derivative bhumi
TRANSCRIPT
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Financial market:-
securities (such as stocks and bonds), commodities (such as precious metals oragricultural goods), Financial markets have evolved significantly over several
hundred years and are undergoing Financial market is a mechanism that allows
people to easily buy and sell (trade) financial constant innovation to improve
liquidity.
A system that facilitates the exchange of money for financial assets. A security
market such as the National Stock Exchange is an example of a financial
market.
Equity market:-
A equity market is a public market for the trading ofcompany stockat an
agreed price; these are securities listed on a stock exchange as well as those only traded
privately.
Derivative market: -
Financial market
Equity market Derivative market
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The derivatives markets are the financial markets for derivatives. The market
can be divided into two, that for exchange traded derivatives (ETD) and that for over-the-
counter derivatives(OTC).
Introduction of derivatives:-
The word DERIVATIVES is derived from the word itself derived of an
underlying asset. It is a future image or copy of an underlying asset which may be shares,
stocks, commodities, stock index, etc.
For example, wheat farmers may wish to sell their harvest at a future date to eliminate therisk of a change in prices by that date. Such a transaction is an example of a derivative. The
price of this derivative is driven by the spot price of wheat which is the "underlying".
Derivatives have become very important in the field finance. They are very
important financial instruments for risk management as they allow risks to be separated and
traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk
means that each party involved in the contract should be able to identify all the risks involved
before the contract is agreed.
It is also important to remember that derivatives are derived from an underlying
asset. This means that risks in trading derivatives may change depending on what happens to
the underlying asset. The underlying asset can be equity, forex, commodity or any other asset.
For example, if the settlement price of a derivative is based on the stock price of a stock for
e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also
changing on a daily basis. This means that derivative risks and positions must be monitored
constantly.
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History of derivatives:-
Derivative products initially emerged as hedging devices against fluctuations in
commodity prices, stock prices and commodity-linked derivatives remained the sole form of
such products for almost three hundred years. Financial derivatives came into spotlight in the
post-1970 period due to growing instability in the financial markets.
However, since their emergence, these products have become very popular and by
1990s, they accounted for about two-thirds of total transactions in derivative products. In
recent years, the market for financial derivatives has grown tremendously in terms of variety
of instruments available, their complexity and also turnover.
In the class of equity derivatives the world over, futures and options on stock
indices have gained more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives. Even small investors find these
useful due to high correlation of the popular indexes with various portfolios and ease of use.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world,
was established in 1848 where forward contracts on various commodities were standardized
around 1865. From then on, futures contracts have remained more or less in the same form,
as we know them today.
Exchange traded financial derivatives were introduced in India in June 2000 at the
two major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges. The derivatives market in India has grown exponentially, especially at NSE.
Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the
total turnover of derivatives at NSE, as on April 13, 2005.
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CONCEPT OF BADLA SYSTEM
Badla is nothing but a carry forward system which means getting something in
return. The badla system was acceptable to be an important need for the investors in the stock
market. Here in this system the investor feels that the price of a particular share is expected to
go up or down, without giving or taking the delivery he can participate in the possible
fluctuation of the share.
In the badla system, a position is carried forward, be it a short sale or a long purchase. In the
event of a long purchase, the market player may want to carry forward the transaction to thenext settlement cycle and for doing this he has to compensate the other party in the contract.
While in case of a short sale, the market player wants tom carry forward the transaction to the
next settlement cycle, he has to borrow the stocks to compensate the other party in the
contract
THUS BADLA IS PURELY A MEANS OF CASH & SHARE FINANCING
ILLUSTRATION
The investor has purchased the 100shares of INFOSYS COMPANY for
Rs.7000 which is trading at Rs. 7300. After this the investor expects to rise further.
Therefore he wishes to carry the contract forward to the next trading session by paying what
are called badla charges.
In any badla transaction there are two key elements, the hawala rate and the
bald charge for the scrip. The badla charge is the interest payable by the investor for carrying
forward the position. It is fixed individually for each scrip by the exchange every Saturday
and it is calculated on what is called the heal rate. The hawala rate is the price at which a
share is squared up in the current settlement and carried forward into the next settlement in
the next trading session. The existing position is squared up against the hawala rate fixed and
carried forward after factoring in the badla rate. The difference is paid to the broker
(charges).
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Thus if hawala rata Rs.7180 is lower than the initial margin the difference is paid to the
broker. The badla charges vary from broker to broker and proper relationship with the broker
If broker insists on a 25% margin, the investor get 400% leverage or four times the amount
investor is ready to deposit as margin. Thus At the end of each settlement, investor carry
forward the position at the hawala rate. This position will also be adjusted for badla. Thus
investor can carry forward the transactions for settlement
BADLA WAS BANNED ON 2nd
JULY 2001
The badla was banned because more exposure was given to the speculation
and also the investor has to wait for 5days for the delivery of shares because the rolling
settlement was T+5 days. As badla system is a combination of lending and borrowingmechanism of the stocks which further associated with risks. As badla was banned between
the intermediator was not the exchanges but the brokers. This system was time consuming
because it involves more Paper work. Thus if the broker becomes insolvent then they are not
responsible for the investors funds.
