Introduction To Derivaties

Vivek College Of Commerce
INTRODUCTION TO DERIVATIVES
A derivative security is a security whose value depends on the value of together
more basic underlying variable. These are also known as contingent claims. Derivatives
securities have been very successful in innovation in capital markets.
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, financial markets are markets 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 don’t 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 riskaverse
investor.
Derivatives are risk management instruments which derives their value from an
underlying asset. Underlying asset can be Bullion, Index, Share, Currency, Bonds,
Interest, etc.
OBJECTIVES OF THE STUDY:
➢ To understand the concept of the Financial Derivatives such as Forwards,

Futures and Options and swaps
➢ To find out profit/loss position of the option writer and option holder
➢ To study various trends in derivatives market
➢ To study the role of derivatives in India financial market
➢ To study in detail the role of futures and options
➢ To examine the advantages and the disadvantages of different
strategies along with situations
➢ To study the different ways of buying and selling of Options
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SCOPE OF THE STUDY
The study is limited to “Derivatives” With special reference to Futures and

Options in the Indian context and the IIFL has been taken as representative sample for
The study cannot be said as totally perfect, any alteration may come. The study
has only made humble attempt at evaluating Derivatives markets only in Indian context.
The study is not based on the International perspective of the Derivatives markets.
LIMITATIONS:
➢ The study does not take any Nifty Index Futures and Options and
International
➢ Markets into the consideration.
➢ This is a study conducted within a period of 45 days.
➢ During this limited period of study, the study may not be a detailed, Full –
fledged and utilitarian one in all aspects.
➢ The study contains some assumptions based on the demands of the analysis.
➢ The study does not provide any predictions or forecast of the selected scripts.
➢ The study was conducted in Hyderabad only.
➢ As the time was limited, study was confined to conceptual understanding of
Derivatives market in India
DERIVATIVES:
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 underlying prices. However, by
locking –in asset prices, derivative products minimizes the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk–averse investors.
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DEFINITION:
Understanding the word itself, Derivatives is a key to mastery of the topic. The
word originates in mathematics and refers to a variable, which has been derived from
another variable. For example, a measure of weight in pound could be derived from a
measure of weight in kilograms by multiplying by two.
In financial sense, these are contracts that derive their value from some
underlying asset. Without the underlying product and market it would have no
independent existence. Underlying asset can be a Stock, Bond, Currency, Index or a
Commodity. Some one may take an interest in the derivative products without having
an interest in the underlying product market, but the two are always related and may
therefore interact with each other.
The term Derivative has been defined in Securities Contracts (Regulation) Act 1956, as:
A. 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.
B. A contract, which derives its value from the prices, or index of prices,
of underlying securities.
IMPORTANCE OF DERIVATIVES:
Derivatives are becoming increasingly important in world markets as a tool for
risk management. Derivatives instruments can be used to minimize risk. Derivatives are
used to separate risks and transfer them to parties willing to bear these risks. The kind
of hedging that can be obtained by using derivatives is cheaper and more convenient
than what could be obtained by using cash instruments. It is so because, when we use
derivatives for hedging, actual delivery of the underlying asset is not at all essential for
settlement purposes.
Moreover, derivatives would not create any risk. They simply manipulate the
risks and transfer to those who are willing to bear these risks.
For example,
Mr. A owns a bike If he does not take insurance, he runs a big risk. Suppose he
buys insurance [a derivative instrument on the bike] he reduces his risk. Thus, having
an insurance policy reduces the risk of owing a bike. Similarly, hedging through
derivatives reduces the risk of owing a specified asset, which may be a share, currency,
etc.
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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 influences, which affect the returns.
1. Price or dividend (interest).
2. Sum are internal to the firm like:
➢ Industry policy
➢ Management capabilities
➢ Consumer’s preference
➢ Labour strike, etc.
These forces are to a large extent controllable and are termed as “Non-systematic
Risks”. An investor can easily manage such non- systematic risks by having a
welldiversified
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 other types of influences, which are external to the firm, cannot be
controlled, and they are termed as “systematic risks”. Those are
➢ Economic
➢ Political
➢ Sociological changes are sources of Systematic Risk
Their effect is to cause the prices of nearly all individual stocks to move together in
the same manner. We therefore quite often find stock prices falling from time to time in
spite of company’s earnings rising and vice –versa.
Rational behind the development of derivatives market is to manage this systematic
risk, liquidity. Liquidity means, being able to buy & sell relatively large amounts
quickly without substantial price concessions.
In debt market, a much larger portion 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. These factors favor for the purpose of both
portfolio hedging and speculation.
India has vibrant securities market with strong retail participation that has
evolved over the years. It was until recently a cash market with facility to carry forward
positions in actively traded “A” group scripts from one settlement to another by paying
the required margins and borrowing money and securities in a separate carry forward
sessions held for this purpose. However, a need was felt to introduce financial products
like other financial markets in the world.
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CHARACTERISTICS OF DERIVATIVES:
1. Their value is derived from an underlying instrument such as stock index,

currency, etc.
2. They are vehicles for transferring risk.
3. They are leveraged instruments.
MAJOR PLAYERS IN DERIVATIVE MARKET:

