Analysis & Study Of Derivatives Market

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Analysis and Study of Derivative Products Analysis and Study of Derivative Products A DISSERTATION Submitted in partial fulfillment of the requirement of the MBA degree BANGALORE UNIVERSITY Submitted By: VIJAY KUMAR B Register No: 06XQCM6119 Under the guidance of: Prof. Sathyanarayana M P BIRLA INSTITUTE OF MANAGEMENT BANGALORE M P BIRLA INSTITUTE OF MANAGEMENT Associate Bharatiya Vidya Bhavan Bangalore 560001 M P Birla Institute of Management, Bangalore 1 Analysis and Study of Derivative Products STUDENT DECLARATION I hereby declare that this project titled “Analysis and Study of  Derivative Products” submitted by me in partial fulfillment of the requirement of Master of Business Administration course, is based on research work done by me under the guidance of Prof. Sathyanarayana, M. P. Birla Institute of Management. This project has not previously formed the basis for the award of any degree or diploma. Place: BANGALORE Date: VIJAY KUMAR B (06XQCM6119) M P Birla Institute of Management, Bangalore 2 Analysis and Study of Derivative Products GUIDE CERTIFICATE I hereby certify that this research work entitled “ Analysis and  study of Derivative Products” has been undertaken and completed by Mr. VIJAY KUMAR B under my guidance and supervision. I also certify that he has fulfilled all the requirements under the covenant governing the submission of dissertation to the Bangalore University for the award of MBA degree. PLACE: BANGALORE DATE: Prof. Sathyanarayana MPBIM M P Birla Institute of Management, Bangalore 3 Analysis and Study of Derivative Products PRINCIPAL’S CERTIFICATE This is to say that this Dissertation undergone and completed by Mr. VIJAY KUMAR B register number  06XQCM6119 under the guidance and supervision of Prof. Sathyanarayana, M P Birla Institute of Management. PLACE: BANGALORE DATE: Dr.Nagesh.S.Malavalli (Principal, MPBIM) M P Birla Institute of Management, Bangalore 4 Analysis and Study of Derivative Products ACKNOWLEDGEMENT The completion of the research would have been impossible without the valuable contributions of people from the academics, family and friends. I hereby wish to express my sincere gratitude to all those who supported me throughout the study. I am thankful to Dr. NAGESH S MALAVALLI, Principal, M P Birla Institute of Management, Bangalore for his valuable guidance, academic and moral support which made this report a reality. I am greatly thankful to Prof. SATHYANARAYANA (Finance), M P Birla Institute of Management, Bangalore for his support in completion of  this report. report. I also thank my family members and friends whose support and encourage has meant a lot to me personally and also for the t he completion of the report. VIJAY KUMAR B (06XQCM6119) M P Birla Institute of Management, Bangalore 5 Analysis and Study of Derivative Products TABLE OF CONTENTS SL No. CHAPTERS Page No. 1 RESEARCH EXRACT 1 2 INTRODUCTION TO DERIVATIVES : 3 • Background of the study • Statement of Problem • Need and importance of study • Objectives of the Study 3 REVIEW OF LITERATURE 15 4 RESEARCH METHODOLOGY : 21 5 DERIVATIVES A DISCUSSION : 23 • Forward Contracts • Future Contracts • Option Contracts 6 ANALYSIS AND INTERPRETATION 37 7 SUMMARY AND CONCLUSION 66 8 BIBILIOGRAPHY 69 M P Birla Institute of Management, Bangalore 6 Analysis and Study of Derivative Products CHAPTER 1 RESEARCH EXTRACT M P Birla Institute of Management, Bangalore 7 Analysis and Study of Derivative Products RESEARCH EXTRACT The emergence of the market for derivative products, most probably 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 probability and cash flow situation of risk-averse investors. This project tries to explain the in depth concepts, about the history, growth and pros and cons in investing and dealing with the derivative instruments. And the analysis part deals with choosing the best available option in i n terms of returns. The main objective of the study is to give the knowledge of derivatives to the investors who are uncomfortable about the equity market would enter if they were given the alternative of buying derivatives, which controls their downside risk. This would enhance the action of the savings of the country, which are routed through the equity market. The study also gives an overview of the derivative products and features and the advantages in dealing with these financial derivatives more importantly derivatives as one of the important hedging tools. The research also reveals the difference in trading derivatives from those of the underlying spot. M P Birla Institute of Management, Bangalore 8 Analysis and Study of Derivative Products CHAPTER 2 INTRODUCTION TO DERIVATIVES M P Birla Institute of Management, Bangalore 9 Analysis and Study of Derivative Products INTRODUCTION Background of the Study: History of derivatives: The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for  products based on financial instruments such as bond, currencies, stocks and stock  indices have now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desai’s government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities were allowed to trade on exchanges. For example, now cotton and oil futures trade in Mumbai, soybean futures trade in Bhopal, pepper futures in Kochi, coffee futures in Bangalore etc. In June 2000, National Stock Exchange and Bombay Stock Exchange started trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November  respectively. Currently there are 41 stocks trading on NSE Derivative and the list keeps growing. 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 M P Birla Institute of Management, Bangalore 10 Analysis and Study of Derivative Products 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. 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 derivative contract in the US, these contracts were called future contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized 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 derivative are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Indian Derivative Markets: Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalization process and Reserve Bank  of India's (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalization process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India the following table shows Chronology of instruments M P Birla Institute of Management, Bangalore 11 Analysis and Study of Derivative Products 1991 Liberalization process initiated 14-Dec-95 NSE asked SEBI for permission to trade index futures. 18-Nov-96 11-May-98 07-Jul-99 SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. 24-May-00 SIMEX chose Nifty for trading futures and options on an Indian index. 25-May-00 SEBI gave permission to NSE and BSE to do index futures trading. 09-Jun-00 Trading of BSE Sensex futures commenced at BSE. 12-Jun-00 Trading of Nifty futures commenced at NSE. 25-Sep-00 Nifty futures trading commenced at SGX. 02-Jun-01 Individual Stock Options & Derivatives In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors' aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India's financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of  India's efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market. M P Birla Institute of Management, Bangalore 12 Analysis and Study of Derivative Products 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 of 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 5. Innovation in the derivatives markets, which optionally 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. Prerequisites for derivatives market: There are five essential prerequisites for derivatives market to flourish in a country: a) Large market capitalization: At a market capitalization of near $1.5 trillion, India is well ahead of many other  countries where derivatives markets have succeeded. b) Liquidity in the underlying: A few years ago, the total trading volume in India used to be around Rs-300crores a day. Today, daily trading volume in India is around Rs-15000crores a day. This implies a degree of liquidity, which is around six times superior to the earlier  conditions. There is empirical evidence to suggest that there are many financial instruments in the country today, which have adequate to support derivative market. c) Clearing house that guarantees trades: Counter party risk is one of the major factors recognized as essential for starting a strong and healthy derivatives market. Trade guarantee therefore becomes imperative before a derivatives market could start. The first clearinghouse corporation guarantees trades have