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Hedgers will not be able to hedge if traders were not present in the system. These arbitragers continuously hunt for the profit opportunities across the markets and products and seize those by executing trades in different markets and products simultaneously.
For example at the end of day 1st March Market price of underlying asset in Rs. If it is so. Suppose price in Rs. Price risk is nothing but change in the price movement of asset.
In real life. Securities Service Tax etc. As seen before. Systematic Risk An investor can diversify his portfolio and eliminate major part of price risk i.
This risk could be reduced to a certain extent by diversifying the portfolio. Before we get to management of systematic risk with index futures. If either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only one leg may get executed and another may not. When this particular risk is hedged perfectly with the help of index-based derivatives. Uses of Index futures Equity derivatives instruments facilitate trading of a component of price risk.
This liquidity in turn results in better price discovery. Even if the systems are seamless and electronic and both the legs of transaction are liquid. This risk is separable from investment and tradable in the market with the help of index-based derivatives. These profit focused traders and arbitrageurs fetch enormous liquidity to the products traded on the exchanges. This risk is inseparable from investing in the securities. This risk broadly divided into two components.
In the entire activity. You have to pay the broker initial margin in order to take a position in futures. You see the market may be volatile due to some reasons. Hedge ratio is calculated as: Let us assume. Since you cannot hedge 1. Beta of your portfolio is 1. In order to calculate beta of a portfolio. Suppose a stock has a beta equal to 2. You will have to hedge using If the prices fall. At this point of time.
If prices rise. As an investor you are comfortable with the second option. Readers may note that for simplification purpose. Reuters etc. Assume one Futures contract has a lot size of W1 is weight of stock 1. W2 is weight of stock 2. It is calculated as weighted average of betas of individual stocks in the portfolio based on their investment proportion.
Perfect hedge means if you make Rs. You are not comfortable with the market movement in the short run. Information on beta of individual stocks is readily available in various financial newspapers.
Assume you are having a portfolio worth Rs. Wn is weight of stock n. This may result in some difference between actual and expected numbers. Only difference between an underlying position and single stock futures is on settlement front.
Any loss due to acquisition of securities at higher price. The amount of loss made in cash market will be partly or fully compensated by the profits on our futures positions.
We may download futures today. This situation can also be taken care of by using the futures. This would also be an example of long hedge. Short hedge: Short Hedge is a transaction when the hedge is accomplished by going short in futures market.
Important terms in hedging Long hedge: Long hedge is the transaction when we hedge our position in cash market by going long in futures market. Hedge against the systematic risk mainly depends upon the relationship of portfolio with the index.
A portfolio has different relationships with different indices used for hedge hence the hedge ratio would change with the change in the index. Rushing to invest all money is likely to drive up the prices to our disadvantage.
On receipt of money. This may go against our plan and may result in reduction in the portfolio value. We expect the market to go up in near future and bear a risk of acquiring the securities at a higher price. We can hedge by going long index futures today. Money comes by reversing the position at higher price later.
These positions are based upon their expectations on price movement of underlying asset. Trading in futures market Traders are risk takers in the derivatives market. If his expectation comes true and index on maturity settles beyond Assume Company C is into export and import business.
To protect against this risk of adverse movement in exchange rate of currency. Traders either take naked positions or spread positions. Hedge contract month: Hedge contract month is the maturity month of the contract through which we hedge our position. When they expect the market to go up. They may trade in futures in this asset to protect the value of their asset in cash market. And they take positions in the futures market without having position in the underlying cash market.
Cross hedge: When futures contract on an asset is not available. Company expects some dollars to flow in after say 6 months. Let us take an example from currency market.
This selling would protect company against any fall of dollar against the local currency. This is an example of cross hedge. This is called cross hedge. Director Finance of the company is expecting the depreciation in dollar vis-a-vis local currency over this period of time. A trader takes a naked long position when he expects the market to go up.
If market moves in the expected direction. At present. Soybean meal and Soybean oil. As spread positions are hedged to a large extent because they are combinations of two opposite positions. Arbitrage occupies a prominent position in the futures world as a mechanism that keeps the prices of futures contracts aligned properly with prices of the underlying assets. The moment an arbitrager spots an arbitrage opportunity. The objective of arbitragers is to make profits without taking risk.
