A study on financial derivative and risk management

GEOJIT BNP PARIBAS LTD

Kollam.

A project Report submitted to the Kerala University In partial fulfillment of the Requirements for the award Of the Degree of

Master of Business Administration

BY

RAJKUMAR.RS4MBA

Under the Guidance of Mrs.Lekshmi.MS

MEMBER SREE NARAYANA PILLAI INSTITUTE OF MANAGEMENT AND TECHNOLOGY

1

2008-2010

DECLARATION

I hereby declare that project entitled “A STUDY ON FINANCIAL

DERIVATIVE AND RISK MANAGEMENT IN GEOJIT BNP PARIBAS LTD

KOLLAM” is based on the original work carried by me under the supervision of

Mrs.LEKSHMI.MS Faculty towards partial fulfillment of the requirements for the M.B.A

course of Kerala University. This has not been submitted in part or full towards any other degree

or diploma.

Place: KOLLAM

Date:…………. RAJKUMAR.R

2

ACKNOWLEDGEMENT

I would like to express my sincere thanks to Dr.S.Gopinadhan. Director, Member Sree

Narayana Pillai Institute of Management and Technology, Chavara, Kollam, for inculcating

me the correct spirit of mind through his valuable advice for doing the training.

I place my heartfelt gratitude of special thanks to my project guide Mrs.Lekshmi.MS, Faculty,

Member Sree Narayana Pillai Institute of Management and Technology, Chavara, Kollam,

who helped me at all time with valuable suggestion to enable me to carry out the training with

great confidence and enthusiasm.

I wish to take this opportunity to express my deep sense of gratitude to

Mr.Rajesh.C,Manager,Geojit BNP Paribas (GQ) branch,Kollam for valuable guidance in

this endeavour.

It is my foremost duty to thank all my respondents, without which this training would not have

been possible.

Above all I bow before ALMIGHTY God whose sacred blessings are there without which I

would not have been completed this Industrial Training Programme.

Place: KOLLAM

Date : RAJKUMAR.R

3

TABLE OF CONTENTS

CHAPTER

NO. TITLEPAGE NO.

1INTRODUCTION

7-10

1.1General introduction

7

1.2Objective of the study

9

1.3Scope of the study

9

1.4Limitations

10

2COMPANY PROFILE

12-28

3DERIVATIVES

29-99

4 FINDINGS,SUGGESTIONS &

CONCLUSION

100-103

5BIBLIOGRAPHY

105

4

5

CHAPTER – 1

INTRODUCTION

General introduction

The liberalization of the Indian economy has ushered in an era of opportunities for

the Indian corporate sector. however, these opportunities are accomplished by challenges. The

corporate are now required to operate at global capacities to be able to reap the benefits of

economies of scale and be competitive. To operate at global capacities, huge investments are

called for and the main source of fund in the public at large. Therefore, the corporate now started

tapping the capital market in a big way. The response is also encouraging.

As the Indian nation integrates with world economy era, small tremors in the world

market starts affecting the Indian economy. As an example, interest rates have been south bound

in the world and the same has happened in the Indian market too. fixed income rates have fallen

drastically due to fall in the real income of people. To overcome this fall , investors have been

continuously seek to increase the yield of their of their investments. But, it is a time-tested fact

that, the yields on investment in equity shares are maximum, the accompanying risks are also

maximum. Therefore, it is absolutely essential that efforts should be made to reduce this factor.

The reduction of risk can be achieved through the process of ‘hedging’ using

‘derivatives’ financial instrument. A hedge is any act that reduced the price risk of an existing or

anticipated position in the cash market. Basically, there are two type of hedging with

futures :long hedge and short hedge.

6

Financial derivatives are a kind of risk management instrument. A derivative's

value depends on the price changes in some more fundamental underlying assets. Many forms of

financial derivatives instruments exist in the financial markets. Among them, the three most

fundamental financial derivatives instruments are: forward contracts, futures, and options. If the

underlying assets are stocks, bonds, foreign exchange rates and commodities etc., then the

corresponding risk management instruments are: stock futures (options), bond futures (options),

currency futures (options) and commodity futures (options) etc. In risk management of the

underlying assets using financial derivatives, the basic strategy is hedging, i.e., the trader holds

two positions of equal amounts but opposite directions, one in the underlying markets, and the

other in the derivatives markets, simultaneously. This risk management

strategy is based on the following reasoning: it is believed that under normal circumstances,

prices of underlying assets and their derivatives change roughly in the same direction with

basically the same magnitude; hence losses in the underlying assets (derivatives) markets can be

offset by gains

in the derivatives (underlying assets) markets; therefore losses can be prevented or reduced by

combining the risks due to the price changes. The subject of this book is pricing of financial

derivatives and risk management by hedging.

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SCOPE OF THE STUDY

Introduction of derivatives in the Indian capital market is the beginning of a new era ,

which is truly exciting. Derivatives, worldwide are recognized risk management products. These

products have a long history in India, in the unorganized sector , especially in currency and

commodity markets. The availability of these products on organized exchanges ha provided the

market participants with broad based risk management tools.

This study mainly covers the area of hedging and speculation. The main aim of the

study is to prove how risks in investing in equity shares can be reduced and how to make

maximum return to the other investment.

IMPORTANCE OF THE STUDY

It helps the researcher to construct a diversified portfolio.

Provide an insight on return and risk analysis.

It helps to make a general study on derivatives.

It helps to identify and reduce by using hedging strategies and speculation.

OBJECTIVE OF THE STUDY

To find out extant to which loss can be reduced by applying hedging strategies.

To determine whether the hedger enjoys better returns from the use of hedgers.

To identify how much reduction in risk is possible.

To find out the extend of loss due to misjudgment on index movements .

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LIMITATION OF THE STUDY

A) While applying the strategies , transaction cost and impact cost are not taken into

consideration.so,it will reflect in the profit calculation on each month of the study.

B) data were collected only on the basis of NSE trading

C) Hedging strategy is applied on historical data. so the direction of each trend in the stock

market is known before hand for the period selected. As a result, some bias could have

been done for the application of hedging strategy.

9

10

CHAPTER – 2

COMPANY PROFILE

PROFILE OF THE COMPANY

INTRODUCTION

Mr. C.J. George and Mr. Ranajit Kanjilal founded Geojit as a partnership firm. In

1993, Mr.Ranajit Kanjilal retired from the firm and Geojit became the proprietary concern of Mr.

C .J. George. In 1994, it became a Public Limited Company named Geojit Securities Ltd. The

Kerala State Industrial Development Corporation Ltd. (KSIDC), in 1995, became a co-promoter

of Geojit by acquiring a 24 percent stake in the company, the only instance in India of a

government entity participating in the equity of a stock broking company. The year 1995 also

saw Geojit being listed on the leading regional stock exchanges. Geojit listed at The Stock

Exchange, Mumbai (BSE) in the year 2000. Company’s wholly owned subsidiary, Geojit

Commodities Limited, launched Online Futures Trading in agri-commodities, precious metals

and energy futures on multiple commodity exchanges in 2003. This was also the year when the

company was renamed as Geojit Financial Services Ltd. (GFSL). The Board consists of

professional directors; including a Kerala Government nominee. With effect from July 2005, the

company is also listed at The National Stock Exchange (NSE). Company is a charter member of

the Financial Planning Standards Board of India and is one of the largest Depository

Participant(DP)..brokers..in..the..country.

On 31st December 2007, the company closed its commodities business and surrendered its

membership in the various commodity exchanges held by Geojit Commodities Ltd. Global

banking major BNP Paribas took a stake in the year 2007 to become the single largest

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shareholder. Consequently, Geojit Financial Services Limited was renamed as Geojit BNP

Paribas Financial Services Ltd.

ABOUT BNP PARIBAS

BNP Paribas is the Eurozone’s leading bank in terms of deposits, and one of the

10 most important banks in the world in terms of net banking income, equity capital and market

value. Furthermore, it is one of the 6 strongest banks in the world according to Standard &

Poor's. With a presence in 85 countries and more than 205,000 employees, 165,200 of which in

Europe, BNP Paribas is a global-scale European leader in financial services. It holds key

positions in its three activities: Retail banking, Investment Solutions and Corporate & Investment

Banking. The Group benefits from its four domestic markets: Belgium, France, Italy and

Luxembourg. BNP Paribas also has a significant presence in the United States and strong

positions in Asia and the emerging markets.

BNP Paribas has been operating in India since 1860 in a number of businesses such as

Investment Banking (CIB), Private banking (BNP Paribas Wealth Management), Life Insurance

(SBI Life) and Asset Management (Sundaram BNP Paribas), Infrastructure Funding (Srei BNP

Paribas), Retail Financing (Sundaram BNP Paribas Home Finance), Car Contract Hiring (Arval),

Institutional Broking (BNP Paribas Securities India) and Securities Services (Sundaram BNP

Paribas Securities Services and BNP Paribas Sundaram Global Securities Operations).

Retail..Financial..Services..Player

Geojit BNP Paribas today is a leading retail financial services company in India with a

growing presence in the Middle East. The company rides on its rich experience in the capital

market to offer its clients a wide portfolio of savings and investment solutions. The gamut of

value-added products and services offered ranges from equities and derivatives to Mutual Funds,

Life & General Insurance and third party Fixed Deposits. The needs of over 460 000 clients are

met via multichannel services - a countrywide network of 500 offices, phone service, dedicated

Customer..Care..centre..and..the..Internet.

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Geojit BNP Paribas has membership in, and is listed on, the National Stock Exchange (NSE)

and the Bombay Stock Exchange (BSE). In 2007, global banking major BNP Paribas joined the

company’s other major shareholders - Mr. C.J.George, KSIDC (Kerala State Industrial

Development Corporation) and Mr.Rakesh Jhunjhunwala – when it took a stake to become the

single..largest..shareholder.

Strategic joint ventures and business partnerships in the Middle East has provided the

company access to the large Non-Resident Indian(NRI) population in the region. Now, as a part

of the BNP Paribas global network, Geojit BNP Paribas is well positioned to further expand its

reach to NRIs in 85 countries. Barjeel Geojit Securities is the joint venture with the Al Saud

group in the United Arab Emirates that is headquartered in Dubai with branches in Abu Dhabi,

Ras Al Khaimah, Sharjah and Muscat. Aloula Geojit Brokerage Company headquartered in

Riyadh is the other joint venture with the Al Johar group in Saudi Arabia. The company also has

a business partnership with the Bank of Bahrain and Kuwait, one of the largest retail banks in

Bahrain..and..Kuwait.

