59184000 financial markets snapshot

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Financial Markets

1

Anil Suvarna

Study Material on

Financial Markets

Compiled by

Prof. Anil Suvarna



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Syllabus

No. Contents

Section 1: Introduction to Equities

1.1 Indian Financial Markets: An Overview

1.2 Classification of Financial Markets

1.3 Evolution of Stock Markets in India

1.4 History of Stock Exchanges in India

1.5 Management of Stock Markets

Section 2: Equities

2.1 Equities: History, Meaning and Definition

2.2 Types of Trading

2.3 Trading Mechanism and its Modernization

2.4 Clearing and Settlement

Section 3: Derivatives

3.1 Derivatives: History, Meaning and Definition

3.2 Classification of Derivatives

3.3 Features, Types and Players in Derivatives

3.4 Forwards: Meaning, Definition & Limitations

Section 4: Futures

4.1 Meaning

4.2 Terminologies

4.3 Payoff Profile

4.4 Numericals

Section 5: Options

5.1 Meaning

5.2 Terminologies

5.3 Payoff Profile

5.4 Numericals



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Section 1: Introduction to Equities

1.1 Financial Markets: An Overview

Financial markets are an integral part of the economy of any nation. They play a key role

in the development of the economy. In simple words financial markets facilitate the

reallocation of savings from savers to entrepreneurs. In India the financial markets and

institutions have, in recent years, undergone significant changes keeping in pace with the

changing needs of market participants. Also the market has gone through various stages

of liberalization that has increased its degree of integration with the global markets.

In the financial markets savings are linked to investments by a variety of intermediaries

through a range of complex financial products called securities. Securities are defined in

the Securities Contracts (Regulation) Act, 1956 to include shares, bond, scrip, stocks, or

other marketable securities of like nature in or of any incorporate company or body

corporate, government securities, derivatives of securities, units of collective investment

scheme, interest and rights in securities, security receipt or any other instruments so

declared by the Central Government.



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1.2 Classification of Financial Markets

The Financial Market Comprises Of Two Broad Groups

Money market

The money market is concerned with the borrowing and lending of short- term funds. It

deals with near substitutes for money like trade bills, promissory notes and government

papers drawn for a short period not exceeding one year. These, short term instruments

can be converted into cash readily without any loss and at low transaction cost. This

market supplies funds for financing current business operations, working capital

requirements, and short period requirements of the Government.

Capital Market

Gilt-edged Securities

MarketSecurities Market

Primary Market

Money Market

Financial Market

Secondary Market



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Capital market

Capital market is concerned with the borrowing and lending of long-term funds. The

capital markets mobilize the savings of the households and of the industrial concerns,

provide them with excellent investment opportunities thus facilitating capital formation

in the country. The capital market makes available funds for various projects in the

private sector as well as public sector. Also institutions raise funds for projects in the

backward areas, which in turn lead to development of the backward areas. A healthy

capital market is an indication of a tremendous economic growth and development of a

country.

Evolution of capital markets

In India the current structure of capital market has evolved over the years due to constant

improvement measures and modifications. A major reason behind this is the growth of

Stock Exchanges in India. Due to this it has become possible for many people to be a part

of the capital market as they have a medium via which they can buy and sell the

securities. The stock exchanges act as a connecting link between the potential demand

and supply.

Setting up of the most important regulatory body in the context of a primary market, i.e.

Securities and Exchange Board of India (SEBI) way back in the year 1988, definitely played

a crucial role in the development of the capital market.

Besides these, the growth of financial institutions such as State Finance Corporations

(SFC’), Industrial Finance Corporation of India (IFCI), State Industrial Development

Corporations (SIDC), a major spurt in the mutual funds industry, development of creditrating industries have also provided a boost to the capital market in India. These

institutions actively participate in the securities market.



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As a result of these significant moves, today our market is rated third in the entire world.

Absence of capital market acts as a deterrent factor to capital formation and economic

growth. Resources would remain idle if finance is not funneled through capital market.

Thus as mentioned earlier it is evident that capital market facilitates increase in

production and productivity in the economy and thus enhances the economic welfare of

the society.

Gilt-edged securities market

This market deals with the securities such as bonds issued by Central Government, State

Government, and All India Financial Institutions like IDBI, State Finance Corporations,

SIDC’s and other government bodies. The securities are issued in the forms of bonds and

credit notes. The buyers of such securities are banks, insurance companies, employee’s

provident funds, RBI and even individuals. These securities are fully backed by the

Government.

Securities Market

This market deals with equities, bonds and derivatives. The securities market has

essentially three categories of participants, namely the issuer of securities, investors insecurities and the intermediaries. The issuers and investors are consumers of services

rendered by the intermediaries. While the investors are consumers of securities issued by

the issuers as they subscribe for and trade in those securities. The Securities Market has

two independent and inseparable segments: The Primary Market and The Secondary

Market.



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Primary Market

The primary market provides the channel for creation of new securities through issuance

of financial instruments by public companies as well as Governments and Government

agencies and bodies. This market provides both existing quoted companies and new

companies with the facility for raising new capital. In India a secondary offering is also

done in a primary market. The primary market issuance is done through: -

Public Issue

Offer for sale

Right Issues

Private Placement

Secondary Market

The secondary market is the place for sale and purchase of existing securities. It enables

an investor to adjust his holdings of securities in response to changes in his assessment

about risk and return. It also enables him to sell securities for cash to meet his liquidity

needs. It essentially comprises of the stock exchanges which provide platform for trading

of securities and a host of intermediaries who assist in trading of securities and clearing

and settlement of trades. The securities are traded, cleared and settled as per prescribedregulatory framework under the supervision of the exchanges and the oversight of SEBI.

The secondary market has further two components, namely:

The Over-The-Counter (OTC) Market

OTC is different from market place provided by the Over The Counter Exchange of

India Limited (OTCEIL). OTC markets are essential informal markets where trade dealsare negotiated. Most of the traders in government securities are in the OTC market.

All the spot trades where securities are traded for immediate delivery and payment

take place in OTC market.



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The Exchange-Trade Market

Trades taking place over a trading cycle, i.e., a day under a rolling settlement, are

settled together after a certain time (currently 2 working days). All the 23 stock

exchanges in the country provide facilities for trading of equities. Traders executed on

the leading exchange (National Stock Exchange of India Limited (NSE) are cleared and

settled by a clearing corporation that provides notations and settlement guarantee.

Alternative Sources of Finance

The selection of alternative sources of capital depends on the urgency of the financial

need, corporate and shareholder objectives, the amount of capital needed, the use to

which the proceeds will be applied, and the relative size and maturity of the company.

Commercial Lenders and Lessors

Strategic Partnerships

Government Loans and Guarantees

Venture Capitalists

Sale or Merger Initial Public Offering



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1.3 Evolution of Stock Market in India

India has a two hundred year old trading in securities. Infact, the first Indian stock

exchange established in Bombay is the oldest exchange in Asia. The pace of growth of stock exchanges was slow till 80’s. After that, there was a capital market revolution in the

country. This was due to gradual liberalization of economic and industrial policies. The

shift from command economy to a market economy brought the importance of stock

exchanges into limelight.

The origin of stock market in India can be traced to the later part of the eighteenth

century. The earliest security dealings were transactions in loans securities of the East

India Company, the dominant institute of those days. Corporate shares came into the

picture by 1830’s, and assumed significance with the enactment of the Companies Act in

1850. The introduction of limited liability marked the beginning of the era of the modern

joint stock enterprises. This was followed by the American civil war in 1860 – 1865.

