Finance Project

Trading of Derivatives in Stock Market
Chapter 1 OBJECTIVE OF study

1. 2. 3. 4. 5. 6. To study and understand the concepts of the Derivative market To study and analyze the various strategies of Derivative market segment. To study the trading segment of Derivative market. To find out the risk of profit and loss of the traders. To understand the exact differences between the various derivatives instruments. To make recommendations if any, to improve the investment portfolio of the investors.
1.1-SCOPE OF STUDY
1.
It is customary that under two year full time course of M.B.A. degree, a student has to undergo different training programs so as to establish himself capable of managing at the place of his work after the completion of this degree. Thus project work is a unique way of studying an organization.
2.
The main purpose of assigning this task of project report is to keep new practical knowledge, establishing relations with different persons outside the organization and to obtain first hand and factual information.
{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}
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3.
The project helps to draw out the differences and similarities between the theoretical knowledge with the actual job conditions, this helps the students to persuade and activate strategy decision-making when they start their carriers. It provides an opportunity to develop communication skill and analytical skills.
1.2 - METHODOLOGY of study

Research in common parlance refers to a search for common knowledge. One can also define research as a scientific and systematic search for pertinent information on a specific topic. Research is an academic activity and as such the term should in a technical sense.
Data collection
The task of data collection begins after a research problem has been defined and plan chalked out. There are two types of data viz. Primary data, secondary data. The primary data those which are collected afresh and for the first time, and thus happen to be original in character. The secondary data, on the other hand, are those which have already been collected by some one else and which have been passed through the statistical process. In research data is divided in to two major parts i.e. Primary Data, Secondary Data.
Primary Data collection

It is the first hand information collected directly form the source required for the project report. The data required is collected mainly from two sources i.e. by taking interviews and discussion. The information obtained from these sources is only for the purpose of project report. Investors, visitors who occupy the front office during the market time are the main source for valuable information. The branch manager is also provided expert knowledge on stock market.
Secondary data collection
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It means the readymade data available from different sources. So it is second hand information, which is generated for some other purpose, which can be used by anybody. The different secondary sources are various derivative websites and books.
CHAPTER-2 COMPANY PROFILE

2.1 - Company History & Background
Asit C. Mehta Investment Interrmediates Ltd. (ACMIIL) was established in the year 1986 with a view to offer a one stop solution to Indian entities for their needs in financial services. Over the last two decades it has achieved the distinction of being amongst the most trusted and reputed brokerage houses in India. It provides a complete bouquet of products in equity, debt, commodities, forex, depository, derivatives and allied services in India. The company is jointly promoted by noted stock market professionals, Mr. Asit C. Mehta and Mrs. Deena A. Mehta, and is a part of the Mumbai-based Nucleus Group of Companies. The other group companies are engaged in IT and IT related services such as development of databases, back-office applications for banks, corporate document management solutions and geographical information systems (GIS).
The FIRSTS to our credit

1. First limited liability Company to acquire membership on Bombay Stock Exchange. 2. First multiple seat holder and multiple exchange members. 3. First private VSAT network user. 4. First to utilize the franchisee business model for sub-brokers. 5. First to achieve the ISO quality certification for business processes. 6. First to receive a CRISIL grading for quality of operations and services.
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7. Company Managing Director Mrs. Deena Mehta was the first lady to be elected to the governing board of the Stock Exchange Mumbai and first and only lady to be the President of Stock Exchange, Mumbai.
Advantage of opening account with acmiil

1. Customer Centric. 2. Focus on wealth creation for the investors. 3. 4. Client Level Risk Management. Auto Pay-in / Pay-out of securities.
5. Transfer of payout directly to the designated customer bank account. 6. Account & Portfolio information through Internet 24x7, 365 days. 7. Strong foundation of Technology, Compliance and Transparency.
Service Standards & Compliance

In order to institutionalize business processes, our company has moved to a documented customer-centric quality management system. This has ensured that the entire organization is driven by the common objective of delivering quality brokerage services that would create a unique brand and top-of-the-mind recall. We are the first brokerage house to be certified under ISO 9001:2000 for the Equity and Debt segments. We are also first stock brokerage house to be graded under the Broker Grading service by Credit Rating & Information Services of India Ltd. (CRISIL) for our quality of operations and services provided to clients.
Potential Growth Areas

India is amongst the least affected countries in the 2008 global meltdown. May 2009 general election in the country provided a fairly stable government. We see great potential for the country in general and financial market in particular in the years to come. Investor participation, product innovations, volume growth is likely to be in exponential
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proportion. Our company is well poised to build a great institution in India to service the Indian and global investors for their financial services needs. The company has created a strong organization driven by processes to handle multifold volume growth
2.2 SEBI Registration NUMBER

