A RESEARCH REPORT ON DERIVATIVES- AN INNOVATIVE TOOL FOR RISK MINIMISATION

FOR THE FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF THE DEGREE OF MASTERS OF BUSINESS ADMINISTRATION U.P.TECHNICAL UNIVERSITY, LUCKNOW

Under the Guidance of

MR. DURGESH AGARWAL

Submitted by
AKHIL VARSHNEY MBA-3rd SEM

Submitted to
MR. SAIF AZAM ASSITANT PROFESSOR (ABIMS)

AL-BARKAAT INSTITUTE OF MANAGEMENT STUDIES, ALIGARH

ACKNOWLEDGEMENT

I would like to take this opportunity to express my sincere gratitude to all the people who have directly and indirectly aided my research and extended his full support to my visit to his company.

I would also like to thank Mr. Durgesh Agarwal, for his support and help anytime I approached him. His advice and support made all the difference to my work and gave it the form it has.

AKHIL VARSHNEY

Table of content Chapters no.

1. Executive summery 2. Company profile 7 3. History of Religare 4. Introduction of derivatives 35 What are derivatives? Features of derivatives Kinds of derivative contracts Advantages and disadvantages of derivatives contracts OTC v/s exchange derivative market Application of derivatives derivative market in India Factors driving the growth of derivatives Pre-requisites for derivative Global derivatives market 5. Review of literature 36-47 The advent of derivatives L.C Gupta committee report 6. Present study 48-109 Derivatives instruments Pay-off of futures and options Options and future strategies for hedger Options strategies 7. Methodology 110-111 8. Results 112-116 Current constraints Need for derivative Market in India Future prospects Precautionary measures to be taken

page
5 68 9-

9. Discussion 117-118 Are derivative a failure? 10. Recommendations 119-123 11. Conclusions 124 12. References 125 13. Appendix 126-133

LIST OF TABLES 1. 2. 3. 4. 5. 6. 7. 8. 9. Forwards v/s futures Requirements for professional clearing membership Eligibility criteria for membership on the F&O segment Option Strategies Option Strategies for a bullish and a bearish market Long call strategy Covered call strategy v/s Long stock strategy Long put strategy Covered put strategy

LIST OF FIGURES 1. Types of derivative contracts 2. Payoff for buyer of futures: long futures 3. Payoff for seller of futures: short futures 4. Payoff of a long call 5. Payoff of a short call 6. Payoff of a long put 7. Payoff of a short put 8. Payoff of a strangle 9. Up and in options 10. Payoff for buyer of call options at various strikes 11. Payoff for writer of put options at various strikes 12. Payoff for seller of call options at various strikes 13. Payoff for buyer of put options at various strikes 14. Payoff of a bull spread 15. Payoff of a bear spread 16. Interest rate swap LIST OF APPENDIX 1. Article- Fall of Barings Bank 2. Article- Orange Club

EXECUTIVE SUMMARY Financial derivatives have crept into the nation's popular economic vocabulary on a wave of recent publicity about serious financial losses suffered by municipal governments,. Well -known corporations, banks and mutual funds that had invested in these products. Government has held hearings on derivatives and financial commentators have spoken at length on the topic. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad". When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy. This is a modest attempt to provide an insight into the world of Derivatives, covering the gamut of products, operators, institutional set up and regulatory framework. A Derivatives is a contractual relationship established by two (or more) parties where payment is based on (or derived from) some agreed upon benchmark. Like any other financial instrument derivatives too require a conducive environment for its success. Although world derivative markets have existed in some form since at least 17th century, modern derivative markets developed in mid 19th century with the opening up of Chicago Board of trust Derivative trading. Since then derivatives have come a long way. Derivative trading is now the worlds largest business with an estimated daily turnover of USD 2.5 trillion and an annual growth rate of around 14%.

THIS PROJECT ATTEMPTS TO FAMILIARIZE THE READER WITH FINANCIAL DERIVATIVES, THEIR USE AND THE NEED TO APPRECIATE AND MANAGE RISK. IT IS NOT A SUBSTITUTE; HOWEVER, COMPETENT PROFESSIONAL ADVICE SHOULD BE

SOUGHT

BEFORE

BECOMING

INVOLVED

IN

FINANCIAL

DERIVATIVE PRODUCT.

COMPANY PROFILE

Religare Enterprises Limited (REL) is a global financial services group with a presence across Asia, Africa, Middle East, Europe and the Americas. In India, RELs largest market, the group offers a wide array of products and services ranging from insurance, asset management, broking and lending solutions to investment banking and wealth management. The group has also pioneered the concept of investments in alternative asset classes such as arts and films .With 10,000 plus employees across multiple geographies, REL serves over a million clients, including corporate

and institutions, high net worth families and individuals, and retail investors Religare is driven by ethical and dynamic process for wealth creation. Based on This, the company started its endeavor in the financial market. Religare Enterprises Limited through Religare Securities Limited, Religare Finevest Limited, Religare Commodities Limited and Religare Insurance Advisory Services Limited provides integrated financial solutions to its corporate, retail and wealth management clients. Today, we provide various financial services which include Investment Banking, Corporate Finance, Portfolio Management Services, Equity & Commodity Broking, Insurance and Mutual Funds. Plus, theres a lot more to come your way. Religare is proud of being a truly professional financial service provider managed by a highly skilled team, who have proven track record in their respective domains. Religare operations are managed by more than 1500 highly skilled professionals who subscribe to Religare philosophy and are spread across its country wide branches. Our business philosophy is to treat each client situation as unique, requiring customized solutions. Our list of corporate clients reads like a Whos Who of the Indian Industry and we have been successful in providing them with practical customized solutions for their requirements. We are propelled by our group vision and desire to strive tirelessly and aim to be the best within this category.

The primary focus of RCL is to cater to services in Commodity Market. The Company is a member of the Multi commodity exchange (MCX) and National commodity derivative exchange (NCDEX). The growing list of financial institutions with whom FCL is empanelled, as approved Broker is a reflection of the high levels of services maintained by the Company. Religare has a very credible team in its Research & Analysis division, which not only caters to the need of our Institutional clientele but also gives their valuable input to Investment Dealers.

History of Religare Ltd.

Religare Securities Limited, a Ranbaxy Promoter Group Company, was founded by late Dr. Parvinder Singh (CMD Ranbaxy Laboratories Limited), with the vision of providing integrated financial care driven by the relationship of trust & confidence. To realize its vision the Religare group provides various financial services which include broking (stocks & commodities), depository participant services, portfolio management services, advisory on mutual fund investments and many more. Working on the philosophy of being Financial Care Partner, Religare unlike other traditional broking firms not only executes the trades for the

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clients but also provides them critical and timely investment advice. The growing list of financial institutions with which Religare is empanelled as an approved broker is a reflection of the high levels of service standard maintained by the company. Religare is a truly professional financial service provider managed by a team of highly skilled professionals who have proven track record in their respective domains. Religare has the widest reach through its Regional, Zonal and Branch Offices spread across the length & breadth of the country.

Religare Enterprises Limited (REL) is one of the leading integrated financial services groups of India. Backed by a blue chip promoter pedigree and a proven track record, RELs businesses are broadly clubbed across three key verticals, the Retail, Institutional and Wealth spectrums, catering to a diverse and wide base of clients. REL offers a multitude of investment options and a diverse bouquet of financial services and can boast of a reach that spreads across the length and breadth of the country with its presence in more than 1460 locations across more than 450 cities and towns. CHAPTER 1 INTRODUCTION The word Derivative has gained popularity by acting as an insulator to risk management. Derivative products such as Options, Futures or Swaps have become a standard risk management tool that involves risk sharing and thus facilitates the efficient allocation of capital to productive investment opportunities. Derivatives have enabled commercial corporations, governments, financial firms, and other institutions worldwide to reduce their exposure to fluctuations in interest rates, currency exchange rates, and the prices of equities and commodities. Derivatives also have enabled users to reduce funding costs and speculate on changes in market 11

rates and prices. A derivative is simply a new name for a tried and trusted set of risk management instruments. It covers any transaction where there is no movement of principle and where the price performance of derivatives is driven by an underlying commodity. "Derivatives is cited as a simile to Aspirin, which when taken as an antidote for headache, will make the pain go away. Paradoxically if the whole bottle is consumed it might lead to disastrous consequences. What are derivatives? The primary objectives of any investor are to maximize returns and minimize risks. Derivatives are contracts that originated from the need to minimize risk. The word 'derivative' originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying. Therefore, derivative is a product which derives its value from the value of one or more basic variables, called bases (underlying asset, index or reference rate) in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean. With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: 1. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

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2. a contract which derives its value from the prices, or index of prices, of underlying securities Features of derivatives: Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price. The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset. For example, a farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production. Lets say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period).In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa. If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable. This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying. If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative.

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If the underlying is a financial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a financial derivative. Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customized as per the needs of the user by negotiating with the other party involved. Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of the farmer above, if he thinks that the total production from his land will be around 150 quintals, he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of soybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard contract on soybean. The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50 quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party, which may exceed the cost associated with leaving a part of the production uncovered.

TYPES OF DERIVATIVE CONTRACTS FUTURES LEAPS DERIVATIVE CONTRACTS 14 BASKETS

FORWARDS WARRANTS

OPTIONS

SWAPOPTIONS SWAPS

FORWARD CONTRACTS

A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest. FUTURES CONTRACT

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash. FORWARDS OTC in nature Customized contract terms Less liquid No margin payment Settlement happens at the end of the period Counterparty risk FUTURES Traded on an organized exchange Standardized contract terms More liquid Requires margin payment Follows daily settlement No counterparty risk

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OPTIONS CONTRACT

Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. Under Securities Contracts (Regulations) Act, 1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities; An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price. Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame. As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strikes

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price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract. SWAPS

Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

WARRANTS

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

The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having a maturity of upto three years. BASKETS

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Basket options are options on portfolio 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. SWAPTIONS

They are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. ADVANTAGES OF DERIVATIVES The advantages are: 1. A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesnt know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price. 2. Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process cant be overstated. 3. Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms. 18

4. Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery. 5. Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements. 6. Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knight rider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they cant take the advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will have to move fast in this direction. Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved. DISADVANTAGES OF DERIVATIVES 1. Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point. 2. Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the

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strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult. 3. Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives. 4. Counter party risk: Most of the derivative instruments are not exchange traded. So there is a counter party default risk in these instruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments. 5. Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian markets capability to provide enough liquidity to derivative trader. Hence, the pros of derivatives outweigh the cons. And moreover, by imposing margin requirements, by limiting the exposure one can take and other measures like that, these vices of derivatives can be controlled. The importance of derivatives for any financial market cant be overstated.

RISKS IN DERIVATIVES

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As derivatives are risk shifting devices, it is important to identify and fully comprehend the risks being assumed, evaluate those risks and continuously monitor and manage those risks. Each party to a derivative contract should be able to identify all the risks that are being assumed (interest rate, currency exchange, stock index etc) before entering into a derivative contract. Risk management is a logical development and execution of a plan to deal with potential losses. The risk management process involves 3 basic steps: Identification of risk Measurement of risk Monitoring and managing of risks The fundamental risks involved in derivative business include: Credit Risk This is the risk of failure of a counter party to perform its obligation as per the contract. Also known as default or counter party risk, it differs with different instruments. Credit risk associated with OTC derivative contracts is generally lower than the exchange-traded derivative instruments. Liquidity Risk: There are two types of liquidity risk. i) Market liquidity risk: Market liquidity risk is the risk that an institution may not be able to, or cannot easily, liquidate or offset a particular position at or near previous market price because of inadequate market depth or disruption in the market place. ii) Funding liquidity risk: Funding liquidity risk is the risk that an institution will be unable to meet its payment obligation on settlement dates or in the event of margin calls Legal Risk: Derivatives cut across judicial boundaries; therefore the legal aspects associated with the deal should be looked into carefully. Legal risk is the risk that contracts are not legally enforceable or documented correctly. There should be 21

guidelines and processes in place to ensure the enforceability of counter party agreements. Operational Risk: the risk of direct loss resulting from inadequate or failed internal processes, people and systems or from external events. The Board of directors and senior management should ensure proper dedication of resources (financial and personnel) to support operations and systems development and maintenance Market Risk: Market risk is the risk to an institution's financial condition resulting from adverse movement in the level or volatility of market prices of the underlying asset/instrument.

OTC V/S EXCHANGE TRADED DERIVATIVES The OTC derivative markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange- traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely stated that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives market has the following features compared to exchange trade derivatives:

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1. The management of counter-party (credit) risk is decentralized and located within individual institutions. 2. There are no formal centralized limits on individual positions, leverage or margining. 3. There are no formal rules for risk and burden sharing. 4. there are no formal rules or mechanisms for ensuring market stability and integrity and for safeguarding the collective interests of market participants and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organization although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: 1. The dynamic nature of gross credit exposure 2. information asymmetries 3. the effects of OTC derivative activities on available aggregate credit 4. the high concentration of OTC derivative activities in major institutions 5. the central role of OTC derivative activities in the global financial system Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts occur, which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainable large and provoke a rapid unwinding of positions.

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There has been come progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management; including counterparty, liquidity and operational risks, and OTC derivatives market continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systematic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal. APPLICATIONS OF DERIVATIVES Any organization which has to divert its time to foreign exchange problems needs and seeks information. Most often, it is confronted with some dilemmas depending on whether the concern is mainly with imports or with exports, with overseas investments, or with the purchase of raw materials or factory installations from abroad. With this view in mind, this section highlights the typical choices and decisions which confront Indian industry today. The analysis is based on the views of a cross section of the industry. The sample interviewed and questioned includes banks, FIs on the one hand and hand and companies into software exports, production and training on the other. The areas discussed below were found to be of the most relevance for the largest number of managing or financial directors in industrial and commercial firms.

Spot or Forward?

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Should those who have entered into a firm commercial commitment to buy from abroad and pay in foreign currency, cover the currency straight away on a forward basis or should they wait until the time of payment or receipt and then cover it on spot basis? Normal prudence suggested that customer should cover forward all their commitments as they provide a professional service to be used without the endbeneficiary being involved in difficult considerations. However, this view was not tenable to more sophisticated companies with frequent and substantial involvement in international transactions. To such a company the argument is like not interviewing a prospective secretary because one's business is the manufacture of shoes and not the assessment of personnel. The Siemens Case presented in the next section highlights the above corporate view. Unfortunately, no two companies have the risks or the cost of cover the same in any weeks of the year. Yet, some common relevant guiding questions emerged from the study: 1. Is it likely that the currency to be bought will be up valued or will float upwards before the time of payment (or that currency to be sold will be devalued or will float downwards)? 2. Is the home currency likely to change its official parity or actual exchange rate against some, many or all foreign currencies or to float out side present limits? 3. Is the foreign currency or home currency likely to be involved in any general realignment of rates during this period, such as occurs in the European Monetary System (EMS) from time to time? 4. How might the foreign currency or home currency fare if there are further changes in the international monetary system, such as the

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introduction of new intervention points or the extension of floating rates or the re-fixing of now freely floating currencies? 5. What is the most that changes feared (whether likely or unlikely to occur) will cost the organization (i) as a percentage, (ii) in actual cash. 6. What is the actual cost of forward cover (the difference between spot now and forward now) : (i) in as a percentage per annum and adjusted for the period of concern, (ii) in actual cash? 7. What is (i) the likely and (ii) the possible improvement or worsening in the spot rate between now and the end of the period? 8. Is the forward rate, as sometimes happens, actually more favorable than the spot rate, so that the forward cover is desirable even though risks (questions a g) are deemed insufficient to justify insurance? Nobody denied the difficulty in answering the above questions. The costs and losses consequent upon an exposed position are such as to merit the most careful consideration in taking the appropriate decisions. These decisions do not always remain valid for long periods and therefore need frequent and careful review. The Duty to Cover Forward

For a commercial transaction which relies heavily on overseas raw materials or overseas sales the fluctuations in exchange rates due to their being floating, profits can be wiped out or doubled. Hence, banks apply the following advice: 1. If already bought in one currency and already sold in another currency, cover forward.

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Deviate from above if there is a danger ahead or only the likelihood of a change in favour and if the amount is small in relation to total trade. Deviate only if knowledge is sufficient and advice good. This is rare and specific to situations. 2. If already bought in one currency and yet to sell in another, the decision is more difficult as in both cases there is an unavoidable risk which contains a large speculative element inevitable to business.

Time options or Swap?

