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Evaluating Derivatives Market in India

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Introduction to Derivatives Market

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.

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. The financial derivatives came into spotlight in 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 both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, 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 indices with various portfolios and ease of use. The lower costs associated with index derivatives vies-versa derivative products based on individual securities is another reason for their growing use.

The following factors have been driving the growth of financial derivatives:

  • Increased volatility in asset prices in financial markets,
  • Increased integration of national financial markets with the international markets,
  • Marked improvement in communication facilities and sharp decline in their costs,


The study is limited to “Derivatives with special reference to futures and option in the Indian context and the Networth Stock Broking Ltd., data for this study is from 27-DEC -2007 to 31-JAN- 2008 which represent sample for the study. The study can't be said as totally perfect. This study is only a humble attempt at evaluating derivatives market in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, CBOT etc.


The Market data that has been used to see whether the Break Even Point (BEP) calculated can be used has an indicator to the investor to maximize the returns on its investment.


1. To understand the concept of derivatives in a more appropriate way.

2. To study various trends in derivative market.

3. To understand the scope and growth of derivatives in India.

4. To study the role of derivatives in Indian financial market

5. To study in detail the role of the future and options.


1. Data Collection :

For this study the date collected is of secondary nature,

The data of the Nifty index have been collected from “Economic Times” and internet. The data collected for January contract and the date consist from period 27th December, 2007 to 31st January, 2008.

2. 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 the option writer, representing the data with s and making the interpretation using data.


Data collected for analyzing this study is from 27-DEC 2007 to 31-JAN-2008. Time taken to complete this project is 45 days


  • The study is conducted in short period, due to which the study may not be detailed in all aspect.
  • Lack of time on performing the project in detail study.
  • Unavailability of software package which will help in calculation
  • Lack of software knowledge to determine the correct future estimations.
  • The data collected is completely restricted to 31st January, 2008; hence this analysis cannot be taken universal.




Introduction To Indian Capital Market

India's financial market began its transformation path in the early 1990s. The banking sector witnessed sweeping changes, including the elimination of interest rate controls, reductions in reserve and liquidity requirements and an overhaul in priority sector lending. Persistent efforts by the Reserve Bank of India (RBI) to put in place effective supervision and prudential norms since then have lifted the country closer to global standards.

Around the same time, India's capital markets also began to stage extensive changes. The Securities and Exchange Board of India (SEBI) was established in 1992 with a mandate to protect investors and improvements into the microstructure of capital markets, while the repeal of the Controller of Capital Issues (CCI) in the same year removed the administrative controls over the pricing of new equity issues. India's financial markets also began to embrace technology. Competition in the markets increased with the establishment of the National Stock Exchange (NSE) in 1994, leading to a significant rise in the volume of transactions and to the emergence of new important instruments in financial intermediation.

For over a century, India's capital markets, which consist primarily of debt and equity markets, have increasingly played a significant role in mobilizing funds to meet public and private entities' financing requirements. The advent of exchange-traded derivative instruments in 2000, such as options and futures, has enabled investors to better hedge their positions and reduce risks.

In total, India's debt and equity markets were equivalent to 130% of GDP at the end of 2005. This is an impressive stride, coming from just 75% in 1995, suggesting issuers' growing confidence in market based financing. However, the size of the country's capital markets relative to the United States', Malaysia's and South Korea's remains low, implying a strong catch-up process for India.

While some form of financial derivatives trading in India dates back to the 1870s, exchange traded derivative instruments started only in 2000. Then, stock index futures, with the Sensex 30 and the S&P CNX Nifty indices as the underlying, began trading at the BSE and NSE. Since their inception, the basket of instruments has expanded and now features individual stock futures, and options for stock index and individual stocks.


The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. 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.

On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, 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.

NSE Mission

1. NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of:

2. Establishing a nation-wide trading facility for equities, debt instruments and hybrids,

3. Ensuring equal access to investors all over the country through an appropriate communication network,

4. Providing a fair, efficient and transparent securities market to investors using electronic trading systems,

5. Enabling shorter settlement cycles and book entry settlements systems, and

6. Meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technologies have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It's that force which is guiding the industry towards new horizons and greater opportunities.

Equity shares

By investing in shares, investors basically buy the ownership right to the company. When the company makes profits, shareholders receive their share of the profits in the form of dividends. In addition, when company performs well and the future expectation from the company is very high, the price of the company's shares goes up in the market. This allows shareholders to sell shares at a profit, leading to capital gains.

