Fundamentals of

Futures and Options

Dr. Tinaikar

Strictly for Private Circulation Only

Topics

⚫ Forwards…………………………....... 3
⚫ Futures……………………………….. 30
⚫ Options……………………………….. 49
⚫ Derivatives Trading………………… 75
⚫ Derivative Mishaps………………… 118
⚫ Derivatives Trading on NSE……… 128

2
Forwards

3
Forward Contract

A forward contract is an O-T-C contract and is

an agreement to buy or sell an asset at a
certain time in the future for a certain price
determined at the origination of the contract

4
Forward Price

⚫ The forward price for a contract is the

delivery price that would be applicable to
the contract if it were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
⚫ The forward price may be different for
contracts of different maturities

5
Forward Contracts-
Characteristics
⚫ It is an OTC contract.
⚫ At the end of the life of the contract the buyer of
the asset buys the asset from the seller at an
agreed price determined at the origination of the
contract
⚫ By contrast in a spot contract there is an
agreement to buy or sell the asset immediately (or
within a very short period of time e.g. T+2)
⚫ There is no daily settlement
⚫ Forward contracts on currencies and interest are
popular and are used to hedge exchange rate and
interest rate risks
6
Spot Price

⚫ In the context of securities market, spot price is

the price determined in the spot market or cash
market in which securities are sold for cash and
delivered immediately
⚫ The NSE’s cash market segment is known as the
Capital Market (CM) Segment where shares of say
SBI, Reliance, Infosys and other public listed
companies are traded and settled on a T+2 basis
⚫ The buyer of the shares receives the shares and
the seller the money two working days after the
trade date.
7
Forward Contract Illustration

8
Terminology

• The party that has agreed to buy the

underlying asset has what is termed
a long position
• The party that has agreed to sell the
underlying asset has what is termed
a short position

9
Foreign Exchange Quotes for
INR/USD Exchange Rate on
April 23, 2019
Spot and forward quotes for USD/INR exchange
rate on April 23, 2019
Blank Bid Offer

Spot 69.7150 69.7250

1-month forward 70.0650 70.0950

3-month forward 70.5650 70.5950
6-month forward 71.3225 71.3525
The quotes are for number of INR per USD
10
Hedging Using Forward
Contracts
⚫ On April 23, 2019 the treasurer of an Indian
company enters into a long forward contract to buy
USD 1 million for payment of imports in six months
at an exchange rate of INR 71.3525/USD
⚫ This obligates the company to pay INR 71.3525
million on October 23, 2019 to buy USD 1 million
⚫ What are the possible outcomes?

11
Hedging Using Forward
Contracts
1. INR spot exchange rate depreciates to INR
72.0000 /USD on 23rd October 2019 the value of
the forward contract is positive because the
company would have saved:
INR/USD (72.0000-71.3525) x USD 1 million =
INR 6,47,500 for the corporation
2. On the other hand if INR appreciates to INR
71.0000/USD on 23rd October 2019 the value of
the forward contract is negative because the
company would have incurred a loss of:
INR/USD (71.0000-71.3525) x USD 1 million =
INR (3,52,500)
12
 Payoff Profile of Long Forward
Payoff
profit

Consider the payoffs at

maturity to a long position
INR6.47 in a six month forward
Lakhs contract on $1,000,000.

St
Spot exchange in 6 months
INR71.0000/USD INR72.0000/USD
INR/USD
INR3.52 INR71.3525/USD
Lakhs

If St = INR 72.0000/USD, Profit = INR/USD (72.0000-71.3525) x USD 1 m

loss

= INR 6,47,500
If St = INR 71.0000/USD, Loss = INR/USD (71.0000-71.3525) x USD 1 m
= INR 3,52,500
13
Payoff from a Long Forward Position (K
= delivery price = forward price at time
contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

The pay off or profit from a long position in a forward contract

on one unit of an asset = ST - K , where K (= INR 71.3525) is
the delivery price and ST is the spot price of the asset at the
maturity of the contract. 14
Payoff from a Short Forward Position (K
= delivery price = forward price at time
contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

The pay off or profit from a short position in a forward contract

on one unit of an asset = K - ST ; where K = INR 71.3525
15
Payoff Profiles of Long and
Short Forward Positions
Long Position Short Position

Profit (+) Profit (+)

Price of Underlying Price of Underlying

at Maturity (ST) K at Maturity (ST)
K

Loss (-) Loss (-)

Pay Off or Profit = ST - K Pay Off or Profit = K - ST

16
Payoff Profiles of Long and Short
Forward Positions
⚫ The pay-off profile from a long position in a
forward contract on one unit of an asset is:
ST – K
⚫ The pay-off profile from a short position in a
forward contract on one unit of an asset is:
K – ST
here ST = Spot price at the time of maturity
the contract
K = Forward Rate or the delivery price
If ST > K the contract has a positive value for
the buyer or long position
If ST < K the contract has a positive value for
the seller or short position
17
 Booking and Cancellation of
Forward Exchange Contracts
⚫ Example 1:
------------------------I------------I----------------
0 3 mth 4 mth 6 mth
I--------------------------------------------------------> (t = 6 mths : INR 73/USD)
I-------------------------------> (t = 3 mths : INR 74/USD)
I-----------------> (t = 4 mths : INR73.50/USD)
1) Importer books forward contract for 6 mths @ INR 73/USD
2) Cancels : t = 3 mths @ INR 74/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR 73.50/USD. Loss = INR 0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR 72.50/USD
If F (t=4) < INR 74/USD  Net Gain by rebooking Forward
If F (t=4) > INR 74/USD  Net Loss by rebooking Forward
Break-Even = INR74/USD
 Booking and Cancellation of
Forward Exchange Contracts
⚫ Example 2:
----------------------I------------I-----------------
0 3 mth 4 mth 6 mth (t=6mth: INR73/USD)
I------------------------------> (t=4mth: INR72/USD)
I-----------------> (t=2mths: INR72.50/USD)
1) Exporter books forward contract for 6 mths @ INR 73/USD
2) Cancels : t = 3 mths @ INR72/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR72.50/USD. Loss = INR 0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR73.50/USD
If F(t=4) > INR 72/USD  Net Gain by rebooking Forward
If F(t=4) < INR 72/USD  Net Loss by rebooking Forward
Break-Even = INR72/USD
Forward Contract Features

Two features of forward contract :

⚫ Default (Credit) risk is two-sided i.e. on both the
counterparties.
⚫ Value of the Forward Contract is realized only at
maturity. No payment is made either at
origination or during the term of the contract i.e.
performance period is the maturity.

20
Forwards

Advantages
⚫ Customized product
⚫ Contract is settled by delivery of the asset
⚫ Contract price not available in the public domain
Disadvantages
⚫ Contract is settled only at maturity and not M-T-M
⚫ Credit instrument and entails counterparty default
or credit risk
⚫ Lack of centralized trading
⚫ Illiquidity in secondary market
21
Forward Prices and Spot Prices

⚫ Suppose a stock which pays no dividend is worth

INR 600 today. You can borrow or lend money for
1 year at risk free interest rate of 5%.
What should the 1-year forward price of the stock
be assuming that:
1) You don’t own the stock and
2) You don’t have any surplus cash to invest

22
Forward Prices and Spot Prices
Suppose the investor borrows INR 600 for 1 year @
5% so that he has to pay INR 630 at the end of 1 year.
Scenario-A (Cash-and-Carry Arbitrage)
If the 1-Year Forward Price is > INR 630 say INR 670
then the investor who does not own the stock will:
(1) Borrow INR 600 @ 5% for 1 year
(2) Buy 1 stock at the current market price of INR 600
(3) Enter into a forward contract to Sell the stock after
1 year for INR 670
(4) Pay the loan with interest = INR 630
(5) Profit after paying off the loan = INR 670 – INR 630
= INR 40 per share 23
Forward Prices and Spot Prices
Scenario-B (Reverse Cash-and-Carry Arbitrage)
If the Forward price of the stock is < INR 630 say INR 580.
The investor who does not own the stock will:
(1) Short the stock at the current market price for INR 600
(2) Invest the proceeds for 1 year @5% and earn INR 630
(3) Enter into a Forward contract to Buy the stock back after
1 year for INR 580
(4) Profit = INR630 - INR 580 = INR 50
Therefore, for there to be no arbitrage the forward price
must be:
F = 600 x (1+0.05) = INR 630
Therefore, F = S (1+r )
24
Forward Prices and Spot Prices