1. BSE CM: INB 010607233 & Derivatives: INF 010607233 2. NSE CM: INB 230607239 & Derivatives: INF 230607239 & WDM: INB 230607239 3. PMS: INP000001920 4. Merchant Banking: INM000010973 5. Depository (CM & Derivatives): IN-DP-CDSL-28-99; Depository (Commodity) DPCDSL 12013200
Management
Chief Executive Officer Whole-time Director : : Mrs. Deena Asit Mehta Mr. Kirit H. Vora
Membership
1. Cash Market: BSE, NSE 2. Derivatives: BSE, NSE 3. Debt: NSE 4. Foreign Exchange: Accredited by FEDAI 5. PMS under SEBI License 6. Merchant Banking: Approved by SEBI under Category I 7. Commodities: NCDEX MCX, DGCX, EAST INDIA COTTON Depository: CDSL
Clearing Bank: State Bank of India Address
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Asit C Mehta Investment Interrmediates Ltd. Nucleus House, Saki Vihar Road, Andheri (E), Mumbai 400 072. India. Call: 91-22-28583333. Fax: 91-22-28577647. Email: acmill@acm.co.in
2.3 SERVICES
1) Equity and Derivatives Trading:Equity trading is offered to retail clients through different channels in the Bombay Stock Exchange (BSE) & the National Stock Exchange of India (NSE), for the cash and the derivatives segments. Investors are serviced through a PAN India network of over 650 associates / locations comprising of 585 franchisee and 65 company branches. (as on July 2009)
2) Online Trading:Investmentz.com is our trading portal that offers online trading to retail investors in the BSE and NSE cash and derivatives segments. The investors can do their own trading through a browser-based interface as well as a streamer-based solution called live exchange. This service is also available through an Interactive Voice Response (IVR) facility for those clients who are unable to access the Internet service at any time. The company has tied up with leading nationalized, private and co-operative banks to offer share trading services to the banks' customers. A seamless gateway has been established between the banking and depository softwares of the bank.
3) Institutional Desk:
Equity trade execution services are provided to institutional investors both domestic and FII by our institutional desk. Research and market information is provided to mutual funds and banks to support them in making investment decisions. These services are provided with seamless connectivity to custodians.
4) Portfolio Advisory Service:-
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ACMIIL holds a portfolio management license issued by SEBI. It service is available to Resident Indian and Non-Resident India (NRI), for managing their equity & mutual fund portfolio.
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5)
Investment Banking:-
ACMIIL has been granted a Category I Merchant Banking license by SEBI. It offers services in mergers, amalgamations, private equity, public offerings and a full gamut of investment banking services.
6) Commodity trading services:These are provided through our associate, Asit C. Mehta Commodity Services Pvt. Ltd. The company is member of Indias premier commodity exchanges, namely, the Multi Commodity Exchange of India Ltd. (MCX), the National Commodity & Derivatives Exchange, India (NCDEX) and the East India Cotton Exchange Association (EICA). The online trading portal also provides facility to trade on NCDEX. One of the group companies is a member of Dubai Gold & Commodity Exchange (DGCX).
7) Mutual Fund and IPO distribution service:These are provided to retail investors directly and indirectly through our Branch/Business Associate network. Seminars are conducted regularly to highlight the importance of investment in mutual funds, especially through Systemic Income Plans (SIP). Advice is provided on initial public offerings and only public issues that have merit are marketed to retail investors.
8)
Debt Market Desk:-
We are members of the Wholesale Debt Market (WDM) segment of the National Stock Exchange of India (NSE). The service involves providing quotes and executing trades in government securities (G-Sec), treasury bills and other state-guaranteed bonds. We are empanelled with most nationalized, foreign, private and major co-operative banks. We are also empanelled with most primary dealers, mutual funds, insurance companies and institutions for trading in debt market instruments.
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9)
Inter-bank Forex Desk:-
Our associate company, Asit C Mehta Forex Pvt. Ltd., undertakes inter-bank forex order execution. Accredited by the Foreign Exchange Dealers Association of India (FEDAI), the company is empanelled with approximately 60 banks and has a reasonable presence in the market.
10) Depository services:These are provided to investors. The company is a depository participant with the Central Depository Service of India Ltd. (CDSL). We are also authorized to provide depository services for commodity trades. 11)Equity and Derivatives Trading:Equity trading is offered to retail clients through different channels in the Bombay Stock Exchange (BSE) & the National Stock Exchange of India (NSE), for the cash and the derivatives segments. Investors are serviced through a PAN India network of over 650 associates / locations comprising of 585 franchisee and 65 company branches. (as on July 2009)
12)Online Trading:Investmentz.com is our trading portal that offers online trading to retail investors in the BSE and NSE cash and derivatives segments. The investors can do their own trading through a browser-based interface as well as a streamer-based solution called live exchange. This service is also available through an Interactive Voice Response (IVR) facility for those clients who are unable to access the Internet service at any time. The company has tied up with leading nationalized, private and co-operative banks to offer share trading services to the banks' customers. A seamless gateway has been established between the banking and depository softwares of the bank.
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13)Institutional Desk:
Equity trade execution services are provided to institutional investors both domestic and FII by our institutional desk. Research and market information is provided to mutual funds and banks to support them in making investment decisions. These services are provided with seamless connectivity to custodians.
14)Portfolio Advisory Service:ACMIIL holds a portfolio management license issued by SEBI. It service is available to Resident Indian and Non-Resident India (NRI), for managing their equity & mutual fund portfolio.
15)Investment Banking:ACMIIL has been granted a Category I Merchant Banking license by SEBI. It offers services in mergers, amalgamations, private equity, public offerings and a full gamut of investment banking services.
16)Commodity trading services:These are provided through our associate, Asit C. Mehta Commodity Services Pvt. Ltd. The company is member of Indias premier commodity exchanges, namely, the Multi Commodity Exchange of India Ltd. (MCX), the National Commodity & Derivatives Exchange, India (NCDEX) and the East India Cotton Exchange Association (EICA). The online trading portal also provides facility to trade on NCDEX. One of the group companies is a member of Dubai Gold & Commodity Exchange (DGCX).
17)Mutual Fund and IPO distribution service:These are provided to retail investors directly and indirectly through our Branch/Business Associate network. Seminars are conducted regularly to highlight the importance of investment in mutual funds, especially through Systemic Income Plans (SIP). Advice is provided on initial public offerings and only public issues that have merit are marketed to retail investors.
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18)Debt Market Desk:We are members of the Wholesale Debt Market (WDM) segment of the National Stock Exchange of India (NSE). The service involves providing quotes and executing trades in government securities (G-Sec), treasury bills and other state-guaranteed bonds. We are empanelled with most nationalized, foreign, private and major co-operative banks. We are also empanelled with most primary dealers, mutual funds, insurance companies and institutions for trading in debt market instruments.
19) Inter-bank Forex Desk:Our associate company, Asit C Mehta Forex Pvt. Ltd., undertakes inter-bank forex order execution. Accredited by the Foreign Exchange Dealers Association of India (FEDAI), the company is empanelled with approximately 60 banks and has a reasonable presence in the market.
20)Depository services:These are provided to investors. The company is a depository participant with the Central Depository Service of India Ltd. (CDSL). We are also authorized to provide depository services for commodity trades.
CHAPTER-3
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MEANING OF STOCK EXCHANGE

The stock exchange has been defined under Section 2(3) of the securities contract (Regulation) Act 1956 as any body of individuals whether incorporated or not, constituted for the purpose of assisting, regulation or controlling the business of buying, selling or dealing in securities. The securities, which are traded in the stock market, are defined under section 2(b) of the Act as: Shares, scrips, stock, bonds, debentures, debentures stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; Government securities; and Rights or interest in securities.
ROLE AND FUNCTIONS OF STOCK EXCHANGE

The stock exchange provides a variety of facilities to joint stock companies for its growth. Here are some of the functions: It provides market place for purchase and sale of different types of securities like shares, bonds, etc. enabling free transferability of securities. It provides a linkage between the savings in the household sector and the investment in the corporate sector. It lays down a number of regulations to be complied by/with companies while mobilizing resources from the public, for safe guarding public interest. The stock exchange provides a market quotation of the prices of securities listed in the exchange that depicts the state of health of each companies and stock price index acts as the barometer of the state of stock market in the country. It encourages investment in the primary market by offering liquidity to investments by way of facility to buy and sell.
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3.1 - Bombay Stock Exchange

The Stock Exchange, Mumbai, popularly known as "BSE" was established in 1875 as "The Native Share and Stock Brokers Association", as a voluntary non-profit making association. It has evolved over the years into its present status as the premier Stock Exchange in the country. It may be noted that the Stock Exchanges is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was founded in 1878. The Exchange, while providing an efficient and transparent market for trading in securities, upholds the interests of the investors and ensures redressal of their grievances, whether against the companies or its own member-brokers. It also strives to educate and enlighten the investors by making available necessary informative inputs and conducting investor education programmes. A Governing Board comprising of 9 elected directors (one third of them retire every year by rotation), two SEBI nominees, seven public representatives and an Executive Director is the apex body, which decides the policies and regulates the affairs of the Exchange.
3.2 - National Stock Exchange of India

The National Stock Exchange of India was promoted by leading financial institutions at the best of the Government of India, and was incorporated in November 1992 as a tax-paying company. In April 1993, it was recognized as a stock exchange under the Securities Contracts (Regulation) Act, 1956. NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment of the NSE commenced operations in November 1994, while operations in the Derivatives segment commenced in June 2000. The National Stock Exchange of India Limited (NSE), is a Mumbai-based stock exchange. It is the largest stock exchange in India in terms of daily turnover and number of trades, for both equities and derivative trading. NSE has a market capitalization of around Rs 47,01,923 crore (7 August 2009) and is expected to become
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the biggest stock exchange in India in terms of market capitalization by 2009 end. Though a number of other exchanges exist, NSE and the Bombay Stock Exchange are the two most significant stock exchanges in India, and between them are responsible for the vast majority of share transactions. The NSE's key index is the S&P CNX Nifty, known as the Nifty, an index of fifty major stocks weighted by market capitalization.
3.3 - OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

The OTC provides a very important service to inactive issues, securities not eligible for listing in the stock exchanges, issues of small companies, actively traded issues listed on the OTC. The OTC market is not a central physical market place but a collection of brokers and dealers scattered across the country. This market is more a way of doing business than a place.
To meet the different characteristics of the companies and objectives of the investors, the multi-tier structure exists in secondary market, which is as follows:
First market: Trading in listed companies on the floor of stock exchange with the help of brokers and dealers. Second market: Trading over the counter for OTC issues. Third market: Trading in listed companies, not on the floor or stock exchange with the help of brokers and dealers. Fourth market: Trading in listed companies, not on the floor of stock exchange, without the help of broker and dealers. It is a direct deal in buyers and sellers.
Buying and selling in unlisted stocks are matched not through the auction process on the floor of the stock exchange but through negotiated bidding over a massive network of telephone that link thousands of securities firms here and abroad.
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Over the counter market is a market where buyers seek out sellers and vice-versa and then attempt to arrange terms and conditions for purchase/sale acceptable to both parties. Thus, in the OTC, trading takes place by putting buy and sells orders on fax, telephone, telex, letter, oral message etc.
CLASSIFICATION OF SECURITIES MARKET
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CHAPTER-4 DERIVATIVES
Derivatives are financial contracts, which derive their values of spot price time series, which is called the underlying assets can be equity, index, commodity or any other assets. Some common examples of derivatives are forwards, futures, options and swaps. The underlying assets can be an agricultural commodity like wheat, tea, coffee, etc, or individual stock like Infosys, ACC, and HPCL. etc stock indexes like standard and poor 500, Nikkei 225, BSE sensex etc. or financial instrument like T-Bill, Notes & Bonds or Currencies lick Dollar, Euro, Yen, Pound etc.
4.1 - DEFINATION OF DERIVATIVES