As carry forward were more a method of lending and borrowing of
shares and Funds. Here the borrower of shares or funds pays a fee or badla charges for the
borrowing and in the badla the futures prices were mixed up with the cash price.
The badla charges include a default risk premium because of the counterparty
risk inherent in the transaction. Further in the badla the position could break down if
borrowing/lending also proved infeasible. There is no expiration date in the badla system
which results into uncertainty. Finally in badla the net long (buy) positions would differ from
the net short (sell) positions.
Aims and objectives of derivatives:-
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1. To explore the derivative market in India.
2. To know what derivatives are available in India.
3. To know derivatives trading mechanism of exchanges.
4. To become aware of what strategies are followed by Indian Investors.
5. To know how derivatives are used in covering risk
6. To know how derivatives give a safe exposure.
Need for derivative market:-
1. They help in transferring risks from risk averse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4.
They increase the volume traded in markets because of participation of risk adverse
people in greater numbers.
5. They increase savings and investment in the long run.
Purpose and benefits of derivative market;-
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1. Today's sophisticated international markets have helped foster the rapid growth in
derivative instruments. In the hands of knowledgeable investors, derivatives can
derive profit from:
Changes in interest rates and equity markets around the world.
Changes in price of assets.
2. Help of hedge against inflation and deflation, and generate returns that are not
correlated with more traditional investments. The two most widely recognized
benefits attributed to derivative instruments are price discovery and risk
management and others.
3. Price discovery: -
The kind of information and the way people absorb it constantly
changes the price of a commodity. This process is known as price discovery. the price
of all future contracts serve as prices that can be accepted by those who trade the
contracts in lieu of facing the risk of uncertain future prices.
4. Risk management: -
This could be the most important purpose of the derivatives
market. Risk management is the process of identifying the desired level of risk,
identifying the actual level of risk and altering the latter to equal the former. This
process can fall into the categories of hedging and speculation.
5. Derivatives help in transferring risks from risk-averse people to risk-oriented people.
6.
By allowing transfer of unwanted risks, derivatives can promote more efficient
allocation of capital across the economy and thus, increasing productivity in the
economy.
7. Derivatives increase the volume traded in markets because of participation of risk-
averse people in greater numbers.
Factors driving the growth of derivatives:-
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Over the last three decades, the derivatives market has seen a
phenomenal growth. A large variety of derivative contracts have been launched at
exchanges across the world. Some of the factors driving the growth of financial
derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns, reduced
risk as well as transactions costs as compared to individual financial assets.
Derivative market is divided in two markets:-
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Over the counter:-
Over the counter derivatives are contracts that are traded (and
privately negotiated) directly between two parties, without going through an exchange or
other intermediary. Products such as swaps and forward rate agreements are almost always
traded in this way. The OTC derivative market is the largest market for derivatives, and is
largely unregulated with respect to disclosure of information between the parties, since the
OTC market is made up of banks and other highly sophisticated parties.
Derivative market
Over the counter (OTC) Exchange traded
derivatives (ETD)
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Because OTC derivatives are not traded on an exchange, there is no
central counterparty. Therefore, they are subject to counterparty risk, like an ordinary
contract, since each counter party relies on the other to perform.
Features of over the counter derivatives:-
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions.
2.
There are no formal centralized limits on individual positions, leverage, or margining.
3. There are no formal rules for risk and burden-sharing.
4. There are no formal rules or mechanisms for ensuring market stability and integrity,
and for safeguarding the collective interests of market participants, and
5.
The OTC contracts are generally not regulated by a regulatory authority and theexchange's self-regulatory organization.
6. When asset prices change rapidly, the size and configuration of counter-party
exposures can become unsustainably large and provoke a rapid unwinding of
positions.
Exchange traded derivatives:-
They are standardized ones where the exchange sets the
standards for trading by providing the contract specifications and the clearing corporation
provides the trade guarantee and the settlement activities. Futures and Options are the
derivatives. Products like futures and options are traded in this way.
In the exchange traded derivatives is the largest market for derivatives.
In this type of derivatives a highly regulated exchange is involved which is Security
Exchange Board of India (SEBI).
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Features of Exchange Traded Derivatives:-
1.
The management of counter party risk is centralized and located with high
institutions.
2. There are formal centralized limits on individual positions, leverage, or
margining
3. There are formal rules for risk and burden-sharing.
4.
There are formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants,
and
5. The exchange traded contracts are generally regulated by a regulatory
authority.
