 th December 2008 to
31st January 2008.

3. Analysis:

The analysis consists of the tabulation of the data assessing the

profitability positions of the option holder and the option writer, representing
the data with graphs and making the interpretations using the data.
 ANALYSIS

ANALYSIS

The objective of this analysis is to evaluate the profit/loss position of

option holder and option writer. This analysis is based on the sample data,
taken RELIANCE COMMUNICATIONS scrip. This analysis considered the
March ending contract of the SBI. The lot size of SBI is 500. The time period
in which this analysis is done is from 30/12/2007 To 31/01/2008

Price of SBI in the Cash Market.

MARKET
DATE PRICE
30-Dec-
07 685.1
31-Dec-
07 714.65
1-Jan-
08 695.6
2-Jan-
08 706.4
3-Jan-
08 717.1
4-Jan-
08 713.45
7-Jan-
08 726.6
8-Jan-
08 724.05
9-Jan-
08 720.85
10-Jan-
08 742.1
11-Jan-
08 736.9
14-jan-
08 734.1
15-Jan-
08 731.75
16-Jan-
08 728
17-Jan-
08 726.2

727.8
18-Jan-
08
21-Jan-
08 722.7
22-Jan-
08 693.25
23-Jan-
08 657.7
24-Jan- 664.4
 08
28-Mar-
08 665.6
29-Jan-
08 641.7
30-Jan-
08 661.05
31-Jan-
08 654.8

The closing price of SBI at the end of the contract period is 654.80 and this is
considered as settlement price.
The following table explains the amount of transaction between option holder
and option writer.

 The first column explains the trading date.

 The second column explains the market price in cash segment on that date.
 The call column explains the call/put options which are considered. Every
call/put has three sub columns.
 The first column consists of the premium value per share of the contracts,
second column consists of the volume of the contract, and the third column
consists of total premium value paid by the buyer.

NET PAYOFF FOR CALL OPTION HOLDERS AND WRITERS

PROFIT NET NET

TO PROFIT TO PROFIT
MARKET VOLUME PREMIUM HOLDER HOLDER TO BUYER
PRICE CALLS ('000) ('000) ('000) ('000) ('000)

654.8 640 199.5 3634.15 2952.6 -681.55 681.55

654.8 660 1463 21600.35 0 -21600.35 21600.35
654.8 680 2008 51831.53 0 -51831.525 51831.525
654.8 700 3297 85603.45 0 -85603.45 85603.45
654.8 720 3796.5 74881.93 0 -74881.925 74881.925
654.8 740 2309.5 30208.4 0 -30208.4 30208.4

OBSERVATIONS AND FINDINGS:

 Six call options are considered with six different strike prices.
 The current market price on the expiry date is Rs.654.80 and this is
considered as final settlement price.
 The premium paid by the option holders whose strike price is far and greater
than the current market price have paid high amounts of premium than those
who are near to the current market price.
 The call option holders whose strike price is less than the current market
price are said to be In-The-Money. The calls with strike price 640 are said
to be In-The-Money, since, if they exercise they will get profits.
 The call option holders whose strike price is less than the current market
price are said to be Out-Of-The-Money. The calls with strike price of 660,
680,700,720,740 are said to be Out-Of-The-Money, since, if they exercise,
they will get losses.

FINDINGS:

The premium of the options with strike price of 700 and 720 is high, since most
of the period of the contract the cash market is moving around 700 mark.
FINDINGS:

 The contracts with strike price 660, 680, 700, 720, 740 get no profit,
since their strike price is more than the settlement price.
 The contract with strike price 640 gets the profit.
NET PAY OFF OF PUT OPTION HOLDERS AND WRITERS.

PROFIT TO NET PROFIT NET PROFIT

MARKET VOLUME PREMIUM HOLDER TO HOLDER TO WRITER
PRICE PUTS ('000) ('000) ('000) ('000) ('000)

654.8 600 25 47.625 0 -47.625 47.625

654.8 640 323.5 993.5 0 -993.5 993.5
654.8 660 1239.5 9506.575 6445.4 -3061.175 3061.175
654.8 680 1399.5 21894 35267.4 13373.4 -13373.4
654.8 700 1858 30871.28 83981.6 53110.325 -53110.325
654.8 720 1468.5 23727.83 95746.2 72018.375 -72018.375

OBSERVATIONS AND FINDINGS:

