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Perception of Derivatives _ SMC INVESTMENT PROJECT REPORT

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Perception of Derivatives _ SMC INVESTMENT PROJECT REPORT Powered By Docstoc
					               SMC INVESMENT SOLUTIONS & SERVICES




                             Table of Contents

Sl.no                     Particulars             Page No.
 1.     Executive Summary                            1.
 2.     Indian Economy Overview                      6
 3      Company Overview                             7
 4      Derivatives
        4.1 Introduction                            10
        4.2   Indian Scenario                       11
 5      Futures Contract                            18
         5.1 Understanding Index Futures            20
        5.2   Hedging                               21
        5.3   Speculation                           24
        5.4   Arbitrage                             25
        5.5   Pricing of Index Futures              26
        5.6   Trading Strategies                    29
        5.7 Settlement Of Futures Contract          36
 6      Options
        6.1   What is an Option?                    41
        6.2   Chicago Board of Options Exchange     44
        6.3   Regulation and Surveillance           45
        6.4   Options Clearing Corporation          45
        6.5   Options Market Participants           45
        6.6   Call Options                          47
        6.7   Put Options                           49
        6.8   Option Styles                         52
        6.9 Option Class & Series                   53
        6.10 Pricing of Options                     54
BABASAB PATIL                                                1
             SMC INVESMENT SOLUTIONS & SERVICES



      6.11 Options Pricing Factors                54
      6.12 Strategies                             58
      6,13 Key Regulations                        75
      6.14 Advantages of option trading           80
      6.15 Settlement of Options                  82
7     Clearing & Settlement                       83
8     Analysis                                    87
9     Findings                                    105
10    Suggestions                                 107
11    Conclusion                                  108
12    Annexure                                    109
13    Bibliography                                111




                        1. Executive Summary:
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                  SMC INVESMENT SOLUTIONS & SERVICES



Topic: -
“ Comprehensive Study of Derivative Products and Investors’ Perception of
Derivative products in Hubli City ”


Name of the Organization:- SMC Investment Solutions & Services, Hubli

Need for the study:-
        Financial Derivatives are quite new to the Indian Financial Market, but the
derivatives market has shown an immense potential which is visible by the growth it has
achieved in the recent past, In the present changing financial environment and an
increased exposure towards financial risks, It is of immense importance to have a good
working knowledge of Derivatives.
        The Derivatives market in Hubli is still in a budding stage, It is necessary to
understand the perception of investors in Hubli city and try to gather information
regarding the behaviour of investors towards Derivatives. So that, the company can
devise certain measures to improve the Derivatives market in Hubli city.



Objectives of the Study:-

To study the Investors perception of Derivatives products in Hubli city, and a detailed

study of Derivative products.



Sub Objectives:
      To study the trading procedures for Derivative products
      To study the features of Derivatives products such as Futures and Options.
      To study the clearing and settlement procedure of Derivatives products
      To know the awareness and perception of Derivative products in Hubli city.




Methodology:-

BABASAB PATIL                                                                        3
                      SMC INVESMENT SOLUTIONS & SERVICES


Methodology explains the methods used in collecting         information to carry out the
project.

      Data collection method
       Primary data as well as secondary data is used to collect the information.
      Primary data
       Information will be gathered through questionnaires and discussion with the
       employees of SMC investment solutions & Services Hubli.
      Secondary data

  Secondary data will be collected from the various books on

      Derivatives,

          Journals

          Magazines and Internet.




                                     10. FINDINGS:

   1. Futures market facilitates for buying and selling futures contracts, which state the
       price per unit, type, value, quality and quantity of the commodity in question, as
       well as the month the contract expires.
BABASAB PATIL                                                                           4
                 SMC INVESMENT SOLUTIONS & SERVICES


  2. Futures accounts are credited or debited daily depending on profits or losses
     incurred. The futures market is also characterized as being highly leveraged due
     to its margins; although leverage works as a double-edged sword.
  3. “Going long,” “going short,” and “spreads” are the most common strategies used
     when trading on the futures market.
  4. Investors use options both to speculate and hedge risk.
  5. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh,
     27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs.
  6. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds
     and Shares.
  7. 53% of the respondents are aware of derivatives.
  8. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e.,
     43% of them are unaware. As you can see the good awareness level among the
     investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by
     the company and create awareness about derivatives.
  9. People above the age of 50 years are unaware of derivatives. They are fond of
     traditional investment instruments.
  10. People above the age of 50 years are unaware of derivatives. They are fond of
     traditional investment instruments.
  11. 37 respondents are aware of Futures and 40 are aware of Options.
  12. The main factors considered while investing in derivatives are risk[20], return
     [24] and volatility [08].




  13. Out of 26 people who have invested in derivatives, only 9 of them are considering
     the risk factor. This means that they perceive derivatives as less risky.
  14. Out of 26 people who have invested their money in derivatives, ALL of them
     consider the return factor. This means that derivatives give good returns, as per
     their experience.

BABASAB PATIL                                                                         5
                 SMC INVESMENT SOLUTIONS & SERVICES


  15. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor
     which is the most important influencer in derivative segment in the market. The
     investors perceive derivatives as volatile investments.
  16. Lot sizes and margins are affecting the investment decisions of the investors to a
     large extent. Lot sizes also determine the decisions of the investors to a large
     extent.
  17. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives.
     And out of them 26 are already the investors. This shows that derivatives are not
     known to approximately about 50% of the people in Hubli
  18. Awareness of derivatives and investing in is positively correlated. This means that
     if there is increase in the number of people being aware of derivatives, the flow of
     investments in derivatives will also be more. Awareness is directly associated
     with investments in derivatives.
  19. The association of risk factor and investing in derivatives is very meager. This
     means that increase in risk does not affect investing in derivatives to a greater
     extent. Investors perceive derivatives as less risky.
  20. Actually derivatives are considered highly volatile. The volatility in the market
     directly affects the price of derivatives. The correlation between volatility and
     investing in derivatives is 0.393 which is again less but it is positive. This
     indicates that an increase in volatility affects the investing in derivatives to some
     considerable extent.
  21. 60 respondents said that they are interested to invest through SMC Investment
     Solutions & Services
                            SUGGESTIONS

  1. The awareness about derivatives among investors should be increased by
     conducting various awareness and educational programs.
  2. The company can conduct seminars to promote their services along with
     educating them about the products they offer. Initially they can start off with
     existing demat account holders.
BABASAB PATIL                                                                            6
                  SMC INVESMENT SOLUTIONS & SERVICES


   3. The company can think of tapping the existing demat account holders and provide
       them enough information on derivatives and enable them to trade in the same.
       This will help the company to increase its earnings of brokerage income.
   4. The company has to create and maintain a database of prospective customers from
       time to time, to keep track of the people falling in different income levels and
       their investing patterns. This is possible if continuous contacts are maintained
       with the customers.
   5. There is a widespread lack of awareness about the role and technique of futures
       trading among the potential beneficiaries. Only traditional players who have been
       participating in such trading either in the formal markets or gray markets are
       conversant with the intricacies of forward trading. These players are willing to
       participate in the trade only in regulated or liberal regulatory environment. The
       approach should be first, to bring these traditional players to the formal market
       and allow the Derivative markets to garner minimum critical liquidity.




                      INDIAN ECONOMY OVERVIEW

       India's economy is on the fulcrum of an ever-increasing growth curve. With
positive indicators such as a stable 8-9 per cent annual growth, rising foreign exchange
reserves of close to US$ 180 billion, a booming capital market with the popular "Sensex"
index topping the majestic 18,000 mark, the Government estimating FDI flow of US$ 12


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billion in this fiscal, and a more than 35 per cent surge in exports, it is easy to understand
why India is a leading destination for foreign investment.

      The economy has grown by 8.9 per cent for the April-July quarter of ’06-07, the
       highest first-quarter growth rate since '00-01.
      The growth rate has been spurred by the manufacturing sector, which has logged
       an 11.3 per cent rise in Q1 ’06-07, according to the GDP data released by the
       Central Statistical Organization. It was 10.7 per cent in the corresponding period
       of the last fiscal year. The GDP numbers come just weeks after the monthly IIP
       growth figures have touched 12.4 per cent.
      Other propellers of GDP growth for the first quarter this fiscal have been the
       trade, hotels, transport and communications sector which grew by 9.5 per cent and
       construction, which grew by 13.2 per cent. In the corresponding period of last
       fiscal, these sectors grew by 11.7 per cent and 12.4 per cent, respectively.
      There has been exceptional growth rate in some specific industries, like
       commercial vehicles at 36 per cent, telephone connections, by 48.9 per cent and
       passenger growth in civil aviation by 32.2 per cent.

   With its manufacturing and services sector on a searing growth path, India’s economy
may soon touch the coveted 10 per cent growth figure.




                          COMPANY OVERVIEW

   SMC Global is one of the largest and most reputed Investment Solutions Company
that provides a wide range of services to its substantial and diversified client base.
Founded in 1990, by Mr. Subhash Chand Aggarwal and Mr. Mahesh Chand Gupta, SMC,
is a full financial services firm catering to all classes of investors. The company is having

BABASAB PATIL                                                                               8
                    SMC INVESMENT SOLUTIONS & SERVICES


its corporate office in New Delhi with regional offices in Mumbai, Kolkata, Chennai,
Ahemdabad, Cochin, Hyderabad, Jaipur plus a growing network of more than 1150
offices across over 300 cities/towns in India and overseas office in Dubai.

   SMC acquired membership of the Delhi Stock Exchange in 1990 and later in 1995
became a trading member of NSE. In 2000 the company became a member of BSE and a
depository participant of CDSL India Ltd. In the same year, the company acquired the
Trading & Clearing Membership of NSE Derivatives and the memberships of leading
commodity exchanges i.e. NCDEX and MCX in subsequent years. In 2006, SMC
expanded globally and acquired the Trading & Clearing Membership of Dubai Gold and
Commodity Exchange (DGCX). In the same year, the company also started its Insurance
Broking division, IPO & Mutual Fund Distribution Division and its Merchant Banking
division

PRODUCTS AND SERVICES

Equity & Derivative Trading

SMC Trading Platform offers online equity & derivative trading facilities for investors
who are looking for the ease and convenience and hassle free trading experience. We
provide ODIN Application, which is a high -end, integrated trading application for fast,
efficient and reliable execution of trades. You can now trade in the NSE and BSE
simultaneously from any destination at your convenience. You can access a multitude of
resources like live quotes, charts, research, advice, and online assistance helps you to take
informed decisions. You can also trade through our branch network by registering with us
as our client. You can also trade through us on phone by calling our designated
representatives in the branches where you are registered as a client.


Clearing Services
Being a clearing member in NSE (derivative) segment we are clearing massive volumes
of trades of our trading members in this segment.

BABASAB PATIL                                                                              9
                   SMC INVESMENT SOLUTIONS & SERVICES




Commodity Trading
SMC is a member of two major national level commodity exchanges, i.e National
Commodity and Derivative Exchange and Multi Commodity Exchange and offers you
trading platform of NCDEX and MCX. You can get Real-Time streaming quotes, place
orders and watch the confirmation, all on a single screen. We use technology using ODIN
application to provide you with live Trading Terminals. In this segment, we have spread
our wings globally by acquiring Membership of Dubai Gold and Commodities Exchange.
We provide trading platform to trade in DGCX and also clear trades of trading members
being a clearing member.


