project sharekhan mba

7/29/2019 Project Sharekhan mba

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A STUDY ON INVESTMENT IN COMMODITY &

DERRIVATIVE ON SHAREKHAN PVT LTD

In the partial fulfillment of the requirement for the degree of

POST GRADUATE PROGRAME IN MANGEMENT

Submitted By

DEEPAK KUMAR VATSENROLL NO. 12BSP1856

Under the guidance of

Dr. SOMBALA N.Assistant Professor, IBS GUGAON


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CERTIFICATE OF ATTENDANCE

This is to certify that Mr. Deepak Kumar Vats, who was engaged in our organization as aSummer Trainee, has been regular & punctual. He has attended the training from 15

thMarch to

4th

of june 2012.

Signature

MOHD. WAKEEL

(Assistant Manager)

Sharekhan Ltd.


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GUIDES CERTIFICATE

This is to certify that Mr. Deepak Kumar Vats, Enroll. No.12BSP1856, a student of Post

Graduate Program In Management, Session 2011-2013, has completed Dissertation report on the

topic INVESTMENT IN COMMODITY & DERRIVATIVE ON SHAREKHAN PVT LTD

under my supervision. He has completed the project report in most systematic and regular way,

his dedication and sincerity during project is highly commendable.

I wish him all the best for his endeavour.

Dr. SOMBALA N.

FACULTY GUIDE

IBS GURGAON


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DECLARATION

I hereby declare that the project work entitled A STUDY ON INVESTMENT IN

COMMODITY & DERRIVATIVE ON SHAREKHAN PVT LTD, submitted to the IBS

GURGAON, in partial fulfillment of the requirement for the award of the degree of Post

Graduate Program In Management is a record bonafide research carried out by me under the

guidance of Dr. Sombala N. Faculty guide at IBS GURGAON, and this project work has not

formed the basis for the award of any Degree/Diploma/Fellowship or similar title to any

candidate of any university.

Deepak kumar vats


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ACKNOWLEDGEMENT

A project is never the work of an individual. It is moreover a combination of ideas, suggestions, review,contribution and work involving many folks. It cannot be completed without guidelines.

It is my pleasure to acknowledge gratefully to all those honorable personalities who helped melot into the creation of this project and shared their experiences.

I would like to express my sincere indebtedness to Dr. SOMBALA N. (Faculty Mentor, IBS

GURGAON) for giving me the opportunity to work on this project and make it a success.

I would like to express my deep sense of gratitude to my Industry guide, MOHD WAKEEL,

Assistant Manager Sharekhan Ltd., Nirman Vihar Branch, New Delhi, who spent his

valuable time and guided me. I have benefited a great deal from his incisive analysis and eruditesuggestions. The atmosphere of a learning organization that he has created along with his peers

in Nirman Vihar Branch has not only helped me but all the other trainees.

Acknowledgements are also due to all the other staff members and executives in Sharekhan Ltd.,

Nirman Vihar Branch for providing information at various point of the project, especially the

discussions on the market.

I am also sincerely thankful to all the faculty members of IBS GURGAON for providing their

help and advice whenever it was needed.

Finally I wish to extend my sincere acknowledgement to my parents for their moral and financial

support.

Deepak kumar vats


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TABLE OF CONTENTS

Certificate

Declaration Acknowledgement

Executive Summary

Objective of the Study

Methodology

Job Description

Chapter 1. Introduction of Sharekhan Limited

About Sharekhan Limited

Sharekhan Limiteds Management Team

Products and Services of Sharekhan Limited

Types of account in Sharekhan Limited

How to open an account with Sharekhan Limited?

Research section in Sharekhan Limited

Awards and Achievements

Chapter 2. Introduction to Derivatives

Derivatives defined

Emergence of Derivatives

History of Derivatives

Global Derivative Markets

Derivatives Market in India

Participants and Functions

Types of Derivative Instruments

Derivative Market at NSE

Approval for Derivative Trading Clearing and Settlements

Index Derivatives

Trading

Order type and Condition

SEBI Advisory Committee on Derivative


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Chapter 3. Introduction to Futures and Options

Forward Contracts Future Contracts

Options Payoffs for Derivative Contracts

Chapter 4. Hedging, Arbitrage and Speculation Strategies

Hedging Strategies with examples Arbitrage Strategies with examples Speculation Strategies with examples

Chapter 5. Applicability of Derivative Instruments

Risk Management: Concept and Definition Risk Management with Future Contract Risk Management with Options Introduction to Option Strategies

Chapter 6. Introducion of Commodity

Introduction of Commodity Why Structured Commodity Market ? CharactersticsOf Future Trading Economic benefit of future trading Commodity are suitable for future tradingNeed For Futures Trading In Commodities

Chapter 7. Hedging Strategies

Hedging

Regulatory body Why CommoditiesMarket?

Chapter 8. Problem Face By Commodity Market In India


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Problem Faced By Commodities Markets InIndia

Risks Associated With Commodities Market Key Factors For Success Of Commodities Market Key FActors For Success Of Commodities Exchange Future prospectis Regulatory approval for fit trading in commodity market

Chapter 9.Online commodity trading

SHAREKHAN COMMODITY ADVANTAGE KEY BENEFITS OF COMMODITIES@ SHAREKHAN

Chapter 10. Research

Research objective

Hypothesis

Source of data

Sampling process

Scope of study

Limitation of study

Analysis & Interpretation

Testing of Hypothesis

Chapter 11. Conclusion

Chapter 12. Suggestions and Recommendations


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Chapter 13. The Reference Material

Glossary Bibliography

EXECUTIVE SUMMARY

Conceptually the mechanism of stock market is very simple. People who are exposed to the same

risk come together and agree that if anyone of the person suffers a loss the other will share the

loss and make good to the person who lost.

The initial part of the project focuses on the job and responsibilities I was allotted as a summer

trainee. It also makes the readers aware about the techniques and methodology used to bring this

report alive. It also describe about the objective of this study.

It also enlightens the readers about Sharekhan Limiteds strategies to acquire new customers.

Further the project tells us about the profile of the company (Sharekhan Ltd.). It provides

knowledge to the readers regarding the companys history, mission, vision, customer base and

the reasons to be associated with the company. Also it gives special emphasis on the selling of

products and management of the company.

The next few chapters are devoted to the study of the Derivative Market and Derivative

Instruments in a very basic way. It also suggests some of the strategies that can be applied to

earn more even when the market is too much volatile. The readers can also find the comparativeanalysis of the Derivative Market and the Cash Market in the Indian context.

The next part of the project throws light upon my findings and analysis about the company and

the suggestions for the company for better performance.


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OBJECTIVE OF THE STUDY

To find out whether the Derivative Instruments are applicable in the Indian Stock Market which

can work both in good and bad times so that it can minimize our risk and maximize our returns.As a result one can have conviction in his portfolio in the hugely volatile stock market because

a difficult and serious problem for all investors today is that there is entirely too much free

information, hype, promotion, personal opinion, and advice about derivative instruments are

there in stock market. One get it from friends, relatives, people at work, the Internet, brokers,

stock analysts, advisers, entertaining cable TV market programs, and other media. It can be very

risky and potentially dangerous.

