Indian Capital Market 5.

21

interest on the bond in the previous example would probably be paid In two installments of
` 40 each.
• Term: A bond’s maturity or the length of time until the principal is repaid varies greatly but
is always more than five years. Debt that matures in less than a year is a “money market
instrument” - such as commercial paper or bankers’ acceptances. A “short-term bond,” on
the other hand, may have an initial maturity of five years. A “long- term bond” typically
matures in 20 to 40 years. The maturity of any bond is predetermined and stated in the
trust indenture.
• Call Feature (if any): A “call feature,” if specified in the trust indenture, allows the bond
issuer to “call in” the bonds and repay them at a predetermined price before maturity.
Bond issuers use this feature to protect themselves from paying more interest than they
have to for the money they are borrowing. Companies call in bonds when general interest
rates are lower than the coupon rate on the bond, thereby retiring expensive debt and
refinancing it at a lower rate.
Suppose IDBI had issued 6 years ` 1000 bonds in 1998 @14% pa. But now the current
interest rate is around 9% to 10%. If the issuer wants to take advantage of the call feature
in the bond’s indenture it will call back the earlier issued bonds and reissue them @9%
p.a. The sale proceeds of this new issue will be used to pay the old debt. In this way IDBI
now enjoys a lower cost for its borrowed money.
Some bonds offer “call protection”; that is, they are guaranteed not to be called for five to
ten years. Call features can affect bond values by serving as a ceiling for prices. Investors
are generally unwilling to pay more for a bond than its call price, because they are aware
that the bond could be called at a lower call price. If the bond issuer exercises the option
to call bonds, the bond holder is usually paid a premium over par for the inconvenience.
• Refunding: If, when bonds mature, the issuer does not have the cash on hand to repay
bondholders; it can issue new bonds and use the proceeds either to redeem the older
bonds or to exercise a call option. This process is called refunding.
Note: The valuation aspects of Bond/Debenture have been covered in forthcoming chapter of
Security Analysis.

10. Derivatives
Derivative is a product whose value is to be derived from the value of one or more basic
variables called bases (underlying assets, index or reference rate). The underlying assets can
be Equity, Forex, and Commodity.
The underlying has a marketable value which is subject to market risks. The importance of
underlying in derivative instruments is as follows:
 All derivative instruments are dependent on an underlying to have value.
 The change in value in a forward contract is broadly equal to the change in value in the
underlying.

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 5.22 Strategic Financial Management

 In the absence of a valuable underlying asset the derivative instrument will have no
value.
 On maturity, the position of profit/loss is determined by the price of underlying
instruments. If the price of the underlying is higher than the contract price the buyer
makes a profit. If the price is lower, the buyer suffers a loss.
Main users of Derivatives are as follows:
Users Purpose
(a) Corporation To hedge currency risk and inventory risk
(b) Individual Investors For speculation, hedging and yield enhancement.
(c) Institutional Investor For hedging asset allocation, yield enhancement and to
avail arbitrage opportunities.
(d) Dealers For hedging position taking, exploiting inefficiencies and
earning dealer spreads.
Before discussing the different derivatives, you should understand the various risks associated
with them. The different types of derivative risks are:
(a) Credit risk: Credit risk is the risk of loss due to counterparty’s failure to perform on an
obligation to the institution. Credit risk in derivative products comes in two forms:
(i) Pre-settlement risk: It is the risk of loss due to a counterparty defaulting on a
contract during the life of a transaction. The level of exposure varies throughout
the life of the contract and the extent of losses will only be known at the time of
default.
(ii) Settlement risk: It is the risk of loss due to the counterparty's failure to perform
on its obligation after an institution has performed on its obligation under a
contract on the settlement date. Settlement risk frequently arises in international
transactions because of time zone differences. This risk is only present in
transactions that do not involve delivery versus payment and generally exists for
a very short time (less than 24 hours).
(b) Market risk: Market risk is the risk of loss due to adverse changes in the market value
(the price) of an instrument or portfolio of instruments. Such exposure occurs with
respect to derivative instruments when changes occur in market factors such as
underlying interest rates, exchange rates, equity prices, and commodity prices or in the
volatility of these factors.
(c) Liquidity risk: Liquidity risk is the risk of loss due to failure of an institution to meet its
funding requirements or to execute a transaction at a reasonable price. Institutions
involved in derivatives activity face two types of liquidity risk : market liquidity risk and
funding liquidity risk.