Distribution of Mutual Funds & IPO’s
SMC offers distribution and collection services of various schemes of all Major Fund
houses and IPO’s through its mammoth network of branches across India . We are
registered with AMFI as an approved distributor of Mutual Funds. We assure you a
hassle free and pleasant transaction experience when you invest in mutual funds and
IPO’s through us. We are registered with all major Fund Houses including Fidelity,
Franklyn Templeton etc. We have a distinction of being leading distributors of
IPOs.Shortly we will be providing the facility of online investment in Mutual Funds and
IPO’s


Online back office support
To provide robust back office support backed by excellent accounting standards to our
branches we have ensured connectivity through FTP and Dotnet based Application. To
ensure easy accessibility to back office accounting reports to our clients, we have offered
facilities to view various user-friendly, easily comprehendible back office reports using
the link My SMC Account.


SMC Depository

BABASAB PATIL                                                                           10
                   SMC INVESMENT SOLUTIONS & SERVICES


We are ISO 9001:2000 certified DP for shares and commodities. We are one of the
leading DP and enjoy the trust of more than 40,000 investors. We offer a quick, secure
and hassle free alternative to holding the securities and commodities in physical form.
We are one of the few Depository Participants offering depository facilities for
commodities. We are empanelled with both NCDEX & MCX.


SMC Research Based Advisory Services
Our massive R&D facility caters to the need of Investors, who are continuously in need
of opportunities for striking rich rewards on their investment. We have one of the most
advanced, hitech in-house R&D wing with some of the best people, process and
technology resources providing complete research solutions on Equity, Commodities,
IPO’s and Mutual Funds. We offer proactive and timely world class research based
advice and guidance to our clients so that they can take informed decisions. Click on
Research to unveil the treasure.




                                      Derivatives
5.1 INTRODUCTION:
       BSE created history on June 9, 2000 by launching the first Exchange traded Index
Derivative Contract i.e. futures on the capital market benchmark index - the BSE Sensex.
The inauguration of trading was done by Prof. J.R. Varma, member of SEBI and
chairman of the committee responsible for formulation of risk containment measures for
the Derivatives market. The first historical trade of 5 contracts of June series was done on


BABASAB PATIL                                                                            11
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June 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik Securities Pvt. Ltd. and M/s
Emkay Share and Stock Brokers Ltd. at the rate of 4755.


       In the sequence of product innovation, the exchange commenced trading in Index
Options on Sensex on June 1, 2001. Stock options were introduced on 31 stocks on July
9, 2001 and single stock futures were launched on November 9, 2002.


       September 13, 2004 marked another milestone in the history of Indian Capital
Markets, the day on which the Bombay Stock Exchange launched Weekly Options, a
unique product unparallel in derivatives markets, both domestic and international. BSE
permitted trading in weekly contracts in options in the shares of four leading companies
namely Reliance, Satyam, State Bank of India, and Tisco in addition to the flagship
index-Sensex.




Indian scenario
                             Indian derivatives markets
   1. Rise of Derivatives
   The global economic order that emerged after World War II was a system where
many less developed countries administered prices and centrally allocated resources.
Even the developed economies operated under the Bretton Woods system of fixed
exchange rates. The system of fixed prices came under stress from the 1970s onwards.
High inflation and unemployment rates made interest rates more volatile. The Bretton
Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less

BABASAB PATIL                                                                        12
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developed countries like India began opening up their economies and allowing prices to
vary with market conditions.
    Price fluctuations make it hard for businesses to estimate their future production costs
and revenues. Derivative securities provide them a valuable set of tools for managing this
risk.


2. Definition and Uses of Derivatives
        A derivative security is a financial contract whose value is derived from the value
of something else, such as a stock price, a commodity price, an exchange rate, an interest
rate, or even an index of prices. Some simple types of derivatives: forwards, futures,
options and swaps.
        Derivatives may be traded for a variety of reasons. A derivative enables a trader
to hedge some preexisting risk by taking positions in derivatives markets that offset
potential losses in the underlying or spot market. In India, most derivatives users describe
themselves as hedgers and Indian laws generally require that derivatives be used for
hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking
positions to profit from anticipated price movements). In practice, it may be difficult to
distinguish whether a particular trade was for hedging or speculation, and active markets
require the participation of both hedgers and speculators. A third type of trader, called
arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices,
and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’s
long history in arbitrage trading, with line operators and traders arbitraging prices
between exchanges located in different cities, and between two exchanges in the same
city. Their study of Indian equity derivatives markets in 2002 indicates that markets were
inefficient at that time. They argue that lack of knowledge, market frictions and
regulatory impediments have led to low levels of capital employed.
        Price volatility may reflect changes in the underlying demand and supply
conditions and thereby provide useful information about the market. Thus, economists do
not view volatility as necessarily harmful.

BABASAB PATIL                                                                            13
                   SMC INVESMENT SOLUTIONS & SERVICES


       Speculators face the risk of losing money from their derivatives trades, as they do
with other securities. There have been some well-publicized cases of large losses from
derivatives trading. In some instances, these losses stemmed from fraudulent behavior
that went undetected partly because companies did not have adequate risk management
systems in place. In other cases, users failed to understand why and how they were taking
positions in the derivatives.
       Derivatives in arbitrage trading in India. However, more recent evidence suggests
that the efficiency of Indian equity derivatives markets may have improved.


3. Exchange-Traded and Over-the-Counter Derivative Instruments
       OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally
negotiated between two parties. The terms of an OTC contract are flexible, and are often
customized to fit the specific requirements of the user. OTC contracts have substantial
credit risk, which is the risk that the counterparty that owes money defaults on the
payment. In India, OTC derivatives are generally prohibited with some exceptions: those
that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of
commodities (which are regulated by the Forward Markets Commission), those that trade
informally in “havala” or forwards markets.
       An exchange-traded contract, such as a futures contract, has a standardized format
that specifies the underlying asset to be delivered, the size of the contract, and the
logistics of delivery. They trade on organized exchanges with prices determined by the
interaction of many buyers and sellers. In India, two exchanges offer derivatives trading:
the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However,
NSE now accounts for virtually all exchange-traded derivatives in India, accounting for
more than 99% of volume in 2003-2004. Contract performance is guaranteed by a
clearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements and
daily marking-to-market of futures positions substantially reduce the credit risk of
exchange traded contracts, relative to OTC contracts.



BABASAB PATIL                                                                          14
                   SMC INVESMENT SOLUTIONS & SERVICES


4. Development of Derivative Markets in India
       Derivatives markets have been in existence in India in some form or other for a
long time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading in 1875 and, by the early 1900s India had one of the world’s largest
futures industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
       In the equity markets, a system of trading called “badla” involving some elements
of forwards trading had been in existence for decades. However, the system led to a
number of undesirable practices and it was prohibited off and on till the Securities and a
clearinghouse guarantees performance of a contract by becoming buyer to every seller
and seller to every buyer.
       Customers post margin (security) deposits with brokers to ensure that they can
cover a specified loss on the position. A futures position is marked-to-market by realizing
any trading losses in cash on the day they occur.
       “Badla” allowed investors to trade single stocks on margin and to carry forward
positions to the next settlement cycle. Earlier, it was possible to carry forward a position
indefinitely but later the maximum carry forward period was 90 days. Unlike a futures or
options, however, in a “badla” trade there is no fixed expiration date, and contract terms
and margin requirements are not standardized.
       Securities Exchange Board of India (SEBI) banned it for good in 2001. A series
of reforms of the stock market between 1993 and 1996 paved the way for the
development of exchange traded equity derivatives markets in India. In 1993, the
government created the NSE in collaboration with state-owned financial institutions.
NSE improved the efficiency and transparency of the stock markets by offering a fully
automated screen-based trading system and real-time price dissemination. In 1995, a

BABASAB PATIL                                                                            15
                   SMC INVESMENT SOLUTIONS & SERVICES


prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for
listing exchange-traded derivatives.
       The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the
J. R. Varma Committee in 1998, worked out various operational details such as the
margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared “securities.” This allowed
the regulatory fMr.Xework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges.
       Finally, a 30-year ban on forward trading was also lifted in 1999. The economic
liberalization of the early nineties facilitated the introduction of derivatives based on
interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible
on current account. These reforms allowed increased integration between domestic and
international markets, and created a need to manage currency risk.


5. Derivatives Users in India
       The use of derivatives varies by type of institution. Financial institutions, such as
banks, have assets and liabilities of different maturities and in different currencies, and
are exposed to different risks of default from their borrowers. Thus, they are likely to use
derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-
financial institutions are regulated differently from financial institutions, and this affects
their incentives to use derivatives. Indian insurance regulators, for example, are yet to
issue guidelines relating to the use of derivatives by insurance companies.


       In India, financial institutions have not been heavy users of exchange-traded
derivatives so far, with their contribution to total value of NSE trades being less than 8%
in October 2005. However, market insiders feel that this may be changing, as indicated

BABASAB PATIL                                                                              16
                    SMC INVESMENT SOLUTIONS & SERVICES


by the growing share of index derivatives (which are used more by institutions than by
retail investors). In contrast to the exchange-traded markets, domestic financial
institutions and mutual funds have shown great interest in OTC fixed income
instruments. Transactions between banks dominate the market for interest rate
derivatives, while state-owned banks remain a small presence. Corporations are active in
the currency forwards and swaps markets, buying these instruments from banks.


Why do institutions not participate to a greater extent in derivatives markets?
        Some institutions such as banks and mutual funds are only allowed to use
derivatives to hedge their existing positions in the spot market, or to rebalance their
existing portfolios. Since banks have little exposure to equity markets due to banking
regulations, they have little incentive to trade equity derivatives. Foreign investors must
register as foreign institutional investors (FII) to trade exchange-traded derivatives, and
be subject to position limits as specified by SEBI. Alternatively, they can incorporate
locally as under RBI directive, banks’ direct or indirect (through mutual funds) exposure
to capital markets instruments is limited to 5% of total outstanding advances as of the
previous year-end. Some banks may have further equity exposure on account of equities
collaterals held against loans in default.
        FIIs have a small but increasing presence in the equity derivatives markets. They
have no incentive to trade interest rate derivatives since they have little investments in the
domestic bond markets. It is possible that unregistered foreign investors and hedge funds
trade indirectly, using a local proprietary trader as a front.
        Retail investors (including small brokerages trading for themselves) are the major
participants in equity derivatives, accounting for about 60% of turnover in October 2005,
according to NSE. The success of single stock futures in India is unique, as this
instrument has generally failed in most other countries. One reason for this success may
be retail investors’ prior familiarity with “badla” trades which shared some features of
derivatives trading. Another reason may be the small size of the futures contracts,
compared to similar contracts in other countries. Retail investors also dominate the

BABASAB PATIL                                                                              17
                   SMC INVESMENT SOLUTIONS & SERVICES


markets for commodity derivatives, due in part to their long-standing expertise in trading
in the “havala” or forwards markets.


