INTRODUCTION

A Derivative is a financial instrument that derives its value

from an underlying asset. Derivative is a financial contract whose

price/value is dependent upon price of one or more basic underlying
assets, these contracts are legally binding agreements made on trading
screens of stock exchanges to buy or sell an asset in the future. The most
commonly used derivatives contracts are forwards, futures and options,
which we shall discuss in detail later.
The main objective of the study is to analyze the derivatives
market in India and to analyze the operations of futures and options.
Analysis is to evaluate the profit/loss position of futures and options
contracts. Derivative market is an innovation to cash market.
Approximately its daily turnover reaches around four times the cash
market segment.
In cash market the profit/loss of the investor depends upon
the market price of the security bought or sold. Derivatives are mostly
used for hedging purpose. But the presence of speculators is equally
important for the liquidity of the market. In bullish market the call option
writer incurs heavy losses so the investor is suggested to go for a call
option to hold, where as the put option holder suffers in a bullish market,
so he is suggested to write a put option. In bearish market the call option
holder will incur more losses so the investor is suggested to go for a call
option to write, where as the put option writer will get more losses, so he
is suggested to hold a put option.
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OBJECTIVES
.
Study of derivative products using their payoff diagrams.
.
To understand how these products are evaluated using mathematical
models.
.
Study of Options Strategies to mitigate risk when markets are highly
uncertain and volatile.
.
Study of important parameters which play an important role in
Portfolio Design.
.
To determine option premium for Reliance Industry using Black
Sholes model and observe the changes in the implied volatility of the
stock as the time to expiration approaches.
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IMPORTANCE OF THE STUDY
In today s time understanding of derivative products is very much
important because they give deep insight about F& O markets. It would
be essential for the perfect way of trading in F&O segment. An investor
can choose the right underlying or portfolio for investment which is risk
free or bearing very little risk. The study would explain the various ways
to minimize the losses and maximize the profits. The study would assist
in understanding the F&O segments in a sense that how futures and
options valuations are carried out. The study would assist in knowing the
different factors that cause for the fluctuations in the F&O market.
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DERIVATIVE
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.
Derivative is a product whose value is derived from the
value of an underlying asset in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset.
Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines
derivative 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.
Rationale behind the Development of Derivatives
Holding portfolio of securities is associated with the risk of the
possibility that the investor may realize his returns, which would be much
lesser than what he expected to get. There are various factors, which
affect the returns:
1. Price or dividend (interest).
2. Some are internal to the firm like
.
Industrial policy
.
Management capabilities
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.
Consumer s preference
.
Labor strike, etc.
To a large extent, these parameters are controllable and are termed
as non Systematic risks. An investor can easily manage such non-
systematic risks by having a well diversified portfolio spread across the
companies, industries and groups so that a loss in one may easily be
compensated with a gain in another.
There are yet other types of influences which are external to the firm
and which cannot be controlled and thus affect large number of securities.
They are termed as systematic risk. They are:
1. Macro Economic Factors
2. Political Instability
3. Sociological changes are sources of systematic risk.
For instance, inflation, interest rate, etc. their effect is to cause
prices of nearly all individual stocks to move together in the same
manner. We therefore quite often find stock prices falling from time to
time in spite of company s earnings rising and vice versa.
Rationale behind the development of derivatives market is to
manage this systematic risk, liquidity and liquidity in the sense of
being able to buy and sell relatively large amounts quickly without
substantial price concessions.
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Economic Functions of Derivative Market
The following are the various functions that are performed by the
derivative markets:
.
Prices in an organized derivative market reflect the perception of
market participants about the future and lead the prices of
underlying to the perceived future level.
.
Derivative market helps to transfer risk from those who are
exposed to it but may like to mitigate it to those who have an
appetite for risk.
.
Derivative market helps increase savings and investment in the
long run.
Commencement of Derivative Trading in India
The derivatives segment on NSE commenced with S&P CNX
Nifty Index futures on June 12, 2000. The F&O segment of NSE
provides trading facilities for the following derivative segment:
1.
Index Futures
2.
Index Options
3. Stock Futures
4. Stock Options
5. Forex Futures (started most recently)
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Participants of Derivative Market
The following are the three broad categories of participants who trade in
derivative market segment.
Hedgers
Hedgers face risk associated with the price of an asset. They use
futures & options markets to reduce or eliminate this risk.
Speculators
Speculators wish to bet on future movements in the price of an
asset. Futures and options contracts can give them an extra leverage; that
is, they can increase both the potential gains and potential losses in a
speculative venture.
Arbitrageurs
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 at the same time to lock in a
guaranteed profit.
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TYPES OF DERIVATIVES
The following are the various types of derivative products. However at
present in India only few of them are exchange traded and popular.

