Derivatives – Indian Scenario -1-

Visit mbafin.blogspot.com for

more

1.0 Introduction to derivatives

The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves
themselves against uncertainties
uncertainties arising out of fluctuatio
fluctuations
ns in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the
use of derivative products, it is possible to partially or fully transfer price risks by
locking-in asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking-in asset
prices, derivative products minimize the impact of fluctuations in asset prices on the
profitability and cash flow situation of risk-averse investors.

Derivat
Derivative
ive product
productss initia
initially
lly emerged
emerged,, as hedgin
hedgingg devices
devices against
against fluctu
fluctuati
ations
ons in
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. The financial derivatives came into spotlight in
post-1970 period due to growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990s, they accounted for
about two-thirds of total transactions in derivative products. In recent years, the market
for financial derivatives
derivatives has grown tremendously
tremendously both in terms of variety
variety of instruments
available, their complexity and also turnover. In the class of equity derivatives, futures
and options on stock indices have gained more popularity than on individual stocks,
especially among institutional investors, who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with
various portfolios and ease of use. The lower costs associated with index derivatives vis-
vis derivative products based on individual securities is another reason for their growing
use.
Derivatives – Indian Scenario -2-

The following factors have been driving the growth of financial derivatives:
1. Increased
Increased volatili
volatility
ty in
in asset prices in financia
financiall markets,
markets,
2. Increased
Increased integration
integration of national
national financial
financial markets
markets with
with the internat
international
ional markets,
markets,
3. Marked improvem
improvement
ent in communic
communication
ation facili
facilities
ties and sharp
sharp decline
decline in their
their costs,
costs,
4. Develo
Developme
pment
nt of more sophist
sophistica
icated
ted risk manageme
management
nt tools, providin
providingg economi
economicc
agents a wider choice of risk management strategies, and
5. Innovat
Innovation
ionss in the derivativ
derivatives
es markets,
markets, which
which optimall
optimallyy combine
combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced
risk as well as trans-actions costs as compared to individual financial assets.

1.1 Derivatives defined

Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of a change in prices by that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which is the “underlying”.
In the Indian context the Securities
Securities Contracts
Contracts (Regulation)
(Regulation) Act, 1956 (SC(R) A) defines
defines
“equity derivative” to include –
1. A secu
securi
rity
ty deri
derive
vedd from
from a debt
debt inst
instru
rume
ment
nt,, shar
share,
e, loan
loan whet
whethe
herr secu
secure
redd or
unsec
unsecure
ured,
d, risk
risk inst
instru
rume
ment
nt or cont
contrac
ractt for diff
differe
erenc
nces
es or any other
other form
form of
security.
2. A cont
contra
ract
ct,, whic
whichh deri
derive
vess its
its valu
valuee from
from the
the pric
prices
es,, or inde
indexx of pric
prices
es,, of
underlying securities.
The derivatives are securities under the SC(R) A and hence the trading of derivatives is
A.1
governed by the regulatory framework under the SC(R) A.

1.2 Types of derivatives

The most commonly used derivatives contracts are forwards, futures and options which
we shall discuss in detail later. Here we take a brief look at various derivatives contracts
that have come to be used.
1
Source: www.nse-india.com
Derivatives – Indian Scenario -3-

Forwards : A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures : A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types

types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

Warrants : Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Derivatives – Indian Scenario -4-

Swaptions : Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.2
1.3 Participants and Functions
Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in
the derivatives market. Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk. Speculators wish to bet on
future movements in the price of an asset. Futures and options contracts can give them an
extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the futures price of an
asset getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.

The derivative market performs a number of economic functions. First, prices in an

organized derivatives market reflect the perception of market participants about the future
and lead the prices of underlying to the perceived future level. The prices of derivatives
converge with the prices of the underlying at the expiration of derivative contract. Thus
derivatives help in discovery of future as well as current prices. Second, the derivatives
market helps to transfer risks from those who have them but may not like them to those
who have appetite for them. Third, derivatives, due to their inherent nature, are linked to
the underlying cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players who would
not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative
trades shift to a more controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants become

2
Source: Options Futures & Other Derivatives John C Hull
Derivatives – Indian Scenario -5-

extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit
that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are
immense. Sixth, derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
Derivatives thus promote economic development to the extent the later depends on the
rate of savings and investment.

1.4 Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified amount of commodities at specified price. A primary motivation for
prearranging a buyer or seller for a stock of commodities in early forward contracts was
to lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.

