Empirical analysis of equity & derivatives
EMPIRICAL ANALYSIS OF EQUITY & DERIVATIVES
A Project Report Submitted In Partial Fulfillment
Of Post Graduate Diploma in Management (PGDM)
To
TIMSR
By
RAJ PANDYA
Batch 2010-11
Under the Guidance of
Prof. Dr. GITIKA MAYANK
THAKUR INSTITUTE OF MANAGEMENT STUDIES AND
RESEARCH
KANDIVILI
MUMBAI
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Empirical analysis of equity & derivatives
CERTIFICATE
This is to certify that the study presented by Raj Pandya to Thakur Institute of
Management Studies and Research in part completion of Post Graduate Diploma in
Management under Empirical analysis of equity and derivatives has been done
under my guidance in the year 2009 - 2011
The Project is in the nature of original work that has not so far been submitted for
any other course in this institute or any other institute. Reference of work and
relative sources of information have been given at the end of the project
Signature of the Candidate
(Raj Pandya)
Forwarded through the Research Guide
Signature of the Guide
(Prof. Dr. Gitika Mayank)
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Empirical analysis of equity & derivatives
ACKNOWLEDGEMENT
The success of my project was not only with my efforts but also with interest,
guidance and help offered to me by others.
It gives me great pleasure to express my gratitude towards all the individuals who
have directly or indirectly helped me in completing this project.
I wish to express my sincere thanks to our Director Dr. Mrinalini Kohojkar and my
project guide Prof. Dr. Gitika Mayank for providing me valuable guidance & inputs
which helped me to complete this project in true sense.
I would also like to express my thanks to my colleagues for their constant help and
guidance throughout the project.
Also, not forgetting the college library facilities and computer lab facilities without
whose help gathering the relevant information would not have been possible.
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Empirical analysis of equity & derivatives
Executive Summary
The project is about the empirical analysis of equity and derivative. It gives the
knowledge of market position of the company. I studied as to how this company
proves to an option for the investors, by studying the performance of investing in
equity & derivative for few months considering their analysis. I selected area of
empirical analysis of equity & derivative, which attract different kinds of investors to
invest in equity derivative and to face high risk and get high returns. I have applied
some option strategies on the live market. The major findings of the project are to
overview of the comparison between equity cash segment and equity derivative
segment . The methodology of the project here is to analyze the Equity & Derivative
performance based on fundamental and option strategies.
The methodology of the project here is to analyze the investment opportunities
available for those investors & study the returns & risk involved in various
investment opportunities and also study of investment management & risk
management. So for that we have to study & analyze the performance of Equity &
Derivative in the market. We know that there is a high risk, high return in equity but
in a long time only. While in derivative there is a high risk, high return in the short
term, because derivative contract is for short time for 1/2/3 months only. So this
project included different types of returns, margin & risk involved in equity, and
types, need, use & margin involved in the derivatives market and also participants &
terms use in derivative market.
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Empirical analysis of equity & derivatives
Objective of the study
Any investor’s vision is a long term investment and short term investment and gets
high returns by bearing high risk. For that objective need to be climbed successfully
an so objectives of this project are,
1) To find the RIGHT SCRIPT to buy and sell at the RIGHT TIME
2) To get good return.
3) To know how derivatives can be use for hedging.
4) To know the outcome of Equity and Derivative.
5) How to apply derivative option strategies.
METHODOLOGY OF THE PROJECT
Defining objective won’t suffice unless and until a proper methodology is to achieve
the objectives.
1) Analyzing and observing the investment opportunities.
2) Analyzing the performance of Equity and Derivative market with the help of
NAV, EPS, P/E ratio etc.
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Empirical analysis of equity & derivatives
INDEX
Sr. No
Topic
Page No.
1
Introduction
1
2
Equity
3
3
Benefits of equity
4
4
Risk in equity investment
6
5
Selection of shares
8
6
Lesson to be learn
10
7
Types of cash margin
14
8
Derivative
17
9
Types of derivatives
19
10
Option strategies
29
11
Types of traders in derivative market
34
12
Types of future & option margin
36
13
Comparative analysis
39
14
Conclusion
44
15
References
45
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Empirical analysis of equity & derivatives
Introduction
Background of the study:
The oldest stock exchange in Asia (established in 1875) and the first in the country to
be granted permanent recognition under the Securities Contract Regulation Act,
1956, Bombay Stock Exchange Limited (BSE) has had an interesting rise to
prominence over the past 133 years. A lot has changed since 1875 when 318 persons
became members of what today is called “Bombay Stock Exchange Limited” paying
a princely amount of Re 1. In 2002, the name "The Stock Exchange, Mumbai" was
changed to Bombay Stock Exchange. Subsequently on August 19, 2005, the exchange
turned into a corporate entity from an Association of Persons (AoP) and renamed as
Bombay Stock Exchange Limited. BSE, which had introduced securities trading in
India, replaced its open outcry system of trading in 1995, with the totally automated
trading through the BSE Online trading (BOLT) system. The BOLT network was
expanded nationwide in 1997.
Since then, the stock market in the country has passed through both good and bad
periods. The journey in the 20th century has not been an easy one. Till the decade of
eighties, there was no measure or scale that could precisely measure the various ups
and downs in the Indian stock market. Bombay stock Exchange Limited (BSE) in
1986 came out with a stock Index that subsequently became the barometer of the
Indian Stock Market.
SENSEX first compiled in 1986 was calculated on a “Market Capitalization
Weighted” methodology of 30 component stocks representing a sample of large, well
established and financially sound companies. The base year of SENSEX is 1978-79.
The index is widely reported in both domestic and international markets through
prints as well as electronic media.
SENSEX is not only scientifically designed but also based on globally accepted
construction and review methodology. From September 2003, the SENSEX is
calculated on a free-float market capitalization methodology. The “free-float Market
Capitalization-Weighted” methodology is a
widely followed index construction methodology on which majority of global equity
benchmarks are based.
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Empirical analysis of equity & derivatives
The growth of equity markets in India has been phenomenal in the decade gone by
Right from early nineties the stock market witnessed heightened activity in terms of
various bull and bear runs. The SENSEX captured all these happenings in the most
judicial manner. One can identify the booms and bust of the Indian equity market
through SENSEX.
