DERIVATIVES AND

RISK
MANAGEMENT
STOCK
FUTURES
⮚Open Interests
⮚Pay-off profiles
⮚Position Limits
⮚Pricing of Futures
 OPEN INTERESTS

An introduction
✔ Open Interest is the total number of contracts outstanding for an
underlying asset.
✔ It is the total number of F &O contracts that are not closed or delivered on
a particular day.
✔ The study of open interests helps in identifying trends/trend reversals in
the futures market.
✔ Only one side of the market i.e. either long or short positions are
considered while calculating open interests.
 OPEN INTERESTS

✔ Open Interests is not the same as the traded volumes.

✔ Volumes are the quantity traded for a specific period and gives us an idea

about the activity for that given period.

✔ Open interests are outstanding positions and hence tells us about the
level of interest in a particular counter.
✔ Open interests tells us about the depth in the market.
 OPEN INTERESTS

Dates Buyer Seller (no Day’s volume Day’s OI (no Cumulative OI

(no of of shares) (no of share) of shares) (no of shares)
shares)
DAY 1 A 100 B 100 100 100 100

DAY 2 C 100 D 100 100 100 200

DAY 3 E 200 F 200 200 200 400

DAY 4 B 100 C 100 100 - 100 300

DAY 5 F 100 A 100 100 - 100 200

 OPEN INTEREST CHANGES

Fresh Long positions

✔ If price rise is accompanied with rise in open interest, then this is

considered as a bullish sign. Fresh buyers are entering the market and
the prices are likely to remain firm.
✔ If the open interest numbers flatten following a rising trend in both price
and open interest, then this could be an early signal of an impending top.
 OPEN INTEREST CHANGES

OI at Market Tops

✔ High open interest at market tops is not a healthy sign. If prices start to
correct, many weak longs will be forced to liquidate their positions
setting–off a self-feeding, downward spiral
✔ An unusually high or record open interest in a bull market is a danger
signal. When a rising trend of open interest begins to reverse, there is a
strong possibility of a trend reversal.
 OPEN INTEREST CHANGES

Short Covering

✔ If the prices rise with a decline in open interest, then it is because of short
covering and not genuine demand.
✔ In these circumstances' money is flowing out of the market.
Consequently, when the short covering has run its course, prices will
decline.
 OPEN INTEREST CHANGES

Long Liquidation/Profit Booking

✔ If both prices and open interests decline, this indicates liquidation by weak
traders with long positions.
✔ As long as this trend continues, it is a bearish sign.
✔ Once open interests stabilizes at lower levels, the liquidation is over, and
prices could be in a position to rally again.
✔ Open Interests should be read with cost of carry to get the correct picture.
 OPEN INTEREST CHANGES

Fresh Shorts

✔ If prices decline with addition of open interest, this indicates that new short
positions are being opened. As long as this process continues it is a bearish signal.
✔ The Markets can be very volatile and ideally one should avoid trading such
markets.
Price OI COC Observations Sign Remarks

Rises Addition Expands Fresh Long Strongly Bullish Buying in Futures

Market.
Rises Addition Contracts Fresh Long Strongly Bullish Buying in Cash
Market.
Rises Declines Expands Short Covering Mildly Bullish Buying in Futures
Market.
Rises Declines Contracts Short Covering Mildly Bullish Buying in Cash
Market.
Falls Declines Expands Long Liquidation Mildly Bearish Selling in Cash
Market.
Falls Declines Contracts Long Liquidation Mildly Bearish Selling in Futures
Market.
Falls Addition Expands Fresh Shorts Strongly Bearish Selling in Cash
Market.
Falls Addition Contracts Fresh Shorts Strongly Bearish Selling in Futures
Market.
 PAY-OFF

✔ A payoff profile is a graphical representation of a long or short position in

the futures market.
✔ It gives an exact idea about the likely profit/ loss that would accrue to a
market participant with change in the price of the underlying asset at
expiry.
✔ As a matter of convention, the prices of the underlying asset are shown on
the X-axis while the profits/ losses are shown on the Y-axis.
 Pay-off profile for Long Futures

