derivatives jan2012

7/31/2019 Derivatives JAN2012

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INDTRODUCTION

Derivatives have made the international andfinancial headlines in the past for mostly with their

association with spectacular losses or institutional

collapses.

But market players have traded derivatives

successfully for centuries and the daily

international turnover in derivatives trading runs

into billions of dollars.

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Derivatives

What is a derivative?:A financial product which has beenderived from another financial product

or commodity.

Without the underlying product ormarket, the derivative would have no

independent existence.


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Are derivative instruments that can only be tradedby experienced, specialist traders? Although it is

true that complicated mathematical models are

used for pricing some derivatives, the basic

concepts and principles underpinning derivativesand their trading are quite easy to grasp and

understand.

Indeed, derivatives are used increasingly bymarket players ranging from governments,

corporate treasurers, dealers and brokers and

individual investors.

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Derivatives have risen from the need tomanage the risk arising frommovements in markets beyond ourcontrol, which may severely impact therevenues and costs of the firm.

Derivatives are used to shift risk and act

as a form of insurance


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Financial derivatives can serve as a risk reduction tool.

Firms are exposed to several risks in the ordinarycourse of operations and borrowing funds

For some risks, management can obtainprotection from an insurance company (fire,loss of profit , loss of stock, marineinsurance)


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Similarly, there are capital market products availableto protect against certain risks. Such risks include :

- Risks associated with a rise in the price ofcommodity purchased as an input

- A decline in a commodity price of a product thefirm sells

- A rise in the cost of borrowing funds

- An adverse exchange rate movement.- The instruments that can be used to provide such

protection are called derivative instruments


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WHAT IS A DERIVATIVE ?

A Derivatives is any security whoseprice is determined by the value ofanother asset.

--- This asset is called the underlying security , orsimply , the Underlying

UNDERLIYINGPRICE

CHANGE

DERIVATIVEPRICE

CHANGE


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WHY DO DERIVATIVES EXIST ?

TWO PURPOSES

HEDGING SPECULATION


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Types of derivatvies

FORWARDS

FUTURES

OPTIONS

SWAPS

A contract to make or take delivery of product in future ,

at a price set in present. Not standardised or regulated

Similar to Forwards . Stanardised , regulated and traded

on exchanges

A contract giving the right ,but not the obligation,tobuy or sell a security for e.g Movie ticket

A contract to exchange stream of cash flows based on certain events

Interest rates ,Currencies , Commodities prices, CREDIT DEFAULT SWAPS


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Futures Contracts

Futures contract is an agreement tobuy or sell specified quantity of theunderlying assets at a price agreed

upon by the buyer and seller, on orbefore a specified time.

By contrast in a spot contract there is

an agreement to buy or sell the assetimmediately (or within a very shortperiod of time)


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When you trade futures

Long is the equivalent of initiating a futures positionby buying a future contract and squaring up byselling it.

Short is the equivalent of initiating the position by

first selling a future contract and then squaring up bybuying it back.

You pay only margin which is a fractional portion ofthe total transaction value, generally about 15% in

case of index futures, and up to 50% in the case ofindividual stock futures

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All the future contracts are dated . For example ,Indian futures and option settlement takes place on

last Thursday of every month. So the current month

futures expire on the months last Thursday. If the

trader has to carry his position to the next month ,he has to shift his position to the next month future.

Futures are generally traded using technical analysis

because product facilitates speculation.You can go long or short on futures depending upon

the short term view of the market and or a stock

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Exchanges Trading Futures

National Stock Exchange ofIndia (NSE)

Bombay Stock Exchange (BSE)

Multi Commodity Exchange (MCX)

MCX Stock Exchange (MCX-SX)

National Commodity andDerivatives Exchange (NCDEX)

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Futures Price

The futures prices for a particularcontract is the price at which you agree

to buy or sell

It is determined by supply and demandin the same way as a spot price

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Cost of carry is the interest cost of a similar

position in cash market and carried to maturity of

the futures contract less any dividend expected

till the expiry of the contract.

Example:

Spot Price of Stock "A" = 3000, Interest Rate =

12% p.a.

Futures Price of 1 month contract = 3000 +3000*0.12*30/365

= 3000 + 30

= 3030

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Electronic Trading

Traditionally futures contracts havebeen traded using the open outcrysystem where traders physically meeton the floor of the exchange

Increasingly this is being replaced byelectronic trading where a computer

matches buyers and sellers


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Terminology

The party that has agreed to buy has

a long positionThe party that has agreed to sell has

a short position


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Example

January: an investor enters into along futures contract to buy 100 oz of

gold @ $1050 in April

April: the price of gold $1065 per oz

What is the investors profit?


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Over-the Counter Markets

The over-the counter market is animportant alternative to exchanges

It is a telephone and computer-linkednetwork of dealers who do notphysically meet

Trades are usually between financialinstitutions, corporate treasurers, andfund managers


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A forward contract is the simplest modeof a derivative transaction.

It is an agreement to buy or sell an

asset (of a specified quantity) at acertain future time for a certain price.

No cash is exchanged when the

contract is entered into.

Forward contract


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Forward Contracts

Forward contracts are similar to futuresexcept that they trade in the over-the-counter market

Forward contracts are popular oncurrencies and interest rates


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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON

NOV17, 2011

Bid/buy Offer/sell

Spot 50.96 50.87

1-month forward 51.28 51.21



Forward rate = Spot rate + Forward margin


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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON NOV

30, 2011

Bid/buy Offer/sell

Spot 52.41 52.32






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FOREIGN EXCHANGE QUOTES FORUSD/INR EXCHANGE RATE ON DEC

16, 2011

Bid/buy Offer/sell

Spot 52.82 52.72






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Shyam wants to buy a TV, which costsRs 10,000 but he has no cash to buy itoutright.

He can only buy it 3 months hence. He,

however, fears that prices of televisionswill rise 3 months from now.

So in order to protect himself from therise in prices Shyam enters into acontract with the TV dealer that 3months from now he will buy the TV forRs 10,000.

Illustration 1:


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What Shyam is doing is that he islocking the current price of a TV for aforward contract. The forward contractis settled at maturity.

The dealer will deliver the asset toShyam at the end of three months andShyam in turn will pay cash equivalentto the TV price on delivery.


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Ram is an importer who has to make apayment for his consignment in sixmonths time.

In order to meet his payment obligationhe has to buy dollars six months fromtoday.

However, he is not sure what the Re/$rate will be then.

Illustration 2:


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In order to be sure of his expenditure hewill enter into a contract with a bank tobuy dollars six months from now at adecided rate.

As he is entering into a contract on afuture date it is a forward contract and

the underlying security is the foreigncurrency.


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Example

If you agree in April with your Aunt that you will buy

five kgs of tomatoes from her garden for Rs 75, to

be delivered to you in July, you just entered into afutures contract!


