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INTRODUCTION

The past decade has witnessed an explosive growth in the use of financial derivatives by a wide range of corporate and financial institutions. This growth has run in the parallel with the increasing direct reliance of the companies on the capital markets as the major source of long term funding. In this respect, derivatives have a vital role to play in enhancing shareholder value by ensuring access to the cheapest source of funds. Furthermore, active use of derivatives instruments allows the overall business risk profile to be modified, thereby providing the potential to improve earning quality by offsetting undesired risks. Derivatives can be indeed be used safely and successfully provided that a sensible controls and management strategy is established and executed. Certainly, a degree of quantitative pricing and risk analysis may be needed, depending on the extent and sophistication of the derivative strategies employed.

History of Stock Market


The Bombay Stock Exchange was set up in 1875. The markets acquired breadth and size in the late 80s and early 90s. Initial momentum provided by MNC dilution. Followed by a spate of public issues. And now, PSU disinvestments.

Till recently, the Indian markets lacked the depth in terms of players and asset classes. As a result, the retail stakeholder was the venture capitalist, speculator and investor all in one.

The Drivers of transition


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POLICIES AND REGULATIONS

SEBI, RBI

THE NATIONAL STOCK EXCHANGE

ELECTRONIC TRADING, SETTLEMENT SYSTEMS

PLAYERS

MFS, FIIS, HEDGE FUNDS, PVT EQUITY INVESTORS, PROF FUND MGR, PVT BKG ARMS OF BANKS PRIVATE EQUITY, DEBT, EQUITIES, DERIVATIVES

ASSET CLASSES

RATING AGENCIES

ICRA, FITCH, CARE, CRISIL

LITERATURE REVIEW AND PROBLEM FORMULATION

LITERATURE REVIEW AND PROBLEM FORMULATION

The effects of introduction of derivatives on Indian capital market have been widely studies across the world. The empirical works have focused on the derivatives Market to address a wide range of issues, such as volatility implication, lead-lag relationship between spot and derivative markets, market efficiency, etc. Other researchers report contradictory finding in different markets. The study on the UK markets by Watt et al. (1992) found that option listing had no effect on beta but unsystematic risk and total risk were found to have declined. Kabir (1999) studied the markets in Netherlands and found that no significant changes in risk took place after the introduction of option in the Dutch markets. In the Indian context Arma (1999) investigated the volatility estimation models comparing LARCH and the EWMA models in the risk management setting. Pander (2002) explored the extreme value estimators and found that they perform better than the traditional close to close estimators although his study does not consider the performance of extreme s clue estimators sersus time varying volatility models. Kaur (2004) examined the nature and characteristics of capital market in India from the literature review the following points emerge. There are a number of studies on the impact of derivatives on the capital market. The results so far are mixed. Some markets have shown increase in volatility following derivative introductions, while in other capital markets has decreased or remained at the same level. Studies in the Indian contest found no significant changes in the volatility of underlying capital market after the introduction of derivative. This study examines more closely whether the advent of future and option trading has led to an in crease in index stocks 4

daily return co variation, systematic risk and volatility in the Indian capital market. In a recent study, Bologna and Cavallo (2002) investigated the stock market volatility in the post derivative period for the Italian stock exchange using Generalized Autoregressive Conditional Heteroscedasticity (GARCH) class of models. To eliminate the effect of factors other than stock index futures ( i.e., the macroeconomic factors) determining the changes in volatility in the post derivative period, the GARCH model was estimated after adjusting the stock return equation for market factors, proxied by the returns on an index (namely Dax index) on which derivative products are not introduced. This study shows that unlike the findings by Antoniou and Holmes (1995) for the London Stock Exchange (LSE), the introduction of index future, per se, has actually reduced the stock price volatility. Bologna and Covalla also found that in the post Index-future period the importance of present news has gone up in comparison to the old news in determining the stock price volatility. A few studies have been undertaken to evaluate the effect of introduction of derivative products on capital markets. While Thenmozhi (2002) showed that the inception of futures trading has reduced the volatility of spot index returns due to increased information flow. According to Shenbagaraman (2003), the introduction of derivative products did not have any significant impact on market volatility in India. In a study made by Snehal Bendivedkar and Saurabh gosh,( following Bologna and Cavallo (2002)) GARCH model has been used to empirically evaluate the effects on volatility of the Indian spot market and to see that what extent the change (if any) could be attributed to the of introduction of index futures. The empirical analysis points towards a decline in spot market volatility after the introduction of index futures due to increased impact of recent news and reduced effect of uncertainty originating from the old news. However, further investigation also reveals that the market wide volatility has fallen during the period under consideration. 5

It is studied to analyze the role played by the Derivatives in the stock market with emphasis on Indian capital market and how the risk can be hedged through derivatives. Indian securities markets have indeed waited for too long for derivatives trading to emerge. Mutual Funds, FIIs and other investors who were deprived of hedging opportunities now have a derivatives market to bank on. First to emerge are the globally popular variety - index futures. While derivatives markets flourished in the developed world Indian markets remain deprived of financial derivatives to the beginning of this millennium. While the rest of the world progressed by leaps and bounds on the derivatives front, Indian market lagged behind. Having emerged in the markets of the developed nations in the 1970s, derivatives markets grew from strength to strength. The trading volumes nearly doubled in every three years making it a trillion-dollar business. They became so ubiquitous that, now, one cannot think of the existence of financial markets without derivatives. Two broad approaches of SEBI is to integrate the securities market at the national level, and also to diversify the trading products, so that more number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc. choose to transact through the Exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark.

