1

A STUDY ON

A STUDY ON DERIVATIVES & TRADING AT IL & FS INVEST SMART LIMITED

PROJECT REPORT
(A Report Submitted in Partial Fulfillment of the Requirement for the Degree of Master of Business Administration in Pondicherry University) Submitted by Mr. RANJITH V R Enrollment No: 2007372113 MBA: FINANCE

DIRECTORATE OF DISTANCE EDUCATION PONDICHERRY UNIVERSITY PONDICHERRY 605 014 (2007-2009)

CERTIFICATE OF THE GUIDE

This is to certify that the Project Work title A STUDY ON DERIVATIVES AND TRADING AT IL & FS INVEST SMART LIMITED with regards to AVIVA Life Insurance is a bonafide work of Mr RANJITH V R, Enroll No: 2007372113 Carried out in partial fulfillment for the award of degree of MBA: Finance (Branch) of Pondicherry University under my guidance. This Project work is original and not submitted earlier for the award of any degree/ diploma or associateship of any other University / Institution.
Signature of the Guide Name and Official Address of the Guide Guides Academic Qualification Designation and Experience

Place: Hyderabad Date:

STUDENTS DECLARATION
I, Mr. RANJITH V R hereby declare that the Project Work titled A STUDY ON DERIVATIVES AND TRADING AT IL & FS INVEST SMART LIMITED is the original work done by me and submitted to the Pondicherry University in partial fulfillment of requirements for the award of Master of Business Administration in Finance is a record of original work done by me under the supervision of

Enroll No: 2007372113 Date:

Signature of the Student

Ranjith V R

ACKNOWLEDGEMENT

Accomplishment of any work involves many people and this project is no exception. I take this opportunity to express my heartfelt thanks to all those who have directly or indirectly contributed to make this Project a success. I am indebted to the Management of IL$FS Investsmart Ltd., for providing me the opportunity to carry out the Project work in their esteemed organization. I take this opportunity to express my heartfelt thanks to K Uma Maheshwara Rao, Branch Manager, Immanuel Issac, Assistant Manager, IL&FS Investsmart Ltd.for their cooperation and support. My special thanks to Mr. me during the preparation of this project. Project guide who guided

I would like to thank my family and friends for the help and cooperation extended in this endeavor of mine.

Chapterization
CHAPTER I INTRODUCTION A. About the Industry. B. Company Profile. D. Nature of the Problem. E. Scope of the Study. F. Objectives of the Study. G. Limitations of the Study. H. Description of the study.

CHAPTER-II: DERIVATIVES A REVIEW A. About derivatives B. Participants C. Functions of derivative market D. Types of derivatives E. Rationale behind the development of derivatives F. Method of Valuation. G. How to price and use derivative H. Derivatives Market in India.

CHAPTER-III: FUTURES /FORWARDS 5

6 A. Introduction to futures B. Introduction to forwards C. Futures Vs Forwards D. Pay- off for futures E. Futures terminology

CHAPTER- IV: OPTIONS/SWAPS A. Introduction to options B. Parties in Option contract C. Types of options D. Pay-off for options E. Options terminology

CHAPTER-V: ANALYSIS CHAPTER-VI: FINDINGS & CONCLUSIONS

CHAPTER-VII: BIBLIOGRAPHY

INTRODUCTION

ABOUT THE INDUSTRY "Emerge as the premier Indian stock exchange by establishing global benchmarks. Bombay Stock Exchange
7

Limited (the Exchange) is the oldest stock exchange in Asia with a rich heritage. Popularly known as "BSE", it was established as "The Native Share & Stock Brokers Association" in 1875. It is the first stock exchange in the country to obtain permanent recognition in 1956 from the Government of India under the Securities Contract (Regulation) Act, 1956.The Exchange's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized and its index, SENSEX, is tracked worldwide. Earlier an Association of Persons (AOP), the Exchange is now a demutualised and corporatised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI).Bombay Stock Exchange Limited received its Certificate of Incorporation on 8th August, 2005 and Certificate of Commencement of Business on 12th August, 2005. The 'Due Date' for taking over the business and operations of the BSE, by the Exchange was fixed for 19th August, 2005, under the Scheme.

With demutualization, the trading rights and ownership rights have been de-linked effectively addressing concerns regarding perceived and real conflicts of interest. The Exchange is professionally managed under the overall direction of the Board of
8

Directors.

The

Board

comprises

eminent

professionals,

representatives of Trading Members and the Managing Director of the Exchange. The Board is inclusive and is designed to benefit from the participation of market intermediaries.

In terms of organization structure, the Board formulates larger policy issues and exercises over-all control. The committees constituted by the Board are broad-based. The day-to-day operations of the Exchange are managed by the Managing Director & CEO and a management team of professionals. and enhance transparency in operations. During the year 2004-2005, the trading volumes on the Exchange showed robust growth.

The Exchange provides an efficient and transparent market for trading in equity, debt instruments and derivatives. The BSE's On Line Trading System (BOLT) is a proprietory system of the Exchange and is BS 7799-2-2002 certified. The surveillance and clearing & settlement functions of the Exchange are ISO 9001:2000 certified.
9

10

The Stock Exchange, Mumbai, is now Bombay Stock Exchange Limited. The Exchange has a new name, and an entirely new perspective. A perspective born out of corporatisation and demutualisation. Bombay Stock Exchange Limited is Asias oldest stock exchange. It carries within itself the depth of knowledge of capital markets acquired since its inception in 1875. Located in Mumbai, the financial capital of India, it has been the backbone of the countrys capital markets.