When the exact data of need of foreign currency may not be known, organizations tend to use time options but these are costly. Thus, some have shown a definite inclination towards a fixed date forward contract followed by an adjusting swap, which may give only partial protection but are cheaper. These are those with a fair volume of business, adequate foreign exchange staff and the will to take small risks. Invoicing in Foreign/Home Currency?

Conventionally, firms have been invoicing in their home currency. The study shows that invoices in foreign currency for exports can increase profitability. Even imports transactions should be analyzed in real terms before taking the course of convenience without thought.

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Do banks advise or merely serve?

There was considerable divergence of opinion among banks and their customers on this issue. However, it is true that professional service needs to be an integral part of a good foreign exchange department while awareness among the customers also has to rise. Currency options : an essential tool in certain situations

Useful to firms which have to tender for projects or some other transactions in a foreign currency. Costing calculations are impossible until it is established in which currency the contract will materialize, but such calculations must be completed before negotiations begin. For most firms however, they are inappropriate where a firm commercial contract already exists. Very few professionals with suitable skills and experience have used them in India as better alternative instruments. The Siemens Case Siemens, the $60 billion German industrial conglomerate, installed a financial risk management system developed by Wall Street Systems to track all its worldwide assets, liabilities, and risks. Not only does it coordinate the company's exposure to foreign currencies in the more than 100 countries where Siemens operates, but it also monitors interest rates on the company's sizable debt portfolio and produces accounting entries for its treasury department. It gives management a better comfort 28

level to know exactly where they stand and know exactly what their position in derivatives and currencies is at any point in time. The system allows Siemens to offset its positions in different parts of he world. A few years ago, if an American subsidiary needed Deutschmarks, Siemens might have hired a bank to match the subsidiary with another Siemens operation willing to swap excess Deutschmarks. Instead of going out and paying a spread to a bank, all financial engineering is done internally. DERIVATIVES MARKET IN INDIA Approval for derivatives trading

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of derivatives. SEBI also set up a group in June 1998 under the chairmanship of Prof .J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The SCRA was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing

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derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three-decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in may 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001, and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/ corporation duly approved by SEBI and notified in the official gazette. Derivatives market at NSE The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12,2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July, 2 2001. Single stock futures were launched on November 9,2001. The index futures and options contract on NSE are based on S&P CNX Nifty index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. Trading mechanism

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The futures and options trading system of NSE, called NEAT- F&O trading system, provides a fully automated screen based trading for nifty futures & options and stock futures and options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operated on strict pricetime priority. It is similar to that of trading of equities in the cash market segment. The NEAT- F&O trading system is accessed by two types of users. The trading members have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed to the system. Various conditions like good-till-day, good-till-canceled, good-till-date, immediate or cancel, limit/ market price, stop loss, etc can be built into an order. The clearing members use the trader workstation for the purpose of monitoring the trading members for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take. Membership criteria NSE admits members on its derivative segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2- tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member does clearing for all his trading members, undertakes risk management and performs actual settlement. There are three types of CMS: 1. Self clearing member: a SCM clears and settles trades executed by him only either on his own account or on account of his clients.

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2. Trading member clearing member: TM-CM is a CM who is also a TM. TMCM may clear and settle his own proprietary trades and clients trades as well as clear and settle for other TMs. 3. Professional clearing member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TMs. Requirements for professional clearing membership Particulars (all F&O segment CM & F&O segment values in Rs. Lakh) Eligibility Trading members of Trading members of NSE/SEBI registered NSE/SEBI registered custodians/ recognized banks custodians/ recognized banks Networth 300 300 Interest Free 25 34 Security Deposit (IFSD) Collateral security 25 50 deposit Annual nil 2.5 subscription Note: the PCM is required to bring in IFSD of Rs. 2 lakh and CSD of Rs.8 Lakh per trading member whose trades he undertakes to clear and settle in F&O segment.

Eligibility criteria for membership on F&O segment Particulars (all values in CM and F&O segment CM,WDM and F&O Rs Lakh) segment Net worth(1) 100 200 Interest free security 125 275 deposit(IFSD)(2) Collateral security deposit 25 25 (CSD)(3) Annual subscription 1 2 1: No additional net worth is required for self clearing members. However, a net worth of Rs. 300 lakhs is required for TM-CM and PCM. 2&3: Additional Rs. 25 lakh is required for clearing membership (SCM, TM-CM). in addition, the claring member is required to bring in IFSD of Rs. 2 lakh and CSD of Rs. 8 lakh per trading member he undertakes to clear and settle.

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The TM-CM and the PCM are required to bring in additional security deposit in every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a certification programme approved by SEBI. Turnover The trading volumes on NSEs derivatives market have seen a steady increase since the launch of the first derivatives contract, i.e. Index futures in June 2000. The average daily turnover now exceeds a 1000 crore. A total of 41, 96,873 contracts with a total turnover of Rs. 1, 01,926 crore was traded during 2001.02. Clearing and settlement NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. 1. Clearing The first step in clearing process is working out open positions or obligations of members. A CMs open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TMs open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. While entering orders on the trading system, TMs are required to identify the orders, whether proprietary ( if they are their own trades) or clients( if entered on behalf of clients). Proprietary positions are calculated on net basis (buysell) position of each individual client for each contract. A TMs open position is the sum of proprietary open position, client open long position and client open short position.

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2. Settlement All futures and options contracts are cash settled .i.e. through exchange of cash. The underlying for index futures/ options of the nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/ clients in respect of MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment. Risk management system The salient features of risk containment measures on the F&O segment are: 1. Anybody interested in taking membership of F&O segment is required to take membership of CM and F&O or CM, WDM and F&O segment. An existing member of CM segment can also take membership of F&O segment. 2. NSCCL charges an upfront margin for all the open positions of a CM upto client level. It follows the VaR based margining system through SPAN system. NSCCL computes the initial margin percentage for each nifty index futures contract on a daily basis and informs the CMs. The CM in turn collects the initial margin from the TMs and their respective clients. 3. NSCCLS on line position monitoring system monitors A CMs open positions on a real time basis. Limits are set for each CM based on his base capital and additional capital deposited with NSCCL. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up NSCCL. NSCCL monitors the CMs and TMs for mark to market value violation and for contractwise position limit violation.

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4. CMs are provided with a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through them. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it withdraws the trading facility provided to such TM. 5. A separate settlement guarantee fund for this segment has been created out of the capital deposited by the members with NSCCL. Factors driving the growth of derivatives

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivatives contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: a. increased volatility in asset prices in financial markets, b. increased integration of national financial markets with the international markets c. marked improvement in communication facilities and sharp decline in their costs, d. development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and e. innovations in the derivatives markets, which optimally combine the risks, returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. Economic function of the derivatives market Inspite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

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1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash market. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energise others to create new businesses, new products and new employment opportunities, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume and activity. Pre-requisites for Derivatives Strong and healthy cash market

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The first and the foremost requirement is the existence of a strong and healthy cash market. An efficient, transparent and fair cash market with short settlement cycles help in building an efficient derivatives market. Empirical evidence from international markets suggests that the derivatives market and cash market are synergistic. A healthy cash market is a prerequisite for developing a good derivatives market, while good derivative volumes make the cash market even healthier. As the derivatives volume grow, it contributes significantly to the cash market volumes resulting from growing opportunities for arbitrage. Clearing corporation and settlement guarantee Existence of a common clearing corporation providing settlement guarantee as well as cross margining is essential for speedy settlement as well as for risk minimization. This is particularly important in case of derivatives where there are often no securities to be delivered; the settlement is arranged in the form of cash 'difference'. Reliable wide area telecommunication network Since derivatives trading must be introduced on nation wide basis so as to providing equal opportunities for hedging to the investors population throughout the country, existing of proven automated trading systems is extremely important. Risk containment mechanism There should exist a strong and disciplined margining system in the form of daily and mark-to-market margins, which provide a cover for exposure along with price risk and notional loss in case of default in settling outstanding positions; thereby minimizing market risk.

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The Indian Derivatives market continues to remain in the Stone Age. This is evident from the fact that only fifteen to twenty corporate including the blue-chips and the government owned companies have been able to make effective use of the limited foreign exchange. While most of the smaller forex earners are undeterred by the developments in the forex and derivatives market. Hedging is an exercise, which involves using derivatives to manage risks. Risk management involves both understanding risks and choosing appropriate techniques to be protected against the risk. The forex market provides a forum in which the operators can exchange risks. To hedge or not to hedge is the million dollar question. Very few corporation have in use policies on the extent to which speculation is permitted in terms of budgets associated and overnight open position to be carried. Examples Essar Gujarat Ltd., one of the leading corporate players in the forex market, has a well defined policy on hedging. Their policy includes a core cover to total exposure ratio in keeping with the market condition which implies that the policy covers a certain minimum proposition of every exposure. Reliance Industries it is which figures among the bigger corporate dealers, has raised funds through Euro in the past one year. The companies foreign exchange exposures are reviewed daily on a market to market basis and the hedging sharing is formulated accordingly Reliance also has an internal loss limits, depending on market conditions. GLOBAL DERIVATIVES MARKETS

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The significant growth of the formal, organized and officially recognized derivatives market globally has taken place only during the past two decades. There are about forty futures and options exchanges in Europe and Japan and about twelve in the U.S. The U.S. alone accounted for 60 per cent of the total futures business in the world in 1990. In the US, the financial futures market accounted for about 73 percent of the total future trading volume in 1990. Among interest rates futures, treasury bonds futures dominate the market. The share of futures in equity indices, foreign currencies, treasury bonds, and interest rates was 5 per cent, 10 per cent, 27 per cent and 45 per cent respectively in 1990 in America. At the global level, the total value of derivatives trading has increased phenomenally from just $ 1,118 billion to $ 27,175 billion i.e. 2,331 percent or at the annual average rate of 259 percent during 1986 to 1995. As a part of this total, the share of OTC traded derivatives has increased over the years. It was 66 percent in 1995, the rest being accounted for by the exchange traded derivatives. Among the later, interest rates futures and interest rates options accounted for 60 to 65 per cent and 24 to 30 per cent respectively during 1986-95. THE INTERNATIONAL DIMENSION One of the more remarkable stories in the history of financial markets came about in the aftermath of the worldwide stock market crash of October 1987. In Japan, regulators asked themselves what needed to be done to prevent such occurrences in future. Regulators and economists who worked with them pondered and came with a completely incorrect diagnosis: they decided that "Programme trading" was to blame. Programme trading enters the picture when the cash index and futures are out of sync. When this happens, arbitrageurs use programme trading to rapidly buy (or sell) all the index stocks using the computer. Japan's regulators made the arbitrage very difficult by putting restrictions upon programme trading. Today, the working of index futures markets is better understood - arbitrage is essential to the functioning of any futures markets. Without the index arbitrage, the 39

index futures market would be useless for hedgers since the price of futures would often stray away form their fair values. But this was perhaps not clearly understood at that time. The sequence of events which followed the clamp down by Japan's regulators was interesting. Thanks to the pervasive mispricing of the Japanese index futures without index arbitrage, the Japanese futures market was unable to meet the needs of the users. Singapore saw a strong derivative exchange as an essential part of its desire to be center for international finance. Simex was created in the early 80s as an example of strategic policy making. It perceived the unmet demand among Japanese users of index futures. A great deal of usage of the futures on the Nikkei 225 moved off to Simex. This was bad for Japanese financial industry as it lost fees but it was good for users who were not locked into using their inferior domestic market: they were able to use the offshore market. The idea commonly recurs with foreign competition: when foreign airlines start operating in India, 8000 workers of Indian Airlines will be hurt and eight million users of air travel in India will benefit. Japan's regulators since removed many restrictions but a very important Nikkei 225 future market remains in Singapore. This is because liquidity is hard to dislodge once it comes about, also because of he elevated transaction and brokerage fees in Japan's highly rigid financial industry. This story is one of the important battles in a burgeoning industry of exchanges competing for order flow on an international scale.

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CHAPTER 5 REVIEW OF LITERATURE

The introduction of derivatives trading will separate leveraged positions from the spot markets and make it easier for exchanges to implement rolling settlement. This should reduce volatility in the existing markets, and make risk containment and regulation easier by making markets safer." Ashish Kumar Chauhan, Vice-President, National Stock Exchange (NSE). "It had to start at one point of time or the other. Just like a plant needs soil, water and minerals to nurture well, for derivatives you need a healthy cash market in place." - Alok Churiwala, Member of Bombay Stock Exchange (BSE).

INTRODUCTION Derivatives may have become popular now but their origin can be traced back to Aristotles writings. Aristotle tells the story of Thales; a poor philosopher who developed a financial devise, which he said, could be universally applicable. Thales had great skill in forecasting and predicting how good the harvest would be in the autumn. Confident about his prediction, he made agreements with area olive press owners to deposit what little money he had with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thale successfully negotiated 41

low prices because the harvest was in future and one knew whether the harvest would be plentiful or pathetic and because the olive press owners were willing to hedge against the possibility of poor yield and these contracts were exercised some 2500 years ago. Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The concept of forward delivery, with contracts stating what is to be delivered for a fixed price at a specified place at a specified date, existed in ancient Greece and Rome. Perhaps the first organized commodity exchange on which forward contracts existed in early 1700s in Japan. Futures and options trading in commodities appear to have originated in the 17th century. The first formal commodity exchange in the United States for spot and forward trading was formed in 1848: the Chicago Board Of Trade (CBOT). Options also have a long history. The concept of options existed in ancient Greece and Rome. Options were used by speculators in the tulip craze of 17th century Holland. Unfortunately there was no mechanism to guarantee the performance of options, terms, and when the tulip craze collapsed in 1636 many of the speculators were wiped out. In particular the put writers refuse to take delivery of the tulip bulbs and pay high prices they had originally agreed to pay. The explosion of growth in the derivative markets coincided with the collapse of the Bretton Woods fixed exchange rate regime and the suspension of the dollars convertibility into gold. Trading in financial futures began in the early 1970s after almost a decade of accelerating inflation, which exposed market participants to the unprecedented levels of exchange and interest rates volatility. A means of managing 42

risk was required. To mitigate this risk, foreign currency derivatives were introduced on an Over the Counter (OTC). Growth in this area has come from the two directions namely innovations in technology and financial economics. This eventually resulted in the creation of the financial derivatives industry.(see table 1 & 2 in the appendix) The process of development in the derivatives market still continues. Over 50 exchanges throughout the world now trade in some form of derivatives or other. Recent trends The global market for derivatives has grown substantially in the recent past. The Foreign Exchange and Derivatives Market Activity survey conducted by Bank for International Settlements (BIS) points to this increased activity. The total estimated notional amount of outstanding OTC contracts increasing to $111 trillion at endDecember 2001 from $94 trillion at end-June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and 2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14% decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be "traditional" foreign exchange derivative instruments, increased by an estimated 10% to US $1.4 trillion. (see table 3 in the appendix) The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures

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contracts have remained more or less in the same form, as we know them today. Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. On June 9, 2000, the Bombay Stock Exchange (BSE) introduced India's first derivative instrument - the BSE30(Sensex) index futures. It was introduced with three month trading cycle the near month (one), the next month (two) and the far month (three). The National Stock Exchange (NSE) followed a few days later, by launching the S&P CNX Nifty index futures on June 12, 2000. National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading. The initial steps to launch derivatives were taken in 1995 with the introduction of the Securities Laws (Amendment) Ordinance, 1995 that withdrew the prohibition on trading in options on securities in the Indian stock market. In November 1996, a 24member committee was set up by the Securities Exchange Board of India (SEBI) under the chairmanship of LC Gupta to develop an appropriate regulatory framework for derivatives trading. The committee recommended that the regulatory framework applicable to the trading of securities would also govern the trading of derivatives. The L C Gupta Committee report SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop 44

appropriate regulatory framework for the derivatives trading and to recommend suggestive bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Committee was also to focus on the financial derivatives and equity derivatives. The Committee submitted its report in March 1998. The Board of SEBI in its meeting held on May 11, 1998 accepted the recommendations and approved the introduction of derivatives trading in India beginning with Stock Index Futures. The Board also approved the "Suggestive Byelaws" recommended by the LC Gupta Committee for Regulation and Control of Trading and Settlement of Derivatives Contracts. SEBI circulated the contents of the Report in June 98. The LC Gupta Committee had conducted a wide market survey with contact of several entities relevant to derivatives trading like brokers, mutual funds, banks/FIs, FIIs and merchant banks. The Committee observation was that there is a widespread recognition of the need for derivatives products including Equity, Interest Rate and Currency derivatives products. However Stock Index Futures is the most preferred product followed by stock index options. Options on individual stocks are the third in the order of preference. The participants took interviews, mostly stated that their objective in derivative trading would be hedging. But there were also a few interested in derivatives dealing for speculation or dealing. Goals of Regulation - Regulatory Objectives LCGC believes that regulation should be designed to achieve specific and welldefined goals. It is inclined towards positive regulation designed to encourage healthy activity and behavior. The Committee outlined the goals of regulation admirably well in Paragraph 3.1 of its report. The important recommendations of L.C.Gupta Committee are reproduced hereunder.

