Derivative Project Report

PROJECT REPORT
ON
HEDGING AND ARBITRAGE

USING INDEX FUTURES
IN DERIVATIVES MARKET
SUBMITTED BY:
JYOTI
Email: Delhi_jyoti2007@yahoo.co.in
TABLE OF CONTENTS
CHAPTER 1
 INTRODUCTION TO STOCK MARKET
 FINANCIAL MARKETS
 MONEY MARKET
 CAPITAL MARKETS
 ABOUT CAPITAL MARKET
 STOCK EXCHANGE
 ROLE OF STOCK EXCHANGE
 VARIOUS STOCK EXCHANGES
 HISTORY OF STOCK EXCHANGE
CHAPTER 2
DERIVATIVES
 CONCEPT
 HISTORY OF DERIVATIVE MARKET IN THE WORLD
 DEVELOPMENT OF DERIVATIVE MARKET IN INDIA
 NEED BEHIND DERIVATIVES USAGE
 PARTICIPITANTS
 TYPES OF DERIVATIVES
 FACTORS BEHIND GROWTH OF FINANCIAL DERIVATIVES
 ACCOUNTING and taxation OF DERIVATIVES
CHAPTER 3
 WORKING OF FUTURES AND OPTIONS

 TRADING STRATEGIES
CHAPTER 4
 RESEARCH WORK
 INTRODUCTION TO RESEARCH TOPIC
 OBJECTIVES OF STUDY
 RESEARCH METHODOLOGY
 RESEARCH DESIGN
 SAMPLING DESIGN
 LIMITATIONS OF THE STUDY
 DATA ANALYSIS
 RESULTS AND FINDINGS
 SUGGESTIONS AND RECOMMENDATIONS
CHAPTER 5
ANNEXURE AND BIBLIOGRAPHY
INTRODUCTION TO STOCK MARKET
Every individual tries to plan and secure his future using various
avenues of investment. An individual invests money on account of
multiple reasons. A few of them are as follows:
1.More and more returns
2.Planning or securing one’s future.
3.Tax benefits
4.Saving for children’s education

5.Safety
6.Hedging against devaluation
7.Possessing liquidity
The growth of economy and hence, development of nation

depends on the amount of resources that are readily available to
various factors of production in the economy.
Savings/investments of the inhabitants and others like
nonresidents,foreigners,both individual play a key role. It is in this
regard that the financial markets help in channelising the saving
and investments into the economy and makes it available to the
factors of production.
FINANCIAL MARKETS
IT COMPROMISES OF
1.MONEY MARKET
2.CAPITAL MARKET
MONEY MARKET provides short-term capital to borrowers for
meeting their short term working requirement.
CAPITAL MARKET is a market for long-term funds.
ABOUT CAPITAL MARKET
The major borrowers in this sector are corporate, agriculture

sector and government. The corporate sector needs funds for
capital investment purposes like capital expansion, diversification,
integration, mergers, and acquisitions. The government needs
funds for its various programs for infrastructure development like
roads, highways, power sanitation and water supply, etc. The
supply of funds for the capital market comes from individual
households, corporate banks, insurance companies, specialized
financial agencies and the government.
Capital market is divided into debt market and equity market. In

general, when we talk about the market we mean equity market
or stock market.
CAPITAL MARKET IS FURTHER DIVIDED INTO
PRIMARY MARKET: It is the market where the security is issued for

the first time.
SECONDARY MARKET: The secondary market is represented by

stock exchange, which provides an organized place for investors
to trade in securities.
STOCK EXCHANGE
Stock exchange is a corporation or mutual organization which

provides facilities for stock brokers and traders to trade
company stocks and other securities. It refers to that
segment of capital market where the securities issued by
corporate entities are traded. It acts as a nervous system of
the capital market.Stock exchanges also provide facilities for
the issue and redemption of securities, as well as, other
financial instruments and capital events including the
payment of income and dividends. The securities traded on a
stock exchange include: shares issued by companies, unit
trusts and other pooled investment products and bonds. To
be able to trade a security on a certain stock exchange, it has
to be listed there. Usually there is a central location at least
for recordkeeping, but trade is less and less linked to such a
physical place, as modern markets are electronic networks,
which gives them advantages of speed and cost of
transactions. Trade on an exchange is by members only. The
initial offering of stocks and bonds to investors is by definition
done in the primary market and subsequent trading is done in
the secondary market. A stock exchange is often the most
important component of a stock market. Supply and demand
in stock markets are driven by various factors which, as in all
free market affect the prices of the stocks.
VARIOUS STOCK EXCHANGES IN THE WORLD

Bombay Stock Exchange
Frankfurt Stock Exchange
New York Stock Exchange

São Paulo Stock Exchange
Singapore Stock Exchange
Tokyo Stock Exchange

Tour de la Bourse, Montreal
Bolsa de Valores de Lima

[edit]
ROLE OF STOCK EXCHANGE
Raising capital for businesses
The Stock Exchange provides companies with the facility to raise

capital for expansion through selling shares to the investing
public.
Mobilizing savings for investment
When people draw their savings and invest in shares, it leads to a

more rational allocation of resources because funds, which could
have been consumed, or kept in idle deposits with banks, are
mobilized and redirected to promote business activity with
benefits for several economic sectors such as agriculture,
commerce and industry, resulting in a stronger economic growth
and higher productivity levels.
Facilitate company growth

Companies view acquisitions as an opportunity to expand product
lines, increase distribution channels, hedge against volatility,
increase its market share, or acquire other necessary business
assets. A takeover bid or a merger agreement through the stock
market is the simplest and most common way to company
growing by acquisition or fusion.
Redistribution of wealth
By giving a wide spectrum of people a chance to buy shares and

therefore, become part-owners (shareholders) of profitable
enterprises, the stock market helps to reduce large income
inequalities. Both casual and professional stock investors through
stock price rise and dividends get a chance to share in the profits
of promising business that were set up by other people.
Corporate governance
By having a wide and varied scope of owners, companies

generally tend to improve on their management standards and
efficiency in order to satisfy the demands of these shareholders
and the more stringent rules for public corporations by public
stock exchanges and the government. Consequently, it is alleged
that public companies (companies that are owned by
shareholders who are members of the general public and trade
shares on public exchanges) tend to have better management
records than privately-held companies (those companies where
shares are not publicly traded, often owned by the company
founders and/or their families and heirs, or otherwise by a small
group of investors). However, some well-documented cases are
known where it is alleged that there has been considerable
slippage in corporate governance on the part of some public
companies (e.g. Enron Corporation, MCI WorldCom, Pets.com,
Webvan, or Parmalat).
Creates investment opportunities for small investors

As opposed to other businesses that require huge capital outlay,
investing in shares is open to both the large and small stock
investors because a person buys the number of shares he/she can
afford. Therefore, the Stock Exchange provides an extra source of
income to small savers.
Government raises capital for development projects
The Government and even local authorities like municipalities

may decide to borrow money in order to finance huge
infrastructure projects such as sewerage and water treatment
works or housing estates by selling another category of securities
known as bonds. These bonds can be raised through the Stock
Exchange whereby members of the public buy them. When the
Government or Municipal Council gets this alternative source of
funds, it no longer has the need to overtax the people in order to
finance development.
Barometer of the economy
At the stock exchange, share prices rise and fall depending,

largely, on market forces. Share prices tend to rise or remain
stable when companies and the economy in general show signs of
stability and growth. An economic recession, depression, or
financial crisis could eventually lead to a stock market crash.
Therefore the movement of share prices and in general of the
stock indexes can be an indicator of the general trend in the
economy.
HISTORY OF STOCK EXCHANGE
More than 200 years ago in front of Trinity church in East
Manhattan in U.S, the oldest stock exchange called New York
Stock Exchange emerged. At that point, there was no paper
money changing hands nor people had any idea of what stock
meant, people traded silver for papers saying they owned shares
in cargo .The trade flourished. During American Revolution, the
colonial government needed money to fund its wartime
operations. They did this by selling bonds. Bonds are pieces of
paper a person buys for a set price, knowing that after a certain
period of time; they can exchange their bonds for a profit. Along
with bonds, the first of the nation’s bank started to sell parts or
shares of their own company to people in order to raise money.
Thus, they sell the part of the company to whoever wanted to buy
it. This led to the emergence of the modern day stock market.
The concept of stock markets came to India in 1875, when

Bombay Stock Exchange (BSE) was established as ‘The Native
Share and Stockbrokers Association', a voluntary non-profit
making association. BSE is the oldest in Asia. Presently, India has
about 10,000 listed companies, the largest number of listed
companies in the world. Stock exchanges in India can be
categorized as: 1) Voluntary Associations such as Bombay, Indore
and Ahmadabad, 2) Public limited companies such as Calcutta
and Delhi, and 3) Guarantee companies such as Hyderabad,
Madras and Bangalore. Besides BSE, India's other major stock
exchange is National Stock Exchange (NSE) that was promoted by
leading financial institutions and was established in April 1993.
Today, these global stock exchanges have become premier
institutions and are highly efficient, computerized organizations
that have fostered the growth of an open, global securities
market. There are various products which are traded in the stock
market such as bonds, shares and debentures.
In this part of my analysis, I have dealt with Derivatives

commonly known as futures and options.
Derivatives are one of the options available to the investor where
he can invest in share market.
Let us move on to understand concept of derivatives.