become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCC). NSCC is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. Other exchanges M P Birla Institute of Management, Bangalore 13 Analysis and Study of Derivative Products are also moving towards setting up separate and well-funded clearing corporations for  providing trade guarantees. d) Physical infrastructure: India’s equity markets are all moving towards satellite connectivity, which allows investors and traders anywhere in the country to buy liquidity services from anywhere else. This telecommunications infrastructure, India’s capabilities in computer hardware and software, will enable the establishment of computer system for creation of  derivatives markets. Setting up of automated trading system as an experience with various prospective exchanges will also be beneficial while setting up the derivative market. e) Risk-taking capability and Analytical skills: India’s investors are very strong in their risk-bearing capacity and can cope with the risk that derivatives pose. Evidence of the volumes traded on the capital markets, which are akin to a futures market, is indicative of this capacity. In contrast, in some other countries, investors simply lack the risk-bearing capacity to sustain the growth of  even the equity market. It is expected that such a barrier will not appear in India. On the subject of analytical skills, derivatives require a high degree of analytical capability for many subtle trading strategies to pricing. India has an enormous pool of  mathematically literate finance professionals, who would excel in this field. Lastly, an obvious advantage for the Indian market is that we have enormous experience with futures markets through the settlement cycle oriented equity which is not truly a spot market but a futures market (including concepts like market-to-market margin, low delivery ratios, and last-day-of settlement abnormalities in prices). We also have active futures markets on six commodities. With this state of development of the capital markets it is felt that there is no major hurdle left for the creation of development of the capital markets. Hence on July 2, 1996 the SEBI board gave an in principal approval for  the launch of derivatives markets in India. M P Birla Institute of Management, Bangalore 14 Analysis and Study of Derivative Products Myths and Realities about Derivatives: In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? What is the underlying truth behind such myths? The myths and the realities behind them are: 1. Derivatives increase speculation and do not serve any economic purpose: Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates. The need for  derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without M P Birla Institute of Management, Bangalore 15 Analysis and Study of Derivative Products selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance. 2. Indian Market is not ready for derivative trading: Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives and how Indian market fares: Large market Capitalization - India is one of the largest market-capitalized countries in Asia with a market capitalization capitali zation of more than Rs.765000crores. High Liquidity in the underlying - The daily average traded volume in Indian capital market today is around 7500crores. Which means on an average every month 14% of  the country's Market capitalization gets traded. These are clear indicators of high liquidity in the underlying. Trade guarantee - The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. A Strong Depository - National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionized the security settlement in our country. A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of  India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices. M P Birla Institute of Management, Bangalore 16 Analysis and Study of Derivative Products 3. Disasters prove that derivatives are very risky and highly leveraged instruments: Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines. Some of the reasons behind disasters related to derivatives are: 1. Lack of independent risk management 2. Improper internal control mechanisms 3. Problems in external monitoring done by Exchanges and Regulators 4. Trader taking unauthorized positions 5. Lack of transparency in the entire process 4. Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding: Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of  India also allows Cross Currency options trading. Forward Markets Commission has allowed trading in Commodity Forwards on Commodities Exchanges, which are, called Futures in international markets. Commodities futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for  the purpose of getting approvals to hedge the user's exposure in international markets. Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920. M P Birla Institute of Management, Bangalore 17 Analysis and Study of Derivative Products History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari, 1998) In that sense, the derivatives are not new to India and are also currently prevalent in various markets including equities markets. 5. The existing capital market is safer than Derivatives? World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3). Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during one-week period for settlement in the following week. The trades are netted for  the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally. In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures and options to M P Birla Institute of Management, Bangalore 18 Analysis and Study of Derivative Products trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. In addition, the existing system although futures style, does not ask for any margins from the clients Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000crores) with a loss of approximately US $ 900 million (around Rs.3,800crores). Statement of Problem: Derivatives are the financial instruments which gives appreciable returns with the transfer of risk and hedging. But many of the investors have lack of knowledge in derivative instruments hence the research study reveals the significance of derivative products, how they can hedge with these products and guides in choosing the best derivative instrument. Need and Importance of the Study: World financial market has witnessed a spectacular change in the field of derivative markets in the past one decade, especially in the field of option, futures and swaps. India also could not become aloof from the world trend and mainly after the liberalization has set in motion. A derivative market has gained momentum since its introduction in India and has played a major role in Indian financial markets. Today the derivative volume in India is Rs.25000crores. Similarly, on the equity market, many retail investors who are uncomfortable about the equity market would enter if they were given the alternative of buying insurance, which controls their downside risk. This would enhance the action of the savings of the country, which are routed through the equity market. More importantly, derivative is one of the important tools of hedging M P Birla Institute of Management, Bangalore 19 Analysis and Study of Derivative Products risk. Therefore, the study of the concept of derivatives is very important to know about various investment alternatives in derivatives. Objectives of the study: 1. To study in depth concept of derivatives and its different variants. 2. To study the risk transformation by buying and selling derivative instruments. 3. To give investors an idea of selecting the best derivative instruments. 4. To evaluate the performance in returns of futures of different companies. M P Birla Institute of Management, Bangalore 20 Analysis and Study of Derivative Products CHAPTER 3 REVIEW OF LITERATURE M P Birla Institute of Management, Bangalore 21 Analysis and Study of Derivative Products Review of Literature Derivatives Defined: Derivative is a product whose value is derived from the value of one or more basic variables called bases (underlying assets) in a contractual manner. The underlying asset can be equity, forex, precious metals, 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 derivatives. A derivative instrument by itself does not constitute ownership. It is, instead, a promise to convey ownership. According to the Securities Contract (Regulation) Act, 1956, derivatives include:  A security derived from a debt instrument, share, and loan whether secured or  unsecured, risk instrument or contract for differences or any other form of  security.  