There are three major players in the derivatives trading.
1. Hedgers
2. Speculators
3. Arbitrageurs
Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek to
protect themselves against price changes in a commodity in which they have an
interest.
Speculators: They are traders with a view and objective of making profits. They are
willing to take risks and they bet upon whether the markets would go up or come down.
Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be
making money even with out putting their own money in, and such opportunities often
come up in the market but last for very short time frames. They are specialized in
making purchases and sales in different markets at the same time and profits by the
difference in prices between the two centers.
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TYPES OF DERIVATIVES
Most commonly used derivative contracts are:
Forwards: A forward contract is a customized contract between two entities where

settlement takes place on a specific date in the futures at today’s pre-agreed price.
Forward contracts offer tremendous flexibility to the party’s to design the contract in
terms of the price, quantity, quality, delivery, time and place. Liquidity and default risk
are very high.
Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense, that the former are standardized exchange traded
contracts.
Options: Options are 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: Longer – dated options are called warrants and are generally traded over –
the – counter. Options generally have life up to one year, the majority of options traded
on options exchanges having a maximum maturity of nine months.
LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These
are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form
of basket options
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Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a pre-arranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are: -
Interest rare swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both the principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in
opposite direction.
RISKS INVOLVED IN DERIVATIVES:
Derivatives are used to separate risks from traditional instruments and transfer these
risks to parties willing to bear these risks. The fundamental risks involved in derivative
business includes
A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation
as per the contract. Also known as default or counterparty risk, it differs with
different instruments.
B. Market Risk: Market risk is a risk of financial loss as a result of adverse

movements of prices of the underlying asset/instrument.
C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing

market prices is termed as liquidity risk. A firm faces two types of liquidity
risks:
➢ Related to liquidity of separate products.
➢ Related to the funding of activities of the firm including derivatives.
D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal
aspects associated with the deal should be looked into carefully.
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DERIVATIVES IN INDIA
Indian capital markets hope derivatives will boost the nation’s economic
prospects. Fifty years ago, around the time India became independent men in Mumbai
gambled on the price of cotton in New York. They bet on the last one or two digits of
the closing price on the New York cotton exchange. If they guessed the last number,
they got Rs.7/- for every Rupee layout. If they matched the last two digits they got
Rs.72/- Gamblers preferred using the New York cotton price because the cotton market
at home was less liquid and could easily be manipulated.
Now, India is about to acquire own market for risk. The country, emerging from a
long history of stock market and foreign exchange controls, is one of the vast major
economies in Asia, to refashion its capital market to attract western investment. A
hybrid over the counter, derivatives market is expected to develop along side. Over the
last couple of years the National Stock Exchange has pushed derivatives trading, by
using fully automated screen based exchange, which was established by India's leading
institutional investors in 1994 in the wake of numerous financial & stock market
scandals.
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Derivatives Segments in NSE & BSE
On June 9, 2000 BSE and NSE became the first exchanges in India to introduce
trading in exchange traded derivative products, with the launch of index Futures on
Sensex and Nifty futures respectively. Index Options was launched in June 2001, stock
options in July 2001, and stock futures in November 2001.
NIFTY is the underlying asset of the index futures at the futures and options
segment of NSE with a market lot of 50 and Sensex is the underlying stock index in
BSE with a market lot of 30. This difference of market lot arises due to a minimum
specification of a contract value of Rs.2 Lakhs by Securities and Exchange Board of
India. For example Sensex is 18000 then the contract value of a futures index having
Sensex as underlying asset will 30x18000 = 540000. Similarly, If Nifty is 5200 its
futues contract value will be 50x5200=260000. Every transaction shall be in multiples of
market lot. Thus, index futures at NSE shall be traded in multiples of 50 and a BSE in
multiples of 30.
Contract Periods:
At any point of time there will be always be available nearly 3months contract
periods in Indian Markets.
These were
1) Near Month
2) Next Month
3) Far Month
For example in the month of September 2007 one can enter into September
futures contract or October futures contract or November futures contract. The last
Thursday of the month specified in the contract shall be the final settlement date for the
contract at both NSE as well as BSE; it is also known as Expiry Date.
Settlement:
The settlement of all derivative contracts is in cash mode. There is daily as well
as final settlement. Outstanding positions of a contract can remain open till the last
Thursday of that month. As long as the position is open, the same will be marked to
market at the daily settlement price, the difference will be credited or debited
accordingly and the position shall be brought forward to the next day at the daily
settlement price. Any position which remains open at the end of the final settlement day
(i.e. last Thursday) shall be closed out by the exchange at the final settlement price
which will be the closing spot value of the underlying asset.
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Margins:
There are two types of margins collected on the open position, viz., initial
margin which is collected upfront which is named as “SPAN MARGIN” and mark to
market margin, which is to be paid on next day. As per SEBI guidelines it is mandatory
for clients to give margins, failing in which the outstanding positions are required to be
closed out.
Members of F&O segment:

There are three types of members in the futures and options segment. They are
trading members, trading cum clearing members and professional clearing members.
Trading members are the members of the derivatives segment and carrying on the
transactions on the respective exchange.
The clearing members are the members of the clearing corporation who deal with
payments of margin as well as final settlements.
The professional clearing member is a clearing member who is not a trading member.
Typically, banks and custodians become professional clearing members.
It is mandatory for every member of the derivatives segment to have approved users
who passed SEBI approved derivatives certification test, to spread awareness among
investors.
Exposure limit:
The national value of gross open positions at any point in time for index futures
and short index option contract shall not exceed 33.33 times the liquid net worth of a
clearing member. In case of futures and options contract on stocks the notional value of
futures contracts and short option position any time shall not exceed 20 times the liquid
net worth of the member. Therefore, 3 percent notional value of gross open position in
index futures and short index options contracts, and 5 percent of notional value of
futures and short option position in stocks is additionally adjusted from the liquid net
worth of a clearing member on a real time basis.
Position limit:
It refers to the maximum no of derivatives contracts on the same underlying
security that one can hold or control. Position limits are imposed with a view to detect
concentration of position and market manipulation. The position limits are applicable
on the cumulative combined position in all the derivatives contracts on the same
underlying at an exchange. Position limits are imposed at the customer level, clearing
member level and market levels are different.
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Regulatory Framework
Considering the constraints in infrastructure facilities the existing stock