In general,

F = S (1+r )T
where:
F = forward price of the stock deliverable in ‘T’ years
S = spot price of the stock
r = 1-year (domestic currency) risk-free rate of interest

• Cash and Carry Arbitrage is also known as Contango

• Reverse Cash and Carry Arbitrage is also known as

Backwardation
25
Hedging Using Forward
Contracts: Conclusion
⚫ The purpose of hedging using forwards contracts
is to reduce risk
⚫ A forward contract protects the hedger against
unfavorable price movement but does not enable
him to take advantage of favorable price
movement
⚫ There is no guarantee that the outcome with
hedging will be better than the outcome
without hedging

26
Futures

27
Futures Contracts

⚫ A futures contract is an agreement to buy or

sell an asset at a certain time in the future for a
certain price determined at the beginning of the
contract
⚫ It is similar to a forward contract
⚫ Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange
⚫ Therefore futures contracts entail margin
requirements, daily settlement procedures,
delivery procedures etc.
28
Exchanges Trading Futures
• CME Group formed when Chicago Mercantile
Exchange (CME) and Chicago Board of Trade
(CBOT) merged
• Intercontinental Exchange (ICE)
• ICE NYSE (formed when ICE purchased NYSE
in 2013)
• Euronext
• Eurex is the largest European Futures and
Options Market
• TIFFE (Tokyo)
• NSE / BSE / MCX(India)
29
Electronic Trading

⚫ Traditionally futures contracts have been traded

using the open outcry system where traders
physically meet on the floor of the exchange
⚫ This has now been largely replaced by electronic
trading (NEAT F&O Trading System on NSE) and
high frequency (algorithmic) trading which
involves the use of computer programs to initiate
trades, often without human intervention, and has
become an important feature of derivatives market

30
Types of Assets Traded

⚫ Commodities e.g. agricultural products, live cattle,

sugar, wool, lumber, copper, aluminum, gold and
tin
⚫ Financial Assets e.g. stocks, stock indices,
currencies, treasury bonds etc.

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Futures Price

⚫ Futures prices are regularly reported in the

financial press
⚫ Futures price is determined by laws of demand
and supply i.e. if more traders want to go long
than short the price goes up and if the reverse is
true then the price goes down

32
History of Futures Markets
⚫ Traced to Middle Ages
⚫ Originally developed to meet the needs of farmers
and merchants
⚫ Example:
⚫ A farmer in June of a certain year who will harvest a
known quantity of wheat in September faces uncertainty
about the price of the wheat he will receive
⚫ A trader of wheat that has ongoing requirement for
wheat is also exposed to price risk.
⚫ The farmer and the trader get together in June or even
earlier to agree on a price (futures contract) for the
farmer’s estimated production of wheat in September
33
Examples of Futures Contracts

Agreement in March to:

⚫ Buy 1 tonne i.e. 1000 kg of wheat in June
⚫ Buy 100 oz. of gold @ US$1300/oz. in
September
⚫ Sell £62,500 @ 1.4500 US$/£ in June
⚫ Sell 1,000 bbl. of oil @ US$50/bbl. in April
⚫ Buy Nifty Futures contract in April at a price
of 2220

34
Payoff of a Buyer of Nifty
Futures at 6000 (Long Futures)

The investor bought a 2- month Nifty index futures contract when the index
was at 6000. If the index goes up, the futures position starts making profit.
35
If
the index falls, his futures positions starts showing losses
Payoff of a Seller of Nifty
Futures (Short Position) at 6000

The investor sold the futures when the Nifty index was at 6000. If the
index goes down, the futures position starts making profit. If the index 36

rises, his futures positions starts showing losses

Example-1

⚫ January: an investor enters into a long

futures contract to buy 100 oz of gold @ INR
1,100 per oz in April
⚫ April: the price of gold is INR 1,175 per oz
What is the investor’s profit or loss?

37
Example-2 (Long Hedge)

1. A long hedge involves holding a long position in the

futures market.
⚫ A long position holder agrees to buy the underlying
asset at the expiry date by paying the agreed
futures/forward price.
⚫ The current spot price of Wipro Ltd. is INR 250 per
stock. An investor does not have the cash now and is
expecting to receive INR 250 at the end of the month.
⚫ This strategy is used by those who will need to acquire
the underlying asset in future and expect the price of
the asset to rise.
38
Example-2 (Long Hedge)

⚫ In such a case, he can buy Wipro in the futures market on

NSE at Rs 250 and lock in the price of the stock
⚫ Scenario-1: Suppose the price of Wipro on the expiry day in
the spot i.e. cash market is INR 300
⚫ As futures price is equal to the spot price on the expiry day,
the futures price would be Rs 300 on expiry day.
⚫ Profit to the investor in the future market = INR 300 - INR 250
= Rs 50
⚫ His investment cost for purchase of one Wipro share is:

= INR 300 (spot price) – INR 50 (profit in the futures market)

= INR 250 i.e. price of the futures contract which the investor
has locked
39
Example-2 (Long Hedge)
⚫ If the investor had not locked in the price of INR 250 he
would have had only INR 250 and would not be able to
buy the Wipro share for INR 300 in the cash market.
⚫ Alternatively if investor had the cash and not locked in
the price of INR 250 he would have to pay INR 300 at the
end of the month.

40
Example-2 (Long Hedge)

⚫ Scenario-2: Suppose the price of Wipro in the cash market

the expiry day is Rs 200
⚫ As futures price tracks the spot price, the futures price would
also be Rs 200 on the expiry day
⚫ The investor will sell Wipro in the futures market at Rs 200

⚫ Loss to the investor in the futures market = Rs 200 – Rs 250

= Rs 50
⚫ So his investment cost for purchase of one Wipro share is:

= Rs 200 (spot price) + Rs 50 (loss in the futures market)

= Rs 250
⚫ Thus the investor has locked in a fixed purchase price of Rs
250 by entering into a futures contract in both the scenarios
41
 Example-3 (Short Hedge)
2. A short hedge involves taking a short position in the
futures market. A short hedge is taken by some one who
already owns the underlying asset and is expecting the
price of the asset to fall.
⚫ An investor holding 1000 shares of Reliance Industries
which he has purchased at Rs 2100 per share is worried
about fall in the price of the share in future say after a
month
⚫ He can hedge the price risk by going short in the futures
market on NSE i.e. selling Reliance share in futures
market on the NSE at Rs 2100 per share
⚫ In case the price of Reliance share falls below Rs 2100,
the loss in the share will be made good by the gain in
Reliance Futures
42
Example-3 (Short Hedge)

⚫ Scenario-1: Suppose spot price on the expiry date i.e.

end of one month is Rs 2000.
⚫ Since the futures price converges to the spot price at
expiry he will buy the futures at Rs 2000
⚫ Gain on futures = (Rs 2100 – Rs 2000) = Rs 100
⚫ So the investor’s effective sale price is:
= Rs 2000 (spot price) + Rs 100 (gains on the futures
contract)
= Rs 2100

43
Example-3 (Short Hedge)

⚫ Scenario-2: Suppose the futures price on the expiry date

i.e. end of one month is Rs 2200.
⚫ Since the futures price converges to the spot price at
expiry he will buy the futures at Rs 2200
⚫ Loss on futures = (Rs 2100 – Rs 2200) = Rs 100
⚫ So the investor’s effective sale price is:
= Rs 2200 (Spot Price) – Rs 100 (Loss on the Futures)
= Rs 2100

⚫ Thus the investor is locked in a fixed sales price of Rs

2100 by entering into a futures contract on Reliance share

44
Example-4 (Short Hedge)

3. A sugar manufacturing company could hedge

against any probable loss in future due to fall in the
prices of sugar by holding a short hedge in the
futures/forwards market
⚫ If the price of sugar falls, the company may lose on
the sugar sale but the loss will be offset by profit
made in the futures contract

45
Forward vs Futures Contract

Forward Futures
Private contract between two Traded on an exchange
parties i.e. OTC contract
Not standardized Standardized
Settled at end of contract Settled daily i.e. mark to market
Profit or Loss realized only on Profit and Losses are realized day
delivery date to day
Delivery or final settlement usual Usually closed out prior to maturity
Credit risk depends on Virtually no credit risk
counterparty
Illiquid Secondary Market Liquid Secondary Market