A contract, which derives its value from the prices or index of prices of  underlying securities. Derivative contracts has several variants namely forwards, futures, options, swaps, warrants, LEAPS, Baskets, Swaptions. The participants in derivative markets are Hedgers, Speculators, and Arbitragers. Types of Derivatives: The most commonly used derivatives contracts are forwards, futures and options, which we shall discuss in detail later. Here 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  M P Birla Institute of Management, Bangalore 22 Analysis and Study of Derivative Products 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. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of  forward contracts. The two commonly used swaps are: • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. • Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants: Options generally have lives of up to 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 up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. M P Birla Institute of Management, Bangalore 23 Analysis and Study of Derivative Products A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. Participants & Functions: Participants in Derivatives markets are hedgers, speculators and arbitragers 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 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. The derivative market performs a number of economic functions. First, 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 derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them. Third, 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 Fourth, 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 markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Fifth, 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 M P Birla Institute of Management, Bangalore 24 Analysis and Study of Derivative Products immense. Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment. Exchange traded derivatives and Over-The-Counter Derivatives: Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12 th century and may well 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 have accomplished the modernization of commercial and investment banking and globalization 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 feature of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchangetraded 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 M P Birla Institute of Management, Bangalore 25 Analysis and Study of Derivative Products 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants 5. The OTC contracts are generally not regulated by a regulatory authority and 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 derivative 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 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. M P Birla Institute of Management, Bangalore 26 Analysis and Study of Derivative Products CHAPTER 4 RESEARCH METHODOLOGY M P Birla Institute of Management, Bangalore 27 Analysis and Study of Derivative Products Research Methodology: The type of research conducted in the study is a Descriptive research with a little bit analysis in choosing the alternate financial instruments of derivative products. And the data collected for conducting the research study is only secondary data and no primary data is collected from any of the companies or corporate. Hence the study is a micro study to guide the investors about the products offered in derivative markets. Secondary Data: The data related to the study is collected only through secondary sources such as internet, bulletins, magazines and tutorials.  Market price: The price at which traders are willing to buy or sell the contracts  Risk free profits made by trading in these derivative contracts  Cost-of-carry model: Used for pricing futures  Black-Scholes model: A mathematical model that allows investors to determine option prices. Formulas used: The tools used in the analysis part of the study are: 1. Formula used for calculating returns is: Returns = Spot Price – Futures price * 100 Futures price 2. Formula used to determine the futures price is: F = Se rT Where S = spot price of underlying e = 2.718 r = cost of financing (using continuously compounded interest rate) T = time till expiration in years M P Birla Institute of Management, Bangalore 28 Analysis and Study of Derivative Products CHAPTER 5 DERIVATIVES A DISCUSSION M P Birla Institute of Management, Bangalore 29 Analysis and Study of Derivative Products Derivatives a Discussion 1. Forward Contracts: A forward contract is a n agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are:  They are bilateral contracts and hence exposed to counter-party risk   Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality  The contract price is generally not available in public domain  On the expiration date, the contract has to be settled by delivery of the asset.  If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. M P Birla Institute of Management, Bangalore 30 Analysis and Study of Derivative Products If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transactions to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator. Limitations of forward contracts: Forward markets world-wide are afflicted by several problems: Lack of centralization of trading Liquidity Counterparty risk  In the first two of these, the basic problem is that of too much flexibility and generally. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts nontradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other  suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty remains a very serious issue. M P Birla Institute of Management, Bangalore 31 Analysis and Study of Derivative Products 2. Futures Contract: A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators. The consensus in the investment world is that the futures market is a major  financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break  down how it functions. While futures are not for the risk-averse, they are useful for a wide range of people. The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, almost all futures contracts end without the actual physical delivery of the commodity. Futures Terminology:  Spot price: The price at which an asset trades in the spot market.  Futures price: The price at which the futures contract trades in the futures market.  Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months & three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a tree-month expiry is introduced for trading. M P Birla Institute of Management, Bangalore 32 Analysis and Study of Derivative Products  Expiry Date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.  Contract Size: The amount of asset that has to be delivered under one contract. For  instance, the contract size on NSE’s NS E’s futures market is 200 Nifties.  Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for  each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.  Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid up to finance the asset less the income earned on the asset.  Initial Margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.  Marking-to-Market: In the future market at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price this is called Marking-to-market  Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin the investor  receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Pricing Futures: Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fare value of a futures contract. Every time the observed price deviates from the fair  value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost-of-carry model used for  pricing futures is given below: F = Se M P Birla Institute of Management, Bangalore rT 33 Analysis and Study of Derivative Products Where S = spot price of underlying e = 2.718 r = cost of financing (using continuously compounded interest rate) T = time till expiration in years 3. Options Contract: An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of Rs.200,000. The owner agrees, but for this option, you pay a price of Rs.3,000. Now, consider two theoretical situations that might arise: 1. It is discovered that the house is actually the true birthplace of some great person. As a result, the market value of the house skyrockets to Rs.1 million. Because the owner  sold you the option, he is obligated to sell you y ou the house for Rs.200,000. In the end, you stand to make a profit of Rs.797,000 (Rs.1 million – Rs.200,000 – Rs.3,000). 