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 Indian Capital Market 5.23

(i) Market liquidity risk: It is the risk that an institution may not be able to exit or
offset positions quickly, and in sufficient quantities, at a reasonable price. This
inability may be due to inadequate market depth in certain products (e.g. exotic
derivatives, long-dated options), market disruption, or inability of the bank to
access the market (e.g. credit down-grading of the institution or of a major
counterparty).
(ii) Funding liquidity risk: It is the potential inability of the institution to meet
funding requirements, because of cash flow mismatches, at a reasonable cost.
Such funding requirements may arise from cash flow mismatches in swap
books, exercise of options, and the implementation of dynamic hedging
strategies.
(d) Operational risk: Operational risk is the risk of loss occurring as a result of inadequate
systems and control, deficiencies in information systems, human error, or management
failure.
(e) Legal risk: Legal risk is the risk of loss arising from contracts which are not legally
enforceable (e.g. the counterparty does not have the power or authority to enter into a
particular type of derivatives transaction) or documented correctly.
(f) Regulatory risk: Regulatory risk is the risk of loss arising from failure to comply with
regulatory or legal requirements.
(g) Reputation risk: Reputation risk is the risk of loss arising from adverse public opinion
and damage to reputation.
The basic differences between Cash and the Derivative market are enumerated below:-
(a) In cash market tangible assets are traded whereas in derivative market contracts based
on tangible or intangibles assets like index or rates are traded.
(b) In cash market, we can purchase even one share whereas in Futures and Options
minimum lots are fixed.
(c) Cash market is more risky than Futures and Options segment because in “Futures and
Options” risk is limited upto 20%.
(d) Cash assets may be meant for consumption or investment. Derivative contracts are for
hedging, arbitrage or speculation.
(e) The value of derivative contract is always based on and linked to the underlying security.
However, this linkage may not be on point-to-point basis.
(f) In the cash market, a customer must open securities trading account with a securities
depository whereas to trade futures a customer must open a future trading account with a
derivative broker.

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 5.24 Strategic Financial Management

(g) Buying securities in cash market involves putting up all the money upfront whereas
buying futures simply involves putting up the margin money.
(h) With the purchase of shares of the company in cash market, the holder becomes part
owner of the company. While in future it does not happen.
The most important derivatives are forward, futures and options. Here we will discuss
derivatives as financial derivatives and embedded derivatives.
10.1 Forward Contract: Consider a Punjab farmer who grows wheat and has to sell it at a
profit. The simplest and the traditional way for him is to harvest the crop in March or April and
sell in the spot market then. However, in this way the farmer is exposing himself to risk of a
downward movement in the price of wheat which may occur by the time the crop is ready for sale.
In order to avoid this risk, one way could be that the farmer may sell his crop at an agreed-
upon rate now with a promise to deliver the asset, i.e., crop at a pre-determined date in future.
This will at least ensure to the farmer the input cost and a reasonable profit.
Thus, the farmer would sell wheat forward to secure himself against a possible loss in future. It
is true that by this way he is also foreclosing upon him the possibility of a bumper profit in the
event of wheat prices going up steeply. But then, more important is that the farmer has played
safe and insured himself against any eventuality of closing down his source of livelihood
altogether. The transaction which the farmer has entered into is called a forward transaction
and the contract which covers such a transaction is called a forward contract.
A forward contract is an agreement between a buyer and a seller obligating the seller to
deliver a specified asset of specified quality and quantity to the buyer on a specified date at a
specified place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated price in
exchange of the delivery.
This means that in a forward contract, the contracting parties negotiate on, not only the price
at which the commodity is to be delivered on a future date but also on what quality and
quantity to be delivered and at what place. No part of the contract is standardized and the two
parties sit across and work out each and every detail of the contract before signing it.
For example, in case a gold bullion forward contract is being negotiated between two parties,
they would negotiate each of the following features of the contract:
 the weight of the gold bullion to be delivered,
 the fineness of the metal to be delivered,
 the place at which the delivery is to be made,
 the period after which the delivery is to be made, and
 the price which the buyer would pay.
Suppose a buyer L and a seller S agrees to do a trade in 100 tolas of gold on 31 Dec 2013 at
` 30,000/tola. Here, ` 30,000/tola is the ‘forward price of 31 Dec 2013 Gold’. The buyer L is
said to be long and the seller S is said to be short. Once the contract has been entered into, L

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 Indian Capital Market 5.25

is obligated to pay S ` 30 lakhs on 31 Dec 2013, and take delivery of 100 tolas of gold.
Similarly, S is obligated to be ready to accept ` 30 lakhs on 31 Dec 2013, and give 100 tolas
of gold in exchange.
10.2 Future Contract: A futures contract is an agreement between two parties that commits
one party to buy an underlying financial instrument (bond, stock or currency) or commodity
(gold, soybean or natural gas) and one party to sell a financial instrument or commodity at a
specific price at a future date. The agreement is completed at a specified expiration date by
physical delivery or cash settlement or offset prior to the expiration date. In order to initiate a
trade in futures contracts, the buyer and seller must put up "good faith money" in a margin
account. Regulators, commodity exchanges and brokers doing business on commodity
exchanges determine margin levels.
Suppose A buyer “B” and a Seller “S” enter into a 5,000 kgs corn futures contract at ` 5 per
kg. Assuming that on the second day of trading the settlement price (settlement price is
generally the representative price at which the contracts trade during the closing minutes of
the trading period and this price is designated by a stock exchange as the settlement price ).
In case the price movement during the day is such that the price during the closing minutes is
not the representative price, the stock exchange may select a price which it feels is close to
being a representative price, e.g., average of the high and low prices which have occurred
during a trading day) of March corn is ` 5.20 per kg. This price movement has led to a loss of
` 1,000 to S while B has gained the corresponding amount.
Thus, the initial margin account of S gets reduced by ` 1,000 and that of B is increased by the
same amount. While the margin accounts, also called the equity of the buyer and the seller, get
adjusted at the end of the day in keeping with the price movement, the futures contract gets
replaced with a new one at a price which has been used to make adjustments to the buyer and
seller’s equity accounts. In this case, the settlement price is ` 5.20, which is the new price at
which next day’s trading would start for this particular futures contract. Thus, each future contract
is rolled over to the next day at a new price. This is called marking-to-market.
Difference between forward and future contract is as follows:
S.No. Features Forward Futures
1. Trading Forward contracts are traded Futures Contracts are traded in a
on personal basis or on competitive arena.
telephone or otherwise.
2. Size of Forward contracts are Futures contracts are
Contract individually tailored and have standardized in terms of quantity
no standardized size. or amount as the case may be.
3. Organized Forward contracts are traded in Futures contracts are traded on
exchanges an over the counter market. organized exchanges with a
designated physical location.
4. Settlement Forward contracts settlement Futures contracts settlements are
takes place on the date agreed made daily via. Exchange’s