Types of derivatives:-
Derivative contracts have several types. The most common variants are forwards,
futures, options and swaps.
1. Forwards:
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed price.
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2. 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.
3. 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.
4. Warrants:
Options generally have lives of up to one year; the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
5.
LEAPS:The acronym LEAPS means Long-Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
6. Baskets:
Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity index
options are a form of basket options.
7. 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 flow 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.
8. 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.
Forward contract:-
It is an agreement between two parties to buy or sell an asset on a specified
date for a specified price. A forward contract is a simple derivative. It is a type of market
where buyer and seller predict the future for the underlying asset which may be stocks,
currency, interest rate etc. One of the parties to the contract assumes a long position which
agrees to buy underlying asset for a certain specified price. The other Party assumes a short
position and agrees to sell at the same price. Forward contract can be 30days, 90days and
180days
The contract is usually between two financial institutions or between a
financial institution and its corporate client. A forward contract is not normally traded on anexchange. It is traded on the OTC (over the counter) derivatives where the intermediator or
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exchange has no role to play and contract is smoothly settled by the parties or normally
traded outside the exchanges.
At delivery, ownership of the good is transferred and payment is made. In
other words, whereas the forward contract is executed today, and the price is agreed upon
today, the actual transaction in which the underlying asset is traded does not take place until a
later date. Typically, no money changes hands on the origination date of a forward contract.
Forward contracts are not standardized unlike futures contracts. They are
customized and each contract is unique in terms of contract size, expiration date and the asset
type and quality. Terms of Forward contracts are negotiated between buyer and seller. As
there is no exchange involved in it there is chance of default of either party.
Forward contracts are very useful in hedging and speculation. Here the
importer and exporter can hedge their risk exposure with respect to exchange rate fluctuations
while entering into the currency forward market.
The first formal commodities exchange in the United States for spot and
forward contracting was formatted in 1848: the Chicago Board of Trade (CBOT).
ILLUSTRATION
On 1st
march 2004 Mukesh has entered into a forward contract with Anil In this Mukesh
takes a long position(buy) on the scrip and Anil takes a short position(short) on the scrip.
Here Mukesh agrees to purchase 100 shares of RELIANCE ENERGY from the Anil for a
predetermined price of Rs.400.The contract is three months forward. Thus on future Anil will
deliver the shares to Mukesh while in return Mukesh will pay the amount of
Rs.40,000(400*100).
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Suppose during the maturity date Mukesh may default for the transaction he refuse to
make the payment for the shares or Anil refuse to deliver the shares. Therefore in this there is
a counter party risk one party may default due to this other party suffers because there is no
standardized exchange between the parties and the contract is OTC in nature and also prices
are decided by the buyers and sellers.
Finally forward contract is settled at maturity. The holder of the short position delivers the
asset to the holder of the long position in return for cash at the agreed upon rate. Therefore, a
key determinant of the value of the contract is the market price of the underlying asset. A
forward contract can therefore, assume a positive or negative value depending on themovements of the price of the asset. For example, if the price of the asset rises sharply after
the two parties have entered into the contract, the party holding the long position stands to
benefit, i.e. the value of the contract is positive for her. Conversely, the value of the contract
becomes negative for the party holding the short position.
Future contract:-
A future contract is similar to a forward contract. It is a standardized
forward contract that can be easily traded. In future contract default risk is lower on futures
than on forwards for several reasons:-
a) The counterparty to all futures trades is actually the clearing house of the futures
exchange, which guarantees that all payments will be made.
b)
Future contracts are marked to market daily settled which means that any change
in the value of the contract is realized as a profit or loss every day.
c) Initial margin, which serves as a performance bond, is required when trading
futures. In contrast, because they are not marked to market, forward contracts can
build up large unrealized profits for one party and equally large unrealized losses
for the other party.
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There is a multilateral contract between the buyer and seller for an
underlying asset which may be financial instrument or physical commodities. But unlike
forward contracts the future contracts are standardized and exchange traded.
The primary purpose of futures market is to provide an efficient and
effective mechanism for management of inherent risks, without counter-party risk. As it is a
future contract the buyer and seller has to pay the margin to trade in the futures market.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery The units of price quotation and minimum price change.
. Location of settlement.
The current market price of INFOSYS COMPANY is Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and Kishore is
bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has
purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size
of Infosys is 300 shares.
Suppose the stock rises to 2200.
Profit
20
2200
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10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the buyer (Hitesh) = Rs.1, 65,000 [(2200-1650*3oo)] and notional profit
for the buyer is 550.
Unlimited loss for the buyer because the buyer is bearish in the market
Suppose the stock falls to Rs.1400
Profit
20
10
0
1400 1500 1600 1700 1800 1900
-10
-20
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Loss
Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the
seller is 250.
Unlimited loss for the seller because the seller is bullish in the market.
