CHAPTER I - INTRODUCTION TO 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.

1.1 DERIVATIVES DEFINED

Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, forex, commodity or any other asset. For example,
wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a
change in prices by that date. Such a transaction is an example of a derivative. The price of
this derivative is driven by the spot price of wheat which is the "underlying".

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines
"derivative" to include-

1. A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying
securities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R)A.

EMERGENCE OF FINANCIAL DERIVATIVE PRODUCTS

Derivative products initially emerged as hedging devices against fluctuations in commodity

prices, and commodity-linked derivatives remained the sole form of such products for
almost three hundred years.

Financial derivatives came into spotlight in the post-1970 period due to growing instability
in the financial markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions in
derivative products. In recent years, the market for financial derivatives has grown
tremendously in terms of variety of instruments available, their complexity and also
turnover. In the class of equity derivatives the world over, futures and options on stock
indices have gained more popularity than on individual stocks, especially among
institutional investors, who are major users of index-linked derivatives. Even small
investors find these useful due to high correlation of the popular indexes with various
portfolios and ease of use.

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1.2 FACTORS DRIVING THE GROWTH OF DERIVATIVES

Over the last three decades, the derivatives market has seen a phenomenal growth. A large
variety of derivative contracts have been launched at exchanges across the world. Some of
the factors driving the growth of financial derivatives are:

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets leading to higher returns, reduced risk as well as
transactions costs as compared to individual financial assets.

1.3 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. We take a brief look at various derivatives contracts that have
come to be used.

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

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

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

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

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

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

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options.

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Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

1.4 PARTICIPANTS IN THE DERIVATIVES MARKETS

The following three broad categories of participants - hedgers, speculators, and arbitrageurs
trade in the derivatives market. Hedgers face risk associated with the price of an asset.
They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet
on future movements in the price of an asset. Futures and options contracts can give them
an extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the futures price of an
asset getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.

1.5 ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Inspite of the fear and criticism with which the derivative markets are commonly looked at,
these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level. The prices
of derivatives converge with the prices of the underlying at the expiration of the derivative
contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like
them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With
the introduction of derivatives, the underlying market witnesses higher trading volumes
because of participation by more players who would not otherwise participate for lack of an
arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the

absence of an organized derivatives market, speculators trade in the underlying cash

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markets. Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets.

History of derivatives markets

Early forward contracts in the US addressed merchants' concerns about ensuring that there
were buyers and sellers for commodities. However 'credit risk" remained a serious
problem. To deal with this problem, a group of Chicago businessmen formed the Chicago
Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a
centralized location known in advance for buyers and sellers to negotiate forward contracts.
In 1865, the CBOT went one step further and listed the first 'exchange traded" derivatives
contract in the US, these contracts were called 'futures contracts". In 1919, Chicago Butter
and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was
changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two
largest organized futures exchanges, indeed the two largest "financial" exchanges of any
kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade. Currently
the most popular stock index futures contract in the world is based on S&P 500 index,
traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became
the most active derivative instruments generating volumes many times more than the
commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three
most popular futures contracts traded today. Other popular international exchanges that
trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in
Japan, MATIF in France, Eurex etc.

5. An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting many
bright, creative, well-educated people with an entrepreneurial attitude. They often energize
others to create new businesses, new products and new employment opportunities, the
benefit of which are immense. In a nut shell, derivatives markets help increase savings and
investment in the long run. Transfer of risk enables market participants to expand their
volume of activity.

1.6 EXCHANGE-TRADED vs. OTC DERIVATIVES MARKETS

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified amount of commodities at specified price. A primary motivation for
pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to
lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.

As the word suggests, derivatives that trade on an exchange are called exchange traded
derivatives, whereas privately negotiated derivative contracts are called OTC contracts.
The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and

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globalisation of financial activities. The recent developments in information technology
have contributed to a great extent to these developments. While both exchange-traded and
OTC derivative contracts offer many benefits, the former have rigid structures compared to
the latter. It has been widely discussed that the highly leveraged institutions and their OTC
derivative positions were the main cause of turbulence in financial markets in 1998. These
episodes of turbulence revealed the risks posed to market stability originating in features of
OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange traded
derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and
for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange's self-regulatory organization, although they are affected indirectly by national
legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market
stability. The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system:

(i) the dynamic nature of gross credit exposures;