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upon between the parties. clearing house.

5. Delivery Forward contracts may be Futures contracts delivery dates
date delivered on the dates agreed are fixed on cyclical basis and
upon and in terms of actual hardly takes place. However, it
delivery. does not mean that there is no
actual delivery.
6. Transaction Cost of forward contracts is Futures contracts entail
costs based on bid – ask spread. brokerage fees for buy and sell
order.
7. Marking to Forward contracts are not Futures contracts are subject to
market subject to marking to market. marking to market in which the
loss on profit is debited or
credited in the margin account on
daily basis due to change in
price.
8. Margins Margins are not required in In futures contracts every
forward contract. participants is subject to maintain
margin as decided by the
exchange authorities.
9. Credit risk In forward contract, credit risk In futures contracts the
is born by each party and, transaction is a two way
therefore, every party has to transaction, hence the parties
bother for the creditworthiness. need not to bother for the risk.

10.3 Pricing/ Valuation of Forward/ Future Contracts: The difference between the
prevailing spot price of an asset and the futures price is known as the basis, i.e.,
Basis = Spot price – Futures price
In a normal market, the spot price is less than the futures price (which includes the full cost-of-
carry) and accordingly the basis would be negative. Such a market, in which the basis is
decided solely by the cost-of-carry is known as a Contango market.
Basis can become positive, i.e., the spot price can exceed the futures price only if there are
factors other than the cost of carry to influence the futures price. In case this happens, then
basis becomes positive and the market under such circumstances is termed as a
backwardation market or inverted market.
Basis will approach zero towards the expiry of the contract, i.e., the spot and futures prices
converge as the date of expiry of the contract approaches. The process of the basis
approaching zero is called convergence.
The relationship between futures prices and cash prices is determined by the cost-of-carry.
However, there might be factors other than cost-of-carry, especially in stock futures in which

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there may be various other returns like dividends, in addition to carrying costs, which may
influence this relationship.
The cost-of-carry model in for futures, is as under:-
Future price = Spot price + Carrying cost – Returns (dividends, etc).
Let us take an example to understand this relationship.
Example
The price of ACC stock on 31 December 2010 was ` 220 and the futures price on the same
stock on the same date, i.e., 31 December 2010 for March 2011 was ` 230. Other features of
the contract and related information are as follows:
Time to expiration - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03. 2011
Face Value of the Stock - ` 10
Based on the above information, the futures price for ACC stock on 31 December 2010 should
be:
= 220 + (220 x 0.15 x 0.25) – (0.25 x 10) = 225.75
Thus, as per the ‘cost of carry’ criteria, the futures price is ` 225.75, which is less than the
actual price of ` 230 on 31 March 2011. This would give rise to arbitrage opportunities and
consequently the two prices will tend to converge.
How Will The Arbitrager Act?
He will buy the ACC stock at ` 220 by borrowing the amount @ 15 % for a period of 3 months
and at the same time sell the March 2011 futures on ACC stock. By 31st March 2011, he will
receive the dividend of ` 2.50 per share. On the expiry date of 31st March, he will deliver the
ACC stock against the March futures contract sales.
The arbitrager’s inflows/outflows are as follows:
Sale proceeds of March 2011 futures ` 230.00
Dividend ` 2.50
Total (A) ` 232.50
Pays back the Bank ` 220.00
Cost of borrowing ` 8.25
Total (B) ` 228.25
Balance (A) – (B) ` 4.25
Thus, the arbitrager earns ` 4.25 per share without involving any risk.

