UNIVERSITY OF MUMBAI PROJECT ON EQUITY DERIVATIVES IN INDIA SUBMITTED BY LACHHANI NISHA M. PROJECT GUIDE. Bhavdas sir BACHELOR OF MANAGEMENT STUDIES

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1 UNIVERSITY OF MUMBAI PROJECT ON EQUITY DERIVATIVES IN INDIA SUBMITTED BY LACHHANI NISHA M. PROJECT GUIDE Bhavdas sir BACHELOR OF MANAGEMENT STUDIES SEMESTER V ( ) V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI COLONY, CHEMBUR

2 UNIVERSITY OF MUMBAI PROJECT ON _EQUITY DERIVATIVES IN INDIA Submitted In Partial Fulfillment of the requirements For the Award of the Degree of Bachelor of Management By LACHHANI NISHA M. PROJECT GUIDE MR. BHAVDAS SIR BACHELOR OF MANAGEMENT STUDIES SEMESTER V ( ) V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI COLONY, CHEMBUR

3 Declaration I LACHHANI NISHA M. student of BMS Semester V ( ) hereby declare that I have completed this project on. The information submitted is true & original to the best of my knowledge. Student s Signature Name of Student LACHHANI NISHA M. 3

4 C E R T I F I C A T E This is to certify that Ms. LACHHANI NISHA Of TYBMS has successfully completed the project on EQUITY DERIVATIVES IN INDIA under the guidance of MR.BHAVDAS SIR. Project Guide Principal Dr. (Mrs) J. K. PHADNIS Course Co-ordinator Mrs. A. MARTINA 4

5 External Examiner ACKNOWLEDGEMENT This project took nearly 2months to complete the task. And this took a lot of hard work from not just me but a lot of people who gave me not only their time and attention but a true response as well. I would like to thank the following people for their dedication and contribution without which this project could have not been created. Firstly, My Family members- my parents and sister for giving me space, time and emotional support I needed to follow and complete what seemed like an endless task. Then to my project guide MR. BHAVDAS who helped me develop a proper project plan, and being my professor showed me the right track to follow. He also encouraged me a lot to take up this topic which seemed easier as I had his support. 5

6 Financial market:- Financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity. A system that facilitates the exchange of money for financial assets. A security market such as the National Stock Exchange is an example of a financial market. Financial market Equity market Derivative market Equity market:- A equity market is a public market for the trading of company stock at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. Derivative market: - 6

7 The derivatives markets are the financial markets for derivatives. The market can be divided into two, that for exchange traded derivatives (ETD) and that for over-the-counter derivatives(otc). Introduction of derivatives:- The word DERIVATIVES is derived from the word itself derived of an underlying asset. It is a future image or copy of an underlying asset which may be shares, stocks, commodities, stock index, etc. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly. 7

8 History of derivatives:- Derivative products initially emerged as hedging devices against fluctuations in commodity prices, stock prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized around From then on, futures contracts have remained more or less in the same form, as we know them today. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these 8

9 exchanges. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, CONCEPT OF BADLA SYSTEM Badla is nothing but a carry forward system which means getting something in return. The badla system was acceptable to be an important need for the investors in the stock market. Here in this system the investor feels that the price of a particular share is expected to go up or down, without giving or taking the delivery he can participate in the possible fluctuation of the share. In the badla system, a position is carried forward, be it a short sale or a long purchase. In the event of a long purchase, the market player may want to carry forward the transaction to the next settlement cycle and for doing this he has to compensate the other party in the contract. While in case of a short sale, the market player wants tom carry forward the transaction to the next settlement cycle, he has to borrow the stocks to compensate the other party in the contract THUS BADLA IS PURELY A MEANS OF CASH & SHARE FINANCING ILLUSTRATION The investor has purchased the 100shares of INFOSYS COMPANY for Rs.7000 which is trading at Rs After this the investor expects to rise further. Therefore he wishes to carry the contract forward to the next trading session by paying what are called badla charges. In any badla transaction there are two key elements, the hawala rate and the bald charge for the scrip. The badla charge is the interest payable by the investor for carrying forward the position. It is fixed individually for each scrip by the exchange every Saturday and it is 9

