Download MBA Finance (Master of Business Administration) 4th Semester Financial Derivatives
UNIT - I
Financial Derivatives
INTRODUCTION
The past decade has witnessed an explosive growth in the use of financial
derivatives by a wide range of corporate and financial institutions. This growth has
run in parallel with the increasing direct reliance of companies on the capital
markets as the major source of long-term funding. In this respect, derivatives have
a vital role to play in enhancing shareholder value by ensuring access to the
cheapest source of funds. Furthermore, active use of derivative instruments allows
the overall business risk profile to be modified, thereby providing the potential to
improve earnings quality by offsetting undesired risks
Despite the clear benefits that the use of derivatives can offer, too often the
public and shareholder perception of these instruments has been coloured by the
intense media coverage of financial disasters where the use of derivatives has been
blamed. The impression is usually given that these losses arose from extreme
complex and difficult to understand financial strategies. The reality is quite
different. When the facts behind the well-reported disasters are analyzed almost
invariably it is found that the true source of losses was a basic organizational
weakness or a failure to observe some simple business controls.
The corollary to this observation is that derivatives can indeed be used
safely and successfully provided that a sensible control and management strategy is
established and executed. Certainly, a degree of quantitative pricing and risk
analysis may be needed, depending on the extent and sophistication of the
derivative strategies employed. However, detailed analytic capabilities are not the
key issue. Rather, successful execution of a derivatives strategy and of business
risk management in general relies much more heavily on having a sound
appreciation of qualitative market and industry trends and on developing a solid
organisation, infrastructure and controls. Within a sound control framework, the
choice of a particular quantitative risk management technique is very much a
secondary concern. The objective of this chapter is to examine the growth of
financial derivatives in world markets and to analyse the impact of these financial
derivatives on the monetary policy.
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FINANCIAL DERIVATIVES: RECENT TRENDS
Changing interest rate and exchange rate expectations, new highs reached by
equity markets and the sharp reversal of leveraged positions in the latter part of
1998 stimulated activity in derivatives markets in 1998. Exchange-traded business
soared in the third quarter of 1998 as investors withdrew from risky assets and
shifted their exposure towards highly rated and liquid government securities.
Competition between exchanges remained intense, particularly in Europe, where the
imminence of the euro and the inexorable advance of automated exchanges
challenged the dominance of established marketplaces. Moreover, exchanges
continued to face competition from the rapidly growing over the counter (OTC)
markets, forcing them to offer a wider range of services to make up for the loss of
their franchises. The sharp increase in OTC outstanding positions in the second half
of 1998 showed that the need for a massive reversal of exposures following the
Russian moratorium more than offset the dampening impact of increased concerns
about liquidity and counter party risks. Nevertheless, the turbulence and related
losses revealed the weaknesses of existing risk management systems in periods of
extreme volatility and vanishing liquidity, prompting market participants to
reconsider their risk models and internal control procedures.
FINANCIAL DERIVATIVE INSTRUMENTS
Exchange-traded instruments
The aggregate turnover of financial contracts expanded further in 1998 (by
9%, to $388 trillion). Interest rate products, which remained by far the most
actively traded, experienced a sustained increase in activity and reached to $350
trillion. Uncertainty over the course of monetary polity in Europe and North
America supported trading in short-term interest rate contracts for much of the
1998, while the flight towards highly rated and liquid government paper boosted
activity along most of the yield curve in the second half of 1998. There was,
however, a decline in turnover towards the end of 1998 owing to the calming effect
of lower official rates, the withdrawal of leveraged investors and the paring-down
of positions ahead of EMU. Contracts on equity indices continued to record much
faster growth than interest rate products (=16%, to $34 trillion) as new indices were
introduced and bouts of downward market pressure and volatility prompted
investors to seek protection. In contrast, the wide fluctuations seen in the major
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currency pairs were not accompanied by an overall upturn of activity in currency-
related contracts (-17%, to $3.5 trillion). Aside from the continuing dominance of
OTC business in the management of currency risk, observers attributed this subdued
activity on exchanges to the stability of European cross rates and investors
reluctance to take positions in emerging market currencies.
The CBOT remained the largest exchange in the world (with a 16% increase
in the number of contracts traded, to 281 million), owing to the sharp rise in the
turnover of US Treasury contracts and the growth of new equity index products.
The CME and the CBOE, the next largest US exchanges, also reported an increase
in activity (by13% and 11% respectively, to 227 million and 207 million contracts).
In Europe, Eurex Germany (formerly the DTB) posted a new record (+87%, to 210
million) and overtook LIFFE as the third busiest marketplace in the world. The
flight t quality in the second half of 1998 propelled its bund futures contract into
third position in the interest rate category after US Treasury bond and Eurodollar
contracts. However, the squeeze which occurred in German government bonds at
the time of the turmoil created concerns that the underlying market might not be
sufficiently large to support futures trading in periods of stress. Meanwhile, overall
activity on LIFFE declined (by 7% to 194 million), as increases in the area of short-
tern interest rate products and in some equity-related products were more than offset
by a contraction in government bond instruments. In particular, the exchange`s
bund contract dried up as trading migrated to Eurex`s cheaper electronic system.
Despite strong advances in technology; trading on MATIF fell sharply 9 ?31%, to
52 million contracts in a context of reduced relative movements between
continental European interest rates.
The anticipated consolidation in European interest rate instruments spurred
the introduction of plethora of euro-compatible contracts, creating concerns that, in
the drive to innovate, liquidity might suffer. Another notable development in
Europe was the significant increase in the trading of equity-related products, which
benefited from attempts to introduce a variety of new pay-European equity indices
and contracts, as well as the reduction in the unit value of certain options. Activity
in the Pacific rim was generally subdued, particularly in Japan, where; despite some
trading opportunities provided by the Japan premium, the record low level of
interest rate (except for a short period at year-end) reduced the demand for interest
rate hedging. There was a tentative recovery in other Asian markets due t more
active trading of equity-related contracts. Nevertheless, activity in Asian and other
emerging markets remains a fraction of that in industrial countries in values terms.
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The battle for European market share took a dramatic new turn as exchanges
that had been based primarily on open outcry, such as LIFFE and MATIF,
surrendered to the relentless expansion of screen-based trading. The agreement
between the Deutsche Borse (DB) and the London Stock Exchange in July, 1998
while focusing on the cash trading of securities, also accentuated pressures for
consolidation and for new regional links. US exchanges, for their part, entered into
a number of joint ventures with wholesale market brokers and specialized IT firms
to introduce electronic facilities for the joint trading of government securities and
related derivative. With the rapid development of trading technology, the battle for
supremacy is gradually shifting from the listing of new contracts to the
technological arena, to the benefit of a small number of cost-efficient hubs. In this
respect, it is worth noting that the proprietary systems of core electronic exchanges
are already being challenged by new generation trading systems that permit the
interconnection of different exchange-traded and OTC facilities (in particular, via
the internet). The growing importance of screen-based facilities cutting across
product and market segments is creating new challenges for regulators wishing to
ensure the soundness and transparency of such systems.
Over-the-counter instruments
Following a pause in 1997, expansion resumed in OTC instruments in 1998.
Although the rise in notional amounts of positions outstanding (76%) was inflated
by the increases in the number of dealers, the adjusted rate of growth remained
significantly higher than the rise in open interest on exchanges (35% and 9%
respectively). In particular, the unwinding of leveraged positions which took place
in the second half of 1998 led to an upsurge in the volume outstanding (since, in
contrast to futures markets, existing positions are not extinguished by the writing of
opposite contracts). However, concerns about credit risk led to a sharp cutback in
credit line to weaker counter parties towards the end of 1998 thus acting as a
damper on overall market expansion. The activity in interest rate products was the
main driving force. Faced with heavy losses, proprietary traders and leveraged
funds unwound their positions, inter alia through asset swapsand structured
securities. In addition, the unusual revolution of Japanese interbank rates and bond
yields towards the end of 1998 generated some trading. As Japanese banks faced
new upward pressures on their interbank liabilities, western-based banks began to
offer negative rates on yen-dominated deposits, prompting a reversal of outstanding
yen swaps and some activity in interest rate floors.
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In the area of cross-currency derivatives the fairly steady appreciation of the
dollar against the yen until August, 1998 fuelled activity in related options,
offsetting somewhat the decline in intra-European business and emerging market
currencies. Thereafter, the massive deliver aging of positions in dollar-denominated
securities was associated with a parallel unwinding of short yen positions, leading
to record volatility in the major exchange rates and a drying-up of activity. There
was, however, some improvement in non-Japanese Asian business, as the
appreciation of local currencies and the recovery of stock markets allowed a gradual
relaxation of monetary policy and a partial resumption of trading in forward
contracts.
In the market for credit derivatives, the crisis in Asia had already focused
the attention of market participants on the issue of credit risk, but its global
extension in the second half of 1998 subjected the market to conflicting influences.
On the one hand, concerns about banks` exposure to highly leveraged institutions
and emerging market countries created broad interest in instruments offering
protection against counterparty risk. On the other hand, the pronounced widening of
credit spreads for emerging market names led intermediaries to exhibit caution in
providing hedges to lower-rated entities. Moreover, market sources reported that
liquidity suffered from doubts about the adequacy of loan documentation, as
highlighted by legal disputes between counterparties over hedges arranged on credit
exposure to Russia. Buyers of protection faced difficulties in enforcing payment
owing to disagreements over the definition of a credit event, the pricing of reference
credits and the settlement of contracts.
INTERMARKET LINKAGES AND TRANSPARENCY
OTC derivatives markets at end-June 1998 provide a snapshot of the
situation prevailing just before the Russian debt moratorium. Four features are of
particular significance in the context of subsequent events. First, notional amounts
showed that exposure to changes in interest rates in OTC derivatives markets,
which was four times that in exchange-traded markets, was the main source of
market risk in the derivatives industry. Such interest-rate-related exposure
accounted for two-thirds of the $72 trillion of OTC aggregate notional amounts
outstanding reported at end-June 1998 (and for 90% of the $14 trillion on
exchanges). It should be noted, however, that the development of sophisticated
trading strategies, the related expansion of cross-market linkages and regulatory
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arbitrage may have reduced the meaningfulness of aggregate data on individual
market risk categories. For instance, the high capital costs of cross-currency swaps
have resulted in their replication through a combination of interest rate and short-
term foreign exchange swaps. This means that the build-up of currency exposure is
not accurately reflected in data on cross-currency swaps.
Second, the national amounts of interest rate and currency-related positions
in OTC derivatives markets are now comparable to total cash positions in global
banking and securities markets. Notional amounts are generally used as a reference
to calculate cash flows under individual contracts. As such, they enable a rough
comparison of the potential transfer of market risk in cash and derivatives markets,
but they do not provide an accurate measure of the gains and losses incurred in such
a transfer A better indicator is the gross market value of OTC contracts, which
measures the replacement cost of all outstanding contracts had thy been closed on
the reporting date. Such replacement costs stood at $2.6 trillion at end-June 1998
(or 3.6% of the notional amounts).
Third, financial institutions other than reporting dealers have become an
important class of counter parties (accounting for 41% of the total notional
amounts), reflecting the rise to prominence of institutional and leveraged investors.
Anecdotal evidence abounded, even before the LTCM debacle that such
intermediaries had built up large positions aimed at profiting from the
divergence/convergence of yields and volatility in a variety of fixed income
instruments. Indeed, as arbitrate opportunities narrowed, the growing pursuit of
such strategies led to an ever-increasing degree of leverage in order to achieve
acceptable returns. One widely favoured strategy was the yen carry trade, which
involved taking short positions in the yen money markets and long positions in
higher-yielding assets in other currencies. The unwinding of such positions in the
wake of the Russian moratorium in August, 1998 large repayments of yen
liabilities, and apparently precipitated the very sharp appreciation of the yen in
September and early October, 1998. Although these strategies were widespread,
they could not be directly captured by existing statistics owing to the variety of
channels used to achieve the required exposure to market and/or credit risk.
Nevertheless, the strong growth of forex swaps, yen currency options and interest
rate swaps since 1995 suggests that the yen carry trade evolved from an initial focus
on the cash market to include a wide range of derivative instruments.
Finally, after allowing for the effect of netting arrangement on gross positive
market values of contracts, the credit exposure of institutions arising from their
undertaking of OTC derivatives positions stood at $1.2 trillion at end-June
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1998.While this was considerably smaller than on-balance sheet exposure, with
hindsight it appears that this figure seriously underestimated potential credit risk.
The LTCM episode may help illustrate this point. LTCM, whose strategy consisted
in exploiting price, differentials between wide varieties of financial market assets
was perhaps the world`s single most active user of interest rate swaps. By August
1998, $750 billion of its total notional derivatives exposure of more than $1 trillion
was in such swaps with about 50 counter parties around the world, with none being
aware of LTCM`s overall exposure. This swap exposure represented more than 5%
of the total reported to central banks by dealers vis-?-vis other financial
institutions. While the current credit exposure of its counter parties was fully
collateralized, these had taken no protection against the potential increases in
exposures resulting from changes in market values. Only when LTCM`s dire
situation became known in September, 1998 did counterparties start to seek
additional collateral. The fund`s efforts to raise cash by selling its most liquid
securities were felt in markets around the world, transmitting the shock wave from
low-rated and illiquid securities to benchmark instruments.
Thus, even if the Russian default was the trigger, the turmoil of 1998
stemmed primarily from the build-up of excessively large and concentrated
exposures to customers who proved to be more vulnerable to market, credit and
liquidity risks than had been supposed. The crisis also revealed the inadequacy of
information supplied by leveraged investors on the extent of their market risk
exposures, the nature of their trading strategies and the validity of their risk
management methodologies. While collateral may have provided participants with a
sense of protection against the associated credit risk the unexpectedly high degree
of interlinkage between positions and intermediaries destabilized even the most
highly rated and liquid securities. This showed that core financial markers are
insulated less than ever from crises that appear at the periphery of the system since
then, lending institutions have begun to review their models` assumptions and to put
greater emphasis on stress testing and fundamental analysis.
GLOBAL FINANCIAL INTEGRATION: FINANCIAL DERIVATIVES AND
THE MONETARY POLICY
In the past two decades the world has moved even closer together. This has
been brought about not only by the dismantling of various regulatory barriers but
also, and in particular, by technical innovations. Global networking is no longer a
mere metaphor for worldwide activities but now describes in very literal terms the
advances in information and communication technology which have been a major
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driving force behind internationalization in many areas of life, but especially in the
economy. Within the economic sector, in turn, it is in the financial markets that
globalization has been particularly dynamic.
The far reaching changes brought about in the financial markets by
innovation in the field of computer technology are layed out in the immaterial
character of the goods traded in these markets. Now-a-days, financial transactions
are as a rule settled through electronic book-keeping operations and thus much more
swiftly and cheaply than before the time of computers. New standards have been
set, and not only for the execution of financial transactions. There has also been a
huge increase in the quantity of available information ? and hence the input for
investment decisions ? as well as in the speed at which it is processed. Finally,
globalization not only stands for product and process innovation, but has also
brought institutional investors into the limelight as a special species of financial
market players.
Financial innovation, internationalization and institutionalization of
investment activities are different but ultimately inseparable aspects of the radical
fundamental changes in the financial sector. The markets for financial derivatives ?
futures and options ? can be regarded as the epitome of these new structures. The
infrastructure of derivatives markets is geared to international transactions. Trading
is as a rule fully computerized, so that portfolio switching can be effected on a large
scale within the shortest possible time regardless of geography. The contract
volumes and trading practices are tailored to the professional market players.
Bearing this in mind, it is not surprising that the derivatives markets are
characterized by exceptionally high degrees of internationality. According to the
findings of the first global survey of derivatives business, which was carried out by
the BIS in the spring of 1995, about half the daily turnover in OTC interest and
currency derivatives, amounting to an average nominal value of over US$ 800
billion, is accounted for by cross-border transactions.
It was not only the industrial countries, with their highly developed and
rapidly growing financial markets that benefited from the strong increase in
international capital flows. Capital on a considerable scale also has flown to the
emerging markets since the end of the eighties after their sources of funds had
almost dried up in the wake of the international debt crisis. According to the
World Bank, aggregated net inflows of resources to the developing countries
increased from US$ 85 billion to over US$ 250 billion between 1989 and 1996.
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The marked increase in international financial flows, the growing speed at
which financial transactions are settled and the considerable turnover volumes show
the momentum and market forces can gather in an environment largely free from
regulation. It is especially this extremely strong dynamism ? which according to the
critics is reflected in particular in a growing volatility of the financial markets ?
which is seen as evidence of the fact that the financial sector has now increasingly
distanced itself from the real sector of the economy. What is then more natural than
reducing the susceptibility of financial markets to abrupt changes in investors`
perception by regulating measures?
As even leading economists are warning of the dangers of vagabond
financial flows, it is not surprising if sociologists and political pundits use this
skepticism to launch a general attach on globalization. The fear generated in this
way can easily be exploited politically. Whereas formerly it was the gnomes of
Zurich, now it is the comparison with AIDS which is cited to demonstrate the
danger of stateless financial capital. A contributory factor here may be that for the
economic layman it is not easy to correctly interpret the inconceivably high
amounts ? especially if one is not interested in doing so. A case in point illustrating
the abuse of statistics is the derivatives markets. According to the findings of the
aforementioned BIS survey, the nominal value of derivatives contracts outstanding
worldwide amounted to US$40,000 billion. Such a virtually incomprehensible
figure is well-suited to kindle the fear of financial markets with their uncontrolled
growth ? in fact, so well-suited that in most cases no mention is made of the fact
that the market value of these contracts ? which gives an idea of the actual payment
lows ?a US$ 1,700 billion, amounts for not even 5% of that amount.
The central bank observe and analyse these developments without agitation,
but very attentively. This is necessary, if only because the central banks are
particularly affected by these changes. Monetary policy measures are focused on the
financial markets and use these as channels through which monetary impulses are
transmitted. Given financial market players` global scope for action and the
associated alternatives, it is by no means a matter of course that monetary policy
can always affect financial market conditions in the manner intended. Moreover, the
central bank depends on its measures influencing expenditure and price decisions ?
i.e. real transactions ? as desired. If the real and monetary spheres are (partially)
detached, this can radically change monetary policy makers` scope for intervention.
Retracing the evolutionary development, so to speak, of monetary policy ?
beginning with archaic forms of direct monetary control by means of credit
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ceilings and administratively set interest rates, moving on to the increasing use of
indirect control mechanisms in still largely segmented markets and finally to a
global financial system ? one could thus conclude that monetary policy is drifting
ever close towards ultimate impotence. Diametrically opposed to this view is the
observation that now the financial markets are evidently responding more
sensitively than ever before to possible changes in the stance of central bank policy;
the research departments of the institutional investors are incessantly trying to
figure out, at a huge expense of time and money, what the future course of the
central bank will be. If it really were ineffective, monetary policy would hardly be
the focus of so much attention. Is it more reasonable, therefore, to conclude, in
direct contradiction to the theory of impotence, that monetary policy makers now
have great international leverage and thus exert even more influence than they did
in the past?
Importence of monetary policy makers in an environment of globalised
markets The importance of monetary policy has been bemoaned in the past in
completely different circumstances. The central banks, for example, indeed almost
completely lost control over their currencies stock under the system of a fixed
exchange rate to the US dollar and unlimited obligatory intervention. There was no
talk yet of the globalization of the financial markets, derivative instruments and the
predominance of institutional investors at the time. It was not until the floating of
the exchange rate vis-?-vis the dollar that the central banks were able to develop and
successfully implement their strategy of monetary targeting. Monetary policy in the
sense of controlling the national inflation rate is thus only at all possible if specific
institutional requirements are met.
Renewed debate about the effectiveness or ineffectiveness of monetary
policy is concerned with something else. The question now is: in an environment of
globalised financial markets, is the central bank able to influence the price level in
the currency area in accordance with its own objectives even if the institutional
requirements ? above all the protection of the economy against external constraints
? are met ? (Let us leave aside the special case of small, open economies in this
context). The answer is basically yes, for the monetary policy lever is effective as
long as there is an adequate demand for central bank money generated by non-
banks` demand for currency, and if appropriate, minimum reserves are required to
be held on interbank money. No direct risk to this leverage capability is posed by
the globalization of the financial markets.
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This may be illustrated more clearly using financial derivatives as an
example. In economic terms, derivatives make it possible to trade market price risk
separately ? without buying or selling the underlying instrument ? and consequently
with a much lower input of liquidity and capital. The isolation of risks allows the
features profile of financial contracts and the risk structure of individual portfolios
to be designed very much more flexibly. In the final analysis, derivatives help to
implement the financial markets and bring the financial sector closer to a world of
perfect markets in the sense of the Arrow-Debreu model. To this extent, they can be
regarded as pointing the way for future innovation trends and are therefore also
predestined to be a benchmark for assessing the monetary policy implications of
globalization.
From a monetary point standpoint, it is essential that financial derivatives
basically do not affect the central bank`s note issuing monopoly (which as a rule is
incorporated in law) and thus cannot compete with the central bank as the supplier
of central bank money. The demand for central bank money, too, is basically
preserved. It is true that derivatives make it possible to flexibly manage risk
positions and thus to insure against a variety of contingencies. But even in the
theoretical ideal state of complete hedging possibilities, this would not affect the
central bank`s ability to control inflation by controlling central bank money.
From the fact that national monetary policy continues to be basically
effective, it follows immediately that differences between individual currency areas
in the movement of the price level may continue to exist. Moreover, there are of
course also other country-specific characteristics, such as the size of the economy
and its degree of diversification and hence its ability to absorb shocks, or the stance
of fiscal policy. All these factors result in internationally largely standardized
financial instruments ? such as government bonds with a ten-year maturity or
futures contract traded on them ? having differing country-specific risk profiles.
The differing country-specific risk profiles of financial assets have two
implications. Firstly, international diversification of financial assets makes it
possible to reduce the portfolio risk, as country-specific non-systemic risks can
ideally be diversified to such an extent that only the global systemic risk and the
exchange risk remain. By structuring assets appropriately, investors basically have
the possibility of an interposal smoothing of consumption flows and a simultaneous
extension of the range of available investment projects. The resulting wealth-
increasing effects of the internationalization of the financial markets are therefore
largely undisputed. For the rest, there is good reason to believe that the existing
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scope for diversification is far from having been fully utilized. Studies suggest at
any rate that investment decisions are still marked by a considerable home bias on
the part of investors.
The second implication concerns monetary policy direct and explains to a
large extent why so much attention is paid in the markets to the central bank`s
actions : If (relative) risks play a crucial role in the valuation of financial assets and
portfolio decisions, it is important to predict price-relevant events as precisely as
possible. Market participants` expectations regarding the inflation outlook are a
major part of this calculation. As long as players in the international financial
markets believe that monetary policy has a systematic influence on the price level in
the domestic currency area, that policy in principle also has an impact on
international capital flows. One cannot therefore talk of the impotence of monetary
policy.
A characteristic feature of the globalization process is that market players`
expectations are playing an ever increasing role. Institutional investors are an
important group of market players for whom it is worthwhile; due to the economies
of scale available to them, to apply resources on a large scale to processing
information and to resort to portfolio shifting in response to even minor changes in
expectations. With derivatives they have instruments at their disposal which allow
incurring positions in the financial markets at particularly low cost. The
combination of innovation and professionalisation thus results in the increased
sensitivity of financial markets to expectations. In principle, this should be
considered a positive development, for it basically implies that more information
affects prices more promptly.
However, one must not overlook the fact that certain incentive structures in
portfolio management ? such as the measurement of one`s own portfolio
performance relative to the market ? may encourage parallel behaviour and
contribute to increasing short-term price fluctuations in the financial markets.
Although the empirical evidence of the trend of volatility does not provide any clear
results so far there is hardly any evidence of a general and sustained increase in
financial market volatility. Recent experiences suggest that while periods of high
volatility are more frequent now, price fluctuations on a longer-term average have
not increased significantly.
That raises the question of the extent to which the monetary policy latitude
must be redefined i.e., the depth the different levels which define the central bank`s
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latitude. Specifically, the question is to what extent the stability of the financial
markets is affected by the process of internationalization, which transmission
channels the central bank can and should use, and what bearing this has on the use
of monetary policy instruments.
Interdependence between monetary policy and macroeconomic
stability: A close mutual relationship exists between the financial system and the
central bank`s measures. On the one hand, for monetary policy makers the financial
markets represent a given institutional arrangement in a given situation. To that
extent the central bank is a dependent agent, and in implementing its policy it must
take due account of these underlying conditions. On the other hand, the financial
sector of a country also reflects the specific impact of monetary policy measures
and thus of past central bank policy.
Stable financial market conditions can develop only in an environment of
monetary stability. Or, to put it another way : a monetary policy stance which is not
in a position to ensure an adequate degree of price stability and to keep inflation
expectations at a low level will inevitably prompt efforts to evade these
uncertainties, if possible, in order to avoid or at least limit the resulting
disadvantages. Viewed from this single, monetary instability can be the driving
force behind the emergence of all kinds of hedging instruments in the domestic
financial markets. In a world of globalised decisions, other currency areas, too,
which are marketed by a higher degree of monetary stability, may be seen as an
alternative. Stability based on a country`s own efforts does not therefore provide
protection against the transmission of disruptions produced by unstable foreign
markets.
In seeking to ensure stable financial market conditions, monetary policy
makers are thus faced with a dual task: firstly, it is important to prevent structural
disruptions and inefficiencies being caused by evasive innovation within the
national currency area, and secondly, instabilities ? say, in the form of sharp price
fluctuations in the financial markets-caused by volatile cross-border capital
movements must be counteracted.
The thrust of monetary policy aimed at safeguarding domestic stability, as
defined in this sense, seems basically unambiguous: inflation expectations, and thus
the incentives for evasive reaction, can be minimized by a consistent non-
inflationary monetary policy. On the external flank, however, such a policy does not
provide unconditional protection against tensions because large-scale and sudden
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capital movements may be sparked off by a change in the country`s relative stability
position. In other words, disruptions may also be caused by a flight to quality on
account of deterioration, in relative terms, of inflation expectations in other
countries, and can confront domestic monetary policy makers with a situation which
is often described, rather rashly, as a confidence trap. As a result, there may be
increasing pressure to counteract the external imbalances ? in the form say, of a
sharp appreciation of the domestic currency ? by monetary policy measures.
Such a policy course seems extremely risky, for it sacrifices the stabilization
of inflation expectations at a low absolute level for the sake of a relative orientation
and may even be towed along by excessive speculative market movements. The
consequences may be serious : a massive loss of confidence in monetary policy may
be caused when the response to changed external conditions is interpreted as a
departure from the counter-inflationary policy. At the same time, this may also
trigger evasive reactions in the domestic markets which will lead to hitherto stable
basic monetary relationships being eroded and ultimately the ground for the longer-
term anchoring of expectations being lost.
Monetary policy makers cannot stand idly by in the event of extreme
disruptions. However, they must proceed with utmost care and, above all, be aware
of their limits. In the longer run, real capital market rates and real exchange rates
which are ultimately decisive are beyond the central bank`s control. Yet in the short
term, too, any attempt to gear monetary policy to varying objectives will soon be
recognized by market participants, thwarted by corresponding counter-movements
and in the end possibly be neutralized. Incidentally, it would probably be
completely pointless to try and reduce short-term price fluctuations by purely
discretionary, supposedly smoothing intervention in the market. Such action would
have to be interpreted by market participants as a downright invitation to
speculation. The only suitable approach for avoiding excess volatility is to
forestall expectations uncertainties as much as possible.
The stabilization of market expectations also seems appropriate in order to
counteract the detachment of the real sector from the monetary sector and limit the
real economic costs caused by disruption in the financial markets. If continued
excessive price movements and increased risk premiums occur on account of highly
uncertain expectations, this impedes growth of the real economy through
misallocation. This is also one reason why the risk of short term disruptions of the
financial system ? with corresponding adverse feedback effects on the real economy
? has tended to increase on account of the risk concentration on individual market
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players with the wider use of derivatives. This not only calls for a non-inflationary
monetary policy, but poses new challenges to banking and financial market
supervisors. This is true, for instance, in terms of limiting and controlling market
price risks or ensuring adequate market transparency.
There is no alternative to a consistent counter-inflationary monetary policy
stance, especially in a system of open financial markets. The unambiguous
commitment of a growing number of central banks to the objective of general price
stability and the successes scored in combating inflation in recent years are clear
indications that this fact is being recognized to an ever increasing extent worldwide.
One reason for this is no doubt that inflation has clearly shown its ugly facein the
form of risk spreads and high interest rates precisely because of the
internationalization of financial markets. This experience has really inspired the
fight against inflation.
Increased complexity of the transmission mechanism: The concept of the
transmission mechanism of monetary policy was for a long time marked by the
notion that interest rate measures taken by the central bank impact on the national
financial markets, which are more or less hermetically sealed off from external
factors, and that they trigger parallel movements of domestic interest rates over the
whole maturity range. This simple, mechanistic idea of the effect of monetary
policy impulses has probably never been correct and must be basically rethought in
two respects in the light of the globalization of financial markets. Firstly, as a result
of the internationalization of capital flows, interest rate stimuli imparted by the
central bank are also increasingly being transmitted through the exchange rate
channel. Secondly ? as mentioned ? market participants` expectations are now
much more significant than they used to be.
The complexity of the transmission of monetary policy impulses has
undoubtedly increased with the globalization of the financial markets. In this
connection, derivatives may be cited once again as an example; by raising the
flexibility of the risk profile, they also enhance the exchangeability between
domestic and foreign financial assets. Monetary impulses then diffuse over a
correspondingly broader range of markets. The scope for discretionary action
narrows in this environment if only because the transmission channels are even
more difficult to identify than before and the effect of such action can virtually not
be calculated.
15
It seems that it is not so much the number of transmission channels with
their ramifications ? i.e. the markets and the available alternative investment
facilities ? which is significant for a monetary policy stance that is consistent with
the target, but rather the fact that the expectation bias of the financial markets is
constantly increasing. With a view to the transmission process it implies two things.
Firstly, the impact of monetary policy is transmitted largely through confidence
effects. A discretionary departure from a counter-inflationary course is penalized
more quickly and harshly ? by capital outflows and rising interest rates. Secondly,
expectation uncertainties are more quickly translated into market action and are
more likely to lead to periods of high price volatility.
Of key importance in this context is a monetary policy strategy which
supplies interest and inflation expectations of private market players with an anchor
through a credible formulation of nominal targets. From the theoretical point of
view, this suggests a rule-formulation of nominal targets. From the theoretical point
of view, this suggests a rule-bound policy ? notably in the form of a money stock
rule ? as it makes monetary policy more predictable. A medium-term policy of
monetary stabilization ? with a sufficient measure of flexibility ? offers a number of
further advantages in terms of steadying expectations; it implies a self-commitment
by the central bank, and what is more, responsibilities are more clearly defined than,
say, in the case of a direct inflation target. Moreover, the quantity theory furnishes
the concept of monetary targeting with a clear theoretical foundation, which is a
major reason for its transparency.
Without a reliable nominal anchor for monetary policy it is hardly possible
for market players to assess the medium to long-term trends of monetary
benchmarks, such as interest rates. This lack of orientation will inevitably lead to
frequent revisions of market expectations and correspondingly sharp price
fluctuations in the financial markets. Basing the strategy on financial market prices
such as interest rates, the yield curve or also exchange rates, particularly seems
highly problematical. A monetary policy which is based on such indicators will
hardly be in a position, particularly in periods of heightened uncertainty and high
volatility, to give reliable guidance to market expectations. In the absence of an
external anchor, it will be very difficult for market participants to assess the
monetary policy stance; this, in turn, is likely to lead to larger swings in
expectations. In the final analysis, the central bank may find itself facing a situation
in which, because the monetary policy strategy is geared to market expectations, the
intended stabilization of the latter is completely foiled. The strategy of monetary
targeting, however, which is geared to the longer term, basically offers a chance of
16
largely decoupling expectations from short-term trend ? and hence volatility ?
through the monetary policy stance. This makes it easier to break the circular
connection between the distortion of monetary indicators, uncertainty about the
monetary policy stance and increasing price fluctuations.
Implications for the use of monetary policy instruments. Especially in
an environment which tends to be more susceptible to shifts in market sentiment,
monetary policy makers must have at their disposal a set of instruments which
enables them to manage the provision of central bank money as precisely as
possible without sending wrong or undesirable signals. There is no room in such a
box of monetary policy tools for dirigisme measures ? such as credit ceilings or
administratively controlled interest rates. For one thing, they are at odds with the
primacy of indirect monetary management, which uses market mechanisms and
seeks to avoid allocative distortions as far as possible. For another, dirigisme
measures would be ineffective anyhow, given the multiplicity of international
evasion routes. At the instrumental level, too, the room for selective intervention by
monetary policy makers has become negligible as a result of globalization. It is
merely a logical consequence that in the operational implementation of monetary
policy, the focus worldwide is now on open market policy.
The role of the minimum reserve instrument has changed radically. Whereas
in he past the Bundesbank tried to actively influence the bank`s money creation
leeway by varying the reserve ratios, which were often very high, the minimum
reserve instrument is now primarily used to smooth out fluctuations in the demand
for central bank money in the money market. The minimum reserves required to be
maintained on an average basis can perform the function of a buffer against
unexpected liquidity fluctuations during the reserve period. This has a steady effect
on the interest rate movements in the money market and enables the central bank to
keep its intervention frequency low. Perpetual fine-tuning of the money market, by
contrast, not only presents greater technical difficulties. A high intervention
frequency in the money market runs a dual risk. For one thing, the central bank
could give the market false signals; for another, the risk of making oneself a
prisoner of market expectations will increase.
With a view to derivatives, the question arises of whether they could
perhaps provide monetary policy makers with a completely new class of
instruments which could be used to exert a more selective and more sophisticated
influence on the markets than in the past. Caution is advisable here: it is tempting,
of course, to use the leverage effect of derivative instruments in order to implement
17
monetary policy intentions in the markets more consistently. Another consideration
is that discreet intervention would be possible using derivatives insofar as, for
example, the sale of an option does not appear immediately in the central bank`s
balance sheet.
However, there are serious reservations against making active use of these
technically tempting features of derivative instruments. The most important
objection is no doubt that intervention in the futures market, too, is bound to fail if
the interest rate or exchange rate level which the central bank considers desirable is
perceived by market participants to be unsustainable. In the event of unsuccessful
intervention the leverage which is offered by derivatives will, on the other hand,
rebound on the central bank, with all the (undesirable) liquidity effects that were
initially avoided.
A potential field of application for derivative instruments is their passive
utilization as indicators in the monetary decision-making process. Option prices
contain information about market participants` expectations which is not available
from other sources. Indicators derived from option prices of the degree of
uncertainty prevailing in the markets ? for instance, implied volatilities and implied
probabilities ? can provide, at the tactical level, useful indications for the timing and
gauging of money policy measures. It must be ensured, however, the tactical
considerations in no way impair a clear strategic orientation of monetary policy.
This use of derivatives in the monetary decision-making process, incidentally, rules
out their simultaneous utilization for intervention purposes because, in the case of
intervention by the central bank, prices no longer reflect market expectations in an
unadulterated form.
The increasing professionalism of investment activities has likewise resulted
? at least in the broader sense ? in an extension of the range of monetary policy
instruments. The significance of the central bank`s information policy and public
relations work is increasing as financial transactions are already triggered by
expected central bank measures. This shows clearly the especially close interlinkage
of the monetary policy strategy and its practical implementation in an expectation-
biased environment. A transparent monetary policy strategy-such as, in particular,
monetary targeting ? provides a much clearer starting point for explaining monetary
policy to the general public than an approach geared to looking at everything.
The changing nature of financial industry, especially as reflected in
developments in the financial derivatives market, provides considerable
18
opportunities for risk sharing or inter-temporal smothering. Portfolio managers or
financial institutions` executives making balance sheet decisions are operating in a
constantly changing environment. What happens to the value of the portfolio when
interest rate changes and how can the risk of value be measured? How can the
interest rate risk be managed with changes in portfolio or balance sheet
composition? How can the others risks of the portfolios, such as credit, liquidity,
and currency risks, be assessed? What actions can be taken to control or plan for
these risks and can value be produced through risk management activities?
Financial derivatives, representing decomposition of risk exposure relative to other
assets or future and forward contracts, have had a revolutionary impact on the
financial service industry. Financial institutions with a solid asset/liability plan
should consider derivatives as a way to reduce exposure to interest rate risk.
Derivatives can complement the traditional methods of matching asset and liability
to minimize interest rate risk. Though, pricing of derivatives, based on arbitrage and
required conditions in financial markets which may not be met in fact, is a complex
but an extremely useful in pricing the risk of insurance against bad financial
outcomes and pricing complex cash flows associated with a variety of financial
instruments.
In the historic transformation of global financial markets, Indian Financial
System India also is in the midst of a process of fundamental structural and
operational changes due in large part to various combinations of a more intensive
competitive environment, the official deregulation moves and the impact of
technology. At the same time the pace of financial innovation has accelerated
bringing with it changes in the risk characteristics in the financial system. The
resulting shifts in the behaviour of market require the authorities, in turn, to revise
their regulatory and control methods, calling proper timing and adequate
preparation. If deregulatory measures are adopted haphazardly, they can actually do
more harm than good to the society. As the first step in the decision-making process
leading to the dismantling of financial regulations, the government must determine
whether the financial market is mature and resilient enough to adapt to the new
financial landscape. These changes are likely to have important implications both
for the structure of financial systems, the operation of financial institutions and the
conduct and operation of monetary policy and prudential regulation.
Futures-INTRODUCTION
19
The liberalization and integration of world capital markets in the 1980s was
inspired by a combination of hope an necessity. The hope lay in the expectation of
more efficient allocation of saving and investment, both within national markets and
across the world at large. The necessity stemmed from the macroeconomic and
financial instability the instability engendered government deficits and external
imbalances that required financing on a scale unprecedented in peace time and that
exceeded the capacity or willingness of the traditionally fragmented financial
markets to cover. This financing need joined with advances in technology and
communications to spawn a host of innovations, ranging from securitization in
place of intermediated bank credit to new derivative instruments. Taken together,
innovation, technology and deregulation have smashed the barriers both within and
among national financial markets.
Today world financial markets are growing in size, sophistication, and
global integration. According to an estimate, the international securities
transactions amounted to $ 6 trillion per quarter in the second half of 1993 about
five to six times the value of international trade-in six Group of Seven countries.
This increased volume of portfolio capital movements has made foreign exchange
markets much more sensitive to changes in financial markets. These markets have
acquired clout as an indicator of the credibility of the government`s actual or
prospective policies, as a disciplining mechanism for inconsistent government
policies, and as an impetus for reform of financial markets in industrial and
developing countries alike.
FUTURES MARKETS
In the past several years, derivatives markets have attracted many new and
inexperienced entrants. The spectacular growth of the new futures markets in
interest rates and stock market indexes has generated a demand for a unified
economic theory of the effects of futures markets in commodities, financial
instruments, stock market indexes and foreign exchange upon the intertemporal
allocation of resources.
The basic assumption of the investment theory is that investors are risk
averse. If risk is to be equated with uncertainty, can we question the validity of this
assumption? What evidence is there? As living, functional proof of the
appropriateness of the risk aversion assumption, there exists entire market whose
sole underlying purpose is to allow investors to display their uncertainties about the
future. These particular markets, with primary focus on the future, are called just
that future markets. These markets allow for the transfer of risk from hedgers (risk
20
adverse individuals), a key element necessary for the existence of futures markets is
the balance between the number of hedgers and operators who are willing to
transfer and accept risk.
What economic theory of futures markets can explain these phenomena?
Keynes viewed the futures market as one where commercial firms hold inventories
of commodities and sell futures to transfer the risk of price fluctuations.
Speculators` are on the other side of the market and purchase these futures at a
discount below the expected price. The magnitude of this discount is the risk
premium demanded by the speculators. His theory of `normal backwardation' has
been the subject of controversy. Set of theories of futures markets, based upon the
capital asset pricing model (CAPM) or the intertemporal CAPM, are incapable of
explaining the essential features of futures markets.
The quality of positive economic theory must be judged by its ability to
explain with precision clarity and simplicity the key elements of a complex
economic phenomenon. Theories which ignore or cannot explain the basic
characteristics cannot qualify as relevant or good theories of futures markets. The
main characteristics of futures markets to be explained by a good economic theory
are: (i) there is only a small number of actively traded products with futures
contracts. The trading unit is large and indivisible; (ii) Almost all of the open
interest is concentrated in the nearby contract, which has a maturity of no more than
three months; (iii) The success ratio of new contracts is about 25 per cent in world
financial markets. Some new contracts succeed and then, which seem to have
similar useful features, fail; (iv) Futures are seldom used by farmers. Instead, they
are forward contracts. The main users of agricultural futures are intermediaries
(dealers) in the marketing process; (v) There are both commercial and non-
commercial users of futures contracts in interest rates and foreign exchange. The
commercial users are to a large extent dealers: intermediaries in the marketing
process; (vi) The position of the commercials and dealers in interest rate futures are
almost evenly divided between long and short positions; (vii) The main use of
futures by the commercials is to hedge corresponding cash and forward positions;
(viii) The positions of the non-commercials are almost entirely speculative
positions; (ix) In foreign exchange futures, the positions of the commercials are
unbalanced. In some currencies they are net short and in others they are net long.
However, their positions are primarily hedging against corresponding cash and
forward positions. The non-commercial positions are against corresponding cash
and forward positions. The non-commercial positions are overwhelmingly
21
speculative positions; and, finally, futures are used in the underwriting of fixed
income securities but not in equity underwriting.
Each of these characteristics entails risk. The spectacular growth of the
derivatives market and the heavy losses incurred recently by several firms
undertaking derivative transactions has reinforced concerns about the possible risks
involved. Need to accelerate the implementation of sound risk management
practices is well recognized to maintain the stability of the derivatives market. With
pools of high-yield-seeking capital growth rapidly, with the technology of
international capital markets making it cheaper and easier to alter the composition
of portfolios at short notice, and with institutional fund managers under continuing
pressure to deliver high performance, the importance of systemic risk control
management cannot be over-emphasized.
The economic theory of futures markets focus upon the inter-related
questions. How do the futures markets affect the intertemporal allocation of
resources? To what extent do these markets post relevant information concerning
supply and demand at a later date? How do these markets affect the risk premiums
that producers charge, when the prices of output or of input are uncertain? These
questions can be combined into the following: How do futures markets affect the
supply functions of output, when there is price uncertainty? What are the welfare
effects of the futures markets? To what extent does the diversity in the forecasting
ability of the futures speculators simply result in transfers of wealth among
themselves and to what extent does it affect the output produced, the price paid by
the consumer and the variance of that price? How does the existence of futures
markets affect the level of expected production and the variance of the price paid by
consumers, relative to the situation that would prevail if there were no futures
markets? How can we evaluate the extent to which a particular futures market
changes the economic welfare? Does trading in financial instruments serve any
economic purpose?
These questions are of great interest to the policy makers as well as to the
academics. Extensive trading in financial futures and increased volatility in security
prices and interest rates affect the formation of real capital in the economy
(particularly that of a long-term nature) and the structure of liquidity in the credit
market.
Widespread recognition of the need for continued progress is felt to reduce
the sources of systematic risk. Recent important initiatives that have been taken
22
include: (i) a proposed extension of the 1988 Basle Capital Accord. (The Basle
Accord established in international framework for measuring regulatory capital and
setting capital adequacy standard). Proposals include a more comprehensive
treatment of the market risk of derivative positions, including separating banks`
loan the trading books; isolating market risk, including risk of unexpected interest
and exchange rate changes from specific risk; and allowing banks to reduce credit
exposures through bilateral netting (that is, creating a single legally binding net
position that replaces a large number of gross obligations; (ii) improved disclosure
and accounting standards. More transparency about consolidated positions in the
derivatives market would help lower the risk of precautionary runs based faulty
information; (iii) improved market infrastructure. Initiatives include moving to real
time gross settlement systems, which provide immediately finality of payments,
thereby reducing settlement risk, and adopting a clearing house structure for netting
and setting standardized over-the counter derivatives.
FUTURES CONTRACTS AND FUTURE TRADING
The future contract is an agreement to buy or sell an asset at a certain time in
the future for a certain price. Equities, bonds, hybrid securities and currencies are
the commodities of the investment business. They are traded on organized
exchanges in which a clearing house interposes itself between buyer and seller and
guarantees all transactions, so that the identity of the buyer or seller is a matter of
indifference to the opposite party. Futures contracts protect those who use these
commodities in their business.