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Need for coordinated development To quote from the report of the Committee -"The Committee's main concern is with equity based derivatives but it has tried to examine the need for financial derivatives in a broader perspective. Financial transactions and asset-liability positions are exposed to three broad types of price risks, viz: "Equities "market risk", also called "systematic risk" (which cannot be diversified away because the stock market as a whole may go up or down from time to time). "Interest rate risk (as in the case of fixed-income securities, like treasury bond holdings, whose market price could fall heavily if interest rates shot up), and "Exchange rate risk (where the position involves a foreign currency, as in the case of imports, exports, foreign loans or investments). "The above classification of price risks explains the emergence of (a) equity futures, (b) interest rate futures and (c) currency futures, respectively. Equity futures have been the last to emerge. "The recent report of the RBI-appointed Committee on Capital Account Convertibility (Tara pore Committee) has expressed the view that "time is ripe for introduction of futures in currencies and interest rates to facilitate various users to have access to a wide spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tara pore Committee has also opined that "a system of trading in futures ... is more transparent and cost-efficient than the existing system (of forward contracts)". There are inter-connections among the various kinds of financial futures, mentioned above, because the various financial markets are closely interlinked, as the recent financial market turmoil in East and South-East Asian countries has shown. The basic principles underlying the running of futures markets and their regulation are the same. Having a common trading infrastructure will have 46

important advantages. The Committee, therefore, feels that the attempt should be to develop an integrated market structure. SEBI-RBI coordination mechanism "As all the three types of financial derivatives are set to emerge in India in the near future, it is desirable that such development be coordinated. The Committee recommends that a formal mechanism be established for such coordination between SEBI and RBI in respect of all financial derivatives markets. This will help to avoid the problem of overlapping jurisdictions." Cash and Futures Market Relationship The Committee felt that the operations of the cash market, on which the derivatives market will be based, needed improvement in many respects. It therefore suggested improvements to the Cash Market.

Derivatives Exchanges The Committee strongly favoured the introduction of financial derivatives to facilitate hedging in a most cost-efficient way against market risk. There is a need for equity derivatives, interest rate derivatives and currency derivatives. There should be phased introduction of derivatives produces. To start with, index futures to be introduced, which should be followed by options on index and later options on stocks. The derivative trading should take place on a separate segment of the existing stock exchanges with an independent governing council where the number of trading members should be limited to 40 percent of the total number. Common Governing Council and Governing Board members not allowed. The Chairman of the governing council should not be permitted to trade (broking/dealing business) on any of the stock exchanges during his term. Trading to be based on On-line screen

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trading with disaster recovery site. Per half hour capacity should be 4-5 times the anticipated peak load. Percentage of broker-members in the council to be prescribed by SEBI. Other recommendations of the Committee about the structure of Derivative Exchanges are as under: The settlement of derivatives to be through an independent clearing corporation/clearing house, which should become counter party for all trades or alternatively guarantee the settlement of all trades. The clearing corporation to have adequate risk containment measures and to collect margins through EFT. The derivative exchange to have both on-line trading and surveillance systems. It should disseminate trade and price information on real time basis through two information vending net works. It should inspect 100 percent of members every year. The segment can start with a minimum of 50 members. The Committee recommended separate membership for derivatives segment. Members of equity segment cannot automatically become members of derivative segment. Provision for arbitration and investor grievances cells to be set up in four regions. Provision of adequate inspection capability and all members to be inspected. Regulatory framework Regulatory control should envisage modern systems for fool-proof and fail-proof regulation. Regulatory framework for derivatives trading envisaged two-level regulation i.e. exchange-level and SEBI-level, with considerable emphasis on selfregulatory competence of derivative exchanges under the overall supervision and guidance of SEBI. There will be complete segregation of client money at the level of trading /clearing member and even at the level of clearing corporation. Other recommendations are as under: Regulatory Role of SEBI

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SEBI will approve rules, bye-laws and regulations. New derivative contracts to be approved by SEBI. Derivative exchanges to provide full details of proposed contract, like - economic purposes of the contract; likely contribution to the market's development; safeguards incorporated for investor protection and fair trading. Specifications Regarding Trading Stock Exchanges to stipulate in advance trading days and hours. Each contract to have pre-determined expiration date and time. Contract expiration period may not exceed 12 months. The last trading day of the trading cycle to be stipulated in advance. Membership Eligibility Criteria The trading and clearing member will have stringent eligibility conditions. The Committee recommended for separate clearing and non-clearing members. There should be separate registration with SEBI in addition to registration with the stock exchange. At least two persons should have passed the certification program approved by SEBI. A higher capital adequacy for Derivatives segment recommended than prescribed for cash market. The clearing members should deposit minimum Rs. 50 lakh with the clearing corporation and should have a net worth of Rs. 3 crore. A higher deposit proposed for Option writers. Clearing Corporation The Clearing System to be totally restructured. There should be no trading interests on board of the CC. The maximum exposure limit to be liked the deposit limit. To make the clearing system effective the Committee stressed stipulation of Initial and mark-to-market margins. Extent of Margin prescribed to co-relate to the level of volatility of particular Scripps traded. The Committee therefore recommended

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margins based on value at risk - 99% confidence (The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days. The concept is identified as "Worst Scenario Loss"). It did not favour the system of Cross-margining (This is a method of calculating margin after taking into account combined positions in futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-hedges). Since margins to be adjusted frequently based on market volatility margin payments to be remitted through EFT (Electronic Funds Transfer). To prevent brokers who fail/default to provide/restore adequate margin from trading further the stock exchange must have the power/facility to disable the defaulting member from further trading. Brokers/sub-brokers also to collect margin collection from clients. Exposure limits to be on gross basis. Own/clients margin to be segregated. No set off permitted. Trading to be clearly indicated as own/clients and opening/closing out. In case of default, only own margin can be set off against members' dues and the CC should promptly transfer client's margin in separate account. CC to close out all open positions at its option. CC can also ask members to close out excess positions or it may itself close out such positions. CC may however permit special margins on members. It can withhold margin or demand additional margin. CC may prescribe maximum long/short positions by members or exposure limit in quantity / value / % of base capital.

Mark to Market and Settlement There should the system of daily settlement of futures contracts. Similarly the closing price of futures to be settled on daily basis. The final settlement price to be as per the closing price of underlying security. Sales Practices Risk disclosure document with each client mandatory 50

Sales personnel to pass certification exam Specific authorization from client's board of directors/trustees

Trading Parameters Each order - buy/sell and open/close Unique order identification number Regular market lot size, tick size Gross exposure limits to be specified Price bands for each derivative contract Maximum permissible open position Off line order entry permitted

Brokerage Prices on the system shall be exclusive of brokerage Maximum brokerage rates shall be prescribed by the exchange Brokerage to be separately indicated in the contract note

Margins from Clients Margins to be collected from all clients/trading members Daily margins to be further collected Right of clearing member to close out positions of clients/TMs not paying daily margins Losses if any to be charged to clients/TMs and adjusted against margins

Other Recommendations

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Removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for speculation.

Creation of derivatives Cell, a derivative Advisory Committee, and Economic Research Wing by SEBI. Declaration of derivatives as securities under section 2(h)(iia) of the SCRA and suitable amendment in the notification issued by the Central Government in June 1969 under section 16 of the SCRA

Consequent to the committee's recommendations the following legal amendments were carried out:

Legal Amendments Securities Contract Regulation Act Derivatives contract declared as a 'security' in Dec 1999 Notification in June 1969 under section 16 of SCRA banning forward trading revoked in March 2000. In order to recommend a guideline for effective implementation of the recommendations of LC Gupta Committee Report, SEBI entrusted the task to another Committee, i.e. JR Verma Committee appointed by it. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005. The plan to introduce derivatives in India was initially mooted by the National Stock Exchange (NSE) in 1995. The main purpose of this plan was to encourage greater participation of foreign institutional investors (FIIs) in the Indian stock exchanges.

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Their involvement had been very low due to the absence of derivatives for hedging risk. However, there was no consensus of opinion on the issue among industry analysts and the media. The pros and cons of introducing derivatives trading were debated intensely. The lack of transparency and inadequate infrastructure of the Indian stock markets were cited as reasons to avoid derivatives trading. Derivatives were also considered risky for retail investors because of their poor knowledge about their operation. In spite of the opposition, the path for derivatives trading was cleared with the introduction of Securities Laws (Amendment) Bill in Parliament in 1998. The introduction of derivatives was delayed for some more time as the infrastructure for it had to be set up. Derivatives trading required a computer-based trading system, a depository and a clearing house facility. In addition, problems such as low market capitalization of the Indian stock markets, the small number of institutional players and the absence of a regulatory framework caused further delays. Derivatives trading eventually started in June 2000.

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CHAPTER 6 PRESENT STUDY Derivative instruments FORWARDS

A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest. FUTURES

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.

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KINDS OF FUTURES 1. Commodity futures: An agreement to buy or sell a set amount of a commodity at a predetermined price and date. Buyers use these to avoid the risks associated with the price fluctuations of the product or raw material, while sellers try to lock in a price for their products. Like in all financial markets, others use such contracts to gamble on price movements. Trading in commodity futures contracts can be very risky for the inexperienced. One cause of this risk is the high amount of leverage generally involved in holding futures contracts. For example, for an initial margin of $5,000, an investor can enter into a futures contract for 1,000 barrels of oil valued at $50,000. Given this large amount of leverage, even a very small move in the price of a commodity could result in large gains or losses compared to the initial margin. Unlike options, futures are the obligation of the purchase or sale of the underlying asset. Simply not closing an existing position could result in an inexperienced investor taking delivery of a large quantity of an unwanted commodity. 2. INDEX FUTURES: When the underlying asset in a futures contract is an indexed it is termed as index futures. Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery.

PAYOFF FOR FUTURES 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 potentially unlimited upside as well as a potentially unlimited downside.

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Example: a speculator who buys a two month nifty index futures contract when the nifty stands at 1220. The underlying asset in this case is the nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. 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 a potentially unlimited upside as well as a potentially unlimited downside.

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Example: a speculator who sells a two month nifty index futures contract when the nifty stands at 2220. The underlying asset in this case is the nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up it starts making losses. PRICING OF FUTURES The cost-of-carry model is used to understand the dynamics of pricing that constitute the estimation of fair value of futures. The cost of Carry Model We use fair value calculation of futures to decide the no-arbitrate limits on the price of a futures contract. This is the basis for the cost-of-carry model where the price of the contract is defined as: Future price = Spot price + Holding costs F = S + C

If F > S + C or F < S + C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage. Holding costs The components of holding cost vary with contracts on different assets. In some cases, it is even negative. 1. Community factors Holding cost = Cost of financing plus Storage costs plus insurance purchased, etc. 2. Equity Futures: Holding Cost = Cost of financing minus Dividend returns. An example: Futures price of 100 Gms of silver one-month down the line i.e. a contract expiring 30th April is computed as follows:

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The spot price of silver. S = Rs. 7000 Kg. The cost of financing for a month, 15% annualized (i.e. rT) = In (1.15) *30/365. Assume storage cost, C = 0 The fair value of futures price. F = S * exp (rT) + C = 700 * exp {In (1.15) * 30 365} = Rs. 708.

If the contract was for a three-month period i.e. expiring on 30th June the cost of financing would increase the futures price. Therefore, the futures price would be F = 700 * exp (In (1.15) * 90/365) = Rs. 725. Futures contracts on equity The main differences between commodity and equity futures are 1. There is no cost of storage considered in holding paper. 2. Equity paper comes with a dividend stream, which is a negative cost if you are long the stock, and a positive cost if you are shorts the stock. C = financing cost dividends. Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures prices. Example What will be the price of a new two-month futures contract on S&P CNX Nifty? 1. Let us assume that Satyam will be declaring a dividend of Rs. 10 per share after 15 days of purchasing the contract. 2. Current value of S&P CNX Nifty is 900 and S&P CNX Nifty is traded with a multiplier of 100.

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3. Since S&P CNX Nifty is traded in multiples of 100, value of the contract is 100*900 = Rs. 90000. 4. If Satyam has a weight of 7% in S&*P CNX Nifty, it is value in S&P CNX Nifty is Rs. 6300. 5. If the market price of Satyam is Rs. 140, then a traded unit of S&P CNX Nifty involves 45 shares of Satyam. 6. Thus, futures price F = 900*exp (In (1.15)*60/365)-45*10*4 exp(In (1.15)*45/365) 100 = Rs. 916.34. Futures Pricing in case of expected dividend yield If the dividend flow throughout 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. Example What is the fair value a two-month S&P CNX Nifty futures contract expiring on April 25? 1. What is the annual dividend yield on S&P CNX Nifty index? The dividend yield on S&P CNX Nifty, 2% annualized = In (1.02)*60/365. 2. What is the spot value of S&P CNX Nifty? Current value of S&P CNX Nifty is 910. 3. What is the cost of financing for two months? RT, cost of financing for a month 15% annualized = In (1.15)*60/365 4. What are the holdings costs? Assume storage cost, C = 0. 5. The fair value of futures price. F=S*esp. (IN (1+r-q))* T + C = 910* exp (In(1.13)*60/365) = Rs. 928.47.

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The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. The difference between the spot price and the futures price is called the basis. In a normal market the basis is negative. APPLICATION OF FUTURES HEDGING: LONG SECURITY, SELL FUTURES

Futures can be used as an effective risk management tool. Example- an investor who holds the share of a company and gets comfortable with market movements in the short run. He sees the value of his security falling from Rs. 450- Rs 390. in the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he needs to do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390. Two-month futures cost him Rs. 402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to rs. 350. the fall in price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of rs. 40 incurred on the security he holds, will be made up by the profits made on his short futures position. Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations). Hence a position

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LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position. Example: if we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs. 1.25 million of nifty futures. However, hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure,.i.e unnecessary risk. The hedged position will make less profit than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. SPECULATION: BULLISH SECURITY, BUY FUTURES

If a speculator has a view on the direction of the market, based on this view he trades. He believes that a particular security trades at Rs.1000 is undervalued and expect its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. he makes a profit of Rs. 1000 on an investment of Rs. 1, 00,000 for a period of two months. This works out to an annual return of 6%. Today a speculator can take exactly the same position on the security by using futures contracts. This works likes this. The security trades at Rs.1000 and the twomonth futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 1, 00,000. He buys 100 security futures for which he pays a margin of Rs 20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs 400 on an investment of Rs 20,000. This works out to an annual return of 12%. Because of the leverage they provide, security futures from an attractive option for speculators.

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SPECULATION: BEARISH SECURITY, SELL FUTURES

Stock futures can be used by a speculator who believes that a particular security os over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasnt much he could do to profit from his opinion. Today all he needs to do is sell the stock futures. Simple arbitrage ensures that futures on an individual securities mover correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls so will the futures price. Now take the case of a trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures on ABC at Rs. 240 (each contract for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures prices converges. He has made a clean profit of Rs. 20 per share. For the one contract that he bought, this works out to be Rs.2000. ARBITRAGE: FUTURES The cost of carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If the futures on a security seem overpriced then you can cash on this opportunity to earn riskless profits. Example: ABC ltd, trades at Rs 1000. One month ABC futures trade at Rs. 1025 and seem overpriced. As an arbitrager, you can make riskless profits by entering into the following set of transaction: 62 OVERPRICED FUTURES: BUY SPOT, SELL

1. On day one, borrow funds; buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month. 4. On the futures expiration date, the spot and the futures price coverage. Now unwind the position. 5. Say the security closes at Rs. 1015. Sell the security. 6. Futures position expires with profit of Rs.10 7. The result is a riskless profit of rs.15 on the spot position and rs.10 on the futures position. 8. Return the borrowed funds. It makes sense to enter into arbitrage when your cost of borrowing funds to buying the security is less than the arbitrage profit possible. This is termed as cash and carry arbitrage. However, exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transaction costs into the arbitrage strategy. ARBITRAGE: UNDERPRICED FUTURES: BUY FUTURES, SELL SPOT Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. In such a case you encash this opportunity by making riskless profits. Example: ABC ltd, trades at Rs 1000. One month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrager, you can make riskless profits by entering into the following set of transaction: 1. On day one, sell the security on the cash/spot market at 1000. 2. Make the delivery of the security. 3. Simultaneously, buy the futures on the security at 965.. 4. On the futures expiration date, the spot and the futures price coverage. Now unwind the position.

