A Study on Futures and Potions

A STUDY ON FUTURES AND POTIONS Project submitted in partial fulfillment for the award of the dot of MASTER OF BUSINESS ADMINISTRATION DECLARATION I hereby declargon that this Project Report titled, A STUDY ON THE DERIVATIVES submitted by me to the Department OF BUSINESS ADMINISTRATION, XXXX and is a bonafide work infra taken by me and it is non submitted to any some early(a) University or Institution for the award of any degree diploma / security measure or published any time onwards. Name and Address of the StudentSignature of the student Date ACKNOWLEDGEMENTI wish to declaim my sincere deep sense of gratitude and excessively thank my guide XXX, Faculty of Finance for his signifi abjuret suggestions and patron in e truly aspect to accomplish the project work. His persisting encouragement, ever conclusioning patience and keen please in discussions retain benefited me to the extent that merchant ship non be spanned by words. I take my pleasure to acknowledge XXXX for th e facilities provided and uninterrupted encouragement. Finally I express bows to everyone who atomic number 18 involved with this project. CONTENTS INTRODUCTION methodological abridgment 1 FUTURES 2 pickS ANALYSIS OF THE STUDYSUMMARY AND CONCLUSIONS BIBLIOGRAPHY INTRODUCTION Nature of the task The turnover of the personal declension of credit commutings has been tremendously increasing from last 10 years. The number of trades and the number of investors, who atomic number 18 participating, have increased. The investors be go outing to reduce their risk, so they ar quest for the risk management barbs. Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many an(prenominal) problems like no strong margining system, unclear expiration assure and generating counter party risk.In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors atomic number 18 see king for a hedging system, which could reduce their portfolio risk. SEBI thought the unveiling of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr. L. C. Gupta to develop the appropriate regulative simulation for derivative trading in India, SEBI accepted the recommendations of the committee on whitethorn 11, 1998 and approved the phased introduction of the derivatives trading beginning with origin index earlys.There ar many investors who are willing to trade in the derivative segment, beca physical exertion of its advantages like limited firing and unlimited collar on by wagesing the small bounteousnesss. IMPORTANCE OF THE STUDY To evaluate the derive/loss position of pickax carrier and excerpt preserver. OBJECTIVES OF THE STUDY ? To analyze the derivatives commercialise in India. ? To analyze the operations of coming(prenominal)s and excerpts. ? To find out the profit/loss position of the plectrum writer and election toter. ? To study about risk management with the inspection and repair of derivatives. SCOPE OF THE STUDYThe study is limited to Derivatives with special reference to risings and creams in the Indian context and the Hyderabad stock supervene upon has been taken as a representative sample for the study. The study cant be verbalise as checkly perfect. Any alteration whitethorn come. The study has only made a humble attempt at evaluating derivatives commercialize only in Indian context. The study is not establish on the international perspective of derivatives markets, which exists in NASDAQ, NYSE etc. LIMITATIONS OF THE STUDY The quest are the limitations of this study. The scrip chosen for analysis is STATE BANK OF INDIA and the direct taken is March 2005 ending one-month ingest. ? The data collected is tout ensemble restricted to the STATE BANK OF INDIA of March 2005 hence this analysis cannot be taken as universal. METHODOLOGY The emergence of the marke t for derivative products, most notably forwards, futures and choices, can be traced back to the willingness of risk-averse economic agents to protection themselves against un realties arising out of fluctuations in plus charges.By their very nature, the fiscal markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transportation terms risks by lockingin asset monetary measure outs. As creatures of risk management, these generally do not influence the fluctuations in the underlie asset measures. However, by locking-in asset outlays, derivative products