In the Indian contact the securities contract act, 1956 SC(R)A defines Derivatives to include-
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1. A security derived from a debt instrument, share, and loan weather secured or unsecured, risk instrument or contract for differences or any other form of securities. 2. A contract which derives its values from the prices, or index of prices of underlying securities. 3. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.
4.2 - History of Derivatives

The derivative market has existence for centuries as a result of the need for both user and producer of natural resources to hedge against price fluctuation in the underlying commodities. Although trading in agriculture and over commodities has been the driving force behind the development of derivatives exchange, the demand for product based on financial instrument such as bonds, currencies, stock and indices- have now for outstripped that for the contracts. Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12 th century and may well have around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swing would inhibit marketing the commodities after a harvest
4.3 - Derivatives in India

Approval for derivative trading
The first step towards introduction of derivative trading in India was the promulgation of the securities laws (amendment) ordinance, 1995, which withdrew the prohibition on option in securities. The market for derivatives however did not take off, as there was no regulatory framework to govern trading of derivative. SEBI set up a 24member committee under the chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India.
Derivative market at NSE

The derivative trading on the exchange commenced with S&P CXN Nifty index future on June 4, 2001. Single stock future was launched on November 9,2001. The index future and option contract on NSE are based on S&P CNX nifty index. Currently, the future contracts are available for trading, with 1 month, 2 month & 3 month expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.
Trading Mechanism
The future and option trading system of NSE called -F&Q trading system, provide a fully automated screen-based trading for nifty future and option and stock future and option on a nation wide basis and an online monitoring an surveillance mechanism. It supports an anonymous order driven market, which provides complete transparency of trading operation, and operate on strict price-time priority. It is similar to that of trading e cash market segment. The NEAT-F&O trading system is accessed by two type of user. The trading members have access to function such as order entry, order matching and order & trade management. It provides tremendous flexibility to user in terms of kind of orders that can be placed in the system. Various conditions like Good till-cancelled, Good till- date, immediate or cancel, limit/ market price, stop loss etc. can be built in to an order. The
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clearing members for whom they can enter and set limits to positions, which a trading member can take.
Clearing and Settlement

NSCCL undertaking clearing and settlement of all executed on the NSEs F&O segment and guarantees settlements.
Membership Criteria
NSE admits member on its derivatives segment in accordance with the rules and regulation of the exchange and the norms specified by the SEBI. NSE follows 2-Tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership in taking membership on CM and F&O segment or CM WDM and F&O segment. Trading and clearing member are admitted. Essentially, clearing members CM does clearing for his entire trading member (TM), undertakes risk management and perform actual settlements. There are three types of CMS 1. Self clearing member: A SCM clear and settles trader executed by him only either on his own account of his client. 2. Trading member and clearing member: TM-CM is a CM who is also a TM. TM-CM may clear and settle his own proprietary trades as well as clear and settle for others TMs.
3.
Professional clearing member: PCM is a CM who is not TMs.
4.4 - Features OF DERIVATIVES

1) Relation between the values of derivatives are the underlying assets when the values of the underlying assets changes, so does the value of the derivatives base on them.
2) It is the easer to take short position in derivatives then in any other assets. 3) Exchange traded derivatives are liquid and hove low transaction cost. 4) It is possible to construct the portfolio that is exactly needed, without having the underlying assets. 5) Potential to provide insurance to investors against wide fluctuation in the market.
4.5 - Economic Role of Derivatives

Derivative market provides three essential economic functions.
1.
Risk Management: - Refer to the ability of the trader to offset financial risk through derivatives.
2.
Price Discovery: - Refer to the better allocation of resources in an economy that is created by the wide availability of an equilibrium price, which serves as measures of value.
3.
Transitional Efficiency: - Refer to increase efficiency of transacting through derivatives. Derivatives markets reduce the cost of trading and rising capital thereby, enhancing their risk management and price discovery functions.
Advantages & disadvantages of Derivatives

Advantages
1. Allows participants to gather information and to assess the situation controls panic.
2.
Brokerages firms can check on customer funding and compliance
3. Exchanges/clearing houses can monitor their members.
Disadvantages
1. Only postpones the inevitable. 2. Limits the flow of market information-no one knows the real value of a stock. They precipitate the matter during volatile moves as participants rush to execute their orders before anticipated trading halt.
LIST OF SCRIPS IN THE INDIAN DERIVATIVES MARKET The minimum quantity you can trade in is one market lot. The market lot is different for different stocks/index. Time to time list keeps changing.
CNXIT Nifty ACC Andhra Bank Arvind Mills Bajaj Auto Bank of Baroda Bank of India BEL BHEL BPCL Canara Bank Cipla Dr. Reddys GAIL Grasim Ind 100 200 1500 4600 4300 400 1400 3800 550 600 550 1600 1000 200 1500 350 HDFC HDFC Bank Hero Honda Hindalco HLL HPCL i-flex ICICI Bank Infosys IOC IPCL ITC M&M Maruti Mastek MTNL 600 800 400 300 2000 650 300 1400 200 600 1100 300 625 400 1600 1600 Oriental Bank PNB Polaris Ranbaxy REL RIL Satyam SBI SCI Syndicate Bank Tata Motors Tata Power Tata Tea TCS Tisco Union Bank 1200 1200 1400 400 550 600 1200 500 1600 7600 825 800 550 250 1350 4200
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Gujarat Ambuja
1100
Nalco
1150
Wipro
600
CHAPTER-5 TYPES OF DERIVATIVES