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Futures in India

Futures exists in various forms

Commodities (MCX, NCDEX)

Interest rate futures (NSE)

Stock and Index Futures (NSE)NSE Stock/Index Futures

1 month, 2 month and 3 month contracts

Near, Mid and Far month


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FUTURES

Futures

Individual stock

future

Index futures

Underlying asset is

the individual stockUnderlying asset is the stock

Index

Bombay Sensex futureNifty Future


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Let us take an example of a simple derivativecontract:

Ram buys a futures contract.

He will make a profit of Rs 1000 if the price ofInfosys rises by Rs 1000.

If the price is unchanged Ram will receivenothing.

If the stock price of Infosys falls by Rs 800 hewill lose Rs 800.


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As we can see, the above contract depends upon

the price of the Infosys scrip, which is the

underlying security.

Similarly, futures trading has already started in

Sensex futures and Nifty futures. The underlyingsecurity in this case is the BSE Sensex and NSENifty

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The Sensex and Nifty

In India the most popular indices have been the

BSE Sensex and S&P CNX Nifty.

The BSE Sensex has 30 stocks comprising the

index which are selected based on market

capitalization, industry representation, tradingfrequency etc.

It represents 30 large well-established and

financially sound companies.

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The Sensex represents a broad spectrum of

companies in a variety of industries. It represents

14 major industry groups.

Then there is a BSE national index and BSE

200. However, trading in index futures has onlycommenced on the BSE Sensex.

While the BSE Sensex was the first stock market

index in the country, Nifty was launched by theNational Stock Exchange in April 1996 taking the

base of November 3, 1995.

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The Nifty index consists of shares of 50

companies with each having a market

capitalization of more than Rs 500 crore.

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Choosing and understanding the right index is

important as the movement of stock index futures

is quite similar to that of the underlying stock

index. Volatility of the futures indexes is generally

greater than spot stock indexes.Everytime an investor takes a long or short

position on a stock, he also has an hidden

exposure to the Nifty or Sensex. As most often

stock values fall in tune with the entire market

sentiment and rise when the market as a whole is

rising.

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Retail investors will find the index derivatives

useful due to the high correlation of the index with

their portfolio/stock and low cost associated with

using index futures for hedging

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U d t di i d f t


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Understanding index futures

A futures contract is an agreement between two

parties to buy or sell an asset at a certain time in

the future at a certain price.

Index futures are all futures contracts where the

underlying is the stock index (Nifty or Sensex)and helps a trader to take a view on the market

as a whole

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Index futures permits speculation and if a trader

anticipates a major rally in the market he can

simply buy a futures contract and hope for a price

rise on the futures contract when the rally occurs.

In India we have index futures contracts based onS&P CNX Nifty and the BSE Sensex and near 3

months duration contracts are available at all

times.

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Each contract expires on the last Thursday of the

expiry month and simultaneously a new contract

is introduced for trading after expiry of a contract

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E l


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Example:

Contract month Expiry/settlement

July 2011 July 28

August 2011 August 25

September 2011 September 29

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Futures contracts in Nifty in July 2011


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Contract month Expiry/settlement

August 2011 August 25

September 2011 September 29

October 2011 October 27

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On July 28

The permitted lot size is 50 or multiples thereof for the Nifty.

That is you buy one Nifty contract the total deal valuewill be 50*5500 (Nifty value)= Rs 2,75,000.

In the case of BSE Sensex the market lot is 15. That is you buy one

Sensex futures the total value will be 15*18000 (Sensex value)= Rs

2,70,000

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Hedging

Stocks carry two types of riskcompany specific and market risk.

While company risk can be minimized

by diversifying your portfolio .Marketrisk cannot be diversified but has to behedged.

So how does one measure the marketrisk? Market risk can be known fromBeta

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Beta measures the relationshipbetween movement of the index tothe movement of the stock.

The beta measures the percentageimpact on the stock prices for 1%change in the index. Therefore, for aportfolio whose value goes down by11% when the index goes down by10%, the beta would be 1.1.

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When the index increases by 10%,the value of the portfolio increases11%.

The idea is to make beta of yourportfolio zero to nullify your losses.

Hedging involves protecting anexisting asset position from futureadverse price movements

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In order to hedge a position, a market playerneeds to take an equal and opposite positionin the futures market to the one held in the

cash market.

Every portfolio has a hidden exposure to theindex, which is denoted by the beta.

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Assuming you have a portfolio of Rs 1 million,which has a beta of 1.2, you can factor acomplete hedge by selling Rs 1.2 mn of S&PCNX Nifty futures.

Steps:

Determine the beta of the portfolio. If the beta of

any stock is not known, it is safe to assume that it

is 1.

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Short sell the index in such a quantum that the

gain on a unit decrease in the index would offset

the losses on the rest of his portfolio.

This is achieved by multiplying the relative

volatility of the portfolio by the market value of hisholdings

Therefore in the above scenario we have to

shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall

gain/loss that accrues:

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Index up 10% Index down 10%

Gain/(Loss) inPortfolio Rs 120,000 (Rs 120,000)

Gain/(Loss) inFutures

(Rs 120,000) Rs 120,000

Net Effect Nil Nil

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Now let us study the impact on the overall gain/loss that accrues


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As we see, that portfolio is completely insulated

from any losses arising out of a fall in market

sentiment.

But as a cost, one has to forego any gains that

arise out of improvement in the overall sentiment.

Then why does one invest in equities if all the

gains will be offset by losses in futures market.

The idea is that everyone expects his portfolio to

outperform the market. Irrespective of whether

the market goes up or not, his portfolio value

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The same methodology can be applied to a

single stock by deriving the beta of the scrip and

taking a reverse position in the futures market.

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Speculation


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Speculation

Speculators are those who do not have any

position on which they enter in futures and

options market.

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. They consider various factors such asdemand supply, market positions, open interests,

economic fundamentals and other data to take

their positions.

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Illustration


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Illustration

Ram is a trader but has no time to track and

analyze stocks. However, he fancies his chances

in predicting the market trend. So instead of

buying different stocks he buys Sensex Futures.

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On May 1, 2001, he buys 100 Sensex futures @

3600 on expectations that the index will rise in

future. On June 1, 2001, the Sensex rises to 4000

and at that time he sells an equal number of

contracts to close out his position.Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain Rs 40,000

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Ram has made a profit of Rs 40,000 by taking a

call on the future value of the Sensex. However, if

the Sensex had fallen he would have made a

loss. Similarly, if would have been bearish he

could have sold Sensex futures and made a profitfrom a falling profit. In index futures players can

have a long-term view of the market up to atleast

3 months.

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Arbitrage


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Arbitrage

An arbitrageur is basically risk averse.He enters into those contracts were hecan earn riskless profits.

When markets are imperfect, buying inone market and simultaneously sellingin other market gives riskless profit.

Arbitrageurs are always in the look outfor such imperfections.