History of future derivatives:-
Merton Miller, the 1990 Nobel laureate had said that 'financial
futures represent the most significant financial innovation of the last twenty years." The first
exchange that traded financial derivatives was launched in Chicago in the year 1972. A
division of the Chicago Mercantile Exchange, it was called the International Monetary
Market (IMM) and traded currency futures. The brain behind this was a man called Leo
Melamed, acknowledged as the 'father of financial futures" who was then the Chairman of the
Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile
Exchange sold contracts whose value was counted in millions. By 1990, the underlying value
of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollar.
FUTURES TERMINOLOGY:-
a) Spot price: The price at which an asset trades in the spot market.
b) Futures price: The price at which the futures contract trades in the futures
market.
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c) Contract cycle: The period over which a contract trades. The index futures
contracts on the NSE have one- month, two-month and three months 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.
d) 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.
e) Contract size: The amount of asset that has to be delivered under one contract.
Also called as lot size.
f) 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.
g) 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.
h)
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.
i) Marking-to-market: In the futures market, at the end of each trading day, the
margin account is adjusted to reflect the investor's gain or loss depending upon
the futures closing price. This is called marking-to-market.
j)
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
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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.
Introduction to options:-
It is an interesting tool for small retail investors. An option is a contract,
which gives the buyer (holder) the right, but not the obligation, to buy or sell specified
quantity of the underlying assets, at a specific (strike) price on or before a specified time
(expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/
oil or financial instruments like equity stocks/ stock index/ bonds etc.
Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does not have to
exercise this right. In contrast, in a forward or futures contract, the two parties have
committed themselves to doing something. Whereas it costs nothing (except margin
requirements) to enter into a futures contract, the purchase of an option requires an up-front
payment. The options are also traded on stock exchange.
Terminologies of options:-
CALL OPTION
A call option gives the holder (buyer/ one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date. The seller
(one who is short call) however, has the obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy. To acquire this right the buyer pays a
premium to the writer (seller) of the contract.
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ILLUSTRATION
Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the
market and other is Rakesh (call seller) who is bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25
1. CALL BUYER
Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be
exercised once the price went above 600. The premium paid by the buyer is Rs.25.The buyerwill earn profit once the share price crossed to Rs.625 (strike price + premium). Suppose the
stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE
scrip from the seller at Rs.600 and sell in the market at Rs.660.
Profit
30
20
10
0 590 600 610 620 630 640
-10
-20
-30
Loss
Unlimited profit for the buyer = Rs.35{(spot price strike price)
premium}
Limited loss for the buyer up to the premium paid.
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2. CALL SELLER:
In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the
stock price fall to Rs.550 the buyer will choose not to exercise the option.
Profit
30
20
10
0 590 600 610 620 630 640
-10
-20
-30
Loss
Profit for the Seller limited to the premium received = Rs.25
Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30
Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has
the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.
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Thus from the above example it shows that option contracts are formed so to avoid the
unlimited losses and have limited losses to the certain extent
Thus call option indicates two positions as follows:
1) LONG POSITION
If the investor expects price to rise i.e. bullish in the market he takes a long position by
buying call option.
2)
SHORT POSITION
If the investor expects price to fall i.e. bearish in the market he takes a short position by
selling call option.
PUT OPTION
A Put option gives the holder (buyer/ one who is long Put), the
right to sell specified quantity of the underlying asset at the strike price on or before an expiry
date. The seller of the put option (one who is short put) however, has the obligation to buy the
underlying asset at the strike price if the buyer decides to exercise his option to sell.
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ILLUSTRATION
Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the
market and other is Amit (put seller) who is bullish in the market.
The current market price of TISCO COMPANY is Rs.800 and premium is Rs.20.
1) PUT BUYER (Dinesh):
Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be
exercised once the price went below 800. The premium paid by the buyer is Rs.20.The
buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit
once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the
option will be exercised the buyer will purchase the RELIANCE scrip from the market at
Rs.700 and sell to the seller at Rs.800.
Profit
20
10
0 600 700 800 900 1000 1100
10
20
Loss
Unlimited profit for the buyer = Rs.80 {(Strike pricespot price)premium}
Loss limited for the buyer up to the premium paid = 20.
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2) PUT SELLER (Amit):
In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. The buyer of
the Put option will choose not to exercise his option to sell as he can sell in the market at a
higher rate.
Profit
20
10
0 600 700 800 900 1000 1100
10
20
Loss
Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for
the seller because the seller is bullish in the market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20
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Thus Put option also indicates two positions as follows:
LONG POSITION
If the investor expects price to fall i.e. bearish in the market he takes
a long position by buying Put option.
SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he takes
a short position by selling Put option.