50
Options

47
Option

An option is a contract which confers the right but

not an obligation to the buyer to buy or sell a
specified quantity of an asset at a specified price
within a specified period of time on payment of an
upfront premium

48
Types of Options

⚫ A call option is an option to buy a certain

asset by a certain date for a certain price (the
strike) by paying an up-front premium asset
⚫ A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price) by paying an up-front premium

49
Premium

It is the upfront fee charged by the writer to the

buyer of the option for conferring a right not an
obligation to buy or sell an asset at a
predetermined price called the strike price. It is also
called the price or premium of the option

50
Strike Price or Exercise Price
⚫ The price at which the option can be exercised
and is predetermined at the time of
buying/writing the option
⚫ It is the price at which the buyer or holder of
the option buys/sells the asset

51
Strike Date/Maturity Date

The time by which the option must be

exercised

52
Types of Options

⚫ An American option can be exercised at

any time during its life
⚫ A European option* can be exercised
only at maturity

*Only European options are traded on NSE

53
Types of Options

⚫ Call Option European = CE

⚫ Call Option American = CA
⚫ Put Option European = PE
⚫ Put Option American = PA

54
Types of Participants in
Options Market

⚫ Buyer or Holder of Call

⚫ Seller or Writer of Call
⚫ Buyer or Holder of Put
⚫ Seller or Writer of Put

55
Example 1: Buying Call Option
⚫ Suppose ‘A’ has bought a Call Option (CA) of 2000
shares of HUL at a strike price of INR 260 per share at a
premium of INR 10 and maturing on or before August 27
2020 (expiry date of the call option)
⚫ The call option gives ‘A’ the right to buy 2000 shares of
HUL from the seller or writer of the option on or before
August 27, 2020.
⚫ The buyer of the call option does not have the obligation
to exercise the call option at strike price of INR 260
⚫ The seller or writer of the call option has the obligation to
sell 2000 shares of HUL at INR 260 per share on or
before August 27, 2020 i.e. when the buyer exercise the
option
56
Example 2: Selling Put Option

⚫ Suppose ‘A’ sold Put Option (PA) on 100 Reliance

Industries (RIL) share at a strike price of INR 2000 at a
premium of INR 8 and maturing on or before August
27, 2020 (expiry date of the put option).
⚫ The buyer of the put option does not have the
obligation to exercise the put option at the exercise
price of INR 2000
⚫ The seller ‘A’ of the put option has an obligation to buy
100 shares of RIL at a price of INR 2000 per share on
or before August 27 2020 i.e. when the buyer of the put
option exercises the option.

57
Google Call Option: Example

⚫ Example-3:
• An investor instructs a broker to buy one December
call option contract on Google shares with a strike
price of $700
• The price of the option (premium) to buy one share
is $52.50.
• Therefore to buy one contract of 100 shares the
investor has to pay $5250.
• The investor must arrange $5250 to be remitted to
the exchange through the broker to CBOE
• The exchange will then arrange for this amount to
be paid to the party the seller
58
Google Call Option: Example
⚫ Example-3 (Cont..):
• By paying $5250 the investor has bought the right to
buy 100 Google shares for $700 each
• If the price of Google share is less than $700 by
December the option is not exercised and the investor
loses $5,250
• If the Google does well and the bid price of the stock
rises to $900 then the investor will exercise the option
by buying the share for $700 and immediately selling
them for $900.
• The profit is $20,000 or $14,750 (= $20,000 - $5250)
taking into account the options cost or premium of
$5250
59
Pay-off profile from purchasing a contract
consisting 100 Google Dec call options
with Strike price of $700
Payoff profile of the Buyer of CE

Payoff = ST - K
Strike Price
= $700

BEP = $752.50
Options Price
= $52.50
BEP = Strike Price + Option Premium
60
Pay-off profile from selling or writing a
contract consisting 100 Google Dec call
options with Strike price of $700
Payoff profile of the Writer of CE

10000
BEP = $752.50
Payoff = ST - K
5000

500 600 700 800 900 1000

- 5000 Options Price Stock Price($)
= $52.50

-10000 Strike Price

= $700

(b)
BEP = Strike Price + Option Premium
61
Google Put Option: Example
⚫ Example-4:
• An investor buys one September put option on Google
shares through a broker with strike price $660 and the
price (premium) of $24.20
• The investor pays 100 x $24.20 = $2,420 through his
broker to the exchange to buy one contract of 100 shares
• If the price of Google share stays above $660 the put
option is not exercised by the buyer and the trader loses
$2,420
• If the Google share price falls to $600 the put option is
exercised by the investor and there is a profit to the
investor
• The investor will sell the shares at $660 when they are
worth only $600. This leads to a profit of $6,000 or $3,580
when the initial amount of $2,420 is paid for the options is
taken into account 62
Pay-off profile from buying a contract
consisting 100 Google Dec September put
options with Strike price of $660
Profit ($) Payoff profile of the Buyer of PE

15,000
Payoff = K - ST
10,000 Strike Price = $660

5,000

500 600 700 800 900 1000

- 5,000 Stock Price ($)

-10,000 BEP = $635.80 Options Price

= $24.20
-15,000
BEP = Strike Price – Option Premium
63
Pay-off profile from selling a contract
consisting 100 Google Dec September put
options with Strike price of $660
Payoff profile of the Writer of PE

Payoff = K - ST

Options Price
BEP = $635.80 = $24.20

Strike Price = $660

BEP = Strike Price – Option Premium
64
Pay-off Profile of European Call Option
of Infosys Technology Ltd. (source:NSE)
“At the money”
Profit Strike price
(INR)
“Out of the money” “In the money”

Unlimited profit
INR 75

Spot price
500 875 950 1500
INR 75 (INR)
Limited loss
Break-even price

Loss
(INR)
Option Price = INR 75
Strike Price = INR 875
Option Life = 3 months
65
Pay-off Profile of European Put Option
of Infosys Technology Ltd. (source:NSE)
“At the money”
Profit
(INR) Strike price

“In the money” “Out of the money”

INR 67
Spot price
500 683 750 1000
INR 67 (INR)
Limited loss

Break-even price

Loss
(INR) Option Price = INR 67
Strike Price = INR 750
Option Life = 3 months
66
Pay-off Profiles of Investors
Long and Short on Nifty
Long Position in Nifty Short Position in Nifty

The investor bought Nifty at 6000 The investor sold Nifty at 6000
67
Pay-off Profiles of Buyer and Writer
of a 3 month Nifty Call Options
Payoff for buyer of call option Payoff for writer of call option
(Long Call) (Short Call)

Strike price of Nifty = 6000

68
Pay-off Profiles of Buyer and Writer
of a 3 month Nifty Put Options
Payoff for buyer of put option Payoff for writer of put option
(Long Put) (Short Put)

Strike price of Nifty = 6000 69

Four Basic Options – the “Building Blocks”
Long call (bought) Long put (bought)

Profit Profit
Loss Loss

Short call (sold) Short put (sold)

Profit Profit
Loss Loss
Google Call Option Prices, May 3, 2016 ;
Stock Price: bid $695.86, offer $696.25; (source
CBOE)
Strike Jun 2016 Jun 2016 Sep 2016 Sep 2016 Dec 2016 Dec 2016
Price Bid Offer Bid Offer Bid Offer

660 43.40 45.10 60.80 62.70 72.70 76.70

680 29.20 30.60 47.70 50.70 60.90 64.70

700 18.30 18.90 37.00 39.20 49.70 52.50

720 9.90 10.50 27.50 29.50 40.10 42.80

740 4.70 5.20 19.8 0 21.60 31.40 34.40

1. Option Strike Prices: $660, $680, $700, $720, $740

2. Maturities: June 2016, Sep 2016, and Dec 2016
3. Expiration Dates: 3rd Friday of expiration month i.e. June 17, 2016; Sep 16, 2016; and Dec 16, 2016
71
 Google Put Option Prices, May 3, 2016
Stock Price: bid $695.86, offer $696.25; (source
CBOE)
Strike Jun 2016 Jun 2016 Sep 2016 Sep 2016 Dec 2016 Dec 2016
Price Bid Offer Bid Offer Bid Offer

