Futures and options

Nature of the problem

The turnover of the stock exchange has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools.

Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margin system, unclear expire date and generating counter party risk. In view of this problem SEBI abolished the BADLA system.

After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr.L.C.Gupta to develop the appropriate framework for derivatives trading in India, SEBI accepted the recommendation of the committee on may 11, 1998 and approved the phase introduction of the derivatives trading beginning with stock index futures.

There are many investors who are willing to trade in the derivatives segment, because of its advantages like limited loss unlimited profit by paying the small premiums.

SCOPE OF THE STUDY:

The study is limited to "Derivatives" with special reference to futures and option in the Indian context and the Inter-Connected Stock Exchange has been taken as a representative sample for the study. The study can't be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluation of derivatives market only in India context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, CBOT etc.

OBJECTIVES OF THE STUDY:

  • To analyze the derivatives market in India.
  • To analyze the operations of futures and options.
  • To find the profit/loss position of futures buyer and seller and also the option writer and option holder.
  • To study about risk management with the help of derivatives.

LIMITATIONS OF THE STUDY:

The following are the limitation of this study.

  • The scrip chosen for analysis is BHARTI AIRTEL and the contract taken is february 2007 ending one -month contract.
  • The data collected is completely restricted to the BHARTI AIRTEL of february 2007; hence this analysis cannot be taken universal.

DESCRIPTION OF THE METHOD:

The following are the steps involved in the study.

  1. Selection of the scrip:- The scrip selection is done on a random and the scrip selected is BHARTI AIRTEL. The lot size is . Profitability position of the futures buyer and seller and also the option holder and option writer is studied.
  2. Data Collection:- The data of the Bharti Airtel has been collected from the "the Economic times" and the internet. The period of data collection is from 29th JAN 2007-22nd FEB 2007.
  3. Analysis:- The analysis consist of the tabulation of the data assessing the profitability positions of the futures buyer and seller and also option holder and option writer, representing the data with graphs and making the interpretation using data.

COMPANY PROFILE

Concept:

Inter-connected stock exchange of India limited [ISE] has been promoted by 14 Regional stock exchanges to provide cost-effective trading linkage/connectivity to all the members of the participating Exchanges, with the objective of widening the market for the securities listed on these Exchanges. ISE aims to address the needs of small companies and retail investors with the guiding principle of optimizing the existing infrastructure and harnessing the potential of regional markets, so as to transform these into a liquid and vibrant market through the use of state-of-the-art technology and networking. The participating Exchanges of ISE in all about 4500 stock brokers, out of which more than 200 have been currently registered as traders on ISE. In order to leverage its infrastructure and to expand its nationwide reach, ISE has also appointed around 450 Dealers across 70 cities other than the participating Exchange centers. These dealers are administratively supported through the regional offices of ISE at Delhi [north], kolkata [east], Coimbatore & Hyderabad [south] and Nagpur [central], besides Mumbai.

ISE has also floated a wholly-owned subsidiary, ISE securities and services limited [ISS], which has taken up corporate membership of the National Stock Exchange of India Ltd. [NSE] in both the Capital Market and Futures and Options segments and The Stock Exchange, Mumbai In the Equities segment, so that the traders and dealers of ISE can access other markets in addition to the ISE markets and their local market. ISE thus provides the investors in smaller cities a one-stop solution for cost-effective and efficient trading and settlement in securities.

With the objective of broad basing the range of its services, ISE has started offering the full suite of DP facilities to its Traders, Dealers and their clients.

OBJECTIVES

  • Create a single integrated national level solution with access to multiple markets for providing high cost-effective service to millions of investors across the country.
  • Create a liquid and vibrant national level market for all listed companies in general and small capital companies in particular.
  • Optimally utilize the existing infrastructure and other resources of participating Stock Exchanges, which are under-utilized now.
  • Provide a level playing field to small Traders and Dealers by offering an opportunity to participate in a national markets having investment-oriented business.
  • Reduce transaction cost.
  • Provide clearing and settlement facilities to the Traders and Dealers across the Country at their doorstep in a decentralized mode.
  • Spread demat trading across the country

SALIENT FEATURES:

Network of intermediaries:

As at the beginning of the financial year 2003-04, 548 intermediaries (207 Traders and 341 Dealers) are registered on ISE. A board of members forms the bedrock for any Exchange, and in this respect, ISE has a large pool of registered intermediaries who can be tapped for any new line of business.