Investors can invest in shares either through primary market offerings or in the secondary market.

The primary market has shown abnormal returns to investors who subscribed for the public issue and were allotted shares.

Stock Exchange:

In a stock exchange a person who wishes to sell his security is called a seller, and a person who is willing to buy the particular stock is called as the buyer. The rate of stock depends on the simple law of demand and supply. If the demand of shares of company x is greater than its supply then its price of its security increases.

In Online Exchange the trading is done on a computer network. The sellers and buyers log on to the network and propose their bids. The system is designed in such ways that at any given instance, the buyers/sellers are bidding at the best prices.

The transaction cycle for purchasing and selling shares online is depicted below:


Role of Clearing House

The clearing house of the exchange interposes itself between the buyer(the long position) and the seller (the short position).this mean clearing house becomes seller to buyer and the buyer to seller. Because the clearing house is obliged to perform on its side of each contract, it is the only party that can hurt if any trader fail to fulfill his obligation. The clearing house protects its interest by imposing margin requirements on traders.

Ever since its inception in 1993, Networth Stock Broking Limited (NSBL) has sought to provide premium financial services and information, so that the power of investment is vested with the client. We equip those who invest with us to make intelligent investment decisions, providing them with the flexibility to either tap into our extensive knowledge and expertise, or make their own decisions. NSBL made its debut in to the financial world by servicing Institutional clients, and proved its high scalability of operations by growing exponentially over a short period of time. Now, powered by a top-notch research team and a network of experts, we provide an array of retail broking services across the globe - spanning India, Middle East, Europe and America. Currently, we are a Depository participant at Central Depository Services India (CDSL) and aim to become one at National Securities Depository (NSDL) by the end of this quarter. Our strong support, technology-driven operations and business units of research, distribution and advisory coalesce to provide you with a one-stop solution to cater to all your broking and investment needs. Our customers have been participating in the booming commodities markets with our membership at Multi Commodity Exchange of India (MCX) and National Commodity & Derivatives Exchange (NCDEX) through Networth Stock.Com Ltd.

NSBL is a member of theNational Stock Exchange of India Ltd (NSE) andthe Bombay Stock Exchange Ltd (BSE)on the Capital Market and Derivatives (Futures & Options) segment. It is also a listed company at theBSE.

Corporate Overview

• Networth is a listed entity on the BSE since 1994

• The company is professionally managed with experience of over a decade in broking and advisory services

• Networth is a member of BSE, NSE, MCX, NCDEX, AMFI, CDSL

• Current network in Southern and Western India with 107 branches and franchise. Presence in major metros and cities

• Empanelled with prominent domestic Mutual Funds, Insurance Companies, Banks, Financial Institutions and Foreign Financial Institutions.

• Strong experienced professional team

• 20000+ strong and growing client base

• Average daily broking turnover of around INR 1 billion

• AUM with Investment Advisory Services of around INR 3 billion

Products and services Portfolio

v Retail and institutional broking

v Research for institutional and retail clients

v Distribution of financial products

v Corporate finance

v Net trading

v Depository services

v Commodities Broking


• A corporate office and 3 divisional offices in CBD of Mumbai which houses state-of-the-art dealing room, research wing & management and back offices.

• All of 107 branches and franchisees are fully wired and connected to hub at corporate office at Mumbai. Add on branches also will be wired and connected to central hub

• Web enabled connectivity and software in place for net trading.

• 60 operative ID's for dealing room

• State of the Art accounting and billing system, on line risk management system in place with 100% redundancy back up.

• In house technology back up team to ensure un-interrupted connectivity.

Online Trading

There is nothing more exhilarating, more daring and more rewarding than making the right trade at the right time. Welcome to our Internet trading platform which brings you a world class experience of online trading.

Clicknetworth is a software application suite that offers comprehensive facilities so users can watch Market Prices while they trade. The application is highly integrated which enables the user to place orders in live environment. The user screen is fully customizable by the user to display information based upon his/her own preferences

Trading Platform

Networth offers advanced and convenient online trading facility with

N-easy and N-swift which are completely safe and secure.

N-easy: A Powerful and user friendly browser based platform ideally suited for Investors

N-swift: An Advanced EXE based application suite that is ideally suited for Traders


* Clients can trade in NSE - Cash, NSE - F&O and BSE - Cash.

* Single screen order / trade entry as you can add NSE-Cash, Derivative & BSE scripts in the same Market Watch.