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.
Some of its characteristics are:
o
These are private contracts between two parties
o
Not Standardized
o
Usually one specified delivery date
o
Settled only on maturity
o
Delivery or final cash settlement takes place
o
Lot of credit risk is involved in the absence of MTM mechanism
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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.
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.
WARRANTS
Options generally have lives of up to one year; the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally
traded over-the-counter.
LEAPS
The acronym LEAPS means Long-Term Equity Anticipation
Securities. These are options having a maturity of up to three years.
BASKETS
Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity
index options are a form of basket options.
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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. The two commonly used
swaps are:
1) Interest Rate Swaps
These entail swapping only the interest related cash flows between
the Parties in the same currency.
2)
Currency Swaps
These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency
than those in the opposite Direction.
SWAPTION
Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a Swaptions is an option on a
forward swap. For example, An option to enter into an interest rate swap
where a specified fixed rate is exchanged for floating
Among all Derivative Products, Futures and Options are highly
popular among investors and generate large turnover.
PURPOSE OF TRADING IN FUTURES MARKET
1)
Investment -take a view on the market and buy or sell
accordingly.
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2)
Price Risk Transfer-Hedging -Hedging is buying and selling
futures contracts to offset the risks of changing underlying market
prices. Thus it helps in reducing the risk associated with exposures
in underlying market by taking a counter -positions in the futures
market. For example, the hedgers who either have security or plan
to have a security is concerned about the movement in the price of
the underlying before they buy or sell the security. Typically he
would take a short position in the Futures markets, as the cash and
futures price tend to move in the same direction as they both react
to the same supply/demand factors.
3)
Arbitrage -Since the cash and futures price tend to move in the
same direction as they both react to the same supply/demand
factors, the difference between the underlying price and futures
price called as basis. Basis is more stable and predictable than the
movement of the prices of the underlying or the Futures price.
Thus arbitrageur would predict the basis and accordingly take
positions in the cash and future markets.
4)
Leverage -Since the investor is required to pay a small fraction of
the value of the total contract as margins, trading in Futures is a
leveraged activity since the investor is able to control the total
value of the contract with a relatively small amount of margin.
Thus the Leverage enables the traders to make a larger profit or
loss with a comparatively small amount of capital.
PURPOSE OF TRADING IN OPTIONS MARKET
Options trading will be of interest to those who wish to:
1) Participate in the market without trading or holding a large quantity
of stock.
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2) Protect their portfolio by paying small premium amount.
FUTURES
DEFINITION
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. To facilitate
liquidity in the futures contract, the exchange specifies certain standard
features of the contract. The standardized items on a futures contract are:
¨ Quantity of the underlying
¨ Quality of the underlying
¨ The date and the month of delivery
¨ The units of price quotations and minimum price change
¨ Locations of settlement
Types of futures
On the basis of the underlying asset they derive, the futures are
divided into two types:
Index futures
Index futures are the futures, which have the underlying asset as an
Index. The Index futures are also cash settled. The settlement price of
the Index futures shall be the closing value of the underlying index on the
expiry date of the contract.
Stock futures
The stock futures are the futures that have the underlying asset as
the individual securities. The settlement of the stock futures is of cash
settlement and the settlement price of the future is the closing price of the
underlying security.
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Parties to Futures Contract
There are two parties in a future contract, the Buyer and the Seller.
The buyer of the futures contract is one who is LONG on the futures
contract and the seller of the futures contract is one who is SHORT on
the futures contract.
The pay off for the buyer and the seller of the futures contract are as
follows.
Payoff for a Buyer of Future Contract

CASE 1:
The buyer bought the future contract at 40; if the futures price
goes above 40 then the buyer gets the profit of (ST1 - 40)
CASE 2:
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The buyer incurs loss when the future price goes below 40; if the

futures price goes below 40 the loss would be equal to (40 ST2)
Payoff for a Seller of Future Contract