About the Bombay Stock Exchange :

As the first stock exchange in India, the Bombay Stock Exchange is considered to have played a very important role in the development of the country's capital markets. The Bombay Stock Exchange is the largest of 22 exchanges in India, with over 6,000 listed companies. It is also the fifth largest exchange in the world, with market capitalization of $466 billion. The Bombay Stock Exchange is also actively involved with the development of the retail debt market. The debt market in India is
10

11

considered extremely important, as the country continues to develop and depends on this type of investment for growth. Until recently, the debt market in India was limited to a wholesale market, with banks and financial institutions as the only participants.
Bombay Stock Exchange Profile :

Address Telephone Web Site Trading Hours Holidays

Phiroze Jeejeebhoy Towers, Dalal Street, Mumbai 400001 91-22-22721233/4 Click here for the Bombay Stock Exchange web site Monday - Friday, 9:55 am - 3:30 pm IST Bakri-Id, Republic Day, Good Friday, Ambedkar Jayanti, Independence Day, Ganesh Chaturthi, Dasera, Diwali (Laxmi Poojan), Diwali (Bhaubeej), Ramzan Id, Guru Nanak Jayanti.

Securities

Stocks, bonds, derivatives

Trading System Electronic

About The National Stock Exchange :

National Stock Exchange of India (NSE) is India's largest Stock Exchange & World's third largest Stock Exchange in terms of transactions. Located in Mumbai, NSE was promoted by
11

12

leading Financial Institutions at the behest of the Government of India, and was incorporated in November 1992 as a tax-paying company. In April 1993, NSE was recognized as a Stock exchange under the Securities Contracts (Regulation) Act-1956. NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. Capital Market (Equities) segment of the NSE commenced operations in November 1994, while operations in the Derivatives segment commenced in June 2000. NSE has played a catalytic role in reforming Indian securities market in terms of microstructure, market practices and trading volumes

NSE was set up with the objectives of:

Establishing nationwide trading facility for all types of securities Ensuring equal access to investors all over the country through an appropriate telecommunication network Providing fair, efficient & transparent securities market using electronic trading system Enabling shorter settlement cycles and book entry settlements Meeting International benchmarks and standards Within a very short span of time, NSE has been able to achieve its
12

13

objectives for which it was set up. Indian Capital Markets are a far cry from what they were 12 years back in terms of market practices, infrastructure, technology, risk management, clearing and settlement and investor service.

NSE's markets:

NSE provides a fully automated screen-based trading system with national reach in the following major market segments: Equity OR Capital Markets {NSE's market share is over 65%} Futures & Options OR Derivatives Market {NSE's market share over 99.5%} Wholesale Debt Market (WDM) Mutual Funds (MF) Initial Public Offerings (IPO)

NSE Mission

NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of: establishing a nation-wide trading facility for equities, debt instruments and hybrids, ensuring equal access to investors all over the country
13

14

through an appropriate communication network, providing a fair, efficient and transparent securities market to investors using electronic trading systems, enabling shorter settlement cycles and book entry settlements systems, and meeting the current international standards of securities markets. The standards set by NSE in terms of market practices and technology have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It's that force which is guiding the industry towards new horizons and greater opportunities.

About the National Stock Exchange of India :

In the fast growing Indian financial market, there are 23 stock exchanges trading securities. The National Stock Exchange of India (NSE) situated in Mumbai - is the largest and most advanced exchange with 1016 companies listed and 726 trading members.The NSE is owned by the group of leading financial institutions such as Indian Bank or Life Insurance Corporation of India. However, in the totally de-mutualised Exchange, the ownership as well as the management does not have a right to trade on the Exchange. Only qualified traders can be involved in
14

15

the securities trading. The NSE is one of the few exchanges in the world trading all types of securities on a single platform, which is divided into three segments: Wholesale Debt Market (WDM), Capital Market (CM), and Futures & Options (F&O) Market. Each segment has experienced a significant growth throughout a few years of their launch. While the WDM segment has accumulated the annual growth of over 36% since its opening in 1994, the CM segment has increased by even 61% during the same period. The National Stock Exchange of India Ltd. provides its clients with a single, fully electronic trading platform that is operated through a VSAT network. Unlike most world exchanges, the NSE uses the satellite communication system that connects traders from 345 Indian cities. The advanced technologies enable up to 6 million trades to be operated daily on the NSE. Trading platform
History of the National Stock Exchange of India :

Three segments of the NSE trading platform were established one after another. The Wholesale Debt Market (WDM) commenced operations in June 1994 and the Capital Market (CM) segment was opened at the end of 1994. In 1996, the National Stock Exchange of India launched S&P CNX Nifty and CNX Junior Indices that make up 100 most liquid stocks in India.
15

16

COMPANY PROFILE

INTRODUCTION TO IL&FS INVESTMART LIMITED

Established in 1997. IL&FS Investsmart has a network of 300 offices across the country, employing 2000 people. It has 1, 50,000 equity and over 10,000 commodity customers and 130 institutional clients. It provides investment products to retail and institutional clients including Equity , Investment banking, Insurance broking and distribution, Mutual funds distribution and related financing services.
OUR DIVISIONS: The Investment Advisory and Broking Division Merchant Banking Division The Project Syndication Division Institutional Equity Broking Division Institutional Debt Broking division OUR RETAIL OFFERINGS: Wealth Management Services
16

17

Portfolio Management Services Securities Broking-Equities and Derivates Depository & Custodial Service & Distribution of financial products. INSTITUTIONAL OFFERINGS: Merchant Banking Product Syndication Institutional Equity & Debt Broking and Sales OUR TEAM

IL&FS Invests marts main strength lies in its formidable team. This team comprising highly qualified and experienced personnel has been responsible for the overall management of the company and has provided direction in diverse areas of business strategy, operating management, regulatory reporting, human resources development and product development No wonder then, IL&FS Investsmart currently caters to more than 53,000 retail customers through 54 locations encompassing around 16 Indian states. Our network involves 29 branches Spread across 16 cities and franchisees across the rest of the country. It is our Endeavour to spread our services to maximum number of Indian locations in the near future.