2. While touring the house, you discover not only that the walls are chock-full of  asbestos, but also the ghost haunts the master bedroom; furthermore, families of superintelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the Rs.3,000 price of the option. This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which mean an option derives its value from M P Birla Institute of Management, Bangalore 34 Analysis and Study of Derivative Products something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index. i ndex. Calls and Puts: The two types of options are calls and puts: Call Option: A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of  calls hope that the stock will w ill increase substantially before the option expires. Put Option: A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.  Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.  Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. Option Terminology:  Index Options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.  Stock Options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.  Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right not the obligation to exercise his option on the seller/writer.  Writer of an option: The writer of a call/option put option is the one receives the option premium and is thereby obligated to sell/buy the asset if he buyer exercises on him.  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. M P Birla Institute of Management, Bangalore 35 Analysis and Study of Derivative Products  Put Option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.  Option price/Premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.  Expiration Date: The date specified in the option Contract is known as the expiration date, the exercise date, the strike date or the maturity.  Strike Price: The price specified in the options contract is known as the strike price or the exercise price.  American Options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American.  European Options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than A merican options, and properties of an American option are frequently deduced from those of its European counter parts.  In-the-money: An in-the money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be In-the-money when the current index stands at a level higher  than the strike price (i.e., spot price > strike price). If the index is much higher than the strike price, the call is to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.  At-the-money: An At-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is At-the-money when the current index equals the strike price (i.e., spot price = strike price).  Out-of-the-money: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e., spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.  Intrinsic value of an option: the option premium can be broken down into two components – intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is max [0, (S t – K)] which means the intrinsic value of a call is the greater of 0 or (S t – K). Similarly, the intrinsic M P Birla Institute of Management, Bangalore 36 Analysis and Study of Derivative Products value of a put is max [0, K – St], i.e., the greater of 0 or (K-S t). K is the strike price and St is the spot price.  Time value of an option: the time value of an option is the difference between its premium and intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. Pricing Options: Black–Scholes model: Robert C. Merton was the first to publish a paper expanding our mathematical understanding of the options pricing model and coined the term "Black-Scholes" options pricing model, by enhancing work that was published by Fischer Black and Myron Scholes. It is somewhat unfair to Merton that the resulting formula has ever since been known as Black-Scholes, but with another hyphen the label l abel would be unwieldy. The paper was first published in 1973. The foundation for their  research relied on work developed by scholars such as Louis Bachelier, A. James Boness, Edward O. Thorp, and Paul Samuelson. The fundamental insight of BlackScholes is that the option is implicitly priced if the stock is traded. Merton and Scholes received the 1997 Nobel Prize in Economics for this and related work; Black was ineligible, having passed away in 1995. An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option. There are various models which help us to the true price of an option. Most of these are variants of the celebrated ce lebrated Black-Scholes model for pricing European options. Today mast calculators and spread-sheets come with a built-in Black-Scholes options pricing formula so to price options we don’t really need to memorize the formula. All we need to know is the variables that go into the model. M P Birla Institute of Management, Bangalore 37 Analysis and Study of Derivative Products The Black-Scholes formulas for the prices of European calls and puts on a nondividend paying stock are: -rT C = SN (d1) – (Xe) N (d2) P = (Xe)-rT N (-d2) – SN (-d1) Where d1 = ln s/x + (r=σ /2) T 2 σ√T and d2 = d1 – σ√T The Black-Scholes equation is done in continuous time. This requires continuous compounding. The “r” that figures in this is ln (1+r). N ( ) is the cumulative normal distribution. N (d 1) is called the delta of the option which is a measure of change in option price with respect to change in the price of the underlying asset. Σ a measure of volatility is the annualized standard deviation of continuously compounded returns on the underlying. When daily sigmas are given, they need to be converted into annualized sigma. Sigma annual = Sigma daily * √Number of trading days per year. On an average there are 20 trading days in a year. X is the exercise price, S the spot price and T the time to expiration measured in years. M P Birla Institute of Management, Bangalore 38 Analysis and Study of Derivative Products ROLE OF DERIVATIVES IN INDIAN ECONOMY Benefits that acquire to the Indian capital markets and the Indian economy from derivatives are discussed here. Derivatives will make possible hedging which otherwise is infeasible this is illustrated by the dollar-rupee forward market. Imports and exports used to take place in the country under the presumption that importer and exporters have to bear currency risk. To the extent that importers and exporters are risk averse, the existence of this risk would lead them to do international trade in smaller quantities than they have liked to. Once the dollar-rupee forward market came about, importers and exporters could hedge themselves against currency risk. Today the use of such hedging is extremely common amongst companies that are exposed to currency risk. This hedging facility has definitely helped importers and exporters do international trade in larger quantities than before. The RBI’s permission for the dollar-rupee forward market is therefore part of the explanation for the enormous growth in imports and exports that has taken place in the last five years. Similarly, on the equity market, many retail investors who are uncomfortable about the equity market would enter if they were given the alternative of buying insurance, which controls their downside risk. This would enhance the action of the savings of the country, which are routed through the equity market. The same would be the case with international investors, who would place limit orders. These improvements in the quality of the underlying market have been observed across a variety of research studies done on foreign markets, which have compared market quality before introduction of derivatives as compared with after. M P Birla Institute of Management, Bangalore 39 Analysis and Study of Derivative Products Overview of the Future & Option Segment: Comparison of the close prices of the NIFTY near month Futures contract of the (F&O segment Oct2007 to March2008) with the underlying movement of the NIFTY Index (Cash Segment), along with the daily traded value of the Future and option segment. M P Birla Institute of Management, Bangalore 40 Analysis and Study of Derivative Products Growth in Index Futures (2007-2008): ( 2007-2008): Month/year No. of Contracts Turnover (Rs. in crores) Mar-08 15692532 359970.21 Feb-08 14064211 352226.38 Jan-08 16148838 450657.09 Dec-07 9609209 287357.02 Nov-07 12668280 365564.04 Oct-07 17842671 485079.24 Sep-07 10904564 256470.34 Aug-07 17052495 363987.55 Jul-07 10605483 238577.03 Jun-07 11407865 240796.92 May-07 10219149 214523.45 Apr-07 10383282 205458 Inference: In the Index Futures Segment in the last year the open interest (no. of  contracts) has been increased by 51.11% and the turnover has been increased by 75.20%. Growth in Stock Futures (2007-2008): Month/year No. of Contracts Turnover Rs. in crores Mar-08 16126212 330390.37 Feb-08 14491601 421838.1 Jan-08 23736610 851213.22 Dec-07 16565236 849996.83 Nov-07 18033294 989112.61 