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5. Say the security closes at Rs. 975. Buy back the security. 6. Futures position expires with profit of Rs.10 7. The result is a riskless profit of rs.25 on the spot position and rs.10 on the futures position. If the returns you get by investing in riskless instruments are more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse cash-and carries arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost of carry. Exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash and carry and reverse cash and carry, we see increased volumes and lower spreads in both the case as well as the derivatives market. OPTIONS 1. Options give you the right to buy or sell an underlying instrument. 2. If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to. 3. If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset. 4. Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price. 5. Options when bought are done so at a debit to the buyer. 6. Options when sold are done so by giving a credit to the seller.

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7. Options are available in several strike prices representing the price of the underlying instrument. 8. The cost of an option is referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. 9. Options are not available on every stock. There are approximately 2,200 stocks with tradable options. Each stock option represents 100 shares of a company's stock. Options are the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. Simply put, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. It is essential to become familiar with the inner workings of both. Every strategy you learn from this point on depends on your thorough understanding of these two kinds of options. There are no margin requirements if you want to purchase an option because your risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless. However, option sellers also have an obligation to buy (put) or sell (call) the underlying instrument if their option is exercised by an assigned option holder. Therefore, selling an option requires a healthy margin. To trade options, you must be acquainted with the select terminology of the option market. The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike 65

prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals. The date the option expires is referred to as the expiration date. A stock option expires by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval: A. January, April, July and October B. February, May, August and November C. March, June, September and December The price of an option is called the premium. An option's premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. An option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the premium of an option is priced at 2, the total premium for that option would be $200 (2 x 100 = $200). Buying an option creates a debit in the amount of the premium to the buyer's trading account. Selling an option creates a credit in the amount of the premium to the seller's trading account: Example: Jane wants to buy a house. After a few weeks of searching, she discovers one she really likes. Unfortunately, she won't have enough money for a substantial down payment for another six months. So, she approaches the owner of the house and negotiates an option to buy the house within 6 months for $100,000. The owner agrees to sell her the option for $2,000.

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Scenario 1: During this 6-month period, Jane discovers an oil field underneath the property. The value of the house shoots up to $1,000,000. However, the writer of the option (the owner) is obligated to sell the house to Jane for $100,000. Jan e buys the house for a total cost of $102,000-$100,000 for the house plus the $2,000 premium paid for the option. She promptly turns around and sells it for a million dollars for huge profit of $898,000 and lives happily ever after.

Scenario 2: Jane discovers a toxic waste dump on the property. Now the value of the house drops to zero and she obviously decides not to exercise the option to buy the house. In this case, Jane loses the $2,000 premium paid for the option to the owner of the property. Call options Call options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available in various strike prices depending on the current market price of the underlying instrument. Expiration dates can vary from one month out to more than a year (LEAPS options). Depending on the mood of the market, you may choose to buy (go long) or sell (go short) a call option. If you choose to buy or go long a call option, you are purchasing the right to buy the underlying instrument at whatever strike price you choose until the expiration date. The premium of a long call option shows up as a debit in your trading account. The premium amount represents the maximum risk a long call strategy can incur. Profit is made on a long call when the price of the underlying asset rises above the strike price of the call. You can then either exercise the call or offset it by selling a call with the same strike price and expiration date. By exercising a long call, you end up with 100 shares per option of the underlying stock at the call strike price. You can then turn around and sell the underlying asset at the current (higher) price to garner a profit on the difference between two (current price - strike price = profit). If you choose to offset the call option, the maximum profit is unlimited. The call's

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premium will increase in value depending on how high the underlying instrument rises in price beyond the strike price of the call. As the price of the underlying asset rises, the long call becomes more valuable because it gives you (or the person you sell it to) the right to buy the underlying stock at the lower strike price of the call. That's why you want to go long a call option in a rising or bull market.

If you choose to sell or go short a call option, you are selling the right to buy the underlying instrument at a particular strike price to an option holder. Selling a call option prompts the deposit of a credit in your trading account in the amount of the call's premium-a limited profit. You get to keep this credit if the option expires worthless. Thus, to make money on a short call, the price of the underlying asset must stay below the call's strike price. If the price of the underlying asset rises above the short call strike price, it will be assigned to an option holder who may choose to exercise it. This gives the option holder the right to buy 100 shares (per option) of the underlying stock from the assigned option buyer at the strike price of the short call. This means that the option seller must buy the underlying asset at the current price and sell it at the call's lower strike price to the assigned option holder, thereby incurring a loss on the trade (current price - strike price = loss). The maximum loss

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is therefore unlimited to the upside, which is why selling "naked" or unprotected call options comes with such a high risk. However, experienced traders who do choose to short call options would be wise to do so in a stable or bear market.

Call options give you the right to buy something at a specific price for a specific time period. However, if the current market price is more than the strike price, the call option is in-the-money (ITM). If the current market price is less than the strike price, the call option is out-of-the-money (OTM). If the current market price is the same as (or close to) the strike price, the call option is at-the-money (ATM). 1. Call options give traders the right to buy the underlying stock at the strike price until market close on the 3rd Friday of the expiration month. A call option is in-themoney (ITM) if its strike price is below the current price of the underlying stock. A call option is out-of-the-money (OTM) if its strike price is above the current price of the underlying stock. A call option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock. 2. Buying Calls - If bullish - believe the market will rise - buy (go long) calls. Buyers have rights. A call buyer has the right, but not the obligation, to buy the underlying stock at the strike price until the expiration date. If you buy a call option, 69

your maximum risk is the money paid for the option, the debit. The maximum profit is unlimited depending on the rise in the price of the underlying asset. To offset a long call, you have to sell a call with the same strike price to close out the position. By exercising a long call, you are choosing to purchase 100 shares of the underlying stock at the strike price of the call option. 3. Selling Calls - If bearish - believe the market will fall - sell (go short) calls. Sellers have obligations. A call seller has the obligation to sell 100 shares of the underlying stock at the strike price to the person to whom the option was sold, if that person chooses to exercise the call option. Sellers have obligations. If you sell a call option, your risk is unlimited to the upside. The profit is limited to the credit received from the sale of the call. When selling calls, make sure to choose options with little time left until expiration. Call sellers want the call to expire worthless so that they can keep the whole premium. To offset a short call, you have to buy a call with the same strike price to close out the position. Put options Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one month out to more than a year (LEAPS options). However, unlike call options, you might consider going long a put option if you expect market prices to fall (bearish). In contrast, if you are bullish (expect the market to rise), you might consider selling a put option. If you choose to buy or go long a put option, you are purchasing the right to sell the underlying instrument at whatever strike price you choose until the expiration date. The premium of the long put option will show up as a debit in your trading account. The cost of the premium is the maximum loss you risk by purchasing a put option.

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The maximum profit is limited to the downside as the underlying stock falls to zero. A profit can be made in one of two ways if the underlying market declines. By exercising a put option, you are short 100 shares of the underlying stock. If and when the underlying stock falls below the put strike price, you can exercise the put to short the shares at a higher price and then buy the underlying stock at a cheaper price to cover the short and exit the trade (strike price - current price = profit). The second technique for profiting on a put comes from offsetting it. If the price of the underlying stock falls, the corresponding put premium increases and can then be sold at a profit. If you go long a put option and the underlying security (index or stock) increases in price, the value of the put will fall. Then you can either sell the put at a loss or let it expire worthless. Long put

If you choose to sell or go short a put option, you are selling the right to sell the underlying stock at a particular strike price to an option holder. The premium of the short put will show up as a credit in your trading account. In most cases, you are anticipating that the short put option will simply expire worthless on the expiration date so that you can keep the premium received. The premium amount is the maximum profit you can receive by selling a put option. If the underlying stock falls below the put strike price, the put will most likely be assigned to an option holder who may choose to exercise the option. The option seller then has an obligation to 71

buy 100 shares (per option) of the underlying stock at the put strike price from the option holder. You will then be long 100 shares of the underlying stock and your loss depends on how low the price of the underlying stock falls as you try to sell the shares to exit the position. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls.

Short put

Put options give you the right to sell something at a specific price for a fixed amount of time. A put option is in-the-money (ITM) when the strike price is higher than the market price of the underlying asset. A put option is at-the-money (ATM) when the price of the underlying is equal (or closes) to its strike price. A put option is out-ofthe-money (OTM) when the price of the underlying security is greater than the strike price. Put options give traders the right, but not the obligation, to sell the underlying stock at the strike price until market close on the 3rd Friday of the expiration month. A put option is in-the-money (ITM) if its strike price is above the current price of the 72

underlying stock. A put option is out-of-the-money (OTM) if its strike price is below the current price of the underlying stock. A put option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock. 2. Buying Puts - If the options trader is bearish -- i.e. believes the underlying stock or index will fall in price -- the trader can buy (go long) puts. When the put is purchased, it is called an opening transaction. Now, the buyer has rights. A put buyer has the right, but not the obligation, to sell the underlying stock at the strike price of the option until the expiration date. Furthermore, if a trader buys a put option, the risk of the trade equals the money paid for the option, or the debit. The profit is equal to the fall in the price of the underlying asset. The profit will result if the underlying security moves lower. The profit is limited because the underlying asset will not fall below zero. Finally, to offset a long put, the trader will sell a put with the same terms (strike price and expiration) to "close" out the position. On the other hand, if the trader exercises a long put, then he or she is selling, or short, the underlying stock or index at the strike price of the put option. 3. Selling Puts - If the options trader is bullish -- believes the market will rise -- the trade can sell (go short) puts. Sellers have obligations. A put seller has the obligation to buy 100 shares (per option) of the underlying stock at the put strike price. In other words, the option seller must be ready to have the stock "put" to him or her. The put seller's risk is the drop in the stock price, which is limited to the stock falling to zero. The profit equals the credit received from the sale of the put. Put sellers often prefer options with little time left until expiration because they want a put to expire worthless. In that way, the seller keeps the entire premium. A short put is offset by purchasing a put with the same strike price and expiration to close out the position. Types of options (a) American. Transaction pursuant to which the right or rights granted is exercisable during an Exercise Period that consists of a period of days.

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(b)

Bermuda. "Bermuda" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only during an Exercise Period, which consists of a number of specified dates.

(c)

European. "European" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only on the Expiration Data.

(d)

Barrier Option An option, which is only exercised when the underlying item reaches a predetermined price.

(e)

Digital Option These options are only exercised when the underlying item reaches a pre-determined price and then only pay a fixed amount regardless of how far in-the-money the option settles.

Strike price of Options The price at which the buyer has a right to buy or sell an underlying asset Is called Strike price or Exercise price. World over options are generally traded on different variety of strike prices. These strike prices are determined by the exchange. For example if a call option is traded at a strike price equal to that of the underlying spot price, then the option is called At The-Money option and if the strike price is higher than the underlying spot price, it is called as Out-of-Money option. In case of put option if the strike price is higher than the underlying spot price it is called InThe-Money and when the strike price lower than the underlying spot price, it is called Out-of-Money option. At-The-Money option is same for both a call and put on the same underlying and the same strike price Expiration Date is the date on which an option expires. Exercise Date is the date on which an option gets exercised by the option holder/buyer. Option Premium is the price paid by the option buyer to the option seller for granting the option. Option premium consists of two parts:

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1. Intrinsic value 2. time value Intrinsic value and time value Intrinsic value and time value are two of the primary determinants of an option's price. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. The following equations will allow you to calculate the intrinsic value of call and put options:
Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price Time Value = Put Options: Call Premium - Intrinsic Value Intrinsic value = Put Strike Price - Underlying Stock's Current Price Time Value = Put Premium - Intrinsic Value

ATM and OTM options don't have any intrinsic value because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration. The intrinsic value of an option is not dependent on the time left until expiration. It is simply an option's minimum value; it tells you the minimum amount an option is worth. Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time. In other words, the time value of an option is directly related to how much time an option has until expiration. The more time an option has until expiration, the greater the option's chance of ending up in-the-money. Time value has a snowball effect. If you have ever bought options, you may have noticed that at a certain point close to expiration, the market seems to stop moving anywhere. That's because option prices are exponential-the closer you get to expiration, the more money you're going to lose i f the market doesn't move. On the expiration day, all an option is worth is its intrinsic value. It's either in-the-money, or it isn't.

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How to use options? Options can be used in a variety of ways to profit from a rise or fall in the underlying market. The most basic strategies employ put and call options as a low capital means of garnering a profit on market movement. Options can also be used as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for trades and investments. They also increase your leverage by enabling you to control the shares of a specific stock without tying up a large amount of capital in your trading account. The amazing versatility that an option offers in today's highly volatile markets is welcome relief from the uncertainties of traditional investing practices. Options can be used to offer protection from a decline in the market price of a long underlying g stock or an increase in the market price of a short underlying stock. They can enable you to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. You can also use option strategies to profit from a move in the price of the underlying asset regardless of market direction. There are three general market directions: market up, market down, and market sideways. It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy stocks. An investor can also combine long and short options and underlying assets in a wide variety of strategies. These strategies limit your risk while taking advantage of market movement. The following tables show the variety of options strategies that can be applied to profit on market movement:

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Bullish Limited Risk Strategies Buy Call Bull Call Spread Bull Put Spread Call Ratio Backspread

Bullish Unlimited Risk Strategies Buy Stock Sell Put Covered Call Call Ratio Spread

Bearish Limited Risk Strategies Buy Put Bear Put Spread Bear Call Spread Put Ratio Backspread

Bearish Unlimited Risk Strategies Sell Stock Sell Call Covered Put Put Ratio Spread

Neutral Limited Risk Strategies Long Straddle Long Strangle Long Synthetic Straddle Put Ratio Spread Long Butterfly Long Condor Long Iron Butterfly

Neutral Unlimited Risk Strategies Short Straddle Short Strangle Call Ratio Spread Put Ratio Spread

It is of paramount importance to be creative with your trading. Creativity is rare in the stock and options market. That's why it's such a winning tactic. It has the potential to beat the next person down the street. You have a chance to look at different scenarios that they do not have the knowledge to construct. All you need to do is take one step above the next guy for you to start making money. Luckily the next person, typically, does not know how to trade creatively.

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OPTIONS STRATEGIES

BULLISH MARKET: BUYING CALLS COVERED CALLS VERTICAL SPREAD BULL CALL SPREAD BULL PUT SPREAD

BEARISH MARKET 1. BUYING PUTS 2. COVERED PUTS 3. BEAR PUT SPREAD 4. BEAR CALL SPREAD

BUYING CALL The long call strategy provides unlimited profit potential with limited risk. It is best used in a bullish market where a rise in the price of the underlying asset above the breakeven is anticipated. Zero margin borrowing is allowed. That means that you don't have to hold any margin in your account to place the trade. You only pay the option's premium-a fairly small investment depending on the market you choose to trade. Let's create an example of a long call strategy by going long 1 October Apple Computers (AAPL) 42 @ call at 4 @. Apple is currently trading at 43 1/16. Figure 1-A reveals the risk graph of this basic option strategy. This example uses an ATM option worth +50 deltas.