Realistically, there are not too many people one can listen to if he want to avoid confusing,

contradictory, and faulty personal market opinions. So one need to confine himself to just a very

few sources of relevant facts and data and a sound system that has proven to be accurate andprofitable over time.

Therefore, the objective of the Dissertation is to do in depth research on these derivative

instruments.


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METHODOLOGY

During this project, I have analyzed the Futures and Options. I have tried to analyze the

instruments as per the Market Participant and the Market Trend. Initially, I have given a brief

introduction about the instruments, so that the reader is aware of basics of the subject.

I have tried to identify various terms related to derivative trading, for which I have introduced a

separate chapter, Terms related to derivative market

Then I have tried to segregate the use of Instruments as per the Market Participants and Market

Trend. I identified hedging, arbitrage and speculation strategies using both futures and options,and then segregated them into a chapter each. Segregation involved a thorough study of the

strategies and possible use.

Then I have done a secondary data based study on growth of Indian Derivative Market, which

includes the comparison of derivative market with cash market, data regarding the traded volume

and number of contracts traded from 2011. I have also analyzed the top five most traded symbols

in futures and options segment.


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JOB DESCRIPTION

The company placed me as a Summer Trainee. I have been handling the

Following responsibilities:

My job profile was to sale the products of the organization.

My job profile was to coordinate the team and also help them to sale the product and also

help them in field.

My job profile was to generate the leads by cold calling.

My job profile was to understand customers needs and advising them to make a portfolio

as per their investment.

My job profile was to do sales promotion through e-mails, canopies, making cold calling,

distributing pamphlets and etc.

AREA ASSIGNED

I covered areas like Delhi, Gurgaon, Ghaziabad, Faridabadand NCR.

TARGET ASSIGNED

To sell 6 accounts .

TARGET MARKET

Different properties dealers.

Charted accountants.

Lawyers

Travel agencies

Transport business

House wives

Businessmen

Corporate Employees etc.


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DAY TO DAY JOB DESCRIPTION

Reporting time: 9.00 AM

Fixing appointment with clients.

Visit clients place.

Demonstrate the product on Internet to the client.

Completing the formalities like filling the application form and documentation.

Cold calling.


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Chapter 1

Introduction ofSharekhan ltd.

INTRODUCTION OF SHAREKHAN LTD.

ABOUT SHAREKHAN LIMITED


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Sharekhan Ltd. is one of the leading retail stock broking house of SSKI Group

which is running successfully since 1922 in the country. It is the retail broking

arm of the Mumbai-based SSKI Group, which has over eight decades of

experience in the stock broking business. Sharekhan offers its customers a

wide range of equity related services including trade execution on BSE, NSE,

Derivatives, depository services, online trading, investment advice etc.

The firms online trading and investment site - www.sharekhan.com - was

launched on Feb 8, 2000. The site gives access to superior content and

transaction facility to retail customers across the country. Known for its

jargon-free, investor friendly language and high quality research, the site has a

registered base of over one lakh customers. The content-rich and research

oriented portal has stood out among its contemporaries because of its steadfast

dedication to offering customers best-of-breed technology and superior market

information. The objective has been to let customers makeinformed decisionsand to simplify the process of investing in stocks.

On April 17, 2002 Sharekhan launched Speed Trade, a net-based executable

application that emulates the broker terminals along with host of other

information relevant to the Day Traders. This was for the first time that a net-

based trading station of this caliber was offered to the traders. In the last six

months Speed Trade has become a de facto standard for the Day Trading

community over the net.

Sharekhans ground network includes over 640 centers in 280 cities in Indiawhich provide a host of trading related services.

Sharekhan has always believed in investing in technology to build its business.

The company has used some of the best-known names in the IT industry, like

Sun Microsystems, Oracle, Microsoft, Cambridge Technologies, Nexgenix,

Vignette, Verisign Financial Technologies India Ltd, Spider Software Pvt Ltd. to

build its trading engine and content. The Morakhiya family holds a majority

stake in the company. HSBC, Intel & Carlyle are the other investors.

With a legacy of more than 80 years in the stock markets, the SSKI group

ventured into institutional broking and corporate finance 18 years ago.

Presently SSKI is one of the leading players in institutional broking and

corporate finance activities. SSKI holds a sizeable portion of the market in each

of these segments. SSKIs institutional broking arm accounts for 7% of the

market for Foreign Institutional portfolio investment and 5% of all Domestic


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Institutional portfolio investment in the country. It has 60 institutional clients

spread over India, Far East, UK and US. Foreign Institutional Investors

generate about 65% of the organizations revenue, with a daily turnover of over

US$ 2 million. The Corporate Finance section has a list of very prestigious

clients and has many firsts to its credit, in terms of the size of deal, sector

tapped etc. The group has placed over US$ 1 billion in private equity deals.

Some of the clients include BPL Cellular Holding, Gujarat Pipavav, Essar,

Hutchison, Planetasia, and Shoppers Stop.

PROFILE OF THE COMPANY

Name of the company: Sharekhan ltd.

Year of Establishment: 1925

Headquarter : ShareKhan SSKIA-206 Phoenix HousePhoenix Mills CompoundLower ParelMumbai - Maharashtra, INDIA- 400013

Nature of Business : Service Provider

Services : Depository Services, Online Services andTechnical Research.

Number of Employees : Over 3500

Revenue : Data Not Available

Website : www.sharekhan.com

Slogan : Your Guide to The Financial Jungle.

Vision

To be the best retail brokering Brand in the retail business of stock market.
http://www.sharekhan.com/http://www.sharekhan.com/


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Mission

To educate and empower the individual investor to make better investment

decisions through quality advice and superior service.

Sharekhan is infact-

Among the top 3 branded retail service providers

No. 1 player in online business

Largest network of branded broking outlets in the country serving more

than 7,00,000 clients.

REASON TO CHOOSE SHAREKHAN LIMITED

Experience

SSKI has more than eight decades of trust and credibility in the Indian stockmarket. In the Asia Money broker's poll held recently, SSKI won the 'India'sBest Broking House for 2004' award. Ever since it launched Sharekhan as itsretail broking division in February 2000, it has been providing institutional-level research and broking services to individual investors.

Technology

With its online trading account one can buy and sell shares in an instant fromany PC with an internet connection. One can get access to its powerful onlinetrading tools that will help him take complete control over his investment inshares.

Accessibility

Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION servicesfor investors. These services are accessible through its centers across the

country over the internet (through the website www.sharekhan.com) as well asover the Voice Tool.

Knowledge

In a business where the right information at the right time can translate intodirect profits, one can get access to a wide range of information on Sharekhan


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limiteds content-rich portal. One can also get a useful set of knowledge-basedtools that will empower him to take informed decisions.