Concept of
derivatives
The word Derivatives is used in our life in many contexts. From
the viewpoint of an English teacher, “quickly” is a derivative of
quick. From the point of chemist, chloroform is a derivative of
methane. In mathematics, change of function is a derivative i.e., a
key concept of calculus.
The word 'derivative' has its origin from mathematics and

Refers to a variable, which has been derived from another
variable. Derivatives are so called because they have no value of
their own. They derive their value from the value of some other
asset, which is known as the underlying.
Derivatives are financial instruments that have no intrinsic value,

but derive their value from something else. They hedge the risk of
owning things that are subject to unexpected price fluctuations,
e.g. foreign currencies, bushels of wheat, stocks and government
bonds.
The primary objectives of any investor are to maximize returns

and minimize risks. Derivatives are contracts that originated from
the need to minimize risk. For example, a derivative of the shares
of Infosys (underlying), will derive its value from the share price
(value) of Infosys. Similarly, a derivative contract on soybean
depends on the price of soybean.
Derivatives are specialised contracts which signify an agreement

or an option to buy or sell the underlying asset of the derivate up
to a certain time in the future at a prearranged price, the exercise
price.
The contract also has a fixed expiry period mostly in the range of
3 to 12 months from the date of commencement of the contract.
The value of the contract depends on the expiry period and also
on the price of the underlying asset.For example, a farmer fears
that the price of soybean (underlying), when his crop is ready for
delivery will be lower than his cost of production.
Let's say the cost of production is Rs 8,000 per ton. In order to

overcome this uncertainty in the selling price of his crop, he
enters into a contract (derivative) with a merchant, who agrees to
buy the crop at a certain price (exercise price), when the crop is
ready in three months time (expiry period).
In this case, say the merchant agrees to buy the crop at Rs 9,000
per ton. Now, the value of this derivative contract will increase as
the price of soybean decreases and vice-a-versa.
If the selling price of soybean goes down to Rs 7,000 per ton, the
derivative contract will be more valuable for the farmer, and if the
price of soybean goes down to Rs 6,000, the contract becomes
even more valuable.
This is because the farmer can sell the soybean he has produced
at Rs .9000 per tonne even though the market price is much less.
If the underlying asset of the derivative contract is coffee, wheat,
pepper, cotton, gold, silver, precious stone or for that matter even
weather, then the derivative is known as a commodity derivative.
If the underlying is a financial asset like debt instruments,

currency, share price index, equity shares, etc., the derivative is
known as a financial derivative.
Derivative contracts can be standardized and traded on the stock

exchange. Such derivatives are called exchange-traded
derivatives. Or they can be customized as per the needs of the
user by negotiating with the other party involved.
Such derivatives are called over-the-counter (OTC) derivatives
Thus, the value of the derivative is dependent on the value of the
underlying.
HISTORY OF
DERIVATIVES
MARKET IN
INDIA
The history of derivatives is surprisingly longer than what most
people think. Some texts even find the existence of the
characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in
incidents that date back to the ages before Jesus Christ.
However, the advent of modern day derivative contracts is
attributed to the need for farmers to protect themselves from any
decline in the price of their crops due to delayed monsoon, or
overproduction.
The first 'futures' contracts can be traced to the Yodoya rice
market in Osaka, Japan around 1650. These were evidently
standardised contracts, which made them much like today's
futures.
The Chicago Board of Trade (CBOT), the largest derivative
exchange in the world, was established in 1848 where forward
contracts on various commodities were standardised around
1865. From then on, futures contracts have remained more or
less in the same form, as we know them today.
Derivatives have had a long presence in India. The commodity
derivative market has been functioning in India since the
nineteenth century with organized trading in cotton through the
establishment of Cotton Trade Association in 1875. Since then,
contracts on various other commodities have been introduced as
well.
Exchange traded financial derivatives (FUTURES AND OPTIONS)
were introduced in India in June 2000 at the two major stock
exchanges, NSE and BSE. There are various contracts currently
traded on these exchanges.
National Commodity & Derivatives Exchange Limited (NCDEX)
started its operations in December 2003, to provide a platform for
commodities trading.
The derivatives market in India has grown exponentially,
especially at NSE. Stock Futures are the most highly traded
contracts on NSE accounting for around 55% of the total turnover
of derivatives at NSE, as on April 13, 2005
Financial Derivatives
market and its
development in India
The first step towards introduction of derivatives trading in India
was the promulgation of the Securities Laws (Amendment)
Ordinance, 1995, which withdrew the prohibition on options in
securities. The market for derivatives, however, did not take off,
as there was no regulatory framework to govern trading of
derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India.
The committee submitted
its report on March 17, 1998 prescribing necessary pre–conditions
for introduction of derivatives trading in India. The committee
recommended that Derivatives should be declared as ‘securities’
so that regulatory framework applicable to trading of ‘securities’
could also govern trading of securities. SEBI also set up a group in
June 1998 under the Chairmanship of Prof. J.R.Varma, to
recommend measures for risk containment in derivative market in
India. The report, which was submitted in October 1998, worked
out the operational details of margining system, methodology for
charging initial margins, broker net worth, deposit requirement
and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in
December 1999 to include Derivatives within the ambit of
‘securities’ and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that
derivatives shall be legal and valid only if such contracts are
traded on a recognized stock exchange. Thus, precluding OTC
derivatives. The government also rescinded in March 2000, the
three–decade old notification, which prohibited forward trading in
securities.
Derivatives trading commenced in India in June 2000 after SEBI

granted the final approval to this effect in May 2001. SEBI
permitted the derivative segments of two stock exchanges, NSE
and BSE, and their clearing house/corporation to commence
trading and settlement in approved derivatives contracts. To
begin with, SEBI approved trading in index futures contracts
based on S&P CNX Nifty and BSE30(Sensex) index. This was
followed by approval for trading in options based on these two
indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001
and the trading in options on individual securities commenced in
July 2001. Futures contracts on individual
stocks were launched in November 2001. The derivatives trading
on NSE commenced with S&P CNX Nifty Index futures on June 12,
2000. The trading in index options commenced
on June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The
index futures and options contracts on NSE are based on S&P CNX
trading. Settlement in derivative contracts is done in accordance
with the rules, byelaws, and regulations of the respective
exchanges and their clearing house/corporations duly approved
by SEBI and notified in the official gazette. Foreign Institutional
Investors(FIIs) are permitted to trade in all exchange traded
derivative products.
The following are some observations based on the trading

statistics provided in the NSE
Report on the futures and options (F&O):
• Single-stock futures continue to account for a sizable proportion
of the F&O segment. It constituted 70 per cent of the total
turnover during June 2002. A primary reason attributed to this
phenomenon is that traders are comfortable with single-stock
futures than equity options, as the former closely resembles the
erstwhile Badla system
• On relative terms, volumes in the index options segment

continues to remain poor. This may be due to the low volatility of
the spot index. Typically, options are considered more valuable
when the volatility of the underlying (in this case, the
Index ) is high. A related issue is that brokers do not earn high
commissions by recommending index options to their clients,
because low volatility leads to higher waiting time for round-trips.
• Put volumes in the index options and equity options segment

have increased since January 2002. The call-put volumes in index
options have decreased from 2.86 in January 2002 to 1.32 in June.
The fall in call-put volumes ratio suggests that the traders are
increasingly becoming pessimistic about the market
.
• Farther month futures contracts are still not actively traded.
Trading in equity options on most stocks for even the next month
was non-existent.
• Daily option price variations suggest that traders use the F&O
segment as a less
risky alternative (read substitute) to generate profits from the
stock price movements. The fact that the option premiums tail
intra-day stock prices is an evidence to this. Calls on Satyam fall,
while puts rise when Satyam falls intra-day.
If calls and puts are not looked as just substitutes for spot trading,
the intra-day stock price variations should not have a one-to-one
impact on the option premiums.
NEED BEHIND USAGE OF DERIVATES
Derivatives market performs a number of economic functions:
1. They help in transferring risks from risk averse people to

risk oriented people
2. They help in the discovery of future as well as current
prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of

participation risk averse people in greater numbers
5. They increase savings and investment in the long run .
The participants in a derivatives market

• Hedgers use futures or options markets to reduce or eliminate
the risk associated with price of an asset.
• Speculators use futures and options contracts to get extra

leverage in betting on future movements in the price of an asset.
They can increase both the potential Gains and potential losses
by usage of derivatives in a speculative venture.
• 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.
Types of Derivatives
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.
WARRANTS: Options generally have life span of up to one year, the

majority of options traded on options exchanges have a maximum
maturity of nine months. Longer-dated options
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. An underlying asset is usually a moving average or a
basket of assets. Equity index options are a form of Basket
options
.
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:
• Interest rate swaps: These entail swapping only the interest

related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and
interest between the parties, with the cash flows in one direction
being in a different currency than those in the opposite direction.
Swap: Swaptions are options to buy or sell a swap that will

become operative at the expiry of the options. Thus a swaption is
an option on a forward swap. Rather than have
Calls and puts, the swaptions market has receiver swaptions and
payer swaptions. A receiver swaption is an option to receive fixed
and pay floating. A payer swaption is an option to
pay fixed and receive floating.
Factors driving the growth of financial

derivatives
1. Increased volatility in asset prices in financial markets.
2. Increased integration of national financial markets with the
international markets.
3. Marked improvement in communication facilities and sharp
decline in their costs.
4. Development of more sophisticated risk management tools,
providing economic agents a wider choice of risk
management strategies.
5. Innovations in the derivatives markets, which optimally
combine the risks and returns
6. Over a large number of financial assets leading to higher
returns, reduced risk as well as low transaction costs as
compared to individual financial assets.
ACCOUNTING OF DERIVATIVES:
The Institute of Chartered Accountants of India (ICAI) has issued
guidance notes on accounting of index futures contracts from the
viewpoint of parties who enter into such
futures contracts as buyers or sellers. For other parties involved in
the trading process, like brokers, trading members, clearing
members and clearing corporations, a trade in equity
index futures is similar to a trade in, say shares, and does not
pose any peculiar accounting problems
Taxation
The Income Tax Act does not have any specific provision
regarding taxability from derivatives. The only provisions, which
have an indirect bearing on derivative transactions are sections
73(1) and 43(5). Section 73(1) provides that any loss, computed
in respect of a speculative business carried on by the assessee,
shall not be set off except against profits and gains, if any, of
speculative business. In the absence of a specific provision, it is
apprehended that the derivatives contracts, particularly the index
futures which are essentially cash-settled, may be construed as
speculative transactions and therefore, the losses, if any, will not
be eligible for set off against other income of the assessee and
will be carried forward and set off against speculative income only
up to a maximum of eight years. As a result, an investor’s losses
or profits out of derivatives even though they are of hedging
nature in real sense, are treated as speculative and can be set off
only against speculative income, that may exceed the cost
associated with leaving a part of the production uncovered.
WORKING OF FUTURES AND