PROBLEM STATEMENT
Investors were too scared in investing in the stock market as they thought it as pure gamble. Moreover their interests were not safe due to lack of proper rules and regulation. But if we look towards the development, which has taken place in the capital market, it has gradually started adding the capital wealth to the investors. As this environment is dynamic and keeps on changing, so accordingly the investor has to mould and turn out the strategies in order to over come the risk and uncertainties of the market. This project will help the investor to measure the market risk (systematic risk).The market risk can be evaluated with the help of Beta. In this way the investor will be able to allocate his funds in various derivative instruments so that the risk is hedged.

OBJECTIVES AND RESEARCH METHODOLOGY

OBJECTIVES OF THE PROPOSED STUDY

1 To study the emergence of derivative concept in the Indian capital marketThis project will highlight the summary of the evolution of the derivatives and the contribution of different committees. 2 To know the various types of derivatives in the stock market- The project will provide an insight into the various kinds of derivatives available in the capital market like: 1. Forward Contract 2. Futures Contract 3. Call Option 4. Put Option 3. To know the various techniques of minimizing risks- In this project we will come across various combinations of derivatives instruments that should be used in a particular market condition (bullish, bearish and stable) in order to avoid risk. 4. To know the regulatory framework for the derivative trading in India- The project will provide information on SEBIs regulatory role which includes approving the rules, bye- laws and regulations of derivatives and approval of proposed derivative contracts before commencement of trading. 5. To know various challenges in trading with derivatives in Indian stock market- As the stock market is very dynamic, the small investors are reluctant to invest their hard earned money. Hence public awareness & education regarding the benefits of trading sensibly is very important.

RESEARCH METHODOLOGY
Research methodology is a way to systematically sole the research problems. It may be understood as a science of study how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along witht the logic behind them. It is necessary for the researcher to know not only research

methods/techniques but also the methodology. Researchers not only need to know how to develop certain indices or tests, how to calculate the mean, the mode, the median or the standard deviation or chi-square, how to apply particular research techniques, but they also need to know which of these methods or techniques, are relevant and which are not, and what would they mean and indicate and why. Research methodology deals with the various methods of research. The purpose of the research methodology is to explain the research procedures used in the research methodology. It helps in carrying out the project report by analyzing the various research findings collected through the data collection method A large number of Illustrations will be included with the aim of providing skills to compute pricing of various derivatives instruments. Terminology of derivatives will be explained in simple language for an easy understanding of the underlying concept. Now for study of derivatives we have two types of data which are in use these are as follows: 1. Primary data 2. Secondary data

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Now, primary data are data gathered and assembled for specifically for the project at hand. In this project I am using different type of primary data collection like Questionnaire Method & some other methodsThis primary data can be slow and high in cost. Secondary, or historical, data like market figures and charts will be used to ascertain better understanding of various concepts and ideas. The derivatives will be more cleared by the use of different scaling techniques. Now thiese scaling techniques are then classified as comaprative and non-comparative. Comparative scale involve the direct measurment of stimulus objects and data hve only ordinal or rank-order properties. Now here by the use of a type of comparative scaling technique called Paired Comparisons where we can make a choice between two objects is has become easy to understand the use of derivatives. Some pricing models were used get the conclusion. Now in this project I have studied the SEBI and RBI reports. I have also worked on the stock exchange reports. I am also covering the growth of derivtives market in the past few years to know more about the derivatives For this I am using some graphs to give more idea about these derivatives. I have also studied how the derivative products are introduced in the global market and how is helps in reducing the risk while investing in shares.

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DATA ANALYSIS

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INTRODUCTION OF DERIVATIVES
Keeping in view the experience of even strong and developed economies the world over, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments, which allow fund managers to better, manage or reduce these risks. For enabling the banks and the financial institutions, among others, to manage their risk effectively, the concept of derivatives comes into picture.

Development of Indian Derivatives Market


1995: Promulgation of the Securities Laws (Amendment) Ordinance 1995 withdrawing prohibition on options in securities. November 1996: SEBI set up a 24 member committee under the chairmanship of Dr. L. C. Gupta with a view to develop regulatory framework for derivatives trading in India. March 1998: L C Gupta Committee submitted its report recommending, interalia, that derivatives be declared as securities so that regulatory framework applicable for trading of securities could also be applicable for derivatives. December 1999: Securities Contract Regulation Act was amended to include derivatives within the purview of securities. Regulatory framework was developed for governing the trading of derivatives. June 2000: Derivative trading started in India. 2001: SEBI permitted the derivative segment of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) and their clearing

house/corporation to commence trading and settlement in approved derivatives contract. 13

Approval and commencement of trading in index futures contract based on S&P CNX Nifty and BSE-30 (Sensex) index as well as for trading in futures on individual securities. Approval and commencement of trading in index options based on S&P CNX Nifty and BSE-30 (Sensex) index as well as for trading in options on individual securities. June 2003:In the first phase, only interest rate futures have been introduced and banks were allowed to hedge interest rate risk inherent in the government securities, portfolio. Accordingly, trading in interest rate futures contracts in notional 10-year GOI Bonds, notional 91-day Treasury Bills and 10-year zero coupon bonds commenced at NSE. Stock exchanges were advised to separate the cash and market segment of the stock exchanges in terms of legal framework governing trading, clearing, and settlement of the derivatives segment, establishment of separate trade/settlement guarantee funds, separate membership and Governing Council/Executive Committees. July 2003: Authorized Dealers in Foreign Exchange were permitted to offer foreign currency-rupee options w.e.f. July 07, 2003 to residents and nonresidents for hedging currency exposures.