* Features such as Lock the Screen, TOP 20 by Most Active Volume, Value, Gainers, Losers, Market Movement and more will help you customise your trading platform according to your specific focus.

* Facility for Online Funds Transfer. Your credit limit increases instantaneously on completion of a successful transfer.
Total holdings with NSBL and NSBL - CDSL DP (POA) can be viewed and delivery sale can also be made.

* Needless to mention other standard features as Real-Time market data, live order status, Real time position updates etc.




Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. There are two types of derivatives that are trades on NSE; namely Futures and Options. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “equity derivative” to include -

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.

A contract, which derives its value from the prices, or index of prices, of underlying securities.The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.


When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the shares at Rs50 and the price appreciates to Rs75, we have made Rs2500 on a mark-to-market basis. If we buy the shares at Rs50 and the price depreciates to Rs25, we have lost Rs2500 on a mark-to-market basis.

Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of Rs50, giving us the right but not the obligation to purchase ABC stock at Rs50 in 1 month's time. Instead of immediately paying Rs5000 and receiving the stock, we might pay Rs700 today for this right. If ABC goes to Rs75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, locking in a net profit of Rs1800. If the ABC stock price goes to Rs25, we have only lost the premium of Rs700. If ABC trades as high as Rs100 after we have bought the option but before it expires, we can sell the option in the market for a price of Rs5300.

Classification of Derivatives

Types of Derivatives

The most commonly used derivatives contracts in NSE are ,FUTURES and OPTIONS which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used.

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 future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

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 given 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.

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

Warrants: Options generally have lives of upto 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 upto three years.

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

Participants and Functions

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

v 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.

v Arbitrageurs are in business to take advantage 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 positions in the two markets to lock in a profit.

The derivative market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment.

The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, etc.

Indian Derivatives Market

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India's (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India



Liberalisation process initiated


NSE asked SEBI for permission to trade index futures.


SEBI setup L.C.Gupta Committee to draft a policy framework for index futures.


L.C.Gupta Committee submitted report.


RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.


SIMEX chose Nifty for trading futures and options on an Indian index.


SEBI gave permission to NSE and BSE to do index futures trading.


Trading of BSE Sensex futures commenced at BSE.


Trading of Nifty futures commenced at NSE.


Nifty futures trading commenced at SGX.


Individual Stock Options & Derivatives


A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.

Swaps Pricing:

There are four major components of a swap price.

v Benchmark price

v Liquidity (availability of counter parties to offset the swap).

v Transaction cost

v Credit risk

Benchmark Price:Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.

Liquidity: which is function of supply and demand, plays an important role in swaps pricing? This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap.

Transaction cost: Say in case of a bank, which has a floating obligation of 91 days T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference.

Yield on 91 day T. Bill - 9.5%

Cost of fund (e.g.- Repo rate) - 10%

The transaction cost in this case would involve 0.5%

Credit risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.

Introduction to Futures

Future contract is the simplest of all financial assets. A future contract is just an agreement between two parties to buy and sell an asset at a fixed price in the future. Futures markets were originally designed to solve the problems of forward markets. Future contracts are managed through an organized future exchange Future contracts are a type of derivative security because the value of the contract is derived from an underlying instrument. The exchange specifies standard features of future contract to facilitate liquidity in the futures contracts. The net value of a future contract is zero because future contract represents a zero sum game between a buyer and a seller. Future contracts are standardized to facilitate convenience in trading and price reporting. A futures contract may be offset before maturity by taking opposite position which means that future trading can be closed by entering into equal into an equal and opposite transaction. Future contract must specify at least five terms of the contract and they are:

1) The identity of the underlying commodity or financial instrument.

2) The future contract size.

3) The future maturity date.

4) The delivery or settlement procedure.

5) The future price.


A commodity future is a future contract in a commodity like cocoa, aluminum etc.

A financial future is a futures contract in a financial instrument like Treasury bill, currency or stock index.

Futures contracts are:

v Futures contracts are organized/ standardized contracts, which are traded on the exchanges.

v These contracts, being standardized and traded on the exchanges are very liquid in nature.

v In futures market, clearing corporation/ house provides the settlement guarantee.

v Every futures contract is a forward contract traded on exchange and clearing corporation/house provides the settlement guarantee for trades.

v Are of standard quantity; standard quality (in case of commodities).

Have standard delivery time and place.

What Does Future Trading Apply to Indian Stocks?