The Exchange also disseminates the Price-Earnings Ratio, the Price to Book Value
Ratio and the Dividend Yield Percentage on day-to-day basis of all its major indices.
The value of all BSE indices are every 15 seconds during the market hours and
displayed through the BOLT system. BSE website and news wire agencies.
All BSE-Indices are reviewed periodically by the “Index Committee” of the
Exchange. The Committee frames the broad policy guidelines for the development
and maintenance of all BSE indices.
Department of BSE Indices of the exchange carries out the day to day maintenance of
all indices and conducts research on development of new indices. Institutional
investors, money managers and small investors all refer to the Sensex for their
specific purposes The Sensex is in effect the substitute for the Indian stock markets.
The country's first derivative product i.e. Index-Futures was launched on SENSEX.
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Empirical analysis of equity & derivatives
Equity
Total equity capital of a company is divided into equal units of small denominations,
each called a share.
 It is a stock or any other security representing an ownership interest.
 It proves the ownership interest of stock holders in a company.
For example:
In a company the total equity capital of Rs 2, 00, 00,000 is divided into 20, 00,000
units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then
is said to have 20, 00,000 equity shares of Rs 10 each. The holders of such shares are
members of the company and have voting rights.
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Empirical analysis of equity & derivatives
Benefits from Equity
The benefits distributed by the company to its shareholders can be: 1) Monetary
Benefits and 2) Non Monetary Benefits.
1. Monetary Benefits:
A. Dividend: An equity shareholder has a right on the profits generated by the
company. Profits are distributed in part or in full in the form of dividends. Dividend
is an earning on the investment made in shares, just like interest in case of bonds or
debentures. A company can issue dividend in two forms: a) Interim Dividend and b)
Final Dividend. While final dividend is distributed only after closing of financial
year; companies at times declare an interim dividend during a financial year. Hence
if X Ltd. earns a profit of Rs 40 crore and decides to distribute Rs 2 to each
shareholder, a holding of 200 shares of X Ltd. would entitle you to Rs 400 as
dividend. This is a return that you shall earn as a result of the investment made by
you by subscribing to the shares of X Ltd.
B. Capital Appreciation: A shareholder also benefits from capital appreciation.
Simply put, this means an increase in the value of the company usually reflected in
its share price. Companies generally do not distribute all their profits as dividend.
As the companies grow, profits are re-invested in the business. This means an
increase in net worth, which results in appreciation in the value of shares. Hence, if
you purchase 200 shares of X Ltd at Rs 20 per share and hold the same for two years,
after which the value of each share is Rs 35. This means that your capital has
appreciated by Rs 3000.
2. Non-Monetary Benefits: Apart from dividends and capital appreciation,
investments in shares also fetch some type of non-monetary benefits to a
shareholder. Bonuses and rights issues are two such noticeable benefits.
A. Bonus: An issue of bonus shares is the distribution free of cost to the shareholders
usually made when a company capitalizes on profits made over a period of time.
Rather than paying dividends, companies give additional shares in a pre-defined
ratio. Prima facie, it does not affect the wealth of shareholders. However, in practice,
bonuses carry certain latent advantages such as tax benefits, better future growth
potential, and an increase in the floating stock of the company, etc. Hence if X Ltd
decides to issue bonus shares in a ration of 1:1, every existing shareholder of X Ltd
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Empirical analysis of equity & derivatives
would receive one additional share free for each share held by him. Of course, taking
the bonus into account, the share price would also ideally fall by 50 percent post
bonus. However, depending upon market expectations, the share price may rise or
fall on the bonus announcement.
B. Rights Issue: A rights issue involves selling of ordinary shares to the existing
shareholders of the company. A company wishing to increase its subscribed capital
by allotment of further shares should first offer them to its existing shareholders. The
benefit of a rights issue is that existing shareholders maintain control of the
company. Also, this results in an expanded capital base, after which the company is
able to perform better. This gets reflected in the appreciation of share value.
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Empirical analysis of equity & derivatives
Risks In equity investment:
Although an equity investment is the most rewarding in terms of returns generated,
certain risks are essential to understand before venturing into the world of equity.
 Market/ Economy Risk.
 Industry Risk.
 Management Risk.
 Business Risk.
 Financial Risk
 Exchange Rate Risk.
 Inflation Risk.
 Interest Rate Risk.
How to overcome risks:
Most risks associated with investments in shares can be reduced by using the tool of
diversification. Purchasing shares of different companies and creating a diversified
portfolio has proven to be one of the most reliable tools of risk reduction.
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Empirical analysis of equity & derivatives
The process of Diversification:
When you hold shares in a single company, you run the risk of a large magnitude.
As your portfolio expands to include shares of more companies, the company
specific risk reduces. The benefits of creating a well diversified portfolio can be
gauged from the fact that as you add more shares to your portfolio, the weightage of
each company’s share gets reduced. Hence any adverse event related to any one
company would not expose you to immense risk. The same logic can be extended to
a sector or an industry. In fact, diversifying across sectors and industries reaps the
real benefits of diversification. Sector specific risks get minimised when shares of
other sectors are added to the portfolio. This is because a recession or a downtrend is
not seen in all sectors together at the same time.
However all risks cannot be reduced:
Though it is possible to reduce risk, the process of equity investing itself comes with
certain inherent risks, which cannot be reduced by strategies such as diversification.
These risks are called systematic risk as they arise from the system, such as interest
rate risk and inflation risk. As these risks cannot be diversified, theoretically,
investors are rewarded for taking systematic risks for equity investment.
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Empirical analysis of equity & derivatives
Selection of Shares
Proper selections of shares are of two types:
1. Fundamental analysis:
It involves in –depth study and analysis of the prospective company whose shares
we want to buy, the industry it operates in and the overall market scenario. It can be
done by reading and assessing the company’s annual reports, research reports
published by equity research houses, research analysis published by the media and
discussions with the company’s management or the other experienced investors.
2. Technical analysis:
It involves studying the prices movement of the stock over an extended period of
time in the past to judge the trend of the future price movement. It can be done by
software programs, which generate stock prices charts indicating upward.
Downward and sideways movements of the stock price over the stipulated time
period.
When to buy & sell shares:
With high volatility prevailing in the market, major price fluctuations in equities are
not uncommon. Therefore, apart from ascertaining ‘which’ stock to buy or sell, it
becomes equally important to consider ‘when’ to buy or sell. Any investor should be
aware of the fact where all the investor is following i.e., Buy Low. Sell High.