Futures trading are to enter into contracts t buy or sell financial instruments,
dealing in commodities or other financial instruments, for forward delivery or
settlement, on standardized terms. The major functions performed by future markets
are: they facilitate stockholding; they facilitate the shifting of risk: they act as a
mechanism for collection and dissemination of information: and they perform a
forward pricing function. To perform these functions for future trading, the
customary condition is that there must be variation in the price of the actual
commodity under consideration; second, there must exist economic agents with
commitments in the actual market; and third, it must be possible to specify a
standard grade of the commodity and to measure deviations from this grade. As a
result of the first two conditions, some economic agents will face a price risk and
there will be a demand for hedging facilities. A futures market established
specifically to meet purely speculative demands is possible but is unknown. The
third conditions which are thought of necessary for the establishment of futures
trading are the presence of speculative capital and financial facilities for payment of
23
margins and contract settlements. In addition, a strong infrastructure is required,
including financial, legal and communication systems.
Financial futures contracts exist to provide risk management services to
participants. Risk and uncertainty in the form of price volatility and opportunism
are major factors giving rise to future trading. Futures trading evolved out of
autonomous forward contracting by merchants, dealers and processors, designed to
increase business efficiency. Indeed, early futures markets were viewed as delivery
markets in which transactions were facilitated by the provision of uniform rules on
grade and delivery terms, and the security provided b the clearing houses in
guaranteeing individual contracts. This evolution from spot to forward to futures
contracts suggest a progressive adaptation of institutions to more efficient methods
of dealing with price risk. It is frequently argued that a pre-condition for futures
trading is a well developed cash market and the breakdown of forward contracting.
Futures markets develop because they are a more efficient means of transferring
those contract rights attached to price. Spot and forward contracting may become
too costly. However, these three contracting modes are not mutually exclusive
ways of transacting. Indeed, the development of futures markets improve the
efficiency of spot and possibly of forward contracting. It is perhaps best to view
futures markets as side' markets designed to deal with price volatility that is poorly
handled by spot and forward markets. This transactional superiority of futures
markets comes mainly from their transaction cost reducing attributes.
Futures markets, by forming prices relating to forward delivery dated,
project their prices into the future. These prices are used by agents to plan future
production to price forward contracts for the supply of commodities, and to tender
for forward contracts. Agents need not transact on future exchanges to use futures
prices in this way, and the information contained in such prices is an externality to
them. Agents may also use futures markets in deciding whether to store a
commodity (using the forward premium as an indicator of whether storage is
expected to be profitable). In addition, futures markets may help agents to decide
the timing of inputs purchases and of processing activities according to the expected
outcome of hedging. Agents in these latter two categories are, of course, transactors
on futures markets. Thus, futures markets perform a forward pricing function, and
in these ways futures prices facilitate the allocation of resources between present
and future uses.
FUTURES VERSUS OPTIONS
24
Investors occasionally make the mistake of confusing a future contract with
an options contract. Some analogies can be made between futures contracts and
option contracts. Both involve a predetermined price and contract duration. An
option, however, is precisely that an option. The person holding an option has the
right, but not the obligation, to exercise the put or call. If an option has no value at
its expiration, the option holder will allow it to expire unexercised. But with futures
contracts, a trade must occur if the contract is held until its delivery deadline.
Futures contracts do not expire until exercised. One party has promised to deliver
an asset, which another party has promised to buy. It is also possible for one or
both parties to the trade to transfer their half of the promise to someone else via an
offsetting trade.
Figure 1 contrasts the situation faced by the buyer and the seller of a call
option with the situation faced by the buyer and the seller of a futures contract.
Specifically, terminal values for buyers and sellers are shown at least possible
moment the expiration date for the option and the delivery date for the futures
contract.
25
26
As shown in panel (a), no matter what the price of the underlying stock, an
option buyer cannot lose and an option seller cannot gain on expiration date.
Option buyers compensate sellers for putting themselves in this position by paying
them a premium when the contract is signed. However, the situation is quite
different with a futures contract. As shown in panel (b), the buyer may gain or lose,
depending on the price of the asset in the delivery month. Whatever the buyer gains
or loses an exactly offsetting loss or gain will be registered by the seller. The
higher the contract price (that is, the price of the futures contract when the buyer
purchased it from the seller), the greater the likelihood that the buyer will lose and
the seller will gain. The lower the contract price, the greater the likelihood that the
seller will lose and the buyer will gain.
Synthetic futures contract can be enacted even in the case of such assets for
which both put and call options are available but future contracts are unavailable.
The clearest example involves European options on equity. The purchase of a
European call option and the sale of a European put option at the same exercise
price and with the same expiration date will provide a value at the expiration that
will be related to the stock price at that time. This is shown in Figure 2 Pane (a)
shows the pay-off associated with the purchase of a call at an exercise price E,
whereas panel (b) shows the pay-off associated with the sale of a put at the same
27
exercise price. The results obtained by taking both position are shown by the solid
line in panel (c).
Depending on the prices (i.e. premiums) of the call and the put, this strategy
may initially either require a net outflow of cash or provide a net inflow. For
comparability with the purchase of a futures contract, this cash flow may be offset
with borrowing or lending as required to bring the net investment to zero. The dash
line in panel (c) shows a case in which the call option costs more than as provided
by the sale of that put option. The difference is borrowed, requiring the loan
repayment shown in figure. The dashed line thus indicates the net end of period
payoffs for a strategy requiring no initial outlay. Because these payoffs are
equivalent to the payoffs for a strategy requiring no initial out lay. Because these
payoffs are equivalent to the payoffs from a futures contract with a contract price
equal to F, a synthetic futures contract has been created. In practice, however, the
equivalence is not perfect. Moreover, synthetic future is not market to market on a
daily basis. Despite these differences, the existence of well functioning markets for
call and put options will enable investors to create arrangements similar to futures
on the underlying asset synthetically.
FUTURES VERSUS FORWARD MARKETS
While futures and forward contacts are similar in many respects, their
differences are more important to fully understand the nature and uses of these
financial instruments. Both futures and forward contracts specify a transaction to
take place at a future date and include pr?cis requirements for the commodity to be
delivered, its price, its quantity, the delivery date, and the delivery point.
Nevertheless these two types of contracts for future delivery of a commodity and
the markets in which they are traded differ in a number of significant ways, some of
which are included in Table 2.
Although most investors are unlikely ever to become involved in the
forward market, it is important to understand some of the attitudes, particularly as a
good deal of the literature on pricing futures contracts typically refers to these
contracts interchangeably. Specifically, it might be inferred from Table-2 that
differences resulting from liquidity, credit risk, search, margin, taxes and
commissions could cause futures and forward contacts not to be price identically.
For instance, in dealing with price risk, futures contracts have several transactional
advantages relative to spot and forward contracts. Sequential spot contracts that are
spot contracts where the terms of the contract are re-negotiated as events unfold; do
28
not inject any certainty into the transaction. Such a method of contracting is
particularly liable to the hazards of opportunism and may deter investment because
of the relatively high probability that the contract will be reached. On the other
hand, forward and futures contracts inject some certainty into their transaction. Both
share the property that the parties agree to perform the terms of the contract at some
future date. In fact, time-dated contracts are generally costlier to enforce than spot
contracts. This is due to the absence of the self-enforcing, near simultaneous
exchange of value for value characteristic of spot transactions and the greater
uncertainty attached both to the eventual outcome and each party`s compliance with
the terms of forward contracts.
29
30
A Comparison of Futures and Forward Markets
Future Market
Forward Market
1.
Trading is conducted in a 1.
Trading is done by telex or
competitive arena by open
telephone,
with
participants
outcry of bids, offers, and
generally dealing directly with
amounts.
broker-dealers.
2.
Contract terms are standardized 2.
All contract terms are negotiated
with all buyers and sellers
privately by the parties.
negotiating only with respect to
price.
3.
Non-member participants deal 3.
Participants deal typically on a
through brokers (exchange
principal-to-principal basis.
members who represent them
on the exchange floor.
4.
Participants
include
banks, 4.
Participants are primarily institutions
corporations
financial
dealing with one other and other
institutions,
individual
interested parties dealing through
investors, and speculators.
one or more dealers.
31
5.
The clearing house of the 5.
A participant must examine the
exchange becomes the opposite
credit risk and establish credit limits
side
to
each
cleared
for each opposite party.
transactions;
therefore,
the
credit risk for a futures market
participant is always the same
and there is no need to analyze
the credit of other market
participants.
6.
Margins deposits are to be 6.
Typically, no money changes hands
required of all participants.
until delivery, although a small
margin deposit might be required of
non dealer customers on certain
occasions.
7.
Settlements are made daily 7.
Settlement occurs on date agreed
through the exchange clearing
upon between the parties to each
house. Gains on open positions
transaction.
may be withdrawn and losses
are collected daily.
8.
Long and short positions are 8.
Forward positions are not as easily
usually liquidated easily.
offset or transferred to other
participants.
9.
Settlements are normally made 9.
Most transactions result in delivery.
in cash, with only a small
percent age of all contracts
resulting actual delivery.
10.
A single, round trip (in and out 10. No commission is typically charged
of the market) commission is
if the transaction is made directly
charged.
It
is
negotiated
with another dealer. A commission is
between broker and customer
charged to both buyer and seller,
and is relatively small in
however, if transacted through a
relation to the value of the
broker.
contract.
11.
Trading is regulated.
11. Trading is mostly unregulated.
12.
The delivery price is the spot 12. The delivery price is the forward
price.
price.
32
Forward and futures contracts differ, however, in their susceptibility to
opportunism, especially in their role of reducing price risk. First forward contracts
that cover all feasible contingencies are costly to devise. The information and
transaction costs will thus preclude a fully specified forward contract and this
contractual incompleteness will give rise to enforcement and execution difficulties.
Incomplete contracting has a clear economic justification. Given the cost of
tailoring the contract to the particular needs of the parties, it will usually be cost-
effective to use standard form contracts. In this regard, organized forward and
futures contracting have identical properties. Nevertheless, enforcement and
execution difficulties can be expected to pose a more serious problem for forward
contracts. This is so for several reasons. First, in forward contracting, individuals
will have to incur the expense of determining the reliability risk of the opposite
party. To the extent that there are scale economies in such specialization by identity,
forward contracting will be more expensive than organized futures contracting
where the exchange ensures the integrity of its members and trading practices.
Forward contracts also are subject to high enforcement costs where personal
markets sanctions are weak. The penalty risk of contract law is costly to enforce and
may not deal effectively with all types of breaches.
Another disadvantage of forward contract is that they are tied transactions.
The forward contract transfers rights relating to quantity, quality and price. The last,
however, may best be separated, especially when the parties are risk averse and
their access to insurance markets limited. Price changes have an unfortunate zero-
sum quality that increases the likelihood of opportunism. Thus, while forward
contracts may inject certainty into the quantity and possibly quality dimensions of
future transactions, it is not clear that they are the least cost adaptation to price risk.
Depending on the transaction costs in alternative markets, and the strength of
governance in each, it may be desirable for both risk-spreading and opportunism-
reducing reasons to separate price risk from the other aspects of time-dated
transactions. Since spot, forward and futures markets deal in different bundles of
rights among different individuals, rights can be divided between those relating to
quantity and quality, and those counseling certainty of profits and costs. Forward
contracts, especially in personal markets, are best suited to ensuring that contract
terms relating to the former are complied with, whereas futures contracts deal with
price volatility.
Future contracts permit the price risk to be separated from the reliability risk
by removing the former from the set of factors giving rise to opportunism. The
governance structure supplied by the exchange authority effectively eliminates
33
reliability risk from futures trading. The seller of futures contracts incurs a liability
not to the buyer, but to the clearing house, and likewise the buyer acquires an asset
from the clearing house. The clearing house in effect guarantees all transactions. In
addition, the exchange rules, especially regarding its members` contract, severely
limit their ability to behave opportunistically. Organized exchanges greatly reduce
default and reliability risk from future contracts. This is achieved by transferring
transactions over price risks from a personal to an impersonal market through
standard form futures contracts traded in a self-regulated market price.
Future contracts are standard form contracts with only one negotiable term:
Price. The standardization of future contracts has significant implications for
transaction costs. This is so for several reasons. First, contract standardization
eliminates the cost of bargaining over non-price terms and of enforcing contract
provisions. Second, it reduces monitoring costs that are generally incurred in
principal-agent relationships. The principal only needs to give his broker
instructions as to price and quantity which are easily observed. The monitoring
costs in the futures market are, therefore, significantly lower than those in the spot
market, where numerous other matters require attention and provide the broker with
opportunities to take advantage of the principal. Third, contract standardization
makes all futures contract is not a property shared by forward contacts.
The liquidity and competitive nature of future trading also reduce the
waiting costs of brokers and speculators for acceptable bids and offers. One
component of the transaction costs of futures trading is the ask-bid spread which in
a competitive situation, is directly correlated with the search costs of finding
acceptable bids and offers. We may live in the information age, but much of the
information we deal with every day is often perplexing. Perhaps most confusing of
all is the world of finance. We are deluged with data, analyses with incomplete
information, buyers and sellers will have to search each other out. The costs of such
search activity will differ and will be greater the more geographically dispersed and
heterogeneous are buyers and sellers. In fact, the transaction cost arises because the
parties to transactions are different individuals with asymmetric information,
divergent motives and mutual suspicions and because expenditure of resources can
reduce the gap in information and protect the parties against each other. Search
costs will not only raise the cost of activities but may preclude otherwise value
maximizing transactions from taking place. The importance of market liquidity
arise not only because it reduces waiting costs, but also because it ensures that
competitive pressures exist to keep waiting cost to a minimum for any volume of
trade. Competition among the futures traders will have the effect of weeding out
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these with excessive search costs and poor forecasting ability. Large speculators
make consistent profits whereas small traders make losses since the performance
difficulties occasioned by opportunism raise the cost of transacting. Each party is
confronted by what can be termed a reliability risk ? the risk that the other party
will default either on the whole transaction or on individual terms in a way that
decreases the expected wealth of the non-defaulting party. Reliability risk is an
important source of transaction costs because it will pay individuals to guard against
opportunism and contract breach. Acquiring information on the reliability of those
with whom one transacts yields benefits in the form of reduced losses due to default
and incomplete or inferior performance. Degree of success of futures markets can
be explained in terms of a net benefits function. The most actively traded
commodities have the most variable prices. Choices can be made among contractual
arrangements on the basis of maximum net benefit, taking account of transaction
costs.
STRATEGIES FOR FUTURES MARKETS.
Today s financial manager must be able to use all of the tools available to
control a company`s exposure to financial risk. Derivative securities have been very
successful innovation in capital markets. Financial futures markets are an
increasingly important feature of the world`s major financial centres. The
introduction of financial futures in the 1970s brought trading volume to previously
unheard of levels and entirely changed the character of futures markets. Markets for
options, stocks, bonds, index funds, foreign currencies, and other currencies have
been profoundly affected by the introduction of related future contracts as well s
future options. Recently active financial futures markets have been introduced in
developed and developing countries alike. Programme trading, a wide array of most
futures contracts as well as futures options, lower transaction costs, increasing
trading volume, expanded trading hours, electronic trading, and domestic and
international intermarket links continue to tie all of these financial markets into a
remarkable a tight and efficient financial trading network. Markets for options,
equities, bonds, index funds, foreign currencies, and other currencies have been
profoundly affected by the introduction of related future contracts as well as future
options.
Futures markets are to provide an opportunity for market participants to
hedge against the risk of adverse price movements. Futures are obligations to buy or
sell a specific commodity on a specific day for a present price. Shares, bonds and
currencies are the commodities of the investment business. Just as the dramatic
35
changes in the price rise affect farmers, rice mills and ultimately the consumer so
does the changes in interest rates, the relative value of currencies and the direction
of the stock market send ripples--and sometimes waves--through the financial
community. Futures contracts based on a financial investment or a financial index
are known as financial futures. Financial futures can be classified as (i) stock index
futures; (2) interest rate futures; and (3) currency futures.
In modern life financial engineering approach keep people and business
going. Today, futures markets are dominated by large commercial firms who
interact with professional risk bearers. Those who want insurance against price risk
should either buy options or engage in forward transactions. In the world financial
markets, futures markets are used by commercial firms to manage but not to
eliminate, the price risk inherent in their ordinary business. Major users of futures
markets are dealers and financial intermediaries who are professional risk--bearers.
If they did not use the futures markets, the risk premium that they would have to
charge their customers would significantly decrease the demand for their services.
Anticipating what this approach will cost fuels the futures market.
The investment manager can tailor a given risk position in a variety of ways.
Without financial futures, investors would have only one trading location to alter
portfolio positions when they get new information that is expected to influence the
value of assets ? the cash market. If they hear economic war that is expected to
impact the value of an asset adversely, investors want to reduce their price risk
exposure to that asset. The opposite would be true if the new information is
expected to impact the value of an asset favourably; an investor would increase
price risk exposure to that asset. There are, of course, transactions costs associated
with altering exposure to an asset ? explicit costs (commission), and execution costs
(bid-as spread and market impact costs).
Thus, the futures market is an alternative market that investors can use to
later their risk exposure to an asset when new information is acquired. But which
market ? cash or futures ? should the investor employ to alter a position quickly on
the receipt of new information ? The answer is simple : the one that most efficiently
achieve the objective. The factor to consider is liquidity, transactions, costs, taxes
and leverage advantages of the futures contract.
There are four basic strategies for using the futures markets : speculation,
hedging, spreading and arbitrate. The most important distinction between these
uses is their different risk-return characteristics. Speculating in futures increases
36
risk not only by undertaking a futures position with potential high returns but also
with the risk of a large loss. Hedging exists when a future position is taken to
reduce the risk of a current or anticipated cash position. Spreading involves taking
almost offsetting future positions that create a net position that typically possesses
significantly less risk than pure speculation, but has lower expected returns.
Arbitrate provides a risk-free profit when a trader takes opposite positions in a cash
asset and the associated futures counter it when these respective instruments are
mispriced in relation to one another.
Speculators wish to take a position in the market. Either they are betting that
a price will go up or they are betting that it will go down. In other words, a
speculative position can be either a long or a short. A long position occurs when the
futures contract is purchased; profits arise when prices increase. A short position
when its futures contract is sold, a short trader profits when prices decrease.
Speculative futures positions are very profitable for those who are able to
forecast correctly both market direction and the extent of the market move. This
profitability is enhanced because the speculator needed to put up only a small
percentage of the value of the underlying cash instrument for margin, there by
allowing a significant degree of leverage. Of course, if a speculator forecasts
incorrectly, then the mark-to-market rules cause a cash outflow as the futures
position deteriorates. Consequently, a speculator needs forecasting ability and
substantial knowledge of the underlying cash markets, plus sufficient funds to
overcome a short-term (or permanent) loss of funds from losing trades.
There is an important difference between speculating using forward markets
and speculating by buying the underlying asset in the spot market. Buying a certain
amount of the underlying asset in the spot market requires an initial cash payment
equal to the total value of what is bought. Entering into a forward contract on the
same amount of the asset requires no initial cash payment. Speculating using
forward markets therefore provide an investor with a much higher level of leverage
than speculating using spot markets. In the highly leveraged futures markets,
minimums are set to ensure that the speculators can afford any potential losses. For
this very reason a levy of 15 per cent margin on the contract price has been
suggested in the Bombay Stock Exchange plans to introduce futures trading on the
exchange parallel to cash transactions on the market. The percentage of margin is to
be constant throughout the contract but the amount of margin will vary based on the
mark to market price. Members are to pay margins on all futures contracts on a
gross basis.
37
In a volatile market, the speculator needs to establish realistic goals for
trades. After reaching these goals, it is best to cover the trade. If a speculator
becomes emotionally involved in a position (which generates greed and fear), the
ability to make a realistic decision about covering a position is impaired. Some
speculators attempt to circumvent such emotional considerations by placing special
trading orders with the broker so that the trader is automatically removed from a
disadvantageous situation. Although such orders are useful for speculators who are
not in constant contact with the market and have specific forecasts of market
movements, many active traders believe that recognizing the current trend in the
market and then adapting to that trend is more important than mechanical position
trading.
Whereas speculators wish to take a position in the market, hedgers want to
eliminate an exposure to movements in the price of an asset. Hedging with financial
futures is an art as well as a science. By future hedging, we mean to take a position
in futures contracts that offset some of the risk associated with some given market
commitment. The essence of hedging is the adoption of a future position that, on
average, generates profits when the market value of the commitment is higher than
expected. The notion of designing a futures strategy to generate losses under certain
circumstances may seem quixotic to some. One must keep in mind the well-
repeated adage: There are no free lunches. One cannot expect trading profits as
well as risk reduction (although that sometimes happens). The key is to coordinate
losses in futures with gains elsewhere, and vice versa. How does one achieve that
kind of coordination? Such futures are not an answer to all investment management
problems, but they do provide the finance manager with new means to act upon
market decisions. An understanding of the futures contracts and how the futures
markets operate is critical to designing a successful hedge strategy. As with any
innovative technique, potential hedgers need to take the time to study the markets
and determine the risk/return potential for each application.
In order to profit from a spread transaction the trader attempts to determine
whether the size of the difference between the prices of the two contracts will
increase or decrease. A spread earns a profit if the correct direction of the price
difference is forecasted and the appropriate spread transaction is set up in
conjunction with the changing price structure of the future contracts.
Spreaders must forecast the relevant factors that cause changes in the
spreads. Change in financial futures spread depends upon the behaviour of interest
38
rate. A profitable spread creates a gain on one side of the spread that is larger than
the loss on the other side of the spread. A pure speculator would make more money
by taking only the profitable side of the market; however, a spread reduces the risk
of a position in case the forecast is incorrect. In recognition of the reduced risks,
margins on spread positions are much less than the margins on pure long or short
positions, and hence the leverage for spreads is increased. Risk is reduced, since
both sides of spread usually move in the same direction, even though their prices
can change by different amounts.
Arbitrage exists when a trader is able to obtain risk-free profits by taking
one position in the cash market and an exact opposite position in the futures market.
The arbitrage position is covered later by delivering the cash security into the
futures position. The arbitrageur can close the position prior to delivery if the profit
potential has been achieved; this situation occurs principally in the stock index
futures market because of the price swings.
Arbitrage keeps the futures and cash prices in line with one another. This
relationship between the cash and fair futures prices is expressed by the simple cost
of carry pricing. This pricing shows that the fair futures prices are the set of buying
the cash asset now and financing this asset until delivery into the futures contract. If
the current futures price is higher than the fair price dictated by the cost of carry
pricing, then arbitrage is possible by buying the cheaper instrument (the cash) and
selling the more expensive instrument (the futures). Alternatively, if the current
futures price is less than the fair price, then the arbitrageur purchases futures and
sells the cash short. This activity forces the prices of the cash and futures
instruments back into their appropriate relationship.
Futures markets reflect the buying and selling activities of many buyers and
sellers of the homogeneous contract. Firms often have the power to affect the
market price in cash and forward markets because they are merchandising contracts
custom-made to the two parties. However, a single party is less able to affect the
price in the broad futures market, i.e., the ability of the firm to trade large quantities
without affecting the price is one of the main reasons why the new futures markets
in financial instruments have flourished.
Futures markets disseminate information quickly, effectively and
inexpensively, and thereby reduce monopoly power. In the cash and forward
markets, a large firm has a substantial advantage over a smaller firm. The larger
firm has more extensive and reliable information concerning current and impending
39
developments. It is difficult for a small firm to gauge the reasonableness of the
dealer`s offer because the costs of search are high. When there is a futures market,
potential buyers and sellers have means of gauging what a broad group of buyers
and sellers expect will be the subsequent price of the commodity specified in the
futures contract and there is a historic relation between the price of the specific
commodity in position and the commodity specified in the futures contract. The
parties evaluate the reasonableness of the dealer`s often in terms of its relation to
the futures price.
In the future markets, who can beat the market? It is observed in most of the
studies that small speculators are big losers, large speculators are small winners, and
hedgers are big winners. Since the profits of the large speculators for the individual
futures markets are small, the speculators do not earn sufficient profits to
compensate for the risk of trading in futures markets. Why do small trades continue
to trade if they consistently lose money? The possible reason to this may be :- (i)
small speculators enjoy playing the game`; it is exciting, dynamic, and a great
conversational topic; (ii) small speculators believe they can forecast; in other words
they remember their profits but forget their losses; (iii) losers drop out, with their
places being taken by new small speculators; meanwhile winners become large
speculators; (iv) the perceived ability of potential large gains is greater than the
disutility of small losses with the possibility of large losses discounted as being
unlikely by the small speculators.
Swaps -INTRODUCTION
Today`s financial swaps markets have their origin to the exchange rate
instability that followed the demise of Bretton Woods system in the early 1990s and
to the controls on international capital movements that most counties maintained in
those days. Swaps are at the center of the global financial revolution. Fantastic
numbers and growth are talked of. All this is true. But what is also certain is that
the current heady acceleration f this market cannot continue. Otherwise, there will
be no other activity left-only swapping. Already the shakeout has started. In the
plain vanilla dollar sector, the profits for brokers and market makers, after costs
and allocation of risk capital, are measured in fewer than five basis points. This is
before the regulators catch u and force disclosure and capital haircuts. At these
spreads the more highly paid must move on to currency swaps, tax-driven deals,
tailored structures and Schlock swaps.
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What is certain that, although the excitement may diminish, swaps are here
to stay. Already, swaps have had a major macro economic impact forging the
linkage between the Euro and domestic markets, flattening the cash yield curves
and reducing central bank monopoly influence on markets. We are all swappers
now. And, when you are offered sweet deals, remember the Tibetan saying
Beware of honey offered on a sharp knife. The problem in following the chaotic
progress of this very important market is quite simply that he who knows does not
speak, he who speaks does not know. A brief glimpse of how the swap market has
matured and a short list of the non-proprietary tools in the swapper`s arsenal is
presented below :
SWAPS ? THE TEENAGE YEARS
The essence of a swap contract is the binding of two counterfeiters to
exchange two different payment steams over time, the payment streams over time,
the payment being tied, at least in part, to subsequent and uncertain market price
developments. In most swaps so far, the prices concerned have been exchange rates
or interest rates, but they increasingly reach out to equity indices and physical
commodities, notably oil and oil products. All such prices have risk characteristics
in common, in quality of not in degree. And for all, the allure of swaps may be
expected cost saving, yield enhancement, or hedging or speculative opportunity.
Financial swaps, simple in principal and versatile in practice, are
revolutionary, especially for portfolio management. A swap coupled with an
existing asset or liability can radically modify effective risk and return.
Individually and together with futures, options and other financial derivatives, they
allow yield curve and currency risks, and liquidity and geographic market
considerations, all to be managed separately ? and also independently of underlying
cash market stocks.
Swaps in their current form started in 1981 with the well-publicized
currency swaps, and in the following year, with dollar interest-ate swaps. The
initial deals were characterized by three critical features.
1. Barter ? two counter parties with exactly offsetting exposures were
introduced by a third party. If the credit risk were unequal, the third party ? if a
bank might interpose itself or arrange for a bank to do so for a small fee.
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2. Arbitrage driven ? the swap was driven by an arbitrage which gave some
profit to all three parties. Generally, this was a credit arbitrage or market-access
arbitrage.
3. Liability driven-almost all swaps were driven by the need to manage a
debt issue on both sides.
The major, dramatic change has been the emergence of the large banks as
aggressive market makers in dollar interest-rate swaps. Major US banks are in the
business of taking credit risk and interest-rate risk. They therefore do not need
counter parties to do dollar swaps. The net result is that spreads have collapsed and
volume has exploded.
Swaps ? The Laundry List
Dollar swaps
1. Plain vanilla
2. Alternate floating rate
3. Floating-floating
4. Variable principle
5. Options on swaps
6. Short date swaps
7. Syndicated swaps
8. Hi-tech swaps
9. Plain deal
10.Without exchange of principle
11. Amortizing swaps
12. Off-market deals
13. Cross-currency interest-rate swaps
14. Amortizing principle
15. Off-market deals
16. Assignability and tradeability
17. Collateralized swaps and Schiock Swaps
18. Extendiable swap
19. Puttable swap
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20. Drawdown swap
Along with swap other important derivatives and institutional developments
which came into prominence are:
Continuous Tender Panel: A compromise between sole-placing agency and
tender panel. The CTP agent agrees on the issue price (the strike offered yield of
SOY) with the issuer, at which price underwriting banks may request protection on
their notional allocations. These allocations are calculated pro rate to their
underwriting commitments, but are only exercisable to the extent that the CTP
agent has not per-sold the issue tranche. The SOY can change during the bidding
period and underwriters may be able to increase their initial allocations by bidding
at, or under, the SOY.
Direct Bid Facility (Unsolicited bidding): An increasingly common
provision in tender panel facilities whereby panel members may make unsolicited
bids to the issuer for particular note amounts/maturities.
Euro-commercial paper: A non-under-written or uncommitted note
issuance programme where typically two or three dealers place the issuer`s papers.
Global Note Facility: The Banks` medium-term underwriting commitment
is available to back up both the issue of US commercial paper and Euro notes.
Should the issuer be unable to roll over USCP, his will trigger off a Euro note
issuance process by tender panel. Bridging finance between the time of failed US
CP roll-over and provision of funds from the Euro note facility is provided by a
Swingling (below).
Global Commercial Paper: The growing concept of non-underwritten Euro
note, issuance programme being old on a global basis with the book moving
between time zones.
GUN: Grantor underwritten note: A floating rate note facility akin to a
Euronote facility whereby a group of banks (grantors) commit to purchase any notes
put back to them by investors on any FRN interest rate fixing date. Put notes are
then auctioned out to the market between the grantors.
Issuer-Set Margin: Similar to continuous tender panel except that,
underwriters are guaranteed the protection on their pro rata allocation of paper.
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Should they opt not to take notes at the issuer-set margin, the lead manager will
instead.
MOF: Multi-option facility: Broader than the classic underwritten
Euronots facility (NIF) in that the banks medium-term commitment is to backstop,
not only the issuance of Euronotes, but a wide range of other short-term
instruments-i.e.-bankers acceptance and short-term advances in a variety of
currencies.
NIF: Note Issuance facility: An addition to RUF and SNIF. Now widely
regarded as a general description for all underwritten Euronote facilities.
PUF: Prima underwriting facility: Same as a RUF except that the
maximum margin is expressed in relation to US prime.
RUF: Revolving underwriting facility: The acronym that started it all.
Classically, a medium term commitment by a group of underwriting banks to
purchase one, three or six-months. Euronotes at a fixed libor related margin should
a safe-placing agents fail to sell the notes to investors at or under, that margin RUF
has since been extended to tender panel placement facilities as well as sole-placing.
SNIF: Short-term note Insurance facility: Came after RUF as a method of
distinguishing tender panel placement from the sole - placing of the RUF.
Otherwise, structurally the same.
Specialized Tender Panel: Similar to the direct bid facility except that
members of the STP are limited to a nucleus of houses with perceived note
placement strength who are expected to make a market in the issuer`s paper.
Stop Out Bid: A refinement of tender panel bidding where by one or more
of the TP participants have an option to post a bid for all or part of an issue tranche
at a price which other tender panel members must then better.
Striking Price Method: The issue price for the whole tranche is set at the
level of the last accepted bid which caused the tranche to be filled-i.e.-notes are not
priced at a sequential level from the most competitive bid upwards as in standard
tender panel.
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Swap Tender Panel: A further refinement of TP whereby the issues can ask
for currency and /or interest rate swaps on a particular note issue tranche.
Swingline: Used in a global note facility or BONUS to allow the issuer to
move from the US CP market to the Euronote market. Typically available for a
maximum of seven days and priced over US prime.
TAP basis: The increasingly frequent method of issuance in Euro CP. The
dealer approaches the issuer for paper in direct response to particular investor
demand, rather than the issuer seeking bids from the dealer.
Tender Acceptance Facility: Precisely the same structure as an
underwriting ten. Euronote facility using a tender panel except that the short-term
instruments under auction are bankers acceptances, euro Euronotes.
Tender Panel: A group including Euronote facility under writers and
additionally appointed banks and dealers, who are invited to bid on an issuer`s
paper in an open auction format. Notes are awarded to bidders in sequential order
from the most competitive bid up wards until the full tranche is allocated.
TRUF: Transferable revolving underwriting facility: The underwriting
banks stringent liability to purchase notes, in the event of non-placement, is fully
transferable.
Although the swap market is now firmly established, there remains a wide
divergence among current and potential users as to how exactly a given swap
structure works, what risks are entailed when entering into swap transactions and
precisely what the swap market is and, for that matter, is not. Hence, among the
many topics and controversies surround.
THE BASIC SWAP STRUCTURES
The growth and continued success of the swap market has been due in no
small part to the creativity of its participants. As a result, the swap structures
currently available and the future potential structures which will in time become just
another market norm are limited only by the imagination and ingenuity of those
participating in the market. None-the less, underlying the swap transactions seen in
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the market today are four basic structures which may now be considered as
fundamental. These structures are:
? the interest Rate Swap
? the Fixed Rate Currency Swap
? the Currency Coupon Swap
? the Basis Rate Swap
RISK OF INVESTMENT
The Webster`s New Collegiate Dictionary definition of risk includes the
following meanings: .........possibility of loss or injury.........the degree or
probability of such loss". This conforms to the connotations put on the term by
most investors. Professionals often speak of downside risk" and "upside
potential". The idea is straightforward enough: risk has to do with bad outcomes,
potential with good ones.
In considering economic and political factors, investors commonly identify
five kinds of hazards to which their investments are exposed. They are:
Business and Financial Risk
Business risk and financial risk are actually two separate types of risks, but
since they are interrelated it would be wise to discuss them together. Business risk,
which is sometimes called operating risk, is the risk associated with the normal day-
to-day operations of the firm. Financial risk is created by the use of fixed cost
securities (that is, debt and preference shares). Looking at the two categories in a
sources and uses context, business risk represents the chance of loss and the
variability of return created by a firm`s uses of funds. Financial risk is the chance of
loss and the variability of the owners` return created by a firm`s sources of funds.
To clarify this important distinction between business and financial risk, let
us examine the income statement contained in Exhibit I. Earnings before interest
and taxes can be viewed as the operating profit of the firm; that is, the profit of the
firm before deducting financing charges and taxes.
Business risk is concerned with earnings before interest and taxes and
financial risk is concerned with earnings available to equity holders. The two
components of business risk signify the chance that the firm will fail because of the
46
inability of the assets of the firm to generate a sufficient level of earnings before
interest and the variability of such earnings. The two components of financial risk
reflect the chance that the firm will fail because of the inability to meet interest
and/or principal payments on debt, and the variability of earnings available to
equity holders caused by fixed financing changes (that is, interest expense and
preferred dividends). Putting it in another way, this second component of financial
risk is the extent to which earnings available to equity holders will vary at a greater
rate than earnings before interest and taxes. In case the firm does not employ debt,
there will be no financial risk.
An important aspect of financial risk is the interrelationship between
financial risk and business risk. In effect, business risk is basic to the firm, but the
firm`s risk can be affected by the amount of debt financing used by the firm.
Whatever be the amount of business risk associated with the firm, the firm`s risk
will be increased by the use of debt financing. As a result, it follows that the amount
of debt financing used by the firm should be determined largely by the amount of
business risk that the firm faces. If its business risk is low, then it can use more debt
financing without fear or default, or a marked impact on the earnings available to
the equity shareholders. Conversely, if the firm faces a lot of business risk, then the
use of a lot of debt financing may jeopardize the firm`s future operations.
EXHIBIT-I
XYZ CORPORATION LIMITED
INCOME AND EXPENDITURE STATEMENT FOR THE FINANCIAL
YEAR ENDED 30TH JUNE, 199X
Income (Rs. In crores)
Sales 60,52.70
Other income 1,04.19
61,56.89
Expenditure
Consumption of materials and stores, power and fuel 31,67.73
Payment to and provision for employees 7,43.21
Other operating expenses 3,86.68
Excise Duty 7,72.35
5,069.97
EarningBeforeInterestand Taxes (EBIT) 10,86.92
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Interest 1,62,09
Depreciation 1,45,02
EarningsBeforeTaxes 7,79.81
Provision for taxation 3,80.00
EarningsafterTaxation 3,99.81
Preferred Dividend .........
Earningsavailableto equity holders 3,99,81
Number of equity shares 43,77,060
Earnings per share 9,13421
Purchasing Power Risk
Whenever investors desire to preserve their economic position over time,
they utilize investment outlets whose values vary with the price level. They select
investments whose market values change with consumer prices which compensates
them for cost of living increase. If they do not, they will find that their total wealth
has been diminished. Inflation is an economic crippler that destroys the economic
power of investors over goods and services. In essence, investors have to be
concerned with the command that their invested money has over goods and services
on a continuing basis. In fact, we have been living with increasing consumer prices
for many years.
The relation between the market rate earned r, the rate of price change AP/P,
and the investor`s rate of change in real purchasing power X is shown in the
equation (1) :
1 r
X
0
.
1
1 AP / P
...(1)
X represents the percentage change in purchasing power resulting from an
investment with a rate of return r. If the investor`s rate of interest just equals the rate
of inflation, r=AP/P, then the investor`s real rate of return is zero, X = 0. In a more
typical situation, the investor`s rate of return r might be 12 per cent while inflation
AP/P is 6 per cent. In this case the investor`s purchasing power is increasing at
(1.12/1.06) ? 1 = 5.66 per cent; this is the investor`s real rate of return after
allowing for inflation. Stock brokers sometimes tell their customers that equity
48
shares are an inflation hedge which will more than protect them from purchasing
power risk. This is a bit of overstatement. It is true that equity shares suffer less
from purchasing power risk than fixed-income investments, but equity shares are
only a hedge against inflation most of the time. It has not always yielded real
increases in purchasing power during inflation.
Market Risk
This hazard arises from the fact that market prices and collateral values of
securities and real property may vary substantially, even when their earning power
does not change. The causes of these prices uncertainties are varied. At times many
markets are simply thin that is, buyers and sellers appear only intermittently. More
commonly, investment prices vary because investors vacillate in their preference for
different forms of investment, or simply because they sometimes have money to
invest and sometimes do not have it. But once the equity has developed a particular
price pattern, it does not change this pattern quickly. The causes of changes in
market price are usually beyond the control of the corporation. An unexpected war
or the end of one, an election year, political activity, illness or death of a president,
speculative activity in the market, the outflow of bullion ? all are tremendous
psychological factors in the market. The irrationality in the securities markets may
cause losses unrelated to the basic risks discussed before. These losses are the result
of changes in the general tenor of the market and are called market risks.
The market risk in equity shares is much greater than it is in bonds. Equity
shares value and prices are related in some fashion to earnings. Current and
prospective dividends, which are made possible by earnings, theoretically, should
be capitalized at a rate that will provide yields to compensate for the basic risks. On
the other hand, bond prices are closely related to changes in interest rates on new
debt. Equity prices are affected primarily by financial risk considerations which, in
turn, affect earnings and dividends. However, equity prices may be strongly
influenced by mass psychology, by abrupt changes in financial sentiment and by
waves of optimism or pessimism. Whenever emotions run high, speculators and
gamblers crave action. They cannot refrain from entering the market arena as their
greed for profits becomes their overpowering motivation. They do not hesitate to
analyze the market environment. They do not base their judgements on an accurate
evaluation of the underlying factors. Instead, they rush into the market and distort
prices beyond any semblance of value. Greed pushes prices up, and fear drives them
49
down. In short, the crux of the market risk is the likelihood of incurring capital
losses from price changes engendered by a speculative psychology.
Interest Rate Risk
A major source of risk to the holders of high quality bonds is changes in
interest rates, commonly referred to as interest rate risk. These high-quality bonds
are not subjected to either substantial business risk or financial risk. Consequently,
they are referred to as high-quality bonds. But since they are high-quality bonds,
their prices are determined mainly by the prevailing level of interest rate in the
market. As a result, if interest rates fall, the prices of these bonds will rise, and vice
versa.
Interest rate risk affects all investors in high quality bonds regardless of
whether the investors hold short-term or long-term bonds. Changes in interest rate
have the greatest impact on the market price of long-term bonds, since the longer
the period before the bond matures, the greater the effect of a change in interest
rates. On the other hand, changes in interest rates will not have much of an impact
on the market price of short-term bonds portfolio may fluctuate markedly from
period to period, as interest rates change. Consequently, changes in interest rates
affect investors in long-term as well as in short-term bonds.
Social or Regulatory Risk
The social or regulatory risk arises where an otherwise profitable investment
is impaired as a result of adverse legislation, harsh regulatory climate, or in extreme
instance nationalization by a socialistic government: The profits of industrial
companies may be reduced by price controls, and rent controls may largely destroy
the value of rental property held for income or as a price-level hedge. The social
risk is really political and thus unpredictable, but under a system of representative
government based on increasing government intervention in business affairs, no
industry can expect to remain exempt from it.
Other Risks
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Other types of risk, particularly those associated with investment in foreign
securities, are the monetary value risk and the political environment risk. The
investor who buys foreign government bonds or securities of foreign corporations
often in an attempt to gain a slightly higher yield than obtained on domestic issues,
runs the calculated risk of (1) a change in the foreign government and repudiation of
outstanding debt, (2) nationalization of business, firms, that is, seizure by
government, or (3) the desire but inability of the foreign government or corporation
to handle its indebtedness. The investor should weigh carefully the possibility of the
additional risks associated with foreign investments against his expected return,
either in the form of interest or dividends or capital gains, when investing in foreign
securities rather than domestic securities.
QUESTION
1. Discuss the growth of financial derivatives in the global financial markets.
2. Critically examine the impact of financial derivatives on the monetary
policy.
3. The changing nature of financial industry, especially as reflected in
developments in the financial derivatives market, provides considerable
opportunities for risk haring or inter-temporal smothering. What actions
can be taken to control or plan for these risks? Can value be produced
through risk management strategies? Explain.
4. Discuss the various financial derivatives instruments traded on organized
exchanges in world financial markets.
5. Critically examine the global positions in OTC derivatives markets by
type of risk instrument.
6. Global networking is no longer a more metaphor for worldwide activities
but now describes in very literal terms the advances in information and
communication technology which have been a major driving force behind
internationalization in many areas of life, but especially in the economy.
Within the economic sector, in turn, it is in the financial markets that
globalization has been particularly dynamic. Comment.
7. Examine the impact of growth of the financial derivatives on the financial
system.
51
Unit II
OPTIONS
Objectives of the study:
The objectives of this unit are to help one understand, in general
The general frame work of Options as a financial derivative
Importance and working of Options in the financial market
Syllabus
Options: Types of options; Option trading; Margins; Valuation of options;
Binomial Option Pricing Model; Black-Schools model for Call Options; Valuation
of put options; Index options; Option markets-exchange traded options, over-the-
counter options, quotes, trading, margins, clearing, regulation and taxation;
Warrants and convertibles.
Contents Design:
2.1. Introduction.
2.2 Options-Meaning
2.3. Participants in the Options Market
2.3. Types of Options
2.4. Reason for using Options.
2.5. Working of options
2.6. Types of Options
2.7. Option Styles
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2.8. Reading an Options Table
2.9. Uses of Options
2.10. Advantages of options trading
2.11. The basic traded stock options
2.11.1. Call option
2.11.2. Put Options
2.12. Pricing of Options
2.12.1. Factors affecting the Option premium
2.12.2. Option zones
2.12.3. Assumptions and Notations
2.12.4. Upper and Lower boundaries for option prices
2.12.5. Greeks
2.13. Options Pricing Models
2.13.1. Binomial options pricing model
2.13.2. Black-Scholes Model
2.14. Trading Strategies
2.14.1. Bull Market Strategies
2.14.2. Bear Market Strategies
2.14.3 Volatile Market Strategies
2.14.4. Stable Market Strategies
2.15. Margin Money
2.16. Index option
2.17. Exchange-Traded Option
2.18. Over-The-Counter
2.19. National Clearance and Depository system
2.20. Regulations
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2.21. Warrants and Convertibles
2.22. Important Terms
2.23. Self analysis Questions
2.24. Activities
2.25. References
2.1. Introduction
Portfolio investments normally include mutual founds stocks and bonds. The
type of securities not end here, as options present a world of opportunity to
sophisticated investors, as another type of security with their veracity. Options can
be as speculative or as conservative as one wants. They are complex securities and
can be extremely risky.