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Growth of Derivatives Market in India Index futures


no. of contracts(in lakhs) 0.91 10.26 21.27 171.92 216.35 585.38 814.87 1565.99 120.63

Year 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009

turnover(Rs in crore) 2365 21483 43952 554446 772147 1513755 2539574 3820667.27 280100.25

index futures
1800 1600
no. of contracts(in lakhs)

4500000 4000000
turnover(Rs. in crores)

1400 1200 1000 800 600 400 200 0 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007- 20082001 2002 2003 2004 2005 2006 2007 2008 2009 time period no. of contracts(in lakhs) turnover(rs in crore)

3500000 3000000 2500000 2000000 1500000 1000000 500000 0

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Index options
no. of contracts(in lakhs) 0 1.76 4.42 17.32 32.94 129.35 251.57 553.66 53.65

year 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009

National turnover (Rs. Cr.) 0 3765 9246 52816 121943 338469 791906 1362110.88 133564.86

index options
600 500 400 300 200 100 0 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007- 20082001 2002 2003 2004 2005 2006 2007 2008 2009 time period no. of contracts(in lakhs) national turnover(Rs. Cr.) 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0
national turnover(rs. cr.)

no. of contracts (in lakhs)

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Global Derivatives Market


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

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Calendar of Introduction of Derivative Products in the Global Market


Year 1874 1972 1973 1975 1981 Products Commodity futures Foreign currency futures Equity options T-bonds futures Currency swaps Interest rate swaps; T notes futures; Eurodollar futures; Equity 1982 index futures; options on T-bond futures; Exchange- listed currency options Options on equity index; Options on T- notes futures; Euro-dollar 1983 futures; options on equity index futures; interest rates caps and floors 1985 1987 1989 1990 1991 1993 1994 Euro-dollar options; swaptions OTC compound options; OTC average options Futures on interest rate swaps; quanto options Equity index swaps Differential swaps Captions; exchange-listed FLEX options Credit default options

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DERIVATIVES AND ITS TYPE


A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. Thus the underlying asset can be equity, forex, commodity or any other asset. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. Derivative contracts have several variants: Forwards Futures Options Swaps

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre agreed price. Futures: It is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price through exchange traded contracts. Options: It is an agreement which gives the buyer the right but not the obligation to buy or sell a given quantity of the underlying assets at a given price on or before a given date. Swaps: These are private agreements between two parties to exchange cash flows in the future according to pre-arranged formula. They can be regarded as portfolios of forward contracts.

TERMINOLOGY

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FUTURES TERMINOLOGY Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered under one contract. For instance, the contract size on NSEs futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket. 20

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. OPTION TERMINOLOGY Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than 21

American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to negative cash flow it was exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equ al. At expiration, an option should have no time value. 22

Derivatives Market at NSE


The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. Trading mechanism The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict pricetime priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-tillDay, Good-till-Cancelled, Good till- Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take. Membership criteria

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NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs: Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. Trading Member Clearing Member: TMCM is a CM who is also a TM. TMCM may clear and settle his own proprietary trades and clients trades as well as clear and settle for other TMs. Professional Clearing Member PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TMs. Clearing and settlement National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. We take a brief look at the clearing and settlement mechanism. Clearing The first step in clearing process is working out open positions or obligations of members. A CMs open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TMs open position i s arrived at as the summation of his proprietary open position and clients open positions, in 24

the contracts in which they have traded. While entering into orders on the trading system, TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each contract. Clients positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. A TMs open position is the sum of proprietary open position, client open long position and client open short position. Settlement All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.

Forward Market
Forward contracts A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. No cash is exchanged when the contract is entered into. 25

Illustration: Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counterparty risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell. 26

Limitations of forward markets Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

Future Market
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying 27

Quality of the underlying

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Understanding index futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contract where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole. In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract. The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 200*1100 (Nifty value) = Rs 2,20,000. In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be 50*4000 (Sensex value) = Rs 2, 00,000.

Option Market
Introduction to options Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back. A contract gives the holder the right to buy or sell shares at the specified price. Buying put options is buying insurance 29

To buy a put option on Nifty is to buy insurance, which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating guaranteed return products. OPTION An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. Option, as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to walk away from the contract. To begin, there are two kinds of options: Call Options and Put Options. A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. A Put Option is an option to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies, If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If

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all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk. With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee. Call options Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date. Illustration: Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8. This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased the right to buy and for that he pays a premium. Now let us see how one can profit from buying an option. Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to 31

exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better. A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-. In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10). He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000). If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited. Call Options-Long & Short Positions 32

When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish. Put Options A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. Illustration: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares). The buyer of a put has purchased a right to sell. Illustration : Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on X. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium). So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

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Illustration: An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro. Quotes are as under: Spot Rs 1040 Jan Put at 1050 Rs 10 Jan Put at 1070 Rs 30 He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium. His position in following price position is discussed below. Jan Spot price of Wipro = 1020 Jan Spot price of Wipro = 1080 In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000. 34

In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000. Put Options-Long & Short Positions When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish. CALL OPTIONS If you expect a fall in price(Bearish) Short PUT OPTIONS

Long

If you expect a rise in price (Bullish)

Long

Short

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USES OF DERIVATIVES

Hedging
We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example. Illustration: Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed. Cost (Rs) Selling price 1000 4000 3000 Profit

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honour the contract Ram will offer a discount of Rs 1000 as incentive. As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honour the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment. 36

The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario. Stocks carry two types of risk company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta. Beta measures the relationship between movements of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses. Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Speculation
Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand, supply, market positions, open interests, economic fundamentals and other data to take their positions.

Illustration: 37

Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures. On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position. Selling Price: 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000 Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a longterm view of the market up to at least 3 months.

Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures market (NSE has provided special software for buying all 50 Nifty stocks in the spot market). Take the case of the NSE Nifty. Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300.

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The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. If there is a difference then arbitrage opportunity exists. Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070. Sale = 1070

Cost= 1000+30 = 1030 Arbitrage profit = 40

These kinds of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.

