Introduction to

Derivatives
Financial Institutions, Instruments & Markets

Submitted to: Prof. Manohar Singh

Submitted by:
Aditya Ganti (P301413CMG291)
Anuj Singhal (P301413CMG299)
Gajanan Tiwari (P301413CMG311)
Gajanand Kumar Sharma (P301413CMG312)
Nukaraju Maroju (P301413CMG331)
Shikar Taneja (P301413CMG367)
MBA (F&B), Batch VI, Term V

Table of Contents
Executive Summary...................................................................................................................4
Introduction................................................................................................................................6
Definition of Derivatives............................................................................................................6
Literature Review.......................................................................................................................7
Objectives...................................................................................................................................7
Importance of Derivatives......................................................................................................7
Advantages of Derivatives.....................................................................................................8
Indian Equity Market A Brief History.....................................................................................8
Products Traded in Derivatives Segment of the BSE.............................................................8
Products Traded in Derivatives Segment of the NSE.............................................................9
Trade Details of Derivatives in NSE......................................................................................9
Trade Details of Derivatives in BSE....................................................................................10
Product-wise Distribution of Turnover of F&O Segment....................................................10
Types of Derivative Markets....................................................................................................11
Major Players in Derivative Markets....................................................................................11
Types of Derivatives.................................................................................................................12
Forward Contracts....................................................................................................................12
Futures Contract.......................................................................................................................13
Futures Terminology.............................................................................................................15
Future Contract Payoffs........................................................................................................16
Pricing of future contract......................................................................................................17
Uses of Futures.....................................................................................................................18
Hedging.............................................................................................................................18
Portfolio Hedging.............................................................................................................18
Modes of Arbitrage...........................................................................................................19
Cash Management.............................................................................................................20
Exposure...........................................................................................................................20
Leveraged Directional Trading.........................................................................................20
Index Futures........................................................................................................................21
Stock Futures........................................................................................................................21
Distinction between Forward Contract & Future Contract......................................................22

Option Contract........................................................................................................................23
Option Contract Terminology...............................................................................................23
Salient Features of Options..................................................................................................24
Option Payoffs......................................................................................................................26
Pricing of Options.................................................................................................................29
Participants in the Options Market.......................................................................................30
Swaps.......................................................................................................................................30
Interest Rate Swaps..............................................................................................................30
Currency Swaps....................................................................................................................30
Equity Derivatives....................................................................................................................30
Equity Options......................................................................................................................31
Warrants................................................................................................................................31
Convertible Bonds................................................................................................................31
Equity Futures, Options & Swaps........................................................................................31
Stock market index futures...............................................................................................31
Equity basket derivatives..................................................................................................31
Single Stock Futures.........................................................................................................31
Equity index swaps...........................................................................................................32
Equity swap.......................................................................................................................32
Exchange-traded derivatives.............................................................................................32
Clearing and Settlement...........................................................................................................32
Clearing Mechanism.............................................................................................................32
Conclusion................................................................................................................................34
References................................................................................................................................35

Executive Summary
We would like to brief about the current Indian market and comparing it with it
past. We are also giving brief data about foreign market.
With over 25 million shareholders, India has the third largest investor base in the
world after USA and Japan. Over 7500 companies are listed on the Indian stock
exchanges (more than the number of companies listed in developed markets of
Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.).
The Indian capital market is significant in terms of the degree of development,
volume of trading, transparency and its tremendous growth potential.
Indias market capitalization was the highest among the emerging markets. Total
market capitalization of The Bombay Stock Exchange (BSE), which, as on July 31,
1997, was US$ 175 billion has grown by 37.5% percent every twelve months and
was over US$ 1565 billion as of December, 2014. Bombay Stock Exchanges
(BSE), one of the oldest in the world, accounts for the largest number of listed
companies transacting their shares on a nationwide online trading system. The
two major exchanges namely the National Stock Exchange (NSE) and the
Bombay Stock Exchange (BSE) ranked in Top 10 in the world, calculated by the
number of daily transactions done on the exchanges.
Derivatives trading in the stock market have been a subject of enthusiasm of
research in the field of finance the most desired instruments that allow market
participants to manage risk in the modern securities trading are known as
derivatives. The derivatives are defined as the future contracts whose value
depends upon the underlying assets. If derivatives are introduced in the stock
market, the underlying asset may be anything as component of stock market
like, stock prices or market indices, interest rates, etc. The main logic behind
derivatives trading is that derivatives reduce the risk by providing an additional
channel to invest with lower trading cost and it facilitates the investors to extend
their settlement through the future contracts. It provides extra liquidity in the
stock market. Derivatives are assets, which derive their values from an
underlying asset.
These underlying assets are of various categories like
Commodities including grains, coffee beans, etc.
Precious metals like gold and silver.
Foreign exchange rate.
Bonds of different types, including medium to long-term negotiable debt
securities issued by governments, companies, etc.
Short-term debt securities such as T-bills.
Over-The-Counter (OTC) money market products such as loans or deposits.
Equities