exchanges are permitted to trade derivatives subject to the following conditions:
➢ Trading should take place through an online screen based trading system
➢ An independent clearing corporation should do the clearing of the
derivative market
➢ The exchange must have an online surveillance capability, which
monitors positions, price and volumes in real time so as to detect market
manipulations. Position limits be used for improving market quality
➢ Information about traded quantities and quotes should be disseminated
by the exchange in the real time over at least two information-vending
networks, which are accessible to the investors in the country
➢ The exchange should have at least 50 members to start derivatives
trading
➢ The derivatives trading should be done in a separate segment with a
separate membership. The members of an existing segment of the
exchange will not automatically become the members of derivatives
segment
➢ The derivatives market should have a separate governing council and
representation of trading/clearing members shall be limited to maximum
of 40% of total members of the governing council
➢ The chairman of the governing council of the derivative
division/exchange should be a member of the governing council. If the
chairman is broker/dealer, then he should not carry on any broking and
dealing on any exchange during his tenure
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Forwards
Forwards are the simplest and basic form of derivative contracts. These are
instruments are basically used by traders/investors in order to hedge their future risks. It
is an agreement to buy/sell an asset at certain in future for a certain price. They are
private agreements mainly between the financial institutions or between the financial
institutions and corporate clients.
One of the parties in a forward contract assumes a long position i.e. agrees to
buy the underlying asset on a specified future date at a specified future price. The other
party assumes short position i.e. agrees to sell the asset on the same date at the same
price. This specified price referred to as the delivery price. This delivery price is
choosen so that the value of the forward contract is equal to zero for both the parties. In
other words, it costs nothing to the either party to hold the long/short position.
A forward contract is settled at maturity. The holder of the short position
delivers the asset to the holder of the long position in return for cash at the agreed upon
rate. Therefore, a key determinate of the value of the contract is the market price of the
underlying asset. A forward contract can therefore, assume a positive/negative value
depending on the movements of the price of the asset. For example, if the price of the
asset rises sharply after the two parties entered into the contract, the party holding the
long position stands to benefit, that is the value of the contract is positive for him.
Conversely the value of the contract becomes negative for the party holding the short
position.The concept of forward price is also important. The forward price for a certain
contract is defined as that delivery price which would make the value of the contract
zero. To explain further, the forward price and the delivery price are equal on the day
that the contract is entered into. Over the duration of the contract, the forward price is
liable to change while the delivery price remains the same.
Essential features of Forward Contracts
➢ A forward contract is a Bi-party contract, to be performed in the future, with the
terms decided today
➢ Forward contracts offer tremendous flexibility to the parties to design the
contract in terms of the price, quantity, quality, delivery time and place
➢ Forward contracts suffer from poor liquidity and default risk
➢ Contract price is generally not available in public domain
➢ On the expiration date the contract will settle by delivery of the asset
➢ If the party wishes to reverse the contract, it is compulsorily to go to the same
counter party, which often results high prices
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Forward Trading in Securities
The Securities Contract (amendment) Act of 1999 has allowed the trading in
derivative products in India. As a further step to widen and deepen the securities market
the government has notified that with effect from March 1st 2000 the ban on forward
trading in shares and securities is lifted to facilitate trading in forwards and futures.
It may be recalled that the ban on forward trading in securities was imposed in 1986 to
curb certain unhealthy trade practices and trends in the securities market. During the
past few years, thanks to the economic and financial reforms, there have been many
healthy developments in the securities markets.
The lifting of ban on forward deals in securities will help to develop index
futures and other types of derivatives and futures on stocks. This is a step in the right
direction to promote the sophisticated market segments as in the western countries.
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FUTURES
The future contract is an agreement between two parties to buy or sell an asset
at a certain specified time in future for certain specified price. In this, it is similar to a
forward contract. A futures contract is a more organized form of a forward contract;
these are traded on organized exchanges. However, there are a number of differences
between forwards and futures. These relate to the contractual futures, the way the
markets are organized, profiles of gains and losses, kind of participants in the markets
and the ways they use the two instruments.
Futures contracts in physical commodities such as wheat, cotton, gold, silver,
cattle, etc. have existed for a long time. Futures in financial assets, currencies, and
interest bearing instruments like treasury bills and bonds and other innovations like
futures contracts in stock indexes are relatively new developments.
The futures market described as continuous auction markets and exchanges
providing the latest information about supply and demand with respect to individual
commodities, financial instruments and currencies, etc. Futures exchanges are where
buyers and sellers of an expanding list of commodities; financial instruments and
currencies come together to trade. Trading has also been initiated in options on futures
contracts. Thus, option buyers participate in futures markets with different risk. The
option buyer knows the exact risk, which is unknown to the futures trader.
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FEATURES OF FUTURES CONTRACTS

