PROJECT DERIVATIVES

Risk Management Through Derivatives in Equity Segment

ACKNOWLEDGEMENT I express my sincere gratitude to the following dignitaries for helping me and providing necessary information during various stages of project thereby making it successful.

I would like to thank my external XYZ for giving me the opportunity to work in their esteemed organization under his guidance, and helping me to complete the project in a successful manner. I am also thankful to all the staff members of Religare securities ltd. Bhubaneswar who extended their hands and cooperation directly or indirectly for successful completion of the training programme.

I am obliged to my Faculty guide XYZ for providing time, effort and most of all his patience in helping me for preparing this project report. I am also thankful to all the faulty members of our college for their kind cooperation with me to write this report.

Last but not least I am thankful to my family members and friends for providing me moral support to do this project successfully.

Date: Place:

XYZ

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Risk Management Through Derivatives in Equity Segment

DECLARATION

I, SOUMYA RANJAN TRIPATHY, pursing MBA (2009-11) from Regional College Of Management Autonomus, Bhubaneswar, bearing Registration No.-0906247039, declare that the project titled “RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT” is an original work of my own and submitted to Regional College Management Autonomous for partial fulfillment of MBA programme.

This project report has not been submitted to any other institute/university for the award of any degree or diploma.

Date: Place:

Soumya Ranjan Tripathy

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Risk Management Through Derivatives in Equity Segment

CORPORATE GUIDE CERTIFICATE

This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY student of RCMA (second year) under my guidence and supervision for partial fulfillment of MBA curriculum of Regional College Of Management Autonomous, Bhubaneswar.

To the best of my knowledge and belief the report: 1. Is an original work done by the candidate himself 2. Has been duly completed.

3. Is up to the standard both in respect to the content and language for being referred to the examiner.

Mr. Sandeep Das Mohapatra Manager, Equity Religare Securities Ltd. Bhubaneswar

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Risk Management Through Derivatives in Equity Segment

FACULTY GUIDE CERTIFICATE This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY, student of RCMA (second year) under the guidance and supervision for partial fulfillment of MBA curriculum of Regional College Of Management Autonomous, Bhubaneswar.

To the best of my knowledge and belief the report: 1. Is an original work done by the candidate himself 2. Has been duly completed.

3. Is up to the standard both in respect to the content and language for being referred to the examiner.

Prof. Ashok Ku. Rath H.O.D. Finance Regional College of Management (Autonomous) Bhubaneswar

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Risk Management Through Derivatives in Equity Segment

ABSTRACT The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial 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 products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. The past decade has witnessed a massive growth in the use of financial derivatives by a wide range of corporate and financial institutions. This growth has run in parallel with the increasing direct reliance of companies on the capital market as the major source of long term funding. In this respect, derivatives have a vital role to play in enhancing shareholder value by ensuring minimum risk of investment.

During this project I got to know different ways or different strategies by using which investor can minimize the loss. An individual always faces the problem as to which strategy he should use in different market condition. During this course of Internship I had gathered a good knowledge of cash and derivative market. This knowledge was helpful in my project to achieve the objective.

I had worked out on 14 strategies by applying which in appropriate market condition an investor can minimize his risk/loss and even earn profit by only taking positions.

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Risk Management Through Derivatives in Equity Segment

EXECUTIVE SUMMARY This is the report submitted by Soumya Ranjan Tripathy studying at Regional College of Management(Autonomous), Bhubaneswar, in the partial fulfillment of the requirement of MBA Program, carried at Religare securities Ltd, Bhubaneswar.

Religare Securities Limited is engaged in providing financial services all across the country and is one of the most renowned broking houses in India.

The project is on RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT and the objective of the project is to identify, understand and analyze the strategy which helps to minimize the Risk in the Indian Equity Derivative Market. Using the findings depicted at the end of the project will helpful for the investor by indicating whether to invest in the option and future or not.

Equity market reforms are a major constituent of the overall economic reforms in India and considering the growing surge in the broking firm, the objective of the project is such set so that it will enable the investors as well as the RMs to formulate strategies as per market trend and investor’s risk appetite.

To achieve the objectives of the project, training was undergone to gain practical knowledge and learn about derivatives and its applications and also to know the behaviors of investor during trading hours.

The training enabled to learn the concepts of secondary market, the derivatives and the importance of various tools that were used to undergo the activities to invest in equity market.

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Risk Management Through Derivatives in Equity Segment

CONTENTS 1. Introduction a. Objectives of the study b. Methodology used 2. Company profile 3. Investment 4. Equity investment 5. Secondary Market 6. Derivatives (I) Forward contract (II) Future contract • Futures terminology • Futures payoffs • Applications of future contract (III)Option contract • Option contracts • Option terminologies • Option strategies 7. Findings 8. Conclusion 9. Bibliography

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Risk Management Through Derivatives in Equity Segment

INTRODUCTION 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.

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Risk Management Through Derivatives in Equity Segment

OBJECTIVE OF THE PROJECT: To learn the basics of secondary market, it includes learning various terminologies used for day-to-day trading.

To give an insight into derivatives and their application in Indian context.

To gain an insight into derivative trading at a broking firm To identify, understand and analyze the strategies which help to minimize the Risk in the Indian Equity Derivative Market in different market conditions.

To implement strategies on investor’s portfolio and measures the profit or loss as a result of implementing the strategies.

METHODOLOGY USED The information used for this study was collected through secondary sources whch are available for public

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Risk Management Through Derivatives in Equity Segment

COMPANY PROFILE OF RELIGARE SECURITIES LTD.

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Risk Management Through Derivatives in Equity Segment

About Religare Enterprises Ltd: A diversified financial services group with a pan-India presence and presence in multiple international locations, Religare Enterprises Limited ("REL") offers a comprehensive suite of customer-focused financial products and services targeted at retail investors, high net worth individuals and corporate and institutional clients.

REL, along with its joint venture partners, offers a range of products and services in India, including asset management, life insurance, wealth management, equity and commodity broking, investment banking, lending services, private equity and venture capital. Religare has also ventured into the alternative investments sphere through its holistic arts initiative and film fund.

With a view to expand and diversify, REL operates in the life insurance space under 'Aegon Religare Life Insurance Company Limited' and has launched India's first wealth management joint venture under the brand name 'Religare Macquarie Private Wealth'.

REL, through its subsidiaries, has launched India's first holistic arts initiative - with a gallery - as well as the first SEBI approved film fund, which is an initiative towards innovation and spotting new opportunities for creation and maximization of wealth for investors.

REL operates from seven domestic regional offices, 43 sub-regional offices, and has a presence in 498 cities and towns controlling 1,837 business locations all over India & having an employee strength of over 10000 employees.