At the forefront of the many fruitful associations between Geojit BNP Paribas and BNP

Paribas is their joint venture, namely, BNP Paribas Securities India Private Limited. This JV

was created exclusively for domestic and foreign institutional clients. An industry first was

achieved when Geojit BNP Paribas became the first broker in India to offer full Direct Market

Access(DMA) on NSE to the JV’s institutional clients.

A strong brand identity and extensive industry knowledge coupled with BNP Paribas’

international expertise gives Geojit BNP Paribas a competitive advantage.

Expanding..range..of..online..products..and..services

Geojit BNP Paribas has proven expertise in providing online services. In the year 2000, the

company was the first stock broker in the country to offer Internet Trading. This was followed

by integrating the first Bank Payment Gateway in the country for Internet Trading, and many

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other industry firsts. Riding on this experience, and harnessing BNP Paribas Personal Investors’

expertise as the leading online broker in Europe, is helping the company to rapidly expanding its

business in this segment. Presently, clients can trade online in equities, derivatives, currency

futures, mutual funds and IPOs, and select from multiple bank payment gateways for online

transfer of funds. Strategic B2B agreements with Axis Bank and Federal Bank enables the

respective bank’s clients to open integrated 3-in-1 accounts to seamlessly trade via a

sophisticated..Online..Trading..platform.

Further, deployment of BNP Paribas’ state-of-the-art globally accepted systems and processes is

already scaling up the sales of Mutual Funds and Insurance.

Wide..range..of..products..and..services

Certified financial advisors help clients to arrive at the right financial solution to meet their

individual needs. The wide range of products and services on offer includes -

Equities | Derivatives | Currency Futures | Custody Accounts | Mutual Funds | Life Insurance &

General Insurance | IPOs | Portfolio Management Services | Property Services | Margin Funding

|Loans..against..Shares

A..growing..footprint

With a presence in almost all the major states of India, the network of 500 offices across 300

cities and towns presently covers Andhra Pradesh, Bihar, Chattisgarh, Goa, Gujarat, Haryana,

Jammu & Kashmir, Karnataka, Kerala, Madhya Pradesh, Maharashtra, New Delhi, Orissa,

Punjab, Rajasthan,Tamil Nadu & Pondicherry, Uttar Pradesh, Uttarakhand and West Bengal.

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OVERSEAS JOINT VENTURES

Barjeel geojit securities, LLC Dubai, is a joint venture of geojit with al Saud group

belonging to sultan bin saud AL Qassemi having diversified interests in the area of equity

markets, real estates and trading. Barjeel geojit is a financial intermediary and the first

licensed brokerage company in USA.

It has facilities for off-line and on-line trading in Indian capital market and also in US,

European and far-eastern capital markets. it also provides depository services and deals in

Indian and international funds. An associate company, global financial investments

S.A.O.G provides similar services in Oman.

Aloua geojit brokerage company, is geojit’s recently promoted joint venture in Saudi

Arabia with the al johar group. Saudi is home to the world’s single largest NRI

population. The new venture is expected to start operations in the latter half of 2008.

The Saudi national and the NRI would be able to invest in the Saudi capital market. The

NRI would also be able to invest in the Indian stock market and in Indian mutual funds.

This joint venture makes geojit the first Indian stock broking company to commence

domestic retail brokerage operations in any foreign country.

OVERSEAS BUSINESS ASSOCIATION

Bank of Bahrain and Kuwait(BBK), one of the largest retail banks in Bahrain&

Kuwait through its NRI-Business, and geojit entered into an exclusive agreement in

September 2007. This association will provide the bank’s sophisticated client base, the

opportunity to diversify their holdings through investments in the Indian stock market.

Services offered are investment advisory,portfolio management, mutual funds, trading in

Indian equity market, demat and bank account, offline share transactions and PAN

CARD.

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MILESTONES BY GEOJIT BNP PARIBAS

1986 Membership in Cochin Stock Exchange (CSE).

       1994

Becomes a Public Limited Company named Geojit Securities Ltd.

       1995

Kerala State Industrial Development Corporation Ltd.(KSIDC) acquires 24 percent

equity stake.

Membership in National Stock Exchange (NSE).

Public Issue

       1996

Launch of Portfolio Management Services with SEBI registration.

       1997

Depository Participant (DP) under National Securities Depository Limited.

       1999

Membership in Bombay Stock Exchange (BSE).

       2000

BSE Listing.

1st broking firm in India to offer online trading facility.

Commences Derivative Trading with NSE.

Integrates the 1st Bank Payment Gateway in the country for Internet Trading.

       2001

16

Becomes India's first DP to launch depository transactions through Internet.

Establishes Joint Venture in the UAE to serve NRI customers.

       

2002

1st in India to launch an integrated internet trading system for Cash & Derivatives

segments.

      2003

Geojit Commodities Limited, wholly owned subsidiary, launched Online Futures Trading

in agri-commodities, precious metals and in energy futures on multiple commodity

exchanges.

National launch of online futures trading in Rubber, Pepper, Gold, Wheat and Rice.

Company renamed as Geojit Financial Services Ltd.

       2004

National launch of online futures trading in Cardamom.

        2005

NSE Listing.

Geojit Credits, a subsidiary, registers with RBI as a Non-Banking Financial Company

(NBFC).

National launch of online futures trading in Coffee.

       2006

Charter member of the Financial Planning Standards Board of India.

       2007

BNP Paribas takes a stake in the company’s equity, making it the single largest

shareholder.

Establishes Joint Venture in Saudi Arabia to serve the Saudi national and the NRI.

17

       2008

BNP Paribas Securities India (P) Ltd. – a Joint Venture with BNP Paribas S.A. for

Institutional Brokerage.

1st brokerage to offer full Direct Market Access execution in India for institutional

clients.

  

 2009

Launch of Property Services division.

Launch of online trading in Currency Derivatives.

Consequent to BNP Paribas becoming the largest stakeholder in Geojit Financial Services,

company is renamed as Geojit BNP Paribas Financial Services Ltd.

BOARD OF DIRECTORS

Mr. A. P. Kurian Non - Executive & Independent Chairman

Mr. C. J. George Managing Director & Chief Promoter

Mr. Manoj Joshi Non - Executive & Independent Director

Mr. Mahesh Vyas Non - Executive & Independent Director

Mr. Rakesh Jhunjhunwala Non - Executive Director)

Mr. Ramanathan Bupathy Non - Executive & Independent Director

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Mr. Punnoose George Non - Executive Director

Mr. Olivier Le Grand Non - Executive Director

Mr. Pierre Rousseau Non - Executive Director

MANAGEMENT

Name Designation

Mr. C. J. George Managing Director

Mr. Satish Menon Director (Operations)

Mr. A. Balakrishnan Chief Technology Officer

Mr. K. Venkitesh National Head - Distribution

Mr. Stefan Groening Director (Planning and Control)

Mr. Jean-Christophe G Director (Marketing)

Mr. Binoy .V.Samuel Chief Financial Officer

Mrs. Jaya Jacob Alexander Chief of Human Resources

CODE OF CONDUCT FOR THE DIRECTORS AND SENIOR OFFICERS

As per Clause 49 of the Listing Agreement with the Stock Exchanges, it shall be

obligatory for the Board of Directors of all listed Companies to lay down a code of conduct for

all Board members and senior management of the Company in order to ensure good Corporate

Governance.

I. CORPORATE GOVERNANCE Corporate governance is about commitment to values and

about ethical business conduct. It is about how an organization is managed. This includes its

corporate and other structures, its culture, its policies and the manner in which it deals with

various stakeholders. Accordingly, timely and accurate disclosure of information regarding the

financial situation, performance, ownership and governance of the company, is an important part

of corporate governance. This improves public understanding of the structure, activities and

19

policies of the organization. Consequently, the organization is able to attract investors, and to

enhance the trust and confidence of the stakeholders.

We believe that sound corporate governance is critical to enhance and retain investor trust.

Accordingly, we always seek to attain our performance rules with integrity. The Board extends

its fiduciary responsibilities in the widest sense of the term. Our disclosures always seek to attain

the best practices in international corporate governance. We are also responsible to enhance long

term shareholder value and respect minority rights in all our business decisions.

II. INTRODUCTION OF CODE (Preamble)

This Code of Ethics for Directors and Senior Executives (the “Code”) helps to maintain the

standards of business conduct for Geojit BNP Paribas Financial Services Limited (the

“Company”) and ensures compliance with legal requirements particularly of Companies Act,

SEBI Regulations and the Listing Agreement with Stock Exchanges. The purpose of the Code is

to deter wrongdoing and promote ethical conduct. The matters covered in this Code are of utmost

importance to the Company, our shareholders and our business partners. Further, these are

essential so that we can conduct our business in accordance with our stated values.

The Code is applicable to the following persons, referred to as “Officers” :

Directors of the Company

Our Senior Management

Members of the Board of Subsidiary Company

Ethical business conduct is critical to our business. Accordingly, Officers are expected to read

and understand this Code, uphold these standards in day-to-day activities, and comply with all

applicable laws, rules and regulations, the Geojit BNP Paribas Code of Conduct, Service rules

and all applicable policies and procedures adopted by the Company that govern the conduct of its

employees.

Because the principles described in this Code are general in nature, Officers should also review

the Company’s other applicable policies and procedures.

20

Officers should sign the acknowledgment form at the end of this Code and return the form to the

HR department indicating that they have received, read and understood, and agree to comply

with the Code. The signed acknowledgement form should be available with officers concerned.

Each year, as part of their annual review, Officers will be asked to sign an acknowledgement

indicating their continued understanding and adherence of the code.

III. HONEST AND ETHICAL CONDUCT

We expect all Officers to act in accordance with highest standards of personal and professional

integrity, honesty and ethical conduct, while working on the Company’s premises, at offsite

locations where the Company’s business is being conducted, at Company sponsored business

and social events, or any other place where Officers are representing the Company.