Although early forward contracts in the US addressed merchants’ concerns about

ensuring that there were buyers and sellers for commodities, “credit risk” remained a
serious problem. To deal with this problem, a group of Chicago businessmen formed the
Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to
provide a centralized location known in advance for buyers and sellers to negotiate
forward contracts. In 1865, the CBOT went one step further and listed the first “exchange
traded” derivatives contract in the US; these contracts were called “futures contracts”. In
1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The
CBOT and the CME remain the two largest organized futures exchanges, indeed the two
largest “financial” exchanges of any kind in the world today.
Derivatives – Indian Scenario -6-

The first stock index futures contract was traded at Kansas City Board of Trad e.
Currently the most popular index futures contract in the world is based on S&P 500
index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures
became the most active derivative instruments generating volumes many times more than
the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the
three most popular futures contracts traded today. Other popular international exchanges
that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE
in Japan, MATIF in France, etc.3

Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)

1995 1996 1997 1998 1999

Exchange traded instruments 9283 10018 12403 13932 13522
Interest rate futures and options 8618 9257 11221 12643 11669
Currency futures and options 154 171 161 81 59
Stock Index futures and options 511 591 1021 1208 1793
Some OTC instruments 17713 25453 29035 80317 88201
Interest rate swaps and options 16515 23894 27211 44259 53316
Currency swaps and options 1197 1560 1824 5948 4751
Other instruments - - - 30110 30134

Total 26996 35471 41438 94249 101723

Table 1.2 Chronology of instruments

1874 Commodity futures
1972 Foreign currency futures
1973 Equity options
1975 Treasury bond futures
1981 Currency swaps
1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures,
Options on T bond futures, Exchange listed currency options
1983 Options on equity index, Options on T-note futures, Options on currency futures,
Options on equity index futures, interest rate caps and floors
1985 Eurodollar options, Swap options
1987 OTC compound options, OTC average options
1989 Futures on interest rate swaps, Quanto options
1990 Equity index swaps
1991 Differential swaps
1993 Captions, exchange listed FLEX options
1994 Credit default options

3
Source: Derivatives in India FAQ Ajay Shah & Susan Thomas
Derivatives – Indian Scenario - 14 -

5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in
cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining contracts, leading to a
loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased over time.
Auditors’ report claims that the losses were caused by the size of the trading
exposure.
Reasons for the losses:
• The transactions carried out by the company were mainly OTC in nature and hence
lacked transparency and risk management system employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the company to use rolling
short term hedge -- problem arising from the hedging strategy
• Basis risk leading to short term loss

2.2.4 Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding
While the fact is...

Trading in standard derivatives such as forwards, futures and options is already prevalent
in India and has a long history. Reserve Bank of India allows forward trading in Rupee-
Dollar forward contracts, which has become a liquid market. Reserve Bank of India also
allows Cross Currency options trading.

Forward Markets Commission has allowed trading in Commodity Forwards on

Commodities Exchanges, which are, called Futures in international markets.
Commodities futures in India are available in turmeric, black pepper, coffee, Gur
(jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures
exchanges in Soya bean oil as also in Cotton. International markets have also been
allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India
also allows, the users to hedge their portfolios through derivatives exchanges abroad.
Derivatives – Indian Scenario - 15 -

Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals
to hedge the user’s exposure in international markets.

Derivatives in commodities markets have a long history. The first commodity futures
exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders
Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-
68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In
oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur
in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market
was set up in Mumbai in 1920.

History and existence of markets along with setting up of new markets prove that the
concept of derivatives is not alien to India. In commodity markets, there is no resistance
from the users or market participants to trade in commodity futures or foreign exchange
markets. Government of India has also been facilitating the setting up and operations of
these markets in India by providing approvals and defining appropriate regulatory
frameworks for their operations.

Approval for new exchanges in last six months by the Government of India also indicates
that Government of India does not consider this type of trading to be harmful albeit
within proper regulatory framework.

This amply proves that the concept of options and futures has been well ingrained in the
Indian equities market for a long time and is not alien as it is made out to be. Even today,
complex strategies of options are being traded in many exchanges which are called teji-
mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998)
In that sense, the derivatives are not new to India and are also currently prevalent in
various markets including equities markets.

2.2.5 Is the existing capital market more safer than Derivatives?

While the fact is...
Derivatives – Indian Scenario - 16 -

World over, the spot markets in equities are operated on a principle of rolling settlement.
In this kind of trading, if you trade on a particular day (T), you have to settle these trades
on the third working day from the date of trading (T+3).

Futures market allow you to trade for a period of say 1 month or 3 months and allow you
to net the transaction taken place during the period for the settlement at the end of the
period. In India, most of the stock exchanges allow the participants to trade during one-
week period for settlement in the following week. The trades are netted for the settlement
for the entire one-week period. In that sense, the Indian markets are already operating the
futures style settlement rather than cash markets prevalent internationally.

In this system, additionally, many exchanges also allow the forward trading called badla
in Gujarati and Contango in English, which was prevalent in UK. This system is
prevalent currently in France in their monthly settlement markets. It allowed one to even
further increase the time to settle for almost 3 months under the earlier regulations. This
way, a curious mix of futures style settlement with facility to carry the settlement
obligations forward creates discrepancies.

The more efficient way from the regulatory perspective will be to separate out the
derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at
the same time allow futures and options to trade. This way, the regulators will also be
able to regulate both the markets easily and it will provide more flexibility to the market
participants.