 Six put options are considered with six different strike prices.
 The current market price on the expiry date is Rs.654.80 and this is
considered as the final settlement price.
 The premium paid by the option holders whose strike price is far and greater
than the current market price have paid high amount of premium than those
who are near to the current market price.
 The put option holders whose strike price is more than the current market
price are said to be In-The-Money. The puts with strike price
660,680,700,720 are said to be In-The-Money, since, if they exercise they
will get profits.
 The put option holders whose strike price is less than the current market
price are said to be Out-Of-The-Money. The puts with strike price of
600,640 are said to be Out-Of-The-Money, since, if they exercise their puts,
they will get losses.
FINDINGS:

 The premium of the option with strike price 700 is higher when compared to
other strike prices. This is because of the movement of the cash market
price of the SBI between 640 and 720.
FINDINGS:

 The put option holders whose strike price is more than the settlement price
are In-The-Money.
 The put options whose strike price is less than the settlement price are Out-
Of-The-Money.
 DATA OF SBI THE FUTURES OF THE JANUARY MONTH

FUTURES CLOSING PRICE CASH CLOSING PRICE

DATE (Rs.) (Rs.)

30-Dec-
07 689.6 685.1
31-Dec-
07 720.65 714.65
1-Jan-
08 700.65 695.6
2-Jan-
08 710.9 706.4
3-Jan-
08 720.85 717.1
4-Jan-
08 716.85 713.45
7-Jan-
08 729.2 726.6
8-Jan-
08 728.25 724.05
9-Jan-
08 723.35 720.85
10-Jan-
08 745.3 742.1
11-Jan-
08 741.35 736.9
14-Jan-
08 738.95 734.1
15-Jan-
08 735.7 731.75
16-Jan-
08 733.15 728
17-Jan-
08 730.75 726.2
18-Jan-
08 732.3 727.8
21-Jan-
08 725.25 722.7
22-Jan-
08 695 693.25
23-Jan-
08 660.1 657.7
24-Jan-
08 666.7 664.4
28-Jan-
08 667.75 665.6
29-Jan-
08 642.7 641.7
30-Jan-
08 662.05 661.05
31-Jan-
08 655.95 654.8
OBSERVATIONS AND FINDINGS:

The cash market price of the SBI is moving along with the futures price.
 If the buy price of the futures is less than the settlement price, then the buyer
of the futures get profit.
 If the selling price of the futures is less than the settlement price, then the
seller incur losses.
 SUMMARY,
CONCLUSIONS
AND
RECOMMENDATINONS
 SUMMARY

 Derivatives market is an innovation to cash market. Approximately its daily

turnover reaches to the equal stage of cash market.
 Presently the available scrips in futures are 89 and in options segment are
62.
 In cash market the profit/loss of the investor depends on the market price of
the underlying asset. The investor may incur huge profits or he may incur
huge losses. But in derivatives segment the investor enjoys huge profits
with limited downside.
 In cash market the investor has to pay the total money, but in derivatives the
investor has to pay premiums or margins, which are some percentage of
total money.
 Derivatives are mostly used for hedging purpose.
 In derivative segment the profit/loss of the option holder/option writer is
purely depended on the fluctuations of the underlying asset.
 CONCLUSIONS

 In bullish market the call option writer incurs more losses so the investor is
suggested to go for a call option to hold, where as the put option holder
suffers in a bullish market, so he is suggested to write a put option.
 In bearish market the call option holder will incur more losses so the
investor is suggested to go for a call option to write, where as the put option
writer will get more losses, so he is suggested to hold a put option.
 In the above analysis the market price of State Bank of India is having low
volatility, so the call option writers enjoy more profits to holders.
 RECOMMENDATIONS

 The derivative market is newly started in India and it is not known by every
investor, so SEBI has to take steps to create awareness among the investors
about the derivative segment.
 In order to increase the derivatives market in India, SEBI should revise
some of their regulations like contract size, participation of FII in the
derivatives market.
 Contract size should be minimized because small investors cannot afford
this much of huge premiums.
 SEBI has to take further steps in the risk management mechanism.
 SEBI has to take measures to use effectively the derivatives segment as a
tool of hedging.
BIBLIOGRAPHY
 BIBLIOGRAPHY

BOOKS:

FUTURES AND OPTIONS - N.D.VOHRA, B.R.BAGRI

DERIVATIVES CORE MODULE

WORKBOOK - NCFM MATERIAL

FUTURES AND OPTIONS - R.MAHAJAN

WEBSITES:

www.nseindia.com
www.equitymaster.com
www.peninsularonline.com

NEWS EDITIONS:

THE ECONOMIC TIMES

BUSINESS LINE