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Figure 1-A: Long 1 OCT AAPL 42 @ Call @ 4 @ / AAPL @ 43 1/16 This trade costs a total of 4 @ or $450 (4 @ x 100 = $450) plus commissions. The maximum risk is the price of the option ($450). The maximum reward is unlimited to the upside as Apple Computer stock continues to rise. The breakeven is calculated by ad ding the strike price (42 @) to the premium of the call option (4 @). In this example, the breakeven is 47 (42 @ + 4 @ = 47). This means that the trade starts to make money when Apple rises above 47. In addition, notice that the risk graph's profit and loss line slopes up from left to right. This represents the trade at expiration. Look to where it crosses the breakeven point at 47 and continues to rise above this point. To exit a long call, you have three options. You can let the call expire and lose the premium (not exactly my first choice). You can exercise the call to receive the underlying stock at the strike price of the option; or you can sell the call. By exercising the call option, you can make money by turning around and selling the stock at the current market price and pocketing the difference. By selling the call, you can make money when the price of the premium rises in value due to a rise in the under lying stock. By choosing to purchase a long call options instead of 100 shares of Apple stock, you have increased your leverage and reduced the risk inherent in the trade. A long call option uses less initial outlay of cash to participate in the trade. In addition, the

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most you can lose by purchasing a call is the price of the premium or $450. The most you can lose if your purchase the stock outright is $4,306.25-the full amount paid for the stock. However, the $450 option still allows you to control $4,306.25 worth of Apple shares. This kind of leverage is what makes options so appealing. LONG Long AAPL Net Debit: 4 Risk: Profit: 47 @ Maximum Maximum Breakeven: Margin: None LONG CALL STRATEGY REVIEW Strategy is Maximum Maximum Breakeven= Margin= None COVERED CALLS In a covered call trade, you are buying the underlying stock shares and selling call options against it. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. This technique allows traders to handle moderate price declines because the call premium reduces the positions breakeven. Since you are counting on the time decay of the short option to render the short call worthless, you do not want to sell a call more 80 Risk= Profit= Call Limited Unlimited strike to to the the amount upside + price paid beyond for the call = Buy a call option anticipated the call premium breakeven Market Opportunity = Look for a bullish market where a rise above the breakeven 1 CALL OCT AAPL @ or $450 Unlimited (42 $450 (4 to @ the (4 @ upside + 4 42 EXAMPLE @ 43 @ x x 100 100 beyond @ the = = = Call @ SPECIFICS 4 @ 1/16 $450) $450) breakeven 47)

than 4 5 days out. However, since the profit on a covered call is limited to the premium received, the premium needs to be high enough to balance out the trade's risk. Table 5-1 illustrates the advantages a covered call offers in comparison to simply purchasing stock. Covered Call Strategy vs. Long Stock Strategy Market Scenario Stock price increases: Call is exercised and the underlying stock shares are sold at the call's strike price Stock price remains stable: Call expires worthless and the trader still owns the stock shares Stock price decreases: Call expires worthless and the trader still owns the stock shares. Covered Call Profits are limited to the premium received on the short call plus the profit made from the difference between the stock's price at initiation and the call strike price Profits are limited to the premium received on the short call. Long Stock Profits may be garnered if the stock is sold at the higher price.

No profit is made.

The breakeven on the stock is lowered by the premium received on the short call.

Losses accumulate as the stock price declines below the initial price paid for the stock.

Table 1-1: Covered Call Strategy vs. Long Stock Strategy Unlike vertical spreads, there are a limited number of choices that depend on the available option premiums. As previously mentioned, the key to a successful covered call lies in finding a stable market with slightly OTM options with less than 45 days till expiration with enough premium to make the trade worthwhile. Using the values in Table 1-2, it's easy to see that the January 80 option is the only viable choice for a covered call strategy. Let's create a covered call by purchasing 100 shares of Wal-Mart Stores stock and selling 1 January WMT 80 call at 4 . The risk graph for this trade is shown in Figure 1-B. The profit line on this trade slopes up from left to right. Conveying the trader's desire for the market price of the stock to

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rise slightly. It also shows the trade's limited protection. If Wal-Mart Stores declines beyond the breakeven, there is unlimited risk on the stock all the way to zero. The breakeven on a covered call is calculated by subtracting the call option premium from the price of the underlying stock at initiation. In this example, the breakeven is 67 (71 @ - 4 = 67 ). Wal-Mart must drop below 67 for the trade to begin to take a loss (not including commission costs). The maximum profit of $1,275 will be received if the stock rises to or above 80 and the call is exercised. Covered calls are the most popular option strategy used in today's markets. If a trader wants to gain additional income on the same stock, he or she can sell a slightly OTM call every month. The risk lies in the strategy's limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. To increase protection, covered calls can be combined with buying long-term puts (over 6 months). Calls can then be sold each month with the added protection of the long puts. COVERED CALL STRATEGY REVIEW Strategy = Buy the underlying security and sell an OTM call option Market Opportunity = Look for a bullish to neutral market where a slow rise in the price of the underlying is anticipated with little risk of decline Maximum Risk = Virtually unlimited to the downside below the breakeven all the way to zero Maximum Profit = Limited to the credit received from the short call option + (short call strike price - price of long underlying asset) times value per point Breakeven = Price of the underlying asset at initiation - short call premium received Margin = Required. The amount is subject to your broker's discretion. VERTICAL SPREAD Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to use strategies that limit your losses to a manageable amount. There are a variety of options strategies that can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that trigger 82

its application in a particular market. Vertical spreads are the most basic limited risk strategies and that's why they are often introduced relatively early. These simple hedging strategies enable traders to take advantage of the way options premiums change in relation to movement in the underlying asset. Vertical spreads combine long and short options with different strike prices and the same expiration date to profit on a directional move in the price of the underlying asset. They offer limited potential profits as well as limited risks. One of the keys to understanding these managed risk spreads comes from grasping the concepts of intrinsic value and time value-variables that provide major contributions to the fluctuating price of an option. In order to understand these important concepts, let's take a closer look at the components that affect option pricing. BULL CALL SPREAD A bull call spread is a debit spread created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying asset. However, the total investment is usually far less than that required to purchase the stock. The strategy has both limited profit potential and limited downside risk. Steps to Using a Bull Call Spread 1. Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move. 2. Check to see if this stock has options. 3. Review call options premiums per expiration dates and strike prices. 4. Investigate implied volatility values to see if the options are overpriced or undervalued.

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5. Explore past price trends and liquidity by reviewing price and volume charts over the last year. 6. Choose a lower strike call to buy and a higher strike call to sell with the same expiration date. 7. Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid. 8. Calculate the maximum potential risk by figuring out the net debit of the two option premiums. 9. Calculate the breakeven by adding the lower strike price to the net debit. 10. Create a risk profile for the trade to graphically determine the trade's feasibility. 11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 12. Contact your broker to buy and sell the chosen call options. 13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock closes at or below the breakeven point. 14. To exit the trade, you need to sell the lower strike call and buy the higher strike call or simply let the options expire. The maximum profit occurs when the underlying stock rises above the short call strike price. If and when the short call is exercised by the assigned option holder, you can exercise the long call and deliver those shares to the option holder at the lower long call price, pocketing the difference plus the premium from the short call.

BULL PUT SPREAD

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A bull put spread is a credit spread created by purchasing a lower strike put and selling a higher strike put with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required buying the stock shares. The strategy has both limited profit potential and limited downside risk. Steps to Using a Bull Put Spread 1. Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move. 2. Check to see if this stock has options. 3. Review put options premiums per expiration dates and strike prices. 4. Investigate implied volatility values to see if the options are overpriced or undervalued. 5. Explore past price trends and liquidity by reviewing price and volume charts over the last year. 6. Choose a lower strike put to buy and a higher strike put to sell with the same expiration date. 7. Calculate the maximum potential profit by computing the net credit of the two option premiums. 8. Calculate the maximum potential risk by multiplying the value per point by the difference in strike prices and subtracting the net credit received. 9. Calculate the breakeven by subtracting the net credit from the higher strike price. 10. Create a risk profile for the trade to graphically determine the trade's feasibility. 11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 85

12. Contact your broker to buy and sell the chosen put options. 13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock falls to or below the breakeven point. 14. To exit the trade, you need to sell the lower strike put and buy the higher strike put or simply let the options expire.

BUYING PUTS In the long put strategy, you are purchasing the right, but not the obligation, to sell the underlying stock at a specific price until the expiration date. This strategy is used when you anticipate a fall in the price of the underlying stock. A long put strategy offers unlimited profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to decrease in price. Let's create an example by going long 1 October Federal-Mogul Corp. (FMO) 65 put at 4 . The Federal-Mogul Corporation's current market price is 63 3/8. This makes the 65 put an ATM option worth -50 deltas. The risk graph for a long put trade slopes upward from right to left. This signifies that the profit increases as the market price of the underlying falls. This strategy offers unlimited profit potential and limited risk over the life of the option, regardless of the movement of the underlying asset. The maximum risk of a long put strategy is limited to the price of the put premium. Therefore, this trade's maximum risk is limited to $425 (4 x 100 = $425) plus commissions. No matter how high the underlying asset rises, you can only lose $425. However, you have a limited profit potential to the downside as the underlying asset falls to zero. The breakeven for a long put strategy is calculated by subtracting the put option premium paid from the strike price of the put option. In

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this example, the breakeven would be at 60-1/4 (65 - 4-1/4 = 60-3/4). That means that as FMO falls below 60-3/4, the trade makes money. This strategy does not require a margin deposit. To exit a long put strategy, you have the same three options as with a long call. You can let the option expire worthless, exercise your right to short the market, or sell a put option with the same strike price. Each alternative comes with its own set of advantages and disadvantages depending on how far the underlying stock moves and in which direction.

LONG PUT EXAMPLE SPECIFICS Long 1 OCT FMO 65 Put @ 4 FMO @ 63 3/8 Net Debit: 4 or $425 (4 x 100 = $425) Maximum Risk: $425 (4 x 100 = $425) Maximum Profit: Limited to the downside as the underlying stock falls to zero. Breakeven: 60 @ (65 - 4 @ = 60 @) Margin: None LONG PUT STRATEGY REVIEW Strategy = Buy a put option Market Opportunity = Look for a bearish market where you anticipate a fall in the price of the underlying stock below the breakeven Maximum Risk = Limited to the price of the put option premium Maximum Profit = Limited to the downside as the underlying stock falls to zero Breakeven = Put strike price - put premium Margin = None COVERED PUTS

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In a covered put strategy, you are selling the underlying stock and selling a put option against it. This strategy is best implemented in a bearish to neutral market where a slow fall in the market price of the underlying stock is anticipated. This strategy's profit-making ability depends on the short options expiring worthless. Therefore, although an option with more time yields a higher premium, never sell puts in a covered put strategy with more than 45 to 60 days until expiration. Too much time increases the chance of the Market price moving into a range where the short option is exercised. If a put option is exercised, the option seller is obligated to buy 100 shares of the underlying stock at the put's strike price from the option holder. Let's create an example of a covered put strategy using Eastman Kodak Co. (EK) by going short 100 shares of EK @ 74 and short 1 January EK 70 put @ 4. For this position to keep the credit, the market price of the stock needs to stay above $70. The maxi mum profit for this trade is the premium received for the short put option plus the money accrued from the sale of the stock if the option is exercised. The maximum reward on the option side of this position is $400 [(4 x 100 = $400). The maximum reward o n the stock side of this position is $400 [(74 - 70) x 100 = $400]. This creates a total profit of $800 (400 + 400 = $800). The maximum risk is unlimited to the upside beyond the breakeven. This trade requires a margin deposit to place. Figure 1-D shows t he risk profile for this trade. The breakeven on a covered put is calculated by adding the put option premium to the price of the underlying stock at initiation. In this example, the breakeven is 78 (74 + 4 = 78). Unfortunately, placing a covered put will not protect you from sharp r ise above the breakeven. If Eastman Kodak rises above 78, the trade will start to lose money. However, selling a put against a short stock does increase the breakeven. If you were to simply the sell the stock, the breakeven would be the purchase price of the stock at initiation or 74. If Eastman Kodak falls below the strike price of the put, there is a possibility that the put will be assigned and you will be obligated to purchase the stock at the strike price. If so, you can return those 88

shares to your brokerage to cover the short shares at the higher initial price and pocket the difference as profit. By tracking this trade, we find that Eastman Kodak actually rose above the breakeven 2 days before expiration, only to plummet to 69 on expiration day. There is a good chance that the put received notice of assignment at which time the short stock position was closed out for a total profit on the trade of $800. Since Eastman Kodak continued in a bearish trend after the option expired, we potentially missed a bigger profit on the stock by having to use the shares to fulfill our obligations on the assign ed short put. Such is life. Covered puts enable traders to bring in some extra premium on short positions. Once again, you can keep selling a put against the short shares every month to increase your profit. However, shorting stock is a risky trade no matter how you look at i t because there is no limit to how much you can lose if the price of the stock rises above the breakeven. COVERED PUT STRATEGY REVIEW Strategy = Sell the underlying security and sell an OTM put option Market Opportunity = Look for a bearish or stable market where a decline in the price of the underlying is anticipated with little risk of the market rising Maximum Risk = Unlimited to the upside Maximum Profit = Limited to the credit received on the short put option plus (price of the short underlying asset - put option strike price) times the value per point Breakeven = Price of the underlying asset + short put premium received Margin = Required. The amount is subject to your broker's discretion.

BEAR PUT SPREAD A bear put spread is a debit spread created by purchasing a higher strike put and selling a lower strike put with the same expiration dates. This strategy is best implemented in a moderately bearish market. It provides high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as

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1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required to buy the stock shares. The strategy has both limited profit potential and limited downside risk.

Steps to Using a Bear Put Spread 1. Look for a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock-not a large move. 2. Check to see if this stock has options. 3. Review put options premiums per expiration dates and strike prices. 4. Investigate implied volatility values to see if the options are overpriced or undervalued. 5. Explore past price trends and liquidity by reviewing price and volume charts over the last year. 6. Choose a higher strike put to buy and a lower strike put to sell with the same expiration date. 7. Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid. 8. Calculate the maximum potential risk by computing the net debit of the two option premiums. 9. Calculate the breakeven by subtracting the net debit from the higher strike price. 10. Create a risk profile for the trade to graphically determine the trade's feasibility. 11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 12. Contact your broker to buy and sell the chosen put options.

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13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock rises to or above breakeven point. 14. To exit the trade, you need to sell the higher strike put and buy the lower strike put or simply let the options expire. The maximum profit occurs when the price of the underlying stock falls below the short put strike price. If and when the short put is exercised by the assigned option holder, you can exercise the long put to sell the shares purchased from the option holder at the higher long put price, pocketing the difference plus the premium of the short put. BEAR CALL SPREAD A bear call spread is a credit spread created by purchasing a higher strike call and selling a lower strike call with the same expiration dates. This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required buying the stock or futures contract. The strategy has both limited profit potential and limited downside risk. Steps to Using a Bear Call Spread 1. Look for a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock-not a large move. 2. Check to see if this stock has options. 3. Review call options premiums per expiration dates and strike prices. 4. Investigate implied volatility values to see if the options are overpriced or undervalued. 5. Explore past price trends and liquidity by reviewing price and volume charts over the last year. 91

6. Choose a higher strike call to buy and a lower strike call to sell with the same expiration date. 7. Calculate the maximum potential profit by computing the net credit of the two option premiums. 8. Calculate the maximum potential risk by multiplying the value per point by the difference in strike prices and subtracting the net credit received. 9. Calculate the breakeven by adding the net credit to the lower strike price. 10. Create a risk profile for the trade to graphically determine the trade's feasibility. 11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 12. Contact your broker to buy and sell the chosen call options. 13. Watch the market closely as it fluctuates. The profit on this strategy is limited - a loss occurs if the underlying stock rises to or above the breakeven point. 14. To exit the trade, you need to sell the higher strike put and buy the lower strike put or simply let the options expire. LEAPS Long-term Equity Anticipation Products (LEAPS) are options that don't expire for at least 9 months and can have expiration 2 or 3 years out. Once an option's expiration gets closer than 9 months, they become plain options again with an entirely new ticker symbol. Be this as it may, LEAPS are in every way an option. Their expirations are a long way off and that makes them prime candidates for long-term plays and secure bets for shorter-term trades. For traders with a traditional buy and hold orientation, options usually carry with them the stigma of being short-term trading tools with tax consequences. LEAPS, by the very nature of their long-term expiration dates, help to overcome this stigma. It 92

isn't unusual for LEAPS traders to hold a position for more than a year. Plus, LEAPS have the added benefit of giving a trader significantly more time to be right about a market move. WHAT AFFECTS EQUITY OPTION PRICING? Option pricing is based on a variety of factors. There are seven main components that affect the premium of an option. These are: 1. The current price of the underlying financial instrument 2. The strike price of the option in comparison to the current market price (intrinsic value) 3. The type of option (put or call) 4. The amount of time remaining until expiration (time value) 5. The current risk-free interest rate 6. The volatility of the underlying financial instrument 7. The dividend rate, if any, of the underlying financial instrument Each of these factors plays a unique part in the price of an option. In most cases, the first 4 are pretty easy to figure out. The rest are often forgotten or overlooked. However, although they may be a little confusing, each is important. For example, when it comes to trading with options, reviewing volatility levels can help traders determine the right options strategy to employ. In addition, it is noteworthy to assess the current risk-free interest rate and whether or not a particular stock is prone to the release of dividends. Higher interest rates can increase option premiums, while lower interest rates can lead to a decrease in option premiums. Dividends act in a similar way, increasing and decreasing an option premium as they increase or decrease the price of the underlying asset. Also, if a stock were to pay a dividend, a short seller would be responsible for that payment.