10 calculated on what is called the heal rate. The hawala rate is the price at which a share is squared up in the current settlement and carried forward into the next settlement in the next trading session. The existing position is squared up against the hawala rate fixed and carried forward after factoring in the badla rate. The difference is paid to the broker (charges). Thus if hawala rata Rs.7180 is lower than the initial margin the difference is paid to the broker. The badla charges vary from broker to broker and proper relationship with the broker If broker insists on a 25% margin, the investor get 400% leverage or four times the amount investor is ready to deposit as margin. Thus At the end of each settlement, investor carry forward the position at the hawala rate. This position will also be adjusted for badla. Thus investor can carry forward the transactions for settlement BADLA WAS BANNED ON 2 nd JULY 2001 The badla was banned because more exposure was given to the speculation and also the investor has to wait for 5days for the delivery of shares because the rolling settlement was T+5 days. As badla system is a combination of lending and borrowing mechanism of the stocks which further associated with risks. As badla was banned between the intermediator was not the exchanges but the brokers. This system was time consuming because it involves more Paper work. Thus if the broker becomes insolvent then they are not responsible for the investors funds. As carry forward were more a method of lending and borrowing of shares and Funds. Here the borrower of shares or funds pays a fee or badla charges for the borrowing and in the badla the futures prices were mixed up with the cash price. The badla charges include a default risk premium because of the counterparty risk inherent in the transaction. Further in the badla the position could break down if borrowing/lending also proved infeasible. There is no expiration date in the badla system which results into uncertainty. Finally in badla the net long (buy) positions would differ from the net short (sell) positions. 10

11 Aims and objectives of derivatives:- 1. To explore the derivative market in India. 2. To know what derivatives are available in India. 3. To know derivatives trading mechanism of exchanges. 4. To become aware of what strategies are followed by Indian Investors. 5. To know how derivatives are used in covering risk 6. To know how derivatives give a safe exposure. Need for derivative market:- 1. They help in transferring risks from risk averse people to risk oriented people. 2. They help in the discovery of future as well as current prices. 11

12 3. They catalyze entrepreneurial activity. 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers. 5. They increase savings and investment in the long run. Purpose and benefits of derivative market;- 1. Today's sophisticated international markets have helped foster the rapid growth in derivative instruments. In the hands of knowledgeable investors, derivatives can derive profit from: Changes in interest rates and equity markets around the world. Changes in price of assets. 2. Help of hedge against inflation and deflation, and generate returns that are not correlated with more traditional investments. The two most widely recognized benefits attributed to derivative instruments are price discovery and risk management and others. 3. Price discovery: - The kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. the price of all future contracts serve as prices that can be accepted by those who trade the contracts in lieu of facing the risk of uncertain future prices. 12

13 4. Risk management: - This could be the most important purpose of the derivatives market. Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation. 5. Derivatives help in transferring risks from risk-averse people to risk-oriented people. 6. By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of capital across the economy and thus, increasing productivity in the economy. 7. Derivatives increase the volume traded in markets because of participation of risk-averse people in greater numbers. Factors driving the growth of derivatives:- Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 13

14 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Derivative market is divided in two markets:- Derivative market Over the counter (OTC) 14 Exchange traded derivatives

15 Over the counter:- Over the counter derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps and forward rate agreements are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counter party relies on the other to perform. 15

16 Features of over the counter derivatives:- 1. The management of counter-party (credit) risk is decentralized and located within individual institutions. 2. There are no formal centralized limits on individual positions, leverage, or margining. 3. There are no formal rules for risk and burden-sharing. 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organization. 6. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. Exchange traded derivatives:- They are standardized ones where the exchange sets the standards for trading by providing the contract specifications and the clearing corporation provides the trade guarantee and the settlement activities. Futures and Options are the derivatives. Products like futures and options are traded in this way. 16

17 In the exchange traded derivatives is the largest market for derivatives. In this type of derivatives a highly regulated exchange is involved which is Security Exchange Board of India (SEBI). Features of Exchange Traded Derivatives:- 1. The management of counter party risk is centralized and located with high institutions. 2. There are formal centralized limits on individual positions, leverage, or margining 3. There are formal rules for risk and burden-sharing. 4. There are formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The exchange traded contracts are generally regulated by a regulatory authority. Types of derivatives:- 17

18 Derivative contracts have several types. The most common variants are forwards, futures, options and swaps. 1. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. 2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. 3. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. 4. Warrants: Options generally have lives of up to one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. 5. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. 18

19 6. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. 7. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flow between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 8. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward Swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. 19

20 Forward contract:- It is an agreement between two parties to buy or sell an asset on a specified date for a specified price. A forward contract is a simple derivative. It is a type of market where buyer and seller predict the future for the underlying asset which may be stocks, currency, interest rate etc. One of the parties to the contract assumes a long position which agrees to buy underlying asset for a certain specified price. The other Party assumes a short position and agrees to sell at the same price. Forward contract can be 30days, 90days and 180days The contract is usually between two financial institutions or between a financial institution and its corporate client. A forward contract is not normally traded on an exchange. It is traded on the OTC (over the counter) derivatives where the intermediator or exchange has no role to play and contract is smoothly settled by the parties or normally traded outside the exchanges. At delivery, ownership of the good is transferred and payment is made. In other words, whereas the forward contract is executed today, and the price is agreed upon today, the actual transaction in which the underlying asset is traded does not take place until a later date. Typically, no money changes hands on the origination date of a forward contract. Forward contracts are not standardized unlike futures contracts. They are customized and each contract is unique in terms of contract size, expiration date and the asset type and quality. Terms of Forward contracts are negotiated between buyer and seller. As there is no exchange involved in it there is chance of default of either party. Forward contracts are very useful in hedging and speculation. Here the importer and exporter can hedge their risk exposure with respect to exchange rate fluctuations while entering into the currency forward market. The first formal commodities exchange in the United States for spot and forward contracting was formatted in 1848: the Chicago Board of Trade (CBOT). 20