For example, a dollar forward is a derivative contract, which gives the buyer a
right & an obligation to buy dollars at some future date. The prices of the
derivatives are driven by the spot prices of these underlying assets.
However, the most important use of derivatives is in transferring market risk,
called Hedging, which is a protection against losses resulting from unforeseen
price or volatility changes. Thus, derivatives are a very important tool of risk
management.

There are various derivative products traded. They are;

1. Forwards
2. Futures
3. Options
4. Swaps
A Forward Contract is a transaction in which the buyer and the seller agree
upon a delivery of a specific quality and quantity of asset usually a commodity at
a specified future date. The price may be agreed on in advance or in future.
A Future contract is a firm contractual agreement between a buyer and seller
for a specified as on a fixed date in future. The contract price will vary according
to the market place but it is fixed when the trade is made. The contract also has
a standard specification so both parties know exactly what is being done.
An Options contract confers the right but not the obligation to buy (call
option) or sell (put option) a specified underlying instrument or asset at a
specified price the Strike or Exercised price up until or an specified future date
the Expiry date. The Price is called Premium and is paid by buyer of the option
to the seller or writer of the option.

Introduction
The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was
sown to the time it was ready for harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
partially or fully transfer price risks by locking-in asset prices. These were simple

contracts developed to meet the needs of farmers and were basically a means of
reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he would
receive for his harvest in September. In years of scarcity, he would probably
obtain attractive prices. However, during times of oversupply, he would have to
dispose off his harvest at a very low price. Clearly this meant that the farmer and
his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would
face a price risk that of having to pay exorbitant prices during dearth, although
favourable prices could be obtained during periods of oversupply. Under such
circumstances, it clearly made sense for the farmer and the merchant to come
together and enter into contract whereby the price of the grain to be delivered in
September could be decided earlier. What they would then negotiate happened
to be futures-type contract, which would enable both parties to eliminate the
price risk.
In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers
and merchants together. A group of traders got together and created the toarrive contract that permitted farmers to lock into price upfront and deliver the
grain later. These to-arrive contracts proved useful as a device for hedging and
speculation on price charges. These were eventually standardized, and in 1925
the first futures clearing house came into existence.
Today derivatives contracts exist on variety of commodities such as corn, pepper,
cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist
on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

Definition of Derivatives
Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines
Derivative 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.
The International Monetary Fund (2001) defines derivatives as financial
instruments that are linked to a specific financial instrument or indicator or
commodity and through which specific risks can be traded in financial markets in
their own right. The value of a financial derivative derives from the price of an
underlying item, such as an asset or index. Unlike debt securities, no principal is
advanced to be repaid and no investment income accrues.
In normal words, we can say that A Derivative is a financial instrument whose
value depends on other, more basic, underlying variables. The variables
underlying could be prices of traded securities and stock, prices of gold or
copper. A derivative is a financial instrument whose value is derived from the
value of another asset, which is known as underlying. It is a contract that derives

its value from changes in the price of the underlying. When the value of
underlying changes the value of derivative also changes.