A has say 3 contacts short in one month futures contract. Well-informed and experienced professional traders. Naked position is long or short in any of the futures contracts but in case of a spread. Arbitrage opportunities in futures market Arbitrage is simultaneous download and sale of an asset or replicating asset in the market in an attempt to profit from discrepancies in their prices.
In commodities market. Exchanges need to provide the required inputs to the system for it to recognize any kind of spread.
Important point to understand is that in an efficient market. Arbitrage in the futures market can typically be of three types: Calendar spread position is always computed with respect to the near month series. To take advantage of the mispricing. To simplify the calculations.
Reverse cash and carry arbitrage refers to long position in futures market and short position in the underlying or cash market. Going by the theoretical price. Position of the arbitrager in various scenarios of stock price would be as follows: In the language of simple mathematics. These three positions are elaborated with the help of examples. Cash and carry arbitrage The following data is available on stock A as on August 1.
Cash and carry arbitrage refers to a long position in the cash or underlying market and a short position in futures market. This would result in the arbitrage profit of Rs.
In a simplified world of the kind described by our assumptions. If we use continuous compounding for computation of the cost. On rare occasions. Cash market price Rs. If cost of carry is defined in the percentage terms. If stock is not available. Stock falls to Rs. The assumption in implementing this arbitrage opportunity is that the arbitrager has got the stock to sell in the cash market. Assuming the contract multiplier for futures contract on stock A is shares.
Case I: Stock rises to Rs. In that case. To execute the reverse cost and carry. Let us look at the following data on stock A as on December 1.
It is important to note that the cost of transaction and other incidental costs involved in the deal must be analyzed properly by the arbitragers before entering into the transaction. If August futures on stock Z are trading at Rs. Inter-market arbitrage This arbitrage opportunity arises because of some price differences existing in same underlying at two different exchanges. As they could be used to either add risk to the existing portfolios or reduce risk of the existing portfolios.
Our assumption in the above example is that both the positions i. On maturity. Let us understand this point with the help of an example. If in the above example of reverse cost and carry. This would be profitable to an arbitrageur.
In the light of above. The positions could be reversed over a period of time when difference between futures prices squeeze. This would result in the following position: Option terminology There are several terms used in the options market. Chapter 4: Option Index 2. The party taking a long position i. An Option is a contract that gives the right. The option downloader has the right but no obligation with regards to downloading or selling the underlying asset.
Options may be categorized into two main types: Some market participants desired to ride upside and restrict the losses. Strike Price: Let us comprehend on each of them with the help of the following price: Quote for Nifty Call option as on September Option type: Call European 5.
Low price: For example options on Nifty. Index options are European. Underlying value: In India. NTPC etc. European option: Stock option: These options have individual stocks as the underlying asset. Open Interest: Close price: Put European 5. High price: In our examples.
For owning this right. Open price: Traded Volume: These options have index as the underlying asset. Premium traded is for single unit of nifty and to arrive at the total premium in a contract. Writer of an option: American option: downloader of an option: The downloader of an option is one who has a right but not the obligation in the contract.
It is the price which the option downloader pays to the option seller. Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty option contracts is Spot price S: It is the price at which the underlying asset trades in the spot market. Out of the money OTM option: Out of the money option is one with strike price worse than the spot price for the holder of option.
Strike price or Exercise price X: Strike price is the price per share for which the underlying security may be downloadd or sold by the option holder.
For an option. In the money ITM option: This option would give holder a positive cash flow. A call option is said to be ITM. At the money ATM option: At the money option would lead to zero cash flow if it were exercised immediately. And a put option is said to be OTM when spot price is higher than strike price. A call option is said to be OTM. The intrinsic value of an option can never be negative. In our example. Intrinsic value: Option premium.
When you are long on equity option contract: Time value: It is the difference between premium and intrinsic value. Nifty is at All option writers should be aware that assignment is a distinct possibility. A Call option gives the downloader the right. Exercise of Options In case of American option. As described above. So in this example. Assignment of Options Assignment of options means the allocation of exercised options to one or more option sellers.
You download a call option with strike price of at a premium of Rs. The issue of assignment of options arises only in case of American options because a downloader can exercise his options at any point of time. When you are short i.