DERIVATIVES DERIVATIVES
Options Options
Swaps Swaps
Futures Futures
Forwards Forwards
Put Put
Call Call Interest Interest Rate Rate
Commodity Commodity Currency Currency
Securities Securities
The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used.
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
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Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.
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.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longerdated options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.
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Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
CHAPTER-6
Participants in the derivatives markets
The following three broad categories of participant hedgers, speculators, and arbitrageurs trade in the derivatives market.
6.1 - Hedgers
Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. Hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return. They face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. In order to understand how one can protect his portfolio from value erosion let us take an example.
Example: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) 1000 Selling price 4000 Profit 3000
However, Ram fears that Shyam may not honor his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honor the contract he will
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have to pay a penalty of Rs 1000. And if Shyam honors the contract Ram will offer a discount of Rs 1000 as incentive. Shyam defaults 1000 (Initial Investment) 1000 (penalty from Shyam) - (No gain/loss) Shyam honors 3000 (Initial profit) (-1000) discount given to Shyam 2000 (Net gain)
As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honors the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment. 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 lack, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 lack of S&P CNX Nifty futures.
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Steps: 1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1. 2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings. Therefore in the above scenario we have to short sell 1.2 * 1 lack = 1.2 lack worth of Nifty. Now let us study the impact on the overall gain/loss that accrues:
Index up 10% Gain/(Loss)in Portfolio Gain/(Loss) in Futures Net Effect Rs 120,000 (Rs 120,000) Nil Index down 10% (Rs 120,000) Rs 120,000 Nil
As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market. Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.
6.2 - Speculators
The speculator takes a view on the market and plays accordingly. If one is bullish on the market, one can buy futures, and vice versa for a bearish outlook. There is another strategy of playing the spreads, in which case the speculator trades the basis. When a risk is taken, the speculator primarily bets on either the cost of carry (interest rate in case of index futures) going down (receive the basis). Pay the basis implies going short on a future with near month maturity while at the same time going long on a future with longer term maturity. Receiving the basis implies going long on a future with near month maturity while at the same time going short on a future with longer term maturity. They wish to bet on future movements in the price of an asset. Future and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Example: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, 2008, he buys 100 Sensex futures @ 15,000 on expectations that the index will rise in future. On June 1, 2008, the Sensex rises to 16000 and at that time he sells an equal number of contracts to close out his position. Selling Price: 16000*100 Less: Purchase Cost: 15000*100 Net gain = Rs. 16, 00,000/= Rs. 15, 00,000/= Rs 1, 00,000/-
Ram has made a profit of Rs 1, 00,000/- 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 long-term view of the market up to at least 3 months
6.3 - Arbitrageurs
Arbitrageurs profit from price differential existing in two markets by
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simultaneously operating in two different markets. All class of investors is required for a healthy functioning of the market. Arbitrageurs bring price uniformity a help price discovery. The market provides a mechanism by which diverse and scattered opinion are reflected in one single price of the underlying. These are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of the cash price, they will take offsetting positions in the two markets to lock in a profit. 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. A. Take the case of the NSE Nifty. B. Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300. C. The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. D. 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 Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070. Sale Cost Arbitrage profit = 1070 = 1000+30= 1030 = 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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Let us see some significant terminologies related to derivatives trading.
Market Makers:-
A dealer is said to make a market when he quote both bid and offer prices at which he stands ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together. He lends liquidity in the system by making trading feasible.
Circuit Breaker:-
Circuit breaker means trading is halted for a specified period in stocks or/and stock index futures, if the market price moves out of a pre-specified band. Circuit filters do not result in trading halt but no order is permitted if it falls out of the specified price range.
Chapter-7 FUTURES
A futures contract can be defined as a standardized agreement between the buyer and the seller in terms of which the seller is obligated to deliver a specified asset to the
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buyer on a specified date and the buyer is obligated to pay to the seller then prevailing futures price in exchange of the delivery of the asset. The futures contracts represent an improvement in the forward contract in terms of standardization, performance guarantee and liquidity. Whereas forward contracts are not standardized, the futures contract are standardized ones, so that 1. The quantity of the commodity or the other asset which could be transferred or would form the basis of gain/loss on maturity of the contract, 2. The quality of the commodity if a certain commodity is involved and the place where delivery of the commodity would be made, 3. The date and month of delivery, 4. The units of price quotation, 5. The minimum amount by which the price would change and the price limits of the days operations, and other relevant details are all specified in a futures contract. Thus, in a way, it becomes a standard asset, like any other asset to be traded. Futures contracts are traded on commodity exchanges or on other futures exchanges. People can buy of sell futures like other commodities. When an investor buys a futures contract (so that he takes a long position) on an organized futures exchange, he is, in fact, assuming the right and obligation of taking delivery of the specified underlying item (say 10 quintals of wheat of a specified grade) on a specified date. Similarly, when an investor sells a contract, to take a short position, one assumes the right and obligation to make delivery of the underlying asset. While there is a risk of non-performance of a forward contract, it is not so in case of a futures contract. This is because of the existence of a clearing house or clearing corporation associated with the futures exchange, which plays a pivotal role in the trading of futures. Unlike a forward contract, it is not necessary to hold on to a futures contract until maturity one can easily close out a position in the futures contract.
7.1-RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE

The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is, among other things, a function of: 1. Demand and supply position of the commodity
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2. Storability depending on whether the commodity is perishable or not 3. Seasonality of the commodity To understand the linkage between spot and futures price, let us consider an example. If John is certain that the demand-supply position of wheat is such that 3 months from now, the price of wheat is likely to go up, he should be tempted to buy wheat now and sell the stock after 3 months at a higher price. For this purpose, he will hire a godown , stock the inventory, pay interest on the money invested If the stock as well as pay incidental charges in holding the inventory, like, handling charges, insurance charges, etc., collectively called the carrying costs. Let us assume that he buys a unit of wheat at Rs. 100 and the carrying costs aggregates Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot price of wheat; 3 months from now should be more than Rs. 106. Now if others also have the same information that the wheat prices are likely to go up beyond the carrying cost, the number of buyers would increase. As the current demand for wheat increases because of this information, the current spot price also starts climbing. The current spot price would keep on increasing till the anticipated future spot price becomes equal to current spot price plus the carrying costs. As we have already seen, the future spot price tends to equal the current spot price plus the carrying costs. Suppose the current spot price is Rs. 100 and the carrying costs are Rs. 6. The predicted futures price, say, 3 months from now is Rs. 110. There would be a tendency for the current spot price to rise from Rs. 100 to Rs. 104, as any increase beyond this level would mean a loss in the transaction.
Thus, the current spot price would tend towards a level where there is no profit or no loss situation for both the buyer and seller alike. The conclusion, therefore, is that in a perfectly predictable and certain market, neither the buyer nor the seller would be interested in futures trading. If, future spot prices could be forecast with 100% certainty, the very idea of futures market would vanish. As a corollary, we can say that it is the element of uncertainty, which gives rise to a futures market.
7.2 - BASIS
The difference between the prevailing spot price of an asset and the futures price is known as the basis, i.e.
Basis = Spot price Futures price

In a normal market, the spot price is less than the futures price (which includes the full cost-of-carry) and accordingly the basis would be negative. Such a market, in which the basis decided solely by the cost-of-carry, is known as the Contango Market. Basis can become positive, i.e. the spot price can exceed the futures price only if there are factors other than the cost-of-carry to influence the futures price. In case this happens, then basis become positive and the market under such circumstances is termed as a Backwardation Market or Inverted Market. Basis will approach zero towards the expiry of the contract, i.e. the spot and futures prices converge as the date of expiry of the contract approaches. The process of the basisapproaching zero is called Convergence. As already explained above, the relationship between futures price and cash price is determined by the cost-of-carry. However, there might be factors other than cost-of-carry; especially in case of financial futures I which there may be carry returns like dividends, in addition to carrying costs, which may influence this relationship. The cost-of-carry model in financial futures, thus, is
Futures price = Spot price + Carrying costs Returns
Example
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The price of ACC stocks on 31st December 2008 was Rs. 220 and the futures price on the same stock on the same date, for March 2009 was Rs. 230. Other features of the contract and related information are as follows: Time of expiration Borrowing rate Annual Dividend on the stock Face value of the stock - 3 months (0.25 year) - 15% p.a. - 25% payable before 31.03.2009 - Rs. 10
Based on the above information, the futures price for ACC stock on 31st December 2008 should be: = 220 + (220 x 0.15 x 0.25) (0.25 x 10) = Rs. 225.75 Thus, as per the cost of carry criteria, the futures price is Rs. 225.75, which is less than the actual price of Rs. 230 in February 2009. This would give rise to arbitrage opportunities and consequently the two prices will tend to converge.
7.3 - Futures Terminology

Spot price: The price at which an asset trades in the spot market.
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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-month 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.
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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 ac-count is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket.
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.
7.4 - Valuation of futures