Literature Review
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.
Derivative products initially emerged, as hedging devices against fluctuations in
commodity prices and commodity-linked derivatives remained the sole form of
such products for almost three hundred years. The financial derivatives came
into spotlight in post-1970 period due to growing instability in the financial
markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions
in derivative products. In recent years, the market for financial derivatives has
grown tremendously both in terms of variety of instruments available, their
complexity and also turnover. In the class of equity derivatives, futures and
options on stock indices have gained more popularity than on individual stocks,
especially among institutional investors, who are major users of index-linked
derivatives.
Even small investors find these useful due to high correlation of the popular
indices with various portfolios and ease of use. The lower costs associated with
index derivatives vis-vis derivative products based on individual securities is
another reason for their growing use.

Objectives

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives
To know the role of derivatives trading in India.
To analyse the performance of Derivatives Trading since 2001with special
reference to Futures & Options

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.

Advantages of Derivatives

Reduces Risk
Enhances liquidity of the underlying asset
Lower transaction costs
Enhances the price discovery process
Portfolio Management
Provides signal of market movements
Facilitates financial markets integration

Indian Equity Market A Brief History

Products Traded in Derivatives Segment of the BSE

Products Traded in Derivatives Segment of the NSE

Trade Details of Derivatives in NSE

Trade Details of Derivatives in BSE

Product-wise Distribution of Turnover of F&O Segment

Types of Derivative Markets

Major Players in Derivative Markets

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. A Hedger is a trader who enters the derivative market to reduce a preexisting risk. In India, most derivatives users describe themselves as hedgers
(Fitch Ratings, 2004) and Indian laws generally require the use of derivatives for
hedging purposes only.
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.
Speculators, the next participant in the derivative market, buy and sell
derivatives to book the profit and not to reduce their risk. They wish to take a
position in the market by betting on future price movement of an asset.
Speculators are attracted to exchange traded derivative products because of
their high liquidity, high leverage, low impact cost, low transaction cost and
default risk behavior. Futures and options both add to the potential gain and
losses of the speculative venture. It is the speculators who keep the market
going because they bear the risks, which no one else is willing to bear.
Arbitrageur
Risk less profit making is the prime goal of arbitrageurs. They could be making
money even without 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 centres. Arbitrageur is basically riskaverse and enters into the contracts, having the potential to earn riskless profits.
It is possible for an arbitrageur to have riskless profits by buying in one market
and simultaneously selling in another, when markets are imperfect (long in one
market and short in another market). Arbitrageurs always look out for such price
differences. Arbitrageurs fetch enormous liquidity to the products which are
exchanges traded. The liquidity in-turn results in better price discovery, lesser
market manipulation and lesser cost of transaction.

Types of Derivatives

Derivativ
es
Forward

Future

Options

Swaps

Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for
a specified price. One of the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain specified future date for a certain
specified price. The other party assumes a short position and agrees to sell the
asset on the same date for the same price. Other contract details like delivery
date, price and quantity are negotiated bilaterally by the parties to the contract.
The forward contracts are normally traded outside the exchanges.
Salient Features of Forward Contracts
They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed, and hence is unique in terms of
contract size, expiration date and the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the
asset.
If the party wishes to reverse the contract, it has to compulsorily go to the
same counter-party, which often results in high prices being charged.
However forward
very standardized,

contracts
in
certain
markets have
become
as
in the case of foreign exchange, thereby

reducing transaction costs and increasing transactions volume. This process

of standardization reaches its limit in the organized futures market. Forward
contracts are often confused with futures contracts. The confusion is primarily
because both serve essentially the same economic functions of allocating risk in
the presence of future price uncertainty. However futures are a significant
improvement over the forward contracts as they eliminate counterparty risk
and offer more liquidity.

