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ACKNOWLEDGEMENT Iam thankful to the management of R.L.P SECURITIES Pvt Ltd.

for their kind gesture of allowing me to undertake this project, and its various employees who lent their helping hand towards the completion of this study The co-operation I received from the wide cross-section of employees of RLP makes it difficult to single out individuals for acknowledgement. However, I am particularly indebted to The Managing Director, Dr. R.M.C.V.PRASAD for allowing me to carry out my project work in the organization and Vice president, Mr.G.MURALIDHAR for guiding & apprising me of the Situation with necessary background and helping me to complete this project. I am also thankful to the staff of RLP SECURITIES Pvt Ltd., for providing their guidance to complete this project. I would like to thank Mr. RAJU and MR. SUBBA RAO sir, professors of Vignana Jyothi institute of management for guiding me through out the project and I am thankful to all my friends who have co-operated me in completion of this project.

DECLARATION

I hereby declare that project entitled derivatives done at R.L.P Securities Pvt.ltd to Vignana Jyothi Institute of Management in the partial fulfillment of the requirement for awarding the degree of POST GRADUATION DIPLOMA IN MANAGEMENT Is my original work and is not submitted for the award of any other degree or other similar title by me or any other person.

Date: Place: Hyderabad E.Sudha Parimala

INDEX

OBJECTIVES LIMITATIONS REASEARCH METHODOLOGY COMPANY PROFILE INTRODUCTION


HISTORY OF SEBI DEFINITION OF STOCK EXCHANGE REGULATION OF STOCK EXCHANGE

DERIVATIVES
INTRODUCTION SPOT TRADE FORWARDS

FUTURES
PARTICIPANTS IN FUTURES MARKET TYPES OF FUTTURES PARTIES IN FUTURES MARKET VALUATION OF FUTURES AND FORWARDS FUTURES TERMINOLOGY MARGINS

OPTIONS
TYPE OF OPTIONS PAY OFF PROFILES OF OPTION HOLDER BLACK SCHOLES PRICING MODEL FACTORS EFFECTING PRICE OF AN OPTION

ANALYSIS CONCLUSIONS

NATURE OF THE PROBLEM


The turnover of stock exchange has been tremendously increasing from past 10 years. The number of trades and the number of investors who are taking part have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Prior to SEBI abolishing the BADLA system the investors had this system as source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk. In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors are seeking for Hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading as a first step. It has set up at 24-member committee under the Chairmanship of Dr.L.C. Gupta to develop the appropriate regulatory framework for derivative trading in India. SEBI accepted the recommendations of the committee on May 11th, 1998 and approved the phased introduction of the derivatives trading beginning with stock index futures. There are many investors who are willing to trade in the derivative segment, because of its advantages like, limited loss and unlimited profit by paying the small premiums.

OBJECTIVES

TO ANALYSE THE DERIVATIVES MAKET IN INDIA TO ANALYSE IN DETAIL THE OPERATIONS OF FUTURES AND OPTIONS TO FIND OUT THE PROFIT / LOSS POSITION OF THE OPTION WRITER AND OPTION BUYER. TO ANALYSE THE ROLE OF STOCK EXCHANGES LIMITATIONS The following are the limitations of this study The scrip chosen for analysis is TATA STEEL and the contract taken is April ending 2008 ending one-month contract. The data collected is completely restricted to the TATA STEEL of April 2008, hence this analysis cannot be taken as universal.

REASEARCH METHODOLOGY

The following steps are involved 1) SELECTION OF THE SCRIP The scrip selection is done on a random basis, and the scrip selected is TATA STEEL. The following points are to be studied Profitability position of the option holder and the option writer Open interests positions of the contract at different strike prices 2) DATA COLLECTION The data of the TATA STEEL has been collected from the NSE website. The data consists of the April contract and the period of data collection is from 1ST APRIL to 24th April 2008. 3) ANALYSIS The analysis consists of the tabulation of the data, assessing the profitability of the option holder and the option writer, representing the data with the graphs and making the interpretation using the data.

. COMPANY PROFILE R.L.P SECURITIES PVT LTD

R.L.P Securities Pvt ltd is one of the leading Stock Brokers operating in all segments of Capital / Derivative / Commodity Markets and also Depository Participant. The company is a corporate Members of NSE / BSE / NCDEX / MCX and Depository Participant (CDSL).