Future trading is a type of investments which involves speculating on the prices of securities in the future. Securities traded in future contract can be a stock (Reliance India Limited, TISCO, etc), Stock Index (NSE Nifty Index), commodity (Gold, Silver, Agricultural Products, etc)

Unlike stocks and bonds, when we involve in future trading then we do not buy or own anything but we speculate the future direction of the price in the security we are trading. Suppose we speculate on Stock Index (NSE Nifty index). If we speculate that the future price of Stock Index can go up in the future then we would buy a future contract. If we speculate that the future price of Stock Index can go down then we would sell a future contract.

Futures Trading accounts

A future exchange allows only exchange members to trade on the exchange floor. There are various things to know about future trading accounts. The first thing is that a margin is always required. A margin is the amount of money that we put up to control a future contract.


How to Trade in S&P CNX NIFTY Futures?


Trading on CNX Nifty futures is just like trading in other security. Before buying or selling we use to predict the direction of the market and based on that prediction we buy or sell the index. A profit is made when the closing price on the expiration day is higher than the value at which we had bought the index. If we had predicted a bearish market, and had sold the index then we make a profit.

Trading cycle for S&P CNX Nifty Futures

The trading cycle for S&P CNX Nifty future contracts is 3 months. On the trading day a new contract is introduced. This contract will be introduced for three month duration. As a result there will be 3 contracts available for trading in the market ( i.e., first contract is in near month, second in mid month and third in far month duration)


If Trading in NIFTY Starts from January 2002 then following chart gives us the beginning and expiry date of the contract.



January 2002

January 28th

February 2002

February 20th

March 2002

March 19th

After January 28th, the first trading day will be on January 29th.



February 2002

February 24th

March 2002

March 30th

April 2002

April 20th

To trade futures in NSE, traders have to open an account with a future brokerage firm known as Future Commission Merchant (FCM). FCM records the trades, monitors them and advice traders of their margin account obligations. Initial margin is required when a future position is established. The margin requirement for future contracts usually ranges between 2% and 5% of the total contract value. While starting the trade in NSE, an upfront or initial margin is paid to the broker. It is nothing but a type of security deposit which is paid to NSE by the broker. The position in the future margin will be market to market. In future trading accounts, the process by which the gains and losses on outstanding future position can be recognized on daily basis is called market to market. There are two ways to invest in future contracts. First, traders can invest in a future pool, which works similar to mutual fund. Investors pool large amount of money with an established future money management firm, which then trades contracts in different markets. The advantages of participating in these pools are that investors have money managers which monitor their trades all the time. The pool works well then it will be liquidated in 5 or 10 years and profits will be distributed to pool participants after deducting 6% of managed assets every year.

The other way of investing in future contracts is to sign up for a discretionary account with a future trading adviser. The benefit of the discretionary account is that the investors can give the broker an order to buy or sell a future contract. The broker in turn transmits the order to the appropriateexchangefloor orelectronic trading system (Jordan. Goodman, 2000)

How much Initial Margin is Required for Trading?

If Patel bought 100 units of NIFTY January expiry contract at Rs 1800, and if daily margin is 5% then the initial margin is calculated as:

Margin money paid upfront by Patel = Rs 1800 x 100 units x 5%

= Rs 9000

Always use Stop Loss.









NIFTY Monthly







NIFTY Weekly








Certain things should be kept in mind before trading Nifty future contracts and that is how to calculate profit and loss. First of all the direction of the market is determined and if the market goes up then it is call bullish market and if the market goes down then it is called bearish market. In bullish market Nifty futures are bought and in bearish market Nifty futures are sold. The profit and loss is very important in future trading and in this case it can be calculated with examples.

If current price of Nifty is Rs 3000 and last date of expiry is 30th January, the profit and loss is calculated by the direction of the market.

In Bullish Market

Future trading in NSE is such that trading can be done at any time till the last date of expiry (till January 30th). If traders do not sell Nifty that they had bought till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry

Buy Nifty future at Rs 3000, size of the future is 50.

I) If Nifty price is Rs 3100 and sold before expiration, then Profit = (Rs 3100- Rs 3000) x 50 = Rs 5000

II) If Nifty price is Rs 2900 and sold before expiration, then Loss = (Rs 3000 - Rs 2900) = Rs 5000

In Bearish Market.