In addition, the existing system although futures style, does not ask for any margins from
the clients. Given the volatility of the equities market in India, this system has become
quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time
of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a
position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a
period of three days. At the same time, the Barings Bank failed on Singapore Monetary
Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000
crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although,
Derivatives – Indian Scenario - 17 -

the exposure was so high and even the loss was also very big compared to the total
exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins
that they did not stop trading for a single minute.

2.3 Comparision of New System with Existing System5

Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system
is very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced much before and NSE had approved it
but was not active because of politicization in SEBI.
6
The figure 2.1 –2.4 shows how advantages of new system (implemented from June
20001) v/s the old system i.e.before June 2001

New System Vs Existing System for Market Players

Figure 2.1

Speculators

Existing SYSTEM New

5
Source: Mr. Rajesh Gajra Senior writer- Intelligent Investor ([email protected])
6
Source: Invest Monitor (Magazine) July 2001
Derivatives – Indian Scenario - 18 -

Approach Peril &Prize Approach Peril

&Prize
1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading& carry price change. 2) Buy Call &Put to premium
forward transactions. by paying paid
2) Buy Index Futures premium
hold till expiry.

Advantages
• Greater Leverage as to pay only the premium.
• Greater variety of strike price options at a given time.

Figure 2.2

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril

&Prize
1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
one and selling in whichever way the promising as still game.
another exchange. Market moves. in weekly settlement
forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price

• Fair Price = Cash Price + Cost of Carry.

Figure 2.3

Hedgers

Existing SYSTEM New

Derivatives – Indian Scenario - 47 -

buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure
5.8 gives the payoff for the writer of a three-month put option (often referred to as short
put) with a strike of 1250 sold at a premium of 61.70.

Figure 5.8 Payoff for writer of put option

The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option.
As the spot Nifty falls, the put option is in-the-money and the writer starts making losses .
If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the
strike price and Nifty-close. The loss that can be incurred by the writer of the option is a
maximum extent of the strike price(Since the worst that can happen is that the asset price
can fall to zero) whereas the maximum profit is limited to the extent of the up-front
option premium of Rs.61.70 charged by him.

Profit

61.70
1250
0 Nifty

Loss

5.3 Pricing Index Futures

Stock index futures began trading on NSE on the 12th June 2000. Ever since, the
volumes and open interest has been steadily growing. Looking at the futures prices on
NSE’s market, have you ever felt the need to know whether the quoted prices are a true
reflection
reflection of the underlying
underlying index’s
index’s price? Have you wondered
wondered whether
whether you could make
risk-less profits by arbitraging between the underlying and futures markets? If so, you
need to know the cost-of-carry to understand the dynamics of pricing that constitute the
estimation of fair value of futures.

5.3.1 The cost of carry model

We use fair value calculation of futures to decide the no-arbitrage limits on the price of a
futures contract. This is the basis for the cost-of-carry model where the price of the
contract is defined as:
Derivatives – Indian Scenario - 48 -

F=S+C
Where:
F: Futures price
S: Spot price
C: Holding costs or carry costs
This can also be expressed as:
F=s (1+r) T
Where:
r: Cost of financing
T: Time till expiration

(1+r)) T or F > s (1+r) T, arbitrage opportunities would exist i.e. whenever the
If F < s (1+r
futures price moves away from the fair value, there would be chances for arbitrage. We
know what the spot and future prices are, but what are the components of holding cost?
The components of holding cost vary with contracts on different assets. At times the
holding cost may even be negative. In the case of commodity futures, the holding cost is
the cost of financing plus cost of storage and insurance purchased etc. In the case of
equity futures, the holding cost is the cost of financing minus the dividends returns.

Note: In the futures pricing examples worked out in this book, we are using the concept
of discrete compounding, where interest rates are compounded at discrete intervals, for
example, annually or semiannually. Pricing of options and other complex derivative
securities requires the use of continuously compounded interest rates. Most books on
derivatives use continuous compounding for pricing futures too. However, we have used
discrete compounding as it is more intuitive and simpler to work with. Had we to use the
concept of continuous compounding, the above equation would have been expressed as:
F= Se rT
Where:
r: Cost of financing (using continuously compounded interest rate)
T: Time till expiration
e: 2.71828
Derivatives – Indian Scenario - 49 -

5.3.2 Pricing futures contracts on commodities

Let us take an example of a futures contract on a commodity and work out the price of
the contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15%
annually, what should be the futures price of 100 gms of silver one month down the line ?
Let us assume that we’re on 1st January 2001. How would we compute the price of a
silver futures contract expiring on 30th January? From the discussion above we know that
the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to
work out the components of the cost-of-carry model.

1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg.
2. What is the cost of financing for a month? (1+0.15) 30/365
3. What are the holding costs? Let us assume that the storage cost = 0.
In this case the fair value of the futures price, works out to be = Rs.708.
F=s (1+r) T + C = 700(1.15) 30/365 =Rs. 708
If the contract was for 3 month period i.e. expiring 30th March the cost of financing would
increase
increase the futures price.
price. Therefore, price would be C = 700(1.15) 90/365 =
Therefore, the futures price
Rs.724.5. On the other hand, if the one-month contract was for 10,000 kg. Of silver
instead of 100 gms, then it would involve a non-zero storage cost, and the price of the
future contract would be Rs. 708 +the cost of storage.