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In the futures market one can takeadvantages of arbitrage opportunitiesby buying from lower priced market andselling at the higher priced market.

In index futures arbitrage is possiblebetween the spot market and the futuresmarket (NSE has provided a specialsoftware for buying all 50 Nifty stocks inthe spot market.

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Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3months Nifty futures is at 1300.

The futures price of Nifty futures can beworked out by taking the interest cost of3 months into account.

If there is a difference then arbitrageopportunity exists.

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Let us take the example of single stock to

understand the concept better.

If Wipro is quoted at Rs 1000 per share andthe 3 months futures of Wipro is Rs 1070 then

one can purchase Wipro at Rs 1000 in spot byborrowing @ 12% annum for 3 months and sellWipro futures for 3 months at Rs 1070.

Sale = 1070Cost= 1000+30 = 1030

Arbitrage profit = 40

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These kind of imperfections continue to existin the markets but one has to be alert to theopportunities as they tend to get exhaustedvery fast.

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Pricing of Index Futures


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Pricing of Index Futures

The index futures are the most popular futures

contracts as they can be used in a variety of ways

by various participants in the market.

How many times have you felt of making risk-less

profits by arbitraging between the underlying andfutures markets. If so, you need to know the cost-

of-carry model to understand the dynamics of

pricing that constitute the estimation of fair value

of futures.

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The cost of carry model


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The cost of carry model

The cost-of-carry model where the price of the

contract is defined as:

F=S+C

where:F Futures price

S Spot price

C Holding costs or carry costs

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If F < S+C or F > S+C, arbitrage opportunities

would exist i.e. whenever the futures price moves

away from the fair value, there would be chances

for arbitrage.

If Wipro is quoted at Rs 1000 per share and the 3months futures of Wipro is Rs 1070 then one can

purchase Wipro at Rs 1000 in spot by borrowing

@ 12% annum for 3 months and sell Wipro

futures for 3 months at Rs 1070.

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Here F=1000+30=1030 and is less than

prevailing futures price and hence there are

chances of arbitrage

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

However, one has to remember that thecomponents of holding cost vary with contracts

on different assets.

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Futures pricing in case of dividend


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Futures pricing in case of dividendyieldWe have seen how we have to consider the cost

of finance to arrive at the futures index value.

However, the cost of finance has to be adjusted

for benefits of dividends and interest income. In

the case of equity futures, the holding cost is thecost of financing minus the dividend returns

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Suppose a stock portfolio has a value of Rs 100

and has an annual dividend yield of 3% which is

earned throughout the year and finance

rate=10% the fair value of the stock index

portfolio after one year will be F= Rs 100 + Rs100 * (0.10 0.03)

Futures price = Rs 107

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If the actual futures price of one-year contract is

Rs 109. An arbitrageur can buy the stock at Rs

100, borrowing the fund at the rate of 10% and

simultaneously sell futures at Rs 109. At the end

of the year, the arbitrageur would collect Rs 3 fordividends, deliver the stock portfolio at Rs 109

and repay the loan of Rs 100 and interest of Rs

10.

The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 =Rs 2.

Thus, we can arrive at the fair value in the case of

dividend yield70


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TRADING STRATEGIES

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Speculation

We have seen earlier that trading in index futures

helps in taking a view of the market, hedging,

speculation and arbitrage.

In this module we will see one can trade in index

futures and use forward contracts in each of

these instances.

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Taking a view of the market

Have you ever felt that the market would godown on a particular day and feared that yourportfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio The problem in both the above cases is that it would be very

cumbersome and costly to sell all the stocks in the index. And in the

process one could be vulnerable to company specific risk. So what is

the option? The best thing to do is to sell index futures.

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Illustration:


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Illustration:

Scenario 1:

On July 13, 2001, X feels that the market will

rise so he buys 200 Nifties with an expiry dateof July 26 at an index price of 1442 costing Rs

2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520so he squares off his position at 1520.

X makes a profit of Rs 15,600 (200*78

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Scenario 2:


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Scenario 2:

On July 20, 2001, X feels that the market will

fall so he sells 200 Nifties with an expiry dateof July 26 at an index price of 1523 costing Rs3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so hesquares off his position at 1456.

X makes a profit of Rs 13,400 (200*67).

In the above cases X has profited fromspeculation i.e. he has wagered in the hope ofprofiting from an anticipated price change.

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Hedging


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edg g

Stock index futures contracts offer investors,

portfolio managers, mutual funds etc severalways to control risk.

The total risk is measured by the variance or

standard deviation of its return distribution. Acommon measure of a stock market risk is the

stocks Beta.

While hedging the cash position one needs todetermine the number of futures contracts to be

entered to reduce the risk to the minimum.

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Have you ever felt that a stock was intrinsically

undervalued? That the profits and the quality ofthe company made it worth a lot more as

compared with what the market thinks?

Have you ever been a stockpicker and carefullypurchased a stock based on a sense that it was

worth more than the market price?

A person who feels like this takes a long positionon the cash market. When doing this, he faces

two kinds of risks:

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1. His understanding can be wrong, and the

company is really not worth more than the marketprice or

2. The entire market moves against him and

generates losses even though the underlyingidea was correct.

Everyone has to remember that every buy

position on a stock is simultaneously a buyposition on Nifty. It carries a long Nifty position

along with it, as incidental baggage i.e. a part

long position of Nifty.

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Let us see how one can hedge positions using

index futures:

X holds HLL worth Rs 9 lakh at Rs 290 per

share on July 01, 2001. Assuming that the beta of

HLL is 1.13. How much Nifty futures does Xhave to sell if the index futures is ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs

1017000 lakh on the index futures i.e. 666 Niftyfutures.

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On July 19, 2001, the Nifty futures is at 1437 and

HLL is at 275. X closes both positions earningRs 13,389, i.e. his position on HLL drops by Rs

46,551 and his short position on Nifty gains Rs

59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs

13,389.

Let us take another example when one has aportfolio of stocks:

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If you sell more than 496 contracts you are

overhedged and sell less than 496 contracts youare underhedged.

Thus, we have seen how one can hedge their

portfolio against market risk.

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Margins


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g

The margining system is based on the JR Verma

Committee recommendations. The actualmargining happens on a daily basis while online

position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

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The computation of initial margin on the futures

market is done using the concept ofValue-at-Risk (VaR).

The initial margin amount is large enough to

cover a one-day loss that can be encountered on99% of the days.

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VaR methodology seeks to measure the amount

of value that a portfolio may stand to lose within acertain horizon time period (one day for the

clearing corporation) due to potential changes in

the underlying asset market price. Initial margin

amount computed using VaR is collected up-

front.

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The daily settlement process called "mark-to-

market" provides for collection of losses thathave already occurred (historic losses) whereas

initial margin seeks to safeguard against potential

losses on outstanding positions. The mark-to-

market settlement is done in cash.