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This means that a short seller in securities not only has unlimited risk of the stock price rising, but also is responsible for the dividends paid out. How to exit options? Once you own an option, there are three methods that can be used to make a profit or avoid loss: exercise it, offset it with another option, or let it expire worthless. By exercising an option you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price. Only option buyers have the choice to exercise an option. Option sellers, on the other hand, may experience having an option assigned to an option holder and subsequently exercised. Offsetting is a method of reversing the original transaction to exit the trade. If you bought a call, you have to sell the call with the same strike price and expiration. If you sold a call, you have to buy a call with the same strike price and expiration. If you bought a put, you have to sell a put with the same strike price and expiration. If you sold a put you have to buy a put with the same strike price and expiration. If you do not offset your position, then you have not officially exited the trade. If an option has not been offset or exercised by expiration, the option expires worthless. If you originally sold an option, then you want it to expire worthless because then you get to keep the credit you received from the option premium. Since an option seller wants an option to expire worthless, the passage of time is an option seller's friend and an option buyer's enemy. If you bought an option, the premium is nonrefundable even if you let the option expire worthless. As an option gets closer to expiration, it decreases in value. It is important to note that most options traded on U.S. exchanges are American style options. In essence, they differ from European options in one main way. American style options can be exercised at any time up until expiration. In contrast,

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European style options can be exercised only on the day they expire. All the options of one type (put or call) which have the same underlying security are called a class of options. For example, all the calls on IBM constitute an option class. All the options that are in one class and have the same strike price are called an option series. For example, all IBM calls with a strike price of 130 (and various expiration dates) constitute an option series. OTHER OPTION STRATEGIES Strap

An options strategy created by being long in one put and two call options, all with the exact same strike price, maturity and underlying asset. Also referred to as a "triple option".

A strap option is used when a trader believes that the future price movement of the underlying security will be large and more likely up than down. By adding two call options the trader has a large gain if he or she is right about the large upward movement. But if the forecast is wrong and the price has a large reversal, the trader is protected by the put option. Strangle

An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset.

This is a good strategy if you think there will be a large price movement in the near

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future

but

is

unsure

of

which

way

that

price

movement

will

be.

The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

For example, imagine a stock currently trading at $50 a share. To employ the strangle option strategy a trader enters into two option positions, one call and one put. Say the call is for $55 and costs $300 ($3.00 per option x 100 shares) and the put is for $45 and costs $285 ($2.85 per option x 100 shares). If the price of the stock stays between $45 and $55 over the life of the option the loss to the trader will be $585 (total cost of the two option contracts). The trader will make money if the price of the stock starts to move outside of the range. Say that the price of the stock ends up at $35. The call option will expire worthless and the loss will be $300 to the trader. The put option however has gained considerable value, it is worth $715 ($1,000 less the initial option value of $285). So the total gain the trader has made is $415. straddle An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.

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Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. As shown in the diagram above, should only a small movement in price occur in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.

Up and In options

An option that can only be exercised when the price of the underlying asset reaches a set barrier level. This is a type of a knock-in barrier option.

The prices of these options tend to be lower than "vanilla options" as the ability to exercise the option is contingent on breaking the barrier. Zero- cost collar

A type of positive-carry collar that secures a return through the purchase of a cap and sale of a floor. Also called "zero cost options" or "equity risk reversals."

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This investment strategy is sometimes used in relation to interest rates, commodities, options, and equities. Investors looking to secure a return will sell a cap and buy a floor, whereas borrowers will sell a floor and buy a cap. For investors, the cost of the cap is offset by the income received from the floor. An example of a zero cost option collar is the purchase of a put option and the sale of a call option with a lower strike price. The sale of the call will cap the return if the underlying falls in price, but it will also offset the purchase of the put. Obviously, upside risk is still unlimited. Similarly, other combinations can be chosen such as butterfly etc. OPTIONS PAYOFF

The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. PAYOFF PROFILE OF BUYER OF ASSET: LONG ASSET

In this basic position, an investor buys the underlying asset, Nifty for instance, for 2220, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be long the asset.

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PAYOFF PROFILE FOR SELLER OF ASSET: SHORT ASSET

In this basic position, an investor shorts the underlying asset, nifty for instance, for 2220, and buys back it back at a future date at an unknown price, St. once it is sold, the investor is said to be short the asset.

PRICING OPTIONS An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This 99

optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option. On dates prior to 31 Dec 2000, the call option on nifty expiring on 31 Dec 2000 with a strike of 1500 will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price. The values shown in Table 7.1 are derived from a theoretical model, namely the Black-Scholes option pricing model. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the prices in the table to come about. There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in BlackScholes options pricing formula so to price options we dont really need to memorize the formula. What we shall do here is discuss this model in a fairly nontechnical way by focusing on the basic principles and the underlying intuition. Introduction to the BlackScholes formulae Intuition would tell us that the spot price of the underlying, exercise price, risk-free interest rate, volatility of the underlying, time to expiration and dividends on the underlying(stock or index) should affect the option price. Interestingly before Black and Scholes came up with their option pricing model, there was a widespread belief that the expected growth of the underlying ought to affect the option price. Black and Scholes demonstrate that this is not true. The beauty of the Black and Scholes model is that like any good model, it tells us what is important and what is not. It doesnt promise to produce the exact prices that show up in the market, but certainly does a remarkable job of pricing options within the framework of assumptions of the

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model. Virtually all option pricing models, even the most complex ones, have much in common with the BlackScholes model. Black and Scholes start by specifying a simple and wellknown equation that models the way in which stock prices fluctuate. This equation called Geometric Brownian Motion, implies that stock returns will have a lognormal distribution, meaning that the logarithm of the stocks return will follow the normal (bell shaped) distribution. Black and Scholes then propose that the options price is determined by only two variables that are allowed to change: time and the underlying stock price. The other factors - the volatility, the exercise price, and the riskfree rate do affect the options price but they are not allowed to change. By forming a portfolio consisting of a long position in stock and a short position in calls, the risk of the stock is eliminated. This hedged portfolio is obtained by setting the number of shares of stock equal to the approximate change in the call price for a change in the stock price. This mix of stock and calls must be revised continuously, a process known as delta hedging. Black and Scholes then turn to a littleknown result in a specialized field of probability known as stochastic calculus. This result defines how the option price changes in terms of the change in the stock price and time to expiration. They then reason that this hedged combination of options and stock should grow in value at the riskfree rate. The result then is a partial differential equation. The solution is found by forcing a condition called a boundary condition on the model that requires the option price to converge to the exercise value at expiration. The end result is the Black and Scholes model.

The BlackScholes option pricing formulae The BlackScholes formulas for the prices of European calls and puts on a nondividend paying stock are:

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_ ___ ___ __

Pricing stock options Factors affecting option price Various factors affect the price of options on stocks. We shall look at the impact of changes in each of these factors on option prices one at a time, assuming that all other factors remain the same. There are six factors affecting the price of a stock option: 1. The stock price: The payoff from a call option is the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and less valuable as the stock price decreases. The payoff from a put option is the amount by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price decreases and less valuable as the stock price increases. 2. The strike price: In the case of a call, as the strike price increases, the stock price has to make a larger upward move for the option to go inthemoney. Therefore, for a call option, as the strike price increases, options become less valuable and as the strike price decreases they become more valuable. Put options behave exactly in the opposite way to call options. 3. Time to expiration: Both put and call American options become more valuable as the time to expiration increases. Consider the case of two options that differ only as 102

far as their expiration date is concerned. The owner of the longlife option has all the exercise opportunities open to the owner of the shortlife option and more. The longlife option must therefore always be worth at least as much as the short life option. 4. Volatility: The volatility of a stock price is a measure of how uncertain we are about future stock price movements. As volatility increases, the chance that the stock will do very well or very poorly increases. The value of both calls and puts therefore increase as volatility increases. APPLICATION OF OPTIONS HEDGING: HAVE PORTFOLIO, BUY PUTS

Owners of equity portfolios often experience discomfort about the overall stock market Movement. As an owner of a portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy portfolio insurance.

SPECULATION: BULLISH INDEX, BUY NIFTY CALLS OR SELL NIFTY PUTS

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There are times when investors believe that the market is going to rise. For instance, after a good budget, or good corporate results, or the onset of a stable government. How does one implement a trading strategy to benefit from an upward movement in the index? Today, using options you have two choices: 1. Buy call options on the index; or, 2. Sell put options on the index We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the market index is going to rise in a months time. Your hunch proves correct and the index does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be wrong and the market index plunges down, what you lose is only the option premium. Having decided to buy a call, which one should you buy? Given that there are a number of onemonth calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. The following options are available: 1. A one month calls on the Nifty with a strike of 1200. 2. A one month calls on the Nifty with a strike of 1225. 3. A one month calls on the Nifty with a strike of 1250. 4. A one month calls on the Nifty with a strike of 1275. 5. A one month calls on the Nifty with a strike of 1300. Which of these options you choose largely depends on how strongly you feel about the Likelihood of the upward movement in the market index, and how much you are willing to lose should this upward movement not come about. There are five one

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month calls and five one month puts trading in the market. The call with a strike of 1200 is deep inthemoney and hence trades at a higher premium. The call with a strike of 1275 is outofthemoney and trades at a low premium. The call with a strike of 1300 is deepoutofmoney. Its execution depends on the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be inthemoney by expiration, in which case the buyer will make profits. In the more likely event of the call expiring outofthemoney, the buyer simply loses the small premium amount of Rs.27.50. As a person who wants to speculate on the hunch that the market index may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. If the index does rise, the buyer of the put will let the option expire and you Will earn the premium. If however your hunch about an upward movement in the market proves to be wrong and the index actually falls, then your losses directly increase with the falling index level. If for instance the index falls to 1230 and youve sold a put with an exercise of 1300, the buyer of the put will exercise the option and youll end up losing Rs.70. Taking into account the premium earned by you when you sold the put, the net loss on the trade is Rs.5.20. Having decided to write a put, which one should you write? Given that there are a number of onemonth puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the upward movement in the market index. If you write an atthe money put, the option premium earned by you will be higher than if you write an outofthemoney put. However the chances of an atthemoney put being exercised on you are higher as well. In the example in Figure 8.2, at a Nifty level of 1250, one option is inthemoney and one is outofthemoney. As expected, the inthemoney option fetches the highest premium of Rs.64.80 whereas the outof themoney option has the lowest premium of Rs.18.15.

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PAYOFF FOR BUYER OF CALL OPTIONS AT VARIOUS STRIKES

PAYOFF FOR WRITER OF PUT OPTIONS AT VARIOUS STRIKES

SPECULATION BEARISH INDEX: SELL NIFTY CALLS OR BUY NIFTY PUTS

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Today, using options, you have two choices: 1. Sell call options on the index; or, 2. Buy put options on the index We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have a hunch that the market index is going to fall in a months time. Your hunch proves correct and the index does indeed fall, it is this downside that you cash in on. When the index falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market index soars up instead, what you lose is directly proportional to the rise in the index. Having decided to write a call, which one should you write? Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose ? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the following options : 1. A one month calls on the Nifty with a strike of 1200. 2. A one month calls on the Nifty with a strike of 1225. 3. A one month calls on the Nifty with a strike of 1250. 4. A one month calls on the Nifty with a strike of 1275. 5. A one month calls on the Nifty with a strike of 1300. Which of these options you write largely depends on how strongly you feel about the likelihood of the downward movement in the market index and how much you are willing to lose should this downward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event

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that the Nifty will rise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the Nifty is above 1300. In the more likely event of the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. As a person who wants to speculate on the hunch that the market index may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the index does fall, you profit to the extent the index falls below the strike of the put purchased by you. If however your hunch about a downward movement in the market proves to be wrong and the index actually rises, all you lose is the option premium. If for instance the index rises to 1300 and youve bought a put with an exercise of 1250, you simply let the put expire. If however the market index does fall to say 1225 on expiration date, you make a neat profit of Rs.25. Having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market index. If you buy an at-the-money put, the option premium paid by you will by higher than if you buy an out-of-the-money put. However the chances of an at-the-money put expiring in-the-money are higher as well. PAYOFF FOR SELLER OF CALL OPTION AT VARIOUS STRIKES

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PAYOFF FOR BUYER OF PUT OPTIONS AT VARIOUS STRIKES

SPECUALATION: ANTICIPATE VOLATILTY, BUY A CALL AND A PUT

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Do you sometimes think that the market index is going to go through large swings in a given period, but have no opinion on the direction of the swing? This could typically happen around budget time or during times of political uncertainty when a change in the government is anticipated. How does one implement a trading strategy to benefit from market volatility? Combinations of call and put options provide an excellent way to trade on volatility. Here is what you would have to do: 1. Buy call options on the index at a strike K and maturity T, and 2. Buy put options on the index at the same strike K and of maturity T. This combination of options is often referred to as a Straddle and is an appropriate strategy for an investor who expects a large move in the index but does not know in which direction the move will be. Consider an investor who feels that the index which currently stands at 1252 could move significantly in three months. The investor could create a straddle by buying both a put and a call with a strike close to 1252 and an expiration date in three months. Suppose a three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00. To enter into these positions, the investor faces a cost of Rs.152.00. If at the end of three months, the index Remains at 1252, the strategy costs the investor Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires worth Rs.2). If at expiration the index settles around 1252, the investor incurs losses. However, if as expected by the investors, the index jumps or falls significantly, he profits. For a straddle to be an effective strategy, the investors beliefs about the market movement must be different from those of most other market participants. If the general view is that there will be a large jump in the index, this will reflect in the prices of the options.

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SPECULATION: BULL SPREADS- BUY A CALL AND SELL ANOTHER

There are times when you think the market is going to rise over the next two months; however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread. How does one go about doing this? This is basically done utilizing two call options having the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level. The spread is a bull spread because the trader hopes to profit from a rise in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bull spread? Compared to buying the underlying asset itself, the bull spread with call options limits the traders risk, but the bull spread also limits the profit potential. In short, it limits both the upside potential as well as the downside risk. The cost of the bull spread is the cost of the option that is purchased, less the cost of the option that is sold.

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Broadly, we can have three types of bull spreads: 1. Both calls initially out-of-the-money, 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bull spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.

SPECULATION: BEAR SPREADS- SELL A CALL AND BUY ANOTHER

There are times when you think the market is going to fall over the next two months, however in the event that the market does not fall, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is,

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two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread. How does one go about doing this? This is basically done utilizing two call options having the same expiration date, but different exercise prices. How a bull is spread different from a bear spread? In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price above the current index level and sells a call option with an exercise price below the current index level. The spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bear spread? Compared to buying the index itself, the bear spread with cal options limits the traders risk, but it also limits the profit potential. In short, it limits both the upside potential as well as the downside risk. A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Broadly we can have three types of bear spreads: 1. Both calls initially out-of-the-money, 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.

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ARBITRAGE: PUT-CALL PARITY VIOLATIONS

Put-call parity To get an intuitive understanding about the put-call parity, we could think of it in the following way. I buy the asset on spot, paying S. I buy a put at X, paying P, so my downside below X is taken care of (if S _ X, I will exercise the put). I sell a call at X, earning C, so if S_ X, the call holder will exercise on me, so my upside beyond X is gone. This gives me X on T with certainty. This means that the portfolio of S+P-C is nothing but a zero-coupon bond which pays X on date T. What happens if the above equation does not hold good? It gives rise to arbitrage opportunities. The put-call parity basically explains the relationship between put, call, and stock and
bond prices. It is expressed as:

Where: S Current index level X Exercise price of option T Time to expiration C Price of call option P Price of put option r- risk-free rate of interest

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The above expression shows that the value of a European call with a certain exercise price and exercise date can be deduced from the value of a European put with the same exercise price and date and vice versa. It basically means that the payoff from holding a call plus an amount of cash equal to {x/ (1+r) ^t} is the same as that of
holding a put option plus the index.
_ __ _ _

Case 1: Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96.50 and the price of a three month Nifty 1260 put is Rs.60. In this case we can see that

What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio A is overpriced relative to portfolio B. What would be the arbitrage strategy in this case? Sell the securities in portfolio A and buy those in portfolio B. This involves shorting the index and a put on the index and buying a call. How would one short the index? One way to do it would be to actually sell off all 50 Nifty stocks in the proportions in which they exist in the index. Another easier way to do this would be to sell units of Index funds instead of the actual index stocks. This would achieve a similar outcome. This entire set of transactions generates an up-front cash-flow of (1265 + 60 - 96.50) = Rs.1228.50. When invested at the risk free rate of 12%, this amount grows to Rs.1265.35. At expiration, if the index is higher than 1260, you will exercise the call. If the index is lower than 1260, the buyer of the put will exercise on you. In either case, the investor ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.5.35 (i.e. 1265.35- 1260).