CASE 1:
The Seller sold the future contract at 40; if the futures price goes
below 40 then the Seller would make a profit of (40 ST1)
CASE 2:
The Seller made a short position at 40. He would incur loss when
the future price goes above 40; The loss would be equal to (ST2 40)
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MARGINS
Margins are the deposits, which reduce counter party risk that arise
in a futures contract. These margins are collected in advance at the time
of entering into the contract in order to eliminate the counter party risk. It
is this concept of margins which differentiates a Futures contract from a
Forward contract. There are three types of margins in a Futures contract:
Initial Margin
Whenever a futures contract is signed, both buyer and seller are
required to deposit initial margin. Both buyer and seller are required to
make security deposits that are intended to guarantee that they will in fact
be able to fulfill their obligation. These deposits are Initial margins and
they are often referred as performance margins. The amount of margin is
varies from 5% to 15% of total contract value of futures contract.
Maintenance Margin
The investor is allowed to withdraw any balance in the margin account in
excess of the initial margin. To ensure that the balance in the margin
account never becomes negative a maintenance margin, which is
somewhat lower than the initial margin, is set. After depositing the initial
margin, if the mark to marking loss occurs, it is made sure that the money
in the initial margin account never falls below the maintenance margin.
Variation Margin
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If the balance in the margin account falls below or touches the
maintenance margin level, the investor receives a margin call from his
broker and he is told to top up the margin account up to the initial margin
level the next day. The top up money deposited is known as Variation
Margin. If the investor does not provide the variation margin, the broker
has the right to close out the open position by selling/buying the contract
without even informing the investor.
Marking to Market & Role of Margins
The process of adjusting the amount in an investor s margin
account in order to reflect the change in the settlement price of futures
contract on a daily basis is known as Marking to Market.
The role of margins in the futures contract is explained in the
following example.
Today is August 1, 2008.Suppose Person X is bullish on August
Nifty Futures and buys one contract of Nifty August Futures @ 4500.
Another person Y is bearish on Nifty so he becomes the counter party by
taking a short position one contract of Nifty August futures. The contract
size of Nifty is 50. The total contract value is 4500 * 50 = 225000. The
initial margin amount is say Rs.30000 and the maintenance margin is say
70% of Initial margin i.e. 21000
Margin Account
Day
Price
of
NiftyAugu
st
Futur
es
Effect
on
Buyer's
Accou
nt
Buyer's
Balan
ce
Amt
Effect
on
Seller'
s
Accou
nt
Seller
's
Balan
ce
Amt
1-Aug 4500
Deposits
30000
3000
0
Deposits
30000
3000
0
2-Aug 4600 CR
5000
3500
0
DR
5000
2500
0
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3-Aug 4700 CR
5000
4000
0
DR
5000
2000
0
4-Aug 4650 DR
2500
3750
0
CR
2500
2250
0
5-Aug 4800 CR
7500
4500
0
DR
7500
&
Seller
Deposits
15000
3000
0
6-Aug 4600 DR
10000
3500
0
CR
10000
4000
0
On August 6, 2008 the positions are closed
out
Total Amt Receivable
from Margin Account
3500
0
4000
0
Total Amount Paid in
Margin Account
3000
0
4500
0
Net Profit / (Loss) 5000 (5000)
Futures terminologies
Spot Price
It is the price at which an asset trades in the cash market segment.
Futures Price
It is the price at which a futures contract trades in the futures
market. It is a future price of the underlying asset as on today. It is
usually equal to spot price plus cost of carrying.
Contract Cycle
It is a period over which a contract trades. The index futures
contracts on the NSE have one-month, two-months 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
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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
It is the number of securities that has to be bought or sold in a
single contract. For instance, the contract size on NSE s Nifty Index
futures is 50.The total contract value is the product of total number of
securities in a single contract and price of a single security.
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.
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Open Interest

It is the total outstanding long or short positions in the market at

any specific time. As total long positions for market would be equal to
short positions, for calculation of open interest, only one side of the
contract is counted.
Pricing the Futures
The fair value of the futures contract is derived from a model
known as the Cost of Carry model. This model gives the fair value of the
futures contract.
Cost of Carry Model
Future Price of an underlying when dividend yield is known in
percentage terms:
F = S*e(r - q) t
Future Price of an underlying when dividend to be received during the
course of contract is known in absolute terms:
F = [ S Q*e-rt ] * ert
Where
F Futures Price
S Spot price of the Underlying
r Cost of Financing in percentage
q Expected Dividend Yield in percentage
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Q Expected Dividend in absolute value
t Holding Period in years
Relationship between Futures Prices and Spot Prices as the delivery
period approaches:

As we can in the diagram, futures price and spot price converge as the
delivery date approaches. This happens to avoid any arbitrage activity. Or
we can say that both these prices converge because of the presence of
arbitrageurs in the market.
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OPTIONS
DEFINITION
Option is a type contract between two persons where one
grants the other the right to buy a specific asset at a specific price within a
specified time period. Alternatively the contract may grant the other
person the right to sell a specific asset at a specific price within a specific
time period. In order to have this right, the option buyer has to pay the
seller of the option premium.
The assets on which options can be derived are stocks,
commodities, indexes etc. If the underlying asset is the financial asset,
then the options are financial options like stock options, currency options,
index options etc, and if the underlying asset is the non-financial asset the
options are non-financial options like commodity options.
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Types of Options
Call Option
A call option gives the holder of the option the right but not the
obligation to buy an asset by a certain date for a certain price. A call
option is bought by an investor when he feels that the stock price will
move upwards. To buy such an option, he has to pay some amount to
acquire this option. This amount is known as call premium.
Put Option
A put option gives the holder of the option the right but not the
obligation to sell an asset by a certain date for a certain price. A put
option is bought by an investor when he believes that the stock price
will move downwards. To buy such an option, he has to pay some
amount to acquire this option. This amount is known as call premium.
American & European Options
Depending upon the time of exercise, options can further be
classified as American Option and European Option.
In case the option is an American Option, the holder of the call
or put option can exercise his option any time during the options contract.
Usually all Stock Options are of American style.
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In case the option is a European Option, the holder of the call or
put option can exercise his option only on the maturity of the option
contract. Usually all Index Options are of European style.
PARTIES IN AN OPTION CONTRACT
The following are the parties in an option contract.
1. Buyer of the Call Option:
The buyer of a call option is the one who by paying the
option premium buys the right but not the obligation to buy the
underlying asset at pre decided price.
2. Writer/Seller of the Call Option:
The writer of a call option is the one who receives the
option premium and is there by obligated to sell the asset if the
buyer exercises the option on him.
3. Buyer of the Put Option:
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The buyer of a put option is the one who by paying the
option premium buys the right but not the obligation to sell the
underlying asset at a pre decided price.
4. Writer/Seller of the Put Option:
The writer of a put option is the one who receives the
option premium and is there by obligated to buy the asset if the
buyer exercises the option on him.
Underlying Asset in Options Contract
The underlying asset of the options contract could be any of the
followings:
Index Options
The Index options have the underlying asset as the index.
Stock Options
A stock option gives the buyer of the option the right to
buy/sell stock at a specified price. Stock options are options on the
individual stocks, there are currently more than 50 stocks are trading in
this segment.
Foreign Currency Options
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This can be used to mitigate the risk arising out of fluctuation
in the exchange rate of currencies. Currency options trading takes place
in over the counter market. NSE and BSE do not have options on
foreign currency.
1) Pay-off Profile for Buyer of a Call Option:
The pay-off of buyer of the option depends on the spot
price of the underlying asset. The following graph shows the pay-off of
buyer of a call option:
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Call Option Buyer
SpotPrice
Strike
Price
Premium
Paid
Break Even
Price
Maximum
Loss
Maximum
Profit
50 50 10 60 -10 Unlimited
A Call Option Holder will Exercise his Option only if Spot goesbeyond Strike Pri
ce
2) Pay-off Profile for Seller of a Call Option:
The pay-off of seller of the call option depends on the
spot price of the underlying asset. The following graph shows the pay-off
of seller of a call option:
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Call Option Writer
SpotPrice
Strike
Price
Premium
Received
Break Even
Price
Maximum
Loss
Maximum
Profit
50 50 10 60 Unlimited 10
A Call Option Writer waits for the option to expire OTM to makeprofit.
3) Pay-off Profile for Buyer of a Put Option:
The pay-off of buyer of the option depends on the spot
price of the underlying asset. The following graph shows the pay-off of
buyer of a call option:
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27
Put Option Buyer
SpotPrice
Strike
Price
Premium
Paid
Break Even
Price
Maximum
Loss
Maximum
Profit
50 50 10 40 -10 40
A Put Option Buyer would Exercise his Option only if Spot falls belowthe Strike
Price
4) Pay-off Profile for Seller of a Put Option:
The pay-off of seller of the option depends on the spot
price of the underlying asset. The following graph shows the pay-off of
seller of a put option:
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28
Put Option Seller
SpotPrice
Strike
Price
Premium
Received
Break Even
Price
Maximum
Loss
Maximum
Profit
50 50 10 60 40 10
A Put Option Seller wishes that the option expires OTM
Options Terminology
· In-The-money Option
In case of a call option, an option is in the money if
the spot price > strike price. In case of a put option, an option in the
money if strike price > spot price.
· At-The-Money Option
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29
Spot price and Strike price are same. In this case the
intrinsic value of an option is zero.
· Out-Of-The-Money Option
In case of a call option, an option is out of money if
spot price < strike price. In case of a put option, an option is out of money
if spot price > strike price.
Intrinsic Value of an Option
For Call Option, Intrinsic Value = max ((Spot Strike) or Zero)
For Put Option, Intrinsic Value = max ((Strike Spot) or Zero)
Factors affecting the price of an option
In general Value of an Option =
Intrinsic Value + Time Value + Volatility in returns

The following are the factors which affect the price of an option:

1) Spot price
2) Strike price
3) Time to expiration
4) Risk-free interest rate
5) Expected Dividend during the course of a contract
6) Volatility
While valuing any option contract, the most difficult parameter
to take into account is the volatility in the returns of the underlying asset
price. It is measured by statistical variable known as standard deviation
and it quantifies the tendency of the underlying asset s return to move
away from the average or expected returns. Higher the standard deviation,
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riskier is the underlying asset and thus higher the value of option
premium.
Effect of Increase in the Relevant Parameter on Option Prices
EUROPEAN OPTIONS
Buying
AMERICAN OPTIONS
Buying
PARAMETERS CALL PUT CALL PUT
Spot Price (S)
Strike Price (Xt)
Time to Expiration (T) ? ?
Volatility ()
Risk Free Interest Rates (r)
Dividends (D)