minimize the impact of fluctuations in asset damages on the positiveness and bills flow situation of risk-averse investors. Derivatives are risk management instruments, which infer their respect from an be asset.The central asset can be bullion, index, share, bonds, currency, absorb etc. tills, securities firms, companies and investors t o 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. DEFINITION Derivative is a product whose value is derived from the value of an be asset in a focusual manner. The be asset can be equity, forex, good or any other asset. Securities reduces (Regulation) Act, 1956 (SC(R) A) defines derivative to include 1.A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or commence for differences or any other form of security. 2. A consume which derives its value from the expenses, or index of worths, of underlying securities. PARTICIPANTS The plaza by side(p) deuce-ace broad categories of participants in the derivatives market. HEDGERS Hedgers face risk associated with the scathe of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS Speculators wish to bet on future movements in the worth of an ass et.Futures and options contracts can give them an extra leverage that is, they can increase both the potential gains and potential losings in a speculative venture. ARBITRAGEURS Arbitrageurs are in business to take advantage of a distinction amid worths in cardinal disparate markets. If, for example, they see the futures wrong of an asset getting out of line with the interchange equipment casualty, they will take offsetting positions in the two markets to lock in a profit. FUNCTIONS OF DERIVATIVES trade The followers are the mixed functions that are performed by the derivatives markets.They are ? Prices in an organized derivatives market conjecture the apprehension of market participants about the future and lead the wrongs 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. ? Derivative trading acts as a catalyst for new entrepreneurial activity. ? Derivatives markets help increase savings and investment in the long run. Types of derivatives the following are the various types of derivatives. They are ForwardsA forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures A futures contract is an agreement between two parties to deal or cover an asset at a real time in the future at a certain price. survival of the fittests Options are of two types bellows and ranks. Calls give the purchaser the well(p) 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 purchaser the beneficial, but not the obligation to transport a given quantity of the underlying asset at a given price on or before a given date.Warrants Options generally have lives of upto one year the majority of options traded on options substitutes having a maximum maturity of nine months. Longer-dated options are discovered warrants and are generally traded over-the-counter. LEAPS The acronym LEAPS means Long-Term Equity prevision Securities. These are options having a maturity of upto 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. SwapsSwaps are private agreements between two parties to exchange hard currency 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 entertain related silver flows between the parties in the selfsame(prenominal) currency. _ Currency swaps These entail swapping both principal and interest between the parties, with the currency flows in one circumspection organism in a divergent currency than those in the opposite Dire ction. Swaptions Swaptions are options to buy or sell a swap that will compel operative at the expiry of the options.Thus a swaption is an option on a forward swap. RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVES Holding portfolio of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much littleer than what he expected to get. There are various factors, which relate the returns 1. Price or dividend (interest). 