The Search to Derive

Welcome to the World of Derivatives…..

Derivatives

By

Parth Mehta (Future CA)

Published By

The Mind Production, Not Limited Co.

14/16, Rameshwar Nagar, Jamnagar-361008 India

Phone: +91-9898530603 Email: parth_destiny@yahoo.co.in

The 1st Edition

(The Exclusive One)

ISO: Waiting for approval

Price: Positive Response

__________________________________________________________________

Every effort has been made to avoid errors or omissions in this publication. In spite of this, errors may creep in.
Any mistake, error or discrepancy noted may be brought to our notice which shall be taken care of in the next
edition. It is suggested that to avoid any doubt the reader should cross-check all the facts and contents of the
publication with the original notifications.

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 Preface

Derivative is complicated subject to understand & digest too, unless a fresh

material is issued with simple wording but in depth knowledge.

The present edition of this material, which is designed to bridge the gap between
theory and application, stands out for your better understanding regards to
derivatives. This material is exclusively written for the students which do not know
what does DERIVATIVE means?

THE SEARCH TO DERIVE…. Completes over this material.

This material contains all basic aspects of derivatives. Through which the readers
have more confidence in dealing with derivatives. Each Topic starts with Analytical
discussion supported by well-thought out original problems. This Material is
designed in such a way as to be a self sufficient tool in the subject.

We are confident that readers will be benefited from this material and they will like
it. We sincerely appreciate any kind of suggestion or pointing out of any kind of
mistake for the improvement of the Material.

- Parth Mehta (Future CA)

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 Contents

1. Introduction of Derivatives…………………………………………………….05

2. Definition of Basic Derivatives………………………………………………..08

3. Applications of Derivatives……………………………………………………..16

4. Trading Futures……………………………………………………………………..22

5. Trading Options……………………………………………………………………..25

6. Derivatives Trading on exchange……………………………………………..34

7. Accounting & Taxation effects of Derivatives…………………………….39

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 1. Introduction of Derivatives

 Definition of Derivatives:

One of the most significant events in the securities markets has been the
development and expansion of financial derivatives. The term “derivatives” is
used to refer to financial instruments which derive their value from some
underlying assets. The underlying assets could be equities (shares), debt (bonds,
T-bills, and notes), currencies, and even indices of these various assets, such as the
Nifty 50 Index. Derivatives derive their names from their respective underlying
asset. Thus if a derivative’s underlying asset is equity, it is called equity derivative
and so on. Derivatives can be traded either on a regulated exchange, such as the
NSE or off the exchanges, i.e., directly between the different parties, which is called
“over-the-counter” (OTC) trading. (In India only exchange traded equity derivatives
are permitted under the law.) The basic purpose of derivatives is to transfer the price
risk (inherent in fluctuations of the asset prices) from one party to another; they
facilitate the allocation of risk to those who are willing to take it. In so doing,
derivatives help mitigate the risk arising from the future uncertainty of prices. For
example, on December 21, 2009 a rice farmer may wish to sell his harvest at a
future date (say January 1, 2010) for a pre-determined fixed price to eliminate the
risk of change in prices by that date. Such a transaction is an example of a
derivatives contract. The price of this derivative is driven by the spot price of rice
which is the "underlying".

 Origin of derivatives:

While trading in derivatives products has grown tremendously in recent times,

the earliest evidence of these types of instruments can be traced back to ancient
Greece. Even though derivatives have been in existence in some form or the other
since ancient times, the advent of modern day derivatives contracts is attributed to
farmers’ need to protect themselves against a decline in crop prices due to various
economic and environmental factors. Thus, derivatives contracts initially developed
in commodities. The first “futures” contracts can be traced to the Yodoya rice market
in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the
future at the time of harvesting. To lock in a price (that is, to sell the rice at a
predetermined fixed price in the future), the farmers entered into contracts with the
buyers. These were evidently standardized contracts, much like today’s futures
contracts.

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 In 1848, the Chicago Board of Trade (CBOT) was established to facilitate
trading of forward contracts on various commodities. From then on, futures contracts
on commodities have remained more or less in the same form, as we know them
today. While the basics of derivatives are the same for all assets such as equities,
bonds, currencies, and commodities, we will focus on derivatives in the equity
markets and all examples that we discuss will use stocks and index (basket of
stocks).
 Derivatives in India:

In India, derivatives markets have been functioning since the nineteenth

century, with organized trading in cotton through the establishment of the Cotton
Trade Association in 1875. Derivatives, as exchange traded financial instruments
were introduced in India in June 2000. The Star heroes for this project were L.C.
Gupta Committee & J. R. Verma Committee who gave the report in regards of
exchange dated derivatives & Risk management system for these instruments. The
efforts taken by them have shown a positive effect in The Securities Contracts
(Regulations) Act, 1956.

The Said Act defined “Derivatives” 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.

At Present, The equity derivatives market is the most active derivatives

market in India. Trading volumes in equity derivatives are, on an average, more
than three and half times the trading volumes in the cash equity markets.

 Milestones in the development of Indian derivative market:

November 18, 1996 L.C. Gupta Committee set up to draft a policy framework
for introducing derivatives

May 11, 1998 L.C. Gupta committee submits its report on the policy
framework

May 25, 2000 SEBI allows exchanges to trade in index futures

June 12, 2000 Trading on Nifty futures commences on the NSE

June 4, 2001 Trading for Nifty options commences on the NSE

July 2, 2001 Trading on Stock options commences on the NSE

November 9, 2001 Trading on Stock futures commences on the NSE

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 August 29, 2008 Currency derivatives trading commences on the NSE

August 31, 2009 Interest rate derivatives trading commences on the NSE

 Two important terms:

Before discussing derivatives, it would be useful to be familiar with two

terminologies relating to the underlying markets. These are as follows:

A. Spot Market:

In the context of securities, the spot market or cash market is a securities

market in which securities are sold for cash and delivered immediately. The delivery
happens after the settlement period. Let us describe this in the context of India. The
NSE’s cash market segment is known as the Capital Market (CM) Segment. In this
market, shares of SBI, Reliance, Infosys, ICICI Bank, and other public listed
companies are traded. The settlement period in this market is on a T+2 bases i.e.,
the buyer of the shares receives the shares two working days after trade date and
the seller of the shares receives the money two working days after the trade date.

B. Index:

Stock prices fluctuate continuously during any given period. Prices of some
stocks might move up while that of others may move down. In such a situation, what
can we say about the stock market as a whole? Has the market moved up or has it
moved down during a given period? Similarly, have stocks of a particular sector
moved up or down? To identify the general trend in the market (or any given sector
of the market such as banking), it is important to have a reference barometer which
can be monitored. Market participants use various indices for this purpose. An index
is a basket of identified stocks, and its value is computed by taking the weighted
average of the prices of the constituent stocks of the index. A market index for
example consists of a group of top stocks traded in the market and its value changes
as the prices of its constituent stocks change. In India, Nifty Index is the most
popular stock index and it is based on the top 50 stocks traded in the market. Just as
derivatives on stocks are called stock derivatives, derivatives on indices such as Nifty
are called index derivatives.