Convenience

One can call its Dial-N-Trade number to get investment advice and execute histransactions. Sharekhan ltd. have a dedicated call-centre to provide thisservice via a Toll Free Number 1800-22-7500 & 1800-22-7050 from anywherein India.

Customer Service

Sharekhan limiteds customer service team will assist one for any help that onemay require relating to transactions, billing, demat and other queries. Itscustomer service can be contacted via a toll-free number, email or live chat onwww.sharekhan.com.

Investment Advice

Sharekhan has dedicated research teams of more than 30 people forfundamental and technical researches. Its analysts constantly track the pulseof the market and provide timely investment advice to its clients in the form ofdaily research emails, online chat, printed reports and SMS on their mobilephone.


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PRODUCTS AND SERVICES OF SHAREKHAN LIMITED

The different types of products and services offered by Sharekhan Ltd. are as

follows:

Equity and derivatives trading

Depository services

Online services

Commodities trading

Dial-n-trade

Portfolio management Share shops

Fundamental research

Technical research


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TYPES OF ACCOUNT IN SHAREKHAN LIMITED

Sharekhan offers two types of trading account for its clients

Classic Account (which include a feature known as Fast Trade Advanced

Classic Account for the online users) and

Speed Trade Account

CLASSIC ACCOUNT

This is a User Friendly Product which allows the client to trade throughwebsite www.sharekhan.com and is suitable for the retail investor who isrisk-averse and hence prefers to invest in stocks or who does not tradetoo frequently. This account allow investors to buy and sell stocks onlinealong with the following features like multiple watch lists, IntegratedBanking, Demat and digital contracts, Real-time portfolio tracking withprice alerts and Instant credit & transfer.

This account comes with the following features:

a. Online trading account for investing in Equities and Derivatives

b. Free trading through Phone (Dial-n-Trade)I. Two dedicated numbers(1800-22-7500 and 39707500) for

placing the orders using cell phones or landline phones

II. Automatic funds transfer with phone banking facilities (for

Citibank and HDFC bank customers)

III. Simple and Secure Interactive Voice Response based system

for authentication

IV. get the trusted, professional advice of Sharekhan limiteds

Tele Brokers

V. After hours order placement facility between 8.00 am and

9.30 am

c. Integration of: Online Trading +Saving Bank + Demat Account.

d. Instant cash transfer facility against purchase & sale of shares.

e. IPO investments.

f. Instant order and trade confirmations by e-mail.

g. Single screen interface for cash and derivatives.


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SPEED TRADE ACCOUNT

This is an internet-based software application, which enables one to buy andsell in an instant. It is ideal for active traders and jobbers who transactfrequently during days session to capitalize on intra-day price movement.

This account comes with the following features:

a. Instant order Execution and Confirmation.b. Single screen trading terminal for NSE Cash, NSE F&O & BSE.c.Technical Studies.d. Multiple Charting.e. Real-time streaming quotes, tic-by-tic charts.f. Market summary (Cost traded scrip, highest value etc.)g. Hot keys similar to brokers terminal.h. Alerts and reminders.i. Back-up facility to place trades on Direct Phone lines.j. Live market debts.

CHARGE STRUCTURE

Fee structure for General Individual:

Charge Classic Account Speed Trade Account

Account Opening Rs. 750/= Rs. 1000/=

BrokerageIntra-day0.10 %

Delivery - 0.50 %

Intra-day - 0.10%

Delivery - 0.50%

Depository Charges:

Account Opening Charges Rs. NIL

Annual Maintenance ChargesRs. NIL first year Rs. 400/= p.a.from second calendar year onward


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HOW TO OPEN AN ACCOUNT WITH SHARE KHAN

LIMITED?

Generally the process of opening an account follows the following steps:

LEAD MANAGEMENT SYSTEM LMS / REFERENCES

CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL

FIXING AN APPOINTMENT WITH THE PERSON

GIVING

DEMONST-

RATION

NOYES

DOCUMENTATION

FILLING UP THE FORM

SUBMISSION OF THE FORM

LOGIN OF THE FORM

SENDING ACCOUNT OPENING KIT TO THE CLIENT

TRADING


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Apart from two passport size photographs, one needs to provide with the

following documents in order to open an account with Sharekhan Limited.:

Photocopy of the clients PAN Card which should be duly attached

Photo copy of any of the following documents duly attached which willserve as correspondence address proof:

a. Passport (valid)

b. Voters ID Card

c. Ration Card

d. Driving License (valid)

e. Electricity Bill (should be latest and should be in the name of the

client)

f. Telephone Bill (should be latest and should be in the name of the

client)

g. Flat Maintenance Bill (should be latest and should be in the name

of the client)

h. Insurance Policy (should be latest and should be in the name of

the client)

i. Lease or Rent Agreement.

j. Saving Bank Statement** (should be latest)

Two cheques drawn in favour of Sharkhan Limited, one for the AccountOpening Fees and the other for the Margin Money (the minimum marginmoney is Rs. 5000).

** A cancelled cheque should be given by the client if he provides SavingBank Statement as a proof for correspondence address.

NOTE: Only Saving Bank Account cheques are accepted for the purpose ofOpening an account.


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RESEARCH SECTION IN SHAREKHAN LIMITED

Sharekhan Limited has its own in-house Research Organisation which isknown as Valueline. It comprises a team of experts who constantly keep an eyeon the share market and do research on the various aspects of the sharemarket. Generally the research is based on the Fundamentals and Technicalanalysis of different companies and also taking into account various factorsrelating to the economy.

Sharekhan Limiteds research on the volatile market has been found accuratemost of the time. Sharekhan's trading calls in the month of November 2007has given 89% strike rate.

Out of 37 trading calls given by Sharekhan in the month of November 2007, 33

hit the profit target. These exclusive trading picks come only to SharekhanOnline Trading Customer and are based on in-depth technical analysis.

As a customer of Sharekhan Limited, one receives daily 5-6 Research Reportson their emails which they can use as tips for investing in the market. Thesereports are named as Pre-Market Report, Eagle Eye, High Noon, Investors Eye,Daring Derivatives and Post-Market Report. Apart from these, SharekhanLimited issues a monthly subscription by the name of Valueline which is easilyavailable in the market.


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AWARDS AND ACHIEVEMENTS

SSKI has been voted as the Top Domestic Brokerage House in the

research category, twice by Euromoney Survey and four times by

Asiamoney Survey.

Sharekhan Limited won the CNBC AWARD for the year 2004.

Chapter 2

Introduction toDerivatives


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INTRODUCTION TO DERIVATIVES

The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averseeconomic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative

products, it is possible to partially or fully transfer price risks by lockingin

asset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by locking-

in asset prices, derivative products minimize the impact of fluctuations in asset

prices on the profitability and cash flow situation of risk-averse investors.

DERIVATIVES DEFINED

Derivative is a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate), in a

contractual manner. The underlying asset can be equity, forex, commodity or

any other asset. For example, wheat farmers may wish to sell their harvest at a

future date to eliminate the risk of a change in prices by that date. Such

transaction is an example of a derivative. The price of this derivative is driven

by the spot price of wheat which is the underlying.