Let us take a simple example of a fixed deposit in a bank. Rs. 100 deposited in the bank at a rate of interest of 10% would become Rs. 110 after 1 yr. Based on annual compounding; the amount will become Rs. 121 after 2 yrs. Thus, we can say that the forward price of the fixed deposit of Rs. 100 is Rs. 110 after 1 yr. and Rs. 121 after 2 yrs.
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As against the usual annual, semi-annual and quarterly compounding, continuous compounding are used in derivative securities. In terms of annual compounding, the forward price can be computed through the following formula: A = P (1 + r / 100)t
Tag
Where A is the terminal value of an amount P invested at the rate of interest of r % p.a. for t years. Now, if compounding was done twice a year, the amount at the end of 2 years can be calculated as follows:
Beginning of period I Halfyear II Half-year III Half-year IV Half-year
Principle 1000 1050 1102.50 1157.625
Interest 1000 x 0.05 = 50 1050 x 0.05 = 52.50 1102.5 x 0.05 =55.125 1157.625 x 0.05 = 57.881
Amt. at the end 1050 1102.50 1157.6254 1215.51
It is observed that with all the inputs being the same, the amount is a little higher when the frequency of compounding is increased from one to two in each year. With the still greater compounding frequency, the amount at the end of the 2 yr period would increase. For instance, for different compounding period at the end of 2 yrs are given below:
Compounding
Quarterly Monthly Weekly Daily
Amount (Rs.)
1218.40 1220.39 1221.17 1221.37
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In general terms, A = P (1 + r / m) m n Where r is the per annum rate of interest, m is the number of compounding per annum and n is the number of yrs. For quarterly compounding, for ex. m = 4, while for daily compounding, m = 365. To carry the idea further, if the number of compounding per annum increases more and more, the time period between successive compounding would steadily fall. In the extreme case, the compounding may be thought to be continuous. In such an event, it can be shown mathematically that the amount may be calculated as follows: A = Pen r Where all symbols carry the same meaning as before and e is a mathematical constant whose value is 2.7183. Since the compounding is continuous, the amount is likely to be the largest. To know the exact amount, we make the following calculation:
A = 1000 x 2.71832 x 0.1 = 1000 x 1.22140 = Rs. 1221.40
In case there is a cash income accruing to the security like dividends, the above formula will read as follows: A = (P I) em r Where I is the present value of the income flow during the tenure of the contract. Example
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Consider a 4 month forward contract on 500 shares with each share priced at Rs. 75. Dividend @ Rs. 2.50 per share is expected to accrue to the shares in a period of 3 months. The CCRRI is 10% p.a. the value of the forward contract is as follows: Dividend proceeds Present value of Dividend = 500 x 2.50 = 1250 = 1250e- (3/12) (0.10) = 1219.13 Value of forward contract = (500 x 75 1219.13) e(4/12) (0.10)
= 36280.87 x e0.033 = Rs. 37498.11
Chapter-8 OPTIONs
Option is a legal contract in which the writer of the contract grants to the buyer, the right to purchase from or to sell to the writer a designated instrument or a scrip at a specified price within a specified period of time. The right to purchase a specified stock is called the call option, while the right to sell a specified stock is called a put option.
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Example:Suppose a writer of an option writes a contract, which conveys or grants to the buyer the right to buy 100 shares of ITC from him, i.e. from the writer at the rate of Rs. 650 per share. This option is called a call option and is designated as 100 ITC 650 call. Similarly, if a writer writes an option which grants to the buyer the right to sell to the writer 100 shares of ITC at Rs. 650 per share, such an option is called a put option and is designated as 100 ITC 650 put. It should be noted that in a call option transaction, there is not put option involved. The writer is writing or selling a call option and the buyer is buying a call option. Similarly, in the case of a put option transaction there is no call option involved. The writer is writing or selling a put option and the buyer is buying a put option.
WHO CAN WRITE AN OPTION?

Anyone eligible to enter into contract as per the Law of Contract can write an option irrespective of the fact whether one owns the underlying stock or not. If the writer of a call option owns the stock that he is obliged to deliver upon exercise of the call he has written, he is called a covered call writer. On the other, if the writer of the call option does not own the stock he has written the option for, he is called an uncovered or naked call writer and the option is called an uncovered or naked call option.
OBLIGATION BUYER
OF
THE
OPTION
WRITER
AND
The writer is legally obligated to perform according to the terms of the option. On the other hand, the buyer of the option has bought a write to exercise the option and is under no obligation to exercise the option. He can conveniently let the option lapse on the date of expiration of the option. The significance of this feature of an option is explained through the following example.
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Example Suppose you buy a 100 ITC 650 Call option contract. During the expiration period, the stock price does not appreciate enough to cover even the premium paid, i.e., you do not gain anything by exercising the option. The options contract confers on you the right to either invoke the contract or let it lapse. Invoking the contract means calling upon the writer to deliver the stock at the contract price. This would be futile as this stock is available at equal to or even less than the exercise price in the market. By letting the option lapse the buyer gets out of the contract, as he is not obligated to perform. However, the writer or the seller is under the obligation to perform right up to the expiry of the contract whenever called upon buy the buyer of the option to do so.
ESSENTIAL INGREDIENTS OF AN OPTION CONTRACT

An options contract has four essential ingredients: 1. The name of the company on whose stock the option contract has been derived. 2. The quantity of the stock required to be delivered in the case of exercise of the option. 3. The price, at which the stock would be delivered, or the exercise price or the strike price. 4. The date when the contract expires, called the expiration date.
8.1 - Option Terminologies

Before into the concepts and mechanics of options trading, we need to be familiar with the basic terminology as they are repeatedly used in case of options and also the factors that influence the option price.
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Index options:- These options have the index as the underlying.
Stock options:- Stock options are options on individual stocks.
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.
Option price/premium:- Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
Exercise Price:- The exercise price (also called the strike price) is the price at which the buyer of a call option can purchase the stock during the life of the option, or the buyer of the put option can sell during the life of the option.
Exercise price is that price at which the writer has to deliver the stock to the call option buyer and buy from the put buyer irrespective of the prevailing market price in case the latter decides to exercise the option.
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Expiration Date:- Expiration Date is the date on which the option contract expires, i.e. the last date on which options contract can be exercised. Options usually have either a monthly and/or quarterly expiration cycle. The maturity period for an option does not normally exceed nine months.
Premium:- Premium is the price that the buyer of an option, whether call or put, pays to the writer of the option, for the rights conveyed by the option. The premium of the option is a function of variables, such as: Current stock price, Strike price, Time to expiration, Volatility of stock, and Interest rates.
The buyer pays the premium to the seller, which belongs to the seller whether the option is exercised, or not. If the owner of an option decided not to exercise the option, the option expires and becomes worthless. The premium becomes the profit of the option writer, while if the option is exercised; the premium gets adjusted against the loss that the writer incurs upon such exercise.
In-the-Money:- A call option is In-the-Money if the prevailing stock price (of the underlying asset) is greater than the exercise price.
At-the-Money:-In case the calls market price is the same as its exercise price, it would bee called at-the-money or at-the-market.
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Out-of-the-Money:-Similarly, if the market price of the stock is less than the exercise price, it shall be called out-of-the-money.
These concepts are tabulated below, wherein S indicates the present value of the stock and E is the exercise price.
Condition S>E S<E S=E
Call Option In-the-Money Out-of-the-Money At-the-Money
Put Option Out-of-the-Money In-the-Money At- the-Money
8.2 - CALL OPTIONS
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A call option gives the buyer the right to purchase a specified number of shares of a particular company from the option writer (seller) at a specified price (called the exercise price) up to the expiry of the option. In other words, the option buyer gets a right to call upon the option seller to deliver the contracted shares any time up to the expiry of the option. The contract, thus, is only one-way obligation, i.e. the seller is obligated to deliver the contracted shares while the buyer has the choice to exercise the option or let the contract lapse. The buyer is not obligated to perform. Position Graphs An option buyer starts with a loss equivalent to the premium paid. He has to carry on with the loss till the stock's market price equals the exercise price as shown in (a). The intrinsic value of the option up to this point remains zero and thus, runs along the X-axis. As the stock price increases further, the loss starts reducing and gets wiped out as soon as the increase equals the premium, represented on the graph by point b, also called the break even point. The profitability line starts climbing up at an inclination of 45 degrees after crossing the X-axis at b and from thereon moves into the positive side of the graph. The inclined line beyond the point b indicates that the option acquires intrinsic value and is, thus referred to as the intrinsic value line. The position graph in (b) represents the profitability status of the writer who does not own the stock, i.e., a naked or an uncovered writer. The graph is logically the inverse of that for the option buyer.
OPERATION OF A CALL OPTION
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Writer sells the option
Holder buys it at a premium Has a right but not an obligation to buy the share on a specified date at a predetermined price.
On the specified date
Share price rises beyond the option Exercise price.
fall below the option Exercise price.
Option exercised
Option Not exercised Premium Amount lost
Loss Difference between Market Prices and exercise price Premium. (e.g.) Price of ACC Today =
Profit Difference between market price and exercise price Premium. Rs. 1000
Buy the call option to buy at a premium of Rs. 5 i.e. at Rs. 1005.
After one Month