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 2. Definition of Basic Derivatives

There are various types of derivatives traded on exchanges across the world.
They range from the very simple to the most complex products. The following are
the four basic forms of derivatives, which are the building blocks for many complex
derivatives instruments (the latter are beyond the scope of this Material):

· Forwards
· Futures
· Options
· Swaps

Knowledge of these instruments is necessary in order to understand the

basics of derivatives. We shall now discuss each of them in detail.

• Forwards

A forward contract or simply a forward is a contract between two parties to

buy or sell an asset at a certain future date for a certain price that is pre-decided on
the date of the contract. The future date is referred to as expiry date and the pre-
decided price is referred to as Forward Price.

In short, a forward is an agreement between two parties in which one party,

the buyer, enters into an agreement with the other party, the seller that he would
buy from the seller an underlying asset on the expiry date at the forward price.
Remember that it is different from a spot market contract, which involves immediate
payment and immediate transfer of asset.

Forward contracts are traded only in Over the Counter (OTC) market and not
in stock exchanges. OTC market is a private market where individuals/institutions
can trade through negotiations on a one to one basis.

The party that agrees to buy the asset on a future date is referred to as a
long investor and is said to have a long position. Similarly the party that agrees to
sell the asset in a future date is referred to as a short investor and is said to have a
short position. The price agreed upon is called the delivery price or the Forward
Price.

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 A. Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements

possible to settle the obligation of the parties: physical settlement and cash
settlement. Both types of settlements happen on the expiry date and are given
below.

I. Physical Settlement:

A forward contract can be settled by the physical delivery of the underlying

asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the
payment of the agreed forward price by the buyer to the seller on the agreed
settlement date. The following example will help us understand the physical
settlement process.

Illustration:

Consider two parties (Tom and Jerry) enter into a forward contract on 1
August, 2009 where, Tom agrees to deliver 1000 stocks of Unitech to Jerry, at a
price of Rs. 100 per share, on 29th August, 2009 (the expiry date). In this contract,
Tom, who has committed to sell 1000 stocks of Unitech at Rs. 100 per share on 29th
August, 2009 has a short position and Jerry, who has committed to buy 1000 stocks
at Rs. 100 per share is said to have a long position. In case of physical settlement,
on 29th August, 2009 (expiry date), Tom has to actually deliver 1000 Unitech shares
to Jerry and Jerry has to pay the price (1000 * Rs. 100 = Rs. 10,000) to Tom. In
case Tom does not have 1000 shares to deliver on 29th August, 2009, he has to
purchase it from the spot market and then deliver the stocks to Jerry. On the expiry
date the profit/loss for each party depends on the settlement price, that is, the
closing price in the spot market on 29th August, 2009. The closing price on any
given day is the weighted average price of the underlying during the last half an hour
of trading in that day. Depending on the closing price, three different scenarios of
profit/loss are possible for each party. They are as follows:

Scenario I:

Closing spot price on 29 August, 2009 (S T) is greater than the Forward price
(FT ) Assume that the closing price of Reliance on the settlement date 29 August,
2009 is Rs. 105. Since the short investor has sold Reliance at Rs. 100 in the Forward
market on 1 August, 2009, he can buy 1000 Reliance shares at Rs. 105 from the
market and deliver them to the long investor. Therefore the person who has a short
position makes a loss of (100 – 105) X 1000 = Rs. 5000. If the long investor sells
the shares in the spot market immediately after receiving them, he would make an
equivalent profit of (105 – 100) X 1000 = Rs. 5000.

Scenario II:

Closing Spot price on 29 August (S T), 2009 is the same as the Forward price
(F T) The short seller will buy the stock from the market at Rs. 100 and give it to the

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long investor. As the settlement price is same as the Forward price, neither party will
gain or lose anything.

Scenario III:

Closing Spot price (S T) on 29 August is less than t he futures price (F T)

Assume that the closing price of Reliance on 29 August, 2009 is Rs. 95. The
short investor, who has sold Reliance at Rs. 100 in the Forward market on 1 August,
2009, will buy the stock from the market at Rs. 95 and deliver it to the long investor.
Therefore the person who has a short position would make a profit of (100 – 95) X
1000 = Rs. 5000 and the person who has long position in the contract will lose an
equivalent amount (Rs. 5000), if he sells the shares in the spot market immediately
after receiving them.

* The main disadvantage of physical settlement is that it results in huge

transaction costs in terms of actual purchase of securities by the party holding a
short position (in this case Tom) and transfer of the security to the party in the
long position (in this case Jerry). Further, if the party in the long position is
actually not interested in holding the security, then she will have to incur further
transaction cost in disposing off the security. An alternative way of settlement,
which helps in minimizing this cost, is through cash settlement.

II. Cash Settlement:

Cash settlement does not involve actual delivery or receipt of the security.
Each party either pays (receives) cash equal to the net loss (profit) arising out of
their respective position in the contract. So, in case of Scenario I mentioned above,
where the spot price at the expiry date (ST) was greater than the forward price (FT),
the party with the short position will have to pay an amount equivalent to the net
loss to the part y at the long position. In our example, Tom will simply pay Rs. 5000
to Jerry on the expiry date. The opposite is the case in Scenario (III), when ST < FT.
The long party will be at a loss and have to pay an amount equivalent to the net loss
to the short party. In our example, Jerry will have to pay Rs. 5000 to Tom on the
expiry date. In case of Scenario (II) where ST = FT, there is no need for any party to
pay anything to the other party.

Please note that the profit and loss position in case of physical settlement and
cash settlement is the same except for the transaction costs which is involved in the
physical settlement.

B. Default risk in forward contracts

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 A drawback of forward contracts is that they are subject to default risk.
Regardless of whether the contract is for physical or cash settlement, there exists a
potential for one party to default, i.e. not honor the contract. It could be either the
buyer or the seller. This results in the other party suffering a loss. This risk of
making losses due to any of the two parties defaulting is known as counter party
risk. The main reason behind such risk is the absence of any mediator between the
parties, who could have undertaken the task of ensuring that both the parties fulfill
their obligations arising out of the contract. Default risk is also referred to as counter
party risk or credit risk.

• Futures

Like a forward contract, a futures contract is an agreement between two

parties in which the buyer agrees to buy an underlying asset from the seller, at a
future date at a price that is agreed upon today. However, unlike a forward contract,
a futures contract is not a private transaction but gets traded on a recognized stock
exchange. In addition, a futures contract is standardized by the exchange. All the
terms, other than the price, are set by the stock exchange (rather than by individual
parties as in the case of a forward contract). Also, both buyer and seller of the
futures contracts are protected against the counter party risk by an entity called the
Clearing Corporation. The Clearing Corporation provides this guarantee to ensure
that the buyer or the seller of a futures contract does not suffer as a result of the
counter party defaulting on its obligation. In case one of the parties defaults, the
Clearing Corporation steps in to fulfill the obligation of this party, so that the other
party does not suffer due to non-fulfillment of the contract. To be able to guarantee
the fulfillment of the obligations under the contract, the Clearing Corporation holds
an amount as a security from both the parties. This amount is called the Margin
money and can be in the form of cash or other financial assets. Also, since the
futures contracts are traded on the stock exchanges, the parties have the flexibility
of closing out the contract prior to the maturity by squaring off the transactions in
the market.