Favourable
Unfavourable
Black Scholes Pricing model
The principle that options can completely eliminate market risk from
a stock portfolio is the basis of Black Scholes pricing model in 1973.
Interestingly, before Black and Scholes came up with their option
pricing model, there was a wide spread belief that the expected
growth of the underlying ought to effect the option price. Black and
Scholes demonstrate that this is not true. The beauty of black and
Scholes model is that like any good model, it tells us what is
important and what is not. It doesn t promise to produce the exact
prices that show up in the market, but certainly does a remarkable
job of pricing options within the framework of assumptions of the
model.
The following are the assumptions;
1. There are no transaction costs and taxes.
2. The risk from interest rate is constant.
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3. The markets are always open and trading is continues.
4. The stock pays no dividend. During the option period the firm
should not pay any dividend.
5. The option must be European option.
6. There are no short selling constraints and investors get full use of
short sale proceeds.
The options price for a call, computed as per the following Black Scholes
formula:
Value of Call Option VC = S * N(d1) X * e-rt * N(d2)
Value of Put Option VP = X * e-rt * N(- d2) S * N(-d1)
d1= [In (S/X) + (r + s 2 / 2)t] / s sqrt (t)
d2= d1-s sqrt (t)

Where
VC= value of call option
VP= value of put option
S = Spot price of the share
X = Strike price of the share
R = Risk free rate
T = time period remaining to expiration
N(d1) = after calculation of d1 value, normal distribution area is to be
identified.
N(d2) = after calculation of d2 value, normal distribution area is to be
identified.
s = Volatility in the stock price movement
In = Natural log
Limitation of Black Sholes Model
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Black Sholes model cannot be used to accurately price options with an
American Style exercise as it only calculates the option price at one point
in time i.e. at expiration only. It does not consider the steps along the way
where there could be the possibility of early exercise of an American
option.
As all exchange traded stock options have American Style exercise, this
model cannot be used to price the stock option premiu
OPTION STRATEGIES
Option strategies can be used effectively to minimize the risk of the
physical portfolio. When an investor has a portfolio of number of shares
and if he is uncertain about the direction in which the market would
move, these strategies can be used to hedge the risk in times of
uncertainty.
Market Outlook: Bullish
Strateg
y
Construc
tion
Market
Outlook Profit/Loss HedgingImplications
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Bull
Spread(CallSpread)
Long CallA + Short
Call B
MildlyBullish
Profit is limited;
Risk is limited
Provides protectionagainst limitedprice rise; If pricerises above B
protection islimited
Bull
Spread(PutSpread)
Long PutA + Short
Put B
MildlyBullish
Profit is limited;
Risk is limited
Provides protectionagainst limitedprice rise; If pricerises above B
protection islimited
Market Outlook: Bearish

Strate
gy
Construc
tion
Market
Outlook Profit/Loss HedgingImplications
Bear
Spread(CallSpread)
Short Call
A + LongCall B
MildlyBearish
Profit is limited to
the difference if
the strike prices;
Risk is limited if
expiration price isat or above B
Provides
protection againstmoderate pricedecline. If pricesfall below A,
protection islimited.
Bear
Spread(PutSpread)
Short Put
A + LongPut B
MildlyBearish
Profit is limited to
the difference if
the strike prices;
Risk is limited if
expiration price isat or above B
Provides
protection againstmoderate pricedecline. If pricesfall below A,
protection islimited.
Market Outlook: Stable
Nitin K Banka
Strate
gy
Constructi
on
Market
Outlook Profit/Loss
HedgingImplicati
ons
Short
Straddl
e
Short Call &
Short Put at
the same
Strike
Stable priceexpectation& no drastic
movements
in either
direction
Profit is limited to
the net premiumincome, if the priceat expiration is equalto strike price. Riskis
potentiallyunlimited as pricemoves up or downthe two strike prices.
LongHedge &
Short
HedgeBenefits
Short
Strangl
e
Short Call &
Short Put at
different
Strikes
Stable priceexpectations& no drastic
movements
in either
direction
Profit is limited to
the premiumreceived if the priceat expiration isbetween two strikes.
Risk is unlimited if
the price moves upor down the two
strikes.
LongHedge &
Short
HedgeBenefits
Market Outlook: Uncertain