(ii) information asymmetries;
(iii) the effects of OTC derivative activities on available aggregate credit;
(iv) the high concentration of OTC derivative activities in major institutions; and
(v) the central role of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counter-party credit events and sharp movements in
asset prices that underlie derivative contracts occur, which significantly alter the
perceptions of current and potential future credit exposures. When asset prices change
rapidly, the size and configuration of counter-party exposures can become unsustainably
large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including counter-
party, liquidity and operational risks, and OTC derivatives markets continue to pose a
threat to international financial stability. The problem is more acute as heavy reliance on
OTC derivatives creates the possibility of systemic financial events, which fall outside the
more formal clearing house structures. Moreover, those who provide OTC derivative
products, hedge their risks through the use of exchange traded derivatives. In view of the
inherent risks associated with OTC derivatives, and their dependence on exchange traded
derivatives, Indian law considers them illegal.

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 CHAPTER III – FUTURES AND OPTIONS
3.1 FORWARDS
Imagine you are a farmer. You grow 1,000 dozens of mangoes every year. You want to sell
these mangoes to a merchant but are not sure what the price will be when the season
comes. You therefore agree with a merchant to sell all your mangoes for a fixed price for
Rs 2 lakhs. This is a forward contract wherein you are the seller of mangoes forward and
the merchant is the buyer. The price is agreed today in advance and The delivery will take
place sometime in the future.

The essential features of a forward contract are:

Contract between two parties (without any exchange between them)

Price decided today

Quantity decided today (can be based on convenience of the parties)

Quality decided today (can be based on convenience of the parties)

Settlement will take place sometime in future (can be based on convenience of the parties)

No margins are generally payable by any of the parties to the other

Forwards have been used in the commodities market since centuries. Forwards are also
widely used in the foreign exchange market.

3.2 FUTURES

Futures are similar to forwards in the sense that the price is decided today and the delivery
will take place in future. But Futures are quoted on a stock exchange. Prices are available
to all those who want to buy or sell because the trading takes place on a transparent
computer system.

The essential features of a Futures contract are:

• Contract between two parties through an exchange

• Exchange is the legal counterparty to both parties

• Price decided today

• Quantity decided today (quantities have to be in standard denominations specified
by the exchange

• Quality decided today (quality should be as per the specifications decided by the
exchange)

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 • Tick size (i.e. the minimum amount by which the price quoted can change) is
decided by the exchange

• Delivery will take place sometime in future (expiry date is specified by the
exchange)

• Margins are payable by both the parties to the exchange

• In some cases, the price limits (or circuit filters) can be decided by the exchange

Forwards have been used since centuries especially in commodity trades. Futures are
specialized forwards which are supported by a stock exchange. Futures, as we know them
now, were first traded in the USA, in Chicago.

3.3 LIMITATIONS OF FORWARDS

Forwards involve counter party risk. In the above example, if the merchant does not buy
the mangoes for Rs 2 lakhs when the season comes, what can you do? You can only file a
case in the court, but that is a difficult process. Further, the price of Rs 2 lakhs was
negotiated between you and the merchant. If somebody else wants to buy these mangoes
from you, there is no mechanism of knowing what the right price is.

Thus, the two major limitations of forwards are:

• Counter party risk

• Price not being transparent

Counter party risk is also referred to as default risk or credit risk.

3.4 ADVANTAGES OF FUTURES

An exchange (or its clearing corporation) becomes the legal counterparty in case of futures.
Hence, if you buy any futures contract on an exchange, the exchange (or its clearing
corporation) becomes the seller. If the other party (the real seller) does not deliver on the
expiry date, you do not have to worry. The exchange (or its clearing corporation) will
guarantee you the delivery. Further, prices of all Futures quoted on the exchange are known
to all players. Transparency in prices is a big advantage over forwards.

3.5 LIMITATIONS OF FUTURES

Futures suffer from lack of flexibility. Suppose you want to buy 103 shares of Satyam for a
future delivery date of 14th February, you cannot. The exchange will have standardized
specifications for each contract. Thus, you may find that you can buy Satyam futures in lots
of 1,200 only. You may find that expiry date will be the last Thursday of every month.
Thus, while forwards can be structured according to the convenience of the trading parties
involved, futures specifications are standardized by the exchange.