We consider honest conduct to be conduct that is free from fraud or misrepresentation or

deception. We consider ethical conduct to be conduct conforming to the accepted professional

standards of conduct. Ethical conduct includes ethical handling of actual or apparent conflicts of

interest between personal and professional relationships. This is discussed in more detail in

Section..IV..below.

IV.CONFLICTS..OF..INTEREST

An Officer’s duty to the Company demands that he or she avoids and discloses actual and

apparent conflicts of interest. A conflict of interest exists where the interests or benefits of one

person or entity conflict with the interests or benefits of the Company. Examples include:

A. Employment/Outside employment:With regard to the employment with the Company,

Officers are expected to devote their full attention to the business interests of the

Company. Officers are prohibited from engaging in any activity that interferes with their

employment with the Company. Our policies prohibit Officers from accepting

simultaneous employment with suppliers, customers, developers or competitors of the

Company, or from taking part in any activity that enhances or supports a competitor’s

position. Additionally, Officers must disclose to the Company’s Audit Committee, any

interest that they have that may conflict with the business of the Company.

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B. Outside directorships: It is a conflict of interest to serve as a director of any company that

competes with the Company. Officers must first obtain approval from the Company’s

audit committee before accepting a directorship.

C. Business Interests: If an Officer is considering investing in any customer, supplier,

developer or competitor of the Company, he or she must first take care to ensure that

these investments do not compromise on their responsibilities to the Company. Our

policy requires that Officers first obtain approval from the Company’s Audit Committee

before making such an investment. Many factors should be considered in determining

whether a conflict exists, including the size and nature of the investments, the Officer’s

ability to influence the Company’s decisions, his or her access to confidential information

of the Company or of the other company, and nature of the relationship between the

Company and the other company. At the time of application for approval, full facts of the

proposed investment shall be placed before the Committee.

D. Related parties: As a general rule, Officers should avoid conducting Company’s business

with a relative, or have business in which a relative is associated in any significant role. A

relative means and includes spouse, children, parents, grandparents, grandchildren, aunts,

uncles, nieces, nephews, cousins, step relationships, and in-laws. Subject to the rules and

regulation, the Company discourages the employment of relatives of Officers in key

positions or assignments within the same department. Further, the Company prohibits the

employment of such individuals in positions that have a financial dependence or

influence (e.g. an auditing or control relationship, or a supervisor/subordinate

relationship). Every employee drawing a monthly salary of Rs.10,000/- or more shall

disclose whether he is a relative or not of any of our directors.

E. Payments or gifts from others: Under no circumstance the Officers shall accept any offer,

payment, promise to pay, or authorisation to pay any money, gift, or anything of value

22

from customers, vendors, consultants, etc., that is perceived as intended, directly or

indirectly, to influence any business decision, any act or failure to act, any commitment

of fraud, or opportunity for the commitment of any fraud. Inexpensive gifts, infrequent

business meals, celebratory events and entertainment, provided that they are not

excessive or create an appearance of impropriety, do not violate this policy. Questions

regarding whether a particular payment or gift violates this policy are to be directed to

Finance Department. Gifts given by the Company to suppliers or customers should be

appropriate to the circumstances and should never be of a kind that could create an

appearance of impropriety. The nature and cost must always be accurately recorded in the

Company’s books and records.

F. Corporate opportunities: Officers may not exploit for their own personal gain,

opportunities that are discovered through the use of corporate property, information or

position, unless the opportunity is disclosed fully in writing to the Company’s Board of

Directors and the Board declines to pursue such opportunity.

G. Interested Contracts: Except with the consent of the Board of Directors of the Company,

any of the Director or his relative or a firm in which a director or his relative is a partner,

any other partner in such a firm, or a private company of which the director is a member

or director shall enter into any contract Whistle Blower Policy: Employees who came

across any unethical or improper practice (not necessarily a violation of law) shall be free

to approach the Audit Committee without necessarily informing their supervisors. All

officers are requested to inform their subordinates about their this right through an

effective manner. For any clarification in this regard please contact Finance Department /

Secretarial Department / Legal Department.

H. Other Situations: It would be impractical to attempt to list all possible situations. If a

proposed transaction or situation raises any questions or doubts, please contact Finance

Department.

23

I. V. COMPLIANCE WITH GOVERNMENTAL LAWS, RULES AND

REGULATIONS

Officers must comply with all applicable governmental laws, rules and regulations,

Officers must acquire appropriate knowledge of the legal requirements relating to their

duties sufficient to enable them to recognise potential dangers, and to know when to seek

advice from the Finance Department. Violations of applicable governmental laws, rules

and regulations will lead to penal action as specified in the respective statutes. In any

doubt about the compliance with laws rules/regulations /guidelines contact appropriate

department of the Company.

VI.…VIOLATIONS..OF..THE..CODE

Part of an Officer’s job, and of his or her ethical responsibility, is to help enforce

this Code. Officers should be alert against possible violations and report this to

appropriate department. Officers must co-operate in any internal or external

investigations of possible violations. Reprisal, threat, retribution or retaliation against any

person who has, in good faith, reported a violation or a suspected violation of law, this

Code or other Company policies, or against any person who is assisting in any

investigation or process with respect to such a violation, is prohibited.

The Company will take appropriate action against any Officer whose actions are

found to violate the Code or any other policy of the Company. Disciplinary actions may

include immediate termination of employment at the Company’s sole discretion. Where

the Company has suffered a loss, it may pursue its remedies against the individuals or

entities responsible. Where laws have been violated, the Company will cooperate fully

with the appropriate authorities.

VII. WAIVERS AND AMENDMENTS OF THE CODE

We are committed to continuously reviewing and updating our policies and

procedures. Therefore, this Code is subject to modification. Any amendment or waiver of

any provision of this Code must be approved in writing by the Company’s Board of

Directors and promptly disclosed on the Company’s website and in applicable regulatory

24

filings pursuant to applicable laws and regulations, together with details about the nature

of amendment or waiver. with the Company for sale, purchase or supply of goods,

materials or services, or for underwriting the subscription of any shares in or debentures

of the Company except for purchase or sale of goods for market price or such contracts

which either party regularly trades or does business. For any clarification in this regard,

the officers are requested to contact to the Finance Department / Secretarial Department /

Legal Department.

J. Whistle Blower Policy: Employees who came across any unethical or improper practice

(not necessarily a violation of law) shall be free to approach the Audit Committee without

necessarily informing their supervisors. All officers are requested to inform their

subordinates about their this right through an effective manner. For any clarification in

this regard please contact Finance Department / Secretarial Department / Legal

Department.

K. Other Situations: It would be impractical to attempt to list all possible situations. If a

proposed transaction or situation raises any questions or doubts, please contact Finance

Department.

V. COMPLIANCE WITH GOVERNMENTAL LAWS, RULES AND REGULATIONS

Officers must comply with all applicable governmental laws, rules and regulations, Officers must

acquire appropriate knowledge of the legal requirements relating to their duties sufficient to

enable them to recognise potential dangers, and to know when to seek advice from the Finance

Department. Violations of applicable governmental laws, rules and regulations will lead to penal

action as specified in the respective statutes. In any doubt about the compliance with laws

rules/regulations /guidelines contact appropriate department of the Company.

VI…VIOLATIONS..OF..THE..CODE

Part of an Officer’s job, and of his or her ethical responsibility, is to help enforce this Code.

Officers should be alert against possible violations and report this to appropriate department.

25

Officers must co-operate in any internal or external investigations of possible violations.

Reprisal, threat, retribution or retaliation against any person who has, in good faith, reported a

violation or a suspected violation of law, this Code or other Company policies, or against any

person who is assisting in any investigation or process with respect to such a violation, is

prohibited.

The Company will take appropriate action against any Officer whose actions are found to violate

the Code or any other policy of the Company. Disciplinary actions may include immediate

termination of employment at the Company’s sole discretion. Where the Company has suffered a

loss, it may pursue its remedies against the individuals or entities responsible. Where laws have

been violated, the Company will cooperate fully with the appropriate authorities.

VII. WAIVERS AND AMENDMENTS OF THE CODE

We are committed to continuously reviewing and updating our policies and procedures.

Therefore, this Code is subject to modification. Any amendment or waiver of any provision of

this Code must be approved in writing by the Company’s Board of Directors and promptly

disclosed on the Company’s website and in applicable regulatory filings pursuant to applicable

laws and regulations, together with details about the nature of amendment or waiver.

26

27

CHAPTER – 3

DERIVATIVES

DERIVATIVES

The word “DERIVATIVES” is derived from the word itself derived of a

underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks,

commodities, stock indices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and

borrowing (bank) does not have its value borrow the value from underlying asset/ basic

variables.

Derivatives is derived from the following products:

A. Shares

B. Debuntures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

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Derivatives is a type of market where two parties are entered into a contract one is bullish and

other is bearish in the market having opposite views regarding the market. There cannot be a

derivatives having same views about the market. In short it is like a INSURANCE market where

investors cover their risk for a particular position.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived

from the value of an underlying primary financial instrument, commodity or index, such as:

interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes

in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.

Hedging is the most important aspect of derivatives and also its basic economic purpose. There

has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives

as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers

in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are

essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion

and acceptance of market economy, that has really contributed towards the growing awareness of

risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced

derivatives in the local currency Interest Rate markets, which have not really developed, but with

the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product

in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index

futures

INTRODUCTION TO FUTURE MARKET

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Futures markets were designed to solve the problems that exit in forward markets. A futures

con tract is an agreement between two parties to buy or sell an asset at a certain time in the future

at a certain price. There is a multilateral contract between the buyer and seller for a underlying

asset which may be financial instrument or physical commodities. But unlike forward contracts

the future contracts are standardized and exchange traded.

PURPOSE

The primary purpose of futures market is to provide an efficient and effective mechanism for

management of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are affected

mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has

to pay the margin to trade in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the

settlement day only, even though the payoffs are on a daily marking to market basis to avoid

default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts

with a fresh opening value. Here both the parties face an equal amount of risk and are also

required to pay upfront margins to the exchange irrespective of whether they are buyers or

sellers. Index based financial futures are settled in cash unlike futures on individual stocks which

are very rare and yet to be launched even in the US. Most of the financial futures worldwide are

index based and hence the buyer never comes to know who the seller is, both due to the presence

of the clearing corporation of the stock exchange in between and also due to secrecy reasons

EXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares.