Why have derivatives?
       Derivatives have become very important in the field finance. They are very
important financial instruments for risk management as they allow risks to be separated
and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of
risk means that each party involved in the contract should be able to identify all the risks
involved before the contract is agreed. It is also important to remember that derivatives
are derived from an underlying asset. This means that risks in trading derivatives may
change depending on what happens to the underlying asset.
       A derivative is a product whose value is derived from the value of an underlying
asset, index or reference rate. The underlying asset can be equity, forex, commodity or
any other asset. For example, if the settlement price of a derivative is based on the stock
price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the
derivative risks are also changing on a daily basis. This means that derivative risks and
positions must be monitored constantly.


Why Derivatives are preferred?
Retail investors will find the index derivatives useful due to the high correlation of the
index with their portfolio/stock and low cost associated with using index futures for
hedging.


Looking Ahead
       Clearly, the nascent derivatives market is heading in the right direction. In terms
of the number of contracts in single stock derivatives, it is probably the largest market
globally. It is no longer a market that can be ignored by any serious participant. With
institutional participation set to increase and a broader product rollout inevitable, the
market can only widen and deepen further.

BABASAB PATIL                                                                            18
                   SMC INVESMENT SOLUTIONS & SERVICES




How does F&O trading impact the market?
         The start of a new derivatives contract pushes up prices in the cash market as
operators take fresh positions in the new month series in the first week of every new
contract. This buying in the derivatives segment pushes up future prices. Higher future
prices are seen as indicators of bullish prices in the days to come. Thus, higher prices
due to new month buying in the derivatives market lead to buying in the physical market.
This lifts prices in the cash market as well.




                              FUTURES CONTRACT:

         A futures contract is similar to a forward contract in terms of its working. The
difference is that contracts are standardized and trading is centralized. Futures markets
are highly liquid and there is no counterparty risk due to the presence of a clearinghouse,
which becomes the counterparty to both sides of each transaction and guarantees the
trade.

What is an Index?

         To understand the use and functioning of the index derivatives markets, it is
necessary to understand the underlying index. A stock index represents the change in
value of a set of stocks, which constitute the index. A market index is very important for
the market players as it acts as a barometer for market behavior and as an underlying in
derivative instruments such as index futures.

The Sensex and Nifty

         In India the most popular indices have been the BSE Sensex and S&P CNX Nifty.
The BSE Sensex has 30 stocks comprising the index, which are selected based on market
capitalization, industry representation, trading frequency etc. It represents 30 large well-

BABASAB PATIL                                                                            19
                   SMC INVESMENT SOLUTIONS & SERVICES


established and financially sound companies. The Sensex represents a broad spectrum of
companies in a variety of industries. It represents 14 major industry groups. Then there is
a BSE national index and BSE 200. However, trading in index futures has only
commenced on the BSE Sensex.

       While the BSE Sensex was the first stock market index in the country, Nifty was
launched by the National Stock Exchange in April 1996 taking the base of November 3,
1995. The Nifty index consists of shares of 50 companies with each having a market
capitalization of more than Rs 500 crore.

Futures and stock indices

       For understanding of stock index futures a thorough knowledge of the
composition of indexes is essential. Choosing the right index is important in choosing the
right contract for speculation or hedging. Since for speculation, the volatility of the index
is important whereas for hedging the choice of index depends upon the relationship
between the stocks being hedged and the characteristics of the index.

       Choosing and understanding the right index is important, as the movement of
stock index futures is quite similar to that of the underlying stock index. Volatility of the
futures indexes is generally greater than spot stock indexes.

       Every time an investor takes a long or short position on a stock, he also has an
hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the
entire market sentiment and rise when the market as a whole is rising.

       Retail investors will find the index derivatives useful due to the high correlation
of the index with their portfolio/stock and low cost associated with using index futures
for hedging.




BABASAB PATIL                                                                             20
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5.1 Understanding index futures

       A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Index futures are all futures contracts where
the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on
the market as a whole.

       Index futures permits speculation and if a trader anticipates a major rally in the
market he can simply buy a futures contract and hope for a price rise on the futures
contract when the rally occurs.

       In India we have index futures contracts based on S&P CNX Nifty and the BSE
Sensex and near 3 months duration contracts are available at all times. Each contract
expires on the last Thursday of the expiry month and simultaneously a new contract is
introduced for trading after expiry of a contract.

Example: Futures contracts in Nifty in January 2008

                           Contract month            Expiry/settlement
                             January 2008               January 31
                            February 2008               February 28
                              March 2008                 March 27


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 On January 27

                            Contract month          Expiry/settlement
                             February 2008             February 28
                              March 2008                March 27
                               April 2008               April 24




       The permitted lot size is 100 or multiples thereof for the Nifty. That is you buy
one Nifty contract the total deal value will be 100*1100 (Nifty value)= Rs 1,10,000.

       In the case of BSE Sensex the market lot is 50. That is you buy one Sensex
futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.



5.2 Hedging

       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:

       Mr.X enters into a contract with Mr.Y that six months from now he will sell to Y
10 dresses for Rs 4000. The cost of manufacturing for X 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, X fears that Y may not honour his contract six months from now. So he
inserts a new clause in the contract that if Y fails to honour the contract he will have to

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pay a penalty of Rs 1000. And if Y honours the contract X will offer a discount of Rs
1000 as incentive.




                           ‘Y’ defaults                  ‘Y’ honours

                     1000 (Initial Investment)        3000 (Initial profit)

                     1000 (penalty from Mr.Y)    (-1000) discount given to Mr.Y

                         - (No gain/loss)               2000 (Net gain)




       As we see above if Mr.Y defaults Mr.X will get a penalty of Rs 1000 but he will
recover his initial investment. If Mr.Y honours the contract, Mr.X will still make a profit
of Rs 2000. Thus, Mr.X has hedged his risk against default and protected his initial
investment.

       The 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 movement 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

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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.




         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 the 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 see the impact on the overall gain/loss that accrues:


                                                Index up 10%   Index down 10%

                     Gain/(Loss) in Portfolio    Rs 120,000     (Rs 120,000)

                     Gain/(Loss) in Futures     (Rs 120,000)     Rs 120,000

                           Net Effect               Nil             Nil


BABASAB PATIL                                                                            24
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       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 understand how one can use hedging in the futures market to offset
losses in the cash market.

5.3 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:

       Mr.X 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

BABASAB PATIL                                                                              25
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Less: Purchase Cost: 3600*100 = Rs.3,60,000

Net gain                           Rs.40,000

       Mr.X 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 it
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
atleast 3 months.

5.4 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.

   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 a
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
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purchase Wipro 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 kind 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.

5.5 Pricing of Index Futures

         The index futures are the most popular futures contracts as they can be used in a
variety of ways by various participants in the market.

         How many times have you felt of making risk-less profits by arbitraging between
the underlying and futures markets? If so, you need to know the cost-of-carry model to
understand the dynamics of pricing that constitute the estimation of fair value of futures.

1. The cost of carry model

The cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs
BABASAB PATIL                                                                             27
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       If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the
futures price moves away from the fair value, there would be chances for arbitrage.

       If Wipro is quoted at Rs.1000 per share and the 3 months futures of Wipro is
Rs.1070 then one can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for
3 months and sell Wipro futures for 3 months at Rs 1070.

       Here F=1000+30=1030 and is less than prevailing futures price and hence there
are chances of arbitrage.

Sale           = 1070

Cost= 1000+30 = 1030

Arbitrage profit       40

However, one has to remember that the components of holding cost vary with contracts
on different assets.




2. Futures pricing in case of dividend yield

       We have seen how we have to consider the cost of finance to arrive at the futures
index value. However, the cost of finance has to be adjusted for benefits of dividends and
interest income. In the case of equity futures, the holding cost is the cost of financing
minus the dividend returns.




Example:




BABASAB PATIL                                                                          28
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       Suppose a stock portfolio has a value of Rs.100 and has an annual dividend yield
of 3% which is earned throughout the year and finance rate=10% the fair value of the
stock index portfolio after one year will be F= Rs.100 + Rs.100 * (0.10 – 0.03)

Futures price = Rs 107

       If the actual futures price of one-year contract is Rs.109. An arbitrageur can buy
the stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sell futures
at Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for dividends, deliver
the stock portfolio at Rs.109 and repay the loan of Rs.100 and interest of Rs.10. The net
profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2. Thus, we can arrive at the fair
value in the case of dividend yield.




5.6 Trading strategies


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1. Speculation

       We have seen earlier that trading in index futures helps in taking a view of the
market, hedging, speculation and arbitrage. Now we will see how one can trade in index
futures and use forward contracts in each of these instances.

Taking a view of the market

Have you ever felt that the market would go down on a particular day and feared that
your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

       The problem in both the above cases is that it would be very cumbersome and
costly to sell all the stocks in the index. And in the process one could be vulnerable to
company specific risk. So what is the option? The best thing to do is to sell index futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expiry
date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

‘X’ makes a profit of Rs 15,600 (200*78)




BABASAB PATIL                                                                             30
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Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expiry
date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of
profiting from an anticipated price change.

2. Hedging

          Stock index futures contracts offer investors, portfolio managers, mutual funds etc
several ways to control risk. The total risk is measured by the variance or standard
deviation of its return distribution. A common measure of a stock market risk is the
stock’s Beta. The Beta of stocks are available on the www.nseindia.com.

          While hedging the cash position one needs to determine the number of futures
contracts to be entered to reduce the risk to the minimum.

          Have you ever felt that a stock was intrinsically undervalued? That the profits and
the quality of the company made it worth a lot more as compared with what the market
thinks?

          Have you ever been a ‘stock picker’ and carefully purchased a stock based on a
sense that it was worth more than the market price?

          A person who feels like this takes a long position on the cash market. When doing
this, he faces two kinds of risks:



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a. His understanding can be wrong, and the company is really not worth more than the
market price or

b. The entire market moves against him and generates losses even though the underlying
idea was correct.

       Everyone has to remember that every buy position on a stock is simultaneously a
buy position on Nifty. A long position is not a focused play on the valuation of a stock. It
carries a long Nifty position along with it, as incidental baggage i.e. a part long position
of Nifty.

Let us see how one can hedge positions using index futures:

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the
beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is
ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666
Nifty futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both
positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short
position on Nifty gains Rs 59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.




Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The
portfolio is to be hedged by using Nifty futures contracts. To find out the number of


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contracts in futures market to neutralise risk . If the index is at 1200 * 200 (market lot) =
Rs 2,40,000, The number of contracts to be sold is:

   a. 1.19*10 crore = 496 contracts

       2,40,000

If you sell more than 496 contracts you are overhedged and sell less than 496 contracts
you are underhedged.

Thus, we have seen how one can hedge their portfolio against market risk.

3. Margins

       The margining system is based on the JR Verma Committee recommendations.
The actual margining happens on a daily basis while online position monitoring is done
on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

       The computation of initial margin on the futures market is done using the concept
of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day
loss that can be encountered on 99% of the days. VaR methodology seeks to measure the
amount of value that a portfolio may stand to lose within a certain horizon time period
(one day for the clearing corporation) due to potential changes in the underlying asset
market price. Initial margin amount computed using VaR is collected up-front. The daily
settlement process called "mark-to-market" provides for collection of losses that have
already occurred (historic losses) whereas initial margin seeks to safeguard against
potential losses on outstanding positions. The mark-to-market settlement is done in cash.
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Let us take a hypothetical trading activity of a client of a NSE futures division to
demonstrate the margins payments that would occur.