That means we should buy stocks at a low price and sell them at a high price.
When to buy
Three ways by which we can figure that out what it is about this stock that makes it
hot.
1. Earnings per Share (EPS): How well the company is doing
EPS is the total earning or profits made by company (during a given period of time)
calculated on per share basis. It aims to give an exact evaluation of the returns that
the company can deliver.
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Empirical analysis of equity & derivatives
Example:
Company XYZ Ltd. Capital: Rs 100 crore (Rs 1 billion).
Capital is the amount the owner has in the business. As the business grows and
makes profits, it adds to its capital. This capital is subdivided into shares (or stocks).
The capital is divided into 100 million shares of Rs 10 each.
Net Profit in 2003-04: Rs 20 crore (Rs 200 million).
EPS is the net profit divided by the total number of shares.
EPS = net profit/ number of shares
EPS = Rs 20 crore (Rs 200 million)/ 10 crore (100 million) shares = Rs 2 per share
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Empirical analysis of equity & derivatives
Lesson to be learnt
If a company's EPS has grown over the years, it means the company is doing well,
and the price of the share will go up. If the EPS declines, that's a bad sign, and the
stock price falls.
Companies are required to publish their quarterly results. Keep an eye out for these
results; check for the trend in their EPS.
Price earnings ratio (PE ratio): How other investors view this share
An indicator of how highly a share is valued in the market. It arrived at by dividing
the closing price of a share on a particular day by EPS. The ratio tends to be high in
the case of highly rated shares. The average PE ratio for companies in an industry
group is often given in investment journal. Two stocks may have the same EPS. But
they may have different market prices. That's because, for some reason, the market
places a greater value on that stock. PE ratio is the market price of the stock divided
by its EPS.
PE = market price/ EPS
Let’s take an example of two companies.
Company XYZ Ltd
Market price = Rs 100
EPS = Rs 2
PE ratio = 100/ 2 = 50
Company ABC Ltd
Market price = Rs 200
EPS = Rs 2
PE ratio = 200/ 2 = 100
In the above cases, both companies have the same EPS. But because their market
price is different, the PE ratio is different.
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Empirical analysis of equity & derivatives
In the case of EPS, it is not so much a high or low EPS that matters as the growth in
the EPS. The company's PE reflects investors' expectations of future growth in the
EPS. A high PE company is one where investors have hopes that earnings will rise,
which is why they buy the share.
Forward PE: Looking ahead
The stock market is not nostalgic. It is forward looking. For instance, it sometimes
happens that a sick company, that has made losses for several years, gets a
rehabilitation package from its bank and a new CEO. As a consequence, the
company's stock shoots up. Because investors think the company will do better in
the future because of the package and new leadership, and its earnings will go up.
And we think it is a good time to buy the shares of the company now. Suddenly, the
demand for the shares has gone up. Because stock prices are based on expectations
of future earnings, analysts usually estimate the future earnings per share of a
company. This is known as the forward PE. Forward PE is the current market price
divided by the estimated EPS, usually for the next financial year.
Forward PE = Current market price/ estimate EPS for the next financial year.
To illustrate what we have been talking about, let's take the example of ABC LTD.
Trailing 12-month EPS = Rs 56.82 (EPS of the last four quarters)
Closing price on January 6 = Rs 2043.15
PE = Price/EPS = 2043.15/ 56.82 = 35.95
Estimated EPS for 2009-10 = Rs 67
Estimated EPS for 2010-11 = Rs 90
these figures are according to brokers' consensus estimates.
Forward PE = current market price/ estimated EPS for next financial year
Forward PE for 2009-10 = 2043.15/ 67 = 30.49
Forward PE for 2010-11 = 2043.15/ 90 = 22.70
With an EPS growth of over 30%, a forward PE of 22.7 is not high, indicating that
there is scope to be optimistic about the stock's price.
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Empirical analysis of equity & derivatives
Sometimes, investors look out for a low PE stock, expecting that its price will rise in
the future. But sometimes, low PE stocks may remain low PE stocks for ages,
because the market doesn't fancy them.
Keep tab on the business news to check out the company's prospects in the future
When to sell
Stock Reaches Fair Value or Target Price
This is the easiest part of selling. We should sell when a stock reaches its fair value. It
is the main reason why we chose to buy it on the first place. The target price can be
computed by assessing the company’s estimated financial performance over the next
3 to 5 years, computing its EPS and using an acceptable P/E ratio to compute the
future market price. Based on this future estimated price and our required return on
our investment, compute our target price.
When the prices reaches Stop loss
It is advisable to always consider the possibility of a loss before making our
investment. We should decide how much loss we are willing to book in the stock.
The lower price i.e., the price at which we are willing curtail our loss, is called ‘Stop
Loss’.
Need the money
The generally happens due to improper planning. However, things happen. Even
the most carefully planned strategy may not work. Catastrophic events may force
investors to sell an investment if his household is affected by it.
The book is unclean
When management left their post abruptly or when the SEBI conduct a criminal
investigation on a company, it may be time to sell. Our assumption may be
inaccurate as a lot of fair value calculation is based on the company's balance sheet,
cash flow or other financial statement published by management.
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Empirical analysis of equity & derivatives
Takeover news
When one of your stock holding is getting bought by other companies, it may be
time to sell. Sure, you might like the acquiring company but you still need to figure
out the fair value of the common stock of the acquiring company. If the acquiring
company is overvalued, then it is best to sell.
Other Investment Opportunity
Let us consider we bought stock A and it has risen to 10% below its fair value.
Meanwhile, we noticed that stock B fallen to below 50% of our calculated fair value.
This is an easy decision. We will sell our stock A and buy stock B. Our goal as an
investor is to maximize our investment return. Sacrificing a 10% of return in order to
earn a 50% return is a sensible way to do that.
Inaccurate Fair Value Calculation
As investors, we sometimes made errors in our fair value calculation. There are
factors that we might not take into accounts when researching a particular company.
For example, satyam scandal.
New Competitors with Better Products
When new competitors sprung up, the company that you hold might have to spend
more money in order to fend off competition. Recent example includes the
emergence of pay-per click advertising by Google. Any advertising business such as
newspapers or cable network, this new product by Google might hurt profit margins
and eventually the fair value of the stock.