MISSION:
17

18

IL&FS Investsmart Limited promoted by IL&FS is a Premier financial Service organization providing individuals and Corporates with Customized financial management solutions. From understanding our Clients financial goals be it individuals or institutions to attaining Them has been our mission. And it has been successful given our Institutional expertise, combined with a thorough understanding of the Financial markets. IL&FS Investsmart is listed on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) and its global depository shares are listed on the Luxembourg Stock Exchange.

Future prospectus:

London-based HSBC Holdings Plc. is the world's largest company and the world's largest banking group, as calculated based on different metrics by the annual Forbes list of the world's largest firms published on April 2, 2008. According to Forbes magazine,
18

19

The world's largest bank (based on a composite score) is currently the fourth largest bank in the world in terms of assets ($2,348.98 billion), The second largest in terms of sales ($146.50 billion), the largest in terms of market value ($180.81 billion), and the most profitable bank in the world with $19.13 billion in net income last year (compared to Citigroup's $3.62 billion in the same period) as on April 2, 2008. HSBC, well-known in banking circles for its diversified and riskaverse approach in its business operations, was named the world's most valuable banking brand by The Banker magazine in February 2008. HSBC, via its subsidiaries, will acquire 43.85 percent from E*Trade Mauritius Limited, a unit of US online brokerage firm E*Trade Financial Corporation and 29.36 percent from Infrastructure Leasing and Financial Services (IL&FS) for $241.6 million or at Rs.200 per share The acquisition, which will be made 100 percent in cash, will help HSBC, which currently has 47 branches in India and is present in 26 locations, tap India's booming economy and expand its retail reach by gaining a foothold in one of the largest retail broking markets in the world
19

20

Among others in the fray to acquire Investsmart were the Aditya Birla Group, India bulls and Religare Securities.

Associate Companies

IL&FS Investsmart Limited IL&FS Investsmart Securities Limited IL&FS Investsmart Insurance & Risk Management Services Limited IL&FS Academy for Insurance & Finance Limited IL&FS Investsmart Asia-Pacific Pvt. Limited IL&FS Investment Financial Services Limited

20

21

NATURE OF THE PROBLEM The turnover of the stock exchange has been tremendously increasing from last 10 years at the sametime fluctuations in prices with high volatility also increased. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margin system, unclear expire date and generating counter party risk. In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading, as a first step it
21

22

has set up a 24 member committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate framework for derivatives trading in India, SEBI accepted the recommendation of the committee on may 11, 1998 and approved the phase introduction of the derivatives trading beginning with stock index futures. There are many investors who are willing to trade in the derivatives segment, because of its advantages like limited loss unlimited profit by paying the small premiums. SCOPE OF THE STUDY The study is mainly focuses on Derivatives and trading with special reference to futures and option in the Indian context and its history and latest developments in the country in Stock Exchange. India Infoline Ltd., has been taken as a representative sample for the study. The study cant be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluation of derivatives market only in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, CBOT etc. The study also keeps a birds eye view on global Stock Exchange and its development.
22

23

OBJECTIVES OF THE STUDY To analyze the derivatives market in India. To analyze the operations of futures and options. To find the profit/loss position of futures buyer and seller and To study about risk management with the help of derivatives. Former Federal Reserve Board chairman Alan Greenspan

also the option writer and option holder.

commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century

23

24

LIMITATIONS OF THE STUDY The following are the limitation of this study. The scrip chosen for analysis is BHARTI AIRTEL and the The data collected is completely restricted to the BHARTI contract taken is February 2008 ending one -month contract. universal. AIRTEL of February 2008; hence this analysis cannot be taken

DESCRIPTION OF THE METHOD The following are the steps involved in the study.

24

25

1. Selection of the scrip: - The scrip selection is done on a random and the scrip selected is BHARTI AIRTEL. The lot size is 500. Profitability position of the futures buyer and seller and also the option holder and option writer is studied. 2. Data Collection: - The data of the Bharti Airtel has been collected from the the Economic times and the Internet. The period of data collection is from 29th JAN 2008-22nd FEB 2008. 3. Analysis: -The analysis consists of the tabulation of the data assessing the profitability positions of the futures buyer and seller and also option holder and option writer, representing the data with graphs and making the interpretation using data.

25

26

DERIVATIVES A REVIEW

26

27

ABOUT DERIVATIVES

Derivatives are financial instruments whose values change in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps. The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) see inflation derivatives or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.

27

28

The emergence of the market for derivatives products, most notably forwards, futures and options, can be tracked back to the willingness of risk-averse economic 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 locking-in 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 product minimizes the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc., Banks, Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future

28

29

DEFINITIONS Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. 1) Securities Contracts (Regulation) Act, 1956 (SCR Act) defines derivative to secured or unsecured, risk instrument or contract for differences or any other form of security. 2) 3) A contract which derives its value from the prices, or A financial contract whose value is derived from the index of prices, of underlying securities. performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

29

30

PARTICIPANTS:

The following three broad categories of participants in the derivatives market.

HEDGERS:

Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.
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,

30

31

they can increase both the speculative venture.

potential gains and potential losses in a

ARBITRAGERS:

Arbitragers are in business to take 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 position in the two markets to lock in a profit.