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 5.28 Strategic Financial Management

In financial forward contracts, the cost of carry is primarily the interest cost.
Let us take a very simple example of a fixed deposit in the bank. ` 100 deposited in the bank
at a rate of interest of 10% would be come ` 110 after one year. Based on annual
compounding, the amount will become ` 121 after two years. Thus, we can say that the
forward price of the fixed deposit of ` 100 is ` 110 after one year and ` 121 after two years.
As against the usual annual, semi-annual and quarterly compounding, which the reader is
normally used to, continuous compounding are used in derivative securities. In terms of the
annual compounding, the forward price can be computed through the following formula:
A=P (1+r/100)t
Where, A is the terminal value of an amount P invested at a rate of interest of r % p.a. for t
years.
However, in case there are multiple compounding in a year, say n times per annum, then the
above formula will read as follows:
A = P (1+r/n)nt
And in case the compounding becomes continuous, i.e., more than daily compounding, the
above formula can be simplified mathematically and rewritten as follows:
A = Per n
Where ‘e’, called epsilon, is a mathematical constant and has a value of 2.72. This function is
available in all mathematical calculators and is easy to handle.
The above formula gives the future value of an amount invested in a particular security now.
In this formula, we have assumed no interim income flow like dividends etc
Example
Consider a 3 month maturity forward contract on a non-dividend paying stock. The stock is
available for ` 200. With compounded continuously risk-free rate of interest (CCRRI) of 10 %
per annum, the price of the forward contract would be:
A = 200 x e(0.25)(0.10) = ` 205.06
In case there is cash income accruing to the security like dividends, the above formula will
read as follows:
A = (P-I)enr
Where I is the present value of the income flow during the tenure of the contract.
Example
Consider a 4 month forward contract on 500 shares with each share priced at ` 75. Dividend
@ ` 2.50 per share is expected to accrue to the shares in a period of 3 months. The CCRRI
is 10% p.a. The value of the forward contract is as follows:
Dividend proceeds = 500 × 2.50 = 1250 = 1250e- (3/12)(0.10) = 1219.13

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 Indian Capital Market 5.29

Value of forward contract = (500 × 75 – 1219.13) e(4/12)(0.10)

= 36280.87 x e0.033
= ` 37498.11
However, in case the income accretion to the securities is in the form of percentage yield, y,
as in the case of stock indices arising on account of dividend accruals to individual stocks
constituting the index, the above formula will read as follows:
A = Pe n(r – y)
Example
Consider the following:
Current value of index - 1400
Dividend yield - 6%
CCRRI - 10%
To find the value of a 3 month forward contract.
n(r – y)
A = Pe
(3/12)(0.10 – .06)
= 1400 x e = ` 1,414
Correlation between Forward and Futures Prices
For contracts of the same maturity, the forward and futures contracts tend to have the same
value subject to the interest rates remaining fixed. In case the interest rates are fluid, the
value of a futures contract would differ from that of a forward contract because the cash flows
generated from marking to the market in the case of the former would be available for
reinvestment at variable rates on a day-to-day basis. However, market imperfections like
transaction costs, taxes and asset indivisibilities bring futures prices close enough to the
forward prices to safely assume the two prices to be practically the same.
10.4 Types of futures contracts
10.4.1 Single Stock Futures: A single stock futures contract is an agreement to buy or sell
shares or stock such as Microsoft, Intel, ITC, or Tata Steel at a point in the future. The buyer
has an obligation to purchase shares or stock and the seller has an obligation to sell shares or
stock at a specific price at a specific date in the future. Thus a stock futures contract is a
standardized contract to buy or sell a specific stock at a future date at an agreed price. Single-
stock futures contracts are completed via offset or the delivery of actual shares at expiration.
Margin on a single-stock futures contract is expected normally to be 20% of notional value.
Each Stock Future contract is standardized and includes basic specifications.
The terms of the contract call for delivery of the stock by the seller at some time specified in
the future. However, most contracts are not held to expiration. The contracts are standardized,
making them highly liquid. To get out of an open long (buying) position, the investor simply

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takes an offsetting short position (sells). Conversely, if an investor has sold (short) a contract
and wishes to close it out, he or she buys (goes long) the offsetting contract.
10.4.2 Index Futures: A contract for stock index futures is based on the level of a particular
stock index such as the S&P 500 or the Dow Jones Industrial Average or NIFTY or BSE
sensex. The agreement calls for the contract to be bought or sold at a designated time in the
future. Just as hedgers and speculators buy and sell futures contracts based on future prices
of individual stocks they may—for mostly the same reasons—buy and sell such contracts
based on the level of a number of stock indexes.
Stock index futures may be used to either speculate on the equity market's general
performance or to hedge a stock portfolio against a decline in value. Unlike commodity futures
or individual stocks, stock index futures are not based on tangible goods, thus all settlements
are in cash. Because settlements are in cash, investors usually have to meet liquidity or
income requirements to show that they have money to cover their potential losses.
Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell
a fixed value of the index. The value of the index is defined as the value of the index multiplied
by the specified monetary amount. In Nifty 50 futures contract traded at the National Stock
Exchange, the contract specification states:
1 Contract = 50 units of Nifty 50 * Value of Nifty 50
If we assume that Nifty 50 is quoting at 8000 , the value of one contract will be equal to
` 4,00,000 (50*8000 ). The contract size of 50 units of Nifty 50 in this case is fixed by National
Stock Exchange where the contract is traded.
Example
Consider the following:
Current value of index - 1400
Dividend yield - 6%
CCRRI - 10%
To find the value of a 3 month forward contract.
A = Pe n(r – y)
= 1400 x e (3/12)(0.10 – .06) = ` 1,414
10.4.3 Trading Mechanism in Stock Futures: While trading in futures contracts (both stock
as well as futures) both buyers and sellers of the contract have to deposit an initial margin with
their brokers based on the value of contract entered. The rules for calculation of margins to be
deposited with the brokers are framed by the stock exchanges.
Another major feature regarding the margin requirements for stock as well index futures is that
the margin requirement is continuous. Every business day, the broker will calculate the margin
requirement for each position. The investor will be required to post additional margin funds if
the account does not meet the minimum margin requirement.