Sell Nifty futures January at Rs 3000, size of the future is 50

I) If Nifty price is Rs 2900 and bought before expiration, then Profit = (Rs 3000- Rs 2900) x 50 = Rs 5000

II) If Nifty price is Rs 3100 and bought before expiration, then Loss = (Rs 3100 - Rs 3000) x 50 = Rs 5000

Future trading in NSE is such that trading can be done at any time till the last date of expiry (till January 30th). If traders do not buy what they had sold till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry.

Maturity of futures contracts :

As mentioned earlier Index futures of different maturities trade simultaneously on the exchanges. For instance, BSE trades three contracts on BSE SENSEX with one, two and three month's maturity. These contracts of different maturities are called near month (one month), middle month (two months) and far month (three months) contracts. At any point of time there will be three futures contracts available for trading.





Operational Mechanism

Not traded on exchange

Traded on exchange

Contract Specifications

Differs from trade to trade.

Contracts are standardized contracts.

Counterparty Risk


Exists, but assumed by Clearing Corporation

Liquidation Profile

Poor Liquidity as contracts are tailor maid contracts.

Very high Liquidity as contracts are standardized contracts.

Price Discovery

Poor; as markets are fragmented.

Better; as fragmented markets are brought to the common platform.


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

In a futures contract, both parties have an obligation,

Ø One to buy the underlying instrument

Ø The other to sell the underlying instrument.

Both the buyer and the seller can make a profit or suffer a loss, due to the fact that the contract price (at which the underlying instrument is bought and sold) is determined at closing of the contract. If the market price at the delivery date is lower than the futures contract price, the buyer suffers a loss because he could have bought the instrument in the market at a lower price. He is now obliged, according to the contract, to buy the underlying instrument at the higher price specified in the contract. The opposite applies when the market value of the underlying instrument is above the futures contract price. The buyer can now buy the underlying instrument at the lower contract price, and sell the instrument immediately at the higher market price, thus making an immediate profit.

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




CASE 1:- The buyer bought the futures contract at (F); if the futures price

Goes to E1 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 E2 then the buyer gets the loss of (FL).




CASE 1:- The seller sold the future contract at (f); if the future goes to E1

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 E2 then the seller gets the loss of (FL).

Futures Terminologies

Spot Price: The price at which an asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures market.

Contract Cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-months 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.

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.

Contract size: The amount of asset that has to be delivered under one contract. For in-stance, 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. 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.

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.

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.

Marking-to-market: In the futures market, at the end of each trading day, the margin ac-count is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

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.

Introduction to Options

Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment.

History of options

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock indexes, foreign currencies and futures contracts. The first trading in options began in Europe and the US as early as the eighteenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms.

The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. It was in 1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early '80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

There are two kind of Options based on the date

The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date.

In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSE

Options 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 stocks. 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.

Ø 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.

Ø 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: Option price is the price which the option buyer pays to the option seller.

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. Most exchange-traded options are American.

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-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 it 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 isN½P which means the intrinsic value of a call is Max [0, (St - K)] which means the intrinsic value of a call is the (St - K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price.


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

S - Strike price OTM - Out of the money

SP- Premium/loss ATM - At the money

E1 - Spot Price 1 ITM - In the money

E2 - Spot price 2

SR - Profit at spot price E1

CASE1:- (Spot price>Strike Price)

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.

CASE2:- (Spot price<Strike price)

As a spot price (E2) of the underlying asset is less than strike price (s). The buyer gets loss of (SP), if goes down less than E2 then also his loss is limited to his premium (SP).


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

S - Strike price OTM - Out of the money

SP- Premium/loss ATM - At the money

E1 - Spot Price 1 ITM - In the money

E2 - Spot price 2

SR - Profit at spot price E1

CASE1:- (Spot price>Strike Price)

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

CASE2:- (Spot price<Strike price)

As a spot price (E2) of the underlying asset is less than strike price (s). The seller gets loss of (SP), if goes down less than E2 then also his loss is limited to his premium (SP).


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

S - Strike price OTM - Out of the money

SP- Premium/loss ATM - At the money

E1 - Spot Price 1 ITM - In the money

E2 - Spot price 2

SR - Profit at spot price E1

CASE1:- (Spot price<Strike Price)

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

CASE2:- (Spot price>Strike price)

As a 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 of buyer is limited to his premium (SP).


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

S - Strike price OTM - Out of the money

SP- Premium/loss ATM - At the money

E1 - Spot Price 1 ITM - In the money

E2 - Spot price 2

SR - Profit at spot price E1

CASE1:- (Spot price<Strike Price)

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

CASE2:- (Spot price>Strike price)

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

Distinction between futures and options



Exchange traded, with novation

Same as futures.