        A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.
        The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as
follows:

Position on Day 1

       Close Price            Loss          Margin released    Net cash outflow
 1400*200 =2,80,000     20,000 (3,00,000-    3,000 (45,000-   17,000 (20,000-3000)
                           2,80,000)            42,000)

 Payment to be made                                                 (17,000)


New position on Day 2

Value of new position = 1,400*200= 2,80,000

Margin = 42,000




       Close Price            Gain           Addn Margin        Net cash inflow

 1510*200 =3,02,000     22,000 (3,02,000-    3,300 (45,300-   18,700 (22,000-3300)
                           2,80,000)            42,000)

  Payment to be recd                                                18,700




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Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 3,300


                    Close Price            Gain               Net cash inflow
                     1600*200         18,000 (3,20,000-   18,000 + 45,300* = 63,300
                     =3,20,000           3,02,000)

                 Payment to be recd                                63,300


Margin account*

Initial margin               =     Rs 45,000

Margin released (Day 1) = (-) Rs 3,000

Position on Day 2                  Rs 42,000

Addn margin                = (+) Rs 3,300

Total margin in a/c                Rs 45,300*




Net gain/loss

Day 1 (loss)             =       (Rs 17,000)

Day 2 Gain                =       Rs 18,700

Day 3 Gain                =       Rs 18,000

Total Gain                =       Rs 19,700

BABASAB PATIL                                                                         35
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The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at
the close of trade is Rs 63,300.




5.7     Settlement of futures contracts:

       Futures contracts have two types of settlements, the MTM settlement which
happens on a continuous basis at the end of each day, and the final settlement which
happens on the last trading day of the futures contract.


1. MTM settlement:




BABASAB PATIL                                                                          36
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   All futures contracts for each member are marked-to-market(MTM) to the daily
settlement price of the relevant futures contract at the end of each day. The profits/losses
are computed as the difference between:


      The trade price and the day’s settlement price for contracts executed during the
       day but not squared up.
      The previous day’s settlement price and the current day’s settlement price for
       brought forward contracts.
      The buy price and the sell price for contracts executed during the day and squared
       up.


   The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount
in cash which is in turn passed on to the CMs who have made a MTM profit. This is
known as daily mark-to-market settlement. CMs are responsible to collect and settle the
daily MTM profits/losses incurred by the TMs and their clients clearing and settling
through them. Similarly, TMs are responsible to collect/pay losses/ profits from/to their
clients by the next day. The pay-in and pay-out of the mark-to-market settlement are
affected on the day following the trade day. In case a futures contract is not traded on a
day, or not traded during the last half hour, a ‘theoretical settlement price’ is computed.



2. Final settlement for futures
       On the expiry day of the futures contracts, after the close of trading hours,
NSCCL marks all positions of a CM to the final settlement price and the resulting
profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the
relevant CM’s clearing bank account on the day following expiry day of the contract.

       All trades in the futures market are cash settled on a T+1 basis and all positions
(buy/sell) which are not closed out will be marked-to-market. The closing price of the


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 index futures will be the daily settlement price and the position will be carried to the
 next day at the settlement price.

           The most common way of liquidating an open position is to execute an offsetting
 futures transaction by which the initial transaction is squared up. The initial buyer
 liquidates his long position by selling identical futures contract.

           In index futures the other way of settlement is cash settled at the final settlement.
 At the end of the contract period the difference between the contract value and closing
 index value is paid.

 How to read the futures data sheet?

           Understanding and deciphering the prices of futures trade is the first challenge for
 anyone planning to venture in futures trading. Economic dailies and exchange websites
 www.nseindia.com and www.bseindia.com are some of the sources where one can look
 for the daily quotes. Your website has a daily market commentary, which carries end of
 day derivatives summary along with the quotes.

           The first step is start tracking the end of day prices. Closing prices, Trading
 Volumes and Open Interest are the three primary data we carry with Index option quotes.
 The most important parameter are the actual prices, the high, low, open, close, last traded
 prices and the intra-day prices and to track them one has to have access to real time
 prices.

           The following table shows how futures data will be generally displayed in the
 business papers daily.


  Series           First   High   Low     Close    Volume (No of    Value      No of    Open interest
                   Trade                             contracts)          (Rs   trades      (No of
                                                                   in lakh)              contracts)
BSXJUN2000         4755    4820   4740    4783.1        146        348.70       104          51

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BSXJUL2000         4900    4900   4800    4830.8          12        28.98        10       2

BSXAUG2000         4800    4870   4800    4835             2         4.84        2        1

   Total                                                  160       38252       116      54


 Source: BSE

          The first column explains the series that is being traded. For e.g. BSXJUN2000
           stands for the June Sensex futures contract.

          The column on volume indicates that (in case of June series) 146 contracts have
           been traded in 104 trades.

          One contract is equivalent to 50 times the price of the futures, which are traded.
           For e.g. In case of the June series above, the first trade at 4755 represents one
           contract valued at 4755 x 50 i.e. Rs.2,37,750/-.

     Open interest indicates the total gross outstanding open positions in the market for
 that particular series. For e.g. Open interest in the June series is 51 contracts.




           The most useful measure of market activity is Open interest, which is also
 published by exchanges and used for technical analysis. Open interest indicates the
 liquidity of a market and is the total number of contracts, which are still
 outstanding in a futures market for a specified futures contract.

     A futures contract is formed when a buyer and a seller take opposite positions in a
 transaction. This means that the buyer goes long and the seller goes short. Open interest
 is calculated by looking at either the total number of outstanding long or short positions –
 not both.




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   Open interest is therefore a measure of contracts that have not been matched and
closed out. The number of open long contracts must equal exactly the number of open
short contracts.


      Action                                          Resulting open interest

      New buyer (long) and new seller (short)                 Rise
      Trade to form a new contract.

      Existing buyer sells and existing seller buys           Fall
      –The old contract is closed.

      New buyer buys from existing buyer. The No change – there is no increase in long
      Existing buyer closes his position by selling contracts being held
      to new buyer.

      Existing seller buys from new seller. The No change – there is no increase in short
      Existing seller closes his position by buying contracts being held
      from new seller.




       Open interest is also used in conjunction with other technical analysis chart
patterns and indicators to gauge market signals. The following chart may help with these
signals.


                         Price        Open interest               Market
                                                                     Strong

                                                              Warning signal

                                                                     Weak

                                                              Warning signal


The warning sign indicates that the Open interest is not supporting the price direction.
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                               7. OPTIONS

6.1 What is an Option?
       An option is a contract giving the buyer the right, but not the obligation, to buy or
sell an underlying asset (a stock or index) at a specific price on or before a certain date
(listed options are all for 100 shares of the particular underlying asset).
       An option is a security, just like a stock or bond, and constitutes a binding
contract with strictly defined terms and properties.
Listed options have been available since 1973, when the Chicago Board Options
Exchange, still the busiest options exchange in the world, first opened.


The World With and Without Options


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        Prior to the founding of the CBOE, investors had few choices of where to invest
their money; they could either be long or short individual stocks, or they could purchase
treasury securities or other bonds.
                     Once the CBOE opened, the listed option industry began, and
investors now had a world of investment choices previously unavailable.

Options vs. Stocks

        In order to better understand the benefits of trading options, one must first
understand some of the similarities and differences between options and stocks.


Similarities:
  Listed Options are securities, just like stocks.
  Options trade like stocks, with buyers making bids and sellers making offers.
  Options are actively traded in a listed market, just like stocks. They can be bought and
  sold just like any other security.


Differences:
  Options are derivatives, unlike stocks (i.e, options derive their value from
  something else, the underlying security).
  Options have expiration dates, while stocks do not.
  There is not a fixed number of options, as there are with stock shares available.
  Stockowners have a share of the company, with voting and dividend rights. Options
  convey no such rights.
Options Premiums
        In this case, XYZ represents the option class while May 30 is the option series.
All options on company XYZ are in the XYZ option class but there will be many
different series.
        An option Premium is the price of the option. It is the price you pay to purchase
the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ

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stock) may have an option premium of $2. This means that this option costs $200.00.
Why? Because most listed options are for 100 shares of stock, and all equity option prices
are quoted on a per share basis, so they need to be multiplied times 100. More in-depth
pricing concepts will be covered in detail in other sections of the course.




Strike Price
       The Strike (or Exercise) Price is the price at which the underlying security (in this
case, XYZ) can be bought or sold as specified in the option contract. For example, with
the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per
share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock
at $30 per share.
       The strike price also helps to identify whether an option is In-the-Money, At-the-
Money, or Out-of-the-Money when compared to the price of the underlying security. You
will learn about these terms in another section of the course.




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Exercising Options
         People who buy options have a Right, and that is the right to Exercise.
For a Call Exercise, Call holders may buy stock at the strike price (from the Call seller).
For a Put Exercise, Put holders may sell stock at the strike price (to the Put seller).
Neither Call holders nor Put holders are obligated to buy or sell; they simply have the
rights to do so, and may choose to Exercise or not to Exercise based upon their own
logic.




6.2 The Chicago Board Options Exchange
         The Chicago Board Options Exchange, or CBOE, was the world's first listed
options exchange, opened in 1973 by members of the Chicago Board of Trade. Almost
half of all listed options trades still occur on CBOE.

NOTE: Options also trade now on several smaller exchanges, including the American
Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), the Pacific Stock
Exchange (PSE) and the International Securities Exchange (ISE).


BABASAB PATIL                                                                           44
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CBOE: The Competitive Advantage
       With over 1500 competing market makers trading more than one million options
contracts per day, the CBOE is the largest and busiest options exchange in the world.

       The members of the Exchange have maintained this stature for over 25 years by
constantly providing deep and liquid markets in all options series for all CBOE
customers.

CBOE Facts
       The CBOE system works to give you the options you need for your investment
strategy, quickly and easily and at the most efficient price. The CBOE offers investors
the best options markets, the most efficient support network, and the most intensive
insight and most recognized educational division in the industry, the Options Institute.




6.3 Regulation and Surveillance:
       Regulation and surveillance are necessary in the options industry in order to
protect customers and firms, and respond to customer complaints.

       CBOE has one of the most technologically advanced and computer-automated
measures for regulation and surveillance, which are unparalleled in the options industry.
CBOE has the premier Regulatory Division, with staff who constantly monitor trading
activity throughout the industry.

       The Securities and Exchange Commission (SEC) oversees the entire options
industry to ensure that the markets serve the public interest.
BABASAB PATIL                                                                              45
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6.4 Options Clearing Corporation:
       The formation of the OCC in 1973 as the single, independent, universal clearing
agency for all listed options eliminated the problem of credit risk in options trading.
Every options Exchange and every brokerage firm who offers its customers the ability to
trade options is a member or is associated with a member of the OCC.

       The OCC stands in the middle of each trade becoming the buyer for all contracts
that are sold, and the seller for all contracts that are bought. Thus, the OCC is, in fact, the
issuer of all listed options contracts, and is registered as such with the SEC.




6.5 Options Market Participants
   Contrary to some beliefs, the single greatest population of CBOE users are not huge
financial institutions, but public investors, just like you. Over 65% of the Exchange's
business comes from them.




   However, other participants in the financial marketplace also use options to enhance
their performance, including:
      Mutual Funds
      Pension Plans
      Hedge Funds
      Endowments
      Corporate Treasurers

   Stock markets by their very nature are fickle. While fortunes can be made in a jiffy
more often than not the scenario is the reverse. Investing in stocks has two sides to it –a)
Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) a
downside which could make you a pauper.