FUNCTION OF DERIVATIVES MARKETS:

The following are the various functions that are performed by the derivatives markets. They are: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the price of underlying to the perceived future level. Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Derivatives trading acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase saving and investment in long run.

Derivatives traded on exchanges are liquid and involves the lowest transaction costs.
31

possible

32

Derivatives can be closely matched with specific portfolio requirement

Derivatives maintain a close relationship between their values and the values of underlying assets; the change in values of underlying assets will have effect on values of derivatives based on them.
.

TYPES OF DERIVATIVES: The following are the various types of derivatives. They are:
FORWARDS:

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays preagreed price.

FUTURES:

A futures contract is an agreement between two parties to buy or sell an asset in a certain time at a certain price, they are standardized and traded on exchange.
32

33

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 traded over-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.

33

34

SWAPS:

Swaps are private agreements between two parties to exchange cash floes in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used Swaps are: Interest rate Swaps: These entail swapping only the related cash flows between the parties in the same currency. Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in on direction being in a different currency than those in the opposite direction.

SWAPTION:

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.
34

35

RATIONALE BEHIND THE DEVLOPMENT OF DERIVATIVES:

Holding portfolios of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser than what he expected to get. There are various factors, which affect the returns: 1. 2. Price or dividend (interest) Some are internal to the firm likea. Industrial policy b. Management capabilities c. Consumers preference d. Labour strike, etc. These forces are to a large extent controllable and are termed as non systematic risks. An investor can easily manage such non-systematic by having a well-diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other. There are yet other of influence which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are:
35

36

1. Economic 2. Political 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all-individual stocks to move together in the same manner. We therefore quite often find stock prices falling from time to time in spite of companys earning rising and vice versa. Rational Behind the development of derivatives market is to manage this systematic risk, liquidity in the sense of being able to buy and sell relatively large amounts quickly without substantial price concession. In debt market, a large position of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small size relative to many common stocks.

REGULATORY FRAMEWORK:

The trading of derivatives is governed by the provisions contained in the SC R A, the SEBI Act, and the regulations framed there under the rules and byelaws of stock exchanges.

36

37

Regulation for Derivative Trading: SEBI set up a 24 member committed under Chairmanship of Dr. L. C. Gupta develop the appropriate regulatory framework for derivative trading in India. The committee submitted its report in March,1998.On May11,1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index Futures. SEBI also approved he suggestive bye-laws recommended by the committee for regulation and control of trading and settlement of Derivative contract. The provision in the SCR Act governs the trading in the securities. The amendment of the SCR Act to include DERIVATIVES within the ambit of securities in the SCR Act made trading in Derivatives possible with in the framework of the Act. 1. Eligibility criteria as prescribed in the L. C. Gupta committee report may apply to SEBI for grant of recognition under section 4 of the SCR Act, 1956 to start Derivatives Trading. 2. The exchange shall have minimum 50 members.

37

38

3.

The members of an existing segment of the exchange will not

automatically become the members of the derivatives segment. The members of the derivatives segment need to fulfill the eligibility conditions as lay down by the L. C. Gupta committee. 4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/clearinghouse. It complying with the eligibility conditions as lay down by the committee has to apply to SEBI for grant of approval. 5. Derivatives broker/dealers and Clearing members are required to seek registration from SEBI. 6. The Minimum contract value shall not be less than Rs.2 Lakh. Exchange should also submit details of the futures contract they purpose to introduce.

38

39

Method of Valuation Total world derivatives from 1998-2007 compared to total world wealth in the year 2000

Market and arbitrage-free prices Two common measures of value are:

Market price, i.e. the price at which traders are willing to buy or sell the contract Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing

Determining the market price For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading are handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

39

40

Determining the arbitrage-free price The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black Scholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.

40

41

Total world derivatives from 1998-2007 compared to total world wealth in the year 2000

41

42

How to price derivatives: the Black-Scholes Model Derivatives are actually easy to understand and use, thanks to two men: Fischer Black and Myron Scholes. Together, these two developed the Black-Scholes Model back in 1973 - a mathematical model that allows investors to determine derivatives prices. With regard to options, the Black-Scholes Model allows you to determine how much an option is worth by plugging numbers into a formula that asks for specific inputs common to all derivatives. Among these factors are: The price of underlying asset-i.e. the stock price. The amount of time until expiration. The strike price of the option. The volatility of the underlying asset (how much it moves up or down in a given period)

42

43

The risk-free rate of return. This is usually the interest rate paid by the government or a bank on guaranteed investments like Treasury notes. Once these factors are entered into the model, it spits out a price that gives you the fair value of the derivative. Black and Scholes won the Noble Prize for developing this model, and it's still widely used today as the guide by which options are priced.

How to use derivatives

Since derivatives allow you to control the underlying asset - either with the right to buy or sell it - you're implying that you can fulfill the transaction in the event that you have to buy or sell the asset. That means that with trillions of dollars worth of assets changing hands in today's marketplace, traders can get into trouble if they don't know what they're doing.

43

44

In most cases, however, investors use derivatives as a trading vehicle to capture the profits from the movement of the underlying investment. Because of this, derivatives are often referred to as leveraged investment. And, whenever leverage is employed, the results can be magnified - both up and down. If an investor decides not close the trade and instead keeps the derivative until expiration, there can be two outcomes: If the underlying investment doesn't meet the parameters set for the derivative, then the option is worthless at expiration. For example: If you buy an option allowing you to purchase underlying shares at $25, but the shares close at $24. In this case, you'd let the option expire - you wouldn't exercise your right to buy a stock at $25 if you could buy it on the open market for $24. Alternatively, you may actually be obligated to buy or sell the underlying security based on the position you've taken. For example: If you sold an option that obligated you to buy shares at $25, but by expiration, shares are trading at $23, then you are obligated to buy the shares at $25 and deliver them to whomever bought the option from you.