Futures Contract
In finance, a futures contract is a standardized contract, traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date in the
future, at a pre-set price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price. The
settlement price, normally, converges towards the futures price on the delivery
date.
A futures contract gives the holder the right and the obligation to buy or sell,
which differs from an options contract, which gives the buyer the right, but not
the obligation, and the option writer (seller) the obligation, but not the right. To
exit the commitment, the holder of a futures position has to sell his long position
or buy back his short position, effectively closing out the futures position and its
contract obligations. Futures contracts are exchange traded derivatives. The
exchange acts as counterparty on all contracts, sets margin requirements, etc.
Salient Features of Future Contracts
1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
The underlying. This can be anything from a barrel of sweet crude oil to a
short term interest rate.
The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.
The currency in which the futures contract is quoted.
The grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only
the quality of the underlying goods but also the manner and location of
delivery. The delivery month.
The last trading date and Other details such as the tick, the minimum
permissible price fluctuation.

2. Margin
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in value,
and creates a credit risk to the exchange, who always acts as counterparty. To
minimize this risk, the exchange demands that contract owners post a form of
collateral, commonly known as Margin requirements are waived or reduced in
some cases for hedgers who have physical ownership of the covered commodity
or spread traders who have offsetting contracts balancing the position.
Initial Margin: is paid by both buyer and seller. It represents the loss on that
contract, as determined by historical price changes, which is not likely to be
exceeded on a usual day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may
exhaust the initial margin, a further margin, usually called variation or
maintenance margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing on a price at the end of each day, called the
"settlement" or mark-to-market price of the contract.
Eg : Mr. X buys Nifty Futures at 1300

To understand the original practice, consider that a futures trader, when taking a
position, deposits money with the exchange, called a "margin". This is intended
to protect the exchange against loss. At the end of every trading day, the
contract is marked to its present market value. If the trader is on the winning
side of a deal, his contract has increased in value that day, and the exchange
pays this profit into his account. On the other hand, if he is on the losing side, the
exchange will debit his account. If he cannot pay, then the margin is used as the
collateral from which the loss is paid.
3. Settlement

Settlement is the act of consummating the contract, and can be done in one of
two ways, as specified per type of futures contract:
Physical delivery - the amount specified of the underlying asset of the contract
is delivered by the seller of the contract to the exchange, and by the exchange to
the buyers of the contract. In practice, it occurs only on a minority of contracts.
Most are cancelled out by purchasing a covering position - that is, buying a
contract to cancel out an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long).
Cash settlement - a cash payment is made based on the underlying reference
rate, such as a short term interest rate index such as Euribor, or the closing
value of a stock market index. A futures contract might also opt to settle against
an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For many
equity index and interest rate futures contracts, this happens on the Last
Thursday of certain trading month. On this day the t+2 futures contract becomes
the t forward contract.

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.

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: Outstanding/unsettled sale position at any time point of time.

Future Contract Payoffs

The buyer of a futures contract agrees to purchase a certain quantity of a
particular commodity or financial instrument at a pre-specified price and time.
The seller of the futures contract promises to deliver the commodity or financial
instrument on the appointed date in return for payment at the settlement price.
The value of these promises (to the buyer) increases as the price of the
underlying asset rises.

Above figure shows the payoff from buying a futures contract. As the price of the
underlying asset rises above the settlement price, the payoff to the futures
contract buyer goes up one for one that is to say, a $1 dollar increase in the
price of the underlying asset raises the payoff to the long position by $1. As the
price falls below the settlement price, the value of the long position falls. In fact,
the payoff from purchasing the underlying asset itself is exactly the same as the
payoff from buying a future, since arbitrage forces the futures price to move with
the price of the underlying asset. The crucial difference is that, in buying a

futures contract, all the buyer needs to do is post margin. While buying a futures
contract is substantially cheaper than buying the underlying asset, it means
accepting greater risk.

The payoff from selling a futures contract, or taking the short position, is shown
in Figure above. This mirror image of previous graph shows that the buyers
gains are the sellers losses, and vice versa. Again, the payoff to the short
position rises and falls one-for-one with the price of the underlying asset a $1
increase in the price of the underlying asset reduces the payoff to the seller by
$1, while a $1 fall in the price raises the payoff by $1.