Not having a valid reason to Buy
When we don't know why we bought a particular stock, we won't know how much
our potential return is or when we should sell it. This is the easiest way of losing
money. When we have no valid reason to buy, we should sell immediately.
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Empirical analysis of equity & derivatives
Types of Cash market margin
1. Value at Risk (VaR) margin.
2. Extreme loss margin
3. Mark to market Margin
1. Value at Risk (VaR) margin :
VaR Margin is at the heart of margining system for the cash market segment. VaR is
a technique used to estimate the probability of loss of value of an asset or group of
assets (for example a share or a portfolio of a few shares), based on the statistical
analysis of historical price trends and volatilities.
A VaR statistic has three components: a time period, a confidence level and a loss
amount (or loss percentage). Keep these three parts in mind as we give some
examples of variations of the question that VaR answers:
 With 99% confidence, what is the maximum value that an asset or portfolio
may lose over the next day?
Example:
Suppose shares of a company bought by an investor. Its market value today is Rs.50
lakhs but its market value tomorrow is obviously not known. An investor holding
these shares may, based on VaR methodology, say that 1-day VaR is Rs.4 lakhs at
99% confidence level. This implies that under normal trading conditions the investor
can, with 99% confidence, say that the value of the shares would not go down by
more than Rs.4 lakhs within next 1-day.
In the stock exchange scenario, a VaR Margin is a margin intended to cover the
largest loss (in %) that may be faced by an investor for his / her shares (both
purchases and sales) on a single day with a 99% confidence level. The VaR margin is
collected on an upfront basis (at the time of trade).
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Empirical analysis of equity & derivatives
How is VaR margin calculated?
VaR is computed using exponentially weighted moving average (EWMA)
methodology. Based on statistical analysis, 94% weight is given to volatility on ‘T-1’
day and 6% weight is given to ‘T’ day returns.
To compute, volatility for January 1, 2008, first we need to compute day’s return for
Jan 1, 2009 by using LN (close price on Jan 1, 2009 / close price on Dec 31, 2008).
Take volatility computed as on December 31, 2008.
Use the following formula to calculate volatility for January 1, 2009:
Square root of [0.94*(Dec 31, 2008 volatility)*(Dec 31, 2008 volatility)+ 0.06*(January
1, 2009 LN return)*(January 1, 2009 LN return)]
Example:
Share of ABC Ltd
Volatility on December 31, 2008 = 0.0314
Closing price on December 31, 2008 = Rs. 360 Closing price on January 1, 2009 = Rs.
330
January 1, 2009 volatility =
Square root of [(0.94*(0.0314)*(0.0314) + 0.06 (0.08701)* (0.08701)] = 0.037 or 3.7%
How is the Extreme Loss Margin computed?
The extreme loss margin aims at covering the losses that could occur outside the
coverage of VaR margins.
The Extreme loss margin for any stock is higher of 1.5 times the standard deviation
of daily LN returns of the stock price in the last six months or 5% of the value of the
position.
This margin rate is fixed at the beginning of every month, by taking the price data on
a rolling basis for the past six months.
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Empirical analysis of equity & derivatives
Example:
In the Example given at question 10, the VaR margin rate for shares of ABC Ltd. was
13%. Suppose the 1.5 times standard deviation of daily LN returns is 3.1%. Then 5%
(which is higher than 3.1%) will be taken as the Extreme Loss margin rate.
Therefore, the total margin on the security would be 18% (13% VaR Margin + 5%
Extreme Loss Margin). As such, total margin payable (VaR margin + extreme loss
margin) on a trade of Rs.10 lakhs would be 1, 80,000/
How is Mark-to-Market (MTM) margin computed?
MTM is calculated at the end of the day on all open positions by comparing
transaction price with the closing price of the share for the day.
Example:
A buyer purchased 1000 shares @ Rs.100/-at 11 am on January 1, 2008. If close price
of the shares on that day happens to be Rs.75/-, then the buyer faces a notional loss
of Rs.25, 000/ -on his buy position. In technical terms this loss is called as MTM loss
and is payable by January 2, 2008 (that is next day of the trade) before the trading
begins.
In case price of the share falls further by the end of January 2, 2008 to Rs. 70/-, then
buy position would show a further loss of Rs.5,000/-. This MTM loss is payable.
In case, on a given day, buy and sell quantity in a share are equal, that is net quantity
position is zero, but there could still be a notional loss / gain (due to difference
between the buy and sell values), such notional loss also is considered for calculating
the MTM payable.
MTM Profit/Loss = [(Total Buy Qty X Close price)] -Total Buy Value] -[Total Sale
Value (Total Sale Qty X Close price)]
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Empirical analysis of equity & derivatives
Derivatives
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 Contracts (Regulation) Act, 1956 (SCRA) 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 the trading of derivatives is
governed by the regulatory framework under the SC(R)A.
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Empirical analysis of equity & derivatives
Factors driving the growth of derivatives
Over the last three decades, the derivatives market has seen a phenomenal growth.
A large variety of derivative contracts have been launched at exchanges across the
world. Some of the factors driving the growth of financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns, reduced
risk as well as transactions costs as compared to individual financial assets.
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Empirical analysis of equity & derivatives
Types of derivatives
1. Forward Contract:
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the asset on the
same date for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
Limitations of Forward Contract
Forward markets world-wide are afflicted by several problems:
 Lack of centralization of trading,
 Illiquidity, and
 Counterparty risk
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Empirical analysis of equity & derivatives
In the first two of these, the basic problem is that of too much flexibility and
generality. The forward market is like a real estate market in that any two consenting
adults can form contracts against each other. This often makes them design terms of
the deal which are very convenient in that specific situation, but makes the contracts
non-tradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the
other suffers. Even when forward markets trade standardized contracts, and hence
avoid the problem of illiquidity, still the counterparty risk remains a very serious
issue.
2. Future Contracts:
Futures markets were designed to solve the problems that exist in forward markets.
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the futures
contracts are standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
 Quantity of the underlying
 Quality of the underlying
 The date and the month of delivery
 The units of price quotation and minimum price change
 Location of settlement
26
Empirical analysis of equity & derivatives
Payoff
The payoff from a long position in a forward contract is
P = S - X, where S is a spot price of the security at time of contract maturity, X is the
delivery price.