But at the same time ignorant of this type of investment places one in a
weak position. Without knowledge about options, one would not only forfeit
having another item in ones investing toolbox but also lose insight into the
workings of some of the world's largest corporations. Whether it is to hedge his risk
of foreign-exchange transactions or to give employees ownership in the form of
stock options, most multi-nationals today use options in some form or another.
2.2 Options-Meaning
An option is a contract whereby one party (the holder or buyer) has the
right, but not the obligation, to exercise the contract (the option) on or before a
future date (the exercise date or expiry). The other party (the writer or seller) has
the obligation to honour the specified feature of the contract. Since the option gives
the buyer a right and the seller an obligation, the buyer has received something of
value. The amount the buyer pays the seller for the option is called the option
premium.
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Because this is a security whose value is determined by an underlying asset,
it is classified as a derivative. The idea behind an option is present in everyday
situations.
For example, you discover a house that you'd love to purchase.
Unfortunately, you won't have the cash to buy it for another three months. You talk
to the owner and negotiate a deal that gives you an option to buy the house in three
months for a price of Rs.200, 000. The owner agrees, but for this option, you pay a
price of Rs.3, 000.
Now, consider two theoretical situations that might arise:
1.
It's discovered that the house is actually the true birthplace of a
great man. As a result, the market value of the house skyrockets
to Rs.1 crore. Because the owner sold you the option, he is
obligated to sell you the house for Rs.200, 000. In the end, you
stand to make a profit of Rs.97, 97,000 (Rs.1 Crore ? Rs.200, 000
? Rs.3, 000).
2.
While touring the house, you discover not only that the walls are
chock-full of asbestos, but also that a ghost haunts the master
bedroom; furthermore, a family of super-intelligent rats have built
a fortress in the basement. Though you originally thought you had
found the house of your dreams, you now consider it worthless.
On the upside, because you bought an option, you are under no
obligation to go through with the sale. Of course, you still lose the
Rs.3, 000 price of the option.
This example demonstrates two very important points. First, when you buy
an option, you have a right but not an obligation to do something. You can always
55
let the expiration date go by, at which point the option becomes worthless. If this
happens, you lose 100% of your investment, which is the money you used to pay
for the option. Second, an option is merely a contract that deals with an underlying
asset. For this reason, options are called derivatives, which mean an option derives
its value from something else. In our example, the house is the underlying asset.
Most of the time, the underlying asset is a stock or an index.
2.3. Participants in the Options Market
There are four types of participants in options markets depending on the
position they take: They are:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are
called writers: furthermore, buyers are said to have long positions, and sellers are
said to have short positions.
-Call holders and put holders (buyers) are not obligated to buy or sell. They have
the choice to exercise their rights if they choose.
-Call writers and put writers (sellers), however, are obligated to buy or sell. This
means that a seller may be required to make good on a promise to buy or sell.
2.4. Reason for using Options.
Two main reasons why an investor would use options are:
a. Speculation
Speculation is the betting on the movement of a security. The advantage of
options is that one isn`t limited to making a profit only when the market goes up.
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Because of the versatility of options, one can also make money when the market
goes down or even sideways.
Speculation is the territory in which the big money is made - and lost. The
use of options for making big money or less is the reason why they have the
reputation of being risky. This is because when one buys an option; one has to be
correct in determining not only the direction of the stock's movement, but also the
magnitude and the timing of this movement. To succeed, one must correctly predict
whether a stock will go up or down, and has to be right about how much the price
will change as well as the time frame it will take for all this to happen commissions
must also be taken into account.
b. Hedging
The other function of options is hedging. Think of this as an insurance
policy. Just as one insures one`s house or car, options can be used to insure the
investments against a downturn. By using options, one would be able to restrict
one`s downslide while enjoying the full upside in a cost-effective way.
2.5. Working of options
In order to understand the working of options, an assumed firm by the name
Justus Company, is taken Let's say that on May 1, the stock price of Justus Co. was
Rs.75 and the premium (cost) was Rs.3.15 for a July 78 Call, which indicated that
the expiration was the third Friday of July and the strike price was Rs.78. The total
price of the contract was Rs.3.15 x 100 = Rs.315. In reality, you'd also have to take
commissions into account, but we'll ignore them for this example.
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Remember, a stock option contract is the option to buy 100 shares; that's
why you must multiply the contract by 100 to get the total price. The strike price of
Rs. 78 means that the stock price must rise above Rs.78 before the call option is
worth anything; furthermore, because the contract is Rs.3.70 per share, the break-
even price would beRs.81.
When the stock price is Rs.67, it's less than the Rs.70 strike price, so the
option is worthless. But don't forget that you've paid Rs.315 for the option, so you
are currently down by this amount.
Three weeks later the stock price is Rs.84. The options contract has
increased along with the stock price and is now worth Rs.6 x 100 = Rs.600.
Subtract what you paid for the contract, and your profit is (Rs.3) x 100 = Rs.300.
You almost doubled the money in just three weeks! You could sell your options,
which are called "closing your position," and take your profits - unless, of course,
you think the stock price will continue to rise. For the sake of this example, let's say
we let it ride. By the expiration date, the price drops to Rs.60. Because this is less
than our Rs.78 strike price and there is no time left, the option contract is worthless.
We are now down to the original investment of Rs.300. Putting it in the form of a
table: here is what happened to our option investment:
Date
May 1
May 21
Expiry Date
Stock Price
Rs.78
Rs.84
Rs.60
Option Price
Rs.3
Rs.6
worthless
Contract Value Rs.300
Rs.600
Rs.0
Paper Gain/Loss Rs.0
Rs.300
-Rs.300
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The price swing for the length of this contract from high to low was Rs.600,
which would have given us over double our original investment.
This is leverage in action.
Option frameworks
The buyer pays the price (premium) to the seller (writer).The buyer assumes a
long position and the writer a corresponding short position. Thus the writer of
a call option is "short a call" and has the obligation to sell to the holder, who is
"long of a call option" and who has the right to buy. The writer of a put option
is "on the short side of the position", and has the obligation to buy from the
taker of the put option, who is "long a put".
The option style determines when the buyer may exercise the option which
will affect the valuation. Generally the contract will either be American style
- which allows exercise up to the expiry date - or European style - where
exercise is only allowed on the expiry date - or Bermudian style - where
exercise is allowed on several, specific dates up to the expiry date. European
contracts are easier to value.
Buyers and sellers of exchange-traded options do not usually interact directly -
the futures and options exchange acts as intermediary. The seller guarantees
the exchange to fulfill his obligation if the buyer chooses to execute.
The risk for the option holder is limited: he cannot lose more than the
premium paid as he can "abandon the option". His potential gain with a call
option is theoretically unlimited;
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The maximum loss for the writer of a put option is equal to the strike price. In
general, the risk for the writer of a call option is unlimited. However, an
option writer who owns the underlying instrument has created a covered
position; he can always meet his obligations by using the actual underlying.
Where the seller does not own the underlying on which he has written the
option, he is called a "naked writer", and has created a "naked position".
Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-
money" option has a positive intrinsic value, options in "at-the-money" or
"out-of-the-money" has an intrinsic value of zero. Additional to the intrinsic
value an option has a time value, which decreases when the option is closer to
its expiry date.
2.6. Types of Options
There are two main types of options:
a. American options can be exercised at any time between the date of
purchase and the expiration date.
b. European options can only be exercised at the end of their lives.
c. Long-Term Options are options with holding times of one, two or
multiple years, which may be more appealing for long-term
investors, which are called long-term equity anticipation
securities (LEAPS). By providing opportunities to control and
manage risk or even to speculate, LEAPS are virtually identical to
regular options. LEAPS, however, provide these opportunities for
much longer periods of time. Although they are not available on all
stocks, LEAPS are available on most widely held issues.
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d. Real option is a choice that an investor has when investing in the
real economy - in the production of goods or services, rather than in
financial contracts ? which may be something as simple as the
opportunity to expand production, or to change production inputs.
They are an increasingly influential tool in corporate finance with
typically difficult or impossible to trade
e. Traded options (also called "Exchange-Traded Options" or "Listed
Options") are Exchange traded derivatives which have: standardized
contracts; quick systematic pricing; and are settled through a clearing
house (ensuring fulfillment.) These include: stock options; bond
options; interest rate options; and swaption.
f. Vanilla options are 'simple', well understood and traded options,
whereas an exotic option is more complex, or less easily understood
and non-standard in nature. Asian options, look back options, barrier
options are considered to be exotic, especially if the underlying
instrument is more complex than simple equity or debt.
g. Employee stock options are issued by a company to its employees
as compensation.
2.7. Option Styles
Settlement of options is based on the expiry date. However, there are three
basic styles of options which affect settlement. The styles have geographical names
but have nothing to do with the location where a contract is agreed. The styles are:
European: These options give the holder the right, but not the obligation, to
buy or sell the underlying instrument only on the expiry date. This means that the
61
option cannot be exercised early. Settlement is based on a particular strike price at
expiration. Currently, in India only index options are European in nature.
American: These options give the holder the right, but not the obligation, to
buy or sell the underlying instrument on or before the expiry date. This means that
the option can be exercised early. Settlement is based on a particular strike price at
expiration. Options in stocks that have been recently launched in the Indian market
are "American Options. American style options tend to be more expensive than
European style because they offer greater flexibility to the buyer.
Bermudian: These options give the holder the right, but not the obligation, to
buy or sell the underlying instrument on several specific dates, on or before the
expiry date.
Option Class & Series: An option "class" refers to all options of the same
type (call or put) and style (American or European) that also have the same
underlying. eg: All Nifty call options are referred to as one class. An option series
refers to all options that are identical: they are the same type, have the same
underlying, the same expiration date and the same exercise price.
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2.8. Reading an Options Table
Column 1: Strike Price is the stated price per share for which an underlying stock
may be purchased (for a call) or sold (for a put) upon the exercise of the option
contract.
Option
strike
prices
typically
move
by
increments.
Column 2: Expiry Date shows the termination date of an option contract.
Column 3: Call or Put column refers to whether the option is a call (C) or put (P).
Column 4: Volume indicates the total number of options contracts traded for the
day. The total volume of all contracts is listed at the bottom of each table.
Column 5: Bid indicates the price someone is willing to pay for the options
contract.
Column 6: Ask indicates the price at which someone is willing to sell an options
contract.
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Column 7: Open Interest is the number of options contracts that are open; these
are contracts that have neither expired nor been exercised.
In India, option tables published in business newspaper and are fairly similar
to the regular stock tables.
The following is the format of the options table published in India`s business
news papers:
Expiry
Strike
Option
Traded
Number of
Traded
Contracts
Open High Low
Date
Price
Type
Quantity Contracts
Value
Call options-American are depicted as 'CA' and Put options-American as
'PA`.
The Open, High, Low, Close columns display the traded premium rates.
2.9.Uses of Options
When using options for insurance, the option holder reduces the risk he
bears by paying the option seller a premium to assume it.
Because one can use options to assume risk, one can purchase options to
create leverage. The payoff to purchasing an option can be much greater than by
purchasing the underlying instrument directly. For example buying an at-the-money
call option for 2 monetary units per share for a total of 200 units on a security
priced at 20 units, will lead to a 100% return on premium if the option is exercised
when the underlying security's price has risen by 2 units, whereas buying the
security directly for 20 units per share, would have led to a 10% return. The greater
leverage comes at the cost of greater risk of losing 100% of the option premium if
the underlying security does not rise in price.
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2.10. Advantages of options trading
a. Risk management: Put options allow investors holding shares to hedge against
a possible fall in their value. This can be considered similar to taking out
insurance against a fall in the share price.
b. Time to decide: By taking a call option the purchase price for the shares is
locked in which gives the call option holder until the Expiry Day to decide whether
or not to exercise the option and buy the shares. Likewise the taker of a put option
has time to decide whether or not to sell the shares.
c. Speculation: The ease of trading in and out of an option position makes it
possible to trade options with no intention of ever exercising them. If an investor
expects the market to rise, they may decide to buy call options. If expecting a fall,
they may decide to buy put options. Either way the holder can sell the option prior
to expiry to take a profit or limit a loss. Trading options has a lower cost than
shares, as there is no stamp duty payable unless and until options are exercised.
d. Leverage: Leverage provides the potential to make a higher return from a
smaller initial outlay than investing directly. However, leverage usually involves
more risks than a direct investment in the underlying shares. Trading in options can
allow investors to benefit from a change in the price of the share without having to
pay the full price of the share.
We can see below how one can leverage ones position by just paying the
premium.
Option Premium
Stock
Bought on Oct 15
Rs. 380
Rs. Rs.4000
Sold Dec 15
Rs. 670
Rs. 4500
65
Profit
Rs. 290
Rs. 500
ROI (Not annualized)
76.3%
12.5%
e. Income generation: Shareholders can earn extra income over and above
dividends by writing call options against their shares. By writing an option they
receive the option premium upfront. While they get to keep the option premium,
there is a possibility that they could be exercised against and have to deliver their
shares to the taker at the exercise price.
f. Strategies: By combining different options, investors can create a wide range of
potential profit scenarios.
2.11. The basic traded stock options
2.11.1. Call option
A call option is a financial contract between the buyer and the seller , where
the buyer of the option has the right, but not the obligation to buy an agreed
quantity of a particular commodity or financial instrument (the underlying
instrument) from the seller of the option at a certain time (the expiration date) for a
certain price (the strike price). The seller (or "writer") has the obligation to sell the
commodity or financial instrument should the buyer so decide. The buyer pays a fee
(called a premium) for this right.
Illustration 1:
Raj purchases 1 Reliance (RELIND)OCT 1300 Call --Premium 10
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This contract allows Raj to buy 100 shares of RELIND at Rs 150 per share
at any time between the current date and the end of next August. For this
privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).
Now let us see how one can profit from buying an option.
Raj purchases a December call option at Rs.40 for a premium of Rs.15.
Here, he has purchased the right to buy that share for Rs.40 in December. If the
stock rises above Rs.55 (40 + 15) he will break even and he will start making a
profit. Suppose the stock does not rise and instead falls, he will choose not to
exercise the option and forego the premium of Rs.15 and thus limiting his loss to
Rs.15.
Let us take another example of a call option on the Nifty to underst and the
concept better. Nifty is at 1310. The following are Nifty traded at following
quotes.
Option Contract
Strike Price
Call Premium
67
Dec Nifty
1325
Rs.6,000
1345
Rs. 2,000
Jan Nifty
1325
Rs.4,500
1345
Rs.5,000
A trader is of the view that the index will go up to 1400 in Jan 2002 but does
not want to take the risk of prices going down. Therefore, he buys 10 options of Jan
contracts at 1345. He pays a ' premium for buying calls (the right to buy the
contract) for 500*10= Rs 5,000/-.
In Jan 2002 the Nifty index goes up to 1365. He exercises the option and
takes the difference in spot index price which is (1365-1345) * 200 (market lot)
= 4000 per contract. Total profit = 40,000/- (4,000*10).
He had paid Rs 5,000/- premium for buying the call option. So he earns by
buying call option is Rs 35,000/- (40,000-5000).
If the index falls below 1345 the trader will not exercise his right and will
opt to forego his premium of Rs 5,000. So, in the event the index falls further his
loss is limited to the premium he paid upfront, but the profit potential is unlimited.
If one is bullish and expects prices to rise, then he will take a long
position by buying calls. If one is bearish and expects prices to fall, then he will
take a short position by selling calls.
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A graphical interpretation of the payoffs and profits generated by a call option buyer. A
higher stock price means a higher profit. Eventually, the price of the underlying (e.g., stock)
The buyer of a call option wants the price of the underlying instrument to rise in the
future; the seller either expects that it will not, or is willing to give up some of the upside
(profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining
the opportunity to make a gain up to the strike price. Call options are most profitable for the
buyer when the underlying instrument is moving up, making the price of the underlying
instrument closer to the strike price. When the price of the underlying instrument surpasses
the strike price, the option is said to be "in the money. The initial transaction in this
context (buying/selling a call option) is not the supplying of a physical or financial asset
(the underlying instrument). Rather it is the granting of the right to buy the underlying
asset, in exchange for a fee - the option price or premium.
Call options can be purchased on many financial instruments other than stock in a
corporation - options can be purchased on futures on interest rates, as well as on
commodities such as gold or crude oil. A call option should not be confused with either
69
Incentive stock options or with a warrant. An incentive stock option, the option to buy
stock in a particular company, is a right granted by a corporation to a particular person
(typically executives) to purchase treasury stock. When an incentive stock option is
exercised, new shares are issued. Incentive stock options are not traded on the open market.
In contrast, when a call option is exercised, the underlying asset is transferred from one
owner to another.
It is clear that a call option has positive monetary value when the underlying
instrument has a spot price (S) above the strike price (K). Since the option will not be
exercised unless it is "in-the-money", the payoff for a call option is
Max[(S - K);0] or formally, (S - K) +
where
Prior to exercise of the option value, and therefore price, varies with the
underlying price and with time. The call price must reflect the "likelihood" or
chance of the option "finishing in-the-money". The price should thus be higher with
more time to expiry (except in cases when a significant dividend is present), and
with a more volatile underlying instrument.
2.11.2. Put Options
A put option (sometimes simply called a "put") is a financial contract
between the buyer and the seller of the option which allows the buyer the right but
not the obligation to sell a commodity or financial instrument (the underlying
instrument) to the seller of the option at a certain time for a certain price (the strike
price) and where the seller has the obligation to purchase at that strike price, if the
buyer does choose to exercise the option.
Eg.1 :
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Raj purchases 1 RELIND (Reliance Industries) AUG 350 Put --Premium 20
This contract allows him to sell 100 shares RELIND at Rs 350 per share at
any time between the current date and the end of August. To have this privilege, he
pays a premium of Rs 2000 (Rs 20 a share for 100 shares).
e.g : 2 :
Raj is of the view that the a stock is overpriced and will fall in future, but
he does not want to take the risk in the event of price rising so purchases a put
option at Rs 70 on 'X'. By purchasing the put option Raj has the right to sell the
stock at Rs 70 but he has to pay a fee of Rs 15 (premium). So he will breakeven
only after the stock falls below Rs 55 (70-15) and will start making profit if the
stock falls below Rs 55.
e.g.: 3:
An investor on Dec 15 is of the view that Wipro is overpriced and will fall
in future but does not want to take the risk in the event the prices rise. So he
purchases a Put option on Wipro. Quotes are as under: Spot Rs 1040; Jan Put at
1050 Rs 10; Jan Put at 1070 Rs 30
He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-.
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He pays Rs 30,000/- as Put premium.
His position in following price position is discussed below.
1. Jan Spot price of Wipro = 1020
2. 2. Jan Spot price of Wipro = 1080
In the first situation the investor is having the right to sell 1000 Wirpro shares at
Rs.1,070/- the price of which is Rs.1020/- By exercise the option he earns Rs.(1070-
1020)= per Put, which totals Rs.50,000/-. His net income is Rs.(50000 ? 30000) =
Rs.20,000.
In the second price situation, the price is more in the spot market, so the
investor will not sell at a lower price by exercising the Put. He will have to allow
the Put option to expire unexercised. He loses the premium paid Rs.30, 000.
If one is bearish and expects prices to fall, then he will take a long position
by buying Puts. If one is bullish and expects prices to rise, then he will take a short
position by selling Puts.
Note that the seller (the writer) of the option is agreeing to buy the
underlying instrument if the buyer of the option so decides. In exchange for having
this option, the buyer pays the seller a fee (the premium).
The most widely-known put option is for stock in a particular company.
However, options are traded on many other assets: financial - such as interest rates
and physical, such as gold or crude oil.
In general, the buyer of a put option expects the price of stock to fall
significantly, but does not want to sell the stock short because that could result in
large losses if the stock does go up anyway. (With a put option, the loss is limited to
the purchase price of the option.) The seller of the put option generally feels that the
stock in question is reasonably priced, and should the price fall, the seller may be
willing to become the owner of the stock at a lower price, considering it to be a
bargain. (On the other hand, the seller of the put may be merely gambling.)
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The put option has positive monetary value when the underlying instrument
has a spot price (S) below the strike price (K). Since the option will not be
exercised unless it is "in-the-money", the payoff for a put option is max[ (K - S) ; 0
] or formally, (K - S) +
where :
Prior to exercise, the option value, and therefore price, varies with the
underlying price and with time. The put price must reflect the "likelihood" or
chance of the option "finishing in-the-money". The price should thus be higher with
more time to expiry, and with a more volatile underlying instrument.
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A graphical interpretation of the payoffs and profits generated by a put
option as by the writer of the option. Profit is maximized when the option expires
worthless (when the price of the underlying exceeds the strike price), and the writer
keeps the premium.
CALL OPTIONS PUT OPTIONS
If one expects a fall in price (Bearish)
Short
Long
Graphical interpretation of the payoffs and profits generated by a put option
by the purchaser of the option. A lower stock price means a higher profit. Eventually,
the price of the underlying (i.e. stock) will be low enough to fully compensate the
price of the option.
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If one expects a rise in price (Bullish)
Long
Short
Summary:
PUT OPTION BUYER
CALL OPTION WRITER (Seller)
Pays premium
Receives premium
Right to exercise and buy the shares
Obligation to sell shares if exercised
Profits from rising prices
Profit from falling prices or remaining
neutral
Limited losses, Potentially unlimited Potentially unlimited losses, limited gain
gain
2.12. PRICING OF OPTIONS
2.12.1. Factors affecting the Option premium:
Options are used as risk management tools and the valuation or pricing of
the instruments is a careful balance of market factors.
There are four major factors affecting the Option premium:
Price of Underlying
Time to Expiry
Exercise Price Time to Maturity
Volatility of the Underlying
And two less important factors:
Short ? Term Interest Rates
Dividends
a. The Intrinsic Value of an Option
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The intrinsic value of an option is defined as the amount by which an option
is in-the immediate exercise value of the option when the underlying position is
marked-to-market.
For a call option: Intrinsic Value = Spot Price ? Strike Price
For a put option: Intrinsic Value = Strike Price ? Spot Price
The intrinsic value of an option must be positive or zero. It cannot be
negative. For a call option, the strike price must be less than the price of the
underlying asset for the call to have an intrinsic value greater than 0. For a put
option, the strike price must be greater than the underlying asset price for it to have
intrinsic value.
Comparing two calls with the same underlying asset, the
higher the exercise price of a call, the lower its premium.
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Call
Comparing two puts with the same underlying asset; the
higher the exercise prices of a put, the higher its premium.
Put
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b. Price of Underlying
The premium is affected by the price movements in the underlying
instrument. For Call options the right to buy the underlying at a fixed strike price ?
as the underlying price raises so does its premium. As the underlying price falls, so
does the cost of the option premium. For put options ? the right to sell the
underlying at a fixed strike price as the underlying price rises, the premium falls; as
the underlying price decreases the premium cost raises.
Call options become more valuable as the stock price increases and less
valuable as the strike price increases. For a put option, the payoff on exercise is the
amount by which the strike price exceeds the stock price. Put options, therefore,
behave in the opposite way to call options. They become less valuable as the stock
price increases and more valuable as the strike price increases.
The price of underlying asset
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The option premium will be higher when the price of the
underlying asset is higher.
Call
The option premium will be lower when the price of the
underlying asset is lower .
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Put
The more the options is in-the-money or out-of-the-money, the lower is its
time value; i.e. the option premium is close to the intrinsic value of the option.
c. The Time Value of an Option
Generally, the longer the time remaining until an option`s expiration, the
higher will be its premium, because the longer an option`s lifetimes, greater is the
possibility that the underlying share price might move so as to make the option in-
the-money. All other factors affecting an option`s price remaining the same, the
time value portion of an option`s premium will decrease with the passage of time.
Both put and call American options become more valuable as the time to
expiration increases. To see this, consider two options that differ only with
respect to the expiration date. The owner of the long-life option has all the
exercise opportunities open to that of the owner of the short-life on- and more.
The long-life option must, therefore, always be worth at least as much as
the short-life option.
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European put and call options do not necessarily become more valuable as
the time to expiration increases. This is because the owner of a long-life European
option does not have all the exercise opportunities open to the owner of a short-
life European option. The owner of the long-life European option can exercise
only at the maturity of that option. Consider two European call options on a
stock, one with an expiration date in one month and the other with an expiration
date in two months. Suppose that a very large dividend is expected in six weeks.
The dividend will cause the stock price to decline. It is possible that this will lead
to the short-life option being worth more than the long-life option.
The value of an option will be lower at the near closer of the expiration date,
when all other factors remaining equal. The loss of time value is faster as the
expiration date approaches.
d. Volatility
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Volatility is the tendency of the underlying security`s market price to
fluctuate either up or down. It reflects a price change`s magnitude; it does not
imply a bias towards price movement in one direction or the other. Thus, it is a
major factor in determining an option`s premium. The higher the volatility of the
underlying stock, the higher the premium because there is a greater possibility that
the option will move in-the-money. Generally, as the volatility of an under-lying
stock increases, the premiums of both calls and puts overlying that stock increase,
and vice versa.
Higher volatility = Higher premium
Lower volatility = Lower premium
The volatility of a stock price, is defined so that is the Standard
deviation of the return on the stock in a short length of time t. It is a measure of
how uncertain we are about future stock price movements. As volatility increases
the chance of the stock will do very well or very poorly increases. For the owner of
a stock, these two outcomes tend to offset each other. However, this is not so for
the owner of a call or put.
The owner of a call benefits from price increases but bas limited downslide
risk in the event of price decreases because the most that the owner can lose is the
price of the option. Similarly, the owner of a put benefits from price decreases but
has limited downslide risk in the event of price increases. The value of both calls
and puts, therefore, increases as volatility increase.
The higher the price volatility of the underlying asset, the higher the
likelihood of the option will end up in-the-money; therefore, the higher the
premium.
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Call
The higher the price volatility of the underlying asset, the
higher the likelihood that the option will end up out-of-the-
money; therefore, the lower the premium.
Put
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e. Interest rates
In general interest rates have the least influence on options
and equate approximately to the cost of carry of a futures
contract. If the size of the options contract is very large, then this
factor may take on some importance. All other factors being
equal as interest rates rise, premium costs fall and vice versa.
The relationship can be thought of as an opportunity cost. In
order to buy an option, the buyer must either borrow funds or
use funds on deposit. Either way the buyer incurs an interest rate
cost. If interest rates are rising, then the opportunity cost of
buying options increases and to compensate the buyer premium
costs fall. Why should the buyer be compensated? Because the
option writer receiving the premium can place the funds on
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deposit and receive more interest than was previously
anticipated. The situation is reversed when interest rates fall -
premiums rise. This time it is the writer who needs to be
compensated.
As interest rates in the economy increases, the expected
growth rate of the stock price tends to increase and the present
value of any future cash flows received by the holder of the
option decreases. These two effects tend to decrease the value of
a put option and hence, put option prices decline as the risk-free
interest rate increases. In the case of calls, the first effect tends to
increase the price and the second effect tends to decrease it. It
can be shown that the first effect always dominates the second
effect; that the price of a call always increases as the risk-free
interest rate increases.
The higher the "risk less interest rate", the higher the call
premium. The higher the "risk less interest rate", the lower the
put premium
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f. Dividends
Dividends have the effect of reducing the stock price on the ex-dividend
date. The value of a call option is negatively related to the size of any anticipated
dividend and the value of a put option is positively related to the size of any
anticipated dividend.
2.12.2. Option zones
The value of the stock option has three different zones, as shown below:
1. Out of the Money : Where the stock price is below the exercise price.
2. At the Money: Where it is close to or at the exercise price.
3. In the Money: Where the stock price is above the exercise price.
These zones are depicted in the chart below:
Say the exercise price is Rs.60. If the stock price is below 60, there is no
economic value. There is only time value; if stock price starts abo ve Rs.60 it will
have been economic value and time value. As seen from the chart time value is
maximum, when the exercise price and stock price are the same but is lower below
the exercise price or above it. If the actual price is lower than the exercise price
there is less change of profit on the call. If the actual price is above the exercise
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price, then there is a chance of profit, and there is less reason to pay a premium over
the economic value (intrinsic value)
2.12.3. ASSUMPTIONS AND NOTATION
Some relationships have been derived between option price that do not
require any assumptions about volatility and the probabilistic behavior of stock
prices For this purposes it is, therefore, reasonable to assume that there are no
arbitrage opportunities.
The following notations have been used: .
So: current stock price
ST: stock price at time T
X: strike price of option
T: time of expiration of option
r: risk-free rate of interest for maturity T (continuously compounded)
C: value of American call option to buy one share
P: value of American put option to sell one share
c: value of European all option to buy one share
p: value of European put option to sell one share
It should be noted that r is the nominal rate of interest, not the real rate of
interest and assumed that r > O. Otherwise, a risk-free investment would provide no
advantages over cash.
2.12.4. UPPER AND LOWER BOUNDS FOR OPTION PRICES
If the option price is above the upper bound or below the lower bound, there
are profitable opportunities for arbitrageurs.
Upper Bounds:
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An American or European call option gives the holder the right to buy one
share of a stock for a certain price. No matter what happens, the option can never be
worth more than the stock. Hence, the stock price is an upper bound to the option
price:
c < So and C < So
If these relationships do not hold, an arbitrageur can easily make a risk less
profit by buying the stock and selling the call option.
An American or European put option gives the holder the right to sell one
share of a stock for X. No matter how low the stock price becomes, the option can
never be worth more than X. Hence
P< X and P < X
For European put options, we know that at time T the option will not be
worth more than X. It follows that its value today cannot be more than the present
value of X:
P < Xe- rT
If this were not true, an arbitrageur could make a risk less profit by selling
the option and investing the proceeds of the sale at the risk-free Interest rate.
Lower Bound for European Calls on Non-Dividend-Paying Stocks
A lower bound for the price of a European call option on a non-dividend-
paying stock is
So -X- rT
First illustrated with a numerical example and then with a more formal
argument.
Suppose that So = Rs20, X = Rs18, r = 10% per annum, and T = 1 year. In this case,
So -Xe- rT = 20 -18e-0-i = 3.71
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or Rs3.71. Consider the situation where the European call price is Rs3.00,
which is less than the theoretical minimum of Rs3.71. An arbitrageur can buy
the call and short the stock. This provides a cash inflow of Rs20.00 ~ Rs3.00 =
Rs17.00. If invested for one year at 10% per annum, the Rs17.00 grows to
Rs18.79. At the end of the year, the option expires. If the stock price is greater
than Rs18, the arbitrageur exercises the option, closes out the short position,
and makes a profit of
Rs18.79 -Rs18.00 = Rs0.79
If the stock price is less than Rs18, the stock is bought in the .market and the
short (X) position is closed out. The arbitrageur then makes an even greater profit.
For example, if the stock price is Rs17, the arbitrageur's profit is
Rs18.79 -Rs17.00 = l. 79
For a more formal argument, we consider the following two portfolios:
Portfolio A: one European call option plus an amount of cash equal to Xe- rT
Portfolio B: one share)
In portfolio A, if the cash is invested at the risk-free interest rate, it will
grow to X at time T. If ST > X, the call option is exercised at time T and portfolio A
is worth ST. If ST < X, the call option expires worthless and the portfolio is worth X.
Hence, at time T portfolio A is worth
max(ST, X)
Portfolio B is worth ST at time T. Hence, portfolio A is always worth at
least as much and is sometimes worth more than, portfolio B at time T. It follows
that it must be , worth at least as much as portfolio B today. Hence
C + X e-rT > So
or
C > So -Xe-rT.
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Because the worst that can happen to a call option is that it expires
worthless, its value must be positive. This means that c > 0 and, therefore,
C+ Xe-rT > So
Or
C > max (So - Xe-rT, 0)
Lower Bound for European Puts on Non-Dividend-
Paying Stocks
For a European put option on a non-dividend-paying stock, a lower bound
for the price is
Xe ?rT - So
Suppose that So = Rs37, X = Rs40, r = 5% per annum, and T = 0.5 year. In
this case
Xe-rT -So = 4Oe-o.osxo.s -37 = 2.01
Rs2.01. Consider the situation where the European put price is Rs1.00,
which is less In the theoretical minimum of Rs2.01. An arbitrageur can borrow
Rs38.00 for six months to buy both the put and the stock. At the end of the six
months, the arbitrageur will be required to repay 38-o.osxo.s = Rs38.96. If the
stock price is below Rs40.00, : arbitrageur exercises the option to sell the stock
for Rs40.00, repays the loan, and makes a profit of
Rs40.00 -Rs38.96 = Rs1.04
If the stock price is greater than Rs40.00, the arbitrageur discards the option,
sells and repays the loan for an even greater profit. For example, if the stock price
is. 2.00, the arbitrageur's profit is
Rs42.00 -Rs38.9.6 = Rs3.04
For a more formal argument, we consider the following two portfolios:
Portfolio C: one European put option plus one share
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Portfolio D: an amount of cash equal to Xe-rT
If ST < X, the option in portfolio C is exercised at time T, and the portfolio
becomes worth X. If ST > X, the put option expires worthless, and the portfolio is
worth ST at time T. Hence portfolio C is worth max (ST. X) at time T. Assuming
that the cash is invested at the risk-free interest rate, portfolio D is worth X at time
T. Hence, portfolio C is always worth as much as, and is sometimes worth more
than, portfolio D at time T. It follows that in the absence of arbitrage opportunities.
Portfolio C must be worth at least as much as portfolio D today. Hence
p + So > Xe-rT
or
p > Xe-rT -So
Because the worst that can happen to a put option is that it expires
worthless, value must be non-negative. This means that
p > max (Xe-rT -So. 0)
Summary - Factors affecting the option premium
Call premium Put premium
Longer time to expiration
+
+
Higher price of underlying
+
-
Higher volatility of underlying
+
+
Higher exercise price
-
+
Higher interest rate
+
-
Dividend
-
+
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2.12.5. Greeks
The more sophisticated tools used to measure the potential variations of
options premiums are as follows:
Delta
Gamma
Vega
Rho
Delta
Delta
Delta is the measure of an option's sensitivity to changes in the price of the
underlying asset. Therefore, it is the degree to which an option price will move
given a change in the underlying stock or index price, all else being equal.
Change in option premium
Delta =
Change in underlying price
For example, an option with a delta of 0.5 will move Rs 5 for
every change of Rs 10 in the underlying stock or index.
Illustration:
A trader is considering buying a Call option on a futures contract, which
has a price of As 19. The premium for the Call option with a strike price of As 19
is 0.80. The delta for this option is +0.5. This means that if the price of the
underlying futures contract rises to As 20 -a rise of Rs.1 -then the premium will
increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = As
1.30.
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Far out-of-the-money calls will have a delta very close to zero, as the
change in underlying price is not likely to make them valuable or cheap. At-the-
money call would have a delta of 0.5 and a deeply in-the-money call would have a
delta close to 1.
While Call deltas are positive, Put deltas are negative, reflecting the fact
that the put option price and the underlying stock price are inversely related. This is
because if one buys a put his view is bearish and expects the stock price to go
down. However, if the stock price moves up it is contrary to his view therefore, the
value of the option decreases. The put delta equals the call delta minus 1.
It may be noted that if delta of one`s position is positive, he desires the
underlying asset to rise in price. On the contrary, if delta is negative, he wants the
underlying asset's price to fall.
Uses: The knowledge of delta is of vital importance for option traders because this
parameter is heavily used in margining and risk management strategies. The delta
is often called the hedge ratio. e.g. if you have a portfolio of 'n' shares of a stock
then 'n' divided by the delta gives you the number of calls you would need to be
short (i.e. need to write) to create a riskless hedge -i.e. a portfolio which would be
worth the same whether the stock price rose by a very small amount or fell by a
very small amount.
In such a "delta neutral" portfolio any gain in the value of the shares held
due to a rise in the share price would be exactly offset by a loss on the value of the
calls written, and vice versa.
Note that as the delta changes with the stock price and time to expiration
the number of shares would need to be continually adjusted to maintain the hedge.
How quickly the delta changes with the stock price are given by gamma, which we
shall learn subsequently.
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Gamma
This is the rate at which the delta value of an option increases or decreases
as a result of a move in the price of the underlying instrument.
Change in an option delta
Gamma =
Change in underlying price
For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then
a rise of +/- 1 in the underlying means the delta will move to 0.55 for a price rise
and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a
car -its acceleration -in moving from a standstill, up to its cruising speed, and
braking back to a standstill. Gamma is greatest for an A TM (at-the- money) option
(cruising) and falls to zero as an option moves deeply ITM (in-the-money ) and
OTM (out-of-the-money) (standstill).
If you are hedging a portfolio using the delta-hedge technique described
under "Delta", then you will want to keep gamma as small as possible as the smaller
it is the less often you will have to adjust the hedge to maintain a delta neutral
position. If gamma is too large a small change in stock price could wreck your
hedge. Adjusting gamma, however, can be tricky and is generally done using
options --unlike delta, it can't be done by buying or selling the underlying asset as
the gamma of the underlying asset is, by definition, always zero so more or less of it
won't affect the gamma of the total portfolio.
Theta
It is a measure of an option's sensitivity to time decay. Theta is the
change in option price given a one-day decrease in time to expiration. It is a
measure of time decay (or time shrunk). Theta is generally used to gain an idea
of how time decay is affecting your portfolio.
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Change in an option premium
Theta =
Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option
value decreases. This is due to the fact that the uncertainty element in the price
decreases.
Assume an option has a premium of 3 and a theta of 0.06. After one day it
will decline to 2.94, the second day to 2.88 and so on. Naturally other factors,
such as changes in value of the underlying stock will alter the premium. Theta is
only concerned with the time value. Unfortunately, we cannot predict with
accuracy the change's in stock market's value, but we can measure exactly the
time remaining until expiration.
Vega
This is a measure of the sensitivity of an option price to changes in market
volatility. It is the change of an option premium for a given change -typically 1 % -
in the underlying volatility.
Change in an option premium
Vega =
Change in volatility
If for example, XYZ stock has a volatility factor of 30% and the current
premium is 3, a Vega of .08 would indicate that the premium would increase to
3.08 if the volatility factor increased by 1 % to 31 %. As the stock becomes more
volatile the changes in premium will increase in the same proportion. Vega
measures the sensitivity of the premium to these changes in volatility.
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What practical use is the Vega to a trader? If a trader maintains a delta
neutral position, then it is possible to trade options purely in terms of volatility -
the trader is not exposed to changes in underlying prices. "
Rho
Rho measures the change in an option's price per unit increase -typically
1 % -in the cost of funding the underlying.
Change in an option premium
Rho =
Change in cost of funding underlying
Example:
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1 %
the price of the option will move by Rs 0.14109. To put this in another way: if the
risk-free interest rate changes by a small amount, then the option value should
change by 14.10 times that amount.
For example, if the risk-free interest rate increased by 0.01 (from 10% to 11
%), the option value would change by 14.10*0.01 = 0.14. For a put option, inverse
relationship exists. If the interest rate goes up the option value decreases and
therefore, Rho for a put option is negative. In general Rho tends to be small except
for long-dated options.
2.13.Options Pricing Models
There are various option pricing models which traders use to arrive at the
right value of the option. Some of the most popular models have been enumerated
below.
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2.13.1. Binomial options pricing model
The binomial options pricing model provides a generalisable numerical
method for the valuation of options. The binomial model was first proposed by Cox,
Ross and Rubinstein (1979). Essentially, the model uses a "discrete-time" model of
the varying price over time of the underlying financial instrument. Option valuation
is then via application of the risk neutrality assumption over the life of the option, as
the price of the underlying instrument evolves.
This model approach is widely used in a variety of conditions for which
other models cannot be easily applied. This is used to value American options
which can be exercised at any point and Bermudan options which can be exercised
at various points. The model is also relatively simple, mathematically, and can
therefore be readily implemented in a software (or even spreadsheet) environment.
Although slower than the Black-Scholes model, it is considered more accurate,
particularly for longer-dated options, and options on securities with dividend
payments.
The Model
The binomial pricing model uses a "discrete-time framework" to trace the
evolution of the option's key underlying variable via a binomial lattice (tree), for a
given number of time steps between valuation date and option expiration.
Each node in the lattice, represents a possible price of the underlying, at a
particular point in time. This price evolution forms the basis for the option
valuation.
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The valuation process is iterative, starting at each final node, and then
working backwards through the tree to the first node (valuation date), where the
calculated result is the value of the option.
Option valuation using this method is a three step process, which is as follows:
1.
price tree generation
2.
calculation of option value at each final node
3.
progressive calculation of option value at each earlier node; the value at the
first node is the value of the option.
The tree of prices is produced by working forward from valuation date to
expiration. At each step, it is assumed that the underlying instrument will move up
or down by a specific factor (u or d) per step of the tree. By definition,
and
.
If S is the current price, then in the next period the price will either be
or
. The up and down factors are calculated using
the underlying volatility, and the time duration of a step, t, measured in years
(using the day count convention of the underlying instrument).
The above is the original Cox, Ross, & Rubinstein (CRR) method; there
are other techniques for generating the lattice, such as "the equal probabilities" tree.
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Option value at each final node
At each final node of the tree -- i.e. at expiration of the option -- the option
value is simply its intrinsic, or exercise, value.
Max [ (S ? K), 0 ], for a call option
Max [ (K ? S), 0 ], for a put option:
(Where K is the Strike price and S is the spot price of the underlying asset)
Option value at earlier nodes
At each earlier node, the value of the option is calculated using the risk
neutrality assumption.
Under this assumption, today's fair price of a derivative is equal to the
discounted expected value of its future payoff. Expected value is therefore
calculated using the option values from the later two nodes (Option up and Option
down) weighted by their respective probabilities -- "probability" p of an up move in
the underlying, and "probability" (1-p) of a down move.
The expected value is then discounted at r, the risk free rate corresponding
to the life of the option. This result, the "Binomial Value", is thus the fair price of
the derivative at a particular point in time (i.e. at each node), given the evolution in
the price of the underlying to that point.
The Binomial Value is found for each node, starting at the penultimate time
step, and working back to the first node of the tree, the valuation date, where the
calculated result is the value of the option. For an American option, since the option
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may either be held or exercised prior to expiry, the value at each node is: Max (
Binomial Value, Exercise Value).
The Binomial Value is calculated as follows.
Binomial Value = [ p ? Option up + (1-p)? Option down] ? exp (- r ? t)
q is the dividend yield of the underlying corresponding to the life of the
option.
Advantage: The big advantage is that it can be used to accurately price American
options. This is because, with the binomial model it's possible to check at every
point in an option's life (ie at every step of the binomial tree) for the possibility of
early exercise (eg where, due to eg a dividend, or a put being deeply in the money
the option price at that point is less than the its intrinsic value).
Where an early exercise point is found it is assumed that the option holder
would elect to exercise and the option price can be adjusted to equal the intrinsic
value at that point. This then flows into ( the calculations higher up the tree and so
on.
Limitation: As mentioned before the main disadvantage of the binomial model is
its relatively slow speed. It's great for half a dozen calculations at a time but even
with today's fastest PCs it's not a practical solution for the calculation of thousands
of prices in a few seconds which is what's required for the production of the
animated charts in strategy evaluation model.
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2.13.2. Black-Scholes Model
The Black?Scholes model is a model of the evolving price of financial
instruments, in particular stocks. It is a mathematical formula for the theoretical
value of European put and call stock options derived from the assumptions of the
model. The formula was derived by Fischer Black and Myron Scholes and
published in 1973. They built on earlier research by Edward Thorpe, Paul
Samuelson, and Robert C. Merton. The fundamental insight of Black and Scholes is
that the option is implicitly priced if the stock is traded.
Merton and Scholes received the 1997 Nobel Prize in Economics for this
and related work; Black was ineligible, having died in 1995.
The key assumptions of the Black?Scholes model are:
The price of the underlying instrument St follows a geometric Brownian
motion with constant drift and volatility :
It is possible to short sell the underlying stock.
There are no arbitrage opportunities.
Trading in the stock is continuous.
There are no transaction costs or taxes.
All securities are perfectly divisible (e.g. it is possible to buy 1/100th of a
share).
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A constant risk-free interest rate exists and is the same for all maturity dates.
The formula
The above lead to the following formula for the price of a call option with
exercise price K on a stock currently trading at price S,
i.e., the right to buy a share of the stock at price K after T years. The
constant interest rate is r, and the constant stock volatility is .
where
Here N is the standard normal cumulative distribution function.