Suppose the stock rises to 2200.

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Profit

20 2200 10 0 1400 1500 1600 1700 1800 1900 -10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400

Profit

20 10 0 1400 1500 1600 1700 1800 1900 -10

-20

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is 250.

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Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some

date in the future. Futures are often used by mutual funds and large institutions to hedge their

positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or

the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in

proportion to the total value of contract

MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract.

Normally the margin requirement has been designed on the concept of VAR at 99% levels.

Based on the value at risk of the stock/index margins are calculated. In general margin ranges

between 10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on

their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin

approximately equals the maximum daily price fluctuation permitted for the contract being

traded. Upon proper completion of all obligations associated with a traders futures position, the

initial margin is returned to the trader.

OBJECTIVE

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The basic aim of Initial margin is to cover the largest potential loss in one day. Both

buyer and seller have to deposit margins. The initial margin is deposited before the opening of

the position in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than

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 to top up the margin account to the initial level before trading

commencing on the next level.

EXAMPLE:-

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty

futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%.

The lot size of nifty futures =200.suppose on MAY 16th

The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the

market. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)

Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th nifty futures settled at 1400.

Profit of buyer will be 10,000[(1450-1350)*200]

Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)

Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

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As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600

While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]

Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)

Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to the

settlement price on a daily basis. Deficiencies in margin requirements are called for the broker,

through margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the

exchange. This is generally imposed when the exchange fears that the markets have become too

volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by

exchange to prevent breakdown.

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.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper

evaluation is done. E.g. Investor has purchase the Wipro FUTURES. and pays the Initial margin.

Suddenly script of Wipro falls then the investor is required to pay the mark-to-market margin

also called as variation margin for trading in the future contract

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HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change to which they are

already exposed.It is a mechanism by which the participants in the physical/ cash markets can

cover their price risk. Hedgers are those persons who don’t want to take the risk therefore they

hedge their risk while taking position in the contract. In short it is a way of reducing risks when

the investor has the underlying security.

PURPOSE:

“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”

Figure 1.1

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages Availability of Leverage

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STRATEGY:

The basic hedging strategy is to take an equal and opposite position in the futures market to the

spot market. If the investor buys the scrip in the spot market but suddenly the market drops then

the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification.

Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging is

implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging

eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes

risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk).

Diversification is affected by choosing a group of assets instead of a single asset (technically, by

adding positively and imperfectly correlated assets).

Example:-

Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of

manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is

completed.

COST SELLING PRICE PROFIT

400 1000 600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the

contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if

Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.

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Shyam defaults Shyam honors

400 (Initial Investment) 600 (Initial profit)

400 (penalty from Shyam (-100) discount given to Shyam

- (No gain/loss) 500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial

investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of

Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and

protected his initial investment.

Now let’s see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that the

market would go down due to some news. Then, to minimize your downside risk you could

hedge your position by buying a Put Option. This will hedge your downside risk in the market

and your loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging

is the removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less

profits than the un-hedged 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 reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are

not subject to margins as in hedging through futures. Options buyers are however required to pay

premium which are sometimes so high that makes options unattractive.

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Example:-

With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the

investor excepts that price will fall by 100.So he decided to buy the put Option b y paying the

premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally

stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor

recovered Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position. Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the security, without any extra risk from fluctuations of the market index. Finally the investor has “HEDGED AWAY” his index exposure.

LONG SECURITY, SELL FUTURES

Here stock futures can be used as an effective risk –management tool. In this case the investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the risk the Hedger enters into a future contract and takes a short position. However the losses suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390Market action = 350Loss = 40Strategy = BUY SECURITY, SELL FUTURESTwo month Futures= 390Premium = 12Short position = 390

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Future profit = 40(390-350)

As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures

will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made

on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of

HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price.

Therefore the solution is buy put options on HLL.

The investor buys put option with a strike of Rs.240. The premium charged is

Rs.10.Here the investor has two possible scenarios three months later.

1) IF PRICE RISES Market action: 215 Loss : 17(232-15) Strike price : 240 Premium : 08 Profit : 17(240-215-8)

Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option bought.

2) IF PRICE RISES: Market share : 250 Loss : 10 Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike price investor chooses) and an unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and selling nifty futures. In the case

of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a

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position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the

LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on 1st May, 2001.

Company Beta Amount of Holding ( in Rs)

Infosys 1.55 400,000.00

Global Tele 2.06 200,000.00

Satyam Comp 1.95 175,000.00

HFCL 1.9 125,000.00

Total Value of Portfolio   1,000,000.00

Trading Strategy to be followed

The investor feels that the market will go down in the next two months and wants to protect him

from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY

futures i.e he has to sell June Nifty. This strategy is called Short Hedge.

Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level

Beta of the above portfolio

=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1st May 2001

= (1,000,000.00 * 1.61) / 1150

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= 1400 Units

Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short Hedge

  Stock Market Futures Market

1st May Holds Rs 1,000,000.00 in stock portfolio

Sell 7 NIFTY futures contract at 1150.

25th June Stock portfolio fall by 6% to Rs 940,000.00

NIFTY futures falls by 4.5% to 1098.25

Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00

  Net Profit: + Rs 15,450.00  

SPECULATORS:

If hedgers are the people who wish to avoid price risk, speculators are those who are willing to

take such risk. speculators are those who do not have any position and simply play with the

others money. They only have a particular view on the market, stock, commodity etc. In short,

speculators put their money at risk in the hope of profiting from an anticipated price change.

Here if speculators view is correct he earns profit. In the event of speculator not being covered,

he will loose the position. They consider various factors such as demand supply, market

positions, open interests, economic fundamentals and other data to take their positions.

SPECULATION IN THE FUTURES MARKET

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Speculation is all about taking position in the futures market without having the

underlying. Speculators operate in the market with motive to make money. They take:

Naked positions - Position in any future contract.

Spread positions - Opposite positions in two future contracts. This is a conservative

speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price

discovery in the market.

Figure 1.2

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading& carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premium hold till expiry.

Advantages

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*Greater Leverage as to pay only the premium.

*Greater variety of strike price options at a given time.

EXAMPLE:-

Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500

Strategy: Buy February PATNI futures contract at 1500

Lot size = 100 shares

Contract value = 1,50,000 (1500*100)

Margin = 15000 (10% of 150000)

Market action = rise to 1550

Future Gain:Rs. 5000 [(1550-1500)*100]

Market action = fall to 1400

Future loss: Rs.-10000 [(1400-1500)*100]

Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from

the view. He study the market and play the game with the stock market

TYPES:

POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until their

target is met.

DAY TRADERS:

. Day traders square off the position during the curse of the trading day and book the profits.

SCALPERS:

Scalpers in anticipation of making small profits trade a number of times throughout the day.

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SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he can buy put or call option

depending upon his perception about future price. If speculator has a bullish outlook, he will buy

calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If

speculator’s view is correct he earns profit. In the event of speculator not being covered, he will

loose the position. A Speculator will buy call or put if his price outlook in a particular direction

is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn

premium in the event of price situations.

Example:-

Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of

Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit

otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE

TELEFILMS stock will come down then he will buy put on the stale price until he can write

either call or put.

Finally Speculators provide depth an liquidity to the futures market an in their absence; the price

protection sought the hedger would be very costly.

STRATEGIES:

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish in the market.

Speculator buys the shares of the company an makes the profit. At the same time the Speculator

enters into the future contract i.e. buys futures and makes profit.

Spot Price of RELIANCE = 1000

Value = 1000*100shares = 1,00,000

Market action = 1010

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Profit = 1000

Initial margin = 20,000

Market action = 1010

Profit = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes

a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the

Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

BUY STOCK

ACC spot price : 150No of shares : 200Price : 150*200 = 30,000Market action : 160Profit : 2,000Return : 6.6% returns over 2months

BUY CALL OPTION:

Strike price : 150Premium : 8Lot size : 200 sharesMarket action :160Profit : (160-150-8)*200 = 400Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a investment of 2months as compared to 6.6% returns over a investment in stocks

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BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall in price. Here simple

arbitrage ensures that futures on an individual securities more correspondingly with the

underlying security as long as there is sufficient liquidity in the market for the security. If the

security price rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240

Lot size = 100shares Margin = 24Market action = 220Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit

because the speculator is bearish in the market and all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can “BUY OR SELL”

the entire index trading on one single security. Once a person is LONG NIFTY using the futures

market, the investor gains if the index rises and loss if the index falls.

1st July = Index will rise

Buy nifty July contract = 960

Lot =200

14th July nifty risen= 967.35

Nifty July contract= 980

Short position =980

Profit = 4000(200*20)

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ARBITRAGEURS :

Arbitrage is the concept of simultaneous buying of securities in one market where the price is

low and selling in another market where the price is higher.

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person

and ready to take the risk He is basically risk averse. He enters into those contracts were he can

earn risk less profits. When markets are imperfect, buying in one market and simultaneously

selling in other market gives risk less profit. Arbitrageurs are always in the look out for such

imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower

priced market and selling at the higher priced market.

JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where

the investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operating in them

simultaneously.

Figure 1.3

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way the promising as still game. another exchange. Market moves. in weekly settlement

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forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Example:

Current market price of ONGC in BSE= 500

Current market price of ONGC in NSE= 510

Lot size = 100 shares

Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES:

In this the investor observing that futures have been overpriced, how can the investor

cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month

ACC futures = 1025.

This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make

risk less profits entering into the following set f transactions.

On day one, borrow funds, buy security on the spot market at 1000

Simultansely, sell the futures on the security at1025

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Take delivery of the security purchased and hold the security for a month

on the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.1015. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures

position

Return the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit

possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash – and-

carry arbitrage.

BUY FUTURES, SELL SPOT:

In this the investor observing that futures have been under priced, how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 965.

This shows that futures have been under priced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.

On day one, sell the security on the spot market at 1000 Mae delivery of the security

Simultansely, buy the futures on the security at 965

On the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.975. Sell the security

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Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from the arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash – and- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between two markets. An

arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to

arbitraged between NIFTY in the futures market and the cash market. If the futures price is any

of the prices given below other than the equilibrium price then the strategy to be followed is

CASE-1

Spot Price of INFOSEYS = 1650

Future Price Of INFOSEYS = 1675

In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free profit Of Rs.25.