However, the bubble burst with the end of the civil war and a disastrous slump followed.

It lasted for a long time. It also resulted in complete ostracism of the broker community.

The tremendous social pressure on the brokers led to their forming an informal

association which later gave birth to, ‘The Native Share and Stock Brokers Association’,

(now known as the Bombay stock exchange) in 1887. . This stock exchange played a major

role during the phase of recovery from the seven year depression. It continued to grow in

stature and the size of operations and became the nerve centre of all financial activity

and the first to be recognized by the government of India.

This was followed by the formation of association/exchanges in:-

Ahmedabad (1894)

Calcutta (1908)

Madras (1937)



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The Second World War resulted in a sharp boom and growth in the number stock

exchanges. However, most of the stock exchanges languished till 1956, when the

government came out with a comprehensive legislation called ‘The Securities Contract

(Regulation) Act’, to regulate the functioning of stock exchanges and to check the

performance and promote a more orderly development of the stock market. This

legislation made it mandatory on the part of the stock exchanges to secure recognition

from central government. Only the established stock exchanges were recognised under

the act. Under this legislation it is mandatory on the part of stock exchanges to seek

governmental recognition.

After this the trading on the stock exchanges in India used to take place without use of

information technology for immediate matching or recording of trades. This was time

consuming and inefficient and also imposed limits on trading volumes and efficiency. In

order to provide efficiency, liquidity and transparency, NSE introduced a nation-wide on-

line fully automated screen based trading system (SBTS) where a member can punch into

the computer quantities of securities and the prices at which he likes to transact and the

transaction is executed as soon as it finds a matching sale or buy order from a counter

party. This allowed faster incorporation of price sensitive information into prevailingprices, thus increasing the informational efficiency of markets.

Owing to development of stock markets in India, this attracted the various foreign players

to invest in the Indian stock market. Various FII’s came to India and got them registered

themselves with SEBI and started investing in Indian stock market. During that time

market also had a variety of deferral products like modified carry forward system, which

encouraged leveraged trading by enabling postponement of settlement. The deferralproducts have been banned and in their place came the existence of Derivative trading in

securities though at the beginning it dint take of well because there was no suitable

regulatory framework to govern the trades.



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So SCRA was amended in December 1999 to expand the definition of securities to include

derivatives so that the whole regulatory framework governing trading of securities could

e applied to derivatives also. Then derivative trading took of in June 2000 on two

exchanges. Now in all there are 23 stock exchange in the country where trading in

equities is carried. This all changes have led to development of stock market in India.

1.4 History of Stock Exchanges in India

In 1860, the exchange flourished with 60 brokers. In fact the 'Share Mania' in India began

when the American Civil War broke and the cotton supply from the US to Europe

stopped. Further the brokers increased to 250. At the end of the war in 1874, the market

found a place in a street (now called Dalal Street). In 1887, "Native Share and Stock

Brokers' Association" was established. In 1895, the exchange acquired a premise in the

street which was inaugurated in 1899.

The stock exchanges are the exclusive centres for trading of securities. Stock exchange

means anybody or individual whether incorporated or not, constituted for the purpose of

assisting, regulating or controlling the business of buying, selling or dealing in securities. It

is an association of member brokers for the purpose of self-regulation and protecting the

interest of the members. It can operate only if it is registered under the Securities

Contracts (Regulation) Act 1956.

The SCRA was made in order to regulate certain matters of stock exchanges which include

opening / closing of the stock exchanges, timing of trading, regulation of bank transfers,

regulation of badla or carry over business, control of the settlement and other activities

of the stock exchange like: -



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Margin regulation, regulation of brokers, broker charges, trading rules on the exchange

and settlement and clearing of the trading, at the end March 2003, there were 23

operative stock exchanges with 9,413 securities listed. On the same date, there were

9,519 registered brokers and 13,291 registered sub – brokers trading on these exchanges

in the listed companies.

Functions of the Stock Exchange:

To Ensure A Measure of Safe Dealing: - The stock exchange operates under a

regulatory framework which favours them heavily by almost banning trading of

securities outside exchanges resulting to protect the interest of the investors. The

rules, regulations of a stock exchange approved by the government are made to

ensure that a reasonable measure of safety is provided to investors and transactions

take place in competitive conditions and no malpractices are to be involved.

Directing the Flow of Capital in The Most Profitable Channels: - Companies which

have more profitable investment opportunities are normally able to generate more

funds through this market, whereas companies which do not have such opportunitiesare not able to do so. In this way stock exchange facilitates the direction of flow of

capital in most profitable channels.

Motivates The Company To Raise Its Standard Of Performance: - When the company

is listed on the stock exchange, the performance of the company is reflected in the

market price of the equity stock, which is readily available for public consumption.

When the companies make profit then the public will invest in the shares of thatcompany resulting to profitability of that company. Such a public exposure induces

companies to raise their standard of performance.



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Providing Liquidity To The Listed Companies: - The stock exchange helps the

companies in raising their funds. The savings of investors flow in the stock exchange

there by resulting in trading in securities. This provides liquidity to the listed

companies.

Recognized Stock Exchanges of India

No. Name Of Exchange Date Of Initial

Recognition

1. The Bombay Stock Exchange 31.03.1957

2. The Ahmedabad Stock Exchange 16.09.1957

3. The Calcutta Stock Exchange 10.10.1957

4. The Madras Stock Exchange 15.10.1957

5. The Delhi Stock Exchange 09.1.1957

6. The Hyderabad Stock Exchange 29.09.1958

7. The Madhya Pradesh Stock Exchange 24.12.1958

8. The Banglore Stock Exchange 16.02.1963

9. The Cochin Stock Exchange 10.05.1979

10. The Uttar Pradesh Stock Exchange 03..6.1982

11. The Pune Stock Exchange 02.09.1982

12. The Ludhiana Stock Exchange 29.04.1983

13. The Gauhati Stock Exchange 01.05.1984

14. The Kanara Stock Exchange 09.09.1985

15. The Magadha Stock Exchange 11.12.1980

16. The Jaipur Stock Exchange 09.01.1989

17. The Bhubaneswar Stock Exchange 05.06.1989

18. The Saurashtra Kutch Stock Exchange 10.07.1989

19. The Vadodra Stock Exchange 05.01.1990

20. The Coimbatore Stock Exchange 18.09.1991

21. The Meerut Stock Exchange 20.09.1991

22. The National Stock Exchange 26.04.1993

23. Over The Counter Exchange of India 23.08.1994



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1.5 Management of Stock Exchanges

The Indian stock exchanges are regulated by the Ministry of Finance, The Securities and

Exchange Board of India (SEBI), and the governing boards of the stock exchanges within

the legal framework provided by the securities contracts (Regulations) Act, 1956, and the

Securities and Exchange Board of India Act, 1992. The internal governance of the stock

exchange is done through the framework of Rules, Bye-laws and Regulations, duly

approved by the government of India.

The securities markets in India are governed under 4 main legislations:

The Securities Contracts (Regulation) Act, 1956: - This prevents undesirable

transaction in the securities by regulating the business of dealing in securities.

The Companies Act, 1956: - Which is a uniform law relating to companies throughout

India.