The price of a put option may be computed from this by put-call parity and
simplifies to
The Greeks under the Black?Scholes model are also easy to calculate:
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Calls
Puts
delta
gamm
a
vega
theta
rho
Here, is the standard normal probability density function. Note that the
gamma and vega formulas are the same for calls and puts.
Instruments paying continuous dividends
The dividend payment paid over the time period [t,t + dt] is then modelled as
for some constant q (the dividend yield).
Under this formulation the arbitrage-free price implied by the Black?Scholes model
can be shown to be
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where now
is the modified forward price that occurs in the terms d1 and d2:
Instruments paying discrete dividends
It is also possible to extend the Black?Scholes framework to options on
instruments paying discrete dividends. This is useful when the option is struck on a
single stock.
A typical model is to assume that a proportion of the stock price is paid
out at pre-determined times T1,T2,.... The price of the stock is then modelled as
where n(t) is the number of dividends that have been paid by time t.
The price of a call option on such a stock is again
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where now
is the forward price for the dividend paying stock.
While in practice more advanced models are often used, many of the key
insights provided by the Black?Scholes formula have become an integral part of
market conventions. For instance, it is common practice for the implied volatility
rather than the price of an instrument to be quoted. (All the parameters in the model
other than the volatility--that is the time to maturity, the strike, the risk-free rate,
and the current underlying price--are unequivocally observable. This means there
is one-to-one relationship between the option price and the volatility.) Traders
prefer to think in terms of volatility as it allows them to evaluate and compare
options of different maturities, strikes, and so on.
However, the Black?Scholes model cannot match option prices at different
strikes and maturities observed on the market. If the Black?Scholes model held,
then the implied volatility surface (the map from strike and maturity to implied
volatility) of an option on a particular stock would be constant. In practice, the
volatility surface (the three-dimensional graph of implied volatility against strike
and maturity) is not flat: for a fixed maturity it is typically smile-shaped (see
volatility smile). That is, at-the-money (the option for which the underlying price
and strike coincide) the implied volatility is lowest; out-of-the-money or in-the-
money the implied volatility tends to be different, usually higher on the put side
(low strikes), and call side (high strikes).
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In fact, the volatility surface of a given underlying instrument depends on,
among other things, its 'perceived' distribution and is constantly changing as
investors, market-makers, and arbitrageurs re-evaluate the probability of the
underlying instrument reaching a given strike and the risk-reward (including factors
related to liquidity) associated to it.
Lognormal distribution: The model is based on a lognormal distribution of stock
prices, as opposed to a normal, or bell-shaped, distribution. The lognormal
distribution allows for a stock price distribution of between zero and infinity (ie no
negative prices) and has an upward bias (representing the fact that a stock price
can only drop 100 per cent but can rise by more than 100 per cent).
Risk-neutral valuation: The expected rate of return of the stock (ie the expected
rate of growth of the underlying asset which equals the risk free rate plus a risk
premium) is not one of the variables in the Black-Scholes model (or any other
model for option valuation). The important implication is that the price of an
option is completely independent of the expected growth of the underlying asset
Thus, while any two investors may strongly disagree on the rate of return they
expect on a stock they will, given agreement to the assumptions of volatility and
the risk free rate, always agree on the fair price of the option on that underlying
asset.
The key concept underlying the valuation of all derivatives --the fact that
price of an option is independent of the risk preferences of investors --is called
risk-neutral valuation. It means that all derivatives can be valued by assuming that
the return from their underlying assets is the risk free rate.
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Advantage: The main advantage of the Black-Scholes model is speed --it lets you
calculate a very large number of option prices in a very short time. Since, high
accuracy is not critical for American option pricing (eg when animating a chart to
show the effects of time decay) using' Black-Scholes is a good option. But, the
option of using the binomial model is also advisable for the relatively few pricing
and profitability numbers where accuracy may be important and speed is irrelevant.
You can experiment with the Black-Scholes model using on-line options pricing
calculator.
Limitation: Dividends are ignored in the basic Black-Scholes formula, but there
are a number of widely used adaptations to the original formula, which enable it to
handle both discrete and continuous dividends accurately.
However, despite these adaptations the Black-Scholes model has one major
limitation: it cannot be used to accurately price options with an American-style
exercise as it only calculates the option price at one point in time --at expiration. It
does not consider the steps along the way where there could be the possibility of
early exercise of an American option.
As all exchange traded equity options have American-style exercise (ie they
can be exercised at any time as opposed to European options which can only be
exercised at expiration) this is a significant limitation.
The exception to this is an American call on a non-dividend paying asset. In
this case the call is always worth the same as its European equivalent as there is
never any advantage in exercising early.
2.14. TRADING STRATEGIES
2.14.1. Bull Market Strategies
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Call in a Bullish Strategy:
An investor with a bullish market outlook should buy call option. It one
expects the market price of the underlying asset to rise, then, he would rather have
the right to purchases at a specified price and sell later at a higher price than have
the obligation to deliver later at a higher price.
The investor`s profit potential on buying a call option is unlimited. His
profit is the market price less the exercise price less the premium. The increase in
price of the underlying increases the investor`s profit.
The investor's potential loss is limited. Even if the market takes a drastic
decline in price levels, the holder of a call is under no obligation to exercise the
option and let the option expire worthless. The investor breaks even when the
market price equals the exercise price plus the premium.
An increase in volatility will increase the value of call and thereby increases
the return. Because of the increased likelihood that the option will become in- the-
money, an increase in the underlying volatility (before expiration), will increase the
value of a long options position.
Puts in a Bullish Strategy
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An investor with a bullish market outlook can also go short on a Put option.
Basically, an investor anticipating a bull market could write put options. If the
market price increases and puts become out-of-the-money, investors with long put
positions will let their options expire worthless.
By writing Puts, profit potential is limited. A Put writer profits when the
price of the underlying asset increases and the option expires worthless. The
maximum profit is limited to the premium received.
However, the potential loss is unlimited. Because a short put position
holder has an obligation to purchase if exercised. He will be exposed to potentially
large losses if the market moves against his position and declines.
The break-even point occurs when the market price equals the exercise
price: minus the premium. At any price less than the exercise price minus the
premium, the investor loses money on the transaction. At higher prices, his option
is profitable.
An increase in volatility will increase the value of your put and decrease
your return. As an option writer, the higher price you will be forced to pay in order
to buy back the option at a later date, lower is the return.
Bullish Call Spread Strategies
A vertical call spread is the simultaneous purchase and sale of identical call
options but with different exercise prices.
To "buy a call spread" is to purchase a call with a lower exercise price and
to write a call with a higher exercise price. The trader pays a net premium for the
position.
To "sell a call spread" is the opposite, here the trader buys a call with a
higher exercise price and writes a call with a lower exercise price, receiving a net
premium for the position.
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An investor with a bullish market outlook should buy a call spread. The
"Bull Call Spread" allows the investor to participate to a limited extent in a bull
market, while at the same time limiting risk exposure.
To put on a bull spread, the trader needs to buy the lower strike call and sell
the higher strike call. The combination of these two options will result in a bought
spread. The cost of Putting on this position will be the difference between the
premium paid for the low strike call and the premium received for the high strike
call.
The investor's profit potential is limited. When both calls are in-the-money,
both will be exercised and the maximum profit will be realised. The investor
delivers on his short call and receives a higher price than he is paid for receiving
delivery on his long call.
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The investor`s potential loss is limited. At the most, the investor can
lose is the net premium. He pays a higher premium for the lower exercise price
call than he receives for writing the higher exercise price call than he receives
for writing the higher exercise price call.
The investor breaks even when the market price equals the lower
exercise price plus the net premium. At the most, an investor can lose is the
net premium paid. To recover the premium, the market price must be as great
as the lower exercise price plus the net premium.
An example of a Bullish call spread:
Let's assume that the cash price of scrip is Rs. 100 and one bought a
November call option with a strike price of Rs. 90 and paid a premium of Rs.
14. At the same time he sold another November call option on scrip with a
strike price of Rs.110 and received a premium of Rs.4. Here, he is buying a
lower strike price option and selling a higher strike price option. This would
result in a net outflow of Rs.10 at the time of establishing the spread.
Now let us look at the fundamental reason for this position. Since this
is a bullish strategy, the first position established in the spread is the long
lower strike price call option with unlimited profit potential. At the same time
to reduce the cost of purchase of the long position a short position at a higher
call strike price is established. While this not only reduces the outflow in terms
of premium but also his profit potential and at the sometime the risk is limited.
Based on the above figures the maximum profit, maximum loss and breakeven
point of this spread would be as follows:
Maximum profit = Higher strike price -Lower strike price -Net premium paid
= 110-90-10
= 10
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Maximum Loss = Lower strike premium -Higher strike premium
= 14-4 = 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100
Bullish Put Spread Strategies
A vertical Put spread is the simultaneous purchase and sale of identical Put
options but with different exercise prices.
To "buy a put spread" is to purchase a Put with a higher exercise price and
to write a Put with a lower exercise price. The trader pays a net premium for the
position.
To "sell a put spread" is the opposite: the trader buys a Put with a lower
exercise price and writes a put with a higher exercise price, receiving a net premium
for the position.
An investor with a bullish market outlook should sell a Put spread.
The "vertical bull put spread" allows the investor to participate to a limited
extent in a bull market, while at the same time limiting risk exposure.
To put on a bull spread can be created by buying the lower strike and
selling the higher strike of either calls or put. The difference between the premiums
paid and received makes up one leg of the spread.
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The investor's profit potential is limited. When the market price reaches or
exceeds the higher exercise price, both options will be out-of-the-money and will
expire worthless. The trader will realize his maximum profit, the net premium.
The investor's potential loss is also limited. If the market falls, the options
will be in-the-money. The puts will offset one another, but at different exercise
prices.
The investor breaks-even when the market price equals the lower exercise
price less the n premium. The investor achieves maximum profit i.e. the premium
received; when the mark price moves up beyond the higher exercise price (both
puts are then worthless).
An example of a bullish put spread.
Lets us assume that the cash price of the scrip is Rs.100. One now buys
November put option scrip with a strike price of Rs.90 at a premium of Rs.5 and
sells a put option with a strike price Rs.110 at a premium of Rs.15.
The first position is a short put at a higher strike price. This has resulted in
some inflow in terms of premium. But here the trader is worried about risk and so
caps his risk by buying another put option at the lower strike price. As such, a part
of the premium received goes off and the ultimate position has limited risk and
limited profit potential. Based on the above figures the maximum profit, maximum
loss and breakeven point of this spread would be as follows:
Maximum profit = Net option premium income or net credit
= 15-5= 10
Maximum loss = Higher strike price -Lower strike price -Net premium
received
= 110-90-10= 10
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Breakeven Price = Higher Strike price -Net premium income
= 110-10= 100
2.14.2. Bear Market Strategies
Puts in a Bearish Strategy
When one purchases a put he is long and wants the market to fall. A put
option is a bearish position which will increase in value if the market falls. By
purchasing put options, the trader has the right to choose whether to sell the
underlying asset at the exercise price. In a falling market, this choice is preferable
to being obligated to buy the underlying at a price higher.
An investor's profit potential is practically unlimited. The higher the fall in
price of the underlying asset, higher the profits.
The investor's potential loss is limited. If the price of the underlying asset
rises instead of falling as' the investor has anticipated, he may let the option expire
worthless. At the most, he may lose the premium for the option.
The trader's breakeven point is the exercise price minus the premium. To
profit, the market price must be below the exercise price. Since the trader has paid
a premium he must recover the premium he paid for the option.
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An increase in volatility will increase the value of the put and increases
the return. An increase in volatility will make it more likely that the price of the
underlying instrument will move, increasing the value of the option.
Calls in a Bearish Strategy
Another option for a bearish investor is to go short on a call with the intent
to purchase it back in the future. By selling a call, you have a net short position
and needs to be bought back before expiration and cancel out your position.
For this an Investor needs to write a call option. If the market price falls,
long call holders will let their out-of-the-money options expire worthless, because
they could purchase the underlying asset at the lower market price.
The investor's profit potential is limited because the trader's maximum profit
is limited to the premium received for writing the option.
Here the loss potential is unlimited because a short call position holder has
an obligation to sell if exercised; he will be exposed to potentially large losses if
the market rises against his position.
The investor breaks even when the market price equals the exercise price:
plus the premium. At any price greater than the exercise price plus the premium,
the trader is losing money. When the market price equals the exercise price plus the
premium, the trader breaks even.
An increase in volatility will increase the value of call and decreases its
return.
When the option writer has to buy back the option in order to cancel out his
position, he will be forced to pay a higher price due to the increased value of the
calls.
Bearish Put Spread Strategies
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A vertical put spread is the simultaneous purchase and sale of identical put
options but with different exercise prices.
To "buy a put spread" is to purchase a put with a higher exercise price and to
write a put with a lower exercise price. The trader pays a net premium for the
position.
To "sell a put spread" is the opposite. The trader buys a put with a lower
exercise price and writes put with a higher exercise price, receiving a net premium
for the position.
To put on a bear put spread buy the higher strike put and sell the lower strike
put.
Sell the lower strike and buy the higher strike of either calls or puts to set up
a bear spread.
An investor with a bearish market outlook should: buy a put spread. The
Bear Put Spread allows the investor to participate to a limited extent in a bear
marker, while at the same time limiting risk exposure.
The investor's profit potential is limited. When the market price falls to or
below the lower exercise price, both options will be in-the-money and the trader
will realize his maximum profit when he recovers the net premium paid for the
options.
The investor's potential loss is limited. The trader has offsetting positions at
different exercise prices. If the market rises rather than falls, the options will be
out-of-the-money and expire worthless. Since the trader has paid a net premium.
The investor breaks even when the market price equals the higher exercise
price less the net premium. For the strategy to be profitable, the market price must
fall. When the market price falls to the high exercise price less the net premium, the
trader breaks even. When the market falls beyond this point, the trader profits.
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An example of a bearish put spread.
Let`s assume that the cash price of the scrip is Rs 100. One buys a
November put option on scrip with a strike price of Rs 110 at a premium of Rs 15
and sell a put option with a strike price of Rs 90 at a premium of Rs 5.
In this bearish position the put is taken as long on a higher strike price put
with the outgo of some premium. This position has huge profit potential on
downslide. The trader may recover a part of the premium paid by him by writing a
lower strike price put option. The resulting position is a mildly bearish position with
limited risk and limited profit profile. Though the trader has reduced the cost of
taking a bearish position, he has also capped the profit potential as well. The
maximum profit, maximum loss and breakeven point of this spread would be as
follows:
Maximum profit = Higher strike price option -Lower strike price option -Net premium paid
= 110-90-10= 10
Maximum loss = Net premium paid
= 15-5= 10
Breakeven Price = Higher strike price -Net premium paid
= 110-10= 100
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Bearish Call Spread Strategies
A vertical call spread is the simultaneous purchase and sale of identical call
options but with different exercise prices.
To "buy a cal' spread" is to purchase a call with a lower exercise price and to
write a call with a higher exercise price. The trader pays a net premium for the
position.
To "sell a call spread" is the opposite: the trader buys a call with a higher
exercise price and writes a call with a lower exercise price, receiving a net premium
for the position.
To put on a bear ca" spread you sell the lower strike call and buy the
higher strike call. An investor sells the lower strike and buys the higher strike of
either calls or puts to put on a bear spread.
An investor with a bearish market outlook should: sell a call spread. The
"Bear Call Spread" allows f the investor to participate to a limited extent in a bear
market, while at the same time limiting risk exposure.
The investor's profit potential is limited. When the market price falls to the
lower exercise price, both out-of-the-money options will expire worthless. The
maximum profit that the trader can realize is the net premium: The premium he
receives for the call at the higher exercise price.
Here the investor's potential loss is limited. If the market rises, the options
will offset one another, At any price greater than the high exercise price, the
maximum loss will equal high exercise price minus low exercise price minus net
premium.
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The investor breaks even when the market price equals the lower exercise
price plus the net premium. The strategy becomes profitable as the market price
declines. Since the trader is receiving a net premium, the market price does not
have to fall as low as the lower exercise price to breakeven.
An example of a bearish call spread.
Let us assume that the cash price of the scrip is Rs.100. One now buys a
November call option on scrip with a strike price of Rs.110 at a premium of Rs.5
and sells a call option with a strike price of Rs.90 at a premium of Rs.15.
In this spread he has to buy a higher strike price call option and sell a lower
strike price option. As the low strike price option is more expensive than the
higher strike price option, it is a net credit strategy. The final position is left with
limited risk and limited profit. The maximum profit, maximum loss and breakeven
point of this spread would be as follows:
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Maximum profit = Net premium received
= 15-5= 10
Maximum loss = Higher strike price option -Lower strike price option -Net premium
received
= 110-90-10= 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100
2.14.3 Volatile Market Strategies
Straddles in a Volatile Market Outlook
Volatile market trading strategies are appropriate when the trader believes the
market will move but does not have an opinion on the direction of movement of
the market. As long as there is significant movement upwards or downwards,
these strategies offer profit opportunities. A trader need not be bullish or bearish.
He must simply be of the opinion that the market is volatile.
A straddle is the simultaneous purchase (or sale) of two identical options,
one a call and the other a put.
To "buy a straddle" is to purchase a call and a put with the same exercise
price and expiration date.
To "sell a straddle" is the opposite: the trader sells a call and a put with the
same exercise price and expiration date.
A trader, viewing a market as volatile, should buy option straddles. A "straddle
purchase" allows the trader to profit from either a bull market or from a bear
market.
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Here the investor's profit potential is unlimited. If the market is volatile, the
trader can profit from an up- or downward movement by exercising the appropriate
option while letting the other option expire worthless. (Bull market, exercise the
call; bear market, the put.)
If the price of the underlying asset remains stable instead of either rising or
falling as the trader anticipated, the maximum he will lose is the premium he paid
for the options.
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In this case the trader has long two positions and thus, two breakeven
points. One is for the call which is exercise price plus the premiums paid, and the
other for the put, which is exercise price minus the premiums paid.
Strangles in a Volatile Market Outlook
A strangle is similar to a straddle, except that the call and the put have
different exercise price usually, both the call and the put are out-of-the-money.
To "buy a strangle" is to purchase a call and a put with the same expiration
date, but differ exercise prices.
To "sell a strangle" is to write a call and a put with the same expiration date,
but different exercise prices.
A trader, viewing a market as volatile, should buy strangles. A "strangle
purchase" allows the trader to profit from either a bull or bear market. Because
the options are typically out-of-the money, the market must move to a greater
degree than a straddle purchase to be profitable.
The trader's profit potential is unlimited. If the market is volatile, the trader
can profit from up or downward movement by exercising the appropriate option,
and letting the other expire worthless. (In a bull market, exercise the call; in a bear
market exercise the put).
The investor's potential loss is limited. Should the price of the underlying
remain stable, the most the trader would lose is the premium he paid for the options.
Here the loss potential is also very minimal because, the more the options are out-
of-the-money, the lesser the premiums.
Here the trader has two long positions and thus, two breakeven points.
One for the call, which breakevens when the market price equal the high
exercise price plus the premium paid, and the put, when the market price equals
the low exercise price minus the premium paid.
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The Short Butterfly Call Spread:
Like the volatility positions, the Short Butterfly position will realize a profit
if the market makes a substantial move. It also uses a combination of puts and calls
to achieve its profit/loss profile -but combines them in such a manner that the
maximum profit is limited.
The profit loss profile of a short butterfly spread looks like two short options
coming together at the center Calls.
One`s potential gains or losses are: limited on both the upside and the
downside.
The Call Ratio Back spread
The call ratio back spread is similar in contraction to the short butterfly call
spread. The only difference is that one omits one of the components (or legs) used
to build the short butterfly when constructing a call ratio back spread.
When putting on a call ratio back spread, one is neutral but wants the
market to move in either direction. The call ratio back spread will lose money if the
market sits. The market outlook one would have in putting on this position would
be for a volatile market, with greater probability that the market will rally.
To put on a call ratio back spread, one sells one of the lower strikes and buy
two or more of the higher strike. By selling an expensive lower strike option and
buying two less expensive high strike options, one receives an initial credit for this
position. The maximum loss is then equal to the high strike price minus the low
strike price minus the initial net premium received.
The profit on the downside is limited to the initial net premium received
when setting up the spread. The upside profit is unlimited.
An increase in implied volatility will make the spread more profitable.
Increased volatility increases a long option position's value. The greater number of
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long options will cause this spread to become more profitable when volatility
increases.
The Put Ratio Backspread
In combination positions (e.g. bull spreads, butterflies, ratio spreads), one
can use calls or puts to achieve similar, if not identical, profit profiles. Like its call
counterpart, the put ratio backspread combines options to create a spread which
has limited loss potential and a mixed profit potential.
It is created by combining long and short puts in a ratio of 2: 1 or 3: 1. In a
3: 1 spread, one would buy three puts at a low exercise price and write one put
at a high exercise price. While one may, of course, extend this position out to six
long and two short or nine long and three short, it is important that one respect
the (in this case) 3: 1 ratio in order to maintain the put ratio backspread
profitless profile.
When put on a put ratio backspread one is neutral but wants the market to
move in either direction.
One`s market expectations here would be for a volatile market with a greater
probability that the market will fall than rally.
Unlimited profit would be realized on the downside.
The two long puts offset the short put and result in practically unlimited
profit on the bearish side of the market. The cost of the long puts is offset by the
premium received for the (more expensive) short put, resulting in a net premium
received.
To put on a put ratio backspread, one buy two or more of the lower strike
and sell one of the higher strike.
One sells the more expensive put and buy two or more of the cheaper put.
One usually receives an initial net premium for putting on this spread. The
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Maximum loss is equal to: High strike price -Low strike price -Initial net
premium received.
2.14.4. Stable Market Strategies
Straddles in a Stable Market Outlook
A straddle is the simultaneous purchase (or sale) of two identical
options, one a call and the other a put.
To "buy a straddle" is to purchase a call and a put with the same
exercise price and expiration date.
To "sell a straddle" is the opposite: the trader sells a call and a put
with the same exercise price and expiration date.
A trader, viewing a market as stable, should: write option straddles. A
"straddle sale" allows the trader to profit from writing calls and puts in a stable
market environment.
The investor's profit potential is limited. If the market remains stable, traders
long out-of-the- money calls or puts will let their options expire worthless. Writers
of these options will not called to deliver and will profit from the sum of the
premiums received.
The investor's potential loss is unlimited. Should the price of the underlying
rise or fall, the writer of a call or put would have to deliver, exposing him to
unlimited loss if he has to deliver on the call and practically unlimited loss if on the
put.
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The breakeven points occur when the market price at expiration equals the
exercise price plus the premium and minus the premium. The trader is short two
positions and thus, two breakeven points; One for the call (common exercise price
plus the premiums paid), and one for the put (common exercise price minus the
premiums paid).
Strangles in a Stable Market Outlook
A strangle is similar to a straddle, except that the call and the put have
different exercise prices. Usually, both the call and the put are out-of-the-money.
To "buy a strangle" is to purchase a call and a put with the same expiration
date, but different exercise prices. Usually the call strike price is higher than the put
strike price.
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To "sell a strangle" is to write a call and a put with the same expiration date,
but different exercise prices.
A trader, viewing a market as stable, should: write strangles.
A "strangle sale" allows the trader to profit from a stable market.
The investor's profit potential is: limited.
If the market remains stable, investors having out-of-the-money long put or
long call positions will let their options expire worthless and seller of the options
will have limited Profit and will be equal to the premium received.
The investor's potential loss is: unlimited.
If the price of the underlying interest rises or falls instead of remaining
stable as anticipated, he will have to deliver on the call or the put.
The breakeven points occur when market price at expiration equals the high
exercise price the premium and the low exercise price minus the premium.
The trader is short two positions and thus, two breakeven points. One for the
call (high exercise price plus the premiums paid), and one for the put (low exercise
price minus the premiums paid).
The risk is lower with a strangle. Although the seller gives up a
substantial amount of potential profit by selling a strangle rather than a
straddle, he also holds less risk. Notice that the strangle requires more of a
price move in both directions before it begins to lose money.
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Long Butterfly Call Spread Strategy: The long butterfly call spread is a
combination of a bull spread and a bear spread, utilizing calls and three different
exercise prices.
A long butterfly call spread involves:
Buying a call with a low exercise price,
Writing two calls with a mid-range exercise price,
Buying a call with a high exercise price.
This spread is put on by purchasing one each of the outside strikes and
selling two of the inside strike. To put on a short butterfly, you do just the opposite.
The investor's profit potential is limited.
Maximum profit is attained when the market price of the underlying interest
equals the mid-range exercise price (if the exercise prices are symmetrical).
The investor's potential loss is limited.
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The maximum loss is limited to the net premium paid and is realized when
the market price underlying asset is higher than the high exercise price or lower
than the low exercise price.
The breakeven points occur when the market price at expiration equals the
high exercise minus the premium and the low exercise price plus the premium. The
strategy is profitable when the market price is between the low exercise price plus
the net premium and the high exercise price minus the net premium.
Calendar Spreads
A calendar spread can be created by selling a call option with a certain strike
price and buying a longer-maturity call option with the same strike price. The
longer the maturity of an option the more experience its. A calendar spread, there
fore required an initial investment. The following figure shows the: profit from a
calendar spread at the time when the short-maturity option expires. (It is assumed
that the long-maturity option is sold at this time.) The trader makes a profit if the
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stock price at the expiration of the short-maturity option is close to the strike price
of the short-maturity option. However, a loss is incurred if the stock price is
significantly above or significantly below this strike price.
To understand the profit pattern from a calendar spread, first consider what
happens if the stock price is very low when the short-maturity option expires. The
short-maturity option is worthless, and the value of the long-maturity option is
close to zero. The trader, therefore, incurs a loss that is only a little less than the
cost of setting up the spread initially. Consider next what happens if the stock
price, ST, is very high when the short-maturity option expires. The short-maturity
option costs the trader ST -' X, I and the long-maturity option is worth a little more
than ST -Xl where Xl is the strike price of die options. Again, the trader has a net loss
that is a little less than the cost of setting up the spread initially. If ST is close to X,
the short-maturity option costs the trader either a small amount or nothing at all.
However, the long-maturity option is still quite valuable. In this case, a significant
net profit is made.
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Calendar Spread Created using two calls.
In a neutral calendar spread a strike price close to the current stock price is
chosen. A bullish calendar spread involves a higher strike price, whereas a bearish
calendar spread, involves a lower strike price.
Calendar spread created using two puts.
Calendar spreads can be created with put options as well as call options. The
trader buys long maturity put option and sells a short-maturity put option. As shown
in the above figure, the profit pattern is similar to that obtained fro
m using calls.
A reverse calendar spread is the opposite trading strategy where the trader
buys a short-maturity option and sells a long-maturity option. A small profit arises
if the stock price at the expiration of the short-maturity option is well above or well
below the strike price of the short-maturity option. However, a significant loss
results if it is close to the strike price.
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Diagonal Spreads
Bull, bear, and calendar spreads can all be created from a long position in
one call (put) and a short position in another call (put). In the case of bull and rear
spreads, the calls (puts) have different strike prices and the same expiration date. In
the case of calendar spreads, the calls (puts) have the same strike price and different
expiration dates. In it diagonal spread both the expiration dates and the strike prices
of the call (puts) are different. There are several types of diagonal spreads. Their
profit pattern is generally variations on the profit patterns from the corresponding
bull or spreads.
COMBINATIONS
A combination is an option trading strategy that involves taking a position in
both calls and puts on the same stock. We will consider straddles, strips, straps, and
strangles.
Straddle
One popular combination is a straddle, which involves buying a call and a
put with the same strike price and expiration date. The profit pattern is shown in
Figure 8.10. The strike price is denoted by X. If the stock price is close to this
strike price at expiration of the options, the straddle leads to a loss. However, if
there is a sufficiently large move in either direction, a significant profit will result
The payoff from a straddle is calculated in Table 8.4.
A straddle is appropriate when a trader is expecting a large move in a stock
price but does not know in which direction the move will be. Consider a trader
who feels that the price of a certain stock, currently valued at Rs69 by the market.
Will move significantly in the next three months. The trader could create
astraddle by buying both a put and a call with a strike price of Rs70 and an
expiration date in three months. Suppose that the call costs Rs4 and the put costs
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Rs3. If the stock price stays at Rs69, it is easy to see that the strategy costs the
trader Rs6. (An up-
Straddle
front investment of Rs7 is required, the call expires worthless, and the put expires
worth Rs1.) If the stock price moves to Rs70, a loss of Rs7 is experienced- (This
is the worst that can happen.)
Range of
Pay of From
Pay of From Total
Stock Price
Call
Put
Payoff
ST < X
0
X-ST
X ? ST
ST > X
ST ? X
0
ST - X
However, if the stock price jumps to Rs90, a profit ofRs13 is made; if the stock
moves down to Rs55, a profit of'i; 8 is made; and so on.
A straddle seems like a natural trading strategy when a big jump in the price of a
company's stock is expected for example, when there is a takeover bid for the
company or when the outcome of a major lawsuit is expected to be announced soon.
However, this is not necessarily the case. If the general view of the market is that
there will be a big jump in the stock price soon, that view will be reflected in the
prices of options. A trader will find options on the stock to be significantly more
expensive i than options on a similar stock for which no jump is expected. For a
straddle to be a t effective strategy, the trader must believe that there are likely to be
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big movements in the stock price, and this belief must be different from those of
most other market participants.
The straddle in Figure 8.10 is sometimes referred to as a bottom straddle or
straddle purchase. A top straddle or straddle write is the reverse position. It is
created by selling a call and a put with the same exercise price and expiration date.
It is a highly risky strategy. If the stock price on the expiration date is close to the
strike price, a significant profit results. However, the loss arising from a large move
in either direction is unlimited.
Strips and Strops
A strip consists of a long position in one call and two puts with the same
strike price and one put with the same price and expiration data. A strap consists
of a long position in two calls and one put with the same strike price and expiration
data. The profit patterns from strips and straps are show in Figure 8.11. In a strip
the trader is betting that there will be a big stock price move and considers a
decrease in the stock price to be more likely than an increase. In a strap the trader
is also betting that there will be a big stock price move. However, in a strap the
trader is also betting that there will be a big stock price move. However, in this
case, an increase in the stock price is considered to be more likely than a decrease.
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Profit potentials from a strip and strap.
Option strategies ? in brief
Combining any of the four basic kinds of option trades (possibly with
different exercise prices) and the two basic kinds of stock trades (long and short)
allows a variety of options strategies. Simple strategies usually combine only a few
trades, while more complicated strategies can combine several.
Covered call -- Long the stock, short a call. This has essentially the same
payoff as a short put.
Straddle -- Long a call and long a put with the same exercise prices (a long
straddle), or short a call and short a put with the same exercise prices (a short
straddle).
Strangle -- Long a call and long a put with different exercise prices (a long
strangle), or short a call and short a put with different exercise prices (a short
strangle).
Bull spread -- Long a call with a low exercise price and shorts a call with a
higher exercise price, or long a put with a low exercise price and short a put
with a higher exercise price.
Bear spread -- Short a call with a low exercise price and long a call with a
higher exercise price, or short a put with a low exercise price and long a put
with a higher exercise price.
Butterfly -- Butterflies require trading options with 3 different exercise
prices. Assume exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2
o
Long butterfly -- long 1 call with exercise price X1, short 2 calls with
exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1
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put with exercise price X1, short 2 puts with exercise price X2, and long 1 put
with exercise price X3.
o
Short butterfly -- short 1 call with exercise price X1, long 2 calls with
exercise price X2, and short 1 call with exercise price X3. Alternatively, short
1 put with exercise price X1, long 2 puts with exercise price X2, and short 1
put with exercise price X3.
Box spreads -- Any combination of options that has a constant payoff at
expiry. For example combining a long butterfly made with calls, with a short
butterfly made with puts will have a constant payoff of zero, and in
equilibrium will cost zero. In practice any profit from these spreads will be
eaten up by commissions (hence the name "alligator spreads").
2.15. Margin Money
The aim of margin money is to minimize the risk of default by either
counter-party. The payment of margin ensures that the risk is limited to the previous
day's price movement on each outstanding position. However, even this exposure is
offset by the initial margin holdings. Margin money is like a security deposit or
insurance against a possible future loss of value.
There are different types of margin:
Initial Margin - Based on 99% Value at Risk (VaR) and worst case loss over
a specified horizon, which depends on the time in which Mark to Market margin is
collected. The basic aim of Initial margin is to cover the largest potential loss in one
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day. Both buyer and seller have to deposit margins. The initial margin is deposited
before the opening of the position in the Futures transaction
Mark to Market Margin (MTM)- collected in cash for all futures contracts
and adjusted against the available liquid net worth for option positions. In
the case of Futures Contracts MTM may be considered as Mark to Market
Settlement. All daily losses must be met by depositing of further collateral -
known as variation margin, which is required by the close of business, the
following day. Any profits on the contract are credited to the client's
variation margin account.
Maintenance Margin - Some exchanges work on the system of maintenance
margin, which is set at a level slightly less than initial margin. The margin is
required to be replenished to the level of initial margin, only if the margin level
drops below the maintenance margin limit. For e.g.. If Initial Margin is fixed at 100
and Maintenance margin is at 80, then the broker is permitted to trade till such time
that the balance in this initial margin account is 80 or more. If it drops below 80,
say it drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the
levels of initial margin. This concept is not being followed in India.
Additional Margin - In case of sudden higher than expected volatility,
additional margin may be called for by the exchange. This is generally imposed
when the exchange fears that the markets have become too volatile and may result
in some crisis, like payments crisis, etc. This is a preemptive move by exchange to
prevent breakdown.
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Cross Margining - This is a method of calculating margin after taking
into account combined positions in futures, options, cash market etc. Hence, the
total margin requirement reduces due to cross-hedges.
Margin calculation
A portfolio based margining approach which takes an integrated view of the
risk involved in the portfolio of each individual client comprising of his positions in
all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and Single
Stock Futures, has been prescribed. The initial margin requirements are required to
be based on the worst case loss of a portfolio of an individual client to cover 99%
VaR over a specified time horizon.
The Initial Margin is Higher of
(Worst Scenario Loss + Calendar Spread Charges)
Or
Short Option Minimum Charge
The worst scenario loss are required to be computed for a portfolio of a
client and is calculated by valuing the portfolio under the scenarios of probable
changes in the value and the volatility of the Index/ Individual Stocks. The options
and futures positions in a client's portfolio are required to be valued by predicting
the price and the volatility of the underlying over a specified horizon so that 99% of
times the price and volatility so predicted does not exceed the maximum and
minimum price or volatility scenario. In this manner initial margin of 99% VaR is
achieved. The specified horizon is dependent on the time of collection of mark to
market margin by the exchange.
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The probable change in the price of the underlying over the specified
horizon i.e. 'price scan range', in the case of Index futures and Index option
contracts are based on three standard deviation (3s ) where 's ' is the volatility
estimate of the Index. The volatility estimate 's ', is computed as per the
Exponentially Weighted Moving Average methodology. This methodology has
been prescribed by SEBI. In case of option and futures on individual stocks the
price scan range is based on three and a half standard deviation (3.5s ) where 's ' is
the daily volatility estimate of individual stock.
For Index Futures and Stock futures it is specified that a minimum margin of
5% and 7.5% would be charged. This means if for stock futures the 3.5s value falls
below 7.5% then a minimum of 7.5% should be charged. This could be achieved by
adjusting the price scan range.
The probable change in the volatility of the underlying i.e. 'volatility scan
range' is fixed at 4% for Index options and is fixed at 10% for options on Individual
stocks. The volatility scan range is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the same
underlying across different expiry. In a portfolio based margining approach all
calendar-spread positions automatically get a margin offset. However, risk arising
due to difference in cost of carry or the 'basis risk' needs to be addressed. It is
therefore specified that a calendar spread charge would be added to the worst
scenario loss for arriving at the initial margin. For computing calendar spread
charge, the system first identifies spread positions and then the spread charge which
is 0.5% per month on the far leg of the spread with a minimum of 1% and
maximum of 3%. Further, in the last three days of the expiry of the near leg of
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spread, both the legs of the calendar spread would be treated as separate individual
positions.
In a portfolio of futures and options, the non-linear nature of options make
short option positions most risky. Especially, short deep out of the money options,
which are highly susceptible to, changes in prices of the underlying. Therefore a
short option minimum charge has been specified. The short option minimum charge
is 5% and 7.5 % of the notional value of all short Index option and stock option
contracts respectively. The short option minimum charge is the initial margin if the
sum of the worst -scenario loss and calendar spread charge is lower than the short
option minimum charge.
To calculate volatility estimates the exchange are required to uses the
methodology specified in the Prof J.R Varma Committee Report on Risk
Containment Measures for Index Futures. Further, to calculated the option value the
exchanges can use standard option pricing models - Black-Scholes, Binomial,
Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two
components:-
The first is creation of risk arrays taking prices at discreet times taking latest
prices and volatility estimates at the discreet times, which have been
specified.
The second is the application of the risk arrays on the actual portfolio
positions to compute the portfolio values and the initial margin on a real
time basis.
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The initial margin so computed is deducted form the available Liquid Net worth
on a real time basis.
Mark to Market Margin
Options - The value of the option are calculated as the theoretical value of the
option times the number of option contracts (positive for long options and negative
for short options). This Net Option Value is added to the Liquid Net worth of the
Clearing member. Thus MTM gains and losses on options are adjusted against the
available liquid net worth. The net option value is computed using the closing price
of the option and are applied the next day.
Futures - The system computes the closing price of each series, which is used for
computing mark to market settlement for cumulative net position. This margin is
collected on T+1 in cash. Therefore, the exchange charges a higher initial margin by
multiplying the price scan range of 3s & 3.5s with square root of 2, so that the
initial margin is adequate to cover 99% VaR over a two days horizon.
MARGIN COLLECTION
Initial Margin - is adjusted from the available Liquid Networth of the Clearing
Member on an online real time basis.
Marked to Market Margins
Futures contracts: The open positions (gross against clients and net of proprietary /
self trading) in the futures contracts for each member are marked to market to the
daily settlement price of the Futures contracts at the end of each trading day. The
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daily settlement price at the end of each day is the weighted average price of the last
half an hour of the futures contract. The profits / losses arising from the difference
between the trading price and the settlement price are collected / given to all the
clearing members.
Option Contracts: The marked to market for Option contracts is computed and
collected as part of the SPAN Margin in the form of Net Option Value. The SPAN
Margin is collected on an online real time basis based on the data feeds given to the
system at discrete time intervals.
Client Margins
Clearing Members and Trading Members are required to collect initial
margins from all their clients. The collection of margins at client level in the
derivative markets is essential as derivatives are leveraged products and non-
collection of margins at the client level would provided zero cost leverage. In the
derivative markets all money paid by the client towards margins is kept in trust with
the Clearing House / Clearing Corporation and in the event of default of the Trading
or Clearing Member the amounts paid by the client towards margins are segregated
and not utilized towards the default of the member.
Therefore, Clearing members are required to report on a daily basis details
in respect of such margin amounts due and collected from their Trading members /
clients clearing and settling through them. Trading members are also required to
report on a daily basis details of the amount due and collected from their clients.
The reporting of the collection of the margins by the clients is done electronically
through the system at the end of each trading day. The reporting of collection of
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client level margins plays a crucial role not only in ensuring that members collect
margin from clients but it also provides the clearing corporation with a record of the
quantum of funds it has to keep in trust for the clients.
2.16. Index option
A stock index is a compilation of several stock prices into a single number.
Indexes come in various shapes and sizes. Some are broad-based and measure
moves in broad, diverse markets. Others are narrow-based and measure more
specific industry sectors of the marketplace. Understand that it is not the number of
stocks that comprise the average that determine if an index is broad-based or
narrow-based, but rather the diversity of the underlying securities and their market
coverage. Different stock indexes can be calculated in different ways. Accordingly,
even where indexes are based on identical securities, they may measure the relevant
market differently because of differences in methods of calculation.
a. Capitalization-Weighted
An index can be constructed so that weightings are biased toward the
securities of larger companies, a method of calculation known as capitalization-
weighted. In calculating the index value, the market price of each component
security is multiplied by the number of shares outstanding. This will allow a
security's size and capitalization to have a greater impact on the value of the index.
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b. Equal Dollar-Weighted
Another type of index is known as equal dollar-weighted and assumes an
equal number of shares of each component stock. This index is calculated by
establishing an aggregate market value for every component security of the index
and then determining the number of shares of each security by dividing this
aggregate market value by the current market price of the security. This method of
calculation does not give more weight to price changes of the more highly
capitalized component securities.
c. Other Types
An index can also be a simple average: calculated by simply adding up the
prices of the securities in the index and dividing by the number of securities,
disregarding numbers of shares outstanding. Another type measures daily
percentage movements of prices by averaging the percentage price changes of all
securities included in the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers
and liquidations or because a particular security is no longer thought to be
representative of the types of stocks constituting the index. Securities may also be
added to an index from time to time. Adjustments to indexes might be made
because of such substitutions or due to the issuance of new stock by a component
security. Such adjustments and other similar changes are within the discretion of the
publisher of the index and will not ordinarily cause any adjustment in the terms of
outstanding index options. However, an adjustment panel has authority to make
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adjustments if the publisher of the underlying index makes a change in the index's
composition or method of calculation that, in the panel's determination, may cause
significant discontinuity in the index level.
Finally, an equity index will be accurate only to the extent that:
the component securities in the index are being traded
the prices of these securities are being promptly reported
the market prices of these securities, as measured by the index, reflect price
movements in the relevant markets.
Equity vs. Index Options
An equity index option is an option whose underlying instrument is
intangible - an equity index. The market value of an index put and call tends to rise
and fall in relation to the underlying index. The price of an index call will generally
increase as the level of its underlying index increases, and its purchaser has
unlimited profit potential tied to the strength of these increases. The price of an
index put will generally increase as the level of its underlying index decreases, and
its purchaser has substantial profit potential tied to the strength of these decreases.
Pricing Factors
Generally, the factors that affect the price of an index option are the same as
those affecting the price of an equity option: value of the underlying instrument (an
index in this case), strike price, volatility, time until expiration, interest rates and
dividends paid by the component securities.
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i. Underlying Instrument
The underlying instrument of an equity option is a number of shares of a
specific stock, usually 100 shares. Cash-settled index options do not relate to a
particular number of shares. Rather, the underlying instrument of an index option is
usually the value of the underlying index of stocks times a multiplier.
ii. Volatility
Indexes, by their nature, are less volatile than their individual component
stocks. The up and down movements of component stock prices tend to cancel one
another out, lessening the volatility of the index as a whole. However, the volatility
of an index can be influenced by factors more general than can affect individual
equities. These can range from investors' expectations of changes in inflation,
unemployment, interest rates or other economic indicators issued by the
government and political for military situations.
iii. Risk
As with an equity option, an index option, buyer's risk is limited to the
amount of the premium paid for the option. The premium received and kept by the
index option writer is the maximum profit a writer can realize from the sale of the
option. However, the loss potential from writing an uncovered index option is
generally unlimited. Any investor considering writing index options should
recognize that there are significant risks involved.
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iv. Cash Settlement
The differences between equity and index options occur primarily in the
underlying instrument and the method of settlement. Generally, when an index
option is exercised by its holder, and when an index option writer is assigned, cash
changes hands. Only a representative amount of cash changes hands from the
investor who is assigned on a written contract to the investor who exercises his
purchased contract. This is known as cash settlement.
v. Purchasing Rights
Purchasing an index option does not give the investor the right to purchase
or sell all of the stocks that are contained in the underlying index. Because an index
is simply an intangible, representative number, you might view the purchase of an
index option as buying a value that changes over time as market sentiment and
prices fluctuate. An investor purchasing an index option obtains certain rights per
the terms of the contract. In general, this includes the right to demand and receive a
specified amount of cash from the writer of a contract with the same terms.
In-the-money, At-the-money, Out-of-the-money
An index call option is in-the-money when its strike price is less than the
reported level of the underlying index. It is at-the-money when its strike price is the
same as the level of that index and out-of-the-money when its strike price is greater
than that level.
An index put option is in-the-money when its strike price is greater than the
reported level of the underlying index. It is at-the-money when its strike price is the
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same as the level of that index and out-of-the-money when its strike price is less
than that level.