Similarly, the payoff from a short position is
P = X - S.
For example, let's say the current price of the stock is $80.00 and we entered in
forward contract to buy this stock in 3 months time for $81.00 (that means we hope
that price will not fall lower than $81.00). If after three months price is more than
$81.00, let's say $83.00, than we can buy the same stock for $81.00 (as stated by
forward contract) and after reselling it on the market our payoff will be
P = $83.00 - $81.00 = $2.00
If at forward maturity the stock price falls to $78.00, than our loss will be
P = $81.00 - $78.00 = $3.00
The graphs above illustrate the forward contract payoff patterns for long and short
positions.
27
Empirical analysis of equity & derivatives
Distinction between futures and forwards
Future terminology
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts
on the NSE have one- month, two-month and three months expiry cycles which
expire on the last Thursday of the month. Thus a January expiration contract expires
on the last Thursday of January and a February expiration contract ceases trading on
the last Thursday of February. On the Friday following the last Thursday, a new
contract having a three- month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered less than one contract.
Also called as lot size.
Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for each
contract. In a normal market, basis will be positive. This reflects that futures prices
normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income earned
on the asset.
Initial margin: The amount that must be deposited in the margin account at the time
a futures contract is first entered into is known as initial margin.
28
Empirical analysis of equity & derivatives
Marking-to-market: In the futures market, at the end of each trading day, the
margin account is adjusted to reflect the investor's gain or loss depending upon the
futures closing price. This is called marking-to-market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to
ensure that the balance in the margin account never becomes negative. If the balance
in the margin account falls below the maintenance margin, the investor receives a
margin call and is expected to top up the margin account to the initial margin level
before trading commences on the next day.
3. Option Contracts
An option is a contract written by a seller that conveys to the buyer the right — but
not the obligation — to buy (in the case of a call option) or to sell (in the case of a put
option) particular asset, at a particular price (Strike price / Exercise price) in future.
In return for granting the option, the seller collects a payment (the premium) from
the buyer. Exchange traded options form an important class of options which have
standardized contract futures and trade on public exchanges, facilitating trading
among large number of investors. Theyprovide settlement guarantee by the Clearing
Corporation thereby reducing counterpartyrisk. Options can be used for hedging,
taking a view on the future direction of the market, for arbitrage or for implementing
strategies which can help in generating income for investors under various market
conditions.
Option Terminology
Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.
29
Empirical analysis of equity & derivatives
Stock options: Stock options are options on individual stoc ks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the right to
buy or sell shares at the specified price.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the
seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises on
him.
Option price/premium: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price
or the exercise price.
American options: American options are options that can be exercised at any time
upto the expiration date. Most exchange-traded options are American.
European options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options,
and properties of an American option are frequently deduced from those of its
European counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to
a positive cash flow to the holder if it were exercised immediately. A call option on
the index is said to be in-the-money when the current index stands at a level higher
than the strike price (i.e. spot price >strike price). If the index is much higher than
the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if
the index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead
to zero cash flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that
would lead to a negative cash flow if it were exercised immediately. A call option on
the index is out-of-the money when the current index stands at a level which is less
than the strike price (i.e. spot price < strike price). If the index is much lower than the
30
Empirical analysis of equity & derivatives
strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two
components intrinsic value and time value. The intrinsic value of a call is the amount
the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it
another way, the intrinsic value of a call is Max[0, (St — K)] which means the
intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of
a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is
the spot price.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that
is OTM or ATM has only time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is an option's time
value, all else equal. At expiration, an option should have no time value.
There are two basic types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an
asset by a certain date for a certain price.
i) Long a call:- person buys the right (a contract) to buy an asset at a certain price. We
feel that the price in the future will exceed the strike price. This is a bullish position.
ii) Short a call:- person sells the right ( a contract) to someone that allows them to
buy to buy an asset at a certain price. The writer feels that asset will devaluate over
the time period of the contract. This person is bearish on that asset.
Put option: A put option gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price.
i) Long a put:- Buy the right to sell an asset at a pre-determined price. We feel that
the asset will devalue over the time of the contract. Therefore we can sell the asset at
a higher price than is the current market value. This is a bearish position.
ii) Short a put:- sell the right to someone else. This will allow them to sell the asset at
a specific price. We feel the price will go down and we do not. This is a bullish
position.
31
Empirical analysis of equity & derivatives
Profit / payoff in Option
 The payoff to a derivative portfolio is the market value of the portfolio at
expiration. (Also gross payoff).
 The profit on a derivative portfolio is the payoff less the cost of acquisition or
assembling the portfolio. (Net profit).
 We will be looking at a number of option strategies and combinations.
 The (gross) payoff is the value (positive or negative) of the option or portfolio
at maturity.
 The payoff does not include the initial cost (or the initial cash inflow) at the
time the was set up.
 Net profit= (gross) Payoff- cost of buying options or other securities+
premium received for selling options or other securities.
32
Empirical analysis of equity & derivatives
If S is a final price of the option underlying security, X is a strike price and OP is an
option price,
than the profit is
Long Call: P = S - X - OP
Short Call: P = X - S + OP
Long Put: P = X - S - OP
Short Put: P = S - X + OP
For example, let's say the stock price is $50.00, we bought European call option with
strike $53.00 and paid $2.00 for this option. If option price is less than $53.00, we will
not exercise the option to buy the stock, because it doesn't make sense to buy
security for higher price than it costs on the market. In this case we lose all initial
33
Empirical analysis of equity & derivatives
investment equal to the option price $2.00. If stock price is more than $53.00, we will
exercise the option. For example if the stock price is $56.00, after exercising the
option and immediately reselling the acquired stock our profit will be:
P = $56.00 - $53.00 - $2.00 = $1.00
if the stock price is $54.00, than the profit is:
P = $54.00 - $53.00 - $2.00 = - $1.00
As we see in latter case we lose money. The reason is that increase of stock price just
by $1.00 above the strike ($53.00) doesn't cover our initial investment of $2.00,
although we still exercise the option to recover at least $1.00 of initial investment. If
the stock price at exercise time is $55.00 than we exercise the option to cover our
initial expenses(equal to option price):
P = $55.00 - $53.00 - $2.00 = $0.00
This latter case corresponds to option graph intersection point with horizontal axis
on the drawing above.