2. Some are internal to the firm like ? Industrial policy ? anxiety capabilities ? Consumers preference ? Labor expunge, 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 change 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 types of influences which are outer to the firm, cannot be controlled a nd affect large number of securities. They are termed as systematic risk. They are 1. Economic 2. governmental 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all one-on-one stocks to move together in the same manner.We at that placefore quite often find stock prices dropping from time to time in spite of companys earnings rising and vice versa. principle behind the development of derivatives market is to manage this systematic risk, liquidity and liquidity in the sense of being able to buy and sell relatively large measures quickly without substantial price concessions. In debt market, a large position of the arrive risk of securities is systematic. Debt instruments are also finite life securities with limited marketability referable to their small size of it relative to many common stocks.Those factors favour for the purpose of both portfolio hedging and speculation, the introduc tion of a derivative security that is on some broader market rather than an individual security. India has vibrant securities market with strong retail participation that has rolled over the years. It was until recently basically cash market with a facility to prevail forward positions in actively traded A group scrips from one settlement to another(prenominal) by paying the required margins and borrowing some money and securities in a separate carry forward session held for this purpose.However, a need was felt to introduce financial products like in other financial markets world over which are characterized with high degree of derivative products in India. Derivative products get the user to transfer this price risk by looking in the asset price there by minimizing the impact of fluctuations in the asset price on his balance sheet and have advised cash flows. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, shares, bonds, currency etc.DERIVATIVE SEGMENT AT NATIONAL STOCK EXCHANGE The derivatives segment on the exchange commenced with S&P CNX Nifty Index futures on June 12, 20007. The F&O segment of NSE provides trading facilities for the following derivative segment 1. Index Based Futures 2. Index Based Options 3. Individual ancestry Options 4. Individual Stock Futures COMPANY NAME CODE LOT SIZE ABB Ltd. ABB 200 Associated Cement Co. Ltd. ACC 750 Allahabad Bank ALBK 2450 Andhra Bank ANDHRABANK 2300 Arvind mill about Ltd. ARVINDMILL 2150 Ashok Leyland Ltd ASHOKLEY 9550 Bajaj Auto Ltd. BAJAJAUTO 200 Bank of Baroda BANKBARODA 1400 Bank of India BANKINDIA 1900 Bharat Electronics Ltd. BEL 550 Bharat Forge Co Ltd BHARATFORG 200 Bharti Tele-Ventures Ltd BHARTI 1000 Bharat lowering Electricals Ltd. BHEL 300 Bharat oil color tummyoration Ltd. BPCL 550 Cadila Healthcare Limited CADILAHC 500 Canara Bank CANBK 1600 Century Textiles Ltd CENTURYTEX 850 Ch ennai Pet federal agencyum Corp Ltd. CHENNPETRO 950 Cipla Ltd. CIPLA 1000 Kochi Refineries Ltd COCHINREFN 1300 Colgate Palmolive (I) Ltd. COLGATE 1050 Dabur India Ltd. DABUR 1800 GAIL (India) Ltd. GAIL 1500 Great Eastern Shipping Co. Ltd. GESHIPPING 1350 Glaxosmithkline Pharma Ltd. GLAXO 300 Grasim Industries Ltd. GRASIM 175 Gujarat Ambuja Cement Ltd. GUJAMBCEM 550 HCL Technologies Ltd. HCLTECH 650 Housing development Finance wad Ltd. HDFC 300 HDFC Bank Ltd. HDFCBANK 400 Hero Honda Motors Ltd. HEROHONDA 400 Hindalco Industries Ltd. HINDALC0 150 Hindustan Lever Ltd. HINDLEVER 2000 Hindustan Petroleum Corporation Ltd. HINDPETRO 650 ICICI Bank Ltd. ICICIBANK 700 Industrial development bank of India Ltd. IDBI 2400 Indian Hotels Co. Ltd. INDHOTEL 350 Indian Rayon And Industries Ltd INDRAYON 500 Infosys Technologies Ltd. INFOSYSTCH 100 Indian Overseas Bank IOB 2950 Indian Oil Corporation Ltd. IOC 600 ITC Ltd. ITC 150 Jet Airways (India) Ltd. JETAIRWAYS 200 Jin dal brand & precedent Ltd JINDALSTEL 250 Jaiprakash Hydro-Power Ltd. JPHYDRO 6250 Cummins India Ltd KIRLOSKCUM 1900 LIC Housing Finance Ltd LICHSGFIN 850 Mahindra & Mahindra Ltd. M&M 625 Matrix Laboratories Ltd. MATRIXLABS 1250 Mangalore Refinery and Petrochemicals Ltd. MRPL 4450 Mahanagar Telephone Nigam Ltd. MTNL 1600 National Aluminium Co. Ltd. NATIONALUM 1150 Neyveli Lignite Corporation Ltd. NEYVELILIG 2950 Nicolas Piramal India Ltd NICOLASPIR 950 National Thermal Power Corporation Ltd. NTPC 3250 Oil & Natural Gas Corp. Ltd. ONGC 300 Oriental Bank of Commerce ORIENTBANK 600 Patni Com stick optioner System Ltd PATNI 650 Punjab National Bank PNB 600 Ranbaxy Laboratories Ltd. RANBAXY 200 