BABASAB PATIL                                                                               46
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   Derivative products are structured precisely for this reason -- to curtail the risk
exposure of an investor. Index futures and stock options are instruments that enable you
to hedge your portfolio or open positions in the market. Option contracts allow you to run
your profits while restricting your downside risk.

   Apart from risk containment, options can be used for speculation and investors can
create a wide range of potential profit scenarios.

   ‘Option’, as the word suggests, is a choice given to the investor to either honour the
contract; or if he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.




6.6 Call options

       Call options give the taker the right, but not the obligation, to buy the underlying
shares at a predetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

       This contract allows Raj to buy 100 shares of SATCOM 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). The buyer of a call has purchased the
right to buy and for that he pays a premium.




BABASAB PATIL                                                                           47
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Now let us see how one can profit from buying an option.

       Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is
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 understand the
concept better.

Nifty is at 1310. The following are Nifty options traded at following quotes.


                  Option contract   Strike price            Call premium
                  Dec Nifty         1325                    Rs.6,000

                                    1345                    Rs.2,000



                  Jan Nifty         1325                    Rs.4,500

                                    1345                    Rs.5000


       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/-.


BABASAB PATIL                                                                          48
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        In Jan 2002 the Nifty index goes up to 1365. He sells the options or 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.

Call Options-Long and Short Positions

        When you expect prices to rise, then you take a long position by buying calls.
You are bullish. When you expect prices to fall, then you take a short position by selling
calls. You are bearish.




6.7 Put Options :
        A Put Option gives the holder of the right to sell a specific number of shares of
an agreed security at a fixed price for a period of time. eg: Sam purchases 1 INFTEC
(Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows Sam to sell
100 shares INFTEC at Rs 3500 per share at any time between the current date and the
end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share
for 100 shares).

        The buyer of a put has purchased a right to sell. The owner of a put option has the
right to sell.

Illustration 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

BABASAB PATIL                                                                              49
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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.




Illustration 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/-. 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. Jan Spot price of Wipro = 1080

BABASAB PATIL                                                                             50
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       In the first situation the investor is having the right to sell 1000 Wipro shares at
Rs.1,070/- the price of which is Rs.1020/-. By exercising the option he earns Rs.(1070-
1020) = Rs 50 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 looses the premium paid Rs 30,000.




Put Options-Long and Short Positions

       When you expect prices to fall, then you take a long position by buying Puts. You
are bearish. When you expect prices to rise, then you take a short position by selling
Puts. You are bullish.




                                                  CALL OPTIONS           PUT OPTIONS

        If you expect a fall in price(Bearish)    Short                  Long

        If you expect a rise in price (Bullish)   Long                   Short


SUMMARY:

      CALL 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                    Profits   from    falling   prices   or
              Limited losses, Potentially unlimited          remaining neutral
               gain                                          Potentially unlimited losses, limited
                                                              gain


BABASAB PATIL                                                                                           51
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      PUT OPTION BUYER                                PUT OPTION WRITER (Seller)

             Pays premium                                  Receives premium
             Right to exercise and sell shares             Obligation to buy shares if exercised
             Profits from falling prices                   Profits   from   rising   prices   or
             Limited losses, Potentially unlimited          remaining neutral
              gain                                          Potentially unlimited losses, limited
                                                             gain




6.8 Option styles

       Settlement of options is based on the expiry date. However, there are three basic
styles of options you will encounter which affect settlement. The styles have
geographical names, which 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 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.

       eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will
settle the contract on the last Thursday of August. Since there are no shares for the
underlying, the contract is cash settled.

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". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12
BABASAB PATIL                                                                                        52
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          Here Sam can close the contract any time from the current date till the expiration
date, which is the last Thursday of September.

          American style options tend to be more expensive than European style because
they offer greater flexibility to the buyer.




6.9 Option Class and Series

          Generally, for each underlying, there are a number of options available: For this
reason, we have the terms "class" and "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.


      Calls                                       Puts
      .            JUL      AUG     SEP           JUL          AUG        SEP
      Wipro
      1300         45       60      75            15           20         28
      1400         35       45      65            25           28         35
      1500         20       42      48            30           40         55


eg: Wipro JUL 1300 refers to one series and trades take place at different
premiums


BABASAB PATIL                                                                            53
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       All calls are of the same option type. Similarly, all puts are of the same option
type. Options of the same type that are also in the same class are said to be of the same
class. Options of the same class and with the same exercise price and the same expiration
date are said to be of the same series




6.10   Pricing of options

       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

6.11 Review of Options Pricing Factors

1. 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
BABASAB PATIL                                                                          54
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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.

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.

The following chart summarizes the above for Calls and Puts.


                      Option          Underlying price        Premium cost

                       Call


                       Put



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.


BABASAB PATIL                                                                              55
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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.


                        Option           Time to expiry    Premium cost

                          Call


                          Put



3. Volatility

        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


          Option                 Volatility               Premium cost

          Call



BABASAB PATIL                                                                          56
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          Put




4. 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.


          Option                Interest rates          Premium cost

          Call


          Put




BABASAB PATIL                                                                             57
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6.12 STRATEGIES

1. Bull Market Strategies

a. Calls in a Bullish Strategy

        An investor with a bullish market outlook should buy call options. If you expect
the market price of the underlying asset to rise, then you would rather have the right to
purchase 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 of buying a call option is unlimited. The investor's
profit is the market price less the exercise price less the premium. The greater the
increase in price of the underlying, the greater the investor's profit.

BABASAB PATIL                                                                            58
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         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. He may
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 your call and increase your
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. As an option holder, your return will also increase.

A simple example will illustrate the above:

         Suppose there is a call option with a strike price of Rs.2000 and the option
premium is Rs.100. The option will be exercised only if the value of the underlying is
greater than Rs.2000 (the strike price). If the buyer exercises the call at Rs.2200 then his
gain will be Rs.200. However, this would not be his actual gain for that he will have to
deduct the Rs.200 (premium) he has paid.

The profit can be derived as follows

Profit       =      Market         price    -      Exercise      price      -      Premium
Profit       =      Market         price     –      Strike      price      –       Premium.
            2200 – 2000 – 100 = Rs.100

b. Puts in a Bullish Strategy

         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.

BABASAB PATIL                                                                             59
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        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.

        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.


BABASAB PATIL                                                                             60
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        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.




BABASAB PATIL                                                                           61
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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.

       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 a scrip is Rs.100 and you buy a November call
option with a strike price of Rs.90 and pay a premium of Rs.14. At the same time you sell
another November call option on a scrip with a strike price of Rs.110 and receive a
premium of Rs.4. Here you are 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 his profit potential as well as 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



BABASAB PATIL                                                                               62
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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.




BABASAB PATIL                                                                              63
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       To put on a bull spread, a trader sells the higher strike put and buys the lower
strike put. The 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.

       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 net premium. The investor achieves maximum profit i.e the premium received,
when the market price moves up beyond the higher exercise price (both puts are then
worthless).


BABASAB PATIL                                                                              64
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An example of a bullish put spread.

       Lets us assume that the cash price of the scrip is Rs.100. You now buy a
November put option on a scrip with a strike price of Rs.90 at a premium of Rs.5 and sell
a put option with a strike price of 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

Breakeven Price = Higher Strike price - Net premium income

                   = 110 - 10 = 100




2. Bear Market Strategies

a. Puts in a Bearish Strategy: When you purchase a put you are long and want the
market to fall. A put option is a bearish position. It will increase in value if the market

BABASAB PATIL                                                                            65
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falls. An investor with a bearish market outlook shall buy put options. 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.




BABASAB PATIL                                                                            66
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       An increase in volatility will increase the value of your put and increase your
return. An increase in volatility will make it more likely that the price of the underlying
instrument will move. This increases the value of the option.

b. 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.




BABASAB PATIL                                                                               67
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        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 your call and decrease your
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

        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. To put on a bear put spread you buy the higher strike put and sell the lower
strike put. You 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 market, while at
the same time limiting risk exposure.



BABASAB PATIL                                                                                68
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       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.

An example of a bearish put spread.




BABASAB PATIL                                                                             69
                   SMC INVESMENT SOLUTIONS & SERVICES


       Lets assume that the cash price of the scrip is Rs.100. You buy a November put
option on a 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 downside. If 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




Bearish Call Spread Strategies


BABASAB PATIL                                                                           70
                   SMC INVESMENT SOLUTIONS & SERVICES


       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: 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 call 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 the investor to participate to a limited extent in a bear market, while
at the same time limiting risk exposure.




BABASAB PATIL                                                                              71
                   SMC INVESMENT SOLUTIONS & SERVICES


       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.

       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. You now buy a November
call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call
option with a strike price of Rs 90 at a premium of Rs 15.

       In this spread you have 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 startegy. The final position is left with limited risk and



BABASAB PATIL                                                                            72
                  SMC INVESMENT SOLUTIONS & SERVICES


limited profit. The maximum profit, maximum loss and breakeven point of this spread
would be as follows:




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




BABASAB PATIL                                                                   73
                     SMC INVESMENT SOLUTIONS & SERVICES




6.13 Key Regulations
          In India we have two premier exchanges The National Stock Exchange of India
(NSE) and The Bombay Stock Exchange (BSE) which 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:

         Market type - N
         Instrument type - OPTSTK
         Underlying - Underlying security
         Expiry date - Date of contract expiry
         Option type - CA/PA


BABASAB PATIL                                                                              74
                   SMC INVESMENT SOLUTIONS & SERVICES


      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. (See Index futures learning centre for further reading)

Strike price intervals: The exchange shall provide a minimum of five strike prices for
every option type (i.e call and 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 required. In order to fix on the at-the-money strike price for
options 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.

BABASAB PATIL                                                                             75
                   SMC INVESMENT SOLUTIONS & SERVICES


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.

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 to the exchange that there is no inadvertent error in
the order entry and that the order is genuine. On such confirmation, the exchange at its
discretion may approve such order subject to availability of turnover/exposure limits, etc.

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.
BABASAB PATIL                                                                               76
                   SMC INVESMENT SOLUTIONS & SERVICES


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 networth.

      Option contracts on individual Securities: Exposure Limit shall be 20 times the
       liquid networth.

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 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 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.
BABASAB PATIL                                                                            77
                       SMC INVESMENT SOLUTIONS & SERVICES


Reading Stock Option Tables

In India, option tables published in business newspapers and are fairly similar
to the regular stock tables.


NIFTY OPTIONS

Contracts    Exp.Date    Str.Price   Opt.Type   Open   High   Low   Trd.Qty   No.of.Cont.   Trd.Value

RELIANCE     7/26/01     360         CA         3      3      2     4200      7             1512000

RELIANCE     7/26/01     360         PA         29     39     29    1200      2             432000

RELIANCE     7/26/01     380         CA         1      1      1     1200      2             456000

RELIANCE     7/26/01     380         PA         35     40     35    1200      2             456000

RELIANCE     7/26/01     340         CA         8      9      6     11400     19            3876000

RELIANCE     7/26/01     340         PA         10     14     10    13800     23            4692000

RELIANCE     7/26/01     320         CA         22     24     16    11400     19            3648000

RELIANCE     7/26/01     320         PA         4      7      2     29400     49            9408000

RELIANCE     8/30/01     360         PA         31     35     31    1200      2             432000

RELIANCE     8/30/01     340         CA         15     15     15    600       1             204000

RELIANCE     8/30/01     320         PA         10     10     10    600       1             192000

RELIANCE     7/26/01     300         CA         38     38     38    600       1             180000

RELIANCE     7/26/01     300         PA         2      2      2     1200      2             360000

RELIANCE     7/26/01     280         CA         59     60     53    1800      3             504000




           The first column shows the contract that is being traded i.e Reliance.
           The second column displays the date on which the contract will expire i.e. the
            expiry date is the last Thursday of the month.
           Call options-American are depicted as 'CA' and Put options-American as'PA'.
           The Open, High, Low, Close columns display the traded premium rates.