The SEBI Act, 1992: - For protection of interest of investors and for promoting

development of and regulating the securities market.

The Depositories Act, 1996: - Which provides for electronic maintaince and transfer

of ownership of dematerialised securities.

Besides, the Ministry of Finance, through the stock exchange division, administers the

SCRA, 1956. It has the powers to apply the provisions of the said Act, provide licenses to

dealers, grant recognition to the stock exchanges and regulate their operations.

Further, it has the appellate and supervisory powers over the SEBI. The Ministry of

Finance has the power to nominate the Presidents and Vice-Presidents and also theapproval on appointment of various representatives of the stock exchanges.



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SEBI - Securities and Exchange Board of India

The Securities and Exchange Board of India (SEBI) was set up on April 12, 1988. To start

with, SEBI was set up as a non-statutory body. It took almost four years for the

government to bring about a separate legislation in the name of SEBI conferring statutory

powers. The Act charged to SEBI with comprehensive powers over practically all aspects

of capital market operations.

SEBI has two Advisory Committees, one each for primary and secondary market. The

committees are constituted from among the market players, recognized investor

associations and eminent persons associated with the capital market. They provide

advisory inputs in framing policies and regulations. These committees are non statutory

in nature and SEBI is not bound by the committees.

Objectives

According to the preamble of the SEBI Act, the primary objective of the SEBI is to promote

healthy and orderly growth of the securities market and secure investor protection. For

this purpose, the SEBI monitors the activities of not only stock exchange but also

merchant bankers etc. The objectives of SEBI are as follows: -

To protect the interest of investors so that there is a steady flow of savings into the

capital market.

To regulate the securities market and ensure fair practices by the issuers of securities

so that they can raise resources at minimum cost.

To promote efficient services by brokers, merchant bankers and other intermediaries

so that they become competitive and professional.

Simultaneously SEBI which came into existence in 1992 was regarded as the capital

market regulator in India. SEBI was given the full authority and jurisdiction over the

securities market under the act.



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Roles

The various roles of SEBI are as follows:-

To ensure better disclosure norms

Introducing free pricing of Public Issues

Establishing the new norms for issue of stock investment

Framing rules for various market participants (bankers, portfolio managers and

brokers)

To protect the interest of the investors in the securities market, promoting the

development of securities market and even regulating the stock market

Setting up advisory panel for primary and secondary markets

Registering brokers and levying appropriate fees to the brokers

Framing rules for Foreign Institutional Investors (FII’s)

Developing a specific code for mergers and takeovers

To collect information and advise the government on matters relating to the stock

and capital markets

Developing norms for insider trading

Powers:

SEBI has been vested with the following powers: -

Power to call periodical returns from recognized stock exchanges

Power to call any information or explanation from recognized stock exchanges or

their members.

Power to direct enquiries to be made in relation to affairs of stock exchanges or

their members.

Power to grant approval to byelaws of recognized stock exchanges.

Power to make or amend byelaws of recognized stock exchanges.

Power to compel listing of securities by public companies.

Power to control and regulate stock exchanges.



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Power to grant registration to market intermediaries.

Power to levy fees or other charges for carrying out the purpose of regulation.

Power to declare applicability of Sec 17 of Securities Contract (Regulation) Act in

any state or area to grant licenses to dealers in securities.

Operational Review of SEBI:

I. The Securities and Exchange Board of India Act, 1992 provides for the establishment

of the Board to: -

Protect the interest of the investors in securities

Promote the development of, and

Regulate the securities market and matters connected therewith or incidental to.

II. The Securities and Exchange Board of India (SEBI) has chalked out a vision of

becoming the "Most Dynamic and Respected Regulator-Globally".

III. SEBI has drawn a comprehensive Strategic Action Plan in order to realize this vision.

The Plan envisages achievement of strategic aims laid down for : -

Investors (Consumers): Investors are enabled to make informed choices and

decisions and achieve fair deals in their financial dealings’

Firms (Corporate): Regulated firms and their senior management understand and

meet their regulatory obligations’

Financial Markets (Exchanges, Intermediaries): Consumers and other participants

have confidence that markets are efficient, orderly and clean’

Regulatory Regime: An appropriate, proportionate and effective regulatory

regime is established in which all the ‘stakeholders’ have confidence’.



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Section 2: Equities

2.1 Equities: History, Meaning and Definition

History

The Indian Equity Market is also the other name for Indian share market or Indian stock

market. Indian Equity Market at present is a lucrative field for the investors and investing

in Indian stocks are profitable for not only the long and medium-term investors, but also

the position traders, short-term swing traders and also very short term intra-day traders.

Foreign investment in general enjoys a majority share in the Indian Equity Market.

Foreign Institutional Investors (FII) need to register themselves with the SEBI and the RBI

for operating in Indian stock exchanges. In fact from the Indian equity market analysis it is

known that in some specific industries foreigners can have even 100% shares. In the last

few years with the facility of the Online Stock Market Trading in India, it has been very

convenient for the FIIs to trade in the Indian equity market.

Thus, the growing financial capital markets of India being encouraged by domestic and

foreign investments is becoming a profitable business more with each day.

Meaning

The market in which shares are issued and traded, either through exchanges or over-the-

counter markets equity market, also known as the stock market, it is one of the most vital

areas of a market economy because it gives companies access to capital and investors a

slice of ownership in a company with the potential to realize gains based on its future

performance. This market can be split into two main sectors: the primary and secondary

market. The primary market is where new issues are first offered. Any subsequent trading

takes place in the secondary market.



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Definition

Equity market or stock market is a system through which company shares are traded. The

equity market offers investors an opportunity to participate in a company's success

through an increase in its stock price. With enhanced opportunity, however, the equity

market usually carries greater risk than debt markets. The worldwide equity market

benefited from freer markets, government privatizations, and companies seeking an

alternative to debt.

2.2 Types of Trading, Types of Traders and Styles of Trading

Types of Trading can be divided into long term and short term. For long term trading we

have delivery trading and for short term trading we have intra-day trading.

1. Delivery Trading:

• This type of trading is done by investors who want to invest their money from

a long term perspective say for more than 1 year.

• Under delivery trading one actually becomes the owner of the share as he

pays full amount for buying the same.

• The investor has full right on the share purchased and can hold it in his demat

a/c forever, in-short he has got no obligations to be fulfilled once have bought

the share.

• Settlement happens on T+2 days and one gets the actually delivery of shares

in his demat a/c.



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2. Intra-day Trading:

• This type of trading is done only by traders; one has complete his trading

activities in the same trading day.

• Under intra-day trading one doesn’t become the owner of the share as he

pays only the margin amount for buying or selling the same.

• The trader has the obligation to square off the position before the closing bell

as he is not allowed to carry forward the position under intra-day.

• Settlement has to be compulsorily done on the same trading day, since intra-

day is cash settled there is no delivery happening.

Types of Traders The stock market also provides opportunities for short-term traders.

When the price starts to fall or rise, other investors will jump on the bandwagon, causing

an even faster acceleration in price. Eventually the market will correct itself, but for savvy

short-term traders who watch the market closely, these price changes can offer

opportunities for profitable trading.

Short term traders are divided into 3 categories: Position Traders, Swing Traders, and Day

Traders.