CALL OPTIONS PUT OPTIONS
Option buyer or
option holder
Buys the right to buy the
underlying asset at the
specified price
Buys the right to sell the
underlying asset at the
specified price
Option seller or
option writer
Has the obligation to sell the
underlying asset (to theoption holder) at the specified
price
Has the obligation to buy the
underlying asset (from theoption holder) at the specified
price.
3)Index options:
These options have the index as the underlying. Some options
are European while others are American. Like index futures contracts, index
options contracts are also cash settled.
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4) Stock options:
Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the
right to buy or sell shares at the specified price.
5)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.
6) Writer of an option:
The writer of a call/put option is the one who receive
the option premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him. There are two basic types of options, call options and put
options.
7) Option price/premium:
Option price is the price which the option buyer paysto the option seller. It is also referred to as the option premium.
8)Expiration date:
The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
9) Strike price:
The price specified in the options contract is known as the strike
price or the exercise price.
10) American options :
American options are options that can be exercised at anytime up to the expiration date. Most exchange-traded options are American.
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11)European options:
European options are options that can be exercised only on
the expiration date itself. European options are easier to analyze than Americanoptions, and properties of an American option are frequently deduced from those
of its European counterpart.
12) In-the-money option:An in-the-money (ITM) option is an option that would lead
to a positive cash flow to the holder if it were exercised immediately. A call
option on the index is said to be in-the-money when the current index stands at alevel higher than the strike price (i.e. spot price >strike price). If the index is much
higher than the strike price, the call is said to be deep ITM. In the case of a put,
the put is ITM if the index is below the strike price.
13) At-the-money option:An at-the-money (ATM) option is an option that would lead
to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price
(i.e. spot price = strike price).
14) Out-of-the-money option:
An out-of-the-money (OTM) option is an option thatwould lead to a negative cash flow if it were exercised immediately. A call option
on the index is out-of-the-money when the current index stands at a level which is
less than the strike price (i.e. spot price < strike price). If the index is much lower
than the strike price, the call is said to be deep OTM. In the case of a put, the put
is OTM if the index is above the strike price.
15) Time value of an option:
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Both calls and puts have time value. An option
that is OTM or ATM has only time value. Usually, the maximum time value
exists when the option is ATM. The longer the time to expiration, the greater is
an option's time value, all else equal. At expiration, an option should have no
time value.
FACTORS AFFECTING OPTION PREMIUM
THE PRICE OF THE UNDERLYING ASSET: (S)
Changes in the underlying asset price can increase or decrease the premium of an option.
These price changes have opposite effects on calls and puts.
For instance, as the price of the underlying asset rises, the premium of a call will increase and
the premium of a put will decrease. A decrease in the price of the underlying assets value
will generally have the opposite effect.
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THE SRIKE PRICE: (K)
The strike price determines whether or not an option has any intrinsic value. An options
premium generally increases as the option gets further in the money, and decreases as the
option becomes more deeply out of the money.
Time until expiration: (t)
An expiration approaches, the level of an options time value, for puts and calls, decreases.
Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an options underlying.
Higher volatility estimates reflect greater expected fluctuations (in either direction) in
underlying price levels. This expectation generally results in higher option premiums for putsand calls alike, and is most noticeable with at- the- money options.
Interest rate: (R1)
This effect reflects the COST OF CARRY the interest that might be paid for margin, in
case of an option seller or received from alternative investments in the case of an optionbuyer for the premium paid.
Higher the interest rate, higher is the premium of the option as the cost of carry increases.
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PLAYERS IN THE OPTION MARKET:-
Developmental institutions
Mutual Funds
Domestic & Foreign Institutional Investors
Brokers
Retail Participants
FUTURES V/S OPTIONS
RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of the underlying assets
at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer
and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the
right & not the obligation, to buy or sell the underlying asset.
RISK:
Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While
options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option),
the downside is limited to the premium (option price) he has paid while the profits may be
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unlimited. For a seller or writer of an option, however, the downside is unlimited while
profits are limited to the premium he has received from the buyer.
PRICES:
The Futures contracts prices are affected mainly by the prices of the underlying asset. While
the prices of options are however, affected by prices of the underlying asset, time remaining
for expiry of the contract & volatility of the underlying asset.
COST:
It costs nothing to enter into a futures contract whereas there is a cost of entering into an
options contract, termed as Premium.
STRIKE PRICE:
In the Futures contract the strike price moves while in the option contract the strike price
remains constant.
Liquidity:
As Futures contract are more popular as compared to options. Also the premium charged is
high in the options. So there is a limited Liquidity in the options as compared to Futures.
There is no dedicated trading and investors in the options contract.
Price behavior:
The trading in future contract is one-dimensional as the price of future depends upon the
price of the underlying only. While trading in option is two-dimensional as the price of the
option depends upon the price and volatility of the underlying.
PAY OFF:
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As options contract are less active as compared to futures which results into non linear pay
off. While futures are more active has linear pay off.