44

45

Derivatives Market in India The most notable development concerning the secondary segment of the Indian capital market is the introduction of derivatives trading in June 2000. SEBI approved derivatives trading based on Futures Contracts at both BSE and NSE in accordance with the rules/by laws and regulations of the Stock Exchanges. A beginning with equity derivatives has been made with the introduction of stock index futures by BSE and NSE. Stock Index Futures contract allows for the buying and selling of the particular stock index for a specified price at a specified future date. Stock Index Futures, inter alia, help in overcoming the problem of asymmetries in information. Information asymmetry is mainly a problem inindividual stocks as it is unlikely that a trader has market-wide private information. As such,the asymmetric information component is not likely to be present in a basket of stocks. This provides another rationale for trading in Stock Index Futures. Trading in index derivativesinvolves low transaction cost in comparison with trading in underlying individual stocks comprising the index. While the BSE introduced Stock Index Futures for S&P CNX Nifty comprising 50 scrips. Stock Index Futures in India are available with one month, two month and three month maturities. While derivatives trading based on the Sensitive Index (Sensex) commenced at the BSE on June 9, 2000, derivatives trading based on S&P CNX Nifty commenced at the NSE on June 12, 2000. SIF is the first attempt in the development of derivatives trading.

Development of Derivative Markets in India

45

46

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades. However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Derivatives OUP Volatility is measured as the yearly standard deviation of the daily exchange rate series. Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and realtime price dissemination.

In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by
46

47

SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991. The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

47

48

FUTURES/ FARWARDS

48

49

Introduction to futures:
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.
FUTURES

Futures markets were designed to solve the problems that exist in forward markets. 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. To facilitate liquidity in the futures contracts, the exchange specifies certain standard 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.

DEFINITION: A Futures contract is an agreement between two parties to

buy or sell an asset a certain time in the future at a certain price. To

49

50

facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. The standardized items on a futures contract are:

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotations and minimum price Location of settlement

FEATURES OF FUTURES :

Futures are highly standardized. The contracting parties need to pay only margin money. Hedging of price risks. They have secondary markets to.

TYPES OF FUTURES:

On the basis of the underlying asset they derive, the financial futures are divided into two types:
50

51

Stock futures: Index futures:

PARTIES IN FUTURES CONTRACT:

There are two parties in a future contract, the buyer and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is who is SHORT on the futures contract.

INTRODUCTION TO FARWARDS A forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying
51

52

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 of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is
52

53

exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator. Limitations of forward markets Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the
53

54

deal, which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious

FUTURES VS. FARWARDS

54

55

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity as they are exchange traded. Above table lists the distinction between the two.

PAY-OFF FOR FUTURES

The pay off for the buyer and the seller of the futures of the contracts are as follows:
55

56

PAY-OFF FOR A BUYER OF FUTURES:

Profit

FP F 0 S2 FL S1

Loss

CASE 1: -The buyer bought the futures contract at (F); if the future price goes to S1 then the buyer gets the profit of (FP). CASE 2: -The buyer gets loss when the future price goes less then (F), if the future price goes to S2 then the buyer gets the loss of (FL).

PAY-OFF FOR A SELLER OF FUTURES:

56

57

Profit

FL S2 F FP Loss S1

F FUTURES PRICE

S1, S2 SETTLEMENT PRICE

CASE 1: - The seller sold the future contract at (F); if the future goes to S1 then the seller gets the profit of (FP). CASE 2: - The seller gets loss when the future price goes greater than (F); if the future price goes to S2 then the seller gets the loss of (FL).

MARGINS:

57

58

Margins are the deposits, which reduce counter party risk, arise in a futures contract. These margins are collected in order to eliminate the counter party risk. There are three types of margins:
Initial Margins:

Whenever a futures contract is signed, both buyer and seller are required to post initial margins. Both buyer and seller are required to make security deposits that are intended to guarantee that they will infact be able to fulfill their obligation. These deposits are initial margins.

Marking to market margins:

In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket
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

58

59

Pricing the Futures: The Fair value of the futures contract is derived from a model knows as the cost of carry model. This model gives the fair value of the contract.

Cost of Carry: F=S (1+r-q) t Where F- Futures price S- Spot price of the underlying r- Cost of financing q- Expected Dividend yield t - Holding Period.

Futures terminology:
Spot price:
The price at which an asset trades in the spot market.

Futures price:

The price at which the futures contract trades in the futures market.
Contract cycle:
59

60

The period over which contract trades. The index futures contracts on the NSE have one- month, two month and three-month expiry cycle, 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 specifies in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

Contract size:

The amount of asset that has to be delivered under one contract. For instance, the contract size on NSEs futures market is 100 nifties.
Basis:

In the context of financial futures, basis can be defined as the futures price minus the spot price. The 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

60

61

measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
Open Interest:

Total outstanding long or short position in the market at any specific time. As total long positions in the market would be equal to short positions, for calculation of open interest, only one side of the contract is counter.