1. Position Traders - Position trading is the longest term trading style of the three.

Stocks could be held for a relatively long period of time compared with the other

trading styles. Position traders expect to hold on to their stocks for anywhere from

5 days to 3 or 6 months. Position traders are watching for fundamental changes in

value of a stock. This information can be gleaned from financial reports and

industry analyses. Position trading does not require a great deal of time. An

examination of daily reports is enough to plan trading strategies. This type of

trading is ideal for those who invest in the stock market to supplement their

income. The time needed to study the stock market can be as little as 30 minutes

a day and can be done after regular work hours.



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2. Swing Traders - Swing traders hold stocks for shorter periods than position traders

- generally from one to five days. The swing trader is looking for changes in the

market that are driven more by emotion than fundamental value. This type of

trading requires more time than position trading but the payback is often greater.

Swing traders usually spend about 2 hours a day researching stocks and executing

orders. They need to be able to identify trends and pick out trading opportunities.

They usually rely on daily and intraday charts to plot stock movements.

3. Day Traders - Day trading is commonly thought of as the most risky way to play

the stock market. This may be true if the trader is uneducated, but those who

know what they are doing know how to limit their risk and maximize their profit

potential. Day trading refers to buying and selling stock in very short periods of

time - less than a day but often as short as a few minutes. Day traders rely on

information that can influence price moves and have to plot when to get in and

out of a position. Day traders need to be rational and analytical. Emotional buyers

will quickly lose money in this type of trading. Because of the close attention

needed to market conditions, day trading is a full-time profession.

Styles of Trading

1. Scalping - The scalper is an individual who makes dozens or hundreds of

trades per day, trying to "scalp" a small profit from each trade by exploiting

the bid-ask spread.

2. Momentum Trading - Momentum traders look to find stocks that are moving

significantly in one direction on high volume and try to jump on board to ride

the momentum train to a desired profit.

3. Technical Trading - Technical traders are obsessed with charts and graphs,

watching lines on stock or index graphs for signs of convergence

or divergence that might indicate buy or sell signals.



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4. Fundamental Trading - Fundamentalists trade companies based on

fundamental analysis, which examines things like corporate events such as

actual or anticipated earnings reports, stock splits, reorganizations or

acquisitions.

5. Swing Trading - Swing traders are really fundamental traders who hold their

positions longer than a single day. Most fundamentalists are actually swing

traders since changes in corporate fundamentals generally require several

days or even weeks to produce a price movement sufficient enough for the

trader to claim a reasonable profit.

2.3 Trading Mechanism and its Modernization

Securities Trading Cycle

Decision

to TradePlanning

Order

Trade

Execution

Clearing

of Trades

Funds /

Securities

Settlement

of Trades



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The above figure is a conceptual model of securities trading cycle. A person holding /

having some amount of securities / funds when either to meet his liquidity needs or to

reshuffle his holdings in response to changes in his perception about risk and return of

the assets, decides to buy / sell the securities. Therefore, the person also influenced by

the marketing activity is influenced to make a decision to either increase or decrease his

share holdings. Then on that basis he contacts the broker and communicates his order i.e.

places his order. Then the order is executed by the broker at the price and quantity of

shares quoted by the investor. The order when matches sell / buy order is converted to

trade. The trades then have to be sent for clearing in order to determine the obligations

of counter parties to deliver securities as per schedule. Next the necessary formalities are

conducted. Finally, the buyer / seller delivers funds / securities and receives securities /

funds and acquires ownership them. So, this was the core concept on which the entire

trading system was based upon which has been evolved from the traditional method to

the computerized method but the transaction cycle hasn’t changed. In the following

pages it may be noticed that with the use of technology how the ill effects of traditional

trading methods has been warded off order to evolve computerized system of trading for

facilitating efficient trading for investors.

Traditional Trading Mechanism

The traditional trading method of stock exchanges dates back at the time of inception of

the stock exchanges wherein, rudimentary techniques of trading were applied. The

trading on stock exchanges in India use to take place through open outcry without the use

of information technology for immediate matching / recording of trades. This type of

trading was called Ring trading / Pit trading.



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Ring trading bares its name due to the brokers trading activities used to be conducted in a

ring or pit. The broker use to shout and quote their prices. The entire transaction was

verbal trading and was a community driven market, mainly dominated by the Gujurathis.

Also the market in the old trading system was location specific i.e. the trading could be

done only in the stock market / exchange. The entire market was not representative as it

was manipulated by few individuals.

The main aspect in the traditional trading mechanism was that of the brokers wherein

they delt with the stock markets as per their Whims and Fancies and many a times

manipulated the prices for their own personal benefit. Hence, the traditional trading

mechanism was time consuming, inefficient and not secure.

Modern Trading Mechanism

As analyzed the traditional trading mechanism had become obsolete because of many

reasons such as increased volume in trade, opening up trade and susceptibility of markets

to scams and manipulations. Therefore, on 14th

March, 1995 history was created by

introducing the Screen Based Trading System (SBTS).

The screen based trading system gave in an accurate and timely statistics on market

activity. Also host of electronic devices such as Tickers, Monitors, Boards and Computer

Terminals had been provided. The endeavour was to set up right kind of user friendliness

performance and functionality.

The main objective of Modern Trading Mechanism was: - Lead to Transparent deals in the market

Improvement in Liquidity in the market

Increase the market depth through quote continuity

Eliminate mismatches and mitigate settlement risks



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Instantaneous dissemination of information through various data-feed channels

Structured MIS reports for analysis

Provide a robust and scalable trading system for growing volumes

The aim of the new system was to provide the accurate information at a faster rate for

the benefit of the traders.

The various benefits of Modern Trading Mechanism were: -

It makes trading accessible--anywhere and at anytime

The pace of communication facilitates a fast response time

Dissemination of data is done at a faster rate

Technology also provides the freedom to create-new systems, new products

It also facilitates transparency of information

Provides global connectivity

It increases awareness of market participants through provision of information

Screen Based Trading System (SBTS)

The Screen Based Trading System provides seamless information flow of the variousscrips which is available to everyone and anyone interested in the markets. The main aim

of the technology was used to carry the trading platform from trading hall of stock

exchanges to premises of broker / investor. The Screen Based Trading System operates on

strict time, price and priority. The order that has been placed by the broker on behalf of

investors via satellite through his computer is registered. The orders are started with best

price order getting the first priority. The orders are matched automatically by the

computer keeping the system transparent, objective and fair. Where an order doesnotfind a match, it remains in the system and is displayed to the whole market, till a fresh

order comes in or the earlier order is cancelled or modified. Also the trading provides

tremendous flexibility to the users in terms of kinds of orders that can be placed on the

system.



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The SBTS has two terminals viz.

1. BOLT

2. NEAT

1. BOLT - BSE ON LINE TRADING SYSTEM

BSE's On Line Trading System, popularly known as the BOLT system took its genesis in the

year 1994, as part of the four phase computerization program to create an automated

trading environment. BOLT system aimed at converting the Open Outcry system of

trading to a screen-based trading system. BSE had the requisite knowledge base and by

virtue of the 125 year track record in the capital markets, BSE embarked on the specified

project in 1991 and seamlessly completed the fourth phase in March 1995.

With the interest of BOLT it helped the performance and response time increase to very

extent. Also there was continuos availability for reliable and continuos information. The

data integrity is restored which inturn guarantee the security of the distributed data

enabling others to access it from anywhere in the network. With the creation of BOLT

accurate and timely statistics was available. Through networking, software and hardware

an open interface specification was available. Through this members had the flexibility touse their own developed application. BOTL also is interfaced with various information

vendors including Bloomberg, Bridge, Reuters and others. Market information is fed to

news agencies to in real time. BOLT plans to enhance the capabilities further to have an

integrated two way information flow.