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The investor can square off his position in the futures contract before expiry or wait till expiry
date when the contracts will automatically stand as squared off at the closing price on the
expiry date. In Indian stock market the expiry date is the last Thursday of the relevant month
to which the future contract belongs.
Example – Margin Requirements
In a stock future contract on ITC stock at ` 120, both the buyer and seller have a margin
requirement of 20% or ` 2400. If ITC stock goes up to ` 122, the account of the long contract
is credited with ` 200 (` 122-` 120 = ` 2 X 100 = ` 200) and the account of the seller (seller)
is debited by the same ` 200. This indicates that investors in futures must be very vigilant -
they must keep close track of market movements.
10.4.4 Purpose of Trading in Futures: Trading in futures is for two purposes namely:
(a) Speculation and
(b) Hedging
(a) Speculation – For simplicity we will assume that one contract= 100 units and the margin
requirement is 20% of the value of contract entered. Brokerage and transaction costs are not
taken into account.
Example- Going Long on a Single Stock Futures Contract
Suppose an investor is bullish on McDonald's (MCD) and goes long on one September stock
future contract on MCD at ` 80. At some point in the near future, MCD is trading at ` 96. At
that point, the investor sells the contract at ` 96 to offset the open long position and makes a
` 1600 gross profit on the position.
This example seems simple, but let’s examine the trades closely. The investor's initial margin
requirement was only ` 1600 (` 80 x 100 = ` 8,000 x 20% = ` 1600). This investor had a
100% return on the margin deposit. This dramatically illustrates the leverage power of trading
futures. Of course, had the market moved in the opposite direction, the investor easily could
have experienced losses in excess of the margin deposit.
The pay off table for the above transaction can be depicted as follows:-
Particulars Details Inflow/(outflow){In `}
Initial Payoff - Margin ` 8000 x 20%= ` 1600 (` 1600)
(Refundable at maturity)
Pay off upon squaring off the Profit (` 96 - ` 80)x100=` 1600 ` 3200
contract Initial Margin= ` 1600
Net Payoff ` 1600

Example- Going Short on a Single Stock Futures Contract

An investor is bearish in Kochi Refinery (KR) stock for the near future and goes short an
August stock future contract on KR at ` 160. KR stock performs as the investor had guessed

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and drops to ` 140 in July. The investor offsets the short position by buying an August stock
future at ` 140. This represents a gross profit of ` 20 per share, or a total of ` 2,000.
Again, let's examine the return the investor had on the initial deposit. The initial margin
requirement was ` 3,200 (` 160 x 100 = ` 16,000 x 20% = ` 3,200) and the gross profit was
` 2,000. The return on the investor's deposit was more than 60% - a terrific return on a short-
term investment.
Particulars Details Inflow/(outflow){In `}
Initial Payoff - Margin ` 160x100x20%= ` 3200 (` 3200)
(Refundable at maturity)
Pay off upon squaring off Profit (` 160 - ` 140 ) x 100=` 2000 ` 5200
the contract Initial Margin= ` 3200
Net Payoff ` 2000
Example- Going Long on an Index Futures Contract
Suppose an investor has a bullish outlook for Indian market for the month of October 2014. He
will go for a long position on October 2014 Nifty Index Future Contract. Assuming that he
enters into long positions when Nifty is trading at 8000 and one month later he squares off his
position when the value of Nifty rises to 8500 his payoff will be as under. (Assuming that one
contract= 50 units of Nifty and margin requirement is 20% of the value of the contract)
Particulars Details Inflow/(outflow){In `}
Initial Payoff - Margin (8000x 50x20%)=` 80,000 (` 80,000)
(Refundable at maturity)
Pay off upon squaring off Profit (8500- 8000)x50= ` 25,000 ` 1,05,000
the contract Initial Margin= ` 80,000
Net Payoff ` 25,000
Example- Going Short on an Index Futures Contract
Suppose an investor has a bearish outlook for Indian banking sector for the month of October
2014. He will go for a short position for one October 2014 Bank Nifty Future Contract.
Assuming that he enters into short positions when Bank Nifty is trading at 25000 and one
month later he squares off his position when the value of Bank Nifty declines to 24000 his
payoff will be as under. (Assuming that one contract=10 units of Bank Nifty and margin
requirement is 20% of the value of the contract)

Particulars Details Inflow/(outflow){In `}

Initial Payoff – Margin (25000x 10x20%)=` 50,000 (` 50,000)
(Refundable at maturity)
Pay off upon squaring Profit(25000-24000)x10= ` 10,000 ` 60,000

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off the contract Initial Margin= ` 50,000

