Contents

1 Introduction to derivatives 7
1.1 Derivatives defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Products, participants and functions . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Types of derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.4 Development of exchange-traded derivatives . . . . . . . . . . . . . . . . . . . . 10
1.5 Global derivatives markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.6 Exchange-traded vs. OTC derivatives markets . . . . . . . . . . . . . . . . . . . 11
1.7 Derivatives market in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.7.1 Approval for derivatives trading . . . . . . . . . . . . . . . . . . . . . . 13
1.7.2 Derivatives market at NSE . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.3 Trading mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.4 Membership criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7.5 Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.7.6 Clearing and settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.7.7 Risk management system . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2 Market index 19
2.1 Understanding the index number . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2 Economic significance of index movements . . . . . . . . . . . . . . . . . . . . 20
2.3 Index construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.4 Types of indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.5 Desirable attributes of an index . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5.1 Capturing behavior of portfolios . . . . . . . . . . . . . . . . . . . . . . 23
2.5.2 Including liquid stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.5.3 Maintaining professionally . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.6 The S&P CNX Nifty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.6.1 Impact cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.6.2 Hedging effectiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.7 Applications of index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.1 Index derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.2 Index funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7.3 Exchange Traded Funds . . . . . . . . . . . . . . . . . . . . . . . . . . 26
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3 Introduction to futures and options 29

3.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.2 Limitations of forward markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.3 Introduction to futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.4 Distinction between futures and forwards contracts . . . . . . . . . . . . . . . . 31
3.5 Futures terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.6 Introduction to options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.7 Option terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.8 Futures and options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.9 Index derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.10 Payoff for derivatives contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.11 Payoff for futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.11.1 Payoff for buyer of futures: Long futures . . . . . . . . . . . . . . . . . 37
3.11.2 Payoff for seller of futures: Short futures . . . . . . . . . . . . . . . . . 38
3.12 Options payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.12.1 Payoff profile for buyer of call options: Long call . . . . . . . . . . . . . 39
3.12.2 Payoff profile for writer of call options: Short call . . . . . . . . . . . . . 40
3.12.3 Payoff profile for buyer of put options: Long put . . . . . . . . . . . . . 40
3.12.4 Payoff profile for writer of put options: Short put . . . . . . . . . . . . . 41

4 Pricing futures 49
4.1 The cost of carry model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.1.1 Pricing futures contracts on commodities . . . . . . . . . . . . . . . . . 50
4.2 Pricing equity index futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.2.1 Pricing index futures given expected dividend amount . . . . . . . . . . 52
4.2.2 Pricing index futures given expected dividend yield . . . . . . . . . . . . 52
4.3 Pricing stock futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.3.1 Pricing stock futures when no dividend expected . . . . . . . . . . . . . 54
4.3.2 Pricing stock futures when dividends are expected . . . . . . . . . . . . 54

5 Using index futures 59

5.1 Hedging: Long security, short Nifty futures . . . . . . . . . . . . . . . . . . . . 59
5.2 Hedging: Short security, long Nifty futures . . . . . . . . . . . . . . . . . . . . 65
5.3 Hedging: Have portfolio, short Nifty futures . . . . . . . . . . . . . . . . . . . . 69
5.4 Hedging: Have funds, buy Nifty futures . . . . . . . . . . . . . . . . . . . . . . 73
5.5 Speculation: Bullish index, long Nifty futures . . . . . . . . . . . . . . . . . . . 77
5.6 Speculation: Bearish index, short Nifty futures . . . . . . . . . . . . . . . . . . 78
5.7 Arbitrage: Have funds, lend them to the market . . . . . . . . . . . . . . . . . . 80
5.8 Arbitrage: Have securities, lend them to the market . . . . . . . . . . . . . . . . 83
5.9 F&O market watch: Spot the mispricing . . . . . . . . . . . . . . . . . . . . . . 86
5.10 F&O market watch: Spread trading . . . . . . . . . . . . . . . . . . . . . . . . . 88
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6 Using futures on individual securities 93

6.1 Difference between trading securities and trading futures on individual securities 93
6.2 Hedging: Long security, sell futures . . . . . . . . . . . . . . . . . . . . . . . . 94
6.3 Speculation: Bullish security, buy futures . . . . . . . . . . . . . . . . . . . . . 94
6.4 Speculation: Bearish security, sell futures . . . . . . . . . . . . . . . . . . . . . 95
6.5 Arbitrage: Overpriced futures: buy spot, sell futures . . . . . . . . . . . . . . . . 95
6.6 Arbitrage: Underpriced futures: buy futures, sell spot . . . . . . . . . . . . . . . 96

7 Pricing options 99
7.1 Introduction to the Black–Scholes formulae . . . . . . . . . . . . . . . . . . . . 100
7.2 The Black–Scholes option pricing formulae . . . . . . . . . . . . . . . . . . . . 100
7.2.1 Pricing index options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
7.2.2 Pricing stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

8 Using index options 109

8.1 Hedging: Have portfolio, buy puts . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts . . . . . . . . . . . 115
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts . . . . . . . . . . . 119
8.4 Speculation: Anticipate volatility, buy a call and a put . . . . . . . . . . . . . . . 123
8.5 Speculation: Bull spreads - Buy a call and sell another . . . . . . . . . . . . . . 125
8.6 Speculation: Bear spreads - sell a call and buy another . . . . . . . . . . . . . . 128
8.7 Arbitrage: Put-call parity violations . . . . . . . . . . . . . . . . . . . . . . . . 131
8.8 Arbitrage: Beyond option price bounds . . . . . . . . . . . . . . . . . . . . . . 135