Strate
gy
Constructi
on
Market
Outlook Profit/Loss
HedgingImplicatio
ns
LongStraddle
Long Call &
Long Put atsame strike
price
Uncertain priceexpectation. Butprice will movedrastically ineither direction
Profit is unlimited
if price moves upor down. Risk is
limited to the
premium paid.
LongHedge &
Short
HedgeBenefits
LongStrangle
Long Call &
Long Put ondifferent
prices A &
B
Uncertain Price
Expectation.
Price may movedrastically inany direction
Profit is unlimited
if prices move upor down. Risk is
limited to the
premium paid, ifthe price atexpiration is inbetween A & B
LongHedge &
Short
HedgeBenefits
PORTFOLIO MANAGEMENT
Nitin K Banka
Portfolio means total holding of securities belonging to one person.
Portfolio management is concerned with efficient management of
investment in securities to optimize returns to suit the objective of the
investor. Optimization of returns stands for maximization of profits and
minimization of risk.
Objective of Portfolio Management
A managed portfolio should offer
1) Security of Principal
2) Stability of Income
3) Capital Growth
4) Liquidity
5) Diversification
Variables that affect Portfolio Design
Return
The return is the compensation that an investor gets for parting with his
liquidity. The return from an investment is the expected cash inflows in
terms of dividends, interest, bonus, capital gain etc.
Riskless Securities
The securities in which the rise can be forecasted with certainty are called
riskless securities.
Risky Securities
Nitin K Banka
The risky securities are those where the return cannot be forecasted with
certainty as there is always risk involved that the cash flows may not
result as expected.
Risk
Risk refers to the variability of return from those that are expected. The
most common and reliable measure of risk is the tendency of returns to
move away from the expected return. This is known as Standard
Deviation.
Standard Deviation & Beta
Risk can be diversifiable risk and non diversifiable risk.
Standard deviation is a measure of total risk whereas another variable
called as Beta measures only non diversifiable risk. Beta is a measure of
systematic risk of an asset relative to that of market portfolio. Beta of
market portfolio is always one whereas Beta for government securities is
zero (risk free).
Standard Deviation should be used only when different investments have
same expected rate of return. It may give misleading results in comparing
the risk if the alternative investments have different expected rate of
return. In such case, another variable known as Coefficient of Variation is
used to compare risk of different investments.
Coefficient of Variation
Coefficient of Variation is a measure of relative dispersion. It is a
measure of total risk per unit of expected return. The larger the CV, larger
is the relative risk of the investment.
CV is used to compare risk of those investment options which have
different expected rate of return.
Nitin K Banka
Correlation Coefficient
It measures the degree of association of two variables. It measures not
only magnitude of co relation but also the direction. It ranges from -1 to
+1. It is shown by r
If r = 0 It indicates there is no correlation
If r = 1 It indicates perfect positive relation
If r = -1 It indicates perfect negative correlation
Existence of correlation between two securities does not necessarily mean
that movement in one security is because of the movement in another
security.
Covariance
It is an absolute measure of variability of one variable in relation to
another variable.
Suppose there are two securities x and y, then Covariance depends upon
Standard deviation of x; Standard Deviation of y & correlation coefficient
between x, y.
Systematic & Unsystematic Risk
Types of Systematic Risk
1) Market Risk
2) Interest Rate Risk
3) Social or Regulatory Risk
4) Purchasing Power Risk
Types of Unsystematic Risk
1) Business Risk
Nitin K Banka
2) Financial Risk
3) Default Risk
Efficient Portfolio
Efficient portfolio is one which provides the maximum return for a
particular degree of risk, or lowest risk for any given rate of return.
In the following figure number of portfolios is shown on the basis of their
tradeoff between expected return and degree of risk. The red line is
known as efficient frontier as every portfolio lying on it offers maximum
return at that level of risk. Portfolios A, B and C are efficient portfolios.

The Security Market Line

It is a graph plotted between required rate of return along Y axis and non
diversifiable risk (beta) of a security along X axis.
Required rate of return is calculated using CAPM model and the beta of
the security. It represents a linear relationship between them.
If we know the beta of number of securities and calculate the required
rate of return using CAPM model, all the securities are expected to be
plotted along one single line which is SML. This SML can be used to
Nitin K Banka
classify securities as aggressive securities and defensive securities. If the
securities with beta greater than one lies above SML, they are aggressive
securities. Securities beta less than one lying below SML are defensive
securities.
The Slope of SML = Required Return using CAPM Risk Free Return
Beta

The Capital Market Line

Capital market line is a trade off between risk and return. Every point on
capital market line represents an efficient portfolio. Therefore, its
Nitin K Banka
correlation with the market portfolio is one as all the possible
diversification is done.
The slope of CML = Required Return Risk Free Return
Standard Deviation

Nitin K Banka
 Company Profile

BIRLA SUN LIFE INSURANCE LIMITED

About Birla Sun Life Insurance Company Limited:

Nitin K Banka
Birla Sun Life Insurance pioneered the unique Unit Linked Life
Insurance Solutions in India.
Within 4 years of its launch, BSLI has cemented its position as a leading
player in the Private Life Insurance Industry.
There has been focus on Investment Linked Insurance Products,
supported with protection products to maintain leadership in product
innovation.
Multi Distribution Channels-Direct Sales Force, Alternate Channels and
Group offering convenient channels of purchase to customers.

Web-enabled IT systems for superior customer services.

First to have issued policies over the Internet.
Corporate governance and a high degree of transparency in all
business practices and procedures.

First to have an operational Business Continuity Plan.

Strong fundamentals based on the Aditya Birla group's local insight
and Sun Life financials's global expertise.
VISION
To create long term value along with market leadership.
MISSION
To help people mitigate risks of life, accident, health and money at all
stages and under all circumstances.
Enhance the financial future of our customers, including enterprises.