Exercise & Assignment
The exercise settlement value is an index value used to calculate how much
money will change hands, the exercise settlement amount, when a given index
option is exercised, either before or at expiration. The value of every index
underlying an option, including the exercise settlement value, is the value of the
index as determined by the reporting authority designated by the market where the
option is traded.
AM & PM Settlement
The exercise settlement values of equity index options are determined by
their reporting authorities in a variety of ways. The two most common are:
PM settlement - Exercise settlement values are based on the reported level
of the index calculated with the last reported prices of the index's component stocks
at the close of market hours on the day of exercise.
AM settlement - Exercise settlement values are based on the reported level
of the index calculated with the opening prices of the index's component stocks on
the day of exercise.
If a particular component security does not open for trading on the day the
exercise settlement value is determined, the last reported price of that security is
used.
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Investors should be aware that the exercise settlement value of an index
option that is derived from the opening prices of the component securities may not
be reported for several hours following the opening of trading in those securities. A
number of updated index levels may be reported at and after the opening before the
exercise settlement value is reported. There could be a substantial divergence
between those reported index levels and the reported exercise settlement value.
American vs. European Exercise
Although equity option contracts generally have only American-style
expirations, index options can have either American- or European-style.
In the case of an American-style option, the holder of the option has the
right to exercise it on or at any time before its expiration date. Otherwise, the option
will expire worthless and cease to exist as a financial instrument. It follows that the
writer of an American-style option can be assigned at any time, either when or
before the option expires, although early assignment is not always predictable.
A European-style option is one that can only be exercised during a specified
period of time prior to its expiration. This period may vary with different classes of
index options. Likewise, the writer of a European-style option can be assigned only
during this exercise period.
Exercise Settlement
The amount of cash received upon exercise of an index option or when it
expires depends on the closing value of the underlying index in comparison to the
strike price of the index option. The amount of cash changing hands is called the
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exercise settlement amount. This amount is calculated as the difference between the
strike price of the option and the level of the underlying index reported as its
exercise settlement value
In the case of a call, if the underlying index value is above the strike price,
the holder may exercise the option and receive the exercise settlement amount. For
example, with the settlement value of the index reported as 79.55, the holder of a
long call contract with a 78 strike price would exercise and receive Rs155 [(79.55 -
78) x Rs100 = Rs155]. The writer of the option would pay the holder this cash
amount.
In the case of a put, if the underlying index value is below the strike price,
the holder may exercise the option and receive the exercise settlement amount. For
example, with the settlement value of the index reported as 74.88 the holder of a
long put contract with a 78 strike price would exercise and receive Rs312 [(78 -
74.88) x Rs100 = Rs312]. The writer of the option would pay the holder this cash
amount.
Closing Transactions
As with equity options, an index option writer wishing to close out his
position buys a contract with the same terms in the marketplace. In order to avoid
assignment and its inherent obligations, the option writer must buy this contract
before the close of the market on any given day to avoid notification of assignment
on the next business day. To close out a long position, the purchaser of an index
option can either sell the contract in the marketplace or exercise it if profitable to do
so.
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Benefits of Listed Index Options
Index options offer the investor an opportunity to either capitalize on an
expected market move or to protect holdings in the underlying instruments. The
difference is that the underlying instruments are indexes. These indexes can reflect
the characteristics of either the broad equity market as a whole or specific industry
sectors within the marketplace.
a. Diversification
Index options enable investors to gain exposure to the market as a whole or
to specific segments of the market with one trading decision and frequently with
one transaction. To obtain the same level of diversification using individual stock
issues or individual equity option classes, numerous decisions and transactions
would be required. Employing index options can defray both the costs and
complexities of doing so.
b. Predetermined Risk for Buyer
Unlike other investments where the risks may have no limit, index options
offer a known risk to buyers. An index option buyer absolutely cannot lose more
than the price of the option, the premium.
c. Leverage
Index options can provide leverage. This means an index option buyer can
pay a relatively small premium for market exposure in relation to the contract value.
An investor can see large percentage gains from relatively small, favorable
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percentage moves in the underlying index. If the index does not move as
anticipated, the buyer's risk is limited to the premium paid. However, because of
this leverage, a small adverse move in the market can result in a substantial or
complete loss of the buyer's premium. Writers of index options can bear
substantially greater, if not unlimited, risk.
d. Guaranteed Contract Performance
An option holder is able to look to the system which includes the brokers
and Clearing Members involved in a particular option transaction, rather than to any
particular option writer for performance.
Index options give you exposure to the securities comprising a share market index.
They offer similar flexibility to that provided by options over individual
stocks, while allowing trading a view on the market as a whole, or on the market
sector covered by the particular index.
Whereas the value of a share option varies according to movements in the
value of the underlying shares, an index option varies according to movements in
the underlying index.
2.17.Exchange-Traded Option
An option traded on a regulated exchange where the terms of each option
are standardized by the exchange so that underlying asset, contract volume,
expiration date(mostly up to six months or one year, options with life spans of more
than one year are rarely available) Delivery/settlement procedures (clearing house)
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and strike price are known in advance. Exchange-traded options are also known as
"listed options".
The benefits to exchange-traded options are the liquidity of the options,
standardized contracts, quick access to prices and the use of clearing houses by
exchanges. The use of clearing houses guarantees that the option contract will be
fulfilled.
Exchange traded options (ETOs) are versatile short dated financial products that
allow investors to;
Protect the value of individual shares or a portfolio
Earn income
Undertake to buy shares for less than their current price
Lock in a buying price
Get exposure to shares for limited risk
2.18.Over-The-Counter
Over-the-counter options are contracts that give clients the right to buy or
sell a security at a fixed and predetermined rate (strike price) at a certain time in
the future, if they pay a premium fee upfront.
A stock is traded over-the-counter usually because the company is small
and unable to meet exchange listing requirements. Also known as "unlisted
stock", these securities are traded by brokers/dealers who negotiate directly with
one another over computer networks and by phone. Instruments such as bonds do
not trade on a formal exchange and are thus considered over-the-counter
securities. Most debt instruments are traded by investment banks making markets
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for specific issues. If someone wants to buy or sell a bond, they call the bank that
makes the market in that bond and asks for quotes. Many derivative instruments
such as forwards, swaps and most exotic derivatives are also traded OTC.
2.19. NATIONAL CLEARANCE AND DEPOSITORY SYSTEM
The new system which the Stock Holding Corporation of India is assigned
to set up by the Ministry of Finance for clearance and depository functions of the
Stock. Exchanges at the national level are called the National Clearance
Settlement and Depositary System. It comprises of (a) National Depository System
(b) National Trade Comparison & Reporting System and (c) National Clearance
System.
From the world wide experience, there does not appear to be any single
system which can be transplanted on Indian soil as it is. There is a complexity of
legal hurdles, procedures and habit problems to face in India for a change of this
type.
The new system will have to be based on a change in legal system, changes in
banking practices, settlement and clearance system. To start with, a book entry
system, for transfers as between broker members can be arranged as is done by the
Bombay Stock Exchange with the Bank of India Holdings, set up separately for this
purpose. At the national level, the National Depository was set up along with many
participants: depositories. The Central depository system was accepted by the
government and SEBI Guidelines were issued for the depositories and the Central
Depository.
2.20. REGULATIONS
SEBIs L C Gupta Committee
SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop
appropriate regulatory framework for the derivatives trading and to recommend
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suggestive bye-laws for Regulation and Control of Trading and Settlement of
Derivatives Contracts. The Committee was also to focus on the financial derivatives
and equity derivatives. The Committee submitted its report in March 1998.
The Board of SEBI in its meeting held on May 11, 1998 accepted the
recommendations and approved the introduction of derivatives trading in India
beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-
laws" recommended by the LC Gupta Committee for Regulation and Control of
Trading and Settlement of Derivatives Contracts. SEBI circulated the contents of
the Report in June 98.
Goals of Regulation - Regulatory Objectives
LCGC believes that regulation should be designed to achieve specific and well-
defined goals. It is inclined towards positive regulation designed to encourage
healthy activity and behaviour. The important recommendations of L.C.Gupta
Committee are reproduced hereunder.
Need for coordinated development
To quote from the report of the Committee -"The Committee's main concern is
with equity based derivatives but it has tried to examine the need for financial
derivatives in a broader perspective. Financial transactions and asset-liability
positions are exposed to three broad types of price risks, viz:
"Equities "market risk", also called "systematic risk" (which cannot be
diversified away because the stock market as a whole may go up or down
from time to time).
"Interest rate risk (as in the case of fixed-income securities, like treasury
bond holdings, whose market price could fall heavily if interest rates shot
up), and
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"Exchange rate risk (where the position involves a foreign currency, as in
the case of imports, exports, foreign loans or investments).
"The above classification of price risks explains the emergence of (a) equity
futures, (b) interest rate futures and (c) currency futures, respectively. Equity futures
have been the last to emerge.
Derivatives Exchanges
The Committee strongly favoured the introduction of financial derivatives to
facilitate hedging in a most cost-efficient way against market risk. There is a need
for equity derivatives, interest rate derivatives and currency derivatives. There
should be phased introduction of derivatives products. To start with, index futures
to be introduced, which should be followed by options on index and later options on
stocks. The derivative trading should take place on a separate segment of the
existing stock exchanges with an independent governing council where the number
of trading members should be limited to 40 percent of the total number. Common
Governing Council and Governing Board members are not allowed. The Chairman
of the governing council should not be permitted to trade (broking/dealing business)
on any of the stock exchanges during his term. Trading to be based on On-line
screen trading with disaster recovery site. Per half hour capacity should be 4-5 times
the anticipated peak load. Percentage of broker-members in the council is to be
prescribed by SEBI.
Regulatory framework
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Regulatory control should envisage modern systems for fool-proof and fail-
proof regulation. Regulatory framework for derivatives trading envisaged two-level
regulation i.e. exchange-level and SEBI-level, with considerable emphasis on self-
regulatory competence of derivative exchanges under the overall supervision and
guidance of SEBI. There will be complete segregation of client money at the level
of trading /clearing member and even at the level of clearing corporation. Other
recommendations are as under:
Regulatory Role of SEBI
SEBI will approve rules, bye-laws and regulations. New derivative contracts to be
approved by SEBI. Derivative exchanges to provide full details of proposed contract, like -
economic purposes of the contract; likely contribution to the market's development;
safeguards incorporated for investor protection and fair trading.
Specifications Regarding Trading
Stock Exchanges are to stipulate in advance trading days and hours. Each
contract is to have pre-determined expiration date and time. Contract expiration
period may not exceed 12 months. The last trading day of the trading cycle is to be
stipulated in advance.
Membership Eligibility Criteria
The trading and clearing member will have stringent eligibility conditions. The
Committee recommended for separate clearing and non-clearing members. There
should be separate registration with SEBI in addition to registration with the stock
exchange. At least two persons should have passed the certification program
approved by SEBI. A higher capital adequacy for Derivatives segment
recommended than prescribed for cash market. The clearing members should
deposit minimum Rs. 50 lakh with the clearing corporation and should have a net
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worth of Rs. 3 crore. A higher deposit proposed for Option writers.
Clearing Corporation
The Clearing System to be totally restructured. There should be no trading
interests on board of the CC. The maximum exposure limit to be liked the deposit
limit. To make the clearing system effective the Committee stressed stipulation of
Initial and mark-to-market margins. Extent of Margin prescribed to co-relate to the
level of volatility of particular Scrips traded. The Committee therefore
recommended margins based on value at risk - 99% confidence (The initial margins
should be large enough to cover the one day loss that can be encountered on the
position on 99% of the days. The concept is identified as "Worst Scenario Loss"). It
did not favour the system of Cross-margining (This is a method of calculating
margin after taking into account combined positions in futures, options, cash market
etc. Hence, the total margin requirement reduces due to cross-hedges). Since
margins to be adjusted frequently based on market volatility margin payments to be
remitted through EFT (Electronic Funds Transfer). To prevent brokers who
fail/default to provide/restore adequate margin from trading further the stock
exchange must have the power/facility to disable the defaulting member from
further trading. Brokers/sub-brokers are also to collect margin collection from
clients. Exposure limits to be on gross basis. Own/clients margin to be segregated.
No set off permitted. Trading to be clearly indicated as own/clients and
opening/closing out. In case of default, only own margin can be set off against
members' dues and the CC should promptly transfer client's margin in separate
account. CC to close out all open positions at its option. CC can also ask members
to close out excess positions or it may itself close out such positions. CC may
however permit special margins on members. It can withhold margin or demand
additional margin. CC may prescribed maximum long/short positions by members
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or exposure limit in quantity / value / % of base capital.
Mark to Market and Settlement
There should the system of daily settlement of futures contracts. Similarly
the closing price of futures is to be settled on daily basis. The final settlement price
is to be as per the closing price of underlying security.
Sales Practices
Risk disclosure document with each client mandatory
Sales personnel to pass certification exam
Specific authorisation from client's board of directors/trustees
Trading Parameters
Each order - buy/sell and open/close
Unique order identification number
Regular market lot size, tick size
Gross exposure limits to be specified
Price bands for each derivative contract
Maximum permissible open position
Off line order entry permitted
Brokerage
Prices on the system shall be exclusive of brokerage
Maximum brokerage rates shall be prescribed by the exchange
Brokerage to be separately indicated in the contract note
Margins From Clients
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Margins to be collected from all clients/trading members
Daily margins to be further collected
Right of clearing member to close out positions of clients/TMs not paying
daily margins
Losses if any to be charged to clients/TMs and adjusted against margins
Other Recommendations
Removal of the regulatory prohibition on the use of derivatives by mutual
funds while making the trustees responsible to restrict the use of derivatives
by mutual funds only to hedging and portfolio balancing and not for
speculation.
Creation of derivatives Cell, a derivative Advisory Committee, and
Economic Research Wing by SEBI.
Declaration of derivatives as securities under section 2(h)(ii a) of the SCRA
and suitable amendment in the notification issued by the Central
Government in June 1969 under section 16 of the SCRA
Consequent to the committee's recommendations the following legal
amendments were carried out:
Legal Amendments
Securities Contract Regulation Act
Derivatives contract declared as a 'security' in Dec 1999
Notification in June 1969 under section 16 of SCRA banning forward
trading revoked in March 2000.
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In order to recommend a guideline for effective implementation of the
recommendations of LC Gupta Committee Report, SEBI entrusted the task to
another Committee, i.e. JR Verma Committee appointed by it.
SEBIs J.R.Verma Committee
The group submitted its report in 1998. The group began by enumerating the
risk containment issues that assumed importance in the Indian context while setting
up an index futures market. The recommendations of the Group as covered by its
report are as under
Estimation of Volatility (Clause 2.1)
Several issues arise in the estimation of volatility:
The Volatility in the Indian market is quite high compared to developed
markets.
The volatility in the Indian market is not constant and is varying over time.
The statistics on the volatility of the index futures markets does not exist and
therefore, in the initial period, reliance has to be made on the volatility in the
underlying securities market. The LC Gupta Committee (LCGC) has prescribed that
no cross margining would be permitted and separate margins would be charged on
the position in the futures and the underlying securities market. In the absence of
cross margining, index arbitrage would be costly and therefore possibly will not be
efficient.
Calendar Spreads (Clause 2.2)
In developed markets, calendar spreads are essentially a play on interest
rates with negligible stock market exposure. As such margins for calendar spreads
are very low. In India, the calendar basis risk could be high due to the absence of
efficient index arbitrage and the lack of channels for the flow of funds from the
organised money market to the index future market.
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Trader Net Worth (Clause 2.3)
Even an accurate 99% "value at risk" model would give rise to end of day
mark to market losses exceeding the margin of approximately once in every 6
months. Trader net worth provides an additional level of safety to markets and
works as a deterrent to the incidence of defaults. A member with a high net worth
would try harder to avoid defaults as his own net worth would be at stake.
Margin Collection and Enforcement (Clause 2.4)
Apart from the right calculation of margin, the actual collection of margin is also of
equal importance. Since initial margins can be deposited in the form of bank
guarantee and securities, the risk containment issues in regard to these need has to
be tackled.
Clearing Corporation (Clause 2.5)
The clearing corporation provides innovation and becomes the counter party for
every trade. In these circumstances, the credibility of the clearing corporation
assumes the importance and issues of governance and transparency need to be
addressed.
Position Limit (Clause 2.6)
It can be necessary to prescribe position limits for the market considering whole and
for the individual clearing member / trading member / client.
Margining System (Clause 3) - Mandating a Margin Methodology not Specific
Margins (Clause 3.1.1)
The LCGC recommended that margins in the derivatives markets would be based
on a 99% (VAR) approach. The group discussed ways of operationalising this
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recommendation keeping in mind the issues relating to estimation of volatility
discussed. It is decided that SEBI should authorise the use of a particular VAR
estimation methodology but should not make compulsory a specific minimum
margin level.
Initial Methodology (Clause 3.1.2)
The group has evaluated and approved a particular risk estimation methodology that
is described in 3.2 below and discussed in further detail in Appendix 1. The
derivatives exchange and clearing corporation should be authorised to start index
futures trading using this methodology for fixing margins.
Continuous Refining (Clause 3.1.3)
The derivatives exchange and clearing corporation should be encouraged to refine
this methodology continuously on the basis of further experience. Any proposal for
changes in the methodology should be filed with SEBI and released to the public for
comments along with detailed comparative back testing results of the proposed
methodology and the current methodology. The proposal shall specify the date from
which the new methodology will become effective and this effective date shall not
be less than three months after the date of filing with SEBI. At any time up to two
weeks before the effective date, SEBI may instruct the derivatives exchange and
clearing corporation not to implement the change, or the derivatives exchange and
clearing corporation may on its own decide not to implement the change.
Initial Margin Fixation Methodology (Clause 3.2)
The group took on record the estimation and back testing results provided by Prof.
Varma (see Appendix 1) from his ongoing research work on value at risk
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calculations in Indian financial markets. The group, being satisfied with these back
testing results, recommends the following margin fixation methodology as the
initial methodology for the purposes of 3.1.1 above.
The exponential moving average method would be used to obtain the volatility
estimate every day.
Daily Changes in Margins (Clause 3.3)
The group recommends that the volatility estimated at the end of the day's trading
would be used in calculating margin calls at the end of the same day. This implies
that during the course of trading, market participants would not know the exact
margin that would apply to their position. It was agreed therefore that the volatility
estimation and margin fixation methodology would be clearly made known to all
market participants so that they can compute what the margin would be for any
given closing level of the index. It was also agreed that the trading software would
itself provide this information on a real time basis on the trading workstation screen.
Margining for Calendar Spreads (Clause 3.4)
The group took note of the international practice of levying very low margins on
calendar spreads. A calendar spread is a position at one maturity which is hedged by
an offsetting position at a different maturity: for example, a short position in the six
month contract coupled with a long position in the nine month contract. The
justification for low margins is that a calendar spread is not exposed to the market
risk in the underlying at all. If the underlying rises, one leg of the spread loses
money while the other gains money resulting in a hedged position. Standard futures
pricing models state that the futures price is equal to the cash price plus a net cost of
carry (interest cost reduced by dividend yield on the underlying). This means that
the only risk in a calendar spread is the risk that the cost of carry might change; this
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is essentially an interest rate risk in a money market position. In fact, a calendar
spread can be viewed as a synthetic money market position. The above example of
a short position in the six month contract matched by a long position in the nine
month contract can be regarded as a six month future on a three month T-bill. In
developed financial markets, the cost of carry is driven by a money market interest
rate and the risk in calendar spreads is very low.
In India, however, unless banks and institutions enter the calendar spread in a
big way, it is possible that the cost of carry would be driven by an unorganised
money market rate as in the case of the badla market. These interest rates could be
highly volatile.
Given the evidence that the cost of carry is not an efficient money market rate,
prudence demands that the margin on calendar spreads be far higher than
international practice. Moreover, the margin system should operate smoothly when
a calendar spread is turned into a naked short or long position on the index either by
the expiry of one of the legs or by the closing out of the position in one of the legs.
The group therefore recommends that:
The margin on calendar spreads is levied at a flat rate of 0.5% per month of
spread on the far month contract of the spread subject to a minimum margin
of 1% and a maximum margin of 3% on the far side of the spread for
spreads with legs upto 1 year apart. A spread with the two legs three months
apart would thus attract a margin of 1.5% on the far month contract.
The margining of calendar spreads is reviewed at the end of six months of
index futures trading.
A calendar spread should be treated as a naked position in the far month
contract as the near month contract approaches expiry. This change should
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be affected in gradual steps over the last few days of trading of the near
month contract. Specifically, during the last five days of trading of the near
month contract, the following percentages of a calendar spread shall be
treated as a naked position in the far month contract: 100% on day of expiry,
80% one day before expiry, 60% two days before expiry, 40% three days
before expiry, 20% four days before expiry. The balance of the spread shall
continue to be treated as a spread. This phasing in will apply both to
margining and to the computation of exposure limits.
If the closing out of one leg of a calendar spread causes the members' liquid
net worth to fall below the minimum levels specified in 4.2 below, his
terminal shall be disabled and the clearing corporation shall take steps to
liquidate sufficient positions to restore the members' liquid net worth to the
levels mandated in 4.2.
The derivatives exchange should explore the possibility that the trading
system could incorporate the ability to place a single order to buy or sell
spreads without placing two separate orders for the two legs.
For the purposes of the exposure limit in 4.2 (b), a calendar spread shall be
regarded as an open position of one third of the mark to market value of the
far month contract. As the near month contract approaches expiry, the
spread shall be treated as a naked position in the far month contract in the
same manner as in 3.4 (c).
Margin Collection and Enforcement (Clause 3.5)
Apart from the correct calculation of margin, the actual collection of margin
is also of equal importance. The group recommends that the clearing corporation
should lay down operational guidelines on collection of margin and standard
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guidelines for back office accounting at the clearing member and trading member
level to facilitate the detection of non-compliance at each level.
Transparency and Disclosure (Clause 3.6)
The group recommends that the clearing corporation / clearing house shall
be required to disclose the details of incidences of failures in collection of margin
and / or the settlement dues at least on a quarterly basis. Failure for this purpose
means a shortfall for three consecutive trading days of 50% or more of the liquid
net worth of the member.
Key Regulations
In India the National Stock Exchange of India (NSE) and the Bombay
Stock Exchange (BSE) offer options trading on stock indices as well as
individual securities.
Options on stock indices are European in kind and settled only on the last
of expiration of the underlying. NSE' offers index options trading on the NSE
Fifty index called the Nifty, While BSE: offers index options on the country's
widely used index Sensex, which consists of 30 stocks.
Options on individual securities are American. The number of stock
options contracts to be traded on the exchanges will be based on the list of
securities as specified by Securities and Exchange Board of India (SEBI).
Additions/deletions in the list of securities eligible on which options contracts
shall be made available shall be notified from time to time.
Underlying: Underlying for the options on individual securities contracts shall be
the underlying security available for trading in the capital market segment of the
exchange.
Security descriptor: The security descriptor for the options on individual
securities shall be:
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Market type ?N
Instrument type ?OPTSTK
Underlying -Underlying security
Expiry date -Date of contract expiry
Option type -CA/PA
.Exercise style -American Premium Settlement method:
Premium Settled;
CA -Call American
PA -Put American.
Trading cycle: The contract cycle and availability of strike prices for
options contracts on individual securities shall be as follows:
Options on individual securities contracts will have a maximum of three-
month trading cycle. New contracts will be introduced on the trading day following
the expiry of the near month contract.
On expiry of the near month contract, new contract shall be introduced at
new strike prices for both call and put options, on the trading day following the
expiry of the near month contract.
Strike price intervals: The exchange shall provide a minimum of five strike prices
for every option type (i.e call & put) during the trading month. There shall be two
contracts in the-money (ITM), two contracts out-of-the-money (OTM) and one
contract at-the-money (ATM). The strike price interval for options on individual
securities is given in the accompanying table.
New contracts with new strike prices for existing expiration
date will be introduced for trading on the next working day based on
the previous day's underlying close values and as and when -
enquired. In order to fix on the at-the-money strike price for options
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on individual securities contracts the closing underlying value shall
be rounded off to the nearest multiplier of the strike price interval.
The in-the-money strike price and the out-of-the-money strike price
shall be based on the at-the-money strike price interval.
Expiry day: Options contracts on individual securities as well as index options
shall expire on the last Thursday of the expiry month. If the last Thursday is a
trading holiday, the contracts shall expire on the previous trading day.
Order type: Regular lot order, stop loss order, immediate or cancel, good till day,
good till cancelled good till date and spread order. Good till cancelled (GTC)
orders shall be cancelled at the end of the period of 7 calendar days from the date
of entering an order.
Permitted lot size: The value of the option contracts on individual securities shall
not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for
the options contracts on individual securities shall be in multiples of 100 and
fractions if any shall be rounded off to the next higher multiple of 100.
Price steps: The price steps in respect of all options contracts admitted to dealings
on the exchange shall be Re 0.05.
Quantity freeze : Orders which may come to the exchange as a quantity freeze
shall be the lesser of the following: 1 per cent of the market wide position limit
stipulated of options on individual securities as given in (h) below or Notional
value of the contract of around Rs 5 crore. In respect of such orders, which have
come under quantity freeze, the member shall be required to confirm J the
exchange that there is no inadvertent error in the order entry and that the order is
genuine. In such confirmation, the exchange at its discretion may approve such
order subject to availability of turnover/exposure limits, etc.
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Base price: Base price of the options contracts on introduction of new contracts
shall be the theoretical value of the options contract arrived at based on Black-
Scholes model of calculation of options premiums. The base price of the contracts
on subsequent trading days will be the daily close price of the options contracts.
However in such of those contracts where orders could not be placed because of
application of price ranges, the bases prices may be modified at the discretion of
the exchange and intimated to the members.
Price ranges: There will be no day minimum/maximum price ranges applicable for
the options contract. The operating ranges and day minimum/maximum ranges for
options contract shall be kept at 99 per cent of the base price. In view of this the
members will not be able to place orders at prices which are beyond 99 per cent of
the base price. The base prices for option contracts, may be modified, at the
discretion of the exchange, based on the request received from trading; members as
mentioned above.
Exposure limits: Gross open positions of a member at any point of time shall not
exceed the' exposure limit as detailed hereunder:
Index Options: Exposure Limit shall be 33.33 times the liquid
net worth.
Option contracts on individual Securities: Exposure Limit shall
be 20 times the liquid net worth.
Member wise position limit: When the open position of a Clearing Member,
Trading Member or Custodial Participant exceeds 15 per cent of the total open
interest of the market or Rs 100 crore, whichever is higher, in all the option
contracts on the same underlying, at any time, including during trading hours.
For option contracts on individual securities, open interest shall be
equivalent to the open positions multiplied by the notional value. Notional Value
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shall be the previous day's closing price of the underlying security or such other
price as may be specified from time to time.
Market wide position limits: Market wide position limits for option contracts on
individual for securities shall be lower of:
*20 times the average number of shares traded daily, during the previous
calendar month, in the relevant underlying security in the underlying segment of
the relevant exchange or, 10 per cent of the number of shares held by non-
promoters in the relevant underlying security i.e. 10 per cent of the free float in
terms of the number of shares of a company.
The relevant authority shall specify the market wide position limits once
every month, on the expiration day of the near month contract, which shall be
applicable till the expiry of the subsequent month contract.
Exercise settlement: Exercise type shall be American and final settlement in
respect of options on individual securities contracts shall be cash settled for an
initial period of 6 months and as per the provisions of National Securities
Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time.
2.21. Warrants and Convertibles
Warrant is a contract/option entered into by the issuing company giving the
holder the right to purchase or subscribe to the stated number of equity shares of
that company within a predetermined specified period of time at a predetermined
price. Warrants are somewhat similar to call options but they also have the
following differences: While the warrants are issued by companies, options are
created by investors, and, as was said earlier, the companies do not have to do
anything with such a creation. Warrants usually have long maturities (of several
years), while options expire in short periods of time such as nine months. Unlike
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options, warrants are not standardized, they are unique. Warrants help companies
in raising fresh capital, options do Dot have such uses.
Warrants are typically issued as sweeteners attached to bonds/debentures
and equity issues so that they are successful in terms of volume and price.
Warrants can be detached and traded separately. It may be possible to issue
callable warrants, and although all the conditions of warrants are specified at
issuance, it may be possible t9 alter the expiration date if certain conditions
transpire. The typical maturity of warrants is 3 to 10 years, but perpetual
warrants also have existed abroad. Warrants can be traded on the exchanges or
over the counter as in the case of equities. Many investors never exercise
warrants; they simply buy and sell them for capital gains. Thus, investors are
often interested in warrants because of their speculative and leverage
opportunities.
Convertible bonds/debentures and convertible preference shares are the
other types of equity derivative securities. They can be fully or partially
converted into equity of the issuing company on specified terms with regard to
the timing, the price and the ratio of conversion. They carry a claim on the
common stock of the same company (issuer). The claim can be exercised at the
owner's initiative. Many convertible bonds cannot be exercised for certain initial
period, say 6 to 24 months. If conversion is not effected, convertibles remain in
existence till maturity (in the case of bonds) or for perpetuity (in the case of
preference shares). Unlike options and warrants, convertibles are valuable in their
own rights; only a part of their value is derived from the option feature. Similarly,
while the option feature is not inseparable from convertibles, warrants can be
detachable. Unlike convertibles, warrants can be issued independently; they need
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not be tied with some other instrument. While warrants can be exercised for cash,
convertibles do not have such a feature.
In India, the SEBI has issued the following guidelines with regard to the
provisions applicable to the fully and partially convertible debentures: (a) the
conversion premium and the conversion timing is to be predetermined and stated
in the prospectus. (b) Any conversion has to be optional i.e., at the volition of the
debenture holder if it takes place at or after 18 months but before 36 months from
the date of allotment. (c) A conversion period of more than 36 months is not
permitted unless conversion is made with put or call options. (d) Compulsory
credit rating is required if the conversion period for fully convertible debentures
exceeds 18 months.
2.22. Important Terms
Annualised return: The return or profit, expressed on an annual basis, the writer of
the option contract receives for buying the shares and writing that particular option.
Assignment The holder of a long American-style option contract can exercise the
option at any time until the option expires. It follows that an option writer may be
assigned an exercise notice on a short option position at any time until that option
expires. If an option writer is short an option that expires in-the-money, assignment
on that contract should be expected, call or put. In fact, some option writers are
assigned on such short contracts when they expire exactly at-the-money. This
occurrence is usually not predictable. To avoid assignment on a written option
contract on a given day, the position must be closed out before that day`s market
close. Once assignment has been received, an investor has absolutely no alternative
but to fulfill his obligations from the assignment per the terms of the contract. An
option writer cannot designate a day when assignments are preferable. There is
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generally no exercise or assignment activity on options that expire out-of-the-
money. Owners generally let them expire with no value.
At-the-Money : The option with strike price equal to that of the market price of the
stock, it is considered as being "At-the-Money" or Near-the-Money
Buy and write: The simultaneous purchase of shares and sale of an equivalent
number of option contracts.
Class of options : Option contracts of the same type -either calls or puts -covering
the same underlying security.
Close
Closing purchase -- a transaction in which the purchaser`s intention is to
reduce or eliminate a short position in a given series of options. This
transaction is frequently referred to as "covering" a short position.
Closing sale -- a transaction in which the seller`s intention is to reduce or
eliminate a long position in a given series of options.
Covered Call Option
Covered option helps the writer to minimize his loss. In a covered call
option, the writer of the call option takes a corresponding long position in the stock
in the cash market; this will cover his loss in his option position if there is a sharp
increase in price of the stock.. Further, he is able to bring down his average cost of
acquisition in the cash market (which will be the cost of acquisition less the option
premium collected).
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Covered Put Option
A writer of a Put Option can create a covered position by selling the
underlying security (if it is already owned). The effective selling price will increase
by the premium amount (if the option is not exercised at maturity). Here again, the
investor is not in a position to take advantage of any sharp increase in the price of
the asset as the underlying asset has already been sold. If there is a sharp decline in
the price of the underlying asset, the option will be exercised and the investor will
be left only with the premium amount. The loss in the option exercised will be
equal to the gain in the short position of the asset.
Delta: The rate in change of option premium due to a change in price of the
underlying securities,
Derivative: An instrument which derives its value from the value of an underlying
instrument (such as shares, share price indices, fixed interest securities,
commodities, currencies, etc.)" Warrants and options are types of derivative.
Early exercise and Assignment
For call contracts, owners might make an early exercise in order to take
possession of the underlying stock in order to receive a dividend. It is therefore
extremely important to realize that assignment of exercise notices can occur early -
days or weeks in advance of expiration day. As expiration nears, with a call
considerably in-the-money and a sizeable dividend payment approaching, this can
be expected. Call writers should be aware of dividend dates, and the possibility of
an early assignment. When puts become deep in-the-money, most professional
option traders will exercise them before expiry. Therefore, investors with short
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positions in deep in-the-money puts should be prepared for the possibility of early
assignment on these contracts.
Exercise If the holder of an American-style option decides to exercise his right to
buy (in the case of a call) or to sell (in the case of a put) the underlying shares of
stock, the holder must direct their broker to submit an exercise notice to ASX. In
order to ensure that an option is exercised on a particular day, the holder must notify
their broker before its exercise cut-off time for accepting exercise instructions on
that day. Once ASX has been notified that an option holder wishes to exercise an
option, it will assign the exercise notice randomly among customers with written
(and not covered) an option contract with the same terms. ASX notify the seller's
broker the next morning and they in turn notify the client that was randomly
selected.
Exercise price: The amount of money which must be paid by the taker (in the
case of a call option) or the writer (in the case of a put option) for the transfer of
each of the underlying securities upon exercise of the option.
Expiry day: The date on which all unexercised options in a particular series expire.
Hedge: A transaction, which reduces or offsets the risk of a current holding. For
example, a put option may act as a hedge for a current holding in the underlying
instrument.
Implied volatility: A measure of volatility assigned to a series by the current
market price.
In-the-money: A Call Option is said to be "In-the-Money" if the strike price is
less than the market price of the underlying stock. A Put Option is In- The-Money
when the strike price is greater than the market price.
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Intrinsic price The different between the market value of the underlying securities
and the excise price of the option. Usually it is not less then zero. It represents
advantage the taker had over the current market price if the option is exercised.
Leverage is the feature of options that allows for higher returns from movements in
the underlying shares trading options rather than the underlying shares themselves.
Options provide leverage because they trade for a fraction of the price of the
underlying shares.
Long: "Long" describes a position (in stock and/or options) in which one has
purchased and own that security in one`s brokerage account. For example, if you
have purchased the right to buy 1000 shares of a stock, and are holding that right in
your account, you are long a call contract. If you have purchased the right to sell
1000 shares of a stock, and are holding that right in your brokerage account, you are
long a put contract. If you have purchased 1,000 shares of stock and are holding that
stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock.
Long-term option: An option with a term to expiry of two or three years from the
date the series was first listed. (This is not available currently in India)
Multiplier: Is used when considering index options. The strike price and premium
of an index option are usually expressed in points.
Open: An opening transaction is one that adds to, or creates a new trading position.
It can be either a purchase or a sale. With respect to an option transaction, consider
both:
Opening purchase -- a transaction in which the purchaser`s intention is to
create or increase a long position in a given series of options.
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Opening sale -- a transaction in which the seller`s intention is to create or
increase a short position in a given series of options.
Open interest: The number of outstanding contracts in a particular class or series
existing in the; option market. Also called the "open position".
Out-of-the-Money : A Call Option is said to be "Out-of-the-Money" if the strike
price is greater than the market price of the stock. A Put option is Out-Of-Money
if the strike price is less than the market price.
Premium is the term used for the price of an option. It varies as the underlying
security`s price fluctuates as well as with the passage of time. The premium is
dependant on other factors including the volatility of the underlying security,
dividends and interest rates. Option premiums are calculated based on models
that take these factors into account and take the guess work out of valuing
options. The most common models are the Black & Scholes and the Binomial
option pricing models.
Put option: An option contract that entitles the taker (buyer) to sell a fixed number
of underlying securities at a stated price on or before a fixed Expiry Day.
Random selection: The method by which an exercise of an option is allocated to a
writer in that series of option.
Series of options: All contracts of the same class having the same Expiry Day and
the same exercise price.
Short: It describes a position in options in which one has written a contract (sold
one that you did not own). In return, now he has the obligations inherent in the
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terms of that option contract. If one has sold the right to buy 1000 shares of a stock
to someone else, it is a short call contract. If one has sold the right to sell 1000
shares of a stock to someone else, it is a short put contract. The writer of an option
collects and keeps the premium received from its initial sale.
Strike price: The Strike Price denotes the price at which the buyer of the option
has a right to purchase or sell the underlying. Five different strike prices will be
available at any point of time. The strike price interval will be of 20. If the index
is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430,
1,450. The strike price is also called Exercise Price. This price is fixed by the
exchange for the entire duration of the option depending on the movement of the
underlying stock or index in the cash market.
Time decay is the cost of holding an option from one day to the next. As options
exist for a limited time only their value diminishes as the expiry approaches in
much the same way as insurance policies lose value as they come to an end. Time
decay is quantifiable and is known by the Greek term "theta".
Time value: The amount investors are willing to pay for the possibility that they
could make a profit from their option position. It is influenced by time to expiry,
dividends, interest rates, volatility .and market expectations.
Underlying securities: The shares or other securities subject to purchase or sale
upon exercise of the option.
Writer: The seller of an option contract.
2.23. Self analysis Questions
1. What are options? Explain the features of any two options?
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2. Explain the advantages of options?
3. Call options and Put options are nothing but the opposites. Do you agree?
Support your answer.
4. Option prices are affected by a number of factors Discuss.
5. Compare and Contrast the two major pricing models?
6. Discuss fully the different market strategies followed in the option trading?
7. Write short notes on: a. margin b. over the counter option
c.
warrant
option
8. Discuss fully the rules and regulations that are followed in option trading?
2.24. Activities
1. Visit the web trading sites like icicidirect.com and go through the domo sites on
Option trading, so that a preliminary knowledge can be gathered.
2. Open a demat account with a depository participant and do some option trading
on your own with of course with little money as well as with little risk taking.
3. Meet a stock broker in your locality and gather as much information as possible
with a lot of patience.
2.25.References:
1. Avadhani,V.A. :Capital Market Management.
2.Avadhani,V.A. :Investments and Securities Markets in India.
3. Avadhani,V.A. : Securities Analysis and Portfolio Management.
4.Bhole,L.M. : Financial Institutions and Markets.
5. Chance, Don M: An Introduction to Derivatives, Dryden Press, International Edition
180
6. Chew, Lilian: Managing Derivative Risk, John Wiley, New Jersey.
7. Das, Satyajit: Swap & Derivative financing, Probus.
8. Hull, J.: Options: Futures and other Derivatives, Prentice Hall, New Delhi.
9. ICICI direct.com : FUTURES & OPTIONS.
10. Kolb, Robert W: Understanding Futures Markets, Prentice Hall Inc., New
Delhi.
LESSON : 3 FUTURES TRADING AT NSE : A
PREMIER
Objectives of the Lesson:
1. What is the Trading Platform for trading Futures at NSE?
2. Basic features of Futures traded in India
3. Lot sizes, order forms, margins, etc
4. Distinction between Index Futures Vs Stock Futures
5. Features of NEAT F& O Screen
Learning Objectives:
After reading this lesson, student should be able to
understand
1. How are Futures traded in India?
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2. What are the basic features of Futures traded
at NSE
3. What is the Lot size, number cycles, etc
4. Features of NEAT F&O Screen
5. Margin requirements, etc for trading in
Futures
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LESSON : 3 FUTURES TRADING AT NSE : A
PREMIER
The derivatives trading on National Stock Exchange (NSE) has
commenced with S&P CNX Nifty Index futures on June 12, 2000.
Single stock futures were launched on November 9, 2001. Currently,
the futures contracts have a maxium of 3 months expiration cycles.
Three contracts are available for trading with 1 month, 2 month and 3
month expiry. A new contract is introduced on the next trading day
following the expiry of the near month contract
Trading Mechanism:
The Futures and Options trading system of NSE is called NEAT
? F&O trading system. It provides a fully automated screen based
trading for Nifty Futures and Options on a nation wide basis as well as
an online monitoring and surveillance mechanism. It supports an order
driven market ad provides complete transparency of trading operations.
It is similar to that of the trading of equities in cash market segment
Basis of trading:
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The NEAT ? F&O segment supports an order driven market, wherein
orders match automatically. Order matching is essentially on the basis
of security, its price, time and quantity. All quantity fields are in units
and price in rupees. The lot size on the futures market is for 200
Nifities. The exchange notifies the regular lot size and tick size for
each of the contracts traded on this segment from time to time. When
an order enters the trading system, it is an active order. It tries to find a
match on the other side of the book. If it finds a match, a trade is
generated. If it does not find a match, the order becomes passive and
goes and sits in the respective outstanding order book in the system
Order types and Conditions:
The NEAT ? F& O allows different types of orders with various
conditions attached to them to meet out the requirements of players.
Based on the type of conditions, the orders may have:
Time conditions
Price conditions
Other conditions
Further, a combinations of above conditions create a wide variety of
flexibility to players . Based on the above said conditions, the order
types differ. A list of them are as follows:
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Time conditions:
Based on time conditions, the orders may be classified as:
Day order: This order is valid for the day. If the
order is not executed, the system cancels the order
automatically at the end of the day
Good till cancelled: GTC order remains in the
system until it is cancelled by the player. There
fore, such orders are likely to be active for few days.
The maximum of number of days an order is
allowed to be active is notified by the Exchange
from time to time after which the order is
automatically gets cancelled
Good till a specific date / days: GTD orders are
allowed to be in the system until specified number
of days or upto a specific day desired by the user
Immediate or Cancel (IOC) : These orders are for
immediate buy or sell at the current rate. The user
does not want to continue such orders, if an
immediate order match not found.
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Price conditions: Based on the price conditions, follwing forms of
orders emerge:
Stop ? Loss order: This type of order allows the user
to release an order into the system when the price of
the security reaches a specific price limit. For
example, a trader has placed a stop loss buy order
with a price trigger of Rs 3327 and Rs 3330 (limit
price), his order will be executed the moment the
market price reaches the level of Rs 3327 and it
would be stopped when the price goes beyond Rs
3330
Other conditions: Based on other conditions, the orders may be
classified as follows:
Market Price Orders ? For these orders no specific
price is mentioned by the buyer or seller at the time
of entering. The prevailing market price is
considered for these types of orders
Trigger Price: Trigger price refers to that price at
which an order gets triggered from the stop loss
book
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Limit price order: Limit price is the price of the
orders after triggering from stop ? loss book
Components of Trading Window:
The NEAT ? F&O trading windows are two types:
The Market Watch window
The Inquiry Window
The Market Watch window is displayed on the traders workstation
screen with the following components
Title bar
Ticker Window of F&O segment
Ticker Window of Underlying Market
Tool bar
Market Watch window
Inquiry window
Snap quote
Order / trade window
System message window
For greater clarity, students advised to visit nearby stock broker who is
dealing with F&O segment and see the live trading window
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The purpose of market watch window is to allow continuous
monitoring of contracts or securities that are of specific interest to the
users. It displays the trading information for contracts selected by the
users. The user also gets the information about the cash market
securities on the screen
Inquiry window: This window enables the user to view information as
to Market by Order, Market by price, previous trades, outstanding
orders, snap quotes, order status, Market movement, Market Inquiry,
Net Position, etc
Placing orders on the Trading System:
The Futures market is always a zero sum game. The total number of
buy positions should be equal to total number of sell positions. Total
number of outstanding contracts (long/short) at any point of time is
called Open Interest . It is an important indicator of the liquidity in
every contract. Usually, the open interest would be high in case of near
month futures
Members can enter their orders on the trading system, however, they
have to identify the order as that of their own or for their clients. The
account numbers of the trading members and clients are to be specified
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Futures on NSE
The F&O segment of NSE provides the following trading facility in
case of Futures:
1. Index based futures
2. Individual stock futures
Index Futures : Contract specifications:
NSE trades Nifty Futures with one month, two month, three month
expiry cyles. All contacts expire on the last Thursday of every month.
On the Friday following the Thursday a new contract having 3 month
expiry would be introduced for trading.
All index futures contracts on NSE` futures trading system are coded.
Each futures contract has a separate limit order book. All passive
orders are stacked in the sytem in terms of price-time priority and trades
take place at the passive order price. The best buy order for a given
futures contract will be the order to buy at the index at the highest index
level where as the best sell order will be the order to sell the index at the
lowest index level.