The basic flow of a transaction between three parties, namely Buyer, Seller
and Clearing Corporation is depicted in the diagram below:

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 Let’s see the difference between Forwards & Futures

Forwards Futures
Privately negotiated contracts Traded on a exchange
Not Standardized Standardized Contract
Settlement dates can be set by the Fixed settlement dates as declared by
parties the exchange
High counter party risk Almost no counter party risk

• Options:

An option is a derivative contract between a buyer and a seller, where one

party (say First Party) gives to the other (say Second Party) the right, but not the
obligation, to buy from (or sell to) the First Party the underlying asset on or before a
specific day at an agreed-upon price. In return for granting the option, the party

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granting the option collects a payment from the other party. This payment collected
is called the “premium” or price of the option.

The right to buy or sell is held by the “option buyer” (also called the option
holder); the party granting the right is t he “option seller” or “option writer”. Unlike
forwards and futures contracts, options require a cash payment (called the premium)
upfront from the option buyer to the option seller. This payment is called option
premium or option price. Options can be traded either on the stock exchange or in
over the counter (OTC) markets. Options traded on the exchanges are backed by the
Clearing Corporation thereby minimizing the risk arising due to default by the
counter parties involved. Options traded in the OTC market however are not backed
by the Clearing Corporation.

There are two types of options—call options and put options—which are
explained below.

A. Call option:

A call option is an option granting the right to the buyer of the option to buy
the underlying asset on a specific day at an agreed upon price, but not the obligation
to do so. It is the seller who grants this right to the buyer of the option. It may be
noted that the person who has the right to buy the underlying asset is known as the
“buyer of the call option”. The price at which the buyer has the right to buy the asset
is agreed upon at the time of entering the contract. This price is known as the strike
price of the contract (call option strike price in this case). Since the buyer of the call
option has the right (but no obligation) to buy the underlying asset, he will exercise
his right to buy the underlying asset if and only if the price of the underlying asset in
the market is more than the strike price on or before the expiry date of the contract.
The buyer of the call option does not have an obligation to buy if he does not want
to.

B. Put option

A put option is a contract granting the right to the buyer of the option to sell
the underlying asset on or before a specific day at an agreed upon price, but not the
obligation to do so. It is the seller who grants this right to the buyer of the option.
The person who has the right to sell the underlying asset is known as the “buyer of
the put option”. The price at which the buyer has the right to sell the asset is agreed
upon at the time of entering the contract. This price is known as the strike price of
the contract (put option strike price in this case). Since the buyer of the put option
has the right (but not the obligation) to sell the underlying asset, he will exercise his
right to sell the underlying asset if and only if the price of the underlying asset in the
market is less than the strike price on or before the expiry date of the contract. The
buyer of the put option does not have the obligation to sell if he does not want to.

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Types of options:
Options can be divided into two different categories depending upon the
primary exercise styles associated with options. These categories are:

European Options:
European options are options that can be exercised only on the expiration
date. All options based on indices such as Nifty, Mini Nifty, Bank Nifty, CNX IT traded
at the NSE are European options which can be exercised by the buyer (of the option)
only on the final settlement date or the expiry date.

American options:
American options are options that can be exercised on any day on or before
the expiry date. All options on individual stocks like Reliance, SBI, and Infosys traded
at the NSE are American options. They can be exercised by the buyer on any day on
or before the final settlement date or the expiry date.

Illustration:

Suppose Salman Khan has “bought a call option” of 2000 shares of Hindustan
Unilever Limited (HLL) at a strike price of Rs 260 per share at a premium of Rs 10.
This option gives Salman Khan, the buyer of the option, the right to buy 2000 shares
of HLL from the seller of the option, on or before August 27, 2009 (expiry date of the
option). The seller of the option has the obligation to sell 2000 shares of HLL at Rs
260 per share on or before August 27, 2009 (i.e. whenever asked by the buyer of
the option).

Suppose instead of buying a call, Salman Khan has “sold a put option” on 100
Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium of Rs 8.
This option is an obligation to Salman Khan to buy 100 shares of Reliance Industries
(RIL) at a price of Rs 2000 per share on or before August 27 (expiry date of the
option) i.e., as and when asked by the buyer of the put option. It depends on the
option buyer as to when he exercises the option. As stated earlier, the buyer does
not have the obligation to exercise the option.

Let’s see the difference between Futures & Options

Futures Options
The buyer of the option has the right
Both the Buyer and Seller are under and not an obligation whereas the
an obligation to fulfill the contract. seller is under obligation to fulfill the
contract if and when the buyer
exercises his right.
The buyer and the seller are subject The seller is subjected to unlimited
to unlimited risk of loss. risk of losing whereas the buyer has

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 limited potential to lose (which is the
option premium).
The buyer and the seller have The buyer has potential to make
potential to make unlimited gain or unlimited gain while the seller has a
loss. potential to make unlimited gain. On
the other hand the buyer has a
limited loss potential and the seller
has an unlimited loss potential.

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• Swaps:

Swap is a contract by which two parties exchange, the cash flow linked to
their liability. It is traded over the Counter (OTC).

Illustration:

Jay has variable rate loan. He wants fixed rate loan.

Viru has fixed rate loan. He wants variable rate loan.

Jay & Viru swaps their interest.

Or it can be easily understood by following pictures:

Father Son

Swaps Like

Father Son

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 3. Application of Derivatives

In this Unit, we look at the participants in the derivatives markets and how they
use derivatives contracts.

 Participants in the Derivatives Market:

Based on the application that derivatives are put to, the investors can be broadly
classified into three groups:

• Hedgers
• Speculators
• Arbitrageurs

We shall now look at each of these categories in detail:

• Hedgers:

These investors have a position (i.e., have bought stocks) in the underlying
market but are worried about a potential loss arising out of a change in the asset
price in the future. Hedgers participate in the derivatives market to lock the prices at
which they will be able to transact in the future. Thus, they try to avoid price risk
through holding a position in the derivatives market. Different hedgers take different
positions in the derivatives market based on their exposure in the underlying market.
A hedger normally takes an opposite position in the derivatives market to what he
has in the underlying market.
Hedging in futures market can be done through two positions, viz. short
hedge and long hedge.

Short Hedge
A short hedge involves taking a short position in the futures market. Short
hedge position is taken by someone who already owns the underlying asset or is
expecting a future receipt of the underlying asset.

For example, an investor holding Reliance shares may be worried about

adverse future price movements and may want to hedge the price risk. He can do so
by holding a short position in the derivatives market. The investor can go short in
Reliance futures at the NSE. This protects him from price movements in Reliance
stock. In case the price of Reliance shares falls, the investor will lose money in the
shares but will make up for this loss by the gain made in Reliance Futures. Note that

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 a short position holder in a futures contract makes a profit if the price of the
underlying asset falls in the future. In this way, futures contract allows an investor to
manage his price risk.
Similarly, a sugar manufacturing company could hedge against any probable
loss in the future due to a fall in the prices of sugar by holding a short position in the
futures/ forwards market. If the prices of sugar fall, the company may lose on the
sugar sale but the loss will be offset by profit made in the futures contract.

Long Hedge
A long hedge involves holding a long position in the futures market. A Long
position holder agrees to buy the underlying asset at the expiry date by paying the
agreed futures/ forward price. This strategy is used by those who will need to
acquire the underlying asset in the future.