Let us take a hypothetical trading activity of a

client of a NSE futures division to demonstrate

the margins payments that would occur.

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Let us take a hypothetical trading activity of a

client of a NSE futures division to demonstratethe margins payments that would occur.

A client purchases 200 units of FUTIDX NIFTY

29JUN2001 at Rs 1500.

The initial margin payable as calculated by VaR

is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

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Assuming that the contract will close on Day + 3

the mark-to-market position will look as follows:

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Position on Day 1


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Close Price Loss Margin released Net cash outflow

1400*200 =2,80,000 20,000 (3,00,000-

2,80,000)

3,000 (45,000-

42,000)

17,000 (20,000-

3000)

Payment to be

made

(17,000)

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New position on Day 2


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Close Price Gain Addn Margin Net cash inflow

1510*200 =3,02,000 22,000 (3,02,000-

2,80,000)

3,300 (45,300-

42,000)

18,700 (22,000-

3300)

Payment to be recd 18,700

90

Value of new position = 1,400*200= 2,80,000

Margin = 42,000

Position on Day 3


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Close Price Gain Net cash inflow1600*200 =3,20,000 18,000 (3,20,000-

3,02,000)

18,000 + 45,300* = 63,300

Payment to be recd 63,300

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Value of new position = 1510*200 = Rs 3,02,000Margin = Rs 45,300


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Margin account*

Initial margin = Rs 45,000

Margin released (Day 1) = (-) Rs 3,000

Position on Day 2 Rs 42,000

Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/loss

Day 1 (loss) = (Rs 20,000)

Day 2 Gain = Rs 22,000

Day 3 Gain = Rs 18,000

Total Gain = Rs 20,000

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The client has made a profit of Rs 20,000 at the

end of Day 3 and the total cash inflow at the closeof trade is Rs 63,300.

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Settlements


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All trades in the futures market are cash settled

on a T+1 basis and all positions (buy/sell)which are not closed out will be marked-to-market.

The closing price of the index futures will bethe daily settlement price and the position willbe carried to the next day at the settlementprice.

The most common way of liquidating an openposition is to execute an offsetting futurestransaction by which the initial transaction issquared up.

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The initial buyer liquidates his long position

by selling identical futures contract.

In index futures the other way of settlement iscash settled at the final settlement. At the end

of the contract period the difference betweenthe contract value and closing index value ispaid.

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How to read the futures data sheet?


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Understanding and deciphering the prices of

futures trade is the first challenge for anyoneplanning to venture in futures trading.

Economic dailies and exchange websites

www.nseindia.com and www.bseindia.comare some of the sources where one can lookfor the daily quotes.

Your website has a daily market commentary,which carries end of day derivatives summaryalong with the quotes

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http://www.nseindia.coma/http://www.bseindia.com/http://www.bseindia.com/http://www.nseindia.coma/


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The first step is start tracking the end of day

prices. Closing prices, Trading Volumes andOpen Interest are the three primary data wecarry with Index option quotes.

The most important parameter are the actualprices, the high, low, open, close, last tradedprices and the intra-day prices and to trackthem one has to have access to real time prices.

The following table shows how futures data willbe generally displayed in the business papersdaily.

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Series FirstTrade

HighLow Close Volume (Noof contracts)

Value(R

s inlakh)

No oftrades

Openinterest(No ofcontracts)

BSXJUN

2000

4755 4820 4740 4783.1 146 348.70 104 51

BSXJUL

2000

4900 4900 4800 4830.8 12 28.98 10 2

BSXAU

G2000

4800 4870 4800 4835 2 4.84 2 1

Total 160 38252 116 54

98

Source: BSE


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The first column explains the series that is being

traded. For e.g. BSXJUN2000 stands for the JuneSensex futures contract.

The column on volume indicates that (in case of

June series) 146 contracts have been traded in104 trades.

One contract is equivalent to 50 times the price of

the futures, which are traded. For e.g. In case ofthe June series above, the first trade at 4755

represents one contract valued at 4755 x 50 i.e.

Rs. 2,37,750/-.

99


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Open interest indicates the total gross

outstanding open positions in the market forthat particular series. For e.g. Open interest inthe June series is 51 contracts.

The most useful measure of market activity isOpen interest, which is also published byexchanges and used for technical analysis.

Open interest indicates the liquidity of amarket and is the total number of contracts,which are still outstanding in a futures marketfor a specified futures contract.

100


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A futures contract is formed when abuyer and a seller take oppositepositions in a transaction.

This means that the buyer goes longand the seller goes short.

Open interest is calculated by looking at

either the total number of outstandinglong or short positions not both.

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Open interest is therefore a measure of

contracts that have not been matchedand closed out.

The number of open long contractsmust equal exactly the number of openshort contracts.

102

Action Resulting open interest


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New buyer (long) and new seller (short)

Trade to form a new contract.

Rise

Existing buyer sells and existing seller

buysThe old contract is closed.

Fall

New buyer buys from existing buyer.

The Existing buyer closes his position

by selling to new buyer.

No change there is no increase inlong contracts being held

Existing seller buys from new seller. The

Existing seller closes his position by

buying from new seller.

No change there is no increase inshort contracts being held

103


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Price Open interest Market

Strong

Warning signal

Weak

Warning signal

104

Open interest is also used in conjunction with other technical analysis

chart patterns and indicators to gauge market signals.The following chart may help with these signals.

The warning sign indicates that the Open interest is notsupporting the price direction.


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Hedge Ratio: The Hedge Ratio is defined as

the number of Futures contracts required tobuy or sell so as to provide the maximumoffset of risk. This depends on the

Value of a Futures contract;

Value of the portfolio to be Hedged; and

Sensitivity of the movement of the portfolio

price to that of the Index (Called Beta). The Hedge Ratio is closely linked to the correlation between the

asset (portfolio of shares) to be hedged and underlying (index)from which Future is derived.

105


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Initial margin: The money a customer needs

to pay as deposit to establish a position in thefutures market. The basic aim of Initial marginis to cover the largest potential loss in oneday.

Mark-to-market: The daily revaluation of openpositions to reflect profits and losses basedon closing market prices at the end of the

trading day

106


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VaR: Value at Risk. A risk management

methodology, which attempts to measure themaximum loss possible on a particularposition, with a specified level of certainty orconfidence.

107


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Options

108

What are options?


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An option is a contract, which gives the

buyer the right, but not the obligation tobuy or sell shares of the underlyingsecurity at a specific price on or before

a specific date.

Option, as the word suggests, is a

choice given to the investor to either

honour the contract; or if he choosesnot to walk away from the contract.

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There are two kinds of options: Call Optionsand Put Options

A Call Option is an option to buy a stock at aspecific price on or before a certain date.

When you buy a Call option, the price you payfor it, called the option premium, secures yourright to buy that certain stock at a specifiedprice called the strike price.