5.3.3 Pricing futures contracts on equity index

A futures contract on the stock market index gives its owner the right and obligation to
buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash
settled; there is no delivery of the underlying stocks.

In their short history of trading, index futures have had a great impact on the world’s
securities
securities markets. Indeed, index futures trading has been accused of making
making the world’s
stock markets more volatile than ever before. The critics claim that individual investors
have been driven out to the equity markets because the actions of institutio
institutional
nal traders in
both the spot and futures markets cause stock values to gyrate with no links to their
fundamental values. Whether stock index futures trading is a blessing or a curse is
Derivatives – Indian Scenario - 50 -

debatable. It is certainly true, however, that its existence has revolutionized the art and
science of institutional equity portfolio management.

The main differences between commodity and equity index futures are that: _

• There are no costs of storage involved in holding equity.

• Equity comes with a dividend stream, which is a negative cost if you are long the
stock and a positive cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends
Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is
an accurate forecasting of dividends. The better the forecast of dividend offered by a
security, the better is the estimate of the futures price.

5.3.4 Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where the carrying
cost is the cost of financing the purchase of the portfolio underlying the index, minus the
present value of dividends obtained from the stocks in the index portfolio.
Example
Nifty futures trade on NSE as one,two and three-month contracts. What will be the price
of a new two-month futures contract on Nifty?

1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15
days of purchasing the contract.
2. Current value of Nifty is 1200 and Nifty trades with a multiplier of 200.
3. Since Nifty is traded in multiples of 200, value of the contract is 200*1200 =
Rs.240,000.
4. If M & M has a weight of 7% in Nifty, its value in Nifty is Rs.16,800 i.e.(240,000 *
0.07).
5. If the market price of M & M is Rs.140, then a traded unit of Nifty involves 120 shares
of M & M i.e.(16,800/140).
6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of
dividend received. The amount of dividend received is Rs.1200 i.e.(120 * 10). The
dividend is received 15 days later and hence compounded only for the remainder of 45
Derivatives – Indian Scenario - 51 -

days. To calculate the futures price we need to compute the amount of dividend received
per unit of Nifty. Hence we divide the compounded dividend figure by 200.
7. Thus, futures price F = 1200(1.15) 60/365 {120*10(1.15) 45/365 /200} =Rs. 1221.80

5.3.5 Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are few
historical cases of clustering of dividends in any particular month, it is useful to calculate
the annual dividend yield.
F = s (1+r-q) T
Where:
F: futures price
S: spot index value
r: cost of financing
q: expected dividend yield
T: holding period

Example
A two-month futures contract trades on the NSE. The annual dividend yield on Nifty is
2% annualized. The spot value of Nifty 1200. What is the fair value of the futures
contract?
Fair value = 1200(1+.015-0.02) 60/365 =Rs. 1224.35

The cost of carry model explicitly defines the relationship between the futures price and
the related spot price. As we know, the difference between the futures price and the spot
price is called the basis.

Nuances

• As the date of expiration comes near, the basis reduces - there is a convergence of the
futures price towards the spot price. On the date of expiration, the basis is zero. If it is
not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when
the basis (difference between spot and futures price) or the spreads (difference
Derivatives – Indian Scenario - 52 -

between prices of two futures contracts) during the life of a contract are incorrect. At
a later stage we shall look at how these arbitrage opportunities can be exploited.
• There is nothing but cost-of-carry related arbitrage that drives the behavior of the
futures price.
• Transactions costs are very important in the business of arbitrage.

Note: The pricing models discussed in this chapter give an approximate idea about the
true future price. However the price observed in the market is the outcome of the price–
discovery mechanism (demand–supply principle) and may differ from the so-called true
price.

5.4 Pricing options

An option buyer has the right but not the obligation to exercise on the seller. The worst
that can happen to a buyer is the loss of the premium paid by him. His downside is
limited to this premium, but his upside is potentially unlimited. This optionality is
precious and has a value, which is expressed in terms of the option price. Just like in
other free markets, it is the supply and demand in the secondary market that drives the
rice of an option. On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31
Dec 2000 with a strike of 1500” will trade at a price that purely reflects supply and
demand. There is a separate order book for each option which generates its own price.
The values shown in Table 5.1 are derived from a theoretical model, namely the Black-
Scholes option pricing model. If the secondary market prices deviate from these values, it
would imply the presence of arbitrage opportunities, which (we might expect) would be
swiftly exploited. But there is nothing innate in the market, which forces the prices in the
table to come about.