In simple word it can be said that Derivatives are financial contracts whose

value/price is dependent on the behavior of the price of one or more basic

underlying assets (often simply known as underlying). These contracts are

legally binding agreements, made on the trading screen of stock exchanges, to


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buy or sell an asset in future. The asset can be a share, index, interest rate,

bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)

defines derivative to include

1. 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.

2. A contract which derives its value from the prices, or index of prices, of

underlying securities.

A very simple example of derivatives is curd, which is derivative of milk. The

price of curd depends upon the price of milk which in turn depends upon the

demand and supply of milk.

EMERGENCE OF DERIVATIVES

Derivative products initially emerged as hedging devices against fluctuations in

commodity 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, theircomplexity 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

lower costs associated with index derivatives visavis derivative products based

on individual securities is another reason for their growing use.

HISTORY OF DERIVATIVES

Early forward contracts in the US addressed merchants concerns about

ensuring that there were buyers and sellers for commodities. However credit

risk remained a serious problem. To deal with this problem, a group of Chicago


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businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary

intention of the CBOT was to provide a centralized location known in advance

for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went

one step further and listed the first exchange traded derivatives contract in the

US, these contracts were called futures contracts. In 1919, Chicago Butter and

Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its

name was changed to Chicago Mercantile Exchange (CME). The CBOT and the

CME remain the two largest organized futures exchanges, indeed the two largest

financial exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade.

Currently the most popular stock index futures contract in the world is based

on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid

eighties, financial futures became the most active derivative instruments

generating volumes many times more than the commodity futures. Index

futures, futures on T-bills and Euro-Dollar futures are the three most popularfutures contracts traded today. Other popular international exchanges that

trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore,

TIFFE in Japan, MATIF in France, Eurex etc.

GLOBAL DERIVATIVE MARKETS

The derivatives markets have grown manifold in the last two decades.. According

to the Bank for International Settlements (BIS), the approximate size of global

derivatives market was US$ 109.5 trillion as at endDecember 2000. The totalestimated notional amount of outstanding overthecounter (OTC) contracts

stood at US$ 95.2 trillion as at endDecember 2000, an increase of 7.9% over

endDecember 1999. Growth in OTC derivatives market is mainly attributable to

the continued rapid expansion of interest rate contracts, which reflected growing

corporate bond markets and increased interest rate uncertainty at the end of

2000. The amount outstanding in organized exchange markets increased by

5.8% from US$ 13.5 trillion as at end December 1999 to US$ 14.3 trillion as at

endDecember 2000.

The turnover data are available only for exchangetraded derivatives contracts.The turnover in derivative contracts traded on exchanges has increased by 9.8%

during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table

1.2). While interest rate futures and options accounted for nearly 90% of total

turnover during 2000, the popularity of stock market index futures and options

grew modestly during the year. According to BIS, the turnover in exchange


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traded derivative markets rose by a record amount in the first quarter of 2001,

while there was some moderation in the OTC volumes.

DERIVATIVE MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern

trading of derivatives. 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. The committee submitted

its report on March 17, 1998 prescribing necessary preconditions for

introduction of derivatives trading in India. The committee recommended that

derivatives should be declared as securities so that regulatory framework

applicable to trading of securities could also govern trading of securities. SEBI

also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to

recommend measures for risk containment in derivatives market in India. The

report, which was submitted in October 1998, worked out the operational

details of margining system, methodology for charging initial margins, broker

net worth, deposit requirement and realtime monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the

ambit of securities and the regulatory framework was developed for governing

derivatives trading. The act also made it clear that derivatives shall be legal and

valid only if such contracts are traded on a recognized stock exchange, thus

precluding OTC derivatives. The government also rescinded in March 2000, the

threedecade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the

final approval to this effect in May 2000. SEBI permitted the derivative segmentsof two stock exchanges, NSE and BSE, and their clearing house/corporation to

commence trading and settlement in approved derivatives contracts. To begin

with, SEBI approved trading in index futures contracts based on S&P CNX Nifty

and BSE30 (Sensex) index. This was followed by approval for trading in options

based on these two indexes and options on individual securities. The trading in


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index options commenced in June 2001 and the trading in options on individual

securities commenced in July 2001. Futures contracts on individual stocks were

launched in November 2001. Trading and settlement in derivative contracts is

done in accordance with the rules, byelaws, and regulations of the respective

exchanges and their clearing house/corporation duly approved by SEBI and

notified in the official gazette.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index

futures on June 12, 2000. The trading in index options commenced on June 4,

2001 and trading in options on individual securities commenced on July 2,

2001. Single stock futures were launched on November 9, 2001. The index

futures and options contract on NSE are based on S&P CNX Nifty Index.

Currently, the futures contracts have a maximum of 3-month expiration cycles.Three contracts are available for trading, with 1 month, 2 months and 3 months

expiry. A new contract is introduced on the next trading day following the expiry

of the near month contract.

PARTICITANTS AND FUNCTIONS

PARTICIPANTS

Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. The following three broad categories of

participants

Hedgers: - Hedgers face risk associated with the price of an asset. They use

futures or options markets to reduce or eliminate this risk

Speculators: - Speculators wish to bet on future movements in the price of an

asset. Futures 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.

Arbitrageurs: - Arbitrageurs 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 line with the cash price, they will take offsetting

positions in the two markets to lock in a profit.


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FUNCTIONS

The derivatives market performs a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the

perceived future level. The prices of derivatives converge with the prices

of the underlying at the expiration of the derivative contract.

2.The derivatives market helps to transfer risks from those who have them

but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying

cash markets. With the introduction of derivatives, the underlying

market witnesses higher trading volumes because of participation by

more players who would not otherwise participate for lack of an

arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators

trade in the underlying cash markets. Margining, monitoring and

surveillance of the activities of various participants become extremely

difficult in these kind of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that

it acts as a catalyst for new entrepreneurial activity. The derivatives have

a history of attracting many bright, creative, well-educated people with

an entrepreneurial attitude. They often energize others to create new

businesses, new products and new employment opportunities, the

benefit of which are immense.

6. Derivatives markets help increase savings and investment in the long

run. Transfer of risk enables market participants to expand their volumeof activity.

TYPES OF DERIVATIVE INSTRUMENTS


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Forwards: A forward contract is a customized contract between two entities,

where settlement takes place on a specific date in the future at todays pre -

agreed price.

Futures: 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.

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.

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 tradedover-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of up to three years.

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.

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:a. Interest rate swaps: These entail swapping only the interest related cash

flows between the parties in the same currency.

b. 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 andreceive floating.

DERIVATIVE MARKET AT NSE


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The derivatives trading on the exchange commenced with S&P CNX Nifty Index

futures on June 12, 2000. The trading in index options commenced on June 4,

2001 and trading in options on individual securities commenced on July 2,

2001. Single stock futures were launched on November 9, 2001. The index

futures and options contract on NSE are based on S&P CNX Nifty Index.