If you decide not to use the option to buy thestock, and you are not obligated to, your onlycost is the option premium

110


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Put Options are options to sell a stock at aspecific price on or before a certain date. Inthis way, Put options are like insurancepolicies

If you buy a new car, and then buy auto

insurance on the car, you pay a premium andare, hence, protected if the asset is damagedin an accident.

If this happens, you can use your policy toregain the insured value of the car. In thisway, the put option gains in value as the valueof the underlying instrument decreases.

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If all goes well and the insurance is not

needed, the insurance company keeps yourpremium in return for taking on the risk.

With a Put Option, you can "insure" a stock

by fixing a selling price. If something happenswhich causes the stock price to fall, and thus,"damages" your asset, you can exercise youroption and sell it at its "insured" price level.

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If the price of your stock goes up, and there is

no "damage," then you do not need to use theinsurance, and, once again, your only cost isthe premium. This is the primary function oflisted options, to allow investors ways tomanage risk.

Technically, an option is a contract betweentwo parties. The buyer receives a privilege for

which he pays a premium. The seller acceptsan obligation for which he receives a fee.

113

OPTIONS


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An option is a contract between two parties

giving the taker (buyer) the right, but not theobligation, to buy or sell a parcel of shares ata predetermined price possibly on, or before apredetermined date. To acquire this right thetaker pays a premium to the writer (seller) ofthe contract.

Call options give the taker the right, but not

the obligation, to buy the underlying shares ata predetermined price, on or before apredetermined date

114

Illustration 1


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Raj purchases 1 Tata motors Aug 150 Call --

Premium 8

This contract allows Raj to buy 100 shares ofTata Motors at Rs 150 per share at any time

between the current date and the end ofAugust.

For this privilege, Raj pays a fee of Rs 800

(Rs eight a share for 100 shares).The buyer of a call has purchased the right to

buy and for that he pays a premium.

115


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116

Now let us see how one can profit from

buying an option

Sam purchases a December call option at Rs40 for a premium of Rs 15.

That is he has purchased the right to buy thatshare for Rs 40 in December.

If the stock rises above Rs 55 (40+15) he will

break even and he will start making a profit.


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Suppose the stock does not rise and instead

falls he will choose not to exercise the optionand forego the premium of Rs 15 and thuslimiting his loss to Rs 15.

117


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Let us take another example of a call option on

the Nifty to understand the concept better.

119


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A trader is of the view that the index will go up


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121

A trader is of the view that the index will go upto 1400 in Jan 2002 but does not want to take

the risk of prices going down.

Therefore, he buys 10 options of Jancontracts at 1345. He pays a premium for

buying calls (the right to buy the contract) for500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365.

He sells the options or exercises the optionand takes the difference in spot index pricewhich is (1365-1345) * 200 (market lot) = 4000per contract. Total profit = 40,000/- (4,000*10).


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Call Options-Long & Short Positions


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When you expect prices to rise,then you take a long position bybuying calls. You are bullish.

When you expect prices to fall, thenyou take a short position by sellingcalls. You are bearish.

123

Put Options


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A Put Option gives the holder of the right to sell aspecific number of shares of an agreed security at a

fixed price for a period of time.

eg: Sam purchases 1 INFTEC (InfosysTechnologies) AUG 3500 Put --Premium 200

This contract allows Sam to sell 100 shares

INFTEC at Rs 3500 per share at any time between

the current date and the end of August. To have this

privilege, Sam pays a premium of Rs 20,000 (Rs200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a putoption has the right to sell.

124

Illustration 2


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Raj is of the view that the a stock is

overpriced and will fall in future, but he doesnot want to take the risk in the event of pricerising so purchases a put option at Rs 70 onX. By purchasing the put option Raj has the

right to sell the stock at Rs 70 but he has topay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls

below Rs 55 (70-15) and will start making profit ifthe stock falls below Rs 55.

125


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An investor on Dec 15 is of the view that Wipro is

overpriced and will fall in future but does not wantto take the risk in the event the prices rise. So he

purchases a Put option on Wipro.

Quotes are as under:Spot Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30


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He purchases 1000 Wipro Put at strike price 1070 at Put price ofRs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

Jan Spot price of Wipro = 1020

Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. Byexercising the option he earns Rs (1070-1020) = Rs 50 per Put,which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs20,000.

In the second price situation, the price is more in the spotmarket, so the investor will not sell at a lower price by exercisingthe Put. He will have to allow the Put option to expireunexercised. He looses the premium paid Rs 30,000.


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CALL OPTIONS PUT OPTIONS

If you expect a fall in

price(Bearish)

Short Long

If you expect a rise in price

(Bullish)

Long Short

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CALL OPTION BUYER CALL OPTION WRITER (Seller)

Pays premium

Right to exercise and buy the shares

Profits from rising prices

Limited losses, Potentially unlimited

gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining

neutral

Potentially unlimited losses, limited

gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, Potentially unlimited

gain

Receives premium

Obligation to buy shares if exercised

Profits from rising prices or remaining

neutral

Potentially unlimited losses, limited

gain

131


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eg: Sam purchases 1 NIFTY AUG 1110 Call --

Premium 20. The exchange will settle thecontract on the last Thursday of August. Since

there are no shares for the underlying, the

contract is cash settled.

134


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American: These options give the holder the

right, but not the obligation, to buy or sell theunderlying instrument on or before the expirydate.

This means that the option can be exercisedearly. Settlement is based on a particularstrike price at expiration.

Options in stocks in the Indian market are"American Options".

135


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eg: Sam purchases 1 ACC SEP 145 Call --

Premium 12

Here Sam can close the contract any time from

the current date till the expiration date, which is

the last Thursday of September.American style options tend to be more

expensive than European style because they

offer greater flexibility to the buyer.

136


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IMPORTANT CONCEPTS

137


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STRIKE PRICE

IN THE MONEY

OUT OF THE MONEY

AT THE MONEYMARKET LOTS

EXPIRATION DATE

OPTION VALUE

138

STRIKE PRICE


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The Strike Price denotes the price at which the

buyer of the option has a right to purchase or sellthe underlying.

The strikes in options of most Indian shares are

in multiples of Rs 5 and Rs 10 . Generallyspeaking , five to six options prices are available

on both sides of the current price of the

underlying.

for example , the ACC stock trading at Rs 200

might have options listed with strike of Rs 150 ,

160 ,170, 180, 190 , 200 ,210 220 230 240 250

139


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The strike price is also called Exercise

Price. This price is fixed by the exchange for theentire duration of the option depending on the

movement of the underlying stock or index in the

cash market.

140

IN THE MONEY (ITM)


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A Call Option is said to be "In-the-Money" if the

strike price is less than the market price of theunderlying stock.

A Put Option is In-The-Money when the strike

price is greater than the market price.For Example , if the ACC stock is trading at Rs

200 , the ACC call option with strike 190, 180,170 and below are all in-the money.