660 7.50 8.20 24.20 26.20 35.60 38.10

680 13.30 14.00 31.90 33.80 43.40 46.00

700 21.70 23.00 40.80 42.70 52.40 55.20

720 33.10 34.80 51.10 53.20 62.60 65.20

740 47.70 49.60 63.10 65.20 74.10 76.70

1. Option Strike Prices: $660, $680, $700, $720, $740

2. Maturities: June 2016, Sep 2016, and Dec 2016
3. Expiration Dates: 3rd Friday of expiration month i.e. June 17, 2016; Sep 16, 2016; and Dec 16, 2016
72
Google Call and Put Options:
Some Observations
⚫ The price of a call option decreases (↓) while the
price of a put option increases (↑) as the strike
price increases
⚫ But call and put options become more valuable as
their time to maturity increases (↑)
⚫ The Expiration dates of the options are 3rd Friday
of the expiration months viz. Jun, Sep, and Dec
⚫ In exchange-traded equity options one contract is
usually to buy or sell 100 shares

73
Google Call and Put Options:
Some Observations
⚫ Option Premium and Strike Price (Intrinsic Value)
K1 K2 S K3 K4 K5

660 680 696 700 720 740 Strike Price

• Call Option will be exercised when the spot price (S) >
the strike price (K)
• As K increases the pay-off from exercising the Call
option decreases i.e. the option becomes less valuable
and so the options premium decreases
• Put Option will be exercised when S < K
• As K increases the probability of exercising the Put
option increases and so the options premium increases
74
Google Call and Put Options:
Some Observations
⚫ Options Premium and Time to Maturity (Time
Value)
⚫ As time to maturity increases the probability of exercising
both the Call and Put Option increases and so both
options become more valuable and the options premium
increases
⚫ The opposite when the time to maturity decreases

75
Exchanges Traded Options

⚫ Chicago Board Options Exchange (CBOE)

⚫ International Securities Exchange
⚫ NYSE Euronext
⚫ Eurex (Europe)
⚫ NSE, BSE
⚫ and many more

76
Options vs Futures/Forwards
⚫ A futures/forward contract gives the holder the
obligation to buy or sell an asset at a certain price
⚫ A futures/forward contract locks the holder into a
fixed price and protects him against adverse price
movements in future but does not allow him to take
advantage of favorable price movements
⚫ An option gives the holder the right but not the
obligation to buy or sell an asset at a certain price
⚫ An options contract provides insurance for investors
by protecting them against adverse price movements
in future while allowing them to benefit from favorable
price movements.
77
Options vs Futures/Forwards
/ Forwards

78
Derivatives Trading

79
Types of Derivatives Traders

⚫ Hedgers
⚫ Speculators
⚫ Arbitrageurs

80
Types of Derivatives Traders
⚫ Hedgers
⚫ Use futures, forwards, and options to reduce
risk from potential future movements in market
variables

⚫ Speculators
⚫ Use derivatives to bet on future direction of a
market variable

⚫ Arbitrageurs
⚫ Take offsetting positions in two or more
instruments or markets to lock in a profit
81
Hedging Using Forward
Contract
⚫ On April 23, 2019 an Indian company known as
Import Co. has entered into a contract with a
U.S. Company to pay USD 10 million on July 23,
2019 for the goods it purchased from the
American supplier. The INR-USD exchange rate
quotes made by a bank are shown in the next
slide

82
Foreign Exchange Quotes for
INR/USD Exchange Rate on April
23, 2019
Spot and forward quotes for INR/USD exchange
rate on April 23, 2019
Blank Bid Offer

Spot 69.7150 69.7250

1-month forward 70.0650 70.0950

3-month forward 70.5650 70.5950
6-month forward 71.3225 71.3525

The quotes are for number of INR per USD from the Reuter screen
83
Hedging Using Forward
Contract – Example 1
⚫ The Import company could hedge its foreign
exchange risk by buying dollars (USD) from a
bank in the 3-month forward market at INR
70.5950/USD
⚫ This would fix the price to be paid to the American
supplier at INR 705.95 million or about INR 70.60
crores
⚫ The company can do better or worse if it chooses
not to hedge than if it chooses to hedge

84
Hedging Using Forward
Contract
⚫ If the spot exchange rate on July 3, 2019 is INR
70.5000/USD instead of INR 70.5950/USD and the
Import Co. had not hedged the USD 10 million that it
has to pay to the American Company, then
⚫ it would have cost INR 0.95 million (0.095 INR/USD
x USD 10 million) i.e. INR 9.5 lakhs less and the
company may wish that it had not hedged
⚫ On the other hand if the exchange rate on July 3,
2019 is INR 71/USD and the Import company had not
hedged it would cost INR 4.05 million (0.405
INR/USD x USD 10 million) i.e. INR 40.5 lakhs more
and the company may wish that it had hedged
85
Hedging Using Forward
Contract – Example 2
⚫ On April 23, 2019 an Indian Company known as
Export Co, which is exporting goods to the U.S.
knows that it will receive USD30 million 3 months later
i.e. on July 23, 2019
⚫ The Export Co. can hedge its foreign exchange risk by
selling USD30 million in the forward market at an
exchange rate of INR 70.5650/USD. This would have
the effect of locking in the exchange rate of 70.5650
and realize INR 2117 million (INR 70.5650/USD x
USD 30 million) or INR 211.70 crores
⚫ The company can do better or worse if it chooses not
to hedge than if it chooses to hedge
86
Hedging Using Forward
Contract
⚫ If the spot exchange rate on July 23, 2019 is less
than INR 70.5650/USD say INR 70.0000/USD the
Export company will be pleased to have made the
right decision to hedge because it would have
received INR 16.95 million (INR 0.5650/USD x USD
30 million) or INR 1.696 crores less if it had not
hedged.
⚫ If the exchange rate is greater than 70.5650 say INR
71.0000/USD the Export company would have
received INR 13.05 million (INR 0.435 x USD 30
million) or INR 1.305 crores more and the company
may wish it had not hedged.
87
Hedging Using Forward
Contract: Conclusion

The purpose of hedging is to reduce risk. There is

no guarantee that the outcome with hedging using
Forward Contract will be better than the outcome
without hedging

88
Hedging Using Options -
Example
⚫ An investor owns 1,000 Microsoft shares
currently worth $28 per share. The investor is
concerned about a possible share price decline in
the next 2 months.
⚫ He wants to protect against fall in the price of the
share by buying a put option.
⚫ A two-month Put with a strike price of $27.50
costs $1.00.
⚫ The size of each put contract is 100 shares

89
 Hedging Using Options –
Example
⚫ The investor decides to hedge by buying 10 put
contracts with each put contract of 100 shares
▪ Each contract costs 100 x $ 1.00 = $ 100 and so 10
contracts cost $1000 which is the cost of hedging.
▪ This would give the right to sell Microsoft shares at
$27.50 per share if the price falls below $27.50.
▪ Scenario-A (Market Price of the Stock falls below $27.50)
▪ The put option will be exercised so that the total amount
realized is ($27,500-$1000) = $26,500
▪ Scenario-B (Market Price of the stock stays above $
27.50)
▪ The put option is not exercised and expires worthless.
The value of the holding will be > $26,500 after taking into
account cost of the options
90
Value of Shares with and
without Hedging

$1.00
Options
Premium
26,500

27.50

‘x’ axis: share price ($)

‘y’ axis: value of holdings ($)
91
Speculation

⚫ Hedgers want to avoid exposure to

adverse movements in the price of an
asset
⚫ Speculators wish to take a position in
the market
⚫ Either they are betting that the price of
the asset will go up or they are betting
that the price of the asset will go down

92
Speculation Using Futures

⚫ Take a long position in futures today if the

underling asset is expected to appreciate in
future and close the position by taking a short
position
⚫ Take a short position in futures today if the
underlying asset is expected to depreciate in
future and close the position by taking a long
position

93
Speculation Using Futures

⚫ A U.S. investor in February thinks that GBP will

appreciate against USD over the next two
months and is willing to bet on £250,000
⚫ The current spot exchange rate is $1.4540/£
⚫ The April futures price is $1.4543/£
What are the alternative speculation strategies?