Currently, the futures contracts have a maximum of 3-month expiration cycles.

Three contracts are available for trading, with 1 month, 2 months and 3

months expiry. A new contract is introduced on the next trading day following

the expiry of the near month contract.

APPROVAL FOR DERIVATIVE TRADING

TRADING MECHANISM

The futures and options trading system of NSE, called NEAT-F&O tradingsystem, provides a fully automated screenbased trading for Nifty futures &

options and stock futures & options on a nationwide basis and an online

monitoring and surveillance mechanism. It supports an anonymous order

driven market which provides complete transparency of trading operations and

operates on strict pricetime priority. It is similar to that of trading of equities

in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed

by two types of users.

The Trading Members(TM) have access to functions such as order entry, ordermatching, and order and trade management. It provides tremendous flexibility

to users in terms of kinds of orders that can be placed on the system. Various

conditions like Good-till-Day, Good-till-Cancelled, Good till- Date, Immediate or

Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The

Clearing Members (CM) uses the trader workstation for the purpose of

monitoring the trading member(s) for whom they clear the trades. Additionally,

they can enter and set limits to positions, which a trading member can take.

MEMBERSHIP CRITERIA

NSE admits members on its derivatives segment in accordance with the rules

and regulations of the exchange and the norms specified by SEBI. NSE follows

2tier membership structure stipulated by SEBI to enable wider participation.

Those interested in taking membership on F&O segment are required to take


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membership of CM and F&O segment or CM, WDM and F&O segment. Trading

and clearing members are admitted separately.

Essentially, a clearing member (CM) does clearing for all his trading members

(TMs), undertakes risk management and performs actual settlement. There are

three types of CMs:

Self Clearing Member:A SCM clears and settles trades executed by him

only either on his own account or on account of his clients.

Trading Member Clearing Member:TMCM is a CM who is also a TM.

TMCM may clear and settle his own proprietary trades and clients

trades as well as clear and settle for other TMs.

Professional Clearing Member:PCM is a CM who is not a TM. Typically,

banks or custodians could become a PCM and clear and settle for TMs.

The TMCM and the PCM are required to bring in additional security deposit in

respect of every TM whose trades they undertake to clear and settle. Besidesthis, trading members are required to have qualified users and sales persons,

who have passed a Certification programme approved by SEBI.

CLEARING AND SETTLEMENTS

NSCCL undertakes clearing and settlement of all deals executed on the NSEs

F&O segment. It acts as legal counterparty to all deals on the F&O segment

and guarantees settlement.

Clearing:

The first step in clearing process is working out open positions or obligations of

members. A CMs open position is arrived at by aggregating the open position of

all the TMs and all custodial participants clearing through him, in the

contracts in which they have traded. A TMs open position is arrived at as the

summation of his proprietary open position and clients open positions, in the

contracts in which they have traded. TMs are required to identify the orders,

whether proprietary (if they are their own trades) or client (if entered on behalf

of clients). Proprietary positions are calculated on net basis (buy-sell) for eachcontract. Clients positions are arrived at by summing together net (buy-sell)

positions of each individual client for each contract. A TMs open position is the

sum of proprietary open position, client open long position and client open

short position.


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Settlement:

All futures and options contracts are cash settled, i.e. through exchange of

cash. The underlying for index futures/options of the Nifty index cannot be

delivered. These contracts, therefore, have to be settled in cash. Futures and

options on individual securities can be delivered as in the spot market.

However, it has been currently mandated that stock options and futures would

also be cash settled. The settlement amount for a CM is netted across all their

TMs/clients in respect of MTM, premium and final exercise settlement. For the

purpose of settlement, all CMs are required to open a separate bank account

with NSCCL designated clearing banks for F&O segment.

INDEX DERIVATIVES

Index derivatives are derivative contracts which derive their value from anunderlying index. The two most popular index derivatives are index futures and

index options. Index derivatives have become very popular worldwide. In his

report, Dr.L.C.Gupta attributes the popularity of index derivatives to the

advantages they offer.

Institutional and large equity-holders need portfolio-hedging facility.

Indexderivatives are more suited to them and more costeffective than

derivatives based on individual stocks. Pension funds in the US are

known to use stock index futures for risk hedging purposes.

Index derivatives offer ease of use for hedging any portfolio irrespective of

its composition.

Stock index is difficult to manipulate as compared to individual stock

prices, more so in India, and the possibility of cornering is reduced. This

is partly because an individual stock has a limited supply, which can be

cornered.

Stock index, being an average, is much less volatile than individual stock

prices. This implies much lower capital adequacy and margin

requirements.

Index derivatives are cash settled, and hence do not suffer fromsettlement delays and problems related to bad delivery, forged/fake

certificates.

Requirements for an index derivatives market


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1. Index: The choice of an index is an important factor in determining the

extent to which the index derivative can be used for hedging, speculation and

arbitrage. A well diversified, liquid index ensures that hedgers and speculators

will not be vulnerable to individual or industry risk.

2. Clearing corporation settlement guarantee: The clearing corporation

eliminates counterparty risk on futures markets. The clearing corporation

interposes itself into every transaction, buying from the seller and selling to the

buyer. This insulates a participant from credit risk of another.

3.Strong surveillance mechanism: Derivatives trading brings a whole class of

leveraged positions in the economy. Hence the need to have strong surveillance

on the market both at the exchange level as well as at the regulator level.

4. Education and certification: The need for education and certification in thederivatives market can never be overemphasized. A critical element of financial

sector reforms is the development of a pool of human resources with strong

skills and expertise to provide quality intermediation to market participants.

With the entire above infrastructure in place, trading of index futures and

index options commenced at NSE in June 2000 and June 2001 respectively.

TRADING

Here, I shall take a brief look at the trading system for NSEs futures and

options market. However, the best way to get a feel of the trading system is to

actually watch the screen and observe how it operates.

Futures and options trading system

The futures & options trading system of NSE, called NEAT-F&O trading

system, provides a fully automated screen-based trading for Nifty futures &

options and stock futures & options on a nationwide basis as well as an online

monitoring and surveillance mechanism. It supports an order driven market

and provides complete transparency of trading operations. It is similar to that

of trading of equities in the cash market segment.

The software for the F&O market has been developed to facilitate efficient and

transparent trading in futures and options instruments. Keeping in view the

familiarity of trading members with the current capital market trading system,


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modifications have been performed in the existing capital market trading

system so as to make it suitable for trading futures and options.

Entities in the trading system

There are four entities in the trading system. Trading members, clearingmembers, professional clearing members and participants.

1. Trading members:Trading members are members of NSE. They can tradeeither on their own account or on behalf of their clients including participants.

The exchange assigns a Trading member ID to each trading member. Each

trading member can have more than one user. The number of users allowed for

each trading member is notified by the exchange from time to time. Each user

of a trading member must be registered with the exchange and is assigned a

unique user ID. The unique trading member ID functions as a reference for all

orders/trades of different users. This ID is common for all users of a particular

trading member. It is the responsibility of the trading

member to maintain adequate control over persons having access to the firms

User IDs.