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3.6 EXPIRY OF FUTURES

Futures contracts will expire on a certain pre-specified date. In India, futures contracts
expire on the last Thursday of every month. For example, a February Futures contract will
expire on the last Thursday of February. In this case, February is referred to as the Contract
month. If the last Thursday is a holiday, Futures and Options will expire on the previous
working day. On expiry, all contracts will be compulsorily settled. Settlement can be
effected in cash or through delivery.

Cash settlement means that one of the parties will pay the other party the difference in cash.
For example if you bought Sensex Futures for 3350 and the closing price on the last
Thursday was 3360, you will be paid profit of 10 by the exchange. The exchange will
collect the 10 from the party who sold the Futures, because that party would have made a
loss of 10. In reality, the amount would not be 10, because the number of Sensex Units in a
contract would be considered. One Sensex contract is made up of 50 Units. Therefore, a
profit of 10 above would translate into a profit of Rs 500 (50 Sensex Units x 10). Thus,
Cash Settlement means settlement by payment/receipt in cash of the difference between the
contracted price and the closing price of the underlying on the expiry day. In the Cash
settled system, you can buy and sell Futures on stocks without holding the stocks at any
time. For example, to buy and sell Futures on Satyam, you do not have to hold Satyam
shares.

In Delivery based Settlement, the seller of Futures delivers to the Buyer (through the
exchange) the physical shares, on the expiry day. For example, if you have bought 1,200
Satyam Futures at Rs 250 each, then you will (on the day of expiry) get 1,200 Shares of
Satyam at the contracted Futures price of Rs 250. It might happen that on the day of expiry,
Satyam was actually quoting at Rs 280. In that case, you would still get Satyam at Rs 250,
effectively generating a profit of Rs 30 for you.

Currently in India (as on the date of writing this Work Book), all Futures transactions are
settled in Cash. There is no system of physical delivery. Students appearing for the exam
should therefore assume that contracts will be settled in cash. It is widely expected that we
will move to a physical delivery system soon. However, Index based Futures and options
will continue to be based on Cash Settlement system.

Contract Value is the price per Futures Unit multiplied by the lot size. The lot size can also
be referred to as the Contract Multiplier. For example, if Sensex Futures are quoting at
3,400 and the Contract Multiplier is 50 Units, the Value of one Futures contract will be Rs
1,70,000.

The profit on the Futures contract at the point of entering into the transaction is zero. Profit
or loss will develop only after passage of time. If Futures prices move up, the buyer will
make a profit and vice versa.

3.7 COMMON UNDERLYING ASSETS FOR DERIVATIVES ARE:

• Equity Shares

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 • Equity Indices

• Debt Market Securities

• Interest Rates

• Foreign Exchange

• Commodities

• Derivatives themselves

3.8 COMMODITIES THAT ARE EASY TO TRADE ON FUTURES EXCHANGES

• Commodities which possess the following characteristics are easy to trade:

• Standardisation

• Fungibility

• Large number of buyers and sellers

• Volatile prices

• Uncertain demand and supply conditions

Cash settlement allows parties to trade in Futures, even when they are not interested in
delivery of the underlying. For example, you could buy and sell Silver Futures without
actually buying Silver or selling Silver at any time.

In Futures, the exchange decides the specifications of each contract. For example, it would
decide that Sensex Futures will have a lot size of 50 units. It would decide that Futures
would expire on the last Thursday of every month, etc.

The exchange will also collect Margins from both buyers and sellers to ensure that trading
operates smoothly without defaults. The exchange does not buy or sell any shares or index
futures or commodities. It does not own any shares or index futures or commodities which
might be traded on the exchange. For example, an exchange where gold futures are traded
might not own any gold at all. It is not necessary that trading in commodities also should
happen in those exchanges where commodity futures are traded. For example, an exchange
where gold futures are traded might not allow trading in physical gold at all.

The exchange is supposed to carry out on-line surveillance of the derivatives segment.
The exchange surveys the market movements, volumes, positions, prices, trades entered
into by brokers on a continuous basis to identify any unusual trades. This process is called
on-line surveillance.

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Lot size for futures contracts differs from stock to stock and index to index. For example,
the lot size for Sensex Futures and Options is 50 units, while the lot size for Satyam
Futures and Options is 1,200 units.

Futures can be bought or sold in various circumstances. But the simplest of these
circumstances could be:

• Buy Futures when you are Bullish

• Sell Futures when you are Bearish

Bullish means you expect the market to rise and Bearish means you expect the market to
fall.