Exchange defines the product

Same as futures.

Price is zero, strike price moves

Strike price is fixed, price moves.

Price is zero

Price is always positive.

Linear payoff

Nonlinear payoff.

Both long and short at risk

Only short at risk.

Interesting question to ask at this stage is -

When would one use options instead of futures ?

Options are different from futures in several interesting senses.

At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.

Buying Put options is buying insurance. To buy a put option on Nifty is to buy insurance, which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating “guaranteed return products”. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty.

Index Derivatives

Index derivatives are derivative contracts, which derive their value from an underlying index. The two most popular index derivatives are Index Futures and Index Options. Index derivatives have become very popular worldwide.

The advantages they offer

v Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes.

v Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.

v Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered

v Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements.

v Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.

The L.C.Gupta committee which was setup for developing a regulatory framework for derivatives trading in India had suggested a phased introduction of derivative products in the following order:

1. Index futures

2. Index options

3. Options on individual stocks

With all the above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.

Pricing Index Futures

Stock index futures began trading on NSE on the 12th June 2000. Ever since, the volumes and open interest has been steadily growing. Looking at the futures prices on NSE's market, have you ever felt the need to know whether the quoted prices are a true reflection of the underlying index's price? Have you wondered whether you could make risk-less profits by arbitraging between the underlying and futures markets? If so, you need to know the cost-of-carry to understand the dynamics of pricing that constitute the estimation of fair value of futures.

Pricing futures contracts on equity index

A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks.

In their short history of trading, index futures have had a great impact on the world's securities markets. Indeed, index futures trading has been accused of making the world's stock markets more volatile than ever before. The critics claim that individual investors have been driven out to the equity markets because the actions of institutional traders in both the spot and futures markets cause stock values to gyrate with no links to their fundamental values. Whether stock index futures trading is a blessing or a curse is debatable. It is certainly true, however, that its existence has revolutionized the art and science of institutional equity portfolio management.

Factors Affecting The Price Of The Options

Stock Price: The pay-ff 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 price 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 a negative effect on the value of call options and a positive effect on the value of put options.

Pricing Options

An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the rice of an option. On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price. The values shown in Table 5.1 are derived from a theoretical model, namely the Black-Scholes option pricing model. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market, which forces the prices in the table to come about.


Risk Management is a process whereby the company (could be a broker, institution, stock exchange) lays down a clear process of how its risks should be managed. The process will include:

v Identifying risk

v Deciding how much credit should be given to each client

v Deciding the frequency of collection of margins

v Deciding how much risk is acceptable

v Controlling risk on continuous basis

v Monitoring risk taken on continuous basis

Kind of risks participants has in the Derivatives markets

Some examples of risks are provided below:

v Counterparty (or default) risk :- very low or almost zero because the exchange takes on the responsibility

v Operational risk :- risk that operational systems might fail

v Legal risk :- risk that legal objections might be raised, regulatory framework might disallow some activities

v Market risk :-risk that market prices may move up or down

v Liquidity risk: - risk that unwinding of transactions might be difficult if the market is illiquid.


Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realized returns will be less than the returns expected Risks can be classified as Systematic risks and Unsystematic risks.

Unsystematic risks:-

These are risks that are unique to a firm or industry. Factors such as management capability, consumer preferences, labor, etc. contribute to unsystematic risks. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio

Systematic risks:-

These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio.

The three main risk associated with investing in a share are

v The value of your investment could fall.

v The amount of income you receive can fall, or stop altogether.

v Your investment may increase at a lower rate than the rate of inflation, thus eroding the purchasing power of your investment.

How to minimize the risks ?

The company specific risks (unsystematic risks) can be reduced by diversifying into a few companies belonging to various industry groups, asset groups or different types of instruments like equity shares, bonds, debentures etc. thus, asset classes are bank deposits, company deposits, gold, silver, land real estate, equity share, computer software etc. Each of them has different risk-return characteristics and investments are to be made, based on individual's risk preferences. The second category of risk (systematic risk) is managed by the use of beta of different company shares.


The gain or lossof a security in a particular period is called return. The return consists of theincomeand thecapital gains relativeon aninvestment. It is usually quoted as a percentage. The general rule isthatthe more risk you take, the greater the potential for higher return - and loss. Return can come from two sources, capital growth and income. Capital growth occurs when the market value of the share increases. Income is the cash flow paid by an share such as dividends.


















































































































































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