Reliance Energy Ltd. REL 550 Reliance heavy(p) Ltd RELCAPITAL 1100 Reliance Industries Ltd. corporate trust 600 Satyam Com sicer Services Ltd. SATYAMCOMP 600 State Bank of India SBIN 500 Shipping Corporation of India Ltd. SCI 1600 due south Ltd SIEMENS 150 Sterlite Indus tries (I) Ltd STER 350 Sun Pharmaceuticals India Ltd. SUNPHARMA 450 Syndicate Bank SYNDIBANK 3800 Tata Chemicals Ltd TATACHEM 1350 Tata Consultancy Services Ltd TCS 250 Tata Power Co.Ltd. TATAPOWER 800 Tata Tea Ltd. TATATEA 550 Tata Motors Ltd. TATAMOTORS 825 Tata Iron and Steel Co. Ltd. TISCO 675 Union Bank of India UNIONBANK 2100 UTI Bank Ltd. UTIBANK 900 Vijaya Bank VIJAYABANK 3450 Videsh Sanchar Nigam Ltd VSNL 1050 Wipro Ltd. WIPRO 300 Wockhardt Ltd. WOCKPHARMA 600 REGULATORY FRAMEWORKThe trading of derivatives is governed by the victuals contained in the SC ( R ) A, the SEBI Act, the and the regulations framed there under the rules and byelaws of stock exchanges. Regulation for Derivative transaction 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 May 11, 1998 SEBI accepted the recommendations of the committe e 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 Derivatives contracts. The commissariat in the SC (R) A govern the trading in the securities. The amendment of the SC (R) A to include DERIVATIVES in spite of appearance the ambit of Securities in the SC (R ) A made trading in Derivatives possible inwardly the framework of the Act. 1. Any exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report may apply to SEBI for assignment of recognition under Section 4 of the SC (R) A, 1956 to start Derivatives vocation.The derivatives exchange/segment should have a separate governing council and representation of trading / clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of i ts members and will obtain approval of SEBI before start of Trading in any derivative contract. 2. The exchange shall have minimum 50 members. 3. The members of an existing segment of the exchange will not automatically become the members of the derivative segment. The members of the derivative segment need to fulfill the eligibility conditions as lay down by the L.C. Gupta Committee. 4. The clearing and settlement of derivates trades shall be through a SEBI approved change Corporation / Clearing house. Clearing Corporation / Clearing House complying with the eligibility conditions as lay down By the committee have to apply to SEBI for grant of approval. 5. Derivatives broker/dealers and Clearing members are required to seek adjustment from SEBI. 6. The Minimum contract value shall not be little than Rs. 2 Lakh. Exchanges should also submit inside information of the futures contract they purpose to introduce. 7.The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI. FUTURES DEFINITION 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. To 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 ? flavor of the underlying ? The date and the month of delivery ? The units of price quotations and minimum price change ? Locations of settlementTYPES OF FUTURES On the bum of the underlying asset they derive, the futures are divided into two types ? Stock futures The stock futures are the futures that have the underlying asset as the individual securities. The settlement of the stock futures is of cash settlement and the settlement price of the future is the closing price of the underlying security. ? Index futures Index futures are the futures, which have the underlying asset as an Index. The Index futures are also cash colonised. The settlement price of the Index futures shall be the closing value of the underlying index on the expiry date of the contract.Parties in the 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 vender of the futures contract is one who is SHORT on the futures contract. The pay off for the buyer and the seller of the futures contract are as follows. devoteOFF FOR A emptor OF FUTURES pic gaucherie 1 The buyer bought the future contract at (F) if the futures price goes to E1 and then the buyer gets the profit of (FP). CASE 2 The buyer gets loss when the future price goes little than (F), if the futures price goes to E2 then the buyer gets the loss of (FL).PAYOFF FOR A SELLER OF FUTURES pic F FUTURES expenditure E1, E2 SETTLEMENT outlay. CASE 1 The Seller sold the future contract at (f) if the f utures price goes to E1 then the Seller gets the profit of (FP). CASE 2 The Seller gets loss when the future price goes greater than (F), if the futures price goes to E2 then the Seller gets the loss of (FL). MARGINS Margins are the deposits, which reduce counter party risk, arise in a futures contract. These margins are collected in regularise to eliminate the counter party risk. There are three types of margins initial MarginWhenever a futures contract is signed, both buyer and seller are required to post initial margin. Both buyer and seller are required to make security deposits that are intend to guarantee that they will infact be able to fulfill their obligation. These deposits are Initial margins and they are often referred as performance margins. The keep down of margin is roughly 5% to 15% of total purchase price of futures contract. fall guy to Market Margin The process of adjusting the equity in an investors account in order to reflect the change in the settlement pri ce of futures contract is known as MTM Margin.Maintenance margin The investor must musical accompaniment the futures account equity equal to or greater than certain ploughshare of the amount deposited as Initial Margin. If the equity goes slight than that percentage of Initial margin, then the investor receives a call for an additional deposit of cash known as Maintenance Margin to bring the equity up to the Initial margin. Role of Margins The role of margins in the futures contract is explained in the following example. S sold a Satyam February futures contract to B at Rs. 300 the following table shows the effect of margins on the contract.The contract size of Satyam is 1200. The initial margin amount is say Rs. 20000, the maintenance margin is 65% of Initial margin. DAY PRICE OF SATYAM EFFECT ON BUYER (B) EFFECT ON SELLER (S) REMARKS MTM MTM P/L P/L Bal. in Margin Bal. n Margin 1 Contract is entered and 300. 00 initial margin is deposited. 2 +13,200 -13,200 B got profit and S got 311(price increased) +13,200 loss, S deposited 3 maintenance margin. B got loss and deposited maintenance 4 -28,800 margin. +15,400 +28,800 287 B got profit, S got loss. Contract settled at 305, totally B got +21,600 profit and S got loss. -21,600 305 Pricing the Futures The fair value of the futures contract is derived from a model known as the Cost of deem model. This model gives the fair value of the futures contract. Cost of Carry Model F=S (1+r-q) t Where F Futures Price S stain price of the central 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 The diaphragm over which a contract trades. The index futures contracts on the NSE have one-month, two-m onths and three-month expiry cycles which decease on the last thorium 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 stipulate 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 sizeThe amount of asset that has to be delivered under one contract. For instance, the contract size on NSEs futures market is 200 Nifties. Basis In the context of financial futures, prat can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry The relationship betwee n 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 remunerative to finance the asset less the income earned on the asset. Open InterestTotal heavy(p) long or short positions in the market at any specific time. As total long positions for market would be equal to short positions, for calculation of open interest, only one side of the contract is counted. optionS DEFINITION 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 specified time full stop. 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 superior. The assets on which options can be derived are stocks, commodities, indexes etc.If the underlying asset is the fina ncial asset, then the options are financial options like stock options, currency options, index options etc, and if the underlying asset is the non-financial asset the options are non-financial options like commodity options. PROPERTIES OF OPTIONS Options have several unique properties that set them apart from other securities. The following are the properties of options ? Limited disadvantage ? High Leverage 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. . Writer/Seller of the Option The writer of a call/put options is the one who receives the option premium