Pricing of future contract

In a futures contract, for no arbitrage to be possible, the price paid on delivery
(the forward price) must be the same as the cost (including interest) of buying
and storing the asset. In other words, the rational forward price represents the
expected future value of the underlying discounted at the risk free rate. Thus, for
a simple, non-dividend paying asset, the value of the future/forward,
be found by discounting the present value

at time to maturity

of risk-free return .

In simple we can write the above in the following way

F=S+C
Where
F - Futures
S - Spot price
C - Holding cost or Carry cost

, will

by the rate

This can also be expressed as

F = S (1+r) T
Where
r - Cost of financing
T - Time till expiration
This relationship may be modified for storage costs, dividends, dividend yields,
and convenience yields. Any deviation from this equality allows for arbitrage as
follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today
(on the spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.
In the case where the forward price is lower:
1. The arbitrageur buys the futures contract and sells the underlying today
(on the spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using
the matured investment. [If he was short the underlying, he returns it
now.]
4. The difference between the two amounts is the arbitrage profit.

Uses of Futures
Hedging
Is a mechanism to reduce price risk, by taking an opposite position in
futures market.
Eg : Equity Investments of USD 1bn
Hedging can be initiated by Selling Nifty Futures.hedge can be for
20%, 50% or 100% based on view
Ideally 25 35% hedge is kept at all times, then based on view, its
increased or decreased
Similarly hedge can be initiated also for a single stock
Portfolio Hedging

Modes of Arbitrage
Lending funds to the market
Scenario: Stock ABC trading at 100, and its one month futures is trading at 110
(Fm)
Stock information on stock
exchange
Spot Price
100
Rate
5%
Theoretical Future price
101.3
Market Future price
110
Strategy
Borrow at 5%
Long stock at spot
Short Futures
Net cash flow

0
100
-100

1 (3 months)
-101.3
110

8.7

Lending securities to the market (assuming we hold the delivery of the

stock)
Scenario: Stock ABC trading at 100, and its one month futures is trading at
101
Action: Sell stock ABC in cash segment and simultaneously Buy its one
month futures

Stock information on stock

exchange
Spot Price
100
Rate
10%
Theoritical Future price
102.5
Market Future price
101
Strategy
Lend at 10%
Sell at spot
Long Futures

0
-100
100

Net cash flow

1 (3 months)
102.5
-101
1.5

Costs Involved

Brokerage (inclusive of service tax of 10.20%)

o Equity: 0.05%
o Futures: 0.05%
Securities Transaction Tax
o Equity: 0.125%
o Futures: 0.0166%
Margin costs
o Initial margin between 15 20%
o Exposure margin between 5 10%
o Mark to market margin depending on the futures movement
Custody and clearing charges

Cash Management
During redemption pressures or during times of tight cash position, equity
positions can be shifted to futures
By doing this, same exposure is maintained at a small margin, thus
releasing much needed cash
Exposure
Exposure can be initiated in futures before the actual fresh fund inflows
Opportunity not missed if markets move up
Leveraged Directional Trading
Trade your short term view on the market or single stock based on budget,
corporate numbers, economic reforms, political scenario, unforeseen
events etc via futures
If you believe that your activity in equity is going to impact the price, then
its worth taking an upfront exposure in futures first
This can lead to generation of incremental returns

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 scrips. 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.
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 contract. If GMRINFRA share goes up to Rs.200 as
expected, we still earn Rs.30 as profit.

Distinction between Forward Contract & Future Contract

FEATURE

FORWARD CONTRACT

FUTURE CONTRACT

Operational

Traded directly between Traded on the exchanges.

Mechanism

two parties (not traded

on the exchanges).

Contract

Differ

Specification

trade.

from

trade

to Contracts are standardized contracts.

s
Counter-

Exists.

Exists. However, assumed by the

party risk

clearing corp., which becomes the

counter party to all the trades or
unconditionally

guarantees

their

settlement.

Liquidation

Low,

Profile

tailor

as

contracts

made

are High, as contracts are standardized

contracts

catering to the needs of

the needs of the parties.

exchange traded contracts.