OPTIONS
WORKING OF FUTURES
A futures contract is a type of derivative or financial contract, in

which two parties agree to transact a set of financial instruments
or physical commodities for future delivery at a particular price.
For instance, ‘A’, a farmer, is expecting a good harvest of wheat
but fears that the prevailing price of wheat may decline in the
future. To hedge against this risk of price fluctuation, ‘A’ enters
into a contract with ‘B’ in January 2005 to deliver, at a later date,
50 Kgs of wheat at the present market price. The contract
between A and B is a futures contract and B (buyer) is said to go
long the contract whereas ‘A’ (seller) is said to go short. The price
agreed to, between the parties, for delivery of 50 Kgs of wheat is
called the settlement price. Now, if the prices were to actually
decline, the farmer would walk away with a profit but if the prices
were to go up instead, he would end up making a loss.
Futures can be traded either over-the-counter (OTC) or over an
exchange. Futures traded OTC are also called forwards. While an
OTC future remains open to counter party risk, there is no such
risk in an exchange. This is because in an exchange both the
parties transact only through the exchange and thus, the
exchange is substituted as one of the parties to the contract. In
other words, the exchange plays the role of a guarantor to both
the parties to the contract. This eliminates the possibility of
counter-party risk.
Let us take a closer look at the working of an exchange traded
futures contract.
Working of futures: The clauses of a futures contract, traded on

the exchange, are generally standardized in respect of the
following items:
• Quantity of the underlying asset
• Quality of the underlying asset(not required in financial
futures)
• Date and month of delivery
• The units of price quotation (not the price itself) and the
minimum change in price (tick-size)
• Location of settlement
• The settlement price is agreed to between the parties.
When a futures contract is opened, the exchange prescribes a
minimum amount of money to be deposited by both the parties to
the contract with the exchange. This original deposit of money is
referred to as the initial margin. The exchange also prescribes a
maintenance margin, which is the lowest amount an account can
reach before being replenished again. This must be distinguished
from initial margin, which is merely the minimum deposit required
to enter into a futures contract. When the margin amount falls
below the maintenance margin, a margin call is made requesting
inducement of additional funds so as to bring up the level back to
the initial margin. Let’s say that the initial margin was Rs.1000
and the maintenance margin Rs.500. A series of losses reduced
the amount to Rs. 400. A margin call may be made requiring
inducement of additional funds.
To understand how futures trade, let us consider the following
illustration.
Illustration: A enters into a contract with B for sale of 100 Kgs of
rice at Rs. 10 /kg at a later date. The settlement price for this
future is, therefore, Rs. 1000. Let’s assume the initial margin
requirement to be Rs. 100 (at 10%). Therefore, on the first day of
trading, both A and B will have Rs. 100 each in their accounts.
Now A has taken the short position because he thinks that the
price of rice would decline whereas B has gone long fearing the
prices to rise.
Mark-to-Market: On the next day, if the price of rice were to rise
to Rs.11, A, would suffer a loss (and B a corresponding gain) of
Rs. 100. In other words, Rs. 100 would be deducted form A’s
account and the same amount credited to B’s account. On the
other hand, if the price of rice were to decline, A’s account would
be credited with Rs. 100 and B’s account deducted by the same
amount. Therefore, all profits and losses are settled on a daily
basis. This is known as the mark-to-market system.
Liquidation: If either of the parties wants to liquidate his position
in the futures contract, he can do so by entering into an equal and
opposite transaction to the one that opened the position. This is
called an offsetting transaction. Consider the above example.
Let’s say the settlement price dipped to Rs. 900 and the farmer
made a profit of Rs. 100 in the process. Now he wants to liquidate
his position so that he retains the profits already made without
incurring any further risks of loss. He can do so by entering into
an identical and opposite transaction to achieve the same.
Consider the following flow chart:
Aà B
Settlement Price 1 = Rs. 1000
(Original)
Settlement Price 2 = Rs. 900
(after price decline)
After a decline in the cost of rice, A’s account would be credited
with Rs. 100 and B’s account debited with the same amount.
Aà B
+100 -100
A’s profit = 1000-900 = Rs. 100
Now, if A wants to liquidate his position, he would have to enter
into an equal and opposite transaction. In other words, instead of
going short, he would have to go long on a contract with the same
expiry date and underlying asset, etc.
Cà A
Settlement Price = Rs. 900
Now, let’s take a situation where the price rose to Rs. 1200 after
the previous day’s decline. Under ordinary circumstances, A
would stand to lose Rs. 300 on his short position. However, after
the offsetting transaction with C, as elucidated above, this loss
would be offset by the gains made on his long position in this
contract. In this case, A’s position is said to be closed out as it
does not reap any profits or losses.
Aà B
+100 –300 -100 + 300
Cà A
-300 +300
A’s Net Profit = Rs. 100
Similarly, B can also liquidate his position by going short on an
identical contract.
Settlement: A futures contract that is not liquidated before its
expiry may be settled in either of the following ways:
1. Physical Delivery: This involves the delivery of the
underlying asset by the seller to the buyer in accordance with the
rules of the Exchange. However, the exchange generally
discourages such physical delivery through the exchange as it
makes the exchange vulnerable to arbitration in case of default
by either of the parties.
2. Cash Settlement: Cash settlement is an important
advance and has broadened the reach of derivatives to products
like stock indices where physical delivery is not possible. In cash
settlement, the underlying asset is not physically delivered on the
expiration of the contract. Instead all open positions are settled
by payment of cash based on the difference between the final
settlement price and the previous day’s settlement price.
Theoretically the final price of the futures contract and the spot
market price of the underlying commodity must converge and be
the same. However, this rarely happens and many exchanges are
known to deem the final settlement price of a futures contract to
be equal to the spot market price. In other words, the terminal
settlement price is assumed to be equal to the prevailing spot
market price and cash settlement is effected by computing the
difference between the prevailing spot market price and the
previous day’s settlement price.
Theoretical Pricing of Futures: The price of a future is derived
from the price of the underlying asset of the futures contract. In
other words, the settlement price of the futures contract is the
same as its settlement price.
As explained above, the settlement price in a futures contract is
never standardized but is agreed to between the parties. This
takes place by way of an offer – bid system. However, a
theoretical way of determining the value of a futures contract
may be summed up in the following formula:
Futures Price = Spot Market Price + Cost of Carry
Cost of carry is the sum of all costs incurred if a similar position is
taken in the cash market and carried to the expiry of the futures
contract, less any revenue that may arise out of holding the
asset. The cost typically includes interest cost in case of financial
futures (insurance and storage costs are also considered in case
of commodity futures).
Market Participants: The following are the broad category of
market participants in futures trading:
1. Hedgers: Hedging is a sophisticated mechanism that provides
the necessary immunity to the above interests in the marketing of
commodities from the risk of price fluctuations. It basically
involves the purchase or sale of a futures contract to reduce or
offset the risk of a position in the underlying asset. A hedger gives
up the potential to profit from a favorable price change in the
position being hedged in order to minimize the risk of loss from an
adverse price change.
A hedge may be either short or long. A short hedge involves a
short position in futures contracts. It is appropriate when the
hedger already owns an asset and expects to sell it at some time
in the future or even when an asset is not owned right now but
will be owned some time in the future. Take, for instance, a
farmer who expects a harvest only after 6 months and is unsure
about the price fluctuations. To hedge this risk, the farmer can
enter into a futures contract for sale of rice, 6 months from now,
at the prevailing market price.
Hedges that involve taking a long position in a futures contract
are known as long hedges. A long hedge is appropriate when a
company / individual knows it will have to purchase a certain
asset in the future and wants to lock in a price now. Taking the
same example as above, if a consumer is uncertain about the
price movements of rice, he can hedge his risk by going long a
futures contract at the prevailing market price. This would
neutralize his position in case of inflation. Though hedging
protects from price risk, a hedged position often suffers from
basis risk.
2. Speculators: Hedging on futures markets cannot be practiced
unless there are operators willing to assume the risk of adverse
price fluctuations, which the hedgers desire to transfer. These
operators are called speculators. Their presence in the futures
market is inevitable as they provide liquidity to the markets.
Unlike hedgers, speculators aim to benefit from the inherently
risky nature of the futures market. They do not seek to actually
own the commodity in question. Rather, a speculator enters the
market to make profits by offsetting rising and declining prices
through the buying and selling of contracts. The basic distinction
between a hedge and a speculative transaction on a futures
market is that in case of a hedge there is a corresponding
transaction in the ready market, which is absent in case of
speculation. In general, a speculator takes a view on the market
and plays accordingly. If one is bullish, one can buy futures and if
one is bearish one can sell futures. For e.g. a person who expects
the price of Reliance stock to increase by March can buy a March
Reliance security futures contract. If the price of the stock rises,
he will make a profit on the futures and can liquidate his position
to freeze his profits.
3. Arbitrageurs: Arbitrage is the simultaneous purchase and sale
of similar commodities or securities, such as derivatives, in
different but related markets, in the hope of gaining from the
price differential. Arbitrage opportunities arise when there is a
difference between the spot and futures prices.
Illustration: Suppose Reliance stock is trading at Rs. 500 in the
spot market and the futures price of Reliance stock is trading at
Rs.550. An arbitrageur in this case would buy (let’s say) 100
shares of Reliance in the spot market and sell an equal amount of
futures. He will then hold his position till the expiration of the
futures contract to make a profit of Rs. 5000 (100 x (550 -500)).
Here the arbitrageur is said to lend money in the spot market
when he buys the stock and is said to get his loan repaid when he
settles his futures obligation. The profits that he makes are said
to be the return on his loans.
Leverage: Futures are highly leveraged instruments. Leverage
refers to having control over large cash amounts of commodities
with small levels of capital. In other words, with a relatively small
amount of cash, you can enter into a futures contract that is
worth much more than you initially have to pay. Initial margins
that are set by the exchange are relatively small compared to the
cash value of the contracts in question. The smaller the margin in
relation to the cash value of the futures, the higher the leverage.
In other words, leverage allows exposure to a given quantity of an
underlying asset for a fraction of the investment needed to
purchase that quantity outright.
Due to leverage, if the price of the futures contract moves up
even slightly, the profits made will be very large in comparison to
the initial margin. However, if the price moves downwards, the
same leverage can result in huge losses in comparison to the
initial margin.
Illustration: Consider a futures contract for 100 kg of coffee at
Rs. 80 per kg. The total value of the contract would be Rs. 8000.
Consider an initial margin of 10% on the value of the contract i.e.
Rs. 800. A slight change in the price of coffee by 6.25% (i.e. to Rs.
85) would result in a corresponding gain and loss of Rs. 500 for
the party going long and short respectively. This is a gain / loss of
62.5% with respect to the initial margin deposited for the purpose
of trading in the contract. Please note that the profit amount
remains the same, what is different is the percentage of gain /
loss.
Price Discovery: Apart from the usual purpose of hedging, a
futures contract also aids in the discovery of prices at the spot
market level. Futures prices are a very good indicator of the
demand-supply levels for a particular commodity in a market. This
is because; futures prices are generally determined by the
relative buying and selling interest on a regulated exchange.
However, futures prices do not always lead spot prices.
Studies have shown that when a commodity comes to the market,
the spot market dominates the spot market in price discovery.
Take for instance, a March futures contract for wheat. If wheat is
harvested by March, obviously, consumers would look at the
trading prices in the spot market (assuming there is a price
difference between the spot market and the futures market).
However, for all other contracts, where the commodity has not
reached the market, the futures prices would lead the spot
market prices.
WORKING OF OPTIONS
An option is a contract between two parties wherein the buyer

receives a privilege for which he pays a fee (premium) and the
seller accepts an obligation for which he receives a fee. It gives
the option buyer the right but not the obligation to buy or sell an
underlying at a specific price on or before a certain date [19. The
underlying asset can be stock, index, commodities, futures,
interest rate, etc.
Let’s understand this with the help of an example. Let’s say there
is a plot of land which Mr.A wishes to purchase but does not have
sufficient cash to buy it for another one month. After negotiations
with the owner, a deal is struck whereby the owner gives Mr.A an
option to buy the plot in one months time for a price of Rs.10
lakhs. For buying this option, Mr.A does not have to pay Rs.10
Lakhs but only a fraction of this amount, as agreed to between
the buyer and seller, lets say Rs.50, 000.
The seller of an option is called an option writer, the buyer of an
option is called an option holder, the right to buy an option is
called a call option, the price which the option holder pays for
buying the option is called the option price or the premium and
the price at which the option is exercised is called the strike price
or the exercise price.
After buying this option, either of the following two situations may
arise.
If the market value of the plot increases, Mr.A will exercise his
option of buying the plot for the agreed price and then may sell it
again for making a profit by way of difference between the price
he paid and the present market value of the plot. The option
holder has only the right and not the obligation to buy or sell the
underlying asset but the option writer is obligated to sell or buy, if
the holder exercises the option.
Or, if the market value of the plot shows a downslide, Mr. A will
not exercise his option of buying the plot, in which case his loss
will be limited to the initial amount of
Rs.50, 000 paid by him, to the seller.
Thus, by using an option, Mr.A is able to limit his loss from future
depreciation in value of the plot and is also able to profit from any
increase in the value of the said plot.
Unlike futures where both the parties are required to maintain a
margin as performance bond, in options only the buyer’s
performance bond is in the form of the premium paid to the seller.
Seller is required to pay a margin as his performance bond.
Further, in options, the premium paid by the buyer is forfeitable
unlike futures where the performance bonds of the parties are
maintained with the exchange and are not forfeitable. Options in
India are traded over the exchange as well as OTC.
Kinds of options
1. Call option - A call option gives the option holder a right to
buy an asset at a certain price within a specified period of time. A
call option buyer is said to have a long position.
2. Put option - A put option gives the option holder a right to sell
an asset at a certain price within a specified period of time. A put
option holder is said to have a short position.
Illustration of Put Option