It has branches all over Andhra Pradesh through Branch / Franchisee Network. It has state of the Art Communication facilities and a strong Back Office team with a dedicated Analytical wing. The company brings out a Daily Research Report at around 9:00 am and weekly review on Sunday. (Samples Enclosed)

The company has strong Financials backed by Institutional tie-ups for undertaking large orders on a continuous basis in all Markets and Segments.R.L.P has Exclusive Terminals, headed by Senior Managers, to cater to High Value Clients, whose Data is maintained with utmost confidentiality. It implements Direct Pay Out of Securities to Clients from Stock Exchanges. The SERVICE COST will be very competitive and match the BEST in the industry.

SECURITIES EXCHANGE BOARD OF INDIA

HISTORY OF STOCK EXCHANGE The stock exchange operating in the 19th century was that of Bombay set up in 1875 and Ahmedabad set up in 1894. Those were organized as voluntary non-profit making association of brokers to regulate and protect their interests. Before the control on securities trading became the central subject under the constitution in 1950, It was a state subject. The Bombay securities exchange (control) act of 1925, used to regulate trading in securities. Under this act, The Bombay stock exchange was recognized in 1927 and Ahmedabad in 1937. DEFENITION OF STOCK EXCHANGE Stock exchange means any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. It is an association of member brokers for the purpose of selfregulation and protecting the interests of its members. After the formation of Indian Republic, The stock Exchanges have become a central subject, Under The Ministry of Finance and were governed by the Securities Contract (Regulation) Act, 1956. The recognition of Stock Exchanges were granted under section 3 of the Act.

BYE LAWS OF THE STOCK EXCHANGES

Besides the above Act, The Securities Contract (regulation) rules, 1957 regulates the rules & regulations of trading on The Stock Exchanges. The BYE LAWS of the Exchanges, Governs the smooth functioning of the Stock Exchanges and also covers the following subjects: Opening/closing of stock exchanges, Timing of trading, Regulation of blank transfers, Regulation of Badla/carry forwards (FUTURES & OPTIONS), Control of settlements and other activities of Stock Exchange, Fixation of margins, Fixation of market prices or Making up prices, Regulation of jobbers etc Regulation of Brokers Trading, Brokerage charges, Trading Rules on The Exchange, Arbitration and Settlement of Disputes, Settlement and Clearing of Trading etc., REGULATION OF STOCK EXCHANGES The Securities Contract (Regulation) Act is the basis for operations of the Stock Exchange in India. No exchange can operate legally without the Recognition. The Stock exchanges are given monopoly in certain areas under section 19 of the above act to ensure that the Control and Regulations are facilitated.

Recognition can also be withdrawn, if necessary. Where there are no stock exchanges, the government can license some of the brokers to perform the functions of Stock Exchange on its absence. The securities under stock exchange are traded in three forms Spot trade Futures Options

DERIVATIVES A Derivative instrument, broadly, is a financial contract whose payoff structure is determined by the value of an underlying commodity, security, interest rate, share price, index, exchange rate, oil price. Thus, a derivative instrument by itself does not constitute ownership. It instead, is a promise to convey ownership. All derivatives are based on some cash products. The underlying basis of a derivative instrument may be any product including Commodities including grain, coffee beans, orange juice etc Precious metals like gold and silver Foreign exchange rate Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies etc Short term debt securities such as T-bills; and Over-the counter (OTC) money market products such as loans or deposits

SPOT TRADE The purchase or sale of Foreign Currency or Share or Commodity for immediate Delivery or Payment. Spot trades are settled on "SPOT" basis i.e., on cash & carry basis. Also known as "cash trades. Spot trades are the opposite of futures contracts, which usually expire well before any physical delivery. Foreign-exchange contracts are the most common kinds of spot trades.

If these kinds of contracts are not settled immediately, traders would expect to be compensated for the time value of their money for the duration of the delivery. Because these contracts are settled electronically, the forex market is essentially instantaneous. SPOT PRICE The current price at which a particular commodity can be bought or sold at a specified time and place In other words, the price that is quoted if you want to buy any commodity today

FORWARD In a forward contract, the buyer agrees to pay cash at a later date when the seller delivers the goods. As an analogy of a forward contract. Typically in a forward contract, the price at which the underlying commodity or asset will be traded is decided at the time of entering into the contract. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. Thus, by entering into forward contract, one is assured of the price at which one can buy/sell goods or other assets. It is evidently a good means of avoiding price risk DELIVERY PRICE- The price at which the contract is agreed LONG POSITION- The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value. SHORT POSITION- The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.