The principal features of the contract are as follows
.
Organized Exchanges: Unlike forward contracts which are traded in an over-
thecounter
market, futures are traded on organized exchanges with a designated physical
location where trading takes place. This provides a ready, liquid market which futures
can be bought and sold at any time like in a stock market.
Standardization: In the case of forward contracts the amount of commodities to be
delivered and the maturity date are negotiated between the buyer and seller and can be
Tailor made to buyer’s requirement. In a futures contract both these are standardized by
the exchange on which the contract is traded.
Clearing House: The exchange acts a clearing house to all contracts struck on the
trading floor. For instance a contract is struck between capital A and B. Upon entering
into the records of the exchange, this is immediately replaced by two contracts, one
between A and the clearing house and another between B and the clearing house. In
other words the exchange interposes itself in every contract and deal, where it is a
buyer to seller, and seller to buyer. The advantage of this is that A and B do not have to
under take any exercise to investigate each other’s credit worthiness. It also guarantees
financial integrity of the market. This enforces the delivery for the delivery of contracts
held for until maturity and protects itself from default risk by imposing margin
requirements on traders and enforcing this through a system called marking – to –
market.
Actual delivery is rare: In most of the forward contracts, the commodity is
actually delivered by the seller and is accepted by the buyer. Forward contracts are
entered into for acquiring or disposing of a commodity in the future for a gain at a price
known today. In contrast to this, in most futures markets, actual delivery takes place in
less than one percent of the contracts traded. Futures are used as a device to hedge
against price risk and as a way of betting against price movements rather than a means
of physical acquisition of the underlying asset. To achieve this most of the contracts
entered into are nullified by the matching contract in the opposite direction before
maturity of the first.
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Margins: In order to avoid unhealthy competition among clearing members in

reducing margins to attract customers, a mandatory minimum margins are obtained by
the members from the customers. Such a stop insures the market against serious
liquidity crisis arising out of possible defaults by the clearing members. The member
collect margins from their clients as may be stipulated by the stock exchanges from
time to time and pass the margins to the clearing house on the net basis i.e. at a
stipulated percentage of the net purchase and sale position.
The stock exchange imposes margins as follows:
1. Initial margins on both the buyer as well as the seller.
2. The accounts of buyer and seller are marked to the market daily.
The concept of margin here is same as that of any other trade, i.e. to introduce a
financial stake of the client, to ensure performance of the contract and to cover day to
day adverse fluctuations in the prices of the securities.
The margin for future contracts has two components:
➢ Initial margin
➢ Marking to market
Initial margin: In futures contract both the buyer and seller are required to perform
the contract. Accordingly, both the buyers and the sellers are required to put in the
initial margins. The initial margin is also known as the “performance margin” and
usually 5% to 15% of the purchase price of the contract. The margin is set by the stock
exchange keeping in view the volume of business and size of transactions as well as
operative risks of the market in general.
The concept being used by NSE to compute initial margin on the futures
transactions is called “value- at –Risk” (VAR) where as the options market had SPAN
based margin system”.
Marking-to-Market: Marking to market means, debiting or crediting the client’s
equity accounts with the losses/profits of the day, based on which margins are sought.
It is important to note that through marking to market process, the clearinghouse
substitutes each existing futures contract with a new contract that has the settlement
price or the base price. Base price shall be the previous day’s closing Nifty value.
Settlement price is the purchase price in the new contract for the next trading day.
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FUTURES TERMINOLOGY
Spot price: The price at which an asset is traded in spot market.
Futures price: The price at which the futures contract is traded in the futures market.
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 contract size on NSE futures market is 100 Nifties.
Basis/Spread:
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 formal 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.
Multiplier:
It is a pre-determined value, used to arrive at the contract size. It is the price per
index point.
Tick Size: It is the minimum price difference between two quotes of similar nature.
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Open Interest:
Total outstanding long/short positions in the market in any specific point of
time. As total long positions for market would be equal to total short positions for
calculation of open Interest, only one side of the contract is counted.
Long position: Outstanding/Unsettled purchase position at any point of time.
Short position: Out standing/unsettled sale position at any time point of time.
Index Futures:
Stock Index futures are most popular financial futures, which have been used to
hedge or manage systematic risk by the investors of the stock market. They are called
hedgers, who own portfolio of securities and are exposed to systematic risk. Stock
index is the apt hedging asset since, the rise or fall due to systematic risk is accurately
shown in the stock index. Stock index futures contract is an agreement to buy or sell a
specified amount of an underlying stock traded on a regulated futures exchange for a
specified price at a specified time in future.
Stock index futures will require lower capital adequacy and margin requirement
as compared to margins on carry forward of individual scrip’s. The brokerage cost on
index futures will be much lower. Savings in cost is possible through reduced bid-ask
spreads where stocks are traded in packaged forms. The impact cost will be much lower
incase of stock index futures as opposed to dealing in individual scrips. The market is
conditioned to think in terms of the index and therefore, would refer trade in stock
index futures. Further, the chances of manipulation are much lesser.
The stock index futures are expected to be extremely liquid, given the
speculative nature of our markets and overwhelming retail participation expected to be
fairly high. In the near future stock index futures will definitely see incredible volumes
in India. It will be a blockbuster product and is pitched to become the most liquid
contract in the world in terms of contracts traded. The advantage to the equity or cash
market is in the fact that they would become less volatile as most of the speculative
activity would shift to stock index futures. The stock index futures market should
ideally have more depth, volumes and act as a stabilizing factor for the cash market.
However, it is too early to base any conclusions on the volume or to form any firm
trend. The difference between stock index futures and most other financial futures
contracts is that settlement is made at the value of the index at maturity of the contract.
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Example:
If NSE NIFTY is at 5800 and each point in the index equals to Rs.50, a contract
struck at this level could work Rs.290000 (5800x50). If at the expiration of the contract,
the NSE NIFTY is at 5900, a cash settlement of Rs.5000 is required (5900-5800) x50).
Stock Futures:
With the purchase of futures on a security, the holder essentially makes a legally
binding promise or obligation to buy the underlying security at same point in the future
(the expiration date of the contract). Security futures do not represent ownership in a
corporation and the holder is therefore not regarded as a shareholder.
A futures contract represents a promise to transact at same point in the future. In
this light, a promise to sell security is just as easy to make as a promise to buy security.
Selling security futures without previously owing them simply obligates the trader to
sell a certain amount of the underlying security at same point in the future. It can be
done just as easily as buying futures, which obligates the trader to buy a certain amount
of the underlying security at some point in future.
Example:
If the current price of the GMRINFRA share is Rs.170 per share. We believe
that in one month it will touch Rs.200 and we buy GMRINFRA shares. If the price
really increases to Rs.200, we made a profit of Rs.30 i.e. a return of 18%.
If we buy GMRINFRA futures instead, we get the same position as ACC in the cash
market, but we have to pay the margin not the entire amount. In the above example if
the margin is 20%, we would pay only Rs.34 per share initially to enter into the futures
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contract. If GMRINFRA share goes up to Rs.200 as expected, we still earn Rs.30 as
profit.
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PAYOFF FOR FUTURES CONTRACTS

Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of a futures contract are unlimited. These
linear payoffs are fascinating as they can be combined with options and the underlying
to generate various complex payoffs.
Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for
a person who holds an asset. He has a potentially unlimited upside as well as potentially
unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures
contract when Nifty stands at 4800. The underlying asset in this case is Nifty portfolio.
When the index moves up, the long futures position starts making profits, and when
index moves down it starts making losses.
Payoff for a buyer of Nifty futures
20
Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has potentially unlimited upside as well as potentially
unlimited downside.
Payoff for a seller of Nifty futures
Take the case of a speculator who sells a two-month Nifty index futures
contract when the Nifty stands at 4800. The underlying asset in this case is the Nifty
portfolio. When the index moves down, the short futures position starts making profits,
and when index moves up, it starts making losses.
21
PRICING FUTURES
Cost of Carry Model:

We use fair value calculation of futures to decide the no arbitrage limits on the
price of the futures contract. This is the basis for the cost-of-carry model where the
price of the contract is defined as follows.
F=S+C
Where
F - Futures
S - Spot price
C - Holding cost or Carry cost
This can also be expressed as
F = S (1+r) T
Where
r - Cost of financing
T - Time till expiration
22
Pricing index futures given expected dividend amount:

The pricing of index futures is also based on the cost of carry model where the
carrying cost is the cost of financing the purchase of the portfolio underlying the index,
minus the present value of the dividends obtained from the stocks in the index portfolio.
Example
Nifty futures trade on NSE as one, two and three month contracts. Money can be
borrowed at a rate of 15% per annum. What will be the price of a new two-month
futures contract on Nifty?
1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days of purchasing of contract.
2. Current value of Nifty is 1200 and Nifty trade with a multiplier of 200.
41
3. Since Nifty is traded in multiples of 200 value of the contract is
200x1200=240000.
4. If ACC has weight of 7% in Nifty, its value in Nifty is Rs.16800 i.e.
(240000x0.07).
5. If the market price of ACC is Rs.140, then a traded unit of Nifty involves 120
shares of ACC i.e. (16800/140).
6. To calculate the futures price we need to reduce the cost of carry to the extent of
dividend received is Rs.1200 i.e. (120x10). The dividend is received 15 days
later and hence compounded only for the remainder of 45 days. To calculate the
futures price we need to compute the amount of dividend received for unit of
Nifty. Hence, we divided the compounded figure by 200.
7. Thus futures price
F = 1200(1.15) 60/365 – (120x10(1.15) 45/365)/200 = Rs.1221.80.
23
Pricing index futures given expected dividend yield

If the dividend flow through out the year is generally uniform, i.e. if there are few
historical cases of clustering of dividends in any particular month, it is useful to
calculate the annual dividend yield.
F = S (1+ r-q) T
Where
F- Futures price
S - Spot index value
r - Cost of financing
q - Expected dividend yield
T - Holding period
Example:
A two-month futures contract trades on the NSE. The cost of financing is 15% and the
dividend yield on Nifty is 2% annualized. The spot value of Nifty is 1200. What would
be the fair value of the futures contract?
Fair value = 1200(1+0.15-0.02) 60/365 = Rs.1224.35
42
Pricing stock futures

A futures contract on a stock gives its owner the right and the obligation to buy
or sell the stocks. Like, index futures, stock futures are also cash settled: There is no
delivery of the underlying stock.
24
Pricing stock futures when no dividend is expected

The pricing of stock futures is also based on the cost of carry model, where the
carrying cost is the cost of financing the purchase of the stock, minus the present value
of the dividends obtained from the stock. If no dividends are expected during the life of
the contract, pricing futures on that stock is very simple. It simply involves the
multiplying the spot price by the cost of carry.
Example:
SBI futures trade on NSE as one, two and three month contracts. Money can be
borrowed at 15% per annum. What will be the price of a unit of new two-month futures
contract on SBI if no dividends are expected during the period?
1. Assume that the spot price of SBI is Rs.228.
2. Thus, futures price F = 228(1.15) 60/365 = Rs.223.30.
Pricing stock futures when dividends are expected