9 Using stock options 137

9.1 Uses of stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.1 Hedging: Have stock, buy puts . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.2 Speculation: Bullish stock, buy calls or sell puts . . . . . . . . . . . . . 138
9.1.3 Speculation: Bearish stock, buy puts or sell calls . . . . . . . . . . . . . 138
9.2 Combination positions using stock futures and stock options . . . . . . . . . . . 139
9.3 Early exercise of American options . . . . . . . . . . . . . . . . . . . . . . . . . 140
9.3.1 Early exercise of calls on non–dividend paying stock . . . . . . . . . . . 140
9.3.2 Early exercise of puts on non–dividend paying stock . . . . . . . . . . . 141
9.3.3 Early exercise of calls on dividend paying stock . . . . . . . . . . . . . . 141
9.3.4 Early exercise of puts on dividend paying stock . . . . . . . . . . . . . . 143
9.4 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

10 Trading 151
10.1 Futures and options trading system . . . . . . . . . . . . . . . . . . . . . . . . . 151
10.1.1 Entities in the trading system . . . . . . . . . . . . . . . . . . . . . . . . 151
10.1.2 Basis of trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
10.1.3 Corporate hierarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
10.1.4 Order types and conditions . . . . . . . . . . . . . . . . . . . . . . . . . 154
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10.2 The trader workstation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

10.2.1 The market watch window . . . . . . . . . . . . . . . . . . . . . . . . . 155
10.2.2 Inquiry window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
10.2.3 Placing orders on the trading system . . . . . . . . . . . . . . . . . . . . 157
10.2.4 Market spread/combination order entry . . . . . . . . . . . . . . . . . . 158
10.2.5 Basket trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
10.3 Futures and options market instruments . . . . . . . . . . . . . . . . . . . . . . 158
10.3.1 Contract specifications for index futures . . . . . . . . . . . . . . . . . . 158
10.3.2 Contract specification for index options . . . . . . . . . . . . . . . . . . 160
10.3.3 Contract specifications for stock futures . . . . . . . . . . . . . . . . . . 162
10.3.4 Contract specifications for stock options . . . . . . . . . . . . . . . . . . 162
10.4 Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

11 Clearing and settlement 167

11.1 Clearing entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.1.1 Clearing members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.1.2 Clearing banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
11.2 Clearing mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
11.3 Settlement mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
11.3.1 Settlement of futures contracts . . . . . . . . . . . . . . . . . . . . . . . 170
11.3.2 Settlement of options contracts . . . . . . . . . . . . . . . . . . . . . . . 172
11.4 Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
11.4.1 NSE–SPAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
11.4.2 Margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
11.4.3 Margin/position limit violations . . . . . . . . . . . . . . . . . . . . . . 177

12 Regulatory framework 185

12.1 Securities Contracts(Regulation) Act, 1956 . . . . . . . . . . . . . . . . . . . . 185
12.2 Securities and Exchange Board of India Act, 1992 . . . . . . . . . . . . . . . . . 186
12.3 SEBI (Stock brokers and Sub–Brokers) Regulations, 1992 . . . . . . . . . . . . 186
12.3.1 Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
12.4 Regulation for derivatives trading . . . . . . . . . . . . . . . . . . . . . . . . . . 187
12.4.1 NSE’s certification in financial markets . . . . . . . . . . . . . . . . . . 188
12.5 Regulation for clearing and settlement . . . . . . . . . . . . . . . . . . . . . . . 189
12.6 Regulation for membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
12.7 Regulations for risk management . . . . . . . . . . . . . . . . . . . . . . . . . . 191
12.7.1 Liquid networth requirements . . . . . . . . . . . . . . . . . . . . . . . 191
12.7.2 Initial margin computation methodology . . . . . . . . . . . . . . . . . . 192
12.7.3 Calendar spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.4 Short option minimum margin . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.5 Net option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
12.7.6 Premium margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
12.7.7 Initial margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
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12.7.8 Exposure limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

12.7.9 Exposure limit for calendar spreads(only for futures contracts) . . . . . . 195
12.7.10 Position limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
12.7.11 Real time computation . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
12.7.12 Eligibility of stocks for futures and option trading . . . . . . . . . . . . . 196
12.7.13 Adjustments for corporate actions . . . . . . . . . . . . . . . . . . . . . 197
12.8 Accounting for futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
12.8.1 Accounting at the inception of a contract . . . . . . . . . . . . . . . . . 199
12.8.2 Accounting at the time of daily settlement . . . . . . . . . . . . . . . . . 200
12.8.3 Accounting for open positions . . . . . . . . . . . . . . . . . . . . . . . 200
12.8.4 Accounting at the time of final settlement . . . . . . . . . . . . . . . . . 200
12.8.5 Accounting in case of a default . . . . . . . . . . . . . . . . . . . . . . . 201
12.8.6 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 201
12.9 Accounting for equity index options and equity stock options . . . . . . . . . . . 202
12.9.1 Accounting at the inception of a contract . . . . . . . . . . . . . . . . . 202
12.9.2 Accounting at the time of payment/receipt of margin . . . . . . . . . . . 202
12.9.3 Accounting for open positions as on balance sheet dates . . . . . . . . . 202
12.9.4 Accounting at the time of final settlement . . . . . . . . . . . . . . . . . 203
12.9.5 Accounting at the time of squaring off an option contract . . . . . . . . . 203
12.10Taxation issues: A discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204