Prices of Futures are discovered during trading in the market. For example, who decides
the price of Infosys in the regular cash market? It is discovered based on trading between
various players during market hours. The same logic applies to Futures and Options.

3.9 ARBITRAGE

Arbitrage means the buying and selling of shares, commodities, futures, options or any
combination of such products in different markets at the same time to take advantage of
any mis-pricing opportunities in such markets. An arbitrageur generally has no view on the
market and tries to capitalize on price differentials between markets.

3.10 HEDGERS

Hedgers are people who are attempting to minimize their risk. If you hold shares and are
nervous that the price of these shares might fall in the short run, you can protect yourself by
selling Futures. If the market actually falls, you will make a loss on the shares, but will
make a profit on the Futures. Thus you will be able to set off your losses with profits.
When you use some other asset for hedging purposes other than the asset you actually own,
this kind of hedge is called a cross-hedge..

Hedging is meant for minimizing losses, not maximizing profits. Hedging helps to create a
more certain outcome, not a better outcome.

Suppose you are a trader of rice. You expect to buy rice in the next month. But you are
afraid that prices of rice could go up within the next one month. You can use Rice Futures
(or Forwards) by buying Rice Futures (or Forwards) today itself, for delivery in the next
month. Thus you are protecting yourself against price increases in rice.

On the other hand, suppose you are a jeweller and you will be selling some jewellery next
month. You are afraid that prices of gold could fall within the next one month. You can use
Gold Futures (or Forwards) by selling Gold Futures (or Forwards). Thus, if the price of
jewellery and gold falls, you will make a loss on jewellery but make a profit on Gold
Futures (or Forwards). If you are an importer and you need dollars to pay for your imports
in the next month. You are afraid that dollar will appreciate before that. You should buy
futures/forwards on Dollars. Thus even if the dollar appreciates, you will still be able to get
Dollars at prices decided today.

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If you are an exporter and you are expecting dollar payments in the next month. You are
afraid that Dollar might depreciate in that period. You can sell futures/forwards on Dollars.
Thus even if the dollar depreciates, you will still be able to get Dollars converted at the
prices decided today.

3.11 ROLE OF PLAYERS IN THE DERIVATIVES MARKET

• Speculators provide liquidity and volume to the market.

• Hedgers provide depth.

• Arbitrageurs assist in proper price discovery and correct price abnormalities.

• Speculators are willing to take risks.

• Hedgers want to give away risks (generally to the speculators).

3.12 KINDS OF TRANSACTIONS IN FUTURES

• Opening Buy means creating a Long Position

• Opening Sell means creating a Short Position

• Closing Buy means offsetting (fully or partly) an earlier Short Position

• Closing Sell means offsetting (fully or partly) an earlier Long Position

• Equal and Opposite Transaction . means . Square Up

3.13 BID AND ASK PRICES

Bid prices are those provided by Buyers who want to buy shares or futures or other
products at these Bid prices. Ask prices are those quoted by Sellers who want to sell shares
or futures or other products at these Ask prices. The difference between Bid and Ask Prices
is called as the Bid-Offer spread and also sometimes referred to as the Jobbing Spread. In
highly liquid markets, the Bid-Offer Spread is small. In illiquid markets, the spread is high.
The difference between Bid and Ask Prices is also called impact cost. If liquidity is poor,
impact cost is high and vice versa.

3.14 IMPACT COST

Impact cost is the cost you end up paying because of movement in the market price
resulting from your order. For example, if the market price of Infosys is Rs 3,410 and you
place an order to buy 1,00,000 shares of Infosys, the market price may go up and your
average cost of buying may come to say Rs 3,417. This difference of Rs 7 is the impact
cost.

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3.15 EXOTIC DERIVATIVES

Standardised derivatives are as specified by exchanges and have simple standard features.
These are also called vanilla derivatives or plain vanilla derivatives. Exotic derivatives
have many non-standard features, which might appeal to special classes of investors. These
are generally not exchange traded and are structured between parties on their own.

3.16 OVER THE COUNTER (OTC) DERIVATIVES

OTC Derivatives are unlisted derivatives structured by parties based on their own
convenience. These are generally popular in the developed markets where leading brokers
and institutions create their own kind of special derivatives and sell to interested investors.
OTC Derivatives generally do not require any margin payments. They are tailor made and
are subject to counter party risk.