Net Payoff ` 10,000
(b) Hedging – Hedging is the practice of taking a position in one market to offset and
balance against the risk adopted by assuming a position in a contrary or opposing market or
investment. In simple language, hedging is used to reduce any substantial losses/gains
suffered by an individual or an organization.
To hedge, the investor takes a stock future position exactly opposite to the stock position.
That way, any losses on the stock position will be offset by gains on the future position.
Example- Using single stock future as a Hedge
Consider an investor who has bought 100 shares of Tata Steel (TS) at ` 300. In July, the
stock is trading at ` 350. The investor is happy with the unrealized gain of ` 50 per share but
is concerned that in a stock as volatile as TS, the gain could be wiped out in one bad day. The
investor wishes to keep the stock at least until September, however, because of an upcoming
dividend payment.
To hedge, the investor sells a ` 350 September stock future contract - whether the stock rises
or declines, the investor has locked in the ` 50-per-share gain.In September on maturity date
of the futures contract (last Thursday of September) , the investor sells the stock at the market
price and buys back the future contract.
The pay-off at various price levels of Tata Steel is as under:-

Particulars September Closing September Closing September Closing

price of Tata price of Tata price of Tata Steel=
Steel= ` 300 Steel= ` 350 ` 400

Initial Payoff ` 300x100 = ` ` 300x100 = ` ` 300x100 = `

Cost of scrip in 30000 30000 30000
cash market ` 350X100X20% = ` 350X100X20% = ` 350X100X20% =
Margin Payment on `7000 `7000 `7000
futures contract ` 37000 ` 37000 ` 37000
Total Initial Payoff
(outflow)
Pay-off at maturity Sale proceeds of TS Sale proceeds of TS Sale proceeds of TS
(September end) in cash market= in cash market= in cash market=
`300x 100 = ` `350x 100 = ` `400x 100 = `
30000 35000 40000

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 5.34 Strategic Financial Management

Margin refund on Margin refund on Margin refund on

futures contract = ` futures contract = futures contract =
7000 ` 7000 ` 7000
Gain on futures No profit /loss on Loss on futures
Total Pay-off at contract(inflow) = futures contract = contract(outflow) =
maturity (Inflow) (` 350-` 300)x100 = (` 350-` 350)x100 = (` 350-` 400)x100 =
- ` 5000) `0 -` 5000

` 42000 ` 42000 ` 42000

Net Payoff ` 5000 ` 5000 ` 5000
Hence it can be observed in the above table that in any case the investor has locked in a
profit of ` 5000 via hedging.
In a similar manner as illustrated above index futures can also be used as a hedge . The
difference would be that instead of single stock futures the investor would enter into a position
into a Index Futures Contract according to the risk potential of the investor.
10.4.5 Marking to Market: It implies the process of recording the investments in traded
securities (shares, debt-instruments, etc.) at a value, which reflects the market value of
securities on the reporting date. In the context of derivatives trading, the futures contracts are
marked to market on periodic (or daily) basis. Marking to market essentially means that at the
end of a trading session, all outstanding contracts are repriced at the settlement price of that
session. Unlike the forward contracts, the future contracts are repriced every day. Any loss or
profit resulting from repricing would be debited or credited to the margin account of the broker.
It, therefore, provides an opportunity to calculate the extent of liability on the basis of
repricing. Thus, the futures contracts provide better risk management measure as compared
to forward contracts.
Suppose on 1st day we take a long position, say at a price of ` 100 to be matured on 7th day.
Now on 2nd day if the price goes up to ` 105, the contract will be repriced at ` 105 at the end
of the trading session and profit of ` 5 will be credited to the account of the buyer. This profit
of ` 5 may be drawn and thus cash flow also increases. This marking to market will result in
three things – one, you will get a cash profit of ` 5; second, the existing contract at a price of
` 100 would stand cancelled; and third you will receive a new futures contract at ` 105. In
essence, the marking to market feature implies that the value of the futures contract is set to
zero at the end of each trading day.
10.4.6 Advantages of Stock Index Futures Trading over Stock Futures Trading: Stock
index futures are most popular financial derivatives over stock futures due to following
reasons:
1. It adds flexibility to one’s investment portfolio. Institutional investors and other large
equity holders prefer this instrument in terms of portfolio hedging purpose. The stock
systems do not provide this flexibility and hedging.

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 Indian Capital Market 5.35

2. It creates the possibility of speculative gains using leverage. Because a relatively small
amount of margin money controls a large amount of capital represented in a stock index
contract, a small change in the index level might produce a profitable return on one’s
investment if one is right about the direction of the market. Speculative gains in stock
futures are limited but liabilities are greater.
3. Stock index futures are the most cost efficient hedging device whereas hedging through
individual stock futures is costlier.
4. Stock index futures cannot be easily manipulated whereas individual stock price can be
exploited more easily.
5. Since, stock index futures consists of many securities, so being an average stock, is
much less volatile than individual stock price. Further, it implies much lower capital
adequacy and margin requirements in comparison of individual stock futures. Risk
diversification is possible under stock index future than in stock futures.
6. One can sell contracts as readily as one buys them and the amount of margin required is
the same.
7. In case of individual stocks the outstanding positions are settled normally against
physical delivery of shares. In case of stock index futures they are settled in cash all
over the world on the premise that index value is safely accepted as the settlement price.
8. It is also seen that regulatory complexity is much less in the case of stock index futures
in comparison to stock futures.
9. It provides hedging or insurance protection for a stock portfolio in a falling market.
Futures also have disadvantages. These include:
• Risk: An investor who is long in a stock can only lose what he or she has invested. In a
stock future contract, there is the risk of losing significantly more than the initial
investment (margin deposit).
• No Stock-holder Privileges: The future owner has no voting rights and no rights to
dividends.
• Requires Continued Vigilance on part of the investor: Stock Futures are investments that
require investors to monitor their positions more closely than many would like to do.
Because future accounts are marked to the market every business day, there is the
possibility that the brokerage firm might issue a margin call, requiring the investor to
decide whether to quickly deposit additional funds or liquidate the position.
10.4.7 Uses/Advantages of Stock Index Futures: Investors can use stock index futures to
perform myriad tasks. Some common uses are:
(1) Investors commonly use stock index futures to change the weightings or risk exposures
of their investment portfolios. A good example of this is investors who hold equities from
two or more countries. Suppose these investors have portfolios invested in 60 percent
U.S. equities and 40 percent Japanese equities and want to increase their systematic risk