6.14 Advantages of option trading
BABASAB PATIL                                                                                         78
                    SMC INVESMENT SOLUTIONS & SERVICES


1. 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.

2. Time to decide: By taking a call option the purchase price for the shares is locked in.
This 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.

3. 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.

4. 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 4000
Sold on Dec 15                 Rs 670                        Rs 4500
Profit                         Rs 290                        Rs 500
ROI (Not annualised)           76.3%                         12.5%



BABASAB PATIL                                                                            79
                      SMC INVESMENT SOLUTIONS & SERVICES


5. 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.

6. Strategies: By combining different options, investors can create a wide range of
potential profit scenarios. To find out more about options strategies read the module on
trading strategies.




6.15 Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise
settlement, interim exercise settlement in the case of option contracts on securities and
final settlement.


1. Daily premium settlement: Buyer of an option is obligated to pay the premium
towards the options purchased by him. Similarly, the seller of an option is entitled to
receive the premium for the option sold by him. The premium payable amount and the
BABASAB PATIL                                                                             80
                   SMC INVESMENT SOLUTIONS & SERVICES


premium receivable amount are netted to compute the net premium payable or receivable
amount for each client for each option contract.


2. Exercise settlement: Although most option buyers and sellers close out their
options positions by an offsetting closing transaction, an understanding of exercise can
help an option buyer determine whether exercise might be more advantageous than an
offsetting sale of the option. There is always a possibility of the option seller being
assigned an exercise. Once an exercise of an option has been assigned to an option seller,
the option seller is bound to fulfill his obligation (meaning, pay the cash settlement
amount in the case of a cash-settled option) even though he may not yet have been
notified of the assignment.


3. Interim exercise settlement: Interim exercise settlement takes place only for
option contracts on securities. An investor can exercise his in-the-money options at any
time during trading hours, through his trading member. Interim exercise settlement is
effected for such options at the close of the trading hours, on the day of exercise. Valid
exercised option contracts are assigned to short positions in the option contract with the
same series (i.e. having the same underlying, same expiry date and same strike price), on
a random basis, at the client level.


                       7. CLEARING AND SETTLEMENT


       National Securities Clearing Corporation Limited (NSCCL) undertakes clearing
and settlement of all trades executed on the futures and options (F&O) segment of the
NSE. It also acts as legal counterparty to all trades on the F&O segment and guarantees
their financial settlement.
Clearing entities
       Clearing and settlement activities in the F&O segment are undertaken by NSCCL
with the help of the following entities:

BABASAB PATIL                                                                          81
                   SMC INVESMENT SOLUTIONS & SERVICES



Clearing members

       In the F&O segment, some members, called self-clearing members, clear and
settle their trades executed by them only either on their own account or on account of
their clients. Some others, called trading member–cum–clearing member, clear and settle
their own trades as well as trades of other trading members(TMs). Besides, there is a
special category of members, called professional clearing members (PCM) who clear and
settle trades executed by TMs. The members clearing their own trades and trades of
others, and the PCMs are required to bring in additional security deposits in respect of
every TM whose trades they undertake to clear and settle.



Clearing banks

       Funds settlement takes place through clearing banks. For the purpose of
settlement all clearing members are required to open a separate bank account with
NSCCL designated clearing bank for F&O segment. The Clearing and Settlement process
comprises of the following three main activities:


1. Clearing
2. Settlement
3. Risk Management

Risk Management
NSCCL has developed a comprehensive risk containment mechanism for the F&O
segment. The salient features of risk containment mechanism on the F&O segment are:

      The financial soundness of the members is the key to risk management.
       Therefore, the requirements for membership in terms of capital adequacy (net
       worth, security deposits) are quite stringent.
      NSCCL charges an upfront initial margin for all the open positions of a CM. It
       specifies the initial margin requirements for each futures/options contract on a

BABASAB PATIL                                                                        82
                  SMC INVESMENT SOLUTIONS & SERVICES


       daily basis. It also follows value-at-risk(VaR) based margining through SPAN.
       The CM in turn collects the initial margin from the TMs and their respective
       clients.
      The open positions of the members are marked to market based on contract
       settlement price for each contract. The difference is settled in cash on a T+1 basis.
      NSCCL’s on-line position monitoring system monitors a CM’s open positions on
       a real-time basis. Limits are set for each CM based on his capital deposits. The
       on-line position monitoring system generates alerts whenever a CM reaches a
       position limit set up by NSCCL. NSCCL monitors the CMs for MTM value
       violation, while TMs are monitored for contract-wise position limit violation.
      CMs are provided a trading terminal for the purpose of monitoring the open
       positions of all the TMs clearing and settling through him. A CM may set
       exposure limits for a TM clearing and settling through him. NSCCL assists the
       CM to monitor the intra-day exposure limits set up by a CM and whenever a TM
       exceed the limits, it stops that particular TM from further trading.
      A member is alerted of his position to enable him to adjust his exposure or bring
       in additional capital. Position violations result in withdrawal of trading facility for
       all TMs of a CM in case of a violation by the CM.
      A separate settlement guarantee fund for this segment has been created out of the
       capital of members. The fund had a balance of Rs. 648 crore at the end of March
       2002. The most critical component of risk containment mechanism for F&O
       segment is the margining system and on-line position monitoring. The actual
       position monitoring and margining is carried out on–line through Parallel Risk
       Management System (PRISM). PRISM uses SPAN(r) (Standard Portfolio
       Analysis of Risk) system for the purpose of computation of on-line margins,
       based on the parameters defined by SEBI.

NSE–SPAN
   The objective of NSE–SPAN is to identify overall risk in a portfolio of all futures and
options contracts for each member. The system treats futures and options contracts
BABASAB PATIL                                                                              83
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uniformly, while at the same time recognizing the unique exposures associated with
options portfolios, like extremely deep out–of–the–money short positions and inter–
month risk. Its over–riding objective is to determine the largest loss that a portfolio might
reasonably be expected to suffer from one day to the next day based on 99% VaR
methodology. SPAN considers uniqueness of option portfolios. The following factors
affect the value of an option:

          Underlying market price
          Strike price
          Volatility(variability) of underlying instrument
          Time to expiration
          Interest rate
As these factors change, the value of options maintained within a portfolio also changes.
Thus, SPAN constructs scenarios of probable changes in underlying prices and
volatilities in order to identify the largest loss a portfolio might suffer from one day to the
next. It then sets the margin requirement to cover this one–day loss. The complex
calculations (e.g. the pricing of options) in SPAN are executed by NSCCL. The results of
these calculations are called risk arrays. Risk arrays, and other necessary data inputs for
margin calculation are provided to members daily in a file called the SPAN risk
parameter file. Members can apply the data contained in the risk parameter files, to their
specific portfolios of futures and options contracts, to determine their SPAN margin
requirements. Hence, members need not execute complex option pricing calculations,
which is performed by NSCCL. SPAN has the ability to estimate risk for combined
futures and options portfolios, and also re–value the same under various scenarios of
changing market conditions.




BABASAB PATIL                                                                               84
                  SMC INVESMENT SOLUTIONS & SERVICES




                             8.ANALYSIS


OBJECTIVES OF THE STUDY
To study the consumer perception of Derivatives products in Hubli city, and a detailed
study of Derivatives and Derivatives trading

Sub- objectives:
    To study the features of derivative products (Futures and Options)
    To study the trading procedures for Derivative products
    To study the strategies used in trading of Derivatives.
    To study the clearing and settlement procedure of Derivatives products
    To know the awareness of Derivative products in Hubli city.


Sampling Design

Population - All the people who are able to save a portion of their income, and possess
the interest of investing those savings in stock market.

Time - During the period of 15th Dec 2007 to 15th April 2008

BABASAB PATIL                                                                       85
                   SMC INVESMENT SOLUTIONS & SERVICES




Sampling Frame - The investors of Hubli

Instrument of data collection. - Questionnaire.

Sample Size     - 100 investors.




                          ANALYSIS OF THE SURVEY
Objectives:
To find out the perception of the investors about derivatives.
To find out the extent of their awareness about derivatives.
To identify the relationship of age, income and awareness with the investment decisions
in derivatives by the investors.
1. Age of the Respondents

                                      Your Age

                                                                     Cumulativ e
                         Frequenc y    Percent      V alid Percent    Percent
   V alid   21-30               45         45.0               45.0         45.0
            30-40               44         44.0               44.0         89.0
            40-50                7          7.0                7.0         96.0
            A bove 50            4          4.0                4.0        100.0
            Total              100        100.0             100.0




BABASAB PATIL                                                                       86
                                  SMC INVESMENT SOLUTIONS & SERVICES



                            Your A ge
                       50



                       40



                       30



                       20
Frequency




                       10



                        0
                                    21 -30            30 -40         40 -50          A bove 5 0


                            Y our Age


                      Out of the 100 investors surveyed, 44 of them fall in the age group of 30-40 years
            and 45 of them in 21-30 years. This implies that the younger people of 21-30 age have
            more income to invest, than the people of 40-50 of the age above 50.




            2. Annual Income of the Respondents

                                                  Annual Incom e

                                                                                       Cumulativ e
                                             Frequenc y   Percent    Valid Percent      Percent
              Valid     < 100000                    18        18.0            18.0           18.0
                        100000-150000               27        27.0            27.0           45.0
                        150000-200000               21        21.0            21.0           66.0
                        > 200000                    34        34.0            34.0          100.0
                        Total                      100       100.0          100.0




            BABASAB PATIL                                                                            87
                                SMC INVESMENT SOLUTIONS & SERVICES



                          Annual Income
                    40



                                                                               34
                    30

                                                  27


                    20                                            21
                                   18


                    10
Frequency




                      0
                                 < 100000                    150000-200000
                                             100000-150000                   > 200000


                          Annual Income

               The graph clearly shows that the income is evenly distributed in the sample of the
            survey. But, majority of the investors earn above 2 lakhs per annum. These respondents
            serve a better group of potentials for investments for the company’s products.
               As there is almost equal share in each income category, almost all of them have
            potentials to invest and save.