and is there 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 options are divided into two types ? INDEX OPTIONS 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 options are options on the individual stocks, there are on-line(prenominal)ly much than 50 stocks are trading in this segment. II. On the basis of the market movement On the basis of the market movement the options are divided into two types. They are ? tender OPTION A call options is bought by an investor when he seems that the stock price moves 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 certain price. ? PUT OPTION A put option is bought by an investor when he seems that the stock price moves downwards. A put option gives the holder of the option right but not the obligation to sell an asset by a certain date for a cer tain price. III. On the basis of exercise of OptionOn 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, most exchange-traded options are American. ? EUROPEAN OPTION European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options. PAY-OFF PROFILE FOR BUYER OF A CALL OPTION The pay-off of a buyer options depends on the spot price of the underlying asset. The following graph shows the pay-off of buyer of a call option S-Strike priceOTM Out of the Money SP -Premium/LossATM At the MoneyE1 Spot price 1 ITM In The Money E2 Spot price 2 SR profit at spot price E1 CASE 1 (Spot price Strike Price) As the spot price (E1) of the underlying asset is much(prenominal) than strike price (S). The buyer gets the profit of (SR), if price increases more than E1 tha n profit also increase more than SR. CASE 2 (Sport price Strike Price) As the 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 than also his loss is limited to his premium (SP). PAY OFF PROFILE FOR SELLER OF A CALL OPTIONThe 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 pic S-Strike priceITM In the Money SP Premium/profitATM At the Money E1-Spot price 1OTM Out of The Money E2 -Spot price 2 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 seller gets the profit of (SP), if the price decreases less than E1 than 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 less than E2 than the loss of the seller also increase more than (SR). PAY-OFF PROFILE FOR BUYER OF A PUT OPTION The payoff of 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 pic S-Strike priceITM-In The Money SP-Premium/profitOTM-Out of The Money E1-Spot price 1ATM-At The Money E2-Spot price 2 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 of (SR), if price decreases less than E1 than the profit 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 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 seller of the option depends on the spot price of the und erlying asset. The following graph shows the pay-off of seller of a put option pic S-Strike priceITM-In The Money SP-Premium/profitATM-At The Money E1-Spot price 1OTM-Out of The Money E2-Spot price 2 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 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 the 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 the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice v ersa. The pay-off from a put option is the amount by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. Strike priceIn the case of a call, as the 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, options become less valuable and as strike price decreases, options become more valuable. Time to expiration Both Put and Call American options become more valuable as the time to expiration increases. Volatility The volatility of n a stock price is a measure of uncertain about future stock price movements. As volatility increases, the go on 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 calls always incr ease as the risk free interest rate increases. Dividends Dividends have the effect of reducing the stock price on the ex dividend date. This has a proscribe effect on the value of call options and a positive affect on the value of put options. PRICING OPTIONS The Black Scholes formulas for the prices of European Calls and puts on a non-dividend paying stock are CALL OPTION C = SN (D1)-Xe-rtN(D2) PUT OPTION P = Xe-rtN(-D2)-SN (-D2) C VALUE OF CALL OPTION S SPOT PRICE OF STOCK X STRIKE PRICE r ANNUAL RISK excess RETURN CONTRACT CYCLE D1 (ln(s/x) +(r+ )/2) t)/ D2 D1- Options Terminology Strike Price The price specified in the options contract is known as the Strike price or Exercise price. Option Premium 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 the expiration date. In-The-Money Option An in the money option is an option that would lead to a positive cash inflow to the hold er if it is 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 OptionAn out of the money option is an option that would lead to a negative cash flow if it is exercised immediately. Intrinsic Value of an Option 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. DESCRIPTION OF THE METHOD The following are the move involved in the study. 1. Selection of the scrip The scrip selection is done on a random basis and the scrip selected is RELIANCE COMMUNICATIONS. The lot size of the scrip is 500. Profitability position of the option holder and option writer is studied. 2. Data appealingnessThe data of the RELIANCE COMMUNICATIONS has been collected from the The Economic Times and the internet. The data consist s of the March contract and the period of data collection is from 30th December 2008 to 31st January 2008. 3. Analysis The analysis consists of the tabulation of the data assessing the profitability positions of the option holder and the option writer, representing the data with graphs and making the interpretations using the data. ANALYSIS ANALYSIS The objective of this analysis is to evaluate the profit/loss position of option holder and option writer. This analysis is based on the sample data, taken RELIANCE COMMUNICATIONS scrip. This analysis considered the March ending contract of the SBI.The lot size of SBI is 500. The time period in which this analysis is done is from 30/12/2007 To 31/01/2008 Price of SBI in the Cash Market. DATE MARKET PRICE 30-Dec-07 685. 1 31-Dec-07 714. 65 1-Jan-08 695. 6 2-Jan-08 706. 4 3-Jan-08 717. 1 4-Jan-08 713. 45 7-Jan-08 726. 6 8-Jan-08 724. 05 9-Jan-08 720. 85 10-Jan-08 742. 1 11-Jan-08 736. 14-jan-08 734. 1 15-Jan-08 731. 75 16- Jan-08 728 17-Jan-08 726. 2 18-Jan-08 727. 8 21-Jan-08 722. 7 22-Jan-08 693. 25 23-Jan-08 657. 7 24-Jan-08 664. 4 28-Mar-08 665. 6 29-Jan-08 641. 7 30-Jan-08 661. 05 31-Jan-08 654. 8 pic The closing price of SBI at the end of the contract period is 654. 80 and this is considered as settlement price. The following table explains the amount of transaction between option holder and option writer. ? The first column explains the trading date. ? The second column explains the market price in cash segment on that date. ? The call column explains the call/put options which are considered. Every call/put has three sub columns. ? The first column consists of the premium value per share of the contracts, second column consists of the account book of the contract, and the third column consists of total premium value paid by the buyer. ? scratch PAYOFF FOR CALL OPTION HOLDERS AND WRITERS MARKET PRICE CALLS VOLUME (000) PREMIUM (000) acquire TO HOLDERNET PROFIT TO NET PROFIT T O (000) HOLDER (000) BUYER (000) 654. 8 640 199. 5 3634. 15 2952. 6 -681. 55 681. 55 654. 8 660 1463 21600. 35 0 -21600. 35 21600. 35 654. 680 2008 51831. 53 0 -51831. 525 51831. 525 654. 8 700 3297 85603. 45 0 -85603. 45 85603. 45 654. 8 720 3796. 5 74881. 93 0 -74881. 925 74881. 925 654. 8 740 2309. 5 30208. 4 0 -30208. 4 30208. 4 OBSERVATIONS AND FINDINGS ? Six call options are considered with six different strike prices. ? The modern market price on the expiry date is Rs. 654. 80 and this is considered as concluding settlement price. The premium paid by the option holders whose strike price is far and greater than the current market price have paid high amounts of premium than those who are near to the current market price. ? The call option holders whose strike price is less than the current market price are state to be In-The-Money. The calls with strike price 640 are said to be In-The-Money, since, if they exercise they will get profits. ? The call optio n holders whose strike price is less than the current market price are said to be Out-Of-The-Money. The calls with strike price of 660, 680,700,720,740 are said to be Out-Of-The-Money, since, if they exercise, they will get losses. pic FINDINGSThe premium of the options with strike price of 700 and 720 is high, since most of the period of the contract the cash market is moving around 700 mark. pic FINDINGS ? The contracts with strike price 660, 680, 700, 720, 740 get no profit, since their strike price is more than the settlement price. ? The contract with strike price 640 gets the profit. NET PAY OFF OF PUT OPTION HOLDERS AND WRITERS. MARKET PRICE PUTS VOLUME (000) PREMIUM (000) PROFIT TO HOLDER NET PROFIT TO HOLDER NET PROFIT TO WRITER (000) (000) (000) 654. 