Distinction between futures and options
34
Empirical analysis of equity & derivatives
The option strategies which are applied by me on live stock
market:
1) Date-1/10/2010-Friday
Expiry of contract -28/10/2010-Thursday
Nifty contract
Market outlook- range bound
Strategy- long put butterfly
Buy 1 Oct. 6000 put @ 43.30 = Rs. 2165/Sell 2 Oct.6100 put @71.50 = Rs. 7150/Buy 1 Oct.6200 put @ 117
= Rs.5850/-
Net debit = Rs.865/Risk is limited to Rs 865/Upper breakeven point = 6217
Lower breakeven point=5982.70
THE PAYOFF SCHEDULE
Nifty SP
Put Buy
6000
5800
5850
5900
5950
6000
6100
6150
6200
6250
6300
6350
6400
156.7
106.7
56.7
6.7
-43.3
-43.3
-43.3
-43.3
-43.3
-43.3
-43.3
-43.3
2 put
Sell
6100
-457
-357
-257
-157
-57
143
143
143
143
143
143
143
Put Buy
6200
Profit/Loss
283
233
183
133
83
-17
-67
-117
-117
-117
-117
-117
-17.3
-17.3
-17.3
-17.3
-17.3
82.7
32.7
-17.3
-17.3
-17.3
-17.3
-17.3
35
Empirical analysis of equity & derivatives
THE PAYOFF CHART
Profit/Loss
100
80
60
40
Profit/Loss
20
0
5600
-20
5800
6000
6200
6400
-40
36
6600
Empirical analysis of equity & derivatives
2) Date-08/06/2010
Expiry of contract: 24/06/2010-Thursday
Nifty contract
Market outlook: moderately bullish
Strategy: Ratio bull call spread
Current nifty = 4987
Sell 18 lots (s.p 5200) call @33.33/-= Rs. 29970/Buy 5 lots (s.p 5000) call @ 250/- = Rs. 30000/-
Short Nifty Call 18 Lots (Strike Price 5200) Premium Received 900@33.30 =
29970
Date
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
900
33.3
8-Jun-10
21.3
12
10800
10800
9-Jun-10
25
-3.7
-3330
7470
10-Jun-10
39.3
-14.3 -12870
-5400
11-Jun-10
35.35
3.95
3555
-1845
14-Jun-10
64.65
-29.3 -26370
-28215
Long Nifty Call 5 Lots (Strike Price 5000) Premium Paid 250@120 = 30000
Date
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
250
120
8-Jun-10
94
-26 -6500
-6500
9-Jun-10
108.3
14.3 3575
-2925
10-Jun-10
150.3
42 10500
7575
11-Jun-10
157
6.7 1675
9250
14-Jun-10
220
63 15750
25000
Net
Nifty
Profit if closing
Profit/Loss
Close
today
4300
4987.1
NIL
4545
5000.3
75
2175
5078.6
19650
7405
5119.35
29837.5
-3215
5197.7
49425
37
Empirical analysis of equity & derivatives
3) Date-08/06/2010
Expiry of contract : 24/06/2010-Thursday
Nifty contract
Market outlook: Range Bound
Strategy: Short Straddle
Current nifty: 4987
Short Nifty call 1 lot (strike price 5000) Premium received 50@ 120= 6000
Short Nifty put 1 lot (strike price 5000) premium received 50@101.80= 5090
Upper BEP =5221
Lower BEP = 4778
Short Nifty Call 1 Lot (Strike Price 5000) Premium Received 50@120 = 6000
Date
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
50
120
8-Jun-10
94
26 1300
1300
9-Jun-10
108.3
-14.3
-715
585
10-Jun-10
150.3
-42 -2100
-1515
11-Jun-10
157
-6.7
-335
-1850
14-Jun-10
220
-63 -3150
-5000
Short Nifty Put 1 Lot (Strike Price 5000) Premium Received 50@101.80 =
5090
Date
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
50
101.8
8-Jun-10
131.9
-30.1 -1505
-1505
9-Jun-10
105.1
26.8
1340
-165
10-Jun-10
63
42.1
2105
1940
11-Jun-10
49.05
13.95 697.5
2637.5
14-Jun-10
18.5
30.55 1527.5
4165
38
Empirical analysis of equity & derivatives
Net
Profit/Loss
-205
420
425
787.5
-835
Nifty
Breakeven Close
Downside Upside
5221.8
4778.2
4987.1
208.9
234.7
5000.3
222.1
221.5
5078.6
300.4
143.2
5119.35
341.15 102.45
5197.7
419.5
24.1
If today is expiry
Profit on
Profit on
Net
SC
SP
Profit
6000
5985
2070
32.5
-3885
4445
5090
5090
5090
5090
10445
11075
7160
5122.5
1205
39
Empirical analysis of equity & derivatives
Types of traders in derivative market
1. Hedgers:- Hedgers are those who protect themselves from the risk associated with
the price of an asset by using derivatives. A person keeps a close watch upon the
prices discovered in trading and when the comfortable price is reflected according to
his wants, he sells futures contracts. In this way he gets an assured fixed price of his
produce.
In general, hedgers use futures for protection against adverse future price
movements in the underlying cash commodity. Hedgers are often businesses, or
individuals, who at one point or another deal in the underlying cash commodity.
Take an example: A Hedger pay more to the farmer or dealer of a produce if its
prices go up. For protection against higher prices of the produce, he hedges the risk
exposure by buying enough future contracts of the produce to cover the amount of
produce he expects to buy. Since cash and futures prices do tend to move in tandem,
the futures position will profit if the price of the produce raise enough to offset cash
loss on the produce.
2. Speculators:
Speculators are somewhat like a middle man. They are never interested in actual
owing the commodity. They will just buy from one end and sell it to the other in
anticipation of future price movements. They actually bet on the future movement in
the price of an asset.
They are the second major group of futures players. These participants include
independent floor traders and investors. They handle trades for their personal clients
or brokerage firms.
Buying a futures contract in anticipation of price increases is known as ‘going long’.
Selling a futures contract in anticipation of a price decrease is known as ‘going
short’. Speculative participation in futures trading has increased with the availability
of alternative methods of participation.
40
Empirical analysis of equity & derivatives
Speculators have certain advantages over other investments they are as follows:
 If the trader’s judgment is good, he can make more money in the futures
market faster because prices tend, on average, to change more quickly than
real estate or stock prices.