80

60

40

20
Profit/Loss in Rs

0
210 220 230 240 250 260 270 280 290 300 310 320 330 340
Traded price
-20

-40

-60

-80
 Pay-off profile for Short Futures

80

60

40

20
Profit/Loss in Rs

0
210 220 230 240 250 260 270 280 290 300 310 320 330 340 350
Traded Price
-20

-40

-60

-80
 ELIGIBILITY CRITERIA FOR STOCKS

✔ Top 500 in terms of Average Daily Market Capitalization and Average Traded Value in
the previous six months on rolling basis.
✔ Stocks Median Quarter-Sigma order size over last 6 months shall not be less than Rs. 25
lakhs.
✔ MWPL in the stock shall not be less than Rs. 500 crores.
✔ Average Daily Delivery value in cash market shall not be less than Rs. 10 crores in
previous six months on rolling basis.
✔ If any stock fails to meet the above criteria for 3 months consecutively, then no fresh
contracts will be issued.
✔ If stock remains on ban period for a significant part of the month for three consecutive
months, then it will be phased out from the F & O segment.
 ELIGIBILITY CRITERIA FOR INDEX

✔ The F & O contracts on an index can be introduced only if the stocks

contributing to 80% weightage of the index are individually eligible for
derivative trading.
✔ No single ineligible stocks in the index shall have more than 5% weight in the
index.
✔ The above is monitored every month.
✔ If index fails to meet the eligibility criteria for 3 consecutive months, then no
fresh month contract shall be issued.
✔ The existing unexpired contacts shall be permitted to trade till expiry and new
CONTINUED ELIGIBILITY CRITERIA FOR INDEX

✔ 15% of trading members active in all index derivatives or 20 trading

members whichever is lower should have traded in any derivative
contract on the index being reviewed in each of the month during the
review period.
✔ Trading on a minimum of 75% of the trading days during the review
period.
✔ Average daily turnover of at least INR 10 crore during the review period.
✔ Average daily open interest of INR 4 crore during the review period.
 MEAN QUARTER SIGMA ORDER SIZE

( In Rs)
Best Buy
306.45
Best Buy 306.45 A single order of Rs 25 lakhs should
A single order of Rs 25 lakhs should not move the price by more than Rs. 0.70 on either side
Best Sell
306.90
Average Price
Best Sell
Best Buy 306.90 not move the price by more than Rs.
0.70 on either side.
306.45
A single order of Rs 25 lakhs should not move the price by more than Rs. 0.70 on either side
Average Price
Best Sell 306.70 306.90
Average Price
One Sigma
One Sigma 0.009 306.70

0.009
Quarter Sigma
Quarter Sigma
Quarter Sigma Price (Average Price * Q Sigma)
0.00225 0.00225

0.70
Quarter Sigma Price 0.70 306.70
One Sigma
(Average Price * Q 0.009
Quarter Sigma
Sigma) 0.00225
Quarter Sigma Price (Average Price * Q Sigma)
0.70
 POSITION LIMITS FOR TM/FPI/MF

Index Futures

The position limits of Trading members / FPIs (Category I & II) / Mutual Funds
in equity index futures contracts is higher of Rs. 500 crores or 15% of the
total open interest in the market in equity index futures contracts. This limit
is applicable on open positions in all futures contracts on a particular
underlying index.
 POSITION LIMITS FOR TM/FPI/MF

Index Options

The position limits of Trading members / FPIs (Category I & II) / Mutual Funds
in equity index options contracts is higher of Rs. 500 crores or 15% of the
total open interest in the market in equity index futures contracts. This limit
is applicable on open positions in all options contracts on a particular
underlying index.
ADDITIONAL EXPOSURE IN INDEX DERIVATIVES

FII/MF

✔ Short positions in index derivatives (short futures, short calls and long puts)
not exceeding (in notional value) the FII‟s/MFs holding of stocks.
✔ Long positions in index derivatives (long futures, long calls and short puts)
not exceeding (in notional value) the FII’s/MFs holding of cash, government
securities, T-Bills, money market mutual funds and gilt funds and similar
instruments.
 POSITION LIMITS

✔ Position Limits are the highest number of F & O contracts that an investor
is allowed to hold on one underlying security.
✔ SEBI/Exchanges establish certain position limits for each contract based on
trading volumes and underlying share quantity.
✔ Market Wide Position Limits (MWPL) for F & O contracts on individual
securities is 20% of the number free float holdings.
 POSITION LIMITS AND F & O BAN