21 ILLUSTRATION On 1 st march 2004 Mukesh has entered into a forward contract with Anil In this Mukesh takes a long position(buy) on the scrip and Anil takes a short position(short) on the scrip. Here Mukesh agrees to purchase 100 shares of RELIANCE ENERGY from the Anil for a predetermined price of Rs.400.The contract is three months forward. Thus on future Anil will deliver the shares to Mukesh while in return Mukesh will pay the amount of Rs.40,000(400*100). Suppose during the maturity date Mukesh may default for the transaction he refuse to make the payment for the shares or Anil refuse to deliver the shares. Therefore in this there is a counter party risk one party may default due to this other party suffers because there is no standardized exchange between the parties and the contract is OTC in nature and also prices are decided by the buyers and sellers. Finally forward contract is settled at maturity. The holder of the short position delivers the asset to the holder of the long position in return for cash at the agreed upon rate. Therefore, a key determinant of the value of the contract is the market price of the underlying asset. A forward contract can therefore, assume a positive or negative value depending on the movements of the price of the asset. For example, if the price of the asset rises sharply after the two parties have entered into the contract, the party holding the long position stands to benefit, i.e. the value of the contract is positive for her. Conversely, the value of the contract becomes negative for the party holding the short position. 21

22 Future contract:- A future contract is similar to a forward contract. It is a standardized forward contract that can be easily traded. In future contract default risk is lower on futures than on forwards for several reasons:- a) The counterparty to all futures trades is actually the clearing house of the futures exchange, which guarantees that all payments will be made. b) Future contracts are marked to market daily settled which means that any change in the value of the contract is realized as a profit or loss every day. c) Initial margin, which serves as a performance bond, is required when trading futures. In contrast, because they are not marked to market, forward contracts can build up large unrealized profits for one party and equally large unrealized losses for the other party. There is a multilateral contract between the buyer and seller for an underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded. The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change.. Location of settlement. 22

23 The current market price of INFOSYS COMPANY is Rs There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and Kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of Infosys is 300 shares. Suppose the stock rises to Profit Loss Unlimited profit for the buyer (Hitesh) = Rs.1, 65,000 [( *3oo)] and notional profit for the buyer is 550. Unlimited loss for the buyer because the buyer is bearish in the market 23

24 Suppose the stock falls to Rs.1400 Profit Loss Unlimited profit for the seller = Rs.75,000.[( *300)] and notional profit for the seller is 250. Unlimited loss for the seller because the seller is bullish in the market. 24

25 History of future derivatives:- Merton Miller, the 1990 Nobel laureate had said that 'financial futures represent the most significant financial innovation of the last twenty years." The first exchange that traded financial derivatives was launched in Chicago in the year A division of the Chicago Mercantile Exchange, it was called the International Monetary Market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the 'father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollar. FUTURES TERMINOLOGY:- a) Spot price: The price at which an asset trades in the spot market. b) Futures price: The price at which the futures contract trades in the futures market. c) Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-month and three months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading. d) Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. 25

26 e) Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. f) Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. g) Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. h) Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. i) Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. j) Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the 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. 26

27 Introduction to options:- It is an interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment. The options are also traded on stock exchange. Terminologies of options:- CALL OPTION A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract. ILLUSTRATION Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market. The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25 27

28 1. CALL BUYER Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be exercised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625 (strike price + premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660. Profit Loss Unlimited profit for the buyer = Rs.35{(spot price strike price) premium} Limited loss for the buyer up to the premium paid. 2. CALL SELLER: 28

29 In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option. Profit Loss Profit for the Seller limited to the premium received = Rs.25 Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30 Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610. Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent 29

30 Thus call option indicates two positions as follows: 1) LONG POSITION If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option. 2) SHORT POSITION If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option. PUT OPTION A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. 30

31 ILLUSTRATION Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit (put seller) who is bullish in the market. The current market price of TISCO COMPANY is Rs.800 and premium is Rs.20. 1) PUT BUYER (Dinesh): Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be exercised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer s breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700 and sell to the seller at Rs.800. Profit Loss 31