Pay-off for long position Pay-off for short position

St-E E-St

St>E Gain Loss

St=E Break even Break even

St<E Loss Gain

ST= MARKET PRICE E =AGREED PRICE

LONG POSITION Gain

SHORT POSITION Gain

E of asset at St

price of the Asset at St E

price

Loss

Loss

On Maturity If market price (St)>agreed price (E) the buyer stands to gain If market price (St)<agrees price (E) the seller stands to gain

FUTURES A futures contract is a standardized contract between two parties where one of the parties commits to sell, and the other to buy, a stipulated quantity (and quality, where applicable) Of a commodity, currency, security, index or some other specified item at an agreed price on a given date in the future. The futures contracts are standardized ones, so that The quantity of the commodity or the other asset which would be transferred or would form the basis of gain/loss on maturity of a contract The quality of the commodity if certain commodity is involved-and the place where delivery of the commodity would be made The date and month of delivery The units of price quotation, The minimum amount by which the price would change and the price limits for a days operation, and other relevant details are all specified in a futures contract. DELIVERY MONTH The month in which a contract expires and delivery of the underlying asset or cash is required. Different types of futures contracts will have a series of different delivery months. As these months are specific to the underlying commodity, they will differ with a change in the specifications of the underlying or contract.

CLEARING HOUSE It is an intermediary for each contract. Once a futures price is agreed upon between the buyer and the seller and the trade is completed, the clearinghouse of the exchange become the opposite party to each one of the parties. Thus, when an investor goes long a Futures contract, he/she effectively buys it from the clearinghouse and similarly, when one goes short a future contract, one is infact liable to the clearing house only. MARGINS The fees collected on transactions from buyers and sellers to execute the contract is known as margin. Thus, when a contract is entered into both the buyer and seller are required to deposit a margin on the contract. PARTICIPANTS IN FUTURES MARKET HEDGERS: Hedger is one who is engaged in a business activity where an unacceptable price risk exists. Hedgers are investors who would like to reduce their risk. The hedgers use derivative segment in order to reduce or eliminate risk. SPECULATORS Speculators are such people who are financially capable of bearing such risk. In fact, the speculative demand for futures contracts is much greater in volume and frequency than the hedging demand. A speculator does not have an economic activity that requires the use of futures but rather finds investments opportunities in the futures market and takes position in an attempt to make profit from the price movements. SCALPERS They are individuals who engage in continuous buying and selling of contracts on their own behalf. They work on low margins but their continuous trading enables them to make good profits on their operations. Of course, when the markets show greater grater volatility, they can make handsome profits.

ARBITRAGERS The arbitragers come into action once hey find that the prices in the spot market and the futures market, or in the futures market in respect of different maturities are deviating from the normal. They thrive on inefficiencies of the market and so there actions help keep the market efficient and functioning well.

TYPES OF FUTURES On the basis of the underlying asset they derive, the futures are divided into two types STOCK FUTURES The stock futures are the futures that have the underlying asset as the individual securities. The settlement of the stock futures is of cash settlement and the settlement price of the future is the closing price of the underlying security. INDEX FUTURES Index futures are the futures, which have the underlying asset as an index. The index futures are also settled. The settlement price of the index futures is the closing value of the underlying security.

Parties in the futures contract There are two parties in a future contract, the buyer and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is one who is SHORT on the futures contract. The payoff for the buyer and the seller of the futures contract are as follows: PAYOFF FOR A BUYER OF FUTURES

PROFIT P E2 F L LOSS

E1

CASE 1 The buyer bought the future contract at (F), if the futures price goes to E1 then the buyer gets the profit of (FP). CASE 2: The buyer gets loss when the futures price goes less than (F), if the futures price goes to E2 then the buyer gets the loss of (FL)

PAYOFF FOR A SELLER OF FUTURES

PROFIT P

E1

E2

L LOSS F-FUTURES PRICE E1, E2-SETTLEMENT PRICE CASE 1 The seller sold the future contract at (F), if the futures price goes to E1 then the seller gets the profit of (FP) CASE 2 The seller gets loss when the future price goes greater than (F), if the futures price goes to E2 then the seller gets a loss of (FL)

VALUATION OF FUTURES AND FORWARDS Carrying price model It is defined as the value of one unit of the asset underlying the contract, is equal to the sum of the spot price and the carrying costs incurred by the buying and holding on to the deliverable asset, less the carry return, if any Price = Spot price + carrying costs carry return Spot price- The current price of of unit of the deliverable asset in the market Carry costs- It refers to the holding costs, including the interest charges on borrowing the cash to buy (or the opportunity cost of using ones own funds) the asset. Carry return- It refers to the income, such as dividends on shares, which may accrue to the investor.