A Farmer Wants To Sell Wheat In The Market After One Month But
Is Unsure Of The Market Prices Or Is Wary Of Falling Market Prices
When His Crop Is Ready To Be Sold. If The Present Market Value
Of Wheat Is Rs.1,000 (For 100 Kgs) The Farmer Will Not Want To
Sell His Produce At A Lesser Price Nor Will He Like To Suffer A
Loss By Selling At The Prevalent Price In Case The Price Of Wheat
Increases In Future. In Such A Situation, Options Provide A Ready
Solution To Him. He Can Buy A Put Option, For Lets Say Rs.100
Where The Value Of The Underlying Is Rs.1, 000. In Other Words,
He Would Have Bought Himself The Right To Sell His Produce For
Rs.1,000 After A Month, By Paying Rs.100 As Premium.
der the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to

develop appropriate regulatory framework for derivatives trading
in India. The committee submitted
its report on March 17, 1998 prescribing necessary pre–conditions
for introduction of derivatives trading in India. The committee
recommended that Derivatives should be declared as ‘securities’
so that regulatory framework applicable to trading of ‘securities’
could also govern trading of securities. SEBI also set up a group in
June 1998 under the Chairmanship of Prof. J.R.Varma, to
recommend measures for risk containment in derivative market in
India. The report, which was submitted in October 1998, worked
out the operational details of margining system, methodology for
charging initial margins, broker net worth, deposit requirement
and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in

December 1999 to include Derivatives within the ambit of
‘securities’ and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that
derivatives shall be legal and valid only if such contracts are
traded on a recognized stock exchange. Thus, precluding OTC
derivatives. The government also rescinded in March 2000, the
three–decade old notification, which prohibited forward trading in
securities.
November 2001. The derivatives trading on NSE commenced with

S&P CNX Nifty Index futures on June 12, 2000. The trading in
index options commenced
On June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The
index futures and options contracts on NSE are based on S&P CNX
trading. Settlement in derivative contracts is done in accordance
with the rules, byelaws, and regulations of the respective
exchanges and their clearing house/corporations duly approved
by SEBI and notified in the official gazette. Foreign Institutional
Investors(FIIs) are permitted to trade in all exchange traded
derivative products.



.
was non-existent.
segment as a less Foreign Institutional Investors(FIIs) are
permitted to trade in all exchange traded derivative products.



.
was non-existent.
segment as a less
risky alternative (read substitute) to generate profits from the
falls intra-day.
-
segment as a less
Risky alternative (read substitute) to generate profits from the
-
If, after a month, the price of wheat increases to Rs.1500, the

farmer will choose not to exercise his option. In such a case, his
loss will be limited to the option price paid by him, which will be
offset against the profit that he makes by selling his produce in
the spot market at Rs.1,500. Here the option is said to be out-of-
money.On the other hand, if the price of wheat falls to Rs.800
after a month, the farmer will exercise his option thereby
protecting himself from selling his produce at a lower price in the
spot market. Here the option is said to be in-the-money.
Leverage - As in futures, one of the biggest advantages of using
an option is the leverage it gives to the investor. By making an
investment in the form of a small premium, the buyer controls a
much larger stake.
Illustration - If the stock of Reliance is trading at Rs.1000, it would
take Rs.1,00,000 to buy 100 shares of the stock. Instead of buying
the stock, Mr.A purchases a call option with a strike price of 100
with expiration after one month. Lets say the premium he pays is
Rs.10 for a share, i.e. Rs.1000 for buying the right to buy 100
shares. Thus, his total investment is Rs.1000.
Lets suppose that the stock rises to Rs.1, 100 after a month. If Mr.
A had purchased 100 shares, the profit that he would have made
is Rs.10,000 (difference between Rs.1,10,000 (Rs.1, 100 x 100)
and Rs.1,00,000), i.e. a profit of 10%. However, by virtue of the
call option bought by Mr. A, on exercising his option of buying the
stock for Rs1, 00,000 and selling the same for Rs.1, 10,000, the
profit that he will be making will be Rs.9, 000 (difference between
investment of Rs.1000 and the profit from sale), i.e. a profit of
900%.
Option Pricing: Option price is the price, which the option holder
pays to the option writer for buying a particular option.
Theoretically, it is the supply and demand in the secondary
market, which drives the option price. Greater the demand for the
underlying higher will be the option price and vice versa. To
understand option pricing, it becomes necessary to define certain
terms.
Intrinsic value of an option is the amount of money that could
currently be realized by exercising the option at its strike price.
An option is said to have an intrinsic value when the option is in
the money. When an option is at-the-money, the intrinsic value is
zero.
Time value is the amount of money, which the option holder is
willing to pay and the option writer is willing to accept, over and
above any intrinsic value of the option. Time value of an option
declines as the option approaches maturity because the volatility
in the price of the underlying reduces.
Reducing option price to a formula, it can be said that:
Option price/premium = Intrinsic value + time value.
In addition to the intrinsic value and time value, price of an option
depends on the price of the underlying, strike price, volatility in
the price of the underlying and risk free rate of interest.
Working of Options
Illustration: On 1st Jan 2006, stock of Wipro is trading at Rs.50
and the premium for a March 55 Call is Rs.5. This means that the
expiration date for the option is last Thursday of March and the
strike price is 55.
Lets say Mr.A has information that the market is bullish and he
makes a decision of buying a March 55 Call. The total price of the
option is Rs.500.
For an option holder to exercise his option, it must yield profit. In
other words, it must have crossed the break-even point. Break-
even point for a call option is the point where the value of the
underlying has crossed a price, which is all inclusive of the option
premium; strike price and the transaction costs. In this case, the
breakeven point will be Rs.60.
After buying the option, till its expiration, there are three things
that Mr.A can possibly do with the option.
1. Exercise the option - An option can be exercised any time
before its expiration . In the above example, if on the day after
buying the option the value of the stock rises to Rs.110, Mr.A may
exercise his option of buying the stock at Rs. 50, in which case, he
makes an immediate profit of Rs.600 (mark-to market) less the
premium paid by him (Rs.500). After exercising his option he may
either continue to hold the stock in anticipation of further price
increase or may sell it in order to make a further profit of Rs.
6,000 (difference between the price paid to buy 100 shares, i.e.
Rs. 5,000 and the price at which shares were sold in the market,
i.e. Rs. 11,000).
2. Continue to hold the option till expiry - If a favorable price
change has not occurred yet, Mr.A may continue to hold the
option till the expiry date still hoping for the anticipated change. If
it does not occur till the last day of trading, the option will not be
exercised and will expire worthless. Loss of Mr.A in not exercising
the option will be limited to Rs.500 (the premium).
3. Offset the option - An option that has been previously
purchased or written can generally be offset at any time prior to
its expiration by making an offsetting sale or purchase. Most
option investors choose to realize their profits or limit their loss
through an offsetting sale or purchase. It must be remembered
that the market may not always be favourable for offsetting an
option position.
Offset of options position by buyer – If the call option for
stock of Reliance is selling at Rs.8, Mr.A is in a profitable position.
He anticipates that the market will be bearish and, therefore
decides to offset his position.
Seller à (A) Buyer
-300 +300
With the option at Rs.11, Mr.A will make a profit of Rs.300. He can
offset his position by selling a call option on stock of Reliance
(same expiry date) at Rs.8, to Mr.C.
(A) Buyer à C
Offset at Rs.800
By offsetting his position, Mr.A realises a profit of Rs.300 along
with the premium (paid by C) in case the stock price makes a
favorable movement.
Offset of options position by seller - If the call option for
stock of reliance is selling at Rs.3, the seller is in a profitable
position.
Seller à (A) Buyer
+200 -200
If he anticipates that the prices will rise, he might want to realize
his profit by offsetting his position, by buying a call option at Rs.3.
By offsetting his position, the seller gets to keep his profit of
Rs.200 and is protected against any future losses in case the
stock price increases.
Seller ß C
Offset at Rs.300
The offsetting procedure is slightly varied when the underlying in
an option is a futures contract. In that case, the buyer or the
seller may offset their options position by entering into an equal
and identical contract. However, if the buyer exercises the option,
the buyer and the seller acquire long and short positions
respectively in the underlying futures. Positions acquired in the
futures can be offset in the manner already explained under
futures.
Market participants: Players operating in options are the

same as those in futures market.
Hedgers – Like futures, options can also be used for hedging. In
case of an unfavourable movement in the value of the underlying,
the maximum that a buyer can lose is the premium paid for the
option, although the profit he can make is unlimited.
Speculators – Speculators use options to gain from the
movement (either ways) in the value of the underlying. They are
willing to take risks in order to profit from price changes in the
underlying . A speculator will buy an option when the strike price
for the option is less than the value of the underlying and will
exercise such option in order to realise the profits because of the
difference between the two prices. Similarly he will sell an option
when the strike price for the option is higher than the value of the
underlying.
Arbitrageurs – An Arbitrageur seek to make a profit from the
difference in the prices in two markets by making simultaneous
transactions in two different markets. For example, an arbitrageur
will buy in the spot market and sell an option or sell in the spot
market and buy an option. If the price of sugar in spot market is
Rs.15 per kg and the strike price for option in sugar is Rs.12 per
kg, to make a profit, the arbitrageur will buy a call on sugar,
exercise his option for buying the sugar at Rs.12 and then sell the
same in the spot market thereby realizing a profit of Rs.3 on
every kg of sugar sold.
These three players increase the volatility in the market and
make it more conducive for trading in options.
Trading strategies
Trading strategies - Participants in the market use
different strategies to maximize their profit or minimize
their loss..
Strategies are specific game plans created by investor based on

