Description
Introduction of derivatives in the Indian capital market marked the beginning of a new era. Worldwide derivatives are seen as risk management instruments. These products have a long history in India especially in the unorganized sector. The availability of these products has provided the market participants with broad based risk management tools.
PROJECT REPORT
ON Study of Equity Derivatives Market in India
GENERAL INTRODUCTION
The liberalization of the Indian economy has ushered in an era of opportunities for the Indian corporate sector. however, these opportunities are accomplished by challenges. The corporate are now required to operate at global capacities to be able to reap the benefits of economies of scale and be competitive. To operate at global capacities, huge investments are called for and the main source of fund in the public at large. Therefore, the corporate now started tapping the capital market in a big way. The response is also encouraging.
After the Indian economy integrates with the world economy, any change, good or bad, anywhere in the world affects the Indian economy also. It is a well known fact that the returns on investment in equity is maximum but so is the risk that is associated with it. Hence it is absolutely essential to have a way or method that keeps this risk under check and this is exactly where the various types of financial derivatives come to play.
The development and origin of derivatives has been one of the significant events in the securities market. The term “derivatives” is used to refer to financial instruments which derive their value from some underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Thus if a derivative’s underlying asset is equity, it is called equity derivative and so on. Derivatives can be traded either on a regulated exchange, such as the NSE or off the exchanges, i.e., directly between the different parties, which is called “over-the-counter” (OTC) trading. (In India only exchange traded equity derivatives are permitted under the law.) The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of risk to those who are willing to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on November 1, 2012 a cotton farmer may wish to sell his harvest at a future date (say January 1, 2013) for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the "underlying".
ORIGIN OF DERIVATIVES The origin of derivative products can be traced back to ancient Greece. Although the derivative instruments have been in existence in one form or the other since ancient times, the advent of modern day derivatives can be attributed to the need of farmers to protect themselves from declining crop prices in future due to the various economic and environmental factors. Thus derivatives market first developed in commodities. The first “futures” contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers. These were evidently standardized contracts, much like today’s futures contracts. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward Contracts. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward remained more or less in the same form, as we know them today.
Scope of the study
Introduction of derivatives in the Indian capital market marked the beginning of a new era. Worldwide derivatives are seen as risk management instruments. These products have a long history in India especially in the unorganized sector. The availability of these products has provided the market participants with broad based risk management tools.
The study mainly helps to understand the different kinds of derivatives available in the equity market which help in managing the risk associated with the underlying asset.
Importance of the study
1) It helps to gain a good insight about various kinds of derivatives available in the market.
2) It helps to understand the ways in which they function and the strategies that are followed to mitigate risk. 3) It helps to understand how hedging works and how a diversified portfolio can be created.
Objectives of the study
Limitations of the study
1) While applying the strategies , transaction cost and impact cost are not taken 2) 3)
into consideration, this may reflect in the profit calculation. The data were calculated on the basis of NSE trading. Hedging has been applied on historical data, hence the trend in the particular stock was known beforehand which may have led to some bias in the application of the strategy.
Methodology
Type of research
The type of research is selected on the basis of problems identified. Here the research type used is descriptive research. Descriptive research includes fact-findings and enquiries of different kinds. The major purpose of descriptive research is a description of the state of affairs, as it exists in the present system. In this project an attempt has been made to discover various issues related to derivatives in the Indian market and how they help to hedge the risk.
Collection of data
The data used in this project has been collected from a host of sources like textbooks(Investment Management by V.K. BHALLA), interviews from stock brokers of Bhubaneswar stock exchange and a number of websites like:
www.maxplanwealth.com www.sherkhan.com www.nseindia.com www.icfai.org www.commodityindia.com
Review of Literature
Financial derivatives are particularly helpful to financial institutions because they help the later to engage in financial transactions in a way which helps reduce the risk associated in such transactions. When a party buys an asset, it takes a long position and when it agrees to sell an asset at a future date it takes a short position, in both the cases it is exposed to risk due to the uncertainty of prices of the particular asset. Financial derivatives can be used to mitigate this risk by using a concept called Hedging. Hedging helps in offsetting the risk associated with a long position by taking an additional short position and vice versa.
Participants of Derivatives Market
There are three types of participants in the derivatives market: 1) Hedgers 2) Speculators 3) Arbitrageurs
Hedgers: They face risk associated with the price of an assets. They use futures or options markets to reduce or eliminate this risk. Speculators: Speculators wish to bet on future movement in the price of an asset, futures and
options contracts to get them an extra leverage; they can increase both the potential gains and losses in a speculative venture.
Arbitrageurs: Arbitrageurs are in business to take advantage of a discrepancy between prices
in two different markets.
Factors affecting growth of Derivatives:
1) 2) 3) 4) Increased volatility in asset prices in financial markets. Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs. Development of more sophisticated risk management tools, providing economic agents, a wider choice of risk management strategies. 5) Innovation in the derivative markets, which optimally combine the risk and returns,
reduced risk as well as transaction costs as compared to individual financial assets.
Types of Derivatives
One way of classifying derivatives is as follows:
EQUITY DERIVATIVES
COMMODITY DERIVATIVES
Derivatives Derivatives
CURRENCY DERIVATIVES
INTEREST RATE DERIVATIVES
Another way of classifying derivatives is to simply classify them as commodity derivatives and financial derivatives.
Commodity Derivatives: These deals with commodities like sugar, gold, wheat, pepper
etc..thus, futures or options on gold, sugar, pepper, jute etc are commodity derivatives.
Financial Derivatives:
Futures or options or swaps on currencies, gift edged securities, stocks
and shares, stock market indices, cost of living indices etc are financial derivatives.
In this project we will focus on equity derivatives in particular.
Derivatives Market in India
In India, derivatives markets have been functioning since the nineteenth century, with organized trading in cotton through the establishment of the Cotton Trade Association in 1875 Derivatives, as exchange traded financial instruments were introduced in India in June 2000. The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract. In a span of one and a half years after the introduction of index futures, index options, stock options and stock futures were also introduced in the derivatives segment for trading. NSE’s equity derivatives segment is called the Futures & Options Segment or F&O Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate segment.
A series of reforms in the financial markets paved way for the development of exchangetraded equity derivatives markets in India. In 1993, the NSE was established as an electronic, national exchange and it started operations in 1994.
Milestones in the development of Indian Derivative Market:
November 18, 1996- L.C. Gupta Committee set up to draft a policy framework introducing derivatives May 11, 1998- L.C Gupta committee submits its report on the policy framework May 25, 2000- SEBI allows exchanges to trade in index futures June 12, 2000- Trading on Nifty futures commences on the NSE July 2, 2001-Trading on Stock options commences on the NSE November 9, 2001- Trading on stock futures commences on the NSE August 29, 2008- Currency derivatives trading commences on the NSE August 31, 2009- Interest rate derivatives trading commences on the NSE
for
February 2010- Launch of currency futures on additional currency pairs October 28, 2010- Introduction of European style stock options October 29, 2010- Introduction of currency options.
Spot Market
In the context of securities, the spot marketer cash market is a securities market in which securities are sold for cash and delivered immediately. The delivery happens after the settlement period. Let us describe this in the context of India. The NSE’s cash market segment is known as the Capital Market (CM) Segment. In this market, shares of SBI, Reliance, Infosys, ICICI Bank, and other public listed companies are traded. The settlement period in this market is on a T+2 basis i.e., the buyer of the shares receives the shares two working days after trade date and the seller of the shares receives the money two working days after the trade date. Index To identify the general trend in the market (or any given sector of the market such as banking), it is important to have a reference barometer which can be monitored. Market participants use various indices for this purpose. An index is a basket of identified stocks, and its value is computed by taking the weighted average of the prices of the constituent stocks of the index. A market index for example consists of a group of top stocks traded in the market and its value changes as the prices of its constituent stocks change. In India, Nifty Index is the most popular stock index and it is based on the top 50 stocks traded in the market.
Definitions of Basic Derivatives The following are the three basic forms of derivatives, which are the building blocks for many complex derivatives instruments (the latter are beyond the scope of this book): • Forwards • Futures • Options
Forwards A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price. It may be noted that Forwards are private contracts and their terms are determined by the parties involved. A forward is thus an agreement between two parties in which one party, the buyer, enters into
an agreement with the other party, the seller that he would buy from the seller an underlying asset on the expiry date at the forward price. Therefore, it is a commitment by both the parties to engage in a transaction at a later date with the price set in advance. This is different from a spot market contract, which involves immediate payment and immediate transfer of asset. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. The price agreed upon is called the delivery price or the Forward Price. Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis. Settlement of forward contracts When a forward contract expires, there are two alternate arrangements possible to settle the obligation of the parties: physical settlement and cash settlement. Both types of settlements happen on the expiry date and are given below. Physical Settlement A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date. The following example will help us understand the physical settlement process. Illustration Consider two parties (A and B) enter into a forward contract on 1 August, 2011 where, A agrees to deliver 1000 stocks of Airtel to B, at a price of Rs. 100 per share, on 29th August 2011 (the expiry date). In this contract, A, who has committed to sell 1000 stocks of Airtel at Rs. 100 per share on 29th August 2011 has a short position and B, who has committed to buy 1000 stocks at Rs. 100 per share is said to have a long position. In case of physical settlement, on 29th August, 2011 (expiry date), A has to actually deliver 1000 Airtel shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A. In case A does not have 1000 shares to deliver on 29th August, 2011, he has to purchase it from the spot market and then deliver the stocks to B. On the expiry date the profit/loss for each party depends on the settlement price, that is, the closing price in the spot market on 29th August 2011. The closing price on any given day is the weighted average price of the underlying during the last half an hour of trading in that day. Depending on the closing price, three different scenarios of profit/loss are possible for each party. They are as follows: Scenario I. Closing spot price on 29 August, 2011 (ST) is greater than the Forward price (FT). Assume that the closing price of Airtel on the settlement date 29 August, 2011 is Rs. 105. Since the short investor has sold Airtel at Rs. 100 in the Forward market on 1 August, 2011, he can buy 1000 Airtel shares at Rs. 105 from the market and deliver them to the long investor. Therefore the person who has a short position makes a loss of (100 – 105) X 1000 = Rs. 5000. If the long investor sells the shares in the spot market immediately after receiving
them, he would make an equivalent profit of (105 – 100 ) X 1000 = Rs. 5000. Scenario II. Closing Spot price on 29 August (ST), 2011 is the same as the Forward price (FT) The short seller will buy the stock from the market at Rs. 100 and give it to the long investor. As the settlement price is same as the Forward price, neither party will gain or lose anything. Scenario III. Closing Spot price (ST) on 29 August is less than the futures price (FT) Assume that the closing price of Airtel on 29 August, 2011 is Rs. 95. The short investor, who has sold Airtel at Rs. 100 in the Forward market on 1 August, 2011, will buy the stock from the market at Rs. 95 and deliver it to the long investor. Therefore the person who has a short position would make a profit of (100 – 95) X 1000 = Rs. 5000 and the person who has long position in the contract will lose an equivalent amount (Rs. 5000), if he sells the shares in the spot market immediately after receiving them. The main disadvantage of physical settlement is that it results in huge transaction costs in terms of actual purchase of securities by the party holding a short position (in this case A) and transfer of the security to the party in the long position (in this case B). Further, if the party in the long position is actually not interested in holding the security, then she will have to incur further transaction cost in disposing off the security. An alternative way of settlement, which helps in minimizing this cost, is through cash settlement.
