A STUDY ON OPTIONS AND FUTURES

LITERATURE REVIEW
INTRODUCTION OF DERIVATIVES

The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very nature,
the financial markets are marked by a very high degree of volatility. Through the use of
derivative products, it is possible to partially or fully transfer price risks by locking-in asset
Prices. As instruments of risk management, these generally do not influence the Fluctuations in
the underlying asset prices. However, by locking-in asset prices, Derivative products minimize
the impact of fluctuations in asset prices on the Profitability and cash flow situation of risk-
averse investors.

Derivatives are risk management instruments, which derive their value from an underlying
asset. The underlying asset can be bullion, index, share, bonds, Currency, interest, etc., Banks,
Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to
make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future.

DEFINITION OF DERIVATIVES

“Derivative is a product whose value is derived from the value of an underlying asset in a
contractual manner. The underlying asset can be equity, Forex, commodity or any other asset.”

 Securities Contract ( regulation) Act, 1956 (SC(R) A)defines “debt instrument, share,
loan whether secured or unsecured, risk instrument or contract for differences or any
other form of security”
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. But unlike forward contract, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contract, the exchange specifies certain
standard features of the contract. It is standardized contract with standard underlying instrument,
a standard quantity and quality of the underlying instrument that can be delivered,
The standardized items in a futures contract are:

 Quantity of the underlying

Margins are the deposits which reduce counter party risk, arise in a futures contract. These
margins are collect in order to eliminate the counter party risk. There are three types of margins:

Initial Margins:-

Whenever a future contract is signed, both buyer and seller are required to post initial margins.
Both buyers and seller are required to make security deposits that are intended to guarantee that
they will infect be able to fulfill their obligation. These deposits are initial margins and they are
often referred as purchase price of futures contract.

Mark to market margins:-

The process of adjusting the equity in an investor’s account in order to reflect the change in the
settlement price of futures contract is known as MTM margin.

Maintenance margin:-

The investor must keep the futures account equity equal to or greater than certain percentage of
the amount deposited as initial margin. If the equity goes less than that percentage of initial
margin, then the investor receives a call for an additional deposit of cash known as maintenance
margin to bring the equity up to the initial margin.

INTRODUCTION TO OPTIONS

In this section, we look at the next derivative product to be traded on the NSE, namely
options. Options are fundamentally different from forward and futures contracts. An option
gives the holder of the option the right to do something. The holder does not have to exercise
this right. In contrast, in a forward or futures contract, the two parties have committed
themselves to doing something. Whereas it costs nothing (except margin requirement) to enter
into a futures contracts, the purchase of an option requires as up-front payment.

DEFINITION

Options are of two types- calls and puts. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyers the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.

TYPES OF OPTIONS

The Options are classified into various types on the basis of various variables. The following are
the various types of options.

1. On the basis of the underlying asset:

Index options:

These options have the index as the underlying. Some options are European while others are
American. Like index futures contracts, index options contracts are also cash settled.

Stock options:

Stock Options are options on individual stocks. Options currently trade on over 500 stocks in the
United States. A contract gives the holder the right to buy or sell shares at the specified price.

2. On the basis of the market movements :

Call Option:

A call Option gives the holder the right but not the obligation to buy an asset by a certain date
for a certain price. It is brought by an investor when he seems that the stock price moves
upwards.
Put Option:

A put option gives the holder the right but not the obligation to sell an asset by a certain date for
a certain price. It is bought by an investor when he seems that the stock price moves downwards.

3. On the basis of exercise of option:

On the basis of the exercise of the Option, the options are classified into two Categories.

American Option:

American options are options that can be exercised at any time up to the expiration date. Most
exchange –traded options are American.

European Option:

European options are options that can be exercised only on the expiration date itself. European
options are easier to analyze than American options, and properties of an American option are
frequently deduced from those of its European counterpart.