idea of how the market will move. Strategies are generally
combinations of various products – futures, calls and puts and
enable you to realize unlimited profits, limited profits, unlimited
losses or limited losses depending on your profit appetite and risk
appetite.
The simplest starting point of a Strategy could be having a clear

view about the market or a scrip. There could be strategies of an
advanced nature that are independent of views, but it would be
correct to say that most investors create strategies based on
views.
There could be four simple views: bullish view, bearish view,

volatile view and neutral view. Bullish and bearish views are
simple enough to comprehend. Volatile view is where one
believes that the market or scrip could move rapidly, but he is not
clear of the direction (whether up or down). He is however sure
that the movement will be significant in one direction or the
other. Neutral view is the reverse of the Volatile view where you
believe that the market or scrip in question will not move much in
any direction.
The following strategies are possible if one has bullish view:
• Buy a Future
• Buy a Call Option
• Sell a Put Option
• Create a Bull Spread using Calls
• Create a Bull Spread using Puts.
If a person buy a Futures Contract, he will need to invest a small

margin (generally 15 to 30% of the Contract value). If the
underlying index or scrip moves up, the associated Futures will
also move up. He can then gain the entire upward movement at
the investment of a small margin. For example, if you buy Nifty
Futures at a price of 1,100 which moves up to 1,150 in say 10
days time, you gain 50 points. Now if you have invested only
20%, i.e. 220, your gain is over 22% in 10 days time, which works
out an annualized return of over 700%.
The danger of the Futures value falling is very important. One

should have a clear stop loss strategy and if your Nifty Futures in
the above example were to fall from 1,100 to say 1,080, you
should sell out and book your losses before they mount.
The
graph of a Buy Futures Strategy appears below:
If one buy a Call Option, His Option Premium is his cost which he
will pay on the day of entering into the transaction. This is also
the maximum loss that he can ever incur. If he buy a Satyam May
260 Call Option for Rs 21, the maximum loss is Rs 21. If Satyam
closes above Rs 260 on the expiry day, he will be paid the
difference between the closing price and the strike price of Rs
260. For example, if Satyam closes at Rs 300, he will get Rs 40.
After setting off the cost of Rs 21, his net profit is Rs 19.
The Call buyer has a limited loss, unlimited profit profile. No

margins are applicable on the buyer. The premium will be paid in
cash upfront. If the Satyam scrip moves nowhere, the buyer is
adversely impacted. As time passes, the value of the Option will
fall. Thus if Satyam is currently at around Rs 260 and remains
around that price till the end of May, the value of the Option
which is currently Rs 21 would have fallen to nearly zero by that
time. Thus time affects the Call buyer adversely.
The graph of a Buy Call position appears below:

Another bullish strategy is to sell a Put Option. As a Put Seller, he
will receive Premium. For example, if he sell a Reliance May 300
Put Option for Rs 18; he will earn an Income of Rs 18 on the day
of the transaction. You will however face a risk that you might
have to pay the difference between 300 and the closing price of
Reliance scrip on the last Thursday of May. For example, if
Reliance were to close on that day at Rs 275, he will be asked to
pay Rs 25. After setting of the Premium received of Rs 18, the net
loss will be Rs 7. If on the other hand, Reliance closes above Rs
300 (as per your bullish view), the entire income of Rs 18 would
belong to him.
As a Put Seller, one is required to put up Margins. These margins

are calculated by the exchange using a software program called
Span. The margins are likely to be between 20 to 35% of the
Contract Value. As a Put Seller, you have a limited profit,
unlimited loss profile which is a high risk strategy. If time passes
and Reliance remains wherever it is (say Rs 300), he will be very
happy. Passage of time helps the Sellers as value of the Option
declines over time.
The
profile of the Put Seller would appear as under:
Bull Spreads
First of all, Spreads are strategies which combine two or more

Calls (or alternatively two or more Puts). Another series of
Strategies goes by the name Combinations where Calls and Puts
are combined.
Bull Spreads are those class of strategies that enable you benefit
from a bullish phase on the index or scrip in question. Bull
spreads allow you to create a limited profit limited loss model of
payoff, which you might be very comfortable with.
Creating Bull Spreads
Bull spreads can be created using Calls or using Puts. One need to
buy one Call with a lower strike price and sell another Call with a
higher strike price and a spread position is created. Interestingly,
one can also buy a Put with a lower strike price and sell another
with a higher strike price to achieve a similar payoff profile.
various bearish strategies

The following major choices are available:
• Sell Scrip Futures

• Sell Index Futures
• Buy Put Option
• Sell Call Option
• Bear Spreads
• Combinations of Options and Futures
In the current Indian system, when one sell Scrip Futures, he is

not required to deliver the underlying scrip. One will be required
to deposit a certain margin with the exchange on sale of Scrip
Futures. If the Scrip actually falls (as per your belief), one can buy
back the Futures and make a profit. For example, Satyam Futures
are quoting at Rs 250 and one sell them today as you are bearish.
One could buy them back after 10 days at say Rs 230 (if they fall
as per your expectations), generating a profit of Rs 20. Question
of delivering Satyam does not arise in the present set up.
You will be required to place a margin with the exchange which

could be around 25% (an illustrative percentage). If you
accordingly place a margin of Rs 62.50, a return of Rs 20 in 10
days time works out to a wonderful 30% plus return.
Obviously, if Satyam Futures move up (instead of down) He face

an unlimited risk of losses. He should therefore operate with a
stop loss strategy and buy back Futures if they move in reverse
gear.
One could adopt the same strategy with Index Futures if you are
bearish on the market as a whole. Similar returns and risks are
attached to this strategy.
Put Option help in a bearish framework.
The Put Option will rise in value as the scrip (or index) drops. If
One buy a Put Option and the scrip falls (as one believe), he can
sell it at a later date. The advantage of a Put Option (as against
Futures) is that his losses are limited to the Premium he pay on
purchase of the Put Option.
For example, a Satyam 260 Put may quote at Rs 21 when Satyam

is quoting at Rs 264. If Satyam falls to Rs 244 in 8 days, the Put
will move up to say Rs 31. He can make a profit of Rs 10 in the
process.
No margins are applicable on you when one buy the Put. One
need to pay the Premium in cash at the time of purchase.
If one is moderately bearish (or neutral or bearish), he can

consider selling a Call. He will receive a Premium when he sell a
Call. If the underlying Scrip (or Index) falls as he expect, the Call
value will also fall at which point he should buy it back.
For example, if Satyam is quoting at Rs 264 and the Satyam 260

Call is quoting at Rs 18, you might well find that in 8 days when
Satyam falls to Rs 244, the Call might be quoting at Rs 7. When
you buy it back at Rs 7, you will make a profit of Rs 11.
However, if Satyam moves up instead of down, the Call will move

up in value. You might be required to buy it back at a loss. One is
exposed to an unlimited loss, but one’s profits are limited to the
Premium he collect on sale of the Call. He will receive the
Premium on the date of sale of the Option. You will however be
required to keep a margin with the exchange. This margin can
change on a day-to-day basis depending on various factors,
predominantly the price of the scrip itself.
One should be very careful while selling a Call as he is exposed

to unlimited losses.
Use Bear Spreads
In a bear spread, One buy a Call with a high strike price and sell a
Call with a lower strike price. For example, one could buy a
Satyam 300 Call at say Rs 5 and sell a Satyam 260 Call at Rs 26.
He will receive a Premium of Rs 26 and pay a Premium of Rs 5,
thus earning a Net Premium of Rs 21.
If Satyam falls to Rs 260 or lower, he will keep the entire Premium
of Rs 21. On the other hand if Satyam rises to Rs 300 (or above)
he will have to pay Rs 40. After set off of the Income of Rs 21, his
maximum loss will be Rs 19.
Satya Profit Profit Premiu Net

m on 260 on 300 m Profit
Closin Strike Strike Receive
g Call Call d on
Price (Gross) (Gross) Day
One
250 0 0 21 21
255 0 0 21 21
260 0 0 21 21
270 -10 0 21 11
281 -21 0 21 0
290 -30 0 21 -9
300 -40 0 21 -19
310 -50 10 21 -19 The pay off
profile
appears as under:
In in a bear spread, one’s profits and losses are both limited.

Thus, one is safe from an unexpected rise in Satyam as
compared to a clean Option sale.
Combinations of Futures and Options

If one sell Futures in a bearish framework, he run the risk of
unlimited losses in case the scrip (or index) rises. He can protect
this unlimited loss position by buying a Call. This combination will
result effectively in a payoff similar to that of buying a Put.
He can decide the strike price of the Call depending on his

comfort level. For example, Satyam is quoting at Rs 264 currently
and you are bearish. You sell Satyam Futures at say Rs 265. If
Satyam moves up, you will make losses. However, you do not
want unlimited loss. You could buy a Satyam 300 Call by paying a
small Premium of Rs 5. This will arrest your maximum loss to Rs
35.
If Satyam moves up beyond the Rs 300 level, he will receive

compensation from the Call, which will offset your loss on Futures.
For example, if Satyam moves to Rs 312, he will make a loss of Rs
37 on Futures (312 – 265) but make a profit of Rs 12 on the Call
(312 – 300). For this comfort, you shell out a small Premium of Rs
5, which is a cost.
STRADDLES, STRANGLES AND BUTTERFLIES …
STRADDLES AND STRANGLES
As a seller of these strategies, one is are to unlimited risk. Most

option writers would prefer to sell strangles rather than straddles.
As one is aware, a straddle sale comprises of a call and a put sold
at the same strike price. For example, if you sell a Satyam 240
Strike Straddle with Call and Put premium at Rs 11 and Rs 13
respectively, you will receive Rs 24 as Income and the two break
even points will be Rs 216 and Rs 264 respectively.
If Satyam moves below Rs 216 or Rs 264, his losses are unlimited.
In a Strangle, the loss range becomes wider as the Call and Put
are at different strike prices. For example, one could sell a
Satyam 220 Strike Put at Rs 5 and a Satyam 260 Strike Call at Rs
6. While he could earn lower premium of Rs 11 (as against Rs 24),
his break-even points are much wider at Rs 209 and Rs 271
respectively.
As a seller of options with a neutral view, one should sell strangles

rather than straddles – this is a relatively lower risk lower return
strategy.
As a buyer of volatility, one would rather buy straddles most of

the time (rather than strangles) as he would expect to profit
faster in a straddle than the strangle. He would consider the
premium that it costs him to buy a straddle, but if that is
reasonable then one would actively pursue this strategy.
The pay off diagrams of the straddle and strangle for the buyer
and seller
STRADDLE BUYER
STRADDLE SELLER
Butterfly
If one is a seller, He is exposed to unlimited losses in both

straddles and strangles..
The butterfly strategy helps one to achieve this result. He would

in this case, cut the wings of your straddle. To cut the wings,
Hewould buy a Call with a higher strike price and buy another put
with a lower strike price than that of the Straddle.
Example:
One has sold a Straddle on Satyam with Strike Price 240 and
generated an Income of Rs 24 (as above). He could buy a 260
Strike Call for Rs 5 and buy a 220 Strike Put for Rs 6. This would
cost you Rs 11, thus reducing your Net Income to Rs 13. It will
however insure you from losses at both ends.
The final payoff table will emerge as under:
Satyam Profit on Profit on Profit on Profit on Net