3.17 SQUARING UP A FUTURES CONTRACT

If you have bought a Futures contract, you can sell it and thus square up. If you sold a
Futures contract, you can buy it back and square up. If you do not square up till the day of
expiry, it will be automatically squared up by the exchange. You need not square up with
the same party from whom you bought or sold. You can simply buy or sell through the
computerized trading system. In practice, most Futures contracts are squared up before
expiry date and hence never result in delivery.

3.18 KINDS OF RISKS ARE FACED BY INVESTORS IN EQUITY MARKETS

Risks faced by investors are categorized into two types. They are

1) Systematic Risk and

2) Non-systematic (unique risk).

Systematic risks arise from developments which affect the entire system (for example the
entire stock market might be affected by a major earthquake or a war). Such risks can be
minimized through Index Futures. If you sell Index Futures and the market drops, you will
make profits. You might make losses on your shares and thus your profits from Index
Futures will give you much needed protection. Unique risks are specific to each share.
Thus the market might go up, while a particular share might move down. To protect against
unique (or unsystematic risks), you should diversify your portfolio. If you hold shares of
many companies, it might happen that some move up and some move down, thus
protecting you.

3.19 LEVERAGE IN THE CONTEXT OF DERIVATIVES

You need not invest the entire contract value when you buy futures or options, whereas in
the cash market, you need to invest the whole amount. While in Futures, you invest an
Initial Margin amount, in the case of Options, you will invest the amount of Option
Premium as a buyer, or provide a certain Margin as a seller. Thus in derivatives, you can
take a larger exposure with a lower investment requirement. This practice increases your
risks and returns substantially. For example, if you buy Satyam shares and it goes up by

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20%, you earn 20% on your investment. But if you buy Satyam Futures which go up by
20%, you will earn much more.

3.20 DETERMINATION OF PRICES OF FUTURES

Prices are determined based on forces of demand and supply and are discovered during
trading hours. Prices of Futures are derived from the price of the underlying. For example,
prices of Satyam Futures will depend upon the price of Satyam in the cash market. You can
expect Futures prices to rise when Satyam price rises and vice-versa. A theoretical model
called Cost of Carry Model provides that prices of Futures should be equal to Spot Prices
(i.e. Cash market prices) plus Interest (also called Cost of Carry). If this price is not
actually found in the market, arbitrageurs will step in and make profits.

Both buyers and sellers of Futures should pay an Initial Margin to the exchange at the point
of entering into Futures contracts. This Initial Margin is retained by the exchange till these
transactions are squared up. Further, Mark to Market Margins are payable based on closing
prices at the end of each trading day. These Margins will be paid by the party who suffered
losses and will be received by the party who made profits. The exchange thus collects these
margins from the losers and pays them to the winners on a daily basis.

3.21 RISK MANAGEMENT

Risk Management is a process whereby the company (could be a broker, institution, stock
exchange) lays down a clear process of how its risks should be managed. The process will
include:

• Identifying risk

• Deciding how much credit should be given to each client

• Deciding the frequency of collection of margins

• Deciding how much risk is acceptable

• Controlling risk on continuous basis

• Monitoring risk taken on continuous basis

If you have bought Futures and the price goes up, you will make profits. If you have sold
Futures and the price goes down, you will make profits.

3.22 SHORT SELLING

Short selling is selling of equity shares by a party who does not have delivery of these
shares. In the Futures market (as per the current Indian system), short selling is freely
permitted as Futures are cash settled.

The number of transactions open at the end of the day is referred to as Open Interest. For
example, if on Day One of the Derivatives Market, 50,000 contracts have been executed

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and none of them squared up so far, the Open Interest will be 50,000 contracts. If on Day
Two, 10,000 contracts are squared up and 15,000 new contracts are executed, the Open
Interest will become 55,000 contracts (50,000 minus 10,000 plus 15,000). The level of
Open Interest indicates the depth of the market.