To make a mark in the global arena, REL acquired UK-based Hichens, Harrison & Co. in 2008 which was subsequently re-named as Religare Hichens Harrison PLC ("RHH"). Hichens, Harrison & Co. was incorporated in London in the year 1803 and is believed to be one of the oldest firms of stockbrokers in the City of London.

Pursuant to expansion of REL's business, the company has grown from largely an equity trading company into a diversified financial services company. With the addition of RHH the REL group now operates out of multiple global locations, other than India, (the UK, the USA, Brazil, South Africa, South East Asia, Dubai and Singapore).

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Risk Management Through Derivatives in Equity Segment

Vision & Mission:

Vision: To build Religare as a globally trusted brand in the financial services domain and present it as the ‘Investment Gateway of India'.

Mission: Providing complete financial care driven by the core values of diligence and transparency.

Brand Essence: Core brand essence is Diligence and Religare is driven by ethical and dynamic processes for wealth creation.

Name:

Religare is a Latin word that translates as 'to bind together'. This name has been chosen

to reflect the integrated nature of the financial services the company offers.

Symbol: The Religare name is paired with the symbol of a four-leaf clover. Traditionally, it is considered good fortune to find a four-leaf clover as there is only one four-leaf clover for every 10,000 three-leaf clovers found. For us, each leaf of the clover has a special meaning. It is a symbol of Hope, Trust, Care, & Good Fortune. For the world, it is the symbol of Religare.

The first leaf of the clover represents Hope. The aspirations to succeed. The dream of becoming. Of new possibilities. It is the beginning of every step and the foundation on which a person reaches for the stars.

The second leaf of the clover represents Trust. The ability to place one’s own faith in another. To have a relationship as partners in a team. To accomplish a given goal with the balance that brings satisfaction to all, not in the binding, but in the bond that is built.

The third leaf of the clover represents Care. The secret ingredient that is the cement in every relationship. The truth of feeling that underlines sincerity and the triumph of diligence in every aspect. From it springs true warmth of service and the ability to adapt to evolving environments with consideration to all.

The fourth and final leaf of the clover represents Good Fortune. Signifying that rare ability to meld opportunity and planning with circumstance to generate those often looked for remunerative moments of success.

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Risk Management Through Derivatives in Equity Segment Hope. Trust. Care. Good Fortune. All elements perfectly combine in the emblematic and rare, four-leaf clover to visually symbolize the values that bind together and form the core of the Religare vision.

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Risk Management Through Derivatives in Equity Segment

Religare Enterprises Limited: Other group companies Religare Securities Limited

Religare Finvest Limited

Equity Broking

Lending and Distribution business

Online Investment Portal

Proposed Custodial business

Portfolio Management Services Depository Services

Religare Insurance Broking Limited Life Insurance

Religare Commodities Limited

General Insurance

Commodity Broking Religare Capital Markets Limited

Reinsurance Religare Arts Initiative Limited

Investment Banking

Business of Art

Proposed Institutional Broking

Gallery launched - arts-i

Religare Realty Limited

Religare Venture Capital Limited

In house Real Estate Management

Private Equity and Investment

Company

Manager

Religare Hichens Harrison**

Religare Asset Management*

Corporate Broking Institutional Broking Derivatives Sales Corporate Finance •

*Religare Asset Management Company (P) Limited is a wholly owned subsidiary of Religare Securities Limited (RSL), which in turn is a 100% subsidiary of Religare Enterprises Limited.

•

** Religare Hichens, Harrison plc. (RHH) is a part of Religare Enterprises Limited (REL).

Hichens, Harrison & Co. plc. (HH), established in 1803, is London’s oldest brokerage and investment firm with a global footprint. Post its acquisition through REL’s indirect subsidiary Religare Capital Markets International (UK) Limited, HH has been rechristened as Religare Hichens Harrison plc

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Risk Management Through Derivatives in Equity Segment

INVESTMENT Investment in a general way is defined as any use of resources intended to increase future production output or income.

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Risk Management Through Derivatives in Equity Segment

In finance investment refers to the purchase or acquisition of an asset or item with a hope to get return from it in the future. The return may be in terms of regular income or value appreciation.

In an economy, people indulge in economic activity to support their consumption requirements. Savings arise from deferred consumption, to be invested, in anticipation of future returns. Investments could be made into financial assets, like stocks, bonds, and similar instruments or into real assets, like houses, land, or commodities.

The main idea behind investment is to utilize the saved idle money to earn a return on it. The money you earn is partly spent and the rest is saved for meeting future expenses. Instead of keeping the savings idle it is a general psychology of people to earn some return by utilizing the savings which form the investment.

Common investment objectives are:•

To earn return on your idle resources

•

To generate specified sum of money for a specific goal in life

•

Make a provision for an uncertain future

One of the important reasons why one needs to invest wisely is to meet the cost of Inflation. Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs to buy the goods and services you need to live. Inflation causes money to lose value. For example, if there will be a 6% inflation rate for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a factor in any long-term investment strategy.

SECURITIES MARKET A securities market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise funds. The definition of ‘Securities’ as per the Securities Contracts egulation Act (SCRA), 1956, includes instruments such as shares, bonds, scrips, stocks or other marketable 16

Risk Management Through Derivatives in Equity Segment securities of similar nature in or of any incorporate company or body corporate, government securities, derivatives of securities, units of collective investment scheme, interest and rights in securities, security receipt or any other instruments so declared by the Central Government. Securities market can be Money market or Capital market. Capital market is defined as a market in which money is provided for periods longer than a year [1], as the raising of short-term funds takes place on the money markets. The capital market includes the stock market (equity securities) and the bond market (debt). A capital market is simply any market where a government or a company can raise money(capital) to fund their operations and long term investments.

In financial terms capital market is a market where financil instruments are issued and traded.

Capital market denotes the securities market where the stocks, bonds and several other derivatives are traded. This market provides necessary fund to different companies and governments also. Both long and short term debts are are raised from this market. At the same time, the capital market provides the investors with the opportunity to make regular income from the market.

The capital market channelizes funds from surplus sources to the needy areas and here a balance is sought to be achieved among diverse market participants. It impels enterprises to focus on performance.

EQUITY INVESTMENT When you buy a share of a company you become a shareholder in that company. Shares are also known as Equities. Shares are issued for the first time through Initial Public Offer(IPO) or Follow on Public Offer (FPO) and subsequently traded in the secondary markets that are the stock exchanges. Equities have the potential to increase in value over time. It also provides your portfolio with the growth necessary to reach your long term investment goals. Research studies have proved that the equities have outperformed most other forms of investments in the long term. This may be illustrated with the help of following examples: Fctors influencing price of a stock Broadly there are two factors which influence the value of a stock (1) stock specific and (2) market specific.