2. NEAT - National Exchange For Automated Trading

The National Stock Exchange (NSE) is India's leading stock exchange covering 364 citiesand towns across the country. NSE was set up by leading institutions to provide a modern,

fully automated screen-based trading system with national reach. The Exchange has

brought about unparalleled transparency, speed & efficiency, safety and market integrity.

It has set up facilities that serve as a model for the securities industry in terms of systems,



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Issuer

NSDL

VSAT Link

R & T Agent

Clearing

CorporationHouse

VSAT Link

Clearing

MemberVSAT Link

DP

Investor

VSAT Link

DP

Investor

practices and procedures. NSE introduced for the first time in India, fully automated

screen based trading. It uses a modern, fully computerised trading system designed to

offer investors across the length and breadth of the country a safe and easy way to invest.

The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a fully

automated screen based trading system, which adopts the principle of an order driven

market.

On – Line Trading Mechanism: A Conceptual Model



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Electronic Linkage Model

The above figure is a conceptual model of trading of securities through electronic linkage.

The main aspect that needs to be considered is that the entire process has to be

electronically networked on every aspect. This electronic network helps in accurate and

fast exchange of information and dealings in order to facilitate the investor. In the above

figure the issuer registers his shares with Registrar & Transfer agent electronically, and

then the DPs trade in the shares on behalf of the investors either by buying or selling of

shares. DPs can be termed as small terminals of NSDL (National Securities Depositaries

Limited) which have electronic link with NSDL and the exchanges. In this system the

investor or the broker either places an order of buy / sell of shares. The NSDL then

connects to the mainframe server of the exchanges and matches the orders with the best

buy and best sell technique. Now let’s get a brief perspective of NSDL.

2.4 Clearing and Settlement

Clearing and settlement is a post trade activity. Clearing Agencies ensures trading

members meet their fund/security obligations. It acts as a legal counter party to all trades

and guarantees settlement for all members. The original trade between the two parties is

cancelled and clearing corporation acts as counter party to both the parties, thus

manages risk and guarantees settlement to both the parties. This process is called

novation.

It determines fund/security obligations and arranges for pay-in of the same. It collects

and maintains margins, processes for shortages in funds and securities. It takes help of

clearing members, clearing banks, custodians and depositories to settle the trades.

The settlement cycle in India is T+2 days i.e. Trade + 2 days. T+2 means the transactions

done on the Trade day, will be settled by exchange of money and securities on the second

business day (excluding Saturday, Sundays, Bank and Exchange Trading Holidays). Pay-in

and Pay-out for securities settlement is done on a T+2 basis.



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The following is the summary of trading and settlement process in India.

• Investors place orders from their trading terminals.

• Broker houses validate the orders and routes them to the exchange (BSE or NSE

depending on the client’s choice)

• Order matching at the exchange.

• Trade confirmation to the investors through the brokers.

• Trade details are sent to Clearing Corporation from the Exchange.

• Clearing Corporation notifies the trade details to clearing Members/Custodians who

confirm back. Based on the confirmation, Clearing Corporation determines

obligations.

• Download of obligation and pay-in advice of funds/securities by Clearing Corporation.

• Clearing Corporation gives instructions to clearing banks to make funds available by

pay-in time.

• Clearing Corporation gives instructions to depositories to make securities available

by pay-in-time.

• Pay-in of securities: Clearing Corporation advises depository to debit pool account of

custodians/Clearing members and credit its (Clearing Corporation’s) account and

depository does the same.

• Pay-in of funds: Clearing Corporation advises Clearing Banks to debit account of

Custodians/Clearing members and credit its account and clearing bank does the

same.

• Payout of securities: Clearing Corporation advises depository to credit pool accounts

of custodians/Clearing members and debit its account and depository does the

same.• Payout of funds: Clearing Corporation advises Clearing Banks to credit account of

custodians/ Clearing members and debit its account and clearing bank does the

same. Note: Clearing members for buy order and sell order are different and Clearing

Corporation acts as a link here.



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• Depository informs custodians/Clearing members through Depository Participants

about pay-in and pay-out of securities.

• Clearing Banks inform custodians/Clearing members about pay-in and pay-out of

funds.

• In case of buy order by normal investors Clearing members instruct his DP to credit

the client’s account and debit its account. The money will be debited (Total settled

amount - margins paid at the time of trade) from the client’s account.

• In case of sell order by normal investors Clearing members instruct his DP to debit

the client’s account and credit its account. The money will be credited to the client’s

account.

BSE Settlement Cycle:

Day Activity T Trading through BOLT (BSE Online Trading)

System, downloading of statements

showing details of transactions and

margins at the end of the day.

Downloading of provisional securities and

funds obligation statements by member-

brokers.

6A/7A entry by the member-brokers/

confirmation by the custodians.

6A/7A: A mechanism whereby the

obligation of settling the transactions done

by a member-broker on behalf of a client is

passed on to a custodian based on

confirmation of latter. The custodian canconfirm the trades done by the member-

brokers on-line and up to 11 a.m. on the

next trading day. The late confirmation of

transactions by the custodian after 11:00

a.m. up to 12:15 p.m., on the next trading

day is, however, permitted subject to



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payment of charges for late confirmation

@ 0.01% of the value of trades confirmed

or Rs. 10,000/-, whichever is less.

Day Activity T +1 Confirmation of 6A/7A data by the

Custodians up to 11:00 a.m. Downloading

of final securities and funds obligationstatements by members.

Day Activity T +2 T+2 - Pay-in of funds and securities by

11:00 a.m. and pay-out of funds and

securities by 1:30 p.m. The member-

brokers are required to submit the pay-in

instructions for funds and securities to

banks and depositories respectively by 10:

30 a.m.

Day Activity T +3 Auction on BOLT at 11.00 a.m.

Day Activity T +4 Auction pay-in and pay-out of funds andsecurities by 12:00 noon and 1:30 p.m.

respectively.

NSE Settlement Cycle:

Day Type of Activity Activity

T Trading Rolling Settlement Trading

T+1 working days Clearing Custodial Confirmation

T+1 working day Delivery Generation

T+2 working day Settlement Securities and Funds pay in

T+2 working daySecurities and Funds pay

out

T+2 working day Valuation Debit

T+3 working day Post Settlement Auction

T+4 working day Bad Delivery Reporting

T+5 working day Auction settlement

T+6 working dayRectified bad delivery pay-

in and pay-out

T+8 working dayRe-bad delivery reporting

and pickup

T+9 working daysClose out of re-bad delivery

and funds pay-in & pay-out



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Functions of Custodian and Depository

Custodian:

A custodian is an entity which holds the documentary evidence of the title to property

belonging like share certificates, etc for safekeeping. In Clearing Corporation, custodian is

a clearing member but not a trading member. He settles trades assigned to him by trading

members. He is required to confirm whether he is going to settle a particular trade or not.

If it is confirmed, the Clearing Corporation assigns that obligation to that custodian and

the custodian is required to settle it on the settlement day. If the custodian rejects (if

there are mismatches due to errors in the system) the trade, the obligation is assigned

back to the trading member. Only on receipt of the rejection message, the broker shall

cancel the rejected contract note and issue a fresh contract note bearing a new number.