Price

Not efficient, as markets

Efficient, as markets are centralized

discovery

are scattered.

and all buyers and sellers come to a

common platform to discover the
price.

Examples

Currency market in India.

Commodities, futures, Index Futures

and Individual stock Futures in India.

Option Contract
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.

Option Contract 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 counterpart.
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.
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 November100 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.

Salient Features of Options

1.
2.
3.
4.
5.
6.
7.
8.
9.

Options holders do not receive any dividend or interest.

Options holders receive only capital gains.
Options holder can enjoy a tax advantage.
Options are traded at O.T.C and in all recognized stock exchanges.
Options holders can control their rights on the underlying asset.
Options create the possibility of gaining a windfall profit.
Options holders can enjoy a much wider risk-return combinations.
Options can reduce the total portfolio transaction costs.
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 does 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 buyers 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 buyers losses are limited and profits are unlimited.
Conversely, the call option writers 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 writers profits are limited and losses are unlimited.
Following is the table, which explains In-the-money, Out-of-the-money and At-the
money position for a Call option.

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. Holders 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.

Option Payoffs
There are four ways to invest in options: buying and selling either a put or a call.
We will begin with the buying of a call option. Remember that buying an option
creates rights but not obligations. Because the buyer need not exercise the
option, the loss from owning it cannot exceed the price paid for it. So long as the
price of the underlying asset is below the strike price of the call, the holder will
not exercise the option, and will lose the premium initially paid for it. This means
that the payoff function is flat, beginning at an underlying asset price of zero and
continuing to the strike price, with a loss equal to the call premium. As the price
of the underlying asset rises beyond the strike price, the call comes into the
money, and the payoff begins to rise one for one with the price of the underlying
asset.

What benefits the call buyer costs the call writer. So long as the underlying asset
price remains below the strike price of the call, the writer pockets the premium,
and the payoff is positive. But when the underlying asset price rises above the
strike price, the writer begins to suffer a loss. The higher the price climbs, the
more the call writer loses, as next Figure shows.

Turning to puts, we can use the same simple process to draw their payoff
diagrams. The buyer of a put purchases the right to sell a stock at the strike
price. Puts have value only when the price of the underlying asset is below the
strike price. The payoff is highest when the price of the underlying asset is
lowest. As the assets price rises, the payoff falls, though it cannot go below the
premium paid for the put.

Writing a put is the reverse of buying one. Again, the writer loses when the
holder gains, so the maximum payoff is the premium. The best outcome for an
option writer is to have the option expire worthless, so that it is never exercised.
Looking at above figure, we can see that the put writers losses are highest when
the price of the underlying asset is lowest; it declines as the price rises. So long
as the asset price exceeds the strike price, the put writers payoff equals the
premium charged to write the put.
Long on Option (Buying)

Short on Option (Selling)

The following are the examples of option on index and stocks:

Nifty Spot Price as on January 2, 2015 is 8395
UnderLying

NIFTY

Produc
t
Symbo
l
OPTIDX

Expiry
Date

Strike
Price

29-Jan15
29-Jan15
29-Jan15

8,400.0
0
8,450.0
0
8,500.0
0

Lot
Size

LTP

Option
Type

NIFTY

OPTIDX

NIFTY

OPTIDX

Underlying

Expiry
Date

Strike
Price

Lot
Size

LTP

Option
Type

NIFTY

Produc
t
Symbo
l
OPTIDX

42033

8100

25

24

Put

NIFTY

OPTIDX

42033

8150

25

28.95

Put

NIFTY

OPTIDX

42033

8200

25

36.1

Put

NIFTY

OPTIDX

42033

8250

25

44.1

Put

25

149.7

Call

25

120.8

Call

25

93.6

Call

ONGC Spot Price:

349.2
Underlying
ONGC

Produc
t
Symbol
OPTSTK

ONGC

OPTSTK

ONGC

OPTSTK

ONGC

OPTSTK

Underlying

Produc
t
Symbo
l

Expiry
Date

Strike
Price

Lot
Size

42,033.
00
42,033.
00
42,033.
00
42,033.
00

310.00

500.00

0.70

Put

320.00

500.00

1.15

Put

330.00

500.00

2.45

Put

340.00

500.00

4.75

Put

Expiry
Date

Strike
Price

Lot
Size

LTP

LTP

Option
Type

Option
Type

ONGC

OPTSTK

ONGC

OPTSTK

ONGC

OPTSTK

29-Jan15
29-Jan15
29-Jan15

350

500

11.7

Call

360

500

Call

370

500

3.95

Call

Pricing of Options
Option premium pricing depends on the following factors:
1.
2.
3.
4.
5.