The stock-specific factor is related to people’s expectations about the company, its future earnings capacity, financial health and management, level of technology and marketing skills. The market specific factor is influenced by the investor’s sentiment towards the stock market as a whole. This factor 17

Risk Management Through Derivatives in Equity Segment depends on the environment rather than the performance of any particular company. Events favourable to an economy, political or regulatory environment like high economic growth, friendly budget, stable government etc. can fuel euphoria in the investors, resulting in a boom in the market. On the other hand, unfavourable events like war, economic crisis, communal riots, minority government etc. depress the market irrespective of certain companies performing well. However, the effect of market-specific factor is generally short-term. Despite ups and downs, price of a stock in the long run gets stabilized based on the stock specific factors. Therefore, a prudent advice to all investors is to analyze and invest and not speculate in shares.

SECONDARY MARKET Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets.

Role of the Secondary Market For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

Difference between the Primary Market and the Secondary Market In the primary market, securities are offered to public for subscription for the purpose of raising capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued securities are traded among investors. Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

INTRODUCTION TO THE STOCK EXCHANGE The stock exchanges in India, under the overall supervision of the regulatory authority, the Securities and Exchange Board of India (SEBI), provide a trading platform, where buyers and sellers can meet to transact in securities. The trading platforms provided by NSE & BSE are electronic based and there is 18

Risk Management Through Derivatives in Equity Segment no need for buyers and sellers to meet at a physical location to trade. They can trade through the computerized trading screens available with the NSE trading members or the internet based trading facility provided by the trading members of NSE. A stock exchange is the place where securities, shares, debentures and bonds of joint stock companies, central & state govt., semi govt. organizations, local bodies and foreign govt. are bought and sold. A stock exchange is the nerve center of capital market. Changes in the capital market are brought about by a complex set of factors, all operating on the market simultaneously. Such changes are subject to secular trends set by the economic progress of the nation, and governed by the factors like general economic situation, financial and monetary policies, tax changes, political environment, international economic and financial development etc. A stock exchange provides necessary mobility to capital and directs the flow of capital into profitable and successful enterprises.

Role of stock exchange  Raising capital for businesses  Mobilizing savings for investment  Facilitate company growth  Redistribution of wealth Gain in stock prices leading to increase in wealth of investors.  Corporate governance Ensures corporate governance (i.e segregating the ownership & management) of listed companies.  Creates investment opportunities for small investors  Government raises capital for development projects  Barometer of the economy Rise/fall of stock markets act as an indicator of economic growth/slowdown.

Evolution and development of Stock Exchanges  18th Century - Beginning of the capital market in India ( East India Company).  Securities trading unorganized until end of the 19th century. (Bombay and Calcutta).

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Risk Management Through Derivatives in Equity Segment  Bombay was the chief trading centre wherein bank shares were the major trading stock.  During American Civil War (1860-61) - Indian stock market witnessed the first boom, lasting half a decade.  1875- Stockbrokers in Bombay organized an informal association “Native Shares and Stock Brokers Association”.  1894 - Ahmedabad Stock Exchange founded.  1908 – Calcutta Stock Exchange founded.  In the post-independence period also, the size of the capital market remained small.  1st & 2nd 5-year plans – Govt. emphasis was to develop PSUs, but their shares were not listed on the stock exchanges.  The Controller of Capital Issues (CCI) closely supervised and controlled the timing, composition, interest rates, pricing, allotment, and floatation costs of new issues. These strict regulations demotivated many companies from going public for almost four and a half decades.  In 1950s - Century Textiles, Tata Steel, Bombay Dyeing, National Rayon, and Kohinoor Mills were the favorite scrips of speculators. As speculation became rampant, the stock market came to be known as 'Satta Bazaar'. Despite speculation, non-payment or defaults were not very frequent.  In 1956 – Govt. enacted Securities Contracts (Regulation) Act, which was characterized by the establishment of a network for the development of financial institutions and state financial corporations.  In 1960s - Characterized by wars and droughts in the country which led to bearish trends. Trends were aggravated by ban in 1969 on forward trading and 'badla‘.  In 1964 - The Unit Trust of India (UTI), first mutual fund of India came into existence. FIs such as LIC and GIC helped to revive the sentiment by emerging as the most important group of investors.  In 1970s - Badla trading was resumed. This revived the market.  On July 6, 1974 – Govt. enforced Dividend Restriction Ordinance, restricting the payment of dividend by companies to 12 per cent of the face value or one-third of the profits of the companies (that can be distributed as computed under section 369 of the Companies Act), whichever was lower. This led to a slump in market capitalization at the BSE by about 20 per cent overnight and the stock market did not open for nearly a fortnight.  1973- Introduction of Foreign Exchange Regulation Act (FERA).

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Risk Management Through Derivatives in Equity Segment  As a result, 123 MNCs offered shares, which were lower than their intrinsic worth. For the first time, many investors got an opportunity to invest in the stocks of such MNCs as Colgate, and Hindustan Liver Limited.  In 1977 - Dhirubhai Ambani, tapped the capital market with Reliance Textiles, the base of today’s entire Reliance empire.  In 1980s - Witnessed an explosive growth of the securities market in India, Major events: -

Participation by small investors, speculation, defaults, ban on badla, and

-

resumption of badla continued.

-

Convertible debentures emerged as a popular instrument of resource mobilization

 in the primary market.

-

The introduction of public sector bonds and the successful mega issues of Reliance

 Petrochemicals and Larsen and Toubro gave a new lease of life to the primary market.

-

The decade of the 1980s was characterized by an increase in the number of stock exchanges,

 listed companies, paid up-capital, and market capitalization.  In1990s - Liberalization and globalization of Indian economy opening new doors for investment.  In 1992 - The Capital Issues (Control) Act, 1947 was cancelled. Emergence of new industrial policy & SEBI as a regulator of capital market.  The securities scam of March 1992 involving Harshad Mehta, a broker as well as bankers was on of the biggest scams in the history of the capital market. which drove away small investors from the market.  In 1995 - The M S Shoes case, one such scam which took place, put a break on new issue activity.  In1990’s - Securities scam revealed the inadequacies of and inefficiencies in the financial system. It was the scam, which prompted a reform of the equity market. The Indian stock market witnessed a sea change in terms of technology and market prices because of all such scams.  Technology brought radical changes in the trading mechanism.  National Stock Exchange, set up in 1994, and Over the Counter Exchange of India, set up in 1992.  The National Securities Clearing Corporation (NSCCL) and National Securities Depository Limited (NSDL) were set up in April 1995 and November 1996 respectively. These institutions improved clearing and settlement and brought about dematerialized trading.  In 1995-96 - The Securities Contracts (Regulation) Act, 1956 was amended for introduction of -

options trading.