Depository:

A depository is an entity where the securities of an investor are held in electronic form.

Depositories help in the settlement of the dematerialized securities. Each

custodian/clearing member is required to maintain a clearing pool account with the

depository. He is required to make available the required securities in the designated

account on settlement day.

The depository runs an electronic file to transfer the securities from accounts of the

custodians/clearing member to that of Clearing Corporation. As per the schedule of

allocation of securities determined by the Clearing Corporation, the depositories transfer

the securities on the payout day from the account of the Clearing Corporation to those of

members/custodians.

Every investor who wants to hold securities in dematerialized form must open an account

with a depository participant (DP) of his choice. Usually this is done by your broker on

behalf of you. Depository Participants (DPs) hold accounts with depositories.



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Just as one can hold funds in a bank account and transfer funds across accounts without

actually handling cash; one can hold securities in a depository account and transfer

securities across depository accounts without actually handling share certificates.

There are two main depositories in India.

1. National Securities Depository Ltd (NSDL)

2. Central Depository Services Ltd (CDSL)

Functions of Clearing Banks

Clearing Bank acts as an important intermediary between clearing member and clearing

corporation. Every clearing member needs to maintain an account with clearing bank. It’s

the clearing member’s function to make sure that the funds are available in his account

with clearing bank on the day of pay-in to meet the obligations. In case of a pay-out

clearing member receives the amount on pay-out day.



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Section: 3 Derivatives

Introduction: Indian Financial Markets: Where does derivative fall?

From the above chart we can see that derivatives fall under secondary market channel.

3.1 Derivatives History, Meaning and Definition

History

Derivatives have been a recent development in the Indian financial markets. But there

have been derivatives in the commodities market. There are Cotton and Oilseed futures

in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in Bangalore

etc. But the players in these markets are restricted to big farmers and industries, who

need these as an input to protect themselves from the vagaries of agriculture sector.

Globally too, the first derivatives started with the commodities, way back in 1894.

Financial derivatives are a relatively late development, coming into existence only in the

1970’s. The first exchange where derivatives were traded is the Chicago Board of Trade



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(CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE) in June

2000. The first derivatives were index futures. The index used was Nifty. Option trading

was started in June 2001, for index as well as stocks. In November 2001, futures on stocks

were allowed. Currently, there are 275 stocks on which derivative trading are allowed.

Meaning

Derivate – “Derives its value from an asset” - What the phrase means is that the

derivative on its own does not have any value. It is considered important because of the

importance of the underlying. When we say an Infosys future or an Infosys option, these

carry a value only because of the value of Infosys.

Definition

A derivative is a financial instrument that derives its value from an underlying asset. This

underlying asset can be stocks, bonds, currency, commodities, metals and even

intangible, pseudo assets like stock indices.

3.2 Classification of Derivatives



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Financial Derivatives

Financial derivatives are instruments that derive their value from financial assets. These

assets can be stocks, bonds, currency etc. These derivatives can be forward rate

agreements, futures, options swaps etc. As stated earlier, the most traded instruments

are futures and options.

3.3 Features of Derivatives

Hedging: To minimize risk arising due to volatility of the market.

Price Discovery: To have better price discovery in terms of huge no. of players.

Liquidity Function: To infuse liquidity in the market by way of lot size trading.

Trading Volumes: To generate huge trading volumes by way of mass trading.

Types of Derivatives

The most commonly used derivatives contracts are forwards, futures and options. Lets

take a brief look at various derivatives contracts that have come to be used.

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

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

Futures: A futures contract is an agreement between two parties to buy or sell an asset at

a certain time in the future at a certain price. Futures contracts are special types of

forward contracts in the sense that the former are standardized exchange-traded

contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price on or

before a given future date. Puts give the buyer the right, but not the obligation to sell a

given quantity of the underlying asset at a given price on or before a given date.



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Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows

between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the

parties, with the cash flows in one direction being in a different currency than

those in the opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-dated options

are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are

options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average or a basket of assets. Equity index options are a form of

basket options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. 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.



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Players in Derivatives

Hedgers: Hedgers face risk associated with the price of an asset they own. They

use derivatives to reduce or eliminate risk.

Speculators: Speculators bet on future movements in the prices of an asset.

Derivatives give them an extra leverage, by which they can increase both the

potential gains and losses.

Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two

different markets.

Jobbers: Jobbers take advantage from the spread between the Bid and Ask price.

3.4 Forwards: Meaning, Definition, Features, Players & Limitations

Meaning

A forward contract is a private contract between a buyer and a seller in which the buyer

agrees to buy and the seller agrees to sell a specific quantity of a certain security or

commodity (known as the underlying instrument ) at the price specified in the contract.

The difference between a forward contract and most other sales contracts is that with the

forward contract, the delivery and payment of the underlying instrument occurs at a

specified future date instead of immediately.

Definition

A forward contract is a customized contract between two parties, where settlement takes

place on a specific date in future at a price agreed today.



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Features of Forwards

The salient features of forward contracts are:

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract size,

expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of the asset.

• If the party wishes to reverse the contract, it has to compulsorily go to the same

counter-party, which often results in high prices being charged.

Players in Forwards

Hedgers: The one who intends to minimize this risk which respect to price

fluctuations

Speculators: The one who speculates / anticipates the price movement in order to

make maximum profits.

Limitations of Forwards

Lack of centralization of trading

Illiquidity

Counter party risk

In the first two of these, the basic problem is that of too much flexibility and generality.

The forward market is like a real estate market in that any two consenting adults can form

contracts against each other. This often makes them design terms of the deal which are

very convenient in that specific situation, but makes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the

transaction. When one of the two sides to the transaction declares bankruptcy, the other

suffers. Even when forward markets trade standardized contracts, and hence avoid the

problem of illiquidity, still the counterparty risk remains a very serious issue.



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Section 4: Futures

4.1 Meaning

Future contracts is an agreement made and traded on the exchange between two parties

to buy or sell a commodity at a particular time in the future for a pre-defined price. Since

both the parties are unaware of each other, the exchange provides a mechanism to give

the party assurance of honored contract. The exchange specifies standardized features of

the contract. The risk to the holder is unlimited, and because the pay off pattern is

symmetrical, the risk to the seller is unlimited as well.

Money lost and gained by each party on a futures contract are equal and opposite. In

other words, futures trading are a zero-sum game. These are basically forward contracts,

meaning they represent a pledge to make a certain transaction at a future date. The

exchange of assets occurs on the date specified in the contract. These are regulated by

overseeing agencies, and are guaranteed by clearing houses. Hedgers often trade futures

for the purpose of keeping price risk in check.

Future contracts are often used by commercial enterprises as ‘hedging tools’ to reduce

the risk of expected future purchases or sales of the underlying asset. If used to

speculate, risk increases. So risk depends on the underlying instrument and the use of the

future.

Advantages of Futures Contracts

•

If price moves are favourable, the producer realizes the greatest return with this

marketing alternative.

• No premium charge is associated with futures market contracts.



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Disadvantages of Future Contracts

• Subject to margin calls

• Unable to take advantage of favourable price moves

• Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occur in future. But

Options are contract on the underlying futures contract where as futures are either to

accept or deliver the actual physical commodity. To make a decision between using a

futures contract or an options contract, producers need to evaluate both alternatives.

