A Study on Futures and Potions

A STUDY ON FUTURES AND POTIONS Project submitted in partial fulfillment for the award of the degree of MASTER OF BUSINESS ADMINISTRATION DECLARATION I hereby declare that this Project Report titled, â€Å"A STUDY ON THE DERIVATIVES† submitted by me to the Department OF BUSINESS ADMINISTRATION, XXXX and is a bonafide work under taken by me and it is not submitted to any other University or Institution for the award of any degree diploma / certificate or published any time before. Name and Address of the StudentSignature of the student Date : ACKNOWLEDGEMENTI wish to express my sincere deep sense of gratitude and also thank my guide XXX, Faculty of Finance for his significant suggestions and help in every aspect to accomplish the project work. His persisting encouragement, everlasting patience and keen interest in discussions have benefited me to the extent that cannot be spanned by words. I take my pleasure to acknowledge XXXX for the facilities provided and constant encouragem ent. Finally I express bows to everyone who are involved with this project. CONTENTS INTRODUCTION METHODOLOGY 1 FUTURES 2 OPTIONS ANALYSIS OF THE STUDYSUMMARY AND CONCLUSIONS BIBLIOGRAPHY INTRODUCTION Nature of the problem: The turnover of the stock exchanges has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk.In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivative trading in India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the phased introduction of the derivatives trading beginning with stock index futures.There are many investors who are willing to trade in the derivative segment, because of its advantages like limited loss and unlimited profit by paying the small premiums. IMPORTANCE OF THE STUDY: To evaluate the profit/loss position of option holder and option writer. OBJECTIVES OF THE STUDY: ? To analyze the derivatives market in India. ? To analyze the operations of futures and options. ? To find out the profit/loss position of the option writer and option holder. ? To study about risk management with the help of derivatives. SCOPE OF THE STUDY:The study is limited to â€Å"Derivatives† with special reference to futures and options in the Indian context and the Hyder abad stock exchange has been taken as a representative sample for the study. The study can’t be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluating derivatives market only in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, NYSE etc. LIMITATIONS OF THE STUDY: The following are the limitations of this study. The scrip chosen for analysis is STATE BANK OF INDIA and the contract taken is March 2005 ending one-month contract. ? The data collected is completely restricted to the STATE BANK OF INDIA of March 2005; hence this analysis cannot be taken as universal. METHODOLOGY The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices.By their very nature, the financial ma rkets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset.The underlying asset can be bullion, index, share, bonds, currency, interest etc. Banks, securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future. DEFINITION: Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying a sset can be equity, forex, commodity or any other asset. Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines â€Å"derivative† to include – 1.A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. PARTICIPANTS: The following three broad categories of participants in the derivatives market. HEDGERS: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS: Speculators wish to bet on future movements in the price of an asset.Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. ARBITRAGEURS: Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. FUNCTIONS OF DERIVATIVES MARKET: The following are the various functions that are performed by the derivatives markets.They are: ? Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices 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: Forwards:A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the futu re at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Options: Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.Warrants: Options generally have lives of upto one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset i s usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps:Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. _ Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite Direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options.Thus a swaption is an option on a forward swap. 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 lesser than what he expected to get. There are various factors, which affect the returns: 1. Price or dividend (interest). 2. Some are internal to the firm like – ? Industrial policy ? Management capabilities ? Consumer’s preference ? Labor strike, etc. These forces are to a large extent controllable and are termed as non Systematic risks.An investor can easily manage such non-systematic by having a well – diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other. There are yet other types of influences which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are: 1. Economic 2. Political 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all individual stocks to move together in the same manner.We therefore quite often find s tock prices falling from time to time in spite of company’s earnings rising and vice versa. Rationale 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 amounts quickly without substantial price concessions. In debt market, a large position of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small size relative to many common stocks.Those factors favour for the purpose of both portfolio hedging and speculation, the introduction 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 carry forward positions in actively traded ‘A’ group scrips from one settlement to another b y 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 allow 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 assured 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 Stock Options 4. Ind ividual 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 Mills 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 Heavy Electricals Ltd. |BHEL |300 | |Bharat Petroleum Corporation Ltd. |BPCL |550 | |Cadila Healthcare Limited |CADILAHC 500 | |Canara Bank |CANBK |1600 | |Century Textiles Ltd |CENTURYTEX |850 | |Chennai Petroleum 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 Corporation 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 | |Jindal Steel & Power 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 La boratories 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 Computer System Ltd |PATNI |650 | |Punjab National Bank |PNB |600 | |Ranbaxy Laboratories Ltd. RANBAXY |200 | |Reliance Energy Ltd. |REL |550 | |Reliance Capital Ltd |RELCAPITAL |1100 | |Reliance Industries Ltd. |RELIANCE |600 | |Satyam Computer Services Ltd. SATYAMCOMP |600 | |State Bank of India |SBIN |500 | |Shipping Corporation of India Ltd. |SCI |1600 | |Siemens Ltd |SIEMENS |150 | |Sterlite Industries (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 FRAMEWORK:The trading of derivatives is governed by the provisions 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 Trading: SEBI set up a 24 member committed under Chairmanship of Dr. L. C. Gupta develop the appropriate regulatory framework for derivative trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of Derivatives trading in India beginning with Stock Index F utures.SEBI also approved he â€Å"Suggestive bye-laws† recommended by the committee for regulation and control of trading and settlement of Derivatives contracts. The provisions in the SC (R) A govern the trading in the securities. The amendment of the SC (R) A to include â€Å"DERIVATIVES† within the ambit of ‘Securities’ in the SC (R ) A made trading in Derivatives possible within 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 grant of recognition under Section 4 of the SC (R) A, 1956 to start Derivatives Trading.