For example, a chocolate manufacturer who needs to acquire sugar in the

future will be worried about any loss that may arise if the price of sugar increases in
the future. To hedge against this risk, the chocolate manufacturer can hold a long
position in the sugar futures. If the price of sugar rises, the chocolate manufacture
may have to pay more to acquire sugar in the normal market, but he will be
compensated against this loss through a profit that will arise in the futures market.
Note that a long position holder in a futures contract makes a profit if the price of the
underlying asset increases in the future.

Long hedge strategy can also be used by those investors who desire to
purchase the underlying asset at a future date (that is, when he acquires the cash to
purchase the asset) but wants to lock the prevailing price in the market. This may be
because he thinks that the prevailing price is very low.

For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per
stock. An investor is expecting to have Rs. 250 at the end of the month. The investor
feels that Wipro Ltd. is at a very attractive level and he may miss the opportunity to
buy the stock if he waits till the end of the month. In such a case, he can buy Wipro
Ltd. in the futures market. By doing so, he can lock in the price of the stock.
Assuming that he buys Wipro Ltd. in the futures market at Rs. 250 (this becomes his
locked-in price), there can be three probable scenarios:

Scenario I:

Price of Wipro Ltd. in the cash market on expiry date is Rs. 300.
As futures price is equal to the spot price on the expiry day, the futures price of
Wipro would be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the
futures market at Rs. 300. By doing this, he has made a profit of 300 – 250 = Rs. 50
in the futures trade. He can now buy Wipro Ltd in the spot market at Rs. 300.
Therefore, his total investment cost for buying one share of Wipro Ltd equals Rs.300
(price in spot market) – 50 (profit in futures market) = Rs.250. This is the amount of
money he was expecting to have at the end of the month. If the investor had not
bought Wipro Ltd futures, he would have had only Rs. 250 and would have been
unable to buy Wipro Ltd shares in the cash market. The futures contract helped him
to lock in a price for the shares at Rs. 250.

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Scenario II:

Price of Wipro Ltd in the cash market on expiry day is Rs. 250.
As futures price tracks spot price, futures price would also be at Rs. 250 on expiry
day. The investor will sell Wipro Ltd in the futures market at Rs. 250. By doing this,
he has made Rs. 0 in the futures trade. He can buy Wipro Ltd in the spot market at
Rs. 250. His total investment cost for buying one share of Wipro will be = Rs. 250
(price in spot market) + 0 (loss in futures market) = Rs. 250.

Scenario III:

Price of Wipro Ltd in the cash market on expiry day is Rs. 200.
As futures price tracks spot price, futures price would also be at Rs. 200 on expiry
day. The investor will sell Wipro Ltd in the futures market at Rs. 200. By doing this,
he has made a loss of 200 – 250 = Rs. 50 in the futures trade. He can buy Wipro in
the spot market at Rs. 200. Therefore, his total investment cost for buying one share
of Wipro Ltd will be = 200 (price in spot market) + 50 (loss in futures market) = Rs.
250.

Thus, in all the three scenarios, he has to pay only Rs. 250. This is an example of a
Long Hedge.

• Speculators:

A Speculator is one who bets on the derivatives market based on his views on
the potential movement of the underlying stock price. Speculators take large,
calculated risks as they trade based on anticipated future price movements. They
hope to make quick, large gains; but may not always be successful. They normally
have shorter holding time for their positions as compared to hedgers. If the price of
the underlying moves as per their expectation they can make large profits. However,
if the price moves in the opposite direction of their assessment, the losses can also
be enormous.

Illustration:

Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market
and also at Rs. 500 in the futures market (assumed values for the example only). A
speculator feels that post the RBI’s policy announcement, the share price of ICICI
will go up. The speculator can buy the stock in the spot market or in the derivatives
market. If the derivatives contract size of ICICI is 1000 and if the speculator buys
one futures contract of ICICI, he is buying ICICI futures worth Rs 500 X 1000 = Rs.
5,00,000. For this he will have to pay a margin of say 20% of the contract value to
the exchange. The margin that the speculator needs to pay to the exchange is 20%
of Rs. 5,00,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for the
futures contract. If the speculator would have invested Rs. 1,00,000 in the spot
market, he could purchase only 1,00,000 / 500 = 200 shares.
Let us assume that post RBI announcement price of ICICI share moves to Rs.
520. With one lakh investment each in the futures and the cash market, the profits
would be: · (520 – 500) X 1,000 = Rs. 20,000 in case of futures market and · (520 –
500) X 200 = Rs. 4000 in the case of cash market.

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 It should be noted that the opposite will result in case of adverse movement
in stock prices, wherein the speculator will be losing more in the futures market than
in the spot market. This is because the speculator can hold a larger position in the
futures market where he has to pay only the margin money.

• Arbitrageurs:

Arbitrageurs attempt to profit from pricing inefficiencies in the market by

making simultaneous trades that offset each other and capture a risk-free profit. An
arbitrageur may also seek to make profit in case there is price discrepancy between
the stock price in the cash and the derivatives markets.

For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in
the cash market and the futures contract of SBI is trading at Rs. 1790, the
arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the
spot market and sell the same number of SBI futures contracts. On expiry day (say
24 August, 2009), the price of SBI futures contracts will close at the price at which
SBI closes in the spot market. In other words, the settlement of the futures contract
will happen at the closing price of the SBI shares and that is why the futures and
spot pr ices are said to converge on the expiry day. On expiry day, the arbitrageur
will sell the SBI stock in the spot market and buy the futures contract, both of which
will happen at the closing price of SBI in the spot market. Since the arbitrageur has
entered into off-setting positions, he will be able to earn Rs. 10 irrespective of the
prevailing market price on the expiry date.

There are three possible price scenarios at which SBI can close on expiry day.
Let us calculate the profit/ loss of the arbitrageur in each of the scenarios where he
had initially (1 August) purchased SBI shares in the spot market at Rs 1780 and sold
the futures contract of SBI at Rs. 1790:

Scenario I:

SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot
market on expiry day (24 August 2009) SBI futures will close at the same price as
SBI in spot market on the expiry day i.e., SBI futures will also close at Rs. 2000. The
arbitrageur reverses his previous transaction entered into on 1 August 2009.

Profit/ Loss (–) in spot market = 2000 – 1780 = Rs. 220

Profit/ Loss (–) in futures market = 1790 – 2000 = Rs. ( –) 210

Net profit/ Loss (–) on both transactions combined = 220 – 210 = Rs. 10 profit.

Scenario II:

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 SBI shares close at Rs 1780 in the spot market on expiry day (24 August
2009) SBI futures will close at the same price as SBI in spot market on expiry day
i.e., SBI futures will also close at Rs 1780. The arbitrageur reverses his previous
transaction entered into on 1 August 2009.

Profit/ Loss (–) in spot market = 1780 – 1780 = Rs 0

Profit/ Loss (–) in futures market = 1790 – 1780 = Rs. 10

Net profit/ Loss (–) on both transactions combined = 0 + 10 = Rs. 10 profit.

Scenario III:

SBI shares close at Rs. 1500 in the spot market on expiry day (24 August
2009) here also; SBI futures will close at Rs. 1500. The arbitrageur reverses his
previous transaction entered into on 1 August 2009.

Profit/ Loss (–) in spot market = 1500 – 1780 = Rs. (–) 280

Profit/ Loss (–) in futures market = 1790 – 1500 = Rs. 290

Net profit/ Loss (–) on both transactions combined = (–) 280 + 290 = Rs. 10 profit.

Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which
was the difference between the spot price of SBI and futures price of SBI, when the
transaction was entered into. This is called a “risk less profit” since once the
transaction is entered into on 1 August, 2009 (due to the price difference between
spot and futures), the profit is locked.

Irrespective of where the underlying share price closes on the expiry y date of
the contract, a profit of Rs. 10 is assured. The investment made by the arbitrageur is
Rs. 1780 (when he buys SBI in the spot market). He makes this investment on 1
August 2009 and gets a return of Rs. 10 on this investment in 23 days (24 August).
This means a return of 0.56% in 23 days. If we annualize this, it is a return of nearly
9% per annum. One should also note that this opportunity to make a risk-less return
of 9% per annum will not always remain. The difference between the spot and
futures price arose due to some inefficiency (in the market), which was exploited by
the arbitrageur by buying shares in spot and selling futures. As more and more such
arbitrage trades take place, the difference between spot and futures prices would
narrow thereby reducing the attractiveness of further arbitrage.

 Uses of Derivatives:

o Risk management:
The most important purpose of the derivatives market is risk management.
Risk management for an investor comprises of the following three processes:

· Identifying the desired level of risk that the investor is willing to take on his
Investments;

30
 · Identifying and measuring the actual level of risk that the investor is
carrying; and
· Making arrangements which may include trading (buying/selling) of
derivatives contracts that allow him to match the actual and desired levels of risk.

The example of hedging discussed above illustrates the process of risk

management through futures.

o Market efficiency:
Efficient markets are fair and competitive and do not allow an investor to
make risk free profits. Derivatives assist in improving the efficiency of the markets,
by providing a self-correcting mechanism. Arbitrageurs are one section of market
participants who trade whenever there is an opportunity to make risk free profits till
the opportunity ceases to exist. Risk free profits are not easy to make in more
efficient markets. When trading occurs, there is a possibility that some amount of
mispricing might occur in the markets. The arbitrageurs step in to take advantage of
this mispricing by buying from the cheaper market and selling in the higher market.
Their actions quickly narrow the prices and thereby reducing the inefficiencies.

o Price discovery:
One of the primary functions of derivatives markets is price discovery. They
provide valuable information about the prices and expected price fluctuations of the
underlying assets in two ways:

· First, many of these assets are traded in markets in different geographical

locations. Because of this, assets may be traded at different prices in different
markets. In derivatives markets, the price of the contract often serves as a proxy for
the price of the underlying asset. For example, gold may trade at different prices in
Mumbai and Delhi but a derivatives contract on gold would have one value and so
traders in Mumbai and Delhi can validate the prices of spot markets in their
respective location to see if it is cheap or expensive and trade accordingly.

· Second, the prices of the futures contracts serve as prices that can be used
to get a sense of the market expectation of future prices. For example, say there is a
company that produces sugar and expects that the production of sugar will take two
months from today. As sugar prices fluctuate daily, the company does not know if
after two months the price of sugar will be higher or lower than it is today. How does
it predict where the price of sugar will be in future? It can do this by monitoring
prices of derivatives contract on sugar (say a Sugar Forward contract). If the forward
price of sugar is trading higher than the spot price that means that the market is
expecting the sugar spot price to go up in future. If there were no derivatives price,
it would have to wait for two months before knowing the market price of sugar on
that day. Based on derivatives price the management of the sugar company can
make strategic and tactical decisions of how much sugar to produce and when.

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 4. Trading Futures

To understand futures trading and profit/loss that can occur while trading,
knowledge of pay-off diagrams is necessary. Pay-off refers to profit or loss in a trade. A
pay-off is positive if the investor makes a profit and negative if he makes a loss. A pay-
off diagram represents profit/loss in the form of a graph which has the stock price on the
X axis and the profit/ loss on the Y axis. Thus, from the graph an investor can calculate
the profit or loss that his position can make for different stock price values. Forwards
and futures have same pay-offs. In other words, their profit/loss values behave in a
similar fashion for different values of stock price. In this Unit, we shall focus on pay-offs
of futures contracts.

 Pay-off of Futures
The Pay-off of a futures contract on maturity depends on the spot price of the
underlying asset at the time of maturity and the price at which the contract was initially
traded. There are two positions that could be taken in a futures contract:

a. Long position: one who buys the asset at the futures price (F) takes the long
position and
b. Short position: one who sells the asset at the futures price (F) takes the short
position.

In general, the pay-off for a long position in a futures contract on one unit of an
asset is: Long Pay-off = S T – F

Where F is the traded futures price and ST is the spot price of the asset at expiry
of the contract (that is, closing price on the expiry date). This is because the holder of
the contract is obligated to buy the asset worth ST for F.

Similarly, the pay-off from a short position in a futures contract on one unit of
asset is: Short Pay-off = F – ST

 Pay-off diagram for a long futures position:

The Figure 4.1 depicts the payoff diagram for an investor who is long on a futures
contract. The investor has gone long in the futures contract at a price F.

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 The long investor makes profits if the spot price (ST) at expiry exceeds the
futures contract price F, and makes losses if the opposite happens. In the above
diagram, the slanted line is a 45 degree line, implying that for every one rupee change
in the price of the underlying, the profit/ loss will change by one rupee. As can be seen
from the diagram, if ST is less than F, the investor makes a loss and the higher the ST ,
the lower the loss. Similarly, if S T is greater than F, the investor makes a profit and
higher the S T, the higher is the profit.

 Pay-off diagram for a short position:

Figure 4.2 is the pay-off diagram for someone who has taken a short position on
a futures contract on the stock at a price F.

Here, the investor makes profits if the spot price (ST) at expiry is below the
futures contract price F, and makes losses if the opposite happens. Here, if ST is less
than F, the investor makes a profit and the higher the ST , the lower the profit.
Similarly, if ST is greater than F, the investor makes a loss and the higher the S T, the
lower is the profit.

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 As can be seen from the pay-off diagrams for futures contracts, the pay-off is
depicted by a straight line (both buy and sell). Such pay-off diagrams are known as
linear pay-offs.

 A theoretical model for Future pricing:

While futures prices in reality are determined by demand and supply, one can
obtain a theoretical Futures price, using the following model:

Where:
F = Futures price
S = Spot price of the underlying asset
r = Cost of financing (using continuously compounded interest rate)
T = Time till expiration in years
e = 2.71828

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be
invested at 11% per annum. The fair value of a one-month futures contract on XYZ is
calculated as follows:

This model is also called the cost of carry model of pricing futures. It calculates
the Fair Value of futures contract (Rs. 1160) based on the current spot price of the
underlying asset (Rs. 1150), interest rate and time to maturity. Every time the market
price for futures (which is determined by demand and supply) deviates from the fair
value determined by using the above formula, arbitragers enter into trades to capture
the arbitrage profit. For example, if the market price of the Future is higher than the fair
value, the arbitrageur would sell in the futures market and buy in the spot market
simultaneously and hold both trades till expiry and book riskless profit. As more and
more people do this, the Future price will come down to its fair value level.

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 5. Trading Options

In this Unit we will discuss pay-outs for various strategies using options and
strategies which can be used to improve returns by using options.