Long Call On October 1. As discussed in futures section. You may download or you may not download. But since you have already paid Rs. If Nifty were to close at So Why will you download something at when you can have the same thing at ?
So you will forego the right. If Nifty closes above at expiry. If Nifty closes at Strike Price X Premium In such a situation. This table is used to draw the pay off chart given in the next page. In this transaction you will make a profit of Rs. Similarly for If the maximum loss for a long call position is equal to the premium paid. Thus at Nifty. But as seen from table and chart you can reduce your losses as soon as nifty goes above Long call position helps you to protect your loss to a maximum of Rs.
When long call position makes a loss of Rs.
Short Call Whenever someone downloads a call option. As Nifty starts rising. The maximum loss for such an option downloader would be equal to BEP is independent of position long or short. Maximum gain for an option seller. This is because the option seller has an obligation and since his losses can be unlimited.
If Nifty stays above In our example breakeven point will be equal to — You download a put option with strike price of at a premium of Rs. Premium is received by the seller of the option. Thus when Nifty starts moving below Nifty can fall only till zero. What can be the maximum profit? The profit in this case will be Rs.
In this example. So maximum profit will be when you download Nifty at zero and sell it at strike price of A put option gives the downloader of the option the right. The pay off chart for long put position is drawn using the below table. So if Nifty goes below at expiry. However he has to pay the margin. The maximum loss in this case as well like in long call position will be equal to the premium paid.
Long Put On October 1. When will you do so? You will do so only when Nifty is at a level lower than the strike price. For a lot size of Breakeven point in this case will be equal to strike price — premium X — P. Just the opposite of that of the put option downloader. A put option downloader need not pay any margin. An extra column is added to the above table to show positions for short put. If maximum loss for long put is the premium paid.
This is because he has already paid the premium and there is no more risk that he can cause to the system. The pay off chart is drawn using this table.
An option downloader either downloader of a call option or a put option has no obligation. A margin is paid only if there is any obligation. If maximum profit for long put is when price of underlying falls to zero at expiry. When long put makes profit. Closing a position A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting download or sale.
It can be either a download or a sale. Leverage also has downside implications. A trader does not close out a long call position by downloading a put or any other similar transaction. But if the stock price goes up.
In our examples above long call and long put. With respect to an option transaction. Seller of the put option receives the premium but he has to pay the margin on his position as he has an obligation and his losses can be huge. With respect to an option transaction: A trader can see large percentage gains from comparatively small. A closing transaction for an option involves the download or sale of an option contract with the same terms.
Options offer their owners a predetermined. In contrast to this. As can be seen above. Leverage An option downloader pays a relatively small premium for market exposure in relation to the contract value. Opening a Position An opening transaction is one that adds to. This is known as leverage. Risk and return profile of option contracts Risk Return Long Premium paid Unlimited Short Unlimited Premium received A long option position has limited risk premium paid and unlimited profit potential.
A short option position has unlimited downside risk. The question is from where did we get these values? On what basis did market participants come to these values of the premiums? What are the parameters that affect these values? Are these fixed by the stock exchanges or by SEBI? The answer lies in understanding what affects options?
Prices are never fixed by stock exchanges or SEBI or anybody for that matter. As long as the option is not expired. Spot price of the underlying asset The option premium is affected by the price movements in the underlying instrument. Stock exchanges only provide a platform where downloaders and sellers meet. Intrinsic value may or may not be there. In fact price discovery is a very critical and basic component of markets. Similarly if the price of the underlying asset falls.
The impact can be same or different for a call and put option. Each variable has its impact on an option. If price of the underlying asset goes up the value of the call option increases while the value of the put option decreases. Thus there are five fundamental parameters on which the option price depends: As explained in the earlier section.
Time value of the option in turn depends upon how much time is remaining for the option to expire and how volatile is the underlying. On the other hand. Time to expiration The effect of time to expiration on both call and put options is similar to that of volatility on option premiums. Options Pricing Models There are various option pricing models which traders use to arrive at the right value of the option.
This is a very accurate model as it is iterative. Some of the most popular models are briefly discussed below: Interest Rates Interest rates are slightly complicated because they affect different options. Strike Price If all the other factors remain constant but the strike price of option increases. It affects both call and put options in the same way.