This can also be expressed as


T

F=S (1+r)
Where r- cost of financing T time till expiration

Pricing index futures given expected dividend amount: The pricing of index futures is also based on the cost of carry model where the carrying cost is the cost of financing the purchase of the portfolio underlying the index, minus the present value of the dividends obtained from the stocks in the index portfolio. Example Nifty futures trade on NSE as one, two and three month contracts. Money can also be borrowed at a rate of 15% per annum. What will be the price of a new two-month futures contract on nifty? 1. Let us assume that ACC will be declaring a dividend of Rs 10/per share after 15 days of purchasing of contract 2. Current value of nifty is 1200 and nifty trade with a multiplier of 200(lot size) 3. Since nifty is traded in multiplies of 200 value of the contract is 200*1200 = 240000 4. If ACC has a weight of 7% in nifty, its value in nifty is 16800 i.e. (240000*0.07) 5. If the market price of ACC is Rs 140,then a traded unit of nifty involves 120 shares of ACC i.e. (16800/140) 6. To calculate the futures price we need to reduce the cost of carry to the extent of dividend received is Rs 1200 i.e. (120*10). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received for unit of nifty. Hence, we divide the compounded figure by 200 7. Thus futures price
60/365 45/365

F=1200(1.15)

- ( 120*10(1.15)

) = Rs 1221.80

Pricing index futures given expected dividend yield If the dividend flow through out the year is generally uniform i.e. if there are few historical cases of clustering of dividends in any particular month. It is useful to calculate the annual dividend yield

F=S (1+r-q) Where F futures price S spot index value r cost of financing q expected dividend yield T holding period Example A two-month futures contract trades on the NSE. The cost of financing is 15% and the dividend yield on nifty is 2% annualized. The spot value of nifty is 1200. What is the fair value of the futures contract?
60/365

Fair value= 1200(1+0.15-0.02) Pricing stock futures

= Rs 1224.35

A futures contract on a stock gives its owner the right and the obligation to buy or sell the stocks. Like index futures, stock futures are also cash settled. There is no delivery of the underlying asset Pricing stock futures when no dividend is expected The pricing of stock futures is also based on the cost of carry model, where the carrying cost is the cost of financing the purchase of the stock, minus the present value of the dividends obtained from the stock. If no dividends are expected during the life of the contract. Pricing futures on that stock is very simple. It simply involves multiplying the spot price by the cost of carry. Example SBI futures trade on NSE as one, two and three month contract. Money can be borrowed at 15% per annum. What will be the price of a unit of new two-month futures contract on SBI if no dividends are expected during the period?

Assume that the spot price of SBI is 228


60/365

Thus, futures price F=228(1.15)

= Rs.223.30

Pricing stock futures when dividends are expected. When dividends are expected during the life of futures contract, pricing involves reducing the cost of carrying to the extent of the dividends. The net carrying cost is the cost of financing the purchase of the stock, minus the present value of the dividends obtained from the stock. Example ACC futures trade on NSE as one, two and three months contracts. What will be the price of a unit of new two-month futures contract on ACC if dividends are expected during the period? 1. Let us assume that ACC will be declaring a dividend of Rs.10.00 per share after 15 days of purchasing the contract. 2. Assume that the market price of ACC is Rs.140.00. 3. To calculate the futures price, we need to reduce the cost of carrying to the extent of the dividend received. The amount of dividend received is Rs.10.00. The dividend is received 15 days later and hence, compounded only for the remaining 45 days. 4. Thus, the futures price
60/365 45/365

F = 140(1.15)

- 10(1.15)

= Rs.133.08

FUTURES TERMINOLOGY: Spot Price: The price at which an asset trades in spot market. Futures price: The price at which the futures contract trades in the futures market. Expiry date: It is the date specified in the futures contract. This is the last date on which the contract will be traded, at the end of which it will cease to exist. Contract Size: The amount of asset that has to be delivered under one contract. For instance, contract size on NSE futures market is 100 Nifties. Basis / Spread: In the context of financial futures basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In formal market, basis will be positive. This reflects that futures price will normally exceed spot price. Cost of carry: The relation between futures prices and spot prices can be summerised in terms of what is known as the cost of carry. This measures the storage cost, plus the interest that is paid to finance the asset, less the income earned on the asset. Multiplier: It is pre-determined value, used to arrive at the contract size. It is the price per index point. Tick size: It is the minimum size difference between two quotes of similar nature. Open interest: Total outstanding long / short positions in the market in any specific point of time. As total long positions for market would be equal to total short positions for calculation of open interest, only one side of the contract is counted. Long position: Outstanding / unsettled purchase position at any point of time. Short position: Outstanding / unsettled sale position at any point of time.