Swaps
Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: Interest rate Swaps Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. Currency Swaps Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash f lows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. Financial Swaps
Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.
Applications of Derivatives
We look at the participants in the derivatives markets and how they use derivatives contracts. Participants in the Derivatives Market As equity markets developed, different categories of investors started participating in the market. In India, equity market participants currently include retail investors, corporate investors, mutual funds, banks, foreign institutional investors etc. Each of these investor categories uses the derivatives market to as a part of risk management, investment strategy or speculation. Based on the applications that derivatives are put to, these investors can be broadly classified into three groups: • Hedgers • Speculators, and • Arbitrageurs
Hedgers These investors have a position (i.e., have bought stocks) in the underlying market but are worried about a potential loss arising out of a change in the asset price in the future. Hedgers participate in the derivatives market to lock the prices at which they will be able to transact in the future. Thus, they try to avoid price risk through holding a position in the derivatives market. Different hedgers take different positions in the derivatives market based on their exposure in the underlying market. A hedger normally takes an opposite position in the derivatives market to what he has in the underlying market. Hedging in futures market can be done through two positions, viz. short hedge and long hedge. Short Hedge A short hedge involves taking a short position in the futures market. Short hedge position is taken by someone who already owns the underlying asset or is expecting a future receipt of the underlying asset. For example, an investor holding Reliance shares may be worried about adverse future price movements and may want to hedge the price risk. He can do so by holding a short position in
the derivatives market. The investor can go short in Reliance futures at the NSE. This protects him from price movements in Reliance stock. In case the price of Reliance shares falls, the investor will lose money in the shares but will make up for this loss by the gain made in Reliance Futures. Note that a short position holder in a futures contract makes a profit if the price of the underlying asset falls in the future. In this way, futures contract allows an investor to manage his price risk. Similarly, a sugar manufacturing company could hedge against any probable loss in the future due to a fall in the prices of sugar by holding a short position in the futures/ forwards market. If the prices of sugar fall, the company may lose on the sugar sale but the loss will be offset by profit made in the futures contract. Long Hedge A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward price. This strategy is used by those who will need to acquire the underlying asset in the future. For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried about any loss that may arise if the price of sugar increases in the future. To hedge against this risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal market, but he will be compensated against this loss through a profit that will arise in the futures market. Note that a long position holder in a futures contract makes a profit if the price of the underlying asset increases in the future. Long hedge strategy can also be used by those investors who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to lock the prevailing price in the market. This may be because he thinks that the prevailing price is very low. For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per stock. An investor is expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is at a very attractive level and he may mi ss the opportunity to buy the stock if he waits till the end of the month. In such a case, he can buy Wipro Ltd. in the futures market. By doing so, he can lock in the price of the stock. Assuming that he buys Wipro Ltd. in the futures market at Rs. 250 (t his becomes his locked-in price), there can be three probable scenarios:
Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300. As futures price is equal to the spot price on the expiry day, the futures price of Wipro would be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the futures market at Rs. 300. By doing this, he has made a profit of 300 – 250 = Rs. 50 in the futures trade. He can now buy Wipro Ltd in the spot market at Rs. 300. Therefore, his total investment cost for buying one share of Wipro Ltd equals Rs.300 (price in spot market) – 50 (profit in futures market) = Rs.250. This is the amount of money he was expecting to have at the end of the month. If the investor had not bought Wipro Ltd futures, he would have had only Rs. 250 and would have been unable to buy Wipro Ltd shares in the cash market. The futures contract helped him to
lock in a price for the shares at Rs. 250. Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250. As futures price tracks spot price, futures price would also be at Rs. 250 on expiry day. The investor will sell Wipro Ltd in the futures market at Rs. 250. By doing this, he has made Rs. 0 in the futures trade. He can buy Wipro Ltd in the spot market at Rs. 250. His total investment cost for buying one share of Wipro will be = Rs. 250 (price in spot market) + 0 (loss in futures market) = Rs. 250. Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200. As futures price tracks spot price, futures price would also be at Rs. 200 on expiry day. The investor will sell Wipro Ltd in the futures market at Rs. 200. By doing this, he has made a loss of 200 – 250 = Rs. 50 in the futures trade. He can buy Wipro in the spot market at Rs. 200. Therefore, his total investment cost for buying one share of Wipro Ltd will be = 200 (price in spot market) + 50 (loss in futures market) = Rs. 250. Thus, in all the three scenarios, he has to pay only Rs. 250. This is an example of a Long Hedge. Speculators A Speculator is one who bets on the derivatives market based on his views on the potential movement of the underlying stock price. Speculators take large, calculated risks as they trade based on anticipated future price movements. They hope to make quick, large gains; but may not always be successful. They normally have shorter holding time for their positions as compared to hedgers. If the price of the underlying moves as per their expectation they can make large profits. However, if the price moves in the opposite direction of their assessment, the losses can also be enormous. Illustration Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and also at Rs. 500 in the futures market (assumed values for the example only). A speculator feels that post the RBI’s policy announcement, the share price of ICICI will go up. The speculator can buy the stock in the spot market or in the derivatives market. If the derivatives contract size of ICICI is 1000 and if the speculator buys one futures contract of ICICI, he is buying ICICI futures worth Rs 500 X 1000 = Rs. 5,00,000. For this he will have to pay a margin of say 20% of the contract value to the exchange. The margin that the speculator needs to pay to the exchange is 20% of Rs. 5,00 ,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for the futures contract. If the speculator would have invested Rs. 1,00,000 in the spot market, he could purchase only 1,00,000 / 500 = 200 shares. Let us assume that post RBI announcement price of ICICI share moves to Rs. 520. With one lakh investment each in the futures and the cash market, the profits would be: • • (520 – 500) X 1,000 = Rs. 20,000 in case of futures market and (520 – 500) X 200 = Rs. 4000 in the case of cash market.
It should be noted that the opposite will result in case of adverse movement in stock prices, wherein the speculator will be losing more in the futures market than in the spot market. This is because the speculator can hold a larger position in the futures market where he has to pay only the margin money.
Arbitrageurs Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous trades that offset each other and capture a risk-free profit. An arbitrageur may also seek to make profit in case there is price discrepancy between the stock price in the cash and the derivatives markets. For example, if on 1st August,2009 the SBI share is trading at Rs. 1780 in the cash market and the futures contract of SBI is trading at Rs. 17 90, the arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the spot market and sell the same number of SBI futures contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will close at the price at which SBI closes in the spot market. In other words, the settlement of the futures contract will happen at the closing price of the SBI shares and that is why the futures and spot prices are said to converge on the expiry day. On expiry day, the arbitrageur will sell the SBI stock in the spot market and buy the futures contract, both of which will happen at the closing price of SBI in the spot market. Since the arbitrageur has entered into off-setting positions, he will be able to earn Rs. 10 irrespective of the prevailing market price on the expiry date. There are three possible price scenarios at which SBI can close on expiry day. Let us calculate the profit/ loss of the arbitrageur in each of the scenarios where he had initially (1 August) purchased SBI shares in the spot market at Rs 1780 and sold the futures contract of SBI at Rs. 1790: Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot market on the expiry day i.e., SBI futures will also close at Rs. 2000. The arbitrageur reverses his previous transaction entered into on 1st August 2009. Profit/ Loss (– ) in spot market = 2000 – 1780 = Rs. 220 Profit/ Loss (– ) in futures market = 1 790 – 2000 = Rs. ( –) 210 Net profit/ Loss (– ) on both transactions combined = 220 – 210 = Rs. 10 profit. Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot mar ket on expiry day i.e., SBI futures will also close at Rs 1780. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss (– ) in spot market = 1780 – 1780 = Rs 0
Profit/ Loss (– ) in futures market = 1790 – 1780 = Rs. 1 0 Net profit/ Loss (– ) on both transactions combined = 0 + 10 = Rs. 10 profit.
Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009) Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss (– ) in spot market = 1500 – 1780 = Rs. (–) 280 Profit/ Loss (– ) in futures market = 1790 – 1500 = Rs. 290 Net profit/ Loss (– ) on both transactions combined = (–) 280 + 290 = Rs. 10 profit. Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which was the difference between the spot price of SBI and futures price of SBI, when the transaction was entered into. This is called a “risk less profit” since once the transaction is entered into on 1 August, 2009 (due to the price difference between spot and futures), the profit is locked. Irrespective of where the underlying share price closes on the expiry date of the contract, a profit of Rs. 10 is assured.
Uses of Derivatives Risk management The most important purpose of the derivatives market is risk management. Risk management for an investor comprises of the following three processes: • • Identifying the desired level of risk that the investor is willing to take on his investments; Identifying and measuring the actual level of risk that the investor is carrying; and
•
Making arrangements which may include trading (buying/selling) of derivatives contracts that allow him to match the actual and desired levels of risk.
Market efficiency Efficient markets are fair and competitive and do not allow an investor to make risk free profits. Derivatives assist in improving the efficiency of the markets, by providing a selfcorrecting mechanism. Arbitrageurs are one section of market participants who trade whenever there is an opportunity to make risk free profits till the opportunity ceases to exist.
Risk free profits are not easy to make in more efficient markets. When trading occurs, there is a possibility that some amount of mispricing might occur in the markets. The arbitrageurs step in to take advantage of this mispricing by buying from the cheaper market and selling in the higher market. Their actions quickly narrow the prices and thereby reducing the inefficiencies.
Price discovery One of the primary functions of derivatives markets is price discovery. They provide valuable information about the prices and expected price fluctuations of the underlying assets in two ways:
•
•
First, many of these assets are traded in markets in different geographical locations. Because of this, assets may be traded at different prices in different markets. In derivatives markets, the price of the contract often serves as a proxy for the price of the underlying asset. Second, the prices of the futures contracts serve as prices that can be used to get a sense of the market expectation of future prices.
Trading Futures
To understand futures trading and profit/loss that can occur while trading, knowledge of payoff diagrams is necessary. Pay-off refers to profit or loss in a trade. A pay-off is positive if the investor makes a profit and negative if he makes a loss. A pay-off diagram represents profit/loss in the form of a graph which has the stock price on the X axis and the profit/ loss on the Y axis. Thus, from the graph an investor can calculate the profit or loss that his position can make for different stock prices values.
Pay-off of Futures
The Pay-off of a futures contract on maturity depends on the spot price of the underlying asset at the time of maturity and the price at which the contract was initially traded. There are two positions that could be taken in a futures contract: a. Long position: one who buys the asset at the futures price (F) takes the long position and b. Short position: one who sells the asset at the futures price (F) takes the short position The pay-off for a long position in a futures contract on one unit of an asset is: Long pay-off= ST-F Similarly, the pay-off for a short position in futures contract of one unit of asset is: Short pay-off= F-ST Pay-off diagram for long and short futures: ‘
The long investor makes profits if the spot price at expiry exceeds the futures contract price X, and makes losses if the opposite happens and in case of a short position, the investor makes profits if the spot prices at expiry is below the futures contract price X and makes losses if the opposite happens.
A Theoretical Model of Future Pricing
While futures prices in reality are determined by demand and supply, one can obtain a theoretical:
Futures price, using the following model: Where: F= Futures Price S=Spot price of the underlying asset r= Cost of financing( using continuously compounded interest rate) T= time till expiration in years E=2.71828 Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% per annum. The fair value of a one-month futures contract XYZ is calculated as follows:
Trading Options
Option Payout There are two sides to every option contract. On the one side is the option buyer who has taken a long position (i.e., has bought the option). On the other side is the option seller who has taken a short position (i.e., has sold the option). The seller of the option receives a premium from the buyer of the option. A long position in a call option: In this strategy, the investor has the right to buy the asset in the future at a predetermined strike price, i.e. K . and the option seller has the obligation to sell the asset at the strike price (K). If the settlement price (underlying stock closing price) of the asset is above the strike price, then the call option buyer will exercise his option and buy the stock at the strike price (K). If the settlement price (underlying stock closing price) is lower than the strike price, the option buyer will not exercise the option as he can buy the same stock from the market at a price lower than the strike price.
A long position in a put option: In this strategy, the investor has bought the right to sell the underlying asset in the future at a predetermined strike price (K). If the settlement price (underlying stock closing price) at maturity is lower than the strike price, then the put option holder will exercise his option and sell the stock at the strike price (K). If the settlement price (underlying stock closing price) is higher than the strike price, the option buyer will not exercise the option as he can sell the same stock in the market at a price higher than the strike price. A short position in a call option: In this strategy, the option seller has an obligation to sell the asset at a predetermined strike price(K) i f the buyer of the option chooses to exercise the option. The buyer of the option will exercise the option if the spot price at maturity is any value higher than (K). If the spot price is lower than (K), the buyer of the option will not exercise his/her option. A short position in a put option: In this strategy, the option seller has an obligation to buy the asset at a predetermined strike price(K) if the buyer of the option chooses to exercise his/her option. The buyer of the option will exercise his option to sell at K if the spot price at maturity is lower than K. If the spot price is higher than K, then the option buyer will not exercise his/her option. The Various pay-off diagrams: 1. Pay-off for a buyer of the call option:
The figure shows the profits/losses for a buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However, if Nifty falls below the strike of 2250, the buyer lets the option expire. His losses are limited to the extent of the premium that he paid for buying the option.
2. Pay-off for a seller of the call option:
The figure shows the profits/losses for a seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the upfront option premium charged by him. 3. Pay-off for a buyer of a put option:
The figure shows the profits/losses for a buyer of a three-month Nifty 2250 put option. As can be seen as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However, if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
4. Pay-off for a seller of a Put option:
The figure shows the profits/losses for a seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the upfront option premium of charged by him.
Option Strategies An option strategy is implemented to try and make gains from the movement in the underlying price of an asset. Long Option Strategy: A long option strategy is a strategy of buying an option according to the view on future price movement of the underlying. A person with a bullish opinion on the underlying will buy a call option on that asset/security, while a person with a bearish opinion on the underlying will buy a put option on that asset/security. An important characteristic of long option strategies is limited risk and unlimited profit potential. An option buyer can only lose the amount paid for the option premium. At the same time, theoretically, the profit potential is unlimited. Calls An investor having a bullish opinion on underlying can expect to have positive returns by buying a call option on that asset/security. When a call option is purchased, the call option holder is exposed to the stock performance in the spot market without actually possessing the stock and does so for a fraction of the cost involved in purchasing the stock in the spot market. The cost incurred by the call option holder is the option premium. Thus, he can take advantage of a smaller investment and maximize his profits.
e.g Mr. A buys a Call on an index (such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81. Consider the values of the index at expiration as 1800, 1900, 2100, an d 2200. For ST= 1800, Profit/loss=0-81= -81(maximum loss=premium paid) For ST= 1900, Profit/loss= 0-81= -81(Maximum loss=premium paid) For ST= 2100, Profit/loss= 2100-2000-81= 19 For ST=2200, Profit/Loss= 2200-2000-81=119 Puts An investor having a bearish opinion on the underlying can expect to have positive returns by buying a put option on that asset/security. When a put option is purchased, the put option buyer has the right to sell the stock at the strike price on or before the expiry date depending on where the underlying price is. e.g Mr. X buys a put at a strike price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at expiration at 1800, 1900, 2100, and2200.. For ST= 1800, Profit/Loss=2000-1800-79=121 For ST=1900,Profit/Loss=2000-1900-79=21 For ST=2100, Profit/Loss= -79(Maximum loss is the premium paid) For ST=2200, Profit/Loss= -79(Maximum loss is the premium paid) Short Option Strategy: A short options strategy is a strategy where options are sold to make money upfront with a view that the options will expire out of money at the expiry date (i.e., the buyer of the option will not exercise the same and the seller can keep the premium). A person with a bullish opinion on the underlying will sell a put option in the hope that prices will rise and the buyer will not exercise the option leading to profit for the seller. On the other hand, a person with a bearish view on the underlying will sell a call option in the hope that prices will fall and the buyer will not exercise the option leading to profit for the seller. Call An investor with a bearish opinion on the underlying can take advantage of falling stock prices by selling a call option on the asset/security. If the stock price falls, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price increases above the strike price. e.g A sells a call at a strike price of Rs 2000 for a premium of Rs 81 Consider values of index at expiration at 1800, 1900, 2100, and 2200. For ST= 1800, Profit/loss= 81 (Maximum profit= Premium received) For ST= 1900, Profit/loss=81(Maximum profit=Premium received) For ST= 2100, Profit/loss= 81-(2100-2000) = -19 For ST=2200, Profit/loss= 81-(2100-2200)= -119
Puts An investor with a bullish opinion on the underlying can take advantage of rising prices by selling a put option on the asset/security. If the stock price rises, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price falls below the strike price. e.g We sell a put at a strike price of Rs 2000 for Rs. 79. Consider values of index at expiration as 1800, 1900, 2100 and 2200. For ST= 1800, Profit/loss=79-(2000-1800)= -121 For ST=1900, Profit/loss= 79-(2000-1900)= -21 For ST=2100, Profit/loss= 79(Maximum profit= premium received) For ST=2200, Profit/loss= 79(Maximum profit= premium received)
Determination of Option Prices The price of an option has two components: Intrinsic value and time value. Intrinsic Value of an option: Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of-the-money (OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (ST-K)] which means the intrinsic value of a put is Max[ 0,(K-ST)] i.e greater of 0 or (K-ST) where K is the strike price and ST is the spot price. Time value of an option: In addition to the intrinsic value, the seller charges a ‘time value’ from the buyers of the option. This is because the more time there is for the contract to expire the greater the chance that the exercise of the contract will become more profitable for the buyer. This is a risk for the seller and he seeks compensation for it by demanding a ‘time value’ The time value of an option can be obtained by taking the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out -of-the-money(OTM) or At-themoney (ATM) has only time value and no intrinsic 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 being equal. At expiration, an option has no time value.
