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Executive Summary

Derivatives are an important class of financial instruments that are central to todays financial and trade markets. They offer various types of risk protection and allow innovative investment strategies. No other class of financial instruments has experienced as much innovation. Product and technology innovation together with competition have fuelled the impressive growth that has created many new jobs both at exchanges and intermediaries as well as at related service providers.

Given the derivatives markets global nature, users can trade around the clock and make use of derivatives that offer exposure to almost any underlying across all markets and asset classes. The derivatives market is predominantly a professional wholesale market with banks, investment firms, insurance companies and corporate as its main participants

There are two competing segments in the derivatives market: the off-exchange or over-thecounter (OTC) segment and the on-exchange segment. Only around 16 percent of the notional amount outstanding is traded on exchanges. From a customer perspective, onexchange trading is approximately eight times less expensive than OTC trading.

The derivatives market has successfully developed under an effective regulatory regime. All three prerequisites for a well-functioning market safety, efficiency and innovation are fulfilled. While there is no need for structural changes in the framework under which OTC players and exchanges operate today, improvements are possible. Particularly in the OTC segment, increasing operating efficiency, market transparency and enhancing counterparty risk mitigation would help the global derivatives market to function even more effectively.

INTRODUCTION
Derivatives
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be index, equity, Forex, bonds, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price 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 this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities

TYPES OF DERIVATIVES

Derivatives Future Option Forward Swaps

FORWARD CONTRACTS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract, size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts incertain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because

both serve essentially t h e same economic functi ons of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. 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 pre-set 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. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc. BASIC FEATURES OF FUTURE CONTRACT 1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.

The last trading date. Other details such as the tick, the minimum permissible price fluctuation.

2. Margin: Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid.

3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. Pricing of future contract In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, maturity , will be found by discounting the present value . at time to

by the rate of risk-free return

OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price.

There are two types of options i.e., CALL OPTION AND PUT OPTION. a) CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. b) PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase. Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

Options - The basic framework


Options are derivative products which, if you buy, give you certain rights. Basic option theory

In, at and out-of-the-money A call option is in-the-money when the underlying price is higher than the options exercise price, and is out-of-the-money when the underlying price is lower than the options exercise price. A put option is in-the-money when the underlying price is lower than the options exercise price, and is out-of-the-money when the underlying price is higher than the options exercise price. An option is at-the-money when the underlying price is equal to the options exercise price. In practice the option with the exercise price nearest to the prevailing underlying price is called the at-the-money option.

Intrinsic and time value The option price, or premium, can be considered as the sum of two specific elements: intrinsic value and time value.

Intrinsic value The intrinsic value of an option is the amount an option holder can realise by exercising the option immediately. Intrinsic value is always positive or zero. An out-of-the-money option has zero intrinsic value.

Intrinsic value of in-the-money call option = underlying product price - strike price Intrinsic value of in-the-money put option = strike price - underlying product price

Time value The time value of an option is the value over and above intrinsic value that the market places on the option. It can be considered as the value of the continuing exposure to the movement in the underlying product price that the option provides. The price that the market puts on this time value depends on a number of factors: time to expiry, volatility of the underlying product price, risk free interest rates and expected dividends.

Time to expiry Time has value, since the longer the option has to go until expiry, the more opportunity there is for the underlying price to move to a level such that the option becomes in-the money. Generally, the longer the time to expiry, the higher the options time value. As expiry approaches, the value of an option tends to zero, and the rate of time decay accelerates.

Volatility The volatility of an option is a measure of the spread of the price movements of the underlying instrument. The more volatile the underlying instrument, the greater the time value of the option will be. This will mean greater uncertainty for the option seller who will charge a high premium to compensate. Option prices increase as volatility rises and decrease as volatility falls.

Option sensitivities The strategy examples refer to market sensitivities of the options involved. These sensitivities are commonly referred to as the Greeks and these are defined below.

Delta: measures the change in the option price for a given change in the price of the underlying and thus enables exposure to the underlying to be determined. The delta is between 0 and +1 for calls and between 0 and -1 for puts (thus a call option with a delta of 0.5 will increase in price by 1 tick for every 2 tick increase in the underlying).

Gamma: measures the change in delta for a given change in the underlying. (e.g. if a call option has a delta of 0.5 and a gamma of 0.05, this indicates that the new delta will be 0.55 if the underlying price moves up by one full point and 0.45 if the underlying price moves down by one full point).

Theta: measures the effect of time decay on an option. As time passes, options will lose time value and the theta indicates the extent of this decay. Both call and put options are wasting assets and therefore have a negative theta. Note that the decay of options is nonlinear in that the rate of decay will accelerate as the option approaches expiry. As the table below illustrates, the theta will reach its highest value immediately before expiry. Vega: measures the effect that a change in implied volatility has on an options price. Both calls and puts will tend to increase in value as volatility increases, as this raises the probability that the option will move in-the-money. Both calls and puts will thus possess a positive Vega.

Market sensitivities are displayed for each strategy in the form of a table based on the position at 30 days to expiry. This shows the approximate sensitivities for when the underlying is at-the-money, as well as when the underlying rises and falls. The tables show the sensitivities of a position as outlined below: +++ ++ + 0 ---= = = = = = = highly positive positive slightly positive neutral slightly negative negative highly negative

Below the sensitivities table for each option strategy, there are brief explanations of movements in option sensitivities including brief descriptions of any departure from the sensitivities table that may occur (for example when the position is nearer to expiry). Summary of options and futures Greek values Individual option positions, e.g. long/short call options, have their own particular Greek values. The table below summarizes these values:

SHORT STRANGLE

The trade: Sell a put (A), sell call at higher strike (B).