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Risk Management Through Derivatives in Equity Segment  Rolling settlement was introduced in January 1998 for the dematerialized segment of all companies.  The Indian capital market entered the twenty-first century with the Ketan Parekh scam. As a result of this scam, badla was discontinued from July 2001 and rolling settlement was introduced in all scrips.  Trading of futures commenced from June 2000, and Internet trading was permitted in February 2000.  On July 2, 2001, the Unit Trust of India announced suspension of the sale and repurchase of its flagship US-64 scheme due to heavy redemption leading to panic on the bourses.  Then, the government's decision to privatize oil PSUs in 2003 fuelled stock prices. One big divestment of international telephony major VSNL took place in early February 2002.

Major Stock Exchanges In INDIA  Bombay Stock Exchange (BSE)  National stock Exchange (NSE) Apart from these 2 there are 21 regional stock exchanges in India. These are: - Ahmedabad Stock Exchange

- Madhya Pradesh Stock Exchange

- Bangalore Stock Exchange - Madras Stock Exchange - Bhubaneshwar Stock Exchange

- Magadh Stock Exchange

- Calcutta Stock Exchange

- Mangalore Stock Exchange

- Cochin Stock Exchange

- Meerut Stock Exchange

- Coimbatore Stock Exchange - Delhi Stock Exchange

- OTC Exchange Of India - Pune Stock Exchange

- Guwahati Stock Exchange - Saurashtra Kutch Stock Exchange - Hyderabad Stock Exchange - Uttar Pradesh Stock Exchange - Jaipur Stock Exchange

- Vadodara Stock Exchange

- Ludhiana Stock Exchange

Bombay Stock Exchange  BSE, earlier known as "The Native Share & Stock Brokers' Association" is the oldest stock exchange in Asia with a rich heritage, now spanning three centuries in its 134 years of existence.  1st stock exchange in the country to obtain permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act 1956.

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Risk Management Through Derivatives in Equity Segment 

It migrated from the open outcry system to an online screen-based order driven trading system in 1995 (BOLT).



Earlier an Association Of Persons (AOP), BSE is now a corporatised and demutualised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI).

 With demutualisation, BSE has two of world's best exchanges, Deutsche Börse and Singapore Exchange, as its strategic partners.  Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the world's 5th in transaction numbers. 

An investor can choose from more than 4,700 listed companies, which for easy reference, are classified into A, B, S, T and Z groups.

 The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature, and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors, and is sensitive to market sentiments and market realities. 

Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices.

Emergence of NSE  The NSE has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.  NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000.  The following years witnessed rapid development of Indian capital market with introduction of internet trading, Exchange traded funds (ETF), stock derivatives and the first volatility index IndiaVIX in April 2008.  August 2008 - introduction of Currency derivatives in India with the launch of Currency Futures in USD-INR by NSE. Interest Rate Futures was introduced for the first time in India by NSE on 31st August 2009, exactly after one year of the launch of Currency Futures.

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Risk Management Through Derivatives in Equity Segment

STOCK TRADING Screen Based Trading The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. This imposed limits on trading volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced a nationwide, on-line, fully automated screen based trading system (SBTS) where a member can punch into the computer the quantities of a security and the price at which he would like to transact, and the transaction is executed as soon as a matching sale or buy order from a counter party is found.

What is NEAT? NSE is the first exchange in the world to use satellite communication technology for trading. Its trading system, called National Exchange for Automated Trading (NEAT), is a state of-the-art client server based application. At the server end all trading information is stored in an in memory database to achieve minimum response time and maximum system availability for users. It has uptime record of 99.7%. For all trades entered into NEAT system, there is uniform response time of less than one second.

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Risk Management Through Derivatives in Equity Segment

DERIVATIVES

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Risk Management Through Derivatives in Equity Segment

INTRODUCTION Financial market have been innovating and acquiring new shapes and dimensions. There are two core factors which directs the financial market, they are increasing returns and reducing risks in investment.

There have been continuous innovations and developments in the financial markets on these two factors.

One of the most significant developments in these two factors in the securities markets has been the development and expansion of financial derivatives. The term “derivatives” is used to refer to financial instruments which derive their value from some underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Thus if a derivative’s underlying asset is equity, it is called equity derivative and so on.

Origin of derivatives While trading in derivatives products has grown tremendously in recent times, the earliest evidence of these types of instruments can be traced back to ancient Greece. Even though derivatives have been in existence in some form or the other since ancient times, the advent of modern day derivatives contracts is attributed to farmers’ need to protect themselves against a decline in crop prices due to various economic and environmental factors. Thus, derivatives contracts initially developed in commodities.

The first “futures” contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers. These were evidently standardized contracts, much like today’s futures contracts. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward contracts on various commodities. From then on, futures contracts on commodities have remained more or less in the same form, as we know them today.

Derivatives in India 26

Risk Management Through Derivatives in Equity Segment In India, derivatives markets have been functioning since the nineteenth century, with organized trading in cotton through the establishment of the Cotton Trade Association in 1875.

Derivatives, as exchange traded financial instruments were introduced in India in June 2000.

The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract.

In a span of one and a half years after the introduction of index futures, index options, stock options and stock futures were also introduced in the derivatives segment for trading. NSE’s equity derivatives segment is called the Futures & Options Segment or F&O Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate segment.

A series of reforms in the financial markets paved way for the development of exchange-traded equity derivatives markets in India. In 1993, the NSE was established as an electronic, national exchange and it started operations in 1994. It improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system with real-time price dissemination. A report on exchange traded derivatives, by the L.C. Gupta Committee, set up by the Securities and Exchange Board of India (SEBI), recommended a phased introduction of derivatives instruments with bi-level regulation (i.e., self-regulation by exchanges, with SEBI providing the overall regulatory and supervisory role). Another report, by the J.R. Varma Committee in 1998, worked out the various operational details such as margining and risk management systems for these instruments. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared as “securities�. This allowed the regulatory framework for trading securities, to be extended to derivatives. The Act considers derivatives on equities to be legal and valid, but only if they are traded on exchanges.

The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to include: 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument, or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

At present, the equity derivatives market is the most active derivatives market in India. Trading volumes in equity derivatives are, on an average, more than three and a half times the trading volumes in the cash equity markets.