When dividends are expected during the life of futures contract, pricing involves
reducing the cost of carrying to the extent of the dividends. The net carrying cost is the
cost of financing the purchase of the stock, minus the present value of the dividends
obtained from the stock.
Example:
ACC futures trade on NSE as one, two and three month contracts.
What will be the price of a unit of new two-month futures contract on ACC if dividends
are expected during the period?
43
1. Let us assume that ACC will be declaring a dividend of Rs.10/- per share after
15 days pf purchasing contract.
2. Assume that the market price of ACC is Rs.140/-
3. To calculate the futures price, we need to reduce the cost of carrying to the
extent of dividend received. The amount of dividend received is Rs.10/-. The
dividend is received 15 days later and hence, compounded only for the
remaining 45 days.
4. Thus, the futures price
F = 140 (1.15) 60/365 – 10(1.15) 45/365 = Rs.133.08.
25
OPTIONS
An option is a derivative instrument since its value is derived from the
underlying asset. It is essentially a right, but not an obligation to buy or sell an asset.
Options can be a call option (right to buy) or a put option (right to sell). An option is
valuable if and only if the prices are varying.
An option by definition has a fixed period of life, usually three to six months.
An option is a wasting asset in the sense that the value of an option diminishes as the
date of maturity approaches and on the date of maturity it is equal to zero.
An investor in options has four choices before him. Firstly, he can buy a call option
meaning a right to buy an asset after a certain period of time. Secondly, he can buy a
put option meaning a right to sell an asset after a certain period of time. Thirdly, he can
write a call option meaning he can sell the right to buy an asset to another investor.
Lastly, he can write a put option meaning he can sell a right to sell to another investor.
Out of the above four cases in the first two cases the investor has to pay an option
premium while in the last two cases the investors receives an option premium.
DEFINITION:
An option is a derivative i.e. its value is derived from something else. In the
case of the stock option its value is based on the underlying stock (equity). In the case
of the index option, its value is based on the underlying index.
Options clearing corporation

The Options Clearing Corporation (OCC) is guarantor of all exchange-traded
options once an option transaction has been completed. Once a seller has written an
option and a buyer has purchased that option, the OCC takes over it. It is the
responsibility of the OCC who over sees the obligations to fulfill the exercises. If I
want to exercise an ACC November 100-call option, I notify my broker. My broker
notifies the OCC, the OCC then randomly selects a brokerage firm, which is short of
46
one ACC stock. That brokerage firm then notifies one of its customers who have
written one ACC November 100 call option and exercises it. The brokerage firm
customer can be chosen in two ways. He can be chosen at random or FIFO basis.
Because, OCC has a certain risk that the seller of the option can’t fulfill the contract,
strict margin requirement are imposed on sellers. This margin requirements acts as a
performance Bond. It assures that OCC will get its money.
26
OPTIONS TERMINOLOGY
Call Option:
A call option gives the holder the right but not the obligation to buy an asset by
a certain date for a certain price.
Put option:
A put option gives the holder the right but the not the obligation to sell an asset
by a certain date for a certain price.
Option price:
Option price is the price, which the option buyer pays to the option seller. It is
also referred to as the option premium.
Expiration date:
The date specified in the option contract is known as the expiration date, the
exercise date, the straight date or the maturity date.
Strike Price:
The price specified in the option contract is known as the strike price or the
exercise price.
American options:
American options are the options that the can be exercised at any time up to the
expiration date. Most exchange-traded options are American.
European options:
European options are the options that can be exercised only on the expiration
date itself. European options are easier to analyze than the American options and
properties of an American option are frequently deduced from those of its European
counter part.
27
In-the-money option:
An in-the-money option (ITM) is an option that would lead to a positive cash
flow to the holder if it were exercised immediately. A call option in the index is said to
be in the money when the current index stands at higher level that the strike price (i.e.
spot price > strike price). If the index is much higher than the strike price the call is said
to be deep in the money. In the case of a put option, the put is in the money if the index
is below the strike price.
At-the-money option:
An At-the-money option (ATM) is an option that would lead to zero cash flow
if it exercised immediately. An option on the index is at the money when the current
index equals the strike price (I.e. spot price = strike price).
Out-of-the-money option:
An out of the money (OTM) option is an option that would lead to a negative
cash flow if it were exercised immediately. A call option on the index is out of the
money when the current index stands at a level, which is less than the strike price (i.e.
spot price < strike price). If the index is much lower than the strike price the call is said
to be deep OTM. In the case of a put, the put is OTM if the index is above the strike
price.
48
Intrinsic value of an option:
It is one of the components of option premium. The intrinsic value of a call is
the amount the option is in the money, if it is in the money. If the call is out of the
money, its intrinsic value is Zero. For example X, take that ABC November-call option.
If ABC is trading at 102 and the call option is priced at 2, the intrinsic value is 2. If
ABC November-100 put is trading at 97 the intrinsic value of the put option is 3. If
ABC stock was trading at 99 an ABC November call would have no intrinsic value and
conversely if ABC stock was trading at 101 an ABC November-100 put option would
have no intrinsic value. An option must be in the money to have intrinsic value.
Time value of an option:
The value of an option is the difference between its premium and its intrinsic
value. Both calls and puts have time value. An option that is OTM or ATM has only
time value. Usually, the maximum time value exists when the option is ATM. The
longer the time to expiration, the greater is an options time value. At expiration an
option should have no time value.
28
CHARACTERISTICS OF OPTIONS:
The following are the main characteristics of options:

1. Options holders do not receive any dividend or interest.
2. Options holders receive only capital gains.
3. Options holder can enjoy a tax advantage.
4. Options are traded at O.T.C and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying asset.
6. Options create the possibility of gaining a windfall profit.
7. Options holders can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable the investors to gain a better return with a limited amount of
investment.
Call Option:
An option that grants the buyer the right to purchase a desired instrument is
called a call option. A call option is contract that gives its owner the right but not the
obligation, to buy a specified asset at specified prices on or before a specified date.
An American call option can be exercised on or before the specified date. But, a
European option can be exercised on the specified date only.
The writer of the call option may not own the shares for which the call is
written. If he owns the shares it is a ‘Covered Call’ and if he des not owns the shares it
is a ‘Naked call’.
Strategies:
The following are the strategies adopted by the parties of a call option.
Assuming that brokerage, commission, margins, premium, transaction costs and taxes
are ignored.
A call option buyer’s profit/loss can be defined as follows:
➢ At all points where spot price < exercise price, there will be a loss.
➢ At all points where spot prices > exercise price, there will be a profit.
➢ Call Option buyer’s losses are limited and profits are unlimited.
Conversely, the call option writer’s profits/loss will be as follows:
➢ At all points where spot prices < exercise price, there will be a profit
➢ At all points where spot prices > exercise price, there will be a loss
➢ Call Option writer’s profits are limited and losses are unlimited.
29
Following is the table, which explains In the-money, Out-of-the-money and At-themoney

position for a Call option.
Exercise call option Spot price>Exercise price In-The-Money
Do not exercise Spot price<Exercise price Out-of the-Money
Exercise/Do not exercise Spot price=Exercise price At-The-Money
Example:
The current price of NTPC share is Rs.260. Holder expect that price in a three
month period will go up to Rs.300 but, holder do fear that the price may fall down
below Rs.260.
To reduce the chance of holder risk and at the same time, to have an opportunity
of making profit, instead of buying the share, the holder can buy a three-month call
option on NTPC share at an agreed exercise price of Rs.250.
1. If the price of the share is Rs.300. then holder will exercise the option since
he get a share worth Rs.300. by paying a exercise price of Rs.250. holder
will gain Rs.50. Holder’s call option is In-The-Money at maturity.
2. If the price of the share is Rs.220. then holder will not exercise the option.
Holder will gain nothing. It is Out-of-the-Money at maturity.
30
Payoff for buyer of call option: Long call

The profit/loss that the buyer makes on the option depends on the spot price of
the underlying asset. If upon expiration, the spot price exceeds the strike price, he
makes a profit. Higher the spot price more is the profit he makes. If the spot price of the
underlying asset is less than the strike price, he lets his option un-exercise. His loss in
this case is the premium he paid for buying the option.
Payoff for writer of call option: Short call

For selling the option, the writer of the option charges premium. Whatever is the
buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike
price, the buyer will exercise the option on the writer. Hence as the spot price increases
the writer of the option starts making losses. Higher the spot price more is the loss he
makes. If upon expiration the spot price is less than the strike price, the buyer lets his
option un-exercised and the writer gets to keep the premium.
31
Put option:
An option that gives the seller the right to sell a designated instrument is
called put option. A put option is a contract that gives the owner the right, but not the
obligation to sell a specified number of shares at a specified price on or before a
specified date.
An American put option can be exercised on or before the specified date. But,
a European put option can be exercised on the specified date only.
The following are the strategies adopted by the parties of a put option.
➢ A put option buyer’s profit/loss can be defined as follows:
At all points where spot price<exercise price, there will be a gain.
At all points where spot price>exercise price, there will be a loss.
➢ Conversely, the put option writer’s profit/loss will be as follows:
At all points where spot price<exercise price, there will be a loss.
At all points where spot price>exercise price, there will be a profit.
Following is the table, which explains In-the-money, Out-of-the Money and At-themoney
positions for a Put option.
Exercise put option Spot price<Exercise price In-The-Money
Do not Exercise Spot price>Exercise price Out-of-The-Money
Exercise/Do not Exercise Spot price=Exercise price At-The-Money
Example:
The current price of RPL share is Rs.250. Holder by a three month put option at
exercise price of Rs.260. (Holder will Exercise his option only if the market price/ spot
price is less than the exercise price).
If the market/Spot price of the NTPC share is Rs.245. then the holder will exercise the
option. Means put option holder will buy the share for Rs.245. In the market and
deliver it to the option writer for Rs.260. the holder will gain Rs.15 from the contract.
32
Payoff for buyer of put option: Long put.

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon the expiration, the spot price is below the
strike price, he makes a profit. Lower the spot price more is the profit he makes. If the
spot price of the underlying asset is higher than the strike price, he lets his option expire
un-exercised
Payoff for writer of put option: Short put

The profit/losses for the seller/writer of a three-monthput option. As the spot Nifty falls,
the put option is In-The-Money and the writer starts
making losses. If upon expiration, Nifty closes below the strike of 4850, the buyer
would exercise his option on writer who would suffer losses to the extent of the
difference between the strike price and Nifty-close.
33
Pricing Options:
Factors determining options value:
Exercise price and Share price:

If the share price is more than the exercise price then the holder of the call
option will get more net payoff, means the value of the call option is more. If the share
price is less than the exercise price then the holder of the put option will get more net
pay-off.
Interest Rate:
The present value of the exercise price will depend on the interest rate. The
value of the call option will increase with the rise in interest rates. Since, the present
value of the exercise price will fall; the effect is reversed in the case of a put option.
The buyer of a put option receives exercise price and therefore as the interest increases,
the value of the put option will decrease.
Time to Expiration:
The present value of the exercise price also depends on the time to expiration
of the option. The present value of the exercise price will be less if the time to
expiration is longer and consequently value of the option will be higher. Longer the
time to expiration higher is the possibility of the option to be more in the money.
Volatility:
The volatility part of the pricing model is used to measure fluctuations
expected in the value of the underlying security or period of time. The more volatile the
underlying security, the greater is the price of the option. There are two different kinds
of volatility.
They are Historical Volatility and Implied Volatility. Historical volatility
estimates volatility based on past prices. Implied volatility starts with the option price
as a given, and works backward to ascertain the theoretical value of volatility which is
equal to the market price minus any intrinsic value.
34
Difference between the Futures and Options
Futures Options
Both the parties are obligated to Only the seller (writer) is
perform. obligated to perform.
1
2. In futures either parties pay . In options the buyer pays the

premium. seller a premium.
2
The parties to the futures contract The buyer of an options contract

must perform at the settlement can exercise the option at any
date only. They are obligated to time prior to expiration date.
3
perform on the maturity date.
The holder of the contract is . The buyer limits the downside

exposed to the entire spectrum of risk to the option premium but
downside risk and had the retain the upside potential.
4
potential for all the upside return.
In futures margins are to be paid. In options premium are to be paid.