32 Unlimited profit for the buyer = Rs.80 {(Strike price spot price) premium} Loss limited for the buyer up to the premium paid = 20. 2) PUT SELLER (Amit): In another scenario, if at the time of expiry, market price of TISCO is Rs The buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. Profit Loss Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = = 30 Limited profit for the seller up to the premium received = 20 32

33 Thus Put option also indicates two positions as follows: LONG POSITION If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put option. SHORT POSITION If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option. Option buyer or option holder Option seller or option writer CALL OPTIONS Buys the right to buy the underlying asset at the specified price Has the obligation to sell the underlying asset (to the option holder) at the specified price PUT OPTIONS Buys the right to sell the underlying asset at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price. 3) Index options: 33

34 These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. 4) Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. 5) Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. 6) Writer of an option: The writer of a call/put option is the one who receive the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. 7) Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. 8) Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. 9) Strike price: 34

35 price or the exercise price. The price specified in the options contract is known as the strike 10) American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American. 11) 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. 12) In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price >strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. 13) At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price). 14) Out-of-the-money option: 35

36 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 price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. 15) Time value of an option: Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value. FACTORS AFFECTING OPTION PREMIUM 36

37 THE PRICE OF THE UNDERLYING ASSET: (S) Changes in the underlying asset price can increase or decrease the premium of an option. These price changes have opposite effects on calls and puts. For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying asset s value will generally have the opposite effect. THE SRIKE PRICE: (K) The strike price determines whether or not an option has any intrinsic value. An option s premium generally increases as the option gets further in the money, and decreases as the option becomes more deeply out of the money. Time until expiration: (t) An expiration approaches, the level of an option s time value, for puts and calls, decreases. Volatility: Volatility is simply a measure of risk (uncertainty), or variability of an option s underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at- the- money options. 37

38 Interest rate: (R1) This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid. Higher the interest rate, higher is the premium of the option as the cost of carry increases. PLAYERS IN THE OPTION MARKET:- Developmental institutions Mutual Funds Domestic & Foreign Institutional Investors Brokers Retail Participants 38

39 FUTURES V/S OPTIONS RIGHT OR OBLIGATION : Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset. RISK: Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. PRICES: The Futures contracts prices are affected mainly by the prices of the underlying asset. While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset. COST: It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium. 39

40 STRIKE PRICE: In the Futures contract the strike price moves while in the option contract the strike price remains constant. Liquidity: As Futures contract are more popular as compared to options. Also the premium charged is high in the options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated trading and investors in the options contract. Price behavior: The trading in future contract is one-dimensional as the price of future depends upon the price of the underlying only. While trading in option is two-dimensional as the price of the option depends upon the price and volatility of the underlying. PAY OFF: As options contract are less active as compared to futures which results into non linear pay off. While futures are more active has linear pay off. FUTURES PAYOFFS Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. 40

41 Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands at The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures contract. Payoff for a buyer of Nifty futures The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at The underlying asset in this case is the Nifty portfolio. When the index moves 41

42 down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure shows the payoff diagram for the seller of a futures contract. Payoff for a seller of Nifty futures The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. OPTIONS PAYOFFS 42

43 The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 2220, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be "long" the asset. Figure shows the payoff for a long position on the Nifty. Payoff profile for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, Nifty for instance, for 2220, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be "short" the asset. Figure shows the payoff for a short position on the Nifty. Payoff profile for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 4.6 gives the payoff for the buyer of a three month call option (often referred to as long call) with strike of 2250 bought at a premium of Payoff for investor who went Long Nifty at

44 The figure shows the profits/losses from a long position on the index. The investor bought the index at If the index goes up, he profits. If the index falls he looses. Payoff for investor who went Short Nifty at

45 The figure shows the profits/losses from a short position on the index. The investor sold the index at If the index falls, he profits. If the index rises, he looses. 45

46 Payoff for buyer of call option The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. 46

47 Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 2250 sold at a premium of Payoff for writer of call option The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty -close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs charged by him. 47

48 Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 4.8 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 2250 bought at a premium of

49 Payoff for buyer of put option The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. 49

50 o Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option unexercised and the writer gets to keep the premium. Figure 4.9 gives the payoff for the writer of a three month put option (often referred to as short put) with a strike of 2250 sold at a premium of o Payoff for writer of put option The figure shows the profits/losses for the seller of a threemonth Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs charged by him. 50

51 APPLICATION OF OPTIONS Since the index is nothing but a security whose price or level is a weighted average of securities constituting the index, all strategies that can be implemented using stock futures can also be implemented using index options. o Hedging: Have underlying buy puts Owners of stocks or equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options. Index and stock options are a cheap and easily implementable way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the index options chosen by you. 51