27

Risk Management Through Derivatives in Equity Segment

Milestones in the development of Indian derivative market November 18, 1996 - L.C. Gupta Committee set up to draft a policy framework for introducing derivatives May 11, 1998 - L.C. Gupta committee submits its report on the policy framework May 25, 2000 - SEBI allows exchanges to trade in index futures June 12, 2000 - Trading on Nifty futures commences on the NSE June 4, 2001 - Trading for Nifty options commences o n the NSE July 2, 2001 - Trading on Stock options commences on the NSE November 9, 2001 - Trading on Stock futures commences on the NSE August 29, 2008 - Currency derivatives trading commences on the NSE August 31, 2009 - Interest rate derivatives trading commences on the NSE

Average Daily Turnover in derivative segment(Rs. cr.)

2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

72392.07 45310.63 52153.3 29543 19220 10107 8388 1752 410 11

Average Daily Turnover (Rs. cr.)

The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of risk to those who are willing to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on November 1, 2009 a rice farmer may wish to sell his harvest at a future date (say January 1, 2010) for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an 28

Risk Management Through Derivatives in Equity Segment example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the "underlying asset".

The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are 1. Future Contracts 2. Forward Contracts 3. Option Contracts and 4. Swaps

FORWARD CONTRACT A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil).

One party agrees to sell, the other to buy, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually two business days). The difference between the spot and the forward price is the forward premium or forward discount. For example, Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery date) from gold mining concern Goldseller. No money changes hands between Goldbuyer and Goldseller at the time the forward contract is created. Rather, Goldbuyer’s payoff depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then Goldbuyer gains Rs. 10 on his forward position (i.e. the difference between the spot and forward prices) by taking delivery of the gold at Rs. 600. Risk

29

Risk Management Through Derivatives in Equity Segment

FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Future urnover with growth percentage 12000000

500%

10000000

400%

8000000

300%

6000000

200%

4000000

100%

2000000

0%

0 National Turnover(Rs cr.)

Growth(%)

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

72998

330485

1860385

2256203

4305452

6370541

11369230.5

7049753.52

9129635.31

0%

352.73%

462.93%

21.28%

90.83%

47.96%

78.47%

-37.99%

29.50%

Year National Turnover(Rs cr.)

Growth(%)

FUTURES TERMINOLOGY o Spot price: The price at which an asset trades in the spot market. o Futures price: The price at which the futures contract trades in the futures market.

30

-100%

Risk Management Through Derivatives in Equity Segment o Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading. o Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. o Contract size: The amount of asset that has to be delivered under one contract called lot size. o Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. o Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. o Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. o Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. o Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

31

Risk Management Through Derivatives in Equity Segment

FUTURES PAYOFFS Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at 5220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures contract.

Payoff for a buyer of index futures The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 5200. If the index goes above 5200, his futures position starts making profit. If the index falls, his futures position starts showing losses. profit

Loss

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts n asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case 32

Risk Management Through Derivatives in Equity Segment of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 5200. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure 4.2 shows the payoff diagram for the seller of a futures contract.

Payoff for a seller of an index futures The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 5200. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

profit

Loss

Difference between futures contract and a forwards contract A Futures contract is similar to a Forward contract, with some exceptions. Futures contracts are traded on exchange markets, whereas forward contracts typically trade on OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-to-market), whereas forwards are settled only at expiration.

33

Risk Management Through Derivatives in Equity Segment

APPLICATION OF FUTURES Hedging: Long security, sell futures Futures can be used as an effective risk-management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he need do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390.

Two-month futures cost him Rs.402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security, will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position.

Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position!

Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.

Speculation: Bullish security, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He believes that a particular security that trades at Rs.1000 is undervalued and 34

Risk Management Through Derivatives in Equity Segment expect its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume he buys a 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs. 1,00,000 for a period of two months. This works out to an annual return of 6 percent.

Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 1,00,000. He buys 100 security futures for which he pays a margin of Rs.20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual return of 12 percent. Because of the leverage they provide, security futures form an attractive option for speculators.

Speculation: Bearish security, sell futures Stock futures can be used by a speculator who believes that a particular security is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell stock futures.

Let us understand how this works. Simple arbitrage ensures that futures on an individual securities move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price.

Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one twomonth contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.

Arbitrage: Overpriced futures: buy spot, sell futures As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price.

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits?

35

Risk Management Through Derivatives in Equity Segment

Say for instance, ABC Ltd. trades at Rs.1000. One- month ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions.

1. On day one, borrow funds, buy the security on the cash/spot market at 1000.

2. Simultaneously, sell the futures on the security at 1025.

3. Take delivery of the security purchased and hold the security for a month.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

5. Say the security closes at Rs.1015. Sell the security.

6. Futures position expires with profit of Rs.10.

7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position.

8. Return the borrowed funds. When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.

Reverse Arbitrage: Under priced futures: buy futures, sell spot Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem underpriced. How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions.

1. On day one, sell the security in the cash/spot market at 1000.

2. Make delivery of the security.

3. Simultaneously, buy the futures on the security at 965.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

5. Say the security closes at Rs.975. Buy back the security.

6. The futures position expires with a profit of Rs.10.

7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position. If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and-carry arbitrage. It is this arbitrage 36

Risk Management Through Derivatives in Equity Segment activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage

involves

trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

37

Risk Management Through Derivatives in Equity Segment

OPTION CONTRACTS Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party that sold, or wrote, the option must fulfill the terms of the contract.

For example, Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery date) from gold mining concern Goldseller. Suppose that Goldbuyer belives that there is some chance for the spot price to fall below Rs.600, so that he losses on his forward position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs. 600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold at the strike price on the expiration date. Then, if the spot price indeed declines, he could choose not to exercise the option, and his loss would be limited to the purchase price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot price is very likely to decline, and attempt to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike price on the expiration date

OPTION

CALL OPTION

PUT OPTION

PUT EUROPEAN

BUY

PUT AMERICAN

CALL EUROPEAN

SELL

BUY

38

CALL AMERICAN

SELL

Risk Management Through Derivatives in Equity Segment

Options turnover over years with growth percentage 9000000

300.00%

8000000 250.00% 7000000 6000000

200.00%

5000000 150.00% 4000000 3000000

100.00%

2000000 50.00% 1000000 0

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

National turnover(Rs cr.)

28928

109377

270023

290779

518722

985701

1721247.43

3960728.65

8534029.38

Growth

0.00%

278.10%

146.87%

7.69%

78.39%

90.02%

74.62%

130.11%

115.47%

National turnover(Rs cr.)

0.00%

Growth

OPTION TERMINOLOGY  Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.  Stock options: Stock options are options on individual stoc ks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.  Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.  Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options.  Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

39

Risk Management Through Derivatives in Equity Segment  Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.  Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.  Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.  Strike price: The price specified in the options contract is known as the strike price or the exercise price.  American options: American options are options that can be exercised at any time upto the expiration date. In India stock options are American options  European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In Indian context Index options are European options  In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.  At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).  Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.  Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is 40

Risk Management Through Derivatives in Equity Segment Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.  Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

FACTS RELATING TO OPTION 1. Option gives its holder the right to buy an underlying asset.