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TRADING STRATEGIES WITH DERIVATIVES Bull Market Strategies


Calls in bullish strategies Puts in bullish strategies Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the market price less the exercise price less the premium. The greater 40

the increase in price of the underlying asset, the greater will be the investor's profit. The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless. The investor breaks even when the market price equals the exercise price plus the premium. An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- themoney, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase. A simple example will illustrate the above: Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 100 (premium) he has paid. The profit can be derived as follows: Profit = Market price - Exercise price Premium or Profit = Market price Strike price Premium. 2200 2000 100 = Rs 100

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Puts in a Bullish Strategy An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines. The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable. An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date, lower is the return.

Bear Market Strategies


Puts in bearish strategies Calls in bearish strategies Puts in a Bearish Strategy When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying

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asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits. The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option. The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option. 43

An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option. Calls in a Bearish Strategy Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position. For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

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The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option. Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised; he will be exposed to potentially large losses if the market rises against his position. The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even. An increase in volatility will increase the value of your call and decrease your return. When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.

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Stable Market Strategies


Straddles in a Stable Market Outlook Strangles in a Stable Market Outlook Straddles in a Stable Market Outlook Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. This market outlook is also referred to as "neutral volatility." A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put. To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date. To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date. A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows the trader to profit from writing calls and puts in a stable market environment.

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The investor's profit potential is limited. If the market remains stable, traders long out-of-the-money calls or puts will let their options expire worthless. Writers of these options will not have be called to deliver and will profit from the sum of the premiums received. The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writer of a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the call and practically unlimited loss if on the put. The breakeven points occur when the market price at expiration equals the exercise price plus the premium and minus the premium. The trader is short two positions and thus, two breakeven points; One for the call (common exercise price plus the premiums paid), and one for the put (common exercise price minus the premiums paid). Strangles in a Stable Market Outlook A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-themoney. To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. Usually the call strike price is higher than the put strike price. 47

To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices. A trader, viewing a market as stable, should: write strangles. A "strangle sale" allows the trader to profit from a stable market. The investor's profit potential is: unlimited. If the market remains stable, investors having out-of-the-money long put or long call positions will let their options expire worthless. The investor's potential loss is: unlimited. If the price of the underlying interest rises or falls instead of remaining stable as the trader anticipated, he will have to deliver on the call or the put. The breakeven points occur when market price at expiration equals...the high exercise price plus the premium and the low exercise price minus the premium. The trader is short two positions and thus, two breakeven points. One for the call (high exercise price plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle?

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The risk is lower with a strangle. Although the seller gives up a substantial amount of potential profit by selling a strangle rather than a straddle, he also holds less risk. Notice that the strangle requires more of a price move in both directions before it begins to lose money. Long Butterfly Call Spread Strategy The long butterfly call spread is a combination of a bull spread and a bear spread, utilizing calls and three different exercise prices. A long butterfly call spread involves: Buying a call with a low exercise price, Writing two calls with a mid-range exercise price, Buying a call with a high exercise price. To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45 strikes. This spread is put on by purchasing one each of the outside strikes and selling two of the inside strike. To put on a short butterfly, you do just the opposite. The investor's profit potential is limited. Maximum profit is attained when the market price of the underlying interest equals the mid-range exercise price (if the exercise prices are symmetrical).

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The investor's potential loss is limited. The maximum loss is limited to the net premium paid and is realized when the market price of the underlying asset is higher than the high exercise price or lower than the low exercise price. The breakeven points occur when the market price at expiration equals ... the high exercise price minus the premium and the low exercise price plus the premium. The strategy is profitable when the market price is between the low exercise price plus the net premium and the high exercise price minus the net premium.

PRICING OF OPTIONS
Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors. There are four major factors affecting the Option premium: Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying 50

And two less important factors: Short-Term Interest Rates Dividends

The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market. For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value. Price of underlying The premium is affected by the price movements in the underlying instrument. For Call options the right to buy the underlying at a fixed strike price as the underlying price rises so does its premium. As the underlying assets price falls so does the cost of the option premium. For Put options the right to sell the underlying at a fixed strike price as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises. The Time Value of an Option Generally, the longer the time remaining until an options expiration, t he higher its premium will be. This is because the longer an options lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an options price 51

remaining the same, the time value portion of an options premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally worth only its intrinsic value. Volatility Volatility is the tendency of the underlying securitys market price to fluctuate either up or down. It reflects a price changes magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. Higher volatility=Higher premium Lower volatility = Lower premium Interest rates In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is 52

reversed when interest rates fall premiums rise. This time it is the writer who needs to be compensated.

The Black & Scholes Model


The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation: unlike the binomial model, it does not rely on calculation by iteration. The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are: S = stock price X = strike price t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). ln = natural logarithm N(x) = standard normal cumulative distribution function e = the exponential function

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Lognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed to a normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution of between zero and infinity (ie no negative prices) and has an upward bias (representing the fact that a stock price can only drop 100 per cent but can rise by more than 100 per cent). Risk-neutral valuation: The expected rate of return of the stock (i.e. the expected rate of growth of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-Scholes model (or any other model for option valuation). The important implication is that the price of an option is completely independent of the expected growth of the underlying asset. Thus, while any two investors may strongly disagree on the rate of return they expect on a stock they will, given agreement to the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that underlying asset. The key concept underlying the valuation of all derivatives -- the fact that price of an option is independent of the risk preferences of investors -- is called riskneutral valuation. It means that all derivatives can be valued by assuming that the return from their underlying assets is the risk free rate. Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely used adaptations to the original formula, which I use in my models, which enable it to handle both discrete and continuous dividends accurately. However, despite these adaptations the Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option.