There are various models, which help us get close to the true price of an option. Most of
these are variants of the celebrated Black-Scholes model for pricing European options.
Today most calculators and spreadsheets come with a built-in Black-Scholes options
pricing formula so to price options we don’t really need to memorize the formula. What
we shall do here is discuss this model in a fairly non-technical way by focusing on the
basic principles and the underlying intuition.
Derivatives – Indian Scenario - 53 -

5.5 Introduction to the Black–Scholes formulae

Intuition would tell us that the spot price of the underlying, exercise price, risk-free
interest rate, volatility of the underlying, time to expiration and dividends on the
underlying (stock or index) should affect the option price. Interestingly before Black and
Scholes came up with their option pricing model, there was a widespread belief that the
expected growth of the underlying ought to affect the option price. Black and Scholes
demonstrate that this is not true. The beauty of the Black and Scholes model is that like
any good model, it tells us what is important and what is not. It doesn’t promise to
Table 5.1 Option prices: some illustrative values

Option strike price

1400 1450 1500 1550 1600

Calls
1 mth 117 79 48 27 13

3 mth 154 119 90 67 48

Puts
1 mth 8 19 38 66 102
3 mth 25 39 59 84 114
Assumptions: Nifty spot is 1500, Nifty volatility is 25% annualized, interest rate is 10%,
and Nifty dividend yield is 1.5%.

produce the exact prices that show up in the market, but definitely does a remarkable job
of pricing options within the framework of assumptions of the model. Virtually all option
pricing models, even the most complex ones, have much in common with the Black–
Scholes model.

Black and Scholes start by specifying a simple and well–known equation that models the
way in which stock prices fluctuate. This equation called Geometric Brownian Motion,
implies that stock returns will have a lognormal distribution, meaning that the logarithm
of the stock’s re-turn will follow the normal (bell shaped) distribution. Black and Scholes
then propose that the option’s price is determined by only two variables that are allowed
to change: time and the underlying stock price. The other factors - the volatility, the
Derivatives – Indian Scenario - 63 -

3. In some cases, such as the land sale above, the person may simply not have cash to
immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually
cheap. He is exposed to the risk of missing out if Nifty rises.

So far, in India, we have had exactly two alternative strategies which an investor can
adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying in cash. With Nifty
futures, a third alternative becomes available:

• The investor would obtain the desired equity exposure by buying index futures,
immediately. A person who expects to obtain Rs.5 million by selling land would
immediately enter into a position LONG NIFTY worth Rs.5 million. Similarly, a
closed end fund which has just finished its initial public offering and has cash which
is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants
to be invested in equity. The index futures market is likely to be more liquid than
individual stocks so it is possible to take extremely large positions at a low impact
cost.
• Later, the investor/closed-end fund can gradually acquire stocks (either based on
detailed research and/or based on aggressive limit orders). As and when shares are
obtained, one would scale down the LONG NIFTY position correspondingly. No
matter how slowly stocks are purchased, this strategy would fully capture a rise in
Nifty, so there is no risk of missing out on a broad rise in the stock market while this
process is taking place. Hence, this strategy allows the investor to take more care and
spend more time in choosing stocks and placing aggressive limit order s.

Hedging is often thought of as a technique that is used in the context of equity exposure.
It is common for people to think that the owner of shares needs index futures to hedge
against a drop in Nifty. Holding money in hand, when you want to be invested in shares,
is a risk because Nifty may rise. Hence it is equally important for the owner of money to
use index futures to hedge against a rise in Nifty!

Table 6.1 Gradual acquisition of stocks, hedged

Derivatives – Indian Scenario - 64 -

On 17 Feb, Iqbal purchased 5000 nifties to obtain a position of Rs.5 million. From 18 Feb
onwards, on each day, Iqbal purchased one security worth Rs.357,000 (at 17 Feb prices)
and sold off a similar value of futures thus shrinking his futures position. For this
example, we deliberately use non–index small stocks; hedging using index futures works
for all portfolios regardless of what stocks go into them. Nifty rose sharply on 27
February and 28 February, so his outstanding futures position generated an infusion of
cash for him on these days. This inflow paid for the higher stock prices that he suffered.

Date Futures position Stock purchase Futur MTM

es profit/loss
sold (In Rs.)
17 Feb +5,000,000
18 Feb 4,597,074 2700 shares of ASIANHOTL 400 -17,042
19 Feb 4,190,807 2800 shares of BATAINDIA 400 38,430
20 Feb 3,786,330 5400 shares of BOMDYEING 400 18,801
23 Feb 3,375,976 55500 shares of SAIL 400 55,828
24 Feb 2,964,000 6050 shares of ESCORTS 400 13,795
25 Feb 2,648,488 1600 shares of DABUR 300 65,300
26 Feb 2,330,165 500 shares of CIPLA 300 25,290
27 Feb 2,007,454 1150 shares of CADBURY 300 35,112
02 Mar 1,673,850 4700 shares of APOLLOTYRE 300 76,248
03 Mar 1,350,948 5100 shares of ICICIBK 300 -64,214
04 Mar 1,019,453 2150 shares of ITCHOTEL 300 42,968
05 Mar 690,853 2100 shares of LAKME 300 -11,582
06 Mar 362,993 700 shares of PFIZER 300 -2,220
09 Mar 29,828 6300 shares of TITAN 300 10,611
Total 4,982,538 249,724

How do we actually do this?