2. The buyer of the option simply has the right to and not obligation to sell the underlying asset.

3. The seller of the option is obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset if the option is exercised.

4. Options are good for a specified period of time, after which they expire and the holder loses the right to buy or sell the underlying instrument at the specified price.

5. Options when bought are done so at a debit to the buyer.

6. Options when sold are done so by giving a credit to the seller 7. Options are available in several strike prices representing the price of the underlying instrument.

8. The cost of an option is referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.

9. Options are not available on every stock. There are approximately 2,200 stocks with tradable options.

41

Risk Management Through Derivatives in Equity Segment

OPTION STRATEGIES BUY CALL Strategy View Investor thinks that the market will rise significantly in the short-term.

Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be. By this strategy, the downside risk is avoided PAY OFF FROM BUY CALL (RELIANCE CAPITAL) Price of Rel Cap on 1st June 2010 Rs 652.56.

The stock is expected to increase up to Rs 765 in Short term.

So buy a call option of Rel cap with a strike price Of Rs 720 of the maturity 24 June.

Premium paid for the option â&#x20AC;&#x201C; Rs 37.50 Exercise the option on 21 June 2010 as on 21 june, the price of the scrip touched Rs 766.05 Payoff = 766.05-(720+37.50)

Buy call

Rs 8.55(profit)

Profit/Loss

Profit

a Stock Price

Loss

This strategy has an unlimited profit potential as the diagram depicts but the loss is limited upto the premium amount paid. The strategy works in a bullish market.

42

Risk Management Through Derivatives in Equity Segment

BUY PUT Strategy View - Investor thinks that the market will fall significantly in the short-term. .

Strategy Implementation - Put option is bought with a strike price of E. The more bearish the investor is, the lower the strike price should be.

Profit

EXAMPLE

Buy Put

E

Stock price

Profit/loss

Loss

Option premium to be paid â&#x20AC;&#x201C; Rs7.50*100 = Rs750 Amount to be received for selling shares = Rs110*100 = Rs11000 If market value of the underlying share will be Rs100 then Profit/Loss = 11000-(10000+750) = 250(profit)

43

Risk Management Through Derivatives in Equity Segment

This strategy gives increaing profit with decrease in price. As the diagram depicts the loss is limited upto the premium amount paid. The strategy works in a bearish market.

SELL CALL Strategy View Investor is certain that the market will not rise and is unsure/ unconcerned whether it will fall.

Strategy Implementation Call option is sold with a strike price of E. If the investor is very certain of his view then at-the-money options should be sold, if less certain, then out-of-the-money ones should be sold.

EXAMPLE Exercise Price

150

Size of the contract

100 shares

Price of the share on the date of contract

144

Price of option on the date of contract

10

44

Risk Management Through Derivatives in Equity Segment

Option premium to be received â&#x20AC;&#x201C; Rs10.00*100 = Rs1000 Amount to be received for selling shares = Rs150*100 = Rs15000 If market value of the underlyned share will be Rs140, then the buyer will not exercise the contract.

Hence Profit/Loss will be the premium received = 100*10 = 1000(profit)

Profit

Sell Call

Stock price

E

Loss

This strategy has a limited profit potential upto the amount of premium received as the diagram depicts but the loss is unlimited with the increase in stock price. The strategy works when the investor is not bullish.

SELL PUT Strategy View Investor is certain that the market will not go down, but unsure/unconcerned about whether it will rise.

Strategy Implementation Put options are sold with a strike price E. If an investor is very bullish, then in-the-money puts would be sold.

EXAMPLE

45

Risk Management Through Derivatives in Equity Segment Exercise price

Rs110

Size of the contract

100 shares

Price of the put option on the date of the contract

Rs7.5

Option premium to be received â&#x20AC;&#x201C; Rs7.50*100 = Rs750.

Amount to be paid for buying shares = Rs110*100 = Rs11000 If market value of the underlyned share will be Rs100, then the buyer will exercise the contract.

Hence Profit/Loss will be the premium received = (100*100)+750-11000 = 250(loss) Possible prices of the share 80 90 100 110 120 130 140 Stock pricce Payoff from short put

Investor Position -2250 -1250 -250 750 750 750 750 Total pay off Net profit= Payoff + premium

S1>110

0(Not exercised)

0

Rs7.50

S1=102.50

102.50 â&#x20AC;&#x201C; 110

- 7.50

-7.50+7.50=0

S1<102.50

X<102.50-110

Profit

Sell Put

Stock price

E

Loss

46

Risk Management Through Derivatives in Equity Segment

This strategy has a limited profit potential as the diagram depicts but the loss is unlimited upto the amount increase in stock cash market price. The strategy works when the investor is not bearish.

BULL SPREAD (CALL) Strategy View Investor thinks that the market will not fall. It is a Conservative strategy for one who thinks that the market is more likely to rise than fall.

Strategy Implementation It involves having two calls on the same stock with same expiry date but with different exercise prices. Call option is bought with a strike price below the stock price and another call option sold with a strike price above the stock price.

PAY OFF FROM BULL SPREAD (SIEMENS) WITH CALL Price of Siemens on 1st June 2010 Rs 684.

The stock is expected to increase up to Rs 735 in Short term.

So buy a call option of 24 June with a strike price of Rs 680 – premium paid Rs 104.90 & sell a call option with same maturity date with a strike price of 700 – premium received Rs 29.00.

Initial outlay = 29 – 104.90 = -76.10 Exercise the option on 23 June 2010 as on 23 June, the price of the scrip touched Rs 738.

Payoff from bought call = 738 -680 = 58 Payoff from sold call = 700-738 = -38 Total payoff = 58 - (76.10+38) = Rs 56.10(loss) Bull Spread (Call) Profit

a b

47 Loss

Stock price

Profit/loss

Risk Management Through Derivatives in Equity Segment

This strategy minimizes the loss up to the amount of initial outlay due to difference in premium paid amount and received amount. The profit is also limited.

BULL SPREAD (PUT) Strategy View Investor thinks that the market will not fall, but wants to minimize the risk. It is a conservative strategy for one who thinks that the market is more likely to rise than fall.

Strategy Implementation It involves writing put b at a higher strike price and buying a put a with a lower strike price.

PAY OFF FROM BULL SPREAD (AXIS BANK) WITH PUT Price of Axis Bank stock on 1st June 2010 Rs 1180.

The stock is expected to increase up to Rs 1250 in Short term.