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As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercised at expiration) this is a significant limitation. The exception to this is an American call on a non-dividend paying asset. In this case the call is always worth the same as its European equivalent as there is never any advantage in exercising early. Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large number of option prices in a very short time. Since, high accuracy is not critical for American option pricing (eg when animating a chart to show the effects of time decay) using Black-Scholes is a good option. But, the option of using the binomial model is also advisable for the relatively few pricing and profitability numbers where accuracy may be important and speed is irrelevant. You can experiment with the Black-Scholes model using on-line options pricing calculator.

The Binomial Model


The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing models which differ according to their hypotheses or the underlying instruments upon which they are based (stock options, currency options, options on interest rates). The binomial model breaks down the time to expiration into potentially a very large number of time intervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration. At each step it is assumed that the stock price will move up or down by an amount calculated using volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices. The tree represents all the possible paths that the stock price could take during the life of the option.

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At the end of the tree -- i.e. at expiration of the option -- all the terminal option prices for each of the final possible stock prices are known as they simply equal their intrinsic values. Next the option prices at each step of the tree are calculated working back from expiration to the present. The option prices at each step are used to derive the option prices at the next step of the tree using risk neutral valuation based on the probabilities of the stock prices moving up or down, the risk free rate and the time interval of each step. Any adjustments to stock prices (at an ex-dividend date) or option prices (as a result of early exercise of American options) are worked into the calculations at the required point in time. At the top of the tree you are left with one option price. Advantage: The big advantage the binomial model has over the Black-Scholes model is that it can be used to accurately price American options. This is because, with the binomial model it's possible to check at every point in an option's life (ie at every step of the binomial tree) for the possibility of early exercise (eg where, due to eg a dividend, or a put being deeply in the money the option price at that point is less than the its intrinsic value). Where an early exercise point is found it is assumed that the option holder would elect to exercise and the option price can be adjusted to equal the intrinsic value at that point. This then flows into the calculations higher up the tree and so on. Limitation: As mentioned before the main disadvantage of the binomial model is its relatively slow speed. It's great for half a dozen calculations at a time but even with today's fastest PCs it's not a practical solution for the calculation of thousands of prices in a few seconds which is what's required for the production of the animated charts in my strategy evaluation model. 56

REGULATORY FRAMEWORK FOR DERIVATIVES MARKET IN INDIA


The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act, the rules and regulations framed there under and the rules and byelaws of stock exchanges. Securities Contracts(Regulation) Act, 1956 SC(R)A aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term securities has been defined in the SC(R)A. As per Section 2(h), the Securities include: 1. Shares, scrip, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes 4. Government securities 5. Such other instruments as may be declared by the Central Government to be securities 6. Rights or interests in securities.

Regulation for Derivatives Trading


SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with 57

stock index futures. SEBI also approved the suggestive bye -laws recommended by the committee for regulation and control of trading and settlement of derivatives contracts. The provisions in the SC(R)A and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of securities in the SC(R)A made trading in derivatives possible within the framework of that Act. 1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start have trading a derivatives. The derivatives and

exchange/segment

should

separate

governing

council

representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange shall have minimum 50 members. 3. The members of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfill the eligibility conditions as laid down by the LC Gupta committee. 4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum networth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The networth of the member shall be computed as follows: 58

Capital + Free reserves Less non-allowable assets viz.

(a) Fixed assets (b) Pledged securities (c) Members card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities 6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also submit details of the futures contract they propose to introduce. 7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time. 8. The L.C.Gupta committee report requires strict enforcement of Know your customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

NSEs Certification in Financial Markets


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A critical element of financial sector reforms is the development of a pool of human resources having right skills and expertise to provide quality intermediation services in each segment of the market. In order to dispense quality intermediation, personnel providing services need to possess requisite skills and knowledge. This is generally achieved through a system of testing and certification. Such testing and certification has assumed added significance in India as there is no formal education/training on financial markets, especially in the area of operations. Taking into account international experience and needs of the Indian financial market, NSE offers NCFM (NSEs Certification in Financial Markets) to test practical knowledge and skills that are required to operate in financial markets in a very secure and unbiased manner and to certify personnel with a view to improve quality of intermediation. NCFM offers a comprehensive range of modules covering many different areas in finance including a module on derivatives. The module on derivatives has been recognized by SEBI. SEBI requires that derivative brokers/dealers and sales persons must mandatory pass this module of the NCFM.

Regulation for Clearing and Settlement


1. The LC Gupta committee has recommended that the clearing corporation must interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades. 2. The clearing corporation should ensure that none of the Board members has trading interests. 3. The definition of net-worth as prescribed by SEBI needs to be incorporated in the application/regulations of the clearing corporation. 4. The regulations relating to arbitration need to be incorporated in the clearing corporations regulations.

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5. Specific provision/chapter relating to declaration of default must be incorporated by the clearing corporation in its regulations. 6. The regulations relating to investor protection fund for the derivatives market must be included in the clearing corporation application/regulations. 7. The clearing corporation should have the capabilities to segregate upfront/initial margins deposited by clearing members for trades on their own account and on account of his clients. The clearing corporation shall hold the clients margin money in trust for the clients purposes only and should not allow its diversion for any other purpose. This condition must be incorporated in the clearing corporation regulations. 8. The clearing member shall collect margins from his constituents (clients/trading members). He shall clear and settle deals in derivative contracts on behalf of the constituents only on the receipt of such minimum margin. 9. Exposure limits based on the value at risk concept will be used and the exposure limits will be continuously monitored. These shall be within the limits prescribed by SEBI from time to time. 10. The clearing corporation must lay down a procedure for periodic review of the net worth of its members. 11. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members in the underlying market. 12. Any changes in the bye-laws, rules or regulations which are covered under the Suggestive byelaws for regulations and control of trading and settlement of derivatives contracts would require prior approval of SEBI.