94
Speculation Using Futures
⚫ Option-1 (Buy GBP in the Spot Market)
• Buy £250,000 by selling $363,500 at the exchange rate
$1.4540/£ in the spot market in the hope that GBP can be
sold at a higher price in the next two months. (The sterling
once purchased could be kept in an interest bearing
account.)
⚫ Option-2 (Take Long Position in the Futures Market)
⚫ Each CME futures contract is worth £62,500
⚫ Take a long position in 4 CME April futures contract on
GBP (4 x £62,500 = £250,500) with the expectation that
GBP will appreciate.
⚫ The initial margin requirement is $5000 per contract.
⚫ The April futures price is $1.4543/£ 95
 Speculation using Spot and
Futures Contracts
Spot Exchange Rate= $/£
• Buy £250,000 • Buy 4 CME April
• Spot Price futures contracts
1.4540$/£ each of £62,500
• Futures Price =
1.4543
• Initial Margin on 4
futures contracts =
4x$5000 = $20,000
Investment $363,500 $20,000

Profit if April Spot =1.5000 $11,500 $11,425

(£ has appreciated) = 250,000 (1.5000 -1.4540) = 250,000 x (1.5000 –
1.4543)
Profit if April Spot =1.4000 - $13,500 - $13,575
(£ has depreciated) = 250,000 (1.4000 – = 250,000 x (1.4000 –
1.4540) 1.4543)
96
Speculation using Spot and
Futures Contracts – Differences
• The first alternative of buying GBP requires an up-front
investments of $363,000
• In contrast the second alternative requires only a small
amount of cash to be deposited by the speculator as
“margin account” i.e. $2000 per contract or $ 20,000 in
total
• The futures market allows the speculator to obtain
leverage i.e. with a small initial outlay, a large
speculative position can be taken
• ROI if the GBP appreciates
▪ 3.16% in the first case and 57% in the second.
• ROI if the GBP depreciates
▪ (3.7%) in the first case and (68%) in the second 97
Speculation using Spot and
Futures Contracts - Conclusion

⚫ Speculation on Futures Contract is

Risky

98
Speculation Using Options

⚫ In October a speculator with $2,000 to invest

feels that a stock price will increase over the
next 2 months. The current stock price is $20
and the price of a 2-month call option with a
strike of $22.50 is $1.00
⚫ What are the alternative strategies?

99
Speculation Example
⚫ Option-1 (Purchase Shares in the Spot Market)
• Purchase 100 shares with investment of $2000
• If the speculator’s hunch is correct and the stock
price rises to $27 in the next 2 months then profit
is:
100 x ($27 – $20) = $700 (ROI = 35%)
• Option-2 (Purchase Call Options on the Shares)
• Purchase 2000 call options on the share with
investment of $2000 (one call option costs $1) and
• Exercise the call option. The total payoff from
2000 options purchased is:
= 2000 x ($27 – $22.50) = $9000
Net Profit = ($9000 – $2000) = $7000
(ROI = 350%) 100
Speculation Example (Cont..)
• The options strategy is 10 times more profitable
than directly buying the stock
• Options also give rise to greater potential loss
• Suppose the stock price falls to $15 by the end
of two months i.e. Dec.
• The first alternative of buying stocks yields a
loss of:
100 x ($20 – $15) = ($500)
• Because the call option expires without being
exercised, the second alternative i.e. options
strategy would result in a loss of US$2000 i.e.
the original amount paid for the options.
101
Speculation Example (Cont..)

• Options provide a form of leverage:

➢For a given investment, the use of options
magnifies the financial consequences.
➢Good outcomes become very good, while
bad outcomes may result in whole initial
investment being lost

102
Comparison of profits from two
alternative strategies for using $2000 to
speculate on stock worth $20 in October
December Stock Price

Speculator’s Strategy $27 $15

(Initial Investment of
$2000)

Buy 100 Shares $700 -$500

=100 x ($27- $20)

Buy 2000 Call Options* $7000# -$2000

• Strike Price = $22.50
• Option Price = $1.00
per call option
# [($27 - $22.5) x 2000 - $2000] = $7000 103
Pay-off Profile from two alterative strategies for
speculating on a stock currently worth $20
“At the money”
Profit
($) Strike price

“Out of the money” “In the money” Unlimited profit

4000
Buy Shares
Buy Options
2000
$ 1.0

Spot price
20 22.5 23.5 27
$1.0 ($)
Limited loss
- 2000
Break-even price

Loss
($) Option Price = $ 1.0
Strike Price = $ 22.5
Option Life = 2 months
BEP = Strike Price + Options Premium
104
Comparison of Futures and
Options
• Both futures and options provide leverage for
speculators
• When a speculator uses futures the potential
loss as well as potential gain is very large
• When options are used, no matter how bad
things get, the speculator’s loss is limited to
the amount paid for the options while the
upside potential is unlimited

105
Arbitrage

Arbitrage involves locking in riskless

profit by simultaneously entering into
two or more markets to exploit price
differentials

106
Arbitrage Example

⚫ A stock price is quoted as $150 in New York and

£100 in London and the current exchange rate is
$1.5300/£. What is the arbitrage opportunity?
⚫ The price of the stock in London = $153
⚫ An arbitrageur would simultaneously buy 100
shares of the stock in N.Y. and sell them in London
to obtain risk-free profit of :
100 x [$153 - $150] = $300
In the absence of transaction costs

107
1. Gold: An Arbitrage
Opportunity?
Suppose that:
• The spot price of gold is US$1,200 per
ounce
• The 1-year forward price of gold is
US$1,300
• The 1-year US$ interest rate is 5% per
annum
• No income or storage costs for gold
Is there an arbitrage opportunity?

108
1. Gold: An Arbitrage
Opportunity?
Solution:
1) Borrow $1200 @ 5% p.a. to purchase 1
oz of gold for $1200
2) Sell 1 oz of Gold in the 1-year forward
market for $1300
3) Profit = $1300 - $1200(1.05)
= $1300 - $1260
= $ 40

109
2. Gold: Another Arbitrage
Opportunity?

Suppose that:
• The spot price of gold is US$1,200
• The 1-year forward price of gold is
US$1,200
• The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

110
2. Gold: Another Arbitrage
Opportunity?
Solution:
Option-1
1) Short-Sell 1 oz of Gold for $1200
2) Invest $1200 Forward for 1-year @5%
3) Buy 1 oz of Gold in the 1-year Forward
Market for $1200
4) Profit = $1200(1.05) - $1200 = $60

111
The Future Price of Gold
(ignores gold lease rate)
If the spot price of gold is S and the futures
price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
For example, S = 1200 USD/oz, T = 1, and r =
0.05 so that
F = 1200(1+0.05) = 1260
112
1. Oil: An Arbitrage Opportunity?

Suppose that:
• The spot price of oil is US$50
• The quoted 1-year futures price of
oil is US$60
• The 1-year US$ interest rate is 5%
per annum
• The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

113
1. Oil: An Arbitrage Opportunity?

Solution:
1) Borrow $50 @ 5%
2) Buy Oil Spot for $50
3) Sell in 1-year Futures market at $60
4) Pay the Loan of $50 with interest @ 5%
and Storage cost of Oil @2%
5) Profit = $60-$50(1.07) = $6.5

114
2. Oil: Another Arbitrage
Opportunity?

Suppose that:
• The spot price of oil is US$50
• The quoted 1-year futures price of oil is
US$40
• The 1-year US$ interest rate is 5% per
annum
• The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

115
1. Oil: An Arbitrage Opportunity?