Market expectation: Direction neutral/volatility bearish. The holder expects low volatility and no major directional move. More cautious than a straddle as profit potential spans a larger range although maximum potential profits will be lower.

Profit & loss characteristics at expiry:

Profit:

Limited to the premium received. Will be highest if the underlying remains within the market level A-B.

Loss: Break-even:

Unlimited for a sharp move in the underlying in either direction. Reached if the underlying falls below strike A or rises above strike B by the same amount as the premium received in establishing the position.

Market sensitivities at 30 days to expiry:

Delta:

Neutral (presumed at-the-money position), becomes highly negative (positive) for large increases (decreases) in the underlying.

Gamma:

Highest at strikes A and B but will tend to decrease as the underlying falls or rises significantly.

Theta: Vega:

Increase in value as options decay. Value of position will decrease as volatility increases.

MODEL APPLIED Assumption 1. Strategy applied is Short Strangle on NIFTY Options. 2. NIFTY range has been taken at 10% range for the year 2011, 2010 & 2009 from the Spot Price and also 15% range for the year 2011 & 2009. 3. For the Spot price, 1st Day of the New Contract of the month as been taken. 4. Non Symmetric data is marked with BLUE Circle on the graph. 5. Unfavourable situation is marked with RED Circle.

Year 2009 with range of 15% from Spot price

SHORT STRANGLE 2009 & 15% RANGE


120 100 4,959 80 60 40 20 0 JAN FEB MAR APR MAY JUNE JULY AUG SEP OCT NOV DEC 37.25 50.8 2,857 2,875 0 0 27.7 24.35 3,109 2,764 0 0 0 0 0 54.55 3,662 47.35 44.95 28.7 21 11.1 0 9.6 0 12.8 0.4 0 4,636 4,449 4,376 4,732 4,712 4,972 110.3

6000 5500 5000 4500 4000 3500 3000 2500


DATA ARE NOT SYMMTERIC
INFLOW OUTFLOW NIFTY

Year 2009 with range of 10% from Spot price


350 300 250 3108.65 200 2857.25 2874.8 2763.65 150 100 81.55 50 0 0 JAN FEB MAR APRIL MAY JUNE JULY AUG SEP OCT NOV DEC 0 0 0 0 0 0 69.8 72.7 119.8 91.55 94.95 2000 74.2 47.1 51.45 1.45 0 29.3 31.65 0.35 0 0 1000 54.4 6000

SHORT STRANGLE 286.75 4958.95 4941.75 4732.35 4711.7 4636.45 2009 & 10 % RANGE 4448.95 4375.5
3654

5000 4000 3000


INFLOW OUTFLOW NIFTY

Year 2010 with range of 10% from Spot price


30 26.8 25 7000

SHORT STRANGLE 20106017.7 & 10% RANGE 26


6143.4 5751.95 6000 24.35 5000

5367.65408.7 5282 5278 5269.05 5232.2 5066.55 4922.3 4882.05 20.85 18.35 15.95 17.55

20

4000
INFLOW OUTFLOW NIFTY

15 11.1 10 3000 10.3 8.2 9.7 7.4 2000

5 1.5 0 0 JAN FEB MAR APRIL MAY JUNE JULY AUG SEP OCT NOV DEC 0 0 0 0 0 0 0 0 1.85 0

1000

Year 2011 with range of 10% from Spot price

25

6134.5

SHORT STRANGLE 2011 & 10% RANGE


22.85 6200 6100 6000 5826.05 5900 5800 11.5 9.95 8.8 5700 5749.5 5600 5500
INFLOW OUTFLOW NIFTY

20

15

10

7.9

5512.15

5522.3

5 0 0 JAN FEB MARCH APRIL MAY 0 0 0 0

5400 5300 5200

Year 2011 with range of 15% from Spot price

SHORT STRANGLE 2011 & 15% RANGE


8 7 6 5 4 3 2 1 0 0 JAN FEB MAR APR MAY 5512.15 3.7 2.65 5522.3 5826.05 4.1 5749.5 6134.5 6.1 7.05 6200 6100 6000 5900 5800 5700 5600 5500 5400 0.25 0 0 0 5300 5200
INFLOW OUTFLOW NIFTY

DATA IS NOT SYMMTERIC

Conclusion
Under this short strangle strategy premium will be received and by looking at the historical data for the each month of the year 2009 at 15% range and at 10 % range, for 2010 at 10% range and for the year 2011 at 15% range and 10 % range we can see in most of the situation here is no outflow of the cash except for the period May 2009 where election was held and same the government was elected, as against the expectation. The market unfortunately was in the bullish trend. Total loss incurred in May 2009 alone wiped out the total gains accumulated in 18 months trading session. Similarly, the Defaults in Derivatives and its Consequences at Global Market are tabulated as given below.

BIBLIOGRAPHY
Books referred: Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah NSEs Certification in Financial Markets: - Derivatives Core module Financial Markets & Services by Gordon & Natarajan Morning Star Guide of Equity Options An Introduction to Derivatives and Risk Management, Orlando:Harcourt College Publishers, 5th ed. 2001) Financial Derivatives, (Florida: Kolb Publishing Company, 2009) LIFFE Options strategies Briys, E. et al., Options, Futures and Exotic Derivatives: Theory, Application and Practice, (Chichester: John Wiley & Sons Ltd, 2008

Websites visited: www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.derivativesindia.com www.investopedia.com www.wikipedia.org

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