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Case 2: Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96 and the price of a three month Nifty 1260 put is 51.50. In this case, we can see that

What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio B is overpriced relative to portfolio A. What would be the arbitrage strategy in this case? Buy the securities in portfolio A and sell those in portfolio B. This involves buying the index and a put on the index and selling a call. How would one buy the index? One way to do it would be to actually buy all 50 Nifty stocks in the proportions in which they exist in the index. An easier way to do this would be to buy units of Index funds instead of the actual index stocks. This would achieve a similar outcome. This entire set of transactions involves an initial investment of Rs.1220.50 (i.e. -1265 - 51.50 + 96) When financed at the risk free rate of 12%, the repayment required at the end of three months is Rs.1257. At expiration if the index is lower than 1260, you will exercise the put. If the index is higher than 1260, the buyer of the call will exercise on you. In either case, the investor ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3 (1260 - 1257). SWAPS

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The Developments of the Swap Market The swap market as we know it today has only existed since 1981, although some single examples can be found dating back to the mid 1970's. The earliest swaps were currency swaps and were developed to overcome some of the problems and complicated domination procedures associated with parallel loans. These swaps were of balance sheet transactions and involved no initial exchange of principal. It there was an initial exchange this consisted of a separate foreign exchange transaction. A landmark in the development of the swap market was the IBM World Bank swap in 1981.

The World's First Swap Deal In 1981, the World Bank was looking for Swiss francs for its normal operations. But the World Bank was not able to raise francs from the Swiss markets as it had accessed those markets very recently with a number of issues. Thus, it was thought that another issue of big size would cost the Bank heavily in terms of the cost of funds. On the other hand, the computer giant IBM was in need for a big loan, and also it had not accessed the Swiss markets. Thus, it was the Bank, which saw an opportunity to create a deal, which would be a win win situation for both the players. Under the deal contract IBM are asked to raise two loans from the Swiss and German markets, while the World Bank issued a Dollar loan for IBM. All the liabilities of the swap were to be honored by the respective parties, i.e., the World Bank would pay for the Franc and Deutsche mark loans and IBM would service the dollar loan. Example: Case (HDFC & STANCHART BANK)

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Under the US Laws, housing finance Companies from developing countries are eligible to raise dollar loans from the American domestic market at very attractive floating rates. The rates are very attractive since these loans are backed by US-AID. HDFC has been very active is raising such loans from the US market. But since the business of HDFC requires it to provide long term Rupee loans only, a need arises to convert these dollar loans into Rupees. For the HDFC has entered into very attractive SWAP deals with the barks in India Under the agreements HDFC gets a long term fixed rate rupee loan white the Bank gets a floating rate dollar parity, when would not b e possible for these Banks on their own.

An Example of such a deal: Float rate loan ($) (LIBOR - o.5%) HDFC $- loan (LIBOR -0.5%) U S markets

Re-loans (fixed) (PLR some points)

Stan chart. Interest rate swap Fixed Rate Borrower A Floating Rate 118 Bank Floating Rate Fixed Rate Borrower B

Floating Rate Lender A

Fixed Rate Lender B

In the figure above, the borrower A takes a loan from lender A at a floating rate of interest but would prefer the certainty provided by a fixed rate loan. The bank agrees that it will provide the borrower A with the funds required to pay the interest on the floating rate loan & accept interest payments at a fixed rate. Lender A is unaffected, his debtor continues to be borrower A and interest payments continue to be received from that source. Lender A need not know that the swap has taken place. Meanwhile, borrower A has simulated a fixed rate liability. The bank seeks to match its commitment by finding a fixed rate borrower wanting a floating rate loan. Borrower B agrees to pay floating rate while receiving fixed rate and thereby simulates a floating rate loan, while lender B retains both fixed rate receipts and original debtor. Currency swaps became popular for three main reasons: First, central bank regulations forced banks to fund term floating - create assets with term liabilities as opposed to short-term deposits. Secondly, counter parties sought to take advantage of one anther's borrowing capacity in the various international markets Finally, a lower cost of funds motivated counterparts to accept credit risk in the swap. Today, there are several reasons why firms use currency swaps:

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First, the currency swap may be used to hedge against foreign exchange risk. A firm may transform the currency denomination of its borrowings to lock in unrealized gains on foreign currency liabilities at a time when exchange rates are favorable.

Second, lower cost of funding may be obtained by borrowing in foreign country ad swapping back to the domestic currency. Third, a firm may be able to use their surplus funds more effectively in blocked currencies. Fourth, the use of swaps may be way of circumventing exchange control regulations. Fifth, currency swaps may be used as a means of exploiting arbitrage opportunities. Finally, the currency swap may be used in conjunction with a portfolio of assets providing a vehicle for more active portfolio management.

A currency swap usually entails an initial exchange of currencies and reverse exchange on minority: however it is not mandatory to exchange principal particularly if the swap is against existing borrowings. Interest payments are made by one counterpart to another based on the principal in the currency being held. A bank may stand between two counter parties either for credit reasons or because the needs of the counterparts do not exactly match. The exchange rate agreed will normally be based on the spot rate however, it is possible to do the exchange with off-market spot rates, but this would reflect in the coupon on the swap. Both parties know what their future liabilities are, but as the party make a foreign exchange profit and the other party, a loss. One way of resolving this, problems is to do front-to-back exchange where the exchanger rate used at the start of the swap is the same as the exchange rate used at maturity.

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The rate agreed on the swap will depend on the general expectations of future currency movements, including potential devaluation, and the influence those expectations have over supply and demand for swaps in that currency in the market. Currency swaps have played an important role in the Eurobond markets in recent years, enabling large borrowers to borrow at sub-LIBOR rates. The following list includes a sample of swaps market participants: Multinational companies: Shell, IBM, Honda, Unilever, Procter & Gamble, Pepsi Co. Banks: Banks participate in the swap market either as an intermediary for two or more parties or as counterparty for their own financial management. Sovereign and public sector institutions: Japan, Republic of Italy, Electricity de France, Sallie Mae (U.S. Student Loan Marketing Association). Super nationals: World Bank, European Investment Bank, Asian Development Bank. Money Managers: Insurance companies, Pension funds.

RESEARCH OBJECTIVE/ RATIONALE: To gain an insight into the working of derivatives Understanding various derivative instruments prevalent in the Indian derivative market such as futures, options, forwards etc and to study their importance and usage. To study the purpose for which Corporates/ individuals indulge into derivative activities (whether hedging, speculation or arbitraging) Under what conditions they choose the specific instruments and what strategy they use.

METHODOLOGY Nature of Study: The nature of study is descriptive as it a literature based analysis. Data Collection: Data collected is primary and secondary in nature. Instrument used: An open ended questionnaire Sources of primary data: 121

1. Stock Brokers: Stock brokers with an in-depth knowledge of derivatives were interviewed. An open ended questionnaire was used. The main questions asked were focused on the usage of the derivative instruments and under what conditions and what purpose they used it. As my research objective was to study the Indian derivatives market, the instruments prevalent, the purpose of using these instruments etc. I tried to include all questions that could answer these questions. Sources of secondary data: Study of literature on derivatives, their emergence, instruments and purpose. Study of articles on derivatives Study of research papers by Wharton school, economics group etc Search on websites

LIMITATIONS AND SCOPE OF THE STUDY The limitations of this study were many. Since the topic is highly subjective in nature and the current data could not be available it wasnt truly able to analyze the current status. Further, due to time constraints, it wasnt possible to interview a larger sample and get a larger opinion. However, the report has been compiled taking into consideration the viewpoints of the various respondents interviewed and hence the analysis is based on the first hand data.

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CHAPTER 8 RESULTS - CURRENT CONSTRAINTS The potential obstacles in the development of a derivatives market in India can be described in two categories: domestic regulations and system and market participants (viz. dealers end users and the regulation). Domestic regulation and system related aspects

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The governments reform are a major hindrance to the growth and maturity of the corporate in India, can use Cross currency options, to father derivative products for liability management is permitted under the approval from the Ministry of Finance and RBI for actual remittances. This causes delay and cumbersome procedures. Further, documentation is not uniform and various internationally accepted practices. Lack of speculation- Speculation is one of the requisites for liquidity in the market. But with all achieving being shacked to an underlying trade transaction. Thus only hedging is allowed in India that too limited to the extent of trade liability which restricts liquidity in turn increasing both risk and transaction costs. liquidity in the money market Rupee derivatives cannot develop until the money market develops. A study on the hedging tools used by Indian corporate reveals that symmetric forwards comprising cross currency forward contracts and swaps find more taken than asymmetric options. This is evident from the fact that the number of option written in close to a year is not more than fifty vis--vis foreign exchange forwards transaction a daily trading volume barrier of $ 50 billion.

Options have a greater asymmetric profile regarding risks and rewards. The Indian experience shows that except for the initial interest and fascination with the new instruments the options market in India has not really taken off. This is because of the following: Directive on back to back covering. Most underlying exposures of Indian corporate are of shorter duration. Options being long term instruments with maturities ranging from 2-3 years finds limited applications among the Indian hedger. Controls on writing options Not all banks are permitted to write options. Option once bought cannot be sold and vice versa. This there is no exit route available which makes it unprofitable for banks. The market for cross currency. Option is essentially limited. The market is expected to pick up only related options one introduced.

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Market participants related aspects The knowledge on derivative produces and their use is lacking in India which may cause to under the market development. The understanding of the derivatives market by regulatory agencies also needs to be considered. A derivative market can pose some specific threats to the cash market and financial system regulatory agencies that lack full understanding of derivative markets are likely to be on probable harmful effects and risks rather than the new value which such products can bring. As the understanding of the market mechanism is lacking in India, the complex operations of the new market may not be easy to grasp by its users. This may revert the efficient utilization for the derivatives market. NEED FOR A DERIVATIVE MARKET IN INDIA An emerging market simply reflects the pace of economic development of a country. It is a key instrument to mobilize the capital which is the driving force of the countries economic development. The following factors contribute to the development of the financial market in India: There is a pressure from the global and regional economic corporations such as General Agreement on Tariff and Trade (GATT), Asian Free Trade Agreement (AFTA) etc. which bring the closer integration of the country's financial market with the world market. Rapid modernization of Technology has made the country's financial and trading conditions more compatible with external conditions. The calls for which is exerted to be sustained in the future accentuates the need for investment. With this, India is one of the Asian emerging markets that provide much higher return. This interest in investment may affect the market to be more costly and volatile. The volume of derivative activities will significantly increase due to fast economic development and financial liberalization. More involvement in a derivative market can be expected with the increased awareness among public and private sectors towards the necessitating and benefits of such market. As at present the market is weak in terms of speed of contract execution and liquidity, it will no longer serve the purpose efficiently with the tremendous demand for derivatives. It is not possible to measure the volume of demand exactly. A significant demand for derivative trading is for the following reasons:

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1. Among the leading commercial corporations, there is a high proportion of activities in foreign currencies e.g. foreign currency debt. Income and expenses included in financial statements. These corporations are not only exposed to volatizing of foreign exchange rate but also to interest rate fluctuations. Thus there is high potential for them to involve in derivative activities in the future. 2. Banks are the major derivative traders participating as both dealers and counterparts. With a significant growth rate of these services expected to take place with deregulation of financial services, the demand for derivatives is bound to increase 3. Steps taken since mid '91 to liberalize the Indian economy and integrate it with global markets, has exposed the corporate and banks to the risk of volatility in exchange rates and in the interest market. Consequently some of the corporate have converted their exposure management functions into separate profit centers thereby accrediting the demand for derivative instruments. FUTURE PROSPECTS The Indian economy's state of reforms aims at integrating its financial markets with world markets. With globalization being the latest corporate fashion, foreign exchange risk management and treasury functions are essential prerequisites. In the near future, with the recommendations of the Sodhani Committee Report, aimed at providing a general stimulus to the highly protected forex market is exerted.) The thrust is thus anticipated to be on the cautious opening up and gradual peeling off the insulation. A vibrant derivatives market is thus aimed at which would ultimately depend on the introduction of Rupee based derivatives. Rupee derivatives would pick up only when their is a risk-free return yield curve. While the government and the RBI have worked towards strengthening and deepening the market, as of recent, the yield has slowly started taking shape, making one optimistic that rupee related options are ready for the take off. This currency markets will thus grow first, spinning the commodity markets to pick up. An increased achieving in the commodity markets will necessarily expose corporate to the other hedging mechanisms available, which will alleviate their fears of hedge instruments. In natural sequence, the forex markets will grow.

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PRECAUTIONARY MEASURES TO BE TAKEN Various Precautionary measures to be taken by the market participants, before considering a derivative transaction: Forecast Have a view on the markets Build a readable market scenario Compare it with market censuses, for example implied forward curves. Analyze work out your cash flows and your risks under various scenarios Determine your target cash flows if you are willing to lose if you are wrong. Reviewing the derivative transaction: 3. Replicate Reverse engineer the transaction by decomposing it into its basic building blocks. Understand its implied trading strategy. Understand which variables have the greatest impact on the value of the transaction. 4. Simulate (i) Compute the transactions break-ever and its evolution with the passage time and under different scenarios. (ii) Compute the leverage over time and under changing scenarios. 5. Scale Determine the optional size and leverage of the transaction. 6. Commit Tie your dealer down to a maximum bid/ask spread quote frequency and dealing size. Check his pricing methodology, his credit standing and check prices with other market markers. Approving the derivative transaction. 7. Authorize Who can commit the firm to a transaction, what and how much he can commit to, and with whom. Under what conditions can he commit the firm to a transaction, especially new structures with which the firms is not familiar. 8. Limit (i) Determine the acceptable overall risk profiles over time. 9. Establish (i) Ensure that the appropriate systems, procedures, accounting documentation and people are in place and able to keep abreast with the changing dynamic of a derivative transaction. 127

Entering into the derivative transaction:10. Monitor Set individual adjustment points in advance: for e.g. stop loss limits or profit lock ins which trigger an automatic close out of a transaction once they are breached.

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CHAPTER 9 DISCUSSION ARE DERIVATIVES A FAILURE? Whereas derivatives have been traded for centuries, stretching back to the option contracts in Amsterdam in the seventeenth century, the modern field of financial engineering leaped forward in 1973, when Fisher Black, Myron Scholes, and Merton developed an approach to creating and valuing option contracts. In the same year, the Chicago Board of Exchange began the first modern market for options by trading calls on a dozen companies' shares. Following these pioneering steps in theory and practice, the past two decades have witnessed an explosion in research and in the understanding of how to structure, price, and manage the risks of derivative instruments. Bridges occasionally collapse, sometimes because of poor engineering and other times because of bad luck. Except in extreme cases, it is often hard to distinguish between the two. Suppose that a bridge designed to withstand an earthquake of a certain size crumples after suffering a slightly larger shock. Is this calamity the result of poor engineering because the specifications should have been tighter, or bad luck because an extremely improbable event occurred? Financial engineering products also sometimes fail, and examining their wreckage to determine culpability is equally difficult. Some would contend that in 1987, Portfolio Insurance - a traditional strategy designed to provide institutional investors with downside protection, failed. It was clear that the strategy was not designed to cover all scenarios. In the aftermath of the crash, financial engineers have searched for alternative ways to deliver insurance. More recently, the failures of financially engineered hedging strategies as of Metallge sells chaft's have prompted much finger-pointing, litigation, and vigorous debate among practitioners and academics alike. The debate may never be resolved, but one can safely wager that clever financial engineers are working on ways to create alternative hedging strategies to avoid the problems that this incident exposed. The Indian Angle One is used to thinking about BSE and NSE competing with each other, but an important issue on the medium term is how to face up to international competition.