1. Mr.Mehta obtained Rs.5 million on 17 Feb 1998. He made a list of 14 stocks to buy, at
17 Feb prices, totaling Rs.5 million.
2. At that time Nifty was at 991.70. He entered into a LONG NIFTY MARCH
FUTURES position for 5000 nifties, i.e. his long position was worth 5,053,600.
3. From 18 Feb 1998 to 09 March 1998 he gradually acquired the stocks (see Table 5.2).
On each day, he purchased one stock and sold off a corresponding amount of futures.
Derivatives – Indian Scenario - 65 -

On each day, the stocks purchased were at a changed price (as compared to the price
prevalent on 17 Feb). On each day, he obtained or paid the ‘mark–to–market margin’ on
his outstanding futures position, thus capturing the gains on the index.
4. By 09 Mar 1998 he had fully invested in all the shares that he wanted (as of 17 Feb)
and had no futures position left.
5. The same sequencing of purchases, without the umbrella of protection of the LONG
NIFTY MARCH FUTURES position, would have cost Rs.249,724 more.

6.5 S1: Bullish index, long Nifty futures

Do you sometimes think that the market index is going to rise? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from an upward movement in the index? Today, you have two choices:

1. Buy selected liquid securities, which move with the index, and sell them at a later date:
or, 2. Buy the entire index portfolio and then sell it at a later date.

The first alternative is widely used – a lot of the trading volume on liquid stocks is based
on using these liquid stocks as an index proxy. However, these positions run the risk of
making losses owing to company–specific news; they are not purely focused upon the
index. The second alternative is cumbersome and expensive in terms of transactions
costs.
How do we actually do this?
When you think the index will go up, buy the Nifty futures. The minimum market lot is
200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000.
When the trade takes place, the investor is only required to pay up the initial margin,
which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the
investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000,
the investor gets a claim on Nifty worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose any of them
to implement this position. The choice is basically about the horizon of the investor.
Derivatives – Indian Scenario - 66 -

Longer dated futures go well with long–term forecasts about the movement of the index.
Shorter dated futures tend to be more liquid.

6.6 S2: Bearish index, short Nifty futures

Do you sometimes think that the market index is going to fall? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from a downward movement in the index? Today, you have two choices:

1. Sell selected liquid securities which move with the index, and buy them at a later date:
or, 2. Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used – a lot of the trading volume on liquid stocks is based
on using these stocks as an index proxy. However, these positions run the risk of making
losses owing to company–specific news; they are not purely focused upon the index.

The second alternative is hard to implement. This strategy is also cumbersome and
expensive in terms of transactions costs.

How do we actually do this?

When you think the index will go down, sell the Nifty futures. The minimum market lot
is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000.
When the trade takes place, the investor is only required to pay up the initial margin,
which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the
investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000,
the investor gets a claim on Nifty worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose any of them
to implement this position. The choice is basically about the horizon of the investor.
Longer dated futures go well with long–term forecasts about the movement of the index.
Shorter dated futures tend to be more liquid.

6.7 A1: Have funds, lend them to the market

Derivatives – Indian Scenario - 72 -

Speculation
S3 Bullish index, buy Nifty calls or sell Nifty puts
S4 Bearish index, sell Nifty calls or buy Nifty puts
S5 Anticipate volatility, buy a call and a put at same strike
S6 Bull spreads, Buy a call and sell another
S7 Bear spreads, Sell a call and buy another

Arbitrage
A3 Put-call parity with spot-options arbitrage
A4 Arbitrage beyond option price bounds14

7.1 H5: Have portfolio, buy puts

Have you ever experienced
experienced the feeling of owning
owning an equity
equity portfolio, and then, one day,
becoming uncomfortable about the overall stock market?
Sometimes you may have a view that stock prices will fall in the near future. Many
investors simply do not want the fluctuations of these three weeks. One way to protect
your portfolio from potential downside due to a market drop is to buy portfolio insurance.

Index options is a cheap and easily implementable way of seeking this insurance. The
idea is simple. To protect the value of your portfolio from falling below a particular level,
buy the right number of put options with the right strike price. When the index falls your
portfolio will lose value and the put options bought by you will gain, effectively ensuring
that the value of your portfolio
portfolio does not fall below a particular level. This level depends
on the strike price of the options chosen by you.

Portfolio insurance using put options is of particular interest to Mutual funds who already
own well-diversified portfolios. By buying puts, the fund can limit its downside in case of
a market fall.

How do we actually do this?

Source: NSE Derivatives Module, www.derivativesindia.com,

14

www.erivativesreview.com, www.rediff/money/derivatives.htm
Derivatives – Indian Scenario - 73 -

We need to know the “beta” of the portfolio. We look at two cases, case one where the
portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1.