3.23 BETA

Beta is a measure of how sensitive a particular stock (or a particular portfolio of stocks) is
with respect to a general market index. For example, if Reliance has a beta of 1.15 with
respect to the Sensex, the implication is that Reliance fluctuations will be 1.15 times the
fluctuations in the Sensex. If the Sensex moves up by 10%, Reliance will move up by
11.5%. Beta is widely used for hedging purposes. If you have Reliance shares worth Rs 10
lakhs and you want to hedge your portfolio using Sensex Futures, you will typically sell Rs
11.50 lakhs of Sensex Futures. Thus if Sensex moves down by 10%, Reliance will move
down by 11.5%. On the Sensex Futures, you will gain Rs 1.15 lakhs (10% of Rs 11.50
lakhs), while on Reliance, you will lose Rs 1.15 lakhs (11.5% of Rs 10 lakhs). High beta
stocks are termed aggressive stocks, while low beta stocks are termed defensive stocks.
Hedge Ratio is related to beta and can be understood as the number of Futures contracts
required to be sold to create a perfect hedge.

3.24 VOLATILITY

Derivative markets create risks, however, it will be more correct to say that Derivative
Markets redistribute risks. There are some participants who want to take on risk
(speculators) while some participants want to reduce risk (hedgers). Derivative Markets
align the risk appetites of such players and thus redistribute risks.

Volatility is the extent of fluctuation in stock prices (or prices of other items like
commodities and foreign exchange). Volatility is not related to direction of the movement.
Thus, volatility can be high irrespective of whether the stock price is moving up or down.
A market index (like the Sensex) would generally be less volatile than individual stocks
(like Satyam). The level of Volatility will dictate the level of Margins. Higher volatility
will result in higher margins and vice-versa. Daily Volatility, if known, can be used to
calculate volatility for any given period. For example, Periodic Volatility will be Daily
Volatility multiplied by the square root of the number of days in that period. For example,
Annual Volatility is generally taken as the square root of 256 (working days
approximately) i.e. 16 times the Daily Volatility.

3.25 OPTIONS

Meaning of Option

An Option is a contract in which the seller of the contract grants the buyer, the right to
purchase from the seller a designated instrument or an asset at a specific price which is
agreed upon at the time of entering into the contract. It is important to note that the option
buyer has the right but not an obligation to buy or sell. if the buyer decides to exercise his
right the seller of the option has an obligation to deliver or take delivery of the underlying
asset at the price agreed upon. Seller of the option is also called the writer of the option.

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Generic terms used in options

Call Option

An option contract is called a ‘call option’, if the writer gives the buyer of the option the
right to purchase from him the underlying asset.

Put Option

An option contract is said to be a ‘put option,’ if the writer gives the buyer of the option the
right to sell the underlying asset.

Exercise Date

The date at which the contract matures.

Strike Price

At the time of entering into the contract, the parties agree upon a price at which the
underlying asset may be brought or sold. This price is referred to as the exercise price or
the striking price. At this price, the buyer of a call option can buy the asset from the seller
and the buyer of a put option can sell the asset to the writer of the option. This is regardless
of the market price of the asset at the time of exercising.

Expiration Period

At the time of introducing an option contract, the exchange specifies the period (not more
than nine months from the date of introduction of the contract in the exchange) during
which the option can be exercised or traded. This period is referred to as the Expiration
Period. An option can be exercised even on the last day of the Expiration Period. Beyond
this date the option contract expires.
Such option, which can be exercised on any day during the Expiration Period are called
American options. There is another class of options called European options. European
options can be exercised only on the last day of the expiration period. For these options the
expiration date is always the last day of the expiration period.
Depending on the expiration period an option can be short term or long term in nature.
Warrants and convertibles belong to the latter category and are often issued by companies
to finance their activities. (In India, Reliance Petroleum Ltd. has recently converted its
warrants issued as a part of triple optional convertible debentures into fully paid equity
shares.)

Option Premium or Option Price

This is the amount which the buyer of the option (whether it be a call or put option) has to
pay to the option writer to induce him to accept the risk associated with the contract. It can
also be viewed as the price paid to buy the option.

Expiration Cycle

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The options listed in the stock exchanges and introduced in certain months expire in
specific months of the year only. This is due to the fact that option contracts have to expire
within nine months from the date of their introduction. Exchanges previously used to
assign an issue to one of the three cycles. First is January, April, July and October; other is
February, May, August and November; third is March, June, September and December.
This has been modified now to include both the current month and the following month,
plus the next two months in the expiration cycle so that the investors are always able to
trade in the options. Therefore, now the first cycle will be January, February, April and
July; the second cycle will be February, March, April and July and the third cycle will be
March, April, July and October.