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This competition is at its most intense in derivatives. This is because derivatives intrinsically tend to have high volumes, and also because there is a great deal of scope for designing interesting kinds of derivatives contracts which might better meet the needs of users. The key lessons of the Nikkei 225 story are worth reiterating: Competition amongst exchanges takes place on a global scale. When users need a product and it is not found domestically, they will go offshore in order to find it. When alternative exchanges trade the same products, the order flow will go to the lowest cost provider (i.e. where impact cost plus brokerage is smaller). Liquidity feeds on liquidity. Once a given exchange obtains low impact cost for a given product, it is extremely hard for another exchange to take away this trading. In India, the GDR market is one example of a competing offshore market; it was born as a response to poor market quality, and restrictions upon FIIs in India. Today, with the benefit of hindsight, we know that the GDR market was not a challenge, for several reasons: 1. Indians dominate India's equity market, and the lack of convertibility meant that Indians could not send their orders to the GDR market, 2. The GDR market is self liquidating in that there is a steady conversion of GDRs into shares, so the domestic market tends to grow over time at the expense of the GDR market, and 3. The way things worked out in India, a total transformation of trading, clearing and settlement took place on India's equity market remarkably swiftly, which eliminated the competitive advantage of trading on the GDR market. Today, the only serious advantage of the GDR market is the method through which the primary issues take place there. This sanguine experience might not be repeated in the future. Convertibility is on its way, derivatives markets are not self-liquidating, and the richness and sophistication of the worldwide derivatives industry far exceeds the present state of knowledge in India. One interesting example of this is the offshore "non-deliverable forward" (NDF) market on the dollar rupee. The NDF is basically a cash-settled forward contract. The RBI forbids many users from accessing the dollar-rupee forward market in India. Hence, there is a natural opportunity for offshore providers to enter into this area. In recent weeks, liquidity on the NDF market has often been comparable to that of the dollar-rupee forward market, which suggests that this market is coming of 130

age. The logical next step in this development is futures market, and two exchanges (one in Chicago and the otherin Dublin) are currently in the process of evaluating the launch of future on the dollar-rupee CHAPTER.10 RECOMMENDATIONS The launch of futures trading has been a milestone on Indian bourses although its full impact is yet not visible due to certain roadblocks. As, the markets are become more volatile and complex, there is a need to hedge these risks and hence for instruments which allow fund managers to manage risk better. The development of derivatives in India will take time. There is a need for structural reform and increased awareness of such products to increase participation. The market is shallow and, as it stands, it may be quite a while before there is fullfledged activity in the market One of the fundamental reasons for the subdued market activity is the lack of institutional participation. The Indian markets lack the kind of institutional presence which is available in the developed countries When activity is limited and there are only a few players, the process of price-discovery slows down and is hampered. Effective price-discovery happens only in a deep and liquid market. The inability of international funds to bring in money from abroad to meet margin payments has been cited by market participants as one of the reasons, at least in the initial days of trading. However, that problem has been eliminated with the RBI permitting funds to bring in advance money for meeting margin requirements. The other factor is that funds and institutions need to take permission from their trustees to engage in derivatives trading. This process seems to take time. Requirement of Minimum contract size of Rs. 2 lakhs is a major deterrent for investors at large to participate in this segment. A large portion of retail Indian investor is already familiar with forward trading system, and for them it is difficult to accept a restrictive contract size and cash settled trades.

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Derivatives markets offer hedging against portfolio of shares and the purpose is defeated when delivery trades are not allowed in the system. Even if these factors are resolved, there is need for a risk-management cell to be put in place. Here, software plays a critical role. There is a lot of talk about the expensive nature of back-office software keeping many potential participants from participating in the market. The BSE introduced a system wherein it bears part of the cost for setting up the software. However, the impact of this on volumes is yet to be established. As our Indian market lacks infrastructure available, therefore ours future market is not perfect as it must be. For example, as we lack a system of electronic fund transfer in the banking sector and we don't even have the short term yield curve which can be used to calculate the fair price for the index future.

As our market is on retail basis therefore we require more protection. It is the regulators that have nurtured the entire derivative initiative and have played a very positive role. They may give us the support, guidance and advice while derivatives have been introduced. To give a real boost to derivative market, participation by the regional stock exchanges, retail brokers, sub-brokers, and small investors should be encouraged. Permitting settlement by delivery in case of stock futures and options by fine-tuning the settlement cycles of the cash and the derivatives segments, reintroduction of stock lending and borrowing and margin trading, introduction of continuous net settlement and amending the income tax law to offer clarity as well as preferential tax treatment to profits/losses in the derivatives trading are some of the changes that regulators need to focus on. The tax authorities are yet to take a view on the profit and loss arising out of derivatives trades, as they treat them as speculative gain or loss. The same is not allowed to be set off against the normal business profit/loss. Due to lack of clarity, major players are refraining from using the derivatives markets in a big way.

Hedging of trade does not take place when there is no Common Margin System in place, combining cash and derivatives trade. As a result, an investor ends up paying a high margin, resulting in high cost per trade. This is a major deterrent for big funds and portfolio investors to participate in the market.

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Proliferation of NSE branches across India with `overlooked day trading activity' in cash and derivatives markets has marginalized BSE. This is posing a serious problem of monopoly of market situation; wherein an investor in the long run would suffer. Fortunately, the regulator is conscious about the need for competition. Probably, it is not too late to offer product differentiation between two exchanges for keeping alive the spirit of competition for enhancing services to investors. But the main problem is investor awareness. Many people have a myth that derivatives are very complex and are not suited for Indian investors. Trading in derivatives requires expertise and sophisticated techniques and tools that many investors are unaware of. However, there is optimism in the air. Derivatives offer excellent growth potential for trading due to its utility for hedging and speculation. Moreover, the Indian investors are already familiar with the indigenous form of derivatives. It could take a while, i.e., a couple of years, before the markets can be termed matured and derivatives market volumes could well beat the cash market volumes sometime in the future. Perhaps most of the participants are going through the learning curve and it will take a reasonable time for them to get a hold on these products. In fact One may expect it to happen at the earliest, seeing the introduction of almost all-financial derivatives in Indian capital market within a span of just two years and also the encouraging market response. Derivatives trading are fragmented, with some exchanges offering commodity derivatives only, and others only equity derivatives only. Currency and interest rate derivatives are currently not traded on exchanges in the country. As a first step towards addressing this fragmentation, the government has announced that it will soon commence trading in interest futures. The Indian experience in equity derivatives has been quite encouraging. Turnover has grown dramatically since its inception in June 2000. But unlike the trend in other countries, where index derivatives generally predominate, in India the turnover of derivatives in individual stocks has far outstripped that of index derivatives.

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For the month of December 2002, derivatives trading on individual stocks accounted for as much as 87.34 per cent of the total turnover in equity derivatives trading on National Stock exchange (NSE). Derivatives trading on 12 additional stocks have commenced on January 31, 2002, thereby taking the list of total stocks with derivatives trading to 41. This could further increase the dominance of individual stocks derivatives in India. Though equity derivatives have made enormous progress in terms of liquidity, the government has shown concerns about their pricing efficiency. The lack of institutional interest in the equity derivatives market is seen as one of the key reasons for pricing inefficiencies. A survey points out that the institutional interest amounted to only 0.77 per cent of the total turnover of the equity derivatives market in December 2002.Therefore, there is a need to re-examine the policy impediments for institutional participation on the derivatives market. Suggested Regulatory Framework Stated below are ten propositions that summarize the essential market monitoring tools and policies that should in my opinion prevent financial disruptions, by keeping the various risk exposures in the financial market under control: Proposition 1: Enhancing confidence and knowledge among all markets participants is a necessary condition in order to guarantee the stability of the derivatives markets. Proposition 2: Adopt efficient risk measurement and monitoring systems. Proposition 3: Enhance information standardization and disclosure at all levels of the derivatives trading industry. Proposition 4: Increase and harmonize and frequency of market, accounting and credit assessment data disclosure in order to allow for daily risk monitoring.

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Proposition 5: Encourage the harmonization and standardization of direct credit risk reduction mechanisms, such as daily marking-to-market, collateral and guarantees specifications valuation. Proposition 6: Facilitate the use and encourage the harmonization of indirect credit risk reduction mechanisms such as netting and settlement agreements between the various official market participants (e.g. central banks, exchanges) and their nonofficial counterparts (e.g. banks, OTC traders, insurance companies, etc.). Proposition 7: Adopt a "global" or portfolio approach to the derivative market's risk exposures measurement and account for correlation effects between the various market segments and risk exposures when implementing risk management policies. Proposition 8: An efficient risk management system for the derivatives industry has to be dynamic" and explicitly consider and monitor the evolution of market, credit and liquidity risk exposures and of their correlation's over target horizons. Proposition 9: In order to enforce the risk management and monitoring at all responsibility levels, the performance measurement and financial compensation schemes of the firm' employees have to be incentive-compatible. Proposition 10: Whenever possible, the reputation of the market participants in the derivative business should be used as a monitoring device to prevent them from adopting excessively risky positions or from engaging in irregular transactions. ANALYSIS OF PRIMARY RESEARCH (sample size: 15 respondents) 1. 90% of the respondents said that Futures and options are more frequently traded than forwards.

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2. 85% firms, individuals and Corporates mainly indulge into derivatives for hedging purposes. 3. The impediments in the growth of the derivatives market are discussed above. 4. 80% of the respondents feel that to further gain popularity in the Indian scenario, investor awareness programs need to be expanded. 75% feel that the government needs to improve its regulatory barriers on this market.

CHAPTER 11 CONCLUSION In the past some decades, fundamental changes in global financial market particularly the increased volatility of interest rates and currency exchange rates prompted a number of public and private institution to develop and use derivatives. Derivatives serve an important function in the global financial market place, providing end users with opportunities to better manage financial risks associated with their business transactions. Derivatives use has been accelerated by the continuing globalization of commerce and financial markets and by major advances in finance, information processing and communication technology.

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This combination of global investment, concentration and linkages means that the sudden failure or abrupt withdrawal from trading of any of large dealers could cause liquidity problems is the markets and could pose risks to the others, and the financial system as a whole. However, there is a major concern about these products and, the risks they may pose to the financial system, individual firms, investors, and taxpayers. These concerns have been heightened by reports of substantial losses by some derivative end users.

Thus, the rapid growth and increasing complexity of derivative reflect both the increasing demands from end users for better ways to manage their financial risks and the innovative capacity of the financial services industry to respond to market demand.

REFERENCES
N.D. Vohra & B.R Bagri Futures and Options pp.276-298 Ranganathan- Investment Analysis And Portfolio Management

(Pearson Education, 1st Edition) pp.259-273 Edition) pp.459-476

Pandian P- Security Analysis And Portfolio Management (Vikas,1st Derivatives Module- NCFM pp.434-520

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Articles from
Business standard Economic times

Data sources:
http//bseindia.com http//nseindia.com

APPENDIX A-1: QUESTIONNAIRE The purpose of this questionnaire is to gain an understanding of the derivatives market. Its usage if purely for academic purposes and hence we request you to give true data. 1. Do you think derivatives are a good solution for hedging risk? Yes No

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2. Which forms of hedging are most frequently used? Futures Forwards Options Swaps 3. What are the present impediments to the growth of the Indian derivatives market?

4. For what purpose are these instruments most frequently used? Hedging Speculating Arbitraging 5. What can be done to make this market high on liquidity and volumes?

6. If an investor perceives a bullish stock market, which form of hedging does he prefer? Options Futures Forwards Swaps 7. If an investor perceives a bearish stock market, which form of hedging does he prefer? Options Futures Forwards Swaps Thank you for sparing your precious time and helping us in our research.

Table.1
HISTORICAL IMPETUS TO THE GROWTH OF DERIVATIVES IS SHOWN IN THE TABLE BELOW. Year 1971 Developments Collapse of Bretton Woods Innovations Chicago Mercantile Exchange, Currency

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Futures 1972 1973 1974 1975 1976 1977-78 End of gold convertibility Managed floating rates Commodity price swings Volatile interest rates Recession Another attempt at exchange rate stability Jamaica Accords European Monetary System NY Futures Exchange Big Bang hits London Federal Reserve to target Money and not Interest rates Reagan Recovery London International Futures Exchange Philadelphia Exchange, Currency Options, Currency Swaps NY Mercantile Exchange Energy Futures Growing interest in commodity futures Interest Rate Futures

1978-79 1979 1979/80 1980-81 1981-82

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A.2 CLASSIFICATION OF DERIVATIVES

Classification of Derivatives

Underlying assets

Nature of contracts

Market mechanism

Stock Index

Currency

Options

Features

Over the counter

Exchange traded

Commodity

Interested

Forward

Swap

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TABLE 2 THE GLOBAL DERIVATIVES INDUSTRY: CHRONOLOGY OF INSTRUMENTS Year 1874 1972 1973 1975 1981 1982 Instruments Commodity Futures Foreign currency futures Equity options T-bond futures Currency swaps Interest rate swaps; T-note futures; Eurodollar futures; Equity index futures; Options on T-bond futures; Exchangelisted currency options Options on equity index; Options on T-note futures; Options on currency futures; Options on equity index futures; Interest rates caps and floors Eurodollar options; Swaptions OTC compound options; OTC average options Futures on interest rate swaps; Quanto options Equity index swaps Differential swaps Captions; Exchange-listed FLEX options

1983

1985 1987 1989 1990 1991 1993

1994 TABLE 3

Credit default options

DERIVATIVES IN INDIA: A CHRONOLOGY Year 1956 1969 1995 14 December 1995 18 November 1996 11 May 1998 June 1998 1999 7 July 1999 2000 May 2000 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 Event Enactment of the Securities Contracts (Regulation) Act which prohibited all options in securities Issue of Notification which prohibited forward trading in securities. Promulgation of the Securities Laws (Amendment) Ordinance which withdrew prohibition on options NSE asked SEBI for permission to trade Index futures Setting up of L. C. Gupta Committee to develop regulatory framework for derivatives trading in India L. C. Gupta Committee submitted report. Constitution of J. R. Verma Group to develop measures for risk containment for derivatives Enactment of the Securities Laws (Amendment) Act which defined derivatives as securities RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. Withdrawal of 1969 Notification SEBI granted approval to NSE and BSE to commence trading of derivatives SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX Trading in index options commenced Ban on all deferral products imposed

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July 2001 Nov. 2001

Trading in stock options commenced Rolling settlement introduced for active securities. Trading in stock futures commenced.

FALL OF BARINGS BANK Oldest merchant bank in Britain Founded in 1762; helped Britain finance Napoleonic wars; five noble titles on family; clients included Queen and royal family GBP 440 million capital in 1995, not one of the largest banks Crisis hit the bank in February 1995 On February 24, 1995 Peter Barings called BOE to report losses in Singapore subsidiary while trading on Nikkei Investigations revealed losses of over $ 1 billion; verge of bankruptcy ING bought Barings for GBP 1 after a week Unauthorized trades and lack of controls In 1992, Barings sent Nick Lee son to Singapore to manage back office Subsidiary traded on SIMEX, mainly client business Lee son passes exams in 1993 and becomes a trader; back office responsibility remains Entered prop trading; thought to be arbitrage between SIMEX and Osaka in Nikkei and JGB Started to move away from arbitrage unknown to Barings management Reported spectacular profits, accounting for large proportion of Barings.

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 Trading strategies Sold options; sold straddles on Nikkei in big way in 1994; also bet on JGB Made losses; bought futures when index fell; recouped losses at one time but index fell again; bought more futures In 5 days after Kobe on Jan 17, 1995 Nikkei fell by 1500; losses of GBP 68 mil In Feb Barings had 49% of OI in Nikkei Mar and 24% in Nikkei June; 88% OI in JGB June; also Euro yen Concealment of losses Lee son incurred losses from beginning GBP 2 m in 1992, GBP 21 m in 1993, GBP 185 m in 1994 Reported spectacular profits by concealment; certain accounts suppressed Massive margin calls funded by London with few questions (GBP 742 m); misrepresentation of need for funds In Feb 1995, official sent to Singapore to investigate; could not reconcile; SIMEX expresses concerns; Lee son disappears Later arrested and sentenced for 6.5 years Market impact SIMEX and Osaka took over positions; market fell precipitously; raised margins; players reluctant to pay; SIMEX solvency questioned Customer funds of GBP 485 million in trouble; segregation not recognized in Japanese law; records not proper.

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ORANGE COUNTRY In December 1994, Orange County became the biggest municipality in US to declare bankruptcy Treasurer Citron lost $ 1.7 billion of tax-payer money Orange County had investment pool of $ 7.6 billion belonging to more than 200 public agencies; invested in US treasury and agency securities of 2 to 5 year notes Treasurer, through reverse repos, increased pool to $ 20.6 billion; borrowed short to go long. Also invested in inverse floaters that lose value when rates rise Fed raised short-term rates leading to losses; Citron continued to increase positions and trade with the hope of recovering losses Came to light when audit reported loss of $ 1.7 billion

SUMITOMO BANK Sumitomo Bank lost $ 1.8 billion in Copper Futures in 1995 Hamanaka was a top trader in world copper markets; Mr. 5% Lawyer; smart; hard working; won Presidents award Granted Power of Attorney to Brokers for trading on Sumitomos account Pattern of trading from 1993 became more complex, large and less transparent through futures, options and swaps

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 Trades were through small, newly formed brokerages with offshore locations Funded positions trough credit lines and prepayment swaps Had authority to open brokerage accounts, bank accounts, sign loan documents and make cash payments On May 17 Hamanaka was reassigned; prices fell by 30% after that date; On June 13 Hamanaka was fired and Sumitomo announced losses of $ 1.8 billion that they say occurred over 10 years Hamanaka sentenced for 8 years.

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