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Trade specifications of a Nifty Futures:
Underlying asset
: S&P CNX Nifty
Exchange of Trading
: NSE
Security Descriptor
: N FUTIDX NIFTY
Contract size
: Permitted lot size is 200
and multiples thereof
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Price steps
: Rs 0.05
Price bands
: Not applicable
Trading Cycle
: Near month
Next Month
Far month
Expiry day
: Last Thursday of the
month
Settlement basis
: Mark to Market and final
settlement will be cash
settled
on T+1 basis
Settlement Price
: Daily settlement price
will be
closing price of futures
contracts for the trading
day
and the final settlement
price
shall be the closing value
of
the underlying index on
the
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last trading day.
Contract Specifications for stock Futures:
Trading in individual stock futures have commenced on NSE from
November 2001. These contracts are cash settled on a T+1 basis. The
expiration cycle for stock futures is the same as for index futures. A
new contract is introduced on the trading day following the expiry of
the near month contract
Charges:
The maximum brokerage chargeale by a trading member in relation to
trades effected in the contracts admitted to dealing on the F& O
segment of NSE is 2.5% of the contract value. The transaction charges
payable by a TM for the trades executed by him on the F&O segmemnt
are fixed at Rs 2 per lakh of turnover (0.002%)(each side) or Rs 1 lakh
annually, which ever is higher. The trading members also contribute o
the Investor Protection Fund of F&O segment at the rate of Rs 10 per
crore of business done
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Exercises:
1. What are the basic features of Futures traded at NSE?
2. Give an account of Margin requirements, other charges relating
to trading in Futures?
3. How are the Futures settled?
I ) Hedging ? Introduction
We have seen how one can take a view on the market with the help of index futures.
The other benefit of trading in index futures is to hedge your portfolio against the
risk of trading. In order to understand how one can protect his portfolio from value
erosion let us take an example.
Illustration:
Amp enters into a contract with Saru roopa that six months from now he will sell to
Saru roopa 10 dresses for Rs 4000. The cost of manufacturing for Amp is only Rs
1000 and he will make a profit of Rs 3000 if the sale is completed.
Cost (Rs)
Selling price
Profit
1000
4000
3000
However, Amp fears that Saru roopa may not honour his contract six months from
now. So he inserts a new clause in the contract that if Saru roopa fails to honour the
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contract she will have to pay a penalty of Rs 1000. And if Saru roopa honours the
contract Amp will offer a discount of Rs 1000 as incentive.
On Saru roopa's default
If Saru roopa honours
1000 (Initial Investment)
3000 (Initial profit)
1000 (penalty from Saru roopa)
(-1000) discount given to Saru roopa
- (No gain/loss)
2000 (Net gain)
As we see above if Saru roopa defaults Amp will get a penalty of Rs 1000 but he
will recover his initial investment. If Saru roopa honours the contract, Amp will still
make a profit of Rs 2000. Thus, Amp has hedged his risk against default and
protected his initial investment.
The above example explains the concept of hedging. Let us try understanding how
one can use hedging in a real life scenario.
Stocks carry two types of risk ? company specific and market risk. While company
risk can be minimized by diversifying your portfolio market risk cannot be
diversified but has to be hedged. So how does one measure the market risk? Market
risk can be known from Beta.
Beta measures the relationship between movements of the index to the movement of
the stock. The beta measures the percentage impact on the stock prices for 1%
change in the index. Therefore, for a portfolio whose value goes down by 11%
when the index goes down by 10%, the beta would be 1.1. When the index
increases by 10%, the value of the portfolio increases 11%. The idea is to make beta
of your portfolio zero to nullify your losses.
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Hedging involves protecting an existing asset position from future adverse
price movements. In order to hedge a position, a market player needs to take
an equal and opposite position in the futures market to the one held in the cash
market. Every portfolio has a hidden exposure to the index, which is denoted by
the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2,
you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.
Steps:
1. Determine the beta of the portfolio. If the beta of any stock is not known, it
is safe to assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the
index would offset the losses on the rest of his portfolio. This is achieved by
multiplying the relative volatility of the portfolio by the market value of his
holdings.
Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million
worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:
Index down
Index up 10%
10%
Gain/(Loss) in Rs 120,000 (Rs 120,000)
Portfolio
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Gain/(Loss) in (Rs 120,000) Rs 120,000
Futures
Net Effect
Nil
Nil
As we see, that portfolio is completely insulated from any losses arising out of a fall
in market sentiment. But as a cost, one has to forego any gains that arise out of
improvement in the overall sentiment. Then why does one invest in equities if all
the gains will be offset by losses in futures market. The idea is that everyone
expects his portfolio to outperform the market. Irrespective of whether the market
goes up or not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the
scrip and taking a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses
in the cash market.
Speculation
Speculators are those who do not have any position on which they enter in futures
and options market. They only have a particular view on the market, stock,
commodity etc. In short, speculators put their money at risk in the hope of profiting
from an anticipated price change. They consider various factors such as demand
supply, market positions, open interests, economic fundamentals and other data to
take their positions.
Illustration:
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Amp is a trader but has no time to track and analyze stocks. However, he fancies his
chances in predicting the market trend. So instead of buying different stocks he
buys Sensex Futures.
On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index
will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he
sells an equal number of contracts to close out his position.
Selling Price : 4000*100 = Rs 4,00,000
Less: Purchase Cost: 3600*100 = Rs 3,60,000
Net gain Rs 40,000
Amp has made a profit of Rs 40,000 by taking a call on the future value of the
Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if
would have been bearish he could have sold Sensex futures and made a profit from
a falling profit. In index futures players can have a long-term view of the market up
to at least 3 months.
Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can
earn riskless profits. When markets are imperfect, buying in one market and
simultaneously selling in other market gives riskless profit. Arbitrageurs are always
in the look out for such imperfections.
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In the futures market one can take advantages of arbitrage opportunities by buying
from lower priced market and selling at the higher priced market. In index futures
arbitrage is possible between the spot market and the futures market (NSE has
provided special software for buying all 50 Nifty stocks in the spot market.
Take the case of the NSE Nifty.
Assume that Nifty is at 1200 and 3 month`s Nifty futures is at 1300.
The futures price of Nifty futures can be worked out by taking the interest
cost of 3 months into account.
If there is a difference then arbitrage opportunity exists.
Let us take the example of single stock to understand the concept better. If Wipro is
quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one
can purchase ITC at Rs 1000 in spot by borrowing @ 12% annum for 3 months and
sell Wipro futures for 3 months at Rs 1070.
Sale = 1070
Cost= 1000+30 = 1030
Arbitrage profit = 40
These kinds of imperfections continue to exist in the markets but one has to be alert
to the opportunities as they tend to get exhausted very fast.
Pricing of options
198
Options are used as risk management tools and the valuation or pricing of the
instruments are a careful balance of market factors.
There are four major factors affecting the Option premium:
Price of Underlying
Time to Expiry
Exercise Price Time to Maturity
Volatility of the Underlying
And two less important factors:
Short-Term Interest Rates
Dividends
Review of Options Pricing Factors
The Intrinsic Value of an Option
The intrinsic value of an option is defined as the amount by which an option is in-
the-money or the immediate exercise value of the option when the underlying
position is marked-to-market.
For a call option: Intrinsic Value = Spot Price ? Strike Price
For a put option: Intrinsic Value = Strike Price ? Spot Price
The intrinsic value of an option must be positive or zero. It cannot be negative. For
a call option, the strike price must be less than the price of the underlying asset for
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the call to have an intrinsic value greater than 0. For a put option, the strike price
must be greater than the underlying asset price for it to have intrinsic value.
1) Price of underlying
The premium is affected by the price movements in the underlying instrument. For
Call options ? the right to buy the underlying at a fixed strike
price ? as the underlying price rises so does its premium. As the underlying price
falls, so does the cost of the option premium. For Put options ? the right to sell the
underlying at a fixed strike
price ? as the underlying price rises, the premium falls; as the underlying price falls
the premium cost rises.
2) The Time Value of an Option
Generally, the longer the time remaining until an option`s expiration, the higher its
premium will be. This is because the longer an option`s lifetime, greater is the
possibility that the underlying share price might move so as to make the option in-
the-money. All other factors affecting an option`s price remaining the same, the
time value portion of an option`s premium will decrease (or decay) with the passage
of time.
Note: This time decay increases rapidly in the last several weeks of an option`s life.
When an option expires in-the-money, it is generally worth only its intrinsic value.
3) Volatility
200
Volatility is the tendency of the underlying security`s market price to fluctuate
either up or down. It reflects a price change`s magnitude; it does not imply a bias
toward price movement in one direction or the other. Thus, it is a major factor in
determining an option`s premium. The higher the volatility of the underlying stock,
the higher the premium because there is a greater possibility that the option will
move in-the-money. Generally, as the volatility of an under-lying stock increases,
the premiums of both calls and puts overlying that stock increase, and vice versa.
Higher volatility=Higher premium
Lower volatility = Lower premium
Interest rates
In general interest rates have the least influence on options and equate
approximately to the cost of carry of a futures contract. If the size of the options
contract is very large, then this factor may take on some importance. All other
factors being equal as interest rates rise, premium costs fall and vice versa. The
relationship can be thought of as an opportunity cost. In order to buy an option, the
buyer must either borrow funds or use funds on deposit. Either way the buyer incurs
an interest rate cost. If interest rates are rising, then the opportunity cost of buying
options increases and to compensate the buyer premium costs fall. Why should the
buyer be compensated? Because the option writer receiving the premium can place
the funds on deposit and receive more interest than was previously anticipated. The
situation is reversed when interest rates fall ? premiums rise. This time it is the
writer who needs to be compensated.
Perfect Hedge
201
A position undertaken by an investor that would eliminate the risk of an existing
position or a position that eliminates all market risk from a portfolio in order to be a
perfect hedge, a position would need to have a 100% inverse correlation to the
initial position. As such, the perfect hedge is rarely found.
A common example of a near-perfect hedge would be an investor using a
combination of held stock and opposing options positions to self-insure against any
loss in the stock position. The cost of this strategy is that it also limits the upside
potential of the stock position.
Hedge Fund
An aggressively managed portfolio of investments that uses advanced investment
Strategies such as leverage, long, short derivative positions in both domestic and
international markets with the goal of generating high returns (either in an absolute
sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that
are open to a limited number of investors and require a very large initial minimum
investment. Investments in hedge funds are illiquid as they often require investors
keep their money in the fund for a minimum period of at least one year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they
cater to sophisticated investors. In the U.S., laws require that the majority of
investors in the fund be accredited. That is, they must earn a minimum amount of
money annually and have a net worth of over Rs.1 million, along with a significant
amount of investment knowledge. You can think of hedge funds as mutual funds for
the super-rich. They are similar to mutual funds in that investments are pooled and
professionally managed, but differ in that the fund has far more flexibility in its
investment
202
strategies.
It is important to note that hedging is actually the practice of attempting to reduce
risk, but the goal of most hedge funds is to maximize return on investment. The
name is mostly historical, as the first hedge funds tried to hedge against the
downside risk of a bear market with their ability to short the market (mutual funds
generally can`t enter into short positions as one of their primary goals). Nowadays,
hedge funds use dozens of different strategies, so it isn`t accurate to say that hedge
funds just hedge risk. In fact, because hedge fund managers make speculative
investments, these funds can carry more risk than the overall market.
Buying Hedge
A transaction that commodities investors undertake to hedge against possible
increase in the prices of the actuals underlying the futures contracts.
Also called a long hedge, this particular strategy protects investors from increasing
prices by means of purchasing futures contracts. Many companies will attempt to
use a long hedge strategy in order to reduce the uncertainty associated with future
prices.
Long Hedge
A situation where an investor has to take a long position in futures contracts in
order to hedge against future price volatility. A long hedge is beneficial for a
company that knows it has to purchase an asset in the future and wants to lock in
the purchase price. A long hedge can also be used to hedge against a short position
that has already been taken by the investor.
For example, assume it is January and an aluminum manufacturer needs 25,000
pounds of copper to manufacture aluminum and fulfill a contract in May. The
current spot price is Rs.1.50 per pound, but the May futures price is Rs.1.40 per
pound. In January the aluminum manufacturer would take a long position in 1 May
203
futures contract on copper. These locks in the price the manufacturer will pay.
If in May the spot price of copper is Rs.1.45 per pound the manufacturer has
benefited from taking the long position, because the hedger is actually
paying Rs.0.05/pound of copper compared to the current market price. However if
the price of copper was anywhere below Rs.1.40 per pound the manufacturer would
be in a worse position than where they would have been if they did not enter into
the futures contract.
Selling Hedge
A hedging strategy with which the sale of futures contracts are meant to offset a
long underlying commodity position. Also known as a short hedge.
This type of hedging strategy is typically used for the purpose of insuring against a
possible decrease in commodity prices. By selling a futures contract an investor can
guarantee the sale price for a specific commodity and eliminate the uncertainty
associated with such goods.
Micro-Hedge
An investment technique used to eliminate the risk of a single asset. In most cases,
this means taking an offsetting position in that single asset.
If this asset is part of a larger portfolio, the hedge will eliminate the risk of the one
asset but will have less of an effect on the risk associated with the portfolio.
Say you are holding the stock of a company and want to eliminate the price risks
associated with that stock. To offset your position in the company, you could take a
short position in the futures market, thereby securing the stock price for the period
of the futures contract. This strategy is used when an investor feels very uncertain
about the future movement of a single asset.
204
II ) HEDGING SCHEMES
Most option traders use more sophisticated hedging schemes than those that
have been described so far. As a first step, they attempt to make their portfolio
immune to small changes in the price of the underlying asset in the next small
interval of time. This is known as delta hedging. They then look. at what are known
as gamma and vega. Gamma is the rate of change of the value of the portfolio with
respect to delta; vega is the rate of change of the portfolio with respect to the asset's
volatility. By keeping gamma close to zero, a portfolio can be made relatively
insensitive to fairly large changes in the price of the asset; by keeping vega close to
zero, it can be made insensitive to changes in the asset's volatility. Option traders
may also look at theta and rho. Theta is the rate of change of the option portfolio
with the passage of time; rho is its rate of change with respect to the risk-free
interest rate. They may also carry out a scenario analysis investigating how the
value of their position will be impacted by alternative future scenarios. In the next
few sections we discuss these approaches in more detail.
A. DELTA HEDGING
205
The delta of a derivative, . It is defined as the rate of change of its price
with respect to the price of the underlying asset . It is the slope of the curve that
relates the derivative's price to the underlying asset price.
Change in option premium
Delta = --------------------------------
Change in underlying price
For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10
in the underlying stock or index.
Illustration:
A trader is considering buying a Call option on a futures contract, which has a price
of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The
delta for this option is +0.5. This means that if the price of the underlying futures
contract rises to Rs 20 ? a rise of Re 1 ? then the premium will increase by 0.5 x
1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.
Consider a call option on a stock. Figure 4.1 shows the relationship between
the call price and the underlying stock price. When the stock price corresponds to
point A, the option price corresponds to point B and the of the call is the slope of
the line indicated. As an approximation,
= c
S
More formally, = f / S. where f is the price of the derivative and S is the price
of the underlying asset.
206
Figure 4.1 Calculation of delta.
where S is a small change in the stock price and c is the corresponding change in
the call price.
Assume that the delta of the call option is 0.6. This means that when the
stock price changes by a small amount, the option price changes by about 60% of
that amount. Suppose that the option price is Rs. 10 and the stock price is Rs. 100.
Imagine an investor who has sold 20 option contracts, that is, options to buy 2,000
shares. The investor's position could be hedged by buying 0.6 x 2,000 = 1,200
shares. The gain (loss) on the option position would tend to be offset by the loss
(gain) on the stock position. For example, if the stock price goes up by Rs. 1 (pro-
ducing a gain of Rs. 1 ,200 on the shares purchased), the option price will tend to go
up by 0.6 x Rs. 1 = Rs. 0.60 (producing a loss of Rs. 1,200 on the options written);
if the stock price goes down by Rs. 1 (producing a loss of Rs. 1 ,200 on the shares
purchased), the option price will tend to go down by Rs. 0.60 (producing a gain of
Rs. 1,200 on the options written).
207
In this example, the delta of the investor's option position is 0.6 x (-2,000)
= -1,200. In other words, the investor loses 1,200 S on the options when the stock
price increases by S. The delta of the stock is by definition 1.0 and the long
position in 1,200 shares has a delta of + 1,200. The delta of the investor's total
position (short 2,000 call options; long 1,200 shares) is therefore zero. The delta of
the position in the underlying asset offsets the delta of the option position. A
position with a delta of zero is referred to as being delta neutral.
It is important to realize that the investor's position remains delta hedged (or
delta neutral) for only a relatively short period of time. This is because delta
changes with both changes in the stock price and the passage of time. In practice,
when delta hedging is implemented, the hedge has to be adjusted periodically. This
is known as rebalancing. In our example, the stock price might increase to Rs. 110
by the end of three days. As indicated by Figure 4.1, an increase in the stock price
leads to an increase in delta. Suppose that delta rises from 0.60 to 0.65. This would
mean that an extra 0.05 x 2,000 = 100 shares would have to be purchased to
maintain the hedge. Hedging schemes such as this that involve frequent adjustments
are known as dynamic hedging schemes.
Delta is closely related to the Black-Scholes analysis. Black and Scholes
showed that it is possible to set up a riskless portfolio consisting of a position in a
derivative on a stock and a position in the stock. Expressed in terms of , their
portfolio is
-1: derivative
+ : shares of the stock
208
Using our new terminology, we can say that Black and Scholes valued
options by setting up a delta-neutral position and arguing that the return on the
position in a short period of time equals the risk-free interest rate.
Uses:
The knowledge of delta is of vital importance for option traders because this
paAmpeter is heavily used in margining and risk management strategies. The delta
is often called the hedge ratio. e.g. if you have a portfolio of n` shares of a stock
then n` divided by the delta gives you the number of calls you would need to be
short (i.e. need to write) to create a riskless hedge ? i.e. a portfolio which would be
worth the same whether the stock price rose by a very small amount or fell by a
very small amount.
In such a "delta neutral" portfolio any gain in the value of the shares held due to a
rise in the share price would be exactly offset by a loss on the value of the calls
written, and vice versa.
Note that as the delta changes with the stock price and time to expiration the
number of shares would need to be continually adjusted to maintain the hedge. How
quickly the delta changes with the stock price are given by gamma, which we shall
learn subsequently.
Delta of Forward Contracts
Equation (3.6) shows that when the price of a non-dividend-paying stock
changes by S, with all else remaining the same; the value of a forward contract on
the stock also changes by S. The delta of a forward contract on one share of a non-
dividend-paying stock is therefore 1.0. This means that a short forward contract on
209
one share can be hedged by purchasing one share, while a long forward contract on
one share can be hedged by shorting one share. These two hedging schemes are
"hedge and forget" schemes in the sense that no changes need to be made to the
position in the stock during the life of the contract. As already mentioned, when an
option or other more complicated derivative is being hedged, delta hedging is not a
hedge-and-forget scheme. If the hedge is to be effective, the position in the stock
must be rebalanced frequently.
Deltas of European Calls and Puts
For a European call option on a non-dividend-paying stock, it can be shown
that
= N(d1)
where d1 is defined in Black-Scholes Pricing formula. Using delta hedging
for a short position in a European call option therefore involves keeping a long
position of N(d1)shares at any given time. Similarly, using delta hedging for a long
position in a European call option involves maintaining a short position of
N(d1)shares at any given time.
For a European on a non-dividend-paying stock, delta is given by
=N(d1) - 1
This is negative, which means that a long position in a put option should be
hedged with a long position in the underlying stock, and a short position in a put
option should be hedged with a short position in the underlying stock. The variation
of the delta of a call option and a put option with the stock price is shown in Figure
210
4.2a & 4.2 b and Figure 4.3 shows typical patterns for the variation of delta with
time to maturity for at-the-money, in-the-money, and out-of-the-money options.
Figure 4.2a: Variation of delta with the stock price for a call option
on a non dividend paying stock
Figure 4.2b Variation of delta with the stock price for a put option on
a non-dividend-paying stock.
Variation of Delta with Time to Expiry :
211
Variation of Delta with Time to Expiry (T) for European option on a non-
dividend-paying share with strike price of X. Red, Blue and Green lines denote
out-of-the-money, at-the-money and in-the-money options respectively.
In the money
At the money
Out of money
Out of money
At the money
In the money
Figure 4.3 Typical pattern for variation of delta with the time to maturity for
a call and put option.
Simulations
Tables 4.1 and 4.2 provide two simulations of the operation of delta hedging
for the example in Section 14.1. The hedge is assumed to be adjusted or rebalanced
212
weekly. In both tables delta is calculated initially as 0.522. This means that as soon
as the option is written, Rs. 2,557,800 must be borrowed to buy 52,200 shares at a
price of Rs. 49. An interest cost of Rs. 2,500 is incurred in the first week.
In Table 4.1 the stock price falls to Rs. 48 by the end of the first week.
This reduces the delta to 0.458, and 6,400 shares are sold to maintain the hedge.
This realizes Rs. 308,000 in cash and the cumulative borrowings at the end of week
I are reduced to Rs. 2,252,300. During the second week the stock price reduces to
Rs. 47 and delta declines again; and so on. Toward the end of the life of the option
it becomes apparent that the option will be exercised and delta approaches 1.0. By
week 20, therefore, the hedger has a fully covered position. The hedger receives Rs.
5,000,000 for the stock held, so that the total cost of writing the option and hedging
it is Rs. 263,400.
Table 4.2 illustrates an alternative sequence of events which are such that
the option closes out of the money. As it becomes progressively clearer that the
option will not be exercised, delta approaches zero. By week 20 the hedger has a
naked position and has incurred costs totaling Rs. 256,600.
In Tables 4.1 and 4.2 the costs of hedging the option, when discounted to the
beginning of the period, are close to but not exactly the same as the BlackScholes
price of Rs. 240,000. If the hedging scheme worked perfectly, the cost of hedging
would; after discounting, be exactly equal to the theoretical price of the option on
every simulation. The reason that there is a variation in the cost of delta hedging is
that the hedge is rebalanced only once a week. As rebalancing takes place more
frequently, the uncertainty in the cost of hedging is reduced.
213
TABLE 4.1 Simulation of Delta Hedging; Option Closes in the Money; Cost
of Option to Writer = Rs. 263,400
Week Stock Delta Shares
Cost of
Cumulative Interest Cost
Price
Purchased Shares
Cost (inch
Purchased interest, in (thousands
(thousands thousands
of dollars)
of dollars) of dollars)
0
49
0.522 52,200
2,557.8
2,557.8
2.5
1
48 0.458
(6,400)
(308.0)
2,252.3
2.2
2
47 0.400
(5,800)
(274.8)
1,979.7
1.9
3
5?
0.596
19,600
984.9
2,966.5
2.9
4
51? 0.693
9,700
502.0
3,471.3
3.3
5
53 0.774
8,100
430.3
3,904.9
3.8
6
53
0.771
(300)
(15.9)
3,892.8
3.7
7
51 0.706
(6,500)
(337.2)
3,559.3
3.4
8
51 0.674
(3,200)
(164.4)
3,398.4
3.3
9
53
0.787
11,300
598.9
4,000.5
3.8
10
49 0.550 (23,700)
(1,182.0)
2,822.3
2.7
11
48 ? 0.413 (13,700)
(664.4)
2,160.6
2.1
12
49 0.542
12,900
643.4
2,806.1
2.7
13
50 0.591
4,900
246.8
3,055.6
2.9
14
52 0.768
17,700
922.6
3,981.2
3.8
15
51 0.759
(900)
(46.7)
3,938.3
3.8
16
52 0.865
10,600
560.5
4,502.6
4.3
17
54 0.978
11,300
620.1
5,127.0
4.9
18
54 0.990
1,200
65.6
5,197.5
5.0
19
55 1.000
1,000
55.9
5,258.3
5.1
20
57? 1.000
0
0.0
5,263.4
214
Table 4.3shows statistics on the performance of delta hedging from 1,000
simulations of stock price movements for our example. The performance measure is
the ratio of the standard deviation of the cost of writing the option and hedging it to
the Black-Scholes price of the option. It is clear that delta hedging is a great
improvement over the stop-loss strategy. Unlike the stop-loss strategy, the
performance of delta hedging gets steadily better as the hedge is monitored more
frequently.
Delta hedging aims to keep the total wealth of the financial institution as
close to unchanged as possible. Initially, the value of the written option is Rs.
240,000. In the situation depicted in Table 14.2, the value of the option can be
calculated as Rs. 414,500 in week 9. Thus the financial institution has lost Rs.
174,500 on its option position between week 0 and week 9. Its cash position, as
measured by the cumulative cost, is Rs. 1,442.700 worse in week 9 than in week 0.
The value of the "hares held have increased from Rs. 2.557.800 to Rs. 4.171, 100
between week 0 and week 9. The net effect of all this is that the overall wealth of
the financial institution has changed by only Rs. 3,900 during the nine-week period.
215
TABLE 4.2 Simulation of Delta Hedging; Option Closes out of the Money;
Cost of Option to Writer = Rs. 256,600
Week Stock Delta Shares
Cost of
Cumulative Interest Cost
Price
Purchased Shares
Cost (incl.
Purchased interest, in (thousands
(thousands thousands of dollars)
Of
of dollars)
dollars)
0
49
0.522 52,200
2,557.8
2,557.8
2.5
1
49? 0.568
4,600
228.9
2,789.1
2.7
2
52
0.705 13,700
712.4
3,504,2
3.4
3
50
0.579 (12,600)
(630.0)
2,877.6
2.8
4
48 0.459 (12,000)
(580.5)
2,299.8
2.2
5
48? 0.443 (1,600)
(77.2)
2,224.8
2.1
6
48? 0.475
3,200
156.0
2,383.0
2.3
7
49 0.540
6,500
322.6
2,707.8
2.6
8
48? 0.420 (12,000)
(579.0)
2.131.4
2.0
9
48? 0.410 (1,000)
(48.2)
2,085.2
2.0
10
51 0.658 24,800
1,267.9
3,355.1
3.2
11
51? 0.692
3,400
175.1
3,533.5
3.4
12
49 0.542 (15,000)
(748.1)
2,788.7
2.7
13
49 0.538
(400)
(20.0)
2,771.5
2,7
14
48? 0.400 (13,800)
(672.7)
2,101.4
2.0
15
47? 0.236 (16,400)
(779.0)
1.324.4
1.3
16
48
0.261
2,500
120.0
1.445.7
1.4
17
46? 0.062 (19,900)
(920.4)
526.7
0.5
18
48 0.183 12,100
582.3
1,109.5
1.1
19
46 0.007 (17,600)
(820.6)
290.0
0.3
20
48 0.000
(700)
(33.7)
256.6
----
216
TABLE 4.3 Performance of Delta Hedging
Hedge performance measure = ratio to theoretical price of option
of standard deviation of cost of option
Time between
Hedge
5
4 2 1 0.5 0.25
Rebalancing
(weeks)
Performance
0.43
0.39 0.26 0.19 0.14 0.09
Measure
Where the Cost Comes From
The delta-hedging scheme in Tables 4.1 and 4.2 in effect creates a long
position in the option synthetically. This neutralizes the short position arising from
the option that has been written. The scheme generally involves selling stock just
after the price has gone down and buying stock just after the price has gone up. It
might be termed a buy high-sell low scheme! The cost of Rs. 240,000 comes from
the average difference between the price paid for the stock and the price realized for
it. Of course, the simulations in Tables 4.1 and 4.2 are idealized in that they assume
that the volatility is constant and that there are no transactions costs.
Delta of Other European Options
For European call options on a stock index paying a dividend yield q,
=e-q(T-t) N(d1)
Where d1 is defined as in European call price C` formula.. For European
put options on the stock index,
= e-q(T-t)[N(d1) ? 1]
217
For European call options on a currency,
= e-r f (T-t)N(d1)
where r f is the foreign risk-free interest rate and d1is defined as in European put
price P` formula. For European put options on a currency,
= e-r f (T-t)[N(d1) ? 1]
For European futures call options,
= e-r (T-t)N(d1)
where d1 is defined as earlier, and for European futures put options,
= e-r (T-t)[N(d1) ? 1]
Example 4.1:
A bank has written a six-month European option to sell ? 1,000,000 at an
exchange rate of 1.6000. Suppose that the current exchange rate is 1.6200, the risk-
free interest rate in the United Kingdom is 13% per annum, the risk-free interest
rate in the United States is 10% per annum, and the volatility of sterling is 15%. In
this case S = 1.6200, X = 1.6000, r = 0.10, rf = 0.13, = 0.15, and T - t = 0.5.
The delta of a put option on a currency is
[N(d1) ? 1] e-rf (T-t)
where d1 is given by equation:
d1= 0.0287
N(d1)=0.5115
The delta of the put option is therefore (0.5115 -l)e-O.13XO.5 = -0.458.This
is the delta of a long position in one put option. The delta of the bank's total short
218
position is - 1,000,000 times this or +458,000. Delta hedging therefore requires
that a short sterling position of ?458,000 be set up initially. This short sterling
position has a delta of -458,000 and neutralizes the delta of the option position. As
time passes, the short position must be changed.
Using Futures
In practice, delta hedging is often carried out using a position in futures
rather than one in the underlying asset. The contract that is used does not have to
mature at the same time as the derivative. For ease of exposition we assume that a
futures contract is on one unit of the underlying asset.
Define:
T*: maturity of futures contract
HA: required position in asset at time t for delta hedging
HF: alternative required position in futures contracts at time t for delta hedging
If the underlying asset is a non-dividend-paying stock, the futures price, F,
is from equation given by
F=Se-r (T*-t)
When the stock price increase by S, the futures price increases by Ser (T*-t)
. The delta of the futures contract is therefore er (T*-t). Thus e-r (T*-t) futures contracts
have the same sensitivity to stock price movements as one stock. Hence
HF= e-r (T*-t) HA
When the underlying asset is a stock or stock index paying a dividend yield q, a
similar argument shows that
219
HF = e- (r-q) (T*-t) HA (4.1)
When it is a currency
HF = e- (r-rf) (T*-t) HA
Example 4.2
Consider again the option in Example 4.1. Suppose that the bank decides to
hedge using nine-month currency futures contracts. In this case T* - t = 0.75 and
e-(r-rf) (T*-t) = 1.0228
so that the short position in currency futures required for delta hedging is 1.0228 x
458,000 = Rs. 468,442. Since each futures contract is for the purchase or sale of
Rs.62,500, this means that (to the nearest whole number) seven contracts should be
shorted.
It is interesting to note that the delta of a futures contract is different from
the delta of the corresponding forward. This is true even when interest rates are
constant and the forward price equals the futures price. Consider the situation where
the underlying asset is a non-dividend-paying stock. The delta of a futures contract
on one unit of the asset is e-r(T*-t) whereas the delta of a forward contract on one unit
of the asset is, as discussed earlier, 1.0.
Delta of a Portfolio
In a portfolio of options and other derivatives where there is a single un-
derlying asset, the delta of the portfolio is a weighted sum of the deltas of the
individual derivatives in the portfolio. If a portfolio, , consists of an amount, Wi,
of derivative i (1 i n ) , the delta of the portfolio is given by
220
n
w
i
i
i1
where i is the delta of ith derivative. This can be used to calculate the
position in the underlying asset, or in a futures contract on the underlying asset,
necessary to carry out delta hedging. When this position has been taken, the delta of
the portfolio is zero and the portfolio is referred to as being delta neutral.
Example 4.3
Consider a financial institution that has the following three positions in
options to buy or sell German marks:
1. A long position in 100,000 call options with strike price 0.55 and exercise date in
three months. The delta of each option is 0.533.
2. A short position in 200,000 call options with strike price 0.56 and exercise date in
five months. The delta of each, option is 0.468.
3. A short position in 50,000 put options with strike price 0.56 and exercise date in
two months. The delta of each option is -0.508.
The delta of the whole portfolio is
0.533 x 100,000 - 200,000 x 0.468 - 50,000 x (-0.508) = -14,900
This means that the portfolio can be made delta neutral with a long position of
14,900 marks.
A six-month futures contract could also be used to achieve delta neutrality in
this example. Suppose that the risk-free rate of interest is 8% per annum in the
United States and 4% per annum in Germany. The number of marks that must be
bought in the futures market for delta neutrality is
14,900e-(0.08-0.04)x0.5 = 14,605
221
B. THETA
The theta of a portfolio of derivatives, e, is the rate of change of the value of
the portfolio with respect to time with all else remaining the same . It is sometimes
referred to as the time decay of the portfolio. Theta is generally used to gain an idea
of how time decay is affecting your portfolio.
Change in an option premium
Theta = --------------------------------------
Change in time to expiry
For a European call option on a non-dividend-paying stock,
SN'(d )
r(T t
)
1
rX
N(d )
2
e
2
T t
where d1 and d2 are defined as in equation and
1
N '(x)
2
x
e
/ 2
2
For a European put option on the stock,
SN'(d )
1
r(T t)
rX
N (d )
2
e
2
T t
For a European call option on a stock index paying a dividend at rate q,
SN'(d )
q(T t)
e
1
qSN(d ) q(Tt)
r(T t)
e
rX
N (d )
2
1
e
2
T t
where d1 and d2 are defined as in equation. The formula for N'(x) is given in
Section. For a European put option on the stock index
SN'(d ) q(Tt)
e
1
qSN(d ) q(Tt)
r (T t )
e
rX
N (d )
2
1
e
2
T t
More formally,
/ t
where II is the value of the portfolio.
222
With q equal to r f, these last two equations give thetas for European call and put
options on currencies. With q equal to rand S equal to F, they give thetas for
European futures options.
Example 4.4
Consider a four-month put option on a stock index. The current value of the
index is 305, the strike price is 300, the dividend yield is 3% per annum, the risk-
free interest rate is 8% per annum, and the volatility of the index is 25% per annum.
In this case, S = 305, X = 300, q = 0.03, r = 0.08, = 0.25, and T - t = 0.3333. The
option's theta is
SN'(d ) q(Tt)
e
1
qSN(d ) q(Tt)
r (T t )
e
rX
N (d ) = -18.15
2
1
e
2
T t
This means that if 0.01 year (or 2.5 trading days) passes with no changes to
the value of the index or its volatility, the value of the option declines by 0.1815.
Theta is usually negative for an option . This is because as the time to
maturity decreases, the option tends to become less valuable. The variation of
with stock price for a call option on a stock is shown in Figure 4.4. When the stock
price is very low, theta is close to zero. For an at-the-money call option, theta is
large and negative. As the stock price becomes larger, theta tends to ?rXe-rT Figure
4.5 shows typical patterns for the variation of with the time to maturity for in-the-
money, at-the-money, and out-of-the-money call options.
Theta is not the same type of hedge paAmpeter as delta and gamma. This is
because there is some uncertainty about the future stock price, but there is no
An exception to this could be an in-tile-money European put option on a non-dividend-paying
stock or an in-the-money European call option on a currency with a very high interest rate.
223
uncertainty about the passage of time. It does not make sense to hedge against the
effect of the passage of time on an option portfolio. As we will see in Section
Gamma, if theta is large in absolute terms, either delta or gamma must be large. If
both the delta and gamma of an option position are zero, theta indicates that the
value of the position will grow at the risk-free rate.
Theta
Stock
X
Price
Figure 4.4 Variation of theta of a European call option with stock price.
Theta
Time to
maturity
Out of the money
In the money
At the money
Figure 4.5 Typical patterns for variation of theta of a European call option with time
to maturity.
224
Assume an option has a premium of 3 and a theta of 0.06. After one day it will
decline to 2.94, the second day to 2.88 and so on. Naturally other factors, such as
changes in value of the underlying stock will alter the premium. Theta is only
concerned with the time value. Unfortunately, we cannot predict with accuracy the
change`s in stock market`s value, but we can measure exactly the time remaining
until expiration
C. GAMMA
The gamma, , of a portfolio of derivatives on an underlying asset is the
rate of change of the portfolio's delta with respect to the price of the underlying
asset .
Change in an option delta
Gamma = -------------------------------------
Change in underlying price
If gamma is small, delta changes only slowly.The adjustments to keep a
portfolio delta neutral need only be made relatively infrequently. However, if
gamma is large in absolute terms, delta is highly sensitive to the price of the
underlying asset. It is then quite risky to leave a delta-neutral portfolio unchanged
for any length of time. Figure 4.6 illustrates this point. When the stock price moves
from S to S`, delta hedging assumes that the option price moves from C to c.' when
in actual fact it moves from C to C". The difference between C' and C" leads to a
hedging error. The error depends on the curvature of the relationship between the
option price and the stock price. Gamma measures this curvature .
More formally, = 2/ S2, where is the value of the portfolio.
lndeed, the gamma of an option is sometimes referred to by practitioners as its curvature.
225
Suppose that S is the change in the price of an underlying asset in a small
interval of time, t, and II is the corresponding change in the price of the port-
folio. If terms such ast2, which are of higher order than t, are ignored, Appendix
14A shows that for a delta-neutral portfolio,
= t + ? S2 (4.2)
Call
Price
C
C`
C
Stock Price
S
S`
Figure 4.6 Error in delta hedging
226
S
S
Slightly positive gamma
Large positive gamma
S
S
Slightly negative gamma
Large negative gamma
Figure 4.7 Alternative relationships between and S for a delta-neutral
portfolio.
227
where is the theta of the portfolio. Figure 4.7 shows the nature of this
relationship between and S. When gamma is positive, theta tends to be
negative.10 The portfolio declines in value if there is no change in the S, but
increases in value if there is a large positive or negative change in S. When gamma
is negative, theta tends to be positive and the reverse is true; the portfolio increases
in value if there is no change in S but decreases in value if there is a large positive
or negative change in S. As the absolute value of gamma increases, the sensitivity
of the value of the portfolio to S increases.
Example 4.5
Suppose that the gamma of a delta-neutral portfolio of options on an asset is
- 10,000. Equation (4.2) shows that if a change of + 2 or - 2 in the price of the asset
occurs over a short period of time, there is an unexpected decrease in the value of
the portfolio of approximately 0.5 x 10,000 x 22 = Rs. 20,000.
For example: if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise
of ?1 in the underlying means the delta will move to 0.55 for a price rise and 0.45
for a price fall. Gamma is rather like the rate of change in the speed of a car ? its
acceleration ? in moving from a standstill, up to its cruising speed, and braking back
to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) and
falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-
money) (standstill).
If you are hedging a portfolio using the delta-hedge technique described under
"Delta", then you will want to keep gamma as small as possible as the smaller it is
the less often you will have to adjust the hedge to maintain a delta neutral position.
If gamma is too large a small change in stock price could wreck your hedge.
Adjusting gamma, however, can be tricky and is generally done using options --
228
unlike delta, it can't be done by buying or selling the underlying asset as the gamma
of the underlying asset is, by definition, always zero so more or less of it won't
affect the gamma of the total portfolio.
Making a Portfolio Gamma Neutral
A position in the underlying asset or in a futures contract on the underlying
asset has zero gamma. The only way a financial institution can change the gamma
of its portfolio is by taking a position in a traded option. Suppose that a delta-neutral
portfolio has gamma equal to and a traded option has a gamma equal to T. If the
number of traded options added to the portfolio isWT, the gamma of the portfolio is
WT T +
Hence the position in the traded option necessary to make the portfolio
gamma neutral is - / T . Of course, including the traded option is liable to change
the delta of the portfolio, so the position in the underlying asset (or futures contract
on the underlying asset) then has to be changed to maintain delta neutrality. Note
that the portfolio is only gamma neutral instantaneously. As time passes, gamma
neutrality can be maintained only if the position in the traded option is adjusted so
that it is always equal to - / T.
Example 4.6
Suppose that a portfolio is delta neutral and has a gamma of - 3,000. The
delta and gamma of a particular traded call option are 0.62 and 1.50, respectively.
The portfolio can be made gamma neutral by including a long position of
3,000 = 2,000
1.5
229
traded call options in the portfolio. However, the delta of the portfolio will then
change from zero to 2,000 X 0.62 = 1,240. A quantity, 1,240, of the underlying
asset must there- fore be sold from the portfolio to keep it delta neutral.
10It will be shown in Section relationship among Delta, Theta, and Gamma
that
+ ?2 S2 = r
for a delta-neutral portfolio.
Making a portfolio gamma neutral can be regarded as a first correction for
the fact that the position in the underlying asset (or futures contracts on the un.
derlying asset) cannot be changed continuously when delta hedging is used.
Calculation of Gamma
For a European call or put option on a non-dividend-paying stock, the gamma is
given by
N'(d
)
1
S T t
Where d1, is defined as in equation and N'(x) is given in Cumulative Normal
Distribution function. This is always positive and varies with S in the way indicated
in Figure 4.8.
230
Gamma
X
Stock Price
Figure 4.8 Typical patterns for variation of gamma with stock price for an option.
Gamma
At the money
Out of the money
In the money
Time to maturity
Figure 4.9 Variation of gamma with time to maturity for a stock option.
231
Typical patterns for the variation of gamma with time to maturity for out-of-
the money, at-the-money, and in-the-money options are shown in Figure 4.9. For an
at-the-money option, gamma increases as the time to maturity decreases. Short-life
at-the-money options have a very high gamma, which means that the value of the
option holder's position is highly sensitive to jumps in the stock price.
For a European call or put option on a stock index paying a continuous div-
idend at rate q,
N '(d )eq(Tt)
1
S T t
Where d1 is defined as earlier. This formula gives the gamma for a European
option on a currency when q is put equal to the foreign risk-free rate and gives the
gamma for a European futures option with q = r and S = F.
Example 4.7
Consider a four-month put option on a stock index. Suppose that the current
value of the index is 305, the strike price is 300, the dividend yield is 3% per
annum, the risk-free interest rate is 8% per annum, and volatility of the index is
25% per annum. In this case, S = 305, X = 300, q = 0.03, r = 0.08, = 0.25, and T -
t = 0.3333. The gamma of the index option is given by
N '(d ) q(Tt)
e
1
0.00857
S T t
Thus an increase of 1 in the index increases the delta of the option by approximately
0.00857.
232
RELATIONSHIP AMONG DELTA, THETA, AND GAMMA
The Black-Scholes differential equation that must be satisfied by the price, f,
of any derivative on a non-dividend-paying stock is
f
f
2 f
1 2 2
rS
S
rf
t
S
2
S
2
Since
2
f
f
f
2
t
S
S
it follows that
1
rS
2
S 2 rf (4.3)
2
This is true for portfolios of derivatives on a non-dividend-paying security as well
as for individual derivatives.
For a delta-neutral portfolio, . = 0 and
1 2
S 2 rf
2
This shows that when is large and positive, gamma tends to be large and
negative, and vice versa. In a delta-neutral portfolio, theta can be regarded as a
proxy for gamma.
233
D. VEGA
Up to now we' have implicitly assumed that the volatility of the asset
underlying a derivative is constant. In practice, volatilities change over time. This
means that the value of a derivative is liable to change because of movements in
volatility as well as because of changes in the asset price and the passage of time.
The vega of a portfolio of derivatives, , is the rate of change of the value of
the portfolio with respect to the volatility of the underlying asset .
Change in an option premium
Vega = -----------------------------------------
Change in volatility
If for example, XYZ stock has a volatility factor of 30% and the current premium is
3, a vega of .08 would indicate that the premium would increase to 3.08 if the
volatility factor increased by 1% to 31%. As the stock becomes more volatile the
changes in premium will increase in the same proportion. Vega measures the
sensitivity of the premium to these changes in volatility.
What practical use is the vega to a trader? If a trader maintains a delta neutral
position, then it is possible to trade options purely in terms of volatility ? the trader
is not exposed to changes in underlying prices.
More formally, = /, where is the value of the portfolio. Vega is also
sometimes referred to as lambda, kappa or sigma.
234
If vega is high in absolute terms, the portfolio's value is very sensitive to
small changes in volatility. If vega is low in absolute terms, volatility changes have
relatively little impact on the value of the portfolio.
A position in the underlying asset or in a futures contract has zero vega.
However, the vega of a portfolio can be changed by adding a position in a traded
option. If is the vega of the portfolio and T is the vega of a traded option, a
position of ? / T in the traded option makes the portfolio instantaneously vega
neutral. Unfortunately, a portfolio that is gamma neutral will not in general be vega
neutral, and vice versa. If a hedger requires a portfolio to be both gamma and vega
neutral, at least two traded derivatives dependent on the underlying asset must
usually be used.