Position limits
Position limits have been specified by SEBI at trading member, client, market and FII levels respectively. 61

Trading member position limits There is a position limit in derivative contracts on an index of 15% of the open interest or Rs.100 Crore, whichever is higher. The position limit in derivative contracts on an individual stock is 7.5% of the open interest in that underlying on the exchange or Rs.50 Crore, whichever is higher. Once a member, in a particular underlying reaches the position limit then he is permitted to take only offsetting positions (which result in lowering the open position of the member) in derivative contracts on such underlying. Client level position limits On index based derivative contracts, at the client level there is a self disclosure requirement as follows: Any person or persons acting in concert who together own 15% or more of the open interest in all futures and option contracts on the same index are required to report this fact to the clearing corporation and failure to do so attracts a penalty. This does not mean a ban on large open positions but is a disclosure requirement. On stock based derivative contracts, the gross open position across all such derivative contracts in a particular underlying of a single customer/client shall not exceed the higher of 1% of the free float market capitalization(in terms of number of shares) or 5% of the open interest in a particular underlying stock(in terms of number of contracts). This position limit is applicable on the combined position in all derivative contracts in an underlying stock at an exchange. Market wide position limits The market wide limit of open positions (in terms of the number of units of underlying stock) on all futures and option contracts on a particular stocks is lower of 30 times the average number of shares traded daily, during the previous calendar month, in the capital market segment of the exchange, or 10% of the number of shares held by nonpromoters i.e. 10% of the free float, 62

in terms of number of shares of a company. This market wide limit is applicable on a particular underlying. When the total open interest in a contract reaches 80% of the market wide limit in that contract, the price scan range and volatility scan range in SPAN would be doubled. Position limits for FIIs The position limits specified for FIIs and their sub-account/s is as under: At the level of the FII In the case of index related derivative products, the position limit is 15% of open interest in all futures and options contracts on a particular underlying index on an exchange, or Rs.100 Crore, whichever is higher. In the case of an underlying security, the position limit is 7.5% of open interest, in all futures and options contracts on a particular underlying security on an exchange or Rs.50 Crore, whichever is higher. At the level of the sub-account The CM/TM is required to disclose to the clearing corporation details of any person or persons acting in concert who together own 15% or more of the open interest of all futures and options contracts on a particular underlying index on the exchange. The gross open position across all futures and options contracts on a particular underlying security, of a subaccount of an FII, should not exceed the higher of 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest in the derivative contracts on a particular underlying stock(in terms of number of contracts). These position limits are applicable on the combined position in all futures and options contracts on an underlying security on the exchange.

Eligibility of stocks for futures and option trading

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The stocks which are eligible for futures and option trading, should meet the following criteria: 1. The stock should be amongst the top 200 scrips, on the basis of average market capitalization during the last six months and the average free float market capitalization should not be less than Rs.750 Crore. The free float market capitalization means the nonpromoter holding in the stock. 2. The stock should be amongst the top 200 scrips on the basis of average daily volume (in value terms), during the last six months. Further, the average daily volume should not be less than Rs.5 Crore in the underlying cash market. 3. The stock should be traded on at least 90% of the trading days in the last six months, with the exception of cases in which a stock is unable to trade due to corporate actions like demergers etc. 4. The non-promoter holding in the company should be at least 30%. 5. The ratio of the daily volatility of the stock visavis the daily volatility of the index (either BSE- 30 Sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous six months. For this purpose the volatility would be computed as per the exponentially weighted moving average (EWMA) formula. 6. The stock on which option contracts are permitted to be traded on one derivative exchange/segment would also be permitted to trade on other derivative exchanges/segments.

Accounting for futures


The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures 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 64

to a trade in, say shares, and does not pose any peculiar accounting problems. Accounting at the inception of a contract Every client is required to pay to the trading member/clearing member, the initial margin determined by the clearing corporation as per the byelaws/regulations of the exchange for entering into equity index futures contracts. Such initial margin paid/payable should be debited to Initial margin - Equity index futures account. Additional margins, if any, should also be accounted for in the same manner. It may be mentioned that at the time when the contract is entered into for purchase/sale of equity index futures, no entry is passed for recording the contract because no payment is made at that time except for the initial margin. At the balance sheet date, the balance in the Initial margin - Equity index futures account should be shown separately under the head current assets. In those cases where any amount has been paid in excess of the initial/additional margin, the excess should be disclosed separately as a deposit under the head current assets. In cases where instead of paying initial margin in cash, the client provides bank guarantees or lodges securities with the member, a disclosure should be made in the notes to the financial statements of the client. Accounting at the time of daily settlement This involves the accounting of payment/receipt of mark-to-market margin money. Payments made or received on account of daily settlement by the client would be credited/debited to the bank account and the corresponding debit or credit for the same should be made to an account titled as Mark -tomarket margin - Equity index futures account. Some times the client may deposit a lump sum amount with the broker/trading member in respect of mark-to-market margin money instead of

receiving/paying mark-to-market margin money on daily basis. The amount so paid is in the nature of a deposit and should be debited to an appropriate 65

account, say, Deposit for mark-to-market margin account. The amount of mark-to-market margin received/paid from such account should be credited/debited to Mark-to-market margin - Equity index futures account with a corresponding debit/credit to Deposit for mark-to-market margin account. At the year-end, any balance in the Deposit for mark-to market margin account should be shown as a deposit under the head current assets. Accounting for open positions Position left open on the balance sheet date must be accounted for. Debit/credit balance in the mark-to-market margin - Equity index futures account, maintained on global basis, represents the net amount

paid/received on the basis of movement in the prices of index futures till the balance sheet date. Keeping in view prudence as a consideration for preparation of financial statements, provision for anticipated loss, which may be equivalent to the net payment made to the broker (represented by the debit balance in the mark-to-market margin - Equity index futures account) should be created by debiting the profit and loss account. Net amount received (represented by credit balance in the mark-to-market margin - Equity index futures account) being anticipated profit should be ignored and no credit for the same should be taken in the profit and loss account. The debit balance in the said mark-to-market margin - Equity index futures account, i.e., net payment made to the broker, may be shown under the head current assets, loans and advances in the balance sheet and the provision created there against should be shown as a deduction there from. On the other hand, the credit balance in the said account, i.e., the net amount received from the broker, should be shown as a current liability under the head current liabilities and provisions in the balance sheet. Accounting at the time of final settlement