CASE-2

Future Price Of ACC = 675

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Spot Price of ACC = 700

In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer

(holder) the right, but not the obligation, to buy or sell specified quantity of the underlying

assets, at a specific (strike) price on or before a specified time (expiration date). The underlying

may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like

equity stocks/ stock index/ bonds etc.  

MONTHLY OPTIONS :The exchange trade option with one month maturity and the contract usually expires on last

Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as the

premium paid for hedging is very high. Also the trader has to pay more money to take a long or

short position which results into iiliquidity in the market.Thus to overcome the problem the BSE

introduced WEEKLY OPTIONS

WEEKLY OPTIONS:

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The exchange trade option with one or weak maturity and the contract expires on last Friday of

every week

ADVANTAGES

Weekly Options are advantageous to many to investors, hedgers and traders. The premium paid for buying options is also much lower as they have shorter time to

maturity. The trader will also have to pay lesser money to take a long or short position. the trader can take a larger position in the market with limited loss. On account of low

cost, the liquidity will improve, as more participants would come in. Weekly Options would lead to better price discovery and improvement in market depth,

resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of

the underlying asset at the strike price on or before expiration date. The seller (one who is short

call) however, has the obligation to sell the underlying asset if the buyer of the call option

decides to exercise his option to buy. To acquire this right the buyer pays a premium to the

writer (seller) of the contract.

Example:-

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market.The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660.

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Profit

30

20 10 0 590 600 610 620 630 640 -10

-20

-30 Loss

Unlimited profit for the buyer = Rs.35{(spot price – strike price) – premium}Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20 10 0 590 600 610 620 630 640 -10

-20

-30

Loss

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Profit for the Seller limited to the premium received = Rs.25Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent

Thus call option indicates two positions as follows:

LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying

call option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling

call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified

quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put

option (one who is short Put) however, has the obligation to buy the underlying asset at the strike

price if the buyer decides to exercise his option to sell.

Example:-

Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put seller) who is bullish in the market.

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The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be

excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer’s

breakeven point is Rs.780(Strike price – Premium paid). The buyer will earn profit once the

share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be

exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the

seller at Rs.800

Profit

20 10 0 600 700 800 900 1000 1100 -10

-20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) – premium} Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.

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profit

20 10 0 600 700 800 900 1000 1100 -10

-20 Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 - 750 = 30 Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITION If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put option.

SHORT POSITIONIf the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option

CALL OPTIONS PUT OPTIONSOption buyer oroption holder

Buys the right to buy the underlying asset at the specified price

Buys the right to sell the underlying asset at the specified price

Option seller oroption writer

Has the obligation to sell the underlying asset (to the option holder) at the specified price

Has the obligation to buy the underlying asset (from the option holder) at the specified price.

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FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)Changes in the underlying asset price can increase or decrease the premium of an option. These

price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and the

premium of a put will decrease. A decrease in the price of the underlying asset’s value will

generally have the opposite effect

THE SRIKE PRICE: (K)The strike price determines whether or not an option has any intrinsic value. An option’s

premium generally increases as the option gets further in the money, and decreases as the option

becomes more deeply out of the money.

Time until expiration: (t)An expiration approaches, the level of an option’s time value, for puts and calls, decreases.

Volatility:Volatility is simply a measure of risk (uncertainty), or variability of an option’s

underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction)

in underlying price levels. This expectation generally results in higher option premiums for puts

and calls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in

case of an option seller or received from alternative investments in the case of an option buyer

for the premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

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PLAYERS IN THE OPTION MARKET:

a) Developmental institutions

b) Mutual Funds

c) Domestic & Foreign Institutional Investors

d) Brokers

e) Retail Participants  

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60

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION : Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a

price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller

are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying

asset.

RISKFutures Contracts have symmetric risk profile for both the buyer as well as the seller.

While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the

option), the downside is limited to the premium (option price) he has paid while the profits may

be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits

are limited to the premium he has received from the buyer.

PRICES:The Futures contracts prices are affected mainly by the prices of the underlying asset.While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.

STRIKE PRICE:

In the Futures contract the strike price moves while in the option contract the strike price remains constant .

Liquidity:

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As Futures contract are more popular as compared to options. Also the premium charged

is high in the options. So there is a limited Liquidity in the options as compared to Futures.

There is no dedicated trading and investors in the options contract.

Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of

the underlying only. While trading in option is two-dimensional as the price of the option

depends upon the price and volatility of the underlying.

PAY OFF:

As options contract are less active as compared to futures which results into non linear

pay off. While futures are more active has linear pay off .

OPTION STRATAGIES:

1. BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month. However, the total investment is usually far less than that required to purchase the stock.

Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of 1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

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On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10

iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid.

The pay-off table:

PATNI COMPUTERS AT EXPIRATION

1485

(below

1490

(At the

1495

(Between

1500

(At BEP)1510

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lower price)

lower price)

lower strike &BEP

Intrinsic value of 1490 long call at expiration (a)

0 0 5 10 20

Premium paid (b) 25 25 25 25 25

Intrinsic value of 1510 short call at expiration (c)

0 0 0 0 0

Premium received (d) 15 15 15 15 15

profit/loss(a-c)-(b- d) -10 -10 -5 0 10

PATNI COMPUTERS AT EXPIRATION

1495

(below higher price)

1510

(At the higher price)

1505

(Between higher strike &BEP

1500

(At BEP)

1520

(Above BEP

Intrinsic value of 1510 short call at expiration (a)

0 0 0 0 10

Premium paid (b) 15 15 15 15 15

Intrinsic value of 1490 long call at expiration (c)

5 20 15 10 30

Premium received (d) 25 25 25 25 25

profit/loss(c-a)-( d - b) -5 10 5 0 10

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Profit

20 10 0 1490 1500 1510 1520 1530 1540 -10

-20

Loss

2. BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares.

Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract.

Premium = 10 ticks per contract(55 paid- 45 received)

Lot size = 200 shares

BREAK- EVEN- POINT= 5510-10 = 5500.

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

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On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the loss of Rs.10 through receiving the net premium.

If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium receive will generate profit .

iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received

If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium received between the strike price an premium paid.

iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic value. while the 4490 put option sold result in maximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic value. while the 5510 put option sold result in the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490 option sold will be assigned (strike price – premium paid) = profit .

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The pay-off table:

INFOSYS AT EXPIRATION

5520

(Above strike)

5510

(At the strike)

5505

(Between lower strike &BEP

5500

(At BEP)4480

Intrinsic value of 5510 long put at expiration (a)

0 0 5 10 30

Premium paid (b) 55 55 55 55 55

Intrinsic value of 4490 short put at expiration (c)

0 0 0 0 10

Premium received (d) 45 45 45 45 45

profit/loss(a-c)-(b- d) -10 -10 -5 0 10

INFOSYS AT EXPIRATION

5505

(Above strike)

4490

(At the strike)

4495

(Between strike &BEP

5500

(At BEP)

4480

(below strike price)

Intrinsic value of 4490 short put at expiration (a)

0 0 0 0 10

Premium received (b) 45 45 45 45 45

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Intrinsic value of 5510 long put at expiration (c)

5 30 15 10 30

Premium paid (d) 55 55 55 55 55

profit/loss[(c-a)-( d - b)] -5 20 15 0 10

Profit

20 10 0 3000 3500 4000 4500 5000 5500 6000 6500 7000 -10

-20

Loss

3. BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market to provide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

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Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell one month put of 1310 (higher price) and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid- 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1300-10 = 1290

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of 5.

iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless. While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t the premium received

iv. ABOVE STRIKE PRICE:

If the index is above1300 say 1310, the 1300 put option buyer has lost the premium while the 1310 put option seller receive premium to the limited profit

If the index is above 1310, say 1320 the 1290 put option buyer will have maximum loss results in deep out the money while the 1310 put option will have the limited profit.

v. BELOW STRIKE PRICE:

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If the index is below 1300 say (1290) , the 1300 put option buyer will have an intrinsic value of 10 while the 1310 put option sold receive only premium as the profit is limited for the seller.

4.BEAR CALL SPREAD:

This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. Here the investor buys a higher strike call and sells a lower strike call with the same expiration dates. However, the total investment is usually far less than that required to buy the stock or futures contract. The strategy has both limited profit potential and limited downside risk.

Current price of ACC is Rs. 1500

Here the investor buys one month call of 1510 at 25 ticks per contract and sell one month call of 1490 and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid - 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1510+10=1520

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

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On expiration if the stock of PATNI COMPUTERS is 1520 then the option will close at Breakeven. The call of 1510 will have an intrinsic value of 10 while the 1490 call option sold will expire worthless and also reduce the premium with the premium outflow.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 1490 and 1500 then the 1510 call option will have no intrinsic value and expire worthless, While 1490 call option sold will not expire which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1510 call option will have an intrinsic value of 0, while 1490 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1510 the 1510 call option will have no intrinsic value and expire worthless. While 1490 call sold receive only premium

If the index is at 1490, the 1510 call option will have no intrinsic value result in deep out the money, While 1490 call sold will have no intrinsic value and expire worthless

iv. ABOVE HIGHER PRICE :

IF the underlying stock is above 1510 say 1520, the 1510 call option will be in the money of Rs.10 while the 1490 option will incur loss to the premium receive

IF the underlying stock is above 1490 say Below1510, the 1510 call option will not be exercised while the 1490 option will incur loss to the premium receive because seller is bearish in the market.

v. BELOW STRIKE PRICE :

IF the underlying stock is below 1510, the 1510 call option will result in deep out the money and 1490 option sold result in loss to the premium paid.

5). STRADDLE:

In this strategy the investor purchase and sell the call as well as the put option of the same strike

price, the same expiration date, and the same underlying. In this strategy the investor is neutral in

the market.

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This strategy is often used by the SPECULATORS who believe that asset prices will move in

one direction or other significantly or will remain fairly constant.

TYPES:

LONG STRADDLE:

Here the investor takes a long position(buy) on the call and put with the same strike price and

same expiration date. In this the investor is beneficial if the price of the underlying stock move

substantially in either direction. If prices fall the put option will be profitable an if the prices rises

the call option will give gains. Profit potential in this strategy is unlimited ,While the loss is

limited up to the premium paid. This will occur if the spot price at expiration is same as the strike

price of the options.