Example 4.8
Consider a portfolio that is delta neutral, with a gamma of -5,000 and a vega
of -8,000. Suppose that a traded option has a gamma of 0.5, a vega of 2.0, and a
delta of 0.6. The portfolio can be made vega neutral by including a long position in
4,000 traded options. This would increase delta to 2,400 and require that 2,400 units
of the asset be sold to maintain delta neutrality. The gamma of the portfolio would
change from - 5,000 to - 3,000.
To make the portfolio gamma and vega neutral, we suppose that there is a
second traded option with a gamma of 0.8, a vega of 1.2, and a delta of 0.5. If w1
and w2 are the amounts of the two traded options included in the portfolio, we
require that
-5,000 + 0.5w1 + 0.8w2 = 0
-8,000 + 2.0 w1+ 1.2 w2 = 0
235
The solution to these equations is w1 = 400, w2 = 6,000. The portfolio can
therefore be made gamma and vega neutral by including 400 of the first traded
option and 6,000 of the second traded option. The delta of the portfolio after the
addition of the positions in the two traded options is 400 X 0.6 + 6,000 X 0.5 =
3,240. Hence 3,240 units of the asset would have to be sold to maintain delta
neutrality.
For a European call or put option on a non-dividend-paying stock, vega is
given by
= S T t N`(d1)
where d1 is defined as in equation (11.22). The formula for N'(x) is given in
Section 11 .8. For a European call or put option on a stock or stock index paying a
continuous dividend yield at rate q,
= S T t N`(d1)e-q(T-t)
where d1 is defined as in equation .This equation gives the vega for a
European currency option with q replaced by rf It also gives the vega for a
European futures option with q replaced by r, and S replaced by F. The vega of an
option is always positive. The general way in which it varies with S is shown in
Figure 4.10.
Calculating vega from the Black-Scholes pricing formula is an approxima-
tion., This is because one of the assumptions underlying Black-Scholes is that
volatility is constant. Ideally, we would like to calculate vega from a model in
which volatility is assumed to be stochastic. This is considerably more complicated.
236
Luckily, it can be shown that the vega calculated from a stochastic volatility
model is very similar to the Black-Scholes vega .
Vega
X
Stock Price
Figure.4.10 Variation of vega with stock price for an option.
Gamma neutrality corrects for the fact that time elapses between hedge
rebalancing. Vega neutrality corrects for a variable . As might be expected,
whether it is best to use an available traded option for vega or gamma hedging
depends on the time between hedge rebalancing and the volatility of the volatility .
See J. Hull and A. White, "The Pricing of Options on Assets with Stochastic Volatilities," Journal
of Finance, 42 (June 1987), 281-300; J. Hull and A. White, "An Analysis of the Bias in Option
Pricing Caused by a Stochastic Volatility," Advances in Futures and Options Research, 3 (1988), 27-
61.
For a discussion of this issue; seeJ.Hull and A. White, "Hedging the Risks from Writing Foreign
Currency Options," Journal of International Money and Finance. 6 (June 1987), 131-52
237
Example 4.9
Consider again the put option in Example 4.7. Its vega is given by
S T t N`(d1)e-q(T-t) = 66.44
Thus a 1 % or 0.01 increase in volatility (from 25% to 26%) increases the
value of the option by approximately 0.6644.
E. RHO
The rho of a portfolio of derivatives is the rate of change of the value of the
portfolio with respect to the interest rate . It measures the sensitivity of the value
of a portfolio to interest rates.
Change in an option premium
Rho = ---------------------------------------------------
Change in cost of funding underlying
Example:
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the
price of the option will move by Rs 0.14109. To put this in another way: if the risk-
free interest rate changes by a small amount, then the option value should change by
14.10 times that amount. For example, if the risk-free interest rate increased by 0.01
(from 10% to 11%), the option value would change by 14.10*0.01 = 0.14. For a put
option the relationship is inverse. If the interest rate goes up the option value
decreases and therefore, Rho for a put option is negative. In general Rho tends to be
small except for long-dated options.
More formally, rho equals
/ r
, where is the value of the portfolio.
238
For a European call option on a non-dividend-paying stock,
rho = X(T - t) e-r (T-t) N(d2)
and for a European put option on the stock,
rho = - X(T - t) e-r (T-t) N(- d2)
Where d2 is defined as in equation earlier. These same formulas apply to
European call and put options on stocks and stock indices paying a dividend yield at
rate q, and to European call and put options on futures contracts, when appropriate
changes are made to the definition of d2.
Example 4.10
Consider again the four: month put option on a stock index. The current
value of the index is 305, the strike price is 300, the dividend yield is 3% per
annum, the risk-free interest rate is 8% per annum, and the volatility of the index is
25% per annum. In this case, S = 305, X = 300, q = 0.03, r = 0.08, = 0.25, T - t =
0.333. The option's rho is
- X(T - t) e-r (T-t) N(- d2) = -42.57
This means that for a one-percentage-point or 0.01 increase in the risk-free interest
rate (from 8% to 9%), the value of the option decreases by 0.4257.
In the case of currency options, there are two rhos corresponding to the two
interest rates. The rho corresponding to the domestic interest rate is given by
previous formulas. The rho corresponding to the foreign interest rate for a European
call on a currency is given by
rho = - (T-t)e-r f ( T-t) SN(d1)
while for a European put it is
rho = (T-t)e-r f ( T-t) SN(-d1)
239
III. PORTFOLIO INSURANCE
Portfolio managers holding a well-diversified stock portfolio are sometimes
interested in insuring themselves against the value of the portfolio dropping below a
certain level. One way of doing this is by holding, in conjunction with the stock
portfolio, put options on a stock index. This strategy was discussed in earlier units.
Consider, for example, a fund manager with a Rs. 30 million portfolio
whose value mirrors the value of the S&P 500. Suppose that the S&P 500 is
standing at 300 and the manager wishes to insure against the value of the portfolio
dropping below Rs. 29 million in the next six months. One approach is to buy 1,000
six-month put option contracts on the S&P 500 with a strike price of 290 and a
maturity in six months. If the index drops below 290, the put options will become in
the money and provide the manager with compensation for the decline in the value
of the portfolio. Suppose, for example, that the index drops to 270 at the end of 6
months. The value of the manager's stock portfolio is likely to be about Rs. 27
million. Since each option contract is on 100 times the index, the total value of the
put options is Rs. 2 million. This brings the' value of the entire holding back up to
Rs. 29 million. Of course, insurance is not free. In this example the put options
could cost the portfolio manager as much as Rs. 1 million
Creating Options Synthetically
An alternative approach open to the portfolio manager involves creating the
put options synthetically. This involves taking a position in the underlying asset (or
futures on the underlying asset) so that the delta of the position is maintained equal
240
to the delta of the required option. If more accuracy is required, the next step is to
use traded options to match the gamma and vega of the required option. The
position necessary to create an option synthetically is the reverse of that necessary
to hedge it. This is a reflection of the fact that a procedure for hedging an option
involves the creation of an equal and opposite option synthetically.
There are two reasons why it may be more attractive for the portfolio man-
ager to create the required put option synthetically than to buy it in the market. The
first is that options markets do not always have the liquidity to absorb the trades that
managers of large funds would like to carry out. The second is that fund managers
often require strike prices and exercise dates that are different from those available
in traded options markets.
The synthetic option can be created from trades in stocks themselves or from
trades in index futures contracts. We first examine the creation of a put option by
trades in the stocks themselves. Consider again the fund manager with a well--
diversified portfolio worth Rs. 30 million who wishes to buy a European put on the
portfolio with a' strike price of Rs. 29 million and an exercise date in six months.
Recall that the delta of a European put on an index is given by
= e-q(T-t)[N(d1) ? 1]
where, with the usual notation,
d1 = In(S/X) + (r-q + 2/2) (T-t)
T t
241
Since, in this case, the fund manager's portfolio mirrors the index, this is
also the delta of a put on the portfolio when it is regarded as a single security. The
delta is negative. Accordingly, to create the put option synthetically, the fund
manager should ensure that at any given time a proportion
e-q(T-t)[1- N(d1) ]
of the stocks in the original Rs. 30 million portfolio have been sold and the proceeds
invested in riskless assets. As the value of the original portfolio declines, the delta
of the put becomes more negative and the proportion of the portfolio sold must be
increased. As the value of the original portfolio increases, the delta of the put
becomes less negative and the proportion of the portfolio sold must be decreased
(i.e., some of the original portfolio must be repurchased).
Using this strategy to create portfolio insurance means that at any given time
funds are divided between the stock portfolio on which insurance is required and
riskless assets. As the value of the stock portfolio increases, riskless assets are sold
and the position in the stock portfolio is increased. As the value of the stock
portfolio declines, the position in the stock portfolio is decreased and riskless assets
are purchased. The cost of the insurance arises from the fact that the portfolio
manager is always selling after a decline in the market and buying after a rise in the
market.
Use of Index Futures
Using index futures to create portfolio insurance can be preferable to using
the underlying stocks, provided that the index futures market is sufficiently liquid to
handle the required trades. This is because the transactions costs associated with
trades in index futures are generally less than those associated with the
corresponding trades in the underlying stocks. The portfolio manager considered
242
earlier would keep the Rs. 30 million stock portfolios intact and short index futures
contracts. From equations (4.1) and (4.4), the amount of futures contracts shorted as
a proportion of the value of the portfolio should be
e-q(T-t) e- (r - q) ( T* - t) )[1- N(d1) ] = e-q ( T* - T) e-r (T* - t) [1- N(d1) ]
Where T* is the maturity date of the futures contract. If the portfolio is
worth. K1 times the index and each index futures contract is on K2 times the index,
this means that the number of futures contracts shorted at any given time should be
k
e-q ( T* - T) e-r (T* - t) [1- N(d
1
1) ]
k2
Example 4.11
In the example given at the beginning of this section, suppose that the
volatility of the market is 25% per annum, the risk-free interest rate is 9% per
annum, and the dividend yield on the market is 3% per annum. In this case, S = 300,
X = 290, r = 0.09, q = 0,03, = 0.25, and T - t = 0.5. The delta of the option that
is required is
e-q(T-t) )[ N(d1) - 1 ] = - 0.322
Hence, if trades in the portfolio are used to create the option, 32.2% of the
portfolio should be sold initially. If nine-month futures contracts on the S&P 500
are used, T* - T = 0.25, T' - t = 0.75, K1 = 100,000, K2 = 500, so that the number of
futures contracts shorted should be
k
e-q ( T* - T) e-r (T* - t) [1- N(d
1
1) ]
= 61.6
k2
An important issue when put options are created synthetically for portfolio
insurance is the frequency with which the portfolio manager's position should be
adjusted or rebalanced. With no transaction costs, continuous rebalancing is
243
,optimal. However, as transactions costs increase, the optimal frequency of rebal-
ancing declines. This issue is discussed by Leland .
Up to now we have assumed that the portfolio mirrors the index. As dis-
cussed in Chapter 12, the hedging scheme can be adjusted to deal with other
situations. Tile strike price for the options used should be the expected level of the
market index when the portfolio's value reaches its insured value. The number of
index options used should be times the number of options that would be required
if the portfolio had a beta of 1.0.
Example 4.12
Suppose that the risk-free rate of interest is 5% per annum, the S&P 500
stands at 500, and the value of a portfolio with a beta of 2.0 is Rs. 10 million.
Suppose that the dividend yield on the S&P 500 is 3%, the dividend yield on the
portfolio is 2%, and that the portfolio manager wishes to insure against a decline in
the value of the portfolio to below Rs. 9.3 million in the next year. If the value of
the portfolio declines to Rs. 9.3 million at the end of the year, the total return (after
taking account of the 2% dividend yield) is approximately -5% per annum. This is
10% per annum less than the risk-free rate. We expect the market to perform 5%
worse than the risk-free rate (i.e., .to provide zero return) in these circumstances.
Hence, we expect a 3% decline in the S&P 500 since this index does not take any
account of dividends. The correct strike price for the put options that are created is
therefore 485. The number of put options required is beta times the value of the
portfolio I divided by the value of the index, or 40,000 (i.e., 400 contracts).
15See H. E. Leland, "Option Pricing and Replication with Transactions Costs," Journal of Finance,
40 (December 1985), 1283-1301.
244
To illustrate that this answer is at least approximately correct, suppose that
the portfolio's value drops to Rs. 8.3 million. With dividends it provides a return of
approximately -15% per annum. This is approximately 20% per annum less than the
risk-free rate.
The S&P 500 plus dividends on the S&P 500 can be expected to provide a
return that is 10% per annum less than the risk-free rate. This means that the index
will reduce by 8%, to 460. The 40,000 put options with a strike price of 485 will
payoff Rs. 1 million, as required.
When is not equal to 1.0 and the fund manager wishes to use trades in the
portfolio to create the option, the portfolio can be regarded as a single security. As
an approximation, the volatility of the portfolio can be assumed to be equal to
times the volatility of the market index .
October 19, 1987 and Stock Market Volatility
Creating put options on the index synthetically does not work well if the
volatility of the index changes rapidly or if the index exhibits large jumps. On
Monday, October 19, 1987, the Dow Jones Industrial Average dropped by over 500
points. Portfolio managers who had insured themselves by buying traded put
options survived this crash well. Those who had chosen to create put options
This is exactly true only if beta is calculated on the basis of the returns in very small time
intervals. By contrast, the argument in Example 4.12 is exactly true only if beta is calculated on the
basis of returns in time intervals of length equal to the life of the option being created.
245
synthetically found that they were unable to sell either stocks or index futures fast
enough to protect their position.
We have already raised the issue of whether volatility is caused solely by the
arrival of new information or whether trading itself generates volatility. Portfolio
insurance schemes such as those just described have the potential to increase
volatility. When the market declines, they cause portfolio managers either to sell
stock or to sell index futures contracts. This may accentuate the decline. The sale of
stock is liable to drive down the market index further in a direct way. The sale of
index futures contracts is liable to drive down futures prices. This creates selling
pressure on stocks via the mechanism of index arbitrage so that the market index is
liable to be driven down in this case as well. Similarly, when the market rises, the
portfolio insurance schemes cause portfolio managers either to buy stock or to buy
futures contracts. This may accentuate the rise.
In addition to formal portfolio insurance schemes, we can speculate that
many investors consciously or subconsciously follow portfolio insurance schemes
of their own. For example, an investor may be inclined to enter the market when it
is rising, but will sell when it is falling, to limit his or her downside risk.
Whether portfolio insurance schemes (formal or informal) affect volatility
depends on how easily the market can absorb the trades that are generated by
portfolio insurance. If portfolio insurance trades are a very small fraction of all
trades, there is likely to be no effect. But as portfolio insurance becomes more
widespread, it is liable to have a destabilizing effect on the market.
246
IV. Conclusion
Historical`Volatility
Historical Volatility reflects how far an instruments price has deviated from
it's average price (mean) in the past. On a yearly basis, this number
represents the one standard deviation % price change expected in the year
ahead. In other words if a stock is trading at 100 and has a volatility of
0.20(20%) then there is a 68% probability(1 standard dev = 68%
probability) that the price will be in the range 80 to 120 a year from now.
Similarly there is a 95% probability that the price will be between 60 and
140 a year from now (2 standard deviations). The higher the volatility
number the higher the volatility.
Within Investor/RT, there are two methods to choose from when computing
volatility: The Close-to-Close Method and the Extreme Value Method. The
Close-to-Close Method compares the closing price with the closing price of the
previous period, while the Extreme Value Method compare the highs and lows
of each period. The method used, along with the number of periods used in the
calculation, and the periodicity (duration of each period) may be set by the user
in the Options Analysis Preferences. (Volatility Computation Details)
Theoretical`Value
The Theoretical Value of an option is expressed without the influences of
the market, such as supply/demand, current volume traded, or expectations.
It is calculated using a formula involving strike price, exercise price, time
until expiration, and historical volatility. Currently, Investor/RT uses the
Black-Scholes model to calculate the theoretical value of the option,
247
although other model options may be added in the future. (Black-Scholes
Computation Details)
Implied`Volatility
Implied Volatility is calculated by inspecting the current option premium,
and determining what the volatility should be in order to justify that
premium. It is determined by plugging the actual option price into our
Theoreticl Value model and solving for volatility. This implied volatility
can be compared to the historical volatility of the underlying in search of
underpriced and overpriced options.
1. Deltas
Delta is the rate of change of the theoretical value of an option with respect to
its underlying. It is also defined as the probablility that an option will finish in
the money. Higher deltas(approaching 1.0) represent deep in-the-money
options, and lower deltas(approaching 0.0) represent further out-of-the-money
options. At-the-money options generally have deltas around 0.50, representing
a 50% chance the contract will be in the money. This also represents the fact
that if the underlying moves 1.0 point, the options should move 0.50.
The delta measures sensitivity to price. The , of an instrument is the derivative
of the value function with respect to the underlying price,
.
2) Gamma
Gamma represents the rate of change of an options Delta. If an options
has a delta of 0.35 and a gamma of 0.05, then the option can be expected
to have a delta of 0.40 if the underlying goes up one point, and a delta of
0.30 if the underlying goes down one point.
248
The gamma measures second order sensitivity to price. The is the second
derivative of the value function with respect to the underlying price,
.
3) Theta
Theta is also commonly referred to as time decay. It represents the
options loss in theoretical value for each day the underlying price
remains unchanged. An option with a theta of 0.10 would lose 10 cents
each day provided the underlying does not move.
The theta measures sensitivity to the passage of time (see Option time
value). is minus the derivative of the option value with respect to the
amount of time to expiry of the option,
.
4) Vega
Vega is the sensitivity of an options price to a change in volatility. An
option with a vega of 0.25 would gain 25 cents for each percentage point
increase in volatility.
The vega, measures sensitivity to volatility. Vega is not a Greek letter, but
sounds like one and starts with v; it is a humorous reference to Scholes's
Chevrolet Vega. The vega is the derivative of the option value with respect
to the volatility of the underlying,
. The term kappa, , is sometimes
used instead of vega, and some trading firms have also used the term tau, .
5) Lambda
Lambda measures the percentage change in an option for a one percent
change in the price of the underlying. A Lambda of 5 means a 1 percent
change in the underlying will result in a 5 percent change in the option.
249
a. The lambda, is the percentage change in option value per
change in the underlying price, or
.
b. The vega gamma or volga measures second order sensitivity to
implied volatility. This is the second derivative of the option
value with respect to the volatility of the underlying,
.
6) Rho
Rho measures the sensitivity of an option's theoretical value to a change
in interest rates.
The rho measures sensitivity to the applicable interest rate. The is the
derivative of the option value with respect to the risk free rate,
.
250
Questions :
1. What do you mean by Hedging?
2. What are the Hedging Schemes?
3. What do you mean by Delta Hedging?
4. What do you mean by Theta in Hedging?
5. What do you mean by Gamma in Hedging?
6. What do you mean by Vega in Hedging?
7. What do you mean by Rho Hedging?
8. Explain hedging with an example
9. Explain the relationship among Delta, Theta, and Gamma.
10. Explain the Error in Delta Hedging.
11. What do you mean by long hedge and hedge funds?
12. Explain the concept Time to Maturity.
13. Explain the concept Price of Underlying
14. Explain the terms In the money, At the money and out of the money.
I. Development of Derivatives Market in India
he first step towards introduction of derivatives trading in India was the
T 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
251
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 derivatives 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 BSE?
30(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
252
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 contract on NSE are based on S&P CNX Trading and settlement in
derivative contracts is done in accordance with the rules, byelaws, and regulations
of the respective exchanges and their clearing house/corporation 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
253
January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the
traders are increasingly becoming pessimistic on 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
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.
254
Table-1: Business growth of futures and options market: NSE Turnover (Rs.cr)
Month
Index
Stock
Index
Stock
Total
futures
futures
options
options
Jun-00
35
-
-
-
35
Jul-00
108
-
-
-
108
Aug-00
90
-
-
-
90
Sep-00
119
-
-
-
119
Oct-00
153
-
-
-
153
Nov-00
247
-
-
-
247
Dec-00
237
-
-
-
237
01-Jan
471
-
-
-
471
01-Feb
524
-
-
-
524
01-Mar
381
-
-
-
381
01-Apr
292
-
-
-
292
01-May
230
-
-
-
230
01-Jun
590
-
196
-
785
01-Jul
1309
-
326
396
2031
01-Aug
1305
-
284
1107
2696
01-Sep
2857
-
559
2012
5281
01-Oct
2485
-
559
2433
5477
01-Nov
2484
2811
455
3010
8760
01-Dec
2339
7515
405
2660
12919
02-Jan
2660
13261
338
5089
21348
02-Feb
2747
13939
430
4499
21616
02-Mar
2185
13989
360
3957
20490
2001-02
21482
51516
3766
25163
101925
Table: Business growth of futures and options market: NSE Turnover (Rs.cr)
255
Commodity Derivatives
Futures contracts in pepper, turmeric, guar (jaggery), hessian (jute fabric), jute
sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are
traded in 18 commodity exchanges located in various parts of the country. Futures
trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in
futures in the new commodities, especially in edible oils, is expected to commence
in the near future. The sugar industry is exploring the merits of trading sugar
futures contracts.
The policy initiatives and the modernisation programme include extensive training,
structuring a reliable clearinghouse, establishment of a system of warehouse
receipts, and the thrust towards the establishment of a national commodity
exchange. The Government of India has constituted a committee to explore and
evaluate issues pertinent to the establishment and funding of the proposed national
commodity exchange for the nationwide trading of commodity futures contracts,
and the other institutions and institutional processes such as warehousing and
clearinghouses.
With commodity futures, delivery is best effected using warehouse receipts (which
are like dematerialised securities). Warehousing functions have enabled viable
exchanges to augment their strengths in contract design and trading. The viability of
the national commodity exchange is predicated on the reliability of the warehousing
functions. The programme for establishing a system of warehouse receipts is in
256
progress. The Coffee Futures Exchange India (COFEI) has operated a system of
warehouse receipts since 1998.
There are two exchanges for commodity in India:
1) National Commodity & Derivatives Exchange Limited
-(Herein referred to as NCDEX` or Exchange`),
2) Multi Commodity Exchange ( MCX )
Table-3: Turnover in Commodity Derivatives Exchanges:
257
.
Turnover in 2005-06
Turnover in 2004-05
Commodity
(Rs. Crore)
(Rs. Crore)
Total*
21,34,472
13,87,780
NCDEX
10,67,696
7,46,775
Top 10 commodities on
NCDEX:
Guar Seed
306,900
--------
Chana
219,000
--------
Urad
178,800
--------
Silver
85,600
33,
200
Gold
47,600
660
Tur
36,600
--------
Guar gum
35,900
--------
Refined Soya Oil
25,900
--------
Sugar
25,600
--------
% of volumes:
Pulse
40%
--------
Guar
30%
--------
Bullion
12%
--------
258
Foreign Exchange Derivatives
The Indian foreign exchange derivatives market owes its origin to the important
step that the RBI took in 1978 to allow banks to undertake intra-day trading in
foreign exchange; as a consequence, the stipulation of maintaining square or near
square position was to be complied with only at the close of each business day.
This was followed by use of products like cross-currency options, interest rate and
currency swaps, caps/collars and forward rate agreements in the international
foreign exchange market; development of a rupee-foreign currency swap market;
and introduction of additional hedging instruments such as foreign currency-rupee
options. Cross-currency derivatives with the rupee as one leg were introduced with
some restrictions in the April 1997 Credit Policy by the RBI. In the April 1999
Credit Policy, Rupee OTC interest rate derivatives were permitted using pure
rupee benchmarks, while in April 2000, Rupee interest rate derivatives were
permitted using implied rupee benchmarks. In 2001, a few select banks introduced
Indian National Rupee (INR) Interest Rate Derivatives (IRDs) using Government
of India security yields as floating benchmarks. Interest rate futures (long bond
and t-bill) were introduced in June 2003 and Rupee-foreign exchange options
were allowed in July 2003.
Fixed income derivatives
Scheduled Commercial Banks, Primary Dealers (PDs) and FIs have been allowed
by RBI since July 1993 to write Interest Rate Swaps (IRS) and Forward Rate
Agreements (FRAs) as products for their own asset liability management (ALM) or
for market making (risk trading) purposes. Since October 2000, IRS can be written
on benchmarks in domestic money or debt market (e.g. NSE MIBOR, Reuter
Mibor, GoI Treasury Bills) or on implied foreign currency interest rates [e.g.
Mumbai Interbank Forward Offer Rate (MIFOR), Mumbai Interbank Tom Offer
259
Rate (MITOR)]. IRS based on MIFOR/MITOR could well be written on a stand-
alone basis, and need not be a part of a Cross Currency Interest Rate Swap (CC-
IRS). This enables corporates to benchmark the servicing cost on their rupee
liabilities to the foreign currency forward yield curve.
There is now an active Over-The-Counter (OTC) IRS and FRA market in India.
Yet, the bulk of the activity is concentrated around foreign banks and some private
sector banks (new generation) that run active derivatives trading books in their
treasuries. The presence of Public Sector Bank (PSB) majors (such as SBI, BoB,
BoI, PNB, amongst others) in the rupee IRS market is marginal, at best. Most PSBs
are either unable or unwilling to run a derivatives trading book enfolding IRS or
FRAs. Further, most PSBs are not yet actively offering IRSs or FRAs to their
corporate customers on a covered basis with back-to-back deals in the inter-
institutional market.
The consequence is a paradox. On the one side you have foreign banks and new
generation private sector banks that run a derivatives trading book but do not have
the ability to set significant counter party (credit) limits on a large segment of
corporate customers of PSBs. And, on the other side are PSBs who have the ability
and willingness to set significant counter party (credit) limits on corporate
customers, but are unable or unwilling to write IRS or FRAs with them. Thereby,
the end user corporates are denied access through this route to appropriate hedging
and yield enhancing products, to better manage the asset-liability portfolio. This
inability or unwilling of PSB majors seemingly stems from the following key
impediments they are yet to overcome:
1. Inadequate technological and business process readiness of their treasuries
to run a derivatives trading book, and manage related risks.
2. Inadequate readiness of human resources/talent in their treasuries to run a
260
derivatives trading book, and manage related risks.
3. Inadequate willingness of bank managements to the risk being held
accountable for bona-fide trading losses in the derivatives book, and be
exposed to subsequent onerous investigative reviews, in a milieu where there
is no penal consequence for lost opportunity profit.
4. Inadequate readiness of their Board of Directors to permit the bank to run a
derivatives trading book, partly for reasons cited above, and partly due to
their own discomfort of the unfamiliar.
Interest rate options and futures:
The RBI is yet to permit banks to write rupee (INR) interest rate options. Indeed,
for banks to be able to write interest rate options, a rupee interest rate futures market
would need to first exist, so that the option writer can delta hedge the risk in the
interest rate options positions. And, according to one school of thought, perhaps the
policy dilemma before RBI is: how to permit an interest rate futures market when
the current framework does not permit short selling of sovereign securities. Further,
even if short selling of sovereign securities were to be permitted, it may be of little
consequence unless lending and borrowing of sovereign securities is first permitted.
II. REGULATORY FRAMEWORK FOR DERIVATIVES
THE GUIDING PRINCIPLES
Regulatory objectives
1. The Committee believes that regulation should be designed to achieve specific,
well-defined goals. It is inclined towards positive regulation designed to
261
encourage healthy activity and behaviour. It has been guided by the following
objectives :
a. Investor Protection: Attention needs to be given to the following four aspects:
i. Fairness and Transparency: The trading rules should ensure that
trading is conducted in a fair and transparent manner. Experience in
other countries shows that in many cases, derivative brokers/dealers
failed to disclose potential risk to the clients. In this context, sales
practices adopted by dealers for derivatives would require specific
regulation. In some of the most widely reported mishaps in the
derivatives market elsewhere, the underlying reason was inadequate
internal control system at the user-firm itself so that overall exposure
was not controlled and the use of derivatives was for speculation rather
than for risk hedging. These experiences provide useful lessons for us
for designing regulations.
ii. Safeguard for clients' moneys: Moneys and securities deposited by
clients with the trading members should not only be kept in a separate
clients' account but should also not be attachable for meeting the broker's
own debts. It should be ensured that trading by dealers on own account
is totally segregated from that for clients.
iii. Competent and honest service: The eligibility criteria for trading
members should be designed to encourage competent and qualified
personnel so that investors/clients are served well. This makes it
necessary to prescribe qualification for derivatives brokers/dealers and
the sales persons appointed by them in terms of a knowledge base.
iv. Market integrity: The trading system should ensure that the market's
integrity is safeguarded by minimising the possibility of defaults. This
262
requires framing appropriate rules about capital adequacy, margins,
clearing corporation, etc.
a. Quality of markets: The concept of "Quality of Markets" goes well beyond
market integrity and aims at enhancing important market qualities, such as cost-
efficiency, price-continuity, and price-discovery. This is a much broader
objective than market integrity.
b. Innovation: While curbing any undesirable tendencies, the regulatory
framework should not stifle innovation which is the source of all economic
progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology.
1. Of course, the ultimate objective of regulation of financial markets has to be to
promote more efficient functioning of markets on the "real" side of the
economy, i.e. economic efficiency.
2. Leaving aside those who use derivatives for hedging of risk to which they are
exposed, the other participants in derivatives trading are attracted by the
speculative opportunities which such trading offers due to inherently high
leverage. For this reason, the risk involved for derivative traders and speculators
is high. This is indicated by some of the widely publicised mishaps in other
countries. Hence, the regulatory frame for derivative trading, in all its aspects,
has to be much stricter than what exists for cash trading. The scope of
regulation should cover derivative exchanges, derivative traders, brokers and
sales-persons, derivative contracts or products, derivative trading rules and
derivative clearing mechanism.
3. In the Committee's view, the regulatory responsibility for derivatives trading
will have to be shared between the exchange conducting derivatives trading on
the one hand and SEBI on the other. The committee envisages that this sharing
263
of regulatory responsibility is so designed as to maximise regulatory
effectiveness and to minimise regulatory costs.
Major issues concerning regulatory framework
4. The Committee's attention had been drawn to several important issues in
connection with derivatives trading. The Committee has considered such issues,
some of which have a direct bearing on the design of the regulatory framework.
They are listed below :
a. Should a derivatives exchange be organised as independent and separate from
an existing stock exchange?
b. What exactly should be the division of regulatory responsibility, including both
framing and enforcing the regulations, between SEBI and the derivatives
exchange?
c. How should we ensure that the derivatives exchange will effectively fulfill its
regulatory responsibility?
d. What criteria should SEBI adopt for granting permission for derivatives trading
to an exchange?
e. What conditions should the clearing mechanism for derivatives trading satisfy in
view of high leverage involved?
f. What new regulations or changes in existing regulations will have to be
introduced by SEBI for derivatives trading?
Should derivatives trading be conducted in a separate exchange?
1. A major issue raised before the Committee for its decision was whether
regulations should mandate the creation of a separate exchange for derivatives
trading, or allow an existing stock exchange to conduct such trading. The
Committee has examined various aspects of the problem. It has also reviewed
the position prevailing in other countries. Exchange-traded financial derivatives
264
originated in USA and were subsequently introduced in many other countries.
Organisational and regulatory arrangements are not the same in all countries.
Interestingly, in U.S.A., for reasons of history and regulatory structure, a future
trading in financial instruments, including currency, bonds and equities, was
started in early 1970s, under the auspices of commodity futures markets rather
than under securities exchanges where the underlying bonds and equities were
being traded. This may have happened partly because currency futures, which
had nothing to do with securities markets, were the first to emerge among
financial derivatives in U.S.A. and partly because derivatives were not
"securities" under U.S. laws. Cash trading in securities and options on securities
were under the Securities and Exchange Commission (SEC) while futures
trading were under the Commodities Futures Trading Commission (CFTC). In
other countries, the arrangements have varied.
2. The Committee examined the relative merits of allowing derivatives trading to
be conducted by an existing stock exchange vis-a-vis a separate exchange for
derivatives. The arguments for each are summarised below.
Arguments for allowing existing stock exchanges to start futures trading:
a. The weightiest argument in this regard is the advantage of synergies arising
from the pooling of costs of expensive information technology networks and the
sharing of expertise required for running a modern exchange. Setting-up a
separate derivatives exchange will involve high costs and require more time.
b. The recent trend in other countries seems to be towards bringing futures and
cash trading under coordinated supervision. The lack of coordination was
recognised as an important problem in U.S.A. in the aftermath of the October
1987 market crash. Exchange-level supervisory coordination between futures
and cash markets is greatly facilitated if both are parts of the same exchange.
265
Arguments for setting-up separate futures exchange:
a. The trading rules and entry requirements for futures trading would have to be
different from those for cash trading.
b. The possibility of collusion among traders for market manipulation seems to be
greater if cash and futures trading are conducted in the same exchange.
c. A separate exchange will start with a clean slate and would not have to restrict
the entry to the existing members only but the entry will be thrown open to all
potential eligible players.
Recommendation
From the purely regulatory angle, a separate exchange for futures trading seems to
be a neater arrangement. However, considering the constraints in infrastructure
facilities, the existing stock exchanges having cash trading may also be permitted
to trade derivatives provided they meet the minimum eligibility conditions as
indicated below:
1. The trading should take place through an online screen-based trading system, which
also has a disaster recovery site. The per-half-hour capacity of the computers and
the network should be at least 4 to 5 times of the anticipated peak load in any half
hour, or of the actual peak load seen in any half-hour during the preceding six
months. This shall be reviewed from time to time on the basis of experience.
2. The clearing of the derivatives market should be done by an independent clearing
corporation, which satisfies the conditions listed in a later chapter of this report.
3. The exchange must have an online surveillance capability which monitors positions,
prices and volumes in realtime so as to deter market manipulation. Price and
position limits should be used for improving market quality.
266
4. Information about trades, quantities, and quotes should be disseminated by the
exchange in realtime over at least two information vending networks which are
accessible to investors in the country.
5. The Exchange should have at least 50 members to start derivatives trading.
6. If derivatives trading are to take place at an existing cash market, it should be done
in a separate segment with a separate membership; i.e., all members of the existing
cash market would not automatically become members of the derivatives market.
7. The derivatives market should have a separate governing council which shall not
have representation of trading/clearing members of the derivatives Exchange
beyond whatever percentage SEBI may prescribe after reviewing the working of the
present governance system of exchanges.
8. The Chairman of the Governing Council of the Derivative Division/Exchange shall
be a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he
shall not carry on any Broking or Dealing Business on any Exchange during his
tenure as Chairman.
9. The exchange should have arbitration and investor grievances redressal mechanism
operative from all the four areas/regions of the country.
10. The exchange should have an adequate inspection capability.
11. No trading/clearing member should be allowed simultaneously to be on the
governing council of both the derivatives market and the cash market.
12. If already existing, the Exchange should have a satisfactory record of monitoring its
members, handling investor complaints and preventing irregularities in trading.
II.A. Derivatives Market Trading Turnover
The number of instruments available in derivatives has been expanded. To begin
with, SEBI only approved trading in index futures contracts based on S&P CNX
267
Nifty Index and BSE-30 (Sensex) Index. This was followed by approval for trading
in options based on these two indices and options on individual securities and also
futures on interest rates derivative instruments (91-day Notional T-Bills and 10-year
Notional 6% coupon bearing as well as zero coupon bonds). Now, there are futures
and options based on benchmark index S&P CNX Nifty and CNX IT Index as well
as options and futures on single stocks (51 stocks).
The total exchange traded derivatives witnessed a value of Rs. 21,422,690 million
during 2003-04 as against Rs. 4,423,333 million during the preceding year. While
NSE accounted for about 99.5% of total turnover, BSE accounted for less than 1% in
2003-04. NSE has created a niche for itself in terms of derivatives trading in the global
market.
A. Derivatives
Single stock futures continue to dominate derivatives market with a percentage
share of about 55- 65 per cent during 2003-04. One important development is that
index futures started picking up during the year. Percentage of number of contracts
traded to the total number of derivatives contracts traded in the market has
increased steadily from about 14 per cent to 34 per cent (a growth of 150 per cent).
Both index options and stock options recorded decline in terms of number of
contracts as well as percentage share. Single stock futures share slid in 2003-04
compared to the previous year. Futures contract appear to be predominant when
compared to option contracts. Single stock futures recorded continuous growth
month after month except for three months i.e. November 2003, February and
March 2004. The growth rate also has been very high. Though the BSE has a very
small share of the total volume of derivatives segment, one important feature is that
index futures not only dominate but also account for almost over 60 per cent of the
268
volume traded. Yet, another specialty is that BSE recorded zero volume turnovers in
the index option segment. In many months even stock options remained dormant.
This is in sharp contrast with NSE trading in derivatives where single stock futures
are the most dominant segment.
269
Table-4: Derivatives Trading Turnover ? NSE
270
271
Table-5: Derivatives Trading Turnover ? BSE
B. Volatility of Stock Markets
Trend of movements in stock prices/indices represent historical movements. An
analysis of such trend indicates the economic fundamentals of the scrip/index.
Augments are made based upon conclusions drawn from a set of variables derived
from the trend in the scrip/index. Such technical indicators afford a quick view on
the next likely move by markets. Charts provide detailed information on the daily
volatility behaviour of various stock indices from different countries in different
regions, representing mature as well as emerging markets. Additionally, annualized
volatility has also been provided for each country. From the table and the charts, it
is evident that volatility, by and large, is lower in mature markets compared to that
in emerging markets. Amongst the developed markets, Germany has highest
volatility and he United States has the lowest volatility. Amongst the emerging
markets, Brazil has the highest volatility while Malaysia has the lowest volatility.
India has an annualized volatility of 22.7 per cent (NSE) and 21.4 per cent (BSE).
Table-6: Investment of FIIs:
Year
Gross
Gross
Net
Net
Cumulative
Purchases
Sales
Investment Investment
Net
(Rs. Crore) Rs. Crore) (Rs. Crore)
in US$
Investment
Million)
US $ mn at
monthly
Exchange
Rate
1992-93
17
4
13
4
4
1993-94
5,593
466
5,126
1,634
1,638
1994-95
7,631
2,835
4,796
1,528
3,167
1995-96
9,694
2,752
6,942
2,036
5,202
272
1996-97
15,554
6,979
8,574
2,432
7,634
1997-98
18,695
12,737
5,957
1,650
9,284
1998-99
16,115
17,699
-1,584
-386
8,898
1999-00
56,856
46,734
10,122
2,339
11,237
2000-01
74,051
64,116
9,934
2,159
13,396
2001-02
49,920
41,165
8,755
1,846
15,242
2002-03
47,061
44,373
2,689
562
15,805
2003-04
1,44,858
99,094
45,767
9,950
25,755
Total
4,46,045
3,38,954
1,07,089
25,755
25,755
III. Derivatives Markets Working and Trading in India
What are Derivatives?
The term "Derivative" indicates that it has no independent value, i.e. its
value is entirely "derived" from the value of the underlying asset. The
underlying asset can be securities, commodities, bullion, currency, live stock
or anything else. In other words, Derivative means a forward, future, option
or any other hybrid contract of pre determined fixed duration, linked for the
purpose of contract fulfillment to the value of a specified real or financial
asset or to an index of securities.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been
included in the definition of Securities. The term Derivative has been
defined in Securities Contracts (Regulations) Act, as:-
A Derivative includes: -
273
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;
b. a contract which derives its value from the prices, or index of prices,
of underlying securities;
What is a Futures Contract?
Futures Contract means a legally binding agreement to buy or sell the
underlying security on a future date. Future contracts are the
organized/standardized contracts in terms of quantity, quality (in case of
commodities), delivery time and place for settlement on any date in future.
Presently, the following future products are available:
Sensex Future: It is a future contract with Sensex as the underlying.
Stock Future: It is a future contract on the stock with respective stock as the
underlying.
What is an Option contract?
Options Contract is a type of Derivatives Contract which gives the
buyer/holder of the contract the right (but not the obligation) to buy/sell the
underlying asset at a predetermined price within or at end of a specified
period. Under Securities Contracts (Regulations) Act,1956 options on
securities has been defined as "option in securities" means a contract for the
purchase or sale of a right to buy or sell, or a right to buy and sell, securities
in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a
put and call in securities;
274
An Option to buy is called Call option and option to sell is called Put option.
Further, if an option that is exercisable on or before the expiry date is called
American option and one that is exercisable only on expiry date, is called
European option. The price at which the option is to be exercised is called
Strike price or Exercise price.
Therefore, in the case of American options the buyer has the right to
exercise the option at anytime on or before the expiry date. This request for
exercise is submitted to the Exchange, which randomly assigns the exercise
request to the sellers of the options, who are obligated to settle the terms of
the contract within a specified time frame.
Presently, the following Option products are available:
Sensex Option: It is an Option contract with Sensex as the underlying.
Stock Option : It is an Option contract on the stock with respective stock as
the underlying.
In- the- money options (ITM) - An in-the-money option is an option that would
lead to positive cash flow to the holder if it were exercised immediately. A Call
option is said to be in-the-money when the current price stands at a level higher
than the strike price. If the Spot price is much higher than the strike price, a Call is
said to be deep in-the-money option. In the case of a Put, the put is in-the-money if
the Spot price is below the strike price.
At-the-money-option (ATM) - An at-the money option is an option that would
lead to zero cash flow if it were exercised immediately. An option on the index is
said to be "at-the-money" when the current price equals the strike price.
Out-of-the-money-option (OTM) - An out-of- the-money Option is an option that
would lead to negative cash flow if it were exercised immediately. A Call option is
275
out-of-the-money when the current price stands at a level which is less than the
strike price. If the current price is much lower than the strike price the call is said to
be deep out-of-the money. In case of a Put, the Put is said to be out-of-money if
current price is above the strike price.
The factors that affect the price of an option:
There are five fundamental factors that affect the price of an option. These are:
1. Price of the underlying stock or index
2. Strike price/exercise price of the option
3. Time to expiration of the option
4. Risk-free rate of interest
5. Volatility of the price of underlying stock or index
Adjust the price for dividend expected during the term of the option to arrive at
fine prices.
Benefits of trading in Futures and Options.
1) Able to transfer the risk to the person who is willing to accept them
2) Incentive to make profits with minimal amount of risk capital
3) Lower transaction costs
4) Provides liquidity, enables price discovery in underlying market
5) Derivatives market is lead economic indicators.
6) Arbitrage between underlying and derivative market.
7) Eliminate security specific risk.
Index Futures and Index Option Contracts
Futures contract based on an index i.e. the underlying asset is the index, are
known as Index Futures Contracts. For example, futures contract on NIFTY
Index and BSE-30 Index. These contracts derive their value from the value of
the underlying index.
276
Similarly, the options contracts, which are based on some
index, are known as Index options contract. However, unlike
Index Futures, the buyer of Index Option Contracts has only the
right but not the obligation to buy / sell the underlying index on
expiry. Index Option Contracts are generally European Style
options i.e. they can be exercised / assigned only on the expiry
date.
An index, in turn derives its value from the prices of
securities that constitute the index and is created to represent
the sentiments of the market as a whole or of a particular sector
of the economy. Indices that represent the whole market are
broad based indices and those that represent a particular sector
are sectoral indices.
In the beginning futures and options were permitted only on S&P Nifty and
BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives
trading subject to fulfilling the eligibility criteria. Derivative contracts may be
permitted on an index if 80% of the index constituents are individually eligible
for derivatives trading. However, no single ineligible stock in the index shall
have a weightage of more than 5% in the index. The index is required to fulfill
the eligibility criteria even after derivatives trading on the index have begun. If
the index does not fulfill the criteria for 3 consecutive months, then derivative
contracts on such index would be discontinued.
By its very nature, index cannot be delivered on maturity of the Index futures or
Index option contracts therefore, these contracts are essentially cash settled on
Expiry.
Benefits of trading in Index Futures compared to any other security :
277
An investor can trade the 'entire stock market' by buying
index futures
instead of buying individual securities with the efficiency of a mutual fund.
The advantages of trading in Index Futures are:
- The contracts are highly liquid
- Index Futures provide higher leverage than any other stocks
- It requires low initial capital requirement
- It has lower risk than buying and holding stocks
- It is just as easy to trade the short side as the long side
- Only have to study one index instead of 100's of stocks
- Settled in cash and therefore all problems related to bad delivery,
forged, fake certificates, etc can be avoided.