Portfolio insurance when portfolio beta is 1.0

1. Assume we have a well-diversified portfolio with a beta of 1.0, which we would like to
insure against a fall in the market.
2. Now we need to choose the strike at which we should buy puts. This is largely a
function of how safe we want to play. Assume that the spot Nifty is 1250 and you decide
to buy puts with a strike of 1125. This will insure your portfolio against an index fall
lower than 1125.
3. When the portfolio beta is one, the number of puts to buy is simply equal to the
portfolio value divided by the spot index.

Now let us look at the outcome. We have just bought two–month Nifty puts at a strike of
1125. This is designed to ensure that the value of our portfolio does not decline below
Rs.0.90 million. (For a portfolio with a beta of 1, a 10% fall in the index directly
translates into a 10% fall in the portfolio value). During the two–month period, suppose
the Nifty drops to 1080. This is a 13.6% fall in the index. The portfolio value too falls at
the same rate and declines
declines to Rs.0.864 million.
million. However the options provide a payoff of
(1125-1080)*4*200
(1125-1080)*4*200 which is equal to Rs.36,000.
Rs.36,000. This is the amount needed to bring the
value of the portfolio back to Rs.0.90 million.
Portfolio insurance when portfolio beta is not 1.0
1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure
against a fall in the market.
2. Now we need to choose the strike at which we should buy puts. This is largely a
function of how safe we want to play. Assume that the spot Nifty is 1200 and we decide
to buy puts with a strike of 1140. This will insure our portfolio against an index fall lower
than 1140.
3. For a portfolio with a non-unit beta, the number of puts to buy equals (portfolio value *
portfolio beta)/Index. Assume our portfolio is worth Rs.1 million with a beta of 1.2.
Hence the number of puts we need to buy to protect our portfolio from a downside is
Derivatives – Indian Scenario - 74 -

(10,00,000 *1.2)/1200 which works out to 1000. At a market lot of 200, it means that we
will have to buy 5 market lots of two month puts with a strike of 1140.

Now let us look at the outcome. We have just bought two month Nifty puts at a strike of
1140. This is designed to ensure the value of our portfolio does not decline below Rs.0.94
million. (For a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in
the portfolio value). During the two-month
two-month period, suppose the Nifty drops to 1080. The
portfolio value has declined to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2,
a 10% fall in the index translates into a 12% fall in the portfolio value). However the
options provide a payoff of (1140-1080)*5*200 which is equal to Rs.60,0000. This is the
amount needed to bring the value of the portfolio back to Rs.0.94 million.

7.2 S3: Bullish index, buy Nifty calls or sell Nifty puts
Do you sometimes think that the market index is going to rise? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from an upward movement in the index? Today, using options you have two
choices:
1. Buy call options on the index; or,
2. Sell put options on the index

We have already seen the payoff of a call option. The downside to the buyer of the call
option is limited to the option premium he pays for buying the option. His upside
however is potentially unlimited.

Having decided
decided to buy a call, which one should you buy? Table 7.1 gives the premia for
one-month calls and puts with different strikes. Given that there are a number of one–
month calls trading, each with a different strike price, the obvious question is: which
strike should you choose? Let us take a look at call options with different strike prices.
Assume that the current index level is 1250, risk-free rate is 12% per year and index
volatility is 30%. The following options are available:

1. A one month call on the Nifty with a strike of 1200.

Derivatives – Indian Scenario - 75 -

2. A one month call on the Nifty with a strike of 1225.

3. A one month call on the Nifty with a strike of 1250.
4. A one month call on the Nifty with a strike of 1275.
5. A one month call on the Nifty with a strike of 1300.
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the market index, and how much you are willing
to lose should this upward movement not come about. There are five one–month calls
and five one–month puts trading in the market.
Table 7.1 One-month calls and puts trading at different strikes

The spot Nifty level is 1250. There are five one-month calls and five one-month puts
trading in the market. Figure 7.1 shows the payoffs from buying calls at different strikes.
Figure 7.2 shows the payoffs from writing puts at different strikes.

Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
As a person who wants to speculate on the hunch that the market index may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited upside and
an unlimited downside.
Having decided to write a put, which one should you write? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious question
is: which strike should you choose ? This largely depends on how strongly you feel about
the likelihood of the upward movement in the market index. In the example in Figure 7.2,
at a Nifty level of 1250, one option is in–the–money and one is out–of–the–money. As
expected, the in–the–money option fetches the highest premium of Rs.64.80 whereas the
out–of–the–money option has the lowest premium of Rs.18.15.

Figure 7.1 Payoff for buyer of call options at various strikes

The figure shows the profits/losses for a buyer of Nifty calls at various strikes. The in–
the–money option with a strike of 1200 has the highest premium of Rs.80.10 whereas the
out–of–the–money option with a strike of 1300 has the lowest premium of Rs.27.50.
Derivatives – Indian Scenario - 76 -

Profit

1200 1250 1300

1280.10 1299.45 1327.50
Nifty
27.50
49.45

80.10

Loss

Figure 7.2 Payoff for writer of put options at various strikes

The figure shows the profits/losses for a writer of Nifty puts at various strikes. The in–
the–money option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas
the out–of–the–money option with a strike of 1200 has the lowest premium of Rs.18.15.