Closing 240 Call 260 Call 220 Put 240 Put Profit
Price Sold Bought Bought Sold Including
Initial
Income
of Rs 13
200 0 0 20 -40 -7
210 0 0 10 -30 -7
220 0 0 0 -20 -7
230 0 0 0 -10 3
240 0 0 0 0 13
250 -10 0 0 0 3
260 -20 0 0 0 -7
270 -30 10 0 0 -7
280 -40 20 0 0 -7
Thus, he will generate a maximum profit of Rs 13 if Satyam

remains at your Straddle Strike price of Rs 240. his maximum loss
is restricted to Rs 7 which happens when Satyam moves either
below Rs 220 or above Rs 260. This loss is capped on both sides.
Conclusions:
Straddle, Strangle and Butterfly are very useful and practical

strategies for neutral and volatile views on the market (index) or
on individual stocks. You need to have a clear view and need to
pick underlying with good volumes and liquidity in order to
execute these strategies well. You also need to keep one eye on
volatility all the time.
RESEARCH WORK
INTRODUCTION TO RESEARCH TOPIC
The study is based on findings how to minimize the risk that is

involved in portfolio using index futures.
What is the meaning of risk Risk is a concept which relates to
human expectations. It denotes a potential negative impact to an
asset or some characteristic of value that may arise from some
present process or from some future event expected returns for
an investor .For an investor it is often defined as the unexpected
variability or volatility of returns, and thus includes both potential
worse than expected as well as better than expected returns. In
stock market an investor constructs a portfolio of stocks in which
he puts his investments.
In context of equity market portfolio an investor has stocks of
those companies in which he has invested his money. Share
prices are subject to fluctuations in share market. So investor
instead of putting his in one kind of stock diversify his investment
by investing in various different stocks. He does this to safe guard
himself from price fluctuations in stock prices. In case the price of
one stock in which he has invested falls in share market and price
of other stock rises in the market. At least he can minimize his
risk by earning from that share whose prices have risen.
OBJECTIVES OF THE STUDY

Every aspect of the research is done keeping in mind some
definite objectives. The objectives of my study are as mentioned
here under:
 Finding out relationship between stock prices and changes in
value of the index.

 How hedging by way of index futures help us to minimize the
risk.
 Finding out how arbitrage opportunities exist between spot
market and derivatives market.

 Find out how far index prices are responsible for bringing
fluctuations in share prices.
RESEARCH METHODOLOGY
Research refers to search of knowledge.
RESEARCH DESIGN
The research design of my study “HEDGING AND ARBITRAGE
THROUGH INDEX FUTURES” is descriptive.
SAMPLING DESIGN
POPULATION : STOCKS OF NSE
SAMPLING TIME : 1st MAY 2006 TO 30th JUNE 2006
SAMPLING UNIT : NSE STOCKS
SAMPLING SIZE :10 STOCKS
SAMPLING TECHNIQUE : CONVENIENCE SAMPLING
DATA COLLECTION
ALL THE SOURCES OF DATA ARE SECONDARY IN NATURE. DATA IS

COLLECTED THROUGH VARIOUS SITES AVAILABLE ON NET.
LIMITATIONS OF THE STUDY
1.The main limitation of this study is that we have taken past
data to predict the future prices of stocks and performance in the
past does not predict the future with 100 percent accuracy.
2.It is not feasible to take into account stocks of all sectors
because the numbers of sectors are very large.
3.Another main limitation of this study is that HEDGING BY WAY
OF INDEX FUTURES is not cent percent accurate. It can minimize
the risk but risk cannot be eliminated totally.
Before going for data analysis one needs to
understand the following terms:
BETA:
A statistical measure of the relative volatility of a stock,

fund, or other security in comparison with the market as a
whole. The beta for the market is 1.00. Stocks with betas
above 1.0 are more responsive to the market, but are also
more risky investments. Stocks with a beta below 1.0 are
less responsive to the market. For example, if the market
moves 1%, a stock with a beta of 3.00 will move 3%; a
stock with a beta of .5 will move 5%.
 INDEX FUTURES:
A future contract in which underlying asset is index in the
stock market is known as index futures. For each index
there may be a different multiple for determining the price
of the futures contract. For example, the S&P 500 index is
one of the most widely traded index futures contracts in the
U.S. Often stock portfolio managers who want to hedge risk
over a certain period of time will use the S&P 500 index
future to do so. By shorting these contracts, stock portfolio
managers can protect themselves from downside price risk
of the broader market. However, by using this hedging
strategy, if perfectly done, the manager's portfolio will not
participate in any gains on the index; instead the portfolio
will lock in gains equivalent to the risk-free rate interest.
Alternatively stock portfolio managers can use index
futures to increase their exposure to movements in a
particular index, essentially leveraging their portfolio. In our
study we have hedged our portfolio using Nifty Futures
(whose underlying index is S&P CNX Nifty) which is an
index futures contract traded on National Stock Exchange
with a minimum lot size of 100.
 COFFICIENT OF CORELATION(r):
It measures the degree of relationship between two
variables. The value of “r” greater than 0.75 indicates high
degree of correlation between two variables.
 COEFFICIENT OF DETERMINATION (r2) :

It is defined as the ratio of the explained variance to the
total variance. If cofficient of determination is 0.8, it means
that 80% of the variation in the dependent variable has
been explained by independent variable.
HOW ONE CAN GAIN IN DERIVATIVES MARKET?
For Gaining In The Derivatives Market, One Will Have To Take

Position In Derivatives Market By Selling Index Futures Of Nifty.
How Many Contracts One Needs To Sell Is A Big Problem So
That One Can Cover The Risk Totally. For That Beta Of The
Portfolio Needs To Be Studied Which Is Computed By
Regressing The Historical Changes In The Value Of Portfolio On
The Changes In The Prices Of Index.
WHAT IS HEDGING AND WHY IS IT REQUIRED?
Protection against downside risk is known as hedging. To hedge

something is to construct a protective fence around it. Applied
to financial markets, hedging means eliminating the risk in an
asset or a liability. Applied to stock market, hedging means
eliminating the risk in an investment portfolio.
One hedges a portfolio because one wants its value to be

locked at particular level. In other words, one do not want any
exposure to price changes. The benefit from hedging is that
one will not lose from subsequent price changes; and the loss
from hedging is that no gain either. One should note that
both benefit and loss from hedging are non-monetary: the
benefit is the protection and the loss is the opportunity.
DATA ANALYSIS
In my study I have chosen a portfolio that consists of ten

securities from different sectors. With exposure to
software, petrochemicals, steel, pharmacy, banking,
cement etc the portfolio is a fair proxy of real market
index. Here I am going to explain how hedging using index
futures would be effective if the investor is afraid of
downside risk in the market.
STOCKS QTY MKT PRICE AMT.(RS)

RELIANCE 800 1059.85 847880
ONGC 800 1108.05 886440
INFOSYSTCH 250 3078.95 769737.5
SBIN 500 727.75 363875
WIPRO 500 513.35 256675
ITC 1550 182.4 282720
CIPLA 1000 216 216000
MARUTI 250 796.7 199175
ACC 300 783.95 235185
TATASTEEL 700 533.65 373555
TOTAL Portfolio Value as on 30/06/06 4431242
This is the portfolio I am studying. The value of portfolio

on 30th June 2006 is Rs.4431242. Here I am going to
explain how hedging using index futures would be
effective if the investor is afraid of downside risk in the
market as he is going to hold the portfolio for the next two
months.
Since I am using index futures as a proxy for the portfolio

being hedged, I need to know the quantitative
relationship between them. For example, we must
establish how much the portfolio will change in value for a
unit change in the value of index futures which is known
as portfolio beta.
Before studying portfolio beta, firstly past data