Robust Operational Systems:

The trading, settlement and funds transfer operations of ISE and ISS are completely automated and state-of-the-art systems have been deployed. The communication network of ISE, which has connectivity with over 400 trading members and is spread across46 cities, is also used for supporting the operations of ISS. The trading software and settlement software, as well as the electronic funds transfer arrangement established with HDFC Bank and ICICI Bank, gives ISE and ISS the required operational efficiency and flexibility to not only handle the secondary market functions effectively, but also by leveraging them for new ventures.

Skilled and experienced manpower:

ISE and ISS have experienced and professional staff, who have wide experience in Stock Exchanges/ capital market institutions, with in some cases, the experience going up to nearly twenty years in this industry. The staff has the skill-set required to perform a wide range of functions, depending upon the requirements from time to time.

Aggressive pricing policy:

The philosophy of ISE is to have an aggressive pricing policy for the various products and services offered by it. The aim is to penetrate the retail market and strengthen the position, so that a wide variety of products and services having appeal for the retail market can be offered using a common distribution channel. The aggressive pricing policy also ensures that the intermediaries have sufficient financial incentives for offering these products and services to the end-clients.

Trading, Risk Management and Settlement Software Systems:

The ORBIT (Online Regional Bourses Inter-connected Trading) and AXIS (Automated Exchange Integrated Settlement) software developed on the Microsoft NT platform, with consultancy assistance from Microsoft, are the most contemporary of the trading and settlement software introduced in the country. The applications have been built on a technology platform, which offers low cost of ownership, facilitates simple maintenance and supports easy upgradation and enhancement. The softwares are so designed that the transaction processing capacity depends on the hardware used; capacity can be added by just adding inexpensive hardware, without any additional software work.

Vibrant Subsidiary Operations:

ISS, the wholly-owned subsidiary of ISE, is one of the biggest Exchange subsidiaries in the country. On any given day, more than 250 registered intermediaries of ISS traded from 46 cities across the length and breadth of the country.

DERIVATIVES:-

The emergence of the market for derivatives products, most notably forwards, futures and options, can be tracked back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative product minimizes the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc.. Banks, Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future.

DEFINITION

Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

  1. Securities Contracts (Regulation)Act, 1956 (SCR Act) defines "derivative" to 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.

Emergence of financial derivative products

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use.

PARTICIPANTS:

The following three broad categories of participants in the derivatives market.

HEDGERS:

Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.

SPECULATORS:

Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

ARBITRAGERS:

Arbitrageurs are in business to take of a discrepancy between prices in two different markets, if, for, example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit.

FUNCTION OF DERIVATIVES MARKETS:

The following are the various functions that are performed by the derivatives markets. They are:

v Prices in an organized derivatives market reflect the perception of market participants about the future and lead the price of underlying to the perceived future level.

  • Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
  • Derivatives trading acts as a catalyst for new entrepreneurial activity.
  • Derivatives markets help increase saving and investment in long run.

TYPES OF DERIVATIVES:

The following are the various types of derivatives. They are:

FORWARDS:

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

FUTURES:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the at a certain price.

OPTIONS:

Options are of two types-calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a give future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants:

Options generally have lives of up to one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the counter.

LEAPS:

The acronym LEAPS means long-term Equity Anticipation securities. These are options having a maturity of up to three years.

BASKETS:

Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

SWAPS:

Swaps are private agreements between two parties to exchange cash floes in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used Swaps are:

Interest rate Swaps:

These entail swapping only the related cash flows between the parties in the same currency.

Currency Swaps:

These entail swapping both principal and interest between the parties, with the cash flows in on direction being in a different currency than those in the opposite direction.

SWAPTION:

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.

RATIONALE BEHIND THE DELOPMENT OF DERIVATIVES:

Holding portfolios of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser than what he expected to get. There are various factors, which affect the returns:

  1. Price or dividend (interest)
  2. Some are internal to the firm like-
  3. Industrial policy
  4. Management capabilities
  5. Consumer's preference
  6. Labor strike, etc.

These forces are to a large extent controllable and are termed as non systematic risks. An investor can easily manage such non-systematic by having a well-diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other.