               3. Your current investments are in
                                        Invt Avenues         No. Of Respondents
                                             FD                      39
                                             Ins                     52
                                           Bonds                     16
                                             MF                      42
                                           Shares                    54
                                           Dervtv                    11
                                           Comm                       4




            BABASAB PATIL                                                                      88
                                    SMC INVESMENT SOLUTIONS & SERVICES




                      60
   No of Respndents




                      50
                      40
                      30
                      20
                      10
                      0




                                                                           es




                                                                                       es
                                         e
                           FD




                                                    s




                                                                ds




                                                                                                     s
                                                  nd
                                         nc




                                                                                                   ie
                                                                                     iv
                                                                        ar
                                                              un




                                                                                                 ot
                                       ra
                         nk




                                                Bo




                                                                                   at
                                                                      Sh




                                                                                               od
                                                            lF
                                     su




                                                                                   iv
                       Ba




                                                                                               m
                                                                                 er
                                                          ua
                                   In




                                                                                             om
                                                                                D
                                                        ut
                                                        M




                                                                                            C
                                                            Instruments




From this question and its graph, it is clear that people in Hubli prefer less risky and
regular income giving investment avenues. 39 respondents have invested in Bank FDs, 52
in Insurance and 42 in Mutual funds. As this question had a multiple choice option, we
find that the respondents’ investments are spread across more than 2 avenues. Talking of
risky instruments like shares, 54 of them have invested their money in shares. This means
that 54% of them are risk takers




4. Are you aware of the concept of derivatives?

                                         Aw arenes s of De ri'ves

                                                                            Cumulativ e
                                   Frequenc y   Percent     Valid Percent    Percent
  Valid                    Yes            53        53.0             53.0         53.0
                           No             47        47.0             47.0        100.0
                           Total         100       100.0           100.0




BABASAB PATIL                                                                                            89
                    SMC INVESMENT SOLUTIONS & SERVICES



                     Awareness of Derivatives
     No

     47.0%




                                                                       Y es
                                                                  53.0%




Extending the last interpretation, by this question we find that 53% of respondents are
aware about derivatives. The concept of derivatives is well understood only if there is
thorough knowledge about investing and trading in shares. Therefore out of the 59
respondents who hold shares, 53 of them know about derivatives. This means that
derivatives are still unknown to 50% of the people in Hubli. These people must be
educated about derivatives in order to develop the market for it in Hubli.


5.        Age-wise description of awareness using crosstab and bar chart

                Your Age & Aw arene ss of Derivatives Cros s tabulation

                   Count
                                    Aw areness of Deri'ves
                                      Yes          No        Total
                   Your    21-30          26           19         45
                   Age     30-40          22           22         44
                           40-50            4            3         7
                           Above 50         1            3         4
                   Total                  53           47       100

BABASAB PATIL                                                                       90
                                 SMC INVESMENT SOLUTIONS & SERVICES




                            30



                                   26


                                               22   22
                            20
                                        19




                            10
Respondents




                                                                                Aw areness of Deri'vs

                                                          4                       Aware of D eriv at iv e
                                                               3          3
                             0                                                    U naware of D erv at iv e
                                    21-30      30-40       40-50    Abov e 50


                                 Age


                 This graph shows that among the 44 people falling in the age group of 21-30, only 26
              are aware of derivatives i.e., 43% of them are unaware. As you can see the good
              awareness level among the investors of the age 30-40, Rest 43% of the age group 21-30
              need to be tapped by the company and create awareness about derivatives.




              6. If yes, which of the derivative products are you aware of?




              BABASAB PATIL                                                                            91
                  SMC INVESMENT SOLUTIONS & SERVICES



                              Awareness of Derivative Products



                         Forwards
                           17%
                                                                    Futures
                Swaps                                                35%
                 10%




                             Options
                              38%




       The pie chart clearly shows the number of people knowing about the concept of
   different derivative products. As in India we have OTC trading of only Futures and
   Options, we find 41 of them aware about Futures and 43 are aware about Options. 20
   people are aware about forwards and only 12 people know about Swaps. In other
   sense we can say that futures are more popular than options in Hubli.
   NOTE: This was a multiple choice question.




7 . Have you invested in Derivatives?
                                                              No. of
                        Invested in Derivatives            Respondents
                                  Yes                          26
                                  No                           27
BABASAB PATIL                                                                     92
                   SMC INVESMENT SOLUTIONS & SERVICES


                                 Total                         53


               Have you invested in D erivatives?




                                                                         Y es
                                                                       49 .0 %

    No

    51 .0 %




Out of the 53 people who are aware of derivatives 49% [26] of them have tried investing
in F&O. The company has to take steps to motivate the rest 51% [27] to invest in
derivatives.



8. Factors that respondents consider while investing in Derivatives.

                                 Factors          No. of
                                               Respondents
                                 Savings           08
                                   Risk              24
                                 Returns             20
                                Volatility           07




BABASAB PATIL                                                                       93
                                           SMC INVESMENT SOLUTIONS & SERVICES




                           Voltality               8
   Factors for investing




                            Return                                     24

                                                                                                                     Series1
                               Risk                               20



                           Savings             7


                                       0               5         10          15             20               25




Even this was a multiple-choice question. The diagram clearly depicts that risk and return
are the main factors considered by the investors. The next share is held by volatility,
which is the main factor for derivatives trading, and 8 people consider this factor while
investing their money.


Now let us see how the investors associate the risk factor, return factor and volatility
with the investing in derivatives:-


“Invested in Dervtv?” And “Risk” : Crosstabulation
                                                                                       Risk
                                                                                                             Total
                                                                                       no        Yes
                                       Invested in Dervtv?             No              55        19          74
                                                                       Yes             17        9           26
                                       Total                                           72        28          100




                                                             9
                                                       yes
                                                                 19
                                                                                       Invested in Dervtv?
BABASAB PATIL                                                                          yes                                     94
                                               Risk




                                                                                       Invested in Dervtv?
                                                                                       no
                                                                 17
                                                       no
                                                                                  55
                      SMC INVESMENT SOLUTIONS & SERVICES




       Out of 26 people who have invested in derivatives, only 9 of them are considering
the risk factor. This means that they perceive derivatives as less risky.

“Invested in derivatives?” and “Return factor” cross tabulation.
                                                            Return
                                                                                Total
                                                            No        Yes
              Invested in Dervtv?            No             52        22        74
                                             Yes                      26        26
              Total                                         52        48        100



                                        26
                                 yes
                                       22
                                                         Invested in Dervtv?
                        Return




                                                         yes
                                                         Invested in Dervtv?
                                                         no
                                 no
                                                   52




       Out of 26 people who have invested their money in derivatives, ALL of them
consider the return factor. This means that derivatives give good returns, as per their
experience.




“Invested in Derivatives?” And “Volatility factor” cross tabulation.
                                                         Volatility            Total
                                                         no       yes
               Invested in Dervtv?           No          57       17           74
                                             Yes         9        17           26
               Total                                     66       34           100



BABASAB PATIL                                                                           95
                   SMC INVESMENT SOLUTIONS & SERVICES




                                               17
                                     yes
                                               17
                                                          Invested in Dervtv?




                        Volatility
                                                          yes
                                                          Invested in Dervtv?
                                                          no
                                           9
                                     no
                                                     57




       Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor
which is the most important influencer in derivative segment in the market.             The
investors perceive derivatives as volatile investments




9. Difficulties encountered by the Respondents while investing in Derivatives.


                                     Difficulties      No. of
                                                    Respondents
                       Lack of Knowledge                   07
                       Clearing Positions                  12
                            Lot Size                       08
                            Margins                        16


BABASAB PATIL                                                                            96
                    SMC INVESMENT SOLUTIONS & SERVICES




                                         16%
          37%                                                   Lack of Know ledge
                                                                Clearing Positions
                                                                Lot Size
                                                   28%          Margins
                       19%




       This graph shows that Lot sizes and Clearing positions are affecting the
investment decisions of the investors to a large extent. They are facing problems in
placing the margin amount and also the leverage options associated with it. Lot sizes also
determine the decisions of the investors to some extent. The next share is the Lack of
knowledge, because of which the investors are not able to try investing in derivatives.




10. Are you interested to invest in Derivatives?

                    R U inter es ted to inves t in De ri'vs

                                                               Cumulativ e
                    Frequenc y    Percent      Valid Percent    Percent
  Valid     Yes            52         52.0              52.0         52.0
            No             48         48.0              48.0        100.0
            Total         100        100.0            100.0




BABASAB PATIL                                                                             97
                  SMC INVESMENT SOLUTIONS & SERVICES



         Are you interested to invest in Derivatives?
    No

    48.0%




                                                                    Y es
                                                                   52.0%




Out of the 100 respondents surveyed, 52 are willing to invest in derivatives. And out of
them 26 are already the investors. This shows that derivatives are not known to
approximately about 50% of the people in Hubli. The company should take necessary
steps to educate them about the same and tap them towards investing through SMC
Investment Solutions & Services.




11. Are you aware of the following services provided by SMC Investment Solutions &
Services?


                                                     No.of
                               Services           Respondents
                         On-line Share Trading        26
                         Trading in Futures &
                                Options                06
                             Mutual Funds              01
                                 IPOs                  08



BABASAB PATIL                                                                        98
                     SMC INVESMENT SOLUTIONS & SERVICES



Are you Aware of following services provided by SMC


     IPO's

     19.5%


     Mutual Funds
     2.4%


     Trading in F utures &
     14.6%                                                       Online Share Trading

                                                                             63.4%




Most of the people are aware of online share trading but very few are aware of the trading
in F&O service provided by SMC Investment Solutions & Serives. This shows that the
company needs to stress more on promoting this service.




12. Having made you aware of various services rendered by SMC Investment Solutions
& Services, would you prefer to invest through SMC Investment Solutions & Services?


                       w ould u pr efe r to inve s t in SMC

                                                                    Cumulativ e
                      Frequenc y    Percent     V alid Percent       Percent
   V alid    Y es            60         60.0              60.0            60.0
             No              40         40.0              40.0           100.0
             Total          100        100.0            100.0




BABASAB PATIL                                                                           99
                              SMC INVESMENT SOLUTIONS & SERVICES



                         would you prefer to invest through SMC?
                    70


                    60
                                        60

                    50


                    40
                                                                  40

                    30


                    20
Frequency




                    10


                     0
                                        Y es                      No




            60% of the respondents showed the interest of investing through SMC Investment
            Solutions & Services. According to the response received during the survey it was clear
            that out of 100 respondents, 61 are not aware of SMC IS&S. The above graph shows that
            they are ready to invest through SMC IS&S provided If we make them aware of various
            services that company renders. So, the company should drag the attention of the potential
            customers & educate them about the benefits you provide for the investors.



                                                 Analysis
            1. Correlation between age and annual income.




            BABASAB PATIL                                                                        100
                       SMC INVESMENT SOLUTIONS & SERVICES



                                    Cor relatio ns

                                                        A nnual
                                                        Income           Y our A ge
     A nnual Inc ome      Pearson Correlation                   1              .272**
                          Sig. (2-tailed)                        .             .006
                          N                                   100               100
     Y our A ge           Pearson Correlation                .272**               1
                          Sig. (2-tailed)                    .006                  .
                          N                                   100               100
        **. Correlation is signif ic ant at the 0.01 level (2-tailed).


         Here we see that the correlation is 0.272. This means that age and annual income
are positively correlated. But the degree of correlation is less than 0.5. This shows that
the association between these two variables is not that strong. It means that, at times these
two variables may not move in the same direction.


2.       Correlation between annual income and investment in derivatives.

                                      Cor relatio ns

                                                                                 Have u
                                                                A nnual         invested
                                                                Income         in Deriv's
     A nnual Inc ome                 Pearson Correlation                1           -.337**
                                     Sig. (2-tailed)                     .           .001
                                     N                                100             100
     Have u inv ested in Deriv 's    Pearson Correlation            -.337**             1
                                     Sig. (2-tailed)                 .001                .
                                     N                                100             100
       **. Correlation is s ignif icant at the 0.01 lev el (2-tailed).