 Option Payout:

There are two sides to every option contract. On the one side is the option buyer
who has taken a long position (i.e., has bought the option). On the other side is the
option seller who has taken a short position (i.e., has sold the option). The seller of the
option receives a premium from the buyer of the option. It may be noted that while
computing profit and loss, premium has to be taken into consideration. Also, when a
buyer makes profit, the seller makes a loss of equal magnitude and vice versa. In this
section, we will discuss payouts for various strategies using options.

 A long position in a call option:

In this strategy, the investor has the right to buy the asset in the future at a
predetermined strike price i.e., strike price (K) and the option seller has the obligation to
sell the asset at the strike price (K). If the settlement price (underlying stock closing
price) of the asset is above the strike price, then the call option buyer will exercise his
option and buy the stock at the strike price (K). If the settlement price (underlying stock
closing price) is lower than the strike price, the option buyer will not exercise the option
as he can buy the same stock from the market at a price lower than the strike price.

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 A long position in a put option:

In this strategy, the investor has bought the right to sell the underlying asset in
the future at a predetermined strike price (K). If the settlement price (underlying stock
closing price) at maturity is lower than the strike price, then the put option holder will
exercise his option and sell the stock at the strike price (K). If the settlement price
(underlying stock closing price) is higher than the strike price, the option buyer will not
exercise the option as he can sell the same stock in the market at a price higher than
the strike price.

 A short position in a call option:

In this strategy, the option seller has an obligation to sell the asset at a
predetermined strike price (K) if the buyer of the option chooses to exercise the option.
The buyer of the option will exercise the option if the spot price at maturity is any value
higher than (K). If the spot price is lower than (K), the buyer of the option will not
exercise his/her option.

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 A short position in a put option:

In this strategy, the option seller has an obligation to buy the asset at a
predetermined strike price (K) if the buyer of the option chooses to exercise his/her
option. The buyer of the option will exercise his option to sell at (K) if the spot price at
maturity is lower than (K). If the spot price is higher than (K), then the option buyer will
not exercise his/her option.

• Option Strategies:

An option strategy is implemented to try and make gains from the movement in
the underlying price of an asset. As discussed above, options are derivatives that give
the buyer the right to exercise the option at a future date. Unlike futures and forwards

30
which have linear pay-offs and do not require an initial outlay (upfront payment),
options have non linear pay-offs and do require an initial outlay (or premium). In this
section we discuss main fundamental strategies which can be used to maximize returns
by using options.

 Long option strategy:

A long option strategy is a strategy of buying an option according to the view on

future price movement of the underlying. A person with a bullish opinion on the
underlying will buy a call option on that asset/security, while a person with a bearish
opinion on the underlying will buy a put option on that asset/security. An important
characteristic of long option strategies is limited risk and unlimited profit potential. An
option buyer can only lose the amount paid for the option premium. At the same time,
theoretically, the profit potential is unlimited.

Calls:
An investor having a bullish opinion on underlying can expect to have positive
returns by buying a call option on that asset/security. When a call option is purchased,
the call option holder is exposed to the stock performance in the spot market without
actually possessing the stock and does so for a fraction of the cost involved in
purchasing the stock in the spot market. The cost incurred by the call option holder is
the option premium. Thus, he can take advantage of a smaller investment and maximize
his profits.
Consider the purchase of a call option at the price (premium) c. We take

ST = Spot price at time T

K = Strike price

The payout in two scenarios is as follows:

Profit/Loss = – c, if S T = K

Profit/Loss = (ST - K) – c if S T = K

Let us explain this with some examples. Mr. Rocketsingh buys a Call on an index
(such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81. Consider the
values of the index at expiration as 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 0 – 81 = – 81 (maximum loss = premium paid)

For ST = 1900, Profit/Loss = 0 – 81 = – 81 (maximum loss = premium paid)
For ST = 2100, Profit/Loss = 2100 – 2000 – 81 = 19
For ST = 2200, Profit/Loss = 2200 – 2000 – 81 = 119

As we can see from the example, the maximum loss suffered by Mr. Rocketsingh
i.e. the buyer of the Call option is Rs. 81, which is the premium that he paid to buy the

30
option. His maximum profits are unlimited and they depend on where the underlying
price moves.

Puts:
An investor having a bearish opinion on the underlying can expect to have
positive returns by buying a put option on that asset/security. When a put option is
purchased, the put option buyer has the right to sell the stock at the strike price on or
before the expiry date depending on where the underlying price is.

Consider the purchase of a put option at price (premium) p. We take

ST = Spot price at time T

K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = (K – ST ) – p if ST = K

Profit/Loss = – p if ST = K

Let us explain this with some examples. Mr. Yuvrajsingh buys a put at a strike
price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at expiration
at 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 2000 – 1800 – 79 = 121

For ST = 1900, Profit/Loss = 2000 – 1900 – 79 = 21
For ST = 2100, Profit/Loss = – 79 (maximum loss is the premium paid)
For ST = 2200, Profit/Loss = – 79 (maximum loss is the premium paid)

As we can see from the example, the maximum loss suffered by Mr. Yuvrajsingh
i.e. the buyer of the Put option is Rs. 79, which is the premium that he paid to buy the
option. His maximum profits are unlimited and depend on where the underlying price
moves.

 Short options strategy:

A short options strategy is a strategy where options are sold to make money
upfront with a view that the options will expire out of money at the expiry date (i.e., the
buyer of the option will not exercise the same and the seller can keep the premium). As
opposed to a long options strategy, here a person with a bullish opinion on the
underlying will sell a put option in the hope that prices will rise and the buyer will not
exercise the option leading to profit for the seller. On the other hand, a person with a
bearish view on the underlying will sell a call option in the hope that prices will fall and

30
the buyer will not exercise the option leading to profit for the seller. As opposed to a
long options strategy where the downside was limited to the price paid for the option,
here the downside is unlimited and the profit is limited to the price of selling the option
(the premium).

Calls:
An investor with a bearish opinion on the underlying can take advantage of falling
stock prices by selling a call option on the asset/security. If the stock price falls, the
profit to the seller will be the premium earned by selling the option. He will lose in case
the stock price increases above the strike price.

Consider the selling of a call option at the price (premium) c. We take

ST = Spot price at time T

K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = c if ST = K

Profit/Loss = c – (ST – K) if S T = K
Now consider this example: Mr. Debojit sells a call at a strike price of Rs 2000 for
a premium of Rs 81. Consider values of index at expiration at 1800, 1900, 2100, and
2200.

For ST = 1800, Profit/Loss = 81 (maximum profit = premium received)

For ST = 1900, Profit/Loss = 81 (maximum profit = premium received)
For ST = 2100, Profit/Loss = 81 – (2100 – 2000) = – 19
For ST =2200, Profit/Loss = 81 – (2100 – 2200) = – 119

As we can see from the example above, the maximum loss suffered by Mr.
Debojit i.e. the seller of the Call option is unlimited (this is the reverse of the buyer’s
gains). His maximum profits are limited to the premium received.

Puts:
An investor with a bullish opinion on the underlying can take advantage of rising
prices by selling a put option on the asset/security. If the stock price rises, the profit to
the seller will be the premium earned by selling the option. He will lose in case the stock
price falls below the strike price.