Structure of Derivative Markets in India
Derivative trading in India takes can place either on a separate and independent
Derivative Exchange or on a separate segment of an existing Stock Exchange.
Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO)
and SEBI acts as the oversight regulator. The clearing & settlement of all trades
on the Derivative Exchange/Segment would have to be through a Clearing
Corporation/House, which is independent in governance and membership from the
Derivative Exchange/Segment.
Working of Derivatives markets in India
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory
framework for derivative trading in India. SEBI has also framed suggestive bye-law
for Derivative Exchanges/Segments and their Clearing Corporation/House which
lay's down the provisions for trading and settlement of derivative contracts. The
278
Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and
their Clearing Corporation/House have to be framed in line with the suggestive
Bye-laws. SEBI has also laid the eligibility conditions for Derivative
Exchange/Segment and its Clearing Corporation/House. The eligibility conditions
have been framed to ensure that Derivative Exchange/Segment & Clearing
Corporation/House provide a transparent trading environment, safety & integrity
and provide facilities for redressal of investor grievances. Some of the important
eligibility conditions are-
Derivative trading to take place through an on-line screen based Trading
System.
The Derivatives Exchange/Segment shall have on-line surveillance
capability to monitor positions, prices, and volumes on a real time basis so
as to deter market manipulation.
The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a real
time basis through atleast two information vending networks, which are
easily accessible to investors across the country.
The Derivatives Exchange/Segment should have arbitration and investor
grievances redressal mechanism operative from all the four areas / regions
of the country.
The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
The Clearing Corporation/House shall perform full novation, i.e., the
Clearing Corporation/House shall interpose itself between both legs of every
279
trade, becoming the legal counterparty to both or alternatively should
provide an unconditional guarantee for settlement of all trades.
The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the
underlying securities market for those Members who are participating in
both.
The level of initial margin on Index Futures Contracts shall be related to the
risk of loss on the position. The concept of value-at-risk shall be used in
calculating required level of initial margins. The initial margins should be
large enough to cover the one-day loss that can be encountered on the
position on 99% of the days.
The Clearing Corporation/House shall establish facilities for electronic
funds transfer (EFT) for swift movement of margin payments.
In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another
solvent Member or close-out all open positions.
The Clearing Corporation/House should have capabilities to segregate initial
margins deposited by Clearing Members for trades on their own account and
on account of his client. The Clearing Corporation/House shall hold the
clients` margin money in trust for the client purposes only and should not
allow its diversion for any other purpose.
The Clearing Corporation/House shall have a separate Trade Guarantee
Fund for the trades executed on Derivative Exchange / Segment.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of
BSE and the F&O Segment of NSE.
Membership categories in the Derivatives Market
280
The various types of membership in the derivatives market are as follows:
1. Professional Clearing Member (PCM):
PCM means a Clearing Member, who is permitted to clear and
settle trades on his own account, on account of his clients and/or
on account of trading members and their clients.
2. Custodian Clearing Member (CCM):
CCM means Custodian registered as Clearing Member, who may clear and
settle trades on his own account, on account of his clients and/or on account
of trading members and their clients.
3. Trading Cum Clearing Member (TCM):
A TCM means a Trading Member who is also a Clearing Member and can
clear and settle trades on his own account, on account of his clients and on
account of associated Trading Members and their clients.
4. Self Clearing Member (SCM):
A SCM means a Trading Member who is also Clearing Member and can
clear and settle trades on his own account and on account of his clients.
5. Trading Member (TM):
A TM is a member of the Exchange who has only trading rights and whose
trades are cleared and settled by the Clearing Member with whom he is
associated.
6. Limited Trading Member (LTM):
A LTM is a member, who is not the members of the Cash Segment of the
Exchange, and would like to be a Trading Member in the Derivatives
Segment at BSE. An LTM has only the trading rights and his trades are
cleared and settled by the Clearing Member with whom he is associated.
281
As on January 31, 2002, there are 1 Professional Clearing Member, 3 Custodian
Clearing Members, 75 trading cum Clearing Members, 93 Trading Members and 17
Limited Trading Members in the Derivative Segment of the Exchange.
Financial Requirement for Derivatives Membership:
The most basic means of controlling counterparty credit and liquidity risks is to
deal only with creditworthy counterparties. The Exchange seeks to ensure that
their members are creditworthy by laying down a set of financial requirements for
membership. The members are required to meet, both initially and on an ongoing
basis, minimum networth requirement. Unlike Cash Segment membership where
all the trading members are also the clearing members, in the Derivatives Segment
the trading and clearing rights are segregated. In other words, a member may opt
to have both clearing and trading rights or he may opt for trading rights only in
which case his trades are cleared and settled by the Clearing Member with whom
he is associated. Accordingly, the networth requirement is based on the type of
membership and is as under:
Table-7: Networth requirement is based on the type of membership:
Type of Membership
Networth
Requirement
Professional Clearing Member, Custodian Clearing Member
300 lakhs
and Trading cum Clearing Member
Self Clearing Member
100 lakhs
Trading Member
25 lakhs
Limited Trading Member
25 lakhs
Limited Trading Member ( for members of other stock
10 lakhs
282
exchange whose Clearing Member is a subsidiary company
of a Regional Stock Exchange)
Requirements to be a member of the derivatives exchange/ clearing
corporation
Balance Sheet Networth Requirements: SEBI has prescribed a networth
requirement of Rs. 3 crores for clearing members. The clearing members are
required to furnish an auditor's certificate for the networth every 6 months to the
exchange. The networth requirement is Rs. 1 crore for a self-clearing member.
SEBI has not specified any networth requirement for a trading member.
Liquid Networth Requirements: Every clearing member (both clearing members
and self-clearing members) has to maintain atleast Rs. 50 lakhs as Liquid
Networth with the exchange / clearing corporation.
Certification requirements: The Members are required to pass the certification
programme approved by SEBI. Further, every trading member is required to
appoint atleast two approved users who have passed the certification
programme. Only the approved users are permitted to operate the derivatives
trading terminal.
Requirements for a Member with regard to the conduct of his business
The derivatives member is required to adhere to the code of conduct specified
under the SEBI Broker Sub-Broker regulations. The following conditions
stipulations have been laid by SEBI on the regulation of sales practices:
Sales Personnel: The derivatives exchange recognizes the persons recommended
by the Trading Member and only such persons are authorized to act as sales
283
personnel of the TM. These persons who represent the TM are known as
Authorised Persons.
Know-your-client: The member is required to get the Know-your-client form
filled by every one of client.
Risk disclosure document: The derivatives member must educate his client on
the risks of derivatives by providing a copy of the Risk disclosure document to
the client.
Member-client agreement: The Member is also required to enter into the
Member-client agreement with all his clients.
Derivative contracts that are permitted by SEBI
Derivative products have been introduced in a phased manner
starting with Index Futures Contracts in June 2000. Index Options
and Stock Options were introduced in June 2001 and July 2001
followed by Stock Futures in November 2001. Sectoral indices were
permitted for derivatives trading in December 2002. Interest Rate
Futures on a notional bond and T-bill priced off ZCYC have been
introduced in June 2003 and exchange traded interest rate futures
on a notional bond priced off a basket of Government Securities
were permitted for trading in January 2004.
Eligibility criteria for stocks on which derivatives trading may be permitted
A stock on which stock option and single stock future contracts are proposed to be
introduced is required to fulfill the following broad eligibility criteria:-
The stock shall be chosen from amongst the top 500 stock in terms of average
daily market capitalisation and average daily traded value in the previous six
month on a rolling basis.
The stock`s median quarter-sigma order size over the last six months shall be
not less than Rs.1 Lakh. A stock`s quarter-sigma order size is the mean order
284
size (in value terms) required to cause a change in the stock price equal to one-
quarter of a standard deviation.
The market wide position limit in the stock shall not be less than Rs.50 crores.
A stock can be included for derivatives trading as soon as it becomes eligible.
However, if the stock does not fulfill the eligibility criteria for 3 consecutive
months after being admitted to derivatives trading, then derivative contracts on
such a stock would be discontinued.
Minimum contract size
The Standing Committee on Finance, a Parliamentary Committee, at the time of
recommending amendment to Securities Contract (Regulation) Act, 1956 had
recommended that the minimum contract size of derivative contracts traded in the
Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this
recommendation SEBI has specified that the value of a derivative contract should
not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In
February 2004, the Exchanges were advised to re-align the contracts sizes of
existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were
authorized to align the contracts sizes as and when required in line with the
methodology prescribed by SEBI.
Lot size of a contract
Lot size refers to number of underlying securities in one contract. The lot size is
determined keeping in mind the minimum contract size requirement at the time of
introduction of derivative contracts on a particular underlying.
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum
contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be
200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
What is corporate adjustment?
285
The basis for any adjustment for corporate action is such that the value of the
position of the market participant on cum and ex-date for corporate action
continues to remain the same as far as possible. This will facilitate in retaining the
relative status of positions viz. in-the-money, at-the-money and out-of-the-money.
Any adjustment for corporate actions is carried out on the last day on which a
security is traded on a cum basis in the underlying cash market. Adjustments mean
modifications to positions and/or contract specifications as listed below:
a. Strike price
b. Position
c. Market/Lot/ Multiplier
The adjustments are carried out on any or all of the above based on the nature of
the corporate action. The adjustments for corporate action are carried out on all
open, exercised as well as assigned positions.
The corporate actions are broadly classified under stock benefits and cash benefits.
The various stock benefits declared by the issuer of capital are:
Bonus
Rights
Merger/ demerger
Amalgamation
Splits
Consolidations
Hive-off
Warrants, and
Secured Premium Notes (SPNs) among others
The cash benefit declared by the issuer of capital is cash dividend.
Margining system in the derivative markets:
286
Two type of margins have been specified -
Initial Margin - Based on 99% VaR (Value at Risk ) and worst case loss over a
specified horizon, which depends on the time in which Mark to Market margin
is collected.
Mark to Market Margin (MTM) - collected in cash for all Futures contracts
and adjusted against the available Liquid Networth for option positions. In the
case of Futures Contracts MTM may be considered as Mark to Market
Settlement.
Dr. L.C Gupta Committee had recommended that the level of initial margin
required on a position should be related to the risk of loss on the position. The
concept of value-at-risk should be used in calculating required level of initial
margins. The initial margins should be large enough to cover the one day loss
that can be encountered on the position on 99% of the days. The
recommendations of the Dr. L.C Gupta Committee have been a guiding
principle for SEBI in prescribing the margin computation & collection
methodology to the Exchanges. With the introduction of various derivative
products in the Indian securities Markets, the margin computation methodology,
especially for initial margin, has been modified to address the specific risk
characteristics of the product. The margining methodology specified is
consistent with the margining system used in developed financial & commodity
derivative markets worldwide. The exchanges were given the freedom to either
develop their own margin computation system or adapt the systems available
internationally to the requirements of SEBI.
A portfolio based margining approach which takes an integrated view of the risk
involved in the portfolio of each individual client comprising of his positions in
all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and
287
Single Stock Futures, has been prescribed. The initial margin requirements are
required to be based on the worst case loss of a portfolio of an individual client
to cover 99% VaR over a specified time horizon.
The Initial Margin is Higher of
(Worst Scenario Loss +Calendar Spread Charges)
Or
Short Option Minimum Charge
The worst scenario loss are required to be computed for a portfolio of a client and is
calculated by valuing the portfolio under 16 scenarios of probable changes in the
value and the volatility of the Index/ Individual Stocks. The options and futures
positions in a client`s portfolio are required to be valued by predicting the price and
the volatility of the underlying over a specified horizon so that 99% of times the
price and volatility so predicted does not exceed the maximum and minimum price
or volatility scenario. In this manner initial margin of 99% VaR is achieved. The
specified horizon is dependent on the time of collection of mark to market margin
by the exchange.
The probable change in the price of the underlying over the
specified horizon i.e. `price scan range', in the case of Index futures
and Index option contracts are based on three standard deviation
(3 ) where ` ' is the volatility estimate of the Index. The volatility
estimate ` ', is computed as per the Exponentially Weighted Moving
Average methodology. This methodology has been prescribed by
SEBI. In case of option and futures on individual stocks the price
scan range is based on three and a half standard deviation (3.5 )
where `' is the daily volatility estimate of individual stock.
If the mean value (taking order book snapshots for past six months) of the impact
cost, for an order size of Rs. 0.5 million, exceeds 1%, the price scan range would
be scaled up by square root three times to cover the close out risk. This means that
288
stocks with impact cost greater than 1% would now have a price scan range of -
Sqrt (3) * 3.5 or approx. 6.06. For stocks with impact cost of 1% or less, the
price scan range would remain at 3.5.
For Index Futures and Stock futures it is specified that a minimum margin of 5%
and 7.5% would be charged. This means if for stock futures the 3.5 value falls
below 7.5% then a minimum of 7.5% should be charged. This could be achieved
by adjusting the price scan range.
The probable change in the volatility of the underlying i.e. volatility scan range`
is fixed at 4% for Index options and is fixed at 10% for options on Individual
stocks. The volatility scan range is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the same underlying
across different expiry. In a portfolio based margining approach all calendar-
spread positions automatically get a margin offset. However, risk arising due to
difference in cost of carry or the basis risk` needs to be addressed. It is therefore
specified that a calendar spread charge would be added to the worst scenario loss
for arriving at the initial margin. For computing calendar spread charge, the
system first identifies spread positions and then the spread charge which is 0.5%
per month on the far leg of the spread with a minimum of 1% and maximum of
3%. Further, in the last three days of the expiry of the near leg of spread, both the
legs of the calendar spread would be treated as separate individual positions.
In a portfolio of futures and options, the non-linear nature of options make short
option positions most risky. Especially, short deep out of the money options,
which are highly susceptible to, changes in prices of the underlying. Therefore a
short option minimum charge has been specified. The short option minimum
charge is 3% and 7.5 % of the notional value of all short Index option and stock
option contracts respectively. The short option minimum charge is the initial
289
margin if the sum of the worst ?scenario loss and calendar spread charge is lower
than the short option minimum charge.
To calculate volatility estimates the exchange are required to uses the
methodology specified in the Prof J.R Varma Committee Report on Risk
Containment Measures for Index Futures. Further, to calculate the option value the
exchanges can use standard option pricing models - Black-Scholes, Binomial,
Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two
components:-
The first is creation of risk arrays taking prices at discreet times taking latest
prices and volatility estimates at the discreet times, which have been specified.
The second is the application of the risk arrays on the actual portfolio positions
to compute the portfolio values and the initial margin on a real time basis.
The initial margin so computed is deducted from the available Liquid Networth on
a real time basis.
CONDITIONS FOR LIQUID NETWORTH
Liquid net worth means the total liquid assets deposited with the clearing house
towards initial margin and capital adequacy; LESS initial margin applicable to the
total gross open position at any given point of time of all trades cleared through
the clearing member.
The following conditions are specified for liquid net worth:
Liquid net worth of the clearing member should not be less than Rs 50 lacs at
any point of time.
290
Mark to market value of gross open positions at any point of time of all trades
cleared through the clearing member should not exceed the specified exposure
limit for each product.
Liquid Assets
At least 50% of the liquid assets should be in the form of cash equivalents viz.
cash, fixed deposits, bank guarantees, T bills, units of money market mutual
funds, units of gilt funds and dated government securities. Liquid assets will
include cash, fixed deposits, bank guarantees, T bills, units of mutual funds, dated
government securities or Group I equity securities which are to be pledged in
favor of the exchange.
Collateral Management
Collateral Management consists of managing, maintaining and valuing the
collateral in the form of cash, cash equivalents and securities deposited with the
exchange. The following stipulations have been laid down to the clearing
corporation on the valuation and management of collateral:
At least weekly marking to market is required to be carried out on all securities.
Debt securities of only investment grade can be accepted.10% haircut with
weekly mark to market will be applied on debt securities.
Total exposure of clearing corporation to the debt or equity of any company not
to exceed 75% of the Trade Guarantee Fund or 15% of its total liquid assets
whichever is lower.
Units of money market mutual funds and gilt funds shall be valued on the basis
of its Net Asset Value after applying a hair cut of 10% on the NAV and any exit
load charged by the mutual fund.
291
Units of all other mutual funds shall be valued on the basis of its NAV after
applying a hair cut equivalent to the VAR of the units NAV and any exit load
charged by the mutual fund.
Equity securities to be in demat form. Only Group I securities would be
accepted. The securities are required to be valued / marked to market on a daily
basis after applying a haircut equivalent to the respective VAR of the equity
security.
Mark to Market Margin
Options ? The value of the option are calculated as the theoretical value of the
option times the number of option contracts (positive for long options and negative
for short options). This Net Option Value is added to the Liquid Networth of the
Clearing member. Thus MTM gains and losses on options are adjusted against the
available liquid networth. The net option value is computed using the closing price
of the option and are applied the next day.
Futures ? The system computes the closing price of each series, which is used for
computing mark to market settlement for cumulative net position. If this margin is
collected on T+1 in cash, then the exchange charges a higher initial margin by
multiplying the price scan range of 3 & 3.5 with square root of 2, so that the
initial margin is adequate to cover 99% VaR over a two days horizon. Otherwise if
the Member arranges to pay the Mark to Market margins by the end of T day itself,
then the initial margins would not be scaled up. Therefore, the Member has the
option to pay the MTM margins either at the end of T day or on T+1 day.
Table-8: Summary of parameters specified for Initial Margin
Computation
Index
Index Stock
Stock Futures
Interest Rate Price Scan
292
Option Futur Optio
Futures
Range
s
es
ns
3
3
3.5
For order size of 3.5 sigma For
sigma
sigma sigma Rs.5 Lakh, if mean order size of
value of impact Rs.5 Lakh, if
cost > 1%, the mean value of
Price Scan Range impact cost >
be scaled up by 1%, the Price
3(in addition to Scan Range be
look ahead days)
scaled up by
3(in addition
to look ahead
days) For long
bond futures,
3.5 sigma and
for notional T-
Bill
futures,
3.5 sigma.
Volatil 4%
10%
ity
Scan
Range
Minim
5%
7.5%
For
long
um
bond futures,
margi
mini
mum
n
margin
is
requir
2%.
For
ement
notional T-
Bill futures
minimum
margin
is
0.2%.
Short
3%
7.5%
option
minim
um
charge
Calen
0.5% per month on the far month contract (min of 1% and max 3%)
293
dar
Sprea
d
Mark
Net Option Value (positive for long positions and negative for short
to
positions) to be adjusted from the liquid networth on a real time basis.
Marke The daily closing price of Futures Contract for Mark to Market
t
settlement would be calculated on the basis of the last half an hour
weighted average price of the contract.
MARGIN COLLECTION
Initial Margin - is adjusted from the available Liquid Networth of the Clearing
Member on an online real time basis.
Marked to Market Margins-
Futures contracts: The open positions (gross against clients and net of proprietary /
self trading) in the futures contracts for each member are marked to market to the
daily settlement price of the Futures contracts at the end of each trading day. The
daily settlement price at the end of each day is the weighted average price of the last
half an hour of the futures contract. The profits / losses arising from the difference
between the trading price and the settlement price are collected / given to all the
clearing members.
Option Contracts: The marked to market for Option contracts is computed and
collected as part of the SPAN Margin in the form of Net Option Value. The SPAN
Margin is collected on an online real time basis based on the data feeds given to the
system at discrete time intervals.
Client Margins
Clearing Members and Trading Members are required to collect initial margins
from all their clients. The collection of margins at client level in the derivative
markets is essential as derivatives are leveraged products and non-collection of
294
margins at the client level would provide zero cost leverage. In the derivative
markets all money paid by the client towards margins is kept in trust with the
Clearing House / Clearing Corporation and in the event of default of the Trading
or Clearing Member the amounts paid by the client towards margins are
segregated and not utilised towards the dues of the defaulting member.
Therefore, Clearing members are required to report on a daily basis details in
respect of such margin amounts due and collected from their Trading members /
clients clearing and settling through them. Trading members are also required to
report on a daily basis details of the amount due and collected from their clients.
The reporting of the collection of the margins by the clients is done electronically
through the system at the end of each trading day. The reporting of collection of
client level margins plays a crucial role not only in ensuring that members collect
margin from clients but it also provides the clearing corporation with a record of
the quantum of funds it has to keep in trust for the clients.
Exposure limits in Derivative Products
It has been prescribed that the notional value of gross open positions at any point
in time in the case of Index Futures and all Short Index Option Contracts shall not
exceed 33 1/3 (thirty three one by three) times the available liquid networth of a
member, and in the case of Stock Option and Stock Futures Contracts, the
exposure limit shall be higher of 5% or 1.5 sigma of the notional value of gross
open position.
In the case of interest rate futures, the following exposure limit is specified:
The notional value of gross open positions at any point in time in futures
contracts on the notional 10 year bond should not exceed 100 times the
available liquid networth of a member.
295
The notional value of gross open positions at any point in time in futures
contracts on the notional T-Bill should not exceed 1000 times the available
liquid networth of a member.
Position limits in Derivative Products
The position limits specified are as under-
1) Client / Customer level position limits:
For index based products there is a disclosure requirement for clients whose
position exceeds 15% of the open interest of the market in index products.
For stock specific products the gross open position across all derivative
contracts on a particular underlying of a customer/client should not exceed the
higher of ?
1% of the free float market capitalisation (in terms of number of shares).
Or
5% of the open interest in the derivative contracts on a particular
underlying stock (in terms of number of contracts).
This position limits are applicable on the combine position in all derivative
contracts on an underlying stock at an exchange. The exchanges are required to
achieve client level position monitoring in stages.
The client level position limit for interest rate futures contracts is specified at
Rs.100 crore or 15% of the open interest, whichever is higher.
2) Trading Member Level Position Limits:
For Index options the Trading Member position limits are Rs. 250 cr or 15% of the
total open interest in Index Options whichever is higher and for Index futures the
Trading Member position limits are Rs. 250 cr or 15% of the total open interest in
Index Futures whichever is higher.
296
For stocks specific products, the trading member position limit is 20% of the
market wide limit subject to a ceiling of Rs. 50 crore. In Interest rate futures the
Trading member position limit is Rs. 500 Cr or 15% of open interest whichever is
higher.
It is also specified that once a member reaches the position limit in a particular
underlying then the member shall be permitted to take only offsetting positions
(which result in lowering the open position of the member) in derivative contracts
on that underlying. In the event that the position limit is breached due to the
reduction in the overall open interest in the market, the member are required to
take only offsetting positions (which result in lowering the open position of the
member) in derivative contract in that underlying and fresh positions shall not be
permitted. The position limit at trading member level is required to be computed
on a gross basis across all clients of the Trading member.
3) Market wide limits:
There are no market wide limits for index products. For stock specific products the
market wide limit of open positions (in terms of the number of underlying stock)
on an option and futures contract on a particular underlying stock would be lower
of ?
30 times the average number of shares traded daily, during the previous
calendar month, in the cash segment of the Exchange,
Or
20% of the number of shares held by non-promoters i.e. 20% of the free float, in
terms of number of shares of a company.
Table-9: Summary of Position Limits
Index
Index
Stock
Stock
Interest
297
Options
Futures
Options
Futures
Rate
Futures
Client Disclosure
Disclosure 1% of free 1% of free Rs.100 crore
level
requirement
requireme
float or 5% float or 5% or 15% of
for any person nt for any of
open of
open the
open
or
persons person or interest
interest
interest,
acting
in persons
whichever is whichever is whichever is
concert
acting in higher
higher
higher.
holding 15% concert
or more of the holding
open interest 15%
or
of
all more
of
derivative
the open
contracts on a interest of
particular
all
underlying
derivative
index
contracts
on
a
particular
underlying
index
Tradi
15% of the 15% of the 20%
of 20%
of Rs. 500 Cr
ng
total
Open total Open Market Wide Market Wide or 15% of
Mem
Interest of the Interest of Limit subject Limit subject open interest
ber
market or Rs. the market to a ceiling to a ceiling whichever is
level
250
crores, or Rs. 250 of Rs.50 cr.
of Rs.50 cr.
higher.
whichever is crores,
higher
whichever
is higher
Mark
30 times the 30 times the
et
average
average
wide
number
of number
of
shares traded shares traded
daily, during daily, during
the previous the previous
calendar
calendar
month, in the month, in the
relevant
relevant
298
underlying
underlying
security
in security
in
the
the
underlying
underlying
segment or, segment or,
- 20% of the - 20% of the
number
of number
of
shares held shares held
by
non- by
non-
promoters in promoters in
the relevant the relevant
underlying
underlying
security,
security,
whichever is whichever is
lower
lower
Requirements for a FII and its sub-account to invest in derivatives
A SEBI registered FIIs and its sub-account are required to pay initial margins,
exposure margins and mark to market settlements in the derivatives market as
required by any other investor. Further, the FII and its sub-account are also
subject to position limits for trading in derivative contracts. The FII and sub-
account position limits for the various derivative products are as under:
299
Table- 10: Requirement for FII
Index
Index
Stock
Single stock Interest
Options
Futures
Options
Futures
rate
futures
Rs. 250 crores Rs.
250 20% of 20%
of Rs.
USD
or 15% of the crores
or Market
Market Wide 100
OI in Index 15% of the Wide
Limit subject million.
options,
OI in Index Limit
to a ceiling of In addition
whichever is futures,
subject to Rs. 50 crores. to
the
higher.
whichever is a ceiling
above, the
In
addition, higher.
of Rs. 50
FII
may
hedge
In addition, crores.
take
positions are hedge
exposure in
permitted.
positions are
exchange
FII
permitted.
traded
in
Level
interest rate
derivative
contracts to
the extent
of the book
value
of
their cash
market
exposure in
Governmen
t Securities.
Disclosure
Disclosure
1%
of 1% of free Rs. 100 Cr
requirement
requirement free float float market or 15% of
for any person for
any market
capitalization total open
or persons
person
or capitaliza or 5% of interest in
Sub-
acting in
persons
tion
or open interest the market
accoun concert
acting
in 5%
of on
a in exchange
t level holding 15%
concert
open
particular
traded
or more of the holding 15% interest
underlying
interest rate
open interest
or more of on
a whichever is derivative
of all
the
open particular higher
contracts,
derivative
interest
of underlyin
whichever
300
contracts on a all
g
is higher.
particular
derivative
whicheve
underlying
contracts on r
is
index
a particular higher
underlying
index
Requirements for a NRI to invest in derivatives
NRIs are permitted in invest in exchange traded derivative
contracts subject to the margin and other requirements which
are in place for other investors. In addition, a NRI is subject to
the following position limits:
Table-11: NRI position limits:
Index
Index
Stock
Single stock Interest
Options
Futures
Options Futures
rate
futures
Disclosure Disclosure
1%
of 1% of free Rs. 100 Cr
requireme
requirement free float float market or 15% of
nt for any for
any market
capitalizatio
total open
person or person
or capitaliz
n or 5% of interest in
persons
persons
ation or open interest the market
acting in acting
in 5%
of on
a in
concert
concert
open
particular
exchange
holding
holding
interest
underlying
traded
15%
or 15%
or on
a whichever is interest
NRI level more
of more of the particula higher
rate
the open open
r
derivative
interest of interest of underlyi
contracts,
all
all
ng
whichever
derivative derivative
whichev
is higher.
contracts
contracts on er
is
on
a a particular higher
particular
underlying
underlying index
index
Measures that have been specified by SEBI to protect the rights of investor in
Derivatives Market
301
The measures specified by SEBI include:
Investor's money has to be kept separate at all levels and is permitted to be used
only against the liability of the Investor and is not available to the trading
member or clearing member or even any other investor.
The Trading Member is required to provide every investor with a risk disclosure
document which will disclose the risks associated with the derivatives trading so
that investors can take a conscious decision to trade in derivatives.
Investor would get the contract note duly time stamped for receipt of the order
and execution of the order. The order will be executed with the identity of the
client and without client ID order will not be accepted by the system. The
investor could also demand the trade confirmation slip with his ID in support of
the contract note. This will protect him from the risk of price favour, if any,
extended by the Member.
In the derivative markets all money paid by the Investor towards margins on all
open positions is kept in trust with the Clearing House/Clearing Corporation and
in the event of default of the Trading or Clearing Member the amounts paid by
the client towards margins are segregated and not utilised towards the default of
the member. However, in the event of a default of a member, losses suffered by
the Investor, if any, on settled / closed out position are compensated from the
Investor Protection Fund, as per the rules, bye-laws and regulations of the
derivative segment of the exchanges.
The Exchanges are required to set up arbitration and investor grievances
redressal mechanism operative from all the four areas / regions of the country.
Table ? 12:Types of F&O contracts at NSE :
302
Index Futures
Stock Futures
Index Options
Stock Options
Underlying
S&P CNX
Futures
S&P CNX
Options
Instrument
NIFTY#
contracts are
NIFTY
contracts are
available on
(European) CE available on the
118 securities
- Call, PE - Put same 118
which are
securities on
traded in the
which
Capital Market
Futures
segment of the
contracts are
Exchange.
available.
(American) CA
- Call , PA -
Put.
Trading
maximum of 3-month trading cycle: the near month (one), the next
cycle
month (two) and the far month (three).
Expiry day
last Thursday of the expiry month or on the previous trading day if the
last Thursday is a trading holiday.
Strike Price
NA
NA
a minimum of
Intervals
five strike
prices for every
option type (i.e.
call & put)
during the
trading
month.At any
ime,
there are two
contracts in-
the-money
(ITM), two
contracts out-
fthe-
303
money (OTM)
and
one contract at-
the money
(ATM).The
strike price
interval is 10.
Contract
lot size of Nifty multiples
of lot size of Nifty multiples
of
size
futures
100
and options
100
and
contracts is 200 fractions if any, contracts is 200 fractions if any,
and multiples
shall be
and
shall be
thereof
rounded off to multiples
rounded off to
the next higher thereof
the next higher
multiple of 100.
multiple of 100.
The permitted
The value of
lot size for the
the
option
futures
contracts
on
contracts on
individual
individual
securities may
ecurities shall
not be less than
be the same for
Rs. 2 lakhs at
options or as
the time of
specified by the
introduction.
Exchange
Quantity
20,000 units or quantity freeze
20,000 units or
the lesser of the
freeze
greater,
shall be
greater
following:1%
after which the
the lesser of the
of the
Exchange
follow-
marketwide
may at its
ing:1% of the
position
discretion
marketwide
limit stipulated
approve further position limit
for open
orders,
stipulated
positions on
on confirmation for open
options on
by the
positions on the
individual
member that
futures and
securities or
304
the order
options on
Notional value
is genuine.
individual
of the contract
securities or
of around Rs.5
Notional value
crores
of the contract
of around Rs.5
crores
Price bands
No day
operating
operating ranges and day
minimum/maxi
ranges are
minimum/maximum
mum
kept at + 20%
ranges for options contract are
price ranges
kept at 99% of the base price
applicable,
however,
operating
ranges
are kept at +
10%,after
which price
freeze would be
removed on
confirmation
by the member
that the
order is
genuine.
Price steps
The price step
The price step
The price step
The price step
in respect
for
in
for
of S&P CNX
futures
respect of S&P options
Nifty futures
contracts is
CNX
contracts is
contracts is
Re.0.05.
Nifty options
Re.0.05.
Re.0.05.
contracts
is Re.0.05.
Base Prices
Base price of
the theoretical
Base price of the new options
S&P CNX
futures
contracts would
305
Nifty futures
price on
be the theoretical value of the
contracts on
introduction
options contract
the first day of
and the daily
arrived at based on Black-Scholes
trading
settlement
model of
would be
price of the
calculation of options premiums.The
theoretical
futures
futures
contracts on
base price of the contracts on subsequent
price. The base subse-
trading days, will be the daily close price
price of the
quent trading
contracts on
days.
of the options contracts, which is the last
subsequent
trading days
half an hour`s weighted average price if
would be the
the contract is traded in the last half an
daily settlement
price of the
hour, or the last traded price (LTP) of the
futures
contracts.
contract. If a contract is not traded during
a day on the next day the base price is
calculated as for a new contract.
Order type
Regular lot order; Stop loss order; Immediate or cancel; Good till
day/cancelled*/date; Spread order
*BSE also has the above derivatives as in NSE
Settlement basis
1. Index Futures / Futures Mark to Market and final settlement on individual
securities be settled in cash on T+1 basis.
2. Index Options Premium settlement on T+1 Basis and Final Exercise settlement
on T+1 basis.
306
3. Options on individual Premium settlement on T+1 basis and securities option
Exercise settlement on T+2 basis.
Settlement price
1. S&P CNX Nifty Futures / Daily settlement price will be the closing Futures price
on individual securities of the futures contracts for the trading day and the final
settlement price shall be the closing value of the underlying index/ security on the
last trading day Index Options /options The settlement price shall be closing on
individual security price of underlying security What are the contract specifications
of the Interest rate Derivatives traded in National Stock Exchange.
Trading cycle
The interest rate future contract shall be for a period of maturity of one year with
three months continuous contracts for the first three months and fixed quarterly
contracts for the entire year. New contracts will be introduced on the trading day
following the expiry of the near month contract.
Table-13: Derivatives Segment at BSE and NSE
307
RISKS INVOLVED IN TRADING IN DERIVATIVES CONTRACTS
Effect of "Leverage" or "Gearing"
The amount of margin is small relative to the value of the derivatives contract so
the transactions are 'leveraged' or 'geared'.
Derivatives trading, which is conducted with a relatively small amount of margin,
provides the possibility of great profit or loss in comparison with the principal
investment amount. But transactions in derivatives carry a high degree of risk.
You should therefore completely understand the following statements
before actually trading in derivatives trading and also trade with
caution while taking into account one's circumstances, financial
resources, etc. If the prices move against you, you may lose a part of
or whole margin equivalent to the principal investment amount in a
308
relatively short period of time. Moreover, the loss may exceed the
original margin amount.
A. Futures trading involve daily settlement of all positions. Every day the open
positions are marked to market based on the closing level of the index. If the
index has moved against you, you will be required to deposit the amount of
loss (notional) resulting from such movement. This margin will have to be paid
within a stipulated time frame, generally before commencement of trading next
day.
B. If you fail to deposit the additional margin by the deadline or if an outstanding
debt occurs in your account, the broker/member may liquidate a part of or the
whole position or substitute securities. In this case, you will be liable for any
losses incurred due to such close-outs.
C. Under certain market conditions, an investor may find it difficult or impossible
to execute transactions. For example, this situation can occur due to factors
such as illiquidity i.e. when there are insufficient bids or offers or suspension of
trading due to price limit or circuit breakers etc.
D. In order to maintain market stability, the following steps may be adopted:
changes in the margin rate, increases in the cash margin rate or others. These
new measures may be applied to the existing open interests. In such conditions,
you will be required to put up additional margins or reduce your positions.
E. You must ask your broker to provide the full details of the derivatives contracts
you plan to trade i.e. the contract specifications and the associated obligations.
1) Risk-reducing orders or strategies
The placing of certain orders (e.g., "stop-loss" orders, or "stop-limit" orders)
which are intended to limit losses to certain amounts may not be effective because
309
market conditions may make it impossible to execute such orders. Strategies
using combinations of positions, such as "spread" positions, may be as risky as
taking simple "long" or "short" positions.
2) Suspension or restriction of trading and pricing relationships
Market conditions (e.g., illiquidity) and/or the operation of the rules of certain
markets (e.g., the suspension of trading in any contract or contact month because
of price limits or "circuit breakers") may increase the risk of loss due to inability
to liquidate/offset positions.
3) Deposited cash and property
You should familiarise yourself with the protections accorded to the money or
other property you deposit particularly in the event of a firm insolvency or
bankruptcy. The extent to which you may recover your money or property may
be governed by specific legislation or local rules. In some jurisdictions, property
which has been specifically identifiable as your own will be pro-rated in the same
manner as cash for purposes of distribution in the event of a shortfall. In case of
any dispute with the member, the same shall be subject to arbitration as per the
byelaws/regulations of the Exchange.
4) Risk of Option holders
1. An option holder runs the risk of losing the entire amount paid for the option in
a relatively short period of time. This risk reflects the nature of an option as a
wasting asset which becomes worthless when it expires. An option holder who
neither sells his option in the secondary market nor exercises it prior to its
310
expiration will necessarily lose his entire investment in the option. If the price
of the underlying does not change in the anticipated direction before the option
expires to the extent sufficient to cover the cost of the option, the investor may
lose all or a significant part of his investment in the option.
2. The Exchange may impose exercise restrictions and have authority to restrict
the exercise of options at certain times in specified circumstances.
5) Risks of Option Writers
1. If the price movement of the underlying is not in the anticipated direction the
option writer runs the risks of losing substantial amount.
2. The risk of being an option writer may be reduced by the purchase of other
options on the same underlying interest-and thereby assuming a spread
position-or by acquiring other types of hedging positions in the options markets
or other markets. However, even where the writer has assumed a spread or
other hedging position, the risks may still be significant. A spread position is
not necessarily less risky than a simple 'long' or 'short' position.
3. Transactions that involve buying and writing multiple options in combination,
or buying or writing options in combination with buying or selling short the
underlying interests, present additional risks to investors. Combination
transactions, such as option spreads, are more complex than buying or writing a
single option. And it should be further noted that, as in any area of investing, a
complexity not well understood is, in itself, a risk factor. While this is not to
suggest that combination strategies should not be considered, it is advisable, as
is the case with all investments in options, to consult with someone who is
experienced and knowledgeable with respect to the risks and potential rewards
of combination transactions under various market circumstances.
311
6) Commission and other charges
Before you begin to trade, you should obtain a clear explanation of all
commission, fees and other charges for which you will be liable. These charges
will affect your net profit (if any) or increase your loss.
7) Trading facilities
The Exchange offers electronic trading facilities which are computer-based
systems for order-routing, execution, matching, registration or clearing of trades.
As with all facilities and systems, they are vulnerable to temporary disruption or
failure. Your ability to recover certain losses may be subject to limits on liability
imposed by the system provider, the market, the clearing house and/or member
firms. Such limits may vary; you should ask the firm with which you deal for
details in this respect.
This document does not disclose all of the risks and other significant aspects
involved in trading on a derivatives market. The constituent should therefore study
derivatives trading carefully before becoming involved in it.
Trading Mechanism
The derivatives trading system, called NEAT-F&O trading system, provides a fully
automated screen based trading for derivatives on a nationwide basis. It supports an
anonymous order driven market which operates on a strict price/time priority. It
provides tremendous flexibility to users in terms of kinds of orders that can be
placed on the system. Various time/price related conditions like, Goodtill- Day,
Good-till-Cancelled, Good-till-Date, Immediate or Cancel, Limit/Market Price,
312
Stop Loss, etc. can be built into an order. It is similar to that of trading of securities
in the CM segment.
The NEAT-F&O trading system is accessed by two types of users. The trading user
has access to functions such as, order entry, order matching, order and trade
management. The clearing user uses the trader workstation for the purpose of
monitoring the trading member(s) for whom he clears the trades. Additionally, he
can enter and set limits to positions, which a trading member can take.
A FEW BASIC STRATEGIES
A. Assumption: Bullish on the market over the short term Possible Action by you:
Buy Nifty calls
Example:
Current Nifty is 1880. You buy one contract of Nifty near month calls for Rs.20
each. The strike price is 1900, i.e. 1.06% out of the money. The premium paid by
you will be (Rs.20 * 200) Rs.4000.Given these, your break-even level Nifty is 1920
(1900+20). If at expiration Nifty advances by 5%, i.e. 1974, then Nifty expiration
level 1974.00 Less Strike Price 1900.00 Option value 74.00 (1974-1900)
Less Purchase price 20.00
Profit per Nifty 54.00
Profit on the contract Rs.10800 (Rs. 54* 200)
Note :
1) If Nifty is at or below 1900 at expiration, the call holder would not find it
profitable to exercise the option and would loose the entire premium, i.e. Rs.4000 in
this example. If at expiration, Nifty is between 1900 (the strike price) and 1920
313
(breakeven), the holder could exercise the calls and receive the amount by which
the index level exceeds the strike price. This would offset some of the cost.
2) The holder, depending on the market condition and his perception, may sell the
call even before expiry.
B. Assumption: Bearish on the market over the short term Possible Action by you:
Buy Nifty puts
Example:
Nifty in the cash market is 1880. You buy one contract of Nifty near month puts for
Rs.17 each. The strike price is 1840, i.e. 2.12% out of the money. The premium
paid by you will be Rs.3400 (17*200). Given these, your break-even level Nifty is
1823 (i.e. strike price less the premium). If at expiration Nifty declines by 5%,
i.e.1786, then
Put Strike Price 1840
Nifty expiration level 1786
Option value 54 (1840-1786)
Less Purchase price 17
Profit per Nifty 37
Profit on the contract Rs.7400 (Rs.37* 200)
Note :
1) If Nifty is at or above the strike price 1840 at expiration, the put holder would not
find it profitable to exercise the option and would loose the entire premium, i.e.
Rs.3400 in this example. If at expiration, Nifty is between 1840 (the strike price)
314
and 1823 (breakeven), the holder could exercise the puts and receive the amount by
which the strike price exceeds the index level. This would offset some of the cost.
2) The holder, depending on the market condition and his perception, may sell the
put even before expiry.
Use Put as a portfolio Hedge:
Assumption: You are concerned about a downturn in the short term market and its
effect on your portfolio.
The portfolio has performed well and you expect to continue appreciate over the
long term but like to protect existing profits or prevent further losses.
Possible Action: Buy Nifty puts.
Example:
You held a portfolio with say, a single stock, HLL valued at Rs.10 Lakhs (@
Rs.200 each share). Beta of HLL is 1.13. Current Nifty is at 1880. Nifty near month
puts of strike price 1870 is trading at Rs.15. To hedge, you bought 3 puts
600{Nifties, equivalent to Rs.10 lakhs*1.13 (Beta of HLL) or Rs.1130000}. The
premium paid by you is Rs.9000, (i.e.600 15). If at expiration Nifty declines to
1800, and Hindustan Lever falls to Rs.195, then
Put Strike Price 1870
Nifty expiration level 1800
Option value 70 (1870-1800)
Less Purchase price 15
Profit per Nifty 55
Profit on the contract Rs.33000 (Rs.55* 600)
Loss on Hindustan Lever Rs.25000
315
Net profit Rs. 8000
A list of some abbreviations used above:
AD: Authorised Dealer
ADR: American Depository Receipt
BIS: Bank for International Settlements
BSE: Bombay Stock Exchange Ltd.
CCIL: Clearing Corporation of India Ltd.
CM: Clearing Member
EUR: Euro
F&O: Futures and Options
FII: Foreign Institutional (portfolio) Investor
FMC: Forward Markets Commission (set up under the
Ministry of Consumer Affairs, Food and Public
Distribution, Government of India)
FRA: Forward Rate Agreement
GBP: Pound
GDR: Global Depository Receipt
INR: Indian National Rupee
IRS: Interest rate swap
JPY: Yen
MF: Mutual Fund
MTM: Mark to Market Margin
NRI: Non-Resident Indian
NSCCL: National Securities Clearing Corporation
(a wholly owned subsidiary of NSE)
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NSE: National Stock Exchange of India Ltd.
OIS: Overnight Index Swap
OTC: Over-the-counter
RBI: Reserve Bank of India
SEBI: Securities and Exchange Board of India
TM: Trading Member
USD: US Dollar
VaR: Value at Risk
Questions- Derivatives Market in India::
1. Explain the L.C.Gupta Committee recommendations
2. What are the LC Gupta Committee recommendations for investor protection
3. Discuss the Business growth of futures and options market.
4. Explain about the derivatives trading available in India.
5. What do you mean by Volatility of Stock Markets?
6. Discuss about the investment of FIIs in Derivatives in India.
7. Explain the types of option and its Trading.
8. Explain the types of Futures and its Trading.
9. What are the factors that affect the price of an option?
10. What are the Benefits of trading in Futures and Options?
11. Explain about Index Futures and Index Option Contracts.
12. What are the advantages of trading in Index Futures?
13. Explain about the Membership categories in the Derivatives Market?
14. Explain the Financial Requirement for Derivatives Membership.
15. Explain the Networth requirement for various type of membership.
16. Explain the Eligibility criteria for stocks on which derivatives trading may be
permitted.
17. Explain the Margining system in the derivative markets.
18. Explain in detail about the position limits.
19. What are the risks involved in trading in derivatives market?
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This post was last modified on 14 March 2022