Oct-07 24008470 1120263.25 Sep-07 17653654 670968.47 Aug-07 15798351 519384.6 Jul-07 18888008 647356.09 Jun-07 14287983 451314.3 May-07 13350667 400096.14 Apr-07 10647866 296629.25 Inference: In the Stock Futures Segment in the last year the open interest has been increased by 51.45% and the turnover has been increased by 11.38%. M P Birla Institute of Management, Bangalore 41 Analysis and Study of Derivative Products Growth in Index Options (2007-2008): ( 2007-2008): Month/year Mar-08 Feb-08 Jan-08 Dec-07 Nov-07 Oct-07 Sep-07 Aug-07 Jul-07 Jun-07 May-07 Apr-07 No. of Contracts 4871249 4119577 3976465 3429425 4008708 6407789 4620426 6439679 4221585 4340991 4055682 4874462 Notional turnover in Cr. 120317.73 110251.39 118827.22 103165.41 116951.58 173992.48 107964.8 140960.78 94561.19 92503.32 85465.42 97149.56 Inference: In the Index Options Segment in the last year the open interest has been decreased by 6.5% and the turnover has been increased i ncreased by 23.84%. Growth in Stock Options (2007-2008): Month/year Mar-08 Feb-08 Jan-08 Dec-07 Nov-07 Oct-07 Sep-07 Aug-07 Jul-07 Jun-07 May-07 Apr-07 No. of Contracts 497679 510315 868550 649434 811631 1126544 940668 945400 1022158 694589 758306 635357 Notional turnover in Cr. 10536.2 14901.05 33183.34 33710.77 45676.22 54327.99 37485.17 32398.36 34582.28 21927.59 23357.81 17049.77 Inference: In the Stock Options Segment in the last year the open interest has been decreased by 21.66% and the turnover has been decreased by 38.04%. M P Birla Institute of Management, Bangalore 42 Analysis and Study of Derivative Products CHAPTER 6 ANALYSIS AND INTERPRETATION M P Birla Institute of Management, Bangalore 43 Analysis and Study of Derivative Products Analysis of performance of derivatives: The Analysis part of the study consists of analyzing the performance a one month expiry Index and Stock futures and Options contracts and the returns that are obtained in buying these contracts and exercising them at the exchange on the expiry date. Then the Future prices and Option prices of the next month contract are been determined by the Cost-of-carry model and Black-Scholes Model Firstly Future contracts of the Indexes namely NIFTY, CNX 100 and NIFTY MIDCAP and the Stock Future contracts of different companies from each sector has been taken. The following table gives a summary of Index and Stock Futures and their  lot sizes that are traded at the exchange: Stock/Index Futures: Sl.No. Underlying Asset Lot Size 1 NIFTY 50 2 CNX 100 50 3 NIFTY MIDCAP 75 4 Arvind Mills 4300 5 Bharti Airtel 250 6 Dr. Reddy’s 400 7 GMR Infra 1250 8 Hero Honda 400 9 Infosys Tech 200 10 ISPAT 4150 11 ITC 1125 12 NTPC 1625 13 RPL 1675 14 TCS 250 15 Vijaya Bank 3450 M P Birla Institute of Management, Bangalore 44 Analysis and Study of Derivative Products The Future prices of these contracts of March month expiring contract which expires on last Thursday of the month i.e. on 27 th March, 2008 are compared with that of the spot price of the underlying asset on expiry. And the corresponding returns have been calculated although the brokerage is not included. The following data gives you a view of returns in buying these following Index Futures and Stock Futures contracts and exercising them on expiry: The formula used to calculate the returns is: Returns = Spot Price – Futures price * 100 Futures price Index Futures: INDEX Futures Price Spot Price on Expiry Profit/Loss Returns (%) NIFTY NIFTY MIDCAP 4894.2 4830.25 -395.3 -1.3 4801 2309.5 -183.65 -14.61 CNX 100 2704.8 4617.35 -63.95 -3.82 Inference: In the index futures the NIFTY index futures achieves -1.3% returns, NIFTY MIDCAP achieves -14.61% returns and CNX100 returns -3.82%. By considering the above index returns we can conclude that the market is bearish and the indexes and also most of the individual stocks results in declining the spot. M P Birla Institute of Management, Bangalore 45 Analysis and Study of Derivative Products Stock Futures: Sl.No. STOCK Futures Price Spot Price on Expiry Profit/Loss Returns (%) 1 Arvind Mills 45.85 36.75 -9.1 -19.84 2 Bharti Airtel 788.1 827 38.9 4.93 3 Dr. Reddy’s 568.35 583.15 14.8 2.6 4 GMR Infra 158.75 150.25 -8.55 -5.38 5 Hero Honda 749.25 686.05 -63.2 -8.4 6 Infosys Tech 1465.85 1441.75 -24.1 -1.64 7 ISPAT 40 30.7 -9.3 -23.25 8 ITC 189.95 200.1 10.15 5.34 9 NTPC 185.9 197.2 11.3 6.08 10 RPL 161 154.35 -6.65 -4.13 11 TCS 841 852.5 11.5 -18.3 12 Vijaya Bank 61.75 50.45 -11.3 1.37 Inference: As the markets are bearish many of the stock stock prices falls as shown in the above table but some of the stocks have beaten the marked outperformed to be bullish even though the markets are declining. M P Birla Institute of Management, Bangalore 46 Analysis and Study of Derivative Products One Month Price Fluctuations of the Underlying Asset in the contract Period: Arvind Mills 49.2 Bharti Airtel 826.25 Arvind Mills 46 Bharti Airtel 792.25 Arvind Mills 44.15 Bharti Airtel 766.9 Arvind Mills 43.7 Bharti Airtel 751.05 Arvind Mills 40.55 Bharti Airtel 751.1 Arvind Mills 41.1 Bharti Airtel 805.2 Arvind Mills 42.55 Bharti Airtel 788.15 Arvind Mills 41.45 Bharti Airtel 812.9 Arvind Mills 38.9 Bharti Airtel 780.65 Arvind Mills 39.95 Bharti Airtel 752.9 Arvind Mills 36.75 Bharti Airtel 742.6 Arvind Mills 38.05 Bharti Airtel 758.55 Arvind Mills 36.85 Bharti Airtel 777.75 Arvind Mills 35 Bharti Airtel 800.4 Arvind Mills 36.8 Bharti Airtel 833.6 Arvind Mills 36.65 Bharti Airtel 803.7 Arvind Mills 37.75 Bharti Airtel 827 Inference: Arvind Mills has been declined by 23.27% in the spot market and Bharti Airtel has been increased by 0.09%. M P Birla Institute of Management, Bangalore 47 Analysis and Study of Derivative Products Dr.Reddy’s 583.7 GMR Infra 174.8 Dr.Reddy’s 571.5 GMR Infra 159.7 Dr.Reddy’s 558.3 GMR Infra 155.65 Dr.Reddy’s 583.6 GMR Infra 156.25 Dr.Reddy’s 569.45 GMR Infra 146.1 Dr.Reddy’s 575.9 GMR Infra 154.2 Dr.Reddy’s 560.05 GMR Infra 164.65 Dr.Reddy’s 554.9 GMR Infra 159.75 Dr.Reddy’s 540.1 GMR Infra 149.6 Dr.Reddy’s 539.95 GMR Infra 152.45 Dr.Reddy’s 534.75 GMR Infra 137.45 Dr.Reddy’s 545.25 GMR Infra 135.55 Dr.Reddy’s 540.95 GMR Infra 131.15 Dr.Reddy’s 563.9 GMR Infra 126.3 Dr.Reddy’s 576.95 GMR Infra 139.75 Dr.Reddy’s 575.3 GMR Infra 145.5 Dr.Reddy’s 583.15 GMR Infra 150.25 Inference: Dr. Reddy’s has been decreased 0.094% and GMR INFRA has been decreased by 14.04% in their spot markets. M P Birla Institute of Management, Bangalore 48 Analysis and Study of Derivative Products Hero Honda 761.65 Infosys Tech 1548.2 Hero Honda 774.9 Infosys Tech 1467.9 Hero Honda 772.55 Infosys Tech 1419.05 Hero Honda 773.5 Infosys Tech 1478.8 Hero Honda 766.65 Infosys Tech 1430.55 Hero Honda 757.15 Infosys Tech 1431.1 Hero Honda 735.6 Infosys Tech 1426.35 Hero Honda 728.25 Infosys Tech 1385.15 Hero Honda 737.2 Infosys Tech 1337.7 Hero Honda 716.3 Infosys Tech 1370.2 Hero Honda 686.3 Infosys Tech 1337.8 Hero Honda 685.05 Infosys Tech 1314.6 Hero Honda 650.35 Infosys Tech 1343.7 Hero Honda 647.7 Infosys Tech 1360.45 Hero Honda 678.7 Infosys Tech 1492.3 Hero Honda 679.6 Infosys Tech 1449.5 Hero Honda 686.05 Infosys Tech 1441.75 Inference: Inference: Hero Honda has been decreased by 9.92% in the spot market and Infosys Technologies has been decreased by 6.87% in the spot. M P Birla Institute of Management, Bangalore 49 Analysis and Study of Derivative Products ISPAT 43.3 ITC 202.75 ISPAT 40.15 ITC 192.55 ISPAT 38 ITC 184.9 ISPAT 37 ITC 194.55 ISPAT 33.9 ITC 190.75 ISPAT 34.7 ITC 191 ISPAT 37.1 ITC 192.25 ISPAT 35.8 ITC 190.5 ISPAT 32.15 ITC 185.6 ISPAT 33.65 ITC 191.7 ISPAT 31.15 ITC 185.75 ISPAT 30.6 ITC 183.05 ISPAT 29.15 ITC 187.3 ISPAT 27 ITC 191.15 ISPAT 29.75 ITC 191.55 ISPAT 30.55 ITC 195.3 ISPAT 30.7 ITC 200.1 Inference: ISPAT has been decreased by 29.09% in the spot market and ITC has been decreased by 1.30% in the spot. M P Birla Institute of Management, Bangalore 50 Analysis and Study of Derivative Products NTPC 202 RPL 175.8 NTPC 189 RPL 161.85 NTPC 190.7 RPL 160.85 NTPC 195.05 RPL 162.35 NTPC 184.95 RPL 153.85 NTPC 185.55 RPL 165.4 NTPC 193.1 RPL 170.05 NTPC 194.65 RPL 167.25 NTPC 186.4 RPL 155.7 NTPC 195 RPL 163 NTPC 187.8 RPL 155.25 NTPC 190.1 RPL 152.95 NTPC 191.8 RPL 151.1 NTPC 191.35 RPL 149.9 NTPC 199.85 RPL 157.25 NTPC 196.65 RPL 155.55 NTPC 197.2 RPL 154.35 Inference: NTPC has been decreased by 2.37% in the spot market and RPL has been decreased by12.20% in the spot. M P Birla Institute of Management, Bangalore 51 Analysis and Study of Derivative Products TCS 877.4 Vijaya Bank 66.25 TCS 848.6 Vijaya Bank 62 TCS 858.8 Vijaya Bank 58.85 TCS 875.3 Vijaya Bank 57.25 TCS 846.15 Vijaya Bank 53.5 TCS 833.65 Vijaya Bank 54.2 TCS 823.5 Vijaya Bank 56.5 TCS 823.55 Vijaya Bank 57.25 