SHORT STRADDLE:

This strategy is reverse of long straddle. Here the investor write(sell) the call as well as the put in

equal number for the same strike price an same expiration. This strategy is normally used when

the prices of the underlying stock is stable but the investor start suffering losses if the market

substantially moves in either direction .

Detailed example of a long straddle

Current market price of BAJAJ AUTO is Rs.600

Here the investor buys one month call of strike price 600 at 20 ticks per contract and two month put of strike price 600 for 15 ticks per contract.

Premium Paid = 35 ticks

Lot size = 400 shares

Lower Break- Even- Point = 600 – 35 = 565

Higher Break- Even- Point = 600 + 35 = 635

i. AT BREAK- EVEN- POINT:

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If the stock is at 565 or at 635, this option strategy will be at Break- Even- Point. At 565 the 600 call will have no intrinsic value an expire worthless but the 600 put will have an intrinsic value of 35.

At 635 the 600 call will have an intrinsic value of 35, while the put 600 will expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 550 then the 600 call will have no intrinsic value and expire worthless while 600 put will have an intrinsic value of 50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 650 the 600 call will have an intrinsic value of 50, while 600 put will have no intrinsic value an will expire worthless.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 6oo then the both call and put option will expire worthless which results in the loss of 35(premium).

The pay-off table:

BAJAJ AUTO AT EXPIRATION

550

(BELOW STRIKE AN D BELOW BEP )

600

(At the strike)

618

(BETWEEN STRIKE & HIGHERBEP

635

(At BEP)

650

(ABOVE STRIKE AN D ABOVE HIGHER BEP

Intrinsic value of 600 long call at expiration (a)

0 0 18 35 30

Premium paid (b) 20 20 20 20 20

Intrinsic value of 600 long put at expiration (c)

50 0 0 0 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -15 -17 0 5

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Profit

40 30

20 10

550 560 570 580 590 600 610 620 630 640 650

-10 -20 -30 -40

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BAJAJ AUTO AT EXPIRATION

550

(BELOW STRIKE AN D BELOW BEP )

600

(At the strike)

583

(BETWEEN STRIKE & LOWER BEP

565

(At LOWER BEP)

650

(ABOVE STRIKE AN D ABOVE HIGHER BEP

Intrinsic value of 600 long call at expiration (a)

0 0 0 0 30

Premium paid (b) 20 20 20 20 20

Intrinsic value of 600 long put at expiration (c)

50 0 17 35 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -15 -18 0 5

BEP

Loss

6. STRANGLE:In this strategy the investor is neutral in the market which involves the purchase of a higher call

and a lower put that are slightly out of the money with different strike price and with the

different expiration date. The premiums are lower as compared to straddle also the risk is more

involved as compare to straddle which not leads to the profit.

TYPES1) LONG STRANGLE: Here the investor purchases a higher call and a lower put with different strike price and with the different expiration date. A long strangle strategy is used to profit from a volatile price an loss from stable prices.

2) SHORT STRANGLE:

In this the investor sells a higher call and a lower put with different strike price and with the different expiration date. A short strangle strategy is used to profit from a stable prices an loss starts when price is volatile.

Detailed example of a short strangle

Current market price of BSE INDEX is Rs.4000

Here the investor sells a two month call of strike price 4050 for 20 ticks per contract and two month put of strike price 3950 for 15 ticks per contract.

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Premium Received = 35 ticks

Lot size = 300 shares

Lower Break- Even- Point = 3950 – 35 = 3915

Higher Break- Even- Point = 4050 + 35 = 4085

On Expiration:

i. AT BREAK EVEN POINT:

If the stock is at 3915 or at 4085, this option strategy will be at Break- Even- Point. At 3915 the 4050 call will have no intrinsic value and expire worthless but the 3950 put will have an intrinsic value of 35

At 4085 the 4050 call will have an intrinsic value of 35, while the put 400 will have no intrinsic value and expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 3900 then the 4050 call will have no intrinsic value and expire worthless while 3950 put will have an intrinsic value of 50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 4100 the 4050 call will have an intrinsic value of 50, while 3950 put will have no intrinsic value and will expire worthless.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 4000 then the both call and put option will expire worthless and limited profit up to the premium received.

v. AT STRIKE PRICE:

If the price is settled at 4050 then 4050 call and 3950 put will have limited profit upto the premium received

The pay-off table:

BSE INDEX AT 3900 4050 4070 4085 4100

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EXPIRATION (BELOW STRIKE AN D BELOW BEP )

(At the strike)

(BETWEEN STRIKE & HIGHER BEP)

(At HIGHER BEP)

(ABOVE STRIKE AN D ABOVE HIGHER BEP

Intrinsic value of 4050 Short call at expiration (a)

0 0 20 35 50

Premium Receive(b) 20 20 20 20 20

Intrinsic value of 3950 short put at expiration (c)

50 0 0 0 0

Premium Receive (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -35 -15 0 15

BSE INDEX AT EXPIRATION

3900

(BELOW STRIKE AN D BELOW BEP )

3950

(At the strike)

3930

(BETWEEN STRIKE & LOWER BEP

3915

(At LOWER BEP)

(ABOVE LOWER STRIKE AN D ABOVE LOWER BEP

Intrinsic value of 600 Short call at expiration (a)

0 0 0 0 0

Premium Receive(b) 20 20 20 20 20

Intrinsic value of 400 short put at expiration (c)

50 0 20 35 0

Premium Receive (d) 15 15 15 15 15

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profit/loss(a+c)-(b+ d) 15 -35 -15 0 -35

Profit

20 10 0 3900 3925 3950 3975 4000 4025 4050 4075 4100 -10

-20

Loss

7) COVERED CALL:

Under this strategy investors buys the shares which shows that they are bullish in the market but suddenly they are scared about the market falls thus they sells the call option. Here the seller

is usually negative or neutral on the direction of the underlying security. 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. Thus if price rises he will not participate in the rally. However he has now reduced loss by the amount of premium received, if prices falls.Finally if prices remains unchanged obtains the maximum profit potential.

EXAMPLE:

Portfolio: 100 shares purchased at Rs.300Components: Sell a two month Reliance call of 300 strike at 25Net premium: 25 ticksPremium received: Rs.2500 (25*100, the multiplier)Break-even-point: Rs.275:Rs.300-25 (Premium received)

Possible outcomes at expiration:

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Break – Even - Point

If the stock closes at 300, the 300 call option will not exercised and seller will receive the premium.If the stock ends at 275, the 300 call option expires worthless equilant to the premium received results into no profit no loss.If the stock ends above 300, the 300 call option is exercised and call writer receives the premium results into the maximum profit potential.

8) COVERED PUT:

Here the writer sell stock as well as put because he overall moderate bearish on the market and profit potential is limited to the premium received plus the difference between the original share price of the short position and strike price of the put. The potential loss on this position, however is substantial if price increases above the original share price of the short position. In this case the short stock will suffer losses which will be offset by the premium received.

9) UNCOVERED CALL:

This strategy is reverse of the covered call. There is no opposite position in the naked call. A call option writer (seller) is uncovered if the shares of the underlying security represented by the option is not owned by the option writer.

The object of an uncovered call writer is to realize income by writing (selling) option without committing capital to the ownership of the underlying shares.

This shows that the seller has one sided position in the contract for this the seller must deposit and maintain sufficient margin with the broker to assure that the stock can be purchased for delivery if option is exercised.

RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE AS FOLLOWS:-

If the market price of the stock rises sharply the calls could be exercised, while as far as the obligation is concerned the seller must buy the stock more than the option strike price, which results in a substantial loss.

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The rise of buying uncovered calls is similar to that of selling stock although, as an option writer, the risk is cushioned somewhat by the amount of premium received.

Example:-

Portfolio: Write reliance call of 65 strike Net premium: 6

Lot size: 100 shares

Market action: price settled at 55

Therefore the option will not be assigned because the seller has no stock position and price decline has no effect on the profit of the premium received.

Suppose the price settled at Rs.75 the option assigned and the seller has to cover the position at a net loss of Rs.400 [1000 (loss on covering call)- 600(premium income)]

Finally the loss is unlimited to the increase in the stock price and profit is limited to the declining stable stock price.

10) PROTECTIVE PUT:

Under this strategy the investor purchases the stock along with the put option because the investor is bearish in the market. This strategy enables the holder of the stock to gain protection from a surprise decline in the price as well as protect unrealized profits. Till the option expires, no matter what the price of underlying is, the option buyer will be able to sell the stock at strike price of put option.

SCENARIO

Price of HLL: 200

Components: Buy a one-month put of strike 200

Net premium: 10 ticks per contract

Premium paid: 1000 (10*100 multiplier)

Break-even-point: 210 (Rs.200+10, Premium paid)

Here the investor pays an additional margin of Rs.10 along with the price of Rs.210 combining a share with a put option is referred as a Protective Put.

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Possible outcomes at expiration

AT BREAK-EVEN-POINT:Previously if the price rises to 200 the investor will gain but now the investor pays an margin of Rs.10. If price rises to Rs.210 then only the investor will gain.

BELOW STRIKE PRICE:In case of fall in the stock price the loss is limited to Rs.18. This means that he maximum loss that the investor would have to bear is limited to the extent of premium paid.If the price falls at 190 the investor will sell at 200.

ABOVE STRIKE PRICE :In case of rise in prices then the put option will expire worthless and the investor will benefit from rise in the stock price.

Finally uncertainty is the biggest curse of the market and a protective put helps override the uncertainty in the markets. Protective put removes the uncertainty by limiting the investor loss at Rs.10. In this case no matter what happens to the investor is protected by the loss of Rs.10. The put option makes the investor life by telling the investor in advance how much it stands to loss. This is also referred to as PORTFOLIO INSURANCE because it helps the investor by insuring the value of investment just like any other asset for which the investor would purchase insurance.

PRICING OF AN OPTION

DELTA

A measure of change in the premium of an option corresponding to a change in the price of the underlying asset.