Solution:
1) Short Sell Oil Spot for $50
2) Invest $50 for 1-year @5% p.a. so that
you get $52.50
3) Buy Oil Forward for $40
4) Pay the storage cost @2% i.e. $1.00
5) Profit = $52.50 - $40.00 -$1.00 = $11.50

116
Dangers

⚫ Traders can switch from being hedgers to

speculators or from being arbitrageurs to
speculators
⚫ It is important to set up controls to ensure that
traders are using derivatives for their intended
purpose
⚫ SocGen is an example of what can go wrong

117
Mini Case Study - SocGen’s Big
Loss in 2008
⚫ Derivatives are versatile instruments – they can be used
for hedging, speculation, and arbitrage
⚫ One of the risks that is faced by a company which trades
derivatives is that an employee who is mandate to hedge
or to look for arbitrage opportunities may become a
speculator
⚫ Jerome Kerviel joined SocGen in 2000 to work in the
compliance area and in 2005 was promoted and became
a junior trader in the bank’s Delta One products team
⚫ He traded equity indices such as German DAX index, the
French CAC 40, and the Euro Stoxx 50.
⚫ His job was to look for arbitrage opportunities
118
Mini Case Study - SocGen’s Big
Loss in 2008
⚫ Arbitrage opportunities arise if:
⚫ A futures contract on a equity index was trading at a
different price on two different exchanges
⚫ They might also arise if equity index futures prices
were not consistent with prices of the shares
constituting the index
⚫ Kerviel used his knowledge of the bank’s procedures to
speculate while giving the appearance of arbitraging
⚫ He took big positions in equity indices and created
fictitious trades to make it appear that he was hedged
⚫ In reality, he had large bets on the direction in which the
indices would move.

119
Mini Case Study - SocGen’s Big
Loss in 2008
⚫ The size of his unhedged position grew over time grew
over tens of billions of euros
⚫ In January 2008, his unauthorized trading was
uncovered by SocGen
⚫ Over a three day period, the bank unwound his position
for a loss of €4.9 billion
⚫ This was at the time the biggest loss created by
fraudulent activity in the history of finance

120
Business Snapshot – Baring
Bank’s Collapse in 1990s
⚫ In the 1990s Nick Leeson, who worked at Barings
Bank, had a mandate to that Jerome Kerviel
⚫ His job was to arbitrage between Nikkei 225 futures
quotes in Singapore and Osaka
⚫ Instead he found a way to make big bets on the
direction of the Nikkei 225 using futures and options
losing $1 billion and destroying the 200-year bank in
the process

121
Hedge Funds
⚫ Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities publicly
⚫ Mutual funds must
⚫ disclose investment policies,
⚫ make shares in the fund redeemable at any time
⚫ limit use of leverage
⚫ Hedge funds are not subject to these constraints.
⚫ Hedge funds use complex trading strategies for
primarily speculation and arbitrage and are big users of
derivatives
⚫ When a trader gets a mandate to use derivatives for
hedging or arbitrage, but then switches to speculation,
large losses can result
⚫ Typical hedge fund fee: 2% of amount invested + plus
20% of the profits 122
Derivatives Mishaps

123
Derivatives Mishaps
⚫ Metallgesellschaft AG (1993)
⚫ Entered into long-term contracts to supply oil and
gasoline and hedged them rolling over short-term
futures. It lost $1.3 billion
⚫ Orange County (1994)
⚫ Activities of the treasurer, Robert Citron resulted in
California municipality losing $2 billion in 1994
⚫ Procter and Gamble (1994)
⚫ The treasury department lost $90 million in 1994
trading highly exotic derivatives contracts with
Banker’s Trust. It later sued Bankers Trust and
settled out of court
124
Derivatives Mishaps
⚫ Barings Bank (1995)
⚫ This 200 years old British bank was destroyed by the
activities of one trader, Nick Leeson, in Singapore, who
made big bets on the future direction of Nikkei 225 using
futures and options
⚫ Long-Term Capital Management (1998)
⚫ The hedged fund lost $4 billion in 1998 s a result of
Russia’s default on its debt and the resultant flight to
quality
⚫ Collapse of Lehman Brothers in (2008)
⚫ Lehman filed for bankruptcy on September 15, 2008.The
risks taken by Lehman included large positions in
instruments created by sub-prime mortgage
125
Derivatives Mishaps
⚫ Sub-prime Mortgage Crisis (2007)
⚫ In 2007 investors lost confidence in the structured
products created fro U.S. subprime mortgages. This led
to credit crunch and losses of tens of billions of dollar by
financial institutions such as UBS, Merill Lynch, and
Citigroup
⚫ Societe General (2008)
⚫ Rogue equity derivatives trader Jerome Kerviel lost
over $7 billion speculating on futures direction of equity
indices in January 2008
⚫ UBS
⚫ In 2011 Kweku Adoboli lost $2.3 billion by taking
unauthorised speculative positions in stock market
indices 126
Derivatives Mishaps

⚫ J.P. Morgan’s Derivatives Loss (2012)

⚫ In April and May 2012, large trading losses to the extent
of $ 2 billion involving credit default swaps (CDS)
occurred at JP Morgan's Chief Investment Office, based
on transactions booked through its London branch.
Trader Bruno Iksil, nicknamed the London Whale,
accumulated outsized CDS positions in the market.

127
Derivatives Trading on NSE

128
Derivatives Trading on NSE

⚫ Derivatives Definition
⚫ The F&O Instruments Traded on NSE
⚫ Growth of F&O Market in India
⚫ F&O Trading System
⚫ Contract Specifications
⚫ Settlement
⚫ Risk Management

129
Derivatives Definition

⚫ Securities Contract Regulation Act (1956)

(SC(R)A) defines “derivative” to include
1. a security derived from a debt instrument, share,
loan, whether secured or unsecured, risk instrument
or contract for differences or any other form of
security
2. A contract which derives its value from the prices, or
index of prices, of underlying securities
⚫ Derivatives are securities under the SC(R)A and
hence their trading is governed by the regulatory
framework under the SC(R)A
130
Derivatives Trading on NSE

⚫ Derivatives trading in India happens mostly on NSE

⚫ NSE is the largest derivatives exchange in India in
terms of volume and turnover
⚫ NSE is the world’s no 1 exchange in terms of
number of contracts traded

131
Equity Derivatives Traded on
NSE

⚫ The F&O segment of NSE provides trading

facilities for the following equity derivatives
instruments:
⚫ Individual stock futures

⚫ Individual stock options

⚫ Index based futures

⚫ Index based options

132
Equity Derivatives Traded on
NSE
⚫ 199 stocks stipulated by SEBI
⚫ Three Major Indices*
⚫ Nifty 50
⚫ Bank Nifty
⚫ Nifty IT

*NSE Indices Ltd. (formerly India Index Services & Products Ltd (IISL))
manages a portfolio of 67 indices under NIFTY Brand

133
Equity Derivatives Traded on
NSE
⚫ How do exchanges decide which stocks are part of
F&O segment?
⚫ Based on SEBI Guidelines such as:
⚫ Among top 500 market cap
⚫ Average order size
⚫ Minimum 500 crs market wide open position limits in
the stock i.e. maximum number of contracts that can
be open at a time
⚫ Average monthly turnover of the stock in the
derivatives segment ≥ Rs 100 crs last three months
⚫ Eligible securities vary from month to month
134
Equity Derivatives Traded on
NSE
⚫ Broad Market Indices
⚫ Nifty 50
⚫ Nifty Next 50
⚫ Nifty 100
⚫ Nifty 200
⚫ Nifty 500
⚫ Nifty Midcap 50
⚫ Nifty Midcap 100
⚫ Nifty Midcap 150
⚫ Nifty Smallcap 50
⚫ Nifty Smallcap 100
⚫ Nifty Smallcap 250
⚫ Nifty MidSmallcap 400

135
Other Derivatives Traded on
NSE
⚫ In addition to the F&O Segment NSE also trades
⚫ Currency Futures
⚫ Currency Options
⚫ Interest Rate Futures
⚫ Interest Rate Options
⚫ Commodity Options & Futures (since 2018)

136
Futures Products Traded on NSE

⚫ Commodity Futures
⚫ Equity Index Futures
⚫ Single Stock Futures
⚫ Interest Rate Futures including Bond Futures
⚫ Currency Futures
⚫ Volatility Futures (trade on volatility index or VIX)

137
Options Products Traded on NSE

⚫ Single Stock Options

⚫ Equity Index Options
⚫ Currency Options
⚫ Interest Rate Options on G-Sec Bonds

138
Volatility Index (VIX)

⚫ It is a measure of markets expectation of volatility

over the near term
⚫ India VIX (India volatility Index) measures the
amount of volatility that traders expect over the next
30 days in the Nifty 50 index
⚫ It is measured in percentage terms and is a
calculation of price swings investors expect in the
market over important market news
⚫ When the value of VIX is low it indicates the
absence of fear factor in the market and vice-versa
⚫ Was introduced on NSE in 2008 and Chicago
exchange in 1993 139
Volatility Index – Utility for
Traders
⚫ Gives intraday stock traders and short term traders
an indication whether volatility is going up or going
down an so they can calibrate their strategy
⚫ Useful indicator for trader in options i.e. the decision
to buy or sell an option is based on volatility
⚫ It is good and reliable gauge of the index movement
– negative correlation. Market tends to peak out
when VIX is bottoming out and vice versa
⚫ It is an invaluable tool for portfolio managers and
mutual fund managers – increase exposure to high
Beta stocks when VIX has peaked out and low beta
stocks when VIX has bottomed out
140
Growth of Derivatives Market in India
based on the Number of Contracts traded

“-” implies that the product had not been introduced in the market 141
Turnover of Derivatives Contracts traded on
NSE every year (in INR billions); (source:
NSE of India)

142
 Turnover of Equity Derivatives
Traded on NSE as on July 12, 2021

As on Jul 12, 2021 15:30:25 IST

Premium
Product No. of contracts Turnover (cr.)*
Turnover (cr.)