So buy a put option with maturity 29 July with a strike price of Rs 1100 – premium paid Rs 18.05 & sell a put option with same maturity date with a strike price of 1250 – premium received Rs 41.00.

Initial payoff = 41.00 – 18.05 = 22.95 Exercise the option on 29 July 2010 as on 23 June, the price of the scrip touched Rs 738.

Payoff from bought call = 0 Payoff from sold call = 0 Total payoff = 22.95(loss)

Profit

Bull Spread (Put)

Profit/loss

a Stock price

b

Loss

48

Risk Management Through Derivatives in Equity Segment

This strategy gives protection from downside risk as loss of sold put gets adjusted with profits from bought put and the strategy gives usually an initial inflow of premium which is a clear profit in an increasing market.

BEAR SPREAD (CALL) Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. It is a conservative strategy for one who thinks that the market is more likely to fall than rise.

Strategy Implementation Call option is sold with a lower strike price of ‘a’ and another call option is bought with a higher strike of ‘b’ PAY OFF FROM BEAR SPREAD (PATNI) WITH CALL Price of Patni stock on 2nd June 2010 = Rs 577.

The stock is expected to be bearish in Short term.

1. Buy a call option with maturity 29 July with a strike price of Rs 600 – premium paid Rs 03.50 2. Sell a call option with same maturity date with a strike price of Rs 540 – premium received Rs 09.75.

Initial payoff = 09.75 – 03.50 = 06.25 Exercise the option on 24th June 2010. Stock price on 24th june = Rs 505 Payoff from bought call = 0 (as the option will not be exercised) Payoff from sold call = 0 (as the option will not be exercised) Total payoff = 06.25 (profit)

Profit

Bear Spread (Call) Profit/loss

a

b Stock price

49 Loss

Risk Management Through Derivatives in Equity Segment

This strategy involves very less risk in a bearish outlook. In this strategy both profit and loss gets limited thus provides a hedge against risk.

BEAR SPREAD (PUT) Strategy View Investor thinks that the market will not rise, but wants to minimize the risk.

Conservative strategy for one who thinks that the market is more likely to fall than rise.

Strategy Implementation Put option is sold with a lower strike price of a and another put option is bought with a strike of b PAY OFF FROM BEAR SPREAD (BPCL) WITH PUT Price of BPCL stock on 1st June 2010 = Rs 583.

The stock is expected to be bearish in Short term.

1. Option 1 - Sell a put option with maturity of 24 th June with an exercise price of Rs 580 – premium received Rs 79.50.

2. Option 2 - Buy a put option with same maturity date with an exercise price price of Rs 600 – premium paid Rs 95.60.

Initial payoff = 79.50 – 95.60 = (-16.10) Exercise the option on 24th June 2010. Stock price on 24th june = Rs 550.05 Payoff from put-1 = 550.05-580 = (-29.95) Payoff from Put-2 = 600-550.05 = 49.95 Net payoff = 49.95- (16.10+29.95) Rs 03.90(profit) .

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Risk Management Through Derivatives in Equity Segment

BUY STRADDLE (LONG STRADDLE) Strategy view Where the Investor expects a sharp movement in the share price, but unsure of direction, it is an appropriate strategy.

Strategy implementation long straddle involves buying a Call & a Put at the same exercise price and for the same tenure. A buyer of the Straddle buys both call & the put.

EXAMPLE ASSUMPTION -- STRIKE = Rs 100 CALL PREMIUM = Rs 5 Put premium = Rs 4 Initial investment = Rs 9 IF END STOCK IS 95 96 97 98 99 100 101 102 103 104 Profit 105

CALL PAYOFF PUT PAYOFF 0 5 0 4 0 3 0 2 0 1 0 0 1 0 2 0 3 0 4 0 Buy Straddle 5 0 Profit/loss

a Stock price

51 Loss

NET PAYOFF -4 -5 -6 -7 -8 -9 -8 -7 -6 -5 -4

Risk Management Through Derivatives in Equity Segment

In this strategy maximum loss can be the amount of total premium paid for the call and put where as the amount of profit can be unlimited as the diagram indicates.

SHORT STRADDLE Strategy view: Investor thinks that the market will be not be very volatile in the short-term. It is a strategy for relatively stable stock. A short straddle works whenever the price remains within the band.

Strategy implementation: A short straddle involves selling both the call and the put.

PAY OFF FROM SHORT STRADDLE (JP ASSOCIATE) Price of BPCL stock on 1st June 2010 = Rs 117.6.

The stock is a relatively less volatile one.

1. Option 1 - Sell a call option with maturity of 29th July with an exercise price of Rs 130 â&#x20AC;&#x201C; premium received Rs 06.00.

2. Option 2 - Sell a put option with same maturity date and exercise price â&#x20AC;&#x201C; premium paid Rs 05.55.

Initial payoff = 06.00 + 05.55 = Rs 11.55 Exercise the option on 22nd July 2010. Stock price on 22nd July Rs 131.50 Payoff from option-1 = 130.00-131.50 = (-01.50) Payoff from option-2 = 0 option will not be exercised.

Net payoff = 11.55-01.50 Rs 10.05(profit)

Profit

Sell Straddle Profit/loss

a Stock price

52 Loss

Risk Management Through Derivatives in Equity Segment

This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.

BUY STRANGLE Strategy view: Investor thinks that the market will be very volatile in the short-term.

Strategy implementation: This is identical to the straddle except that the call has an exercise price above the stock price and the put has an exercise price below the stock price and the premium paid is less.

PAY OFF FROM BUY STRANGLE (TATA STEEL) Price of Tata Steel stock on 1st June 2010 = Rs 493.17.

The stock shows a high volatility in the short term.

1. Option 1 - Buy a call option with maturity of 24 th June with an exercise price of Rs 480.00 – premium paid Rs 14.25.

2. Option 2 – Buy a put option with same maturity date and exercise price of Rs 500.00 – premium paid Rs 01.05.

Initial outlay = -(14.25 + 01.05) = -15.30 Exercise the option on 24th June 2010. Stock price on 24th June Rs 501.12 Payoff from option-1 = 501.12-480.00 = 21.12 Payoff from option-2 = 0 option will not be exercised.

Net payoff = 21.12-15.30 Rs 05.82(profit) Profit

Buy Strangle Profit/loss From put option

Profit/loss From call option

a

b Stock price

53 Loss

Risk Management Through Derivatives in Equity Segment

In this strategy maximum loss can be the amount of total premium paid for the call and put where as the amount of profit can be unlimited as the diagram indicates.

SELL STRANGLE Strategy view: The investor thinks that the market will not be volatile within a broadish band.

Strategy implementation: This is identical to the straddle except that the call has an exercise price above the stock price and the put has an exercise price below the stock price and the premium paid is less.