Illustration In the following two tables, five different examples are given for call option and put option respectively. 1. For Call Options Underlying Strike Price(Rs) Premium(Rs) Intrinsic Time Value(Rs) Price(Rs) Value(Rs) 100 90 12 10 2 101 90 13 11 2 103 90 14 13 1 88 90 1 0 1 95 90 5.50 5 5.50 2. For Put Options
Underlying Price(Rs) 100 99 97 112 105
Strike Price(Rs) Premium(Rs) 110 110 110 11 110 12 13 14 1 5.50
Intrinsic Value(Rs) 10 11 13 0 5
Time Value(Rs) 2 2 1 1 5.50
Factors affecting Option Prices
1.The underlying price: Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases. Thus, in the case of a Call option, the higher the price of the underlying asset from strike price, the higher is the value (premium) of the call option. On the other hand, in case of a put option, the higher the price of the underlying asset, the lower is the value of the put option. 2.The Strike price: The strike price is specified in the option contract and does not change over time. The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option. Everything else remaining constant, as the strike price increases, the value of a call option decreases and the value of a put option increases. Similarly, as the strike price decreases, the price of the call option increases while that of a put option decreases. 3.Time to expiration: Time to expiration is the time remaining for the option to expire. Obviously, the time remaining in an option’s life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing. The time value of both call as well as put option decreases to zero (and hence, the price of the option falls to its intrinsic value) as the time to expiration approaches zero. As time passes and a call option approaches maturity, its value declines, all other parameters remaining constant. Similarly, the value of a put option also decreases as we approach maturity. This is called “time-decay”. 4.Volatility: Volatility is an important factor in the price of an option. Volatility is defined as
the uncertainty of returns. The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same. 5.Risk free rate: Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government. Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally. It may however be noted that option prices do not change much with changes in the risk free rate.
Open Interest and contract in the enclosed charts
Open interest is the total number of options and/or futures contracts that are not closed out on a particular day, that is contracts that have been purchased and are still outstanding and not been sold and vice versa. A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct since there could be huge volumes but if the volumes are just because of participants squaring off their positions then the open interest would not be large. On the other hand, if the volumes are large because of fresh positions being created then the open interest would also be large. The Contract column tells us about the strike price of the call or put and the date of their settlement. For example, the first entry in the Active Calls section (4500.00 -August) means it is a Nifty call with Rs 4500 strike price, that would expire in August. It is interesting to note from the newspaper extract given above is that it is possible to have a number of options at different strike prices but all of them have the same expiry date. For example, there are a number of call options on Nifty with different strike prices, but all of them expiring on the same expiry date in August. There are different tables explaining different sections of the F&O markets 1. Positive trend: It gives information about the top gainers in the futures 2. Negative trend: It gives information about the top losers in the futures market. 3. Future OI gainers: It lists those futures whose % increases in open interest are among the highest on that day 4. Future OI losers: It lists those futures whose % decreases in open interest are among the highest on that day 5. Active Calls: Calls with high trading volumes on that particular day 6. Active Puts: Puts with high trading volumes on that particular day.
Settlement of Derivatives
Settlement refers to the process through which trades are cleared by the payment/receipt of currency, securities or cash flows on periodic payment dates and on the date of the final settlement. The settlement process is somewhat elaborate for derivatives instruments which are exchange traded. (They have been very briefly outlined here. For a more detailed explanation, please refer to NCFM Derivatives Markets (Dealers) Module). The settlement process for exchange traded derivatives is standardized and a certain set of procedures exist which take care of the counterparty risk posed by these instruments. At the NSE, the National
Securities Clearing Corporation Limited (NSCCL) undertakes the clearing and settlement of all trades executed on the F&O segment of NSE. It also acts as a legal counterparty to all trades on the F&O segment and guarantees their financial settlement. There are two clearing entities in the settlement process: Clearing Members and Clearing Banks. Clearing Members A Clearing member (CM) is the member of the clearing corporation i.e., NSCCL. These are the members who have the authority to clear the trades executed in the F&O segment in the exchange. There are three types of clearing members with different set of functions: 1) Self -clearing Members: Members who clear and settle trades executed by them only on their own accounts or on account of their clients. 2) Trading cum Clearing Members: They clear and settle their own trades as well as trades of other trading members (TM). 3) Professional Clearing Members (PCM): They only clear and settle trades of others but do not trade themselves. PCMs are typically Financial Institutions or Banks who are admitted by the Clearing Corporation as members.
Settlement of Futures
When two parties trade a futures contract, both have to deposit margin money which is called the initial margin. Futures contracts have two types of settlement: (i) the mark-to-market (MTM) settlement which happens on a continuous basis at the end of each day, and (ii) the final settlement which happens on the last trading day of the futures contract i.e., the last Thursday of the expiry month. Mark to Market settlement To cover for the risk of default by the counterparty for the clearing corporation, the futures contracts are marked-to-market on a daily basis by the exchange. Mark to market settlement is the process of adjusting the margin balance in a futures account each day for the change in the process of adjusting the margin balance in a futures account each day for the change in the contracts. This process helps the clearing corporation in managing the counterparty risk of the future contracts by requiring the party incurring a loss due to adverse price movements to part with the loss amount on a daily basis. Simply put, the party in the loss position pays the clearing corporation the margin money to cover for the shortfall in cash. Illustration To illustrate this concept, let us consider a futures contract that has been bought on the XYZ Ltd. at an initial price of Rs. 1000. The exchange sets two margins; Initial Margin and Maintenance Margin. Both parties to a derivative contract have to pay a certain Margin the moment they enter into the Contract; it is called Initial Margin. Maintenance margin is the level at which the margin has to be always maintained. In case the margin falls to maintenance margin or below, additional funds are called for to take have to take the margin to the Initial margin level.
Let us say, Initial Futures Price = Rs. 1000; Initial Margin requirement = Rs. 500; Maintenance Margin Requirement = Rs. 300; Contract size = 10 (that is, one futures contract has 10 shares of XYZ. How the end of day margin balance of the holder of (i) a long position of a contract and ii) a short position of a contract, varies with the changes in settlement price from day to day is given below.
Mark to Market margin of a long position Day Beginning Balance (Rs) 0 1 2 3 4 5 6 0 500 580 900 400 150 550 Funds Deposited (Rs) 500 0 0 0 0 350 0 Settlement Price (Rs) Future Price change (A)(Rs) --8 -32 50 25 -5 10 Gain/Loss=A Ending X contract Balance size(Rs) (RS) --80 -320 500 250 -50 100 -420 100 1000 1250 1200 1300
1000 992 960 1010 1035 1030 1040
Mark to Market margin of a short position Day Beginning Balance (Rs) 0 1 2 3 4 5 6 0 500 580 900 400 150 550 Funds Deposited (Rs) 500 0 0 0 0 350 0 Settlement Price (Rs) Future Price change (A)(Rs) -8 32 -50 -25 5 -10 Gain/Loss=A Ending X contract Balance size(Rs) (RS) -80 320 -500 -250 50 -100 -580 900 400 150 550 450
1000 992 960 1010 1035 1030 1040
Final settlement of Futures After the close of trading hours on the expiry day of the futures contracts, NSCCL marks all positions of clearing members to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss is debited and final settlement profit is credited to the relevant clearing bank accounts on the day following the expiry date of the contract. Suppose the above contract closes on day 6 (that is, it expires) at a price of Rs. 1040, then on the day
of expiry, Rs. 100 would be debited from the seller (short position holder) and would be transferred to the buyer (long position holder).
Settlement of Options
There are basically two types of settlement in stock option contracts: daily premium settlement and final exercise settlement. Options being European style, they cannot be exercised before expiry.
Daily premium settlement Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the options sold by him. The same person may sell some contracts and buy some contracts as well. The premium payable and the premium receivable are netted to compute the net premium payable or receivable for each client for each options contract at the time of settlement. Final Exercise Settlement On the day of expiry, all in the money options are exercised by default. An investor who has a long position in an in-the-money option on the expiry date will receive the exercise settlement value which is the difference between the settlement price and the strike price. Similarly, an investor who has a short position in an in-the-money option will have to pay the exercise settlement value. The final exercise settlement value for each of the in the money options is calculated as follows: Call Options = Closing price of the security on the day of expiry – strike price (if closing price > strike price, else 0) Put Options = Strike price – closing price of the security on the day of expiry (if closing price < strike price, else 0)
Accounting and Taxation of Derivatives
The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index future contracts from the view point of parties who enter into such future contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations a trade in equity index futures is similar to a trade in, say shares, and accounting remains similar as in the case of buying or selling of shares.
Prior to the year 2005, the Income Tax Act did not have any specific provision regarding taxability of derivatives. The only tax provisions which had indirect bearing on derivatives transactions were sections 73(1) and 43(5). Under these sections, trade in derivatives was considered “speculative transactions” for the purpose of determining tax liability. All profits and losses were taxed under the speculative income category. Therefore, loss on derivatives transactions could be set off only against other speculative income and the same could not be set off against any other income. This resulted in high tax liability.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives carried out in a “recognized stock exchange” from ‘speculative transaction’. This implies that derivatives transactions that take place in a “recognized stock exchange” are not taxed as speculative income or loss. They are treated under the business income head of the Income tax Act. Any losses on these activities can be set off against any business income in the year and the losses can be carried forward and set off against any other business income for the next eight years.