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 5.36 Strategic Financial Management

in the U.S. market and reduce these risks to the Japanese market. They can do this by
buying U.S. stock index futures contracts in the indexes underlying their holdings and
selling Japanese contracts (in the Nikkei Index).
(2) Stock index futures also allow investors to separate market timing from market selection
decisions. For instance, investors may want to take advantage of perceived immediate
increases in an equity market but are not certain which securities to buy; they can do this
by purchasing stock index futures. If the futures contracts are bought and the present
value of the money used to buy them is invested in risk-free securities, investors will
have a risk exposure equal to that of the market. Similarly, investors can adjust their
portfolio holdings at a more leisurely pace. For example, assume the investors see that
they have several undesirable stocks but do not know what holdings to buy to replace
them. They can sell the unwanted stocks and, at the same time, buy stock index futures
to keep their exposure to the market. They can later sell the futures contracts when they
have decided which specific stocks they want to purchase.
(3) Investors can also make money from stock index futures through index arbitrage, also
referred to as program trading. Basically, arbitrage is the purchase of a security or
commodity in one market and the simultaneous sale of an equal product in another
market to profit from pricing differences. Investors taking part in stock index arbitrage
seek to gain profits whenever a futures contract is trading out of line with the fair price of
the securities underlying it. Thus, if a stock index futures contract is trading above its fair
value, investors could buy a basket of about 100 stocks composing the index in the
correct proportion—such as a mutual fund comprised of stocks represented in the
index—and then sell the expensively priced futures contract. Once the contract expires,
the equities could then be sold and a net profit would result. While the investors can keep
their arbitrage position until the futures contract expires, they are not required to. If the
futures contract seems to be returning to fair market value before the expiration date, it
may be prudent for the investors to sell early.
(4) Investors often use stock index futures to hedge the value of their portfolios. Provide
hedging or insurance protection for a stock portfolio in a falling market. To implement a
hedge, the instruments in the cash and futures markets should have similar price
movements. Also, the amount of money invested in the cash and futures markets should
be the same. To illustrate, while investors owning well-diversified investment portfolios
are generally shielded from unsystematic risk (risk specific to particular firms), they are
fully exposed to systematic risk (risk relating to overall market fluctuations). A cost-
effective way for investors to reduce the exposure to systematic risk is to hedge with
stock index futures, similar to the way that people hedge commodity holdings using
commodity futures. Investors often use short hedges when they are in a long position in a
stock portfolio and believe that there will be a temporary downturn in the overall stock
market. Hedging transfers the price risk of owning the stock from a person unwilling to

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 Indian Capital Market 5.37

accept systematic risks to someone willing to take the risk.

To carry out a short hedge, the hedger sells a futures contract; thus, the short hedge is
also called a "sell-hedge."
Example
Consider investors who own portfolios of securities valued at $.1.2 million with a dividend
of 1 percent. The investors have been very successful with their stock picks. Therefore,
while their portfolios' returns move up and down with the market, they consistently
outperform the market by 6 percent. Thus, the portfolio would have a beta of 1.00 and an
alpha of 6 percent. Say that the investors believe that the market is going to have a 15
percent decline, which would be offset by the 1 percent received from dividends. The net
broad market return would be -14 percent but, since they consistently outperform the
market by 6 percent, their estimated return would be -8 percent. In this instance, the
investors would like to cut their beta in half without necessarily cutting their alpha in half.
They can achieve this by selling stock index futures. In this scenario, the S&P 500 index
is at 240. The contract multiplier is $500, and therefore each contract represents a value
of $120,000. Since the investors want to simulate the sale of half of their $1.2 million
portfolios, they must sell five contracts (5 × $120,000 = $600,000). Thus, their portfolios
would be affected by only half of the market fluctuation. While the investors could protect
their portfolios equally well by selling half of their shares of stock and buying them again
at short time later, using a short hedge on stock index futures is much cheaper than
paying the capital gains tax plus the broker commissions associated with buying and
selling huge blocks of stock.
At the extreme, stock index futures can theoretically eliminate the effects of the broad
market on a portfolio. Perfect hedges are very unusual because of the existence of basis
risk. The basis is the difference between the existing price in the futures market and the
cash price of the underlying securities. Basis risk occurs when changes in the economy
and the financial situation have different impacts on the cash and futures markets.
(5) Stock index futures add flexibility to his or her portfolio as a hedging and trading
instrument.
(6) Create the possibility of speculative gains using leverage. Because a relatively small
amount of margin money controls a large amount of capital represented in a stock index
contract, a small change in the index level might produce a profitable return on one’s
investment if he or she is right about the market's direction.
(7) Maintain one’s stock portfolio during stock market corrections. One may not need
"insurance" for all the time, but there are certain times when one would like less
exposure to stocks. Yet, one doesn't want to sell off part of a stock portfolio that has
taken him or her a long time to put together and looks like a sound, long-term investment
program.