TCS 779.7 Vijaya Bank 55.45 TCS 803.85 Vijaya Bank 55.55 TCS 791.85 Vijaya Bank 50.05 TCS 817.7 Vijaya Bank 47.75 TCS 811.45 Vijaya Bank 47.85 TCS 823.7 Vijaya Bank 47.05 TCS 876.5 Vijaya Bank 51.35 TCS 878.35 Vijaya Bank 51.35 TCS 852.5 Vijaya Bank 50.45 Inference: TCS has been decreased by 2.83% in the spot market and Vijaya Bank has been decreased by 23.84% in the spot. M P Birla Institute of Management, Bangalore 52 Analysis and Study of Derivative Products NIFTY 5223.5 CNX 100 5072.15 NIFTY 4953 CNX 100 4803.75 NIFTY 4864.25 CNX 100 4706.7 NIFTY 4921.4 CNX 100 4746.25 NIFTY 4771.6 CNX 100 4589.45 NIFTY 4800.4 CNX 100 4613.15 NIFTY 4965.9 CNX 100 4696.55 NIFTY 4872 CNX 100 4699.4 NIFTY 4623.6 CNX 100 4448.15 NIFTY 4745.8 CNX 100 4565.5 NIFTY 4503.1 CNX 100 4315.4 NIFTY 4533 CNX 100 4331.95 NIFTY 4573.95 CNX 100 4362.55 NIFTY 4609.85 CNX 100 4385.05 NIFTY 4877.5 CNX 100 4654.45 NIFTY 4828.85 CNX 100 4620.5 NIFTY 4830.25 CNX 100 4617.35 Inference: Nifty Index has been decreased by 7.52% in the spot market and the CNX100 has been decreased by 8.967% in the spot. M P Birla Institute of Management, Bangalore 53 Analysis and Study of Derivative Products NIFTY MIDCAP 2800.6 NIFTY MIDCAP 2688.8 NIFTY MIDCAP 2624.95 NIFTY MIDCAP 2600.2 NIFTY MIDCAP 2483.8 NIFTY MIDCAP 2486.55 NIFTY MIDCAP 2578.75 NIFTY MIDCAP 2559.45 NIFTY MIDCAP 2400.8 NIFTY MIDCAP 2440.55 NIFTY MIDCAP 2255.05 NIFTY MIDCAP 2240.8 NIFTY MIDCAP 2223.05 NIFTY MIDCAP 2176.05 NIFTY MIDCAP 2314.9 NIFTY MIDCAP 2331.3 NIFTY MIDCAP 2309.05 Inference: The NIFTY MIDCAP INDEX has been decreased by 17.53% in the spot price of the market. M P Birla Institute of Management, Bangalore 54 Analysis and Study of Derivative Products Interpretation of results: By looking at the above data it is clear that the market is bearish over the contract period and the buyers of future contracts are incurring the above shown loses. From the above furnished data analysis the buyers of index futures namely NIFTY, CNX 100 and Nifty Midcap have incurred negative returns of -1.30, -14.61 and -3.82 respectively. And when it comes to stock futures as the market declines many of the individual stocks also declines. In our study i.e. Arvind Mills, GMR Infrastructures, Hero Honda Motors, Infosys Technologies, ISPAT Industries, RPL and Vijaya Bank  show a positive correlation with that of the market movements. But some of the stocks like Bharti Airtel, Dr.Reddy’s laboratories; ITC, NTPC and TCS have overcome the market and shows appreciable returns in buying those futures. From the above data the highest positive returns are obtained by buying NTPC futures and highest negative returns are obtained by buying ISPAT Futures. Although when it comes to the percentage of declining no Index will have such declining returns when compared to that of the individual stocks i.e. ISPAT ISPA T in our study. The reasons for this declining movement may be many like overpricing of the underlying, economic activities, Foreign Institutional Investors withdrawing money from our markets like this many of the reasons will lead the market to the bearish state, so one should also consider such factors in buying future contracts along with the past data analysis. Hence a person who is bullish about the market here expects the underlying asset prices to rise and buys the future contracts and the market doesn’t move as per his expectations and he incurs loses. Instead of buying such selling of  futures are profitable as the market is bearish and results futures price is greater than the spot price on expiry. M P Birla Institute of Management, Bangalore 55 Analysis and Study of Derivative Products Determination of Futures Prices for upcoming contracts: The Futures price of the above Stock and Index Futures for the next one month expiry i.e. which expires on last Thursday of April contract can be determined by using the cost of carry model: F = Se rT Here ‘F’ is the Futures price for the next month contract, ‘S’ is the spot price of the underlying asset as on March 27, 2008, ‘e’ is the exponential constant i.e. 2.718, ‘r’ is rate of interest @ 11% and ‘T’ is the period of expiry of contract i.e. one month. Index Futures: INDEX Spot Price Futures Price NIFTY 4830.25 4874.72 CNX 100 3862.25 3897.81 NIFTY MIDCAP 2309.5 2330.76 Stock Futures: Sl.No. STOCK Spot Price Futures Price 1 Arvind Mills 36.75 37.08 2 Bharti Airtel 827 834.61 3 Dr. Reddy’s 583.15 588.51 4 GMR Infra 150.25 151.63 5 Hero Honda 686.05 692.36 6 Infosys Tech 1441.75 1455.02 7 ISPAT 30.7 30.98 8 ITC 200.1 201.94 9 NTPC 197.2 199.01 10 RPL 154.35 155.77 11 TCS 852.5 860.34 12 Vijaya Bank 50.45 50.91 M P Birla Institute of Management, Bangalore 56 Analysis and Study of Derivative Products Application of Futures: Here it is refereed to single stock futures, however since the index is nothing but a security whose price or level is a weighted average of securities consisting an index, all strategies that can be implemented using stock futures can also be implemented using index futures. 1. Hedging: Long security, sell futures Futures can be used as an effective risk management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390. in the absence of stock futures; he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he needs to do is enter into offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390. two-month futures cost him Rs.402. for this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350 the fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position. Index futures in particular can be very effectively used to get rid of the market risk  of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30-60% of the securities risk  is accounted for by index fluctuations). Hence a position Long Portfolio + Short Nifty can often become one-tenth as risky as the Long Portfolio position. Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the un hedged position, half the time. One should not M P Birla Institute of Management, Bangalore 57 Analysis and Study of Derivative Products enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. 2.1 Speculators: Bullish Security, buy Futures Take the case of a speculator who has a view on the direction of the market. He would like trade based on this view. He believes that a particular security that trades at Rs.1000 is undervalued and expects its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. he makes a profit of Rs.1000 on an investment of Rs.1,00,000 for a period of  two months. This works out to annual return of 6 percent. Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works, the security trades at Rs.1000 and the twomonth futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 100000. He buys 100 security futures for which he pays a margin of  Rs.20000. two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs.400 an investment of Rs,20000. This works out to an annual return of 12 percent. Because of they provide, security futures form attractive option for speculators. 2.2 Speculators: Bearish Security, Sell Futures Stock futures can be used by a speculator who believes that a particular security is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to do is sell stock futures. Simple arbitrage ensures that futures on an individual securities move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures on ABC at Rs.240 (each contract for underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the M P Birla Institute of Management, Bangalore 58 Analysis and Study of Derivative Products day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000. 