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Introduction of derivatives in the Indian capital market marked the beginning of a new era. Worldwide derivatives are seen as risk management instruments. These products have a long history in India especially in the unorganized sector. The availability of these products has provided the market participants with broad based risk management tools.
PROJECT REPORT
ON Study of Equity Derivatives Market in India
GENERAL INTRODUCTION
The liberalization of the Indian economy has ushered in an era of opportunities for the Indian corporate sector. however, these opportunities are accomplished by challenges. The corporate are now required to operate at global capacities to be able to reap the benefits of economies of scale and be competitive. To operate at global capacities, huge investments are called for and the main source of fund in the public at large. Therefore, the corporate now started tapping the capital market in a big way. The response is also encouraging.
After the Indian economy integrates with the world economy, any change, good or bad, anywhere in the world affects the Indian economy also. It is a well known fact that the returns on investment in equity is maximum but so is the risk that is associated with it. Hence it is absolutely essential to have a way or method that keeps this risk under check and this is exactly where the various types of financial derivatives come to play.
The development and origin of derivatives has been one of the significant events in the securities market. The term “derivatives” is used to refer to financial instruments which derive their value from some underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Thus if a derivative’s underlying asset is equity, it is called equity derivative and so on. Derivatives can be traded either on a regulated exchange, such as the NSE or off the exchanges, i.e., directly between the different parties, which is called “over-the-counter” (OTC) trading. (In India only exchange traded equity derivatives are permitted under the law.) The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of risk to those who are willing to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on November 1, 2012 a cotton farmer may wish to sell his harvest at a future date (say January 1, 2013) for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the "underlying".
ORIGIN OF DERIVATIVES The origin of derivative products can be traced back to ancient Greece. Although the derivative instruments have been in existence in one form or the other since ancient times, the advent of modern day derivatives can be attributed to the need of farmers to protect themselves from declining crop prices in future due to the various economic and environmental factors. Thus derivatives market first developed in commodities. The first “futures” contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers. These were evidently standardized contracts, much like today’s futures contracts. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward Contracts. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward remained more or less in the same form, as we know them today.
Scope of the study
Introduction of derivatives in the Indian capital market marked the beginning of a new era. Worldwide derivatives are seen as risk management instruments. These products have a long history in India especially in the unorganized sector. The availability of these products has provided the market participants with broad based risk management tools.
The study mainly helps to understand the different kinds of derivatives available in the equity market which help in managing the risk associated with the underlying asset.
Importance of the study
1) It helps to gain a good insight about various kinds of derivatives available in the market.
2) It helps to understand the ways in which they function and the strategies that are followed to mitigate risk. 3) It helps to understand how hedging works and how a diversified portfolio can be created.
Objectives of the study
Limitations of the study
1) While applying the strategies , transaction cost and impact cost are not taken 2) 3)
into consideration, this may reflect in the profit calculation. The data were calculated on the basis of NSE trading. Hedging has been applied on historical data, hence the trend in the particular stock was known beforehand which may have led to some bias in the application of the strategy.
Methodology
Type of research
The type of research is selected on the basis of problems identified. Here the research type used is descriptive research. Descriptive research includes fact-findings and enquiries of different kinds. The major purpose of descriptive research is a description of the state of affairs, as it exists in the present system. In this project an attempt has been made to discover various issues related to derivatives in the Indian market and how they help to hedge the risk.
Collection of data
The data used in this project has been collected from a host of sources like textbooks(Investment Management by V.K. BHALLA), interviews from stock brokers of Bhubaneswar stock exchange and a number of websites like:
www.maxplanwealth.com www.sherkhan.com www.nseindia.com www.icfai.org www.commodityindia.com
Review of Literature
Financial derivatives are particularly helpful to financial institutions because they help the later to engage in financial transactions in a way which helps reduce the risk associated in such transactions. When a party buys an asset, it takes a long position and when it agrees to sell an asset at a future date it takes a short position, in both the cases it is exposed to risk due to the uncertainty of prices of the particular asset. Financial derivatives can be used to mitigate this risk by using a concept called Hedging. Hedging helps in offsetting the risk associated with a long position by taking an additional short position and vice versa.
Participants of Derivatives Market
There are three types of participants in the derivatives market: 1) Hedgers 2) Speculators 3) Arbitrageurs
Hedgers: They face risk associated with the price of an assets. They use futures or options markets to reduce or eliminate this risk. Speculators: Speculators wish to bet on future movement in the price of an asset, futures and
options contracts to get them an extra leverage; they can increase both the potential gains and losses in a speculative venture.
Arbitrageurs: Arbitrageurs are in business to take advantage of a discrepancy between prices
in two different markets.
Factors affecting growth of Derivatives:
1) 2) 3) 4) Increased volatility in asset prices in financial markets. Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs. Development of more sophisticated risk management tools, providing economic agents, a wider choice of risk management strategies. 5) Innovation in the derivative markets, which optimally combine the risk and returns,
reduced risk as well as transaction costs as compared to individual financial assets.
Types of Derivatives
One way of classifying derivatives is as follows:
EQUITY DERIVATIVES
COMMODITY DERIVATIVES
Derivatives Derivatives
CURRENCY DERIVATIVES
INTEREST RATE DERIVATIVES
Another way of classifying derivatives is to simply classify them as commodity derivatives and financial derivatives.
Commodity Derivatives: These deals with commodities like sugar, gold, wheat, pepper
etc..thus, futures or options on gold, sugar, pepper, jute etc are commodity derivatives.
Financial Derivatives:
Futures or options or swaps on currencies, gift edged securities, stocks
and shares, stock market indices, cost of living indices etc are financial derivatives.
In this project we will focus on equity derivatives in particular.
Derivatives Market in India
In India, derivatives markets have been functioning since the nineteenth century, with organized trading in cotton through the establishment of the Cotton Trade Association in 1875 Derivatives, as exchange traded financial instruments were introduced in India in June 2000. The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract. In a span of one and a half years after the introduction of index futures, index options, stock options and stock futures were also introduced in the derivatives segment for trading. NSE’s equity derivatives segment is called the Futures & Options Segment or F&O Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate segment.
A series of reforms in the financial markets paved way for the development of exchangetraded equity derivatives markets in India. In 1993, the NSE was established as an electronic, national exchange and it started operations in 1994.
Milestones in the development of Indian Derivative Market:
November 18, 1996- L.C. Gupta Committee set up to draft a policy framework introducing derivatives May 11, 1998- L.C Gupta committee submits its report on the policy framework May 25, 2000- SEBI allows exchanges to trade in index futures June 12, 2000- Trading on Nifty futures commences on the NSE July 2, 2001-Trading on Stock options commences on the NSE November 9, 2001- Trading on stock futures commences on the NSE August 29, 2008- Currency derivatives trading commences on the NSE August 31, 2009- Interest rate derivatives trading commences on the NSE
for
February 2010- Launch of currency futures on additional currency pairs October 28, 2010- Introduction of European style stock options October 29, 2010- Introduction of currency options.
Spot Market
In the context of securities, the spot marketer cash market is a securities market in which securities are sold for cash and delivered immediately. The delivery happens after the settlement period. Let us describe this in the context of India. The NSE’s cash market segment is known as the Capital Market (CM) Segment. In this market, shares of SBI, Reliance, Infosys, ICICI Bank, and other public listed companies are traded. The settlement period in this market is on a T+2 basis i.e., the buyer of the shares receives the shares two working days after trade date and the seller of the shares receives the money two working days after the trade date. Index To identify the general trend in the market (or any given sector of the market such as banking), it is important to have a reference barometer which can be monitored. Market participants use various indices for this purpose. An index is a basket of identified stocks, and its value is computed by taking the weighted average of the prices of the constituent stocks of the index. A market index for example consists of a group of top stocks traded in the market and its value changes as the prices of its constituent stocks change. In India, Nifty Index is the most popular stock index and it is based on the top 50 stocks traded in the market.