MARGINS Margins are the deposists, which reduce counter party risk, arise in a futures contract. These margins are collected in order to eliminate the counter party risk. There are three types of margins INITIAL MARGIN Whenever a futures contract is signed, both buyer and seller are required to post initial margin. Both buyer and seller are required to make security deposits that are intended to guarantee that they will infact be able to fulfill their obligation. These deposits are initial margins and they are often referred as performance margins. The amount of margin is roughly 5% to 15% of total purchase price of futures contract. MARKING TO MARKET MARGIN The process of adjusting the equity in an investors account in order to reflect the change in the settlement price of futures contract is known as MTM margin. MAINTENANCE MARGIN The investor must keep the futures equity to or greater than certain percentage of the amount deposited as initial margin. If the equity goes less than that percentage of initial margin, then the investor receives a call for an additional deposit of cash known as maintenance margin to bring the equity up to the initial margin. Role of margins The role of margins in futures contract is expected in the following example S sold a satyam June futures contract to B at Rs 480; the following table shows the effect of margins on the contract. The contract size of satyam is 600. The initial margin is say 45000,the maintenance margin is say 65% of initial margin

Day

Price of satyam

Effect on buyer (B) MTM P/L Bal. In margin

Effect on seller (S) MTM P/L Bal. In margin

Remarks

480

Contract is entered & initial margin deposited +3000 -3000 +3000

485(say price increased)

Due to increase in price B got a profit and S got a loss, s deposited the mark to market margin B incurred loss and deposited mark to market margin B again incurred a loss and deposited MTM

470(price decreased)

-6000 Net loss is -3000

+ 3000 Net gain

475(price increased)

-3000 Total net loss Total net gain is is -6000 +6000

OPTIONS An option is a legal contract, which gives the holder the right to buy or sell a specified amount of underlying asset at a fixed price within a specified period of time. It gives the holder the right to buy (or sell) a designated asset. The holder is, however not obliged to sell (or buy) the same. PROPERTIES OF OPTIONS Options have several unique properties that set them apart from other securities. The following are the properties of options Limited loss High leverage potential Limited life There are two parties to option contract One party takes long position that is, it buys the option and is called the buyer, while the other takes short position, that is, it sells the option and is known as the writer to the contract. Types of options The options are classified into various types on the basis of various variables. The following are the various types of options 1) On the basis of the underlying asset: On the basis of the underlying asset the options are divided into two types INDEX OPTION The index options have the underlying asset as the index. STOCK OPTION A stock option gives the buyer of the option the right to buy/ sell stock at a specified price. Stock options are options on the individual stocks, there are currently around 230 stocks are traded in this segment. 2) On the basis of market movement:

On the basis of the market movement the options are divided into two types. They are CALL OPTION A call option is bought by an investor when he seems that the stock price moves upwards. A call option gives the holder of the option the right but not the obligation to BUY an asset by a certain date at a certain price. PUT OPTION A put option is bought by an investor when he seems that the stock price moves downwards. A put option gives the holder of the option the right but not the obligation to SELL an asset by a certain date at a certain price. Option type Call Put Buyer of option (Long position) Right to buy asset Right to sell asset Writer of option (Short position) Obligation to sell asset Obligation to buy asset

3) On the basis of exercise of option: On the basis of the exercising of the option, the options are classified into two categories AMERICAN OPTION: American options are options that can be exercised at any time up to the expiration date, most exchange-traded options are American. In India all stock specific are American. EUROPEAN OPTION: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options. In India Indices Options are European. Pay-off profile for buyer of a call option

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

PROFIT R E2 ITM S OTM ATM P LOSS

E1

S-SPOT PRICE SP-PREMIUM/LOSS E1-SPOT PRICE1 E2-SPOT PRICE2 SR-PROFIT AT SPOT PRICE E1 OTM-OUT OF THE MONEY ATM-AT THE MONEY ITM-IN THE MONEY CASE1:(spot price>strike price) As the spot price (E1) of the underlying asset is more than the strike price (S). The buyer gets the profit of (SR), if the price increases more than E1 than profit also increase more than SR. CASE2:(spot price<strike price) As the spot price (E2) of the underlying asset is less than strike price (S). The buyer gets loss, if the price goes down less than E2 than also his loss is limited to his premium (SP). Pay-off profile for seller of call option:

The pay-off of seller of call option depends on the spot pric of the underlying asset. The following graph shows the pay-off of seller of call-option PROFIT P ITM S E1 R LOSS ATM E2 OTM

S-SPOT PRICE SP-PREMIUM/LOSS E1-SPOT PRICE1 E2-SPOT PRICE2 SR-PROFIT AT SPOT PRICE E1 OTM-OUT OF THE MONEY ATM-AT THE MONEY ITM-IN THE MONEY CASE1:( spot price<strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The seller gets the profit of SP, if price decreases less then E1 than also profit of the seller does not exceed (SP) CASE2:(spot price>strike price) As the spot price (E2) of the underlying asset is more than strike price (S). The seller gets loss of (SR), if price goes more less than E2 then the loss of the seller also increase more than (SR)