 Futures are highly leveraged investments. The trader puts up a small fraction
of the value of the underlying contract as margin, yet he can ride on the full
value of the contract as it moves up and down. The money he puts up is not a
down payment on the underlying contract, but a performance bond. The
actual value of the contract is only exchanged on those rare occasions when
delivery takes place.
3. Arbitrators:
According to dictionary definition, a person who has been officially chosen to make
a decision between two people or groups who do not agree is known as Arbitrator.
In commodity market Arbitrators are the person who takes the advantage of a
discrepancy between prices in two different markets. If he finds future prices of a
commodity edging out with the cash price, he will take offsetting positions in both
the markets to lock in a profit. Moreover the commodity future investor is not
charged interest on the difference between margin and the full contract value.
41
Empirical analysis of equity & derivatives
Types of Futures and Options Margins
Margins on Futures and Options segment comprise of the following:
1) Initial Margin
2) Exposure margin
In addition to these margins, in respect of options contracts the following additional
margins are collected;
1) Premium Margin
2) Assignment Margin
How is Initial Margin Computed?
Initial margin for F&O segment is calculated on the basis of a portfolio (a collection
of futures and option positions) based approach. The margin calculation is carried
out using software called -SPAN® (Standard Portfolio Analysis of Risk). It is a
product developed by Chicago Mercantile
Exchange (CME) and is extensively used by leading stock exchanges of the world.
SPAN® uses scenario based approach to arrive at margins. It generates a range of
scenarios and highest loss scenario is used to calculate the initial margin. The margin
is monitored and collected at the time of placing the buy / sell order.
The SPAN® margins are revised 6 times in a day -once at the beginning of the day, 4
times during market hours and finally at the end of the day.
Obviously, higher the volatility, higher the margins.
How is exposure margin computed?
In addition to initial / SPAN® margin, exposure margin is also collected.
42
Empirical analysis of equity & derivatives
Exposure margins in respect of index futures and index option sell positions have
been currently specified as 3% of the notional value.
For futures on individual securities and sell positions in options on individual
securities, the exposure margin is higher of 5% or 1.5 standard deviation of the LN
returns of the security (in the underlying cash market) over the last 6 months period
and is applied on the notional value of position.
How is Premium and Assignment margins computed?
In addition to Initial Margin, a Premium Margin is charged to trading members
trading in Option contracts.
The premium margin is paid by the buyers of the Options contracts and is equal to
the value of the options premium multiplied by the quantity of Options purchased.
For example, if 1000 call options on ABC Ltd are purchased at Rs. 20/-, and the
investor has no other positions, then the premium margin is Rs. 20,000.
The margin is to be paid at the time trade.
Assignment Margin is collected on assignment from the sellers of the contracts.
How Marked to Market Margins are computed?
1. Future contracts:-The open positions (gross against clients and net of proprietary/
self trading) in the futures contracts for each member are marked to market to the
daily settlement price at the end of each day is the weighted average price of the last
half an hour of the futures contract. The profits/losses arising from the different
between the trading price and the settlement price are collected/ given to all clearing
members.
2. Option contracts:-the marked o market for option contracts is computed and
collected as part of the Initial Margin in the form of Net Option Values. The Initial
Margin is collected on an online real time basis based on the data feeds given to the
system at discrete time intervals.
43
Empirical analysis of equity & derivatives
How Client Margins are computed?
Client Members and Trading Member are required to collect initial margins from all
their clients. The collection of margins at client level in the derivatives markets is
essential as derivatives are leveraged products and non-collection of margins at the
client level would provide zero cost leverage. In the derivative markets all money
paid by the client towards margins is kept in trust with the Clearing House/
Clearing Corporation and in the event of default of the Trading or Clearing Member
the amounts paid by the client towards margins are segregated and not utilized
towards the dues of the defaulting member.
Therefore, Clearing members are required to report on a daily basis details in respect
of such margin amounts due and collected from their Trading members/ clients
clearing and settling through them. Trading members are also required to report on
a daily basis details of the amount due and collected from their clients. The reporting
of the collection of the margins by the clients is done electronically through the
system at the end of each trading day. The reporting of collection of client level
margins plays a crucial role not only in ensuring that members collect margin from
clients but it also provides the clearing corporation with a record of the quantum of
funds it has to keep in trust for the clients.
44
Empirical analysis of equity & derivatives
Comparative Analysis
Comparative analysis is easy to understand when we are analysis with the example
of the real market situation.
Now I would like to quote a real life example during my internship where I
understood the actual comparison of equity and derivative market.
Example:
There was an investor Mr. Jaichand. He has Rs. 1, 00,000/-and he wants to invest it
in share market. Now he has two options either to invest in equity cash market or
equity derivative market (F&O).
Now suppose if he invest in equity cash market and buy shares of Rs. 1, 00, 000/and diversified risk so he buys different scrips. So he purchases 10 RIL shares of Rs.
2350/-each. 10 L&T shares of Rs 800/-each, 15 Religare Enterprises Shares of Rs.
45
Empirical analysis of equity & derivatives
370/-each, 20 ICICI bank shares of Rs. 800/-each, 10 Tata power shares of Rs. 1250
each and 10 BHEL shares of Rs. 1595/each.
So for investing Rs. 1, 00,000/-in equity cash market he has to pay Rs. 1,00,000/-and
gets the delivery of the shares.
Now suppose if he invest in equity derivative market then he will able to purchase
the shares worth Rs. 5,00,000/-though he has capital of Rs. 1,00,00/-only, because of
the margin payment.
But he has to purchase the share in a lot size. So he is able to purchase the 1 lot (100
shares) of RIL at Rs. 2350/-, 1 lot (50 shares) of L&T at 2650/-, 2 lots (100 shares each)
of Religare Enterprises at Rs. 370/-and 1 lot (70 shares) of ICICI bank at Rs. 800/-.
Here Mr. Jaichand has to pay Rs. 1,00,000/-as a margin money and he is able to
purchase a shares worth Rs. 5,00,000/But he has to pay the full amount of money at
T+3 basis. So he has to pay the remaining amount on the 3rd day of the trading if he
wants the delivery.
I. Returns
Mr. Jaichand gets return on equity by two ways. One is when the share price of the
holding shares will increases in futures, called as capital appreciation. Second is by
getting a dividend income from the holding shares.