FUTURES PAYOFFS
Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are
fascinating as they can be combined with options and the underlying to generate various
complex payoffs.
Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person
who holds an asset. He has a potentially unlimited upside as well as a potentiallyunlimited downside. Take the case of a speculator who buys a two month Nifty index
futures contract when the Nifty stands at 2220. The underlying asset in this case is the
Nifty portfolio. When the index moves up, the long futures position starts making profits,
and when the index moves down it starts making losses. Figure 4.1 shows the payoff
diagram for the buyer of a futures contract.
Payoff for a buyer of Nifty futures
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The figure shows the profits/losses for a long futures position. The investor bought futures
when the index was at 2220. If the index goes up, his futures position starts making profit. If
the index falls, his futures position starts showing losses.
Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two-month Nifty index futures contract
when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When
the index moves down, the short futures position starts making profits, and when the index
moves up, it starts making losses. Figure shows the payoff diagram for the seller of a futures
contract.
Payoff for a seller of Nifty futures
The figure shows the profits/losses for a short futures position. The investor sold futures
when the index was at 2220. If the index goes down, his futures position starts making profit.
If the index rises, his futures position starts showing losses.
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OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited; however the profits are
potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited
to the option premium; however his losses are potentially unlimited. These non-linear payoffs
are fascinating as they lend themselves to be used to generate various payoffs by using
combinations of options and the underlying. We look here at the six basic payoffs.
Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance,
for 2220, and sells it at a future date at an unknown price, St. Once it is
purchased, the investor is said to be "long" the asset. Figure shows the payoff
for a long position on the Nifty.
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Payoff profile for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, Nifty for instance, for 2220, and
buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be
"short" the asset. Figure shows the payoff for a short position on the Nifty.
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot price of
the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit.
Higher the spot price more is the profit he makes. If the spot price of the underlying is lessthan the strike price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option. Figure 4.6 gives the payoff for the buyer of a three
month call option (often referred to as long call) with strike of 2250 bought at a premium of
86.60.
Payoff for investor who went Long Nifty at 2220
The figure shows the profits/losses from a long position on the index. The investor bought the
index at 2220. If the index goes up, he profits. If the index falls he looses.
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Payoff for investor who went Short Nifty at 2220
The figure shows the profits/losses from a short position on the index. The investor sold the
index at 2220. If the index falls, he profits. If the index rises, he looses.
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Payoff for buyer of call option
The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As
can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty
closes above the strike of 2250, the buyer would exercise his option and profit to the extent of
the difference between the Nifty-close and the strike price. The profits possible on this option
are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option
expire. His losses are limited to the extent of the premium he paid for buying the option.
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Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the
strike price,
the buyer will exercise the option on the writer. Hence as the spot price increases the writer of
the option starts making losses. Higher the spot price more is the loss he makes. If upon
expiration the spot price of the underlying is less than the strike price, the buyer lets hisoption expire un-exercised and the writer gets to keep the premium. Figure gives the payoff
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for the writer of a three month call option (often referred to as short call) with a strike of 2250
sold at a premium of 86.60.
Payoff for writer of call option
The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As
the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If
upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on
the writer who would suffer a loss to the extent of the difference between the Nifty -close and
the strike price. The loss that can be incurred by the writer of the option is potentially
unlimited, whereas the maximum profit is limited to the extent of the up-front option
premium of Rs.86.60 charged by him.
Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on
the spot price of the underlying. If upon expiration, the spot price is below the strike
price, he makes a profit. Lower the spot price more is the profit he makes. If the spot
price of the underlying is higher than the strike price, he lets his option expire un-
exercised. His loss in this case is the premium he paid for buying the option. Figure 4.8
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gives the payoff for the buyer of a three month put option (often referred to as long put)
with a strike of 2250 bought at a premium of 61.70.
Payoff for buyer of put option
The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As
can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty
closes below the strike of 2250, the buyer would exercise his option and profit to the extent of
the difference between the strike price and Nifty-close. The profits possible on this option can
be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the
option expire. His losses are limited to the extent of the premium he paid for buying the
option.
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o Payoff profile for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer's profit is the seller's loss.
If upon expiration, the spot price happens to be below the strike
price, the buyer will exercise the option on the writer. If upon expiration the spot price of the
underlying is more than the strike price, the buyer lets his option unexercised and the writer
gets to keep the premium. Figure 4.9 gives the payoff for the writer of a three month putoption (often referred to as short put) with a strike of 2250 sold at a premium of 61.70.
o Payoff for writer of put option
The figure shows the profits/losses for the seller of a
three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money andthe writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the
buyer would exercise his option on the writer who would suffer a loss to the extent of the
difference between the strike price and Nifty-close. The loss that can be incurred by the
writer of the option is a maximum extent of the strike price (Since the worst that can happen
is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of
the up-front option premium of Rs.61.70 charged by him.