Consider the sale of a put option at the price (premium) p. We take:

ST = Spot price at time T

K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = p – (K – ST) if S T = K

Profit/Loss = p if ST = K

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 We sell a put at a strike price of Rs. 2000 for Rs. 79. Consider values of index at
expiration as 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 79 – (2000 – 1800) = (–) 121

For ST = 1900, Profit/Loss = 79 – (2000 – 1900) = (–) 21
For ST = 2100, Profit/Loss = 79 (maximum profit = premium received)
For ST = 2200, Profit/Loss = 79 (maximum profit = premium received)

As we can see from the example above the maximum loss suffered by the seller
of the Put option is unlimited (this is the reverse of the buyer’s gains). His maximum
profits are limited to the premium received.

• Determination of option prices:

Like in case of any traded good, the price of any option is determined by the
demand for and supply of that option. This price has two components: intrinsic value
and time value.
• Intrinsic value of an option:

Intrinsic value of an option at a given time is the amount the holder of the option
will get if he exercises the option at that time. In other words, the intrinsic value of an
option is the amount the option is in-the-money (ITM). If the option is out-of the-
money (OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a
call is Max [0, (St — K)] which means that the intrinsic value of a call is the greater of 0
or (St — K).
Similarly, the intrinsic value of a put is Max [0, K — St] i.e., the greater of 0 or
(K — S t) where K is the strike price and S t is the spot price.

• Time value of an option:

In addition to the intrinsic value, the seller charges a ‘time value’ from the
buyers of the option. This is because the more time there is for the contract to expire,
the greater the chance that the exercise of the contract will become more profitable for
the buyer. This is a risk for the seller and he seeks compensation for it by demanding a
‘time value’. The time value of an option can be obtained by taking the difference
between its premium and its intrinsic value. Both calls and puts have time value. An

30
 option that is Out-of-the-money (OTM) or At-the-money (ATM) has only time value and
no intrinsic 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 being equal.
At expiration, an option has no time value.

Illustration:
In the following two tables, five different examples are given for call option and
put option respectively. As stated earlier, premium is determined by demand and
supply. The examples show how intrinsic value and time value vary depending on
underlying price, strike price and premium.

Intrinsic and Time Value for Call Options: Example (Amt in Rs)

Underlying Strike Price Premium Intrinsic Time Value

Price Value
100 90 12 10 2
101 90 13 11 2
103 90 14 13 1
88 90 1 0 1
95 90 5.50 5 0.50

Intrinsic and Time Value for Put Options: Example (Amt in Rs)

Underlying Strike Price Premium Intrinsic Time Value

Price Value
100 110 12 10 2
99 110 13 11 2
97 110 14 13 1
112 110 1 0 1
105 110 5.50 5 0.50

Factors affecting Options Prices:

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 The supply and demand of options and hence their prices are influenced by the
following factors:

· The underlying price,

· The strike price,
· The time to expiration,
· The underlying asset’s volatility, and
· Risk free rate

Each of the five parameters has a different impact on the option pricing of a Call
and a Put.

The underlying price:

Call and Put options react differently to the movement in the underlying price. As
the underlying price increases, intrinsic value of a call increases and intrinsic value of a
put decreases. Thus, in the case of a Call option, the higher the price of the underlying
asset from strike price, the higher is the value (premium) of the call option. On the
other hand, in case of a put option, the higher the price of the underlying asset, the
lower is the value of the put option.

The strike price:

The strike price is specified in the option contract and does not change over time.
The higher the strike price, the smaller is the intrinsic value of a call option and the
greater is the intrinsic value of a put option. Everything else remaining constant, as the
strike price increases, the value of a call option decreases and the value of a put option
increases.
Similarly, as the strike price decreases, the price of the call option increases while
that of a put option decreases.

Time to expiration:

Time to expiration is the time remaining for the option to expire.

Obviously, the time remaining in an option’s life moves constantly towards zero.
Even if the underlying price is constant, the option price will still change since time
reduces constantly and the time for which the risk is remaining is reducing. The time
value of both call as well as put option decreases to zero (and hence, the price of the
option falls to its intrinsic value) as the time to expiration approaches zero. As time
passes and a call option approaches maturity, its value declines, all other parameters
remaining constant. Similarly, the value of a put option also decreases as we approach
maturity. This is called “time-decay”.

Volatility:

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 Volatility is an important factor in the price of an option. Volatility is defined as
the uncertainty of returns. The more volatile the underlying higher is the price of the
option on the underlying. Whether we are discussing a call or a put, this relationship
remains the same.

Risk free rate:

Risk free rate of return is the theoretical rate of return of an investment which
has no risk (zero risk). Government securities are considered to be risk free since their
return is assured by the Government. Risk free rate is the amount of return which an
investor is guaranteed to get over the life time of an option without taking any risk. As
we increase the risk free rate the price of the call option increases marginally whereas
the price of the put option decreases marginally. It may however be noted that option
prices do not change much with changes in the risk free rate.

The impact of all the parameters which affect the price of an option is given in
the table below:

With an Increase in Price of Call Option Price of Put Option

Parameter:
Asset Price(Underlying Price) ⇑ ⇓
Exercise Price(Strike Price) ⇓ ⇑
Time of Expiration ⇑ ⇑
Volatility ⇑ ⇑
Risk Free Rate ⇑ ⇓

Even though option prices are determined by market demand and supply, there
are various models of getting a fair value of the options, the most popular of which is
the Black Scholes - Merton Model. In this model, the theoretical value of the options is
obtained by inputting into formula values of the above-mentioned five factors. It may be
noted that the prices arrived at by using this model are only indicative.

6. Derivatives Trading On Exchange

NSE trades in futures and options (F&O) contracts on its F&O Segment. Its derivatives
markets clock daily volumes of Rs 60,000 crores on an average.

Derivatives Trading on NSE:

The F&O segment on NSE provides trading facilities for the following derivative instruments:

· Index futures,
· Index options,

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· Individual stock futures, and
· Individual stock options.

As an investor one can invest in any of these products. All these products have different
Contract specifications.

 Contract specifications for index based futures:

Index futures are futures contracts on an index, like the Nifty. The underlying asset
in case of index futures is the index itself. For example, Nifty futures traded in NSE track
spot Nifty returns. If the Nifty index rises, so does the pay off of the long position in Nifty
futures. Part from Nifty, CNX IT, Bank Nifty, CNX Nifty Junior, CNX 100, Nifty Midcap 50
and Mini Nifty 50 futures contracts are also traded on the NSE. They have one-month, two-
month, and three month expiry cycle: a one-month Nifty futures contract would expire in
the current month, a two-month contract the next month, and a three-month contract the
month after. All contracts expire on the last Thursday of every month, or the previous
trading day if the last Thursday is a trading holiday. Thus, a September 2009 contract would
expire on the last Thursday of September 2009, which would be the final settlement date of
the contract. Table 6.1 summarizes contract specifications for S&P Nifty Index Futures.

Table 6.1: Contract Specification for S&P Nifty Index Futures

Underlying Index S&P CNX Nifty

Exchange of trading National Stock Exchange of India Limited

Security Descriptor FUTIDX NIFTY

Contract Size Permitted lot size is 50

(minimum value Rs 2 lakh)

Trading Cycle The future contracts have a maximum of

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 Three month trading cycle - the near
month (one), the next month (two), and
the far month (three). New contracts are
introduced on the next trading day
following the expiry of the near month
Contract.