Pay-off profile for the buyer of a put option The pay-off of buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of buyer of a call option PROFIT R ITM E2 E1 S OTM P LOSS

S-SPOT PRICE SP-PREMIUM/LOSS E1-SPOT PRICE1 E2-SPOT PRICE2 SR-PROFIT AT SPOT PRICE E1 OTM-OUT OF THE MONEY ATM-AT THE MONEY ITM-IN THE MONEY CASE1:(spot price<strike price) As the spot price (E1) of the underlying asset is less than strike (S). The buyer gets the profit of (SR), if price decreases less than E1 than the profit also increases more than (SR). CASE2:(spot price>strike price) As the spot price (E2) of the underlying asset is more than strike price (S). The buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium.

Pay-off profile for the seller of a put option The pay-off of seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option P ATM E1 S OTM R

ITM E2

S-SPOT PRICE SP-PREMIUM/LOSS E1-SPOT PRICE1 E2-SPOT PRICE2 SR-PROFIT AT SPOT PRICE E1 OTM-OUT OF THE MONEY ATM-AT THE MONEY ITM-IN THE MONEY CASE1:(spot price<strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The seller gets the loss of (SR), if price decreases less than E1 than the loss also increases more than (SR). CASE2:(spot price>strike price) As the spot price (E2) of the underlying asset is more than strike price (S). The seller gets the profit of (SP) , if price gets more than E2 than the profit of the seller is limited to his premium(SP) BLACK SCHOLES PRICING MODEL:

The principle that options can completely eliminate market risk from a stock portfolio is the basis of black scholes pricing model in 1973. Interestingly, before Black and Scholes came up with their option pricing model, there was a wide spread belief that the expected growth of the underlying ought to effect the option price. Black and Scholes demonstrated that this is not true. The beauty of Black and Scholes model is that like any good model, it tells us what is important and what it is not. It does not promise to produce the exact prices that show up in the market, but certainly does a remarkable job of the pricing options within the framework of the model. The following are the assumptions: There are no transactions costs and taxes. The risk from interest rate is constant. The markets are always open and trading is continuous. The stock pays no dividend. During the option period the firm should not pay any dividend. The option must be European option. There are no short selling constraints and investors get full use of short sale proceeds. The options price for a call, computed as per the following Black Scholes formula:
(RF)(T)

Vc = Ps N(d1)-Px/(e)

N(d2)

The value of put option as per Black Scholes formula is:


(RF)(T)

Vp = Px/ (e)

N(d2) - N(d1)

Where 2 d1 = In [Ps/Px]+T[RF+(S.D) /2] / S.D(sqrt (T)) d2= d1-S.D(sqrt(T)) Vc = value of call option Vp = value of put option Ps = current price of the share

Px = exercise of the share RF = Risk free rate T = Time period remaining to expiration. N(d1) = After calculation of d1, value normal distribution area is to be identified. N(d2) = After calculation of d2, value normal distribution area is to be identified. S.D = Risk rate of the share In = Natural log value of ratio of Ps and Px.

FACTORS EFFECTNG THE PRICE OF AN OPTION The following are the various that factors that affect the price of an option. They are Stock price The pay-off from a call option is the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. Strike price In the case of a call, as the strike price increases, the stock price has to make a larger upward move for the option to go in-the money. Therefore, for a call, as the strike price increases, options become less valuable and as the strike price decreases, options become more valuable. Time to expiration Both put and call American options become more valuable as the time to expiration increases. Risk free interest rate The put option prices decline as the risk-free rate increases where as the prices of calls always increase as the risk-free interest rate increases Dividends Dividends have the effect of reducing the stock of reducing the stock price on the exchange dividend date. This negative effect on the value of call options and a positive affect on the value of put options.