OPTIONS/
61

62

SWAPS

INTRODUCTION TO OPTIONS:

Option is a type of contract between two persons where one grants the other the right to buy a specific asset at a specific price within a specific time period. Alternatively the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. In order to have this right. The option buyer has to pay the seller of the option premium The assets on which option can be derived are stocks, commodities, indexes etc. If the underlying asset is the financial asset, then the option
62

63

are financial option like stock options, currency options, index options etc, and if options like commodity option.
PROPERTIES OF OPTION:

Options have several unique properties that set them apart from other securities. The following are the properties of option: Limited Loss High leverages potential Limited Life

PARTIES IN AN OPTION CONTRACT: 1. Buyer of the option:

The buyer of an option is one who by paying option premium buys the right but not the obligation to exercise his option on seller/writer.
2. Writer/seller of the option:
63

64

The writer of the call /put options is the one who receives the option premium and is their by obligated to sell/buy the asset if the buyer exercises the option on him

TYPES OF OPTIONS: The options are classified into various types on the basis of various variables. The following are the various types of options.
I. On the basis of the underlying asset:

On the basis of the underlying asset the option are divided in to two types:
INDEX OPTIONS

64

65

The index options have the underlying asset as the index.

STOCK OPTIONS:

A stock option gives the buyer of the option the right to buy/sell stock at a specified price. Stock option are options on the individual stocks, there are currently more than 150 stocks, there are currently more than 150 stocks are trading in the segment.
II. On the basis of the market movements:

On the basis of the market movements the option are divided into two types. They are:
CALL OPTION:

A call option is bought by an investor when he seems that the stock price moves certain price.
PUT OPTION:

upwards. A call option gives the holder of the option

the right but not the obligation to buy an asset by a certain date for a

A put option is bought by an investor when he seems that the stock price moves downwards. A put options gives the holder of the option right but not the obligation to sell an asset by a certain date for a certain price.

65

66 III.

On the basis of exercise of option:

On the basis of the exercising of the option, the options are classified into two categories.
AMERICAN OPTION:

American options are options that can be exercised at any time up to the expiration date, all stock options at NSE are American.
EUOROPEAN OPTION:

European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options. All index options at NSE are European.

PAY-OFF FOR OPTIONS

66

67

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION: The pay-off of a buyer options depends on a spot price of an underlying asset. The following graph shows the pay-off of buyer of a call option.

Profit

ITM SR 0 SP E2 OTM S ATM E1

Loss
67

68

S - Strike price SP - Premium/ Loss E1 - Spot price 1 E2 Spot price 2 SR - profit at spot price E1 CASE 1: (Spot price > Strike price)

OTM ATM ITM

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

As the spot price (E1) of the underlying asset is more than strike price (S). The buyer gets profit of (SR), if price increases more than E1 then profit also increase more than SR. CASE 2: (Spot price < Strike price) As a spot price (E2) of the underlying asset is less than strike price (s) The buyer gets loss of (SP), if price goes down less than E2 then also his loss is limited to his premium (SP)

68

69

PAY-OFF PROFILE FOR SELLER OF A CALL OPTION:

The pay-off of seller of the call option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a call option:

Profit SR OTM E1 SP
69

S ITM ATM

E2

70

Loss

- Strike price

ITM ATM OTM

In the money At the money Out of the money

SP - Premium /profit E1 - Spot price 1 E2 - Spot price 2 SR Loss at spot price E2

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying is less than strike price (S). the seller gets the profit of (SP), if the price decreases less than E1 then also profit of the seller does not exceed (SP).
CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S) the seller gets loss of (SR), if price goes more than E2 then the loss of the seller also increase more than (SR).

70

71

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION: The pay-off of the buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of the buyer of a call option.

Profit

71

72

SP E1 ITM SR S ATM OTM E2

Loss

Strike price Premium /profit Spot price 1 Spot price 2

ITM

In the money Out of the money At the money

SP E1 E2 -

OTM ATM -

SR - Profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the profit (SR), if price decreases less than E1 then profit also increases more than (SR).
72

73

CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (s), the buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION: The pay-off of a seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option:

Profit SP E1 OTM SR Loss S Strike price Premium/ profit Spot price 1 Spot price 2
73

S ATM

ITM

E2

ITM ATM OTM -

In the money At the money Out of the money

SP E1 E2 -

74

SR -

Loss at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of (SR), if price decreases less than E1 than the loss also increases more than (SR).
CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of (SP), if price goes more than E2 than the profit of seller is limited to his premium (SP).

Factors affecting the price of an option: The following are the various factors that affect the price of an option they are: Stock price: The pay off from a call option is a amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock

74

75

price. Put options therefore become more valuable as the stock price increases and vice versa.
Strike price: In case of a call, as a strike price increases, the stock price

has to make a larger upward move for the option to go in-the-money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable.
Time to expiration: Both put and call American options become more

valuable as a time to expiration increases.

Volatility: The volatility of a stock price is measured of uncertain about

future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increase as volatility increase.

Risk-free interest rate: The put option prices decline as the risk-free rate

increases where as the prices of call always increase as the risk-free interest rate increases.
Dividends: Dividends have the effect of reducing the stock price on the

x- dividend rate. This has an negative effect on the value of call options and a positive effect on the value of put options.

Pricing the options

75

76

The black- scholes formula for the price of European calls and puts on a non-dividend paying stock are:
CALL OPTION: C = SN (D1)-Xe-r t N (D2)
PUT OPTION P = Xe-r t N (-D2)-SN (-D2) Where C = VALUE OF CALL OPTION S = SPOT PRICE OF STOCK N= NORMAL DISTRIBUTION V= VOLATILITY X = STRIKE PRICE r = ANNUAL RISK FREE RETURN t = CONTRACT CYCLE d1 = Ln (S/X) + (r+ v2/2) t

d2 = d1- v\/t

Options Terminology:
Strike price:

The price specified in the options contract is known as strike price or Exercise price.
Options premium:
76

77

Option premium is the price paid by the option buyer to the option seller.
Expiration Date:

The date specified in the options contract is known as expiration date. In-the-money option:
An In the money option is an option that would lead to positive cash inflow to the holder if it exercised immediately.