The types of Options are available are Call Options and Put Options. Call Options give the
buyer the right to buy a specified underlying at a set price on or before a particular date.
For example, Satyam 260 Feb Call Option gives the Buyer the right to buy Satyam at a
price of Rs 260 per share on or before the last Thursday of February. The price of 260 in
the above example is called the strike price or the exercise price. Call Options are also
called teji in the Indian markets. Put Options give the buyer the right to sell a specified
underlying at a set price on or before a particular date. For example, Satyam 260 Feb Put
Option gives the Buyer the right to sell Satyam at a price of Rs 260 per share on or before
the last Thursday of February. Put Options are also called mandi in the Indian markets.

Call Option Sellers are under obligation to deliver shares whenever the Call Option Buyer
exercises his right. Put Option Sellers are under obligation to buy shares whenever the Put
Option Buyer exercises high right. In case of Index Options, delivery of Index is not
possible. Hence, these Options are cash settled. The seller of Options is under obligation to
pay the difference between Market Value of the Index and Strike Price of the Option to the
Option Buyer.

American style Options can be exercised at any time on or before the expiry day. European
style Options can be exercised on the day of expiry.
In India, both styles are available. Index Options are European style, while individual stock
options are American style. On exercise, the buyer calls upon the exchange to pay up the
difference between the market price and the
strike price. The exchange in turn asks one of the Option sellers to make this difference
payment.

It is generally believed that American style Call Options should not be exercised early, as it
does not generate any special benefit to the buyer. The Buyer may be advised to sell such
Options rather than exercise. On the other hand, American style Put Options could be
exercised in some circumstances.

American Options will have a value at least equal to European Options. They are more
flexible. The minimum value of American Options will be the Intrinsic Value at all times.
All Options on the same underlying, same expiry and same type (Calls or Puts) are called
as one Option Class (for example Reliance Feb Calls). Within one Class, you can have
several Series for each strike price (for example Reliance Feb 280 Calls). Market Makers
are the players who offer continuous bid and ask quotes for particular securities/series.
Strike Prices are decided by the exchange under SEBI guidelines. Margins are paid only by
Sellers in the Options market. Buyers pay Premium and hence no Margins are applicable.

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Options can be created on various underlying assets including Index, Shares, Foreign
Exchange, Commodities, Swaps, other Derivatives. An option over a Swap is called a
Swaption.

3.25.1 COMPONENTS OF OPTION VALUE

Option Value is made up of two components viz. Intrinsic Value and Time Value. Intrinsic
Value is the amount the buyer would get if the option is exercised. The additional value
(over and above the Intrinsic Value) is called Time Value. None of these three values can
be negative. Intrinsic Value is also called .parity value. Time Value is also called .premium
over parity.. For example, if a Satyam Feb 260 Call is quoting for Rs 25 while the Market
Price of Satyam is Rs 262, the values are as under:

Total Option Value (i.e. Option Price) : Rs 25

Intrinsic Value (262 . 260) Rs 2
Time Value (25 . 2) Rs 23

Option Values depend on the following six factors:

• Market Price

• Strike Price

• Volatility

• Time to Expiry

• Interest Rates

• Dividends

Call Options:

Higher Market Price, Higher Option Value

Higher Strike Price, Lower Option Value
Higher Volatility, Higher Option Value
Longer Time to Expiry, Higher Option Value
Higher Interest Rates, Higher Option Value
Higher Dividends, Lower Option Value

Put Options:

Higher Market Price, Lower Option Value

Higher Strike Price, Higher Option Value
Higher Volatility, Higher Option Value
Longer Time to Expiry, Higher Option Value
Higher Interest Rates, Lower Option Value
Higher Dividends, Higher Option Value

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3.26 THE GREEKS

3.26.1 Delta is the rate of change of option price with respect to the price of the underlying
asset. For example, the delta of a stock is 1. It is the slope of the curve that relates the
option price to the price of the underlying asset. Suppose the of a call option on a stock is
0.5. This means that when the stock price changes by one, the option price changes by
about 0.5, or 50% of the change in the stock price. Expressed differently, is the change in
the call price per unit change in the spot.

3.26.2 Gamma is the rate of change of the option's Delta with respect to the price of the
underlying asset. In other words, it is the second derivative of the option price with respect
to price of the underlying asset.