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APPLICATION OF OPTIONS
Since the index is nothing but a security whose price or level is a weighted average of
securities constituting the index, all strategies that can be implemented using stock futures
can also be implemented using index options.
o Hedging: Have underlying buy puts
Owners of stocks or equity portfolios often experience discomfort
about the overall stock market movement. As an owner of stocks or an equity portfolio,
sometimes you may have a view that stock prices will fall in the near future. At other times
you may see that the market is in for a few days or weeks of massive volatility, and you do
not have an appetite for this kind of volatility.
The union budget is a common and reliable source of such volatility:
market volatility is always enhanced for one week before and two weeks after a budget.
Many investors simply do not want the fluctuations of these three weeks. One way to protect
your portfolio from potential downside due to a market drop is to buy insurance using put
options.
Index and stock options are a cheap and easily implementable way of seeking this insurance.
The idea is simple. To protect the value of your portfolio from falling below a particular
level, buy the right number of put options with the right strike price. If you are only
concerned about the value of a particular stock that you hold, buy put options on that stock.
If you are concerned about the overall portfolio, buy put options on the
index. When the stock price falls your stock will lose value and the put options bought by you
will gain, effectively ensuring that the total value of your stock plus put does not fall below a
particular level. This level depends on the strike price of the stock options chosen by you.
Similarly when the index falls, your portfolio will lose value and the put options bought by
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you will gain, effectively ensuring that the value of your portfolio does not fall below a
particular level. This level depends on the strike price of the index options chosen by you.
Portfolio insurance using put options is of particular interest to mutual funds who already
own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a
market fall.
Speculation: Bullish security, buy calls or sell puts
There are times when investors believe that security prices are going to rise.
For instance, after a good budget, or good corporate results, or the onset of a stable
government. How does one implement a trading strategy to benefit from an upward
movement in the underlying security? Using options there are two ways one can do this:
1. Buy call options; or
2. Sell put options
We have already seen the payoff of a call option. The downside to the
buyer of the call option is limited to the option premium he pays for buying the option. His
upside however is potentially unlimited. Suppose you have a hunch that the price of a
particular security is going to rise in a months time. Your hunch proves correct and the price
does indeed rise, it is this upside that you cash in on.
However, if your hunch proves to be wrong and the security price
plunges down, what you lose is only the option premium. Having decided to buy a call,
which one should you buy? Table 4.1 gives the premium for one month calls and puts with
different strikes. Given that there are a number of one-month calls trading, each with a
different strike price, the obvious question is: which strike should you choose? Let us take a
look at call options with different strike prices. Assume that the current price level is 1250,
risk-free rate is 12% per year and volatility of the underlying security is 30%.
The following options are available:
1. A one month calls with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
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5. A one month call with a strike of 1300.
Which of these options you choose largely depends on how strongly you feel
about the likelihood of the upward movement in the price, and how much you are willing to
lose should this upward movement not come about. There are five one-month calls and five
one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and
hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and
trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends
on the unlikely event that the underlying will rise by more than 50 points on the expiration
date. Hence buying this call is basically like buying a lottery. There is a small probability that
it may be in-the-money by expiration, in which case the buyer will make profits. In the more
likely event of the call expiring out-of-the-money, the buyer simply loses the small premium
amount of Rs.27.50.
As a person who wants to speculate on the hunch that prices may rise, you
can also do so by selling or writing puts. As the writer of puts, you face a limited upside and
an unlimited downside. If prices do rise, the buyer of the put will let the option expire and
you will earn the premium. If however your hunch about an upward movement proves to be
wrong and prices actually fall, then your losses directly increase with the falling price level.
If for instance the price of the underlying falls to 1230 and you've sold a put with an exercise
of 1300, the buyer
Of the put will exercise the option and you'll end up losing Rs.70. Taking into account the
premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which
strike should you choose? This largely depends on how strongly you feel about the likelihood
of the upward movement in the prices of the underlying. If you write an at-the-money put, the
option premium earned by you will be higher than if you write an out-of-the-money put.
However the chances of an at-the-money put being exercised on you are higher as well.
o
One month calls and puts trading at different strikes
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The spot price is 1250. There are five one-month calls and five one-month puts trading in the
market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher
premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely
event that the price of underlying will rise by more than 50 points on the expiration date.
Hence buying this call is basically like buying a lottery. There is a small probability that it
may be in-the-money by expiration in which case the buyer will profit. In the more likely
event of the call expiring out-of-the-money, the buyer simply loses the small premium
amount of Rs. 27.50. Figure 4.10 shows the payoffs from buying calls at different strikes.
Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium
than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-
money and will only be exercised in the unlikely event that underlying falls by 50 points on
the expiration date.
Show the payoffs from writing puts at different strikes.
Underlying Strike price of
option
Call premium
(Rs.)