Mr. Jaichand gets return on equity derivative when the future prices of the shares
are increase in short term called as capital gain through price fluctuation or through
options premium.
II. Risk:
There are four types of risk involved in equity cash market.
1. Company Specified risk:-If company is not performing well than process of the
shares will declining and vice versa.
2. Sector specified risks:-If the sector is not performing well i.e. power sector, metal
sector, oil & gas sector, banking sector then prices of the shares will go down and
vice versa.
46
Empirical analysis of equity & derivatives
3. Global risk:-If global cues are positive then prices will increases but if global cues
are not good than prices of shares will go down.
4. General market risk:-General market risk is also affect the equity cash market like
inflation, banks interest rates etc.
So Mr. Jaichand has to consider all these risk factors while dealing in the equity
cash market.
There are four types of risk involved in equity derivative market.
1. Market risk:-In derivative market we have to calculate the market risk or mark to
market risk involved in the stocks or securities, that is the exposure to potential loss
from fluctuations in market prices (as opposed to changes in credit status). It is
calculated on the tradable assets i.e., stocks, currencies etc.
2. Credit risk: It may possible in derivative contract that the counterparty may be fail
to perform the contract or say defaulted then it is a risk for us. It is calculated on
non-tradable assets i.e., loans. So generally it is for long term purpose.
3. Liquidity Risk:-If Mr. Jaichand will not able to find a price( or a price within a
reasonable tolerance in terms of the deviation from prevailing or expected prices) for
one or more of its financial contracts in the secondary market. Consider the case of a
counterparty who buys a complex option on European interest rates. He is exposed
to liquidity risk because of the possibility that he cannot find anyone to make him a
price in the secondary market and because of the possibility that the price he obtains
is very much against him and the theoretical price for the product.
4. Settlement Risk:-The risk of non-payment of an obligation by a counterparty to a
transaction, exacerbated by mismatches in payment timings.
So, Mr. Jaichand has to consider all these factors while dealing in the equity
derivative market.
I. Margins:
Now Mr. Jaichand has also seen the margin paid in the equity cash segment.
1. Var Margin: -Now Mr. jaichand bought shares of a company. Its market value
today is Rs. 1, 00,000/-Obviously, we do not know what would be the market value
of these shares next day. Now Mr. Jaichand holding these shares may, based on VaR
47
Empirical analysis of equity & derivatives
methodology, say that 1-day Var is Rs. 1, 00,000/-at the 99% confidence level. This
implies that under normal trading conditions the investors can with 99% confidence,
say that the value of shares would not go down by more than Rs. 1,00,000/- within
next 1-day.
2. Extreme loss margin: -In the above situation, the VaR margin rate for shares of
RIL was 13%. Suppose that SD would be 1.5 x 3.1= 4.65. Then 5% (which is higher
than 4.65%) will be taken as the Extreme Loss margin rate.
Therefore, the total margin on the security would be 18% (13% VaR Margin + 5%
Extreme Loss margin). As such, total margin payable( VaR margin + extreme loss
margin) on a trade of Rs. 23, 500/- woud be 4, 230/3.
3.Mark to Market Margin:-Now Mr. Jaichand purchased 10 shares of RIL @ Rs.
2350/-, at 11 am on May 12, 2009. If close price of the shares on that happened to be
Rs. 2350, then the buyer faces a notional loss of Rs. 500/-on his buy position. In
technical term this loss is called as MTM loss and is payable by May 13, 2009 (that is
next day of the trade) before the trading begins.
In case, price of the shares falls further by the end of May 13 2009 to Rs. 2200/-, then
buy postion would show a further loss of Rs. 1, 000/-. This MTM loss is payable by
next day.
Now we will consider the margin payable under the equity derivatives segment.
i) Initial Margin: The initial margin required to be paid by the investor would be
equal to the highest loss the portfolio would suffer in any of the scenarios
considered. The margin is monitored and collected at the time of placing the buy/
sell order. As higher the volatility, higher the initial margin.
ii) Exposure Margin: Exposure margins in respect of index futures and index option
sell position are 3% of the notional value.
iii) Premium margin:-If 1000 call option on RIL are purchased at Rs. 20/and Mr.
Jaichand has no other positions, then the premium margin Rs. 20,000.
iv) Assignment Margin: Assignment Margin is collected on assignment from the
sellers of the contract.
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Empirical analysis of equity & derivatives
I. Duration:
Generally equity market is a long term market and people invested in it for more
than one year and then only they get good return on equity. Generally any safe
investors can invest in it because here risk is comparatively low then derivative
market.
While in derivative market investors are investing for less than one yea, generally for
2 months or 3 months. Here they get high returns on it because they are bringing
high risk.
II. Participants:
Generally any long term investors can invest in equity or hedgers are investing in
the equity, who wants to reduce their risk. Any person who wants to be safe
investors and wanted to earn a good amount of returns after a period of more than
one year is also invested in equity.
In derivative market mostly speculators and arbitragers are invested because they
wanted quick money in short time period and hedgers are also invested in
derivative market to reduce their risk.
III. Expiry date:
It’s a last Thursday of any month in case of a derivative market but no such things in
case of an equity market.
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Empirical analysis of equity & derivatives
Conclusion
This project has covered several areas. Its main conclusions are:
 Derivatives market growth continues almost irrespective of equity cash
market turnover growth. Since 2000 Cash equity turnover has fallen in the
developed markets, but derivatives turnover continued to rise steeply and
steadily.
 Equity market volume and derivative market notional value are strongly
correlated- with a ratio significant differences between individual markets.
 A number of cash equity markets- particularly in developing Asia- do not
have equity derivatives markets. Comparison of their cash market volumes
with those that do have derivative exchanges shows that the markets without
derivatives are of similar size. I am not convinced that market or
infrastructure differences explain this, but suspects that regularity barriers
have effectively prevented the development, markets in several developing
Asian countries.
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Empirical analysis of equity & derivatives
References
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Securities Laws and Regulations of Financial Markets
National Securities Depository Limited
Fundamentals of Futures & Options Markets- John C. Hull
Financial Derivatives- S. L. Gupta
Websites:www.world-exchange.org
www.nseindia.com
www.bseindia.com
www.religaresecurities.com
www.moneycontrol.com
www.indiamart.com
www.finpipe.com
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