Share price Amount lost Share price Loss Share price Profit =Rs. 995 option not exercised =Rs. 5(option premium) =1007. Option exercised = [5 (1007-1005)] = Rs.3 = Rs. 1120 option exercised = [(1120 - 1005) 5] = Rs. 10.
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RATIONALE OF BUYING CALL OPTIONS

There are broadly three reasons why an investor could buy a call option instead of buying the stock outright. These are as follows: 1. Return on Investment An investor anticipates that a stock is shortly going to appreciate from Rs. 300 to Rs. 400 per share and buying 100 shares of the stock would involve an investment of Rs. 30,000. However, a call option on the stock is available at a premium of Rs. 20. Let us assume that the stock's share actually goes up to Rs. 400 within the currency of the option. The investor thus makes a profit of Rs. 80 per share (400 (300+20)]. His investment was only to the extent of premium paid, i.e. Rs. 20 per share. Thus, the investor got an appreciation of 400% on his investment. Had he bought the stock outright, the investor would have made Rs. 100 per share on an investment of Rs. 300, i.e. 33%. This should be sufficient motivation for the investor to go in f6r call options on the stock as against outright buying of the stock.
2. Hedging
Trading with the objective of reducing or controlling risk is called HEDGING. An investor, having short sold a stock, can protect himself by buying a call option. In the event of an increase in the stock's price, he would at least have the commitment of the option writer to deliver the stock at the exercise price, whenever he is to effect delivery for the stock, sold short. The maximum loss the investor may be exposed to would be limited to the premium paid on the call option. Options can thus be used as a handy tool for hedging.
3. Arbitrage
Arbitrage involves buying at a lower price and selling- at a higher price, if it so exists. As in any other trade, options arbitrage provides an opportunity to earn money by exploiting the pricing inefficiencies, which may exist within a market or between two markets or two products and as a result tends to bring perfection to the market.
8.3 - PUT OPTION
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A put option gives a buyer the right to sell a specified number of shares of a particular stock to the option writer at a specified price (called the exercise price) any time during the currency of the option.
RATIONALE OF BUYING A PUT OPTION

An investor, if he anticipates fall in the price of some stock, has the following alternatives: All the stock short, i.e. enter a sales transaction without owning the stock. In the event of a fall in the stock price, he can buy the stock at a lower price and can deliver the stock sold to the buyer, thus making profit equal to the fall in the price. However, in case the stock price appreciates instead of declining, the investor would be exposed to unlimited loss. 1. Write a call option without owning the stock, i.e. writing a naked call option. Writing such an option is similar to selling short, the only difference being that the loss in the event of appreciation in the stock price would be curtailed to the extent of the premium received on writing the call option, which may not be sufficient attraction.
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Option Type
Buyer of Call (Long Position)
Writer of Call (Short Position) Obligation to sell asset Obligation to buy asset
Call Put
Right to buy asset Right to sell asset
2. Purchase a put option. The purchase of a put option is the most desirable policy as compared to either going short or writing a naked call option. The first reason is that the investment in buying a put option is restricted to the premium as against a larger sum required for going short. Thus, as in the case of a call option, the return on investment on buying a put option is much higher as compared to going short on the stock. Secondly, in the event of increase in the stock price, the loss to the put option buyer is restricted to the premium paid.
AMERICAN v/S EUROPEAN OPTIONS

The definitions of options, both call and put, given above apply to the Americanstyle options. An American option can be exercised by its owner at any time on or before the expiration date. Besides the American type there are European-style options as well. In case of European options, the owner can exercise his right only on the expiration date and not before it. It may be pointed out however, that most of the options traded in the world, including those in Europe, are of the American style.
OPERATION OF A PUT OPTION
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Writer sells the option
Holder buys the put option at a premium. Has the right but no obligation to sell the shares at specified price on a specified date. On the specified Date
The share price rise above the below Option exercise price.
The share price fall Option exercise price.
Option not exercised Premium amount lost
Option exercised
Profit Difference between market Price and exercise price is More than the premium.
Loss Difference between the market Price and exercise price is Less than the premium.
(e.g.) Price of ACC Today

After one month Share price Loss Share price Loss Share price Profit
Rs. 1000
But a put option to sell the share at Rs. 1005 premium = Rs. 5
= Rs. 1008. Option not exercised = Premium amount (Rs. 5) = Rs. 1003 option exercised = [5 (1005 -1003)] = Rs. 3 = Rs. 950 = [(1005-950) 5] = Rs. 50
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Chapter-9 Comparative study

9.1 - primary market V/s secondary market
PRIMARY MARKET
New Issues Market Channel for issuing new securities
SECONDARY MARKET
OTC and Exchanges-traded market Deals in securities previously issued
Enable companies to raise funds through Enable participants to hold securities private placement or public issue
9.2 - STOCK EXCHANGE V/s OTCEI

STOCK EXCHANGE
Trading is done in a trading hall. Stock exchanges are introducing screen hared trading. Rampant speculation is permitted. Weekly or fortnightly settlement system. Jobbers may or may not offer quotes. network Spot deals with fully transparency. Settlement is on a daily basis. Market maker has to compulsorily offer two-way quotation. Shares certificate is the transferable document. Companys permission is required in shares transfer. Counter receipt is the transferable document. Automatic transfer for up to 0.5 percent of the equity capital.
OTC EXCHANGE
Screen based trading through a computer
9.3 - FORWARD v/s FUTURE

FUTURE
Standardized contract terms
FORWARD
Customized contract terms
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No liquidity problem. Require margin payment. Trade on organized exchange. Follows daily settlement
It contain problem of liquidity. No margin payment require. Trade on Over-The-Counter exchange. Settlement happens at the end of period.
No Party risk is there
Party risk is there
9.4 debentures v/s stocks

DEBENTURES
safe and secure income.
STOCKS
willing to take risks for the sake of high returns.
Debentures are for those people who want a While stocks are for those people who are
Less risk in debentures. Here low risk and low return. Receive fixed interest regularly.
High risk in stock. Here high risk and high return. If company gets more profit than
expectation then dividend paid to the stock holders.
9.5 - option V/s future
OPTIONS
contract. the contract.
FUTURES
Only the seller is obligated to perform the Both the parties are obligated to perform
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Premium is paid by the buyer to the seller.
No premium is paid by any party
The seller is subject to unlimited risk of The buyer and seller are subject to losing whereas the buyer has a limited unlimited risk of losing. potential to lose. Options prices are affected not only by Future prices affected mainly by the prices of the underlying asset but also the underlying asset time remaining for expiry of the contract and volatility of the underlying asset Option contract can be exercised any time Future contract can be honored by both the till the maturity by the buyer Price is always positive Strike price is fixed and price moves Only short at risk parties only on the date specified Price is always zero Price is zero and strike price moves Both long and short at risk
9.6 derivative v/s Equity

DERIVATIVE
Derivatives are traded in lot size Only premium amount required for transaction Very low level of credit risk in derivative High level of credit risk in equity
EQUITY
Equity are traded in single share also Full amount required for transaction
The parties of the contract must perform at The parties of the contract can exercise the settlement date. They are not obligated
to perform before the date It works in forward and future contract Less liquidity than equity Derivatives are analyzed using Quantitative Analysis. The basic framework of quantitative analysis is to treat stocks, interest rates,
any time No such facility available Equity have highly liquidity Equities, on the other hand, are analyzed using Fundamental Analysis and Capital Asset Pricing Model
CHAPTER-10 Practical illustrations