Profit

64.80

37.00

18.15

1200 1250 1300

1981.85 1213 1235.20 Nifty

Loss

7.3 S4: Bearish index: sell Nifty calls or buy Nifty puts
Derivatives – Indian Scenario - 77 -

Do you sometimes think that the market index is going to drop? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from a downward movement in the index? Today, using options, you have two
choices:
1. Sell call options on the index; or,
2. Buy put options on the index
We have already seen the payoff of a call option. The upside to the writer of the call
option is limited to the option premium he receives upright for writing the option. His
downside however is potentially unlimited. Having decided to write a call, which one
should you write? Table 7.2 gives the premiums for one month calls and puts with
different strikes. Given that there are a number of one-month calls trading, each with a
different strike price, the obvious question is: which strike should you choose ? Let us
take a look at call options with different strike prices. Assume that the current index level
is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the
following options :
1. A one month call on the Nifty with a strike of 1200.
2. A one month call on the Nifty with a strike of 1225.
3. A one month call on the Nifty with a strike of 1250.
4. A one month call on the Nifty with a strike of 1275.
5. A one month call on the Nifty with a strike of 1300.

Which of this options you write largely depends on how strongly you feel about the
likelihood of the downward movement in the market index and how much you are willing
to lose should this downward movement not come about.

Table 7.2 One month calls and puts trading at different strikes

The spot Nifty level is 1250. There are five one-month calls and five one-month puts
trading in the market. Figure 7.3 shows payoff for seller of various calls at different
strikes. Figure 7.4 shows the payoffs from buying puts at different strikes.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
Derivatives – Indian Scenario - 78 -

1250 1300 27.50 64.80

As a person who wants to speculate on the hunch that the market index may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited downside.
If the index does fall, you profit to the extent the index falls below the strike of the put
purchased by you. Having decided to buy a put, which one should you buy? Given that
there are a number of one-month puts trading, each with a different strike price, the
obvious question is: which strike should you choose? This largely depends on how
strongly you feel about the likelihood of the downward movement in the market index.

Figure 7.3 Payoff for seller of call option at various strikes

The figure shows the profits/losses for a seller of Nifty calls at various strike prices. The
in–the–money option has the highest premium of Rs.80.10 whereas the at–the–money
option has the lowest premium of Rs.27.50.

Profit
80.10

1327.5
49.45

27.50

1200 1250 1300

Nifty

Loss 1280.10
1299.45

Figure 7.4 Payoff for buyer of put options at various strikes

The figure shows the profits/losses for a buyer of Nifty puts at various strike prices. The
in–the–money option has the highest premium of Rs.64.80 whereas the at–the–money
option has the lowest premium of Rs.18.50.

Profit
Derivatives – Indian Scenario - 79 -

1182.85 | 1213 235.20 | |

1200 1250 1300 Nifty
18.15

37.00

64.80

Loss

7.4 S5: Anticipate volatility; buy a call and a put

Do you sometimes think that the market index is going to go through large swings in a
given period, but have no opinion on the direction of the swing? This strategy is useful in
times of uncertainty (e.g. recently during the WTC attacks). How does one implement a
trading strategy to benefit from market volatility? Combinations of call and put options
provide an excellent way to trade on volatility. Here is what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.

This combination of options is often referred to as a Straddle and is an appropriate

strategy for an investor who expects a large move in the index but does not know in
which direction the move will be.

Consider an investor who feels that the index which currently stands at 1252 could move
significantly in three months. The investor could create a straddle by buying both a put
and a call with a strike close to 1252 and an expiration date in three months. Suppose a
three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same
strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00. If
at the end of three months, the index remains at 1252, the strategy costs the investor
Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires
worth Rs.2). If at expiration the index settles around 1252, the investor incurs losses.
However, if as expected by the investors, the index jumps or falls significantly, he profits.

For a straddle to be an effective strategy, the investor’s beliefs about the market
movement must be different from those of most other market participants. If the general
Derivatives – Indian Scenario - 91 -

Books
1. Options Futures, and other Derivatives by John C Hull
2. Derivatives FAQ by Ajay Shah
3. NSE’s Certification in Financial Markets: - Derivatives Core module
4. Investment Monitor Magazine July 2001

Reports
1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta
2. Risk containment in the derivatives markets by Prof.J.R.Verma

Websites
• www.derivativesindia.com
• www.nse-india.com
• www.sebi.gov.in
• www.rediff/money/derivatives.htm
• www.igidr.ac.in/~ajayshah
• www.iinvestor.com
• www.appliederivatives.com
• www.erivativesreview.com
• www.economictimes.com
• www.cboe.com (Chicago Board of Exchange)
• www.adtading.com
• www.numa.org

Visit mbafin.blogspot.com for

more
Derivatives – Indian Scenario - 92 -