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 its members and will obtain approval of SEBI before start of Trading in any derivative co ntract. 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 Clearing 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 registration from SEBI. 6. The Minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also submit details 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 Futur es 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 ? Quality 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 basis 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 settled. The settlement price of the Inde x 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 seller 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. PAYOFF FOR A BUYER OF FUTURES: [pic] CASE 1: The buyer bought the future contract at (F); if the futures price goes to E1 then the buyer gets the profit of (FP). CASE 2: The buyer gets loss when the future price goes less 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 PRICE E1, E2 – SETTLEMENT PRICE. CASE 1: The Seller sold the future contract at (f); if the futures 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 order to eliminate the counter party risk. There are three types of margins: Initial Margin:Whenever 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 intended 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 amount of margin is roughly 5% to 15% of total purchase price of futures contract. Marking to Market Margin: The process of adjusting the equity in an investor’s account in order to reflect the change in the settlement price of futures contract is known as MTM Margin.Maintenance margin: The investor must keep the fut ures account equity equal to or greater than certain percentage of the amount deposited as Initial Margin. If the equity goes less 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 Carry 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 – Spot price of the Underlying r – Cost of Financing q – Expected Dividend Yield T – Holding Period. FUTURES TERMINOLOGY: Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market.Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size:The amount of asset that has to be delivered under one contract. For instance, the contract size on NSE’s futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Open Interest:Total outstanding 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 period. Alternatively the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. In order to have this right, the option buyer has to pay the seller of the option premium. The assets on which optio ns can be derived are stocks, commodities, indexes etc.If the underlying asset is the financial 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 Loss ? 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 var ious 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 currently more 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: ? CALL 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 op tion right but not the obligation to sell an asset by a certain date for a certain price. III. On the basis of exercise of Option:On the basis of the exercising of the option, the options are classified into two categories. ? AMERICAN OPTION: American options are options that can be exercised at any time up to the expiration date, 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 more than strike price (S). The buyer gets the profit of (SR), if price increases more than E1 than 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 OPTION:The pay-off of seller of the call option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a call option: [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 underlying 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: Stoc k 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 versa. 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 price:In 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 chance that the stock will do very well or very poor increases. Th e 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 increase 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 negative 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 FREE 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: O ption 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 holder 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 Option:An 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 steps involved in the study. 1. Selection of the scrip: The scrip selection is done on a random basis and the scrip selec ted is RELIANCE COMMUNICATIONS. The lot size of the scrip is 500. Profitability position of the option holder and option writer is studied. 2. Data collection:The data of the RELIANCE COMMUNICATIONS has been collected from the â€Å"The Economic Times† and the internet. The data consists 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 31/0 1/2008 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 volume of the contract, and the third column consists of total premium value paid by the buyer. ?NET PAYOFF FOR CALL OPTION HOLDERS AND WRITERS |MARKET PRICE |CALLS |VOLUME (‘000) |PREMIUM (‘000) |PROFIT TO HOLDER|NET PROFIT TO |NET PROFIT TO | | | | | |(‘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 current market price on the expiry date is Rs. 654. 80 and this is c onsidered as 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 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 said 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 option 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] FINDINGS:The 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: ? The 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 FUT URES OF THE JANUARY MONTH |DATE |FUTURES CLOSING 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 f utures get profit. ? If the selling price of the futures is less than the settlement price, then the seller incur 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 derivatives the investor has to pay premiums or margins, which are some percentage of total money. ? Derivatives are mostly used for hedging purpose. ? In derivative segment the profit/loss of the option 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 steps 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 minimiz ed 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