Index Futures 2,63,346 21,954.96 -

Stock Futures 5,73,261 47,205.33 -
Index Options 3,53,10,535 34,93,187.66 12,836.58
Stock Options 17,51,750 1,48,323.90 2,660.56
F&O Total 3,78,98,892 37,10,671.85 15,497.14

* In case of Options contracts “Turnover” represents “Notional Turnover” i.e.

turnover which includes premium obtained on selling of the option +
absolute profit 143
Turnover of Interest Rate Futures
Contracts as on July 12, 2021
As on 12-Jul-2021 17:00:00 IST

OPEN
VOLUME(CONTR
TRADE DATE VALUE(₹ LAKHS) INTEREST(CONT
ACTS)
RACTS)

12-Jul-2021 951 1,850.25 29,605.00

09-Jul-2021 2,706 5,286.90 29,515.00

08-Jul-2021 8,275 16,177.68 29,951.00
07-Jul-2021 1,270 2,477.46 31,807.00
06-Jul-2021 7,084 13,833.70 31,033.00

144
Turnover of Currency Derivatives
Traded on NSE as on July 12, 2021
JUL-2021

CURRENCY FUTURES CURRENCY OPTIONS TOTAL

TOTAL
AVERAGE
DATE NOTIONAL PREMIUM DAILY
NO. OF TURNOVER(₹ NO. OF NO. OF TURNOVER(₹
TURNOVER(₹ TURNOVER**
CONTRACTS LAKHS) CONTRACTS CONTRACTS LAKHS) TURNOVER*(
LAKHS) (₹ LAKHS) ₹ LAKHS)

12-Jul-2021 31,26,037 24,97,603.77 24,50,171 18,37,683.86 3,241.20 55,76,208 43,35,287.63 43,35,287.63

09-Jul-2021 23,78,145 18,93,315.06 53,13,641 39,77,167.70 6,712.03 76,91,786 58,70,482.76 58,70,482.76

08-Jul-2021 4,87,120 4,74,868.46 7,47,311 5,58,430.37 847.43 12,34,431 10,33,298.83 10,33,298.83

07-Jul-2021 32,19,937 25,71,785.03 51,21,452 38,37,503.37 5,843.08 83,41,389 64,09,288.40 64,09,288.40

06-Jul-2021 30,12,446 23,72,040.52 30,30,806 22,66,910.71 3,697.19 60,43,252 46,38,951.22 46,38,951.22

05-Jul-2021 28,10,764 21,93,508.50 42,48,746 31,78,976.18 5,956.05 70,59,510 53,72,484.68 53,72,484.68

145
Turnover of Derivatives Traded
on NSE
⚫ Index Options and Stock Options are most actively traded
derivatives with highest volume (number of transactions)
and turnover
⚫ Single Stock Futures and Index Futures are also popular
⚫ Single Stock Futures is the predominant derivative
instrument traded in the Futures segment in the market
as observed from the data in the previous slides
⚫ Interest Rate Futures are not actively traded
⚫ Currency Futures and Options trading is much lower
compared to trading in F&O segment on NSE

146
Liquidity of Futures Products in
India

⚫ Commodity Futures – most active

⚫ Equity Futures and then Index Futures – popular
⚫ Currency Futures – gaining ground
⚫ Interest Rate Futures – Not very active

147
Rank of NSE Globally in Different
Derivatives Segment by Number
of Trades
Segment Rank
Single Stock Options 8
Single Stock Futures 2
Stock Index Options 1
Long Term Interest Rate 8
Options & Futures
Currency Options & Futures 1
Contracts

Source: NSE: Indian Securities Market: A Review 2019

148
Contract Specification - Trading
Cycles on NSE
⚫ All Stock and Index Futures
⚫ 3 month trading cycle
⚫ Near month (one)
⚫ Next month (two)
⚫ The far month (three)
⚫ Expires on last Thursday of every month
⚫ VIX derivatives – expire weekly every Tuesday
⚫ Global Index Derivatives - expire on 3rd Friday of
every month
⚫ Bank Nifty Index and Nifty 50 Index - expire
weekly every Thursday
149
Contract Specification of Nifty 50 Futures

150
Contract Specification of Nifty-50 Options

151
Contract Specification of Stock Futures

152
Contract Specification of Stock Options

153
Futures and Options Trading
System
⚫ National Exchange for Automated Trading (NEAT)
system
⚫ NSE operates a what is called NEAT-F&O trading
system
⚫ It provides a fully automated screen based trading
system for Index futures & options and Stock futures &
options on a nationwide basis as well as online
monitoring and surveillance mechanism
⚫ It is similar to that of trading of equities in the cash
market
⚫ It supports an order driven market wherein orders are
matched automatically on the basis of security, its price
and quantity 154
Futures and Options Trading
System
⚫ Two types of trading systems
⚫ Order Driven
⚫ All of the orders of both the buyers and sellers are
displayed detailing:
▪ the price at which they are willing to buy or sell a
security and
▪ the amount of the security that they are willing to
buy or sell at that price
⚫ Quote Driven
⚫ Quote driven market only displays the bid and ask
offers of the designated market makers and dealers
155
Futures and Options Trading
System

⚫ Entities in the Trading System

⚫ Trading Members (TMs)
⚫ Clearing Members (CMs)
⚫ Participants

156
Futures and Options Trading
System

⚫ Entities in the Trading System

⚫ Trading Members (TMs)
⚫ They are members of the NSE
⚫ They can trade either on their own account or on
behalf of their clients
⚫ The exchange assigns IDs to each TM and each TM
can have more than one user
⚫ TMs have access to functions such as order entry,
order matching, and order and trade management

157
Futures and Options Trading
System
⚫ Entities in the Trading System
⚫ Clearing Members (CMs)
⚫ They are members of NSE Clearing Ltd. (formerly
National Securities Clearing Corporation Limited
(NSCCL)) which is a wholly owned subsidiary of NSE
responsible for clearing and settlement of all trades
executed on NSE
⚫ The CM performs the following functions:
▪ Clearing
▪ Settlement
▪ Risk Management
158
Futures and Options Trading
System
⚫ Clearing Members (CMs)
⚫ CMs are of three types:
▪ Self Clearing Member
▪ Clears and settles trades executed by him only
either on his own account or on account of his
clients
▪ Professional Clearing Member
▪ Clearing member who is not a trading member

▪ Trading-cum-Clearing Member
▪ Member who executes trades and clears and settles
the trades executed on his own account as on
account of his clients
159
Futures and Options Trading
System
⚫ Participants
⚫ Clients of TMs e.g. financial institutions
⚫ Clients may trade through multiple TMs but settle
through a single CM

⚫ Clearing Banks
⚫ Funds settlement takes place through clearing banks
⚫ CMs are required to open a separate bank account with
a bank designated by NSE Clearing Ltd.
⚫ CMs keep a margin amount in these bank accounts

160
Order Types and Conditions

⚫ The system allows the trading members to enter

orders with various conditions attached to them as
per their requirements
⚫ These conditions are broadly divided into the
following categories:
⚫ Time Conditions:
⚫ On the basis of time
⚫ Price Conditions:
⚫ On the basis of price

161
Order Types and Conditions

162
Order Types and Conditions
⚫ Time Conditions
⚫ Day Order
⚫ Is an order which is valid for the day on which it is
entered
⚫ If the order is not executed during the day, the
system cancels the order automatically at the end of
the day
⚫ Immediate or Cancel (IOC)
⚫ Allows the user to buy or sell a contract as soon as
the order is released into the system, failing which
the order is cancelled from the system
⚫ Partial match is possible for the order and the
unmatched portion of the order is cancelled
immediately
163
Order Types and Conditions
⚫ Price Condition
⚫ Limit Price/Order
⚫ An order that allows the price to be specified while
entering the order into the system
⚫ Market Price/Order
⚫ An order to buy or sell securities at the best price
obtainable at the time of entering the order
⚫ Stop Loss(SL) Price/Order
⚫ Allows the Trading Member to place an order which
gets activated only when the market price of the
relevant security reaches or crosses a threshold
price
⚫ Until then the order does not enter the market
164
Order Types and Conditions

⚫ Stop Loss(SL) Price/Order (cont..)