Definitions of Basic Derivatives The following are the three basic forms of derivatives, which are the building blocks for many complex derivatives instruments (the latter are beyond the scope of this book): • Forwards • Futures • Options
Forwards A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price. It may be noted that Forwards are private contracts and their terms are determined by the parties involved. A forward is thus an agreement between two parties in which one party, the buyer, enters into
an agreement with the other party, the seller that he would buy from the seller an underlying asset on the expiry date at the forward price. Therefore, it is a commitment by both the parties to engage in a transaction at a later date with the price set in advance. This is different from a spot market contract, which involves immediate payment and immediate transfer of asset. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. The price agreed upon is called the delivery price or the Forward Price. Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis. Settlement of forward contracts When a forward contract expires, there are two alternate arrangements possible to settle the obligation of the parties: physical settlement and cash settlement. Both types of settlements happen on the expiry date and are given below. Physical Settlement A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date. The following example will help us understand the physical settlement process. Illustration Consider two parties (A and B) enter into a forward contract on 1 August, 2011 where, A agrees to deliver 1000 stocks of Airtel to B, at a price of Rs. 100 per share, on 29th August 2011 (the expiry date). In this contract, A, who has committed to sell 1000 stocks of Airtel at Rs. 100 per share on 29th August 2011 has a short position and B, who has committed to buy 1000 stocks at Rs. 100 per share is said to have a long position. In case of physical settlement, on 29th August, 2011 (expiry date), A has to actually deliver 1000 Airtel shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A. In case A does not have 1000 shares to deliver on 29th August, 2011, he has to purchase it from the spot market and then deliver the stocks to B. On the expiry date the profit/loss for each party depends on the settlement price, that is, the closing price in the spot market on 29th August 2011. The closing price on any given day is the weighted average price of the underlying during the last half an hour of trading in that day. Depending on the closing price, three different scenarios of profit/loss are possible for each party. They are as follows: Scenario I. Closing spot price on 29 August, 2011 (ST) is greater than the Forward price (FT). Assume that the closing price of Airtel on the settlement date 29 August, 2011 is Rs. 105. Since the short investor has sold Airtel at Rs. 100 in the Forward market on 1 August, 2011, he can buy 1000 Airtel shares at Rs. 105 from the market and deliver them to the long investor. Therefore the person who has a short position makes a loss of (100 – 105) X 1000 = Rs. 5000. If the long investor sells the shares in the spot market immediately after receiving
them, he would make an equivalent profit of (105 – 100 ) X 1000 = Rs. 5000. Scenario II. Closing Spot price on 29 August (ST), 2011 is the same as the Forward price (FT) The short seller will buy the stock from the market at Rs. 100 and give it to the long investor. As the settlement price is same as the Forward price, neither party will gain or lose anything. Scenario III. Closing Spot price (ST) on 29 August is less than the futures price (FT) Assume that the closing price of Airtel on 29 August, 2011 is Rs. 95. The short investor, who has sold Airtel at Rs. 100 in the Forward market on 1 August, 2011, will buy the stock from the market at Rs. 95 and deliver it to the long investor. Therefore the person who has a short position would make a profit of (100 – 95) X 1000 = Rs. 5000 and the person who has long position in the contract will lose an equivalent amount (Rs. 5000), if he sells the shares in the spot market immediately after receiving them. The main disadvantage of physical settlement is that it results in huge transaction costs in terms of actual purchase of securities by the party holding a short position (in this case A) and transfer of the security to the party in the long position (in this case B). Further, if the party in the long position is actually not interested in holding the security, then she will have to incur further transaction cost in disposing off the security. An alternative way of settlement, which helps in minimizing this cost, is through cash settlement.
Swaps
Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: Interest rate Swaps Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. Currency Swaps Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash f lows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. Financial Swaps
Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.
Applications of Derivatives
We look at the participants in the derivatives markets and how they use derivatives contracts. Participants in the Derivatives Market As equity markets developed, different categories of investors started participating in the market. In India, equity market participants currently include retail investors, corporate investors, mutual funds, banks, foreign institutional investors etc. Each of these investor categories uses the derivatives market to as a part of risk management, investment strategy or speculation. Based on the applications that derivatives are put to, these investors can be broadly classified into three groups: • Hedgers • Speculators, and • Arbitrageurs
Hedgers These investors have a position (i.e., have bought stocks) in the underlying market but are worried about a potential loss arising out of a change in the asset price in the future. Hedgers participate in the derivatives market to lock the prices at which they will be able to transact in the future. Thus, they try to avoid price risk through holding a position in the derivatives market. Different hedgers take different positions in the derivatives market based on their exposure in the underlying market. A hedger normally takes an opposite position in the derivatives market to what he has in the underlying market. Hedging in futures market can be done through two positions, viz. short hedge and long hedge. Short Hedge A short hedge involves taking a short position in the futures market. Short hedge position is taken by someone who already owns the underlying asset or is expecting a future receipt of the underlying asset. For example, an investor holding Reliance shares may be worried about adverse future price movements and may want to hedge the price risk. He can do so by holding a short position in
the derivatives market. The investor can go short in Reliance futures at the NSE. This protects him from price movements in Reliance stock. In case the price of Reliance shares falls, the investor will lose money in the shares but will make up for this loss by the gain made in Reliance Futures. Note that a short position holder in a futures contract makes a profit if the price of the underlying asset falls in the future. In this way, futures contract allows an investor to manage his price risk. Similarly, a sugar manufacturing company could hedge against any probable loss in the future due to a fall in the prices of sugar by holding a short position in the futures/ forwards market. If the prices of sugar fall, the company may lose on the sugar sale but the loss will be offset by profit made in the futures contract. Long Hedge A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward price. This strategy is used by those who will need to acquire the underlying asset in the future. For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried about any loss that may arise if the price of sugar increases in the future. To hedge against this risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal market, but he will be compensated against this loss through a profit that will arise in the futures market. Note that a long position holder in a futures contract makes a profit if the price of the underlying asset increases in the future. Long hedge strategy can also be used by those investors who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to lock the prevailing price in the market. This may be because he thinks that the prevailing price is very low. For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per stock. An investor is expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is at a very attractive level and he may mi ss the opportunity to buy the stock if he waits till the end of the month. In such a case, he can buy Wipro Ltd. in the futures market. By doing so, he can lock in the price of the stock. Assuming that he buys Wipro Ltd. in the futures market at Rs. 250 (t his becomes his locked-in price), there can be three probable scenarios:
Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300. As futures price is equal to the spot price on the expiry day, the futures price of Wipro would be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the futures market at Rs. 300. By doing this, he has made a profit of 300 – 250 = Rs. 50 in the futures trade. He can now buy Wipro Ltd in the spot market at Rs. 300. Therefore, his total investment cost for buying one share of Wipro Ltd equals Rs.300 (price in spot market) – 50 (profit in futures market) = Rs.250. This is the amount of money he was expecting to have at the end of the month. If the investor had not bought Wipro Ltd futures, he would have had only Rs. 250 and would have been unable to buy Wipro Ltd shares in the cash market. The futures contract helped him to
lock in a price for the shares at Rs. 250. Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250. As futures price tracks spot price, futures price would also be at Rs. 250 on expiry day. The investor will sell Wipro Ltd in the futures market at Rs. 250. By doing this, he has made Rs. 0 in the futures trade. He can buy Wipro Ltd in the spot market at Rs. 250. His total investment cost for buying one share of Wipro will be = Rs. 250 (price in spot market) + 0 (loss in futures market) = Rs. 250. Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200. As futures price tracks spot price, futures price would also be at Rs. 200 on expiry day. The investor will sell Wipro Ltd in the futures market at Rs. 200. By doing this, he has made a loss of 200 – 250 = Rs. 50 in the futures trade. He can buy Wipro in the spot market at Rs. 200. Therefore, his total investment cost for buying one share of Wipro Ltd will be = 200 (price in spot market) + 50 (loss in futures market) = Rs. 250. Thus, in all the three scenarios, he has to pay only Rs. 250. This is an example of a Long Hedge. Speculators A Speculator is one who bets on the derivatives market based on his views on the potential movement of the underlying stock price. Speculators take large, calculated risks as they trade based on anticipated future price movements. They hope to make quick, large gains; but may not always be successful. They normally have shorter holding time for their positions as compared to hedgers. If the price of the underlying moves as per their expectation they can make large profits. However, if the price moves in the opposite direction of their assessment, the losses can also be enormous. Illustration Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and also at Rs. 500 in the futures market (assumed values for the example only). A speculator feels that post the RBI’s policy announcement, the share price of ICICI will go up. The speculator can buy the stock in the spot market or in the derivatives market. If the derivatives contract size of ICICI is 1000 and if the speculator buys one futures contract of ICICI, he is buying ICICI futures worth Rs 500 X 1000 = Rs. 5,00,000. For this he will have to pay a margin of say 20% of the contract value to the exchange. The margin that the speculator needs to pay to the exchange is 20% of Rs. 5,00 ,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for the futures contract. If the speculator would have invested Rs. 1,00,000 in the spot market, he could purchase only 1,00,000 / 500 = 200 shares. Let us assume that post RBI announcement price of ICICI share moves to Rs. 520. With one lakh investment each in the futures and the cash market, the profits would be: • • (520 – 500) X 1,000 = Rs. 20,000 in case of futures market and (520 – 500) X 200 = Rs. 4000 in the case of cash market.
It should be noted that the opposite will result in case of adverse movement in stock prices, wherein the speculator will be losing more in the futures market than in the spot market. This is because the speculator can hold a larger position in the futures market where he has to pay only the margin money.
Arbitrageurs Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous trades that offset each other and capture a risk-free profit. An arbitrageur may also seek to make profit in case there is price discrepancy between the stock price in the cash and the derivatives markets. For example, if on 1st August,2009 the SBI share is trading at Rs. 1780 in the cash market and the futures contract of SBI is trading at Rs. 17 90, the arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the spot market and sell the same number of SBI futures contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will close at the price at which SBI closes in the spot market. In other words, the settlement of the futures contract will happen at the closing price of the SBI shares and that is why the futures and spot prices are said to converge on the expiry day. On expiry day, the arbitrageur will sell the SBI stock in the spot market and buy the futures contract, both of which will happen at the closing price of SBI in the spot market. Since the arbitrageur has entered into off-setting positions, he will be able to earn Rs. 10 irrespective of the prevailing market price on the expiry date. There are three possible price scenarios at which SBI can close on expiry day. Let us calculate the profit/ loss of the arbitrageur in each of the scenarios where he had initially (1 August) purchased SBI shares in the spot market at Rs 1780 and sold the futures contract of SBI at Rs. 1790: Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot market on the expiry day i.e., SBI futures will also close at Rs. 2000. The arbitrageur reverses his previous transaction entered into on 1st August 2009. Profit/ Loss (– ) in spot market = 2000 – 1780 = Rs. 220 Profit/ Loss (– ) in futures market = 1 790 – 2000 = Rs. ( –) 210 Net profit/ Loss (– ) on both transactions combined = 220 – 210 = Rs. 10 profit. Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot mar ket on expiry day i.e., SBI futures will also close at Rs 1780. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss (– ) in spot market = 1780 – 1780 = Rs 0
Profit/ Loss (– ) in futures market = 1790 – 1780 = Rs. 1 0 Net profit/ Loss (– ) on both transactions combined = 0 + 10 = Rs. 10 profit.
Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009) Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss (– ) in spot market = 1500 – 1780 = Rs. (–) 280 Profit/ Loss (– ) in futures market = 1790 – 1500 = Rs. 290 Net profit/ Loss (– ) on both transactions combined = (–) 280 + 290 = Rs. 10 profit. Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which was the difference between the spot price of SBI and futures price of SBI, when the transaction was entered into. This is called a “risk less profit” since once the transaction is entered into on 1 August, 2009 (due to the price difference between spot and futures), the profit is locked. Irrespective of where the underlying share price closes on the expiry date of the contract, a profit of Rs. 10 is assured.
Uses of Derivatives Risk management The most important purpose of the derivatives market is risk management. Risk management for an investor comprises of the following three processes: • • Identifying the desired level of risk that the investor is willing to take on his investments; Identifying and measuring the actual level of risk that the investor is carrying; and
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Making arrangements which may include trading (buying/selling) of derivatives contracts that allow him to match the actual and desired levels of risk.
Market efficiency Efficient markets are fair and competitive and do not allow an investor to make risk free profits. Derivatives assist in improving the efficiency of the markets, by providing a selfcorrecting mechanism. Arbitrageurs are one section of market participants who trade whenever there is an opportunity to make risk free profits till the opportunity ceases to exist.
Risk free profits are not easy to make in more efficient markets. When trading occurs, there is a possibility that some amount of mispricing might occur in the markets. The arbitrageurs step in to take advantage of this mispricing by buying from the cheaper market and selling in the higher market. Their actions quickly narrow the prices and thereby reducing the inefficiencies.
Price discovery One of the primary functions of derivatives markets is price discovery. They provide valuable information about the prices and expected price fluctuations of the underlying assets in two ways:
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First, many of these assets are traded in markets in different geographical locations. Because of this, assets may be traded at different prices in different markets. In derivatives markets, the price of the contract often serves as a proxy for the price of the underlying asset. Second, the prices of the futures contracts serve as prices that can be used to get a sense of the market expectation of future prices.
Trading Futures
To understand futures trading and profit/loss that can occur while trading, knowledge of payoff diagrams is necessary. Pay-off refers to profit or loss in a trade. A pay-off is positive if the investor makes a profit and negative if he makes a loss. A pay-off diagram represents profit/loss in the form of a graph which has the stock price on the X axis and the profit/ loss on the Y axis. Thus, from the graph an investor can calculate the profit or loss that his position can make for different stock prices values.
Pay-off of Futures
The Pay-off of a futures contract on maturity depends on the spot price of the underlying asset at the time of maturity and the price at which the contract was initially traded. There are two positions that could be taken in a futures contract: a. Long position: one who buys the asset at the futures price (F) takes the long position and b. Short position: one who sells the asset at the futures price (F) takes the short position The pay-off for a long position in a futures contract on one unit of an asset is: Long pay-off= ST-F Similarly, the pay-off for a short position in futures contract of one unit of asset is: Short pay-off= F-ST Pay-off diagram for long and short futures: ‘
The long investor makes profits if the spot price at expiry exceeds the futures contract price X, and makes losses if the opposite happens and in case of a short position, the investor makes profits if the spot prices at expiry is below the futures contract price X and makes losses if the opposite happens.
A Theoretical Model of Future Pricing
While futures prices in reality are determined by demand and supply, one can obtain a theoretical:
Futures price, using the following model: Where: F= Futures Price S=Spot price of the underlying asset r= Cost of financing( using continuously compounded interest rate) T= time till expiration in years E=2.71828 Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% per annum. The fair value of a one-month futures contract XYZ is calculated as follows:
Trading Options
Option Payout There are two sides to every option contract. On the one side is the option buyer who has taken a long position (i.e., has bought the option). On the other side is the option seller who has taken a short position (i.e., has sold the option). The seller of the option receives a premium from the buyer of the option. A long position in a call option: In this strategy, the investor has the right to buy the asset in the future at a predetermined strike price, i.e. K . and the option seller has the obligation to sell the asset at the strike price (K). If the settlement price (underlying stock closing price) of the asset is above the strike price, then the call option buyer will exercise his option and buy the stock at the strike price (K). If the settlement price (underlying stock closing price) is lower than the strike price, the option buyer will not exercise the option as he can buy the same stock from the market at a price lower than the strike price.
A long position in a put option: In this strategy, the investor has bought the right to sell the underlying asset in the future at a predetermined strike price (K). If the settlement price (underlying stock closing price) at maturity is lower than the strike price, then the put option holder will exercise his option and sell the stock at the strike price (K). If the settlement price (underlying stock closing price) is higher than the strike price, the option buyer will not exercise the option as he can sell the same stock in the market at a price higher than the strike price. A short position in a call option: In this strategy, the option seller has an obligation to sell the asset at a predetermined strike price(K) i f the buyer of the option chooses to exercise the option. The buyer of the option will exercise the option if the spot price at maturity is any value higher than (K). If the spot price is lower than (K), the buyer of the option will not exercise his/her option. A short position in a put option: In this strategy, the option seller has an obligation to buy the asset at a predetermined strike price(K) if the buyer of the option chooses to exercise his/her option. The buyer of the option will exercise his option to sell at K if the spot price at maturity is lower than K. If the spot price is higher than K, then the option buyer will not exercise his/her option. The Various pay-off diagrams: 1. Pay-off for a buyer of the call option:
The figure shows the profits/losses for a buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However, if Nifty falls below the strike of 2250, the buyer lets the option expire. His losses are limited to the extent of the premium that he paid for buying the option.
2. Pay-off for a seller of the call option:
The figure shows the profits/losses for a seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the upfront option premium charged by him. 3. Pay-off for a buyer of a put option:
The figure shows the profits/losses for a buyer of a three-month Nifty 2250 put option. As can be seen as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However, if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
4. Pay-off for a seller of a Put option:
The figure shows the profits/losses for a seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the upfront option premium of charged by him.
Option Strategies An option strategy is implemented to try and make gains from the movement in the underlying price of an asset. Long Option Strategy: A long option strategy is a strategy of buying an option according to the view on future price movement of the underlying. A person with a bullish opinion on the underlying will buy a call option on that asset/security, while a person with a bearish opinion on the underlying will buy a put option on that asset/security. An important characteristic of long option strategies is limited risk and unlimited profit potential. An option buyer can only lose the amount paid for the option premium. At the same time, theoretically, the profit potential is unlimited. Calls An investor having a bullish opinion on underlying can expect to have positive returns by buying a call option on that asset/security. When a call option is purchased, the call option holder is exposed to the stock performance in the spot market without actually possessing the stock and does so for a fraction of the cost involved in purchasing the stock in the spot market. The cost incurred by the call option holder is the option premium. Thus, he can take advantage of a smaller investment and maximize his profits.
e.g Mr. A buys a Call on an index (such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81. Consider the values of the index at expiration as 1800, 1900, 2100, an d 2200. For ST= 1800, Profit/loss=0-81= -81(maximum loss=premium paid) For ST= 1900, Profit/loss= 0-81= -81(Maximum loss=premium paid) For ST= 2100, Profit/loss= 2100-2000-81= 19 For ST=2200, Profit/Loss= 2200-2000-81=119 Puts An investor having a bearish opinion on the underlying can expect to have positive returns by buying a put option on that asset/security. When a put option is purchased, the put option buyer has the right to sell the stock at the strike price on or before the expiry date depending on where the underlying price is. e.g Mr. X buys a put at a strike price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at expiration at 1800, 1900, 2100, and2200.. For ST= 1800, Profit/Loss=2000-1800-79=121 For ST=1900,Profit/Loss=2000-1900-79=21 For ST=2100, Profit/Loss= -79(Maximum loss is the premium paid) For ST=2200, Profit/Loss= -79(Maximum loss is the premium paid) Short Option Strategy: A short options strategy is a strategy where options are sold to make money upfront with a view that the options will expire out of money at the expiry date (i.e., the buyer of the option will not exercise the same and the seller can keep the premium). A person with a bullish opinion on the underlying will sell a put option in the hope that prices will rise and the buyer will not exercise the option leading to profit for the seller. On the other hand, a person with a bearish view on the underlying will sell a call option in the hope that prices will fall and the buyer will not exercise the option leading to profit for the seller. Call An investor with a bearish opinion on the underlying can take advantage of falling stock prices by selling a call option on the asset/security. If the stock price falls, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price increases above the strike price. e.g A sells a call at a strike price of Rs 2000 for a premium of Rs 81 Consider values of index at expiration at 1800, 1900, 2100, and 2200. For ST= 1800, Profit/loss= 81 (Maximum profit= Premium received) For ST= 1900, Profit/loss=81(Maximum profit=Premium received) For ST= 2100, Profit/loss= 81-(2100-2000) = -19 For ST=2200, Profit/loss= 81-(2100-2200)= -119
Puts An investor with a bullish opinion on the underlying can take advantage of rising prices by selling a put option on the asset/security. If the stock price rises, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price falls below the strike price. e.g We sell a put at a strike price of Rs 2000 for Rs. 79. Consider values of index at expiration as 1800, 1900, 2100 and 2200. For ST= 1800, Profit/loss=79-(2000-1800)= -121 For ST=1900, Profit/loss= 79-(2000-1900)= -21 For ST=2100, Profit/loss= 79(Maximum profit= premium received) For ST=2200, Profit/loss= 79(Maximum profit= premium received)
Determination of Option Prices The price of an option has two components: Intrinsic value and time value. Intrinsic Value of an option: Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of-the-money (OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (ST-K)] which means the intrinsic value of a put is Max[ 0,(K-ST)] i.e greater of 0 or (K-ST) where K is the strike price and ST is the spot price. Time value of an option: In addition to the intrinsic value, the seller charges a ‘time value’ from the buyers of the option. This is because the more time there is for the contract to expire the greater the chance that the exercise of the contract will become more profitable for the buyer. This is a risk for the seller and he seeks compensation for it by demanding a ‘time value’ The time value of an option can be obtained by taking the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out -of-the-money(OTM) or At-themoney (ATM) has only time value and no intrinsic 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 being equal. At expiration, an option has no time value.