regarding prices of shares involved in portfolio need to be
studied to know how share prices have behaved in the
past with respect to changes in price of index.
Prices of stocks for past two months(02nd May-30th
June2006)
ON
DATE RELIANCE INFOSYS SBIN WIPRO ITC CIPLA MARUTI ACC TATASTEEL
02-May-06 1031.15 1323.85 3164.25 937.65 539.3 207.5 263.05 942.2 991.2 671.05
03-May-06 1035.55 1332.25 3171.4 961.7 539.2 208.9 266.5 963.45 985.4 665.4
04-May-06 1080.2 1328.65 3211.3 958.95 540.85 209.4 268.2 957.65 975.05 656.25
05-May-06 1099.25 1364.95 3212.1 953.85 539.45 208.45 275.55 940.7 987.55 640.45
08-May-06 1155 1379.35 3228.25 956.9 538.5 207.8 272.4 939.55 1007.2 644.5
09-May-06 1154.1 1439.9 3237.15 976.05 538.7 206.35 274.7 965.8 1002.9 659.95
10-May-06 1169.8 1484.2 3256.25 1002.2 542.6 205.05 273.4 952.95 977.25 668.1
11-May-06 1110.25 1456.75 3256.05 976.45 544.85 203.75 271.05 937.2 964.95 639.05
12-May-06 1066.85 1420.5 3242.3 958.65 544.55 201.5 269.8 932.8 897.45 643.85
15-May-06 1021.65 1368.4 3151.1 923.9 534.6 191 259.8 885.75 862.85 586.65
16-May-06 1043.7 1361.25 3150.05 923.95 534.15 194.8 263.25 882.3 904.35 574.25
17-May-06 1086.2 1442.4 3208.2 989.7 543.95 204.3 257.95 912.55 908.7 611.9
18-May-06 1004.8 1349.2 3033.95 906.35 507.55 191.15 245.35 820.5 799.6 545.05
19-May-06 978.1 1288.05 2974.45 869.1 487.7 179.9 223.9 783.55 751.2 504.3
22-May-06 929.4 1207 2823.7 859.8 441.8 171.55 227.2 748.6 726.65 470.9
23-May-06 967.1 1235.55 2910.65 872.55 474.15 178 225.45 805.7 752.75 510.75
24-May-06 938.55 1163.2 2860.95 867.85 454.4 174.1 230.9 762.7 769.15 483.9
25-May-06 950 1204.95 2828.55 870.5 486.25 181.4 222.05 792.95 792.5 515.85
26-May-06 958.5 1179.75 2934.25 874.45 475 183.2 235.7 791.7 799.2 538.95
29-May-06 955.95 1194.65 2967.7 881.85 470.65 177.95 237.55 791.3 799.95 562.15
30-May-06 954.95 1179.15 3026.5 860.25 471.1 176.5 241.5 768.85 779.95 547
31-May-06 954.15 1116.25 2909.85 832.65 449.7 165.4 229.35 735 762.9 517.2
01-Jun-06 925.35 1064.75 2829.85 818.75 444.7 160.15 218.8 683.6 740.65 488.95
02-Jun-06 958.1 1126.9 2886 838.75 469.9 164.4 223 769.7 786.4 517.8
05-Jun-06 925.35 1085.65 2824.25 813.95 457.5 160.05 218.05 736.05 742.75 494.4
06-Jun-06 906.5 1039.8 2765.4 840.1 445.2 152.55 212.7 730.9 726.45 480.35
07-Jun-06 893 993.65 2763.25 806.65 445.35 151.8 211.65 715.5 709 460.9
08-Jun-06 825.7 959.45 2703.8 768.4 419.55 147.65 198.35 718.1 700.7 424.9
09-Jun-06 922.75 991.55 2794.65 771.6 434.9 160.5 203.85 770.05 754.85 456.05
12-Jun-06 901.05 977.15 2763.2 746.4 422.3 154.4 198.5 750.65 715.85 426.85
13-Jun-06 858.65 977.05 2639.1 750.55 395.3 146.25 191.2 702.3 704.9 388.1
14-Jun-06 858.45 989.7 2485.2 741.25 389.5 147.35 191.9 680.75 695.4 384.15
15-Jun-06 895.35 1030.65 2727.05 772.15 420 155.6 201.3 715.55 736.7 413.8
16-Jun-06 921.6 1012.65 2801.15 766.85 440.5 163.2 210.85 727.5 732.1 460.3
19-Jun-06 933.7 1018.9 2871.2 753.3 435.85 164.55 222.25 755.85 766.8 476.4
20-Jun-06 925 1012.6 2844 736.75 421.9 161.65 216.9 752.95 760.05 465.85
21-Jun-06 964.15 1026.55 2923.25 739.9 438.9 168.75 220.1 757.25 769.5 477.9
22-Jun-06 975.1 1063.05 2951.85 773.45 450.45 170.85 225.25 776.5 778.95 489.5
23-Jun-06 1011.9 1100.4 2991.55 762.65 469.6 170.8 226.3 773.1 786.2 512.6
25-Jun-06 1007.2 1113.55 2989.65 754.1 475.35 171.75 226.7 776.85 782.35 532.35
26-Jun-06 981.2 1066.35 2900.2 728.65 463.9 166.3 218.1 735.75 746.15 496.75
27-Jun-06 985.75 1062.7 2967.45 730.05 473.9 175.95 214.85 721.3 754.75 518.55
28-Jun-06 1000.95 1034.45 2974.5 714.6 484.15 177.05 212.85 723.25 746.25 514.3
29-Jun-06 1008.35 1055 2993.65 708.7 496.7 175.8 209.8 733.65 740.1 509.7
30-Jun-06 1059.85 1108.05 3078.95 727.75 513.35 182.4 216 796.7 783.95 533.65
Graph show ing com parision betw een portfolio stocks and index
4000
3500
RELIANCE
3000 ONGC
INFOSYSTCH
2500 SBIN
WIP RO
2000 ITC
CIP LA
1500 MARUTI
ACC
1000 TATASTEEL
NIFTY
500
Dates
After looking at this graph one can observe the changes

in the prices of shares that are involved in the portfolio.
One can observe there is fall in the market prices of all
shares included in the portfolio.
PORTFOLIO
6000000
5000000
VALUE
4000000
3000000 PORTFOLIO
2000000
1000000
0
30/05/2006
27/06/2006
02/05/2006
16/05/2006
13/06/2006
DATES
The value of portfolio has fallen by 11.41% between two

dates 2nd may 2006 and 30 th June 2006.
Before going further one needs to study whether there is

any association between market index and value of our
portfolio. For this coefficient of correlation is to be
calculated.
Calculating coefficient of correlation :

DATE PORTFOLIO VALUE % Change NIFTY % Change
02-May-06 5000857.5 3595
03-May-06 5030097.5 0.585 3612.4 0.484
04-May-06 5063877.5 0.672 3627.4 0.415
05-May-06 5099437.5 0.702 3644.1 0.460
08-May-06 5164930 1.284 3685.85 1.146
09-May-06 5240690 1.467 3712.95 0.735
10-May-06 5299947.5 1.131 3745.4 0.874
11-May-06 5186245 -2.145 3692.9 -1.402
12-May-06 5087310 -1.908 3633 -1.622
15-May-06 4875862.5 -4.156 3462.05 -4.705
16-May-06 4899567.5 0.486 3520.3 1.683
17-May-06 5095447.5 3.998 3641.25 3.436
18-May-06 4716810 -7.431 3363.85 -7.618
19-May-06 4511935 -4.344 3224.35 -4.147
22-May-06 4293722.5 -4.836 3020.9 -6.310
23-May-06 4449257.5 3.622 3190.5 5.614
24-May-06 4318667.5 -2.935 3087.25 -3.236
25-May-06 4409775 2.110 3180.15 3.009
26-May-06 4453497.5 0.991 3179.15 -0.031
29-May-06 4483342.5 0.670 3175 -0.131
30-May-06 4453752.5 -0.660 3125.35 -1.564
31-May-06 4285337.5 -3.781 3032.4 -2.974
01-Jun-06 4133660 -3.539 2889.9 -4.699
02-Jun-06 4312450 4.325 3061.55 5.940
05-Jun-06 4169632.5 -3.312 2957.3 -3.405
06-Jun-06 4077097.5 -2.219 2902.8 -1.843
07-Jun-06 3987277.5 -2.203 2838.05 -2.231
08-Jun-06 3812417.5 -4.385 2705.6 -4.667
09-Jun-06 4024180 5.555 2831.25 4.644
12-Jun-06 3916742.5 -2.670 2716 -4.071
13-Jun-06 3777862.5 -3.546 2629.15 -3.198
14-Jun-06 3733200 -1.182 2618.25 -0.415
15-Jun-06 3950675 5.825 2786.7 6.434
16-Jun-06 4038887.5 2.233 2880.75 3.375
19-Jun-06 4104240 1.618 2909.4 0.995
20-Jun-06 4050210 -1.316 2839.35 -2.408
21-Jun-06 4149127.5 2.442 2912.1 2.562
22-Jun-06 4240960 2.213 2982.25 2.409
23-Jun-06 4332847.5 2.167 3042.25 2.012
25-Jun-06 4353212.5 0.470 3043.9 0.054
26-Jun-06 4190737.5 -3.732 2930.6 -3.722
27-Jun-06 4239905 1.173 2981.1 1.723
28-Jun-06 4223295 -0.392 2983.5 0.081
29-Jun-06 4246315 0.545 3003 0.654
30-Jun-06 4431242.5 4.355 3118 3.830
Graph show ing com parison betw een % change in PORTFOLIO and INDEX
8.000
6.000
4.000
2.000
0.000
PORTFOLIO
INDEX
-2.000
-4.000
-6.000
-8.000
-10.000
DATES
This graph shows how percentage change in the value of portfolio
is in tune with the market. As market has risen portfolio has
reacted to that in the same manner. Similarly when markets have
fallen, portfolio value has diminish in the same manner.
FORMULA FOR COEFFICIENT OF CORRELATION(R)=
R =Σ xy/(N*σ x *σ y)
Σ xy=covariance of x and y
N=No of observations
σ x=standard deviation of x i.e independent variable
σ y= standard deviation of y i.e dependent variable
Covariance is the sum of product of deviations of x and y variable

taken from mean.
It is statistical function. The value of cofficient of

correlation comes out to be 0.97. This value indicates that
changes in value of portfolio is associated with change in
the value of nifty.Thus I came to know there is high
degree of correlation between portfolio stocks and index .
Since I am using index futures as a proxy for the portfolio being

hedged, I need to know the quantitative relationship between the
two. For that, I need to calculate how much the portfolio will
change in value for a unit change in the value of index futures.
This relationship is portfolio beta.
PORTFOLIO BETA
FORMULA FOR CALCULATING BETA=
COVAR (x,y)/VAR(y) * N/(N-1)
y = value of underlying index i.e. independent variable
x = Value of portfolio i.e. dependent variable
N = No of days for which data is taken.
Covariance is the sum of product of deviations of x and y variable taken from

mean
Beta of Portfolio = (9.674/11.03226) * (45/44) = 0.9
BETA VALUES INTERPRETATION

More than 1 % Change in portfolio is more than % change in index
Equal to 1 Change in portfolio is same as that of index
Lesser than 1 % Change in portfolio is less than % Change in index
In our portfolio the value of beta is 0.9, it indicates
that risk in our portfolio is 90% that of risk in the market
that means risk is still present. The value of portfolio on
30th June is RS.4431242. The investor is looking for
holding the portfolio for the next two months. But he is
afraid that after two months the value of portfolio might
decrease in value or he expects downward trend in the
market in next two months. Thus, he is taking a risk by
investing in the stocks. He can minimise this risk using
index futures, by selling index futures in the derivatives
market.
Selling index futures in derivatives market would minimise risk to

some extent that he would face in spot market by gaining in the
derivative contract.
In our case S&P CNX Nifty index would be underlying asset. For
selling index futures, there is market lot that is fixed by the
exchange. In case of nifty futures lot size is 100. There are three
future month contracts available for trading at the same time.
Therefore in our case, the investor can sell any index future
month contract among july/aug/sep. month contracts, since the
investor is going to hold the portfolio for two months i.e. till 31st
August,2006 therefore he will be selling the nifty index futures for
the month of august expiry only.
In our case selling index futures can help us to minimize
risk. How many contracts he is required to sell of index futures,
this would be calculated using the following formula:
No of contracts =
Portfolio beta * (Current value of portfolio/(Current market price of

nifty futures * market lot size of nifty futures)).
Portfolio Beta O.9
Current value of Portfolio Rs.
4431242
Current market price for Nifty Rs. 3100
Futures
(August contract)
Market lot size of Nifty Futures 100
= 0.9 * (4431243 / (3100*100))