Underlying equity price

Strike price
Volatility
Maturity
Open Interest

Participants in the Options Market

There are four types of participants in options markets depending on the

position they take:
o Buyers of calls
o Sellers of calls
o Buyers of puts
o Sellers of puts
Buyers are holders (who pay the premium) and sellers are writers (who
receive the premium upfront).
The writers profit or loss is the reverse of that for the purchaser of the
option.

Swaps
Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a SWAP. In case of swap, only the
payment flows are exchanged and not the principle amount. The two commonly
used swaps are:

Interest Rate Swaps

Interest rate swaps is an arrangement by which one party agrees to exchange
his series of fixed rate interest payments to a party in exchange for his variable
rate interest payments. The fixed rate payer takes a short position in the forward
contract whereas the floating rate payer takes a long position in the forward
contract.

Currency Swaps
Currency swaps is an arrangement in which both the principle amount and the
interest on loan in one currency are swapped for the principle and the interest

payments on loan in another currency. The parties to the swap contract of

currency generally hail from two different countries. This arrangement allows the
counter parties to borrow easily and cheaply in their home currencies. Under a
currency swap, cash flows to be exchanged are determined at the spot rate at a
time when swap is done. Such cash flows are supposed to remain unaffected by
subsequent changes in the exchange rates.

Equity Derivatives
In finance, an equity derivative is a class of derivatives whose value is at least
partly derived from one or more underlying equity securities. Options and futures
are by far the most common equity derivatives; however there are many other
types of equity derivatives that are actively traded.

Equity Options
Equity options are the most common type of equity derivative. They provide the
right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1
contract = 100 shares of stock), at a set price (strike price), within a certain
period of time (prior to the expiration date).

Warrants
In finance, a warrant is a security that entitles the holder to buy stock of the
company that issued it at a specified price, which is much lower than the stock
price at time of issue. Warrants are frequently attached to bonds or preferred
stock as a sweetener, allowing the issuer to pay lower interest rates or dividends.
They can be used to enhance the yield of the bond, and make them more
attractive to potential buyers.

Convertible Bonds
Convertible bonds are bonds that can be converted into shares of stock in the
issuing company, usually at some pre-announced ratio. It is a hybrid security
with debt- and equity-like features. It can be used by investors to obtain the
upside of equity-like returns while protecting the downside with regular bond-like
coupons.

Equity Futures, Options & Swaps

Investors can gain exposure to the equity markets using futures, options and
swaps. These can be done on single stocks, a customized basket of stocks or on
an index of stocks. These equity derivatives derive their value from the price of
the underlying stock or stocks.
Stock market index futures
Stock markets index futures are futures contracts used to replicate the
performance of an underlying stock market index. They can be used for hedging
against an existing equity position, or speculating on future movements of the