VALUES
Integrity
Commitment
Nitin K Banka
Passion
Seamlessness
Speed
Board of Directors

Mr. Kumar M. Birla

Mr. Donald A. Stewart
Mr. Bishwanath N. Puranmalka
Mr. Ajay Srinivasan
Mr. Suresh N. Talwar
Mr. Gian P. Gupta
Mr. Stephan Rajotte
Dr. Bharat K. Singh
Mr. Venkatesh S. Mysore

At Birla Sun Life Distribution, we put knowledge, expertise and

experience to good use to preserve, nurture and nourish your
wealth. For your today and your tomorrow.
We are a part of the Joint Venture between The Aditya Birla
Group and Sun Life Financial of Canada. The synergy of these
two accomplished conglomerates brings you global financial
know-how and local market insight.
It is said that: "To acquire wealth is difficult, to preserve it more
difficult, but to nourish it wisely, the most difficult of all."
Our commitment to excellence along with roots up approach to
research and analysis, coupled with technology driven processes
has enabled us to emerge as one of the leading wealth
management & investment Advisory Services Company in the
country.
Achievements:

Leading Distribution House in the country

Over 2,50,000 customers countrywide
6000 plus business associates
Nitin K Banka
Business across all important segments : Institutional,
Private Client Group, Direct Sales and Channel
National presence 40 Branches across the country.
Leading corporate agent of Birla Sun Life Insurance.
"Knowledge is a treasure but practice is the key to it"
We believe that the desire for knowledge increases with the
acquisition of it. At Birla Sun Life Distribution Co Ltd., we make
the best use of intellect and expertise putting knowledge to good
practice. As and when and where you need it.
For us the concept of perfect service is constantly expanding. This
along with transparent business ethics, inspired and innovative
solutions is what our investors have come to expect from us.
A fact, which has been reaffirmed by recognition and awards,
conferred on us by the leading names of the India Financial
Services Industry.
Nitin K Banka
Data analysis and
Observations

Application of Black Sholes Model for Reliance Industry

Why Reliance Industry has been picked for Analysis ?
Nitin K Banka
This particular analysis was carried out during the month of July 2008.
During that period all the index heavyweights except Reliance Industry
were trading far below than their 52 weeks high/low because of poor
global financial scenario. People have lost the trust in most of the
heavyweights which form the benchmark index Sensex or Nifty. But the
faith in the stock of Reliance Industry was intact and it was getting traded
at higher volume as well.
This is the reason Reliance Industry has been chosen and option pricing is
calculated using Black Sholes model as no dividend was expected within
a period of 15 days.
The data for closing price of call option premium as well as put option
premium at the available strike prices is obtained. Data was input in the
excel sheet and option premiums were calculated 1) neglecting volatility
factor and then 2) by using Black Sholes model assuming the stock as
non dividend paying stock.
The analysis and the graphs are shown below:
Today s Date ExpirationDate
Risk Free
Return Spot Lot
Size
Volatil
ity
16-Jul-08 31-Jul-08 8.24% 1976.
8 75 42.00%
Nitin K Banka
Strike
Price Type Neglecting s
Black Scholes
Pricing
Actual
Premium
ImpliedVolatility
1890 ITM 93.19 122.40 NA
1920 ITM 63.29 102.46 NA
1950 ITM 33.39 84.58 90.05 43.34%
1980 ATM 3.49 68.83 74.35 45.40%
2010 OTM 0.00 55.19 59.35 44.55%
2040 OTM 0.00 43.60 48.10 44.75%
2070 OTM 0.00 33.92 36.50 43.63%
2100 OTM 0.00 26.00 27.75 43.16%
2130 OTM 0.00 19.63 25.00 46.46%
2160 OTM 0.00 14.59 15.75 43.24%
2190 OTM 0.00 10.69 10.75 42.20%
2220 OTM 0.00 7.71 9.65 44.74%
2250 OTM 0.00 5.49 7.30 45.22%
2310 OTM 0.00 2.66 4.45 46.81%
2340 OTM 0.00 1.81 3.30 47.15%
2370 OTM 0.00 1.22 3.70 51.00%
2400 OTM 0.00 0.81 3.45 53.28%
2500 OTM 0.00 0.19 3.00 60.52%

Today s Date ExpirationDate

Risk Free
Return Spot Lot
Size
Volatil
ity
16-Jul-08 31-Jul-08 8.24% 1976.
8 75 42.00%
Nitin K Banka
Strike
Price Type Neglecting s
Black Scholes
Pricing
Actual
Premium
ImpliedVolatility
1890 OTM 0.00 29.21 46.40
1920 OTM 0.00 39.17 56.50
1950 OTM 0.00 51.19 63.60 49.50%
1980 ATM 0.00 65.33 80.30 50.98%
2010 ITM 26.41 81.60 91.10 47.45%
2040 ITM 56.30 99.90 108.85 47.05%
2070 ITM 86.20 120.13 128.85 47.11%
2100 ITM 116.10 142.10 148.00 45.32%
2130 ITM 146.00 165.63 173.75 47.35%
2160 ITM 175.90 190.49 200.95 50.00%
2190 ITM 205.80 216.49 224.00 47.95%
2220 ITM 235.70 243.41 239.00 Nil
2250 ITM 265.59 271.08 NA
2310 ITM 325.39 328.05 NA
2340 ITM 355.29 357.10 NA
2370 ITM 385.19 386.41 NA
2400 ITM 415.09 415.90 NA
2500 ITM 514.75 514.94 NA