     Here the correlation is Negative i.e., -0.337 but it is less than 0.5. These two variables
     are not strongly correlated though positive. An increase in annual income may not
     lead to increase the investments in derivatives.
     3. Correlation between awareness about derivatives and investments in derivatives.




BABASAB PATIL                                                                                 101
                  SMC INVESMENT SOLUTIONS & SERVICES



                                       Cor relations

                                                                                Have u
                                                               A w areness     invested
                                                               of Deri'ves    in Deriv's
     A w areness of Deri'ves      Pearson Correlation                     1         .818**
                                  Sig. (2-tailed)                          .        .000
                                  N                                     100          100
     Have u inv es ted in Deriv's Pearson Correlation                  .818**          1
                                  Sig. (2-tailed)                      .000             .
                                  N                                     100          100
       **. Correlation is s ignif icant at the 0.01 level (2-tailed).



  Here the correlation is very strong i.e., 0.558. This means that if there is increase in
  the number of people being aware of derivatives, the flow of investments in
  derivatives will also be more. Awareness is directly associated with investments in
  derivatives.


  4. Correlation between Risk factor and investment in derivatives.

                                       Cor relations

                                                                Invested
                                                               in Derv tv?       Risk
     Invested in Dervtv? Pearson Correlation                             1          .087
                         Sig. (2-tailed)                                 .          .388
                         N                                            100            100
     Risk                Pearson Correlation                         .087              1
                         Sig. (2-tailed)                             .388               .
                         N                                            100            100

  The association of risk factor and investing in derivatives is very meager. This means
  that increase in risk does not affect investing in derivatives to a greater extent. Risk is
  an insignificant consideration.


  5. Correlation between Return and investing in derivatives.



BABASAB PATIL                                                                                102
                   SMC INVESMENT SOLUTIONS & SERVICES



                                        Cor relations

                                                                 Invested
                                                                in Derv tv?    Return
     Invested in Dervtv? Pearson Correlation                              1       .617**
                         Sig. (2-tailed)                                  .       .000
                         N                                             100         100
     Return              Pearson Correlation                          .617**          1
                         Sig. (2-tailed)                              .000            .
                         N                                             100         100
        **. Correlation is s ignif icant at the 0.01 level (2-tailed).

  The correlation is 0.617. This shows that increase in return definitely increases the
  flow of investments in derivatives.


  6. Correlation between volatility and investing in derivatives.

                              Cor relations

                                                   Invested
                                                  in Derv tv?  V olatility
 Invested in Dervtv? Pearson Correlation                    1       .393**
                     Sig. (2-tailed)                        .       .000
                     N                                   100         100
 V olatility         Pearson Correlation                .393**            1
                     Sig. (2-tailed)                    .000               .
                     N                                   100         100
   **. Correlation is s ignif icant at the 0.01 level (2-tailed).


     Actually derivatives are considered highly volatile. The volatility in the market
  directly affects the price of derivatives. The correlation between volatility and
  investing in derivatives is 0.393 which is again less but it is positive. This indicates
  that an increase in volatility increases the investing in derivatives to some
  considerable extent.


                                        9. FINDINGS:


BABASAB PATIL                                                                              103
                 SMC INVESMENT SOLUTIONS & SERVICES


  22. Futures market facilitates for buying and selling futures contracts, which state the
     price per unit, type, value, quality and quantity of the commodity in question, as
     well as the month the contract expires.
  23. Futures accounts are credited or debited daily depending on profits or losses
     incurred. The futures market is also characterized as being highly leveraged due
     to its margins; although leverage works as a double-edged sword.
  24. “Going long,” “going short,” and “spreads” are the most common strategies used
     when trading on the futures market.
  25. Investors use options both to speculate and hedge risk.
  26. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh,
     27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs.
  27. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds
     and Shares.
  28. 53% of the respondents are aware of derivatives.
  29. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e.,
     43% of them are unaware. As you can see the good awareness level among the
     investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by
     the company and create awareness about derivatives.
  30. People above the age of 50 years are unaware of derivatives. They are fond of
     traditional investment instruments.
  31. People above the age of 50 years are unaware of derivatives. They are fond of
     traditional investment instruments.
  32. 37 respondents are aware of Futures and 40 are aware of Options.
  33. The main factors considered while investing in derivatives are risk[20], return
     [24] and volatility [08].




  34. Out of 26 people who have invested in derivatives, only 9 of them are considering
     the risk factor. This means that they perceive derivatives as less risky.

BABASAB PATIL                                                                         104
                 SMC INVESMENT SOLUTIONS & SERVICES


  35. Out of 26 people who have invested their money in derivatives, ALL of them
     consider the return factor. This means that derivatives give good returns, as per
     their experience.
  36. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor
     which is the most important influencer in derivative segment in the market. The
     investors perceive derivatives as volatile investments.
  37. Lot sizes and margins are affecting the investment decisions of the investors to a
     large extent. Lot sizes also determine the decisions of the investors to a large
     extent.
  38. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives.
     And out of them 26 are already the investors. This shows that derivatives are not
     known to approximately about 50% of the people in Hubli
  39. Awareness of derivatives and investing in is positively correlated. This means that
     if there is increase in the number of people being aware of derivatives, the flow of
     investments in derivatives will also be more. Awareness is directly associated
     with investments in derivatives.
  40. The association of risk factor and investing in derivatives is very meager. This
     means that increase in risk does not affect investing in derivatives to a greater
     extent. Investors perceive derivatives as less risky.
  41. Actually derivatives are considered highly volatile. The volatility in the market
     directly affects the price of derivatives. The correlation between volatility and
     investing in derivatives is 0.393 which is again less but it is positive. This
     indicates that an increase in volatility affects the investing in derivatives to some
     considerable extent.
  42. 60 respondents said that they are interested to invest through SMC Investment
     Solutions & Services


                            10. SUGGESTIONS



BABASAB PATIL                                                                          105
                  SMC INVESMENT SOLUTIONS & SERVICES


   6. The awareness about derivatives among investors should be increased by
       conducting various awareness and educational programs.
   7. The company can conduct seminars to promote their services along with
       educating them about the products they offer. Initially they can start off with
       existing demat account holders.
   8. The company can think of tapping the existing demat account holders and provide
       them enough information on derivatives and enable them to trade in the same.
       This will help the company to increase its earnings of brokerage income.
   9. The company has to create and maintain a database of prospective customers from
       time to time, to keep track of the people falling in different income levels and
       their investing patterns. This is possible if continuous contacts are maintained
       with the customers.
   10. There is a widespread lack of awareness about the role and technique of futures
       trading among the potential beneficiaries. Only traditional players who have been
       participating in such trading either in the formal markets or gray markets are
       conversant with the intricacies of forward trading. These players are willing to
       participate in the trade only in regulated or liberal regulatory environment. The
       approach should be first, to bring these traditional players to the formal market
       and allow the Derivative markets to garner minimum critical liquidity.




                             11. CONCLUSIONS
     Financial derivatives market has been growing at a phenomenal rate over the past
few years. Advances in derivatives market, improvements in computer and

BABASAB PATIL                                                                       106
                    SMC INVESMENT SOLUTIONS & SERVICES


telecommunications capability and robust clearing and settlement, significantly expanded
opportunities and lowered the costs of operations for hedging risks not readily managed
in earlier decades. These products contributed to the development of a more flexible and
efficient financial system, both domestically and internationally. The development of
Financial Derivatives and its extensive use in the financial sector has been synonymous
with the rapid growth in the financial sector itself.

       In the context of the changing financial environment and the consequent increase
in the nature and quantum of financial risks it is mandatory to have a thorough
knowledge about financial derivatives..

        Financial Derivatives are of recent origin and are quite new to the Indian
Financial markets, As a finance professional one should have good working knowledge
of instruments like options, futures which is necessary for managing risks in the present-
day financial world.

       The derivatives market in Hubli is not as developed when compared to the
metropolitan cities. It is because of lack of exposure among investors in Hubli city
towards derivatives, hence there is a need to increase the awareness and educate the
investors about derivatives, So that they can make informed and wise decisions, which
would lead to the growth in Hubli Derivatives market.
Limitations of the Project.

      The period considered for study is short to understand the study of“Derivatives”.
      Survey is limited to Hubli city.
      The sample of respondents considered for the study is for undertaking a Market
       research.
Though with these limitation, I am satisfied with the work conducted as it is carefully
administered keeping in line with the advices of experts.
                                 12. ANNEXURES:
Questionnaire:


Dear Sir / Madam,


BABASAB PATIL                                                                         107
                     SMC INVESMENT SOLUTIONS & SERVICES


      I am pursuing my MBA (IV Sem) As a part of my curriculum, I am undertaking a project
on “Comprehensive Study Of Derivative Products And Investors’ Perception of
Derivatives in Hubli City”, in S.M.C Investment solutions and Services at Hubli. I
request you to kindly help me in making my project effective by filling this
questionnaire. I assure you that the information provided by you will be used for
academic purpose only.

Name       __________________________________________________________________

Address __________________________________________________________________

           __________________________________________________________________

Tel.No     ___________________     E Mai   _____________________________________


1. Your Age

          21 to 30         30 to 40               40 to 50            Above 50

2. Annual Income

Less than 1 Lakh                           1 Lakh to 1.5 Lakh

1.5 lakh to 2 lakh                         More than 2 Lakh

3. Your Current investments are in

Bank F D                Insurance                    Bonds                      Mutual Funds

Shares                  Derivatives                  Commodities

4. Are you aware of the concept of Derivatives?

          Yes                    No                          ( If “No” go to Question No. 9)



5. If Yes , which of the Derivatives product are you aware of ?

Futures                  Options                         Swaps                      Forwards


6. Have you invested in Derivatives?

          Yes                    No

7. What are the factors you consider while investing in Derivatives?

 Saving                  Risk               Return                     Volatility

BABASAB PATIL                                                                                  108
                     SMC INVESMENT SOLUTIONS & SERVICES



8. What are the difficulties encountered by you while investing in Derivatives?

Lack of Knowledge            Clearing Positions       Lot Size             Margins

9. Are you interested to invest in Derivatives?
        Yes                           No

10. Have you traded through online share trading?

        Yes                           No

11. .Are you aware of S.M.C.Investents solutions & Services?

        Yes                           No


12. Are you aware of the following services provided by S.M.C.Investents solutions & Services ?
On-line Share Trading           Trading in Futures & Options             Mutual Funds

IPO’s

13. Having made you aware of various services rendered by S.M.C.Investents solutions &
Services, would you prefer to invest through S.M.C.Investents solutions & Services?

        Yes                           No



                Thank You for your Valuable Time



                                  13. BIBILOGRAPHY

The data was collected from the list of Books and websites given below:
Options, Futures and Other Derivatives – John C Hull.
www.samgloabalsecurities.com
www.investopedia.com
www.icicidirect.com
www.nseindia.com
BABASAB PATIL                                                                              109
             SMC INVESMENT SOLUTIONS & SERVICES



www.economywatch.com
www.businessline.com
www.economictimes.com




BABASAB PATIL                                     110

				
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