2. Clearing members:Clearing members are members of NSCCL. They carry

out risk management activities and confirmation/inquiry of trades through the

trading system.

3. Professional clearing members: A professional clearing members is a

clearing member who is not a trading member. Typically, banks andcustodians become professional clearing members and clear and settle for their

trading members.

4. Participants: A participant is a client of trading members like financial

institutions. These clients may trade through multiple trading members but

settle through a single clearing member.

BASIS OF TRADING

The NEAT F&O system supports an order driven market, wherein orders match

automatically. Order matching is essentially on the basis of security, its price,

time and quantity. All quantity fields are in units and price in rupees. The lot

size on the futures market is for 200 Nifties. The exchange notifies the regular

lot size and tick size for each of the contracts traded on this segment from time

to time. When any order enters the trading system, it is an active order. It tries


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to find a match on the other side of the book. If it finds a match, a trade is

generated. If it does not find a match, the order becomes passive and goes and

sits in the respective outstanding order book in the system.

ORDER TYPES AND CONDITIONS

The system allows the trading members to enter orders with various conditions

attached to them as per their requirements. These conditions are broadly

divided into the following categories:

Time conditions

Price conditions

Other conditionsSeveral combinations of the above are allowed thereby providing enormous

flexibility to the users. The order types and conditions are summarized below.

Time conditions

Day order:A day order, as the name suggests is an order which is valid

for the day on which it is entered. If the order is not executed during the

day, the system cancels the order automatically at the end of the day.

Good till canceled (GTC):A GTC order remains in the system until the

user cancels it. Consequently, it spans trading days, if not traded on the

day the order is entered. The maximum number of days an order can

remain in the system is notified by the exchange from time to time after

which the order is automatically cancelled by the system. Each day

counted is a calendar day inclusive of holidays. The days counted are

inclusive of the day on which the order is placed and the order is

cancelled from the system at the end of the day of the expiry period.

Good till days/date (GTD):A GTD order allows the user to specify thenumber of days/date till which the order should stay in the system if not

executed. The maximum days allowed by the system are the same as in

GTC order. At the end of this day/date, the order is cancelled from the

system. Each day/date counted are inclusive of the day/date on which


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the order is placed and the order is cancelled from the system at the end

of the day/date of the expiry period.

Immediate or Cancel(IOC):An IOC order allows the user to buy or sell a

contract as soonas the order is released into the system, failing which

the order is cancelled from the system.Partial match is possible for the

order, and the unmatched portion of the order is cancelledimmediately.

Price condition

Stop loss:This facility allows the user to release an order into the

system, after the market price of the security reaches or crosses a

threshold price e.g. if for stoploss buy order, the trigger is 1027.00, the

limit price is 1030.00 and the market (last traded) price is 1023.00, then

this order is released into the system once the market price reaches or

exceeds 1027.00. This order is added to the regular lot book with time of

triggering as the time stamp, as a limit order of 1030.00. For the stop

loss sell order, the trigger price has to be greater than the limit price.

Other conditions

Market price:Market orders are orders for which no price is specified atthe time the order isentered (i.e. price is market price). For such orders,

the system determines the price.

Trigger price:Price at which an order gets triggered from the stoploss

book.

Limit price:Price of the orders after triggering from stoploss book.

Pro:Pro means that the orders are entered on the trading members ownaccount.

Cli:Cli means that the trading member enters the orders on behalf of a

client.


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Inquiry window

The inquiry window enables the user to view information such as Market by

Order(MBO), Market by Price(MBP), Previous Trades(PT), Outstanding

Orders(OO), Activity log(AL), Snap Quote(SQ), Order Status(OS), MarketMovement(MM), Market Inquiry(MI), Net Position, On line backup, Multiple

index inquiry, Most active security and so on. Relevant information for the

selected contract/security can be viewed. We shall look in detail at the Market

by Price (MBP) and the Market Inquiry (MI) screens.

Placing orders on the trading system

For both the futures and the options market, while entering orders on the

trading system, members are required to identify orders as being proprietary orclient orders. Proprietary orders should be identified as Pro and those of

clients should be identified as Cli. Apart from this, in the case of Cli trades,

the client account number should also be provided.

The futures market is a zero sum game i.e. the total number of long in any

contract always equals the total number of short in any contract. The total

number of outstanding contracts (long/short) at any point in time is called the

Open interest. This Open interest figure is a good indicator of the liquidity in

every contract.

Based on studies carried out in international exchanges, it is found that open

interest is maximum in near month expiry contracts.

Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination

trades. shows the spread/combination screen. This enables the user to input

two or three orders simultaneously into the market. These orders will have the

condition attached to it that unless and until the whole batch of orders finds a

counter match, they shall not be traded. This facilitates spread and

combination trading strategies with minimum price risk.

Basket trading

In order to provide a facility for easy arbitrage between futures and cash

markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket


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trading screen. This enables the generation of portfolio offline order files in the

derivatives trading system and its execution in the cash segment. A trading

member can buy or sell a portfolio through a single order, once he determines

its size. The system automatically works out the quantity of each security to be

bought or sold in proportion to their weights in the portfolio.

Futures and options market instruments

The F&O segment of NSE provides trading facilities for the following derivative

instruments:

1. Index based futures

2. Index based options

3. Individual stock options

4. Individual stock futures

Contract specifications for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-

month expiry cycles. All contracts expire on the last Thursday of every month.

Thus a January expiration contract would expire on the last Thursday of

January and a February expiry contract would cease trading on the last

Thursday of February. On the Friday following the last Thursday, a new

contract having a three-month expiry would be introduced for trading.

Depending on the time period for which you want to take an exposure in

index futures contracts, you can place buy and sell orders in the respectivecontracts.

The Instrument type refers to Futures contract on index and Contract symbol

- NIFTY denotes a Futures contract on Nifty index and the Expiry date

represents the last date on which the contract will be available for trading.

Each futures contract has a separate limit order book. All passive orders are

stacked in the system in terms of price-time priority and trades take place at

the passive order price (similar to the existing capital market trading system).

The best buy order for a given futures contract will be the order to buy the

index at the highest index level whereas the best sell order will be the order tosell the index at the lowest index level.

Trading is for a minimum lot size of 200 units. Thus if the index level is around

1000, then the appropriate value of a single index futures contract would be

Rs.200,000. The minimum tick size for an index future contract is 0.05 units.

Thus a single move in the index value would imply a resultant gain or loss of

Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units.


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Contract specification for index options

On NSEs index options market, contracts at different strikes, having one-

month, two-month and three-month expiry cycles are available for trading.

There are typically one-month, two-month and three-month options, each withfive different strikes available for trading.

Contract specifications for stock options

Trading in stock options commenced on the NSE from July 2001. These

contracts are American style and are settled in cash. The expiration cycle for

stock options is the same as for index futures and index options. A new

contract is introduced on the trading day following the expiry of the near

month contract. NSE provides a minimum of five strike prices for every option

type (i.e. call and put) during the trading month. There are at least two inthe

money contracts, two outof themoney contracts and one atthemoney

contract available for trading.