⚫ A buy order in the Stop Loss book gets triggered
when the last traded price in the normal market
reaches or exceeds trigger price of the order
⚫ A sell order in the Stop Loss book gets triggered
when the last traded price in the normal market
reaches or falls below the trigger price of the order

165
Order Processing and
Matching
⚫ Neat F&O trading system follows an order driven
approach
⚫ Orders, as and when received are first and
immediately processed for potential match
⚫ If a match is not found, then the orders are stored
in different “books”
⚫ The best “buy” order will match with the best “sell”
order
⚫ For order matching, the best buy order is the one
with the highest price and the best sell order is the
one with the lowest price 166
Order Processing and
Matching
⚫ This is because a computer views all buy orders
available from the point of view of the seller and al
sell orders from the point of view of the buyers in
the market
⚫ So of all buy orders available in the market, the
seller would like to sell at the highest possible
“buy” price
⚫ Hence the best buy order is the order with the
highest price and the best sell order is the the one
with the lowest price
167
Clearing and Settlement
⚫ Settlement Procedure
⚫ All F&O contracts are cash settled i.e. through
exchange of cash by Clearing Members
⚫ The underlying for index futures/options of Nifty
index cannot be delivered and therefore these
contracts have to be settled in cash
⚫ Although futures and options on individual securities
will be delivered as in the spot market on maturity,
else the settled in cash
⚫ Settlement of futures contracts:
⚫ Mark to Market (MTM) daily settlement

⚫ Final Settlement on the expiry day of the futures

168
Settlement

Futures Contract

169
Settlement
⚫ Settlement Procedure for Futures Contracts
⚫ Mark to Market (M-T-M) Daily Settlement
⚫ The profit/loss is the difference between the price of
the futures contract on the settlement day and the
price on the previous day i.e. the trade day.
⚫ To cover the risk of default by the counter-party
⚫ Margin balance in the futures account each day is
adjusted for change in the value of the contract from
the previous day based on daily settlement price of
the futures contract
⚫ The party in the loss position pays the Clearing
Corporation the margin money to cover the shortfall
in cash
⚫ Daily M-T-M settlement is on a T+0 basis 170
Settlement

⚫ Settlement Procedure of Futures Contracts

⚫ Final Settlement
⚫ After the close of the trading NSE Clearing marks all
the positions of CMs to the final settlement price
and the resulting profit / loss position is settled in
cash
⚫ Final settlement loss/profit is debited/credited to the
relevant CMS clearing bank account on T+1 day

171
Settlement
⚫ Settlement Procedure of Options
⚫ Daily Premium Settlement on a net basis i.e. premium
payable and premium receivable are netted
⚫ Final Exercise Settlement
⚫ On the expiry date all in-the-money options will be
exercised by default
⚫ An investor who is in-the-money on the exercise date will
receive the exercise settlement value which is the
difference between the settlement price and the exercise
price
⚫ The final exercise price settlement value for in-the- money
options is:
▪ Call Options = Closing price on the day of expiry –
strike price
▪ Put Options = Strike Price - Closing Price 172
Risk Management
⚫ Risk Management of derivatives products is managed by
Standard Portfolio Analysis of Risk (SPAN)
⚫ It is a sophisticated VaR methodology that calculates the
margin requirements under any market scenario
⚫ The objective of SPAN is to identify overall risk in a
portfolio of futures and options contracts for each
member
⚫ It determines the largest loss that a portfolio might be
expected to suffer from one day to the next based on
99% VaR methodology and thus calculates the margin
requirements
⚫ The margin requirements are set to cover one-day loss
173
Value-at-Risk

⚫ VaR is one of the standard measures to quantify

market risk
⚫ It is a statistical risk measure to estimate the potential
loss from adverse market movements in a normal
market environment over a given period of time
⚫ VaR is defined as the maximum potential loss in the
value of a portfolio due to adverse market movements
over a certain period of time (e.g.1 day) for a given
probability or confidence level (e.g. 99%)

174
Value-at-Risk

⚫ For e.g. with a 99% confidence level, VaR estimates

the loss level such that 99% of the time (e.g. 99
trading days out of 100), the actual loss level will be
less than that number
⚫ VaR measures are used both for risk management
and for regulatory purposes i.e. required capital for
banks exposure to risk

175
Value at Risk (Var) Models
⚫ Example-1
Suppose a Fund estimates its portfolio’s daily average
VaR is INR 100 million over a 10-day interval with 99%
level of confidence
If the VaR estimate of INR100 million is correct, losses in
portfolio value > INR100 million should occur less than
1% of the time
In other words, the bank’s management anticipates losing
at most INR100 million for 99 out of 100 ten-day intervals

176
Value at Risk (Var) Models
⚫ Example-2
Fund X’s risk management team calculates a 1-day 99%
VaR for market risk to be USD 3 million.
This means that there is a 1% chance that bank X could
lose more than USD 3 million.
That also means that there is a 99% chance that losses
will be less than USD 3 million the next day.

177
Value at Risk (Var) Models

⚫ The VaR models are complex computer algorithms

used to determine the maximum amount a bank
might lose at a given confidence level over a
specified time period
⚫ They attempt to measure the market risk of a
portfolio whose value may decline due to adverse
movements in interest rates, stock prices, currency
values or commodity prices

178
Derivatives Trading on NSE
⚫ Vijay, a manager of Prime Fund, wants to enter into a
derivatives contract to hedge the risk of a decrease in the
value of his portfolio
⚫ Step-1
⚫ Vijay will contact NSE broker and place an order with the
limit price (price specified) to sell 5 June contracts of
CNX Nifty Index Futures on NSE
⚫ Step-2
⚫ The broker will key in the order placed by Vijay in the
order book of NSE and the order will be matched by the
computer
⚫ If there is an order already in the order book to sell 5
futures contracts of CNX Nifty Index Futures the NSE
computer will automatically match the two orders 179
Derivatives Trading – Example
⚫ Step-3
⚫ The CM is responsible for fulfilling the contract clearing
the trade.
⚫ Once the CM clears the trade it takes the responsibility
of fulfilling the obligation of the contract at maturity
⚫ The purpose of having the CM responsible for clearing
the trade is to ensure organized functioning of the
derivatives exchange so that the default rate is
minimized
⚫ Step-4
⚫ For the CM to be responsible for the fulfilment of the
contract at maturity, the CM will have to post a margin
that is usually based on the volatility of the underlying
asset price and notified by the NSE
180
Derivatives Trading - Example
⚫ Step-5
⚫ Since the CM only clears the trade and does not take
any position in the trade, the CM will ask the broker to
provide the funds for the margin which will be collected
by the broker from Vijay
⚫ Step-6
⚫ The broker will maintain an account know as the margin
account, which will be updated daily based on settlement
price of that day, known as mark-to-market
⚫ Step-7
⚫ As long as Vijay wants to keep his position in futures
market before maturity, his only responsibility is to follow
the instructions of the broker w.r.t. the margin account
181
Derivatives Trading - Example

⚫ In case the margin balance falls below the variation

margin the broker will issue a margin call to Vijay,
informing that the margin has fallen and informing him to
deposit additional money
⚫ Step-8
⚫ At maturity the contract will be settled
⚫ The settlement price will be calculated by NSE and if
the margin account shows a positive amount the amount
is a gain for Vijay (amount credited to his account) and
if it is a negative amount it is a loss (amount debited
from his account).

182