                Change in option premium Delta = --------------------------------                 Change in underlying price

FACTORS AFFECTING DELTA OPTION:

Strike price Risk free interest rate

Volatility

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Underlying price

Time to maturity

Example:-

The investor has buys the call option in the future contract for the strike price of Rs.19. The premium charged for the strike price of 19 at 0.80 The delta for this option is 0.5.Here if the price of the option rises to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.

Here in the money call option will increase the delta by 1.which will make the value more and expensive while at the money option have the delta to 0.5 and finally out the money call option will have the delta very close to 0 as the change in underlying price is not likely to make them valuable or cheap and reverse for the put option

Delta is positive for a bullish position (long call and short put) as the value of the position increases with rise in the price of the underlying. Delta is negative for a bearish position (short call and long put) as the value of the position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from –1 to 0 for put options. Some people refer to delta as 0 to 100 numbers.

ADVANTAGE

The delta is advantageous for the option buyer because it can tell him much of an option and accordingly buyer can expect his short term movements by the underlying stock. This can help the option of an buyer which call/put option should be bought.

GAMMA

A measure of change in the delta that may occur corresponding to the rise or fall in the price of the underlying asset.

Gamma = change in option delta

__________________

change in underlying price

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The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying. For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased. suppose the delta changed to 0.5-0.04 = 0.46 thus the rate of premium will decreased .

In simple terms if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices

THETA:

A measure of change in the value of an option corresponding to its time to maturity. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.

                  Change in an option premiumTheta = --------------------------------------                  Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases.

Example:-

Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs.4.5.

ADVANTAGE

Theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.

DISADVANTAGETheta is always negative for the buyer of an option, as the value of the option goes

down each day if his view is not realized.

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In simple words theta tells how much value the option would lose after one day, with all the other parameters remaining the same.

VEGA

The extent of extent of change that may occur in the option premium, given a change in the volatility of the underlying instrument.

Change in an option premiumVega = -----------------------------------------                      Change in volatility

Example:-

Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatility of theunderlying is 35%. As the volatility increases to 36%, the premium of the optionwould change upward to Rs15.6. Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put).

ADVANTAGE

Simply put, for the buyer it is advantageous if the volatility increases after he hasbought the option.

DISADVANTAGE

For the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility.

In simple words Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.

DERIVATIVES PRODUCTS OFFERED BY BSE

SENSEX FUTURES

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A financial derivative product enabling the investor to buy or sell underlying sensex on a future date at a future price decided by the market forces

First financial derivative product in India.

Useful primarily for Hedging the index based portfolios and also for expressing the views on the market

SENSEX OPTIONS:

A financial derivative product enabling the investor to buy or sell call or put options (to be exercised on a future date) on the underlying sensex at a premium decided by the market forces

Useful primarily for Hedging the Sensex based portfolios and also for expressing the views on the market.

STOCK FUTURES:

A financial derivative product enabling the investor to buy or sell underlying stock on a future date at a price decided by the market forces

Available on ____ individual stocks approved by SEBI

Useful primarily for Hedging, Arbitrage and for expressing the views on the market.

STOCK OPTIONS:

A financial derivative product enabling the investor to buy or sell call options(to be exercised at a future date) on the underlying stock at a premium decided by the market forces

Available on individual stocks approved by SEBI

Useful primarily for Hedging, Arbitrage and for expressing the views on the market.

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CONTRACT SPECIFICATIONS

PARTICULARS SENSEX FUTURES AND OPTIONS

STOCK FUTURES AND OPTIONS

Underlying Asset Sensex Corresponding stock in the cash market

Contract Multiplier50 times the sensex (futures)

100 times the sensex (options)

Stock specific E.g. market lot of RIL is 600, Infosys is 100 & so on

Contract Months3 nearest serial months (futures)

1, 2 and 3 months(options)

1, 2 and 3 months

Tick size 0.1 point 0.01*

Price Quotation Sensex point Rupees per share

Trading Hours 9:30a.m. to 3:30p.m. 9:30a.m. to 3:30p.m.

Settlement value In case of sensex options the closing value of the sensex on the expiry day

In case of stock options the closing value of the respectative in the cash segment of BSE

Exercise Notice Time In case of sensex options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant.

In case of stock options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant.

Last Trading Day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day

Last Thursday of the contract month. If it is a holiday, the immediately preceding business day

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Final Settlement On the last trading day, the closing value of the Sensex would be the final settlement price of the expiring futures/option contract.

The difference is settled in cash on the expiration day on the basis of the closing value of the respectative underlying scrip in the cash market on the expiration day

DERIVATIVES PRODUCTS OFFERED BY NSE

INDEX FUTURES

Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index future

Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation. The S&P 500 futures products are the largest traded index futures product in the world.

Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000

ADVANTAGES OF INDEX FUTURES

The contracts are highly liquid Index Futures provide higher leverage than any other stocks It requires low initial capital requirement It has lower risk than buying and holding stocks Settled in cash and therefore all problems related to bad delivery,

forged, fake certificates, etc can be avoided.

INDEX OPTIONS

An index option provides the buyer of the option, the right but not the obligation to buy or sell the underlying index, at a pre-determined strike price on or before the date of expiration, depending on the type of option.

Index option offer investors an opportunity to either capitalize on an expected market move or hedge price risk of the physical stock holdings against adverse market moves.

NSE introduce index option in June 2001.

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FUTURES ON INDIVIDUAL SECURITIES

A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001.

NSE defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.

CONTRACT SPECIFICATIONS

PARTICULARS INDEX FUTURES AND OPTIONS FUTURES AND OPTIONS ON INDIVIDUAL SECURITIES

Underlying S&P CNX Nifty and CNX ITIndividual Securities, at present 53 stocks

Contract Size S&P CNX Nifty Futures / Permitted lot size 200 and multiplesS&P CNX Nifty Options there of (minimum value Rs.2 lakh)

Futures / Options on Minimum value of Rs 2 Lakh for eachindividual securities Individual Security

Strike Price Interval S&P CNX Nifty Options Rs. 10/-2. Options on individual Between Rs.2.50 and Rs. 100.00securities : depending on the price of underlying

Trading Cycle Maximum of three month trading cycle- near month(one), the next month (two)and the far month (three). New series of contract will be introduced on the next trading day following expiry of near month contract

Maximum of three month trading cycle- near month(one), the next month (two)and the far month (three). New series of contract will be introduced on the next trading day following expiry of near month contract.

Expiry Date The last Thursday of the expiry month or the Previous trading day if the last Thursday of the month is a trading holiday

The last Thursday of the expiry month or the Previous trading day if the last Thursday of the month is a trading holiday

Settlement Basis Index Futures / Futures Mark to Market and final settlement on

Options on individual Premium settlement on T+1 basis and

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individual securities be settled in cash on T+1 basisIndex Options Premium settlement on T+1 Basis andFinal Exercise settlement on T+1 basis

securities option Exercise settlement on T+2 basis.

Settlement Price S&P CNX Nifty Futures / Daily settlement price will be the closing value of the underlying indexIndex Options The settlement price shall be closing value of underlying index

Final settlement price shall be the closing value of the underlying security on the last trading day

The settlement price shall be closing on individual security price of underlying security.

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OPEN INTEREST(OPTIONS)

Open Interest is a crucial measure of the derivatives market. The total number of options contracts outstanding in the market at any given point of time. In short Sum of all positions taken by different traders reflects the Open Interest in a contract. Opposite positions taken by a trader in a contract reduces the open interest. However, opposing positions taken (in the same contract) by two different traders are added to the open interest. 

Assuming that the market consists of three traders only following table indicates how Open Interest changes on different day’s trades in PATNI COMPUTERS with a call American option at a strike price of Rs. 180

DAY TRADER 1 TRADER 2 TRADER 3 OPEN INTEREST

1 LONG 1200 SHORT 2400 LONG 1200 48002 NO TRADE LONG 1200 SHORT 1200 24003 LONG 1200 NO TRADE SHORT 1200 24004 SHORT 2400 LONG 1200 LONG 1200 0

OPEN INTEREST (FUTURES)

The total number of net outstanding futures contracts is called as open interest i.e. long minus short contracts. A decline in open interest of the near term futures indicates a short-term weakness whereas an increase in the open interest in the long term futures indicate that the markets may bounce back after some time provided this trend persists for a long time

A rising open interest in an uptrend is Bullish A declining open interest in an uptrend is Bearish A rising open interest in a downtrend is Bearish A declining open interest in a downtrend is Bullish

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“RELIANCE ADD 5 LAKH SHARES IN THE OPEN INTEREST”

This shows that total number of option contracts comprising of 5lakh shares are outstanding in the market. There has been no square off positions(opposite positions) in the market. Thus from the open interest we come to know long and short positions made by the investor.

RELATIONSHIP OF OPEN INTEREST WITH MARKET VOLUMES

If open interest and market volumes increases but the market is bullish this shows that there has been buying positions in the market, which results into the positive open interest.

If open interest and volumes increases but the market is in the bearish phase this shows that there has been selling positions made by the investor which results into the negative open interest

If open interest remains constant and volumes are increasing and market is also bullish this shows that there has been intra day trading in the market.

RELATIONSHIP OF OPEN INTEREST WITH PRICES

If both open interest and prices are increasing, this shows that the buyers have entered in the market unfolding. Expect the uptrend to continue.

If on the other hand, open interest is increasing while prices decline, sellers are expecting for the price rise in a technically weak market. As open interest is growing while prices decline, buyers are obviously the more aggressive party.

In the event of open interest declining while prices are also slipping, liquidation by long positions is the implication, therefore suggesting a technically strong market overall. In other words, the market is strong as open interest declining suggests no new aggressive shorts, as this would entail an increase in open interest.

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When open interest is declining and prices are increasing, short covering is the most likely cause suggesting that overall the market is weak - i.e. attracting new buyers would be required for a technically strong market and consequently open interest would rise.

EXAMPLE

Suppose there are only two brokers Mr. A and Mr. B in the market. A buys and B sells contracts on Index futures on a specific day. At the end of the day , we may say that open interest in the market is 10 contracts and volume for the day is 10 contracts.

Now, if next day a new trader Mr. C comes from Mr. A, open interest at the endo f the 2 day of trading remains same 10 contracts and volume for the day is again 10 contracts. Understand that on the second day, Mr. C assumes Mr. A’s position on first day of trading. But for the market as a whole, at the end of the 2nd day all only 10 contracts remain open.