To put it in simpler way high interest rates will result in an increase in the value of a call option and a decrease in the value of a put option. This is also known as time decay. So if all things remain constant throughout the contract period. It is also interesting to note that of the two component of option pricing time value and intrinsic value. It has proved over time to be the most flexible. Thus option sellers are at a fundamental advantage as compared to option downloaders as there is an inherent tendency in the price to go down.
Higher the volatility of the underlying stock. The original formula for calculating the theoretical Option Price OP is: Vega and Rho. Unlike the binomial model.
Delta for call option downloader is positive. This measures the sensitivity of the option value to a given small change in the price of the underlying asset. It is one of the most popular. Delta for put option seller will be same in magnitude but with the opposite sign positive. This means that the value of the contract increases as the share price rises.
It may also be seen as the speed with which an option moves with respect to price of the underlying asset.
The value of the contract increases as the share price falls. Delta for put option downloader is negative. Delta for call option seller will be same in magnitude but with the opposite sign negative.
This is called a second derivative option with regard to price of the underlying asset. It is a measure of time decay. The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. Theta is the change in option price given a one-day decrease in time to expiration. Show related SlideShares at end. WordPress Shortcode. Srinivasan Thiagarajan , Co-Founder at www.
Full Name Comment goes here. Are you sure you want to Yes No. Kannan Srinivasan Kannan. Penki Anilkumar. Arpita bain , Student at Nagpur University. Show More. No Downloads. Views Total views. Actions Shares. Embeds 0 No embeds. No notes for slide. Register Now! Over the last 7 years, we have delivered over 10, Hours of mass outreach education toFinancial intermediaries, Bankers, Individual agents, Students etc in over 20 Cities. Our Profiles: We provide training on any subject related to Stock market.
Com, B. Kindly Contact Mr. Equity Derivatives Certification ExaminationAssessment Structure The examination consists of questions of 1 mark each and shouldbe completed in 2 hours. Basics of DerivativesDerivative is a contract or a product whose value is derived from value of some other assetknown as underlying.
Derivatives are based on wide range of underlying assets. These include: Some of the factors driving the growth of financial derivatives are: Both the contractingparties are committed and are obliged to honour the transaction irrespective of price of theunderlying asset at the time of delivery. Since forwards are negotiated between two parties, theterms and conditions of contracts are customized.
These are OTC contracts. Futures A futures contract is similar to a forward, except that the deal is made through anorganized and regulated exchange rather than being negotiated directly between two parties.
Indeed, we may say futures are exchange traded forward contracts. Options An Option is a contract that gives the right, but not an obligation, to download or sell theunderlying on or before a stated date and at a stated price. Swaps A swap is an agreement made between two parties to exchange cash flows in the futureaccording to a prearranged formula. Swaps are series of forward contracts. Swaps help marketparticipants manage risk associated with volatile interest rates, currency exchange rates andcommodity prices.
There are broadly three types of participants in the derivatives market - hedgers, traders alsocalled speculators and arbitrageursThe OTC derivatives markets — transactions among the dealing counterparties, have followingfeatures compared to exchange traded derivatives: For example hedgers want to giveaway the risk where as traders are willing to take risk. Risk management mechanism and surveillance of activities of various participants inorganized space provide stability to the financial systemMarket participants, who trade in derivatives are advised to carefully read the Model RiskDisclosure Document, given by the broker to his clients at the time of signing agreement.
Chapter 2: Understanding IndexIndex is a statistical indicator that measures changes in the economy in general or in particularareas. In case of financial markets, an index is a portfolio of securities that represent a particularmarket or a portion of a market. Each Index has its own calculation methodology and usually isexpressed in terms of a change from a base value. Financial indices are created to measure price movement of stocks,bonds, T-bills and other type of financial securities.
More specifically, a stock index is created toprovide market participants with the information regarding average share price movement in themarket. Types of Stock Market IndicesMarket capitalization weighted indexIn this method of calculation, each stock is given weight according to its market capitalization. So higher the market capitalization of a constituent, higher is its weight in the index. Indeed, both Sensex and Nifty, over a period oftime, have moved to free float basisPrice-Weighted IndexA stock index in which each stock influences the index in proportion to its price.