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This involves accounting at the time of final settlement or squaring-up of the contract. At the expiry of a series of equity index futures, the profit/loss, on final settlement of the contracts in the series, should be calculated as the difference between final settlement price and contract prices of all the contracts in the series. The profit/loss, so computed, should be recognized in the profit and loss account by corresponding debit/credit to mark-to-market margin Equity index futures account. However, where a balance exists in the provision account created for anticipated loss, any loss arising on such settlement should be first charged to such provision account, to the extent of the balance available in the provision account, and the balance of loss, if any, should be charged to the profit and loss account. Same accounting treatment should be made when a contract is squared-up by entering into a reverse contract. It appears that, at present, it is not feasible to identify the equity index futures contracts. Accordingly, if more than one contract in respect of the series of equity index futures contracts to which the squared-up contract pertains is outstanding at the time of the squaring of the contract, the contract price of the contract so squared-up should be determined using First-In, FirstOut (FIFO) method for calculating profit/loss on squaring-up. On the settlement of an equity index futures contract, the initial margin paid in respect of the contract is released which should be credited to I nitial margin Equity index futures account, and a corresponding debit should be given to the bank account or the deposit account (where the amount is not received). Accounting in case of a default When a client defaults in making payment in respect of a daily settlement, the contract is closed out. The amount not paid by the Client is adjusted against the initial margin. In the books of the Client, the amount so adjusted should be debited to mark-to-market - Equity index futures account with a corresponding credit to Initial margin - Equity index futures account. The amount of initial margin on the contract, in excess of the amount adjusted against the mark-to market margin not paid, will be released. The accounting 67

treatment in this regard will be the same as explained above. In case, the amount to be paid on daily settlement exceeds the initial margin the excess is a liability and should be shown as such under the head current liabilities and provisions, if it continues to exist on the balance shee t date. The amount of profit or loss on the contract so closed out should be calculated and recognized in the profit and loss account in the manner dealt with above.

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Accounting for equity index options and equity stock options


The Institute of Chartered Accountants of India issued guidance note on accounting for index options and stock options from the view point of the parties who enter into such contracts as buyers/holder or sellers/writers. Following are the guidelines for accounting treatment in case of cash settled index options and stock options: Accounting at the inception of a contract The seller/writer of the option is required to pay initial margin for entering into the option contract. Such initial margin paid would be debited to Equity Index Option Margin Account or to Equity Stock Option Margin Account, as the case may be. In the balance sheet, such account should be shown separately under the head Current Assets. The buyer/holder of the option is not required to pay any margin. He is required to pay the premium. In his books, such premium would be debited to Equity Index Option Premium Account or Equity Stock Option Premium Account, as the case may be. In the books of the seller/writer, such premium received should be credited to Equ ity Index Option Premium Account or Equity Stock Option Premium Account as the case may be. Accounting at the time of payment/receipt of margin Payments made or received by the seller/writer for the margin should be credited/debited to the bank account and the corresponding debit/credit for the same should also be made to Equity Index Option Margin Account or to Equity Stock Option Margin Account, as the case may be. Sometimes, the client deposit a lump sum amount with the trading/clearing member in respect of the margin instead of paying/receiving margin on daily basis. In such case, the amount of margin paid/received from/into such accounts should be debited/credited to the Deposit for Margin Account. At the end of the year the balance in this account would be shown as deposit under Current Assets. Accounting for open positions as on balance sheet dates 69

The Equity Index Option Premium Account and the Equity Stock Option Premium Account should be shown under the head Current Assets or Current Liabilities, as the case may be. In the books of the buyer/holder, a provision should be made for the amount by which the premium paid for the option exceeds the premium prevailing on the balance sheet date. The provision so created should be credited to Provision for Loss on Equity Index Option Account to the Provision for Loss on Equity Stock Options Account, as the case may be. The provision made as above should be shown as deduction from Equity Index Option Premium or Equity Stock Option Premium which is shown under Current Assets. In the books of the seller/writer, the provision should be made for the amount by which premium prevailing on the balance sheet date exceeds the premium received for that option. This provision should be credited to Provision for Loss on Equity Index Option Account or to the Provision for Loss on Equity Stock Option Account, as the case may be, with a corresponding debit to profit and loss account. Equity Index Options Premium Account or Equity Stock Options Premium Account and Provision for Loss on Equity Index Options Account or Provision for Loss on Equity Stock Options Account should be shown under Current Liabilities and Provisions. In case of any opening balance in the Provision for Loss on Equ ity Stock Options Account or the Provision for Loss on Equity Index Options Account, the same should be adjusted against the provision required in the current year and the profit and loss account be debited/credited with the balance provision required to be made/excess provision written back.