PAY OFF FROM SELL STRANGLE (SUZLON) Price of Suzlon stock in June 2010 = Rs 55.6.

The stock shows a relative stability in the short term.

1. Option 1 - Sell a call option with maturity of 24 th June with an exercise price of Rs 60.00 â&#x20AC;&#x201C; premium received Rs 00.60.

2. Option 2- Sell a put option with same maturity date and exercise price of Rs 50.00 â&#x20AC;&#x201C; premium received Rs 00.05.

Initial payoff = 00.60+00.05 = 00.65 Exercise the option on 24th June 2010. Stock price on 24th June Rs 57.65 Payoff from option-1 = 0 (option will not be exercised).

Strangle Payoff from option-2 = 0 (option will notSell be exercised).

Net payoff = 00.65(Profit) Profit

Profit/loss From put option

a

b

54 Loss

Profit/loss From call option

Risk Management Through Derivatives in Equity Segment

This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.

BUTTERFLY SPREAD Strategy view: This strategy hopes that the price will remain within a steady range , but does not want exposure to an unexpected rise or fall.

Strategy implementation: This involves the following;1. Buying a call at low exercise price 2. Buying a call at higher exercise price 3. Selling two calls at an intermediate price.

PAYOFF OF BUTTERFLY SPREAD (UNITECH) Price of Suzlon stock in June 2010 = Rs 69.00.

1. Option 1 - Buy a call option with maturity of 24th June with an exercise price of Rs 65.00 – premium paid Rs 10.00.

2. Option 2- Buy another call option with same maturity date and exercise price of Rs 75.00 – premium paid Rs 00.05.

3. Option 3&4- Sell two calls with the same maturity of intermediate strike price of Rs 70.00 – premium received 2*4.35 = Rs 08.70 Initial payoff = 08.70-(10.00+00.05) = -01.35 Exercise the option on 23rd June 2010. Stock price = Rs 76.45 Payoff from option-1 = 76.45- 65.00 = Rs 11.45 Payoff from option-2 = 76.45- 75.00 = Rs 01.45 Payoff from option-3&4 = 2*(70.00- 76.45) = -12.90 55

Risk Management Through Derivatives in Equity Segment Net payoff = 01.35(Loss)

In this strategy there is very minimum risk and limited profit. This strategy should be used when proper strike prices are available to make this strategy.

FINDINGS BULLISH STRATEGIES A. Buy Call: This strategy is very easy to implement and give good amount of return if price increase. Here maximum loss is only the premium paid.

B. Buy Futures: Futures has given large amount of profits as compared to options strategies but at the same time risk associated with it also very high.

C. Bull Spread (Call): It provides limited profits and limited loss. If Index/ Scrip goes up then one can have profits and vice-versa. This strategy should be use when expected volatility in the market is less.

D. Bull Spread (Put): It provides limited profit and limited loss. The maximum gain can be net premium received in this strategy.

E. Sell Put: In this strategy maximum profit is premium received and loss is unlimited.

If a person expects bullish view then he may go with this strategy but this strategy is quite risky.

NEUTRAL STRATEGIES F. Buy Straddle: This strategy should only be used when expected volatility is very high and market outlook is not known. If scrip remains at the same price then loss will be maximum.

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Risk Management Through Derivatives in Equity Segment G. Buy Strangle: This strategy should be used in very volatile market.

H. Sell Strangle: This strategy should be used when volatility is very less.

I.

Long Butterfly: In this strategy there is very minimum risk and limited profit. This strategy should be used when proper strike prices are available to make this strategy.

J.

Short Butterfly: This strategy led to profit when volatility is very high in the option market.

K. Sell Straddle: When investor want more returns at higher risk then he may go with this strategy. IF suddenly the volatility increases at a very high rate then huge losses may occur.

BEARISH STRATEGIES L. Buy Put: This strategy should be used when investors perceive that the option price will go down.

M. Sell Future: This strategy can be use to hedge or it can be use as a speculative strategy when option market is expected to fall.

N. Bear Spread (Put) & Bear Spread (Call): This strategy involves very less risk & bearish outlook. So for those investors who expect the option prices will go down but they are not sure about it then they may use this strategy.

O. Sell Call: In this strategy maximum profit earned and maximum loss is unlimited. So less risk takers should select very lower strike price while selecting this strategy.

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Risk Management Through Derivatives in Equity Segment

CONCLUSION AND RECOMMENDATIONS Although derivative market is growing in a faster rate still it is not so popular in Indian financial market.

Due to lack of awareness or risk averseness, Indian investors donâ&#x20AC;&#x2122;t show interest to use derivatives to hedge in equity market. Notwithstanding the endorsement of derivatives by financial economists and business persons, there is a widespread belief among regulators, bureaucrats and politicians that derivatives are employed mainly for speculation purposes, and they accentuate the volatility of the underlying cash markets.

Many in the profession, however, disagree vehemently with the view that derivatives accentuate volatility in the cash markets. On the contrary volatility in the underlying cash market declines with the introduction of derivatives. Since hedging opportunities prove valuable only if the underlying cash markets are volatile, derivatives are introduced only when the underlying asset prices become more volatile.

After studying about financial

derivatives

and different derivative

strategies following

recommendations are suggested: Many strategies like straddle, strangle and butterfly depend upon volatility of scrip or index and give returns accordingly. So volatility should be forecasted before forming any strategy.

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Risk Management Through Derivatives in Equity Segment Fundamental and Technical analysis of the scrip or index should be done before formulating any strategy.

Specific strategy should be used according to the purpose of investor instead of investing haphazardly in futures and options.

Derivative market is highly ill- famed among the investor. Thus it is required to provide in depth knowledge of the market to investors.

Strategies should be evaluated daily for better returns and less risk.

Theoretical price of an option should be found out using option pricing models and those

options

whose

price

is

less

than theoretical price should be used for

formulation of strategy.

By using a hedging strategy an investor can recover some of his losses and can also make profit.

When the movement and volatility of market or scrip is not known at that time investor should use hedging strategies.

Investor should make

strategy

according

accordingly make strategy.

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to position in the cash

market and

Risk Management Through Derivatives in Equity Segment

BIBLIOGRAPHY

Books (a) Options, futures and Other Derivatives by JOHN C. HULL (b) NCFM Derivative Market (dealers) Module (c) Future and Optionâ&#x20AC;&#x2013; second edition Tata McGraw- Hill by N D VOHRA, B R Bagri

Websites (a) www.nseindia.com (c) www.bseindia.com (d) www.investopedia.com (f ) http://www.cboe.com/Strategies/EquityOptions/BuyingCalls/Part1.aspx (g) www.religare.in

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