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 5.38 Strategic Financial Management

(8) One of the major advantages of futures markets, in general, is that one can sell contracts
as readily as he or she can buy them and the amount of margin required is the same.
Mutual funds do not specialize in bear market approaches by short selling stocks but,
and also it is not possible for individuals to short sell stocks in a falling market to make
money.
(9) Transfer risk quickly and efficiently. Whether one is speculating, looking for insurance
protection (hedging), or temporarily substituting futures for a later cash transaction, most
stock index futures trades can be accomplished quickly and efficiently. Many mutual
funds require investors to wait until the end of the day to see at what price they were able
to purchase or sell shares. With today's volatility, once-a-day pricing may not give one
the maneuverability to take positions at exactly the time he or she wants. Stock index
futures give individual the opportunity to get into or out of a position whenever he or she
wants.
10.4.8 The Indian Scenario: In India, trading of NSE Nifty 50, CNX Stock Index and S&P
CNX Nifty Index have become really popular.
(a) S&P CNX Nifty Index Futures: The NSE Nifty futures contract is a forward contract,
which was traded on the National Stock Exchange (NSE) on June 12, 2000. The index futures
contracts are based on the popular market benchmark S&P CNX Nifty index.
(i) Trading cycle: S&P CNX Nifty futures contracts have a maximum of 3-month trading
cycle - the near month (one), the next month (two) and the far month (three). A new contract is
introduced on the trading day following the expiry of the near month contract. The new
contract will be introduced for a three month duration. This way, at any point in time, there will
be 3 contracts available for trading in the market i.e., one near month, one mid month and one
far month duration respectively.
(ii) Expiry day: S&P CNX Nifty futures contracts expire on the last Thursday of the expiry
month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
(iii) Trading Parameters/ Contract size: The value of the future contract may not be less
than 2 lakhs at the time of introduction. The permitted lot size for future and option contract is
the same for given underlying or such lot size as may be stipulated by Exchange from time to
time.
Price steps: The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.
Base Prices: Base price of S&P CNX Nifty futures contracts on the first day of trading would
be theoretical futures price. The base price of the contracts on subsequent trading days would
be the daily settlement price of the futures contracts.
Price bands: There are no day minimum/maximum price ranges applicable for S&P CNX Nifty
futures contracts. However, in order to prevent erroneous order entry by trading members,
operating ranges are kept at +/- 10 %.
Quantity freeze: Quantity Freeze for S&P CNX Nifty futures contracts would be 15,000 units or
greater.

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 Indian Capital Market 5.39

Order type/Order book/Order attribute: The different order types may be Regular lot order,
Stop loss order, Immediate or cancel and Spread order.
(b) S&P CNX NSE Nifty 50 Index: It is a well diversified 50 stock index accounting for 24
sectors of the economy. The total traded value of all Nifty stocks is about 50% of the traded
value of all stocks on the NSE. Nifty stocks represent about 60% of the total market
capitalisation.
You can trade the 'entire stock market' instead of individual securities.
Index Futures are:
- Highly liquid
- Large intra-day price swings
- High leverage
- Low initial capital requirement
- Lower risk than buying and holding stocks
- Just as easy to trade the short side as the long side
- Only have to study one index instead of 100's of stocks
Index futures are settled in cash and therefore all problems related to bad delivery, forged,
fake certificates, etc can be avoided. Since the index consists of many securities (50
securities) it is very difficult to manipulate the index.
You are required to pay a small fraction of the value of the total contract as margins. This
means that trading in Stock Index Futures is a leveraged activity since the investor is able to
control the total value of the contract with a relatively small amount of margin.
[Source: NSE Website]

11. Options
An Option may be understood as a privilege, sold by one party to another, that gives the buyer
the right, but not the obligation, to buy (call) or sell (put) any underlying say stock, foreign
exchange, commodity, index, interest rate etc. at an agreed-upon price within a certain period
or on a specific date regardless of changes in underlying’s market price during that period.
The various kinds of stock options include put and call options, which may be purchased in
anticipation of changes in stock prices, as a means of speculation or hedging. A put gives its
holder an option to sell, or put, shares to another party at a fixed price even if the market price
declines. A call gives the holder an option to buy, or call for, shares at a fixed price even if the
market price rises.
11.1 Stock Options: Stock options involve no commitments on the part of the buyers of the
option contracts individual to purchase or sell the stock and the option is usually exercised
only if the price of the stock has risen (in case of call option) or fallen (in case of put option)

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