Illustration In the following two tables, five different examples are given for call option and put option respectively. 1. For Call Options Underlying Strike Price(Rs) Premium(Rs) Intrinsic Time Value(Rs) Price(Rs) Value(Rs) 100 90 12 10 2 101 90 13 11 2 103 90 14 13 1 88 90 1 0 1 95 90 5.50 5 5.50 2. For Put Options
Underlying Price(Rs) 100 99 97 112 105
Strike Price(Rs) Premium(Rs) 110 110 110 11 110 12 13 14 1 5.50
Intrinsic Value(Rs) 10 11 13 0 5
Time Value(Rs) 2 2 1 1 5.50
Factors affecting Option Prices
1.The underlying price: Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases. Thus, in the case of a Call option, the higher the price of the underlying asset from strike price, the higher is the value (premium) of the call option. On the other hand, in case of a put option, the higher the price of the underlying asset, the lower is the value of the put option. 2.The Strike price: The strike price is specified in the option contract and does not change over time. The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option. Everything else remaining constant, as the strike price increases, the value of a call option decreases and the value of a put option increases. Similarly, as the strike price decreases, the price of the call option increases while that of a put option decreases. 3.Time to expiration: Time to expiration is the time remaining for the option to expire. Obviously, the time remaining in an option’s life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing. The time value of both call as well as put option decreases to zero (and hence, the price of the option falls to its intrinsic value) as the time to expiration approaches zero. As time passes and a call option approaches maturity, its value declines, all other parameters remaining constant. Similarly, the value of a put option also decreases as we approach maturity. This is called “time-decay”. 4.Volatility: Volatility is an important factor in the price of an option. Volatility is defined as
the uncertainty of returns. The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same. 5.Risk free rate: Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government. Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally. It may however be noted that option prices do not change much with changes in the risk free rate.
Open Interest and contract in the enclosed charts
Open interest is the total number of options and/or futures contracts that are not closed out on a particular day, that is contracts that have been purchased and are still outstanding and not been sold and vice versa. A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct since there could be huge volumes but if the volumes are just because of participants squaring off their positions then the open interest would not be large. On the other hand, if the volumes are large because of fresh positions being created then the open interest would also be large. The Contract column tells us about the strike price of the call or put and the date of their settlement. For example, the first entry in the Active Calls section (4500.00 -August) means it is a Nifty call with Rs 4500 strike price, that would expire in August. It is interesting to note from the newspaper extract given above is that it is possible to have a number of options at different strike prices but all of them have the same expiry date. For example, there are a number of call options on Nifty with different strike prices, but all of them expiring on the same expiry date in August. There are different tables explaining different sections of the F&O markets 1. Positive trend: It gives information about the top gainers in the futures 2. Negative trend: It gives information about the top losers in the futures market. 3. Future OI gainers: It lists those futures whose % increases in open interest are among the highest on that day 4. Future OI losers: It lists those futures whose % decreases in open interest are among the highest on that day 5. Active Calls: Calls with high trading volumes on that particular day 6. Active Puts: Puts with high trading volumes on that particular day.
Settlement of Derivatives
Settlement refers to the process through which trades are cleared by the payment/receipt of currency, securities or cash flows on periodic payment dates and on the date of the final settlement. The settlement process is somewhat elaborate for derivatives instruments which are exchange traded. (They have been very briefly outlined here. For a more detailed explanation, please refer to NCFM Derivatives Markets (Dealers) Module). The settlement process for exchange traded derivatives is standardized and a certain set of procedures exist which take care of the counterparty risk posed by these instruments. At the NSE, the National
Securities Clearing Corporation Limited (NSCCL) undertakes the clearing and settlement of all trades executed on the F&O segment of NSE. It also acts as a legal counterparty to all trades on the F&O segment and guarantees their financial settlement. There are two clearing entities in the settlement process: Clearing Members and Clearing Banks. Clearing Members A Clearing member (CM) is the member of the clearing corporation i.e., NSCCL. These are the members who have the authority to clear the trades executed in the F&O segment in the exchange. There are three types of clearing members with different set of functions: 1) Self -clearing Members: Members who clear and settle trades executed by them only on their own accounts or on account of their clients. 2) Trading cum Clearing Members: They clear and settle their own trades as well as trades of other trading members (TM). 3) Professional Clearing Members (PCM): They only clear and settle trades of others but do not trade themselves. PCMs are typically Financial Institutions or Banks who are admitted by the Clearing Corporation as members.
Settlement of Futures
When two parties trade a futures contract, both have to deposit margin money which is called the initial margin. Futures contracts have two types of settlement: (i) the mark-to-market (MTM) settlement which happens on a continuous basis at the end of each day, and (ii) the final settlement which happens on the last trading day of the futures contract i.e., the last Thursday of the expiry month. Mark to Market settlement To cover for the risk of default by the counterparty for the clearing corporation, the futures contracts are marked-to-market on a daily basis by the exchange. Mark to market settlement is the process of adjusting the margin balance in a futures account each day for the change in the process of adjusting the margin balance in a futures account each day for the change in the contracts. This process helps the clearing corporation in managing the counterparty risk of the future contracts by requiring the party incurring a loss due to adverse price movements to part with the loss amount on a daily basis. Simply put, the party in the loss position pays the clearing corporation the margin money to cover for the shortfall in cash. Illustration To illustrate this concept, let us consider a futures contract that has been bought on the XYZ Ltd. at an initial price of Rs. 1000. The exchange sets two margins; Initial Margin and Maintenance Margin. Both parties to a derivative contract have to pay a certain Margin the moment they enter into the Contract; it is called Initial Margin. Maintenance margin is the level at which the margin has to be always maintained. In case the margin falls to maintenance margin or below, additional funds are called for to take have to take the margin to the Initial margin level.
Let us say, Initial Futures Price = Rs. 1000; Initial Margin requirement = Rs. 500; Maintenance Margin Requirement = Rs. 300; Contract size = 10 (that is, one futures contract has 10 shares of XYZ. How the end of day margin balance of the holder of (i) a long position of a contract and ii) a short position of a contract, varies with the changes in settlement price from day to day is given below.
Mark to Market margin of a long position Day Beginning Balance (Rs) 0 1 2 3 4 5 6 0 500 580 900 400 150 550 Funds Deposited (Rs) 500 0 0 0 0 350 0 Settlement Price (Rs) Future Price change (A)(Rs) --8 -32 50 25 -5 10 Gain/Loss=A Ending X contract Balance size(Rs) (RS) --80 -320 500 250 -50 100 -420 100 1000 1250 1200 1300
1000 992 960 1010 1035 1030 1040
Mark to Market margin of a short position Day Beginning Balance (Rs) 0 1 2 3 4 5 6 0 500 580 900 400 150 550 Funds Deposited (Rs) 500 0 0 0 0 350 0 Settlement Price (Rs) Future Price change (A)(Rs) -8 32 -50 -25 5 -10 Gain/Loss=A Ending X contract Balance size(Rs) (RS) -80 320 -500 -250 50 -100 -580 900 400 150 550 450
1000 992 960 1010 1035 1030 1040
Final settlement of Futures After the close of trading hours on the expiry day of the futures contracts, NSCCL marks all positions of clearing members to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss is debited and final settlement profit is credited to the relevant clearing bank accounts on the day following the expiry date of the contract. Suppose the above contract closes on day 6 (that is, it expires) at a price of Rs. 1040, then on the day
of expiry, Rs. 100 would be debited from the seller (short position holder) and would be transferred to the buyer (long position holder).
Settlement of Options
There are basically two types of settlement in stock option contracts: daily premium settlement and final exercise settlement. Options being European style, they cannot be exercised before expiry.
Daily premium settlement Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the options sold by him. The same person may sell some contracts and buy some contracts as well. The premium payable and the premium receivable are netted to compute the net premium payable or receivable for each client for each options contract at the time of settlement. Final Exercise Settlement On the day of expiry, all in the money options are exercised by default. An investor who has a long position in an in-the-money option on the expiry date will receive the exercise settlement value which is the difference between the settlement price and the strike price. Similarly, an investor who has a short position in an in-the-money option will have to pay the exercise settlement value. The final exercise settlement value for each of the in the money options is calculated as follows: Call Options = Closing price of the security on the day of expiry – strike price (if closing price > strike price, else 0) Put Options = Strike price – closing price of the security on the day of expiry (if closing price < strike price, else 0)
Accounting and Taxation of Derivatives
The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index future contracts from the view point of parties who enter into such future contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations a trade in equity index futures is similar to a trade in, say shares, and accounting remains similar as in the case of buying or selling of shares.
Prior to the year 2005, the Income Tax Act did not have any specific provision regarding taxability of derivatives. The only tax provisions which had indirect bearing on derivatives transactions were sections 73(1) and 43(5). Under these sections, trade in derivatives was considered “speculative transactions” for the purpose of determining tax liability. All profits and losses were taxed under the speculative income category. Therefore, loss on derivatives transactions could be set off only against other speculative income and the same could not be set off against any other income. This resulted in high tax liability.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives carried out in a “recognized stock exchange” from ‘speculative transaction’. This implies that derivatives transactions that take place in a “recognized stock exchange” are not taxed as speculative income or loss. They are treated under the business income head of the Income tax Act. Any losses on these activities can be set off against any business income in the year and the losses can be carried forward and set off against any other business income for the next eight years.
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