Today sDate
ExpirationDate
Risk Free
Rate Spot Lot
Size
Volatil
ity
29-Jul-08 31-Jul-08 8.24% 2085.2 75 55.00%
Nitin K Banka
Strike
Price Type Neglecting s
Black Scholes
Pricing
Actual
Premium
ImpliedVolatility
1890 ITM 196.05 196.26 NA
1950 ITM 136.08 137.74 150.00 97.98%
1980 ITM 106.09 110.00 NA
2010 ITM 76.11 84.27 86.20 59.76%
2040 ITM 46.12 61.48 65.00 61.40%
2070 ITM 16.13 42.41 42.45 54.95%
2100 ATM 0.00 27.50 25.20 51.15%
2130 OTM 0.00 16.68 16.65 54.76%
2160 OTM 0.00 9.42 10.90 58.48%
2190 OTM 0.00 4.95 6.90 60.78%
2220 OTM 0.00 2.41 4.20 63.01%
2250 OTM 0.00 1.09 3.25 68.44%
2280 OTM 0.00 0.46 1.95 70.23%
2310 OTM 0.00 0.18 1.65 76.22%
2340 OTM 0.00 0.06 1.00 77.70%
2350 OTM 0.00 0.04 1.00 80.21%
2400 OTM 0.00 0.01 1.00 91.81%
2500 OTM 0.00 0.00 0.15 91.50%

Today sDate
ExpirationDate
Risk Free
Rate Spot Lot
Size
Volatil
ity
29-Jul-08 31-Jul-08 8.24% 2085.2 75 55.00%
Strike
Price Type Neglecting s
Black Scholes
Pricing
Actual
Premium
ImpliedVolatility
Nitin K Banka
1890 OTM 0.00 0.20 1.85 77.08%
1950 OTM 0.00 1.66 2.40 59.47%
1980 OTM 0.00 3.91 4.05 55.70%
2010 OTM 0.00 8.17 6.75 51.33%
2040 OTM 0.00 15.36 14.15 52.51%
2070 OTM 0.00 26.28 20.00 44.37%
2100 ATM 13.85 41.35 36.85 47.44%
2130 ITM 43.84 60.51 52.60 39.28%
2160 ITM 73.82 83.25 80.05 46.70%
2190 ITM 103.81 108.76 107.30 48.88%
2220 ITM 133.80 136.21 132.95 Nil
2250 ITM 163.78 164.87 164.30 Nil
2280 ITM 193.77 194.23 193.00
2310 ITM 223.76 223.93 224.40
2340 ITM 253.74 253.81 NA
2350 ITM 263.74 263.78 NA
2400 ITM 313.72 313.72 NA
2500 ITM 413.67 413.67 NA

Nitin K Banka
Observations
Nitin K Banka
52
Implied at every strike price was calculated for call option premium and it
has been observed that
1) As the time to expiration approaches, the perception of the market
participant about the volatolity changes significantly.
2) The uncertainty about the movement in the price increases as the time
to expiration reduces.
3) 15 days before the expiration the implied volatility was ranging
between 42% to 62% but just two days before the expiration date, the
new range for implied volatility was seen at 51% to 98%.
4) Implied volatility was seen increasing at higher strike prices
5) For a Call Option, volatility was seen increasing as the option is more
out of the money.
6)This trend of implied volatility with the strike price is called as
volatility smile.
Nitin K Banka
Observations
Nitin K Banka
Implied volatility at every strike price was calculated for put option
premium and it has been observed that
1) As the time to expiration approaches, the perception of the market
participant about the volatility changes significantly.
2) The uncertainty about the movement in the price increases as the time
to expiration reduces.
3) 15 days before the expiration the implied volatility was ranging
between 44% to 52% but just two days before the expiration date, the
new range for implied volatility was seen at 40% to 78%
4) Implied volatility was seen higher at lower strike prices.
5) For a Put Option, volatility was seen increasing as the option is more
out of the money.
6) This trend of implied volatility with the strike price is called as
volatility smile.
.BIBLOGRAPHY
Nitin K Banka
Books
.
Derivatives Dealers Module Work Book - NCFM
.
Options, Futures and other derivatives John C Hull
News Papers
.
ECONOMIC TIMES
WEB SITES
www.birlasunlife.com
www.nseindia.com
www.bseindia.com
Nitin K Banka