4.2 Terminologies

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

• Futures price: The price at which the futures contract trades in the futures market.

• Contract cycle: The period over which a contract trades. The index futures contracts

on the NSE have one- month, two-months and three- months expiry cycles which

expire on the last Thursday of the month. Thus a January expiration contract expires

on the last Thursday of January and a February expiration contract ceases trading on

the last Thursday of February. On the Friday following the last Thursday, a new

contract having a three- month expiry is introduced for trading.

• Expiry date: It is the date specified in the futures contract. This is the last day on

which the contract will be traded, at the end of which it will cease to exist.

• Contract size: The amount of asset that has to be delivered under one contract. Also

called as lot size.



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• Basis: In the context of financial futures, basis can be defined as the futures price

minus the spot price. There will be a different basis for each delivery month for each

contract. In a normal market, basis will be positive. This reflects that futures prices

normally exceed spot prices.

• Cost of carry: The relationship between futures prices and spot prices can be

summarized in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance the asset less the income earned on the

asset.

•

Initial margin: The amount that must be deposited in the margin account at the timea futures contract is first entered into is known as initial margin.

• Marking-to-market: In the futures market, at the end of each trading day, the margin

account is adjusted to reflect the investor's gain or loss depending upon the futures

closing price. This is called marking-to-market.

• Maintenance margin: This is somewhat lower than the initial margin. This is set to

ensure that the balance in the margin account never becomes negative. If the balance

in the margin account falls below the maintenance margin, the investor receives a

margin call and is expected to top up the margin account to the initial margin level

before trading commences on the next day.



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Propose of Futures

Hedging: Hedging is a mechanism to reduce price risk. Price Risk can be reduced

by taking an opposite position in futures market. Hedging can be initiated by

Selling Nifty Futures or a stock ….hedge can be for 20%, 50% or 100% based on

view. Ideally 25 – 35% hedge is kept at all times, then based on view, its increased

or decreased.

Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two

different markets.

Eg. Buy L&T in cash market @ Rs. 800/- sell in future market @ Rs .840/- thereby

profit Rs. 40/-

Jobbing: Jobbing is nothing but taking advantage from the spread between the Bid

and Ask price.

Eg. Powergrid

4.3 Payoff Profile

A payoff is the likely profit or loss that would accrue to a market participant with

change in the price of the underlying asset

Futures have a linear payoff, i.e. the losses as well as profits for the trader of

futures contract are unlimited



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-250

-150

-50

50

150

250

1,000 1,100 1,200 1,300 1,400 1,500

-250

-150

-50

50

150

250

1, 000 1,100 1,200 1,300 1,400 1,500

Payoff for Futures Buyer

Payoff for Futures Seller



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4.4 Numericals

Q.1. Krishna Seth sold a January Nifty futures contract for Rs.240,000 on 15th

January.

Each Nifty futures contract is for delivery of 100 Nifties. On 25th

January, the index closed

at 2350. How much profit/loss did she make?

a. -7,000

b. -5,000

c. +5,000

d. +7,000

Solution: Krishna Seth sold one futures contract costing her Rs.240,000. At a market lot of

100, this works out to be Rs.2400 per Nifty future. On the futures expiration day, the

futures price converges to the spot price. If the index closed at 2350, this must be the

futures close price as well. Hence she will have made of profit of (2400 - 2350)*100. The

correct answer is number 3.

Q.2. Santosh is bullish about Company XYZ and buys ten one- month XYZ futures contracts

at Rs.2,96,000. On the last Thursday of the month, XYZ closes at Rs.271. He makes a ___

a. profit of Rs. 15000

b. profit of Rs.25000

c. loss of Rs.15000

d. loss of Rs.25000

Solution: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures, i.e.

2,96,000/(10 * 100). On expiration day the spot and futures converge. Therefore he

makes a loss of (296 - 271) * 1000 = 25000. The correct answer is number 4.



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Q.3. Rajiv is bearish about Company ABC and sells twenty one- month ABC futures

contracts at Rs.3,04,000. On the last Thursday of the month, ABC closes at Rs.134. He

makes a _____.

a. profit of Rs. 18000

b. profit of Rs.36000

c. loss of Rs. 18000

d. loss of Rs.36000

Solution: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures, i.e.

3,04,000/(20 * 100). On expiration day the spot and futures converge. Therefore his profit

is (152-134) * 2000 = 36000. The correct answer is number 2.

Q.4. Ms. Sweta is short on NTPC; the details of her position are as follows:

Lot size: 1625 Shares

Net Future Value: Rs. 2, 59,431.25/-

Initial Margin: 33.95%Span Margin / Maintenance Margin: 23.95%

At what price will she get the margin call and what is the Margin Amount she has to bring

in if she gets a margin call from her broker?

a. Price Rs. 172.55/- and Amount Rs. 22350.50/-

b. Price Rs. 175.62/- and Amount Rs. 25,943.13/-

c. Price Rs. 181.13/- and Amount Rs. 30,056.25/-d. Price Rs. 180.00/- and Amount Rs. 29,596.50/-



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Q.5. Mr. Ankit is long on BHEL, the details of her position are as follows:

Lot size: 75 Shares

Price: Rs. 1355/- per share

Initial Margin: 34.26%

Span Margin / Maintenance Margin: 24.26%

At what price will she get the margin call and what is the Margin Amount she has to bring

in if she gets a margin call from her broker?

a. Price Rs. 1219.50/- and Amount Rs. 10,162.50/-

b. Price Rs. 1220.50/- and Amount Rs. 10,262.50/-

c. Price Rs. 1221.50/- and Amount Rs. 10,362.50/-

d. Price Rs. 1222.50/- and Amount Rs. 10,462.50/-



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Section 5: Options

5.1 Meaning

Options give the buyer the right not the obligation to buy or sell a specified underlying at a

set price, on or before a specified date

5.2 Terminologies

Index options: These options have the index as the underlying. Some options are

European while others are American. Like index futures contracts, index options contracts

are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on

over 500 stocks in the United States. A contract gives the holder the right to buy or sell

shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium

buys the right but not the obligation to exercise his option on the seller/writer.

Seller / Writer of an option: The writer of a call/put option is the one who receives the

option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset

by a certain date for a certain price.



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Put option: A put option gives the holder the right but not the obligation to sell an asset

by a certain date for a certain price.

Option price/premium: Option price is the price which the option buyer pays to the

option seller. It is also referred to as the option premium.

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

date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the

exercise price.

American options: American options are options that can be exercised at any time upto

the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only on the

expiration date itself. European options are easier to analyze than American options, andproperties of an American option are frequently deduced from those of its European

counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a

positive cash flow to the holder if it were exercised immediately. A call option on the

index is said to be in-the-money when the current index stands at a level higher than the

strike price (i.e. spot price > strike price). If the index is much higher than the strike price,the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the

strike price.



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At-the-money option: An at-the-money (ATM) option is an option that would lead to zero

cashflow if it were exercised immediately. An option on the index is at-the-money when

the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would

lead to a negative cashflow if it were exercised immediately. A call option on the index is

out-of-the-money when the current index stands at a level which is less than the strike

price (i.e. spot price < strike price). If the index is much lower than the strike price, the call

is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike

price.