ANALYSIS
The objective of this analysis is to evaluate the profit/loss position of option holder & option writer. This analysis is based on the sample data, taken TATA STEEL scrip. This analysis considered the April ending contract of the TATA STEEL. The lot size of TATA STEEL is 382. The time period in which this analysis is done is from 1-4-2008 to 24-4-2008. Price of TATA STEEL in the cash market DATE MARKET PRICE 1-4671.40 2008 2-4648.85 2008 3-4660.15 2008 4-4661.40 2008 7-4680.55 2008 DATE MARKET PRICE 8-4657.05 2008 9-4678.85 2008 10-4- 684.80 2008 11-4- 693.25 2008 15-4- 692.15 2008 DATE MARKET DATE MAREKT PRICE PRICE 16-4- 691.15 24-4- 776.35 2008 2008 17-4- 717.80 2008 21-4- 776.25 2008 22-4- 782.40 2008 23-4- 797.50 2008

GRAPH ON THE PRICE MOVEMENTS OF THE TATA STEEL

MARKET PRICECHART
1000 800 600 400 200 0
00 8 00 8 8 00 8 20 08 00 8 00 8 20 0 /2 /2 /2 /2 /2 20 08

DAYS

MARKET PRICE

4/

4/

1/ 4

3/ 4

9/ 4

16 /4

21 /4

7/

11 /

PRICE

The closing price of TATA STEEL at the end of the contract period is 776.35 and this is considered as the settlement price. The following table explains the amount of transaction between the option holder and the option writer The first column explains the trading date

The second column explains the market price in cash segment on that date The call column explains the call/put options, which are considered. Every call/put has three sub columns The first column consists of the volume of the contract, and the third column consists of total premium value paid by the buyer

23 /

4/

NET PAYOFF FOR CALL OPTION HOLDERS AND WRITERS AS ON 1ST APRIL
Profit to holder(on a Lot size Premium single lot) Net profit/loss to holder Net profit/loss to writer 660 382 43 73.35 28019.7 -28019.7 680 382 30.9 65.45 25001.9 -25001.9 700 382 22.8 53.55 20456.1 -20456.1 720 382 17 39.35 15031.7 -15031.7 740 382 11.4 24.95 9530.9 -9530.9 760 382 8 8.35 3189.7 -3189.7 780 382 6.05 -9.7 -3705.4 3705.4 800 382 5 -28.65 -10944.3 10944.3 820 382 0 -43.65 -16674.3 16674.3

Market price Call 776.35 776.35 776.35 776.35 776.35 776.35 776.35 776.35 776.35

INTERPRETATIONS Nine call options are considered with nine different strike prices The current market price on the expiry is 776.35 and this is considered as the final settlement price The premium paid by the option holders whose strike price is far and greater than the current market price have paid higher amount of premium than those who are near to the current market price.

The call option holders whose strike price is less than the current market price are said to be In-the-money. The calls ranging from 660-760 are said to be In-the-money and if unexercised will leave the holder with profits The call options whose strike price is more than the current market price are said to be out-of-the-money. The call ranging from 780-820 are said to be out-of-the-money and the holder leaves it unexercised losing the amount paid as premium

Graph showing the premium amount transacted for a call option:


Call options Premium 660 43 680 30.9 700 22.8 720 17 740 11.4 760 8 780 6.05 800 5 820 0

PREMIUM OF CALL OPTIONS


1000 PREMIUM 800 600 400 200 0 1 2 3 4 5 6 7 8 9 CALL OPTIONS Call Premium

INTERPRETATIONS

The premium for the options with strike price of 660 and 700 are observed to be high as the cash market was ranging from 660770 As the strike price increases the premium amount declined because the strike rate was converging with the market rate on nearing the date of settlement

Graph showing profit of call position


Call Net profit/loss to holder 660 28019.7 680 25001.9 700 20456.1 720 15031.7 740 9530.9 760 3189.7 780 -3705.4 800 -10944.3 820 -16674.3

PAY OFF OF HOLDER


30000 25000 20000 15000 10000 5000 0 -5000 -10000 -15000 -20000

PAY OFF

Call Net profit/loss to holder

CALL OPTIONS

Interpretations The contracts with strike price of 660-760 get profits as their strike prices are below the settlement price i.e. 776.35 The contracts with higher strike prices such as 780-820 are at loss of just the premium amount

Net pay off of put option holders and writers as on 1st april

Market price Put 776.35 776.35 776.35 776.35 776.35 776.35 776.35 776.35

Lot size Premium Profit to holder Net profit/loss to holder Net profit/loss to writer 660 382 33.75 -82.6 31553.2 -31553.2 680 382 40 -56.35 21525.7 -21525.7 700 382 52 -24.35 9301.7 -9301.7 720 382 86.7 30.35 -11593.7 11593.7 740 382 77.7 41.35 -15795.7 15795.7 760 382 114.45 98.1 -37474.2 37474.2 780 382 129.55 133.2 -50882.4 50882.4 800 382 145.25 168.9 -64519.8 64519.8

Interpretations Eight put options have been considered with eight different strike prices The current market price as on the expiry date is 776.35, and this is considered as the final settlement price The premium paid by the option holders whose strike price is far and greater than the current market price have paid less premium than those who are near to the current market price The put option holders whose strike price is more than the current market price are said to be in-the-money. The puts ranging from 700 to 800 are said to be in-the-money because if exercised they will get profits The put option holders whose strike price is less than the current market price are said to be out-of-the-money. the puts with strike price ranging from 660-760 are said to be out-of-the-money, since ,if they are exercise their puts they will get losses.