They are approximately 15% to But they are less as compare to
20% on the current stock price. margin in futures.
5
35
CONCLUSIONS
➢ Derivatives have existed and evolved over a long time, with roots in
commodities market. In the recent years advances in financial markets and the
technology have made derivatives easy for the investors.
➢ Derivatives market in India is growing rapidly unlike equity markets.

Trading in derivatives require more than average understanding of finance.
Being new tmarkets maximum number of investors have not yet understood the
ful implications of the trading in derivatives. SEBI should take actions to create
awareness in investors about the derivative market.
➢ Introduction of derivatives implies better risk management. These markets can

give greater depth, stability and liquidity to Indian capital markets. Successful
risk management with derivatives requires a thorough understanding of
principles that govern the pricing of financial derivatives.
➢ In order to increase the derivatives market in India SEBI should revise some of
their regulation like contract size, participation of FII in the derivative market.
Contract size should be minimized because small investor cannot afford this
much of huge premiums.
➢ In cash market the profit/loss is limited but where in F& O an investor can enjoy
unlimited profits/loss.
➢ At present scenario the Derivatives market is increased to a great position. Its

daily turnover teaches to the equal stage of cash market.
➢ The derivatives are mainly used for hedging purpose.
➢ 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.
➢ In derivative segment the profit/loss of the option holder/option writer is purely

depended on the fluctuations of the underlying asset.
36
Suggestions to Investors
The investors can minimize risk by investing in derivatives. The use of derivative
equips the investor to face the risk, which is uncertain. Though the use of derivatives
does not completely eliminate the risk, but it certainly lessens the risk.
It is advisable to the investor to invest in the derivatives market because of the greater
amount of liquidity offered by the financial derivatives and the lower transactions costs
associated with the trading of financial derivatives.
The derivatives products give the investor an option or choice whether to exercise the
contract or not. Options give the choice to the investor to either exercise his right or
not. If on expiry date the investor finds that the underlying asset in the option contract
is traded at a less price in the stock market then, he has the full liberty to get out of the
option contract and go ahead and buy the asset from the stock market. So in case of
high uncertainty the investor can go for options.
However, these instruments act as a powerful instrument for knowledgeable traders to
expose them to the properly calculated and well understood risks in pursuit of reward
i.e. profit.
37

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Vivek College Of Commerce

OBJECTIVES OF THE STUDY:

➢ To understand the concept of the Financial Derivatives such as Forwards,

SCOPE OF THE STUDY

The study is limited to “Derivatives” With special reference to Futures and

RATIONALE BEHIND THE DEVELOPMENT OF

1. Their value is derived from an underlying instrument such as stock index,

MAJOR PLAYERS IN DERIVATIVE MARKET:

Most commonly used derivative contracts are:

Forwards: A forward contract is a customized contract between two entities where

RISKS INVOLVED IN DERIVATIVES:

B. Market Risk: Market risk is a risk of financial loss as a result of adverse

C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing

Derivatives Segments in NSE & BSE

Members of F&O segment:

Considering the constraints in infrastructure facilities the existing stock

Forward Trading in Securities

FEATURES OF FUTURES CONTRACTS

Margins: In order to avoid unhealthy competition among clearing members in

Spot price: The price at which an asset is traded in spot market.

PAYOFF FOR FUTURES CONTRACTS

Payoff for buyer of futures: Long futures

Payoff for a buyer of Nifty futures

Payoff for seller of futures: Short futures

Payoff for a seller of Nifty futures

Cost of Carry Model:

Pricing index futures given expected dividend amount:

Pricing index futures given expected dividend yield

Pricing stock futures

Pricing stock futures when no dividend is expected

Pricing stock futures when dividends are expected

Options clearing corporation

The following are the main characteristics of options:

Following is the table, which explains In the-money, Out-of-the-money and At-themoney

Exercise call option Spot price>Exercise price In-The-Money

Do not exercise Spot price<Exercise price Out-of the-Money

Exercise/Do not exercise Spot price=Exercise price At-The-Money

Payoff for buyer of call option: Long call

Payoff for writer of call option: Short call

Exercise put option Spot price<Exercise price In-The-Money

Do not Exercise Spot price>Exercise price Out-of-The-Money

Exercise/Do not Exercise Spot price=Exercise price At-The-Money

Payoff for buyer of put option: Long put.

Payoff for writer of put option: Short put

Exercise price and Share price:

Difference between the Futures and Options

2. In futures either parties pay . In options the buyer pays the

The parties to the futures contract The buyer of an options contract

The holder of the contract is . The buyer limits the downside

In futures margins are to be paid. In options premium are to be paid.

➢ Derivatives market in India is growing rapidly unlike equity markets.

➢ Introduction of derivatives implies better risk management. These markets can

➢ At present scenario the Derivatives market is increased to a great position. Its

➢ The derivatives are mainly used for hedging purpose.

➢ In derivative segment the profit/loss of the option holder/option writer is purely

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