141


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AT- THE MONEY (ATM)


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This is an option that has a strike price equal to

the current price of the underlying stock

The ACC option with strike of Rs 200 as at- the

money when the stock is trading at or near the

strike price .

143

OPTION (PREMIUM) VALUE


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The option value is composed of two parts :

Intrinsic value

Time value

Intrinsic value is the amount by which theoption is in the money.

For example , lets suppose the ACC stock istrading at Rs 220 and 200 ACC call option istrading at a premium of Rs 32. of thepremium of Rs 32 , the intrinsic value is Rs 20

144


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Time value is the part of an option premium

that exceeds its intrinsic value . In the aboveexample , therefore , the time value is Rs 12.

Just to clarify in terms of which options to

buy ; if I am bullish on ACC and the share istrading at Rs 200 , I would take quotes of 200,210 220 ACC call options and compare theintrinsic values with the time values and buy

the one with the maximum intrinsic value.

145

Out of the money (OTM) options costs less


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Out of the money (OTM) options costs lessthan in the money (ITM) options because thechances of appreciation are higher in ITMoptions . Personally , I buy in the moneyoptions with the least amount of time value in

them.Thus in the above ACC example , if the 200

call is selling for Rs 30 and 210 call is sellingfor Rs 25., I would buy the 200 call even if thismeans paying Rs 5 more. This is because theless time value there is in the option, thelower is the value that is lost because of time

146


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Currently , in India only the near month

(current month) options are actually liquidenough to trade. Accordingly , unless thereare strong trending moves , the options time

value can evaporate in a hurry.

Options with more time till expiration costmore than those with less time.

147

EXPIRATION DATE


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The date when the term of an options contract

terminates is called its expiration date.

The expiry of Indian options mandated by the stockexchanges is the last Thursday of every month.

Technically speaking , options contract are availablefor the near month ( current ), mid month (next) andfar month ( the month after next) . Currently , however,only the near month options usually have tradableliquidity and only towards the last week of the near

month do the options of the mid month gatherenough liquidity to be traded comfortably

148

MARKET LOTS


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The stock exchanges in their wisdom decided

to limit the Indian derivatives market to therelatively larger players and thus introducedmarket lots with a minimum contract size ofRs 2 lakh.

As the derivative market was firstimplemented at a Nifty level of about 1000 ( orSensex 3,300 )the average contract sizes in

some cases rose close to over Rs 10 lakh.When the market rallied.

149


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FACTORS THAT DETERMINE THE PRICE OF AN OPTION

150


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The minor factors are :

Prevalent risk free interest rate

Dividend rate of the underlying stock

152

The Intrinsic Value of an Option


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The intrinsic value of an option is defined as the

amount by which an option is in-the-money, orthe immediate exercise value of the option when

the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price -Strike Price

For a put option: Intrinsic Value = Strike Price- Spot Price

153

f


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The intrinsic value of an option must be positive

or zero. It cannot be negative.

For a call option, the strike price must be less

than the price of the underlying asset for the call

to have an intrinsic value greater than 0. For a put option, the strike price must be greater

than the underlying asset price for it to have

intrinsic value.

154

Price of underlying

The premium is affected by the price


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The premium is affected by the pricemovements in the underlying instrument.

For Call options the right to buy theunderlying at a fixed strike price as theunderlying price rises so does its premium.

As the underlying price falls so does the cost ofthe option premium.

For Put options the right to sell the underlyingat a fixed strike price as the underlying pricerises, the premium falls; as the underlying pricefalls the premium cost rises.

155


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Option Underlying price Premium cost

Call

Put

156

The following chart summarises the above for Calls and Puts.

The Time Value of an Option

G ll th l th ti i i til


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Generally, the longer the time remaining until an

options expiration, the higher its premium will be.

This is because the longer an options lifetime,

greater is the possibility that the underlying share

price might move so as to make the option in-the-money.

All other factors affecting an options price

remaining the same, the time value portion of an

options premium will decrease (or decay) with

the passage of time.

157

N t Thi ti d i idl i th l t


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Note: This time decay increases rapidly in the last

several weeks of an options life. When an optionexpires in-the-money, it is generally worth only its

intrinsic value.

158


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Option Time to expiry Premium cost

Call

Put

159


Volatility

V l tilit i th t d f th d l i


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Volatility is the tendency of the underlying

securitys market price to fluctuate either upor down.

It reflects a price changes magnitude; it does

not imply a bias toward price movement inone direction or the other.

160

Th s it is a major factor in determining an


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Thus, it is a major factor in determining an

options premium. The higher the volatility of the underlying

stock, the higher the premium because there

is a greater possibility that the option willmove in-the-money.

Generally, as the volatility of an under-lyingstock increases, the premiums of both callsand puts overlying that stock increase, andvice versa

161

Hi h l tilit Hi h


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Higher volatility=Higherpremium

Lower volatility = Lower

premium

162


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Option Volatility Premium cost

Call

Put

163


Volatility

Volatility is a measure of the fluctuation in a


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Volatility is a measure of the fluctuation in a

stock s ( or index s ) price and often playsthe most important role in option trading.

Knowing the volatility can help you :

1. Choose and implement an appropriatestrategy

2. Improve your timing in entering or exiting

positions3. Identify overpriced and underpriced options

164

Understanding Volatility

Volatility is a measure of the amount by which


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Volatility is a measure of the amount by which

an asset s price fluctuation in a given time .Mathematically , volatility is the annualizedstandard deviation of an asset s daily price

changes.

There are two types of volatility:

1. Historical volatility , and

2. Implied volatility

165

Historical volatility is a measure of actual


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Historical volatility is a measure of actual

changes in an assets price over a specificperiod of time. Historical volatility is availablein most trading software.

Implied volatility is a measure of how muchthe market expects an option price move.

Thus it is the volatility that the market itself isimplying , rather than that indicated by thepast movements of the stock price.

166

The inputs you need to calculate implied


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volatility are very simple .

You need the current date and the date of expiry, the options strike price , the current price of theunderlying , risk free rate and historical

volatility.

Given these , you will automatically get theimplied volatility in the option.

Traders should avoid buying options which havelot of volatility premiumsor time value in it ,instead should sell a high volatility option

167

Interest rates

In general interest rates have the least influence


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In general interest rates have the least influence

on options and equate approximately to the costof carry of a futures contract.

If the size of the options contract is very large,

then this factor may take on some importance. All other factors being equal as interest rates

rise, premium costs fall and vice versa.

The relationship can be thought of asan opportunity cost.

168

In order to buy an option the buyer must either


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In order to buy an option, the buyer must either

borrow funds or use funds on deposit.

Either way the buyer incurs an interest rate cost.

If interest rates are rising, then the opportunity

cost of buying options increases and tocompensate the buyer premium costs fall.

Why should the buyer be compensated?

Because the option writer receiving the premium

can place the funds on deposit and receive more

interest than was previously anticipated.