1) Anant is bullish about BHEL. Spot BHEL is 2200. He decides to buy a call option with a strike of 2260, at a premium of Rs.15. At the expiry BHEL closes at 2295, the lot size of the BHEL is 100. What is his payoff on the position? Strike price is 2260 and premium 15 Break even point is 2260+15 = 2275 Now BHEL closes at 2295 Profit per unit is 2295 2275 =20 Total profit is 100 * 20 = 2000 2) Vicky has sold one R-Com future at 760 and bought one call option of R-Com strike price 770 @ Rs.15, closing price is 800 and the lot size is 500.
Sol:- spot price is 2200
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Sol:- Loss in futures per unit 800 760 = 40 Break even point for option 770 + 15 = 785 Profit on R-Com option 800 785 = 15 Net Loss per unit 40 15 = 25 Net Loss suffered 500 * 25 = 12500 3) Ranjit bought 10 REL futures @ 1700 and sell 5 call option strike price 1700 @ Rs.10 premium. At the end of the day it closes on 1800 and lot size is 200. What is the position at the end of the day? Profit on futures 1800 1700 = 100 Therefore profit is 100 * 2000 = 200000 Break even point for call option 1700 + 10 =1710 Loss 1800 1710 = 90 Loss on sale of 5 call option 90 * 1000 = 90000 Profit earned 200000 90000 = 110000
Sol:- Total quantity is 10 * 200 = 2000
4)
The following are the details of trading member of an Asit C. Mehta Investment Intermediates Ltd. Client A-Buy 600 units @ 1020 & Sell 1800 units @ 1025 Client B- Buy 2000 units @ 1015 Client C- Buy 1600 units @1016 & Sell 800 units @1022
The closing price is 1023. What is Asit C. Mehtas MTM position? Sol:- Profit of client A on buying 600 units =(1023-1020)*600 =3 * 600 Profit of client A on selling 1800 units Profit of client B on buying 2000 units = 2 * 1800 = 1,800/= 3,600/= (1025-1023) *1800 = (1023-1015)*2000
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= 8 * 2000 = 16,000/Profit of client C on buying 1600 units Loss of client C on selling 800 units = (1023-1016)*1600 = 7 * 1600 = -1 * 800 as Profit :- 1800 + 3600 + 16000 + 11200 = 32600 And Loss:- 800 Net position 32600 800 = 31800 profit =11,200/= -8,00/= (1022-1023) * 800
Now, the MTM position of Asit C. Mehta Investment Intermediates Ltd. is
CHAPTER-11 Ten Commandments of Futures & Options Trading

1.
Start simple transactions:- Do not bog down by complex F&O strategies to begin
with. Look at simple strategies like buying nifty, selling nifty and later you are segment. Once you are compatible with these basic futures transactions, you can gradually move to buying calls and buying put options. Please keep call selling and put selling for the last phase since these are better taken up by the informed investors.
2.
Understand the benefits:- Grasp the benefits of futures and options in the proper
perspective. For E.g.:- if you buy 150 shares of Reliance in the cash market, you need to shell out Rs.300000 by T+2 day. The same transaction if he undertakes in futures, he
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has only to pay Rs.55000. Now, if Reliance appreciated by 10% in 5 days time, then his return on investment is a mere 10% in the cash market, while it is a whopping 66% in the futures segment. Also in the cash market, if you go short you need to cover it up intraday. However, in case of futures you can carry forward even a short position till settlement.
3.
Lot size does not matter:- Many investors are of the view that the minimum lot
size of Rs.2 lacks in F&O is too high. Please understand that Rs.2 lacks is the notional lot size and not the amount that investors have to pay. E.g. If you buy one lot nifty futures in the F&O market consisting of 50 units, the notional value may be Rs.3.25 lacks but what an investor needs to pay is just the margin of Rs.25000. this is definitely not a very large sum for any investor who is serious about investing in the markets.
4.
Stop loss is a must:- Day-in and Day-out we come across clients who failed to put
a stop loss and hence are stuck in positions. Please understand that stop loss is a safety net in the event of market going against your call. Please ensure that any position in the F&O market is taken with a strict stop loss only.
5.
Diversify your money across calls:- On any average day, there may be a few F&O
calls that go wrong. These are factors totally beyond anybodys control. If you have taken a position in any one call that has gone wrong you may have developed an aversion to all calls. It is hence very important that you take positions in all calls so that your risk is minimized.
6.
The brokerage myth;- Low cost (brokerage) need not always translate into high
profits. Very often, such low cost services lack quality in the recommendations. This
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may lead to inferior returns over a period of time. On the other hand, good quality will be reflected only into the well worked ideas. This will be backed by sound research. Hence, this quality might come at a price (high brokerage), but this will convert into superior returns into long term.
7.
Dont panic when in loss:- One of the common practices among investors is to
panic when the call goes against them. F&O is sufficient flexible to bail you out of most situations. Markets are by nature volatile. E.g. If you have bought Reliance futures at 1900 and it has come down to 540. If your advisor is confident that it will not cross 1900 now then you can write a 1900 call and reduce your cost of holding. Remember, when you panic, you subsidize the person who does not panic.
8.
Profit is what you book:- Greed gets the better of most investors in this market.
Especially in F&O it is very critical that investors do not get too greedy and book profits when the target return is achieved. If you bought nifty futures at 1800 and your 1-month target return is 3% then book profits at 1850, even if your broker has given you a target of 1875. It makes sense to book profits twice in a run rather than try to wait too long. In the market, what you book is your profits, everything else is book profits.
9.
Assured returns are dead:- The investors should never be assured of guaranteed
return on F&O. anybody who is looking for assured return will never invest in equities, but would stick to RBI bonds. It is important to know that F&O offers all the benefits of the cash market with some additional advantages, but is surely not a product that can be termed as risk-free.
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10.
Stick to one trading methodology:- Each brokerage house follows its own method
to study and research which will be different from those others. It is advisable for an investor to follow one house for sustainable returns like the one provided by Karvy. This consistency increases significantly the likelihood of high returns.
CHAPTER-12 MISCONCEPTION ABOUT DERIVATIVE & SUGGESTION TO OVERCOME THE MISCONCEPTION

Derivatives are new complex and high technique financial product. Financial derivatives are not new and have been prevalent in India since many years. Derivatives as the name implies are the contracts derived from some underlying stock or index. Most of common derivatives instruments are future and options. Huge investment is required to trade in derivatives. Trading in future and options does not require huge amount. It does not require huge amount to enter into future trading except for margin deposit (20% of contract value). Only risk seeking organization like MNC, Banks and FII have a purpose of trading in derivatives.
There is fall notion among the investors that derivatives trading are only meant for MNCs, Large Banks and FIIs. But the fact is that retail investors can also trade in derivatives to the maximum extent given the number of benefits it offers. Derivatives help the investors in managing their cash flows in better fashion. Making profit in cash market is much easier than future and options. This is must common misconception that hassle many investors. But the thing is they have to realize that it is possible to make huge profits in F&O also. They have to use different strategies in different market trends i.e. bullish, bearish, range bound and volatile market. But it is not easy to make profits in cash market in different market trends. Only when market is bullish investors can make profits, whereas in futures even if it volatile, we can take the advantage of averaging 5 times in futures with the same money in comparison to only once in cash (due to 20% margin) paid in futures.
As a retail investor one can just have numerous opportunities as derivatives are without any misapprehension. What is really attractive in derivatives trading is investor can play high games with small amount of margin in this segment (compared to cash market) It is not possible to protect the investment in falling market. Derivatives have become important tool to help investors to manage risk in falling market. Infact the concept of derivatives was brought into light to hedge against specific risks. Derivatives are contracts, so cannot be carried forward. In cash segment investor cannot carry forward short position but in derivatives, they can carry forward short positions same way like they do with long positions. Derivatives are meant only speculation. Derivative trading by individual is generally considered as speculative business. But derivatives apart from speculation provide investor with a multitude of uses namely hedging and arbitration.
Hedging is the technique that involves taking a position in the cash market and simultaneously taking a reverse position in the future market as a means to protect against losses. Speculation is the process by which market players take positions on the belief that the market will move in a particular direction that they anticipate. Coming to Arbitration it is generally called risk-free profit. Generally Arbitrageurs buy and sell the same security or derivatives at different prices. Like this investors can take advantage of derivative.
CHAPTER-13 REGULATORY FRAMEWORK FOR DERIVATIVES TRANSACTION