Intrinsic value of an option: The option premium can be broken down into two

components - intrinsic value and time value. The intrinsic value of a call is the amount the

option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

Time value of an option: The time value of an option is the difference between its

premium and its intrinsic value. Both calls and puts have time value. An option that is

OTM or ATM has only time value. Usually, the maximum time value exists when theoption is ATM. The longer the time to expiration, the greater is an option's time value, all

else equal. At expiration, an option should have no time value.

ITM-OTM-ATM – Thumb Rule

Market Scenario Call Option Put Option

Market Price > Strike Price ITM OTM

Market Price < Strike Price OTM ITM

Market Price = Strike Price ATM ATM



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Trading Strategies

Strategy 1:

Strategy: 2



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5.3 Payoff Profile

Payoff Profile of a Call Buyer:

The maximum loss for a call optionbuyer is the premium paid by him,

while maximum gains are

unlimited.

Payoff Profile of a Call Seller:

The maximum gain for a seller of the

call option is premium

Payoff Profile of a Put Buyer:

The maximum loss for a buyer of

the put option is the premium paid

by him, while maximum gains are

unlimited.

Payoff Profile of a Put Seller:

The maximum gain for a seller of

the put option is premium.

-250

-200

-150

-100

-50

0

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1,000 1,100 1,200 1,250 1,350 1,450 1,550

-150

-100

-50

0

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1,000 1,100 1,200 1,2 50 1 ,3 50 1 ,4 50 1 ,550

-150

-100

-50

0

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950 1050 1150 1250 1350 1450 1550

-250

-200

-150

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-50

0

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950 1050 1150 1250 1350 1450 1550



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Payoff Profile for Options – Thumb Rule

Call

Buyer • Profits unlimited

• Losses limited to the extend premium paid

Seller • Profits limited to the extend premium

received

• Losses unlimited

Put

Buyer • Profits unlimited

• Losses limited to the extend premium paid

Seller • Profits limited to the extend premium

received

• Losses unlimited

PCR – Put Call Ratio

Put Call Ratio means, the Volume of Put Options to the Volume of Call of Options.

As you may know, Put option indicates, the Price of the Stock is going to fall and a Call

Option buyer anticipates the Stock is going to rise.

When calls are more than Puts, means the anticipation of market moving up is more.

(Bullish Sentiment) When puts are more than calls, means it is a sentiment of Bearish

Market. At the end of the day, when Put to call ratio is taken; the overall market

sentiment can be captured.

• When Put - call ratio is Low, That means, Calls are more than Puts - BullIish Market

Sentiment.

• When Put - Call Ratio is high, that means, puts are more than calls, Bearish Market

Sentiment.



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PCR – Thumb Rule

PCR Higher Puts Are More Than Calls Bearish

PCR Lower Calls Are More Than Puts Bullish

Open Interest

Open Interest is the number of Outstanding Shares (yet to be settled), in the Futures and

Options trading. If you buy 2 futures from me, the Open Interest is 2. If I in turn buy 4

futures from C, the open interest is 6. These are un-setlled contracts. Thus to analyseOpen Interest, it needs to be analyzed along with Price of the Shares.

These are the 4 common analysis parameters:

Open Interest Analysis – Thumb Rule

Contract Increases Price Increases Bullish

Contract Increases Price Decreases Bearish

Contract Decreases Price Increases Bullish

Contract Decreases Price Decreases Bearish

Thus PCR needs to be studied in co-relation with Open Interest for a complete analysis.



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5.4 Numericals

Q.1. Chetan is bullish about the index. Spot nifty stands at 2200. He decides to buy one 3

month nifty call option contract with a strike of 2260 @ Rs. 60 a call. Three months

later the index closes at 2240. His payoff on the position is (Lot Size = 100)a. -7000

b. -4000

c. -12000

d. -6000

Solution: The call expires out of the money, so he simply loses the call premium he

paid, i.e 60 * 100 = Rs.6, 000. The correct answer is d.

Q.2. On 1st April, Ms. Sapna has bought 400 calls (1 Lot) on Cipla at a strike price of Rs200/- for a premium of Rs 20 per call. On expiry Cipla closes at Rs. 240/-. What is net

payoff in terms of profit / loss?

a. Profit of Rs. 16000

b. Profit of Rs. 8000

c. Loss of Rs. 16000

d. Loss of Rs. 8000

Solution: On the 400 calls sold by her, she receives a premium of Rs.8000. However

on the calls assigned to her, she loses Rs. 16,000(400 * (240-200)). Her payin

obligation is Rs.8000. The correct answer is b.

Q.3. Miss Manisha has sold 800 calls on Dr. Reddys Lab at a strike price of Rs. 882 at a

premium of Rs 25 per call on Jan 1st

. The closing price of equity shares on Dr. Reddys

lab is Rs. 884 on that day. If the call option is assigned to her on that day, what is her

net obligation on Jan 1st

?

a. Pay out of Rs. 18300

b. Pay in of Rs. 18300

c. Pay in of Rs 13800

d. Pay out of Rs. 18400

Solution: She will receive the premium amount of Rs. 20,000/- (i.e.800*25). Since she is an

option writer her max. profit is Rs. 20,000/- wherein losses can be unlimited. Now if the

price goes above 882 she stands to loose and if it remains @ 882 or goes below 882 she

stands to gain Rs. 20,000/-. As prices move up from 882 to 884 i.e. diff of Rs.2/- she stands

to loose Rs. 1600/- (800*2). Her profit amount has gone down by 1600, thus she will



Financial Markets

receive the payout from the exchange of Rs. 18400/- instead of Rs. 20,000/-. The correct

answer in d.

Q.4. Miss Shweta has sold 600 calls on DLF at a strike price of Rs. 1403 for a premium of Rs. 30 per call on March 1

st. The closing price of equity shares of DLF is Rs. 1453 on

that day. If the call option is assigned against her on that day, what is her net

obligation on March 1st

?

a. Pay out of Rs. 21600

b. Pay in of Rs 15000

c. Pay out of Rs 13400

d. Pay in of Rs 12000

Solution: She will receive the premium amount of Rs. 18,000/- (i.e.600*30). Since she is an

option writer her max. Profit is Rs. 18,000/- wherein losses can be unlimited. Now if the

price goes above 1403 she stands to loose and if it remains @ 1403 or goes below 1403

she stands to gain Rs. 18,000/-. As prices move up from 1403 to 1453 i.e. diff of Rs.50/-

she stands to loose Rs. 30,000/- (600*50). Now over here her entire profit amount of Rs.

18,000/- has got eroded but on top of that she has made a loss of 12,000/- (i.e. 30000 –

18000) thus she will have to pay in Rs. 12000 to the exchange. The correct answer in d.

Q.5. The May futures contract on XYZ Ltd. closed at Rs.3940 yesterday. It closes today at

Rs.3898.60. The spot closes at Rs.3800. Raju has a short position of 3000 in the May

futures contract. He sells 2000 units of May expiring put options on XYZ with a strike

price of Rs.3900 for a premium of Rs.110 per unit. What is his net obligation to/fromthe clearing

corporation today?

a. Payin of Rs.344200

b. Payout of Rs.640000

c. Payout of Rs.344200

d. Payin of Rs.95800

Solution: On the short position of 3000 May futures contract, he makes a profit of

Rs.124200 (i.e. 3000 * (3940 - 3898.60)). He receives Rs.220000 on the put options sold by

him. Therefore his net obligation from the clearing corporation is Rs.344200. The correct answer in c.

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