3.1 Arbitraging: Overpriced futures: Buy spot, Sell Futures: As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair  value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seen overpriced, how can you cash in this opportunity to earn risk less profits? Say for  instance, ABC Ltd. Trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions. a) On day one, borrow funds; buy the security on the cash/spot market at 1000. b) Simultaneously, sell the futures on the security at 1025. c) Take delivery of the security purchased and hold the security for a month. d) On the futures expiration date, the spot and the futures price converge. Now unwind the position. e) Say the security closes at Rs.1015. Sell the security. f) Futures position expires with profit of Rs.10. g) The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position. h) Return the borrowed funds. When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy. 3.2 Arbitraging: Underpriced Futures: Buy Futures, Sell Spot: Whenever the futures price deviates substantially from its fair, value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem underpriced. How can you cash in on this opportunity to earn risk less M P Birla Institute of Management, Bangalore 59 Analysis and Study of Derivative Products profits? Say for instance ABC Ltd trades at Rs.1000. one-month ABC futures trade at Rs.965 and seem underpriced. As an arbitrageur you can make risk less profit by entering into the following set of transactions. a) On day one, sell the security in the cash/spot market at 100. b) Make delivery of the security. c) Simultaneously, buy the futures an the security at 1965. d) On the futures expiration date, the spot and the futures price converge. Now unwind the position. e) Say the security closes at Rs.975. buy back the security. f) The futures position expires with a profit of Rs.10. g) The result is a risk less profit of Rs.25 on the spot position and Rs.10 on the futures position. If the returns you get by investing in risk less instruments are more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cashand-carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market. M P Birla Institute of Management, Bangalore 60 Analysis and Study of Derivative Products Futures Segment top 5 traded symbols in March 2008: Symbol Traded value (Rs. in Crores) Percentage NIFTY 347980 50.41% RELIANCE 30294 4.39% RELCAPITAL 17221 2.49% REL 13985 2.03% RPL 12803 1.85% 268078 38.83% 690361 100% OTHERS TOTAL M P Birla Institute of Management, Bangalore 61 Analysis and Study of Derivative Products Top 5 Symbols by Open Interest (No. of contracts) on 27 th March 2008: Symbol Open Interest(no. of contracts) Percentage NIFTY 915502 39.72% RELIANCE 133294 5.78% ICICIBANK 47314 2.05% RCOM 41508 1.80% SBIN 38984 1.69% OTHERS 1128504 49.96% TOTAL 2305106 100% M P Birla Institute of Management, Bangalore 62 Analysis and Study of Derivative Products Options Segment: Here it is refereed to single stock futures, however since the index is nothing but a security whose price or level is a weighted average of securities consisting an index, all strategies that can be implemented using stock options can also be implemented using index options. 1. Hedging: Have underlying buy puts: Owners of stock and equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other  times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for  one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these weeks. One way to protect your portfolio from potential downside due to a market drop is i s to buy insurance using put options. Index and stock options are a cheap and easily implemantable way of seeking this insurance. This idea is simple to protect the value of your portfolio from failing below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock  options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your  portfolio does not fall below a particular level. This level depends on the strike price of  the index options chosen by you. Portfolio insurance using put options is of particular  interest to mutual funds who already own well-diversified portfolios. By using puts, the fund can limit its downside in case of a market fall. M P Birla Institute of Management, Bangalore 63 Analysis and Study of Derivative Products 2.1 Speculation: Bullish Security, buy calls or sell puts There are times when investors believe that security prices are going to rise. For  instance, after a good budget, or good corporate results, or the onset of a stable government, how does one implement a trading strategy to benefit from an upward movement in the underlying security? Using options there are two ways one can do this: 1. Buy call options 2. Sell put options The downside to the buyer of the call option is limited to the opinion premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a month’s time. Your  hunch proves correct and the price does indeed rise, it is the upside that you cash in on. However, if your hunch proves to be wrong and the security price plunges down, what you lose is only the option premium. Having decided to buy a call, which one should you buy? The table gives the premia for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, te obvious questions is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current price level is 1250, risk-free rate is 12% per year and volatility of the underlying security is 30%. The following options are available: o A one month call with a strike of 1200 o A one month call with a strike of 1225 o A one month call with a strike of 1250 o A one month call with a strike of 1275 o A one month call with a strike of 1300 One month calls and puts trading at different strikes: The spot price is 1250 there are five f ive one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the price of underlying will rise by more than 50 points on the M P Birla Institute of Management, Bangalore 64 Analysis and Study of Derivative Products expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration in which case the buyer will profit. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs.27.50. the following shows the payoffs from buying calls at different strikes. Similarly the put with a strike of 1300 is deep in-themoney and trades at a higher premium than the at-the-money put at a strike of 1250. the put with a strike of 1200 is deep out-of-the-money and will only be experienced in the unlikely event that underlying falls by 50 points on the expiration date. The table shows the payoffs from writing puts at different strikes. Underlying Strike price of option Call premium(Rs.) Put premium(Rs.) 1250 1200 80.10 18.15 1250 1225 63.65 26.50 1250 1250 49.45 37.00 1250 1275 37.50 49.80 1250 1300 27.50 64.80 Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the price, and how much you are willing to loose should this upward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 120 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration, in which case the buyer will make profits. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs.27.50 As a person who wants to speculate on the hunch that prices may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. If prices do rise, the buyer of the put will let the option expire and you will earn the premium. If however your hunch about an upward movement proves to be wrong and prices actually fall, then your losses directly increase with the M P Birla Institute of Management, Bangalore 65 Analysis and Study of Derivative Products falling price level. If for instance the price of the underlying falls to 1230 and you’ve sold a put with an exercise of 1300, the buyer of the put will exercise the option and you’ll end up losing Rs.70 taking into account the premium earned by you when you sold the put, the net loss on trade is Rs.5.20. Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the upward movement in the prices of the underlying. If you write an at-the-money put, the option premium earned by you will be higher than if you write an out-the-money put. However the chances of an at-the-money put being exercised on you are higher as well. In the example at a price level of 1250, one option is in-the-money and one is out-the-money. As expected, the in-the-money option fetches the highest premium of Rs.64.80 whereas the out-of-the-money option has the lowest premium of Rs.18.15. 2.2 Speculation: Bearish security, Sell Calls or Buy Puts: Do you sometimes think the market is going to drop? That you could make a profit by adopting a position on the market Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. How does one implement a trading strategy to benefit from a downward movement in the market? Today using options you have two choices: 1. Sell Call Options 2. Buy Put Options We have already seen the payoff of a cal option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have that the price of a particular security is going to fall in a month’s time. Your hunch proves correct and it does indeed fall, it is this downside that you cash in on. When the price falls, the buyer  of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security. Having decided to write a call, which one should you write? The table gives the premiums for one month calls and puts with different strikes. Given that there are a M P Birla Institute of Management, Bangalore 66 Analysis and Study of Derivative Products number of one-month calls trading, each with a different strike price, the obvious question is: assume that the current stock price is 1250; risk-free rate per year and stock  volatility is 30%. You could write the following options: o A one month call with a strike of 1200 o A one month call with a strike of 1225 o A one month call with a strike of 1250 o A one month call with a strike of 1275 o A one month call with a strike of 1300 One month Calls and Puts trading at different strikes: The spot price is 1250. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the price will raise by more than 50 points on the expiration date. Hence writing this call is a fairly f airly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer  suffers losses to the extent that the price is above 1300. in the more likely event of the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. the payoffs from writing calls at different strikes similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be exercised in the unlikely event that the price falls by 50 points on the expiration date. The choice of which put to buy depends upon how much the speculator expects the market to fall. The table t able shows the payoffs from buying puts at different strikes. M P Birla Institute of Management, Bangalore 67 Analysis and Study of Derivative Products Price Strike price of option Call Premium Put Premium (Rs.) (Rs.) 1250 1200 80.10 18.15 1250 1225 63.65 26.50 1250 1250 49.45 37.00 1250 1275 37.50 49.80 1250 1300 27.50 64.80 Which of these options you write largely depends on how strongly you feel about the likelihood of the downward movement of prices and how much you are willing to lose should this downward movement not come about. There are five onemonth calls and five one-month puts trading in the market. The call with a strike of  1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-money. Its execution depends on the unlikely event that the stock will raise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. in the more likely event of call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50 As a person who wants to speculate on the hunch that the market may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall, you profit to the extent the price falls below the strike of the put purchased by you. If however your hunch about a downward movement in the market in the market proves to be wrong and the price actually rises, all you lose is the option premium. If for instance the security price rises to 1300 and you’ve bought a put with an exercise of 1250, you simply let the put expire. If however the price does fall to say 1225 on expiration date, you make a neat profit of Rs.25. having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market. If you buy an at-the-money put, the option M P Birla Institute of Management, Bangalore 68 Analysis and Study of Derivative Products premium paid by you will by higher than if you buy an out-of-the-money put. However  the chances of an at-the-money put expiring in-the-money are higher as well. Options Segment top 5 traded symbols in March 2008: Symbol NIFTY Traded value (Rs. in Crores) Percentage 120307.28 91.94% 2937.30 2.24% 114.02 0.87% RNRL 600.81 0.46% TATASTEEL 564.23 0.43% RELIANCE RPL OTHERS TOTAL 5300 130388.45 M P Birla Institute of Management, Bangalore 4.05% 100% 69 Analysis and Study of Derivative Products Top 5 Symbols by Open Interest (No. of contracts) on 27 th March 2008: Call Options: Symbol Open Interest(no. of contracts) NIFTY 478057 82.20% RELIANCE 28548 4.91% RPL 5129 0.881% IFCI 4535 0.78% RNRL 4232 0.73% OTHERS 61101 10.51% TOTAL 581602 M P Birla Institute of Management, Bangalore Percentage 100% 70 Analysis and Study of Derivative Products Put Options: Symbol Open Interest(no. of contracts) NIFTY 477636 95.55% RELIANCE 7174 1.44% RPL 1389 0.28% RNRL 873 0.17% DLF 849 0.17% OTHERS 11964 2.39% TOTAL 499885 M P Birla Institute of Management, Bangalore Percentage 100% 71 Analysis and Study of Derivative Products CHAPTER 7 SUMMARY AND CONCLUSIONS M P Birla Institute of Management, Bangalore 72 Analysis and Study of Derivative Products Summary of Findings and Suggestions Findings: 1. The derivative products help to transfer risks from those who have them but may not like them to those who have an appetite for them. 2. The players in the Derivatives market are hedgers and speculators. A hedger tries to minimize risk by buying or selling now in an effort to avoid rising or declining prices. Conversely, the speculator will try to profit from the risks by buying or  selling now in anticipation of rising or declining prices. 3. Buying and selling in the futures market can seem risky and complicated. Futures and Options trading are not for everyone, but it works for a wide range of people. The futures market is a global marketplace, initially created as a place for farmers and merchants to buy and sell commodities for either spot or future delivery. This was done to lessen the risk of both waste and scarcity. 4. Rather than trade in physical commodities, futures markets buy and sell futures contracts, which state the price per unit, type, value, quality and quantity of the commodity in question, as well as the month the contract expires. 5. The futures market is also characterized as being highly leveraged due to its margins. Prices of derivative instruments converge with the prices of the underlying at the expiration of the derivative contracts. 6. Always there will be three contracts available for trading with 1 month, 2 months and 3 months which of those expires on the last Thursday of the respective month. 7. In forward contracts counterparty risk arises from the possibility of default by any one of the party to the transaction wherein future contracts exchanges acts as a counterparty and it is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered at a standard timing of such settlement. M P Birla Institute of Management, Bangalore 73 Analysis and Study of Derivative Products 8. In forward and future contracts both the parties are obligated to exercise the contract at expiry wherein options the buyer of an option contract is not obligated to exercise the contract it’s his wish to exercise or not on the expiry date. 9. Future contracts have linear payoffs; it means that the losses as well as profits for  the buyer and the seller of a futures contract are unlimited. 10. Whereas option contracts have non-linear payoffs; it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer the payoff is exactly the opposite his profits are limited to the option premium; however his losses are potentially unlimited. Suggestions: 1. So to deal with the Derivatives one should have a clear knowledge about the products and specifications and he should know the upside and downside in buying are selling the product and should have the ability to analyze its behavior with that of the spot price of the underlying asset. 2. It is preferred to use the derivative products as hedging tool, if the buyers are risk  averse i.e. they can use these products as insurance to their asset price fluctuations in the spot market. 3. There are numerous derivatives strategies, but the common thread is that they all allow you to either buy or sell an investment without actually taking possession of  it, with the ultimate goal of allowing you to profit from a move in the underlying asset in a specified amount of time. And because derivatives trade for a fraction of  the price of the underlying asset, you have the opportunity to spend less money to control more of the asset. M P Birla Institute of Management, Bangalore 74 Analysis and Study of Derivative Products CONCLUSION Financial derivatives should be considered for inclusion in any portfolio as a risk-control tool. Using derivatives allows risk to be broken into pieces that can be managed independently. Without a clearly defined risk management strategy, excessive use of financial derivatives can be risky. They can cause serious losses, hence it is important that users of derivatives fully understand the complexity of financial derivative contracts and accompanying risks. Derivatives being an important risk management tool necessitate its users to understand the intended function and the safety precautions before being put to use. Derivatives remain a type of financial instruments that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by investing in a Mutual Fund whose underlying assets may include derivative products. Even, the financial derivatives have changed the face of finance by creating new ways to understand measure and manage financial risks. M P Birla Institute of Management, Bangalore 75 Analysis and Study of Derivative Products BIBILIOGRAPHY Books: “Investment Analysis and Portfolio Management”, Second Edition - Prasanna Chandra “Introduction to Futures and Options Market” - Hull, John Websites: www.nseindia.com www.derivativesindia.com www.sharekhan.com www.moneycontrol.com www.investopedia.com www.businessmapsofindia.com www.finance.yahoo.com M P Birla Institute of Management, Bangalore 76