Graph showing the amount of premium transacted of put options


Put 660 680 700 720 740 760 780 800 Premium 33.75 40 52 86.7 77.7 114.45 129.55 145.25

PREMIUM PAID BY PUT OPTION


1000 PREMIUM 800 600 400 200 0 1 2 3 4 5 6 7 8 PUT OPTIONS Put Premium

Interpretations Here we can infer that strike price and premium are directly proportional to each other it implies that as the strike rate increases the premium also increases This is because the cash price of the stock as on the settlement day has increased to Rs 776

Graph showing profit of put option holders


Put 660 680 700 720 740 760 780 800 Net profit/loss to holder -31553.2 -21525.7 -9301.7 11593.7 15795.7 37474.2 50882.4 64519.8

PAYY OFF OF PUT HOLDER


70000 60000 50000 40000 30000 20000 10000 0 -10000 -20000 -30000 -40000

PAY OFF

Put Net profit/loss to holder

PUT OPTIONS

Interpretations Only put options from 720 and 800 leave the holder of a put with profit, as these are the only strike prices where the strike price along with the premium is more than the settlement price i.e. 776.35 i.e. these options are in-themoney All other options can be left unexercised and the only loss would be the premium paid DATA OF TATA STEEL THE FUTURES OF THE APRIL MONTH

DATE FUTURES CLOSING PRICE 1-Apr 2-Apr 3-Apr 4-Apr 7-Apr 8-Apr 9-Apr 10-Apr 11-Apr 15-Apr 16-Apr 17-Apr 21-Apr 22-Apr 23-Apr 24-Apr

CASH CLOSING PRICE

675.2 652.1 663.9 664.05 683.6 660.1 680.75 687.25 696.1 695.1 693.1 719.5 777.35 783.15 798.2 776.35

671.40 648.85 660.15 661.40 680.55 657.05 678.85 684.80 693.25 692.15 691.15 717.80 776.25 782.40 797.50 776.35

GRAPH SHOWING THE PRICE MOVEMENT OF FUTURES VS CASH MARKET

FUTURE VS CASH
800 790 780 770 760 750 740 730 720 710 700 690 680 670 660 650 640 630
2Ap r 4Ap r 8Ap 10 r -A p 15 r -A p 17 r -A p 22 r -A p 24 r -A pr

FUTURES CLOSING PRICE CASH CLOSING PRICE

PRICE

DAYS

INTERPRETATIONS The cash market of the TATA STEEL is moving in accordance with the future price

There seems to be highly liquid and the market for TATA STEEL is highly balanced and is a perfect example for arbitrage.

The comparison of TATA STEEL with SENSEX graph shows a perfect hedging based on the BETA factor of the TATA STEEL. Based on the Volumes Traded AND the Volatility in the TATA STEEL futures lots of opportunities are there for speculators.

CONCLUSION

Derivatives have existed and evolved over a long time, with roots in commodities market and in the recent years advances in financial markets and the technology have made derivatives easy for the investors. Derivatives market in India is growing rapidly unlike equity markets. Trading in derivatives require more than average understanding of finance. Being new to markets maximum number of investors have not yet understood the full implication of trading in derivatives. SEBI should take action to create such awareness. Introduction of derivatives implies better risk management. These markets can give greater depth, stability and liquidity to Indian capital markets. Successful risk management with derivatives requires the understanding of the principals that govern the pricing of financial derivatives. In order to increase the derivatives market in India SEBI should revise sum of their regulations such as, contract size, participation of FII in derivatives market. Contract size should be minimized because small investors cannot afford huge premiums.

SUGGESTIONS

The investor can minimize the risk by investing in derivates. The derivatives market has recently been introduced in India and is not known to everyone. So SEBI should take necessary actions to create awareness among investors. SEBI should revise some of their regulations like contract size, participation of FII in derivatives market so that it enables the small investors to invest. SEBI has to take steps to reduce high speculations in derivatives market. Risk management mechanisms need to be enhanced. Investor must be made aware of effective tools, such as hedging using derivatives. Derivates market offers greater liquidity and lower transaction costs. The derivates product gives the investor an option / choice whether to exercise the contract or not. However, these instruments act as a powerful instrument for knowledgeable traders to expose them to the properly calculated and well-understood risks in pursuit of reward, i.e. PROFIT. *******