✔ Aggregate OI of security across Exchanges is considered for purpose

of monitoring MWPL.
✔ If aggregate OI across Exchanges exceeds 95% of MWPL, no fresh
positions are permitted from the subsequent trading day.
✔ Normal trading in the security is resumed only after the aggregate OI
across Exchanges comes down to 80% or below of the MWPL.
 POSITION LIMITS

✔ A sub-account of FII or any scheme of MF or any person or

persons acting in concert who together own 15% or more of
the open interest on a particular underlying index is required
to report this fact to the Exchange and the Clearing
Corporation.
✔ MWPL for F&O contracts on individual stocks is 20% of the
number of shares held by non-promoters. i.e. 20% of the
free float in terms of the number of shares of a company.
 GROSS POSITION LIMITS

FII sub account and MF Scheme Position Limits

The gross open position across all F&O contracts for a specific
security will be the higher of:

✔1% of the FF Mkt Cap (number of shares) OR

✔5% of the total OI across all F & O contracts for the same security
(number of shares).
 FUTURES PRICING

✔ Mathematical relationship exists between the Spot and the Future

(Forward) prices.
✔ Financial Forwards and Futures are priced using the cost of carry model.
✔ Forward or Future prices will be equal to the spot price plus the
carrying costs incurred by buying and holding on to the deliverable
asset less the carry returns, if any.
✔ Forward Price = Spot Price + Carry Costs – Carry Returns.
 FUTURES PRICING

Continuous Compounding

✔ All calculations in derivatives markets are based on the

concept of continuous compounding.
✔ Compounding is widely used in everyday life and particularly
so in the context of banks loans and bank deposits.
 FUTURES PRICING

Continuous Compounding

In the normal course, money is compounded for a period and is represented by the following equation:
FV = PV (1 + r) ^n where

FV is the future value of the amount invested.

PV is the present value of the amount invested.
“r” is the interest rate at which the amount was invested.
“n” is the no of years.
 FUTURES PRICING

Continuous Compounding

Rs. 10,000 is invested @10% for 3 years. Its future vale can be calculated as
follows:
✔ FV = 10,000 * (1+0.10) ^3 = 10,000 * 1.3310 = Rs. 13,310.
✔ The above is a simple example of annual compounding.
✔ The Future Value will change if we increase the frequency of compounding.
✔ Higher frequency will lead to increased value.
 FUTURES PRICING

Continuous Compounding

Semi-annual compounding
FV = 10,000 * (1+0.10/2) ^3*2 = Rs. 13,401.
Quarterly compounding
FV = 10,000 * (1+0.10/4) ^3*4 = Rs. 13,449.
Monthly compounding
FV = 10,000 *(1+0.10/12) ^3*12 = Rs. 13,482.
Daily compounding
FV = 10,000 *(1+0.10/365) ^3*365 = Rs. 13,498.
 FUTURES PRICING

Continuous Compounding
In continuous compounding money is compounded every instant and is
represented as follows:
F = S * e^ rt

F is the fair value of the forward contract.

S is the spot price or the underlying price.
“e” is the mathematical constant whose value is 2.718. It is also the base of
the natural logarithm.
“r” is risk-free rate in the economy.
“t” is the time till maturity
 FUTURES PRICING

Continuous Compounding for securities providing no income

The spot price is Rs.1,000, risk free rate is 8%, what should be the fair
value of a 3-month forward contract?

Answer:
F = S * e^ rt
F = 1000 * e^0.08*3/12 = 1020.20
 FUTURES PRICING

Continuous Compounding for securities providing cash income

Consider a 6-month contract on 100 shares priced at Rs.50. Rf
rate is 10%. Stock will give dividend of Rs. 2.00 after 4 months.
The fair value of the forward contract will be:

F = (S-I) * e^ rt where I is the PV of dividends.

PV of I = 100 *2.00 *e – (4/12*0.10) = Rs. 193.44
Value Futures = (5000-193.44) *e(0.5*0.10)
= Rs. 5052.99 or 50.53 per share
 FUTURES PRICING

Continuous Compounding for securities providing a known yield.

The Dividend Yield on the index is 2%. The Index value is 1000 and risk-free
rate of return is 10%. The fair value of a 3-month forward contract will be :
Value Futures = 1000*e (0.10-0.02)*(0.25)
= 1020.20.
THANK YOU