index. Indices for futures include well-established indices such as S&P 500, FTSE
100, DAX, CAC 40 and other G12 country indices. Indices for OTC products are
broadly similar, but offer more flexibility.
Equity basket derivatives
Equity basket derivatives are futures, options or swaps where the underlying is a
non-index basket of shares. They have similar characteristics to equity index
derivatives, but are always traded OTC (over the counter, i.e. between
established institutional investors),[dubious discuss] as the basket definition is
not standardized in the way that an equity index is.
These are used normally for correlation trading.
Single Stock Futures
Single-stock futures are exchange-traded futures contracts based on an
individual underlying security rather than a stock index. Their performance is
similar to that of the underlying equity itself, although as futures contracts they
are usually traded with greater leverage. Another difference is that holders of
long positions in single stock futures typically do not receive dividends and
holders of short positions do not pay dividends. Single-stock futures may be
cash-settled or physically settled by the transfer of the underlying stocks at
expiration, although in the United States only physical settlement is used to
avoid speculation in the market.
Equity index swaps
An equity index swap is an agreement between two parties to swap two sets of
cash flows on predetermined dates for an agreed number of years. The cash
flows will be an equity index value swapped, for instance, with LIBOR. Swaps can
be considered as being a relatively straightforward way of gaining exposure to an
asset class you require. They can also be relatively cost efficient.
Equity swap
An equity swap, like an equity index swap, is an agreement between two parties
to swap two sets of cash flows. In this case the cash flows will be the price of an
underlying stock value swapped, for instance, with LIBOR. A typical example of
this type of derivative is the Contract for difference (CFD) where one party gains
exposure to a share price without buying or selling the underlying share making
it relatively cost efficient as well as making it relatively easy to transact.
Exchange-traded derivatives
Other examples of equity derivative securities include exchange-traded funds
and Intellidexes.

Clearing and Settlement

National Securities Clearing Corporation Limited (NSCCL) is the clearing and
settlement agency for all deals executed on the Derivatives (Futures & Options)
segment. NSCCL acts as legal counter-party to all deals on NSE's F&O segment
and guarantees settlement.

A Clearing Member (CM) of NSCCL has the responsibility of clearing and

settlement of all deals executed by Trading Members (TM) on NSE, who clear and
settle such deals through them.

Clearing Mechanism
A Clearing Member's open position is arrived by aggregating the open position of
all the Trading Members (TM) and all custodial participants clearing through him.
A TM's open position in turn includes his proprietary open position and clients
open positions.
Proprietary / Clients Open Position
While entering orders on the trading system, TMs are required to identify them
as proprietary (if they are own trades) or client (if entered on behalf of clients)
through 'Pro / Cli' indicator provided in the order entry screen. The proprietary
positions are calculated on net basis (buy - sell) and client positions are
calculated on gross of net positions of each client i.e., a buy trade is off-set by a
sell trade and a sell trade is off-set by a buy trade.

Open Position
Open position for the proprietary positions are calculated separately from client
position.
For Example: For a CM - XYZ, with TMs clearing through him - ABC and PQR
Proprietary
Position
TM
AB
C

Security
NIFTY
January
contract

PQ
R

NIFTY
January
contract

Client 1

Client 2

Buy
Qty

Sell
Qty

Net
Qty

Buy
Qty

Sell
Qty

Net
Qty

Buy
Qty

Sell
Qty

Net
Qty

400
0

200
0

200
0

300
0

100
0

200
0

400
0

200
0

200 Long
0 6000

300
0

100
0

200
0

Long
- 1000
100 Short
0 2000

200
0

200
0

100
0

XYZs open position for Nifty January contract is:

Member
ABC
PQR
Total for
XYZ

Net
Memb
er

Long
Short
Position
Position
6000
0
1000
2000
7000

2000

100
0

100
0

Conclusion
The Indian derivative market has achieved tremendous growth over the years,
and also has a long history of trading in various derivatives products. The
derivatives market has seen ups and downs. The new and innovative derivative
products have emerged over the time to meet the various needs of the different
types of investors. Though, the derivative market is burgeoning with its divergent
products, yet there are many issues. Among the issues that need to be
immediately addressed are those related to, lack of economies of scale, tax and
legal bottlenecks, increased off-balance sheet exposure of Indian banks, need for
an independent regulator etc. Solution of these issues will definitely lead to boost
the investors confidence in the Indian derivative market and bring an overall
development in all the segments of this market.

References
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.ncdex.com
www.google.com
www.derivativesindia.com
Books referred:
Options Futures, and other Derivatives by John C Hull
Derivatives FAQ by Ajay Shah
NSEs Certification in Financial Markets: - Derivatives Core module
Financial Markets & Services by Gordon & Natarajan