600 25 47. 625 0 -47. 625 47. 625 654. 8 640 323. 5 993. 5 0 -993. 5 993. 5 654. 8 660 1239. 5 9506. 575 6445. 4 -3061. 175 3061. 175 654. 8 680 1399. 5 21894 35267. 4 13373. 4 -13373. 4 654. 8 700 1858 30871. 28 83981. 6 53110. 325 -53110. 325 654. 720 1468. 5 23727. 83 95746. 2 72018. 375 -72018. 375 OBSERVATIONS AND FINDINGS ? Six put options are considered with six different strike prices. ? The current market price on the expiry date is Rs. 654. 80 and this is considered as the final settlement price. ? The premium paid by the option holders whose strike price is far and greater than the current market price have paid high amount of premium than those who are near to the current market price. The put option holders whose strike price is more than the current market price are said to be In-The-Money. The puts with strike price 660,680,700,720 are said to be In-The-Money, since, if they exercise they will get profits. ? The put option holders whose strike price is less than the current market price are said to be Out-Of-The-Money. The puts with strike price of 600,640 are said to be Out-Of-The-Money, since, if they exercise their puts, they will get losses. pic FINDINGS ? Th e premium of the option with strike price 700 is higher when compared to other strike prices. This is because of the movement of the cash market price of the SBI between 640 and 720. pic FINDINGS The put option holders whose strike price is more than the settlement price are In-The-Money. ? The put options whose strike price is less than the settlement price are Out-Of-The-Money. DATA OF SBI THE FUTURES OF THE JANUARY MONTH DATE FUTURES finale PRICE (Rs. ) CASH CLOSING PRICE (Rs. ) 30-Dec-07 689. 6 685. 1 31-Dec-07 720. 65 714. 65 1-Jan-08 700. 5 695. 6 2-Jan-08 710. 9 706. 4 3-Jan-08 720. 85 717. 1 4-Jan-08 716. 85 713. 45 7-Jan-08 729. 2 726. 6 8-Jan-08 728. 25 724. 05 9-Jan-08 723. 35 720. 5 10-Jan-08 745. 3 742. 1 11-Jan-08 741. 35 736. 9 14-Jan-08 738. 95 734. 1 15-Jan-08 735. 7 731. 75 16-Jan-08 733. 15 728 17-Jan-08 730. 75 726. 2 18-Jan-08 732. 727. 8 21-Jan-08 725. 25 722. 7 22-Jan-08 695 693. 25 23-Jan-08 660. 1 657. 7 24-Jan-08 666. 7 664. 4 28- Jan-08 667. 75 665. 6 29-Jan-08 642. 7 641. 7 30-Jan-08 662. 5 661. 05 31-Jan-08 655. 95 654. 8 pic OBSERVATIONS AND FINDINGS The cash market price of the SBI is moving along with the futures price. ? If the buy price of the futures is less than the settlement price, then the buyer of the futures get profit. ? If the sell price of the futures is less than the settlement price, then the seller perplex losses. SUMMARY, CONCLUSIONS AND RECOMMENDATINONS SUMMARY ? Derivatives market is an innovation to cash market. Approximately its daily turnover reaches to the equal stage of cash market. Presently the available scrips in futures are 89 and in options segment are 62. ? In cash market the profit/loss of the investor depends on the market price of the underlying asset. The investor may incur huge profits or he may incur huge losses. 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 deri vatives 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 holder/option writer is purely depended on the fluctuations of the underlying asset. CONCLUSIONS 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 State Bank of India is having low volatility, so the call option writers enjoy more profits to holders. RECOMMENDATIONS ? The derivative market is newly started in India and it is not known by every investor, so SEBI has to take step to create awareness among the investors about the derivative segment. 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. BIBLIOGRAPHY BIBLIOGRAPHY BOOKS FUTURES AND OPTIONS N. D. VOHRA, B. R. BAGRI DERIVATIVES CORE MODULE WORKBOOK NCFM MATERIAL FUTURES AND OPTIONS R. MAHAJAN WEBSITES www. nseindia. com www. equitymaster. com www. peninsularonline. com NEWS EDITIONS THE ECONOMIC TIMES BUSINESS LINE