169

The situation is reversed when interest rates fall


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The situation is reversed when interest rates fall

premiums rise. This time it is the writer whoneeds to be compensated

170

While the stock price itself usually undergoes a single


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While the stock price itself usually undergoes a single

adjustment by the amount of the dividend, optionprices anticipate dividends that will be paid in theweeks and months before they are announced.

The dividends paid should be taken into account

when calculating the theoretical price of an optionand projecting your probable gain and loss whengraphing a position. This applies to stock indices aswell. The dividends paid by all stocks in that index(adjusted for each stock's weight in the index) should

be taken into account when calculating the fairvalue of an index option.

171
http://www.investopedia.com/terms/f/fairvalue.asphttp://www.investopedia.com/terms/f/fairvalue.asphttp://www.investopedia.com/terms/f/fairvalue.asphttp://www.investopedia.com/terms/f/fairvalue.asp


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Option Interest rate Premium cost

Call

Put

172


DIVIDENDS

It's easier to pinpoint how dividends affect


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It s easier to pinpoint how dividends affect

option premium.Cash dividends affect option prices through

their effect on the underlying stock price.

Because the stock price is expected to dropby the amount of the dividend on the ex-dividend date, high cash dividends implylower call premiums and higher put

premiums.

173

Greeks

The options premium is determined by the


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The options premium is determined by the

three factors mentioned earlier intrinsicvalue, time value and volatility. But there aremore sophisticated tools used to measure thepotential variations of options premiums.

They are as follows:Delta

Gamma

Vega

Rho

174

Delta

Delta is the measure of an options sensitivity


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to changes in the price of the underlyingasset. Therefore, its is the degree to which anoption price will move given a change in theunderlying stock or index price, all else being

equal. Change in option premium

Delta = --------------------------------Change in underlying price

For example, an option with a delta of 0.5 willmove Rs 5 for every change of Rs 10 in theunderlying stock or index.

175

Illustration:

A trader is considering buying a Call option


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A trader is considering buying a Call option

on a futures contract, which has a price of Rs19.

The premium for the Call option with a strike

price of Rs 19 is 0.80.The delta for this option is +0.5. This means

that if the price of the underlying futurescontract rises to Rs 20 a rise of Re 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.

176

`

Far out-of-the-money calls will have a delta


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Far out of the money calls will have a delta

very close to zero, as the change inunderlying price is not likely to make themvaluable or cheap.

An at-the-money call would have a delta of0.5 and a deeply in-the-money call would havea delta close to 1.

177

TABLE : TISCO CALL OPTION

Strike price : 300


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Price of the underlying

TISCO

Calculated option

premium

Delta

280 5.75 +.29

285 7.32 +.343

290 9.15 +.397

295 11.26 +.452300 13.64 +.508

305 16.30 +.562

310 19.22 +.614

315 22.39 +.664

320 25.81 +.71

178

While Call deltas are positive, Put deltas are


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While Call deltas are positive, Put deltas are

negative, reflecting the fact that the put optionprice and the underlying stock price areinversely related.

This is because if you buy a put your view isbearish and expect the stock price to godown. However, if the stock price moves up itis contrary to your view therefore, the value of

the option decreases. The put delta equals thecall delta minus 1.

179

It may be noted that if delta of your position is


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It may be noted that if delta of your position is

positive, you desire the underlying asset torise in price.

On the contrary, if delta is negative, you wantthe underlying assets price to fall.

180

TABLE : TISCO PUT OPTION

Strike price : 300


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Price of the underlying

TISCO

Calculated option

premium

Delta

320 7.44 -.29

315 8.99 -.336

310 10.78 -.386

305 12.82 -.438300 15.13 -.492

295 17.71 -.548

290 20.57 -.603

285 23.7 -.657

280 27.1 - .71

181

Uses:

The knowledge of delta is of vital importance forti t d b thi t i h il


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option traders because this parameter is heavily

used in margining and risk managementstrategies.

The delta is often called the hedge ratio. e.g. if you

have a portfolio of n shares of a stock then ndivided by the delta gives you the number of callsyou would need to be short (i.e. need to write) tocreate a riskless hedge i.e. a portfolio which

would be worth the same whether the stock pricerose by a very small amount or fell by a very smallamount.

182

Gamma

This is the rate at which the delta value of an


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This is the rate at which the delta value of an

option increases or decreases as a result of amove in the price of the underlyinginstrument.

Change in an option deltaGamma =-------------------------------------

Change in underlying price

For example, if a Call option has a delta of

0.50 and a gamma of 0.05, then a rise of 1 inthe underlying means the delta will move to0.55 for a price rise and 0.45 for a price fall.

183

Gamma

Gamma is rather like the rate of change in the


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Ga a s at e e t e ate o c a ge t e

speed of a car its acceleration in movingfrom a standstill, up to its cruising speed, andbraking back to a standstill.

Gamma is greatest for an ATM (at-the-money)option (cruising) and falls to zero as an optionmoves deeply ITM (in-the-money ) and OTM(out-of-the-money) (standstill).

184

If you are hedging a portfolio using the


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If you are hedging a portfolio using the

delta-hedge technique described under"Delta", then you will want to keepgamma as small as possible as the

smaller it is the less often you will haveto adjust the hedge to maintain a deltaneutral position.

If gamma is too large a small change instock price could wreck your hedge.

185

Adjusting gamma, however, can be tricky and


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j g g , , y

is generally done using options -- unlike delta,it can't be done by buying or selling theunderlying asset as the gamma of theunderlying asset is, by definition, always zero

so more or less of it won't affect the gamma ofthe total portfolio.

186

Theta

It is a measure of an options sensitivity to time


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p y

decay. Theta is the change in option price given aone-day decrease in time to expiration. 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 premium

Theta = --------------------------------------

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.187

Assume an option has a premium of 3 and a


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p p

theta of 0.06. After one day it will decline to 2.94,the second day to 2.88 and so on. Naturally other

factors, such as changes in value of the

underlying stock will alter the premium. Theta is

only concerned with the time value.Unfortunately, we cannot predict with accuracy

the changes in stock markets value, but we can

measure exactly the time remaining until

expiration.

188

Vega

This is a measure of the sensitivity of an option


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y p

price to changes in market volatility. It is thechange of an option premium for a given change

typically 1% in the underlying volatility.


Vega = -----------------------------------------

Change in volatilityIf for example,

XYZ stock has a volatility factor of 30% and the

current premium is 3, a vega of .08 wouldindicate that the premium would increase to 3.08

if the volatility factor increased by 1% to 31%.

189

As the stock becomes more volatile the changes


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g

in premium will increase in the same proportion.Vega measures the sensitivity of the premium to

these changes in volatility.

What practical use is the vega to a trader? If a

trader maintains a delta neutral position, then it is

possible to trade options purely in terms of

volatility the trader is not exposed to changes in

underlying prices.