There are yet other of influence which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are:

  1. Economic
  2. Political
  3. Sociological changes are sources of systematic risk.

For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all-individual stocks to move together in the same manner. We therefore quite often find stock prices falling from time to time in spite of company's earning rising and vice versa.

Rational Behind the development of derivatives market is to manage this systematic risk, liquidity in the sense of being able to buy and sell relatively large amounts quickly without substantial price concession.

In debt market, a large position of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small size relative to many common stocks. Those factors favor for the purpose of both portfolio hedging and speculation, the introduction of a derivatives securities that is on some broader market rather than an individual security.

REGULATORY FRAMEWORK:

The trading of derivatives is governed by the provisions contained in the SC R A, the SEBI Act, and the regulations framed there under the rules and byelaws of stock exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of Dr. L. C. Gupta develop the appropriate regulatory framework for derivative trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index Futures. SEBI also approved he "suggestive bye-laws" recommended by the committee for regulation and control of trading and settlement of Derivative contract.

The provision in the SCR Act governs the trading in the securities. The amendment of the SCR Act to include "DERIVATIVES" within the ambit of securities in the SCR Act made trading in Derivatives possible with in the framework of the Act.

  1. Eligibility criteria as prescribed in the L. C. Gupta committee report may apply to SEBI for grant of recognition under section 4 of the SCR Act, 1956 to start Derivatives Trading. The derivative exchange/segment should have a separate governing council and representation of trading/clearing member shall be limited to maximum 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain approval of SEBI before start of Trading in any derivative contract.
  2. The exchange shall have minimum 50 members.
  3. The members of an existing segment of the exchange will not automatically become the members of the derivatives segment. The members of the derivatives segment need to fulfill the eligibility conditions as lay down by the L. C. Gupta committee.
  4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/clearing house. Clearing Corporation/Clearing House complying with the eligibility conditions as lay down By the committee have to apply to SEBI for grant of approval.
  5. Derivatives broker/dealers and Clearing members are required to seek registration from SEBI.
  6. The Minimum contract value shall not be less than Rs.2 Lakh. Exchange should also submit details of the futures contract they purpose to introduce.
  7. The trading members are required to have qualified approved user and sales persons who have passed a certification programme approved by SEBI

Introduction to futures and options

In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.

Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are:

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

Limitations of forward markets

Forward markets world-wide are afflicted by several problems:

  • Lack of centralization of trading,
  • Illiquidity, and
  • Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious

Introduction to futures

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

Distinction between futures and forwards

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. Table 3.1 lists the distinction between the two

DEFINITION: A Futures contract is an agreement between two parties to buy or sell an asset a certain time in the future at a certain price. To facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. The standardized items on a futures contract are:

  • Quantity of the underlying
  • Quality of the underlying
  • The date and the month of delivery
  • The units of price quotations and minimum price change
  • Location of settlement

FEATURES OF FUTURES:

  • Futures are highly standardized.
  • The contracting parties need not pay any down payments.
  • Hedging of price risks.
  • They have secondary markets to.

TYPES OF FUTURES:

On the basis of the underlying asset they derive, the futures are divided into two types:

  • Stock futures:
  • Index futures:

Parties in the futures contract:

There are two parties in a future contract, the buyer and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is who is SHORT on the futures contract.

The pay off for the buyer and the seller of the futures of the contracts are as follows:

PAY-OFF FOR A BUYER OF FUTURES:

CASE 1:-The buyer bought the futures contract at (F); if the future price goes to S1 then the buyer gets the profit of (FP).

CASE 2:-The buyer gets loss when the future price goes less then (F), if the future price goes to S2 then the buyer gets the loss of (FL).

PAY-OFF FOR A SELLER OF FUTURES:

CASE 1:- The seller sold the future contract at (F); if the future goes to S1 then the seller gets the profit of (FP).

CASE 2:- The seller gets loss when the future price goes greater than (F), if the future price goes to S2 then the seller gets the loss of (FL).

MARGINS:

Margins are the deposits which reduce counter party risk, arise in a futures contract. These margins are collect in order to eliminate the counter party risk. There are three types of margins:

Initial Margins:

Whenever a futures contract is signed, both buyer and seller are required to post initial margins. Both buyer and seller are required to make security deposits that are intended to guarantee that they will infact be able to fulfill their obligation. This deposits are initial margins and they are often referred as purchase price of futures contract.