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 bye-laws of stock exchange. 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 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 the Act.
1.
Any exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta
committee report can apply to SEBI for grant of recognition under section 4 of the SC(R)A, 1956 to start trading derivatives.
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2.
The exchange should have minimum 50 members.
3.
The members of an existing segment of the exchange would not automatically
become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid by the L.C.Gupta committee.
4.
The clearing and settlement of derivatives trade would be through a SEBI approved
clearing corporate/house. Clearing corporation/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.
5.
Derivative brokers/dealer 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 net worth for clearing members of the derivatives clearing corporation / house shall be Rs 300Lakhs. The net worth of the members shall be computed as follows. o o Capital + Free reserves. Less non-allowable asset viz. Fixed assets, Pledged securities, Members card, Non-allowable securities, Bad deliveries, Doubtful debt and advances, prepaid expenses, Intangible assets, 30% marketable securities
6.
The minimum contract value shall not be less than Rs 2 Lacks. Exchange has to
submit details of the futures contracts they propose to introduce.
7.
The initial margin requirement, exposure limits linked to capital adequacy and
margin demand related to the risk of loss on the position will be prescribed by SEBI / Exchange from time to time.
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8.
The L.C.Gupta committee report required strict enforcement of Know your
Customer rule and requires that every client shall be registered with the derivatives brokers. The members of the derivatives segment are also require to make their client aware of 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 program approved by SEBI.
CHAPTER-14 FINDINGS
1) Derivatives, as their name implies, are contracts they are based on or derived from some underlying assets, reference rate, or index. Most common financial derivatives, described later, can be classified as one, or a combination, of four types: swaps, forwards, futures, and options that are based on interest rates or currencies. 2) There are several risks inherent in financial transactions. A derivative allows us to manage these risks more efficiently by unbundling the risks and allowing either hedging or taking only one risk at a time. 3) Different trading strategies can be used by investors under different market trends i.e. bullish, bearish, range bound and volatile market. But it is not easy to make profits in cash market in different market trends. 4) The turnover as well as growth of derivatives is much higher than cash segment. 5) Without a clearly defined risk-management strategy, use of financial derivatives can be dangerous.
6) Many investors feel that making profits in Cash Market is much easier than Futures and Options. But the thing is they have to realize that it is possible to make huge profit in F and O also. 7) Most of the investors have not sufficient knowledge of derivative instruments, and hence they deal in cash market (equity market) only.
CHAPTER-15 LIMITATION
During the project the following limitations are found:
The major limitation of the project was time span i.e. only 2 month. So it was difficult to go in depth study in the respective subject.
It is very difficult to collect the financial data relating to the derivatives or company, because it comes under business secrecy.
The project was undertaken in the Khamgaon City, which is relatively a big city, and so that the clients very huge in number.
Many of the clients were not able to define the strategies used by them.
Difference of theory from practice.
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CHAPTER-16 SUGGESTIONS
Following suggestion have been drawn after doing this project-
The concept of derivatives is not very simple. An investor should therefore have sound knowledge of technical terms in Derivatives before dealing in Future market.
Even though, the concept of derivatives is touch. But it is become easy to understand once the person starts trading in it.
An investor can use different strategies like bullish, bearish, range bound and volatile market.
The investor should also note that the price of future contracts depend on many factors, which are uncontrollable. Therefore he should take care of such factors.
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CHAPTER-17 CONCLUSION
The project was done in order to understand and study various trading strategies used in derivatives. It included the study of various instruments like forward, future and options. On the basis of the analysis done, I conclude the following-
Derivatives are the contracts derived form some underlying stock or index. Most of common derivative instruments are future and options.
Various trading strategies like bullish, bearish, and neutral and the investors according to the market trends can use volatile strategies.
There are very few people knowing exactly what derivatives is all about.
In a volatile market, the option stands a greater chance of becoming profitable to exercise.
Uses of derivatives require understanding not only the underlying instrument but also of the derivatives itself.
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In my concluding part I would like to say that Derivatives could be a very effective tool to take advantage of a rising, falling and range bound underling. But for that awareness is to be created about the terminology of derivatives.
BIBLIOGRAPHY
Books Referred:Author name, book name, edition & year, publisher. 1) Dr. V. A. Avadhani, Investment Management, Seventh Edition-2008, Himalaya Publishing house, Mumbai. 2) Bishnupriya Mishra & Satya Swaroop Debasish, Financial Derivatives, First Edition 2007, Anurag Jain for Excel Books, New Delhi-110 002. 3) I. M. Pandey, Financial Management, Ninth Edition 2007, Vikash Publishing House Pvt. Ltd. 4) V. K. Bhalla, Management of Financial Services, First Edition 2002, Anmol Publications Pvt. Ltd., New Delhi-110 002. 5) Alak Ghosh, Emerging Money Market in India, 2001, Deep & Deep Publications Pvt. Ltd., New Delhi.
6)
Jane Cowdell, Investment, Fifth Edition 2002, A.I.T.B.S. Publishers & Distributers (Regd.)
7) King, Investment Management, 2000, Kings Book, New Delhi. 8) Gary A. Porter & Curtis L. Norton, Financial Accounting The Impact on Decision Makers, Second Edition 1995, The Dryden Press, NewYork. 9) P. C. Tulsian, Financial Accounting, 2000, Tata McGraw Hill Publishing Co. Ltd., New Delhi. 10) Eugene F. Brigham, Fundamental of Financial Management, Fifth Edition 1989, The Dryden Press Holt, Finehart & Winston Sunders College Publishing.
11)
M. Y. Khan, Financial Services, Second Edition 2002, Anurag Jain for Excel Books, New Delhi.
12) Nitin Balwani, Accounting & Finance for Managers, Second Edition 2002,
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Anurag Jain for Excel Books, New Delhi. 13) Financial Management & Policy, First Edition 1997, Anmol Publications Pvt. Ltd., New Delhi,
14)
V. K. Bhalla, Investment Management, S. Chand & Co., New Delhi.
Reports issued by National Stock Exchange of India Limited. 1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta
2.
NCFM- Derivatives Market (Dealers) Module Work Book - 2008
3. Indian Securities Market Volume XI 2008 4. Derivatives Update December 2009

5.
Fact Book 2009
Websites
1. 2. 3. 4. 5. 6. 7. 8. 9.
www.derivativesindia.com www.derivativesreview.com www.economictimes.com www.capitalmarket.com www.investmentz.com www.bseindia.com www.investor.com www.nseindia.com www.sebi.gov.in
10. www.google.com
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Trading of Derivatives in Stock Market

Chapter 1 OBJECTIVE OF study

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

1.2 - METHODOLOGY of study

Primary Data collection

Secondary data collection

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

CHAPTER-2 COMPANY PROFILE

The FIRSTS to our credit

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

Advantage of opening account with acmiil

Service Standards & Compliance

Potential Growth Areas

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

2.2 SEBI Registration NUMBER

Clearing Bank: State Bank of India Address

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

4) Portfolio Advisory Service:-

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

Debt Market Desk:-

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

Inter-bank Forex Desk:-

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

Trading of Derivatives in Stock Market

MEANING OF STOCK EXCHANGE

ROLE AND FUNCTIONS OF STOCK EXCHANGE

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

3.1 - Bombay Stock Exchange

3.2 - National Stock Exchange of India

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

3.3 - OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

CLASSIFICATION OF SECURITIES MARKET

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Trading of Derivatives in Stock Market

4.1 - DEFINATION OF DERIVATIVES

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Trading of Derivatives in Stock Market

4.2 - History of Derivatives

4.3 - Derivatives in India

Trading of Derivatives in Stock Market

Derivative market at NSE

{GODAVARI INSTITUTE OF MANAGEMENT & RESEARCH, JALGAON}

Trading of Derivatives in Stock Market

Clearing and Settlement

Professional clearing member: PCM is a CM who is not TMs.

4.4 - Features OF DERIVATIVES

Trading of Derivatives in Stock Market