Derivatives market: The derivatives market has been very successful as it involves a .lot of liquidity.

This is the reason that it has attracted different types of investors. Derivatives have widely been used as they facilitate hedging, that is, they enable fund mangers of an underlying asset portfolio to transfer some parts of the risk of price changes to others who are willing to bear such risk. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Factors driving the growth of 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, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Participants in the derivatives market: The 3 broad categories that are identified are: Hedgers Speculators Arbitrageurs

Hedgers: They are in a position the face the risk associated with the price of an asset and they use forwards, futures and options to reduce the risk they face from potential future movements in the market. Speculators: They use forwards, futures and options to bet on the future direction of a market variable. They can be classified in: o Scalpers - They watch very short-term trends and attempt to profit from small changes in the contract price. They usually hold their positions for few minutes. o Day traders They hold their position for less than one trading day. They are unwilling to take risk that adverse news will occur overnight. o Position traders They hold their positions for much longer periods of time and hope to make significant profits from major movements in the market. Arbitrageurs: They take offsetting positions in two or more instruments to lock in profits. Economic function of the derivative market: 1. Prices in an organized derivative market reflect the perception of the market participants in the future. 2. It helps to transfer the risk to those who have them but may not like them to those who have an appetite for them. 3. Higher trading volumes because of participation by more players who wouldnt otherwise participate if they couldnt transfer them. 4. Help increase savings and investment in the long run. Derivatives Trading in India: The Indian equity market has widely been regarded as one of the best performing market amongst the emerging markets of the world like China, Indonesia, Brazil, Russia, Mexico, Korea etc. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It 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 regulatory framework for derivatives trading in India. In its report, the committee prescribed necessary pre-conditions for introduction of derivatives trading in India; it recommended that derivatives should be declared as 'securities' so that the 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 derivatives market. The Report 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 SC(R) A was amended in December 1999 to include derivatives within the ambit of 'securities'. Thereafter a regulatory framework was developed for governing the trading in derivatives. Derivatives were formally defined to include: (a) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security, and (b) a contract which derives its value from the prices, or index of prices, or underlying securities. The Act also made it clear that derivatives are legal and valid, but only if such contracts are traded on a recognized stock exchange. The Government also rescinded in March 2000 the three-decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India after SEBI granted the final approval to commence trading and settlement in approved derivative contracts on the NSE and BSE. This has also been proved beyond doubt across the financial world that the regulatory norms in place governing the Indian Capital Market are one of the best in the world. Recently NSE has been awarded Derivative Exchange of the year by Asia Risk Magazine. Forward Contracts: A forward contract is particularly a simple derivative. It is agreement to buy or sell an asset at a future for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter market usually between two financial institutions or a financial institution and its client. Forward contract are very useful for hedging and speculation.

Futures: Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. Many of the participants in the futures markets are hedgers. The main aim to use the futures market is to reduce a particular risk they face. Investment strategies in the futures market: Hedging: Buy securities, sell futures An investor who holds shares of a company and gets uncomfortable with the position and gets uncomfortable with the market movements in the short run. With securities futures he can minimize his price risk. All he needs to do is enter in an offsetting stock futures position, in this case take on short futures position. Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30- 60% of the securities risk is accounted for by index fluctuations). Speculation: Bullish security, buy futures If the investor expects the security market to be bullish in nature then instead of investing in security and earning the profit the investor can invest in the futures by paying only the margin amount for the futures and hence earns more returns thereof on the amount invested. Speculation: Bearish security, sell futures Stock futures can be used by a speculator who believes that a particular security is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral

product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell stock futures. Arbitrage: Whenever futures price deviates substantially from its fair value, arbitrage opportunities arise. If the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense to arbitrage. This is termed as cash-and-carry arbitrage. Overpriced futures: buy spot and sell futures Borrow funds if required and buy security on the cash/spot market. Sell the futures on the security Take the security purchased and hold it for some time. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Sell the security and get profit on futures on future expiration. Return the funds if borrowed. Underpriced futures: sell spot and buy futures Sell the security in the cash/spot market Make delivery of the security. Simultaneously, buy the futures on the security On the futures expiration date, the spot and the futures price converge. Now unwind the position. Buy back the security. The futures position expires with some profit Options An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer. Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

Investment strategies in Options trading:

Speculation: Bullish stock/index, buy call option Buying a call is the most basic of all options strategies. When you buy it means you are bullish. Buying a Call means you are very bullish and expect the underlying stock / index to rise in future. Risk: Limited to the Premium. Reward: Unlimited Speculation: Bearish stock/index, sell call option A Call option means an Option to buy. Selling a Call option means an investor expects the underlying price of a stock / index to fall in future. Risk: Unlimited Reward: Limited to the Premium. Hedging: Buy stock, buy put In this strategy, we purchase a stock since we feel bullish about it and buy a put option in case the prices went down. This gives the investor the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which the investor bought the stock (ATM strike price) or slightly below In case the price of the stock rises he gets the full benefit of the price rise. In case the price of the stock falls, he can exercise the Put. Risk: Losses limited to Stock price + Put Premium Put Strike price Reward: Profit potential is unlimited. Speculation: Bearish stock/index, buy put option When an investor is bearish, he can buy a Put option. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk. Risk: Limited to the amount of Premium paid. Reward: Unlimited Speculation: Bullish stock/index, sell put option An investor Sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When an investor sells a Put, he can earn a Premium (from the buyer of the Put). The investor has sold someone the right to sell him the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium. But, if the stock price decreases below the strike price, by more than the amount of the premium, the Put seller will lose money.

Risk: Put Strike Price Put Premium. Reward: Limited to the amount of Premium received. Hedging: Stock, sell call This strategy is used by the investor when he is neutral to moderately bullish about the market. The investor has shares or has bought shares of a company which he thinks may not rise to a great extent in the near future. So he sells a call option on the stock he owns. The Call Option is generally out-of-the-money call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. Risk: Stock Price Paid Call Premium (In case the stock price falls to zero) If the stock rises beyond the Strike price the investor gives all the gains on the stock Reward: Call Strike Price Stock Price Paid + Premium received on call Speculation: Bullish stock/index, sell a put and buy call If an investor is expecting the price of a stock to move up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call. Risk: Unlimited Reward: Unlimited Hedging: Sell stock, buy call This is a strategy wherein an investor has gone short on a stock and buys a call to hedge. An investor shorts a stock and buys an ATM or slightly OTM Call. In case the stock price falls the investor gains in the downward fall in the price. However, incase there is an unexpected rise in the price of the stock the loss is limited. The pay-off from the Long Call will increase thereby compensating for the loss in value of the short stock position. This strategy hedges the upside in the stock position while retaining downside profit potential. Risk: Limited. Maximum Risk is Call Strike Price Stock Price + Premium Reward: Maximum is Stock Price Call Premium Hedging: Neutral to Bearish stock/index, sell stock, sell put on the options on the stock The Put that is sold is generally an OTM Put. The investor shorts a stock because he is bearish about it, but does not mind buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price). Selling a Put means, buying the stock at the strike price if exercised. If the stock falls below the Put strike, the investor will be exercised and will have to

buy the stock at the strike price (which is anyway his target price to repurchase the stock). The investor makes a profit because he has shorted the stock and purchasing it at the strike price simply closes the short stock position at a profit. And the investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place. If the stock price does not change, the investor gets to keep the Premium. He can use this strategy as an income in a neutral market. Risk: Unlimited if the price of the stock rises substantially Reward: Maximum is (Sale Price of the Stock Strike Price) + Put Premium : Highly volatile on either side This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index show volatility to cover the cost of the trade, profits are to be made. With this strategy it indicates that the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction. Risk: Limited to the initial premium paid Return: Unlimited : Market is less volatile and not much movement It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index do not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, incase the stock / index moves in either direction, up or down significantly, the investors losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made. Risk: Unlimited Return: Limited to the premium received

: Market highly volatile on either side, payment dividend

This strategy involves the simultaneous buying of a slightly out-of-themoney (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since the call and put options are purchased out-of-themoney it is comparatively cheaper than the options that are purchased in-the-money or at-the-money. Risk: Limited to the initial premium paid Reward: Unlimited : Market is less volatile but greater movement between the break-even points It tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date. Since the options are purchased out-of-the-money the net credit received by the seller is less, but the break-even points are widened. Risk: Unlimited Reward: Limited to the premium received Hedging: Market conservatively bullish, Buy stock, buy Put and sell Call The investor buys the stock expecting the market to be bullish, then insuring against the downside by buying put and financing it by selling a call. The put is generally ATM and the call is OTM having the same expiration month and the same number of shares. It is a low risk strategy since it is covered by buying put. Risk: Limited Returns: Limited Speculation: Bullish to moderately bullish stock/index, buy Call and sell Call A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month. The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is exercised when investor is moderately bullish to bullish, because the investor will make a profit only when the stock price / index rise. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of

the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit. Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below. Reward: Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike. Sp

Objectives of the study: The study is aimed to achieve the following objectives: a) To examine the performance of various derivatives based investment strategies b) To examine the risk associated with different investment strategies. c) To assess the level of margin required to reduce the risk of stop losses being triggered; d) To examine the extent to which derivatives have been able to hedge the risk; and