At-the-money option:
An at the money option is an option that would lead to zero cash flow if it is exercised immediately.

Out-of-the-money option:
An out-of-the-money option is an option that would lead to negative cash flow if it is exercised immediately.

Intrinsic value of money:

The intrinsic value of an option is ITM, if option is ITM. If the option is OTM, its intrinsic value is zero.

Time value of an option:

The time value of an option is the difference between its premium and its intrinsic value.

77

78

INTRODUCTION TO SWAPS In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the underlying prices. STRUCTURE; A swap is an agreement between two parties to exchange future cash flows according to a prearranged formula. They can be regarded as portfolios of forward contracts. The streams of cash flows are called legs of the swap. Usually at the time when contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as interest rate, foreign exchange rate, equity price or commodity price.
78

79

Most swaps are traded Over The Counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets, for instance Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG. David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein. The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.
The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC Derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product -- which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as: Notional outstanding in USD trillion End End 2001 20.9 18.9 10.1 5.0 End 2002 31.5 23.7 12.8 6.2 End 2003 44.7 33.4 17.4 7.9 End 2004 59.3 44.8 21.5 11.6 End 2005 81.4 74.4 25.6 15.1 End 2006 112.1 97.6 38.0 22.3
79

Currency

2000 Euro 16.6 US dollar 13.0 Japanese yen 11.1 Pound 4.0

80

sterling Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5 Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0 Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1], "OTC Derivatives Market Activity in the Second Half of 2006", BIS, [2].

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent trade body.
Example:

Take the case of a plain vanilla fixed-to-floating interest rate swap. Here party A makes periodic interest payments to party B based on a variable interest rate of LIBOR +50 basis points. Party B in turn makes periodic interest payments based on a fixed rate of 3%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR.

80

81

Valuation: The value of a swap is the net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future cash flows is equal to zero.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

assume the position with the lower present value of payments, and borrow funds equal to this present value

meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments which have a higher present value use the received payments to repay the debt on the borrowed funds
81

82

pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

TYPES OF SWAPS: Credit default swap Cross currency swap Equity swap Foreign exchange swap Constant maturity swap Yield curve Variance swap Interest rate swap Total return swap

82

83

83

84

ANALYSIS

84

85

ANALYSIS:
The objective of this analysis is to evaluate the profit/loss position futures and options. This analysis is based on sample data taken of Bharti Airtel scrip. This analysis considered the February contract of Bharti Airtel. The lot size of Bharti Airtel is 500, the time period in which this analysis done is from 29-01-2008 to 22.02.08
Date 29th Jan 31st Jan 1st Feb 2nd Feb 5th Feb 6th Feb 7th Feb 8th Feb 9th Feb 12th Feb 13th Feb 14th Feb 15th Feb 19th Feb 20th Feb 21st Feb 22nd Feb Market Price 713.25 709.25 731.55 770.60 781.25 770.50 773.80 766.80 752.80 728.80 739.60 760.90 791.75 797.60 791.40 806.30 801.95 Future Price 707.40 701.60 731.50 771.70 782.60 771.80 774.20 767.95 750.70 726.60 732.30 760.80 792.70 799.95 791.40 809.60 803.75

85

86
GRAPH ON FUTURE PRICES
820 800 780 760 740 720 700 680 660 640 29th 31st 1st Jan Jan Feb 2nd Feb 5th Feb 6th Feb 7th 8th Feb Feb 9th Feb 12th 13th 14th 15th 19th 20th 21st 22nd Feb Feb Feb Feb Feb Feb Feb Feb

VALUES

DATES

The closing price of Bharti Airtel at the end of the contract period is 801.95 and this is considered as settlement price. The following table explains the market price and premiums of calls.

The first column explains trading date Second column explains the SPOT market price in cash segment The third column explains call premium amount

on that date. 660,680,700,720,740,760,780 and 800.

86

87

Call options:
Premium 700 720 30 22 24.10 16.60 39.5 29.95 76.5 57 0 0 0 0 0 0 0 0 0 0 35.5 0 40.6 0 0 0 80 0 0 0 0 0 0 0 0 0

Date 29th Jan 31st Jan 1st Feb 2nd Feb 5th Feb 6th Feb 7th Feb 8th Feb 9th Feb 12th Feb 13th Feb 14th Feb 15th Feb 19th Feb 20th Feb 21st Feb 22nd Feb

Market Price 713.25 709.25 731.55 770.60 781.25 770.50 773.80 766.80 752.80 728.80 739.60 760.90 791.75 797.60 791.40 806.30 801.95

660 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

680 0 0 0 90.5 0 0 0 0 0 0 0 0 0 0 0 0 0

740 0 0 15.75 43.9 0 0 0 0 0 0 0 0 0 0 0 0 0

760 0 0 0 0 37.2 30.85 0 25 16.90 11 13.7 19.3 38.15 43.15 32.5 50 0

780 0 0 0 0 26.5 22.95 21.95 17 10.50 7.70 10.5 12.8 22.35 22 15.55 30.05 24.5

800 0 0 0 0 18.35 15.25 14.85 10.60 6.75 4.90 5.65 8.05 13.80 11.80 7.85 12.20 5.3

OBSERVATIONS AND FINDINGS:

CALL OPTION: BUYER PAYS OFF

87

88

As bought 1 lot of Bharti Airtel that is 500, those who buy for 700 paid 30 premium per share. Settlement price is 801.95 Formula: Pay off = spot strike 801.95-700=101.05 Because it is positive it is in the money contract hence buyer will gain. So his profit will be 101.05-30=71.05 He will get the profit of 35525 i.e. 71.05*500 SELLER PAY OFF: It is in the money for the buyer so it is out of the money for seller, hence He is in loss The loss is equal to the profit of buyer

88

89

Put options:

Date 29th Jan 31st Jan 1st Feb 2nd Feb 5th Feb 6th Feb 7th Feb 8th Feb 9th Feb 12th Feb 13th Feb 14th Feb 15th Feb 19th Feb 20th Feb 21st Feb 22nd Feb

Market Price 660 713.25 ) 0 709.25 ) 0 731.55 0 770.60 0 781.25 0 770.50 0 773.80 0 766.80 0 752.80 0 728.80 0 739.60 0 760.90 0 791.75 0 797.60 0 791.40 0 806.30 0 801.95 0

680 0 0 0 3.75 0 0 0 0 0 0 0 0 0 0 0 0 0

700 0 0 0 4.15 3.9 0 0 0 3.80 9.7 5.05 2.05 0 0 0 0 0

Premium 720 0 0 0 0 0 0 0 0 0 18 20 4.75 0 0 0 0 0

740 0 0 0 0 0 0 0 0 0 26 17 10.35 0 0 0 0 0

760 0 0 0 0 14 18.85 0 0 0 36.6 0 0 3.9 2.7 0 0 0

780 0 0 0 0 0 0 0 0 0 0 0 0 12 4.55 5.80 0 0

800 0 0 0 0 0 0 0 0 0 0 0 0 0 12.05 16.95 4.20 2.10

OBSERVATION AND FINDINGS:

PUT OPTION: BUYER PAY OFF:

Those who have purchase put option at a strike price of 700,

the premium payable is 4.15.

89

90

On the expiry date the spot market price enclosed at 801.95 4.15*500 =2075 That is total loss=2075

and the strike price is 700 so the buyer will lose only premium

SELLER PAY OFF:

As seller is entitled only for premium if he is in profit.

So his profit is only premium i.e. 4.15*500=2075

DATA OF BHARTI AIRTEL - THE FUTURES OF THE FEBRUARY MONTH

90

91

Date 29th Jan 31st Jan 1st Feb 2nd Feb 5th Feb 6th Feb 7th Feb 8th Feb 9th Feb 12th Feb 13th Feb 14th Feb 15th Feb 19th Feb 20th Feb 21st Feb 22nd Feb

Market Price 713.25 709.25 731.55 770.60 781.25 770.50 773.80 766.80 752.80 728.80 739.60 760.90 791.75 797.60 791.40 806.30 801.95

Future Price 707.40 701.60 731.50 771.70 782.60 771.80 774.20 767.95 750.70 726.60 732.30 760.80 792.70 799.95 791.40 809.60 803.75

GRAPH ON THE PRICE MOVEMENTS OF FUTURE V/S SPOT MARKET OF BHARTI AIRTEL
850 800 S 750 E U 700 L 650 A V 600
Market Price

DATES

OBSERVATIONS AND FINDINGS

price.

The future price of Bharti Airtel is moving along with the market

91

92

If the buy price of the future is less than the settlement price, If the selling price of the future is less than the settlement price,

then the buyer of a future gets profit.

then the seller incur losses.

SUMMARY

Derivates

market

is

an

innovation

to

cash

market.

Approximately its daily turnover reaches to the equal stage of cash market. The average daily turnover of the NSE derivative segments In cash market the profit/loss of the investor depend on the

market price of the underlying asset. The investor may incur huge

92

93

profits or he may incur huge loss. But in derivatives segment the investor enjoys huge profits with limited downside. In cash market the investor has to pay the total money, but in

derivatives the investor has to pay premiums or margins, which are some percentage of total money. Derivatives are mostly used for hedging purpose. In derivative segment the profit/loss of the option writer is

purely depend on the fluctuations of the underlying asset.

93

94

FINDINGS & CONCLUSIONS

FINDINGS; The derivative market is newly started in India and it is not

known by every investor, so SEBI has to take steps to create awareness among the investors about the derivative segment.

94

95

In order to increase the derivatives market in India, SEBI should

revise some of their regulations like contract size, participation of FII in the derivatives market. Contract size should be minimized because small investors

cannot afford this much of huge premiums. SEBI has to take further steps in the risk management

mechanism. SEBI has to take measures to use effectively the derivatives

segment as a tool of hedging

CONCLUSIONS:
95

96

In bullish market the call option writer incurs more losses so the

investor is suggested to go for a call option to hold, where as the put option holder suffers in a bullish market, so he is suggested to write a put option. In bearish market the call option holder will incur more losses so

the investor is suggested to go for a call option to write, where as the put option writer will get more losses, so he is suggested to hold a put option. In the above analysis the market price of Bharti Airtel is having low volatility, so the call option writers enjoy more profits to holders.

96

97

BIBLIOGRAPHY

97

98

BIBLIOGRAPHY

WEBSITES

www.derivativesindia.com www.pcssecurities.co.in www.nseindia.com www.bseindia.com www.capitalmarket.com www.icicidirect.com www.kotaksecurities.com www.indiainfoline.com

TOMS:

Derivatives Core Module Workbook NCFM material Financial Markets and Services Gordan and Natrajan Financial Management Prasanna Chandra Financial Management Ravi M. Kishore Institute of costs and works accountants of India.

98

99

NEWSPAPER

Economic times of India Business world Business standards The financial express

99