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Accounting at the time of final settlement On exercise of the option, the buyer/holder will recognize premium as an expense and debit the profit and loss account by crediting Equity Index Option Premium Account or Equity Stock Option Premium Account. Apart from the above, the buyer/holder will receive favorable difference, if any, between the final settlements price as on the exercise/expiry date and the strike price, which will be recognized as income. On exercise of the option, the seller/writer will recognize premium as an income and credit the profit and loss account by debiting Equity Index Option Premium Account or Equity Stock Option Premium Account. Apart from the above, the seller/writer will pay the adverse difference, if any, between the final settlement prices as on the exercise/expiry date and the strike price. Such payment will be recognized as a loss. As soon as an option gets exercised, margin paid towards such option would be released by the exchange, which should be credited to Equity Index Option Margin Account or to Equity Stock Option Margin Account, as the case may be, and the bank account will be debited. Accounting at the time of squaring off an option contract The difference between the premium paid and received on the squared off transactions should be transferred to the profit and loss account. Following are the guidelines for accounting treatment in case of delivery settled index options and stock options: The accounting entries at the time of inception, payment/receipt of margin and open options at the balance sheet date will be the same as those in case of cash settled options. At the time of final settlement, if an option expires unexercised then the accounting entries will be the same as those in case of cash settled options. If the option is exercised then shares will be transferred in consideration for cash at the strike price. For a call option the buyer/holder will receive equity shares for which the call option was entered into. The buyer/holder should debit the relevant equity 71

shares account and credit cash/bank. For a put option, the buyer/holder will deliver equity shares for which the put option was entered into. The buyer/holder should credit the relevant equity shares account and debit cash/bank. Similarly, for a call option the seller/writer will deliver equity shares for which the call option was entered into. The seller/writer should credit the relevant equity shares account and debit cash/bank. For a put option the seller/writer will receive equity shares for which the put option was entered into. The seller/writer should debit the relevant equity shares account and credit cash/bank. In addition to this entry, the premium paid/received will be transferred to the profit and loss account, the accounting entries for which should be the same as those in case of cash settled options.

Taxation issues
The income tax Act does not have any specific provision regarding taxability from derivatives. Hence we restrict ourselves to a discussion on the topic of taxability of derivatives. The reader may keep track of the developments in this regard as and when they occur. The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. Section 43(5) of the Act defines a speculative transaction as a transaction in which a contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips. It excludes the following types of transactions from the ambit of speculative transactions: 1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations;

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2. A contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinary course of business as such member. From the above, it appears that a transaction is speculative, if it is settled otherwise than by actual delivery. The hedging and arbitrage transactions, even though not settled by actual delivery are considered non-speculative. A transaction to be speculative therefore requires that: 1. The transaction is in commodities, shares, stock or scrips 2. The transaction is settled otherwise than by actual delivery 3. The participant has no underlying position 4. The transaction is not for jobbing/arbitrage In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to maximum of eight years. The fact, however, is that derivative contracts are not for purchase/sale of any commodity, stock, share or scrip. Derivatives are a special class of securities under the SC(R)A, 1956 and does not any way resemble any other type of securities like share, stocks or scrips. Derivative contracts, particularly index futures are cash-settled, as these cannot be settled otherwise. As explained earlier, derivative contracts are entered into by hedgers, speculators and arbitrageurs. A derivative contract has any of these two parties and hence some of the derivative contracts, not all, have an element of speculation. At least one of the parties to a derivative contract is a hedger or an arbitrageur. It would, therefore, be unfair to treat derivative transactions as speculative. 73

Otherwise it would be a penalty on hedging which the Securities Laws (Amendment) Act, 1999 seeks to promote. In view of these difficulties in applying the existing provisions, it is desirable to clarify or make special provision for derivatives of securities. Section 43 is relevant in case of contracts where actual delivery is possible, but these are settled otherwise than by actual delivery. This provision cannot be applied to derivatives, particularly index futures, which can be settled only by cash. There cannot be actual delivery. Hence the actual delivery for a contract to be non-speculative cannot be applied to derivatives contracts. As emphasized earlier by the L C Gupta Committee, the futures market should have speculative appeal. This means, the speculators have to be treated equitably, that is at least at par with hedgers, if not better. All types of participants need to be provided level playing field so that the market is competitive and efficient. As regards taxability, the law should not treat income of the hedger, speculators and arbitrageurs differently. Income of all the participants from derivatives needs to be treated uniformly. Further, a transaction is considered speculative, if a participant enters into a hedging transaction in scrips outside his holdings. It is possible that an investor does not have all the 30 or 50 stocks represented by the index. As a result an investors losses or profits out of derivatives transactions, even though they are of hedging nature in real sense, it is apprehended, may be treated as speculative. This is contrary to capital asset pricing model which states that portfolios in any economy move in sympathy with the index although the portfolios do not necessarily contain any security in the index. The index futures are, therefore, used even for hedging the portfolio risk of non-index stocks. An investor who does not have the index stocks can also use the index futures to hedge against the market risk as all the portfolios have a correlation with the overall movement of the market (i.e. the index). In view of the practical difficulties in administration of tax for different purposes of the same transaction, inherent nature of derivative contract requiring its 74

settlement otherwise than by actual delivery, need to promote level playing field to all parties to derivatives contracts, and the need to promote derivatives markets, it is suggested that the exchange-traded derivatives contracts are exempted from the purview of speculative transactions. These must, however be taxed as normal business income. This would be fiscally more prudent.

Securities and Exchange Board of India Act, 1992


SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India (SEBI) with statutory powers for: a) Protecting the interests of investors in securities b) Promoting the development of the securities market and c) Regulating the securities market. Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for: regulating the business in stock exchanges and any other securities markets Registering and regulating the working of stock brokers, sub brokers etc. promoting and regulating self-regulatory organizations prohibiting fraudulent and unfair trade practices calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries and selfregulatory organizations in the securities market

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performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956,as may be delegated to it by the Central Government

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