Charges

The maximum brokerage chargeable by a TM in relation to trades effected in

the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5%

of the contract value in case of index futures and 2.5% of notional value of the

contract[(Strike price + Premium) * Quantity] in case of index options, exclusive

of statutory levies. The transaction charges payable by a TM for the trades

executed by him on the F&O segment are fixed at Rs.2 per lakh of turnover

(0.002%)(Each side) or Rs.1 lakh annually, whichever is higher. The TMs

contribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per

crore of turnover (0.0001%).

SEBI ADVISORY COMMITTEE ON DERIVATIVES

The SEBI Board in its meeting on June 24, 2002 considered some important

issues relating to the derivative markets which include:

Physical settlement of stock options and stock futures contracts.

Review of the eligibility criteria of stocks on which derivative products are

permitted.

Use of sub-brokers in the derivative markets.


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Norms for use of derivatives by mutual funds.

The recommendations of the Advisory Committee on Derivatives on some of

these issues were also placed before the SEBI Board. The Board desired that

these issues be reconsidered by the Advisory Committee on Derivatives (ACD)

and requested a detailed report on the aforesaid issues for the consideration of

the Board.

REGULATORY OBJECTIVES

The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of

its report.

We endorse these regulatory principles completely and base our

recommendations also on these same principles. We therefore reproduce this

paragraph of the LCGC Report:

The Committee believes that regulation should be designed to achieve specific,

Well-defined goals. It is inclined towards positive regulation designed to

encourage healthy activity and behavior. It has been guided by the following

objectives:

(a) Investor Protection: Attention needs to be given to the following four

aspects:

(i) Fairness and Transparency

(ii) Safeguard for clients moneys(iii) Competent and honest service

(b) Quality of markets: The concept of Quality of Markets goes well beyond

market integrity and aims at enhancing important market qualities, such as

cost-efficiency, price-continuity, and price-discovery. This is a much broader

objective than market integrity.

(c) Innovation: While curbing any undesirable tendencies, the regulatory

framework should not stifle innovation which is the source of all economic

progress, more so because financial derivatives represent a new rapidly

developing area, aided by advancements in information technology.


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Chapter 3

Introduction to

Futures andOptions


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INTRODUCTION TO FUTURES AND

OPTIONS

In recent years, derivatives have become increasingly important in the field of

finance. While futures and options are now actively traded on many exchanges,

forward contracts are popular on the OTC market. In this chapter we shall

study in detail these three derivative contracts.

FORWARD CONTRACT

A forward contract is an agreement to buy or sell an asset on a specified date

for a specified price. One of the parties to the contract assumes a long position

and agrees to buy the underlying asset on a certain specified future date for a

certain specified price. The other party assumes a short position and agrees to

sell the asset on the same date for the same price. Other contract details like

delivery date, price and quantity are negotiated bilaterally by the parties to the

contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are:

They are bilateral contracts and hence exposed to counterparty risk.

Each contract is custom designed, and hence is unique in terms ofcontract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to

the same counterparty, which often results in high prices being charged.

Forward contracts are very useful in hedging and speculation. The classic

hedging application would be that of an exporter who expects to receive

payment in dollars three months later. He is exposed to the risk of exchangerate fluctuations.

Limitations of forward markets

Forward markets world-wide are afflicted by several problems:

Lack of centralization of trading,


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Illiquidity, and

Counterparty risk

FUTURE CONTRACT

Futures markets were designed to solve the problems that exist in forwardmarkets. A futures contract is an agreement between two parties to buy or sell

an asset at a certain time in the future at a certain price. But unlike forward

contracts, the futures contracts are standardized and exchange traded. In

simple words, Futures are exchange-traded contracts to buy or sell an asset in

future at a price agreed upon today. The asset can be share, index, interest

rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton, coffee

etc.

To facilitate liquidity in the futures contracts, the exchange specifies certainstandard features of the contract. It is a standardized contract with standard

underlying instrument, a standard quantity and quality of the underlying

instrument that can be delivered, (or which can be used for reference purposes

in settlement) and a standard timing of such settlement.

A futures contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of futures transactions are offset this

way.

The standardized items in a futures contract are:

Quantity of the underlying asset

Quality of the underlying assets (not required in case of financial futures)

The date and the month of delivery

The units of price quotation (not the price)

Minimum fluctuation in price (tick size)

Location of settlement

Settlement style.

ADVANTAGES OF FUTURE TRADING IN INDIA

1. High Leverage:The primary attraction, of course, is the potential for large

profits in a short period of time. The reason that futures trading can be so

profitable is the high leverage. To own a futures contract an investor only has


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to put up a small fraction of the value of the contract (usually around 10-20%)

as margin.

2. Profit in Both Bull & Bear Markets:In futures trading, it is as easy to sell

(also referred to as going short) as it is to buy (also referred to as going long).

By choosing correctly, you can make money whether prices go up or down.

3. Lower Transaction Cost: Another advantage of futures trading is much

lower relative commissions. Your commission for trading a futures contract is

one tenth of a percent (0.10-0.20%).

4. High Liquidity: Most futures markets are very liquid, i.e. there are huge

amounts of contracts traded every day. This ensures that market orders can be

placed very quickly as there are always buyers and sellers for most contracts.

USING FUTURES ON INDIVIDUAL SECURUTIES

Index futures began trading in India in June 2000. A year later, options on

index were available for trading. July 2001 saw the launch of options on

individual securities (herein referred to as stock options) and the onset of

rolling settlement. With the launch of futures on individual securities (herein

referred to as stock futures) on the 9th of November, 2001, the basic range of

equity derivative products in India seems complete. Of the above mentioned

products, stock futures are particularly appealing due to familiarity and ease in

understanding. A purchase or sale of futures on a security gives the traderessentially the same price exposure as a purchase or sale of the security itself.

In this regard, trading stock futures is no different from trading the security

itself. Besides speculation, stock futures can be effectively used for hedging

and arbitrage reasons.

DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT

Forward contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic functions ofallocating risk in the presence of future price uncertainty. However futures are

a significant improvement over the forward contracts. A future contract is

nothing but a form of forward contract. One can differentiate a forward

contract from a future contract on the following lines:


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Customized vs Standardized: Forward contracts are customized whilefuture contracts are standardized. Terms of forward contracts are

negotiated between the buyer and the seller. While the terms of future

contracts are decided by the exchange on which these are traded.

Counter Party Risk: In forward contracts there is a risk of counterparty default. In case of futures, the exchange becomes counter party to

each trade and guarantees settlement.

Liquidity: Futures are much more liquid and their price is transparentas their price and volume are reported in media. But this is not so in the

case of forward contract.

Squaring off: A forward contract can be reversed with only the samecounter party with whom it was entered into. A future contract can be

reversed on the screen of the exchange as the latter is the counter party

to all futures trades.