Put premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
At a price level of 1250, one option is in-the-money and one is out-of-the-money. As
expected, the in-the-money option fetches the highest premium of Rs.64.80 whereas the out-
of-the-money option has the lowest premium of Rs. 18.15.
o Speculation: Bearish security, sell calls or buy puts
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Do you sometimes think that the market is going to drop? That you could
make a profit by adopting a position on the market? Due to poor corporate results, or the
instability of the government, many people feel that the stocks prices would go down. How
does one implement a trading strategy to benefit from a downward movement in the market?
Today, using options, you have two choices:
1. Sell call options; or
2. Buy put options
We have already seen the payoff of a call option. The upside to the writer of the
call option is limited to the option premium he receives upright for writing the option. His
downside however is potentially unlimited. Suppose you have a hunch that the price of a
particular security is going to fall in a months time. Your hunch proves correct and it does
indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call
lets the call expire and you get to keep the premium. However, if your hunch proves to be
wrong and the market soars up instead, what you lose is directly proportional to the rise in the
price of the security.
REGULATORY FRAMEWORK
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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 exchanges.
SECURITIES CONTRACTS (REGULATION) ACT, 1956
SC(R)A aims at preventing undesirable transactions in securities by
regulating the business of dealing therein and by providing for certain other matters
connected therewith. This is the principal Act, which governs the trading of securities in
India. The term securities has been defined in the SC(R)A. As per Section 2(h), the
Securities include:
1.
Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body corporate.
2. Derivative
3. Units or any other instrument issued by any collective investment scheme to the
investors in such schemes.
4. Government securities
5. Such other instruments as may be declared by the Central Government to be
securities.
6. Rights or interests in securities.
Derivative is defined to include:
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A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of underlying
securities.
Section 18A provides that notwithstanding anything contained in any other law for the time
being in force, contracts in derivative shall be legal and valid if such contracts are:
Traded on a recognized stock exchange Settled on the clearing house of the recognized stock
exchange, in accordance with the rules and byelaws of such stock exchanges.
SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992
SEBI Act, 1992 provides for establishment of Securities and Exchange Board
of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities
(b) promoting the development of the securities market and (c) regulating the securities
market. Its regulatory jurisdiction extends over corporates in the issuance of capital and
transfer of securities, in addition to all intermediaries and persons associated with securities
market. SEBI has been obligated to perform the aforesaid functions by such measures as it
thinks fit. In particular, it has powers for:
regulating the business in stock exchanges and any other securities markets.
registering and regulating the working of stock brokers, subbrokers etc.
promoting and regulating self-regulatory organizations.
prohibiting fraudulent and unfair trade practices.
calling for information from, undertaking inspection, conducting inquiries and audits of the
stock exchanges, mutual funds and other persons associated with the securities market and
intermediaries and selfregulatory organizations in the securities market.
performing such functions and exercising according to Securities
Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.
REGULATION FOR DERIVATIVES TRADING
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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. On
May 11, 1998 SEBI accepted the recommendations of the committee and approved the
phased introduction of derivatives trading in India beginning with stock index futures. The
provisions in the SC(R)A and the regulatory framework developed there under govern trading
in securities. The amendment of the SC(R)A to include derivatives within the ambit of
securities in the SC(R)A made trading in derivatives possible within the framework of that
Act.
1. Any Exchange fulfilling the eligibility criteria as prescribed in the 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.
The derivatives exchange/segment should have a separate governing council and
representation of trading/clearing members shall be limited to maximum of 40% of the total
members of the governing council. The exchange would have to regulate the sales practices
of its members and would have to obtain prior approval of SEBI before start of trading in
any derivative contract.
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 down by the L. C. Gupta committee.
4. The clearing and settlement of derivatives trades would be through a
SEBI approved clearing corporation/house. Clearing corporations/houses complying with the
eligibility conditions as laid down by the committee have to apply to SEBI for grant of
approval.
5. Derivative brokers/dealers and clearing members are required to
seek registration from SEBI. This is in addition to their registration as brokers of existing
stock exchanges. The minimum net worth for clearing members of the derivatives clearing
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corporation/house shall be Rs.300 Lakh. The networth of the member shall be computed as
follows:
Capital + Free reserves
Less non-allowable assets viz.,
(a) Fixed assets
(b) Pledged securities
(c) Members card
(d) Non-allowable securities (unlisted securities)
(e) Bad deliveries
(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities
6.The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to
submit details of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and
margin demands related to the risk of loss on the position will be prescribed by
SEBI/Exchange from time to time.
8. The L. C. Gupta committee report requires strict enforcement of Know your
customer rule and requires that every client shall be registered with the derivatives broker.
The members of the derivatives segment are also required to make their clients aware of the
risks involved in derivatives trading by issuing to the client the Risk Disclosure Document
and obtain a copy of the same duly signed by the client.