Marking to market margins:

The process of adjusting the equity in an investor's account in order to reflect the change in the settlement price of futures contract is known as MTM margin.

Maintenance margin:

The investor must keep the futures account equity equal to or grater than certain percentage of the amount deposited as initial margin. If the equity goes less than that percentage of initial margin, then the investor receives a call for an additional deposit of cash known as maintenance margin to bring the equity upto the initial margin.

Role of Margins:

The role of margins in the futures contract is explained in the following example.

S sold a satyam June futures contract to B at Rs.300; the following table shows the effect of margins on the contract. The contract size of satyam is 1200. The initial margin amount is say Rs.20000, the maintenance margin is 65%of initial margin.

Pricing the Futures:

The Fair value of the futures contract is derived from a model knows as the cost of carry model. This model gives the fair value of the contract.

Contract cycle:

The period over which contract trades. The index futures contracts on the NSE have one- month, two -month and three-month expiry cycle which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

Expiry date:

It is the date specifies in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

Contract size:

The amount of asset that has to be delivered under one contract. For instance, the contract size on NSE's futures market is 200 nifties.

Basis:

In the context of financial futures, basis can be defined as the futures price minus the spot price. The will be a different basis for each delivery month for each contract, In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost carry:

The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

Open Interest:

Total outstanding long or short position in the market at any specific time. As total long positions in the market would be equal to short positions, for calculation of open interest, only one side of the contract is counter.

OPTION:

Option is a type of contract between two persons where one grants the other the right to buy a specific asset at a specific price within a specific time period. Alternatively the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. In order to have this right. The option buyer has to pay the seller of the option premium

The assets on which option can be derived are stocks, commodities, indexes etc. If the underlying asset is the financial asset, then the option are financial option like stock options, currency options, index options etc, and if options like commodity option.

PROPERTIES OF OPTION:

Options have several unique properties that set them apart from other securities. The following are the properties of option:

  • Limited Loss
  • High leverages potential
  • Limited Life

PARTIES IN AN OPTION CONTRACT:

  1. Buyer of the option:
  2. The buyer of an option is one who by paying option premium buys the right but not the obligation to exercise his option on seller/writer.

  3. Writer/seller of the option:

The writer of the call /put options is the one who receives the option premium and is their by obligated to sell/buy the asset if the buyer exercises the option on him

TYPES OF OPTIONS:

The options are classified into various types on the basis of various variables. The following are the various types of options.

On the basis of the underlying asset:

On the basis of the underlying asset the option are divided in to two types :

INDEX OPTIONS

The index options have the underlying asset as the index.

STOCK OPTIONS:

A stock option gives the buyer of the option the right to buy/sell stock at a specified price. Stock option are options on the individual stocks, there are currently more than 50 stocks, there are currently more than 50 stocks are trading in the segment.

On the basis of the market movements:

On the basis of the market movements the option are divided into two types. They are:

CALL OPTION:

A call option is bought by an investor when he seems that the stock price moves upwards. A call option gives the holder of the option the right but not the obligation to buy an asset by a certain date for a certain price.

PUT OPTION:

A put option is bought by an investor when he seems that the stock price moves downwards. A put options gives the holder of the option right but not the obligation to sell an asset by a certain date for a certain price.

On the basis of exercise of option:

On the basis of the exercising of the option, the options are classified into two categories.

AMERICAN OPTION:

American options are options that can be exercised at any time up to the expiration date, most exchange-traded option are American.

EUOROPEAN OPTION:

European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options.

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION:

The pay-off of a buyer options depends on a spot price of a underlying asset. The following graph shows the pay-off of buyer of a call option.

As the spot price (E1) of the underlying asset is more than strike price (S). the buyer gets profit of (SR), if price increases more than E1 then profit also increase more than SR.

As the spot price (E1) of the underlying is less than strike price (S). the seller gets the profit of (SP), if the price decreases less than E1 then also profit of the seller does not exceed (SP).

As the spot price (E2) of the underlying asset is more than strike price (S) the seller gets loss of (SR), if price goes more than E2 then the loss of the seller also increase more than (SR).

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION:

The pay-off of the buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of the buyer of a call option.