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Mark-to-market and final settlement are

cash settled on T+1 basis

Settlement Price Daily Settlement price is the closing price

of the futures contracts for the trading day
and the final settlement price is the value
of the underlying index on the last trading
day

 Contract specifications for index based options:

Index based options are similar to index based futures as far as the underlying is
concerned i.e., in both the cases the underlying security is an Index. As the value of the
index increases, the value of the call option on index increases, while put option value
reduces. All index based options traded on NSE are European type options and expire on the
last Thursday of the expiry month. They have expiries of one month or two months, or three
months. Longer dated expiry contracts with expiries up to 3.5 years have also been
introduced for trading. Table 6.2 summarizes contract specifications for S&P Nifty Index
Options.

Table 6.2: Contract Specification for S&P CNX Nifty Options

Underlying Index S&P CNX Nifty

Security Descriptor OPTIDX NIFTY

Contract Size Permitted lot size is 50

(minimum value Rs 2 lakh)

Trading Cycle The Option contracts have a maximum of
three month trading cycle---the near
month (one), the next month (two), and
The far month (three). New contracts are

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 introduced on the next trading day
following the expiry of the near month
Contract.

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Cash Settlement on T+1 basis

Style of Option European

Daily Settlement Not Applicable
Settlement Price Daily Settlement price is the closing price
of the futures contracts for the trading day
and the final settlement price is the value
of the underlying index on the last trading
day

 Contract specifications for stock based futures

Stock based futures are futures based on individual stocks. The underlying on these
futures are the individual company stocks traded on the Exchange. The expiration cycle of
the stock futures is same as that of index futures. Table 6.3 summarizes the contract
Specification for Stock Futures.

Table 6.3: Contract Specification for Stock Futures

Underlying Index Individual Securities

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 Security Descriptor NSE

Contract Size As Specified by the exchange (Minimum

Value of Rs. 2 lakh)
Trading Cycle The futures contracts have a maximum of
three month trading cycle---the near
month (one), the next month (two), and
The far month (three). New contracts are
introduced on the next trading day
following the expiry of the near month
contract

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Mark to market and final settlement is cash

settled on T+1 basis

Settlement Price Daily settlement price is the closing price

of the futures contracts for the trading day
and the final settlement price is the closing
price of the underlying security on the last
Trading day.

 Contract specifications for stock based options:

Stock based options are options for which the underlying is individual stocks. As
opposed to index based options, all the stock based options at the NSE have American style
settlement. Table 6.4 summarizes the contract specification for Stock Options.

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 Table 6.4: Contract Specification for Stock Options

Underlying Index Individual Securities available for trading in

cash market

Security Descriptor OPTSTK

Contract Size As Specified by the exchange (Minimum

Value of Rs. 2 lakh)
Trading Cycle The options contracts have a maximum of
three month trading cycle—the near month
(one), the next month (two), and the far
Month (three). New contracts are
introduced on the next trading day
following the expiry of near month contract

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Daily Settlement on T+1 basis and final

option exercise settlement on T+1 basis

Style of Option American

Daily Settlement Premium Value (Net)
Settlement Price Closing price of underlying on exercise day
or on expiry day

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 7. Accounting & Taxation effects of Derivatives

Accounting Area

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on
accounting of index future contracts from the view point of parties who enter into such
future contracts as buyers or sellers. For other parties involved in the trading process, like
brokers, trading members, clearing members and clearing corporations a trade in equity
index futures is similar to a trade in; say shares, and accounting remains similar as in the
case of buying or selling of shares. As such after getting the real importance of the
Derivatives in the market, The Institute of Chartered Accountants of India (ICAI) has also
issued Accounting Standard 30 – “Financial Instruments – Recognition and Measurement”
which emphasis on the materiality of the derivative concept including its Accounting and
Taxation effects;

Accounting for Futures:

1. Accounting at the inception:

• Initial Margin paid to be debited:

“Initial Margin-Future A/c”
• Additional Margins to be accounted as above.
• When contract is made, no entry to be passed.
• On the Balance Sheet date the above account is shown under the heads Current
Assets.
• Initial Margin in the form of Bank guarantees or by lodging securities should be
disclosed in notes to A/cs.

2. Accounting at the time of daily settlement:

• Payments made or received on account of daily settlement is credited/debited to:

“Mark-to-Market Margin – Future A/c”

3. Accounting for open positions:

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• Anticipated loss to be provided for and anticipated profits to be ignored.
• Net payment made to the broker – “current assets, loans and advances (net of
provision for loss)”

4. Accounting at the time of final settlement:

• Profit/Loss = Final settlement price – Contract price

• Debited/Credited to “Mark to Market Margin – Futures A/c”
• Loss to be adjusted first against the provision made for the anticipated losses and
balance from the P&L.
• FIFO Method is followed.

Accounting for Options:

1. Accounting at the Inception:

• Initial Margin paid to be paid by Seller to be debited:

• “Equity Index/ Stock Option Margin A/c”
• Buyer/holder not required to pay margin.
• Premium is to be paid to the seller by the holder of the option.
Which is debited:
• “Equity Index/ Stock Option Premium A/c”

2. Accounting at the time of payment/receipt of margin:

• Payments made or received on account of daily settlement is credited/debited by

the seller to:
• “Equity Index/ Stock Option Margin A/c”
• In case of deposit made by him instead of Bank A/c “Deposit for Margin A/c” will
be debited or credited.
• On Balance sheet date balance in the above A/c is shown under the head
“Current Assets”.

3. Accounting for open positions:

• Loss to the Buyer = Premium paid – Premium on the B/S date.

• The above loss to be provided for and to be shown as deduction from “Equity
Index/ Stock Option Premium A/c” under “current assets, loans and advances”.

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 4. Accounting at the time of final settlement:

• On exercise of the option:

A. For Buyer premium to be debited to P&L and credited to “Equity Index / Stock
Option Premium A/c”
B. For Seller premium to be credited to P&L and debited to “Equity Index / Stock
Option Premium A/c”
• Final settlement price - Strike price = if -ve then paid by the writer.

Taxation Area

Prior to the year 2005, the Income Tax Act did not have any specific provision
regarding taxability of derivatives. The only tax provisions which had indirect bearing on
derivatives transactions were sections 73(1) and 43(5). Under these sections, trade in
derivatives was considered “speculative transactions” for the purpose of determining tax
liability. All profits and losses were taxed under the speculative income category. Therefore,
loss on derivatives transactions could be set off only against other speculative income and
the same could not be set off against any other income. This resulted in high tax liability.

Finance Act, 2005 has amended section 43(5) so as to exclude transactions in

derivatives carried out in a “recognized stock exchange” from ‘speculative transaction’. This
implies that derivatives transactions that take place in a “recognized stock exchange” are
not taxed as speculative income or loss. They are treated under the business income head
of the Income tax Act. Any losses on these activities can be set off against any business
income in the year and the losses can be carried forward and set off against any other
business income for the next eight years.

In simple words it can be said Income from derivative contracts:

-Not a speculative income

-Treated as Business income

-Losses can be set off against any other income during the year & Carried forward to eight
subsequent years

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-Securities transaction tax paid on such transactions is eligible as deduction.

Derivatives Are New Packages of Old Things – Peter Fortune

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The End

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