= 12.86 contracts of Nifty Futures
Although one is required to sell 12.86 contracts of Nifty Futures

but, since the minimum market lot size for Nifty Futures is 100,
therefore to hedge one’s portfolio one will be selling minimum 13
contracts of nifty futures (or 1300 nifty futures).
Now there are two options available to him, either he can
keep his portfolio till expiry date on he can square up his portfolio
in between that is before the expiry date. In future there can be
two possible situations:
 The market may moves up or
 The market may go down.
In case the market moves up investor will gain by appreciation in
value of portfolio and losses in the index futures. In case the
market goes down the investor will gain in index futures and bear
losses due to fall in value of portfolio.
SITUATION RESULT
IN CASE MARKET MOVES UP GAIN IN PORTFOLIO AND
LOSS IN INDEX FUTURES
IN CASE MARKET GOES DECREASE IN THE VALUE OF
DOWN PORTFOLIO AND GAINS IN
THE INDEX FUTURES
If the investor squares off his position in between the hedge period i.e.
before expiry on 31st August,2006 :
Let us presume that the investor decides to square up his
portfolio which he had entered on 1st July, 2006 with an
investment of Rs.4431242 before the expiry date for August
contract i.e. 31st August, 2006 on 31st July,2006.
STOCKS QTY. PRICE AS ON 31st July, 2006 AMOUNT

RELIANCE 800 978.8 783040
ONGC 800 1173.15 938520
INFOSYSTCH 250 1655.55 413887.5
SBIN 500 810.25 405125
WIPRO 500 490.8 245400
ITC 1550 167.4 259470
CIPLA 1000 236 236000
MARUTI 250 787.85 196962.5
ACC 300 843.8 253140
TATASTEEL 700 496.2 347340
PORTFOLIO VALUE as on 31st July, 2006 4078885
The value of portfolio On 31st July is Rs.4078885 whereas

originally the value of our portfolio on 30th June was
Rs.4431242, that means the value of our portfolio has fallen by
Rs.352357.
In derivatives market the value of nifty futures (August
contract) on 31st July is Rs.3111.45, whereas to hedge the
portfolio the investor had earlier sold the Nifty Futures contract
at Rs. 3100 on 1st July. Therefore he has also incurred loss in
Nifty Futures of Rs. 14885((3100-3111.45)*1300).
Thus in total he has incurred a loss of
Rs.367242(352357+14885).
If the investor holds his position till 31st august 2006:

If the investor holds his position till 31st august 2006, then he
would square up his position in same way as done on 31st July.
HOW TO TAKE ADVANTAGE OF ARBITRAGE OPPORTUNITIES
BETWEEN THE CAPITAL MARKET AND FUTURES MARKET:
There exist a good opportunity to make riskless returns in the
stock market by exploiting the arbitrage opportunities that
exist between the capital market and the futures market. A
person can take arbitrage position in the stock market by
buying shares in the capital market and simultaneously
shortselling the same number of shares in the futures market.
Since the minimum lot size for each futures stock is defined in
market, therefore an investor has to buy those minimum
number of shares in the capital market to take perfect
arbitrage position between the futures market and the capital
market.
Now With the help of an example we can analyze how one can
take the advantage of arbitrage opportunities that exist due to
the difference in the prices of the capital market and the futures
market. In our example we have taken the capital and future
price data for Reliance Industries for the period of May expiry i.e.
from 28th April, 2006 to 25th May, 2006.
CAPITAL
Date FUTURE PRICE PRICE DIFFERENCE
28-Apr-06 1012 1008.9 3.1
29-Apr-06 1030.5 1022.95 7.55
2-May-06 1042 1031.15 10.85
3-May-06 1041.85 1035.55 6.3
4-May-06 1089 1080.2 8.8
5-May-06 1113.8 1099.25 14.55
8-May-06 1177 1155 22
9-May-06 1168 1154.1 13.9
10-May-06 1184.5 1169.8 14.7
11-May-06 1117 1110.25 6.75
12-May-06 1076.15 1066.85 9.3
15-May-06 1016.5 1021.65 -5.15
16-May-06 1057 1043.7 13.3
17-May-06 1092.2 1086.2 6
18-May-06 1005 1004.8 0.2
19-May-06 980 978.1 1.9
22-May-06 924.9 929.4 -4.5
23-May-06 964 967.1 -3.1
24-May-06 938 938.55 -0.55
25-May-06 949.65 950 -0.35
One can easily notice the price difference between the two
markets i.e. the Capital Market and the Futures Market. These
price differences do exist between the two markets because of
the Cost of Carry. Due to this Cost of Carry the Futures market
(stock) trades at a premium to the capital market(stock).
Now whenever there exist 1% difference between the Capital

market and the Futures market, one can create an arbitrage
position by buying 600 shares in the capital market of Reliance
and simultaneously selling one lot of 600 shares in the futures
market. Since the minimum lot size of Reliance in the Futures
market is 600 shares, therefore a trader will be required to buy
minimum 600 shares of Reliance in the capital market.
In the table given above the 1% difference arises on 2nd May,

2006, therefore the trader will buy 600 shares in the capital
market and simultaneously sell one lot of 600 shares in the
futures market. Now he has created an arbitrage position
between the two markets at a difference of Rs.10.85. Now one
can see as the month passes the difference between the two
markets starts decreasing and almost converges on the last day
of expiry, i.e. on the 25th May 2006. This is the day when the
trader can reverse or square up his arbitrage position by selling in
the capital market and simultaneously buying in the futures
market. In this way he made a riskless profit of
Rs.6300((10.85-.35)*600).
Results & findings
Thus main results of my study:
1.Selling index futures in the

derivative market
Can minimize the risk faced by investor holding portfolio in the
cash market but it is not in every case. Generally amount of
loss incurred by investor in spot market is offset by profit
earned by selling index futures in derivatives market.
2.No of index futures is also dependent on the beta value
Beta value No of contracts
0.9 12.86=13 contracts
1 14.29=14 contracts
1.2 17.15=17 contracts
Thus number of contracts to be sold of index futures is

dependent on the value of portfolio beta value.
3.In case the amount of loss would be fully compensated by

profits earned that would be known as perfect hedge.
.
Still there are lots of limitations of this study.
 The index futures cannot be sold or bought in fractional
quantities which is known as basis risk in case of index
futures keep on changing day to day
 There is cumbersome procedure of mark to market in case
of index futures.
 Also there is tracking error between cash position and
futures position as they are not identical and relationship
between them is not constant.
 In case of arbitrage, cost of carry changes daily as it is
dependent on demand and supply forces in the market.
Thus index futures are a way to minimise the risk involved in
portfolio by selling index futures in the derivatives market.
Risk of loss in trading in derivatives can be substantial. One
should carefully consider whether trading is appropriate for
him in the light of his experiences. Derivatives trading thus
require not only necessary financial resources but also
financial and emotional temperament,
Suggestions and recommendations
1. Every investor should not blindly enter in to the market. He

should try to study the market thoroughly and then take
position in to derivatives market.
2. The margin amount should be reduced so that more
positions can be taken in the derivatives by paying small
amount of margins. And more and more investors can trade
in derivatives market in India.
3. For arbitrage opportunities in derivatives market investor
must try to calculate the price of asset so as to know
whether there is overpricing or under pricing of shares in
derivatives and spot market.
Conclusion
Thus one can say that index futures are useful to cover the risk
but it can’t eliminate the risk totally .It can minimise the risk to
some extent I would conclude my study by saying that
Derivatives are a tool available to minimize the risk to a particular
extent only.
Annexures and bibliography

www.valuenotes.com
www.nseindia.com
www.bseindia.com
ncfm module
www.indiainfoline.com
Disclaimer
The content of the analysis done by the summer trainees under the premises of
SMC cannot be copied, reproduced, republished, uploaded, posted, transmitted or
distributed for any non-personal use without obtaining prior permission from SMC
Global Securities Limited.
SMC Global Securities Limited is not responsible for the content of any of the
linked sites. By providing access to other web-sites, SMC Global Securities
Limited is neither recommending nor endorsing the content available in the linked
websites
The information gathered is to enable the students in their course of study and if
need arises, SMC reserves the right and may disclose such information to other
authorities in good faith.
Disclaimer
The content of the analysis done by the summer trainees under the premises of
SMC cannot be copied, reproduced, republished, uploaded, posted, transmitted or
distributed for any non-personal use without obtaining prior permission from SMC
Global Securities Limited.
SMC Global Securities Limited is not responsible for the content of any of the
linked sites. By providing access to other web-sites, SMC Global Securities
Limited is neither recommending nor endorsing the content available in the linked
websites
The information gathered is to enable the students in their course of study and if
need arises, SMC reserves the right and may disclose such information to other
authorities in good faith.

Derivative Project Report

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PROJECT REPORT

HEDGING AND ARBITRAGE

 ACCOUNTING and taxation OF DERIVATIVES

 WORKING OF FUTURES AND OPTIONS

INTRODUCTION TO STOCK MARKET

1.More and more returns

2.Planning or securing one’s future.

4.Saving for children’s education

6.Hedging against devaluation

The growth of economy and hence, development of nation

CAPITAL MARKET is a market for long-term funds.

ABOUT CAPITAL MARKET

The major borrowers in this sector are corporate, agriculture

Capital market is divided into debt market and equity market. In

CAPITAL MARKET IS FURTHER DIVIDED INTO

PRIMARY MARKET: It is the market where the security is issued for

SECONDARY MARKET: The secondary market is represented by

Stock exchange is a corporation or mutual organization which

VARIOUS STOCK EXCHANGES IN THE WORLD

Frankfurt Stock Exchange

New York Stock Exchange

Singapore Stock Exchange

Tokyo Stock Exchange

Bolsa de Valores de Lima

ROLE OF STOCK EXCHANGE

Raising capital for businesses

The Stock Exchange provides companies with the facility to raise

Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to a

Facilitate company growth

By giving a wide spectrum of people a chance to buy shares and

By having a wide and varied scope of owners, companies

Creates investment opportunities for small investors

Government raises capital for development projects

The Government and even local authorities like municipalities

Barometer of the economy

At the stock exchange, share prices rise and fall depending,

The concept of stock markets came to India in 1875, when

In this part of my analysis, I have dealt with Derivatives

Let us move on to understand concept of derivatives.

The word 'derivative' has its origin from mathematics and

Derivatives are financial instruments that have no intrinsic value,

The primary objectives of any investor are to maximize returns

Derivatives are specialised contracts which signify an agreement

Let's say the cost of production is Rs 8,000 per ton. In order to

If the underlying is a financial asset like debt instruments,

Derivative contracts can be standardized and traded on the stock

Derivatives trading commenced in India in June 2000 after SEBI

The following are some observations based on the trading

• On relative terms, volumes in the index options segment

• Put volumes in the index options and equity options segment

Derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to

4. They increase the volume traded in markets because of

The participants in a derivatives market

• Speculators use futures and options contracts to get extra

• Arbitrageurs are in business to take advantage of a

Forwards: A forward contract is a customized contract between

Futures: A futures contract is an agreement between two parties

WARRANTS: Options generally have life span of up to one year, the

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation

• Interest rate swaps: These entail swapping only the interest

Swap: Swaptions are options to buy or sell a swap that will