190

Rho

The change in option price given a one


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g p p g

percentage point change in the risk-free interestrate. Rho measures the change in an options

price per unit increasetypically 1% in the cost

of funding the underlying.


Rho = ---------------------------------------------------

Change in cost of funding underlying

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Example

Assume the value of Rho is 14.10. If the risk free


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interest rates go up by 1% the price of the optionwill move by Rs 0.14109. To put this in another

way: if the risk-free interest rate changes by a

small amount, then the option value should

change by 14.10 times that amount. For example,if the risk-free interest rate increased by 0.01

(from 10% to 11%), the option value would

change by 14.10*0.01 = 0.14. For a put option the

relationship is inverse. If the interest rate goes upthe option value decreases and therefore, Rho for

a put option is negative. In general Rho tends to

be small except for long-dated options. 192


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OPTIONS PRICING MODELS

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There are various option pricing models which


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traders use to arrive at the right value of theoption.

Some of the most popular models have been

enumerated below

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The Binomial Pricing Model

The binomial model is an options pricing model


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which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing

models which differ according to their hypotheses

or the underlying instruments upon which they

are based (stock options, currency options,

options on interest rates).

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The Black & Scholes Model

The Black & Scholes model was published in 1973

by Fisher Black and Myron Scholes


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by Fisher Black and Myron Scholes.

It is one of the most popular options pricing

models.

The Black-Scholes model is used to calculate atheoretical call price (ignoring dividends paid during

the life of the option) using the five key

determinants of an option's price: stock price, strike

price, volatility, time to expiration, and short-term(risk free) interest rate.

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The original formula for calculating the theoretical


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option price (OP) is as follows:

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The variables are:

S = stock price


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X = strike pricet = time remaining until expiration

r = current continuously compounded risk-free

interest rate

v = annual volatility of stock price (the standarddeviation of the short-term returns over one year).

ln = natural logarithm

N(x) = standard normal cumulative distribution

functione = the exponential function

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BACK UP SLIDES

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Indicative on Thursday November 17, 2011

IMPORT EXPORT

S t 1 th 3 th 6 th C S t 1 th 3 th 6 th


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Spot 1month 3months6months Currency Spot 1month 3months6months

0.7426 0.7427 0.742 0.7414 Euro 0.7424 0.7427 0.7426 0.7421

0.6354 0.6356 0.636 0.6364 Pound Sterling 0.6353 0.6354 0.6356 0.636

76.9905 76.9392 76.8008 76.5811 Japanese Yen* 77.0291 76.9959 76.9368 76.8052

0.9214 0.9208 0.9196 0.9169 Swiss Franc 0.9217 0.9214 0.9208 0.9197

1.295 1.2949 1.2944 1.2915 Singapore Dollar 1.2957 1.2948 1.2949 1.2946

7.792 7.7815 7.7759 7.7779 Hong Kong Dollar 7.7902 7.7827 7.7888 7.7791

0.9945 0.9944 1.0039 1.0116 Australian Dollar 0.9943 0.9946 0.9979 1.0048

5.7909 5.8009 5.8166 5.8313 Norwegian Kroner 5.8005 5.793 5.8022 5.817

6.7947 6.8101 6.8763 6.8401 Swedish Kroner 6.8008 6.8008 6.8037 6.822

1.0243 1.0252 1.0264 1.0276 Canadian Dollar 1.025 1.0244 1.0252 1.0266

50.96 51.28 51.71 52.19 Indian Rupees 50.8700 51.21 51.64 52.12

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Rolling Settlement

Rolling Settlement is a mechanism of settling


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trades done on a stock exchange on T i.e. tradeday plus "X" trading days, where "X" could be

1,2,3,4 or 5 days.

In other words, in T+5 environment, a trade done

on T day is settled on the 5th working day

excluding the T day.

w.e.f. April 1, 2002, the trades in all the scrips

listed and traded on the exchange are nowsettled on T+3 basis.

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Instrument wise volume and turnover

As on Dec 02, 2011 15:30:24 IST


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Product No. of contracts Traded Value(Rs crores)

Index Futures 6,03,261 14,001.34

Stock Futures 5,06,921 11,659.79

Index Options 33,57,031 84,448.92

Stock Options 1,47,517 3,426.77

F&O Total 46,14,730 1,13,536.82

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Daily Mark to Market settlement

The positions in the futures contracts for each


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member is marked-to-market to the dailysettlement price of the futures contracts at the

end of each trade day.

The profits/ losses are computed as the

difference between the trade price or the previous

day's settlement price, as the case may be, and

the current day's settlement price.

203

The CMs who have suffered a loss are required


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to pay the mark-to-market loss amount to NSCCLwhich is passed on to the members who have

made a profit. This is known as daily mark-to-

market settlement.

Theoretical daily settlement price for unexpired

futures contracts, which are not traded during the

last half an hour on a day, is currently the price

computed as per the formula detailed below:F = S * e rt

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where :


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F = theoretical futures priceS = value of the underlying index

r = rate of interest (MIBOR)

t = time to expiration

Rate of interest may be the relevant MIBOR rate

or such other rate as may be specified.

After daily settlement, all the open positions are

reset to the daily settlement price.

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CMs are responsible to collect and settle the daily


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mark to market profits / losses incurred by theTMs and their clients clearing and settling

through them.

The pay-in and pay-out of the mark-to-market

settlement is on T+1 days (T = Trade day). The

mark to market losses or profits are directly

debited or credited to the CMs clearing bank

account.

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On the expiry of the futures contracts, NSCCL


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marks all positions of a CM to the final settlementprice and the resulting profit / loss is settled in

cash.

The final settlement of the futures contracts is

similar to the daily settlement process except for

the method of computation of final settlement

price.

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The final settlement profit / loss is computed as


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the difference between trade price or the previousday's settlement price, as the case may be, and

the final settlement price of the relevant futures

contract.

Final settlement loss/ profit amount is debited/

credited to the relevant CMs clearing bank

account on T+1 day (T= expiry day).

Open positions in futures contracts cease to existafter their expiration day

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Futures Quiz

In India, futures contracts have an expiry period
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of

Choices:

One month

Two months

Three months

All of the above

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The cost of carry is represented by
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Choices:

F= S+C

F=S-C

F=S+C-B

None of the above

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In the case of index futures the contract expires
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on the last ______ of the month

Choices:

Monday

Thursday

Friday

Saturday

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4. In the case of index futures all positions are


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daily marked-to-market

Choices:

True

False

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In stock index futures trading, profits are
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received or losses are paid

Choices:

In the delivery month

On daily settlement

On the day of the expiry of the contract

On a weekly settlement basis

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The underlying asset for a derivatives instrument


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can be

Choices:

Equity

Commodities

Interest rate intruments

All of the above

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The beta of ACC is 0.8. Assuming you have a
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derivatives jan2012

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