Stocks with ahigher price will be given more weight and therefore, will have a greater influence over theperformance of the index. Equal Weighted IndexAn equally-weighted index makes no distinction between large and small companies, both ofwhich are given equal weighting. The value of the index is generated by adding the prices ofeach stock in the index and dividing that by the total number of stocksThe difference between the best download and the best sell orders is 0.
Impact cost varies with transaction size. Also, it would be differentfor download side and sell side. These funds invest in index stocks in the proportions in whichthese stocks exist in the index. For instance, Sensex index fund would get the similar returns asthat of Sensex index.
They have number of advantages over other mutual funds asthey can be bought and sold on the exchange. Since, ETFs are traded on exchanges intradaytransaction is possible. Introduction to Forwards and FuturesEssential features of a forward are: Anyalteration in the terms of the contract is possible if both parties agree to it.
Corporations, tradersand investing institutions extensively use OTC transactions to meet their specific requirements.
Major limitations of forwardsLiquidity Risk Liquidity is nothing but the ability of the market participants to download or sell thedesired quantity of an underlying assetCounterparty risk Counterparty risk is the risk of an economic loss from the failure ofcounterparty to fulfil its contractual obligationIn addition to the illiquidity and counterparty risks, there are several issues like lack oftransparency, settlement complications as it is to be done directly between the contracting partiesCurrently, all equity derivatives contracts both on indices and individual stocks on NSE arecash settled whereas on BSE, derivative contracts on indices are cash settled while the contractson individual stocks are delivery settled.
Tick Size: It is minimum move allowed in the price quotations. Exchanges decide the tick sizeson traded contracts as part of contract specification. Tick size for Nifty futures is 5 paisa. Bidprice is the price downloader is willing to pay and ask price is the price seller is willing to sell. Contract Size and contract value: Futures contracts are traded in lots and to arrive at thecontract value we have to multiply the price with contract multiplier or lot size or contract size.
The difference between the spot price and the futures price is called basis. If the futuresprice is greater than spot price, basis for the asset is negative.
Similarly, if the spot price isgreater than futures price, basis for the asset is positive. During the life of the contract, the basismay become negative or positive, as there is a movement in the futures price and spot price. Further, whatever the basis is, positive or negative, it turns to zero at maturity of the futurescontract i.
Forequity derivatives, carrying cost is the interest paid to finance the download less minus dividendearned. Margin Account As exchange guarantees the settlement of all the trades, to protect itself againstdefault by either counterparty, it charges various margins from brokers. Brokers in turn chargemargins from their customersInitial Margin The amount one needs to deposit in the margin account at the time entering afutures contract is known as the initial marginMarking to Market MTM In futures market, while contracts have maturity of several months,profits and losses are settled on day-to-day basis — called mark to market MTM settlement.
Theexchange collects these margins MTM margins from the loss making participants and pays tothe gainers on day-to-day basis.
Open Interest and Volumes Traded An open interest is the total number of contractsoutstanding yet to be settled for an underlying asset.
The level of open interest indicates depthin the market. Calendar spread position is a combination of two positions in futures on the same underlying -long on one maturity contract and short on a different maturity contract.
For instance, a shortposition in near month contract coupled with a long position in far month contract is a calendarspread position. Calendar spread position is computed with respect to the near month series andbecomes an open position once the near month contract expires or either of the offsettingpositions is closed. A calendar spread is always defined with regard to the relevant months i.
This model assumes that in an efficient market, arbitrage opportunities cannotexist. In other words, the moment there is an opportunity to make money in the market due tomispricing in the asset price and its replicas, arbitrageurs will start trading to profit from thesemispricing and thereby eliminating these opportunities.
The cash and carry model is not applicable to these types ofunderlying assets. As a human tendencywe store more than what is required for our real consumption during a crisis. If every personbehaves in similar way then suddenly a demand is created for an underlying asset in the cashmarket. This indirectly increases the price of underlying assets. In such situations people arederiving convenience, just by holding the asset.
This is termed as convenience return orconvenience yield. Similarly, if futures price are lower than spot price of an asset, market participants may expectthe spot price to come down in future.