3.26.3 Theta of a portfolio of options, is the rate of change of the value of the portfolio
with respect to the passage of time with all else remaining the same. Is also referred to as
the time decay of the portfolio. is the change in the portfolio value when one day passes
with all else remaining the same. We can either measure "per calendar day" or "per trading
day". To obtain the per calendar day, the formula for Theta must be divided by 365; to
obtain Theta per trading day, it must be divided by 250.

3.26.4 Vega of a portfolio of derivatives is the rate of change in the value of the portfolio
with respect to volatility of the underlying asset. If is high in absolute terms, the portfolio's
value is very sensitive to small changes in volatility. If is low in absolute terms, volatility
changes have relatively little impact on the value of the portfolio.

3.24.5 Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the interest rate. It measures the sensitivity of the value of a portfolio to interest
rates.

Option Greeks help us to understand Option behaviour better. They measure the extent of
the impact of various factors on Option Prices. Delta stands for the change in Option
Premium for a unit change in the Price of the Underlying Share or Index (also stands for
Hedge Ratio). Gamma stands for the change in Delta for a unit change in the Price of the
Underlying Share or Index. Vega stands for the change in Option Premium for a unit
change in the Volatility of the Underlying Share or Index. Theta stands for the change in
Option Premium for a unit change in the Time to expiry. Rho stands for the change in
Option Premium for a unit change in the Interest Rates.

3.25 In the Money, At The Money and Out of the Money Options

Those options which, if exercised, will generate Positive Return can be understood as In
the Money, without taking the premium paid by the buyer into consideration. For example,
Satyam 260 Feb Call will be In the Money when Satyam share price is above Rs 260. If the
share price is Rs 282, the Option will generate Rs 22 on exercise.
Infosys 3500 Feb Put will be In the Money when Infosys share price is below Rs 3,500. If
the share price is Rs 3,375, the Option will generate Rs 125 on exercise. Out of the Money
Options are those which will not generate Negative Return if exercised. That is why, out of
the money, options are usually never exercised. For example, Satyam 300 Feb Call will be
Out of the Money when Satyam share price is Rs 282. Infosys 3000 Feb Put will be Out of
the Money when Infosys share price is Rs 3,375. At the Money Options are those whose

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Call Seller . Bearish or Neutral
Put Buyer . Bearish
Put Seller . Bullish or Neutral

3.31 OPTION PREMIUM

Option Premium is paid by the Buyer of the Options to the Seller of Options through the
exchange. The Option Premium paid is the maximum loss a Buyer can ever make and
represents the maximum profit the Seller can ever make.

3.32 OPTION STRATEGIES

Option strategies are complex positions created including a combination of options and
underlying shares (and futures) which help the investor to benefit from his views.
Some common examples are:

Writing a Covered Call . where you hold the underlying shares and sell a Call Option with
an objective to earn Call premium

Protective Put . where you hold the underlying shares and buy a Put Option to provide
protection against fall in the value of the underlying shares

Bull Spread . where you buy one call option at a low strike price and sell another call
option at a higher strike price (on the same underlying) and want to benefit in a limited
manner from bullish view . you could also do this through put options.

Bear Spread . where you buy one call option with a high strike price and sell another call
option with a lower strike price (on the same underlying) and want to benefit in a limited
manner from bearish view . you could also do this through put options

Straddle . where you sell a call option and a put option at the same strike price (or
alternatively buy a call option and a put option at the same strike price) (these are also
called Jhota / Duranga in the Indian markets)

Strangle . where you sell a call option and a put option at different strike prices on the same
underlying (or alternatively buy a call option and a put option at different strike prices)

Combinations . other strategies involving a put and a call (also called fatak in Indian
markets)

3.33 SQUARING UP OF OPTIONS

A buyer can square up his position by selling a similar option (same underlying, same
option type, same expiry month, same strike price). A seller can square up his position by
buying a similar option. The positions which expire worthless at the expiry automatically
get squared up. The option may be exercised by the buyer and thus the position
extinguished.

There are currently no restrictions on who can buy or sell Options. Accordingly, all
investors can buy or sell Options.

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3.34 OVER THE COUNTER OPTIONS

Over the Counter Options are non-exchange traded products. These are generally structured
by large broking firms and institutions and sold to their clients directly, without the
intervention of the exchange. These Options are generally customized to suit client needs.
Participants do face counterparty risk in such Options.

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