THEORETICAL WAY OF PRICING FUTURES

The theoretical price of a futures contract is spot price of the underlying plus

the cost of carry. Please note that futures are not about predicting future prices

of the underlying assets.

In general, Futures Price = Spot Price + Cost of Carry

The Cost of Carry is the sum of all costs incurred if a similar position is taken

in cash market and carried to expiry of the futures contract less any revenue

that may arise out of holding the asset. The cost typically includes interest cost

in case of financial futures (insurance and storage costs are also considered in

case of commodity futures). Revenue may be in the form of dividend.

Though one can calculate the theoretical price, the actual price may varydepending upon the demand and supply of the underlying asset.

FUTURES TERMINOLOGIES

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-months and three-

month expiry cycles which expire on the last Thursday of the month.

Thus a January expiration contract expires on the last Thursday of

January and a February expiration contract ceases trading on the last

Thursday of February. On the Friday following the last Thursday, a new

contract having a three-month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the

last day on which the contract will be traded, at the end of which it will

cease to exist.

Contract size: The amount of asset that has to be delivered less than

one contract. For instance, the contract size on NSEs futures market is

200 Nifties.

Basis: In the context of financial futures, basis can be defined as the

futures price minus the spot price. There will be a different basis for each

delivery month for each contract. In a normal market, basis will be

positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices

can be summarized in terms of what is known as the cost of carry. This

measures the storage cost plus the interest that is paid to finance the

asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin

account at the time a futures contract is first entered into is known as

initial margin.

Marking-to-market: In the futures market, at the end of each trading

day, the margin account is adjusted to reflect the investors gain or loss

depending upon the futures closing price. This is called markingto

market.


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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.

OPTIONS

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 upfront payment.

OPTIONS TERMINOLOGIES

Index options: These options have the index as the underlying. Some

options are European while others are American. Like indexing futures

contracts, indexing options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options

currently trade on over 500 stocks in the United States. A contract givesthe holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying

the option premium buys the right but not the obligation to exercise his

option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who

receives the option premium and is thereby obliged to sell/buy the asset

if the buyer exercises on him. There are two basic types of options, call

options and put options.

Call option: A call option gives the holder the right but not the

obligation to buy an asset by a certain date for a certain price.


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Put option: A put option gives the holder the right but not the

obligation to sell an asset by a certain date for a certain price.

Option price: Option price is the price, which the option buyer pays to

the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as

the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the

strike price or the exercise price.

American options: American options are options that can be exercised

at any time upto the expiration date. Most exchange-traded options are

American.

European options: European options are options that can be exercised

only on the expiration date itself. European options are easier to

analyze than American options, and properties of an American option

are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that

would lead to a positive cash flow to the holder if it were exercised

immediately. A call option on the index is said to be in-the-money when

the current index stands at a level higher than the strike price (i.e. spotprice > strike price). If the index is much higher than the strike price,

the call is said to be deep ITM. In the case of a put, the put is ITM if the

index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that

would lead to zero cash flow if it were exercised immediately. An option

on the index is at-the-money when the current index equals the strike

price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an

option that would lead to 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


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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.

Time value of an option: The time value of an option is the difference

between its premium and its intrinsic value. Both calls and puts have

time value. An option that is OTM or ATM has only time value. Usually,

the maximum time value exists when the option is ATM. The longer the

time to expiration, the greater is an options time value, all else equal.

At expiration, an option should have no time value.

TYPES OF OPTIONS

1. Call Options-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 theobligation to sell the underlying asset if the buyer of the call option decides to

exercise his option to buy.

Example: An investor buys One European call option on Infosys at the strike

price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the

day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike

Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor

will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in

the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) -

Premium}.

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say

suppose it touches Rs. 3000, the buyer of the call option will choose not to

exercise his option. In this case the investor loses the premium (Rs 100), paid

which should be the profit earned by the seller of the call option.

2.Put Options-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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Example: An investor buys one European Put option on Reliance at the strike

price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance,

on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in

the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium

paid) i.e., investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys

Reliance share in the market @ Rs. 260/- & exercises his option selling the

Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15

{(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Reliance is Rs 320/

-, 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. In this case the investor loses the

premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of thePut option. (Please see table)

THE OPTIONS GAME

Call Option Put Option

1.Option

buyer oroption holder

Buys the right to

buy the underlyingasset at the

specified price

Buys the right to sell

the underlying assetat the specified price

2. Option

seller or

option writer

Has the obligation to

sell the underlying

asset (to the option

holder) at the

specified price

Has the obligation to

buy the underlying

asset (from the

option holder) at the

specified price

LEVERAGE AND RISK


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Options can provide leverage. This means an option buyer can pay a

relatively small premium for market exposure in relation to the contract value

(usually 100 shares of underlying stock). An investor can see large percentage

gains from comparatively small, favorable percentage moves in the underlying

index. Leverage also has downside implications. If the underlying stock price

does not rise or fall as anticipated during the lifetime of the option, leverage

can magnify the investment's percentage loss. Options offer their owners a

predetermined, set risk. However, if the owner's options expire with no value,

this loss can be the entire amount of the premium paid for the option. An

uncovered option writer, on the other hand, may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money

An option is said to be at-the-money, when the option's strike price is equal to

the underlying asset price. This is true for both puts and calls.

A call option is said to be in-the-moneywhen the strike price of the option is

less than the underlying asset price.For example, a Sensex call option with

strike of 3900 is in-the-money, when the spot Sensex is at 4100 as the call

option has value.The call holder has the right to buy a Sensex at 3900, no

matter how much the spot market price has risen. And with the current price

at 4100, a profit can be made by selling Sensex at this higher price.

On the other hand, a call option is out-of-the-moneywhen the strike price is

greater than the underlying asset price. Using the earlier example of Sensexcall option, if the Sensex falls to 3700, the call option no longer has positive

exercise value. The call holder will not exercise the option to buy Sensex at

3900 when the current price is at 3700. (Please see table)

Striking the price


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Call Option Put Option

1.In-the-money Strike Price less than

Spot Price ofunderlying asset

Strike Price greater

than Spot Price ofunderlying asset

2. At-the-money Strike Price equal to

Spot Price of

underlying asset

Strike Price equal to

Spot Price of

underlying asset

3. Out-of-the-

money

Strike Price greater

than Spot Price of

underlying asset

Strike Price less than

Spot Price of

underlying asset

A put option is in-the-money when the strike price of the option is

greater than the spot price of the underlying asset. For example, a

Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100.

When this is the case, the put option has value because the put holdercan sell the Sensex at 4400, an amount greater than the current Sensex

of 4100.

Likewise, a put option is out-of-the-money when the strike price is

less than the spot price of underlying asset. In the above example, the

buyer of Sensex put option won't exercise the option when the spot is at

4800. The put no longer has positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if the

exercise price is at significant variance with the underlying asset price.

The amount by which an option, call or put, is in-the-money at any given

moment is called its intrinsic value. Thus, by definition, an at-the-money or

out-of-the-money option has no intrinsic value;

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