As the spot price (E1) of the underlying asset is less than strike price (S). the buyer gets the profit (SR), if price decreases less than E1 then profit also increases more than (SR).

As the spot price (E2) of the underlying asset is more than strike price (s), the buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION:

The pay-off of a seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option:

As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of (SR), if price decreases less than E1 than the loss also increases more than (SR).

As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of (SP), if price goes more than E2 than the profit of seller is limited to his premium (SP).

Factors affecting the price of an option:

The following are the various factors that affect the price of an option they are:

Stock price: The pay -off from a call option is a amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa.

Strike price: In case of a call, as a strike price increases, the stock price has to make a larger upward move for the option to go in-the-money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable.

Time to expiration: Both put and call American options become more valuable as a time to expiration increases.

Volatility: The volatility of a stock price is measured of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increase as volatility increase.

Risk-free interest rate: The put option prices decline as the risk-free rate increases where as the prices of call always increase as the risk-free interest rate increases.

Dividends: Dividends have the effect of reducing the stock price on the x- dividend rate. This has an negative effect on the value of call options and a positive effect on the value of put options.

PRICING OPTIONS

The black- scholes formula for the price of European calls and puts on a non-dividend paying stock are :

Options Terminology:

Strike price:

The price specified in the options contract is known as strike price or Exercise price.

Options premium:

Option premium is the price paid by the option buyer to the option seller.

Expiration Date:

The date specified in the options contract is known as expiration date.

In-the-money option:

An In the money option is an option that would lead to positive cash inflow to the holder if it exercised immediately.

At-the-money option:

An at the money option is an option that would lead to zero cash flow if it is exercised immediately.

Out-of-the-money option:

An out-of-the-money option is an option that would lead to negative cash flow if it is exercised immediately.

Intrinsic value of money:

The intrinsic value of an option is ITM, If option is ITM. If the option is OTM, its intrinsic value is zero.

Time value of an option:

The time value of an option is the difference between its premium and its intrinsic value.

OBSERVATIONS AND FINDINGS

  • The future price of Bharti Airtel is moving along with the market price.
  • If the buy price of the future is less than the settlement price, then the buyer of a future gets profit.
  • If the selling price of the future is less than the settlement price, then the seller incur losses.

SUMMARY

  • Derivates market is an innovation to cash market. Approximately its daily turnover reaches to the equal stage of cash market. The average daily turnover of the NSE derivative segments
  • In cash market the profit/loss of the investor depend on the market price of the underlying asset. The investor may incur huge profits or he may incur huge loss. But in derivatives segment the investor enjoys huge profits with limited downside.
  • In cash market the investor has to pay the total money, but in derivatives the investor has to pay premiums or margins, which are some percentage of total money.
  • Derivatives are mostly used for hedging purpose.
  • In derivative segment the profit/loss of the option writer is purely depend on the fluctuations of the underlying asset.

Conclusion

  • In bullish market the call option writer incurs more losses so the investor is suggested to go for a call option to hold, where as the put option holder suffers in a bullish market, so he is suggested to write a put option.
  • In bearish market the call option holder will incur more losses so the investor is suggested to go for a call option to write, where as the put option writer will get more losses, so he is suggested to hold a put option.
  • In the above analysis the market price of Bharti Airtel is having low volatility, so the call option writers enjoy more profits to holders.

RECOMMENDATIONS

  • The derivative market is newly started in India and it is not known by every investor, so SEBI has to take steps to create awareness among the investors about the derivative segment.
  • In order to increase the derivatives market in India, SEBI should revise some of their regulations like contract size, participation of FII in the derivatives market.
  • Contract size should be minimized because small investors cannot afford this much of huge premiums.
  • SEBI has to take further steps in the risk management mechanism.
  • SEBI has to take measures to use effectively the derivatives segment as a tool of hedging.

BIBILOGRAPHY

WEBSITES

  • www.derivativesindia.com
  • www.indianinfoline.com
  • www.nseindia.com
  • www.bseindia.com
  • www.5paisa.com

BOOKS:

  • Derivatives Core Module Workbook - NCFM material
  • Financial Markets and Services - Gordan and Natrajan
  • Financial Management - Prasanna Chandra

NEWSPAPER

  • Economic times of India

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