COST OF CARRY

The relationship between futures and spot prices can be summarized in terms of what is know 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.

Cost of carry gives us an idea about the demand-supply forces in the futures market. It basically indicates the annualized interest cost which players are willing to pay (receive) for buying (selling) a futures contract.

In the Indian markets the cost of carry marketing varies between a negative 35% per annum to a positive 35 % per annum. It can even be higher or lower than the 35% figure but that would be an extraordinary event. We all know that at expiry the futures price closes at the cash price of the security or an index.

The cost-of-carry model in financial futures, thus, is

Futures price = Spot price + Carrying cost — Returns (dividends, etc.)

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RELATIONSHIP OF FUTURES PRICE WITH SPOT PRICE

FUTURES PRICE HIGHER THAN THE CASH PRICE

Here futures price exceeds the cash price which indicates that the cost of carry is negative and the market under such circumstances is termed as a backwardation market or inverted market.

EXAMPLE

Suppose the RELIANCE share is trading at Rs.400 in the spot market. While RELIANCE FUTURES is trading at Rs.406.Thus in this circumstances the normal strategy followed by investors is buy the RELIANCE in the spot market and sell in the futures. On expiry, assuming RELIANCE closes at Rs 450, you make Rs.50 by selling the RELIANCE stock and lose Rs.44 by buying back the futures, which is Rs 6 in a month. Thus Futures prices are generally higher than the cash prices, in an overbought market.

CASH PRICE HIGHER THAN THE FUTURES PRICE

Here cash price exceeds the futures price which indicates that the cost of carry is positive and this market is termed as oversold market. This may be due to the fact that the market is cash settled and not delivery settled, so the futures price is more a reflection of sentiment, rather than that of the financing cost.

EXAMPLE

Now let us assume that the RELIANCE share is trading at Rs.406 in the spot market. While RELIANCE FUTURES is trading at Rs.400.Thus in this circumstances the normal strategy followed by investors is buy the RELIANCE FUTURES and sell the RELIANCE in the spot market. So at expiry if Reliance closes at Rs 450, the investor will buy back the stock at a loss of Rs 44 and make Rs 50 on the settlement of the futures position. This is applied when the cost of carry is high.

Thus the arbitrageur can apply this strategy and make the profits

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VOLATILITY

Volatility is one of the most important factors in an option’s price. It measures the amount by which an underlying asset is expected to fluctuate in an given period time. It significantly impacts the price of an option’s premium and heavily contributes to an option’s time value.

In basic terms, volatility is merely a term used to describe how fast a stock, future or index changes with respect to change in the price. It can be viewed as the speed of change in the market, although the investor may prefer to think of it is as market confusion. The more confused a market is the better the chance an option of ending up “in the money”. A stable market moves slowly. Volatility measures the speed of change in the price of the underlying instrument or the option. Higher the volatility the more the chance an option of becoming profitable by expiration

RELATIONSHIP OF PRICE VOLATILITY WITH PREMIUM

Higher the price volatility of the underlying stock of the put option, higher would be the premium.

Lower the price volatility of the underlying stock of the call option, lower would be the premium.

TYPES OF VOLATILITY

HISTORICAL VOLATILITY:

This (also called statistical volatility) measures price movement in terms of past. Historical volatility is calculated by using the standard deviation of underlying asset price changes from close to close of trading for a given period - month, half yearly, annualized

IMPLIED VOLATILITY:

It is the option market predication of volatility of the underlying instrument over the life of the option. It helps in determining what strategies are to be used.When implied volatility is high, the market price of the option will be greater than their theoretical price.

Example

Stock Price: Rs 280

Strike Price: Rs 260

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Annual volatility: 50%

Days to expiry 20 days

Interest rate 12% annual

The price of the Option applying Black-Scholes Model comes to Rs 26.28. But the actual price of that Option in the market might be (say) Rs 29.50. This means that the market is imputing another volatility to that option going forward. Now instead of providing the volatility figure yourself, you can provide the Option price instead. Now if the investor work backwards and find out what is the volatility that would support the price of Rs 29.50, that volatility comes to 65 per cent.

While the value of a call option is an increasing function of the value of its underlying, it is also an increasing function of the volatility of its underlying. That is, the more uncertain the underlying, the more the option is worth.

From the above scenario it is possible that the players are expecting the scrip to increase another possibility is that the market is mis-pricing the option and could fall. It could also be possible that the market is anticipating some development, which could push the stock higher. If you believe that volatility would rise and the underlying then you may go in for a bull strategy or if you are an aggressive player you could sell the option with a belief to buy them at a later date.

Most traders, however, use a general rule of thumb: Buy options in low volatility and sell options during periods of high volatility.

If you see low implied volatilities, you should buy the At the Money (ATM) option and sell an Out of the Money (OTM) option. You can also create a similar position using puts. In this case, you should buy ATM and sell In the Money (ITM) put options. If you see high implied volatilities, you should buy an In the Money (ITM) Call and sell an ATM call. You will find that both the calls are expensive, but the ATM will be in most circumstances more expensive than the others. Thus, by selling the ATM call, you can realize a good price.

Finally implied volatility can increase or decrease even without price changes ion the underlying security. This is because implied volatility is the level of expected volatility i.e. it is also based not on actual prices of the security, but expected price trends. Implied voltility also declines, as the option gets closer to expiration, as changes in volatility become less significant with fewer trading days

BEST STRATEGY TO BE FOLLOWED IN CASE OF IMPLIED VOLATILITY

SHORT STRADDLE:

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These involve simultaneously selling put and call options for the same stock, same strike price and with the same expiration date. In contrast, a short strangle involves simultaneously selling both a put and call on the same stock and same expiration date, but with the different strike price.

EXAMPLE

Let's choose the strike price 165 in Satyam for the June contracts. Satyam is one of the most actively traded contracts in the NSE F&O segment.

The IV for the call is 97.66 per cent and that of put is 99.40 per cent on April 25, 2005 Since the IV is high, it is a premium-selling time. (a good time to sell calls and puts)

# On May 25, the investor `short straddle' the Satyam by selling the 165 call and put for Rs 27.

# The inflow in this strategy is Rs 54 (2X27).

# The underlying spot has been trading within a range of 157-177.

# However, the call IV has ranged from 99.40 - 63.36 and that of put has ranged from 97.66-46.01

# On May 29, 2003 the IV of call and put are low, hence the investor can square off positions.

# The respective IV was 63.36 for call and 46.01 for put. The underlying Satyam was Rs 169.50.

# The call closed at Rs 11.45 and the put closed at Rs 9.50.

# Square-off position by buying call and put of the same strike. Your outflow would be 20.95 (11.45+9.50). Hence, your net profits would be Rs 33.05 (54-20.95).

Here the strategy has “limited profit and unlimited losses”. Here the Profit is limited to the premiums received. Losses would be unlimited if you are wrong on the stock outlook and the volatility outlook.

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CHAPTER – 4

FINDINGS,SUGGESTIONSAND CONCLUSION

FINDINGS

> The study reveals the effectiveness of risk reduction using hedging strategies. It has

found out that risk cannot be avoided. But can only be minimized.

>Through the study. it has found out that, the hedging provides a safe position on an

underlying security. The loss gets shifted to a counter party. Thus the hedging covers the

loss and risk. Sometimes, the market performs against the expectation. This will trigger

losses. so the hedger should be a strategic and positive thinker.

>The anticipation of the hedger regarding the trend of the movement in the prices of the

underlying security plays a key role in the result of the strategy applied.

>It has been found that, all the strategies applied on historical data of the period of the

study were able to reduce the loss that rose from price risk substantially.

>If the trader is not sure about the direction of the movement of the profits of the current

position, he can counter position in the future contract and reduces the level of risks.

>The trader can effectively use the strategy for return enhancement provided he has the

correct market anticipation.

>In general, the anticipation of the strategies purely for return enhancement is a risky

affair, because, if the anticipation about the performance of the market and the underlying

goes wrong, the position taker would end up in higher losses.

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SUGGEESTIONS

If an investor wants to hedge with portfolios, it must consist of scrips from different

industries, since they are convenient and represent true nature of the securities market as

a whole.

The hedging tool to reduce the losses that may arise from the market risk. Its primary

objective is loss minimization, not profit maximization .The profit from futures or shares

will be offset from the losses from futures or shares, as the case may be. as a result, a

hedger will earn a lower return compared to that of an unhedger. But the unhedger faces a

high risk than a hedger.

The hedger will have to be a strategic thinker and also one who think positively. He

should be able to comprehend market trends and fluctuations. Otherwise, the strategies

adopted by him earn him earn losses.

The hedging tool is suitable in the short term period. They can be specifically adopted by

the investor, who are facing high risks and has sufficient liquid cash with them. Long

term investor should beware from the market, because of the volatile nature of the

market.

A lot more awareness needed about the stock market and investment pattern, both in spot

and future market. The working of BSE Training Institute and NSE Institutes are

apprehensible in this regard.

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CONCLUSION

Derivative use for hedging is only to increase due to the increased global linkages and

volatile exchange rates. Firms need to look at instituting a sound risk management system and

also need to formulate their hedging strategy that suits their specific firm

characteristics and exposures.

In India, regulation has been steadily eased and turnover and liquidity in the foreign

currency derivative markets has increased, although the use is mainly in shorter maturity

contracts of one year or less. Forward and option contracts are the more popular instruments.

Regulators had initially only allowed certain banks to deal in this market however now

corporates can also write option contracts. There are many variants of these derivatives which

investment banks across the world specialize in,and as the awareness and demand for these

variants increases, RBI would have torevise regulations.

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CHAPTER – 5

BIBLIOGRAPHY

BIBLIOGRAPHY

BOOKS

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – PUNITHAVATHY PANDYAN

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – KEVIN DERIVATIVES AND FINANCIAL INNOVATION –

THE BOMBAY STOCK EXCHAHGE PUBLICATION

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

POTFOLIO MANAGEMENT HAND BOOK – ROBORT.A.STRONG

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – JEFFERY.V.BAILERY

Websites

www.nseindia.com www.bseindia.com www.capitaline.com www.geojit.com www.derivativeindia.com www.capitalmarket.com www.indiabulls.com

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